1. Introduction

In a statement in 2012, Andrew Haldane, Chief Economist and Executive Director of Monetary Analysis at the Bank of England, singled out the shortage of capital as one of the main motives that prevented banks and financial institutions to weather the financial crisis of 2007-2008 that led to the consequent controversial bailouts. Apparently, his view is shared by supranational regulators like the Basel Committee of Banking Supervision (BCBS), given the scale of the changes of Basel III with respect to its predecessor Basel II, particularly in key areas like market, credit and liquidity risks. However, even though the main objectives residing in strengthening the capital base and increasing the liquidity and credit risk provisions seem achieved, the Basel mandate is continually evolving.

Even though Basel III is still in implementation phase, in the meantime, the BCBS is reviewing its structure with a view to carry out some modifications to improve some departments, especially through a programme specifically directed to address market risks. Acknowledging the academics’ opinion, the BCBS issued a document comprising the guidelines of the future Capital Framework with such depth that many practitioners ventured to call it Basel IV² (^{Heltman (2014)}). The Directive contains a radical overhaul to the capital ratio, risk weights and the two appraisals designed to compute the Minimum Capital Requirements (MCR): the SA and the IMA, which might be interpreted as a move away from the latter towards the former. The appearances suggest that the BCBS was suspicious of the banks’ reliance on internal models and therefore demanded the implementation of different new standards imposing a much higher floor that may eventually result appropriate for some institutions but inadequate for others. The whole new regulatory body seemsto be shifting away from a models-based structure towards an arguably easier scheme characterised by simpler and tougher capital ratios, combined with additional risk measures. Market-risk models, then, give the impression of being thrown into oblivion, thus obscuring their outlook.

It is precisely there where the motivations of the current study lie. Due to the extent of the new regulations, the opportunity to raise objections and to express the concerns is proper. Furthermore, as for the first time in the history of the supranational regulations the BCBS makes a distinction between developed and emerging markets, dealing with the latter to the detriment of the former adds an extra layer of interest in the novelty of the route taken here. Consequently, the article will be focused onand contribute to the financial literature carrying out a thorough quantitative evaluation of the prospective norms in the context of the Mexican emerging economy, carefully ascertaining the characteristics of the newly enacted SA and IMA (employing a considerable array of techniques); assessing the appropriateness of the capital floors and gauging the balance between the SA and the IMA. A perusal of the regulatory body suggests a crackdown on modelling, characterised by the stressed calibration for ES-based models accompanied by the stringent set of validation tests, which, coupled with the radical revamp of SA designed to hike minimum capital levels, lends to hypothesise that the future for models under Basel IV would look grim, possibly rendering themshort of useless because of two potential reasons: a) their capital levels could exceed those of the SA by huge margins, or b) they may deliver capital levels smaller tan SA’s but, although still sufficient enough to provide protection against huge market slumps, be ineligible on the grounds of situating below the official floor. The main objective, then, is to evaluate the test the appropriateness of the proposed regulations through the hypothesis of the disadvantageous position in which the theoretical assessment of the norms locate the modelling avenue; (if) and once it is determined, the paper will proceed to recommend straightforward alternatives to align SA and IMA and find a reasonable compromise that may allow banks to select between them instead of adopting a mandatory alternative.

The paper unfolds as follows. Section 2 synthetically outlines the basic notions underpinning the Basel IV reform, spanning the characteristics of the SA and the IMA and specifically emphasising the interaction between both approaches regarding the new floor embodied in the SA; Section 3 sketches a review of the literature that permits the location of the current study among the existing academic body and spot its distinctive elements that may contribute to the field; Section 4 explains the methodology that guided the study, from the construction of the portfolios to the calculation of the MCR and the respective validation standards; Section 5 details the results of the experiment from the regulatory stance and identifies the incentives (or, more precisely, the lack of) embedded into one or the other alternative and, furthermore, into the several possibilities belonging to the IMA and, finally, Section 6 provides the concluding remarks that reflect on the whole process and highlights the policy implications that the Basel IV framework might bring about stemming from its impact on the capital structure of the firms, simultaneously suggesting an alternative way -inside Basel platform- susceptible of remedying the imbalances found.

