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Central banks 24 Dec 2019

Completion of Basel III: The final twist to banking regulation?

Last summer, European institutions greenlighted the latest major banking reform package (CRR2 or, as it was also known, the risk reduction package, or banking package). The announcement was well received in the market, as a clear indication that, after almost 10 years of regulatory reform, the definitive framework for credit institutions was finally starting to take shape.

However, the calm after the milestone did not last long. Just a few months after it was approved, the European Commission began working on the implementation of the latest reforms passed by the Basel Committee in December 2017. These reforms are widely referred to as Basel IV in the industry, although authorities insist that it is actually the completion of Basel III. With these last set of standards, authorities seek to restore trust in capital ratios, since in recent years they have been perceived as lacking comparability between entities and complex in their calculation.

The review focuses on the calculation of Risk-Weighted Assets (RWAs) compromised by main sources of risks in banking: credit, market and operational risks.  Specifically, the reform focuses on internal models, which are considered responsible for the improper increase in complexity in the calculation of capital requirements and for hindering comparability between the capital ratios of institutions.

On the one hand, for credit risk, the reform proposes a series of changes to both internal models and the standard method. For some categories, it limits the use of internal models to the simplest, restricting banks’ ability to act. In other categories (such as variable income), it bans the use of internal models in favor of the standard method. In parallel, it also sets out a series of amendments to the standard method, as a measure to compensate for the possible loss of risk sensitivity that may result due to internal model restrictions.

One of the most substantial changes is introduced in operational risk. In this case, the new reform bans the use of internal models altogether for calculating capital requirements and replaces all previously existing approaches with a single, simpler standard method that aims to guarantee risk sensitivity.

Finally, a capital floor is introduced, as final restriction to the use of internal models. Capital land defines a minimum amount of RWAs (calculated as a percentage of RWAs using the standard approach) that entities using internal models should keep in their balances. Thus, regardless of the figure obtained by entities with these models, the minimum RWAs will be 72.5% of the RWAs using the standard approach. This measure seeks to reduce the variability in capital requirements between entities that use internal models and those that do not.

The negotiation of this package at European level is expected to be a complex process, mainly due to its expected impact on the European banking sector. According to European Banking Authority’s conservative estimates, it will result in an increase in capital requirements of nearly 24%, a figure that is not only clearly above what global regulators initially forecasted (5 to 10%), but which also differs between jurisdictions.

The capital floor will most likely become the most controversial issue, as it is primarily responsible for the impact of these regulations on European banks. The new capital requirement calculation methodology is also expected to stir significant controversy. In particular, the inclusion of a loss factor that takes into account past operational losses as a predictor of future ones, will most likely also draw a lot of attention during the rounds of negotiations. All things considered, it will be extremely hard for the European Union to meet the January 22 deadline initially set by the Basel Committee for the implementation of the standards.

But, and what comes next?, will this be the end of the regulatory reform? Although finalizing the implementation of Basel III will signify a pivotal step towards the culmination of the regulatory framework reform, the truth is that everything seems to indicate that there are still other steps pending. Future changes will probably not be related to potential shortcomings detected in current standards, but to new challenges facing the industry, such as the regulation of sustainable finance or digital banking.

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