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Impact of Basel 4 on EU banks

Impact of Basel4 on EU banks

The European Banking Authority (EBA) has published (PDF 1.08MB) an analysis of the impact of Basel 4 on EU banks, showing increases in capital requirements of around 25 percent for large and internationally active banks. The main results are broadly consistent with initial estimates using the KPMG Peer Bank tool.

Implications for firms

Capital - as discussed in KPMG’s series of papers on Basel 4 earlier this year, some banks will face significantly higher minimum capital requirements as a result of the new Basel Committee standards. In some cases these higher requirements are already met through banks holding capital well in excess of current minimum requirements, but some banks will need to take important decisions on whether to improve their capital ratios through issuing new capital, retained earnings, or a reduction in risk weighted assets, during a period when return on equity is likely to remain low.

Capital optimisation – irrespective of whether they are capital constrained, banks will need to decide whether to apply to use internal model approaches (where these are still available), and whether to adjust their asset portfolios in response to changes in risk weightings.

Data and systems - for many banks the most significant impact of the new Basel standards will be on the need to upgrade their data, systems and (internal and external) reporting, rather than on meeting higher capital requirements.

Wider context – banks need to assess and respond to the impact of the revised capital standards in the broader context of other regulatory reforms and market developments – the European Central Bank (ECB)’s review of internal models, additional loss absorbing capacity (where the 15-20 percent increase in risk weighted assets under Basel 4 will also drive correspondingly higher TLAC and MREL requirements), recovery and resolution planning, addressing non-performing exposures, additional supervisory reporting and Pillar 3 public disclosures, the possibility of changes to the capital treatment of sovereign risk exposures, and the competitive threats and opportunities posed by fintech.

Main results

The EBA’s analysis finds that the risk-based Basel 4 reforms (to credit, market and operational risk, the output floor and the credit valuation adjustment) will increase the weighted average Tier 1 minimum risk-based capital requirement of the sample of 38 large and internationally active EU banks by 23 percent (and by 26 percent for the global systemically important banks (G-SIBs) within this sample).

The contributors to these increases were:

  • The output floor - an increase in overall risk-based capital requirements of 6.5 percent (5.4 percent for G-SIBs). This becomes significant once the output floor reaches 65 percent (scheduled for January 2025). 
  • Operational risk requirements - increase of 6.4 percent (7.5 percent for G-SIBs). The largest impacts here are on banks migrating from the advanced measurement approach, on banks with high past operational losses, and on large banks that will be subject to high marginal coefficients on their business indicators.
  • Credit risk requirements – increase of 4.5 percent (4.7 percent for G-SIBs). The EBA analysis finds that the largest increases by asset class are for equities, equity investment in funds, and subordinated debt and capital instruments other than equity, although these asset classes are unlikely to be major contributors to the overall increase in minimum capital requirements for credit risk.
  • Credit valuation adjustment – increase of 3.8 percent (5.4 percent for G-SIBs).
  • Market risk – increase of 2.3 percent (3.4 percent for G-SIBs). A substantial average increase in minimum capital requirements for market risk of 52 percent for large and internationally active EU banks (and around 70 percent for G-SIBs) translates into a relatively small impact on overall capital requirements, because for most banks market risk is a relatively small component of total risk weighted exposures. Minimum capital requirements for market risk under the standardised approach increase on average by 200 percent, while the impact on minimum capital requirements under the internal models approach is much more muted (at around 20 percent).

An alternative presentation of the impact is to compare banks’ capital ratios under the (fully loaded) Basel 4 standards against their ratios under the fully loaded Basel 3 (EU CRR and CRD4) requirements. This shows a reduction in CET1 capital ratios from 13.8 percent to 11.1 percent (and from 12.7 percent to 10.1 percent for G-SIBs).

These reductions in capital ratios also generate capital shortfalls for some banks when compared against Basel 4 capital requirements, including the requirements for the capital conservation buffer and any G-SIB capital surcharge. These shortfalls are concentrated on G-SIBs, who face shortfalls of €5 billion and €12 billion against CET1 and Tier 1 capital requirements respectively.

The EBA observes that these are relatively small shortfall amounts compared with the amounts of capital that banks have raised or retained since 2010, and given the long transitional period before Basel 4 comes fully into effect. However, it should also be noted that the EBA analysis compares actual capital ratios against only a sub-set of minimum capital requirements – the Basel 4 capital requirements used by the EBA do not include all the capital buffers that banks are required to meet, including in particular any additional systemic risk buffers and Pillar 2 capital requirements. These could add 5 percentage points or more to minimum capital requirements, which would increase substantially the measured capital shortfalls.

To some extent the impact of the risk-based reforms is offset by the latest reforms to the leverage ratio. These revisions increase banks’ leverage ratios from 5.1 percent to 5.4 percent for the large and internationally active EU banks in the EBA sample (and from 4.8 percent to 5.2 percent for G-SIBs). This makes the leverage ratio a binding constraint for fewer banks (notwithstanding the higher leverage ratio for G-SIBs). So the overall binding minimum Tier 1 capital requirements (the higher of the risk-based and leverage ratio requirements for each bank) increase by 19 percent (and by 25 percent for G-SIBs).

The EBA’s analysis also shows – consistent with KPMG’s estimates using the Peer Bank tool – a wide range of outcomes at the individual bank level (although the EBA does not identify these banks). This is most pronounced for market risk, where the impact ranges are very wide.

Methodology

The EBA’s analysis assesses the impact on EU banks of the Basel Committee’s final revisions (as agreed in December 2017) to the leverage ratio, credit risk, operational risk, and the introduction of the aggregate output floor; and of the new standards for market risk (as agreed in January 2016) and credit valuation adjustment (CVA). The analysis does not cover requirements on banks to meet additional capital buffers or to meet loss absorbing capacity (MREL and TLAC) requirements.

The impact is assessed using end-2017 data, assuming the full implementation of the Basel reforms (including the full phasing in of the output floor, scheduled to be completed by 2027). The analysis is based on a sample of 38 ‘Group 1’ banks (internationally active banks with Tier 1 capital in excess of €3 billion) and 63 ‘Group 2’ (all other) banks.

The estimation of the leverage ratio-based minimum capital requirement includes both the minimum requirement (of 3 percent) for all banks and the additional 50 percent of the risk‐based capital surcharge for global systemically important banks, where applicable.

The current assessment is intended to provide a first indication of the impact of Basel 4, ahead of a more detailed report (based on an expanded sample and on data as of end-June 2018) in response to the European Commission’s call for advice.

 

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