Basel IV Implementation Guide: RWA Changes & Software

The aggregate output floor is the cornerstone of Basel IV. It mandates that total RWA calculated using internal models cannot be less than 72.5% of the RWA calculated under standardized approaches. This directly limits the capital benefit banks can derive from internal models (IRB, IMA) and is the primary driver of increased capital requirements.

The floor applies at the consolidated level and covers all risk types: credit risk, market risk, operational risk, and CVA risk. It phases in gradually starting at 50% in 2023, increasing to 55% (2024), 60% (2025), 65% (2026), 70% (2027), and reaching the final 72.5% by January 1, 2028.

SA-CCR replaces the Current Exposure Method (CEM) and the Standardised Method (SM) for measuring counterparty credit risk on derivative transactions. It provides a more risk-sensitive framework that better recognizes the benefits of netting and collateral while applying appropriate risk weights to different derivative asset classes.

The SA-CCR exposure calculation consists of two components: Replacement Cost (RC), which captures current mark-to-market exposure, and Potential Future Exposure (PFE), which captures potential increases in exposure over the margin period of risk. PFE is calculated using an aggregation formula across five asset classes: interest rates, FX, credit, equity, and commodities. Each asset class has specific supervisory factors and correlation parameters.

The FRTB fundamentally redesigns how banks calculate market risk capital. It replaces Value-at-Risk (VaR) with Expected Shortfall (ES) as the primary risk measure, capturing tail risk more effectively. The framework introduces stricter boundary rules between the trading book and banking book, a revised standardized approach (SA) based on risk sensitivities, and a redesigned Internal Models Approach (IMA) with desk-level approval.

Key FRTB components include:

• •Sensitivities-Based Method (SbM): The core component of the revised SA, using delta, vega, and curvature risk charges across seven risk classes.
• •Default Risk Charge (DRC): Captures jump-to-default risk separately from market risk, replacing the Incremental Risk Charge.
• •Residual Risk Add-On (RRAO): A capital add-on for exotic instruments with risks not captured by the SbM.
• •P&L Attribution Test: IMA desks must pass P&L attribution tests comparing risk-theoretical and hypothetical P&L to maintain model approval.

Basel IV replaces all existing operational risk approaches (Basic Indicator Approach, Standardized Approach, Advanced Measurement Approach) with a single Standardized Measurement Approach (SMA). The SMA combines a financial-statement-based proxy for operational risk exposure (Business Indicator Component, or BIC) with an institution's own historical loss experience (Internal Loss Multiplier, or ILM).

The Business Indicator (BI) is calculated from three components: the Interest, Leases, and Dividends Component (ILDC), the Services Component (SC), and the Financial Component (FC). The BI is mapped to marginal coefficients (12%, 15%, 18%) in three size buckets. Jurisdictions have discretion on whether to apply the ILM or set it to 1, meaning the BIC alone determines the capital requirement.

The standardized approach for credit risk receives significant enhancements to improve risk sensitivity. Key changes include LTV-based risk weights for residential mortgages (replacing flat 35%), more granular risk weights for corporates and banks based on external ratings, new treatments for specialized lending, and enhanced due diligence requirements when using external credit ratings.

On the IRB side, Basel IV constrains internal model use: the Advanced IRB (A-IRB) approach is no longer permitted for exposures to banks, other financial institutions, and large corporates (consolidated revenue above EUR 500 million). For these exposures, banks must use Foundation IRB (F-IRB) or the standardized approach. Input floors are introduced for PD (5 basis points for most exposures) and LGD (25% for unsecured corporate, 0% for secured with financial collateral).

Basel IV introduces a revised framework for Credit Valuation Adjustment (CVA) risk, which captures the risk of mark-to-market losses on derivatives and securities financing transactions due to counterparty credit spread movements. The new framework consists of a Basic Approach (BA-CVA) and a Standardized Approach (SA-CVA) aligned with the FRTB sensitivities-based method.

The internal models approach for CVA has been removed entirely, reflecting the Committee's view that CVA risk is too complex and illiquid for reliable internal modeling. Banks must choose between BA-CVA (simpler but potentially more conservative) and SA-CVA (more risk-sensitive but requiring sensitivity computation infrastructure).