The BCBS also provided clarification with respect to the scope of the equity exposure class, specifying which instruments banks should categorise into this category, and introduced risk weights over a five-year transition period from 100 to 250%. Also, in the case of LGD it decided that input floors should range between 0 and 50%, depending on the type of the exposure and the collateral type. It also noted that it will review the slotting approach at a later stage (BCBS, 2017a, b). In the case of jurisdictions that do not permit ratings or for unrated exposures, the risk weights range from 65 to 100% depending on the risk categories. However, as mentioned earlier, it subsequently deferred the implementation by one year as part of its COVID-19 measures. The BCBS allows a five-years transitional period for banks to adopt the new rules. Secondly, it removes the internally modelled approach and introduces a revised standardised approach to CVA risks. In this case, banks with above-average historical losses will not be subject to higher own funds requirements but banks with a less severe loss history would not receive a capital relief either (EC, 2019). Banks may also consider removing high LTV residential mortgages, which have higher interest rates, and maintaining a low LTV portfolio, which generally carry lower interest rates. In response to concerns with respect to the wide variability in RWA arising from banks' internal models, Basel IV introduces an aggregate internal rating model floor to replace the so-called Basel I floor, constraining the extent to which banks can use their internal risk models to drive down their capital requirements. However, the BCBS does not specify the level of application of the capital output floors in terms of the levels of the banking group, e.g. Generally speaking, the impact of Basel IV on banks' credit risk capital requirements will depend on the composition and quality of their respective loan portfolios. It introduces new risk weights ranging between 20 and 105% depending on whether the mortgage is classified as general residential or IPRE, i.e. This new prudential regime provides a regulatory foundation for a resilient and stable banking system by enhancing both the quantity and quality of regulatory capital, with a Capital Conservation Buffer (CCB), an optional Countercyclical Capital Buffer (CCyB) and capital buffers for Global Systemically Important Banks (G-SIBs). Otherwise, the risk weight will depend on the three distinct phases of the project (pre-operational phase, operational phase and high quality operational phase), ranging between 80 and 130%. This is because the revised standards remove the capital benefits of the use of IRB models. In terms of the implementation of the operational risk framework, the EU already has certain regulations which differ from the Basel II standards. However, as can be seen in Table 11, the EU Banking Package does not include the remaining elements of Basel IV such as the revised capital risk SA approach, capital output floors, CVA requirements and the revised operational risk SA standards, which are likely to have a very significant impact on the EU banking sector (EBA, 2018, 2019). Pugsley, J. Although Basel IV CVA framework does not exempt any derivative transactions from the calculation of the CVA capital requirement, the current CRR in the EU provides a number of exemptions with respect to derivative transactions with counterparties that were exempted from the clearing and margining requirements under EMIR. However, aiming to improve the granularity and risk sensitivity, as well as reducing the mechanistic reliance on credit ratings, BCBS introduced a relatively more granular approach for unrated exposures to banks and corporates, recalibrated risk weights for rated exposures; and introduced separate treatments for covered bonds, specialised lending (SL) [4] and exposures to small and medium-sized enterprises (SMEs) (BCBS, 2017a, b). Thirdly, while the postponement of the implementation date of Basel IV for a duration of 1year and the deferral of the transitional arrangements for the capital output floor to 1 January 2028 due to COVID-19 pandemic is welcome and is not expected to dilute the capital strength of the global banking system, this could potentially jeopardize the global implementation of the standards, affecting the motivation of the national regulators to transpose it into their respective domestic regulations. Feridun, M. (2019b), Inconsistent Implementation of the FRTB Could Jeopardize Post-Crisis Banking Reforms, Duke Law Global Financial Markets Center FinReg Blog, available at: https://sites.duke.edu/thefinregblog/2019/11/20/inconsistent-implementation-of-the-frtb-could-jeopardize-post-crisis-banking-reforms (accessed 20 November 2019). BCBS (2017b), High-level Summary of Basel III Reforms, December 2017, available at: https://www.bis.org/bcbs/publ/d424_hlsummary.pdf. This is partially driven by the European Banking Authority's (EBA) reports, recommending the full