The purpose of the Basel III 2017 reforms (aka. Basel III Endgame or Basel IV) was to address the perceived weakness that came out of the global financial crisis and to restore credibility and consistency in the calculation of risk weighted assets (RWAs) and to improve the comparability of banks’ capital ratios by tackling the wide variation in risk-measurement methodology. 

The implementation of the final package of measures of Basel III will have not only quantitative effects on capital, but it will require an individual approach, one which considers all aspects linked to the implementation of the standards in a holistic manner. Each individual bank will need to carry out an impact analysis of the new standards, which will be, by and large, dependent on its business model, on the use of internal models, on the market situation and, finally, on the profitability targets of the institute. The day of the first application in 2023 has come faster than imagined: an early assessment and a regular follow-up of the exercise would greatly contribute to a bank’s readiness.

 

What are the key changes introduced by the committee? 
Output Floor: 

The major stumbling block for the Basel Committee on Banking Supervision’s (BCBS’s) Group of Central Bank Governors and Heads of Supervision (GHOS) was the controversial “output floor”, a limit for the calculation of risk-weighted assets (RWAs). The introduction of floors means that the RWAs calculated using internal models cannot fall below a given percentage of the RWAs calculated using the standardized approach.  The compromise reached between the various members was a calibration of the output floor to 72.5 %. 

The introduction of the output floor, as calculated according to the formula  

RWA = MAX [RWAIM; RWASA x 72.5%], 

means that the RWA will be the greater of that calculated using an internal model and the revised standardized model multiplied by 72.5%. This last percentage will apply from 1 January 2028. During the five-year transitional period, the following values will be used:  

2023: 50% 

2024: 55% 

2025: 60% 

2026: 65% 

2027: 70% 

2028: 72.50% 

Furthermore, the following caveats have to be considered: 

  • the output floor is applied at the total capital level (and not per risk type or portfolio),
  • national discretions may be implemented to cap incremental RWA increase, and
  • the calculation of the floor will be constantly reviewed by the BCBS.
 
Leverage Ratio: 

On 1 January 2023, the revised leverage ratio standard together with the buffer for global systemically important banks (G-SIBs) will go into effect.

 

Credit Risk – New Standardized Approach: 

In the CR-SA, within the standardized credit risk assessment approach (SCRA) for financial institutions exposures, an intermediate “A+” grade, with a risk weight (RW) of 30%, is added. The RWs have been lowered for specialized finance, pre-operational finance project and the operational cluster, and criteria introduced for qualifying for an 80% RW. In residential and commercial real estate, it is permitted to split the credit into a “property” part (up to 55% of the property value with a RW of 20% or 60% respectively) and a “counterparty” component – the remaining loan value - to be evaluated according to the creditworthiness of the client (for retail 75% RW). Other measures from the supervisor regarding retail exposures and commitments aim to soften the impact of the CR-SA on IRB banks.  

All in all, the BCBS attempts to graduate the previously suggested approach and to alleviate the impact of the introduction of a floor.  However, only an individual impact analysis will be able to give a first assessment of the application of the finalized rules for the single case.

 

Credit Risk – IRBA Limits: 

As far as the IRBA is concerned, the BCBS maintains the applicability of the method except for the equity exposure class. However, for exposures to financial institutions and corporates only the foundation-IRB will be allowed. Exposures to specialized lending, retail and SMEs may still be treated under the advanced-IRB. The scaling factor of 1,06% is removed. However, conservative measures are introduced by raising the input floors with respect to probability of default (PD) and loss given default (LGD).

 

Credit Value Adjustment (CVA):

In terms of CVA, the FRTB internal-model-based approach is no longer valid (as already suggested in BCBS 362). The standardized approach, basically following the FRTB methodology, must be approved by the supervisor. The standardized approach is based on the sensitivity of the credit spread of the counterparty. Historical calibration is not allowed. Accounting values for exposure at default (EAD) are permitted. For the alternative CVA basic approach (BA-CVA), the major differences are the lower risk rates and EAD per sector. Here the supervisor reacted to the criticism of the stakeholders and introduced a discount factor reducing conservatism. The fallback scenario for those institutions not calculating CVA foresees the adoption of twice the counterparty credit risk capital requirement, and not ten times, as in the previous consultation paper. 

 

Operational Risk – New Standardized Approach: 

For operational risk, there is a change in naming convention: the supervisor speaks simply of “standardized” approach (the word “measurement” is obsolete). The components are still the interest/lease/dividend (ILDC), the service (SC) and the financial component (FC). In terms of calculation, the formula is strongly simplified. Furthermore, the business indicators are allocated to three buckets instead of the four of the previous consultation paper and a marginal coefficient and an internal loss multiplier (only for Bucket 2 and 3) are to be considered.

 

Market Risk – Revised Framework for Standardized: FRTB 

On 27 March 2020, the BCBS announced a set of measures to provide additional operational capacity for banks and supervisors to respond to the immediate financial stability priorities resulting from the impact of COVID-19 on the global banking system. The GHOS endorsed the deferral of the implementation dates of the Basel III standards finalized in December 2017, the revised market-risk framework finalized in January 2019, and the revised Pillar-3 disclosure requirements finalized in December 2018 by one year to 1 January 2023. The accompanying transitional arrangements for the output floor are also to be extended by one year to 1 January 2028.

 

How does the implementation vary across different jurisdictions? 

The implementation of Basel IV varies across different jurisdictions, with each jurisdiction having its own specific timeline and approach.  

EBA 

The EU supervisory authorities are expected to adopt the new rules and the national competent supervisors to have finalized the implementation by this deadline. It will be extremely important for institutions to meet this deadline gradually: this will not only prevent any unpredictable effects of a sudden introduction, but also help the management to take all the necessary measures in terms of strategy and refinement of profitability targets in advance. The only possible way will be to start an impact analysis and to repeat this exercise regularly until the implementation deadline.

 

UK 

In November 2022, the Prudential Regulation Authority (PRA) published a consultation paper on the Implementation of the Basel 3.1 standards. Awaiting feedback from consultation period that ended on 31 March 2023, implementation is targeted for Q2 2025.

 

Canada 

OSFI announced their intent for final Basel III reform changes back in January 2022, with the first set of compliance set for Q2 2023.  Everything other than CVA risk and market risk would be required by financial institutions in the first deadline, including the new standardized for credit risk and operational risk.  The final deadline of Q1 2024 would incorporate the rest of the market risk changes including FTRB and calculation methodologies and CVA.   

OSFI also introduced a more simplified RWA calculation methodology for small and medium-sized deposit-taking institutions (SMSB), reducing the data and calculation burden for smaller-banks. OSFI recognized the different risk levels these financial institutions have over their larger counterparties and the significant resource constraints to meet compliance.

 

United States 

Although the final proposals have yet to be announced, the US regulators (FED, OCC, FDIC) in a joint announcement back on July 27, 2023, released their draft version for consultation.  The “Basel III Endgame” is targeted for July 1, 2025, timeline with a 3-year transition period ending July 1, 2028, for full compliance. 

The proposal has followed BCBS’s lead in introducing the new Standardized Credit Risk methodology, standardized floor, FRTB and CVA calculations and Operational risk.  The one major deviation to note is unlike other countries, the US has decided to abandon the IRB approach altogether for credit risk RWA.  This will result in higher required capital by larger financial organizations that were able to take advantage in the previous iteration of Basel, putting a clear disadvantage for firms operating in the US. 

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