TWN Info Service on Finance and Development (Dec17/01)
15 December 2017
Third World Network

BCBS finalises Basel III/IV reforms
Published in SUNS #8595 dated 13 December 2017

Geneva, 12 Dec (Chakravarthi Raghavan*) - After a long period of consultations and efforts to bridge mainly trans-Atlantic differences, top international central bankers and regulators have struck a deal on bank capital rules, and made public the global regulatory framework of the banking sector, enhancing capital requirements for banks to ensure a resilient banking system to support the real economy through the economic cycle.

The long-awaited standards and regulatory framework were finalised and made public last week (on Thursday, 7 December) by the Basel Committee on Banking Supervision (BCBS), with its secretariat located at the Bank for International Settlements (BIS) in Basel.

While the framework of reforms and changes announced formally is to the current regulatory framework in Basel-III, they are so wide-ranging (in the wake of the global financial crisis unleashed in 2008) that the framework is now being unofficially characterised as Basel IV.

Formally (for BCBS), the package is a tightening up of the Basel III, but bankers dubbed it Basel IV because of its stringent requirements.

However, only the future will tell whether Basel IV will avert the kind of crisis that the financial sector saw after 2008 (with banks having to be rescued by the public tax-payer) or whether the actors in the financial sector, now many times the size of the real economy and seemingly with a life of its own, will find ways to get around regulations, and spring a new financial crisis on the world.

Many of the standards and requirements of Basel IV will kick in over a long period of about 10 years, with national banking supervisors given an element of flexibility in applying them, both on time-periods and relaxing (temporarily) capital requirements.

Initial indications are that European banks would be most impacted, needing to increase their capital, due among others, to limits on how much their biggest banks can diverge from regulators' risk calculations for assets such as mortgages.

[According to US media reports, citing the Institute of Bankers, many of these major European and non-US banks, functioning in the USA, with large loan operations in the US, will also be hit as a result of proposed changes to the US tax code, passed in both houses of Congress and in process of different versions being reconciled, about to be enacted in the US. Reports show that unless there are last-minute changes, these foreign banks in the US will be forced to cut back on their lending operations.]

The reformed global regulatory framework of the banking sector, enhancing capital requirements for banks, will ensure a resilient banking system and provide a foundation for a resilient system to support the real economy through the economic cycle, according to the documents made public by BCBS.

A press release and executive summary of the detailed note published by the BCBS, summarises the main features of the finalised Basel III reforms.

The standards text, which provides the full details of the reforms, is published separately and is available on the BIS website at

The revised Basel III framework is a central element of the Basel Committee's response to the global financial crisis. It addresses a number of shortcomings in the pre-crisis regulatory framework and provides a foundation for a resilient banking system that will help avoid the build-up of systemic vulnerabilities. The framework will allow the banking system to support the real economy through the economic cycle.

The initial phase of Basel III reforms focused on strengthening of several components of the regulatory framework.

The Committee's now finalised Basel III reforms complement these improvements to the global regulatory framework. The revisions seek to restore credibility in the calculation of risk-weighted assets (RWAs) and improve the comparability of banks' capital ratios.

Credit risk accounts for the bulk of most banks' risk-taking activities and hence their regulatory capital requirements.

The standardised approach is used by the majority of banks around the world, including in non-Basel Committee jurisdictions. This approach has now been revised to enhance the regulatory framework, and are outlined in Table 1 of the documents made public.

In summary, the key revisions are as follows:

* A more granular approach has been developed for un-rated exposures to banks and corporates, and for rated exposures in jurisdictions where the use of credit ratings is permitted.

* For exposures to banks, some of the risk weights for rated exposures have been re-calibrated. In addition, the risk-weighted treatment for un-rated exposures is more granular than the existing flat risk weight. A standalone treatment for covered bonds has also been introduced.

* For exposures to corporates, a more granular look-up table has been developed. A specific risk weight applies to exposures to small and medium-sized enterprises (SMEs). In addition, the revised standardised approach includes a standalone treatment for exposures to project finance, object finance and commodities finance.

* For residential real estate exposures, more risk-sensitive approaches have been developed, whereby risk weights vary based on the LTV ratio of the mortgage (instead of the existing single risk weight) and in ways that better reflect differences in market structures.

* For retail exposures, a more granular treatment applies, which distinguishes between different types of retail exposures. For example, the regulatory retail portfolio distinguishes between revolving facilities (where credit is typically drawn upon) and transactors (where the facility is used to facilitate transactions rather than a source of credit).

* For commercial real estate exposures, approaches have been developed that are more risk-sensitive than the flat risk weight which generally applies.

* For subordinated debt and equity exposures, a more granular risk weight treatment applies (relative to the current flat risk weight).

* For off-balance sheet items, the credit conversion factors (CCFs), which are used to determine the amount of an exposure to be risk-weighted, have been made more risk-sensitive, including the introduction of positive CCFs for unconditionally cancellable commitments (UCCs).

Several major banks however use an internal ratings-based (IRB) approach for credit risk, rather than the standardised approach.

The 2008 financial crisis highlighted a number of shortcomings related to the use of internally modelled approaches for regulatory capital, including the IRB approaches to credit risk.

These shortcomings include the excessive complexity of the IRB approaches, the lack of comparability in banks' internally modelled IRB capital requirements and the lack of robustness in modelling certain asset classes.

To address these shortcomings, the BCBS has made several revisions to the IRB approaches: (i) removed the option to use the advanced IRB (A-IRB) approach for certain asset classes; (ii) adopted "input" floors (for metrics such as probabilities of default (PD) and loss-given-default (LGD)) to ensure a minimum level of conservativism in model parameters for asset classes where the IRB approaches remain available; and (iii) provided greater specification of parameter estimation practices to reduce RWA variability.


