Basel IV: the regulatory gift we've always wanted?

Live from RiskMinds International 2017 in Amsterdam, we heard from two expert speakers about the latest regulatory reforms and the wider risk landscape.

“Basel IV”

This Thursday (7th, December 2017) brings with it an early Christmas present for risk professionals. The Basel Committee on Banking Supervision releases its reforms to Basel III, perhaps better known as “Basel IV”.

But it isn’t Basel IV, as Deputy Secretary General of the Basel Committee on Banking Supervision, Neil Esho reminded us. It’s the continuation of some “unfinished business” in Basel III regarding the RWA framework.

While we have to wait until this Thursday’s official announcement from the Committee to see what’s in store, Neil nonetheless gave us a brief outline of what to expect.

Fundamental changes

The fundamental changes were as follows:

• Revised standardised approaches for credit risk: “Relative to current approaches, there will be some greater risk sensitivity in the framework, particularly in the area of real estate,” said Neil. “And there’ll also be approaches that distinguish for jurisdictions that use credit ratings, and those that don’t.”

• Revisions to the internal ratings-based approach for credit risk: “There are certain exposures where the advanced IRB will no longer be permitted, and there will also be a wider use of inputs on PDs and LGDs into the advanced IRB formula,” he said.

• A revised standard for operational risk: “There will be one single standardised approach, which will replace the existing four approaches,” Neil said. “It will be a combination of a revenue-based measure with some adjustment for historical losses.”

• A revised approach for CVA: “This is a standardised approach, it removes the internal model approach, and is also a much more simplified version for those banks that don’t have much derivatives business.”

• A revised output floor that is “very carefully and accurately calibrated,” according to Neil.

• Modifications to the leverage ratio exposure measure, and some adjustments for how G-SIBs are treated under the leveraged ratio.

Ultimately, we should expect a significant transition period - the rules won’t come into effect immediately and there will be an implementation phase. That said, the market would undoubtedly force some changes to move through faster, admitted Neil.

Effects and impacts of the reforms

At the aggregate level, there wouldn’t be a significant increase in capital, said Neil. That said, there will certainly be differences at a jurisdictional level and across individual banks; with some banks experiencing a significant increase, and others a significant decline.

But the forecast impact was always different to the actual impact, added Neil. “We know the banks will respond – there’ll be a whole load of portfolio changes, and typically, those responses mean that the impact ends up being a lot lower than what the QIA analysis suggests.”

In addition, you could make a distinction between banks using standardised approaches and those that have used internal models, said Neil.

“For banks using standardised approaches it should be relatively flat, or even bring a reduction in capital requirements. The biggest issue for standardised approach banks is some of the operational aspects. There is a bit more risk sensitivity built into the new standardised approaches, which brings with it a larger operational burden for them.

“Overall, you will see a narrowing of the gap between the risk weights that small or standardised approach banks use, and the ones that larger internal model banks use, and that’s a good thing in terms of competition,” he concluded.

The supervisory response

The other aspect of the impact that is important to consider is the supervisory response, Neil continued. Three elements would have some bearing at the national level, he reported.

1. There are some important policy options built into the revised framework, it will be up to each jurisdiction which one they take.
2. Gold-plating - it’s up to jurisdictions to decide whether to go above it or not.
3. The package covers things that were previously picked up in Pillar 2. This could mean a dial back of Pillar 2 adjustments, now contained in Pillar 1.

It was also important to distinguish between the impact on capital ratios and capital shortfalls. “With these new reforms there shouldn't be much of a capital shortfall,” argued Neil.

In conclusion, Neil said that he didn’t see more regulatory reform in the near future. “The shift really should be towards implementation and supervision,” he said.

Macro risk

But the risk landscape is broad and reaches well beyond regulatory reform, as we heard from another speaker during Day One in Amsterdam.

Howard Davies, Chairman of the Royal Bank of Scotland, has sat on 122 risk meetings - and counting. That puts him in a fantastic position to outline what he thinks the main things are that risk professionals should be thinking about.

The increased focus on capital and liquidity is very well understood by the boards of banks and insurance companies, began Howard. But there are other risks that are becoming very much more prominent.

For instance, there was much more of a focus now on risk culture. In addition, risk committees now had more of a direct responsibility to approve capital and solvency plans. There was also a direct accountability on the part of the Chair.

Then there was the myriad of risk categories for risk committees to consider: cyber, regulatory, legal, HR & Succession, reputational, and threats to the very business model itself.

Immediate risks on the horizon

Of the risks immediately on the horizon, Howard was particularly concerned by the asset price bubble. “Equity prices look pretty high, especially in the US,” he explained. “It brings to mind the dotcom bubble. You have to ask yourselves “what’s going on there?”. Is a correction due? And what would happen if it did occur?”

And since one of the reasons for elevated prices is QE, what would happen when this was unwound?

“If you look at the US, the UK, the Eurozone and Japan we’re all at different stages,” he said. “But we don’t know what will happen as this artificial support for markets begins to unwind. We don’t know if, at some point in the tightening, there will be a sudden realisation that people are over-leveraged.”

And what might happen in the event of another economic downturn during this period? “What ammunition will central banks have to respond?” asked Howard.

The market value of banks

There was a pessimistic view of banks in the market – their value was still marked well below book value – which pointed to dangers beyond the balance sheet, suggested Howard.

Such as the fact that, whilst banks had strengthened their capital since the financial crisis, could their traditional business model survive in the face of such intense fintech disruption?

“Though there are some signs that investment into fintech might have peaked in terms of deal count and amount of capital, there are still real threats to banks’ business models,” said Howard.

That said, it was a very exciting time to be involved in risk. “It’s time to stop looking back at the financial crisis and look forward. On the capital side we’re stuffed full, but we may not be making enough money, because the fundamental business model is being challenged.

“Let’s try to move away from some of this traditional focus and move forward to looking at risks to the future viability of the business,” he said. “That is the shift that risk professionals are going to need to make.”