implementation of the final Basel III framework in the EU in response to the European Commission's (EC) call for technical advice in May 2018 (EBA, 2019b). The final SA approach to credit risk allows banks to use external ratings, where available and permitted by national supervisors, for exposures to banks and corporates. Hence, as part of the Basel IV reform package BCBS overhauled the credit risk SA approach, improving its granularity and risk sensitivity. Angelini, P., Clerc, L., Crdia, V., Gambacorta, L., Gerali, A., Locarno, A., Motto, R., Roeger, W., Van den Heuvel, S. and Vlek, J. On the other hand, the BCBS provided institutions with smaller derivatives portfolios with a simple alternative to the revised CVA, allowing banks below a materiality threshold of 100bn, relating to the aggregate notional amount of non-centrally cleared derivatives to calculate their CVA capital requirement as 100% of their counterparty credit risk requirements. While the leverage ratio buffers will initially apply to G-SIBs only, the EC plans to consider extending it to other systemically important institutions (O-SIIs). Introducing radical changes to the methodologies for the determination of capital requirements, the final stage of the Basel III standards, which is referred to as Basel IV by the industry, will be a significant challenge for the global banking sector. The authors would like to thank two anonymous referees for their valuable comments and suggestions. The academic literature to date has examined various aspects of the Basel III reforms and (Angelini et al., 2011; Allen et al., 2012; Sayah, 2017; Rubio and Yaob, 2019; James and Quaglia 2020). However, these banks are allowed to use bank-specific ILM should their loss data collection meet the relevant regulatory preconditions (EC, 2019). Anyone may reproduce, distribute, translate and create derivative works of this article (for both commercial and non-commercial purposes), subject to full attribution to the original publication and authors. The BCBS decided that income producing real estate which receives different treatment under the SA approach should be considered SL under the IRB approach. Rubio, M. and Yaob, F. (2020), Bank capital, financial stability and Basel regulation in a low interest-rate environment, International Review of Economics and Finance, Vol. Under this approach a flat risk weight of 100% is applicable to all corporate exposures, with the exception of, exposures to corporate SMEs and to investment grade corporates, which are assigned 85 and 65% risk weights, respectively (EC, 2019). 25, pp. See https://europa.eu/rapid/press-release_MEMO-19-2129_en.pdf. The capital requirements for delta and vega risks, on the other hand, is a sum of capital requirements calculated independently for interest rate, foreign exchange, counterparty credit spread, reference credit spread, equity and commodity risk types. On the other hand, the EBA's Basel III monitoring exercise of October 2019 indicated that once fully implemented, Basel IV standards would lead to an average increase of around 20% in banks' Tier 1 minimum required capital, driven mostly by the capital output floor and operational risk capital requirement (EBA, 2019a). Besides, the BCBS recalibrated credit conversion factors (CCFs) for off-balance-sheet items to range from 10% for Unconditionally Cancellable Commitments (UCCs) to 100% for direct credit substitutes and other off-balance-sheet exposures as can be seen in Table 5. The capital impact of Basel IV will also depend on whether the bank currently uses the SA approach or the IRB models for its credit risk. 1-38, doi: 10.4236/jmf.2017.71001. Firstly, as the article emphasised, the EU is the first jurisdiction to start implementation of the Basel IV. It allows banks to use one of the two alternative approaches, namely the loan splitting (LS) approach and the whole loan (WL) approach. In jurisdictions that allow the use of external ratings, banks are allowed to determine the risk weights in the SA approach using external credit ratings of institutions that are recognised as eligible for capital purposes by national supervisors. In addition, the FRTB and the updated Pillar 3 disclosures regime are currently being implemented (Feridun, 2019a, b). Published by Emerald Publishing Limited. It also deferred the transitional arrangements for the capital output floor to 1 January 2028 (BCBS, 2020a, b). Regarding SL, the BCBS also retained the use of both A-IRB and F-IRB, despite its initial proposal. SCRA is more granular than the procedure in Basel II as it classifies all exposures to unrated institutions into one of three grades based on certain quantitative and qualitative criteria. Feridun, M. (2020b), COVID-19 Should Not Jeopardize the Implementation of Basel IV, Duke Law Global Financial Markets Center FinReg Blog, available at: https://sites.duke.edu/thefinregblog/2020/04/23/covid-19-should-not-jeopardize-the-implementation-of-basel-iv (accessed 23 April 2020). These additional EU-specific