Agefi Luxembourg - février 2025

AGEFI Luxembourg 24 Février 2025 Fonds d’investissement B asel IV represents a significant overhaul of banking regula- tion, bringingwith it newre- quirements designed to improve financial stability and riskmanage- ment in the global banking sector. Among these changes, the intro- duction of theOutput Floor (OF) is a critical element that aims to address the va- riability of Risk-Weighted Assets (RWAs) calculated using Internal Ratings- Based (IRB). This article examines the far- reachingimplicationsoftheOF,fo- cusing on its impact on banks using the IRB approach for capital adequacy. It delves into whetherthesebankswillretaintheirIRBortransition toStandardizedApproach (SA) andexamines the re- sulting impact on regulatory compliance, capital re- quirements, andoverall riskmanagement practices. Understanding theOF: ARegulatoryGame-Changer BaselIVintroducestheOFasawaytocontrolthevari- ability of RWAs calculated using IRB. While it is ex- pected to be fully implemented by 1 st January 2028, andappliedat the consolidated level, theOFwill im- pact the entire banking group rather than individual banks. The OF requires that capital from IRB-based calculations is not less than 72.5%of the amount cal- culated under SA. This ensures that if a bank’s RWA from IRB drops below 72.5% of the RWA calculated under SA, the bank’s capital requirement alignswith the standardized threshold, ensuring a minimum level of capital that reflects SA (EBA, 2017). BylimitingthereductionofRWAsachievablethrough IRB, theOFpresents significant challenges for banks, particularlyintermsofincreasedcapitalrequirements and operational costs. According to the European Commission, Basel IV is expected to increase mini- mumcapital requirements by 6.4%to 8.4%by 2030. This regulatory shift poses challenges for banks rely- ingontheIRBapproach,whichpermitstheuseofin- ternal risk models to calculate RWAs. While this approachprovides greater flexibility andmore accu- rate riskmeasurement, it comeswith higher require- mentsrelatedtomodeldevelopment,validation,and maintenance. The Output Floor reduces RWA vari- ability, ensuring a level playingfieldand strengthen- ing confidence in capital adequacy (FSB, 2020). IRBvs. SA:AComparativeOverview The IRB approach is widely used in major financial hubslikeGermany,FranceandItaly,withleadingEU bankssuchasBNPParibas,DeutscheBank,andUni- Credit relyingheavily on thesemodels.According to the ECB, over 90 banks under the Single Supervisory Mechanism (SSM) are authorized to use IRB for at least some of their risk assessments. The IRB approach allows banks to assess credit risk using internallydevelopedmodels, subject to regula- tory approval. This model is highly sensitive to a bank’s actual risk profile, which can result in lower capital requirements, especially for large institutions with complex operations. However, using IRB comeswith challenges: -Complexity :DevelopingandvalidatingIRBmodels requires substantial expertise. Ongoing regulatory scrutiny further adds to the challenges (TRIM, 2020). - Regulatory Approval : The IRB approach necessi- tatesapprovalfromregulators,withinitiativeslikethe TargetedReviewofIRBensuringcomplianceandro- bustness - Flexibility :While the IRBapproachallows banks to tailor theirmodels to their unique riskprofile, theOF increasingly constrains this advantage. In contrast, the SA approach uses fixed risk weights determined by regulators for various asset classes. While simpler and less costly than the IRB approach, it has its own set of drawbacks: - Higher Capital Requirements : SA generally leads to higher capital requirements since it does not ac- countforthespecificriskprofilesofindividualbanks. As a result, banks with complex portfolios or lower- risk exposuresmayfindSA less efficient. -SimplicityandTransparency :SAisstraightforward, using prescribed risk weights for various exposures. It is also more transparent, with clear guidelines on how risk weights are applied to assets (IMF, 2018). However, this simplicity comes at the cost of granu- larity andprecision. - LowComplianceBurden : SAdoes not require reg- ulatory approval or ongoing validation, making it more accessible for smaller banks. Most SME banks in the EU, often referred to as Less Significant Institutions (LSIs), tend to use SA due to limited resources. There are over 2,500 LSIs in the Eurozone, andmany of these banks rely ex- clusively on SA. HowtheOF redefinesCapitalAdequacy Pricing strategies : By adopting differenti- ated pricing across various portfolio seg- ments, banks can enable certain areas to absorb the increased capital requirements. This approachdistributes the financial bur- den