Info Service on Finance and Development (Dec17/01)
15 December 2017
Third World Network
BCBS finalises Basel III/IV reforms
Published in SUNS #8595 dated 13 December 2017
Geneva, 12 Dec (Chakravarthi Raghavan*) - After a long period of consultations
and efforts to bridge mainly trans-Atlantic differences, top international
central bankers and regulators have struck a deal on bank capital
rules, and made public the global regulatory framework of the banking
sector, enhancing capital requirements for banks to ensure a resilient
banking system to support the real economy through the economic cycle.
The long-awaited standards and regulatory framework were finalised
and made public last week (on Thursday, 7 December) by the Basel Committee
on Banking Supervision (BCBS), with its secretariat located at the
Bank for International Settlements (BIS) in Basel.
While the framework of reforms and changes announced formally is to
the current regulatory framework in Basel-III, they are so wide-ranging
(in the wake of the global financial crisis unleashed in 2008) that
the framework is now being unofficially characterised as Basel IV.
Formally (for BCBS), the package is a tightening up of the Basel III,
but bankers dubbed it Basel IV because of its stringent requirements.
However, only the future will tell whether Basel IV will avert the
kind of crisis that the financial sector saw after 2008 (with banks
having to be rescued by the public tax-payer) or whether the actors
in the financial sector, now many times the size of the real economy
and seemingly with a life of its own, will find ways to get around
regulations, and spring a new financial crisis on the world.
Many of the standards and requirements of Basel IV will kick in over
a long period of about 10 years, with national banking supervisors
given an element of flexibility in applying them, both on time-periods
and relaxing (temporarily) capital requirements.
Initial indications are that European banks would be most impacted,
needing to increase their capital, due among others, to limits on
how much their biggest banks can diverge from regulators' risk calculations
for assets such as mortgages.
[According to US media reports, citing the Institute of Bankers, many
of these major European and non-US banks, functioning in the USA,
with large loan operations in the US, will also be hit as a result
of proposed changes to the US tax code, passed in both houses of Congress
and in process of different versions being reconciled, about to be
enacted in the US. Reports show that unless there are last-minute
changes, these foreign banks in the US will be forced to cut back
on their lending operations.]
The reformed global regulatory framework of the banking sector, enhancing
capital requirements for banks, will ensure a resilient banking system
and provide a foundation for a resilient system to support the real
economy through the economic cycle, according to the documents made
public by BCBS.
A press release and executive summary of the detailed note published
by the BCBS, summarises the main features of the finalised Basel III
The standards text, which provides the full details of the reforms,
is published separately and is available on the BIS website at www.bis.org/bcbs/publ/d424.htm
The revised Basel III framework is a central element of the Basel
Committee's response to the global financial crisis. It addresses
a number of shortcomings in the pre-crisis regulatory framework and
provides a foundation for a resilient banking system that will help
avoid the build-up of systemic vulnerabilities. The framework will
allow the banking system to support the real economy through the economic
The initial phase of Basel III reforms focused on strengthening of
several components of the regulatory framework.
The Committee's now finalised Basel III reforms complement these improvements
to the global regulatory framework. The revisions seek to restore
credibility in the calculation of risk-weighted assets (RWAs) and
improve the comparability of banks' capital ratios.
Credit risk accounts for the bulk of most banks' risk-taking activities
and hence their regulatory capital requirements.
The standardised approach is used by the majority of banks around
the world, including in non-Basel Committee jurisdictions. This approach
has now been revised to enhance the regulatory framework, and are
outlined in Table 1 of the documents made public.
In summary, the key revisions are as follows:
* A more granular approach has been developed for un-rated exposures
to banks and corporates, and for rated exposures in jurisdictions
where the use of credit ratings is permitted.
* For exposures to banks, some of the risk weights for rated exposures
have been re-calibrated. In addition, the risk-weighted treatment
for un-rated exposures is more granular than the existing flat risk
weight. A standalone treatment for covered bonds has also been introduced.
