Many executives have concerns about the measures required to plan and implement Basel IV, and for good reason. The scope of the new rules is enormous and not just a matter of risk assessments. They will force banks to increase their capital levels and may require wholesale adjustments to their businesses.

For example, banks with a large trading function may need to regroup this activity. Higher capital requirements could affect corporate structures more deeply. In some areas it may influence where a business is active. In short, the regulations will have a material impact on operations, corporate structure, risk, costs and the global financial ecosystem.

Looking at risk assessments in isolation, the rules are likely to influence banks’ thinking on credit risk, market risk, operational risk and liquidity levels. A Wolters Kluwer survey of close to 150 senior bank executives ranked credit risk the biggest challenge in implementing Basel IV and the Capital Requirements Directive (CRD V).

Bankers said credit risk is likely to be among the most difficult requirements to comply with, as factors relating to it govern risk management efforts throughout the organization and have an impact on both profitability and financial strength.

“If you are not very happy with your current credit risk solution, Basel IV offers a clear opportunity to replace it,” says Xavier Dubois, Product Management Director, EMEA at Wolters Kluwer.

He says further, “If you are planning to upgrade, you have to ask whether the solution to which you are upgrading will meet the requirements for the entire Basel IV period. Ultimately, banks are coming to the point where they will need to make a strategic choice. They will need to ask themselves whether the prudential risk solution they are putting in place today will be sufficient for the next ten to twenty years.”

For one in five survey respondents, counterparty credit risk (CCR) was the largest concern. For banks to understand fully how a counterparty failure may impact them, they need to construct accurate aggregated views of their exposures. To do this, they must have a clear picture of the counterparty’s legal structure, credit support annexes and the end obligor.

If you are not very happy with your current credit risk solution, Basel IV offers a clear opportunity to replace it

CCR is not confined to default or insolvency. It can extend to dilution, fraud and, in some cases, performance risk. Christoph Gugelmann, Founder and Chief Executive of Tradeteq, a firm that offers technology-driven financial analysis, says banks should consider the transaction risk, rather than purely the potential to default.

“This analysis requires a sophisticated process, utilizing the latest artificial intelligence-based credit scoring,” he adds.

Some organizations are likely to find compliance with the new rules easier than others do. The new liquidity requirements are one area for which this is likely to be the case.

“We have already seen Hong Kong, Singapore and China implement the net stable funding ratio (NSFR),” says George Phillips, Senior Business Consultant at Capco, a management and technology consultancy. “Similarly, in North America we have seen Canada implement the NSFR, while efforts are ongoing in the United States. At a high level, the liquidity risk requirements are similar across regions. However, from an implementation perspective, there are regional differences.”

Under the timetable set by the Basel Committee on Banking Supervision (BCBS), a five-year implementation period for Basel IV is due to begin on January 1, 2023. How banks and supervisory authorities are using the two-plus years until then varies from one jurisdiction to another.

The establishment of regulatory frameworks across the European Union is relatively advanced, while regulators in Asia-Pacific and the Americas have only finalized a handful of elements.

CRD V and the latest Capital Requirements Regulation (CRR II) in Europe came into force on 27 June 2019 and provide a solid text on which implementation can be based. Succeeding drafts, CRR III and CRD VI, were anticipated in the first half of 2020 but have been delayed by the COVID-19 pandemic.

Moving on to North America, Canadian regulators have finalized most of the Basel IV building blocks, with still a number awaiting public proposal. Bart Everaert, Product Management Director, Americas at Wolters Kluwer, says, “The United States has experienced a regulatory slowdown since the start of the Trump administration and has only seen the Federal Reserve issue a handful of updates that comply with the 19 BCBS Basel IV components.”

This presents an opportunity for banks to determine how implementation challenges can be resolved to give them their best chance of meeting the deadline, as well as to research the issues they are likely to face after implementation. It is a chance to review everything within each bank’s “Basel chain,” to investigate whether these components are ready for the future. This means reviewing credit risk, market risk, operational risk, liquidity, leverage ratios and all the reporting systems and system data that align with those elements.

In terms of risk infrastructure, much has changed. But that does not necessarily mean that organizations must replace their entire systems architecture. Banks are advised to review their systems step by step and then make a call.

Suitability assessment

Firms need to identify whether they would prefer a patchwork replacement for elements of their current solutions or whether it makes more sense to embark on a full-scale overhaul. They should evaluate this by considering levels of satisfaction with existing elements, but also whether any upgrades will be fit for purpose beyond the next several years.