requirements aim to achieve higher standards of operational risk management than required by the BCBS in its SA approach to operational risk. 338, available at: https://www.bis.org/publ/work338.pdf. Other excluded items under CRR 2 leverage ratio include securitised exposures from traditional securitisations that meet the conditions for significant risk transfer, trade exposure of credit derivatives and SFTs if the institution is a member of a qualifying Central Counterparty (CCP) under the European Market Infrastructure Regulation (EMIR) and meet certain conditions set out in Article 306 of the CRR (BCBS, 2017a, b). This article discusses that Basel IV will introduce strategic, operational and regulatory challenges for banks in scope. On the other hand, in the case of Bucket 1 banks whose BI is equal to or below 1bn, calculation of operational risk capital depends only on BIC. SL comprises project finance, object finance and commodities finance. As can be seen Table 4, the BCBS developed more granular risk weights for subordinated debt and equity exposures to range from 150% for subordinated debt and capital other than equities to 250% for equity exposures other than equity exposures to certain legislated programmes and speculative unlisted equity. CRR 2 also excludes parts of exposures arising from passing-through promotional loans to other credit institutions, where the firm is not a public development credit institution. The implementation of the remaining standards under Basel IV in the EU has been a source of controversy. As a result, it allows banks to realise the capital benefit from those hedges which have been put in place to reduce exposure to CVA risk. These reforms are expected to facilitate the comparability of banks' capital ratios. This article reviews the main components of the new framework, analyses its ongoing implementation in the European Union and discusses its potential impact on banks, putting forward policy recommendations. However, arguing that CVA risk, which refers to the change in the mark-to-market value of a bank's exposures to its derivative counterparties, cannot be fully modelled internally by banks, the BCBS removed the use of a fully internally modelled approach and introduced a new, risk sensitive standardised approach referred to as SA-CVA as a default methodology. For exposures to sovereigns, public sector entities, multilateral development banks, institutions, covered bonds and corporates, the BCBS decided to retain the use of external ratings with alternative approaches available in the case of the unrated exposures to institutions. International Review of Financial Analysis, Basel III: long-term impact on economic performance and fluctuations, International convergence of capital measurement and capital standards a revised framework comprehensive version, Basel III: Finalising Post-crisis Reforms, Governors and Heads of Supervision Announce Deferral of Basel III Implementation to Increase Operational Capacity of Banks and Supervisors to Respond to Covid-19, Basel Committee Sets Out Additional Measures to Alleviate the Impact of Covid-19, Basel III Monitoring Exercise Results Based on Data as of 31 December 2017, Basel III Monitoring Exercise Results Based on Data AS of 31 December 2018, Basel III Reforms: Impact Study and Key Recommendations Macroeconomic Assessment, CVA and Market Risk and Corresponding Policy Advice on Basel III Reforms on CVA and Market Risk. As can be seen other CCFs include 50% for Note Issuance Facilities (NIFs), Revolving Underwriting Facilities (RUFs) and certain transaction-related contingent items, as well as 20% CCF for short-term self-liquidating trade letters of credit arising from the movement of goods. The implementation of Basel IV will complete the global reform of the regulatory framework, which began in the wake of the financial crisis. Those remaining elements are expected to be implemented via the forthcoming the Capital Requirements Directive 6 (CRD 6) and Capital Requirements 3 (CRR 3) framework. It also introduces a nonrisk-based leverage ratio and two new liquidity ratios, Liquidity Coverage Ration (LCR) and Net Stable Funding Ratio (NSFR). Thirdly, it revises the SA approach for operational risk and removes the advanced measurement approaches (AMA). Basel IV comprises measures that aim at enhancing the robustness and risk sensitivity of the standardised approaches (SA) for credit risk and operational risk. Fifthly, it introduces a leverage ratio buffer for G-SIBs, which will take the form of a Tier 1 capital buffer set at 50% of a G-SIB's risk-weighted capital buffer (BCBS, 2017a, b). BCBS (2017a), Basel III: Finalising Post-crisis Reforms, December 2017, available at: https://www.bis.org/bcbs/publ/d424.pdf. This article concludes that the global implementation of the reforms by all jurisdictions and transposition into national banking laws concurrently with the European Union in line with the Basel Committee's implementation timeline is important from a financial stability