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Basel IV Emerging

8 June 2017 by Gary Kirk

Rumours are circling that the Basel Committee on Banking Supervision (BCBS) may be about to announce an agreement on so-called Basel IV at their next meeting in Sweden on June 14-15th

The key proposal will be surrounding the phasing out of banks relying on internal models to calculate risk weighted assets (RWAs) on their balance sheets. The BCBS is proposing a move whereby the RWA calculation is based on a standardised model with a so-called ‘output floor’. This is a contentious move with some banks accusing the BCBS of merely creating another round of capital-raising by the back door. Policy makers have argued that the intention is not to raise overall capital but to simplify assessment methods and make it easier to compare how different banks calculate risk.  The Chairman of BCBS, Stefan Ingves, summed up the rationale behind the proposal by saying “addressing the issue of excessive variability in risk-weighted assets is fundamental to restoring market confidence in risk-based capital ratios”. In addition, and to help alleviate the challenges for some banks, the BCBS have indicated a transition period to 2026 in order to fulfil these changes.

This is an important proposal by the BCBS, as credit risk currently accounts for around 70% of the RWAs sitting on the books of a bank’s balance sheet, which in turn are the key denominator in the all-important fraction that determines a bank’s capital ratios.

The BCBS proposal includes floors for different risk products based on probability of default, loss given default and exposure at default; we assume that this will have a negative impact for some banks, while others may see no change at all (or possibly see their capital ratios improve). In general the BCBS is proposing that loans to financial institutions and to large corporates (which the BCBS define as businesses with total assets more than €50bn) will have to adopt to the new methodology of calculating risk. It is still consulting on how to assess sovereign risk as part of separate proposals.

For assets where banks can still use their own models, BCBS is still calculating the right level of a so-called output floor, which is designed to “ensure a minimum level of conservatism.” This minimum level was initially guided towards a calibrated range of 60-90% but now the rumours are the BCBS is settling for 75% – although most EU banks have been arguing that anything above 70% would be too onerous.

As always the devil will be in the detail but yet again we are faced with another round of impending rules to get to grips with (although there is a lengthy transition period), however this time the final outcome should result in a far more straightforward way to compare different entities in the banking sector.

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