2. The prospective Basel IV

In spite of the fact that Basel III remains to be fully applied, the BCBS embarked on a thorough revision of the Basel III Capital Accord after realising that, in many respects, the Basel 2.5/III package “…did not fully address the shortcomings of theframework” (^{BCBS (2013)}). In a series of Consultative Documents (^{BCBS (2012}, ²⁰¹³ and ²⁰¹⁴⁾), the BCBS specified that the main areas of focus lay in: a) the trading book/banking book boundary, b) the treatment of credit, c) the approach to risk measurement, d) the incorporation of market illiquidity, e) the treatment of hedging and diversification, f) the relationship between the IMA and SA, and g) the comprehensive revision of the IMA and SA. In view of the strong bearing on the Pillar 1, namely the capital adequacy rules, the current article discourses on topics c), f) and g) where Basel IV brings, prior to any consideration about its adequacy, several radical changes compared with Basel III.

3. Literature review

The issue of capital sufficiency has always been a contentious one and appears far from being settled, either from the regulatory or academic points of view. Even though the advent of the successive Basel Capital Accords allowed the amendment of the glitches in the previous regulations, the literature remains at odds regarding the virtues of the mandates. In this sense, while ^{Caruana (2005)} hails Basel II in view of its evolutionary aspects referred to implementation, calibration, validation and cross-border supervision, ^{Repullo and Suarez (2013)} question the procyclicality of Basel II. The authors go beyond, venturing to assert that Basel II bears more procyclical elements than Basel I, but, on the other hand, its capital levels turn banks into safer business units. The snags of Basel II become more evident in ^{Herring (2005)}, who emphasises that the alleged gains from the adoption of Basel II are far outweighed by the costs of implementation and compliance.

The BCBS, performing its role as the supranational regulatory authority, typically employs the financial crises as a real time test to assess the adequacy of the Capital Accords, and, after proper consultation periods, and QIS, enacts partial or radical modifications to the existing order. However, it seems that it usually overlooks many important implications; ^{Demirguc-Kunt, Detragiache and Merrouche (2013)} study a multicountry panel of banks before and after the subprime crisis of 2007-2008 and argue that different forms of capital exert different effects on the performance of the banks. Furthermore, they advocate the endorsement of higher forms of capital such as the Tier 1 and tangible common equity as alternatives to the BCBS’s risk-adjusted capital ratio on the grounds of their relevance on the constitution of a stronger capital position.

After the 2007-2008 crisis and the consequent Basel 2.5 Amendment and Basel III Capital Accord, many authors commented on the patterns of the new regulations. Perhaps not surprisingly, the most stinging criticisms are referred to VaR, which application asa risk measure was bolstered in Basel III. From the seminal paper of ^{Artzner et. al. (1999)}, VaR has been branded an ‘incoherent’ risk metric given its failure to comply with the subadditivity property that any risk measure must portray¹⁶. Furthermore, ^{Artzner et. al. (1999)} emphasise that VaR, by construction, can only estimate a quantile which does not enable it to inform about losses beyond that point. That alleged flaw prompted the BCBS to suggest other alternatives which may bridge those deficiencies like ES as well as other Spectral Risk Measures (SRM) (^{Acerbi (2004)}), of which the former seems to be the BCBS’s preferred choice.

ES has been extensively studied (^{Artzner et. al. (1999)}, ^{Acerbi and Tasche (2002)}, ^{Föllmer and Schied (2002)}, ^{Yamai and Yoshiba (2005)}) and branded as an intuitive and coherent risk measure. ^{McNeil, Frey and Embrechts (2005)} highlight that ES reverts themost notorious VaR’s snags given that: i) ES always complies with the ‘coherence’ axioms established by ^{Artzner et. al. (1999)}; ii) ES ameliorates the risk of selecting a particular confidence level as it represents the average of losses beyond that confidence level. This last property reveals especially important for regulatory bodies, which are undoubtedly concerned with shortfalls greater than VaR, i.e., losses posing risk to the financial health of the entity (^{BCBS (2012)}).