standpoint. Visit emeraldpublishing.com/platformupdate to discover the latest news and updates, Answers to the most commonly asked questions here, Europe to Reconsider Banks' Internal Models. Sayah, M. (2017), Counterparty credit risk in OTC derivatives under Basel III, Journal of Mathematical Finance, Vol. Based on this review, a number of conclusions emerge, which have important implications for policymakers and practitioners in other jurisdictions. EBA (2019a), Basel III Monitoring Exercise Results Based on Data AS of 31 December 2018, October 2019, available at: https://eba.europa.eu/sites/default/documents/files/documents/10180/2551996/4686802a-94b7-474e-b937-adaa4e6faa26/Basel III monitoring exercise.pdf?retry=1. There is currently an ongoing discussion regarding the risk weights of these exposures and the definition of speculative unlisted equity exposures in the EU. In the case the External Credit Risk Assessment Approach (ECRA), on the other hand, exposures to rated corporates are assigned a risk weight ranging from 20 to 150% depending on the credit quality. As can be seen in Table 2, in the case of exposure to corporates, the BCBS introduces a more granular risk weights for SMEs, whereas, it distinguishes between general corporates and SL in the case of exposures to non-SME corporates. Finally, it provides policy implications for policymakers and practitioners. EC (2019), Public Consultation Document Implementing the Final Basel III Reforms in the EU, available at: https://ec.europa.eu/info/sites/info/files/business_economy_euro/banking_and_finance/documents/2019-basel-3-consultation-document_en.pdf (accessed 11 October 2019). In terms of the implementation of the leverage ratio, CRR 2 adopts the Basel framework, setting the Tier 1 capital-based leverage ratio requirement at 3% for all EU banks. There are also ongoing discussions in some other areas with respect to the CVA risks. As a result, as part of Basel IV, BCBS introduced a new SA approach to operational risk, replacing the internal model-based AMA approach and the three existing SA approaches with a single risk-sensitive standardised approach to be used by all banks. The EC is expected to submit a report to the European Parliament and the European Council by 31 December 2020. However, delays in concurrent implementation could put the BCBS's post-crisis efforts to enhance the prudential framework for the global banking sector in jeopardy. Huez, H. and Feridun, M. (2019), CRR II and CRD V Are Finally Here: What Should Firms Expect?, PwC Being Better Informed, July 2019, available at: https://www.pwc.co.uk/financial-services/assets/pdf/being-better-informed-july-2019.pdf. Removal of these exemptions is currently subject to debate in the EU. In particular, Basel IV provides a much greater degree of sensitivity in the case of residential mortgages where Basel II uses a risk weight of 35% for secure mortgages [6]. However, due to the lack of adequate public information from the respective national regulators on their implementation efforts, their progress remains uncertain. The BCBS sets the minimum threshold for including a loss event in the data collection and calculation of average annual losses at 20,000, allowing national regulators to increase this threshold to 100,000 for Bucket 2 and Bucket 3 banks in line with their respective risk profiles (EC, 2019). From a financial stability standpoint, it is imperative that all national authorities remain aligned with BCBS's implementation timeline. The BCBS sets only the minimum standards and jurisdictions may elect to implement more conservative requirements and accelerated transitional arrangements. Basel IV has been complemented by the revised market risk standard known as the Fundamental Review of the Trading Book (FRTB) [1] and the updated Pillar 3 disclosure requirements [2], both of which are beyond the scope of this article. Table 1 shows the revised implementation timeline and also summarises the intended revisions under Basel IV. This will require the industry to make a significant investment in technology, risk modelling and new staff members, with a subsequent increase in compliance costs. In the case of the latter, respective risk weight buckets have become more granular based on the LTV ratio and depending on whether the exposure is to IPRE or general residential real estate. However, the potential quantitative impact of Basel IV in one jurisdiction may differ from that in another. In the case of IPRE, it requires banks to undertake an assessment of the cash flows generated by the respective individual property in relation to all other cash flows of the borrower. It also extended the scope of the CVA framework to SFTs that are fair valued, leading to an increase in the CVA capital requirement for those banks with sizeable fair value SFT portfolios. Quantitative impact studies will also need to assume that assume that banking regulations will remain unchanged during the implementation of Basel III. 378-392. Section 3 will present the conceptual