Bank regulators in many countries will implement changes to their capital rules in 2025, based on the final elements of the international Basel III standards. Given the role that securitization can play in bank funding and balance sheet management, these reforms could have far-reaching effects on securitization activity, although many uncertainties remain. While market participants variously refer to the upcoming regulatory changes as Basel 3.1, Basel IV, or the Basel III endgame, all these monikers generally refer to the same aspects of the Basel III rules.

The new frameworks could have implications for different banks' relative competitiveness, banking system structures, and the economics of various types of lending, all of which could have knock-on effects for securitization markets. One area of particular focus is banks' issuance of SRT or credit risk transfer (CRT) securitizations. When structured appropriately, these transactions enable bank originators to reduce their regulatory capital charge on a pool of loan assets by transferring some of the associated credit risk to third-party investors. With regulatory capital requirements generally set to rise under Basel 3.1, this tool could become more popular.

Major Changes Under Basel 3.1 In The EU And The U.S.

The Basel Committee on Banking Supervision (BCBS) sets the global standards for the prudential regulation of banks and is comprised of member institutions from 28 jurisdictions.   The Basel III rules were the BCBS's response to the global financial crisis of 2008-2009. However, individual jurisdictions have discretion over when and how to adopt the Basel standards. In addition, some countries have previously chosen to adopt more stringent standards than those designed by the BCBS.

Regulators globally have implemented many of the initial aspects of Basel III.   These included an improved definition of regulatory capital, changes to the minimum level of capital required against market and counterparty risk, an overall leverage ratio to complement risk-weighted capital requirements, as well as new standards to mitigate liquidity risk and excessive maturity transformation. However, certain final aspects of the Basel III package, published in 2017, are not yet implemented and these constitute the Basel 3.1 reforms.

Basel 3.1 aims to limit the regulatory capital benefit that some banks could receive by using internal models to assess risk.   For example, the new rules remove model-based approaches for assessing operational risk and place limits on the input parameters for model-based approaches to assessing credit risk.

The reforms also introduce an overall "output floor."   This limits the extent to which banks that employ internal model-based approaches can achieve lower overall capital charges than if they only used the so-called standardized approach (SA).

Finally, Basel 3.1 aims to improve aspects of the SA.   For example, the reforms intend to make the SA more sensitive to credit and operational risks. Transition arrangements mean that the effects of some of these reforms will be gradual and materialize over several years.

Securitization effects vary across geographies.   Different national and regional regulatory authorities have proposed different approaches in their interpretation and implementation of the final Basel III text, likely making any securitization effects region-specific. We explore these below, focusing on the proposed EU, U.S., and U.K. implementations and the types of asset pools that are historically relevant for securitization: mortgages and consumer loans, loans to large corporates, and those to small and midsize enterprises (SMEs).

The Output Floor Leads To Most Changes In The EU

In the EU, the regulatory text that implements Basel 3.1 has been endorsed by policymakers.   This means the new policies should take effect from Jan. 1, 2025. The European Banking Authority estimated that the weighted-average tier 1 capital requirements across the EU banking system will rise by almost 13% by 2028, which is when all reforms will be fully implemented.

The output floor contributes significantly to this increase.   This feature of Basel 3.1 requires that advanced banks--which calculate aspects of their regulatory capital requirements based on model-driven, internal ratings-based (IRB) approaches--hold the greater of the IRB approach capital and a percentage of the capital requirement obtained by using the SA. This percentage will progressively rise over several years to a final value of 72.5%. The output floor therefore creates a more level playing field between banks that use the IRB approach and those that use the SA.

When assessing the potential effect on securitizations, we focus only on credit risk capital requirements.   We also make the simplifying assumption that the output floor is applied just to this area and on individual loan portfolios, rather than at a higher level of aggregation. In addition, we ignore most transitional arrangements, essentially assessing the effects once the transition period is complete.