Up to the so-called Basel IV¹⁷ Consultative Document, the BCBS had intendedto remedy VaR’s glitches with the introduction of several refinements, shaped in the enactment of the stressed VaR and the exogenously determined Capital Conservation and Countercyclical Capital Buffers (^{BCBS (2009)}). However, instead of celebrating those amendments, the literature demanded the end of VaR-based models in the capital framework: ^{Danielsson, Shin and Zigrand (2009)} and ^{Adrian and Shin (2013)} opine that VaR accelerates the crises instead of halting their progress. Basel IV effectively replaces VaR for ES (^{BCBS (2012}, ²⁰¹³⁾) in what constitutes a significant departure from the previous regulatory approaches to determine bank capital -both conceptually and procedurally-, a move partially suggested by ^{Hellwig (2009)} and ^{Danielsson, Shin and Zigrand (2009)}. However, in addition to the most renowned snags referred to the IMA that the BCBS intends to tackle (^{BCBS (2013)}), it remains to be evaluated whether the inception of ES as the official market risk measure reduces the alleged VaR ‘manipulation’ that may enable banks to erect lower capital requirements, as highlighted by ^{Hellwig (1995}, ¹⁹⁹⁶⁾ and ^{Danielsson and Zigrand (2006)}, though the latter make use of derivatives.

The BCBS took special care in strengthening the process of evaluating the capital estimation; in addition to the qualitative considerations, Backtesting and Stress tests contained on Basel III, a new battery of tests is proposed. Hence, admitting the difficulty in backtesting ES in view of its inherent structure (^{Kerkhof and Melenberg (2004)}), the BCBS improves the current framework keeping an enhanced VaR-based Backtesting (“Breach test”) and adding two P&LAT, which are designed to attest whether VaR models keep track of the variations in the dynamic properties of risk as demanded by ^{Berkowitz and O’Brien (2002) 18}.

The BCBS maintains its stance at the time of dealing with the schemes within the IMA as there are no specific indications on that respect. Consequently, all the techniques developed by the practitioners might in principle be applied to estimate ES, much in the same fashion than in Basel II and Basel III; in this vein, alternatives like Historical Simulation (^{Manganelli and Engle (2001)}, ^{Dowd (2005)}), Filtered Historical Simulation (^{Barone-Adesi, Bourgoin and Giannakopoulos (1998)}, ^{Boudoukh, Richardson andWhitelow (1998)}), Conditional Volatility (^{McNeil, Frey and Embrechts (2005)}, ^{Alexander (2008)}, ^{Engle (1982)}, ^{Bollerslev (1986)}, ^{Taylor (1986)}, ^{Nelson (1991)}) and Extreme Value Theory (^{Embrechts, Klüppelberg and Mikosch (1997)}, ^{McNeil and Saladin (1997)}, ^{McNeil, Frey and Embrechts (2005)}, ^{Coles (2001)}, ^{Reiss and Thomas (2007)}) are available, among many others (^{Christoffersen (2003)}, ^{Alexander (2008)}). The fitting prowess of the representations remain to be analysed, particularly in the event of major crises (which constitute the BCBS’s major concern), although ^{Rossignolo, Fethi and Shaban (2012}, ²⁰¹³⁾ show that highly leptokurtic models could -under certain circumstances- have prevented banks from falling into bankruptcy to the point of avoiding the more stringent Basel III regulations.

The SA has also been subject to a major revamp under Basel IV proposed reform in order to achieve the major objectives outlined by the ^{BCBS (2014)} materialised in: providing an alternative methodology for banks not qualifying for the IMA, finding a credible fallback for models and, finally, facilitating the comparison of capital levels across borders. In this sense, the BCBS put forward a sensitivity-based approach that resembles the Markowitz framework (¹⁹⁵²), although the market correlations are prescribed by the BCBS. The ^{BCBS (2014)} nonetheless informs that market participants were demanding the ditching of the flat rate characteristic of Basel II and Basel III in favour of a more market oriented appraisal.

