With the advent of the Basel IV credit risk rules, banks and markets will face an unprecedented regulatory shock: risk-weighted assets (RWA) may increase by two-digit percentage numbers, the burden for banks using the internal-ratings based (IRB) approach due to the output floor is expected to be heavy and the mortgage business will be particularly affected. This is the general view; however, the impact will vary greatly - from specific product areas like mortgage lending to strategical implications for funding.

There are a few major drivers for an increase in RWA

In December 2017, the Group of Central Bank Governors and Heads of Supervision adopted the finalization of the Basel III reform package- known as Basel IV within the industry. The main objective of the latest reforms is to increase the risk sensitivity of the standardized approaches and likewise the comparability of RWA calculations by constraining the use of internal models. As credit risk is known to be the main driver of a bank’s RWA, the extensive changes that come with the revised credit risk framework represent the biggest challenge for banks.

The setting of a capital floor was particularly controversial during the Basel IV consultation process. Finally, an output floor of 72,5 percent was agreed: that is to say, capital requirements for banks with internal risk models cannot be less than 27,5 percent below the requirements calculated using the standardized approaches. The amendments will be put into place gradually from 2022 onwards until reaching the final level of 72,5 percent in 2027. The output floor will present a huge challenge for IRB banks. Quantitative analysis performed with our customers, for instance, implied that IRB banks will be heavily affected by Basel IV: the output floor itself leads to an average RWA increase of 10 percent - 20 percent among representative institutions.

In the standardized approach for credit risk (SA-CR), almost all exposure classes have undergone a fundamental revision. Whenever external ratings are used, the mandatory due diligence (for almost all exposure classes) adds a substantial qualitative component. The two classes in which the most critical changes have been identified are mortgages and corporates.

For the mortgage class, a new procedure essentially relying on the loan-to-value ratio (LTV) will be applied under the revised SA-CR. Impact studies with representative banks revealed significantly higher RWAs for those portfolios compared to the old Basel III rules. The benefits of the reintroduced but adjusted loan-splitting approach, in contrast to the LTV approach, also shows to be less advantageous than initially assumed.

In the corporate class, a wide range of changes must be considered. For instance, specialized lending, well known from the internal approaches, is now also introduced for the revised SA-CR. Additionally, the new standardized approach for counterparty credit risk (SA-CCR) will also affect the RWA in the corporate exposure class. In practice, corporates hedge only one direction of the risk without allowing to get benefits from netting and especially long-maturity interest swaps become very expensive. Another effect on the corporates comes from a lack of ratings: as most of the European medium-sized corporates fund themselves via banks and not via the capital markets, they are not rated and will have, regardless of their creditworthiness, a higher default risk weight under the standardized approach as compared to a lower risk weight under the IRB approach. This will be reflected in the output floor for IRB banks.

Further noticeable changes by Basel IV target the restriction and recalibration of certain internal approaches. For instance, the advanced IRB (A-IRB) approach will be removed for large corporates and financial institutions. For equities, internal approaches will no longer be permitted.

To sum up, Basel IV credit risk will be a challenge for every financial institution. However, in order to estimate the severity of changes for an individual bank, an analysis on a case-by-case basis is inevitable, due to the extent of the changes and the variation according to business model and portfolio mix.

The challenges for financial institutions can be clustered into four dimensions

Banks face many different challenges due to the introduction of the new Basel IV credit risk framework, but these can be grouped roughly into four dimensions:

  1. implications on current business models and practices (analysis of the current state);
  2. the strategical implication (determination of the future state and the long-term response to the new framework);
  3. the operational application, which still has many open questions, for example, how to apply certain new rules; and
  4. the technical implementation and associated challenges.
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