Even before Basel III has been fully implemented, the market is already discussing the advent of new capital adequacy rules, informally being referred to as Basel IV. At a recent conference co-hosted by S&P Global Market Intelligence and the NYU Stern School of Business, leading industry figures gave their take on the new proposals.
Commentators in the financial services media have been quick to latch on to ‘Basel IV’ as the latest regulatory impediment. Among the most hotly debated issues are the Fundamental Review of the Trading Book (FRTB) final rules and proposed changes to the use of internal models for calculating credit risk.
On the surface, it’s easy to see why these proposals have provoked such a negative reaction from industry commentators. But are the changes really as seismic as they appear?
As a refresher, in mid-January, the Basel Committee published the final FRTB rules. Change was necessary because the original measures put in place post-crisis under Basel 2.5 were only ever a stop-gap. Weaknesses in the rules were recognized from the start and a review process soon began.Changes under the final FRTB rules include a revised boundary between the banking book/trading book in order to reduce the opportunity for arbitrage and the adoption of a more consistent approach to modelling tail risks. According to the Basel Committee, these latest changes to the FRTB rules will result in an estimated 40% weighted average increase in total market risk capital requirements1.
Another key aspect of Basel IV is the revised framework for credit risk in the banking book2 which aims to deliver consistency of capital requirements across banks. In brief, proposals issued in December 2015 and March 2016 by the BCBS discourage, and in some cases prohibit, banks from using an internal ratings-based (IRB) model for calculating risk weighted assets (RWA) related to credit risk. Banks will instead have to use a standardized approach prescribed by global regulators – which industry participants argue is not sufficiently sensitive to risk.
Inevitably, these changes will result in more work for banks and, in many instances, higher capital requirements. But speaking at S&P Global Market Intelligence’s recent conference, Mark Carey, Associate Director in the Division of International Finance at the Federal Reserve, said that the latest proposals should not come as a big surprise to the market. The FRTB has been ongoing for some time, he noted, and banks should recognize that regulatory requirements are constantly shifting.Moreover, US banks are in many ways already ahead of Basel IV, said Carey. PwC echoed this in a recent note on the changes to the IRB approach, saying that “US banking institutions are already subject to risk-based capital floors, under the Dodd-Frank Act’s Collins Amendment, that are more stringent than the proposal’s restrictions on the use of internal models. Although the US could, in theory, impose similar restrictions on the use of internal models to align with this proposal, such harmonization would have no bearing on required capital for US banking organizations that are already constrained by standardized approaches under the Collins Amendment.3”
Interestingly, Mark Flannery, Chief Economist and Director of Economic and Risk Analysis at the Securities and Exchange Commission, said that the market is currently placing too much focus on the first pillar of Basel (minimum capital requirements) – which is often tweaked and amended. This emphasis detracts from an area that Flannery thinks deserves greater attention, namely the supervisory review process (pillar 2).Generally speaking, he noted, there is no reliable mechanism or standard in place whereby supervisors restore or maintain forward-looking risk-absorbing capital. Without that, the question of what constitutes an adequate level of capital is almost immaterial.
Against that backdrop, perhaps it is time for market participants and commentators to re-read the Basel IV proposals with fresh eyes, and above all, an open mind.
2 Bank for International Settlements, Basel Committee on Banking Supervision (2015, December), Revisions to the Standardised Approach for credit risk & Basel Committee on Baking Supervision (2016, March), Reducing variation in credit risk-weighted assets – constraints on the use of internal model approaches.