Europe's big banks equipped to handle transition to final Basel III rules

Big European banks are well positioned to navigate the implementation of the final Basel III reforms given their already strong capital levels and local adjustments that would ease the adoption of the new rules.

Most large European banks have increased their common equity Tier 1 (CET1) ratios since the final Basel III rules were agreed at the end of 2017. Of the 25 biggest by assets, more than half have boosted ratios by more than 110 basis points, S&P Global Market Intelligence data shows.

Under the latest proposals, banks in the EU and the UK will get extra time to fully adopt the final reforms and some relief in phasing in the so-called output floor — a measure limiting banks' use of internal models to assess the riskiness of their assets. Reforms in the EU are set to start Jan. 1, 2025, and in the UK on July 1 that year, with a phase-in period running until Jan. 1, 2030, compared to a Jan. 1, 2028, deadline set by global regulators.

The output floor would be the key driver of the increase in minimum capital requirements, especially for large European banks, which use internal risk-assessment models more widely than smaller domestic peers or counterparts elsewhere in the world. Large European banks are facing a 14.6% rise in minimum requirements as a result of the final Basel III reforms, compared to a 0.9% rise for big banks in the Americas and a decline of 2.6% for big banks in other global regions, according to the latest estimates from the Bank for International Settlements.

Sufficient resources

Even so, large European banks have the resources to navigate the challenges of implementation given the work already done to boost their capitalization and the longer phase-in period, Paul van der Westhuizen, a senior strategist at Rabobank, said in an interview.

Excess capital above minimum requirements at the banks in the sample ranged from 244 basis points to 833 basis points, with over half of the institutions holding buffers of more than 400 basis points.

Leverage ratios — a measure added to Basel III as a backstop for the risk-based capital measures — have also increased at most banks in the sample since the first quarter of 2018.

The capital shortfall to meeting fully loaded minimum Tier 1 capital requirements stands at €600 million, increasing to €6.5 billion if all additional regulatory buffers are included, according to the latest European Banking Authority (EBA) estimates.

"This is a very small shortfall to full implementation," van der Westhuizen said.

Proposed EU-specific transitional arrangements would push full adoption of the output floor on certain asset classes, like mortgages and exposures to low-risk unrated corporates, even beyond the 2030 deadline. In its end phase, the output floor would prevent banks' internally modeled amounts of risk-weighted assets (RWAs) falling below 72.5% of the amount computed by the Basel Committee's standardized approach.

Given the long phase-in period, EU banks will have "substantial time to address any required increase in regulatory capital, either through capital accretion, exposure management, or both," S&P Global Ratings analysts said in a Sept. 18 analysis. Industry and public policy considerations taken in the bloc will also soften the final impact, they said.

The UK aims at full adoption of the output floor by 2030 and follows the final Basel III standards closer than the EU, yet it also proposes some adjustments for risk-weighing of property and investment-grade unrated corporate exposures.

"We expect a manageable impact on UK banks' capital requirements from these revised rules," the Ratings analysts said.

Time to prepare

High-quality mortgage and unrated corporate loans are considered the asset classes that could see the strongest RWA increase from the output floor in Europe as many banks have used internal modeling to keep lighter risk weights on such loans given their historically low default rates. An increase in RWAs — a key measure for the riskiness of an asset — would affect CET1 ratios, which are a core measure of banks' capital strength.

RWA density — the ratio of RWAs to total assets — has historically been lower in Europe than in the US. At Europe's largest banks the average density stood at 31% at the end of June, compared to about 51% at US banks, according to regulatory data.

Yet European banks have had a long time to prepare for the impact, and countries such as the Netherlands have partly adopted the output floor, according to Rabobank's van der Westhuizen.

"We've had an output floor in place for a couple of years now," the analyst said.

The Dutch National Bank in October 2019 introduced a floor on RWAs in big banks' residential mortgage loan portfolios. The floor on mortgages with up to 55% loan-to-value was set at 12%, while that for higher loan-to-value loans was set to 45%. Similarly, Sweden has had a 25% floor on mortgage loans since 2018.

Nordic and Dutch banks are seen as the most affected by the final Basel III package given their large, low-risk-weighted mortgage books. RWA density at Dutch banks has increased in recent years, and while the rise in RWAs has driven a recent decline in CET1 ratios, the banks remain among some of the best capitalized in Europe, Market Intelligence data shows.

'Headache' for global banks

Nevertheless, the implementation of the final Basel III rules comes with a host of other challenges, especially for internationally operating banks, which would have to run parallel remodeling and compliance processes due to the diverging implementation timelines and versions of the final reforms across the EU, the UK and the US.

Those regional differences have created a lot of complexity for global banks in the past, said Laurie Mayers, an associate managing director of European banks at Moody's Investors Service.

"The final Basel III requirements are no exception and are not likely to level the playing field completely," Mayers said in an interview.

US authorities aim for a more stringent implementation of the final reforms with a shorter phase-in period from July 1, 2025, to July 1, 2028. The so-called Basel III endgame proposal seeks to remove the use of internal ratings-based models for measuring credit risk entirely and introduces a standardized floor for assessing market risk, among other deviations from the original standards, Jared Chebib, partner at the financial services consulting practice of EY, said in a post on LinkedIn. The divergent reforms would open opportunities for regulatory arbitrage, he said.

The UK's decision to align the start of implementation of what is dubbed Basel 3.1 by local authorities "removes a headache" for global banks, Mayers said.

"If the timelines are misaligned, the overseas subsidiaries would have to produce the Basel III reporting data for the parent, but they would not be able to use it locally," the Moody's analyst said.

As reforms are still being debated and finalized across jurisdictions, the EU might still decide to align the start of implementation to the US and UK, Mayers said.