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Executive Education

Professor Jean Dermine
Professor Jean Dermine
Risk Management in Banking

Basel IV: Big Bang or Damp Squib?

Professor Jean Dermine

Jean Dermine, Professor of Banking and Finance at INSEAD, Programme Director for both Risk Management in Banking and Strategic Management in Banking programmes, discusses the implications of Basel IV for the global banking sector.

"Now, after some 10 years of hard work, the BCBS hopes its job is finally done.
But is it really the end? That’s the question!" Professor Jean Dermine

On 7 December 2017, the Basel Committee on Banking Supervision (BCBS) finalised the Basel III reforms. The BCBS, which is the primary global standard setter for the prudential regulation of banks, has been working for years to achieve this. What is the impact of this development?

For almost 50 years, the BCBS has been trying to overhaul global capital standards and establish a voluntary regulatory framework on bank capital adequacy. In simple terms, this means devising guidelines to strengthen banks’ resilience by improving capital and liquidity management and reducing banks’ solvency.

So far, the BCBS has come up with various sets of rules, known as the Basel Accords. The BCBS started developing a third instalment of these rules, Basel III, in response to deficiencies in financial regulation revealed by the 2007–09 global financial crisis.

However, it’s taken until now – almost a decade – for the BCBS to declare Basel III complete. The last 12 months have been especially difficult, with BCBS members struggling to reach agreement on a complex set of revisions to Basel III – revisions which some commentators dubbed ‘Basel IV’. Now, after some 10 years of hard work, the BCBS hopes its job is finally done. But is it really the end? That’s the question!

In big-picture terms, what does Basel IV mean for the banking industry? What must banks now do differently as a result of the reforms?

Broadly, the philosophy behind Basel IV is to reduce the flexibility given to banks in measuring risk, and to stop them from setting their own risk rules.

About 10 years ago, the BCBS came up with a set of credit risk measurement techniques that it recommended banks adopt. Known as the internal ratings–based approach, it gave banks leeway to use their own bespoke models to gauge asset risk and calculate capital requirements.

Basel IV aims to reform the use of such models for calculating risk. The regulators and central banks had become concerned over the wide variations among banks in the way they calculated the risk of holding the same assets. To combat this, the BCBS is recommending imposing limits on how far the biggest banks’ models can diverge from the regulators’ more conservative calculations.

Under the new framework, banks’ total assets, weighted for risk using their own models, cannot be less than 72.5 per cent of the amount calculated using the simpler standardised approach put forward by BCBS.

How has the sector reacted to these proposed reforms?

As banks assess the strategic implications and start working out how they are going to allocate capital, I see many already asking themselves: “Are we really better off sustaining the tremendous costs required to implement these immensely complex reforms? Would it not make sense for everyone to simply go back to using the less costly standardised approach?”

Do you agree with those commentators?

No. The standardised approach is too crude and limited to achieve results. My main concern about Basel IV is its rigidity. We’re almost going back to where we were with Basel I, some 30 years ago. The inflexibility and simplicity of that protocol gave rise to ingenious ways of circumventing some of its more stringent rules. For example, banks were required to set aside what many considered was far too much capital for safe assets. This created a massive incentive for them to move business outside the balance sheet and into a securitisation-backed ‘shadow banking’ system. Obviously, any type of shadow banking system is highly problematic, not least because in such a situation risk doesn’t disappear – it is just moved elsewhere.

Are there other areas where you think more work needs to be done to make the Basel rules more consistent?

The proposed treatment of banks’ sovereign debt holdings is a concern. It gives regulators discretion to allow banks to treat their government bond holdings denominated in domestic currency as safe. In other words, banks are free to set the risk weight on such bonds as zero, which means they can load up on domestic sovereign bonds without needing to raise any more capital. As a result, some banks currently serve as major creditors to their respective governments. But that introduces concentrated risk into the banking system – if investors turned against those bonds, for instance, the banks concerned could suffer severe losses and the creditworthiness of their respective governments could be called into question, causing more instability. It’s a loose end that the BCBS still needs to resolve.

Then there is the issue of bail-in bonds, a key instrument in the BCBS’s plan to impose principal losses on creditors – rather than on the public purse – during times of firm-wide financial distress. The Basel rules require all new non-equity capital to have a bail-in feature, but it is not clear how this will work in practice. And because it puts investors at risk, it also creates massive instability in the banking system.

Some commentators have said that the new Basel rules mean that banks may now face a combined capital shortfall. What’s your view? Will some banks have to consider raising more capital?

I don’t think there will be a capital shortfall. The reforms will result in an average increase in minimum capital of 12.9 per cent for banks in the European Union, according to estimates by the European Banking Authority, based on 2015 balance sheets.[1]  That’s not that large an increase. In any case, if they were going to have to raise vastly more capital, countries with the largest banks would never have signed up to the agreement.

But wasn’t there prolonged resistance from France and Denmark, especially to the proposed reforms? How was this resolved?

France and Germany opposed Basel IV because they felt the reforms would disproportionately affect their banks. European banks tend to keep mortgages on their balance sheets, whereas many US banks often sell on or securitise mortgages. So, the European banks were concerned that any move to constrain their internal models for calculating risk in asset classes such as mortgages would affect them more than their US counterparts. In the end, the BCBS came up with a more flexible set of rules for real estate financing that was acceptable to both US and European banks and means that neither will need to risk more capital.

Do you think Basel IV will make the financial system robust enough to withstand another global financial crisis?

I hope so but, in many respects, the rigidity of Basel IV almost takes us back to Basel I, which is clearly not satisfactory. So, we must expect that the BCBS will need to make further changes.

However, I have great faith in the current chair of the BCBS, Stefan Ingves, who is also governor of Sweden’s central bank, the Sveriges Riksbank. He was a driving force behind sorting out Sweden’s banking crisis in the early 1990s, and if anyone can make the Basel rules fit for purpose, it’s him.

[1] European Banking Authority, Cumulative Impact of the Basel Reform Package, 7 December 2017