Basel IV: The Next Step for Capital Requirements

Introduction

Basel IV will certainly have operational impacts on the day-to-day governance and risk management of financial institutions – but it also stands to have a wider impact on the competitive banking market. These effects could include industry consolidation and a change in banking portfolios, which could eventually lead to a reduction in choice for their customers.

On the one hand, Basel IV will instigate a higher level of financial disclosure, meaning that customers will have more information to help them make choices. However, on the other hand, customers may discover that providers have shrunk their portfolios to mitigate the capital impact of the changes, leaving fewer options open to them.

Basel IV forms part of the arsenal deployed to protect economies from the risk of another financial crisis. A large part of its impact will be on capital requirements, with a projected average increase of an eye-popping 40 percent. While the mandate on capital requirements is intended to create a stronger banking system overall, such a leap clearly represents a sea change for individual banks.

At the same time, the revised method of calculating capital requirements is designed to bring standardization and consistency to the industry.

Measuring Up

The capital requirements of cumulative Basel requirements – coupled with other measures that impact how market, credit and operational risk is managed – create a public standard against which banks will be judged. How they measure up against this standard is increasingly subject to public scrutiny, and there is a higher level of interest in the aftermath of the financial crisis. Consumers are now increasingly more aware of (1) the significance of banks’ operational activities; (2) banks’ policies, processes and practices; and (3) how these policies, processes and practices can impact the economy and society at large.

Most recently, results of the Bank of England’s stress testing – which looked at banks’ capital adequacy and resilience to stand up to a range of challenging hypothetical scenarios – highlighted where more needs to be done by banks to shore up their financial strength. Encouragingly, the banking system as a whole stood up to the test, but some individual shortcomings were exposed – most notably at the Royal Bank of Scotland. Revelations like these can give rise to speculation over how a bank will alter its activities to better capitalize.

Through increased transparency, standardization and stress testing, customers, analysts and investors become more aware of how regulated institutions perform and stack up. Indeed, a lot less is now open to interpretation.

Each institution’s level of compliance and performance becomes a measure of its own good governance and stands to impact the level of trust and faith that customers, investors and analysts have in the business. This in turn impacts the company’s reputation and the choices that investors and individuals make.

The Shift from Tactical to Strategic

Mandates around capital requirements and other market, credit and operational risk activities are shaping the way banks approach risk management. They are also paving the way for more consistent approaches to be taken across the industry.

For the risk manager, this means more standardization with a lot less left up to the judgement of the individual bank. Institutions with a healthy outlook on change will recognize that this presents opportunities as well as challenges.

Undoubtedly, it creates a burden of knowledge acquisition and maintenance – e.g., governance, risk and compliance (GRC) professionals must get (and stay) up-to-speed on all new and changing regulatory requirements.

In the case of the new standardized measurement approach (SMA) capital model, once compliance is in place, the resources that had previously been devoted to the company’s bespoke advanced measurement approach (AMA) capital model can be reassigned to focus on other activities. The adaptable business will ensure these activities add strategic rather than tactical value by, for example, generating business insight through data analytics.

There is also an opportunity to realize efficiencies by replacing or complementing in-house solutions with third-party, enterprise-level software that can routinize the approach to operational risk data management and ensure regulatory compliance.

All of this results in higher levels of interest in an integrated GRC approach and, in particular, the advantages this can bring in terms of information integration across the business and the rapid and efficient transformation of data into management information.

For providers of GRC solutions in the financial services industry, this regulatory reshaping of the way banks manage risk is a significant change. Solutions providers are well positioned to take advantage of the consistency that regulation brings through compliant solutions that calculate, measure and manage risk in line with standards. For banks, the upside is freed-up internal expertise that can refocus on meaningful business analytics to generate opportunities and create market advantage.

Transparency for Informed Choice

For consumers, standardization supports consistency of measurement and reporting. Moreover, much of this goes to the public record, accessible by any investor including consumers. Through this information, consumers are better able to understand how well their bank is capitalized relative to other banks, and are therefore able to make their own judgements over whether that bank is creditworthy enough for them.

This increase in transparency is evident across a range of factors, including operational aspects such as customer service levels. With higher quality information available on the performance of all banks, customers are better able to make informed choices based on the criteria that are important to them.

For banks’ corporate customers, there is likely to be concern over the impact tighter regulation will have on market choice and the cost of providing their services. A competitive marketplace and strict regulatory regime can lead to a reduction in competition, because of bank consolidation and reduced portfolio offerings. The upshot being that, although more information may be available to help consumers and businesses make informed choices about the bank they want to do business with, there may be less choice and higher pricing.

Public scrutiny can lead banks to raise the level of self-assessment they routinely undertake. Generally speaking, this is a positive thing for companies of any type. Regular internal audits and assessments can lead to greater levels of efficiency, a culture of continuous improvement and a focus on the most compliant and effective ways of working.

For banks that are seen to be performing well through their Basel IV reporting, stress test outcomes and other assessments, it is reassuring to customers — and those with a vested interest in those organizations – to know that they meet requirements and are resilient enterprises. Pleasing outcomes from regulatory monitoring and assessments paint a solid picture of an institution’s governance, compliance and risk management.

Shifting Risk

The reasons behind recent regulatory measures, including the latest Basel implementations, are clear. However, the wider impact that these measures will have in a competitive market – including the effects on industry consolidation and consumer choice – should also be considered.

While increased capital requirements are designed to create a stronger banking system, there are implications for the industry as a whole. In the broadest sense, risk within the system will simply be moved around, rather than removed.

If one institution won’t lend to a corporate customer because it can’t cover the risk and meet its capital requirement, that business is still going to get funding from somewhere. The source that provides funds will most likely be one that, while still part of the collective risk of the economy, is less visible than those in the regulated banking market.

The original article was published by GARP. You can view the full article here.