Agreement on Basel III: more regulatory clarity and stability for European banks

On December 7, the Basel Committee on Banking Supervision announced the finalization of the review process of the Basel III regulatory framework, which contains a series of reforms that should help boost banks’ resilience in the event of future financial crises.

As BBVA Research's Santiago Muñoz and Pilar Soler point out in their Basel III End Game report, this is a very welcome announcement. After almost a decade of negotiations, the agreement will allow the banking system and markets to have greater clarity about the prudential framework that applies to banks. The new standards are set to be implemented by January 1, 2022, except for one of its elements, which will not enter into full force until 2027. BBVA Research’s Santiago Muñoz points out that “the finalization of Basel III is very positive, due to the regulatory certainty it provides, after almost 10 years of modifications. The challenge now is to implement the elements in a complete, consistent and opportune manner."

Among the pieces that were approved, the calibration of the capital output floor was the most significant pending element. It will reduce the excessive variability in the calculation of risk-weighted assets, which will help improve the comparability and transparency of the capital ratios of the different banks. However, in their paper, the BBVA Research team point out that it is important to verify whether the new framework will provide adequate risk sensitivity.

According to BBVA Research, the cumulative impact of this reform will be limited in aggregate terms - in line with the commitment of G-20 leaders, but uneven at the jurisdictional and institutional levels. The most significant impact will fall on global systemic institutions, especially some European ones. However, from their point of view, the banking system seems to have had sufficient internal capital generation capacity since December 2015 to cover the additional minimum capital requirements. Nevertheless, the implementation of the new standards are likely to be challenging, as they imply significant changes in banks’ internal processes that will now need to be adjusted.

The principal reforms that have been approved are the following:

• The establishment of a floor in the calculation of risk-weighted assets of banks, using internal models that will guarantee that they do not fall below 72.5% of the aggregate risk-weighted assets as computed by the standardized approaches. Banks will also be required to declare the amount of the resulting RWAs, based on standardized models. This requirement will be implemented in different stages, and should be completed in 2027.
• The approval of a standardized and reviewed approach to credit risk. It will improve resilience and sensitivity to existing risk. Risk-weights have been recalibrated, for example, for banks and corporations’ exposures; also the risk-weight for residential real estate is now more sensitive, depending on the LTV (Loan-to-value) of mortgages (before, all mortgage loans were subject to the same weight).
• Limitation of the use of advanced models for some types of assets for which it is hard to establish a solid model. For example, exposures to large and medium-sized companies, or banks and other financial institutions.
• Regarding operational risk, a new standardized model has been established that will replace existing ones. The new approach determines the capital requirements for operational risk of a bank based on two components: (i) a measure of a bank’s income (the higher the income, the higher the risk) and (ii) a measurement of a bank’s historic losses (which considers that have experienced greater operational risk losses in the past are more likely to experience similar losses in the future).
• An additional requirement is established in the leverage ratio for global systemically important banks: The G-SIB leverage ratio will need to be satisfied with Tier 1 capital. A leverage ratio buffer has been set at 50% of the G-SIB’s risk-weighted higher loss absorbency requirements.
• The treatment of exposure to sovereign risk does not change, as no consensus was reached in this regard. Therefore, the debt of OECD member countries will still be considered as having no risk.