What does Basel IV mean for EU banks? A quick review of the challenges and opportunities

The finalisation of Basel IV marks a significant milestone in the ongoing evolution of global banking regulation. These comprehensive reforms, concluded by the Basel Committee on Banking Supervision in 2017, introduce critical changes across various dimensions, including risk measurement, capital adequacy, and reporting requirements. In the European Union, Basel IV translates into substantial amendments to the Capital Requirements Regulation (CRR III) and Capital Requirements Directive (CRD VI), embedding the final Basel III framework into EU law with specific regional adjustments.

Last month, the European Parliament has passed the EU Banking Package, including amendments to Directive 2013/36/EU, known as the Capital Requirements Directive or CRD VI and Regulation (EU) No 575/2013, the Capital Requirements Regulation 3 (CRR3), signaling for the banks that have put off their preparations to start their preparation. As banks brace for the phased implementation of these rigorous standards, the path forward demands strategic planning, substantial investments in technology, and robust risk management practices to navigate the complex regulatory landscape and ensure compliance while maintaining competitiveness in the global market.

To begin with, Basel IV leads to changes in capital requirements, with an increase in Tier 1 Minimum Required Capital (MRC) for EU banks. Overall, the increase in Tier 1 MRC for EU banks under the implementation of Basel IV signifies a shift towards stronger capital buffers and enhanced risk management practices to promote financial stability and resilience in the banking sector. The implementation of the final Basel III standards under the EU-specific scenario is expected to raise Tier 1 MRC, driven by factors such as the output floor, operational risk, and market risk. These changes in capital requirements reflect the impact of Basel IV on the regulatory landscape for EU banks, necessitating adjustments to meet the new standards and ensure compliance with the updated framework.

This means that EU banks will need to ensure they have sufficient Tier 1 capital to meet the increased Tier 1 Minimum Required Capital (MRC) requirements under Basel IV. This may involve raising additional capital through various means such as issuing new shares or retaining earnings. Also, with changes in capital requirements driven by factors like the output floor, operational risk, and market risk, EU banks will need to enhance their risk management practices. This includes improving risk measurement models, monitoring operational risks more closely, and managing market risk exposures effectively.

Inevitably, adapting to the new Basel IV standards may incur additional compliance costs for EU banks. This could involve investments in technology, staff training, and regulatory reporting systems to meet the updated requirements. Overall, the increase in Tier 1 MRC may impact the competitiveness of EU banks compared to their global counterparts. Banks that effectively manage the transition to Basel IV and maintain strong capital positions may have a competitive advantage in the market. This means that the EU banks will need to incorporate the impact of Basel IV into their strategic planning processes. This includes assessing the implications of higher capital requirements on business strategies, capital allocation decisions, and overall risk appetite.

Basel IV also introduces changes to market risk regulations, particularly through the Fundamental Review of the Trading Book (FRTB). Overall, the changes to market risk regulations under Basel IV, including the FRTB, will require EU banks to enhance their risk management capabilities, adjust their capital planning strategies, manage compliance costs, and make operational changes to meet the new regulatory requirements effectively. FRTB redefines the boundary between the banking book and the trading book, introduces new standardized and internal model approaches, and enhances risk-sensitive rules for capital absorption. New templates capture detailed information on instruments and positions under different approaches.

Changes to the FRTB framework can have several impacts on EU banks. To begin with, the redefinition of the boundary between the banking book and the trading book, along with the introduction of new standardized and internal model approaches, will require EU banks to enhance their risk management practices. Banks will need to improve their ability to measure and monitor market risk exposures more accurately. Furthermore, the implementation of the FRTB under Basel IV may lead to changes in capital requirements for EU banks. The new risk-sensitive rules for capital absorption could result in adjustments to the amount of capital banks need to hold to cover market risks.

It should also be considered that adapting to the new market risk regulations and implementing the FRTB framework may incur additional compliance costs for EU banks. This includes investments in technology, data management, and risk modeling capabilities to comply with the enhanced requirements. But more importantly, EU banks will need to make operational changes to ensure they can capture detailed information on instruments and positions under the different approaches mandated by Basel IV. This may involve updating systems, processes, and reporting mechanisms to meet the new regulatory standards. Banks should consider these as an opportunity as effective implementation of the FRTB requirements and management of market risks in line with Basel IV standards may enhance their competitive positioning. Strong risk management practices and compliance with regulatory standards can contribute to a bank's reputation and stability in the market.

