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What is Basel IV & What Does it Mean for Banks?

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Banks handle large amounts of money at all times, which is why regulations must be implemented. These rules ensure that banking institutions remain in good management, safeguarding a country’s general financial system. Germany, in particular, recently reiterated the need for its banks to be regulated to compete globally. Christian Lindner, Finance Minister of Germany, emphasized the need for regulation that focuses on German banks’ competitiveness and support growth through innovation. To their credit, banks such as Deutsche Bank and Commerzbank have recently launched restructuring plans alongside rising interest rates to boost lending income. Meanwhile, the German government — Commerzbank’s biggest shareholder — has been satisfied with its performance thus far. In this post, we’ll look at the recently introduced Basel IV, an EU-wide framework for regulation, and what it means for banks:

What is Basel IV?

Developed by the Basel Committee on Banking Supervision (BCBS), based in Basel, Switzerland, the Basel accords are international banking accords meant to improve the quality of banking supervision worldwide. The BCBS technically has no enforcement powers, and Basel compliance relies on the regulators based on a participating country’s implementations. This means that different countries may apply different solutions from each other, as long as they comply with Basel requirements at the end of the day.

Basel IV is a result of changes in provisions from Basel III — a sum total of the changes made in Basel III by the BCBS. Basel IV is set to begin implementation on January 1, 2023, but banks will have five years to comply with the accords fully. According to the Basel Committee, the principal goal of Basel IV is to restore credibility in the calculations of risk-weight assets (RWAs) and improve the comparability of banks’ capital ratios. As Basel compliance ultimately relies on how participating countries will meet these requirements, this begs the question: how will Basel IV affect European banks?

Banks must comply with the output floor

One of the critical components of the Basel IV implementation is the introduction of the output floor, which was not previously present in Basel III. The output floor is designed to reduce inconsistencies in risk-weighted assets, preventing RWAs and minimum capital requirements from falling below inappropriately low levels. Initially, the European Commission’s Basel IV proposals aimed for an output floor to only apply in full at the highest level, or by standalone institutions within the EU. In August 2022, the legislative amendments from the European Parliament proposed that the output floor should apply in full to all financial institutions. The only exception is to be made for institutions that are part of a group with a parent company based in the same EU member state and which is itself subject to the output floor.

Banks need to comply with additional risk management regulations

In banking, risk management refers to the development and execution of a plan to mitigate potential losses. The weaker the risk management, the more vulnerable a financial institution is to loss of monetary assets and data. As such, banks will need to invest in a Basel IV reporting solution that collects higher volumes of data to apply the required calculations, projects Basel constraints under stress and BAU scenarios for business optimization. This will then take Basel constraints into account to produce capital planning that follows the framework’s demands. Investing in Basel IV reporting solutions can also help banks deliver their prudential risk reporting in a timely and accurate manner. Banks should look at potential scalable solutions and tools that cover all standardized approaches across as many risk types and as many bank sizes.

Banks face high implementation costs and higher capital requirements

Lastly, banks in Europe are particularly affected by Basel IV as they are faced with higher capital requirements as a result of the revised standards. This is because many European banks use internal models extensively, and their exposure is often significantly concentrated in areas with lower risk weightings. With the introduction of the output floor discussed above, the limits on risk weightings will strongly impact many European banks. Ultimately, banks must work on adapting systems, processes, and methodologies to comply with the new Basel IV standards while retaining a competitive edge.

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