Banks breathe a little sigh of relief as Basel III is completed

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By:
Graham Bippart
Published on:

Basel III – or IV, if you’re a banker – is finally complete, and if implemented harmoniously across countries, it could force banks to raise huge amounts of capital, but tweaks to the final proposals render them less harsh than many expected.

Stefan-Ingves-Basel-Committee-R-600
Stefan Ingves, chairman of the Basel Committee, on Thursday, when new
documentation was released

The Basel Committee’s oversight body – titled the group of central bank governors and heads of supervision – has agreed on an output floor for banks that use internal models to calculate credit risk.

It was perhaps the most contentious piece of the Basel III framework, and disagreements over what the output-floor level should be caused a year-long delay to its finalization.

The group agreed on a risk-weighted asset (RWA) floor of 72.5% of what a given bank would have used under the more onerous standardized approach to assessing credit risk. That’s smack in the middle of the 70% to 75% floor the market was expecting.

According to Credit Suisse, the requirement could consume capital equivalent to about 13% of European bank lending capacity, but the committee made concessions that will ease the impact overall.

Implementation will be gradual, over a nine-year period — a longer transition period than many expected. A 50% floor comes into effect at the start of 2022, followed by 5% increases every year until 2026, when 70% will be the floor. The final 72.5% floor will be in effect in 2027.

And revisions to the standardized approach (SA) to assessing credit risk will mean that the effective burden of the 72.5% floor will be materially less for many banks. Some jurisdictions, particularly those whose banks are heavy on mortgage lending, argued the SA was too punitive.

Under the newly revised approach, banks will be able to vary risk weights on some mortgage exposures depending on their loan-to-value ratios, “and in ways that better reflect differences in market structures”, according to documents released by the Committee on Thursday. The old method allowed only flat risk-weights across mortgages.

National discretion

The announcement also included language that seems to allow for national discretion, saying a “supervisory specified risk weight” could be allowed.

Credit Suisse thinks the proposals, as well as the potential for national discretion, could lower average risk weights on mortgages by up to a third. Corporate exposures will also see risk weights fall by about 9%, the bank estimates.

Overall, the proposed floor will cause RWA inflation of 30.5%.

Banks with a high sensitivity to the floor, such as Société Générale and Danske Bank, all saw their stock prices rise the day after the announcement. The STOXX Europe 600 Banks index jumped from 181 on Thursday to 186 the next day – the biggest one-day jump since late September.

“Our first read is that relative winners are mortgage-heavy banks with manageable impact and/or size buffers [such as ABN Amro, Danske Bank and Lloyds] and banks with historically high litigation [such as BNP Paribas and Lloyds]” since operational risk requirements were also watered down, states Jan Wolter, Credit Suisse analyst, in a note.

The Committee replaced existing approaches to operational risk, which were based on banks’ internal models, with a new standardized approach based on banks’ income and historical operational losses, but local supervisors can set one of the variables at the lowest level, one, for all banks in their jurisdictions, easing the effect on capital.

In its quantitative-impact study, the Committee estimated that of internationally active banks with tier-1 capital of more than €3 billion, tier-1 capital for operational risk will be reduced by 25%. Of those, the global systemically important banks (G-Sibs), will see their tier-1 capital reduced by 30.2%.

Pillar 2

Wolter said that the announcement is “not the end, but rather the beginning of a new political negotiation”. He thinks European authorities might respond by reducing Pillar 2 capital requirements, potentially lessening the capital effect by about 150 basis points.

Martin Noréus, deputy head of Finansinspektionen, the Swedish financial supervisory authority, states that lowering Pillar 2 requirements was a possibility.

“The Basel reforms set minimum requirements, but a substantial part of the Swedish regulatory capital structure is made up of Pillar 2 buffers,” he says.

“While Pillar 1 requirements may go up, the room to use Pillar 2 buffers may be more constrained under the EU’s implementation of those rules – such as whether Sweden can use systemic risk capital charges, or whether we can use Pillar 2 add-ons for the risks in mortgage lending.”

However, he added: “One cannot assume that we will fully compensate in Pillar 2 for the possibly higher Pillar 1 requirements. In our view, buffers have a great value in providing capital that can actually be used in going concern long before the bank is in breach of its minimum requirements.”