while maintaining competitiveness in keymarket segments. Balance Sheet Adjustments : The OF can have broad implications for banks’ balance sheets, requiring strategic capital allocation adjust- ments. Thismay compel banks to revise their lending practices or explore securitization and other capital optimization strategies to mitigate the impact (ABBL, 2023). Also, large banking groups could adopt a strategic approach by adjust- ing the balance sheet structure and leveraging capital requirements within their various subsidiaries. Shift toCapitalMarkets : The strat- egy that involves restricting high- risk segments or less profitable areas, could potentially reduce creditofferingstocertainsectors.As aresult,banksmightshiftlong-term financing to capital markets, with larger corporate clients opting to issue bonds as a more attractive al- ternative to banking products. Systemic RiskMitigation : The OF aimsprimarily tocurbsystemic risk by ensuring that banks maintain sufficient capital buffers,evenwhenIRBmightunderestimateRWAs. By setting a minimum capital level, the OF reduces the chances of underestimating risk exposure, par- ticularly during economic turmoil. This approach aligns with recommendations from the FSB on strengthening the resilience of the banking sector. Adapting to theOF: StrategicApproaches In response to theOF, banks using the IRB approach arelikelytoadoptahybridstrategytomanagethein- creasedburdenof compliance: - Selective IRB Retention : Banks could strategically retain IRB for high-risk portfolios where the benefits ofdetailedriskassessmentoutweighthecosts.Forless critical segments, adopting SAmayprovemore cost- effective. - Model Optimization : To counter the OF’s impact, banks may refine their IRB models to align more closelywithSAriskweights,minimizingcapitalpres- sures imposed by the floor. Advanced analytics and machine learning techniques couldplay a role in im- provingmodel efficiency. -RegulatoryEngagement :Activedialoguewith reg- ulators will be essential. Collaborative efforts could help banks align their strategies with evolving regu- latory expectations (EBA, 2017). Financial Implications: Costs andSavings fromIRBModels While the OF limits the capital savings achievable throughIRB,thecost-benefitdynamicsoftheIRBap- proachversus SAremain important: - Development Costs : Large banks could spend up to $200 million on IRB development, while smaller banksmayinvestsignificantlyless.Maintenancecosts also add to the financial burden. -CapitalSavings :TheIRBapproach,despitethecon- straintsoftheOF,stillofferspotentialsavings.Forex- ample, a bank using IRB might achieve a 27.5% reduction in RWAs compared to SA, though the OF caps the benefits. These savings, coupledwith strate- gic deployment of IRBmodels, can offset the associ- atedhigh costs. -Operational Efficiency : The customization allowed by IRB enables large banks to optimize their capital more effectively thanunder SA, justifying the invest- ment in complex systems for certainportfolios. Conclusion:ABalancingAct for Banks The introduction of OF under Basel IV is a game- changerforbanksutilizingtheIRBapproach.Bylim- iting the reduction of RWAs achievable through IRB, theOFpresentssignificantchallengesintermsofcap- ital requirements and operational costs. To address these challenges, banks can consider a hybrid ap- proach, leveraging IRB for high-risk portfolios while usingSAforsimplerexposures.Thisstrategybalances cost efficiencywith the advantages of IRB.Addition- ally, advancements in data analytics and machine learningofferopportunitiestoenhanceIRBefficiency. Ultimately, the OF underscores the need for a dy- namic approach to capital adequacy, one that com- binesregulatorycompliancewithstrategicinnovation. Bynavigatingthesechangeseffectively,bankscannot onlymeetregulatoryexpectationsbutalsostrengthen their resilience in an evolvingfinancial landscape. Nadine KHODR Senior Manager – Risk Management Alma DIZDAREVIC Manager – Risk Management HACA Partners Consulting France S.