Basel 4 – the final countdown?

The Basel Committee’s 1 January 2023 implementation date for Basel 4 is approaching rapidly, with banks expecting to hear soon hear precisely what will be required of them in the EU, UK and US. Regulators are sticking to their guns on the need for completion of the final reforms although some banks question the timing. Implementation has been deferred once due to the pandemic and may be delayed further due to the regulatory process.

On 6 July 2021, the Basel Committee for Banking Supervision (BCBS) published its preliminary assessment¹ of the effectiveness of implemented Basel reforms during the COVID-19 pandemic. The report found that higher quality capital and liquidity levels required by the reforms had helped banks to absorb the impact of the shock. As had been said in many speeches and in many industry forums over the previous months, the banking system would have found itself under much greater stress were it not for the lessons learned and, crucially, acted upon, in the aftermath of the 2008 financial crisis and the support measures taken by public authorities.

There has been broad consensus from regulators and bankers about the value of the measures implemented so far, but with the deferred 1 January 2023 date looming, and with policy announcements expected imminently in the UK, EU and US, banks must now move forward with the Basel 3 final reforms, variously referred to as Basel 3.1 or Basel 4.

And here opinion has been divided: regulators insist that implementation must press forward in accordance with the BCBS timeline and without major deviations from the globally agreed standard. Banks are arguing for consideration of the additional stress that this would place them under, particularly in reference to additional capital requirements, the output floor, and considerations of proportionality and regional specificity.

Recap — what is Basel 4?

Basel 4 refers to the finalisation of the Basel 3 reform package which had taken more than a decade to develop and was split into two pieces – the final amendments elements being agreed by the Basel Committee in December 2017. Basel 4 included new standards for credit risk and operational risk and a credit valuation adjustment. It also introduced an output floor, revisions to the definition of the leverage ratio and the application of the leverage ratio to global systemically important banks. A revised market risk framework had already been largely finalised in January 2016.

The implementation timeline

Implementation of Basel 4 was originally intended to start on 1 January 2022, with a phasing in of the output floor to 1 January 2027. In March 2020, in response to the pandemic, the BCBS deferred the implementation timeline for Basel 4 by 12 months, from 1 January 2022 to 1 January 2023.

Key regulatory announcements are required in order to implement Basel 4 in the EU, UK and US:

• The European Commission is expected to present its CRR3 legislative proposal on 27 October
• Released from the requirement to follow CRR3 post-Brexit, the Prudential Regulation Authority (PRA) is targeting the end of 2021 for its consultation paper on UK implementation, although this may run over into early 2022. A policy statement will follow later in 2022
• In the US, a Notice of Proposed Rulemaking (NPR) is expected from the Federal Reserve Board in November

Support from central banks and regulators

EU and UK Central banks and prudential regulators have been unequivocal in their support for the remaining reforms and the BCBS timeline.

In a letter² in September 2021, the European Central Bank (ECB) and European Banking Authority (EBA) called on the European Commission to stick to the letter and spirit of the Basel reforms, supporting a “full, timely and consistent implementation of all aspects of the (…) framework”. They described the final reforms as “essential to maintain the credibility of European banking regulation and confidence in European banks” and noted that any additional postponement “would be to the detriment of the European public interest”.

The ECB and EBA specifically defended the output floor which was designed to limit variability in how banks risk-weight their assets and therefore improve consistency and comparability and warned against moves towards a more flexible “parallel stack” approach³ such as that championed by the European Banking Federation (EBF).

In the UK, HM Treasury (HMT) and the PRA have expressed support for completion of the implementation in a way that is faithful to the Basel text: “We remain committed to the full, timely and consistent implementation of the Basel 3.1 standards and we will work together towards a UK implementation timetable that is consistent with the one year delay”⁴.

The US is also understood to be targeting January 2023 although final capital rules are yet to be set.

Concerns from banks

Banks in the EU cite the difficulties of continuing to lend to the real economy and supporting the transitions to green and digital finance if the reforms proceed as planned. They continue to challenge the regulators on questions of proportionality and the “level playing field”, arguing that Basel 4 disadvantages them versus their US or global counterparts. Some banks support the exercise of national flexibility to the fullest, while regulators support a more harmonised approach. There are also questions around application of the output floor at consolidated or solo level and elements of the capital stack to be considered for the output floor.

Banks have been quick to reference the BCBS principle that capital requirements should not be higher as a result of the reforms. However, Basel 4 will increase capital requirements for those banks which are likely undercapitalised, which is how the framework was intended to operate. At the system level, the relative cost of capital for banks will change depending on their business model. Banks should be considering how to manage potential increases in their capital requirements, for example by combining Pillar 1 and Pillar 2 measures and ensuring thorough capital planning. 

Where do we go from here?

There is no doubt that banks are better capitalised and have more liquidity than they did in past crises. They functioned well through the pandemic, but this was due in no small part to government support, without which capital buffers might not have been able to absorb the impacts - hence the regulators insistence that the full benefits of the Basel reforms will only be realised when the programme is complete.

Despite lobbying in the EU, there is a strong desire from legislators and regulators to stick to globally agreed standards.

In September 2021, Carolyn Rogers, Secretary General of BCBS expressed⁵ concern that some stakeholders continue to lobby against a consistent and timely implementation of Basel 4 and reflected that some “fault-lines” in the banking system “remain as important as they were pre-pandemic”. She pointed in particular to banks’ measurement of capital requirements using internal models and the need for an output floor to address issues of consistency and comparability. She also rejected the arguments for disproportionate impacts on certain banks and certain jurisdictions saying that “any stakeholder that argues that a global standard needs to be domestically adjusted to reduce the impact on outlier banks has lost sight of the purpose and value of the global standards”.

Delays and divergence

It is possible that the implementation date will move again, but this will be due to the legislative or regulatory process rather than a dilution of intent. The regulators have admitted that it has been challenging to land final policy and, based on typical timelines, it may simply not be practicable to implement until 2024 or later.

It is also possible that the legislative and regulatory proposals will result in different approaches in different regions. Whilst it is too early to say how significant these differences might be, banks with international operations will need to factor in the potential for diverging requirements in each major location and adapt accordingly.

Early indications suggest that the European Commission will indeed stick to the “single stack” but will look for other ways to keep capital increases below 10%, such as applying the requirements at the highest level of consolidation. The EU may opt to use flexibility in the framework, for example to reduce the impact of historical losses feeding through to capital, deployment of transitional regimes for loans to unrated corporates and low-risk mortgages and maintaining regional carve-outs for small businesses, infrastructure and derivatives.

In the US, with a new Vice Chair for Supervision due to be appointed in October, it is possible that previous references to maintaining capital neutrality may ultimately give way to a harder line.

Whatever the final proposals and timelines look like, banks must now engage or re-engage with the potential requirements of Basel 4. The clock is ticking.