In bank capital, it’s quality over quantity

Last month, an article in the FT said European Central Bank (ECB) officials were split over whether to publish a report showing capital requirements for European Union (EU) banks are less stringent than those for US banks. The report apparently suggests that if the biggest EU banks were subject to the same rules as their Wall Street rivals, their capital requirements would rise by double-digit percentages.

Without seeing the report itself it is difficult to know which specific differences are being highlighted, but the timing is sensitive given regulators (including the ECB) are busy finalising the post-crisis global bank capital framework, otherwise known as Basel IV or the ‘Basel endgame’. 

A brief history of bank capital

It is important to first understand the historical context behind “global” capital rules, and why they differ for EU and US banks.

The global rulebook for capital requirements is set by the Basel Committee on Banking Supervision (BCBS) via various Basel accords. These rules are agreed at the global level and subsequently implemented in local jurisdictions into capital requirements through legislation.

The first Basel accord was implemented in 1988 (they are typically referred to using Roman numerals, so it is known as Basel I). Basel I introduced standardised risk weights for calculating banks’ risk-weighted assets (RWAs); today’s Common Equity Tier 1 (CET1) ratios are calculated by dividing a bank’s equity capital by its RWAs. The idea was that if bank A held riskier assets than bank B, then for bank A to have the same capital ratio as bank B, bank A would need to have higher capital levels. Soon enough, the regulators discovered the standardised models were sub-optimal because they did not account for differences in individual borrower risk; commercial loans for example were 100% risk-weighted whether they were made to highly rated or distressed companies.

In response to these shortcomings, and the financial innovation that took place in the years that followed Basel I, in 2004 the Basel Committee implemented Basel II. Under this new framework, banks were allowed to develop internal models (subject to regulatory approval) for calculating RWAs based on their own historical experience of losses and recoveries in individual asset classes, rather than using those prescribed by global standardised rules. Regulators also had the power to apply additional capital requirements on banks (so-called Pillar 2 requirements) if they felt some risks were not captured by the rulebook.

This is when a bigger divergence between US and EU banks began to emerge. Basel II was formally adopted in Europe in 2006, and banks began to implement their internal models for RWAs in the years that followed. In the US, the implementation of rules took considerably longer as the authorities were concerned that the use of internal models would result in a significant reduction in capital requirements (and as a result US banks are still not allowed to rely on these alone).

Basel III and risk weights

Clearly, the events of the global financial crisis showed neither approach was particularly successful in managing systemic risk in the banking system, so along came Basel III.

Basel III increased capital requirements significantly, but European banks (especially the biggest ones) largely continued using their internal risk-based models for calculating RWAs. These bespoke calculations resulted in very different capital requirements between jurisdictions and individual institutions, given the variance of defaults and losses banks experienced through the crisis. Banks could hold far less capital against assets such as UK or Dutch mortgages, which had historically shown very low levels of losses, than they could against mortgages in periphery European countries for example.

As a result, some banks have reported a perfectly adequate CET1 ratio (equity divided by RWAs) but look less well capitalised when it comes to their leverage ratio, which is a measure of capital to total assets where the asset side of the equation isn’t impacted by the bank’s internal model. Indeed, banks in Europe with a history of higher loan losses do have higher leverage ratios. All this is not to say that banks’ risk weights are wrong or only an outcome of aggressive modelling practices, but it is easy to see how the difference in inputs can produce different capital requirements from one bank or jurisdiction to the next.

Basel IV – the best yet?

Like Basel II before it, the perceived inadequacies and incompleteness of the Basel III framework led to talk of Basel IV even before its predecessor had been fully implemented at the national level.

In our view, one of Basel IV’s most important elements is preventing risk weights from being too low for certain assets, even where historically losses have been insignificant. The intention is to cap the benefit from internal models with “output floors”, which set limits (or floors) around the benefits banks receive from internal model outcomes (or outputs). The objective is to reduce the scope banks have for optimising their models too significantly, and also to limit the risk that historical losses may not be indicative of future credit performance of the same exposures. In anticipation of the change, several European national regulators have already implemented these floors and as a result, many banks already hold more capital than they would be required to if they calculated their requirements purely via internal models.