* For exposures to corporates, a more granular look-up table has been
developed. A specific risk weight applies to exposures to small and
medium-sized enterprises (SMEs). In addition, the revised standardised
approach includes a standalone treatment for exposures to project
finance, object finance and commodities finance.
* For residential real estate exposures, more risk-sensitive approaches
have been developed, whereby risk weights vary based on the LTV ratio
of the mortgage (instead of the existing single risk weight) and in
ways that better reflect differences in market structures.
* For retail exposures, a more granular treatment applies, which distinguishes
between different types of retail exposures. For example, the regulatory
retail portfolio distinguishes between revolving facilities (where
credit is typically drawn upon) and transactors (where the facility
is used to facilitate transactions rather than a source of credit).
* For commercial real estate exposures, approaches have been developed
that are more risk-sensitive than the flat risk weight which generally
* For subordinated debt and equity exposures, a more granular risk
weight treatment applies (relative to the current flat risk weight).
* For off-balance sheet items, the credit conversion factors (CCFs),
which are used to determine the amount of an exposure to be risk-weighted,
have been made more risk-sensitive, including the introduction of
positive CCFs for unconditionally cancellable commitments (UCCs).
Several major banks however use an internal ratings-based (IRB) approach
for credit risk, rather than the standardised approach.
The 2008 financial crisis highlighted a number of shortcomings related
to the use of internally modelled approaches for regulatory capital,
including the IRB approaches to credit risk.
These shortcomings include the excessive complexity of the IRB approaches,
the lack of comparability in banks' internally modelled IRB capital
requirements and the lack of robustness in modelling certain asset
To address these shortcomings, the BCBS has made several revisions
to the IRB approaches: (i) removed the option to use the advanced
IRB (A-IRB) approach for certain asset classes; (ii) adopted "input"
floors (for metrics such as probabilities of default (PD) and loss-given-default
(LGD)) to ensure a minimum level of conservativism in model parameters
for asset classes where the IRB approaches remain available; and (iii)
provided greater specification of parameter estimation practices to
reduce RWA variability.
The BCBS agreed on various additional enhancements to the IRB approaches
to further reduce unwarranted RWA variability, including providing
greater specification of the practices that banks may use to estimate
their model parameters.
Adjustments were made to the supervisory specified parameters in the
F-IRB approach, including: (i) for exposures secured by non-financial
collateral, increasing the haircuts that apply to the collateral and
reducing the LGD parameters; and (ii) for unsecured exposures, reducing
the LGD parameter from 45% to 40% for exposures to non-financial corporates.
Given the enhancements to the IRB framework and the introduction of
an aggregate output floor, BCBS has agreed to remove the 1.06 scaling
factor that is currently applied to RWAs determined by the IRB approach
to credit risk.
CVA RISK FRAMEWORK
The initial phase of Basel III reforms introduced a capital charge
for potential mark-to-market losses of derivative instruments as a
result of the deterioration in the creditworthiness of a counterparty.
This risk - known as CVA risk - was a major source of losses for banks
during the global financial crisis, exceeding losses arising from
outright defaults in some instances.
BCBS has now agreed to revise the CVA framework to: enhance its risk
sensitivity; strengthen its robustness; and, improve its consistency.
OPERATIONAL RISK FRAMEWORK
The financial crisis highlighted two main shortcomings with the existing
operational risk framework. First, capital requirements for operational
risk proved insufficient to cover operational risk losses incurred
by some banks.
Second, the nature of these losses - covering events such as misconduct,
and inadequate systems and controls - highlighted the difficulty associated
with using internal models to estimate capital requirements for operational
BCBS has now streamlined the operational risk framework. The advanced
measurement approaches (AMA) for calculating operational risk capital
requirements (which are based on banks' internal models) and the existing
three standardised approaches are replaced with a single risk-sensitive
standardised approach to be used by all banks.
The new standardised approach for operational risk determines a bank's
operational risk capital requirements based on two components: (i)
a measure of a bank's income; and (ii) a measure of a bank's historical
Conceptually, it assumes: (i) that operational risk increases at an
increasing rate with a bank's income; and (ii) banks which have experienced
greater operational risk losses historically are assumed to be more
likely to experience operational risk losses in the future.
