Critically assess the three pillars of the regulatory framework under the Basel Accords

“Basel Committee on Banking Supervision” (BCBS) has issued a series of Basel Accords with the objective to increase the soundness and stability of the international banking system. The aim of these accords is to institute risk measurements and capital requirements for global banks, ascertaining that financial institutions uphold enough capital to assimilate unexpected losses and to conform to their obligations. Basel IV comprises the most recent reforms set related to the “Basel regulatory framework”. It was established upon the former Basel III accord and proposes to cover the weaknesses and gaps in the banking system. Under this framework of Basel IV, emphasis is on the extra capital requirements, more risk assessment methodologies, and raised the overall resilience of banks. Under Basel IV, the three pillars of the regulatory framework remain important to promote the soundness and stability of the banking system by minimizing potential financial crises.

Supervisory Review Process

This pillar of the Basel Accords underlines the significance of effective regulatory authorities’ supervision. It necessitates banks to take continuance assessments of the capital adequacy, internal controls, and risk management process. The aim is to ascertain that banks have full-bodied risk management models and that the supervisors possess the requisite tools to assess and deal with potential risks. Basel IV has introduced additional requirements to strengthen this pillar, Basel IV intends that banks need to take stress tests and raise their risk management capacities. In this regard, Basel IV put more focus on the utilization of innovative risk management techniques, including different internal models, important to compute capital requirements. It requires that banks need to place robust risk management techniques to evidence that capital adequacy is commensurable with the risk profile.

Market Discipline and Disclosure

Pillar three of the Basel Accords is concerned with transparency enhancements through disclosure requirements, this pillar aims to ascertain that the information being disclosed should not only be understandable but also comprehensive which could facilitate the participants to make appropriate decisions based on that information moreover, it will also help to reduce information asymmetry. It is urged for banks to reveal pertinent information regarding risk profile, risk assessment activities, and capital adequacy which is considered significant for transparency as well as market discipline. The proposed, Basel IV further aims to enhance these disclosure requirements by inducing the need to reveal information regarding liquidity risk and leverage ratios in addition to a more elaborated disclosure of practices of risk assessment, capital adequacy, and risk profile. The proposed more comprehensive disclosure practices would assist investors in understanding bank-related risks and it would be an effective step towards a more transparent and disciplined market.

Minimum Capital Requirements

This pillar of the “Basel Accords” emphasizes instituting “minimum capital requirements” for banks. Its objective is to ascertain that banks maintain enough capital level to maintain financial stability and absorb losses. Under Basel III, the calculation of the capital requirement based on “risk-weighted assets” (RWAs) was at the discretion of banks, however, Basel IV was designed to solve this issue by bringing credibility to these calculations and enhancing capital ratios comparability. Credit risk could be calculated based on internal rating, for the operational risk the standardized approach, focused on the leverage ratio and also imposed an output floor with a 72.5% threshold of the RWAs calculated by using a standardized approach. Basel IV brings in more rigid capital requirements, with the inclusion of the “Common Equity Tier 1” (CET1) capital ratio, which necessitates banks to uphold a minimal quantity of “high-quality capital” in proportion to their RWAs. Additionally, under Basel IV, this pillar also urges to computation of the RWAs based on operational, market, and credit risks. In this regard, Basel IV incorporated the changed standardized operational risk, credit risk, market risk and “credit valuation adjustment” (CVA) risk approaches. The capital requirements are not raised however, due to output floor and other models, the capital requirement could be raised. Under Basel IV, the new requirements are contrived to be more risk-sensitive and effectively manifest the inherent risks in portfolios of banks.

In sum, these pillars function in combination to raise the resilience and stability of the banking system. Basel IV presents a positive pace towards a greater risk-sensitive and robust regulatory framework. However, there would be different associated challenges in applying the new standards, the new frameworks require complex models and calculations, arousing worries concerning potential loopholes and regulatory compliance. On the other hand, the implementation process across different jurisdictions could undermine the overall effect. Moreover, there would be challenges, especially for smaller banks lacking the capabilities of sophisticated risk assessment techniques, additionally, the raised capital requirement would be a burden and could impact credit growth, and the leverage ratio would lead towards riskier behavior. With the implementation of Basel IV, banks would find themselves in the position of violating the capital requirements despite having the same equity/deposit amount. Thus, the associated cost could outweigh the gain of a more resilient and stable banking sector.