Basel IV Explained: Impact on U.S. Banks and Global Finance Reforms

What Is Basel IV?

Basel IV is a package of banking reforms developed in response to the 2008-09 financial crisis. It is a comprehensive set of measures that will make significant changes to the way banks, particularly those in the U.S., calculate risk-weighted assets (RWAs).

Basel IV is the informal name for a set of proposed banking reforms building on the international banking accords known as Basel I, Basel II, and Basel III. It is also referred to as Basel 3.1. It began implementation on Jan. 1, 2023, although its full adoption is expected to take until 2025 and the stages of implementation vary by country.

Exploring the Global Impact of Basel Accords

Basel I, II, and III are international accords by the Basel Committee on Banking Supervision (BCBS) in Basel, Switzerland. Members include central banks and global banking regulators. The U.S. is represented on the committee by the Board of Governors of the Federal Reserve System, the Federal Reserve Bank of New York, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corp. (FDIC).

The overall objective of the Basel Accords, as they are collectively known, is to "improve supervisory understanding and the quality of banking supervision worldwide," according to the BCBS.  

The committee aims to exchange information on national supervision, improve supervisory techniques, and set minimum standards.

The accords' standards are voluntary. The BCBS can't enforce them and depends on national regulators for implementation. Regulators can set stricter rules if they choose.

Unraveling Basel I, II, and III: A Historical Overview

Basel I: Known at the time as the Basel Capital Accord, Basel I was issued in 1988. Its purpose was to address what the central bankers perceived as a need for a "multinational accord to strengthen the stability of the international banking system and to remove a source of competitive inequality arising from differences in national capital requirements."

Basel II: In 2004, roughly a decade and a half after the first Basel accord, the committee released an update, Basel II. Basel II refined Basel I's way of calculating the minimum ratio of capital to RWAs, dividing bank assets into tiers based on liquidity and risk level, with Tier 1 capital being the highest- quality. Under Basel II, banks still had to maintain a reserve of 8%, but at least half of that (4%) now had to be Tier 1 capital.

Basel III: After the subprime mortgage meltdown in the U.S. and worldwide financial crisis of 2007-2008 showed the risk-mitigation measures of Basels I and II to be inadequate, the committee got to work on Basel III. Begun in 2009, it was originally scheduled to begin implementation by 2015, but the deadline has been pushed back several times and started to roll out Jan. 1, 2023, although certain provisions are already in effect in some countries.

Among other changes, Basel III increased the Tier 1 capital requirement to 6% from 4%, while also requiring that banks maintain additional buffers, raising the total capital requirement to as much as 13%.

Anticipating the Changes Basel IV Brings to Global Banking

As Basel III awaited its final implementation deadline, the BCBS continued to tweak its provisions. In parts of the financial community, those proposals have come to be known by the unofficial name of Basel IV. However, William Coen, then-secretary general of the Basel Committee, said in a 2016 speech that he didn’t believe the changes were substantial enough to merit their own Roman numeral.

Whether it is merely the final phase of Basel III or a "Basel" in its own right, Basel IV began implementation on Jan. 1, 2023. Its principal goal, the committee says, is to "restore credibility in the calculation of RWAs and improve the comparability of banks' capital ratios."  

Toward that end, it proposes a number of changes, some highly technical. They include:

• Improving the earlier accords' standardized approaches for credit risk, credit valuation adjustment (CVA) risk, and operational risk. These rules lay out new risk ratings for various types of assets, including bonds and real estate. Credit valuation risk refers to the pricing of derivative instruments.
• Constraining the use of the internal model approaches used by some banks to calculate their capital requirements. Banks generally will have to follow the accords' standardized approach unless they obtain regulator approval to use an alternative. Internal models have been faulted for allowing banks to underestimate the riskiness of their portfolios and how much capital they must keep in reserve.
• Introducing a leverage ratio buffer to further limit the leverage of global systemically important banks (banks considered so large and important that their failure could endanger the world financial system). The new leverage ratio requires them to keep additional capital in reserve.
• Replacing the existing Basel II output floor with a more risk-sensitive floor. This provision refers to the difference between the amount of capital that a bank would be required to keep in reserve based on its internal model rather than the standardized model. The new rules would require banks by the start of 2027 to hold capital equal to at least 72.5% of the amount indicated by the standardized model, regardless of what their internal model suggests.

While Basel IV began implementation on Jan. 1, 2023, banks will have five years to fully comply. Based on recent history, it's still possible that the deadline will be extended, as well as that some provisions may be modified further before they go into effect.

The Bottom Line

Basel IV, also known as Basel 3.1, is the latest in a series of international accords intended to bring greater standardization and stability to the worldwide banking system. It builds on the reforms begun by Basel I in 1988 that were later followed and supplemented by Basel II and Basel III. Its primary objective is to restore credibility in risk-weighted asset calculations and improve capital ratio comparability across banks worldwide.

Basel IV introduces technical changes that impact how banks assess credit, operational, and CVA risks, specifically underscoring improvements to risk standardization. The reforms require banks to adapt by 2025 with a full compliance timeline extending to 2027, suggesting a timeline for stakeholder preparedness. U.S. banks and other institutions globally must focus on how these reforms might affect regulatory approaches and capital management strategies. They aim to strengthen the global financial system, ensuring consistency in banking practices worldwide with an eye toward avoiding past financial crises.