CRD V/CRR II: Overhauling risk and compliance management
Credit Risk Management Under
Basel IV and Beyond
By Xavier Dubois, Director of Risk & Finance, Wolters Kluwer
Published April, 2020
Basel IV has changed the way banks need to
deal with the impact of credit risk on their
finance, risk and regulatory compliance
functions. It is no longer enough to address
credit risk in isolation, as was the case under
the Basel I and II guidelines. Today, banks
need to take a holistic view of how credit risk
impacts – and will impact – their operations,
taking into account the credit risk implications
of various regulatory initiatives that may affect
different aspects of their organization.
Under Basel I, credit risk was isolated as a single point
of focus for banks, making compliance a relatively
straightforward task. This is because all credit risk
considerations were concentrated on a single constraint.
Basel II brought in more complexity by focusing on credit
risk, and at the same time combining capital adequacy
measures from operational and market risk.
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IRRBB – Economic Value of Equity (EVE)
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But regulators were not satisfied that these measures
provided a true perspective of a bank’s risk situation. It
transpired that some banks did not have sufficient data to
drive their internal capital calculation models, rendering
them useless. In other cases, the models were found to be
underestimating the bank’s actual credit risk exposure. The
global financial crisis revealed some serious deficiencies in
Basel II based capital adequacy.
To address these issues, Basel III introduced a fundamental
shift in measuring credit risk by introducing elements
derived from market risk – notably the Fundamental Review
of the Trading Book (FRTB), and carrying that principle of
credit market integration into enhanced measures like
Credit Valuation Adjustment (CVA) and other measures of
an overall counterparty credit risk (CCR).
Basel III has evolved as well, and with further revised
standards like Basel IV, regulators have recommended
further stringency in standards. These standards comprise
a number of additional constraints – relating to CCR,
CVA risk, large capital exposures, and leverage ratios –
that banks must take into account in their credit risk
mitigation efforts.
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2 Credit Risk Management Under Basel IV and Beyond
At the same time, credit risk requirements have been
added to other regulations, among them IFRS 9 and CECL.
This array of interconnected metrics is expected to give
regulators a much more sensitive overall view of credit risk
– especially by way of harmonizing measures like expected
and unexpected losses and provisioning across multiple
standards.
Credit risk impact of Basel IV
The emergence of more stringent rules under Basel IV
means that banks now need to deal with many more
interrelated parameters in order to get a more accurate,
holistic view of their risk and counterparty level exposures.
But banks are increasingly embracing the new metrics
derived from these efforts as practical tools to manage
and improve upon their business activities, with many
preferring to use the new regulatory models over internal
models.
This is, in part, because the new requirements pose real
restraints. To some extent, the original Basel rules were
too simplistic, and many banks configured their systems
merely to comply in what amounted to a box-ticking
exercise. Meeting the new and evolving requirements will
require a real effort on behalf of the banks.
Affected entities need to address the array of credit risk
constraints as they relate to various areas of the business,
and directly impact the finance, risk and regulatory
reporting areas (FRR) of the bank. Banks that are able
to address credit risk in this holistic way not only will
be able to fully assess their current situation, they will
also be able to project scenarios and run stress-tests on
future situations, giving them a forward view otherwise
unavailable through existing approaches.
So, what are the various credit risk constraints banks are
facing under the new Basel IV landscape?
Expected credit loss (ECL)
Within the Basel IV framework, banks will be required
to identify and calculate expected credit loss (ECL)
and assess its impact on the finance function. These
requirements are embodied in IFRS 9 globally and in the
CECL standard for FASB countries such as the US, Israel,
Switzerland and Japan. Between them, the regulations
require firms across the entire global banking sector to
put in place credit risk models that guide ECL calculation.
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Specifically, banks now need to forecast potential credit
impairments of assets on their books, rather than after
the event, as had been required previously. The sheer
number of variables required to make useful forecasts,
as well as the frequency of calculation, make this a data-
intensive requirement.
The message is clear: Banks need to estimate ECL so that
they can take a view of future impact on their financial
situations. This is a significant exercise – and some
commentators have called for relaxing the standards
on some of these requirements due to the coronavirus
pandemic. All estimates of defaults require simulations
and scenario testing that take account of macroeconomic
factors. This is a very demanding element of credit risk
and has a direct impact on capital requirements. ECL is
a key factor for credit risk that influences both financial
statements and capital within the Basel framework.
Concentration risk
The Basel IV framework enshrines the accepted concept
of concentration risk through its measures relating to
large exposures. This deals with a bank’s exposure
to specific counterparties and, like other forms of
concentration risk, is an important aspect of credit risk.
The Basel IV framework aligns concentration risk with its
credit risk categories, while at the same time lowering
the definitional threshold, thereby tightening the capital
adequacy standards. Large exposures are now defined
relative to 10% of the Tier 1 capital, while before it was
defined to 10% of eligible capital, which was always larger
or equal to Tier 1 capital. This means the threshold to
large exposure is now lower than before.
Non-performing loans
Another aspect of the new credit risk requirement relates
to non-performing loans, often referred to as non-
performing exposures (NPEs). Banks need to monitor their
exposures to ensure their banking books’ exposures don’t
exceed regulatory guidelines.
In Europe, the latest iteration of the Capital Requirements
Regulation (CRR 2), which came into force in April 2019,
created a backstop for non-performing loans, requires
a deduction from bank’s own funds when NPEs are not
sufficiently covered by provisions or other adjustments.
Among other things, the new rules describe how to
measure the impact of forbearance measures on NPE
classification and provide for pre-defined calendars for
applying deductions once a loan has received an NPE
classification. Combined, the new measures represent
another data-heavy obligation for regulated banks.
Credit Risk Management Under Basel IV and Beyond
Stress testing
The new CRR 2 also makes provisions for stress tests
on the credit-risk concentrations of large exposures.
According to the regulation, the stress tests should
address “risks arising from potential changes in market
conditions that could adversely impact the institutions’
adequacy of own funds and risks arising from the
realization of collateral in stressed situations.”
To meet this requirement, banks need the ability to
calculate both expected and unexpected losses then apply
stress-testing scenarios across all credit and counterparty
risk parameters.
New mitigations around credit risk
In addition to the measures described above, Basel IV
introduces new mitigations around credit risk. The Basel
IV approach to counterparty credit risk introduces two
new methodologies, the standardized and simplified
standardized approaches, which determine how banks
should calculate exposure at default (EAD). These CCR
methodologies are used in four aspects of Basel IV:
covering credit risk, CVA risk, leverage ratios and
large exposures.
From a business perspective, banks need to realize that
the standardized approach to counterparty credit risk
(SA-CCR) while more expensive to implement, gives higher
levels of business benefit compared with the simplified
approach to CCR.
3
Banks that are able to address credit
risk in this holistic way not only will
be able to fully assess their current
situation, they will also be able to
project scenarios and run stress-tests
on future situations, giving them a
forward view heretofore unavailable
through existing approaches.
Integrating metrics across finance, risk
and regulatory reporting
From a risk perspective, banks need to make changes
in order to be consistent. They need to apply the same
calculation across the four risk aspects of Basel IV; failure
to do so raises the prospect of inconsistency. Banks that
are inconsistent will incur regulatory reporting issues in
validation, and these will be identified by the regulators.
And those banks that fail to pass regulatory audits
will face regulatory strictures.
Together, these new credit risk measures present firms
seeking to both comply and derive business benefit with
an integration challenge that straddles the finance, risk
and regulatory reporting (FRR) spectrum.
Banks that are able to formulate an integrated response to
the financial aspects of IFRS 9/CECL, with the requirements
on concentration risk, NPEs and stress testing, will not
only benefit from a holistic view of their current credit risk
situation, but will also be able to project scenarios going
forward to derive a realistic future view. This approach
allows the bank to assess the different aspects of credit
risk within a single environment. It will show the current
as well as the future impact across finance, risk and
regulatory compliance, as well as the impact on capital
and liquidity.
Credit Risk Management Under Basel IV and Beyond 4

