Basel IV: Look beyond the average impact

Jonas Bjarke Jensen (JBJ) and Antti Lemberg (AL) from the economic consultancy firm Copenhagen Economics talk to Nordea Thematics's Johan Trocmé (JT) about their take on the implementation of Basel IV (finalisation of Basel III). It remains to be seen if the current proposal will be the final one, but in its current form it will sharply raise capital requirements for banks that are big users of internal risk models, of which there are many in Sweden, Denmark and the Netherlands. Transition rules have softened the average impact, but differences between banks remain great.

JT: Could you briefly describe what Copenhagen Economics does and what your specific role is?

JBJ & AL: We are experts on regulatory impact assessments, supporting commercial investment decisions and competition economics. One of our core industry specialisations is the financial sector, where we support clients in understanding what drives changes within the financial sector and how to respond to these changes. We work all over Europe with banks, payment system providers, insurers, asset managers, financial sector regulators and trade associations.

(Jonas Bjarke Jensen leads the work on prudential regulation at Copenhagen Economics, while Antti Lemberg takes the lead on consumer, competition and conduct regulation.)

JT: Could you give us an overview of the work you have done over the years related to the Basel regulations? Who are you writing these reports for, and what have the key focus areas of your research been?

JBJ & AL: Since 2016, we have been analysing the impact of the final Basel III in its various forms, from the first initial recommendations by the Basel Committee to the current European Commission proposal for EU implementation. We have carried out these assessments for different private-sector clients – some of the work has been published.

JT: Do you see a reasonably level playing field for how banks across the world will be affected by Basel IV? Do Nordic banks stand out in some regard? What are some key questions or concerns for Nordic banks?

JBJ & AL: Banks across the globe will be impacted very differently by this package. For example, most US banks are affected to a very small degree, whereas a much larger impact is expected in the EU. Even within the EU, we see large differences between banks, with large banks, with low-risk lending portfolios, using the internal ratingsbased (IRB) approach to measure risk-adjusted lending being the most affected.

In particular, if bound by the output floor, low default risk is completely disregarded in capital adequacy calculations, leaving risk sensitivity only for loan-to-value measures. This is a problem for banks with relatively high loan-to-value levels which have been mitigated by historically low default risk.

Many Danish, Swedish and Dutch banks can be assigned to this category, meaning we expect the largest increases in capital requirements in these countries. But some large IRB-using banks in other countries could also see a significant impact, e.g. in Germany and France. For these banks, the Basel III finalisation package will drive a wedge between prudential capital requirements and necessary capital from a risk perspective.

JT: What do you think the biggest changes for banks from the implementation of Basel IV will be? And how will lending to corporates be affected? Impact on availability or pricing?

JBJ & AL: The finalisation of Basel III, which you call Basel IV, will fundamentally change how capital costs are allocated. While the average impact has been significantly reduced in the Commission's recent proposal, there are still large differences within different lending portfolios.

For banks bound by the output floor, corporate exposures will see a significant rise in capital requirements – for example, for some banks they could double. In contrast, we expect a smaller impact on retail mortgage lending, as it has received more favourable capital requirements in the Commission's proposal.

Furthermore, in several countries, we expect only part of the IRB-using banks' lending to be bound by the output floor. This means that some banks will not really see a strong increase in capital requirements, while other banks – operating in the same market – will see a massive increase. This will likely impact the competitive dynamics for different customer segments, with some banks becoming more competitive in terms of pricing, e.g. within corporate exposures. As a result, banks experiencing a large increase in capital costs might be reluctant to pass on the higher capital costs to the specific customer segment – but that would still beg the question as to how they should pay the bill.

Of course, there is quite a lot going on at the moment: Ukraine, inflation, the weaning off from QE, to name a few major macroeconomic influences. It is difficult to fully disentangle all the different individual effects.

JT: Would you expect Basel IV to affect the funding strategy or mix for Nordic large corporates? Long versus short funding? Loans versus bonds? Parent company guarantees? The case for a credit rating? Other factors?

JBJ & AL: Yes. Bank borrowing will become relatively more expensive, which should trigger responses from borrowers. Bonds should become more attractive relative to loans, given the particularly high increase in capital requirements for corporates. Also, the case for a credit rating is definitely worth a fresh look, as rated corporates will receive lower capital charges. We do not really expect to see much in the downstream guarantee space: if those sorts of strategies were effective at bringing down the cost of borrowing in the first place, they should be implemented regardless of the Basel regulations.

However, we have noted that several market participants have highlighted that the proposed legislation will create barriers to securitisation of bank lending that is not warranted by underlying risks. We think this is worth looking into further, notably also in the context of the EU's wider plan to support the Capital Market Union.

JT: Do you think the current proposal for Basel IV will be the final version, or could there be more changes ahead?

JBJ & AL: I think there will likely be some changes in the trilogue process. The big question is whether the transitional arrangements proposed by the Commission will be included in the final agreement. The Commission has even left the door open to make some of these arrangements permanent. This will be very decisive for the impact on the banking sector – in particular for banks with large retail mortgage portfolios.

JT: Do you see any important areas where further research could be needed on what effects the regulations will have?

JBJ & AL: Up until now, the main focus has been on the average impact. This has beensomewhat watered down compared to the original proposal – although still significant for some banks. We think the focus will now turn to the impact on the relative capital costs for different customer segments, and how this could impact pricing for the individual banks as well as competitive dynamics in the markets they operate in.

Also, we do not really see the average impact as being the relevant metric for the evaluation of reform. Again, going back to basics, it is important that there is a strong link between actual risks and capital requirements bank-by-bank. This has, for example, also been stressed in some of the publications provided by the ECB. So, we are interested in seeing how this pans out.