Basel IV: Six Things Swedish Banks Need to Know

“The right change, the right way, with the right people”

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More than a decade has passed since the based on four classes of risk: loans to state, financial crisis of 2007-08 and almost a year since banks, housing and corporates. the Basel Committee for Banking Supervision published Basel IV. In this 421 Perspectives “This was considered too inflexible, and in Basel paper, we look at some of the ramifications on II it was changed to capital requirements that the banking sector in Sweden. are more based on risk, and where the level of risk can be calculated by the banks themselves. Background However, this system, with internal models for risk calculation, has led to a dramatic drop in the Before we get to Basel IV, let’s rewind back to capital requirements,” stated af Jochnick the initial phase of Basel I-III, which all aimed to enhance the stability of the financial system Basel III introduced output floors to prevent risk after the financial crisis of 2007-08 by increasing weighted assets (RWA) from reaching too low regulatory capital. levels.

Around the time Basel III was launched, the The new floor would mean that no bank would Swedish House of Finance here in Stockholm be allowed to have their RWA below a certain arranged a seminar to discuss the potential quota of their value. impact on the Swedish banking sector. The European Banking Authority (EBA)’s October Kerstin af Jochnick, from the Riksbank (Sweden’s 2018 report, Basel III Monitoring Exercise, central bank and one of the parties representing details a “five year transitional period for the Sweden at the Basel Committee for Banking implementation of the output floor, according Supervision), discussed how, in the first directive, to which the percentage of the floor, i.e. the Basel I, the size of the capital requirements was percentage of the non‐-modelled RWA, will

gradually increase from 50% in 2022 to fully 2. There are new constraints on the use of phased‐ in level of 72.5% in 2027. internal models for credit risk (BCBS 362)

The impact of the output floor during the first The constraint is made to the estimates of risk two years of the phase ‐in period is negligible for parameters used by the banks to calculate the G‐SIIs, while it is significantly above 1% for Group risk-weighted assets using the internal ratings- 2 banks. Table 11 shows that the increase in the based (IRB) approach. The constraint implies output floor percentage has an impact on the e.g. removing the option to use the A-IRB output floor during the phase ‐in period.” approach for exposures to large corporations and financial institutions. Imposing loss given More Robust and Resilient Swedish Banking default, probability of default and exposure at Sector default floors for remaining corporate and retail IRB-approaches. The successor, Basel IV, presented on 7th December 2017, seeks to restore credibility in the 3. Operational risk gets a standardized calculations of the RWA. It essentially completes measurement approach (BCBS 355) the work that the Basel Committee for Banking Supervision has been undertaking since 2012 to Eliminating the advanced measurement recalibrate the Basel III framework. approach (AMA) for operational risks. Also, fines for bad behavior and cost of computer hacks are Basel IV places stronger emphasis on the now considered in the capital requirement to standardized models and to reduce the variability cover such operational risks. of the framework for RWA. The impact of Basel IV reforms is mainly concentrated in credit risk 4. The output floor has been revised (BCBS and are primarily driven by the new output floor. 306/362)

Here are six things the Swedish banking sector As mentioned above, the revised output floor needs to know about Basel IV to encourage a will limit the amount of capital benefit a bank more robust and resilient banking sector here can derive from using internal models, relative in Sweden. to using the standardized approaches. The output floor has been set to 72.5% but will be 1. There Are Revised Standardized Approaches implemented over a five-year period, starting for Credit Risk (BCBS 347) from 50 % on 1st of January 2022. This will help ensure reasonable and orderly transition to the The revised standardized approach mortgages new standards. risk weights depend on the loan-to-value (LTV) ratio of the mortgage, instead of assigning a 5. There’s a new framework for market risk flat risk weight to all residential mortgages. Risk (FRTB) (BCBS 352) weights for banks and companies is determined by external credit ratings. Strengthening capital standards for market risk. The new framework will better be capturing tail and liquidity risks. New boundary between

exposures in the trading book and the banking Banks might also consider lifting exposures books. This becomes effective by 2022. from the balance sheet. This could be especially interesting for those banks that have a higher 6. There are additional requirements for G-SIBs proportion of assets covered by the IRB approach.

The leverage ratio framework includes a leverage European banks have historically not used ratio surcharge for the largest banks, introducing securitization to reduce funding costs or lower a leverage ratio buffer of 50% of the risk-based capital requirements, the new regulations might capital buffer. E.g. a bank with a 4% risk-based change that. buffer will have a 2% leverage ratio buffer and hence will be expected to maintain a leverage Are the shock absorbers thick enough? ratio of at least 5%. The new Basel framework will increase the The Basel IV Effect thickness of banks’ shock absorbers. It will also facilitate the possibility to compare the risks In late 2016, a study disclosed that the four between banks better, since the output floors largest Swedish banks might need as much as will limit impact of differences in the internal 65 billion SEK in additional CET1 capital under models. the new regulatory requirements. This can be compared to the four largest banks’ total profit of But the trillion-kronor question is if the shock 105.7 billion SEK during 2017. absorbers are thick enough when put to real use in an economy where ultra-low interest rates has The reason why Swedish banks are more exposed left the central banks out of ammunition. Only to the new changes compared to others, can be time will tell... se found in their low losses in mortgage portfolios, and to the extent which they have chosen to use the internal models. Since Swedish banks have relatively low loss given default (LGD) estimates, there will be a need for more regulatory capital 421 is a trusted consulting partner under the new rule. within the financial services sector with extensive experience in Regulatory What can Swedish banks do? Compliance, Business Development and IT Transformation. Contact us at There are different ways of how to bolster [email protected] the balance sheets with more equity, hence increasing the regulatory capital:

• Raise new equity • Reduce lending volumes • Lower dividend pay-outs • Increase interest rates on lending and adjust the price of their product offering.