Xavier Dubois, Product Management Director, EMEA at Wolters Kluwer, says: “We believe it is far more prudent to consider whether their selected architecture will fulfill regulatory obligations and meet audit and business requirements in the coming years and well into the future. Assessments should be conducted at a global level and across the entire Basel framework, not limited to credit or market level.”

Firms need to identify whether they would prefer a patchwork replacement for elements of their current solutions or whether it makes more sense to embark on a full-scale overhaul

One criticism of the Basel framework currently in force is that there is an imbalance in the regulatory expectations for smaller regional banks, compared to global giants with more significant investment. Organizations have been expected to follow all the rules, regardless of the degree of complexity or risk in their business models.

Under Basel IV, a proportionality principle has been introduced to put requirements on banks based on their size and risk level. Small, simpler banks do not have to deal with complex calculation methods and requirements. Banks in general will face standards as demanding as their size, complexity and risk levels warrant.

The proportionality principle is being put into practice somewhat differently in Europe. Risk assessment standards and calculation methods there will vary for several types of risk – such as market risk or CCR, or for determining the credit valuation adjustment (CVA) – depending on a bank’s size and the complexity of its operations.

In the United States, the Federal Reserve has defined categories of banks based on risk-based indicators, similar to the criteria used to define global systemically important banks: size, cross-jurisdictional activity, non-bank assets, short-term wholesale funding and off-balance-sheet exposure. This categorization of banks will drive the complexity of the approaches that a bank must take to calculate its various risk exposures.

When we look at Asia-Pacific, the initiatives are relatively mature due to proactive interventions by the Australian Prudential Regulation Authority and the Monetary Authority of Singapore. Many of the largest banks have already looked at options around the current Basel framework extensively, with some having implemented core calculations on market and credit risk.

There is still a long way to go on the journey to Basel IV, especially concerning the alignment of data, processes, and systems, as well as the deployment of Basel metrics for business, not just for compliance. “The full regulatory scope of proportionality needs to be covered,” Dubois says.

Firms often have preferred suppliers but, as Dubois notes, the decision to employ separate vendors for different parts of the Basel IV risk assessment, notably CCR, CVA risk, large exposure and leverage ratio calculations, can lead to difficulties later.

For example, the rules for CCR are reused in assessing CVA risk, large exposure and leverage ratio calculations. If a bank uses a variety of vendor software, there is no guarantee that each vendor will employ the same aggregation methods. This could lead to inconsistencies, not only in results, but in subsequent reporting, perhaps leading to questions from regulators.

Some organizations are likely to prefer a fully integrated solution for that reason. It guarantees consistency and enables easier reconciliation comparisons, reducing the need to employ further resources to match datasets and verify accuracy.

Generating consistency is vital. That is why Wolters Kluwer looks at the full scope of risk, whereas some specialist vendors confine their assessment to limited, discrete elements of it. Banks that use multiple specialists therefore increase the likelihood of inconsistencies in their regulatory submissions.

Being compliant at all times

Basel IV’s mandate that institutions be compliant at all times is designed to ensure that organizations large and small are continuously aware of their risk exposures.

Regulators will expect larger banks to provide a comprehensive risk assessment within a few hours. Smaller firms, such as local savings banks, will have a few days or weeks. That reflects an understanding that smaller firms are much less engaged in risk-based market activities.

Larger banks that have not reviewed their systems for several years will need to do so with some urgency. The timeliness requirement underscores the need to explore whether their existing technology allows quick, intraday calculations, a capability that many legacy solutions lack.

Examining your system to assess its viability over the long haul should be a priority in the run-up to the Basel IV deadline. It will ensure that your bank makes the best use of those crucial months and help to keep costs down after that.

Banks are expected under the current Basel framework to provide a risk profile at the time of assessment – a snapshot of the present situation. Basel IV will require them to estimate their capital and liquidity profile several weeks ahead by employing technology for scenario modeling, forecasts and projections.

“In the past, you could just say ‘tomorrow is another day,’ but not any longer,” says Xavier Dubois, Product Management Director, EMEA at Wolters Kluwer. “Now you will need to have projection capabilities and be able to anticipate.”

