Dr. Philipp Wackerbeck, Jeroen Crijns, Dr. Christel Karsten, Felix Becht
November 24, 2016
Many banks, especially in Europe, are struggling to produce sufficient returns on equity. This is partly due to the stringent capital and liquidity requirements banks have been subjected to over the past decade. The Basel III regulatory framework, defined in 2011 and now nearly fully effective, required banks to hold considerably higher capitalization levels and wider liquidity buffers. On top of this, the Basel Committee has recently issued new regulatory proposals, which it refers to as a “recalibration” of Basel III, but which bankers are calling “Basel IV.” These proposals pose a new and potentially even greater challenge to banks’ viability than all the regulatory measures of the past six years put together.
This report examines the aggregated impact of the current reform proposals on banks’ required capital. Our estimations are based on publicly available market estimates of the increases in required capital resulting from credit risk, market risk, operational risk, and credit-value adjustment risk. We have analyzed these estimates and supplemented them with our analysis of “Basel IV” to derive an aggregated impact range.
Our analysis indicates that European banks would face major capital shortages under the proposed regulations, with shortfalls of 30 to 50 percent of currently available capital. As such, implementation of the proposals — as they stand today — seems unrealistic.
Still, simply waiting for the final version of the “Basel IV” regulations is not an option for bank executives. Even if significant amendments are made to the new proposals, the increase in capital requirements — potentially as much as 20 percent for some banks — will put further pressure on the profitability of most European banks.
Senior bankers will be forced to reconsider their business model, including their approach to capital management, portfolio composition, product structures, and the extent to which they rely on their balance sheets to generate income. If they do not consider “Basel IV” sufficient justification to make drastic strategic changes, it might be the beginning of the end for European banking.
In addition to understanding the technical regulatory details of the “Basel IV” reforms, senior bankers are well advised to step back and develop a perspective on their strategic impact, which will depend largely on the bank’s current business model. Banks that focus on a single line of business, such as specialized lending or commercial real estate, and that use internal models to calculate RWA will likely need a more drastic strategic response to the new rules than would a captive financial-services company that uses the standardized approach to RWA calculations today.
Irrespective of their current business, very few European banks will be in a position to fully absorb the impact of “Basel IV” through traditional measures such as raising additional capital or cost cutting. A shift in the degree to which banks are using their balance sheets to conduct business will be required, and that will likely force them to create a very different balance sheet structure and devise a fundamentally different way to make money. The sooner banks embark on this complex transition, the greater the strategic advantage they will gain over their slower peers.
Our study analyzed the 103 banks that participated in the 2015 European Banking Authority transparency exercise, with German, Italian, Spanish, and French institutions representing more than half of the sample.1 Altogether, these banks carry an aggregate RWA of €10.9 trillion. Credit risk makes up, on average, 85 percent of the banks’ RWA, operational risk makes up 10 percent, and the remaining 5 percent consists of market and CVA risk (Exhibit A).
We estimated the RWA impact of “Basel IV” in a top-down manner for the key risk types: credit risk, operational risk, market risk, and CVA risk 2 (Exhibit B). For each risk type, we identified the ranges of estimated impact based on numerous studies published by a broad selection of institutions and professional service firms and supplemented them with our internal analysis of the combined proposals. 3
For all risk types other than credit risk, the estimates of the impact range were applied directly to current RWA. To illustrate, this means that RWA for CVA was increased by 50 percent to reflect low impact and by 100 percent to reflect high impact.
For credit risk, we applied a more granular analysis. Based on detailed credit data derived from the ECB transparency exercise, we estimated the RWA impact for each type of credit exposure (such as mortgage, retail, or large corporate loans) and method of assessing the risk (internal model versus standardized). For all exposures assessed under the standardized approach, we assumed an impact range on RWA of 10 to 30 percent, in line with public studies. To reflect the differences in approach in the “Basel IV” proposals for exposures under internal models, we applied different approaches for each asset class.
Mortgage, small and medium-sized enterprise, and other corporate loans: To estimate the increase for credit risk exposures assessed under internal models, we applied a floor of 60 percent relative to the risk weights that would be applicable under the revised standardized approach for those exposures. This floor of 60 percent is based on the current BCBS proposals, which suggest capital floors of 60 to 90 percent; we took the more realistic end of this spectrum.
To apply the floor, we had to determine the risk weights that would be applicable if the credit exposures — currently assessed with internal models — had been assessed under a standardized approach. As a reference, we applied the average risk weight in a country applicable for those types of loans assessed under the standardized approach. The average is number-weighted, so that all banks in our study from the same country count equally.
Specialized lending exposures: The applied floor for these exposures has been set at 100 percent, as the “Basel IV” proposals require banks to apply the standardized approach to these exposures. As the reference for the value under the standardized approach, we applied the risk weights for exposures to corporates under the standardized approach.
Large corporate exposures: This portfolio can consist of two types of corporate exposures: the largest corporates (with assets exceeding €50 billion), and slightly smaller corporates that still earn revenues above €200 billion. Exposures to the first set of large corporates would be fully transitioned to the standardized method, so we applied standardized risk weights. Exposures to the second type of corporates are expected to face a 60 percent floor, combined with restrictions on the inputs to the model. To reflect this combination, we applied an 80 percent floor to the entire portfolio of large corporates.
Bank exposures: For exposure to banks, the estimated impact from “Basel IV” on RWA ranges between a low of 30 percent and a high of 50 percent. This reflects the significant changes in the standardized approach specifically for bank exposures and the proposal to require the standardized approach for all bank exposures.
All ranges are indicative only, and revisions to the BCBS proposals may alter the appropriate ranges for the expected impact.
1In consequence, all calculations and data shown are as of the first half of 2015, if not explicitly stated otherwise.
2We recognize that “Basel IV” proposals go beyond these risks (for example, counterparty credit risk), though additional risks appear moderate in terms of their impact on banks’ overall business models.
3Including publications from Barclays, BCBS, Bloomberg, Börsen-Zeitung, Bundesverband deutscher Banken, Deutsche Bank, DZ Bank, ISDA, PwC US, Reuters, and Risk Control Limited.