Basel IV
Basel IV — formally known as the 'Finalization of Basel III' — is a set of amendments to the Basel framework published by the Basel Committee on Banking Supervision in December 2017 and subsequently revised, with full implementation targeted for January 2026. It fundamentally reforms how banks calculate risk-weighted assets, constrains the use of internal models, and introduces an output floor that limits the capital benefit banks can derive from proprietary credit and market risk models.
Key takeaways
- The output floor requires that a bank's total RWAs calculated using internal models be no lower than 72.5% of what they would be under standardized approaches — effectively limiting model-driven capital reduction.
- Basel IV overhauls the standardized approach for credit risk, making it more risk-sensitive with finer granularity on residential mortgage and corporate exposures.
- The internal ratings-based (IRB) approach is restricted: advanced IRB (A-IRB) for large corporate, bank, and sovereign exposures is eliminated, requiring use of the foundation IRB (F-IRB) or standardized approach.
- The fundamental review of the trading book (FRTB) revamps how banks calculate market risk capital, replacing value-at-risk (VaR) with expected shortfall (ES) and tightening the boundary between the banking and trading books.
- Implementation will increase capital requirements for many European and Asian banks significantly — industry estimates suggest a 15–25% increase in total RWAs — with disproportionate impact on banks with sophisticated internal models.
Explanation
The impetus for Basel IV was the Basel Committee's recognition that excessive variability in risk-weighted assets across banks — even for identical portfolios — was undermining market confidence in reported capital ratios. Studies found that RWA calculations for the same hypothetical portfolio could vary by 30–40% across different banks using internal models, making cross-institution capital comparisons meaningless. The output floor is the principal mechanism to address this: by requiring that model-derived RWAs be at least 72.5% of standardized RWAs, the framework sets a lower bound that prevents banks from using ever-more-optimistic models to perpetually reduce their capital base.
The FRTB, arguably the most technically complex element of Basel IV, requires banks to fundamentally reconstruct their market risk infrastructure. The shift from 99th percentile VaR (10-day horizon) to 97.5th percentile expected shortfall (ES) at varying liquidity horizons (10 to 120 days, depending on asset class) is designed to better capture tail risks. The internal models approach under FRTB requires that each individual trading desk pass statistical backtesting requirements independently — a material escalation from the entity-level test under Basel II.5. Desks that fail backtesting are 'expelled' to the standardized approach, creating strong incentives for banks to improve model quality or consolidate trading books.
The restriction on internal models for credit risk — particularly the elimination of A-IRB for large corporate and financial institution exposures — reflects the Committee's view that banks were systematically underestimating probability of default (PD) and loss given default (LGD) for these exposures. Under F-IRB, banks can estimate PDs but must use regulatory-prescribed LGDs (45% for senior unsecured corporate claims), removing a key lever of capital optimization. Banks heavily reliant on A-IRB for large corporate lending — particularly European universal banks — face the largest incremental capital requirements from this change.
For hedge funds and asset managers, Basel IV has practical implications through the counterparty credit risk and CVA (credit valuation adjustment) frameworks. The revised standardized approach for counterparty credit risk (SA-CCR) replaces the older current exposure method (CEM) and is significantly more sensitive to the netting benefits of central clearing. This creates a stronger incentive for banks to push clients toward cleared derivatives — consistent with post-Dodd-Frank policy goals. Hedge funds accessing uncleared OTC derivatives (e.g., exotic FX options, bespoke total return swaps) will face higher margin and financing costs as banks pass through the incremental SA-CCR capital charge.
Formula
Output Floor: Internal Model RWA >= 72.5% x Standardized Approach RWA FRTB ES (Expected Shortfall): ES = (1/(1-alpha)) x integral from alpha to 1 of VaR(u) du, where alpha = 0.975
Example
A European universal bank currently calculates corporate loan RWAs of €200 billion using its A-IRB model, which applies an average risk weight of 20% (reflecting its optimistic internally-estimated PDs and LGDs). Under Basel IV, it must switch large corporate exposures to F-IRB with prescribed LGDs, increasing the average risk weight to 35%, and the output floor then applies: the standardized approach for the same portfolio yields an average risk weight of 45%, so the floor requires minimum RWAs of 72.5% × (45% × portfolio) = 32.6% average risk weight. The bank's effective corporate loan RWAs increase from €200 billion to approximately €326 billion — a 63% increase — requiring roughly €9 billion of additional CET1 capital at the 7% minimum ratio. This drives the bank to either raise capital, reduce the size of its corporate loan book, or accept a meaningfully lower return on equity.
Related terms
Aml Anti Money Laundering Backtesting Basel Iii Clearing Credit Risk Default Equity Expected Shortfall Floor Liquidity Margin Market Manipulation