Basel IV in the U.S: Key Takeaways from the Fed’s NPR

On July 27, 2023, the U.S. Federal Reserve released its long-anticipated Notice of Proposed Rulemaking (NPR), introducing sweeping changes to capital management and regulatory reporting. The proposal marked a significant shift in the measurement of credit, market, operational risks and credit valuation adjustment (CVA), aligning U.S. regulations more closely with Basel IV standards.

As the industry continues to assess the implications of these changes and amid continued debate over their implementation, this article revisits the key elements of the NPR and their potential impact on U.S. credit institutions.

The 2023 NPR signaled a shift in the U.S. toward greater risk sensitivity and standardization, reducing reliance on modeled approaches. While internal models remain permitted for market risk, new complexities make it more difficult for firms to secure model approvals across trading desks.

The NPR introduced more substantial credit risk charges, including:

• Changes to risk weights and revised definitions for asset classes, such as real estate, as well as new methodologies for Standardized Approach for Counterparty Credit Risk (SA-CCR), securities financing transactions (SFTs), equity in funds and securitizations.
• Significant updates to market risk requirements for both modeled and standardized approaches, with potential operational impacts across banks.

Additionally, the NPR required:

• Standardized Market Risk calculations for all in-scope banks, necessitating tight integration with middle-office and risk systems to generate risk sensitivities across asset classes and risk buckets.
• A more uniform Standardized Operational Risk Rule, aligned with international standards but still data- and computation-intensive, relying on historical loss data and business volume.
• New limitations on eligible capital instruments, affecting deferred tax assets (DTAs), mortgage servicing assets (MSA) and minority interests.

The NPR introduced significant revisions to regulatory reporting, requiring material rewrites across multiple reports. Moreover, enhanced public disclosure requirements now demand both qualitative and quantitative substantiation, increasing the need for firms to carefully track data lineage and ensure transparency in reporting.

Source: “Interagency Overview of the Notice of Proposed Rulemaking for Amendments to the Regulatory Capital Rule Applicable to Large Banking Organizations and to Banking Organizations with Significant Trading Activity.” Released July 27, 2023.

Banks have already been paying closer attention to regulatory capital amid volatility in equity prices, rising Allowance for Loan and Lease Losses (ALLL), increasing Net Charge-Offs (NCO) and broader economic uncertainty.

Adding to the pressure, the NPR proposes changes to the treatment of Accumulated Other Comprehensive Income (AOCI), which could further impact capital ratios throughout the transition period. Additionally, reporting updates have been proposed for FR Y-14 Schedule A.1.d.

The NPR aligns U.S. credit risk-weighted asset (RWA) calculations more closely with international standards, introducing several fundamental changes:

• Revised risk weights, segmentation, and calculation methodologies, along with increased data granularity requirements.
• Significant reporting updates, including proposed changes to FR Y-9C, FR Y-14Q (Schedules A and H), FR Y-14M (Schedules A, B, and D), and FFIEC 101.

To comply, banks must reassess the comprehensiveness of their credit risk policies, data pipelines from systems of record and definitions within operational data sources.

The NPR adopts a Standardized Approach to Market Risk (SA-MR), closely aligned with the Fundamental Review of the Trading Book (FRTB), the international standard set by the Basel Committee on Banking Supervision (BCBS).

Many large banks will likely prefer the Internal Model (IM) approach due to potential RWA savings. However, this requires a new model validation process, including a supervisory trading desk-level approach with a specific focus on tail risk and illiquid positions, reflecting lessons from recent market events. Additionally, the desk-centric approach may limit offset and diversification benefits unless banks secure model approvals for all desks.

Notably, the Market Risk rules now apply to firms with less than $100B in total assets if they meet one of the following criteria:

• Trading Assets + Liabilities exceed $5B, OR
• Trading Assets + Liabilities exceed 10% of Total Assets.

Proposed reporting changes include updates to FR Y-14 Schedule A.1.c.1 and likely significant revisions to FFIEC 102.

Revisiting CVA

Banks must now calculate Credit Valuation Adjustment (CVA) capital charges using either the Basic Approach (BA-CVA) or the Standardized Approach (SA-CVA).

While BA-CVA offers a simplified compliance process, banks looking to offset CVA exposure through hedging will likely prefer SA-CVA. However, using SA-CVA requires regulatory approval, adding an extra layer of potential complexity to the implementation.

Banks must now quantify operational risk using actual historical loss data and business volume, reflecting a shift toward a more data-driven, quantitative approach.

The growing frequency of operational risk incidents, such as cyber threats, underscores the need for more precise risk assessment. Additionally, firms must calculate:

• The Business Indicator Component (BIC), derived from three sets of income-based factors.
• The Internal Loss Multiplier (ILM), based on the average annual operational losses over the past 10 years.

Proposed reporting updates include changes to FR Y-14Q Schedule E.

Navigating the path forward

To successfully adapt to the 2023 NPR and forthcoming Basel IV requirements, banks must strike a balance between speed, accuracy and capital optimization. Managing compliance will require dedicated workstreams across all impacted areas—including policy, data strategy, technology, risk management and internal/external reporting—with strong executive oversight to ensure an effective implementation.