LEVERAGE RATIO FRAMEWORK
The leverage ratio complements the risk-weighted capital requirements
by providing a safeguard against unsustainable levels of leverage
and by mitigating gaming and model risk across both internal models
and standardised risk measurement approaches.
To maintain the relative incentives provided by both capital constraints,
the finalised Basel III reforms introduce a leverage ratio buffer
for G-SIBs (global systemically important banks). Such an approach
is consistent with the risk-weighted G-SIB buffer, which seeks to
mitigate the externalities created by G-SIBs.
The leverage ratio G-SIB buffer must be met with Tier 1 capital and
is set at 50% of a G-SIB's risk-weighted higher-loss absorbency requirements.
The leverage ratio buffer takes the form of a capital buffer akin
to the capital buffers in the risk-weighted framework.
As such, the leverage ratio buffer will be divided into five ranges.
As is the case with the risk-weighted framework, capital distribution
constraints will be imposed on a G-SIB that does not meet its leverage
ratio buffer requirement.
The distribution constraints imposed on a G-SIB will depend on its
CET1 risk-weighted ratio and Tier 1 leverage ratio.
A G-SIB that meets: (i) its CET1 risk-weighted requirements (defined
as a 4.5% minimum requirement, a 2.5% capital conservation buffer
and the G-SIB higher loss-absorbency requirement) and; (ii) its Tier
1 leverage ratio requirement (defined as a 3% leverage ratio minimum
requirement and the G-SIB leverage ratio buffer) will not be subject
to distribution constraints. A G-SIB that does not meet one of these
requirements will be subject to the associated minimum capital conservation
requirement (expressed as a percentage of earnings).
A G-SIB that does not meet both requirements will be subject to the
higher of the two associated conservation requirements.
REFINEMENTS TO THE LEVERAGE RATIO EXPOSURE MEASURE
In addition to the introduction of the G-SIB buffer, the BCBS has
agreed to make various refinements to the definition of the leverage
ratio exposure measure. These refinements include modifying the way
in which derivatives are reflected in the exposure measure and updating
the treatment of off-balance sheet exposures to ensure consistency
with their measurement in the standardised approach to credit risk.
It has also agreed that jurisdictions may exercise national discretion
in periods of exceptional macroeconomic circumstances to exempt central
bank reserves from the leverage ratio exposure measure on a temporary
Jurisdictions that exercise this discretion would be required to re-calibrate
the minimum leverage ratio requirement commensurately to offset the
impact of excluding central bank reserves, and require their banks
to disclose the impact of this exemption on their leverage ratios.
The BCBS continues to monitor the impact of the Basel III leverage
ratio's treatment of client-cleared derivative transactions. It will
review the impact of the leverage ratio on banks' provision of clearing
services and any consequent impact on the resilience of central counterparty
The Basel II framework introduced an output floor based on Basel I
capital requirements. That floor was calibrated at 80% of the relevant
Basel I capital requirements.
Implementation of the Basel II floor has been inconsistent across
countries, partly because of differing interpretations of the requirement
and also because it is based on the Basel I standards, which many
banks and jurisdictions no longer apply.
The Basel III reforms replace the existing Basel II floor with a floor
based on the revised Basel III standardised approaches. Consistent
with the original floor, the revised floor places a limit on the regulatory
capital benefits that a bank using internal models can derive relative
to the standardised approaches. In effect, the output floor provides
a risk-based backstop that limits the extent to which banks can lower
their capital requirements relative to the standardised approaches.
This helps to maintain a level playing field between banks using internal
models and those on the standardised approaches. It also supports
the credibility of banks' risk-weighted calculations, and improves
comparability via the related disclosures. Banks will also be required
to disclose their risk-weighted assets based on the revised standardised
approaches. Details about these disclosure requirements will be set
forth in a forthcoming consultation paper.
The BCBS documents made public on 7 December have also outlined the
transitional arrangements and the various implementation dates related
to the revised standards.
[* Chakravarthi Raghavan is the Editor-Emeritus of the SUNS.]