Why global regulatory standards are fragmenting as Basel 4 is implemented

As the Basel 4 capital standard makes its way into legislation, consistency in its implementation is buckling, with worrying consequences.

In brief

• Efforts to implement Basel 4 are resulting in significant differences to global capital standards.
• This is creating challenges for firms and potential risks for the financial system.

The final mile of any regulatory standard being implemented is its journey through into country-specific legislation. The legislative processes that make a regulatory standard binding can result in divergences from the previously established global consensus on its shape and impact. This is exactly what seems to be happening with Basel 4. It was originally conceived by the Basel Committee on Banking Supervision (BCBS) in 2017, representing the biggest change in regulatory capital standards in a decade, and it is in the final stages of being implemented across the globe:

• The European Union (EU) implementation of Basel 4
  
  In October 2021, the European Commission (EC) published its proposed implementation of the Basel 4 standard, with a go-live date of 1 January 2025. The Capital Requirements Regulation (CRR) III and the Capital Requirements Directive (CRD) VI seek to balance two objectives: implementing the proposals of the BCBS to enhance financial stability and supporting EU institutions’ ability to continue financing the economy.
  
  CRR III and CRD VI introduce changes to the Basel Committee’s proposals to reflect specific EU needs. These changes are being fiercely debated. Many of the EU-specific divergencies are intended to be temporary, but there are calls variously either to reduce or make permanent the differences, or indeed to introduce further changes. However these are resolved, the EU is very likely to end up with a specific local implementation of the Basel 4 standard.
  
  
• The United States (US) implementation of Basel 4
  
  The Federal Reserve has not yet released its Notice of Proposed Rulemaking (NPR), which will define the US implementation of Basel 4. Despite the lack of published regulations, most well-informed industry players expect that the US intends to diverge significantly from the Basel Committee’s standards.  It is expected that the US version of Basel 4 will move away entirely from allowing most internally modeled capital approaches, in particular those for credit and counterparty credit risk. This would extend further the current differences between the US prudential capital regime and those of other major financial centers, which are generally retaining modeled options in setting capital.
   
  
• The United Kingdom (UK) implementation of Basel 4
  
  In the UK, the Bank of England has announced that Basel 4 will go live on 1 January 2025, a date that aligns with the EU. It has not yet published a UK version of the standard, but has indicated that it will be consulting on the final rules in Q4 of 2022. Many market participants expect the UK to stick broadly to the BCBS standard, but also to follow some EU divergencies and potentially introduce UK-specific ones.
  
  Looking across these three key financial centers, and indeed more broadly globally, it is difficult to see how the Basel 4 endgame will result in a level regulatory playing field. Indeed, it seems likely to be less a smooth surface with occasional pockmarks, and more a significantly uneven field blighted by ditches and hills. But does this really matter?

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.

Regional restrictions

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.}