Abstract:
Globalization is at its peak form, with the rapid advancement of the internet and trade developments, due to which the regulation of the banking regime globally has gained greater importance. International organizations have taken proactive steps to ensure that there is a free flow of capital and other required financial assistance for those requiring international banking facilities. The Bank for International Settlement (BIS) is one such organization, focusing on serving central banks of other states and they have introduced various guidelines to ensure statutory compliances and other measures to prevent financial distress. This article attempts to provide a brief overview of the three Basel Accords while focusing on the latest Basel norm, which is, Basel IV. Further, this paper will critically examine the implementation of Basel IV and its differentiation from its predecessors.
The financial chaos of 1973 altered the existing banking regime, following which the Basel Committee on Banking Supervision (BCBS) was created from the ashes of the Bretton Woods System.[1] This committee was formed by the central bank governors of G10 countries under the Bank for International Settlements (BIS), for enhancing the quality of banking supervision universally.[2] Over time, the committee launched a series of standards and guidelines on numerous areas of the regulatory framework[3], and the Basel norms are a set of guiding canons framed by the committee.[4] Even though these norms are legally non-binding[5], it is expected that the authorities of the individual nations take the initiative to implement the sound practices suggested by them. Given below is a brief overview of these norms: –
- Basel I focused solely on credit risk. It also aimed to avoid competitive conflicts between the global players and to ensure that banks had sufficient capital balance to absorb losses without triggering systemic complications[6].
- ● Basel II framework provides for credit, market and operational risks. Developed on the pillars of Basel I, this guideline seeks to advance the capital framework’s sensitivity to the risk banks deal with.[7] It also introduced three pillars to boost the quality of banks’ control methods, promote risk management and establish uniform practices.
- Basel 2.5 was introduced with the aim to expand the framework’s risk coverage in specific parts and extend the total level of capital requirements. Further, it also highlighted the trading instruments exposed to credit risks.[8]
- Basel III was introduced as the response to the global financial crisis of 2007-2009.[9] It focused on improving risk management, administration and individual banks capability to endure financial tensions and alleviate system-wide shocks. Although the guideline was welcomed as a paradigm of universal regulation and law-making, [10] the framework did meet with certain protests due to the need for rigorous commitments to be made by financial institutions.[11]
With a view to reforming the Basel III framework, the BCBS introduced Basel IV, which is expected to be implemented from January 2023 (or, within a one-year delay due to the pandemic). The focus of this norm would be to change the approach for calculating “Risk-Weighted Assets” (RWA)[12]. RWA is to regulate the least amount of capital that is required to be held by the financial institution to reduce the peril caused by insolvency.[13] There is a significant shift from the norms set under Basel III, as Basel IV addresses all the various elements of risk areas and considers the is interdependency between these components of risk. Following are a few key features and potential implications of Basel IV:
- A new capital floor framework is introduced by the new norm which will replace the earlier standards. Capital floor refers to the minimum amount of capital that is required to be maintained by the banks, which is based on their RWA. This will reduce the model risk that would arise from internally modelled methods. As determined through the new standardized approach, the capital floors will be 72.5%, which will be introduced in 2020 over the term of five years.
- There will be decreased dependence on complex internal models, unlike Basel II. The use of the Standardized Approach will be severe as it will diminish the discrepancy in calculating capital level for similar levels of risk across banks.
- Basel IV also attempts to restructure banks’ trading activities and portfolio structures. This will force most of the big European financial institutions that possess substantial market decisions to reconsider their business model. The change in the model would also have an impact on non-banking financial institutions as well.
- Another significant change in this framework is the improved transparency and comprehensive risk reporting. .[14]
- For calculating RWA, external credit ratings will no longer be considered fundamental rather, these external credit ratings will be considered for economic valuations used for customer selection.
- There will also be a significant shift in the IT architecture as it should be made more prevailing to sustain the corresponding calculation of standardized and internal styles, at the same time ensuring data integrity as well as security. The human resources also need to be equipped with the knowledge of the latest technical developments to aid the overall process.
