North Carolina Journal of International Law

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Why European Banks are strongly against the Capital floor proposed by Basel IV

By: Joshua Stephens

Basel III, an international regulatory accord published in 2009 by the Basel Committee on Bank Supervision (BCBS), was part of the world’s response to the financial crisis of 2008, which saw massive bank failures after the burst of the housing bubble.[1]  Basel III built on its predecessors, Basel I and Basel II, and its ultimate goal was to better equip banks to deal with financial stress (like what occurred in 2008), improve risk management, and increase transparency in the industry.[2]

Although Basel III  will not be fully implemented until March 2019, this has not stopped the BCBS from working on proposed further regulations, known as Basel IV.[3]  The BCBS has been trying to reach a deal on these regulations since last year and is facing strong opposition from European Banks, even though these changes will not likely come into effect until 2024 or 2025.[4] The debate is so intense that the BCBS has postponed its September 2017 meeting due to European Banks concerns with the new regulation.[5] In particular, the BSCS’s proposed capital floor for big banks has European banks up in arms.[6] This report looks at why the capital floor is opposed by most of Europe and how it will affect the region going forward.

Why the BCBS Wants a Capital Floor

The primary reason the BCBS wants a capital floor has a lot to do with bank capital. Bank capital is the difference between the bank’s assets and its liabilities and indicates the banks net worth.[7] Bank assets include cash, government securities and interest earning loans, whereas liabilities include loan loss reserves and debt.[8] Bank capital serves as a buffer that allows banks to absorb losses.[9]  When banks are undercapitalized it can lead to bank runs, bank failures and wider systemic distress.[10] The proposed capital floor reduces the ability of banks to game the system by mandating a more accurate and uniform representation of banks capital structure[11]

According to the International Monetary Fund (IMF), the capital floor addresses the issue of banks gaming the system, while still allowing for the best of both worlds: the continued use of internal models with the safety of a minimum standardized approach.[12] The BCBS could argue that the floor is a great alternative to not using internal models at all.  It could mandate a standardized approach across the board, which would certainly raise capital requirements.[13] The IMF further explains the benefit of a floor by stating

Well-capitalized banks are more likely to lend to the real economy and less likely to indulge in excessive risk-taking that could threaten the stability of the financial system. This only strengthens the case for a robust capital framework. Properly calibrated and carefully phased, the Basel III enhancements of a floor on risk models can help prevent excessive variability in capital outcomes and allow for meaningful comparison across institutions and countries, while still permitting for risk sensitive approaches to take hold. The capital floor is a linchpin of this system.[14]

The ultimate goal of all the Basel regulations has been to promote a more stable financial industry and prevent economic crashes like the one experienced in 2008. The IMF argues that the floor model is the best way to do this, as compared to alternatives like adjusting the capital adequacy ratio or leverage ratio. [15]

The Capital Floor

The minimum amount of capital a bank is allowed to have is determined by the size of the risk weighted assets (RWA) that bank has.[16]  A RWA is a bank’s assets weighted according to risk.[17]  “For example, a loan that is secured by a letter of credit is considered to be riskier and requires more capital than a mortgage loan that is secured with collateral.”[18]

Large banks have been allowed to use their own internal models to calculate the risk of their RWA’s since 1996.[19] The capital floor proposed by the BCBS would limit the extent to which banks can use their own models to calculate the riskiness of lending.[20] European countries, far more than countries like the United States, use internal rating systems to evaluate the value of RWAs.[21]  A capital floor would prevent the banks from using risk estimates that are too far below the outputs of a standardized model, and would therefore  give a more realistic and uniform look at the actual capital of banks around the world.[22] For example, if a capital floor was set at 75%, a bank’s measure of its RWA’s could be no lower than 75% of what the value of the RWA would be if a standardized approach was used.

Basel members, like the United States, are advocating for a floor of 75%, while European banks are pushing for the floor to be 70%.[23]  Bank of France governor Francois Villeroy de Galhau urged that a floor of 75% would impact to many European banks, while many for the higher capital floor suggest that this is because European banks simply do not have enough capital.[24]

Why Europe opposes the higher floor

Opponents of the of the capital floor argue that the floor only further increases bank capital requirements and reduce profitability, something that Basel III already did. The BCBS has said that the enhancements to Basel III should not lead to a significant, overall increase in capital requirements across banks but recent studies (discussed further below) suggest otherwise.[25]

Bank lending and profitability have been down since the financial crisis of 2008, and additional capital requirements are likely to make this worse.[26]  Banking in Europe will be far more affected by the floor than countries like the United States. Banks in the United States already have a capital floor of 100% thanks to the Dodd Frank Act of 2010. [27] The impact of the floor was studied extensively by McKinsey & Company in an April 2017 report entitled “Basel IV: What’s next for banks?”[28]  They studied the impact that a gradual phase-in of the output floor would have on a country-by-country basis. In total, by the time a floor of 75% was fully implemented, the CET1 ratio (a measure of the amount of common stock a bank holds against its risk weighted assets)[29] of Europe would drop by 1.3 percentage points, from 13.4% down to 12.1%.[30]  When combined with other Basel IV regulations, Europe’s CET1 ratios fall even further down to 9.5%. Using a 10.4 % minimum CET1 Ratio, European banks would experience a capital shortfall of 120 billion.[31] The phase-in used by McKinsey & Company starts at 55% in 2021 and builds to 75% in 2025.[32]

