Addressing Basel IV using AI

17 January 2018

 Scott Dam, Director at Synechron Business Consulting

Basel III is a major piece of legislation that aims to improve the capital in banks and help manage risk. Its ultimate aim is to avoid a repeat of the 2008 financial crash, which makes it a vital part of how banks can do business in the modern world. In December 2017, the Basel Committee for Banking Supervision (BCBS) finalized its reforms, also known as Basel IV, were announced and were shown to focus more on the calculation of risk-weighted assets (RWAs) and capital floors for banks globally. The capital floors piece has been postponed until 2022, with floors gradually increasing up to 72.5% by 2027.

While the long-term pipeline of gradual change means that banks won’t feel any major changes, and certainly won’t see much change right away, the new reforms that make up Basel IV are an important step toward standardization in the industry, and banks globally should prioritize changes associated with adherence to Basel IV’s requirements. Compliance cannot be achieved through small changes alone. As an example, banks conducted initial Liquidity Coverage Ratio (LCR) calculations in 2015, and concluded that the process required a better data management solution than what was initially in place. With Basel IV’s new requirements, banks must look to new and innovative solutions in order to meet these obligations and standardization.

This solution needs to go beyond strong data governance and instead requires a more comprehensive approach that is able to consolidate data from disparate locations. As they head into 2018, financial institutions will need to focus on three key calculations to make Basel IV compliance a smoother process.

Managing liquidity with BCBS 248

Liquidity management stands to be a major part of Basel IV and BCBS 248 will place greater pressure on banks to ensure they are providing the right information to the regulator. BCBS 248 will require banks to manage the intraday liquidity across various asset classes and products. While it may seem to be a simple process, the fact remains that most of this liquidity exists in multiple locations and are not centralized.

To make things even more challenging, accurate BCBS 248 calculations need to be conducted in real time. Aside from the manpower that real time analysis requires, the ever-changing landscape of the financial industry means that accurate results are impacted by numerous factors which all need to be taken into account in order to draw the correct results.

Being covered

It is not enough for banks to ensure compliance for the present; they are also under pressure to adhere to the regulation as it changes over the coming years. This is most notable in the liquidity buffers that are in place to ensure the business is prepared for any major market changes or developments.

By 2019, all banks will need to provide 100% of their LCR, with additional buffer requirements by 2022. This year will be a key period for banks as they look to create liquidity buffers that satisfy this requirement. While it’s important that these businesses build robust buffers that can withstand major shocks to the market, this will be hugely ineffective and counterproductive to day to day operations.

However, if banks are able to anticipate certain fluctuations and recognize peaks and troughs to their liquidity management, they will be able to adapt their buffers effectively without hindering business operations. Combined with building a robust buffer, companies will therefore have much more control over their operations and will avoid being crippled by Basel IV’s implementation.

This is often easier to theorize than it is to put in place, however. In order to effectively build this strategy, banks need to seamlessly combine their BCBS 248 calculations with LCR requirements in order to build a strong buffer that is able to adapt to the day to day changes in the business.

It’s more than numbers

However, these calculations go beyond number crunching. While the LCR requirements and BCBS 248 will help manage the liquidity that banks will need to comply, companies will also need to adhere to best practice for reporting as well as risk data aggregation. Basel IV’s BCBS 239 sets out these guidelines and it cannot be ignored if banks are aiming to meet compliance.

While it can seem like a minor element to Basel IV regulation, BCBS 239 will help support the calculations around liquidity of the business. If effectively compiled, BCBS 239 will validate the other calculations in Basel IV and make the company’s efforts in meeting compliance far more reliable. It can also act as an overall snapshot of the bank’s health and effectiveness of its data initiatives.

The AI element

It is a challenge to strike this balance, however. Financial institutions need to make sure they have enough liquidity to account for 100% of the risk while still operating the business as usual. Organizations clearly do not want this regulation to impact their revenues, yet achieving compliance is far from easy. As such, in order to deal with these requirements effectively, banks will need to run a full assessment of their data management capabilities. This will not only help identify less robust areas that need consolidating, but will also show where automated processes could improve the data management of the business.

For example, to ensure the business can accurately calculate the BCBS 248 calculation, the company can develop methods to automate the calculations and incorporate machine learning into the processes already in place. With the support of AI, banks will be able to predict intraday liquidity rather than constantly responding to fluctuations in the market. Combined with the work being done for LCR, this will mitigate the challenge of having to base calculations on constantly fluctuating data.

By utilising AI and automation in this way, organisations can find the right balance and continue to run their business as usual. Although the calculations that are needed to achieve compliance with Basel IV can pose a strain on the organisation, they will ultimately help improve the operation of the business and streamline some of the back-end processes that have become clogged with manual processing.

In short, Basel IV is an opportunity for businesses to improve their operations while also achieving compliance. Viewed in this way, banks will be able to find new ways to improve their processing capabilities and review historical practices that have since become redundant. As a result, whilst compliance is mandatory, it is also a chance for organizations to become more effective in their day-to-day business practices. 

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