Basel III and IV

Basel III and Basel IV are the third and fourth generations of the Basel Accords, international banking regulations set by the Basel Committee on Banking Supervision (BCBS). They were developed in response to the global financial crisis of 2007–2008 and its aftermath, and aim to strengthen the regulation, supervision and risk management of banks. Basel III was agreed upon by the BCBS in 2010 and implemented from 2013 to 2018. It introduced higher capital requirements for banks, as well as new rules on liquidity and leverage.

Basel IV is nearing implementation and it builds on Basel III and introduces potentially higher capital requirements, as well as new rules on banks’ use ofinternal models for calculating risk-weighted assets. The main objectives of Basel III and Basel IV are to:

• Improve the quality and quantity of capital held by banks

• Enhance banks’ risk management and governance

• Encourage banks to use less risky funding models

Basel III has been generally successful in achieving its objectives. However, there have been some unexpected challenges, particularly around the issue of transitional arrangements. Under Basel III, banks are required to hold more high-quality Tier 1 capital, which consists of equity and certain types of subordinated debt. This has led to a sharp increase in banks’ issuance of Additional Tier 1 (AT1) capital instruments, which are a type of subordinated debt that can be written down or converted to equity in times of stress. However, there have been concerns that some AT1 instruments do not meet the intended criteria of being truly loss-absorbing. In particular, there are concerns that so-called “covenant-lite” AT1 instruments may allow banks to avoid taking corrective action in a timely manner when they are in distress.

There have also been concerns about the treatment of deferred tax assets (DTAs) under Basel III. DTAs can arise when a bank makes losses, which can then be offset against future profits for tax purposes. This can provide a valuable source of loss-absorbing capital for banks. However, Basel III includes a number of provisions that restrict the amount of DTAs that can be included in Tier 1 capital. This has led to fears that banks may be less able to absorb losses in a future crisis. Basel IV builds on Basel III and introduces even potentially higher capital requirements, as well as new rules on banks’ use of internal models for calculating risk-weighted assets.

One of the key changes under Basel IV is the introduction of the standardised approach for measuring credit risk (SA-CCR). This replaces the current practice of using internal models to calculate risk-weighted assets (RWAs), and is intended to provide a more level playing field between banks. However, there are concerns that the SA-CCR may unintentionally penalise banks that have low levels of leverage, as it does not take account of offsetting risk factors such as collateral. This could make it more difficult for such banks to compete with their higher-levered peers.

Another key change under Basel IV is the introduction of the Net Stable Funding Ratio (NSFR). This is intended to encourage banks to fund themselves with more stable sources of funding, such as deposits, rather than more volatile sources such as wholesale funding. However, there are concerns that the NSFR may unintentionally penalise banks that engage in activities such as lending to small businesses, as such activities often require a higher proportion of volatile funding. This could make it more difficult for such banks to compete with their larger peers.

The finalisation of Basel IV had been delayed due to disagreements between national regulators over some of the details. In particular, there is still no agreement on how to treat sovereign debt when calculating risk-weighted assets. This is a significant issue, as sovereign debt is held by many banks and represents a large proportion of their total assets. Another area of disagreement is around the treatment of so-called “too big to fail” banks. There is a proposal to introduce a “systemically important bank” surcharge, which would require these banks to hold even higher levels of capital than other banks. However, this proposal is opposed by some countries, who argue that it would unfairly penalise their largest banks.

The finalisation of Basel IV was also being delayed by the ongoing Brexit negotiations. The UK is a member of the BCBS, but will become a “third country” after Brexit. This means that it will no longer have a say in the development of international banking regulations. However, the UK has said that it intends to continue to implement Basel IV after Brexit. This will require negotiation with the EU, as well as with the BCBS itself. Given the current state of negotiations, it is unclear how this will be achieved. In summary, Basel III has been generally successful in achieving its objectives, but there have been some unexpected challenges. Basel IV is still in the process of being implemented, and may introduce higher capital requirements and new rules on banks’ use of internal models for calculating risk-weighted assets.