Dubois says many of the requirements under Basel IV are close to being finalized by regulators in Europe, the Middle East, Africa and Asia-Pacific, allowing banks to get a head start on implementation. Guidance on interest rate risk in the banking book (IRRBB) and the fundamental review of the trading book (FRTB) are a good place to begin. American regulators, by contrast, have defined very little of these to date.

In the past, you could just say ‘tomorrow is another day.' Now you will need to have projection capabilities and be able to anticipate

It is worth remembering, though, that the new requirements will involve pulling together all the data on exposures, reaching an aggregate view of market prices and liquidity, and making internal assessments of areas such as internal ratings.

“The market risk overhaul under Basel IV, known as FRTB, imposes new requirements on length of history and, for those using internal models, proof of liquidity through real prices,” explains Martijn Groot, Vice President of Strategy at the data management firm Asset Control and a former Risk Systems Team Leader at ABN AMRO. “Robust data management will have a key role to play in meeting these needs.”

Be ready to pivot

European banks that had started projects in individual business units before publication of the final revisions to CRR II and CRD V may need to pivot. While it has certainly been possible to make good progress within individual business units, Basel IV requires that firms understand the interdependencies among sources of risk to ensure an accurate, holistic assessment of their exposures.

This picture is complicated further by the Investment Firm Regulation and Directive (IFR/IFD), the harmonized European prudential regime for investment firms due to go into effect in 2021. Organizations must understand which entities will have to follow the requirements set out in Basel IV and which must follow IFR/IFD rules.

“In the European Union, the need to stop and understand the impact of IFR/IFD on Basel IV has been another pain point in firms’ efforts to implement Basel IV,” says George Phillips, Senior Consultant at Capco.

“For much of the industry, work on FRTB started long before the release of the final Basel IV text that came in 2019,” Phillips goes on to say. “As a result, industry readiness for FRTB is much more mature than for many of the other Basel IV requirements like large exposures, NSFR and intermediate parent undertaking.”

Charlie Browne, Head of Market Data & Risk solutions at GoldenSource, an enterprise data management firm, says there needs to be close cooperation between finance and risk departments to ensure consistency of approaches and to conform to Basel IV, among other frameworks.

“International Financial Reporting Standard (IFRS) 9 is an accounting regulation that specifies the rules banks need to adhere to for the calculation of credit losses in the banking book,” says Browne, who previously served as Lloyds Banking Group’s Head of Independent Price Verification and Valuations. “The Basel rules, on the other hand, are regulatory capital rules that specify the amount of capital which needs to be set aside for credit risk purposes. Clearly there is a strong link between the two. And any inconsistencies of methodology will be picked up by auditors and regulators alike.”

Meeting the challenges

Accounting standards such as IFRS 9 - Impairment and Current Expected Credit Loss have forced banks to focus on estimating losses from risk-based activities like lending and trading. Basel IV will extend the required forecasting to consider losses in a variety of possible circumstances, often the sort encountered amid stressful macroeconomic conditions.

The balance-sheet management and capital planning needed to comply with the accounting standards and Basel IV call for an investment in resources that will enhance both endeavors, while helping to improve corporate confidence and better gauge a firm’s financial strength. There are other challenges banks will have to navigate, such as moving from a disparate spreadsheet or tactical architecture to one that is more strategic.

“Given the growth in data volumes, one challenge is to run risk calculations and scenarios fast enough to act on the outcome,” Groot says. “Another challenge is to streamline the data collection process and aggregation needed for the risk assessments. This will also help keep track of the required metadata, as financial services firms need to answer many questions.

“How was the data sourced? How was it analyzed, and what checks has it undergone? What is the data not telling us?” are questions that Groot says firms must be able to address. “And more specific FRTB challenges will include getting sufficient historical data and aggregating the liquidity metrics.”

Global eye

A further consideration for those preparing a final Basel IV implementation checklist is to make sure capital calculations are applied globally. This means banks will need to allocate associated costs to each of their business units to comply.

Once Basel IV rules are fully phased in, banks may need to hold up to 250 percent more capital than previously required

Christoph Gugelmann, Founder of Tradeteq, who was formerly at Morgan Stanley and Goldman Sachs, says the new rules may lead some financial institutions to become less inclined to invest in higher-risk assets as the fallout could severely damage a bank's capital and compliance with the new rules.

Further regulatory discretions in certain jurisdictions have made the capital requirements even more onerous, impacting hurdle rates to secure new deals. This has led Australian banks to urge the Prudential Regulation Authority to consider harmonizing its standards with global guidelines.

