The Road to Basel IV: Navigating the challenge facing European banks

European banks have raised billions in capital to meet higher requirements since the latest Basel reforms were launched at the end of 2010. Yet, the industry must brace for another increase in minimum requirements over the next decade as the final part of the reform package – known as Basel IV – is implemented until 2030.

The transition to the new rules will pose a number of challenges for European banks as they adjust to a standardized approach to assessing credit risks and move away from the widely-used internal risk models.

The latest Banking Essentials Webinar, co-hosted by S&P Global Market Intelligence and the European Banking Federation, delved into some of those challenges and their potential solutions. To view the on-demand replay of the webinar held on December 6, 2022, please click here.

Below are key takeaways from the discussion led by Gonzalo Gasos, Senior Director of Prudential Policy and Supervision at the EBF, and Salman Khan, Director of Product Strategy at the Financial Institutions Group of S&P Global Market Intelligence.

European banks are well capitalized

Over the last decade, European banks have raised far more capital than their global peers. Total capital ratios in Europe rose by nearly 20% between 2012 and 2021, compared to 17.5% in the rest of the world and 15% in the Americas, Basel Committee data shows. This is important and speaks for the level of resilience built up in the European banking system, Gasos said during his presentation.

The audience agreed, with roughly 65% of the polled 533 attendees saying European banks do not need additional capital requirments and are already well capitalized to withstand future shocks.

European specificities must be addressed

Internal risk models are more broadly used in Europe than in other regions due to characteristics of the local markets. As European banks adjust to a new standarized approach to assess portfolio risks, they could face a larger increase in requirements than global peers. Among the key issues here is the risk weighting of unrated corporate exposures and low-risk mortgages. To ease the impact of Basel IV on domestic banks and level the playing field for them in terms of global competition, European regulators have proposed adjustments to the implementation of the final Basel rules in the EU. The proposals will be discussed by the responsible EU authorities in the course of 2023 and their outcome will be crucial for European banks. But there are also additional regulatory requirements specific to Europe which do not account for the new Basel rules and make implementation more challenging for European banks. These include systemic and countercyclical buffers as well as the minimum requirement for own funds and eligible liabilities, or MREL. "The EU is arguably the jurisdiction that has the highest cost of regulation," Gasos noted.

Banks need a multipronged approach and clean data

European banks face multifaceted challenges in the implementation of Basel IV. Webinar attendees named data management (roughly 35% of votes), complexity (roughly 34%) and managing Basel requirements across geographies (some 21% of votes) as the top three main challenges to implmenting the capital framework.

The multitude of challenges means banks "cannot just have a one-stop solution to implement Basel as a whole" but need to approach the issues from various aspects, Khan said during his presentation.

The right data and reporting solutions are critical to ensure compliance with the Basel framework while also keeping the cost of compliance under control, according to Khan. Banks must have "a centralized, clean data resource" across all types of risk measured in the Basel framework, he said. This is the only way banks will be able to make accurate estimates of capital, liquidity and leverage ratio changes, to report these to supervisors in multiple reporting formats, Khan noted.

SME financing issues – an unintended consequence of Basel reforms

While the post-crisis Basel reforms have been successful in boosting banks' capital, and with that the sector's resilience to future crises, they have created problems for small and medium-sized enterprises as an asset class. SMEs were left behind other asset classes because they carry a little bit more risk and do not contribute to liquidity ratios. Therefore, when banks have to decide where to allocate their capital, SMEs are in a disadvantage compared to others, Gasos said. With Basel IV banks will have to reshuffle the costs and benefits of each asset class in their portfolios because at the end, the market would rule which assets would fare best under the new regime, he said. Every time prudential regulation is being changed, there is a shift in capital allocation to the most profitable products, Gasos noted.

Securitization key to unleash bank financing power  

European economies are heavility dependent on bank lending and with financing needs growing, European authorities must review securitization rules in the Basel framework. The European Commission has vowed to raise investments in the green transition, while also driving digital transformation and ensuring the financing of the economic recovery. Banks will play a key role in those projects, but they need flexiblity to be able to provide funding to the EU economy while also preparing to meet higher capital requirements. "One of the key benefitial factors that could help unlock the financing power of the banks in Europe would be to revive securitization," Gasos said. In their upcoming discussions in 2023, the EU authorities must agree on steps that would allow the European securitization market to return to the high issuance levels it had in the past, Gasos said. Tighter rules in the Basel framework are seen as a barrier to growth of the European securitization market in particular, with the industry calling on EU authorities to adjust the rules in order to unlock excess capital needed to support the real economy.