The BCBS agreed on various additional enhancements to the IRB approaches to further reduce unwarranted RWA variability, including providing greater specification of the practices that banks may use to estimate their model parameters.

Adjustments were made to the supervisory specified parameters in the F-IRB approach, including: (i) for exposures secured by non-financial collateral, increasing the haircuts that apply to the collateral and reducing the LGD parameters; and (ii) for unsecured exposures, reducing the LGD parameter from 45% to 40% for exposures to non-financial corporates.

Given the enhancements to the IRB framework and the introduction of an aggregate output floor, BCBS has agreed to remove the 1.06 scaling factor that is currently applied to RWAs determined by the IRB approach to credit risk.


The initial phase of Basel III reforms introduced a capital charge for potential mark-to-market losses of derivative instruments as a result of the deterioration in the creditworthiness of a counterparty.

This risk - known as CVA risk - was a major source of losses for banks during the global financial crisis, exceeding losses arising from outright defaults in some instances.

BCBS has now agreed to revise the CVA framework to: enhance its risk sensitivity; strengthen its robustness; and, improve its consistency.


The financial crisis highlighted two main shortcomings with the existing operational risk framework. First, capital requirements for operational risk proved insufficient to cover operational risk losses incurred by some banks.

Second, the nature of these losses - covering events such as misconduct, and inadequate systems and controls - highlighted the difficulty associated with using internal models to estimate capital requirements for operational risk.

BCBS has now streamlined the operational risk framework. The advanced measurement approaches (AMA) for calculating operational risk capital requirements (which are based on banks' internal models) and the existing three standardised approaches are replaced with a single risk-sensitive standardised approach to be used by all banks.

The new standardised approach for operational risk determines a bank's operational risk capital requirements based on two components: (i) a measure of a bank's income; and (ii) a measure of a bank's historical losses.

Conceptually, it assumes: (i) that operational risk increases at an increasing rate with a bank's income; and (ii) banks which have experienced greater operational risk losses historically are assumed to be more likely to experience operational risk losses in the future.


The leverage ratio complements the risk-weighted capital requirements by providing a safeguard against unsustainable levels of leverage and by mitigating gaming and model risk across both internal models and standardised risk measurement approaches.

To maintain the relative incentives provided by both capital constraints, the finalised Basel III reforms introduce a leverage ratio buffer for G-SIBs (global systemically important banks). Such an approach is consistent with the risk-weighted G-SIB buffer, which seeks to mitigate the externalities created by G-SIBs.

The leverage ratio G-SIB buffer must be met with Tier 1 capital and is set at 50% of a G-SIB's risk-weighted higher-loss absorbency requirements. The leverage ratio buffer takes the form of a capital buffer akin to the capital buffers in the risk-weighted framework.

As such, the leverage ratio buffer will be divided into five ranges. As is the case with the risk-weighted framework, capital distribution constraints will be imposed on a G-SIB that does not meet its leverage ratio buffer requirement.

The distribution constraints imposed on a G-SIB will depend on its CET1 risk-weighted ratio and Tier 1 leverage ratio.

A G-SIB that meets: (i) its CET1 risk-weighted requirements (defined as a 4.5% minimum requirement, a 2.5% capital conservation buffer and the G-SIB higher loss-absorbency requirement) and; (ii) its Tier 1 leverage ratio requirement (defined as a 3% leverage ratio minimum requirement and the G-SIB leverage ratio buffer) will not be subject to distribution constraints. A G-SIB that does not meet one of these requirements will be subject to the associated minimum capital conservation requirement (expressed as a percentage of earnings).

A G-SIB that does not meet both requirements will be subject to the higher of the two associated conservation requirements.


In addition to the introduction of the G-SIB buffer, the BCBS has agreed to make various refinements to the definition of the leverage ratio exposure measure. These refinements include modifying the way in which derivatives are reflected in the exposure measure and updating the treatment of off-balance sheet exposures to ensure consistency with their measurement in the standardised approach to credit risk.

It has also agreed that jurisdictions may exercise national discretion in periods of exceptional macroeconomic circumstances to exempt central bank reserves from the leverage ratio exposure measure on a temporary basis.

Jurisdictions that exercise this discretion would be required to re-calibrate the minimum leverage ratio requirement commensurately to offset the impact of excluding central bank reserves, and require their banks to disclose the impact of this exemption on their leverage ratios.

The BCBS continues to monitor the impact of the Basel III leverage ratio's treatment of client-cleared derivative transactions. It will review the impact of the leverage ratio on banks' provision of clearing services and any consequent impact on the resilience of central counterparty clearing.


The Basel II framework introduced an output floor based on Basel I capital requirements. That floor was calibrated at 80% of the relevant Basel I capital requirements.

Implementation of the Basel II floor has been inconsistent across countries, partly because of differing interpretations of the requirement and also because it is based on the Basel I standards, which many banks and jurisdictions no longer apply.

The Basel III reforms replace the existing Basel II floor with a floor based on the revised Basel III standardised approaches. Consistent with the original floor, the revised floor places a limit on the regulatory capital benefits that a bank using internal models can derive relative to the standardised approaches. In effect, the output floor provides a risk-based backstop that limits the extent to which banks can lower their capital requirements relative to the standardised approaches.

This helps to maintain a level playing field between banks using internal models and those on the standardised approaches. It also supports the credibility of banks' risk-weighted calculations, and improves comparability via the related disclosures. Banks will also be required to disclose their risk-weighted assets based on the revised standardised approaches. Details about these disclosure requirements will be set forth in a forthcoming consultation paper.

The BCBS documents made public on 7 December have also outlined the transitional arrangements and the various implementation dates related to the revised standards.

[* Chakravarthi Raghavan is the Editor-Emeritus of the SUNS.]