“For trade finance, a relatively low-risk asset class based on the International Chamber of Commerce trade finance register can provide an opportunity for increased investment and growth,” Gugelmann says.

But he cautions: “Once Basel IV rules are fully phased in, banks may need to hold up to 250 percent more capital than previously required.”

Banks need to be fully aware of the impact these rules will have on their global operations and understand that balance-sheet forecasts must be incorporated into their overall prudential exercise.

And no risk assessment is complete without the rigor of scenario analyses and stress testing. Whether for liquidity analysis or balance-sheet forecasting, banks must implement analytical systems and processes that accurately capture environmental and market volatilities to protect asset quality and prevent capital erosion.

Amid the fraught conditions that led to a flurry of bank mergers during the global financial crisis, due diligence and suitability were often overlooked in the rush to get a deal done, with the details left to be sorted out later.

With the crisis receding further into history, financial institutions are expected to fine-tune their expertise and broaden customer value propositions again. Instead of seeking out mergers of equals, large banks are eyeing a cluster of FinTechs, as well as smaller players, that could help them expand product ranges and capture new markets by offering a tailored experience to clients with diverse needs.

After a decade of asset quality improvement and continued capital prudence that have produced stronger balance-sheets, many banks find themselves in a robust position to head to market. It is critical for them to remember that mergers and acquisitions need to be accomplished through a rigorous due diligence process.

The adoption of Basel IV standards, with their focus on capital, liquidity and funding, is drawing close attention to the strategy, business, operating model and process optimization of banks and their prospective acquisition targets or merger partners. Due diligence will assume additional significance, given the dimensions of the exercise.

Basel guidelines have brought disclosures to the forefront over the years, with increased granularity in reporting as the guidelines have evolved. Banks are required to provide quarterly updates on their position across Tier 1 and Tier 2 capital, asset quality and liquidity, alongside a host of related metrics intended to reveal the health of an entity by assessing a range of interconnected factors. The liquidity coverage ratio (LCR) is a key component of this new holistic approach to regulation. A measure of capital adequacy, the LCR seeks to measure a bank’s ability to withstand market volatility.

The adoption of Basel IV standards, with their focus on capital, liquidity and funding, is drawing close attention to the strategy, business, operating model and process optimization of banks and their prospective acquisition targets or merger partners

“Its intention is to ensure that banks have enough high-quality liquid assets to fund cash outflows for 30 days or more,” says Sam Mukhopadhyay, Director, Risk and Finance, APAC at Wolters Kluwer. It has been clearly highlighted over the last decade that capital adequacy can be an effective measure, but only if banks have suitable liquidity to support their businesses.”

If a bank’s funding base is a combination of X percent equity, Y percent retail deposits and Z percent corporate deposits, with appropriate maturity gap analyses, it is possible to infer potential panic outflow in the event of a serious downturn in market conditions. This can also indicate how much liquidity would have to be added. Basel IV guidelines provide a standardized model to calculate relevant metrics, which should enable banks to prevent another major crisis.

The disclosure of these metrics as part of the due diligence process before an intended merger or acquisition provides concrete data to assess the potential synergies between entities. In a prospective merged balance-sheet, this helps to project capital structure, funding patterns across business units, and liquidity and transfer pricing – all of which help to identify relative strengths and weaknesses.

This pre-merger analysis is critical to determining how the business as a whole would work. Business and operating model alignment is another essential element; banks need to streamline operations to enhance efficiencies and, at the same time, address regulatory requirements that have been introduced over the past decade.

Regulators are taking a watchful stance when it comes to deal-making in this new Basel world. In their view, a merged entity must address the partners’ relative deficiencies and ensure that it will not operate in ways that could lead to a deterioration of their overall risk profile or aggravate systemic issues. Such developments – in particular, a concentration of assets in securitized subprime mortgage portfolios at some institutions – helped to precipitate the financial crisis.

Enhanced attention needs to be paid to retail portfolios being created by a spate of new virtual banks – who many a time compromise on rigorous credit quality assessment in the drive to gain market share  

“With a lens on mergers, the key lesson to learn is that retail pools of the merged entity should be diversified enough in their risk-return profile to prevent a repeat of the past,” Mukhopadhyay says. “Also, enhanced attention needs to be paid to retail portfolios being created by a spate of new virtual banks – who many a time compromise on rigorous credit quality assessment in the drive to gain market share. This is an amber flag in the current environment, when banks are spinning off or buying into virtual banks.”

