Govind Gurnani

Basel IV Framework : Strengthening Capital Requirements In

The Banks

Basel IV is a package of banking reforms developed in response to the

2008-09 financial crisis. It is a comprehensive set of measures that
makes significant changes to the way banks calculate risk-weighted
assets for capital adequacy ratio. Basel IV included new standards for
credit risk, operational risk and a credit valuation adjustment. It
introduced an output floor, revisions to the definition of the leverage ratio
and the application of the leverage ratio to global systemically important
banks.

1. New Standards For Credit Risk

An analysis of Internal Rating Based approaches for credit risk by the

Basel Committee on Banking Supervision highlighted a high degree of
variability in bank’s calculation of their risk weighted assets. It was
found that advanced internal risk models give banks the most freedom
to estimate their credit risk, often yielding a much lower risk than the
regulator’s standard model. Basel IV reforms for credit risk aims to
restore credibility in those calculations by constraining banks’ use of
internal risk models.

Revised Standardised Approach For Credit Risk

The new Standardised Approach framework for credit risk explicitly

requires banks to assess the risk of their exposures at origination and
on an annual basis. Banks are also required to assess whether risk
weights applied are appropriate and prudent.

Exposure To Banks And Corporates

Risk weights have been modeled based on underlying external ratings

and due diligence to ensure that the rating properly re ects underlying
risk of the exposure. It is to be assumed that 5 per cent of total
exposures fail the due diligence requirement and need to be backed by
a higher risk weight. Corporate SME exposure receives a risk weight of
85 percent.
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 Exposure To Sovereign

Risk weight for exposure to sovereign is to be applied according to

external rating of the country.

Regulatory Retail And Other Retail Exposures

i) Regulatory Retail : Qualifying revolving retail exposure and other non-

SME exposures receive a risk weight of 75 percent.

ii) Other Retail : All other retail exposures are to be risk weighted at 100
per cent.

Exposures Related To Equity And Subordinated Debt

Risk weights for equity and subordinated debt exposure are to be

applied in the range of 150-250 per cent. It is assumed that average
risk of approximately 200 per cent is applied to these exposures.

Exposure To Real Estate

There is increased sensitivity for exposures secured by commercial and

retail real estate, with greater emphasis placed on the loan to value ratio
as the driver of the risk weight. Under this, it is to be assumed that 20
per cent of the exposures is highly dependent on the cash ow of the
underlying property.

2. New Standards For Operational Risk

As de ned by the BCBS, operational risk refers to the risk of loss

resulting from inadequate or failed internal processes, people and
systems or from external events. This de nition includes legal risk, but
excludes strategic and reputational risk.

Prior to Basel IV, there were 3 approaches for assessment of

operational risk capital under Basel Accord viz. Basic Indicator
Approach, The Standardised Approach, and Advanced Measurement
Approach.
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 Under Basel IV, Standardised Measurement Approareplaces above
mentioned three approaches for assessment of operational risk capital.

Standardised Measurement Approach

Under the new standardised measurement approach (SMA), operational

risk capital is calculated as follows:

Operational Risk Capital = Business Indicator Component x Internal

Loss Multiplier

Business Indicator Component

Business Indicator Component (BIC) corresponds to a progressive

measure of income that increases with a bank’s size. It serves as the
baseline capital requirement and is calculated by multiplying the
Business Indicator (BI) by marginal coe cients.

The BI is a nancial statement-based proxy for operational risk

consisting of sum of three following elements, each calculated as the
average over three years:
1. the interest, leases and dividend component;
2. the services component; and
3. the nancial component.

Marginal coe cients are regulatory determined constants based on the

size of the BI.

Internal Loss Multiplier

The internal loss multiplier (ILM) is a risk-sensitive component capturing

a bank’s internal operational losses. It serves as a scaling factor that
adjusts the baseline capital requirement depending on the operational
loss experience of the bank. It is proportional to the ratio of the loss
component (LC) and the BIC, whereby the LC corresponds to 15 times
the average annual operational risk losses incurred over the previous 10
years. In calculating the LC, banks need to meet the requirements on
loss data identi cation, collection and treatment.
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 3. Standards For Credit Valuation Adjustment

Credit valuation adjustment (CVA) risk of derivative instruments was a

major source of loss for banks during the Global Financial Crisis and
was revised in 2020 following the release of the Basel III reforms.

Meaning Of CVA Risk

CVA risk refers to the risk of losses arising from changing CVA values in
response to movements in counterparty credit spreads and market risk
factors that drive prices of derivative transactions and securities
nancing transactions (SFTs).

What Are SFTs?

Securities nancing transactions (SFTs) allow investors and rms to use

assets, such as the shares or bonds they own, to secure funding for
their activities.

