The impact on firms and the competitive environment
The changes that Basel 4 is implementing, combined with the uneven way they are being implemented, is creating challenges and inefficiencies for firms, and impacting the competitive environment. Moreover, it is possible that this will lead to unanticipated risks for individual firms and even systemic risks that will ultimately trouble regulators.
Regulatory capital changes
In the original creation of Basel 4, and in its subsequent evolution, there has been much focus on how it changes regulatory capital requirements. Regulators have focussed on changes to levels of aggregate capital in the system, while firms are, understandably, more concerned with how the changes impact them and their direct competitors.
With any significant overhaul of the capital system, there will inevitably be winners and losers. We know that the capital impacts on a firm are dependent on business mix, business quality, and the firm’s current regulatory approaches and permissions. To that list, we can now add the jurisdiction that the firm, or rather its constituent parts, sits in.
But some of the changes that Basel 4 introduces does result in unintuitive outcomes. The main example of this is the impact of the overall output floor for capital, based on standardized capital measures. This effectively limits the aggregate capital benefit that a firm can derive from internal risk models. But it also means that different firms will experience different capital requirements for the same risk. This is a feature of the current capital framework. But under Basel 4, it is likely that firms will end up with less consistent capital requirements, potentially adding to differences that already exist. This is frustrating when one of the original intentions of the reforms was to iron out unwarranted inconsistencies in the capital framework.
Global differences in implementation
As we have seen, even though many details are yet to be finalized, markedly different implementations of Basel 4 are emerging. These will likely combine with the inherent differences in capital requirements to create significant inconsistencies in the ways that risks are treated between jurisdictions, resulting in globally different capital requirements and skewed incentives.
This is likely to motivate the industry to exploit arbitrage opportunities, and booking models are likely to evolve to shift risk and capital around the globe to maximize capital benefits. Some types of exposure and even whole businesses located in some jurisdictions may become less economically viable.
One clear feature in the implementation of Basel 4 is the trend towards regional restrictions on capital. This is consistent with the direction of regulatory travel, and existing requirements around Intermediate Holding Companies (IHCs) in the US and Intermediate Parent Undertakings (IPUs) in the EU.
But for global banks, or even for any firm that operates across jurisdictions, these requirements risk trapping capital and liquidity in region. This hampers the ability of firms to manage their financial resources globally, and recycle capital and liquidity efficiently.
Firms need to have a comprehensive response to these challenges, which at a minimum, should include:
- “Wargaming” scenarios for different implementations of Basel 4
- Understanding likely capital changes at every organizational and jurisdictional level, and the impacts on financial resources, performance indicators and business strategies, and
- Pursuing ongoing communications and lobbying efforts with rule makers.
This article is co-authored by EY's Dr. Sonja Körner, Global FS Risk Banking Capital Markets Lead and EMEIA Prudential Risk Solutions Lead.