The increase in credit risk charges will be most pronounced for EU IRB banks' lending to consumers

IRB banks in the EU will likely see an increase in credit risk-weighted assets for most loan types that are historically relevant for securitization (see chart 1).   In other words, the gap between SA risk weights and our stylized IRB risk weight assumptions is sufficiently large that the output floor applies for each of the illustrative loan portfolios.

Chart 1

The extent of the output floor effect is larger for lower-risk assets, where the difference between SA and IRB risk weights is typically most pronounced.   For example, using our stylized figures, the IRB risk weight for mortgage loans--the lowest-risk asset class--would effectively more than double to over 25%, from 12.5%, due to the output floor.

These capital charge increases apply to the types of asset pools that may be used to back securitizations.   However, to explore potential changes in securitization incentives, we must also consider the consequences of Basel 3.1 on capital charges for securitization exposures. Since the effects will ultimately depend on how the transactions are structured and distributed, we consider simplified scenarios representing two generic uses of securitization technology that are relevant for bank originators: capital relief and funding.

Incentives could rise for consumer-backed capital relief trades in the EU

With regulatory capital charges on asset pools generally set to rise under Basel 3.1 in the EU, IRB banks may have more incentives to use securitization for capital relief through SRT transactions.   SRT transactions enable banks to reduce the regulatory capital charge on pools of loan assets that they originate by transferring some of the associated credit risk to third-party investors. But while Basel 3.1 could increase the incentives for such activity, it also increases the challenges of structuring and selling SRT securitizations. For each of our illustrative asset pools, we simulated the construction of SRT securitizations that achieve capital relief for the originating bank while minimizing the size of junior tranches that must be sold to investors, both before and after the implementation of Basel 3.1 (see chart 2). For example, before Basel 3.1, our pool of large corporate loans would attract a capital charge equivalent to 4% of the portfolio balance. But by securitizing and selling--or synthetically transferring the risk on--a junior tranche that is sized at 6% of the portfolio, the originating bank's capital charge would fall to about 1%.

Chart 2

Under Basel 3.1, higher asset risk weights could increase the amount of capital relief available through SRT trades and therefore increase banks' incentives to conduct such securitizations.   However, due to the effects of Basel 3.1 on the treatment of securitization exposures, the thickness of the junior tranches that would have to be sold to achieve this capital relief will also increase in most cases. If structured as before, an originating bank's retained exposure to the senior tranche of an SRT trade would generally incur a higher capital charge under Basel 3.1 due to the output floor. This would generally reduce the available capital relief from the trade. In some cases, the conditions for "significant risk transfer" might no longer be met under Basel 3.1, resulting in no capital relief at all. Instead, originating banks could sell thicker junior tranches to lower the retained capital charge to about 1% as before.

For our illustrative mortgage loan portfolio, the current capital framework does not allow capital relief through securitization for IRB banks.   This is because the capital charge on the unsecuritized mortgage portfolio is already lower than the capital charge achievable on any retained senior securitization tranche. However, this could change under Basel 3.1, when the output floor could substantially raise the effective IRB capital charge for unsecuritized mortgage loans. This could hypothetically create new incentives for some banks to perform SRT trades backed by mortgage loans. In absolute terms, however, the resulting capital relief would be small and banks would still have more incentives to issue SRT trades backed by higher risk assets, such as corporate loans.

For consumer loans, the incentive to use SRT securitization could increase under Basel 3.1 for IRB banks, due to rising capital charges on the pre-securitization asset pool.   However, the effect on the securitization structure required to achieve capital relief would be minimal. This could lead to more consumer loan-backed SRT securitization.

For corporate and SME loans, the incentives for SRT transactions will be limited under Basel 3.1.   That said, the banks in our example would have to sell approximately three percentage points more of the capital structure to achieve capital relief that is similar in scale to what they can achieve under current rules.