A securities nancing transaction can be

1⃣ a repurchase transaction - selling a security and agreeing to

repurchase it in the future for the original sum of money plus a return for
the use of that money

2⃣ lending a security for a fee in return for a guarantee in the form of

nancial instruments or cash given by the borrower

3⃣ a buy-sell back transaction or sell-buy back transaction

4⃣ a margin lending transaction

The CVA risk capital requirements are calculated for a bank’s “CVA
portfolio” on a standalone basis. The CVA portfolio includes CVA for a
bank’s entire portfolio of covered transactions and eligible CVA hedges.

Approaches For CVA Capital Requirements

There are two approaches for calculating CVA capital requirements: the
standardised approach (SA-CVA) and the basic approach (BA-CVA).
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Banks must use the BA-CVA unless they receive approval from their
relevant supervisory authority to use the SA-CVA.

Basic Approach -CVA

The BA-CVA has been revised into a reduced and full version. This
approach has more granular counterparty type risk weights while the
rating buckets have been simpli ed into two categories. Banks have to
adjust parameters in their regulatory calculation engine and evaluate
how they record their CVA weight mappings.

Furthermore, banks employing CVA hedges will have to manage bigger

impacts on their calculations, due to the intricacies involved in its
consideration of hedges, as well as it being a two-part calculation
(reduced and full) that must be combined for the nal CVA result.

Standardised Approach - CVA

The new standardised approach (SA-CVA) is more granular and risk

sensitive, requiring pre-modelled inputs not previously needed for CVA.
In the past, CVA could have been done within the credit risk process
with only credit risk inputs; however, banks now need to consider
market volatilities, correlations, and credit spreads given that CVA
aligns with the revised market risk framework.

4. Introduction Of Output Floor

Since the publication of Basel II, the banks generally use two methods
to determine minimum capital requirements viz. Standardised Approach
(SA) and Internal Ratings Based Approach (IRBA).

Standardised Approach prescribes risk weights for all categories of

risk assets.

Internal ratings based approach considers the actual risk situation of

a bank by modelling credit risk based on internal and external
customer-speci c data. The use of IRBA requires constant investment
in model development and validation but allows a great deal of leeway
to determine and possibly reduce a bank’s minimum capital
requirements. As a result of these advantageous e ects, major banks
have implemented IRBA years ago with the introduction of Basel II
requirements.
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 However, the targeted review of internal rating models used in the
banks by BCBS in 2019 concluded that the risk-weighted assets (RWA)
calculated using internal models are in some cases highly inconsistent
and therefore unreliable, unlike RWA calculated using SA. At di erent
banks, the risk quanti cation of the same loan portfolio led to varying
RWA results due to critical de ciencies in the development of
probability of default (PD) and loss given default (LGD) models and in
the assessment of data quality. The numerous shortcomings of internal
models are now to be corrected by introducing the output oor from the
nalised Basel III reform.

The introduction of output oors means that the RWAs calculated using
internal models cannot fall below a given percentage of the RWAs
calculated using the standardised approach.

From 2023 onwards, an RWA result calculated according to the IRBA

should be at least 50% of the RWA calculated with SA. Subsequently,
the output oor will increase by ve percentage points annually until it
reaches its nal value of 72.5 % in 2028 viz.
2023 : 50%
2024 : 55%
2025 : 60%
2026 : 65%
2027 : 70%
2028 : 72.5%

Despite the gradual introduction of the output oor, it is essential that

the banks and nancial institutions should start looking into the
acquisition of additional capital, as the cost of capital is likely to
increase due to rising demand.

5. Revised De nition Of Leverage Ratio

The leverage ratio is de ned as the capital measure, being Tier 1 capital
divided by exposure measure, with this ratio expressed in percentage.

The exposure measure is the sum of following exposures : i) on balance

sheet exposures (excluding on balance sheet derivative and SFT
exposures ii) derivative exposures iii) SFT exposures and iv) o balance
sheet (OBS) exposures.
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In the light of impact over leverage ratio, the BCBS has proposed
amendments to the exposure measure of leverage ratio.

The Basel IV standard includes :

i) more detail and examples in response to speci c challenges raised by
the industry ( the treatment of regular way purchases and cash pooling
in the exposure measure)

ii) an alignment of elements of the LR framework with the other

elements of Basel IV package (e.g. SA-CR and securitisations
framework for OBS exposures and SA-CCR for derivative potential
future exposure calculations); and

iii) adjustments to various other elements of the calculation of the

exposure measure.

Banks globally have been prescribed to hold a leverage ratio at 3% of.

the tier 1 capital (common equity tier 1 plus Additional tier 1 capital)
against total exposures. RBI’s prescription for LR is at 4% for D-SIBs
and 3.5% for other banks.

6. Additional Requirement Of Leverage Ratio For Global- Systemic

Important Banks (G-SIBs)

In order to maintain the relative roles of the risk-based capital and

leverage ratio requirements, the banks identi ed as G-SIBs are require
to meet a leverage ratio buffer requirement.The leverage ratio buffer will
be set at 50% of a G-SIB’s higher loss-absorbency risk-based
requirements. For example, a G-SIB subject to a 2% higher loss-
absorbency requirement would be subject to a 1% leverage ratio buffer
requirement.

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