Finalisation of Basel III Regulation

On 7 December last year, the Basel committee, which gathers bank supervisors from the largest economies, announced that they had reached an agreement on the last major piece of the regulatory reforms that were launched almost ten years ago, known as the Basel III framework. This last set of changes completes the overhaul of bank regulation that was undertaken in the wake of the global financial crisis.

Several important measures have already been agreed upon at the international level over the last few years and have been, or are currently being, implemented in Europe. These include for instance increases in the level and quality of bank capital and the first requirement to address liquidity risks, by demanding that banks hold buffers of liquid assets that can easily and quickly be sold to raise cash in case of panic. And a leverage ratio, which constrains the amount of money a bank can borrow compared to its capital, regardless of the riskiness of its assets, in an attempt to set a lower limit on capital requirements calculated based on internal models.

While these previous measures bolstered banks’ balance sheets, the aim of the latest batch of reforms is slightly different. It aims at restoring credibility in the calculation of risk-weighted assets (‘RWAs’), an estimate of risk on which bank capital requirements are based and thereby to improve the comparability between banks’ capital ratios. For that purpose, changes have been made to enhance the risk-sensitivity of the standardised approaches used to measure credit risk, operational risk and credit value adjustment (CVA) risk, while the use of the internal model has been constrained. Limits have been set on the inputs that banks can use to calculate their capital requirements with their own models and, in some cases such as operational risk and CVA, the use of models has been forbidden altogether.

However, the most controversial innovation is the introduction of an output floor for internal models. The idea is to limit the benefit in terms of lower capital requirements that the use of an internal model can bring compared to a situation where the bank would use the standardised approach. This element was difficult to agree on, notably because of structural differences between the US and the European banking systems. The floor would typically bite for banks that hold a lot of relatively safe assets, where a bank’s historical data can justify the application of lower risk weights than the more one-size-fits-all standardised approach would prescribe. This is the case of European banks, which typically hold a large proportion of their mortgages on balance sheets, while US banks sell them to government-owned agencies such as Freddie Mac or Fannie Mae. Hence the US were in favour of a higher floor, while most Europeans did not consider a floor as an essential part of the framework, also because the leverage ratio already acts as a lower limit on internal models. Eventually, an agreement was found for an output floor of 72.5%.

What is the estimated impact on banks? A first assessment by the European Banking Authority (EBA) for large EU banks reveals a decrease in Tier 1 capital of 12.9%. The main driver behind the decrease is the output floor, which alone contributes to 6.6%. Average capital levels in the EU banking sector would however remain at comfortable levels, and banks have time to prepare: international standards foresee that most measures take effect in 2022, but the output floor will be gradually introduced and become fully applicable only in 2027. And in any case, the European Commission will conduct a thorough impact assessment and a public consultation before proposing how to implement these rules in the EU.”

April 2018
By Tommy De Temmerman

The views expressed in the text are the private views of the author and may not, under any circumstances, be interpreted as stating an official position of the European Commission.