There is also no requirement for European banks to stick to a single approach for their entire balance sheet. Among the largest banks, some have as little as 45% of their book under internal models while others are above 90%. And as if there weren’t enough variables here already, it is worth noting that many European banks are on multi-year roll-out plans which aim to increase the proportion of their RWAs calculated using internal models.

In the meantime, the US aversion to internal models continues. US banks are required to calculate their capital requirements using both Basel I standardised and internal methods, and they must stick to whichever calculation is higher.

However, in both regions banks are subject to so-called Pillar 2 requirements, where regulators impose additional capital requirements over and above the global standards on a bank-by-bank basis. If a regulator considers a bank’s legal or operational risk to be higher than it is comfortable with, for example, it can increase the bank’s Pillar 2 requirements to reflect this. Both regions also conduct stress test exercises to further verify the adequacy of banks’ capital requirements. 

Another noteworthy difference is that US banks do have to adhere to a higher leverage ratio (5%) than their European peers (3%). Though in any case, European banks with a history of higher loan losses do have leverage ratios in excess of 5%.

Is the US or European approach “better”?

First, a “better” approach to bank capital requirements would be one that leads to fewer bank failures and more financial stability. In this context, the current US framework is far from guaranteeing the soundness of individual banks. That much was made clear in early 2023 when sharp interest rate rises led to the collapse of several mid-size banks due to the accumulation of excessive interest rate risk in the banking book (within liquid assets) which was not covered by capital (interest rate risk exposure among European banks is far more contained). In Europe, Credit Suisse’s 14% CET1 ratio (well above the regulatory minimum) did nothing to prevent its own collapse in the same period. Capital rules, however calibrated, will not change the fact that banks across all jurisdictions will always rely on significant amounts of leverage.

Second, we would not characterise either of the approaches as necessarily “better”. Naturally, if you calculate capital in multiple ways to estimate your requirements (the US system) and use the highest of the outcomes, then the likelihood is banks end up with higher capital, all else equal. This can be reflected in the higher leverage ratios of US banks, which are often cited in comparisons to Europe, though again it is worth noting that the failed Silicon Valley Bank had a leverage ratio of 7.96% at the end of 2022, comfortably above that of JP Morgan and numerous European banks. Significantly, under the dual approach used by US banks the difference between CET1 ratios calculated under internal and standardised models is no greater than 1.7 percentage points (and in some cases, both yield the same results). That said, the fact that capital is calculated in multiple ways does not necessarily mean it is more adequately reflecting the riskiness of the underlying assets – it is just generally requiring banks to hold more capital. The same could be said for the generally higher RWA density (RWAs divided by total assets) of US banks versus European peers. Again though, as we mentioned above, European banks with a history of higher loan losses tend to have higher leverage ratios and higher RWA density.

The internal model approach that is embedded in Basel III regulation and used extensively in Europe is, in our view, more adequately reflecting the specificities of individual regions and issuers (which is also better suited to the more fragmented nature of the European banking system). Indeed, banks with mortgages in Ireland have higher risk weights than those in Sweden or the Netherlands due to their higher history of losses. Banks with a history of poor underwriting standards (and the resulting worse asset performance) will have more punitive capital requirements than those with historically more robust standards. Behavioural, cultural, and legislative differences can also have a big impact on the historical and future losses that feed into the current internal models. As an example, the “non-recourse” nature of US consumer lending markets means borrowers can walk away from arrangements that have become unaffordable (in the case of home loans they can hand the keys back to the bank and leave), with no fear of further action. In Europe, the law allows lenders to pursue defaulting borrowers for years, which has helped preserve a greater stigma around bad debts than exists in the US. 

In our view, the European approach of incorporating internal models but limiting their impact via output floors (which set limits around the benefits from those models) more precisely account for local considerations which are inevitably overlooked in a standardised global capital framework. The question is not which region has higher or lower capital requirements, but whether those capital requirements are commensurate with the risk profile of the region’s or lender’s assets. In other words, one size does not fit all when it comes to bank capital. We continue to think the current capitalisation of European banks is adequate, and the efforts to strengthen it further are supportive to the story of an ongoing improvement in fundamentals.

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