Basel IV: Unintended consequences of levelling the playing field

Basel IV will change the playing field for corporate funding, particularly in Europe and the Nordic countries. While the regulator's aim is to restore confidence in banks' internal risk models, resilient banking systems, such as those in the Nordics, will suffer the greatest impact, losing the benefits from proven advanced risk models, according to Nordea's Tim Farrar (TF), Head of Public Affairs for Large Corporates & Institutions and Karsten Skov (KS), Pricing, Balance Sheet Management. They also explain in this interview with Johan Trocmé, Director of Nordea Thematics, why one likely outcome is a further shift from banks to bonds for large corporate funding.

JT: The Basel IV framework from bank regulation is planned to start replacing the current Basel III in a couple of years. How would you in simple terms describe the main changes in Basel IV versus Basel III?

KS: The biggest changes relate to the extent to which banks in reality are able to benefit from using more risk sensitive internal credit risk models instead of standard models. There are currently three different approaches for measuring risk:

• Standard models
• Foundation internal models (F-IRB)
• Advanced internal models (A-IRB)

More advanced models can make it possible for a bank to more accurately measure credit risk and hence show more precise risk-weighted assets and accordingly increase its return on capital. Basel IV will remove the possibility for banks to use A-IRB for lending to larger corporate (above EUR 500m in revenues) and institutions. They will instead have to use F-IRB models.

In addition, the magnitude of the benefit of using internal risk models could be reduced as a result of the new output floor. The output floor sets a lower limit for how much risk-weighted assets - measured using internal models - can be more reflective of the actual risk banks carry versus what they would be if standard credit risk models were used.

The exact impact will vary among banks. Using a top-down approach in standard models instead of more refined internal models will arguably remove a lot of risk sensitivity in models. They will become more blunt. And the changes from Basel IV will kick in at different times and differ from bank to bank, making it even more difficult to evaluate the exact impact on banks in advance.

JT: Why is the Basel Committee revising the Basel III framework? Have there been perceived problems in the eyes of the regulator, with different banks using different kinds of models?

TF: The Basel Committee describes it as reducing excessive variability of banks' risk-weighted assets, improving comparability and restoring confidence in banks' risk models. It is therefore a major final piece in the post-financial-crisis reforms. It aims to achieve this by constraining the use of internal models largely via the application of an output floor (and in some cases removing the option entirely to use internal models) and improving the risk-sensitivity and robustness of standardised approaches. This represents a fundamental change in how banks will need to calculate regulatory capital.

Making comparisons between standardised and banks' internal risk models can also be difficult if standardised approaches do not achieve sufficient risk sensitivity. It may not be possible to say with confidence that the risk measured using internal risk models genuinely deviates by a certain percentage from the outcome when using standard models, unless the standardised approaches are able to reasonably accurately measure the actual risk the bank carries. In order to compare, you must have something meaningful to compare to. A lot of the variation in risk weighted assets can be attributed to underlying fundamentals.

For example, lending to all unrated corporates (above SME size) under Basel IV will attract a 100% risk weight when calculating a bank's risk-weighted assets, regardless of the real credit quality of the corporate. This means that it is not possible to make a meaningful risk assessment of the company by simply using a standardised approach to risk weights. This makes it harder to get a proper overview of the bank's actual risk, as all risks are treated on par, and it will not support comparability or act as a reasonable basis for constraining the internal models.

JT: What consequences do you see for the banking system from the implementation of the Basel IV framework? Will there be regional or individuals differences among banks?

TF: The expected global impact from Basel IV, if one considers the US, Asia, and the EU combined, is reasonably modest. However, it is a very different picture in Europe, where estimates according to the European Banking Authority show that banks would have to carry significantly more capital to meet the requirements. Looking within Europe, there will definitely be a greater impact for banks in the Nordic countries, the Netherlands, Germany, and to some degree France. One can start to understand this by noting that much of the impact stems from the output floor, which is also a function of how the standardised approaches have been calibrated and the extent to which banks have deployed internal models.

