Basel III: some banks will lose out

International Financial Law Review
By Olly Jackson
15 January 2018

The Basel III reform reached at the end of last year were less restrictive than many expected. The new output floor of 72.5% is lower than the 80% discussed at the beginning of talks – and the 90% feared by some – but the changes are expected to affect mortgage banks more than others in financial services.

Citigroup Global Markets estimates that European banks assets weighed for risk (or RWAs) will increase by about 20% or €1.6 trillion ($1.9 trillion) as a result of new requirements. Regulators are concerned that banks have downplayed the risk of mortgages in their risk models and therefore proposed new rules on how to assess these, together with a new output floor that is be fully enforced by January 2022. Under the plan, banks’ total RWAs cannot be less than 72.5% of a figure calculated using an official standardised model approach devised by regulators.


“The market consensus was always somewhere between 70% and 80%, but it could also have been 90%, with the upper boundaries looking quite high and fairly costly for some financial institutions,” said AxiomSL product manager Richard Moss. “The heads of risk have been carrying out cash flow analyses on their internal model functions to see when pay back would actually happen.”

General frustration

Linklaters partner Allegra Miles said that while banks are encouraged that the final outcome was less severe than anticipated, changes to the output floor added to the tighter rules in regards to risk calculations, have left many banks feeling frustrated.

“There is a general frustration that there has been just too much prudential regulation piled on top of more regulation and a feeling that the regulator has not fully assessed the potential aggregate impact of all these changes,” she said.

While it is believed that there is a general feeling that banks begrudgingly accepted more consistent regulatory oversight, banks are frustrated with the implementation of a new floor based on standardised rules.

“It is frustrating for regulators to give the thumbs up to internal models on the one hand but then implement a floor based on new standardised rules on the other hand, thus undermining the value of internal models,” she said.

This is a thought echoed by Otto ter Haar, Basel regulation adviser at the Dutch Banking Association (NVB), who said that risk sensitivity is a cornerstone of the prudential framework.

“We need to have clear view on banks’ risks to ensure a correct capital amount is allocated,” he said. “The European Central Bank scrutinises internal models by detailed analyses and benchmarking exercises, improving the comparability between and the quality of banks’ internal models.”


The Basel reforms are likely to affect mortgage banks more than others, given that the new models assess mortgages to be far more risky than previously;

Dutch banks and countries with high loan to value ratios are also likely to suffer most;
These reforms, together with the long-running European NPL problem could see bank’s profits fall, in areas where banks’ profits are likely to be low beforehand.

“The European Banking Authority proposed detailed methodological improvements that strengthens the comparability even further,” he added.

In a poll conducted by IFLR last year, 46% of respondents said that introducing the standardised approach to calculating operational risk would prove to be the biggest challenge for US banks. There are also concerns that this move would only serve to increase the cost of capital and reduce liquidity.

Miles suggested that as a result there may be fundamental changes made to business models as a result. “There will be a definite increase in capital for most banks and some banks may choose to focus on more high-risk areas if there is not much difference in their treatment, in particular under the non-risk based leverage ratio,” she said.

However for those who run the business, regulation is just one of a multitude of factors to consider.

High loan to value ratios

It’s anticipated that mortgage banks will bear the brunt of the new regulatory changes. The full output floor is quite a way off but banks will in the meantime have higher capital requirements to comply with. These revisions may affect certain European banks more than others, in particular those banks which have high mortgage loan to value (LTV) ratios.

In particular, Dutch banks are expected to suffer more than most. The Dutch housing market is highly exposed to residential mortgages with high LTV ratios. The NVB claimed in 2014 that Dutch banks’ funds ratio would fall by between 45% and 60% as a result of a revised standardised approach and a new capital floor implemented. LTV ratios in the Dutch market are among the highest in Europe because the Dutch tax system allows full deductibility of mortgage interest payments from taxable income. The average standard risk weight for Dutch residential mortgages would increase from 35% to 45% under the new weightings and this would have a big effect on capital charges. Other countries like Finland are likely to suffer from the same problems.

On a more general level, banks with a fairly low risk portfolio could prove to be the worst hit. Nordic banks, for instance, which are heavily dependent on their relatively low-risk mortgage and lending businesses, could also be significantly affected. The winners are the more diverse portfolio banks – the larger EU banks, for instance.

“Some mid-tier banks were preparing to move away from their own models and use the standardised approach,” said Moss.

While Basel is trying to introduce more comparability in the global financial system by setting the output floor, this approach clearly has a lot of critics. Some of the differences stem from the fact that banks hold different assets, but others originate from how banks determine and attribute risk.

“If you go down that route, you need to ensure the standardised approach is correct,” said ter Haar. “The risk profile of a loan-to-value ratio of 80% is clearly not the same for a Brazilian and a German mortgage, there are so many underlying risk drivers.”

“A floor only makes sense if the base is correct,” he added.

Nevertheless, banks can take some consolation from the fact that the output floor is not as high as it could have been.

NPL issue and reform could hit bank profits

There are fears that the regulatory changes could exacerbate a long-running capital problem in Europe. Non-performing loans in southern European countries like Italy and Greece remain high. In Greece, for example, 45% of the country’s total loans portfolio was non-performing last year. The EU average of 5.1% as of June 2016 is well above the US and Japan, both at 1.5% at the end of 2016. This long-standing issue, together with the tighter capital requirements under Basel, could shrink banks’ profit margins particularly in locations where banks can ill afford to see risk increased.

“There is a general frustration that there has been just too much prudential regulation”. Founder of LC Macro Advisors and former director general at the Treasury Department of the Italian Ministry of Economy and Finance, Lorenzo Codogno, believes the NPL problem could have a destabilising effect.

“It’s a problem, not so much a financial stability one or a systemic problem but it still absorbs a lot of capital.,” he said. “If the economy continues to grow, banks will not be able to provide capital. You need to have enough to sustain the economy.”

One solution could be to create a European private sector platform that would trade debt, which is believed to be a work in progress.

In late November, the ECB said a platform should be created that would address the £714.7 billion worth of non-performing loans that currently exist inside the EU.

With the new Basel rules in place, this could be a solution that becomes all the more necessary.

As published in IFLR.