6 minute read 12 Mar 2021
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How banks are preparing for capital reform in the shadow of COVID-19

Authors
Federico Guerreri

EY Global Financial Services Risk Leader

Risk transformation leader in financial services. Speaker at external and internal events. Passionate about meeting people; everyone can learn a lot from the others. Globetrotter. Husband and father.

Jared Chebib

Associate Partner, Financial Services Risk and Regulatory Services, Ernst & Young LLP

Financial services enthusiast. Dedicated to helping our clients transform to manage their risks better and meet their regulatory commitments. People coach and leader.

6 minute read 12 Mar 2021

Banks now have less than two years to prepare for the Basel 3 Reforms. Our third global survey looks at how ready banks are.

In brief
  • The COVID-19 pandemic and low interest rates have added further capital pressure to banks as they prepare for the Basel 3 Reforms.
  • With less than two years to go to the deadline, we have uncovered significant differences in firms’ levels of preparedness.
  • Our analysis shows that progress is highly size dependent, and findings also vary by region.

Like many regulatory initiatives, implementation of the Basel 3 Reforms (commonly known as Basel IV) has been significantly impacted by the COVID-19 pandemic. In March 2020, the regulators announced a one-year delay to the timetable, to permit banks more time to deal with the pandemic. However, regulators have made clear the Reforms have been postponed, not cancelled, and banks should work towards the current deadline for implementation of 1 January 2023.

In addition, the pandemic has resulted in banks reporting significant increases in impairment charges, as they deal with the fallout from the dramatic drop in economic activity. The next 12-18 months are likely to see that stress increase, as economies continue to struggle, and government and central bank help is reduced. Dealing with rising defaults at the same time as managing the Basel 3 Reform capital changes will be a real test of banks’ capabilities and strategic focus. 

The Basel 3 Reforms were always going to be one of the most significant regulatory changes banks faced, and the extra demand on capital from the pandemic gives it even more significance. Regulators also face a tricky balance between ensuring firms have enough capital to be resilient and making sure the sector can support businesses and individuals to drive economic growth.

Our latest survey again asked global respondents, comprising some of the world’s biggest financial institutions, on how they are preparing for change. While there has been significant progress, we found many are leaving themselves a relatively short space of time to get ready.

Good progress for most

Most banks (83%) have now established Basel 3 Reform programs, with the biggest focus on credit risk, although many programs also cover operational risk, counterparty credit risk and credit valuation adjustment (CVA) changes. The most notable change in scope, compared to our last survey in Q4 2019, was a big jump from 42% to 71% in the number of banks who included Fundamental Review of the Trading Book (FRTB) and market risk in their delivery programs.

With less than two years to go to the regulatory deadline of 1 January 2023, the majority of respondents are confident of meeting the deadline, or experiencing only minor delays. However, a small minority (7%) are assuming a deadline later than 2023. This is a high-risk strategy given the capital, regulatory and reputational stakes involved.

Divergent approaches emerge

In our third survey, we have started to see some marked differences in banks’ approaches. Some of these reflect the fact that some banks started their programs early — 14% of respondents had set up and funded a delivery program in 2018.

90% of Global Systemically Important Bank (G-SIB) respondents are using the Reforms to extend the scope of delivery to transform related aspects of business and operations, either significantly or incrementally. This transformational rather than compliance-only approach, combined with their bigger size, is reflected in the average spend for G-SIBs being US$70-80m, and for D-SIBs US$30-40m. Many banks recognize that their current operating models are sub-optimal. In most cases, the impact of layering on successive new regulations and short-term cost-cutting initiatives can worsen the problem.

Banks are responding by changing their operations, typically focusing on using technology to digitize operations, and make them more efficient and better able to meet business and regulatory needs. Basel 3 presents an opportunity for banks to embrace digital technology to improve customer experience, better use data analytics, modernize operating models and free themselves from old core IT systems. Real transformation can then be pursued on an ongoing basis, driven by a clear set of organizational goals.

Basel 3 Reforms are a major opportunity for banks to reimagine the future

Basel 3 presents an opportunity for banks to embrace digital technology to improve customer experience, better use data analytics, modernize operating models and free themselves from old core IT systems.
Filippo Mastropietro
EY EMEIA Financial Services Consulting Partner; EMEIA Financial Services Banking Transformation Leader

The majority (64%) of G-SIB respondents see a significant material reduction in their CET1 ratio from the overall standardized floor, which reflects their higher usage of internal models. For both global and domestic banks, the vast majority have not yet determined an approach to allocate the capital impact of the standardized floor. Even without the impact of the standardized floor, we found the majority of respondents see capital requirements increasing over many risk types.

There is also a large contrast between G-SIB and D-SIB plans on voluntarily disclosing capital impacts externally within the next 12 months. 46% of G-SIB respondents reported they had already disclosed but almost half of D-SIBs are not planning on disclosing at all in the next year. Across all respondents, a quarter had or planned to disclose in the next year, with 41% having no plans to do so and a third unsure. We would expect increased analyst and market pressure to disclose as we move nearer the deadline, especially as some of the capital impacts are likely to be significant rather than incremental. Just as important will be banks’ ability to explain what mitigating actions they will adopt.

Will we see a significant geographic split in approach?

Regionally, banks headquartered in Asia are behind other regions – their average readiness is 19% behind banks in EMEIA and the Americas. Yet they are the most (83%) highly confident of going live on 1 January 2023. There is also a clear geographic split in how banks are driving reforms through. In the US and EMEIA, over half of respondents report the identified sponsor or accountable executive is from Finance, whereas in Asia-Pacific over half say it sits within Risk. This reflects regional variations of where regulatory capital is typically managed. It will be interesting to see if this leads to a marked difference in regional approaches going forward.

Over half of Asia-Pacific respondents are unsure when they will disclose capital impacts, in contrast to the 40% of EMEIA respondents who have already or will disclose capital impacts.

Data and controls are key challenges

When asked to identify the most significant challenges in delivering the reforms, respondents again identified the quality and availability of data, as they did in Q4 2019. Interestingly there was a rise in concerns round the delivery of a Risk-Weighted Asset (RWA) control framework, from number seven concern to number four this year. This reflects that controls are often looked at later in programmes but also increased regulatory scrutiny post some high-profile RWA control failures. One challenge that has faded since Q4 2019 is the concern over funding for projects, reflecting the maturity of programmes.

Mitigation planning higher

There is a better understanding of the strategic and commercial impacts of the Basel 3 Reforms. 49% of respondents have identified or are carrying out mitigation, compared to 37% in last year’s survey. According to our survey, most respondents are planning for multiple mitigating strategies including:

  • Changing internal capital allocations or business mix
  • Tuning modelling and regulatory approaches
  • Changing pricing

Significant external steps like securitization, changes to dividends or raising capital are less likely to have been identified to date.  

Summary

Basel 3 Reforms were always going to be a major undertaking for the banks, with significant implications for financial resources. The pressure on capital from the pandemic will further test banks’ capital positions. Our survey shows most banks are well under way, but we are now seeing different approaches emerge.

About this article

Authors
Federico Guerreri

EY Global Financial Services Risk Leader

Risk transformation leader in financial services. Speaker at external and internal events. Passionate about meeting people; everyone can learn a lot from the others. Globetrotter. Husband and father.

Jared Chebib

Associate Partner, Financial Services Risk and Regulatory Services, Ernst & Young LLP

Financial services enthusiast. Dedicated to helping our clients transform to manage their risks better and meet their regulatory commitments. People coach and leader.