Navigating Basel IV

Basel IV, also known as Basel 3.1, is the latest in a set of banking reforms developed in response to the 2008-09 financial crisis. It extends the international banking accords known as Basel I, Basel II, and Basel III that built on one another to put in place greater standardization and stability to the worldwide banking system. Basel IV began implementation on January 1, 2023, although banks will have five years to fully comply, with requirements for implementation varying across countries.^[1]

The Basel Committee has explained that Basel IV will help reduce the variability in how banks treat risk-weighted assets (RWAs), which will improve cross-bank comparability and raise confidence in the risk models being used. It represents a fundamental change in how banks will need to calculate regulatory capital.

Impact on Internal Ratings-based (IRB) Approaches

Europe

Basel IV constrains the use of IRB approaches. Internal risk models are more broadly used in Europe than in other regions due to characteristics of the local markets. In addition, over the last decade, European banks have raised far more capital than their global peers. Total capital ratios in Europe rose by nearly 20% between 2012 and 2021, compared to 17.5% in the rest of the world and 15% in the Americas, Basel Committee data shows.^[2]

As European banks adjust to a new standardized approach (SA) to assess portfolio risks, they could face a larger increase in requirements than their global peers. Among the key issues here is the risk weighting of unrated corporate exposures and low-risk mortgages.

To ease the impact of Basel IV on European domestic banks and level the playing field for them in terms of global competition, European regulators have proposed adjustments to the implementation of the final Basel rules in the EU. The proposals will be discussed by the responsible EU authorities in the course of 2023 and their outcome will be crucial for European banks. But there are also additional regulatory requirements specific to Europe that do not account for the new Basel rules and make implementation more challenging for European banks. These include systemic and countercyclical buffers, as well as the minimum requirement for own funds and eligible liabilities (MREL).

The U.K.

In the U.K., the Prudential Regulation Authority (PRA) proposals include:^[3]

• Removing the option to use the IRB approach for certain categories of exposures and restricting modelling within the IRB approach for certain other categories of exposures where it is judged that the model parameters cannot be estimated reliably for regulatory capital purposes. As such, firms using the IRB approach would no longer be required to model all material exposure classes.
• Adopting exposure-level, model parameter floors (‘input floors’) to help ensure a minimum level of conservatism for portfolios where the IRB approaches remain available.
• Providing greater specification of parameter estimation practices to reduce variability in RWAs for portfolios where the IRB approaches remain available.
  
  

Perceived Shortcomings of IRB Models

The Basel Committee believes there are three shortcomings with IRB models.

1. Lack of robustness for certain asset classes.
2. Excessive complexity.
3. Lack of comparability.

S&P Global Market Intelligence’s Credit Assessment Scorecards (“Scorecards”) address each of the three concerns. They provide a consistent framework for calculating credit risk, drawing on a mixture of forward-looking qualitative factors, converging trends, and relationships between key drivers to derive standalone probability of default scores, which are broadly aligned to S&P Global Ratings criteria^[4] and are further supported by historical default data back to 1981.

Scorecards address:

1. Lack of robustness for certain asset classes. 

• Include various qualitative risk drivers in addition to financial data.
• Calibrate with S&P Global’s proprietary default database that goes back to 1981.
• Rely on subject-matter credit expertise for asset classes where statistical modelling is not possible.
  
  

2. Excessive complexity.

• Include a shadow-rating methodology to reduce complexity.
• Have a simple, open-form and technology-agnostic solution that is easy to implement in client internal systems.
  
  

3. Lack of comparability.

• Have consistent rules on how to assess credit ratings.
• Ensure comparability of risk drivers with S&P Global Ratings’ rated universe.

Scorecards are Transparent, Comprehensive, Comparable, and Verifiable

Scorecards are especially useful when there is a lack of internal data to construct statistical models that can be calibrated and validated. Their structure is completely transparent, enabling users to view the entire credit scoring process, including the use of parameters and weights. A rigorous annual review process validates the Scorecard methodologies, and in-depth model development and maintenance documentation helps explain the structure of the Scorecards, the use of data, and overall performance.

Learn more about how Scorecards can help you effectively manage your capital requirements.