For consumer-based funding trades in the EU, charges rise less than for assets

In securitizations aimed at raising funding, an originating bank typically retains a subordinated, riskier portion of the capital structure and sells lower-risk, more senior tranches to third-party investors, which may include other banks.   Since much of the economic risk of the underlying portfolio remains with the originating bank, it could still incur the same capital charge as if no securitization had taken place. However, any other banks investing in the placed tranches will also incur a capital charge on those securitization exposures. To assess how "securitization-friendly" the Basel 3.1 rules are in this context, relative to current rules, we again consider hypothetical transactions backed by each of our illustrative asset pools. This time, we assume that the originating bank retains a junior portion of the capital structure and sells a senior portion. For simplicity, we assume that the investor-placed senior tranche is distributed to other banks that are subject to the IRB framework and therefore measure the combined regulatory capital effect, aggregated across originating and investing institutions.

While IRB capital charges will rise under Basel 3.1 for pre-securitization asset pools and aggregated post-securitization exposures, the increases vary in scale.   For example, our hypothetical pre-securitization mortgage pool sees an increase of more than 100% in capital charges, but aggregate charges on a corresponding securitization might only rise by 40%-50%, depending on the senior tranche size (see chart 3).

Chart 3

Compared with the current capital framework, the Basel 3.1 regime may therefore be more favorable toward the transformation of mortgage and consumer loan assets into securitization tranches.   This is because the Basel 3.1 output floor strongly increases pre-securitization IRB capital charges on these asset types but has minor effects on the treatment of some securitization tranches. In particular, senior securitization tranches with sufficient credit enhancement can have the same risk weight floor under both the SA and the IRB approach, meaning the output floor has no effect on them.

An originator's decision to issue a securitization for funding purposes is typically based on considerations such as achievable funding costs and diversification of the institution's investor base, rather than regulatory capital effects.   However, solely in terms of aggregate capital requirements, Basel 3.1 may be more "securitization-friendly" for consumer-related asset classes than for corporate ones. Of course, investors in senior securitization tranches of such funding transactions are not all banks and therefore not all bound by these regulatory capital rules, which, in practice, would dilute the effects.

U.S. Banks Face Higher Charges On Securitization Exposures

In July 2023, U.S. regulators released their own proposal for implementing the remaining aspects of Basel III, in this case known as the Basel III endgame.   The proposal seeks to modify the approaches applicable to large banks and will likely result in higher capital requirements for many of them. In aggregate, regulators estimate that the proposal would increase bank holding companies' total risk weights by 20%.

In line with the wider Basel III philosophy, the U.S. proposal standardizes more aspects of the capital framework and aims to make the largest banks less reliant on internal models.   The proposal also aims to align the capital requirements for any bank with more than $100 billion in assets with the more stringent requirements for global systemically important banks, providing a single approach for all large institutions. If the proposal is finalized as drafted, the transition to the new framework would begin on July 1, 2025, with full compliance by July 1, 2028. But after receiving many comments on the proposal, regulators indicated that they will likely make "broad and material changes" before setting the final rules. In this article, we take the proposal at face value and consider possible effects related to securitization, as we did for the EU.

The differences between the EU and the U.S. are material, both in terms of the existing regulatory capital frameworks for banks and the proposed changes related to Basel 3.1.   For example, even under current rules, the largest U.S. banks are subject to a dual requirement, whereby they calculate capital charges under a model-based, advanced approach and a simpler SA. Their overall regulatory capital requirements are then based on the worst case between these two approaches, meaning many are already bound by the SA, unlike in the EU. Conceptually, this is similar to those banks already being subject to a 100% output floor.

The Basel III endgame proposal will largely eliminate model-based approaches (except for market risk assessment) and replace them with a new formula-centric method, known as the "expanded risk-based approach" (ERBA).   The dual requirement is retained but will compare results between the new ERBA and the SA. After these changes, large U.S. banks' overall capital charges will generally be bound by the ERBA, as it will likely lead to higher capital requirements in aggregate than the current SA. That said, capital charges related specifically to credit risk could decline under this new regime, due to the ERBA's higher risk sensitivity.