The advent of FinTechs, with their business model limitations, especially the inability to hold and churn assets, is a cause for concern, too. While some of them contribute meaningfully to the financial intermediation value chain by enhancing reach, they can create assets that are harder to retain, and increase volatility in liquidity and associated metrics.

The upshot of this rapid and unpredictable evolution in financial services is that multiple dimensions and complex considerations must be taken into account across all stages of deal-making. The stringent regulatory guidelines of Basel IV are expected to act as a tap on the brakes, keeping merger activity under control. Still, only time will tell what comes next.

The impact of Basel IV on individual companies will vary based on several criteria, including their location, size and complexity.

As the global consultancy McKinsey notes: “No set of mitigating actions could uniformly address every situation.”

Banks in different jurisdictions have had to assess their own capital positions and work out an appropriate strategy. Ones with concentrated business models could face significant increases to their required output floor, McKinsey says, but those with more diversified portfolios would likely be able to make small adjustments to comply.

Initial assessments from the European Banking Authority indicate that banks in the region could see their Tier 1 capital ratio increase by 16.1 percent on average by the time the Basel reforms are fully implemented. The impact could be much higher or lower for any given firm, depending on how it adapts its operations and whether it disposes of capital-intensive activities.

“The European Central Bank (ECB) is leveling the playing field, and all countries in its remit will apply the new capital rules, albeit some detailed legal rules are still to be finalized,” says Richard Crecel, Executive Director at the banking industry association Global Credit Data. “Already, expectations regarding capital model methodologies have been heightened by the ECB following a targeted review of current bank practices that resulted in specific recommendations bank by bank.”

Bumps in the road

For banks operating in multiple jurisdictions, implementing the Basel IV reforms could hit stumbling blocks as local differences emerge, creating bumps in the expected level playing field, according to some industry experts.

“Anecdotally, we hear regulators are going to be taking slightly different views and nuances,” says Jared Chebib, Associate Partner in the financial services practice at Ernst & Young. “If you are a bank operating in multiple jurisdictions, you have to be able to comply with every different version. We have clients that operate in 60-plus countries, and many of them will have several versions [to comply with]. That does create a lot of complexity.”

If you are a bank operating in multiple jurisdictions, you have to be able to comply with every different version

“This is particularly true in North America, where we see varying standards being set,” says Bart Everaert, Product Management Director, Americas at Wolters Kluwer. “The Office of the Superintendent of Financial Institutions, the Canadian regulator, follows the BCBS standards very closely for most components, while the U.S. Federal Reserve appears likely to conform to its history of putting its own stamp on capital adequacy regulations.”

Tier 1 banks in Australia, China and Singapore have followed expansion strategies, especially into neighboring emerging economies. It is obligatory for them to adhere to jurisdictional requirements in these subsidiaries or joint stock institutions. While this does not create an impact on financial statements, it is an additional burden.

Simplification and rationalization

In search of a more agile and cost-effective approach to managing Basel IV, multinational groups have opted to simplify and shrink their regulatory capital frameworks. This has led to a shared-services approach with industry peers to ensure comparability and a critical mass of data, and has been a catalyst for the development of next-generation technology solutions that can deal with applying multiple rulebooks on multiple consolidation layers of these banking groups.

Some banks may be forced to drop certain specialist activities that require more capital to try to reduce the impact of the new rules. This could create particularly damaging outcomes in the European Union, according to Virginie Mennesson, Head of Regulatory Affairs at Mazars Group, an international audit and accountancy firm. “This may have unintended consequences,” she says, “including a dip in specialized lending at a time when banks are expected to play a central role in financing a transition to a low-carbon economy.”

For Xavier Dubois, Product Management Director, EMEA at Wolters Kluwer, successful risk management requires banks to break down traditional silos and bring together compliance and risk functions.

“The future of risk management lies in integration,” he says. “This starts with the integration of regulatory metrics and regulatory requirements into daily risk management, breaking the wall between compliance and risk.

“Secondly, integration into the group entity structure will take into account the limitation of liquidity movements. This combines exact regulatory metrics on current situations and on future business projections.”

Fostering a holistic approach, particularly at multinational banks, is vital to ensure regulatory compliance in an efficient way, with minimal impact on profitability.

To learn more on these topics and potential solutions for your organization, please visit our OneSumX for Basel IV website.