Businesses: Basel IV for Dummies

Have you heard of Basel IV, the set of regulatory reforms adopted by the Basel Committee on Banking Supervision? If not, it’s high time you found out about it! And for good reason – Basel IV has a serious impact on the assessment of credit risk, and therefore on the terms on which financing is granted to companies. myLIFE is here to give you the broad outlines of what’s in store for you, and then a few tips to help you get prepared.

Basel IV in a nutshell

Continuing along the lines of Basel III, the main aim of Basel IV is to improve banks’ resilience to financial crises by stepping up capital adequacy requirements and fine-tuning methods for assessing banking risk, especially credit risk. Many experts see it more as the “Basel III Endgame”, rather than a major development that justifies the new name. Be that as it may, while all these regulatory reforms mainly affect the banks, businesses like yours could be affected.

No need to go over the legal framework that is already in place, or delve into the nuances and technicalities of these reforms; it’s sufficient for companies to bear in mind these impacts on banks:

• • Higher capital requirements to improve banks’ capacity to absorb losses. The underlying idea is simple: A bank that exposes itself to too many risks must have more capital and reserves to offset those risks. Among other things, Basel IV introduces stricter rules for calculating capital requirements, obliging banks to maintain a higher ratio of capital to the riskier assets they hold. For businesses, this means that banks will be more restricted in their capacity to grant you financing, or they may need to demand additional terms.
  • A revision in the methods for calculating risk-weighted assets (RWA) and limits on the use of “advanced” internal risk calculation models, to ensure a more standardised and consistent approach between banks. Risk weightings are important for credit institutions, because they determine the amount of capital the banks must hold in reserve to cover the loans they grant. Although it may seem reasonable that credit institutions should be able to maintain less capital in reserve for low-risk lending, Basel IV induces banks to move away from their internal models, thus promoting a more standardised approach to risk assessment. To achieve this, Basel IV introduces a regulatory output floor to be applied to banks that want to continue using their internal models, regardless of the risk associated with the loan. This could result in an increase in the cost of credit for private and business clients who had previously been considered low-risk. So, where a credit institution using the advanced model for certain types of client only had to hold reserves of 50% of what was required for an institution using the standard method, by 2030 it will have to hold at least 72.5%.

Apart from greater solvency, banks must maintain an increased level of high-quality liquid assets to cover any possible cash outflows.

• • Improved transparency. These regulatory changes will oblige the banks to provide even more detailed disclosures on their risk exposure and financial status in order to bolster the confidence of both investors and clients. Basel IV imposes stricter and more regular disclosure requirements. In regard to risk calculation methods, Basel IV requires that banks explain the internal models they use to assess probability of default (PD), loss given default (LGD) and exposure at default (EAD). This will allow regulators and investors to have a better understanding of how the banks assess their risks.

All these regulations must be implemented gradually over several years to enable banks to adapt to the new requirements without throwing the financial markets into disarray. However, there are key deadlines for the different requirements: Banks will have to comply with Basel IV requirements as a whole by 1 January 2030 and, for a few specific requirements, by 2032. This includes adjustments to capital requirements in particular.

The Basel Committee is not empowered to issue legally binding regulations. Its rules must therefore be put into effect by national authorities.

Useful info: Although Basel IV establishes a common framework, the implementation deadlines may vary from country to country due to the need for transposition into national law, the decisions of lawmakers, and the particularities of local markets. In fact, the Basel Committee is not empowered to issue legally binding regulations. Its rules must therefore be put into effect by national authorities. Consequently, there are differences between countries regarding both content and timeframe. For EU countries, however, Basel IV is implemented via CRR III and CRD VI and comes into force in January 2025.

How will it impact businesses?

Just reading this brief summary of Basel IV, it will be clear to you that this set of regulations may significantly affect credit cost and accessibility for many companies. Lending terms could become stricter, and/or there could be higher collateral requirements. For you, this potential impact may take various forms.

• • Impact on solvency if the banks tighten their lending terms. If you need financing to fuel your expansion plans or to tide you over temporary difficulties, you may encounter obstacles if the banks consider the risk too great. This could also hinder your relations with other creditors or investors. If the cost of the loan becomes too high, this may reduce your profit margins, not to mention growth and innovation opportunities. And hence affect solvency in the long term.
  • Impact on the real estate sector. Basel IV influences how banks assess financial ratios in the real estate sector. Entrepreneurs with activity in this sector must step up their documentation and financial disclosures to meet the banks’ new requirements. Failure to prepare adequately, or inability to meet bank terms and conditions, may adversely affect lenders’ perception of your solvency. The answer is for developers to understand the new requirements and respond proactively to terms which would mean a reduction in capital requirements for the banks – which isn’t particularly complicated. Another part of the solution would be for the banks to adapt their product range to take account of Basel IV requirements.
  • Impact on financing terms. The implementation of the Basel IV output floor represents a major challenge for banks when managing their loan-to-value ratios (LTV), particularly in the real estate sector. With the introduction of minimum risk weightings based on LTV thresholds, banks must steer through the complexities of bringing their lending practices into line with the new regulatory requirements. The challenge lies in maintaining a balance between the need to offer competitive financing options for borrowers and compliance with stricter capital requirements that reflect the increased risk associated with higher LTV ratios. Now that a higher risk weighting is applied to loans with higher LTV ratios, banks must contend with the potential impact on their loan portfolios and profitability. The change in regulations is encouraging banks to adopt more prudential risk management strategies to guarantee their resilience, while maintaining their market position in a competitive world.
  • The impact of Basel IV on financial instruments is reflected in strengthened regulations as regards capital requirements and liquidity coverage. Banks must now adjust their financial instrument portfolios to meet the stricter risk-weighting requirements, which could influence their investment strategy and, as a result, their clients’ access to financing.

Not all businesses will be affected equally. Some sectors will be more impacted than others, depending on their risk profile and reliance on bank financing.

Not all businesses will be affected equally, of course. Some sectors will be more impacted than others, depending on their risk profile and reliance on bank financing. But regardless, in order to face up to any potential impact, it is highly advisable to forestall eventualities and get in touch with experts to discuss your situation. There’s no better time to forge closer ties with your bank!

What you can do to prepare

Even if things are rather out of their hands when it comes to Basel IV, that doesn’t mean that companies can’t make moves to get ready for it. Here are a few ideas for you to think about…

• • Take stock of your financial situation. Start by carrying out an internal analysis of the company and a summary of its current financial situation. Analyse your assets, liabilities, cash flows and solvency ratios. This will give you a better picture of your position, and it will be simpler to react should certain changes prove necessary in order to obtain the financing you seek.
  • Strengthen your equity capital if possible, so as to reduce your risk profile. This could mean reinvesting profits or calling on investors to increase your capital. A sounder capital base can make you more attractive in the eyes of the banks.
  • Manage your cash proactively. Adopt more stringent cash management in order to better anticipate future needs. Make sure you have sufficient reserves and consider negotiating credit lines before your needs become too acute.
  • Consult your bank to help steer you through these changes. Your banker can give you personalised advice tailored to your specific situation and help you draw up a strategy. It’s just as much in their interest as it is in yours if they want to continue a long-term partnership with your company.

Stepping up capital adequacy requirements and fine-tuning methods for assessing banking risk, Basel IV will have a major influence on the way your bank does business and on the terms on which your company is able to access financing in the future. All the more reason to take stock of your financial situation and together with your banker examine how you can best prepare for what lies ahead.