The implementation of the final Basel standards is unlikely to lead to any notable increase in European banks' capitalization. If anything, it will likely provide more capacity for the recently renewed capital distributions by banks in the region. This reflects likely delays and dilution in the implementation of the globally agreed standards in Europe, such that the implementation will have a more modest impact on regulatory metrics than European banks were initially anticipating. We don't expect the proposals to materially affect bank ratings.

On Oct. 27, the European Commission (EC) published its draft directive and regulatory proposals to translate the Basel III supervisory framework into EU law. It was part of a broader banking package that also included proposals on sustainability risk requirements for banks and enforcement tools for regulators. This package would finalize the implementation of the global revisions to Basel III (published in 2017) that aim to reduce disparities in the way global banks calculate credit, operational, and market risk, notably through their use of internal models. Already the result of intense lobbying, the EC proposal faces further political debate and potential tweaks before it is finalized and transposed into national laws. Originally targeted for implementation in 2022, then moved across regions to 2023 after the pandemic hit, the revised rules will likely now not be finalized until 2022 and not take effect in the EU until 2025.

The expected dilution in the rules to be implemented in the EU will largely offset the erosion in regulatory capital metrics that we would have expected based on a full implementation of the final global standards. According to the September 2021 European Banking Authority (EBA) impact study, full implementation of the rules would have led to a--in our view manageable--13.7% average pro forma increase in risk-weighted assets (RWA). We don't expect that this would have meant a material hike in European banks' overall capitalization, given, among other things:

• The phased implementation of the rules;
• The buffers in excess of minimum requirements that have already been built by banks in anticipation of tougher standards; and
• Continued management actions to reduce the impact.

The likely deviations in the EU from the global standards will curb the impact to a single-digit percentage increase in RWA. This supports our core expectation that the "high water mark" of regulatory capital requirements in Europe is behind us for now, and further illustrates why global comparability in regulatory metrics may remain an elusive goal (see “The Basel Capital Compromise For Banks: Better Buffers, Elusive Comparability,” June 3, 2021).

The proposal contains some widely predicted elements but also some surprising ones. Stakeholder focus was partly on the output floor that seeks to limit capital relief for banks in using internal models to measure capital requirements. Here, the commission did not choose the "parallel stack option" (see box 1) supported by certain industry groups. It opted instead for a "single stack" implementation and proposes to apply it at the group level only, rather than at each subsidiary.

But at the same time, the proposal upends Basel through the suggestion to create a new class of low-risk mortgages that would get beneficial capital treatment under the standardized approach (in other words, relating to the asset class where the output floor was most controversial from the perspective of European banks). Similarly, it deviates from the Basel recommendations with a suggested lower standardized risk weight for nonrated corporates that are deemed low-risk. These two major deviations, currently planned to last through the output floor transition phase only, would in turn negate much of the implied effect of the output floor until 2030.

It remains to be seen whether these deviations and additional delays in implementing the rules will embolden certain jurisdictions outside the EU to also materially adjust or materially delay the implementation of the 2017 globally agreed revisions to the Basel standards.

Parliament Will Have The Last Say On How Basel III Will Be Implemented In Europe

With its proposal, the EC aims to transpose into EU law the final revisions globally agreed in 2017 to the Basel III framework--but with some adjustments. After having postponed the implementation into legislation of Basel III due to the pandemic, in line with other jurisdictions, the EC is finally going ahead with its draft proposal (https://ec.europa.eu/commission/presscorner/detail/en/ip_21_5401). Some choices made that deviate from the globally agreed standards appear to reflect an assessment by the EC that bank capitalization in the EU is reaching a point where the benefits of higher bank capital requirements to financial stability offset a detrimental effect on banks and lending capacity, highlighting the policy role of the banking system in supporting sustainable economic growth. Some stakeholders supporting these deviations also point to the fact that banks around the world have held up well during COVID-19, demonstrating the effectiveness of Basel rules for increased capital over the past 10 years; indeed, common equity Tier 1 about doubled for the world's 100 largest banks over that time.

We agree that capitalization in Europe and other regions is now at least adequate for almost all large banks, even if we believe that banks' resilience during COVID-19, including in Europe, was also underpinned by massive monetary and fiscal support (see “Top 100 Banks: Capital Ratios Show Resilience To The Pandemic,” published Sept. 28, 2021). The main impact of these proposals will likely be slower progress toward greater comparability of regulatory metrics globally than some may have hoped when the Basel standards were published four years ago.

