Why Basel IV Should Be a Pressing Priority for Banks in 2021

February 18, 2021

In this interview, Ilia Bolotine, SVP, Financial Services Industry Leader, Adastra Corporation, talks about the upcoming Basel IV reforms, their impact on banks, and why banks should start implementing the changes necessitated by the regulations as soon as possible.

The regulatory environment for the Canadian banking ecosystem is constantly evolving with the objective of standardizing processes, mitigating risks, providing a safer customer experience, and keeping pace with global reforms.

The Final Set of Basel III reforms (informally known as the Basel IV reforms) were first published by the Basel Committee on Banking Supervision (BCBS) in December 2017, and after a few postponements, the implementation deadline for the reforms is now set for 1st January 2023.

The earlier installments of the Basel Reforms had set the groundwork to minimize risks pertaining to credit, capital adequacy, and risk-weighted assets (RWAs). Basel I established minimum capital requirements based on their risk profile with the goal of minimizing credit risk, and Basel II expanded those rules and set disclosure requirements for the assessment of capital adequacy of banks. The Basel III reforms, which were introduced in 2009, were designed to address weaknesses in banks’ resiliency by setting thresholds for reserve capital and requiring banks to maintain proper leverage ratios.

The Basel IV reforms, in turn, seek to enhance credibility in the calculation of risk-weighted assets and improve comparability and transparency in banks’ capital ratios. This includes revisions to the Standardized Approach and Internal Ratings-Based (IRB) approach for calculating credit risk and operational risk, the leverage ratio framework, and credit valuation adjustment requirements. The Basel IV reforms also replace the existing Basel I capital floor of 50% with a more risk-sensitive output floor of 72.5%.

Proportionality for Small and Medium Sized Financial Institutions

The reforms introduce the concept of “proportionality” for federally regulated small and mid-sized banks (SMSBs) and OSFI has set out criteria to segment these smaller institutions based on the size and complexity of their business. The implementation scope for SMSBs will be limited in comparison to their larger counterparts, but smaller banks will need to review and make changes to their processes for capital adequacy, leverage, and liquidity adequacy.

Unlike larger banks, that have previous experience with Basel adherence, the reforms are relatively new for SMSBs, which were previously only required to implement the simplified approach. It will be imperative that they fully understand the implications this will have on their technology, data, reporting systems. The specific requirements will vary based on which of the 3 SMSB categories the bank falls under, with the larger SMSBs also being required to implement calculations for Net Cumulative Cash Flow (NCCF) and Net Stable Funding Ratio (NSFR), if they have more than 40% reliance on wholesale funding. Our article Building for the Future with Basel IV talks in greater detail about the categorization of SMSBs and how that will impact prescribed approaches and calculations.

Impact of Basel IV on Technology

The technology impact of Basel IV, as apparent from the BCBS publications and OSFI consultative papers, can be split into three categories: impact on operational environments, data, and reporting. Broadly, IT architectures will need to become more robust to support parallel calculation of standardized and internal approaches. The more complex approaches will inevitably require larger volumes of more granular data, and the infrastructure and systems will have to be enhanced to handle expanding data volumes.

As per the published documents, meeting OSFI mandates will likely require high-quality financial, liquidity and risk reports, as frequently as daily by region, legal entity, and line-of-business with consolidated views over multiple time dimensions. To handle these significantly expanded reporting requirements, banks will need to enhance their data management processes and technology and embrace automation. While OSFI is yet to publish the final Basel Capital Adequacy Reporting (BCAR) requirements, we anticipate significant changes in data points and validation rules for both small and large banks.

Why Should Banks Prioritize Basel IV Implementation?

With the implementation deadline pushed to 1st January 2023 and the publication of the revised version of the BCBS guidelines still pending, many banks are taking a wait and watch approach to Basel IV. With less than 2 years left to the deadline, however, the prudence of this approach is questionable. Looking back at banks’ experiences with Basel II and III, it is worth noting that in both cases it took banks between 18 to 24 months to implement technology changes. Basel IV implementation, with its expanded set of requirements, will likely require a similar amount of time.

Moreover, SMSBs, which were previously outside the purview of the Basel Reforms, will now have to implement certain provisions of the regulations. Smaller banks typically do not have the resources and expertise to implement large-scale changes and may have to rely on external partners to understand the Basel IV requirements and modernize their architecture to comply with the regulations.

Regardless of whether the expertise is internal or external, banks will need time to absorb the mandates, plan their target architecture, onboard partners, and implement the solutions. With the deadline looming ahead, banks would be well-advised to look into the Basel IV requirements, architecture, and data sourcing sooner rather than later.

While the final OSFI publication may vary slightly from the BCBS guidance and consultative papers, we do not anticipate any drastic changes. Ideally, banks should start with the interpretation of OFSI requirements and understand the technology impact these will have on their business. A technology implementation gap assessment will give banks a fair estimate of the time and resources that will be required for implementation. Next, banks can start designing a draft solution architecture, ideally on the cloud. Banks can also start building a set of Basel IV-specific data requirements, and accordingly, profile their systems, extract business metadata, and undertake a data quality assessment to fill in any gaps or errors in their data. This will set the stage for a target data architecture. Banks may also want to enhance their existing data governance frameworks to address all aspects of data quality, including data attributes not covered by the existing BCBS-239 (RDARR) framework.

Once OSFI publishes their guidance, banks will have their hands full with designing, building, testing, and implementing calculation engines, data pipelines, and reporting engines.

As a leading data and technology solution provider, Adastra’s experts have thoroughly reviewed the OSFI and BCBS publications and developed a Basel IV Technology Implementation Roadmap for Small and Medium Sized Banks, which provides a step-by-step approach to Basel IV implementation. We can help banks develop and implement a Basel IV solution that is tailored to their needs and fully addresses the prescribed regulatory requirements. Based on our expertise in the financial services sector, we understand the evolving nature of regulations, and we will help you design a solution that is scalable and expandable to accommodate future iterations of Basel Reforms.

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