The floor affects all countries differently.[33] For example, countries like Sweden, Denmark, Belgium and the Netherlands will be affected right away in 2021 by the 55% floor, whereas countries like Germany and the United Kingdom won’t see the impact until 2024 when the floor hits 70%.[34]  Even further down the line is France, which would remain the same until the final 75% in 2025.[35]

One possible solution to this problem, meet in the middle. Both sides could agree on a floor of 72.5%, which would still impact Europe, but to a lesser extent.[36] The BCBS seems intent on instituting a floor in the 70% range, so a compromise to avoid the higher 75% might be in the best interest of countries like France and the United Kingdom, which wouldn’t be impacted until the figured reached its peak in 2025.[37]

Conclusion

While regulations like Basel IV and its proposed output floor are important to preventing another financial crisis like the one seen in 2008, they come at a cost, especially to financial institutions in Europe, who are looking at a requirement of €120 billion in additional capital, and a reduction in the banking sector’s return on equity by 0.6 percentage points.”[38] This is a game changer for the banking industry, and Europe is expected to keep fighting against it.

 

[1] Basel III, Investopedia, https://www.investopedia.com/terms/b/basell-iii.asp (last visited Nov. 10, 2017) [https://perma.cc/D56D-LR2T].

[2] Id.

[3] Sia Partners, Basel 4 Upcoming Regulatory Changes for Financial Institutions and Their Impact on the Banking Industry 2 (Jan. 2017).

[4] Huw Jones, Regulators to delay meeting in bid to reach bank capital deal, Thomson Reuters (Aug. 2, 2017, 7:57 AM), [https://perma.cc/5ZCM-FN99].

[5] Id.

[6] Id.

[7] Bank Capital, Investopedia, https://www.investopedia.com/terms/b/bank-capital.asp (last visited Nov. 10, 2017) [https://perma.cc/JV9R-QAPW].

[8] Id.

[9] Tobias Adrian & Aditya Narain, Why Talk of Bank Capital ‘Floors’ Is Raising the Roof, IMF Blog (Jun. 8, 2017), [https://perma.cc/W692-NGT8].

[10] Id.

[11] Id.

[12] Id.

[13] Id.

[14] Id.

[15]Tobias Adrian & Aditya Narain, Why Talk of Bank Capital ‘Floors’ Is Raising the Roof, IMF Blog (Jun. 8, 2017), [https://perma.cc/W692-NGT8].

[16] Steyn Verhoeven, Why Dutch banks fear Basel’s new capital floor, Zanders (Mar. 1, 2016), https://zanders.eu/en/latest-insights/why-dutch-banks-fear-basels-new-capital-floor [https://perma.cc/R3U5-HAJU]

[17]Risk-Weighted Assets, Investopedia, https://www.investopedia.com/terms/r/riskweightedassets.asp?ad=dirN&qo=investopediaSiteSearch&qsrc=0&o=40186 (last visited Nov. 10, 2017) [https://perma.cc/3JXQ-67PE]

[18] Id.

[19] Tobias Adrian & Aditya Narain, Why Talk of Bank Capital ‘Floors’ Is Raising the Roof, IMF Blog (Jun. 8, 2017), [https://perma.cc/W692-NGT8].

[20] See McKinsey & Company, Basel “IV”: What’s next for banks? (Apr. 2017).

[21] Id.

[22] Id.

[23] Huw Jones, Regulators to delay meeting in bid to reach bank capital deal, Thomson Reuters (Aug. 2, 2017, 7:57 AM), [https://perma.cc/5ZCM-FN99].

[24] Id.

[25] Tobias Adrian & Aditya Narain, Why Talk of Bank Capital ‘Floors’ Is Raising the Roof, IMF Blog (Jun. 8, 2017), [https://perma.cc/W692-NGT8].

[26] KPMG, The World Awaits: Basel 4 Nears Completion 7 (Dec. 2016).

[27] See McKinsey & Company, Basel “IV”: What’s next for banks? 11 (Apr. 2017).

[28] Id.

[29] Common Equity Tier 1 (CET1), Investopedia, https://www.investopedia.com/terms/b/bank-capital.asp (last visited Nov. 10, 2017) [https://perma.cc/GJQ6-9JMG].

[30] See McKinsey & Company, Basel “IV”: What’s next for banks? 9 (Apr. 2017)..

[31] Id.

[32] Id. at 11

[33] Id.

[34] Id.

[35] Id.

[36] Huw Jones, Regulators to delay meeting in bid to reach bank capital deal, Thomson Reuters (Aug. 2, 2017, 7:57 AM), [https://perma.cc/5ZCM-FN99].

[37] See McKinsey & Company, Basel “IV”: What’s next for banks? (Apr. 2017).

[38] McKinsey & Company, Basel “IV”: What’s next for banks? (Apr. 2017).

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