That the Nordics are such an outlier from these global reforms should raise a red flag for EU policymakers, given the characteristics of the Nordic economies and banking sector. These economies are open, competitive and ranking high on economic welfare indicators. They have high employment rates, good incomes, strong social safety nets and solid government finances.

They have effective legal systems providing a high degree of creditor protection. All elements combined provide a strong macroeconomic shock absorption capacity. Other key indicators such as the capital levels of Nordic banks, plus low levels of mortgage defaults and non-performing loans, should also draw into question why Nordic banks would need to hold significantly more capital than today. This appears to be penalising jurisdictions and market participants that act in a prudent manner and could set incentives that would be contrary to policymakers' objectives.

There will be variations in the impact across banks for some of the reasons mentioned, and also depending on the bank’s portfolio composition and starting point going into Basel IV. However, a general observation from the Nordics is that the combination of the output floor and risk-insensitive standardised approaches tends to penalise low-risk portfolios, in particular high-credit quality, unrated corporates and low-risk mortgages.

JT: Have these difference in expected impact from Basel IV specifically been sought by regulators, or are they just a side effect from a greater cause?

TF: I do not believe this is the real intention, more of an unfortunate side effect, and it speaks to the challenges of having a single rule book that at the same time can cater for regional differences. If you consider that there was a commitment from the EU to not significantly increase capital levels through the Basel III finalisation, then it’s not unreasonable to say that has not been met at the Nordic or even the EU level. It seems hard to conceive that after all the (post-financial crisis) measures already put in place, policymakers would still target the Nordic banking sector as needing to hold significantly more capital, as the impact assessments play out. Again, the unfortunate thing is that Basel IV is likely to impose the most restrictions on the banking systems for the countries whose financial systems have behaved in the right way and done all the right things.

KS: Sometimes it is like comparing apples and oranges when assigning risk weights. For example, a mortgage loan in the Nordics is so different from a mortgage loan in the US. Putting it simply, in the Nordic countries, debt will essentially follow you for life, and you have far-reaching social support when losing your job, while in the US you are able to hand the keys to your property to your bank if you default, and walk away. But they are treated the same way in the Basel framework, even though historical default rates are very different.

TF: This is very difficult, and I have some sympathy for policymakers. They try to create a global level playing field, and are at the same time not able to cater for every specific banking market in the world. So, it is essentially a balancing act for the Basel Committee to take into account some degree of regional, national and product variations into a one-size-fits-all regulatory framework. But I think in some key areas they need to do better at taking into account significant regional differences in the framework, as we are now seeing at the European level.

This is important, not least because European companies have a greater preference for funding themselves with bank lending than in the capital markets, even if in the past years we have seen a shift in that direction. And this is one reason why many European corporates do not have a credit rating. It has not been necessary for getting bank funding.

JT: How do you see Basel IV affecting funding for large corporates?

KS: It depends on the timing, and the impact will vary among individual banks. There should not be much impact in the short to medium term. In the longer term, banks that get hit hard by the raised output floor may need to reconsider the economics of their corporate lending, given the increase in risk-weighted assets they will face. They may lend less to corporates, unless they are able to compensate for the higher capital reserve requirements through pricing or other measures. On the global level, however, the impact from Basel IV is expected to be more modest. I think it is likely that Basel IV will stimulate the already ongoing shift from bank to bond funding for corporates, particularly in Europe.

TF: And this also seems to be what development policymakers are striving for. They want to lower the corporates' reliance on bank lending and to further develop capital markets within the EU, hence all the initiatives in the Capital Markets Union. There is not a specific target in terms of the balance between the two, but we see a general desire for European companies to have more diversified funding sources available, for example in the SME growth market, and also more risk sharing in the system overall. If there is less reliance on bank lending then you may reduce systemic risk in the banking sector also, if risks are distributed to other parts of the financial system.

KS: This shift is mainly for the larger corporates. In my view, the SMEs will not be able to go to the bond market like the large corporates, and will still have to rely primarily on banks. And bank funding also suits SMEs better. It is very different having a bond investor, in case you run into trouble and have to renegotiate credit terms, versus having a relationship with your bank. The bank knows you and your business, and has its own view and analysis of its viability. These aims of policymakers may make sense for large corporates, but could at the same time create challenges for small corporates.

