Credit risk under Basel 4 – Putting the seatbelts back on?

Moving the dial article series

December 2022

Credit risk typically represents more than 75% of banks’ risk-weighted assets. Getting the credit risk approach right under Basel 4 is therefore critically important.

The good news is that most of the ‘legwork’ has already been done, as internal models for credit risk have been or are in the process of being built to address existing regulatory requirements. Basel 4’s internal ratings-based (IRB) approach requirements expand upon those currently in force. Meeting these new requirements is more about reviewing and refining existing models rather than creating new ones.

This will not however be an easy task as it is already proving challenging to develop IRB models that meet with regulatory approval. During the process of developing the Basel 4 rules, regulators restricted the use of advanced models for certain portfolios to reduce the framework’s complexity, improve the comparability of banks’ capital requirements and because of the difficulties associated with demonstrating that they performed robustly. Regulators have raised the bar with respect to the rigour with which banks estimate their regulatory capital requirements and this has been very visible in the regulatory approval process of banks’ models. 

As a result, there may be something of a reduction in freedoms as Basel 4 brings back some of the regulatory prescription that existed previously as the use of internal models is tightened.

Here’s a reminder of the evolution of the global regulatory capital framework for credit risk:

• 1988: Under Basel 1, there was a relatively crude system of regulatory-assigned risk weight categories and no ability to use banks’ internally-modelled risk estimates for regulatory capital purposes;
• 2006: Basel 2 introduced the IRB approaches and permitted the use of internal models for credit risk; 
• 2010: Basel 3 focused on strengthening the quality and quantity of a bank’s capital resources and expanded the risk coverage of the regulatory framework; and
• 2017: The final revisions were published in 2017 and included:
  • A reduced scope in what is eligible for the advanced IRB approaches (banks will have to exclude some portfolios such as lending to large corporates and other banks);
  • The introduction of ‘input floors’ or parameter levels that act as further backstops to deal with concerns about the accuracy of modelling for eligible portfolios;
  • The introduction of an ‘aggregate output floor’ of 72.5% that limits the extent to which banks can lower their capital requirements relative to the standardised approaches; and
  • A greater focus on the robustness of model development, governance and validation.

Consequently, there will be greater use of less sophisticated approaches (e.g. for large corporate portfolios). For many banks this will lead to an increase in the overall Pillar 1 capital they are required to maintain for credit risk. This increase is likely to vary quite significantly between banks depending on their specific lending portfolios, with the highest potential impacts in Nordic countries such as Sweden and Denmark. In some countries, such increases may be partially offset by reductions in Pillar 2 capital (depending on stress testing results).

Regardless of the capital impact, there will be a significant amount of work to do reviewing and refining Basel 3 models. Also, the introduction of the ‘output floor’ becomes an important consideration for many banks. Calculating the capital requirement under the standardised approach for a portfolio will be necessary even if a bank uses the IRB approach.

Of course, there will be significant regional variations: more use of internal models (and more focus on their governance and validation) in Europe; greater use of standardised approaches in the Americas (where the regulatory Comprehensive Capital Analysis and Review – CCAR – stress tests significantly drive overall levels of capital); and a more straightforward application of the rules in other regions.

Regardless of the size, complexity or location of a bank, there will be much to do to meet the Basel 4 requirements. Already there are clear ‘no regrets’ actions that banks should be taking as they continue along the evolutionary Basel journey: focusing on data sourcing, data lineage, enhancements to model development and validation standards.

Whilst in some respects it might be seen as moving backwards, as regulators restrict, and are more prescriptive about, internal model use for capital purposes, at the same it’s about moving forward and strengthening the organisation’s credit risk profile and capital position. There is much for banks’ credit risk teams to consider as they develop optimal solutions.