The issue of capital sufficiency, finally, has always been subject to heated controversy, particularly because of its close connection with the regulatory requirements, given that banks usually tend to adjust their capital buffers in such a manner that they only exceed the minimum levels by a small margin (^{Berger et. al. (2008)}). Consequently, the adequacy of the capital framework acquires utmost relevance and, consequently, it is not surprising to find opposing views: from ^{Haldane (2011)} who underlines the complexity and lack of robustness of the regulatory structure which augments the model error in the IMA and the ensuing inappropriateness of the capital ratios, to the staunch support of the countercyclical capital buffers in ^{Shim (2013)} and the criticism launched by ^{Rossignolo, Fethi and Shaban (2013)} who question the application of Basel III and propose the utilisation of Basel II with highly leptokurtic models, as well as a complete revision of the SA.

The current article contributes to the literature from different angles, with reference to the new proposals susceptible of being labelled Basel IV: in the first place, it targets the quantification of the introduction of ES in the respective settings forthe estimation of MCR using a variety of models (IMA) in comparison with the analogous requirements in Basel II and Basel III; in the second place, it critically evaluates the numerical relationship between the ES-based IMA and the market sensitive SA assessing the incentives to develop accurate internal models and, in the third place, it fosters the suitable and (easily) applicable calibration remedies in order to align incentives, specifications and capital buffers between IMA and SA.

4. Methodology

To assess the impact of the new proposals on the banks’ capital base, the present paper works on long stock portfolios comprising Mexican companies. For the sake of simplicity and tractability, two classes of three asset portfolios are constructed: Portfolio 1 -equally weighted- and Portfolio 2 -minimum risk-¹⁹, and firms are selected and allocated pursuing data reliability and consistency employing primary data extracted from Thomson Reuters® and finally applying Basel IV criteria referred to the allocation in terms of ‘large’ or ‘small’ firms²⁰ (Table 5, Columns [8-9]).

IMA and SA allow the determination of capital levels. With regards to the former, the article employs Historical Simulation (HS), Filtered Historical Simulation (FHS) featuring GARCH and EGARCH specifications appended by Normal and Student-t distributions(FHS/GN, FHS/EN, FHS/Gt and FHS/Et), Conditional Volatility (CV) encompassing GARCH and EGARCH techniques estimated with Normal and Student-t distributions (CV/GN, CV/EN, CV/Gt and CV/Et), Extreme Value Theory (EVT) via Peaks Over Threshold (POT) after GARCH-Normal pre-whitening (^{Embrechts et. al. (2005)}) as well as the so-called Linear schemes (enhanced by Normal and Student-t distributions) as indicated by ^{Penza and Bansal (2001)}. All IMA representations are afterwards tested applying the preceding Steps 1 to 2 (Backtesting and P&LAT), whereas, Step 3 (Risk Factor Analysis), Portfolios 1 and 2 from every country are mapped to the respective market index and the resulting R2 calculated²¹.

The paper proceeds comparing the ERC arising from every (validated) IMA with that surging from the SA for both portfolios in a bid to gauge the pertinence of the corresponding levels. Furthermore, the contrast between the MCR belonging to Basel’s IV most accurate IMA and SA with Basel’s III MCR using the same models, conveys an idea about the profundity of the modifications contained in Basel IV.

Finally, the article proposes some straightforward routes to solve the likely problems that may arise because of the disparity in the capital levels derived from IMA and SA, furthermore contributing to deal with the incentives problem that -again- appears in Basel IV. The paper bolsters the use of a series of calibration parameters that contribute to level the Loss Coverage Ratio (LCR) across the approaches.

5. Results

The outcome of Basel IV methodology displays several differences compared with its predecessor Basel III, from the validation process that the IMA appraisal is subject to the behaviour of the SA.