JT: More specifically, how do you see Basel IV affecting bank lending to corporates, including how banks are likely to respond to the changes?

KS: For large corporates, the requirement for banks to abandon advanced IRB models and instead use the simpler foundation IRB models means all their loan maturities are going to be treated as 2.5 years. At present, under Basel III, longer-term corporate bank funding is slightly more expensive, and short-term vice versa, owing to maturity effects. This will no longer be the case under F-IRB in Basel IV, increasing the relative attraction for corporates of longer-term bank loans compared with short-term loans. This conflicts with the policymakers' aims of steering corporates towards more bond funding.

Smaller corporates with revenues below EUR 500m will not be affected at first, but all corporates should feel an effect when the raised output floor under Basel IV is implemented. Some banks will then see an increase in their risk-weighted assets and hence need to hold more capital reserves against that lending, all else being equal. The banks will want to earn a return on that additional capital, of course. And what happens next is up to the banks. They could try to charge more for their lending, exit less profitable lending, or try to work with other tools to mitigate the increase in RWA.

The largest corporates use the bonds for their core long-term funding, with a syndicated revolving credit facility (RCF) from banks to diversify funding and as a backup credit. Is this going to continue as before? With Basel IV, as long as the banks have the capital, it will be all about the price, and whether or not the corporates find it attractive. Short-term bank loans will likely become less attractive for corporates, as their pricing will not benefit as much from having shorter maturity as under Basel III.

The most affected category of borrowers is arguably large corporates without an external credit rating. They typically receive a favourable treatment from advanced IRB models under Basel III, but will face a 100% risk weighting for calculation of a bank's risk-weighted assets under Basel IV. This is clearly worse than both rated large corporates and non-rated SMEs in IRB models.

TF: The impact assessments show there will be an overall capital shortfall. However, I think banks have proven to be adaptable to such changes, so they will adjust to the new rules. That said, it would be naive to think that banks will simply soak up the impact especially as many are facing pressure with their profitability. I would rather predict a scenario where several changes take effect, for example, where there is a cost impact to the real economy, where some capacity could be taken out of the banking sector, where funding (and therefore risk) shifts to other parts of the financial system (possibly to less well-regulated parts), and banks will adjust as needed to soak up the impact.

What I would be more concerned about in the long term is that we have a regulatory capital framework that creates a misalignment between the actual risks banks carry and the banks' regulatory required loss absorption capacity, and the ongoing impact this has on banks' business selection, pricing and capacity to support the real economy.

Banks have a critical role in the economy and wider society, so it is important to have strong, well-capitalised banks. However, it is also important that regulatory capital requirements reflect the risks that banks carry. If there is an overstatement of the risk, banks will have to be overcapitalised, and that creates idle capital that could have been put to use somewhere else or additional cost for providing credit. The Basel framework, while achieving many good outcomes, is by no means perfect. In some areas I think it should be improved to be more risk sensitive.

JT: Last year was characterised by the COVID-19 Pandemic. When it comes to the timing of the implementation of Basel IV, where do you think we stand today?

TF: Initially, the Basel Committee moved it from 2022 to 2023. COVID-19 has probably played a part, but the Basel Committee has to make an overall assessment of how prepared each of the jurisdictions are to implement Basel IV in time. Banks have made some preparations for a negative impact from COVID-19 which has not fully materialised so far. However, whatever discussions there may be around the COVID impact on the Basel implementation plans, it should not distract from the fact that in the long term we need a framework that reasonably well reflects the risks banks carry so risk and capital views are aligned. Also in terms of the COVID impact, the effect on banks' capacity to support the economy during the pandemic under a Basel III scenario should be properly assessed. Importantly, the output floor is not a measure that can be suspended during a crisis in order to increase lending capacity. I don’t see this scenario currently forming part of the ongoing COVID-related impact assessments, but would think it should be looked at from this angle also.