As Basel IV sets forth to take shape, it is recommended that the banks adopt a holistic approach as it is evident from the analysis that it’s pointless to address the individual elements without linking them together. The response for the latest Basel norm still remains unclear, whether the global players will respond negatively to Basel IV as it had been to the previous guidelines. Few experts have also recommended these institutions to develop new internal risk models through the use of Artificial Intelligence (AI) or blockchain tokens to optimize RWAs.[15] Since it is also expected that the impact of the latest Basel norms will be much greater than anticipated, these institutions may need to tailor their compliances according to their individual circumstances.
Furthermore, the pandemic has added more pressure to the smooth functioning of the financial systems.[16] The financial regulators have taken a “swift and forceful”[17] act to aid both government and corporate players. Nevertheless, the effect of Basel IV may differ by location, and also by the type and corporate model of banks. It is recommended that banks start remodelling their capital management strategies so as to be adequately equipped for Basel IV.
[This article is authored by Nikitha Mathew, a 4th-year law student at Symbiosis Law School, Pune. The author can be contacted at: 18010126134@symlaw.ac.in]
[1] Kevin L Young, Transnational Regulatory Capture? An Empirical Examination of the Transnational Lobbying of the Basel Committee on Banking Supervision, 4 Rev Int Polit Econ. 663-668 (2012).
[2] A brief history of the Basel Committee (2014) http://www.spaeth.ru/HS20152016/artikel_14.pdf
[3]Deloitte, Basel : The Next Generation What is the future for internal regulatory capital models?, https://www2.deloitte.com/content/dam/Deloitte/uk/Documents/financial-services/deloitte-uk-basel-the-next-generation-0615.pdf
[4]What are Basel Norms? (June 5 2012), https://www.moneycontrol.com/news/business/personal-finance/-1753225.html
[5] Mandira Sharma, Understanding Basel Norms, 42 EPW. 3364-3367 (2007).
[6] Adrian Blundell-Wignall & Paul Atkinson, Thinking Beyond Basel Iii: Necessary Solutions For Capital And Liquidity, OECD Journal (2010).
[7] Rupa Rege Nitsure, Basel II : Norms Emerging Market Perspective with Indian Focus, 40 EPW. 1162-1166 (2005).
[8]Basel Committee on Banking Supervision, The market risk framework In brief (Jan 2019), https://www.bis.org/bcbs/publ/d457_inbrief.pdf
[9] Huberto M Ennis & David A Price, The Federal Reserve Bank of Richmond, Basel III and the Continuing Evolution of Bank Capital Regulation, 1 Economic Brief (2011).
[10] Anne Maria Slaughter, The Real New World Order, 76 Foreign Aff. 183 (1997)
[11] Narissa Lyngen, Basel III: Dynamics of State Implementation, 53 HARV. INT’l L.J. 519 (2012).
[12] PWC, Basel IV : Big bang- or the endgame of Basel III?, (2017), https://www.pwc.com/gx/en/financial-services/assets/basel-iv-big-bang.pdf
[13] Alicia Tuovila, Risk-Weighted Assets (2020), https://www.investopedia.com/terms/r/riskweightedassets.asp
[14]Capgemini Consulting, Basel IV, Changing the Regulatory Landscape of Banks, https://www.capgemini.com/consulting-nl/wp-content/uploads/sites/33/2017/08/02-014.15_report_road_to_basel_iv_webpdf.pdf
[15] Oleksii Dakal, Basel IV: How can innovation be used to implement the stricter capital requirements? (2020), https://www.capgemini.com/2020/06/getting-ready-to-implement-basel-iv-now-is-the-time-for-innovation/
[16] KPMG, Basel 4 – the journey continues (Sep 2020) https://assets.kpmg/content/dam/kpmg/xx/pdf/2020/08/basel-4-the-journey-continues.pdf
[17] Paolo Cavallino &Fiorella De Fiore, Central banks’ response to Covid-19 in advanced economies, BIS Bulletin (2020), https://www.bis.org/publ/bisbull21.pdf
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