Furthermore, Basel IV significantly impacts banks' risk measurement and models, requiring adjustments to comply with the new standards. Banks with legacy IT, data, and reporting systems may face cost pressures as they update their systems to meet the new requirements. This means that banks with legacy IT, data, and reporting systems may face significant cost pressures as they need to update their systems to comply with the new risk measurement standards under Basel IV. This could require investments in technology infrastructure, data management systems, and reporting tools to meet the enhanced requirements. Implementing new risk measurement models and adjusting existing systems to comply with Basel IV can pose operational challenges for EU banks. This may involve redesigning processes, training staff on new systems, and ensuring data accuracy and consistency across the organization.

Again, adapting to the new risk measurement and modeling requirements of Basel IV may lead to increased compliance costs for EU banks. This includes expenses related to system upgrades, staff training, and regulatory reporting to ensure alignment with the updated standards. Hence, banks that effectively navigate the challenges of updating their risk measurement and modeling systems under Basel IV may enhance their competitive position. Banks that can efficiently implement the necessary changes and maintain robust risk management practices may differentiate themselves in the market.

Basel IV also introduces changes in reporting areas, including shadow banking, crypto assets, non-performing exposures, and ESG. Banks will need to adapt their systems to collect, analyze, and report the necessary data in these areas. This will require banks to adapt their systems to collect, analyze, and report data related to these new reporting areas, which may require enhancements to data collection processes, data management systems, and analytical capabilities to ensure accurate and timely reporting. In particular, adapting to the new reporting requirements for shadow banking, crypto assets, non-performing exposures, and ESG can pose compliance challenges for banks. Ensuring that the necessary data is collected, analyzed, and reported in accordance with regulatory guidelines may require additional resources and expertise.

On the other hand, the inclusion of new reporting areas in Basel IV highlights the importance of effective risk management practices in these areas. Banks will need to assess and manage risks associated with shadow banking activities, crypto assets, non-performing exposures, and ESG factors to comply with regulatory requirements and safeguard their financial stability. Needless to mention, implementing changes in reporting areas under Basel IV may necessitate operational adjustments within banks. This could involve updating reporting systems, training staff on new reporting requirements, and establishing processes to ensure data accuracy and completeness in the identified areas. From a strategic standpoint, it is imperative that banks incorporate the impact of changes in reporting areas into their strategic planning processes. Understanding the implications of reporting on shadow banking, crypto assets, non-performing exposures, and ESG factors can help banks align their business strategies and risk management practices with regulatory expectations.

From a time-planning perspective, it should be noted that the deadline for implementing the Banking Package – Capital Requirements Directive VI (CRD VI) and Capital Requirements Regulation 3 (CRR3) in the EU is 1 January 2025, whereas the date for the first application of reports based on the Basel III requirements in the EU, as part of the European Banking Authority's (EBA) two-step sequential approach to amend Pillar 3 disclosures and supervisory reporting ITS is 31 March 2025, as announced in its December roadmap. This means that implementation will not be a one-off event, but an ongoing process for some time, that banks must prepare for. These key dates mark significant milestones in the implementation of Basel IV and the regulatory changes affecting banks in the European Union, emphasizing the importance of compliance and readiness for the new standards and reporting requirements.

With substantial changes to capital requirements, risk measurement models, market risk regulations, and reporting standards, banks must adapt to ensure compliance and maintain competitiveness. The increase in Tier 1 Minimum Required Capital, the introduction of the Fundamental Review of the Trading Book, and new reporting areas, including shadow banking and ESG, necessitate robust risk management and substantial investments in technology and systems. EU banks must incorporate these regulatory changes into their strategic planning, aligning their business strategies, capital allocation, and risk appetite with the new standards.

While the transition to Basel IV may incur additional compliance costs and operational challenges, it also offers banks the opportunity to strengthen their risk management practices and enhance their market position. Banks are urged to take proactive steps now to navigate these reforms effectively, ensuring they are well-prepared to meet the new regulatory landscape and capitalize on the benefits of a more resilient and stable financial system.