The EC decided on several critical aspects for Europe around the output floor, the new operational risk framework, and more specific adjustments, including on mortgages and corporate exposures. Key elements of the EC proposals include:

• Creating a specific category of "low risk mortgages." Capital requirements for such mortgages under the standardized approach would be lowered. This would be the case during the phase-in period of the output floor, but we believe they could be made more permanent. For low-risk exposures secured by mortgages on residential property when calculating the output floor, during the transition period, banks could apply a preferential risk weight of 10% to the secured part of the exposure up to 55% of the property value, and a risk weight of 45% to the remaining part of the exposure up to 80% of the property value, provided certain conditions are met. The proposal aims to ensure that these loans are low risk, compared with a standard 35% risk weight. The practical effect will be to substantially negate the effect of the output floor.
• A risk weight for unrated corporates deemed low risk well below the 100% that prevails in Basel III. This percentage could fall to the 65% that Basel defines as applicable to investment-grade corporates under the standardized credit risk assessment approach applied by jurisdictions that do not allow the use of external ratings for capital charges.
• The output floor would be calculated at the highest level of consolidation in the EU, whereas subsidiaries located in other member states than the EU parent should calculate, on a subconsolidated basis, their contribution to the output floor requirement of the entire banking group.
• Intrasector participations will continue to carry a risk weight of 100% instead of 250%.
• Fundamental Review of the Trading Book (FRTB) capital requirements in the EU will apply along other jurisdictions.

The EC did not decide to implement a "green supporting factor" for now, instead introducing targeted adjustments to the framework to promote sustainability objectives.

Delays

The implementation has been postponed to 2025, with a five-year phase-in period, so that the framework will be fully in place by 2030 at the earliest (see chart 1).

Dilutions

The EU is already assessed as "materially non-compliant" for its implementation of current Basel III rules, and we believe this will likely remain the case with the proposal to pass the revised standards into law. Existing elements, such as the small and medium enterprise and infrastructure supporting factors and the exemptions from the credit valuation adjustment framework, remain in place. Other elements such as using the discretion for historic losses in the operational risk framework will rely on banking regulators, which opens the possibility of being less predictable.

Risk weights for unrated corporates are adjusted under the proposal, mitigating the risk from borrowing costs rising once the Basel III rules are effective for entities still largely dependent on bank funding.

The Controversial Output Floor Loses Its Bite

The implementation of the output floor was one of the most controversial aspects of the Basel reform and was previously assessed as the largest contributor to the impact of the Basel reforms in several countries. It will be phased in over a period of five years, until 2030. The Basel Committee designed this tool to cap the capital relief banks can get from using internal models to calculate their capital requirements. Internal models have already been examined by the European Central Bank through the targeted review of internal models. Combined with the implementation of EBA guidelines regarding the probability of defaults/loss given defaults, this may well explain why RWA inflation has already occurred since 2019, with more recent impact studies showing a lower impact arising from the Basel reforms.

The output floor by its nature impacts banks that benefit from much lower risk weights using internal models compared with standardized risk weights. Given the size of mortgage portfolios on European bank balance sheets, and the resilience of their performance, the output floor could have had a material impact on a number of European banks. The proposed changes to standardized risk weights for low-risk mortgages could therefore materially dent the impact of the output floor.

Conversely, we note the EC's decision against using the option known as the "parallel stack approach," which would also have reduced the impact of the output floor (see box 1).

Overall, the output floor was more challenging for the European banking sector than in other regions since it has a significantly greater role in financing the economy than in other geographies, where capital markets play a more important role, because European banks typically keep mortgages and corporate loans on their balance sheets. It is therefore not entirely surprising that the EC recommends a number of steps that ultimately mitigate the impact of the output floor on minimum capital requirements.

With Or Without Basel, Business Models Will Remain Under The Spotlight

A more literal implementation of the Basel III standards could have prompted further business model adjustments for European banks. It could, for instance, have encouraged banks to shift more assets off-balance sheet, and prompted certain European banks to align their business model closer to U.S. peers, albeit with the handicap of less developed pan-European capital markets compared with the U.S. Granted, the EC proposal on the Basel rules won't in and of itself put additional pressure on European banks' return on equity. But the profitability challenge for many will remain front of mind in the coming years, with interest rates, internal market fragmentation, and growing competition--including from nonbank players and tech companies--likely to remain material hurdles.

Related Research

• U.S. Banks' Growing Balance Sheets May Pose Regulatory Capital Constraints, Oct. 11, 2021
• As Near-Term Risks Ease, The Relentless Profitability Battle Lingers For European Banks, June 24, 2021
• The Basel Capital Compromise For Banks: Better Buffers, Elusive Comparability, June 3, 2021
• Bank Regulatory Buffers Face Their First Usability Test, June 11, 2020
• The Basel Capital Compromise For Banks: Less Impact Than Meets The Eye, Dec. 8, 2017