From Basel I to Basel IV: The next evolution of banking risk management
Financial institutions face all sorts of risk. From credit to liquidity, trading to operations, banks open their doors each day to potential losses if something goes wrong.
Risk management practices have evolved to help banking executives minimise those exposures and protect the value of their assets. By understanding where a loss could occur, they’re in a better position to remove or mitigate the conditions that created the risk, while preparing contingency plans to speed-up recovery should something go wrong.
Though the concept first arose as a subject of serious study in the 1950s, banking risk management as we know it today really crystallised decades later.
In the early 1990s banking executives and policymakers began gathering to discuss the growing complexity of banking risk management as a pressing international industry issue. Ideas for a common framework that could level the playing were first articulated in 1997, when the Basel Committee on Banking Supervision (BCBS) published its core principles for effective banking supervision.
The Basel Framework
From the first Basel I accord on minimum capital requirements to today’s comprehensive Basel III framework, ‘Basel’ has been a significant catalyst for improvement.
Risk management is now an essential component of corporate governance, the role of corporate risk officers is now clearly defined, and boards establish a bank’s risk appetite, as well as risk management policies and strategies.
Having both a risk and an audit committee is now standard in most banks, with growing awareness of the value of maintaining risk oversight as a separate function.
Basel has evolved and matured to address different aspects of banking risk management. Basel I focused on credit risk, while Basel II firmly established the link between different types of market risk and the capital requirements bank’s needed to maintain in order to mitigate exposures as well as credit risk enhancements
ollowing the financial crisis of 2008/2009, Basel III built on its predecessors by introducing higher and better-quality capital as well as higher risk coverage. A leverage ratio was established to promote building-up capital reserves that banks could from in periods of stress. Two global liquidity standards were introduced: Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR)
Basel IV: Linking risk management and data quality
Basel continues to evolve, and the BCBS committee recently published final reforms to Basel III – which are increasingly referred to as ‘Basel IV’ given game-changing impact on how banks operate.
Basel IV changes how risk-weighted assets (RWAs) – a bank’s assets weighted according to risk – are calculated, raising their required capital ratios. Banks are also subject to more regular and detailed disclosure of reserves and other indicators of financial health.
The rule changes mean banks will have to review capital consumption across their lending product and service offerings and potentially to pricing. This will necessitate major adjustments to business models and strategies. It will also mean a greater reliance on fast, accurate, and up-to-date business data.
As banks press on with moves to digitise sales and customer service, day-to-day operations are becoming more automated. Risk management must now take into account data quality and stable access to relevant and accurate customer and transactional information.
To react effectively to Basel IV, banks will need to consider their IT investments to ensure they can handle growing data volumes, and improve their ability to analyse activity at a granular level.
The implementation of Basel IV represents one of the biggest challenges banks will face in the coming years. New rules around the calculation of risk-weighted assets and their required capital ratios will influence how banks’ engineer their future business models.
In many cases, banks will need to upgrade IT systems and implement dedicated risk management solutions. Otherwise, poor data quality will bring new risks: compromising decision-making, hiding emerging exposures, and creating roadblocks to achieving business objectives.
