Sticking points as Basel IV takes shape

The final piece of the Basel IV reform looks to have been put in place with global regualtors moving to ensure that the banks don’t understate risks when they calculate the riskiness of their loan book.

After reviewing various types of “output floors”, Swiss regulators have opted to put an aggregate floor on banks’ internal regulatory capital models, rather than individual floors on specific risks.

This output floor will essentially limit the extent to which an ‘advanced’ bank’s risk weights for capital can go below those of a ‘standardised’ bank. In other words, a bank's overall measure of its risk-weighted assets should be relatively similar to the results that a standardised approach would deliver.

By opting for a single overall floor for total risk-weighted assets, the Basel Committee on Banking Supervision has rejected the option of the floor applying differently to certain products.

The Committee has chosen the “simplest form output floor” which applies to all of a bank’s assets including “exposure class”, which weighs up the type of exposures such as mortgages, and “risk types” which take into account credit risk and market risk.
 

Policy decision pending

What’s left to do is to calibrate the aggregate floor - a decision that William Coen, secretary general of the Basel Committee, said is expected in the "near future”.

“There is momentum,” he said. “This is being discussed at the highest levels, where it needs to be discussed. The technical work has been done; we just need to make a policy decision.”

“However, we still don’t have closure,” argued Kevin Nixon, head of Deloitte Centre for Regulatory Strategy. “It all depends on where that floor is set, which was a sticking point at the end of last year.

“The committee itself has still not agreed - they are still calling a range between 70 per cent to 75 per cent, maybe 80 per cent - which from the banks' perspective leads to three different outcomes."

The Committee might have agreed on aggregate floor, but the calibration of the floor is far from finalised.

Coen referred to a 70 to 75 per cent range and recent media reports have suggested that US and European regulators might be closer to agreeing to a 75 per cent floor. In this case, for example, the banks’ internal measure of risk-weighed assets can in aggregate be no lower than 75 per cent of the risk-weighted assets that would result if a lender had applied the standardised approach to determine risk-weighted assets.

According to Nixon, the Basel Committee cannot formally agree Basel IV until the new US representative on the Committee is put in place. President Trump has yet to announce that appointment, which would then need to be approved by Congress, he noted.

“The US is in the room but Congress has made it clear to the Federal Reserve that they shouldn’t agree to anything until the vice chair of the Fed is appointed, so at a Basel level an agreement is still some months away. In our view, an agreement is unlikely until later this year.”
 

Risk-weight clarity 

Meanwhile, Morgan Stanley described an aggregate floor as a good outcome for Australian banks as it will provide more flexibility on the use of internal models for each risk portfolio.

Regarding the Aussie banks, an "aggregate" output floor is less onerous than an "exposure class / type" or "risk type" floor, as it means a larger gap for one type of exposure can be offset by a smaller gap for another, according to banking analyst Richard Wiles.

“However, it does not mean that existing IRB risk weights will be high enough.”

The analyst earlier concluded that the major Australian banks' international internal ratings-based risk weights were less than 60 per cent of potential standardised risk weights for mortgages and for SME lending, which together account for 70 per cent credit

“As such, we continue to believe that the majors' risk-weighted assets will increase once Basel IV is finalised.”

According to Wiles, a decision by the Basel Committee in the "near future" on the calibration of the output floor could also help APRA finalise changes to risk weights sooner than expected.

The investment banker is expecting APRA to provide more clarity on "the extent of further capital strengthening require" in late June or early July.

“While APRA should allow a minimum two-year transition period, market forces could shorten the time frame for capital build and lead to revisions to the banks' capital management strategies and investors' expectations.”

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