framework wth respect to the potential capital impact of Basel IV, whereas Section 4 will review the implementation of Basel IV in the EU. Under the revised CVA framework, the BCBS introduces four different approaches to calculate the capital requirements, allowing banks with different levels of complexity to calculate their CVA capital requirements using the approach most appropriate to their circumstances. However, CRR 2 leverage ratio rules exclude certain EU-specific items from the exposure measure, such as exposures arising from assets that constitute claims on central governments, regional governments and local authorities where the firm is a public development credit institution. Basel II allows banks either to use the SA or the IRB approaches to calculate their credit risk capital requirements, which has resulted in risk weights ending up incomparable across banks (BCBS, 2004). As discussed earlier, these measures are expected to restore credibility in the calculation of RWAs and improve the comparability of banks' capital ratios. However, this will require them to carefully evaluate the impact on their net interest income. Public Consultation Document Implementing the Final Basel III Reforms in the EU, Integration of Pillar 3 Disclosures into Regulatory Reporting: New Challenges and Opportunities, Inconsistent Implementation of the FRTB Could Jeopardize Post-Crisis Banking Reforms, Duke Law Global Financial Markets Center FinReg Blog, COVID-19 Outbreak Requires Prompt and Innovative Regulatory Response, Duke Law Global Financial Markets Center FinReg Blog, COVID-19 Should Not Jeopardize the Implementation of Basel IV, Duke Law Global Financial Markets Center FinReg Blog, CRR II and CRD V Are Finally Here: What Should Firms Expect?, PwC Being Better Informed, The UK and Multi-Level Financial Regulation: From Post-crisis Reform to Brexit, ECB Aims to Raise Credibility of Internal Models, Bank capital, financial stability and Basel regulation in a low interest-rate environment, International Review of Economics and Finance, Counterparty credit risk in OTC derivatives under Basel III, https://doi.org/10.1108/JCMS-04-2020-0006, http://creativecommons.org/licences/by/4.0/legalcode, https://www.bis.org/bcbs/publ/d424_hlsummary.pdf, https://eba.europa.eu/file/362841/download?token=050iTyEx, https://europa.eu/rapid/press-release_MEMO-19-2129_en.pdf, https://eba.europa.eu/regulation-and-policy/credit-risk/guidelines-on-specification-of-types-of-exposures-tobe-associated-with-high-risk, https://www.globalriskregulator.com/Subjects/Capital/Europe-to-reconsider-banks-internal-models, https://eba.europa.eu/sites/default/documents/files/documents/10180/2380948/e2e09646-2594-48a5-b794-a7c2348257db/2018 Basel III Monitoring ExerciseReport.pdf?retry=1, https://eba.europa.eu/sites/default/documents/files/documents/10180/2551996/4686802a-94b7-474e-b937-adaa4e6faa26/Basel III monitoring exercise.pdf?retry=1, https://www.ebf.eu/wp-content/uploads/2019/06/EBF_033787-EBF-summary-paper-on-Basel-IV-in-Europe-final-updated-clean.pdf, https://www.europarl.europa.eu/RegData/etudes/BRIE/2016/587361/IPOL_BRI(2016)587361_EN.pdf, https://ec.europa.eu/info/sites/info/files/business_economy_euro/banking_and_finance/documents/2019-basel-3-consultation-document_en.pdf, https://www.finextra.com/blogposting/18385/integration-of-pillar-3-disclosures-into-regulatory-reporting-new-challenges-and-opportunities, https://sites.duke.edu/thefinregblog/2019/11/20/inconsistent-implementation-of-the-frtb-could-jeopardize-post-crisis-banking-reforms, https://sites.duke.edu/thefinregblog/2020/04/07/covid-19-outbreak-requires-prompt-and-innovative-regulatory-response/, https://sites.duke.edu/thefinregblog/2020/04/23/covid-19-should-not-jeopardize-the-implementation-of-basel-iv, https://www.pwc.co.uk/financial-services/assets/pdf/being-better-informed-july-2019.pdf, https://www.globalriskregulator.com/Subjects/Capital/ECB-aims-to-raise-credibility-of-internal-models?ct=true, Revised leverage ratio framework and G-SIB buffer, Revised standard approach for credit risk, Revised internal rating-based approach for credit risk, Revised credit valuation adjustment framework, 1 January 2022; transitional arrangements to 1 January 2027, 1 January 2023; transitional arrangements to 1 January 2027, Subordinated debt and capital other than equities, Equity exposures to certain legislated programmes, Short-term self-liquidating trade letters of credit, Direct credit substitutes and other exposures, Large and mid-sized corporates (consolidated revenues>500, EAD subject to a floor that is the sum of (i) the on balance sheet exposures, and (ii) 50% of the off-balance-sheet exposure using the applicable CCF under the SA approach, Extension of leverage ratio buffers to O-SIIs, Enhanced due diligence requirements, Sl., CCFs, EU-specific governance, reporting and control rules, Exemptions for certain derivative transactions, Level of application within banking groups.
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