The transition period to Basel IV starts in July and will take place over five years.
The Basel framework is a set of measures developed to strengthen the regulation and risk management of banks. To minimise the fears of banks that loans will not be repaid (this is termed credit risk), regulators have imposed capital buffers. When loans go south, this capital buffer is meant to absorb the shock. If all the capital is used to absorb the shock, the bank collapses, which was the case in 2008. More recently, Credit Suisse’s additional tier 1 capital (AT1) was used to absorb the shock.
Over the years, and through various crises, the Basel Committee of Banking Supervision (BCBS) introduced capital requirements for the banks. Basel I had standardised capital requirements (Standardised Approach). That is, for every $100, the bank sets aside $8 in capital. Banks do not have to put aside the entire $8 (8%), If the loan carries a 90% risk weight, the bank puts aside $7.20.
Basel I had five categories of risk weights. The banking sector claimed that this incentivised some types of loans and disincentivised other loans.
Basel II introduced an internal ratings-based (IRB) approach to credit risk, operational risk and market risk. Basel II also introduced the concept of capital tiers.
Basel III was formulated as the global financial crisis unfolded. It introduced what is now common equity tier 1 (CET-1) which comprises retained earnings and ordinary shares, AT1 and so on.
Basel IV, which kicks in in July, constrains the use of internal models via an output floor which ensures capital does not fall below 72.5% of the amount required in the standardised approach.
”After 30-40 years we are going back to a version of Basel I, although Basel IV is an improvement. To prevent variability, they introduce a capital floor,” says Lee Wai Fai, group CFO, United Overseas Bank U11 (UOB).
In a report about a year ago, Moody’s Analytics says Basel IV “represents a fundamental change in how banks will need to calculate regulatory capital”. According to Moody’s report, Basel IV removes the Advanced IRB (A-IRB) approach for large corporate and financial institutions and the IRB approach for equity, and there will be new risk ratings for corporate bonds and real estate among other types of loans.
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“Under the IRB approach, some asset classes, like retail mortgages, are currently assigned very low-risk weights by many banks (about 10% on average). As a result, IRB banks that are most heavily exposed to retail mortgages will be particularly hit by the output floor, which will be based on standard risk weights ranging from 20% to 70%. On the other hand, since the output floor is calculated on a consolidated basis, more diversified banks might be able to offset RWA shortfalls on some asset classes by RWAs above the output floor on some other classes,” Moody’s Analytics says.
The Singapore situation for mortgages is different from other developed countries. “Although mortgages last for a lifetime, in Singapore we refinance the mortgages every three years, unlike in the US which has a 30-year lock-in. These are the things we can vary to increase asset utilisation,” Lee says.
Interestingly, SME loans are likely to carry lower risk-weights. “During the GFC, SMEs were ok,” Lee observes. Previously, SMEs were viewed as risky credits.
Moody’s Analytics says: “The most affected category of borrowers is likely to be large corporates that lack an external credit rating. Under Basel III they typically receive favourable treatment from A-IRB models but will face a 100% risk weighting under Basel IV, which is worse than both rated large corporates and non-rated SMEs in IRB models.”
