Basel Committee discussions on “Basel IV” at the end of November may expose deep divisions between national members and could lead to further differentiation between the EU and internationally agreed Basel standards, Fitch Ratings says. This would exacerbate challenges for market participants attempting to compare the capital strength of banks globally and could undermine confidence in a framework aimed at promoting a level playing field.
The latest Basel III amendments (sometimes referred to as “Basel IV”) seek to restrict the use of internal risk models, which are associated with wide divergences in risk-weighted measures, and potentially set overall capital requirements using the revised standardised approaches. EU politicians have expressed significant concerns in their parliamentary submissions ahead of a vote on the EU’s finalisation of Basel III on 24 November. Meanwhile, regulators such as Thomas Hoenig of the US FDIC recently warned against the dilution of the reforms and support tougher equity-based requirements.
If enacted the proposals are likely to increase capital requirements for lower risk-weight portfolios, such as mortgage loans, despite the committee’s intention not to significantly raise capital requirements for banks globally. European banks generally hold larger mortgage portfolios and would be more affected. EU regulators seek to balance the economic consequence of any increase in capital requirements against the challenges banks face to boost capital internally in light of negative yields and low growth prospects. EU lawmakers say they are aiming for “global standards with local calibration”.
In contrast, US banks would be less affected as they typically sell their mortgage loans to US government agencies and larger firms already hold capital on the higher of the standardised and internal ratings-based (IRB) approaches. US supervisors also might be more willing to set higher capital standards due to the more supportive operating environment and lower reliance on loan-based finance than the EU.
These tensions are likely to be reflected in two key areas in the 28-29 November Basel discussions. The proposal for a capital floor based on a certain percentage of the standardised approaches has the greatest potential for EU divergence. Whether the committee sets an overall floor or one for each risk category is important. EU lawmakers have publicly protested that a floor would severely punish stable banks focused on traditional low-risk lending, while banks with higher-risk assets would be less affected. The impact on European mortgage banks may be a key consideration here as residential mortgage loans are potentially most vulnerable, especially if a permanent capital floor were to be applied on a risk-category basis.
We believe outright elimination of internal ratings models for certain credit exposures is unlikely. The speech by Stefan Ingves, chair of the Basel Committee on 10 November did not mention this. EU lawmakers are concerned about the impact on credit flow to the real economy and have argued that working to enhance trust in IRB models is preferable to abandoning them for portfolios such as large corporates. We believe there would be a generous transitional phase-out period even if the committee does move away from using models for these portfolios.
We think it is more likely that specific constraints will be introduced to reduce risk-weight variability, as proposed for modelling mid-sized corporate and retail exposures, and to ensure a minimum level of conservatism, for example through the introduction of specific loss given default floors in models for residential and commercial real estate exposures. But other measures, such as a model floor for unconditionally cancellable commitments, which may effectively increase capital charges for these exposures, face opposition from both sides of the Atlantic due to concerns it would constrain banks’ lending capacity.