à r.l. Basel IV and the Output Floor (OF) Navigating the Future of Capital Adequacy Empowering Financial Services with Specialized RiskManage- ment Training T he LuxembourgAsso- ciation for RiskMana- gement (ALRiM) and theGlobal FundRiskAsso- ciation (GFR) have joined forces to introduce a ground- breaking initiative in the field of riskmanagement. These two esteemed organi- zations, eachwith a strong commitment to fostering a culture of riskmanagement, are proud to announce the launch of their collaborative risk academy. This compre- hensive venture ismeticu- lously designed to address the evolving needs and chal- lenges facedby professio- nals in financial services. ALRiM has been at the forefront of riskmanagement development inLuxembourg since its inception in1997.Theassociation’scoremis- sion is to cultivate a thriving cul- ture of risk management across Luxembourg. ALRiM’s mem- bership comprises a diverse group of individuals, experts, and professionals who are pas- sionate about risk management. They hail fromvarious sectors of the financial industry and the broader economy. To achieve its objectives of promoting a culture of riskmanagement,ALRiMhas two main focuses. Thefirstistheorganizationofcon- ferences,incollaborationwithlocal associations such as ALFI, ABBL, ILA, ALCO, CFA, IIA, but also withentitiesoutsideLuxembourg such as theWEF. The second area of promotion is financial educa- tion. Since its creation,ALRiMhas beeninvolvedinthedevelopment and implementation of compre- hensive training courses focusing on riskmanagement. TheGlobal FundRisk (GFR) is a newAssociationdedicatedtopro- motingworldwidethecultureand best practices of riskmanagement specifically for investment funds. GFR’s membership is global and diverse,includingindividuals,ex- perts, and professionals from all sectors of the fund industry. To achieve its objectives, the GFR or- ganizes conferences, notably in collaborationwithALRiM,andfa- cilitates the exchange of informa- tiononriskmanagementbetween itsmembers. Members gain access through a rigorous certification exam, demonstrating their expertise in riskmanagement.Thecertification exam is entirely based on the ref- erence book “Risk Management for Investment Funds,”published by McGraw Hill. Certification exam sessions have already been held in Luxembourg, Milan and Boston.Furthersessionsaresched- uled over the coming months in Paris, Luxembourg, Milan. The plan is to hold further sessions in other countries, both inEurope, in US andAsia, to welcome profes- sionals interested in risk manage- mentforinvestmentfundsfromall over the world. The collaborative efforts of ALRiM and GFR have culminatedintheestablishmentof theALRiM/GFRRiskAcademy , apioneeringinitiativeaimedaten- hancingriskmanagementcapabil- ities within the financial services sector. This academy is set tooffer a diverse range of specialized courses tailored specifically to the needs of investment funds. Theacademy’sinitialofferingcon- cerns preparatory courses for the GFR certification exam, now re- placing the former certification program offered in collaboration betweenALRiMandtheHouseof Training. These first sessions start at the beginning of April. The courses are prepared and deliv- ered bywell-known experts from numerousinstitutionsinthefinan- cial community. The risk academy aims to be a valuable instrument for the finan- cial centre, and even beyond its borders. Like the conferences of- fered by the two associations, the riskacademywilltakeacollabora- tive approach with existing enti- ties, and will in no way compete with any other organization. Its primary vocation is, and will re- main, the promotion of riskman- agement culture, and the development of best practices. Future Expansion Looking ahead, the ALRiM/GFR Risk Academy is committed to broadening its curriculum to ad- dress other critical areas of finan- cial riskmanagement. In the near future,theacademyplanstointro- duce courses focused on the pre- vention of money laundering (AML) and the combating of ter- rorist financing (CFT). The pro- posed AML/CFT program will focus on a risk-based approach, making the best use of risk man- agement techniques. These addi- tions will further equip professionals with the necessary skills and knowledge to navigate the complex and dynamic land- scape of financial risk. The launch oftheALRiM/GFRRiskAcademy marks a significant milestone in the field of risk management ed- ucation. By combining the strengthsandexpertiseofALRiM and GFR, this academy is poised to become a leading resource for professionals seeking to enhance their proficiency in risk manage- ment.Theacademy’scomprehen- sive and evolving curriculum is designed to meet the current and future needs of the financial serv- ices industry, ensuring that prac- titioners are well-prepared to addressthechallengesandoppor- tunities that lie ahead. In conclusion, the ALRiM/GFR Risk Academy embodies the shared vision of ALRiM and GFR to foster a robust culture of risk management through edu- cation and collaboration. This initiative underscores the impor- tance of continuous learning and adaptation in the ever-changing world of financial services, ulti- mately contributing to the stabil- ity and resilience of the global financial system. More information inthewebsite: www.globalfundrisk.org/courses ALRiM and GFR launch Innovative RiskAcademy