Costs in the new U.S. SRT market would rise substantially under the endgame proposal

Interest and volumes in the U.S. bank-originated SRT securitization market have picked up since mid-2023, from close to zero, not least due to better regulatory clarity on how such transactions can be treated.   However, the net effects of the Basel III endgame proposal on SRT securitization are uncertain. On the one hand, higher overall capital charges resulting from the proposal could generally incentivize a higher use of securitization to reduce underlying risk-weighted assets. On the other hand, the proposal makes the formulae for capital charges on securitization exposures more conservative, potentially making SRT transactions less viable than they are today. We, again, use our illustrative asset pools to quantify these effects (see chart 4).

Chart 4

For unsecuritized asset pools, the changes--and, more likely, declines--in credit-related capital charges will be limited.   Yet the incentives for originating banks to remove risk-weighted assets from their regulatory balance sheet through SRT securitization could be substantial, due to non-credit-related effects of the Basel III endgame that are outside the scope of this analysis.

After the implementation of the Basel III endgame, SRT securitizations will require the sale of substantially larger portions of the capital structure to achieve capital relief of a similar scale as under the current rules.   With mortgage collateral, for example, the size of the sold tranche would have to roughly double. All else being equal, such an increase would likely be more costly for originators and potentially reduce the feasibility of SRT transactions.

More conservative securitization calibrations incrementally favor unsecuritized assets for bank holdings

As we did for the EU, we can also assess whether the Basel III endgame rules might have any second-order effects in the context of funding-related securitizations, relative to the current U.S. regime.   While capital charges on our pre-securitization asset pools generally will either remain similar or fall under the Basel III endgame, the equivalent effect on aggregated post-securitization exposures is less favorable (see chart 5). These charges generally either decline by less than those for the pre-securitized pools or increase by more. This is due to some changes introduced in the ERBA for securitizations, compared with the existing SA. The ERBA has a lower risk weight floor of 15%, which applies to some senior securitization exposures, compared with 20% in the SA. However, the new method also increases the p factor in the capital formulae to 100%, compared with 50% in the SA, which generally increases the charges. The Basel III endgame proposal states that this will "help to ensure that the framework produces appropriately conservative risk-based capital requirements" when combined with the more lenient risk weight floor. However, overall this will result in an increase in securitization capital charges, relative to charges on the underlying assets. All else being equal, this could be a disadvantage for securitizations.

Chart 5

Securitization-Related Aspects Of Basel III Are Still Under Discussion In The U.K.

Most aspects of the Basel 3.1 implementation in the U.K. have been agreed, with new rules set to begin in mid-2025 and various transition arrangements running until 2030.   However, certain elements related to securitization remain subject to an ongoing discussion and consultation process, whose outcomes are uncertain.

While the current U.K. rules were essentially inherited from the EU post-Brexit, the regulatory authorities are gradually moving away from them.   In particular, in October 2023, the Prudential Regulation Authority published a discussion paper (DP3/23) that acknowledged potential issues regarding the Basel III output floor's interaction with the economics of SRT securitizations. The paper requested industry comments on several options to address this, including a similar approach to that already adopted by the EU, but alternatively entertaining the idea of a more widespread recalibration of regulatory capital charges on securitization exposures. This could have significant consequences for the effect of the Basel 3.1 implementation on U.K. securitization markets. Further proposals are expected later this year.

A Mixed Picture

The potential effects of the Basel 3.1 implementation on securitization markets around the world remain highly uncertain. In general, though, aggregate regulatory capital requirements look set to rise under Basel 3.1. This could incentivize banks to more actively manage their risk-weighted assets with techniques that could include more SRT securitization issuance. Compared with current rules, however, Basel 3.1 will generally make SRT securitizations more challenging and costly to execute, due to parallel effects on the capital charges for securitization exposures. Multi-year transition arrangements mean the effects of these changes may only gradually become apparent, but we will continue to watch for shifts in securitization market practices as the implementation begins.

Related Research

• Banks Ramp Up Credit Risk Transfers To Optimize Regulatory Capital, Feb. 22, 2024
• How The U.S. Proposes To Implement Basel III Capital Rules And The Impact On U.S. Bank Capital Ratios, Jan. 11, 2024
• EU Banking Package: Inconsistencies Temper Framework Improvements, Jan. 9, 2024