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Basel IV: Your path to a more profitable business

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Wolters Kluwer logoThe deadlines for implementing the latest round of Basel guidelines have been delayed to help institutions cope with the personal and commercial toll of the Covid-19 pandemic. As urgent as resolving issues related to the pandemic are, firms must maintain their focus on preparing for Basel IV. New or revamped technology will be required. New or revamped thinking and organisational structures, too. And not just during implementation, but long after. 

Along with the obstacles that Basel IV presents, there is a path to greater productivity and profitability – an opportunity to become a better bank, not just a more compliant one. But only if an institution is prepared to seize it. You must adopt the right attitude – viewing compliance as a potential asset, not just a liability – and change how your operations, and your data management systems, are structured. Doing so will reduce costs, enhance efficiency and create a more profitable business. The time to start is now.

The high cost of compliance

 Basel IV compliance will require a significant expenditure of time and money for many firms, although there are ways to limit it. A key decision for larger firms is whether to use internal models in risk calculations, taking into account the additional calibration and validation they entail.

 Basel IV’s burdens generally fall harder on larger, more complex banks. Under the so-called interdependency principle, models must factor the sensitivity of each source of risk into others that an institution must account for. Creating, testing, adjusting and executing calculations for each risk source – and ensuring consistency – demand cognitive and technological sophistication beyond what the industry has had to muster until now. The principle also creates potential ironies, notably for banks that trade for their own account. If they maintain a well-diversified asset portfolio to better mitigate risk, activities related to each asset class will influence credit, market and liquidity risk calculations, making compliance and reporting more complicated.

 Cost reduction is the first step in making Basel IV pay off, but it will not be easy. You may find that you can live without an internal model, for example, but regulators still often demand that larger firms use them. One way around this is for banks to simplify their businesses by choosing less complex asset portfolios. That is a tricky proposition, though, because it requires executives to determine, and then admit, that their complicated portfolios produce advantages so marginal that they evaporate when higher compliance costs are factored in.

Banks can also reduce costs by simplifying their organisational structure and limiting the number of entities that must file submissions. But as with portfolios, a bank must have had a reason for organizing itself as it has and may not see shrinking compliance costs as reason enough to change.

Connecting compliance to commerce

Basel IV reflects regulators’ longstanding emphasis on the importance of prospective thinking: anticipating events from a range of alternatives, instead of accumulating and analysing data that shows only current conditions. Once such a mindset has been adopted, executives can adapt Basel IV for business to conduct institution-level strategic analysis and “what-if” planning for present and future risks. These include critical matters like Covid-19 and climate change, and more run-of-the-mill macroeconomic threats. And because the news is not bad all the time, the same techniques can be used to study the profit potential of new business lines or expansion into new territory.

Another big-picture use of Basel IV for business is balance sheet optimisation: forecasting the best balance sheet size for a given risk appetite. Alternatively, institutions can tweak inputs to find a sweet spot between risk and reward. The same strategy can be used to determine an ideal investment portfolio.

Where there’s a will – and the right tools – there’s a way

To realise the vast potential of Basel IV for business, senior executives must be open to the concept and communicate its importance to key people who will execute it. That means fostering a mindset that considers each decision, from the details of individual deals to strategic planning, along with its likely impact, a matter best addressed from multiple viewpoints covering various risks and opportunities. Just as crucial, staff must be supported by similarly structured data management architecture.

In these perilous times, however, boards may be reluctant to commit resources to new initiatives. It is essential that they realise that maximising productivity and profit potential, and gaining an edge over the competition, can reap especially great long-term rewards when achieved at times like these. Leaders of financial institutions have a lot on their minds, but there is a persuasive case to be made for seizing the opportunity presented by Basel IV for business right now.

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