6. Conclusions and policy implications

As part of the extensive review of the failures of the regulatory framework in the context of the major crisis of 2007-2008, the BCBS introduced a package of reforms collectively named Basel 2.5 and Basel III to be fully implemented by 2019. However, despite containing stark differences with their predecessor Basel II, they came under scrutiny and are currently subject to ongoing analysis.

One of the stated aims of the proposed reform is to design a new overall approach to risk measurement for the determination of MCR, characterised by the complete overhaul of the SA and the IMA. Under the scheme, the former appears more risk oriented, thusresembling the Markowitz’s setting, whereas the latter derives from two major drivers: replacement of VaR for ES and stressed adjustment of the ES-based MCR formula. The BCBS’s overt main objective undoubtedly resides in strengthening and increasing the capital base in order to avoid the costly anomalies of former directives. The analysis presented confirms that declared aim, in the sense that Basel IV appears as a move in the right direction: the ES for the IMA and the risk tilt for the SA bring about a substantial overall increase in the MCR. However, as it seems customary for all regulations, it leaves many points to improve, many of which appear underpinned by the results of the study.

In the SA department, the BCBS correctly detected and modified the setting to enact a more risk sensitive appraisal capable of producing higher capital buffers than its predecessor Basel III. Those equity cushions seem almost uniformed across countries and portfolios, therefore facilitating the comparison across jurisdictions, namely another of the BCBS’s aim in Basel IV. That homogeneity, arguably achieved through the fixation of the risk weights and correlation parameters across the assets, nevertheless raises lack of efficiency connotations as shown by the substantially high LCR, given the fact that it gives the impression to snub the changing pattern of the correlations among securities. Regarding the IMA, the article points out that the procedure for the validation of the models is excessively restrictive, thus stifling the development of techniques and limiting the scope for innovation. Only the EVT overcomes the subprime crisis unscathed and, although some others like CV/GARCH-t still manage to put in a reasonable performance, its results are tainted by the numerous Backtesting penalties. Furthermore, the study also detects the presence of inconsistencies, as the most precise techniques may be obliged to constitute higher capital levels than lessaccurate ones.

The interaction between the SA and the IMA posits the most serious concerns. Undoubtedly the BCBS attained its goals of bolstering the capital base by radically revamping both SA and IMA, notwithstanding which the study finds the methodology rather debatable. Although the transformation of the SA into a more risk-sensitive appraisal is healthy, its efficiency remains questionable given that the fixed correlation and risk weights parameters may play to its detriment by neglecting the changing nature of thecorrelations among assets and, consequently, raising the cost of capital. On the other hand, the IMA is at a (significant) disadvantage as a result of the rise in the capital floor embodied in the SA’s values, thus blurring the advantages of the approach and generating a very gloomy perspective for the models as many institutions will undoubtedly carry out the MCR calculations via the SA.

In order to bridge that arguably unintended consequence, the paper puts forward the introduction of calibrating parameters operating as multiplicative factors in the SA and IMA formulas within the structure of Basel IV. This modification would entail greater powers and responsibility to national regulators, who must decide on the appropriate values according to the respective environments. These parameters are developed to align the incentives between the SA and the IMA and, consequently, to restore confidence in market risk models. As was manifested in the study, by determining the right combination of mc*, ms and sa, the supervisors could, in principle, find a common platform upon which a sound and balanced MCR framework could ground providing the correct incentives to apply SA and the accurate IMAs.

The major contributions of the paper root in the ensuing distinct points. Initially, it contains a relatively thorough quantitative idea of the impact that the novel Basel’s MCR framework could exert on the banks’ capital structure, particularly in the context of emerging stock markets; secondly, it confirms the traces of moral hazard and lack of accuracy incentives for the IMA avenue; thirdly, it highlights that Basel IV upholds the intrinsic imbalances of the dual alternative (SA-IMA) present in Basel II and Basel III, to the point of rendering the IMA somewhat useless and fourthly, it proposes a (simple) sustainable solution likely to reduce the ostensible difference between SA and IMA materialised in the introduction of the calibration parameters mc*, ms and sa within the established framework susceptible of providing adequate capital coverage in the event of major abnormal market slumps.