Euro banks well prepared as Basel marathon enters final stretch

The global financial crisis was a seismic shock to banking systems globally, and triggered a regulatory marathon with banks having to adapt to a far stricter set of rules (known as Basel III) set out by the Basel Committee on Banking Supervision (BCBS).

Some 16 years since the apex of the crisis, regulators are now on the cusp of adopting the final iteration of this new global rulebook – often referred to as Basel IV or the Basel endgame – which will be incorporated into law across different jurisdictions with some modifications to account for local specificities.

Understandably at this juncture, we are seeing lobbying efforts from banks and other interested parties making frequent headlines, as well as delays to certain elements of the new rules (such as the Fundamental Review of the Trading Book) and other last-minute adjustments. Much of the recent focus has been on the largest US banks, and the prospect of their ‘gold-plated’ capital requirements being watered down in the wake of Federal Reserve Chairman Jerome Powell’s comments in March that he expected “broad and material changes” to the current proposals.

For European banks, the Basel endgame represents an evolution rather than revolution of the existing regulations, and they are generally in a good position to address the upcoming changes.

Less onerous and more targeted than Basel III

First, it is worth noting Basel IV is not entirely new – the BCBS first published the main text of these proposals back in December 2017. Since then, individual countries and regulators have been working on the transposition of these rules, with Covid-19 understandably delaying some of these efforts. Notwithstanding these delays, individual authorities have moved ahead of others in terms of the final adoption. Dutch, Norwegian and Swedish regulators, for example, imposed higher risk weight floors on mortgages, which had previously benefitted from low capital charges under internal risk-based (IRB) models due to historically low credit losses. These changes effectively forced banks to hold more capital against the modelled risk well ahead of the new rules being adopted. This is in stark contrast to the implementation of Basel III, which despite the generous transitional period was imposed rather quickly following the global financial crisis with some banks still in vulnerable positions.

Second, and again unlike Basel III, Basel IV does not bring a universal change in capital requirements. Banks will not have to hold a higher level of Common Equity Tier 1 capital as a percentage of risk-weighted assets (RWAs). Basel IV is more targeted – the focus, among other things, is on specific riskier activities such as lending to SMEs and unrated corporates, historical operational risk-related losses, and limiting the benefit of the IRB models that European banks rely on to model capital requirements.

The implication of this is that the new rules will not have an even effect on the European banks, and some will not be materially affected by them. The UK regulator, for example, sees Basel IV increasing Tier 1 capital requirements for major UK banks overall by 3.2%, compared to estimates of 9.9% for European and 16% for US banks. Given the adoption of the rules differs across jurisdictions and these estimates are still subject to change when the rules are finalised, we do not find the percentages particularly comparable, but they could offer a glimpse into the scale of the changes each banking sector will need to adapt to the new regulatory environment.

Biggest impact will be on individual activities

In the context of the impeding changes, we believe the biggest adjustment we will see is to the way banks deploy capital to individual activities, as opposed to increasing levels of capital across the board (which was the case with Basel III). Banks have already been pro-actively selling portfolios of certain assets, adjusting product offerings and in some cases exiting activities altogether (such as SME lending). Capital and portfolio optimisation is of course a daily task for any bank, so these practices are nothing new, but for management Basel IV will likely highlight whether certain business lines are a viable long-term proposition from a capital efficiency perspective. This will alter the global competitive landscape for certain activities since regional variations could create advantages or disadvantages for individual business lines in different regions. As risk weights increase, all else being equal, banks will find it more difficult to deliver the same return on equity in the affected business lines. All else is rarely equal, however, so some products will be repriced or restructured, while more capital-intensive activities may be reduced. In general, banks will have to be smarter about the way they utilise their balance sheets and focus on less capital-intensive activities – this will shift some of the credit risks outside of the banking sector.

Basel IV also comes at a time when some firms progress through their multi-year IRB roll-out plans, aimed at increasing the percentage of credit-related RWAs calculated under the IRB method. We estimate about 75% of credit-related RWAs for major banks are calculated under IRB, with the remainder being calculated under the standardised method, but this figure differs across banks and is often more than 90%. The timing of these IRB roll-out plans is less concrete, and delays are partly driven by lack of regulatory capacity, but Basel IV inevitably adds another layer of complexity to banks’ internal capital planning. Indeed, some banks that were already utilising advanced internal models will move back to the standardised or simplified internal model framework in response to more onerous requirements for the modelling of certain portfolios.

Third, we would note that the impact of the rules on individual European banks is seen as being manageable. As per the BCBS recommendations, some elements of the regulation are being phased in over a period of five to seven years, and can still be extended, rather than applying on day one. To account for the specificities of the European banking system, banks will further benefit from certain adjustments to the initial BCBS recommendations, such as in the treatment of lending to SMEs or unrated corporates, both of which lower the impact of Basel IV considerably versus the global proposals. Again, in some cases banks have already been operating under higher risk weight floors well ahead of the new rules coming in, therefore the marginal impact from now on will be lowered.

Banks have range of capital optimisation tools

Finally, and possibly most importantly, we believe European banks have a range of tools and options to address Basel IV and the broader topic of capital optimisation. Banks’ starting position for the adoption of these finalised rules is much different to pre-Basel III. Some banks have already engaged in portfolio sales for targeted activities. Synthetic risk transfer (SRT) transactions involving performing loans (see Chart 1) are another tool banks have been pro-actively using in recent years to manage credit risk and optimise their capital positions.

Most importantly, the Basel endgame is coming at a time of higher interest rates when banks are seeing record profitability (and capital generation), another stark difference to the Basel III implementation era (see Chart 2). The share prices of most European banks have recovered significantly in the higher rate environment, and in our view the current equity valuations across the sector are supported by adequate capital positions. Furthermore, regulators are acutely aware of the new rules, and have been approving higher share buybacks and capital distributions as profits have increased.

Clarity around final rules will provide relief for sector

For bond investors, the Basel endgame will provide a clear picture around capital requirements and encourage banks to fine-tune their business models to these global guidelines. This clarity should lead to better business model optimisation for individual issuers and therefore even stronger balance sheets, though regional variations in the rules will certainly alter the global competitive landscape in certain businesses.

The Basel endgame will also resolve any uncertainty around bank solvency levels in Europe and elsewhere; closing the final chapter of the rulebook will reduce the potential for headline risk, the likes of which we have seen in recent months as lobbying efforts have intensified.

Globally, banks’ capital optimisation efforts will not end when the rules are agreed – they may even accelerate at that point. But once the headlines around the final calibration of the Basel framework die away, the ultimate result will be higher levels of capital on bank balance sheets. For fixed income investors that is typically a positive, though keeping in mind there is a point at which higher capital demands begin to hurt profitability and impact lending.