What is needed
For banks today, this vision is appealing. To date, firms Banks that are able to formulate
generally have managed each of these credit risk aspects
– and the impact on target areas of the business – on an integrated response to the
an individual basis. This absence of a holistic view has
hampered efforts to project credit risk and its future financial aspects of IFRS 9 /
impact across the board – namely, by sector, by country
and by business line. CECL, with the requirements
To establish a more holistic view of their credit risk on concentration risk, NPEs
situation, banks need to navigate this new regulatory
landscape. To formulate this broad view, they need new and stress testing, will not only
tools that can facilitate the multifaceted management of
the credit risk elements governed within the new post- benefit from a holistic view
Basel IV regulatory framework.
on their current credit risk
For those embracing the challenge, the benefits are
significant. Besides compliance with the gamut of new situation, but will also be able
rules governing credit risk, banks stand to gain from
enjoying future risk projections for the first time. Although to project scenarios going
some banks have attempted to derive a forward-looking
view using internal models or proxies, these approaches forward to derive a realistic
have been fragmented, time-consuming and potentially
misleading. future view.
What is needed is a system that allows banks to project
their current situation forward, allowing them to assess
the impact of future scenarios on their activities. The
system needs to pull together the bank’s current business
situation, as well as metrics derived from its Basel IV and, Achieving true interconnectedness across Basel IV,
IFRS and CECL calculations. By adopting this approach, IFRS 9, CECL and other credit risk measures finally gives
banks can assess future impact, enabling them to make banks the metrics they need to properly manage risk
the right decisions for the business going forward. exposure and their businesses.

About Wolters Kluwer

Wolters Kluwer (WKL) is a global leader in professional information, software solutions, and
services for the healthcare; tax and accounting; governance, risk and compliance; and legal and
regulatory sectors.

Wolters Kluwer reported 2019 annual revenues of €4.6 billion. The group serves customers in over
180 countries, maintains operations in over 40 countries, and employs approximately 19,000 people
worldwide. Wolters Kluwer shares are listed on Euronext Amsterdam (WKL) and are included in the
AEX and Euronext 100 indices.

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