European banks and European corporates have a very close and long relationship. The latest prudential regulatory package from the Basel Committee on Banking Supervision (BCBS) could well change all of that.

The BCBS, as the leading global standard setter for the prudential regulation of banks, has issued a series of recommendations (standards) over the years – known as the Basel Accords – with the aim of ensuring banks’ resilience to crises.

These standards prescribe how much capital and liquidity banks need to hold against all their exposures.¹ The first Basel framework was published in 1988 and, via multiple reviews, the fourth version (Basel IV) will be adopted in Europe over the next couple of years.²

With this latest version, the framework for how banks calculate the amount of capital they need to hold against each exposure is completely overhauled. One of the biggest changes comes from the introduction of the output floor. This will lead to banks focussing more on the use of the standardised approach when calculating their risk-weighted assets (RWAs) instead of applying internal models. The risk weights under the standardised approach are in general much higher than under the internal model approaches, and will therefore lead to an increase in the amount of capital banks need to hold.

Most of the larger European banks use internal models, so having to use the prescribed standardised approach will lead to a significant increase in RWAs. The European Banking Authority has estimated this increase at 28% on average, which translates into a total capital shortfall of €135bn for European banks. The banks will need to absorb this shortfall in one form or other, either by increasing pricing or by stepping out of certain businesses or products.

Eighty percent of all European corporates turn to their relationship banks for their funding needs. This means that any increase banks see in RWAs would directly impact their clients in terms of pricing and availability of funding.

More concretely – and again, this is very Europe-specific – all exposures to corporates that do not have an external credit rating will see significant RWA increases: from the current levels of 20–50% to 100% under the new framework. Being externally rated is not the norm in Europe, as corporates traditionally have good relationships with their banks. To give a sense of the scale of the problem, 80% of European corporates are unrated.

Another issue arising from the limitations that Basel IV puts on the use of internal models is the calculated maturity of transactions under the foundation internal ratings-based (FIRB) approach, a simplified internal model. Under the FIRB, the maturity is fixed at 2.5 years, so the final figures do not differentiate maturity. This could be a cause for concern. For instance, when calculating RWA, the input for a 10-year loan would be the same as that for a short-term trade finance product (which would typically have a maturity of less than 12 months).

Last, due to changes in how banks need to calculate exposures to derivatives, it will become far more expensive for corporates themselves to use derivatives to hedge their own foreign exchange and interest rate risks. Again, this can be traced back to the difference between internal models and the need to apply standardised approaches.

As the global Basel standards are not directly applicable in each jurisdiction, they need to be transposed into European law. The European Commission is currently working on these proposals, which will be published via the Capital Requirements Regulation III (CRR III).

Many elements of the impact of the Basel package for European banks and European corporates can be traced back to Europe-specific characteristics: the lack of a culture of having external ratings, and the dominance of the dollar in global trade translating to higher hedging needs for EU corporates. The Commission, the member states and the European Parliament are therefore carefully assessing exactly how they will implement the package. In this respect the BCBS announced on 27 March 2020 to delay the implementation of the package by one year because of Covid-19³. This is to allow banks and supervisors to focus on more urgent tasks, such as providing critical services to the real economy. It would also allow for more time to assess how to implement the package in Europe.

Koen Holdtgrefe is Head of Prudential Regulatory Affairs at Deutsche Bank

Sources

¹ See the BCBS consolidated Basel Framework and tutorial video https://bit.ly/3oNTInm at bis.org
² See Basel yesterday, today and tomorrow at flow.db.com
³ See BIS press release https://bit.ly/38ILXcY at bis.org