Basel IV: The next big Update in the Banking System
Banking regulations have seen significant evolution over the years, with the Basel Committee for the Bank of International Settlements (BIS) playing a pivotal role in global coordination. Since its establishment in 1973, this committee, comprising 63 central banks from countries contributing to 95% of global GDP (Gross Domestic Product), has been instrumental in shaping the framework for international banking standards.
The journey of banking regulations witnessed a succession of frameworks, with the Basel Committee introducing the first Basel framework in 1988, followed by Basel II in 2004. Basel II expanded standardized rules and introduced the concept of using internal risk models for capital calculations, granting banks more flexibility.
In the aftermath of the 2009 global financial crisis, the Basel Committee introduced Basel III, a set of reforms designed to enhance the resilience and risk management practices of the global banking system. Key components of Basel III included the increase in capital ratio, the introduction of countercyclical capital buffer, and the leverage ratio requirement. These measures aimed to mitigate risks and ensure greater stability within the banking sector.
Enter Basel IV: Building on the foundation of Basel III, the Basel Committee introduced substantial changes in 2017, leading to what is now commonly referred to as Basel IV. These comprehensive reforms, slated to take effect under transition rules from 2025, address the variability in banks' calculation of risk-weighted assets and aim to restore credibility to these calculations. The key features of Basel IV are:
Constraints on Internal Risk Models: Basel IV restricts the use of advanced internal risk models for large corporates with turnovers of at least 500 million EUR. This shift seeks to ensure that banks no longer derive significantly lower risk estimates compared to the regulator's standard model.
Output Floor Introduction: A notable addition is the output floor, preventing a bank's internal risk exposure measurement from falling below 72.5% of the standardized approach. This alteration aims to limit the benefits gained from internal risk models.
Leverage Ratio and Risk Framework Changes: Basel IV revises the definition of a bank's total exposure in the leverage ratio and introduces modifications to the credit valuation adjustment (CVA) and operational risk frameworks.
Basel IV's objective is to harmonize risk calculation practices among banks globally. While the reforms are not intended to significantly increase global capital levels, their impact may vary across regions due to differences in banks' use of internal models. European and Nordic banks, known for their reliance on internal risk models, are expected to experience a more substantial impact.
Corporate borrowing costs are projected to rise due to Basel IV's increased capital requirements. Companies without credit ratings and relying on bank loans may face higher borrowing costs, particularly those falling under the large corporate category.
With Basel IV's impending implementation, corporates are advised to explore diverse funding options and maintain flexibility including tapping in the growing private credit markets. Having a credit rating may become even more crucial, as unrated large corporates might face higher perceived risks.
Basel IV marks a significant step in global banking reforms, seeking to ensure consistent risk calculation practices and enhance the stability of the financial sector. As financial institutions and corporations brace for these changes, careful preparation and adaptability will be key to navigating the evolving landscape of international banking regulations.
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