What it means
Basel III fixed the amount and quality of capital, and left large banks free to calculate risk weighted assets using internal models approved by their regulator. Over time it became clear that two banks holding near identical loans could report very different risk figures depending on how their models were built.
Basel IV addresses that inconsistency head on. The output floor is the main tool.
A bank's risk weighted assets can no longer fall below 72.5% of what the standardised approach would produce, so a model can still reduce the requirement, but only within a defined limit. Alongside the floor sit revised standardised approaches for credit risk, market risk and operational risk, plus tighter constraints on where internal models may be used at all.
Together these changes tend to raise reported risk weighted assets for banks that had leaned hardest on modelling, especially in mortgage and specialised lending books. The commercial effect falls on borrowers rather than on bank shareholders alone.
Lending that internal models had treated as very low risk, such as well secured mortgages and lending to large corporates, attracts a higher floor based weight, which pushes banks either to reprice it or to lend less of it. Implementation has been staggered, with jurisdictions phasing in the floor over several years and starting from different dates.
That timing difference is itself commercially important, because a bank operating under the full floor competes against one that has not reached it yet.
In practice
Real-world examples.
Example
A large mortgage lender with sophisticated internal models finds its residential book, previously risk weighted in single figures, pushed up by the output floor. It responds by repricing its lowest margin fixed rate products rather than raising equity.
Example
A bank exits a specialised shipping finance business after concluding that the revised standardised approach makes the capital cost of the portfolio higher than the returns justify. The loans are sold to a fund that faces no bank capital rules at all.
Example
A finance director negotiating a corporate facility is told the margin has risen despite an unchanged credit rating. The bank explains that the floor has raised the capital it must hold against that class of lending, which shows how a technical rule change reaches an ordinary borrower.
Think of it
“Basel IV is the newest banking rulebook-the latest refinements to bank capital standards.
Formula
Calculation
Floored risk weighted assets = the higher of internally modelled risk weighted assets and 72.5% of risk weighted assets under the standardised approach
A bank's internal models produce risk weighted assets of $20,000,000,000, while the same book measured under the standardised approach gives $32,000,000,000. The floor is 72.5% x $32,000,000,000 = $23,200,000,000, which is higher than the modelled figure, so $23,200,000,000 becomes the number that counts.
With common equity tier 1 capital of $2,320,000,000, the reported ratio falls from $2,320,000,000 / $20,000,000,000 = 11.6% to $2,320,000,000 / $23,200,000,000 = 10.0%. Nothing about the loans has changed, yet restoring an 11.6% ratio would now take 11.6% x $23,200,000,000 = $2,691,200,000 of capital, a further $371,200,000.Case study
Seen in the real world.
This is an illustrative and clearly fictional scenario. Northgate Union Bank, an invented lender with a strong modelling team, had spent a decade refining internal models that produced very low risk weights on its prime mortgage book. Its reported capital ratio was among the highest in its market, and its management presented that as evidence of conservative lending.
When the fictional regulator confirmed the phase in of the output floor, Northgate's internal projections showed its headline ratio falling by well over a percentage point without a single loan changing. The board had to decide whether to raise equity, retain more earnings, or reshape the balance sheet.
Northgate chose to hold back two years of dividend growth and shift new lending towards products where its models and the standardised approach broadly agreed. The invented chief executive described the exercise as discovering that a good model is not the same thing as a good capital position.
Watch out
Common mistakes.
- Treating Basel IV as a brand new accord, when it is the finalisation of the Basel III reforms and builds on the same framework.
- Assuming the output floor raises requirements for every bank, when banks already using the standardised approach are largely unaffected.
- Comparing capital ratios across countries while ignoring how far each has progressed through the phase in schedule.
Questions
People also ask.
Does Basel IV require banks to hold more capital overall?
Not by raising minimum percentages, but by increasing measured risk weighted assets it raises the amount of capital those percentages translate into.
Why is it called Basel IV if regulators reject the name?
Because the practical impact on measurement is large enough that the industry treats it as a separate reform package.
Who ultimately pays for the change?
Borrowers in the affected categories, through wider margins or reduced availability, and shareholders through slower distributions during the transition.
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