Europe's banks set to offload risk for Basel preparation in 2024

European banks are likely to alter the composition of their loan portfolios in 2024 ahead of the implementation of new Basel capital rules.

The Basel III regulations will enhance the leverage ratio framework and introduce a so-called output floor, which would prevent banks' internally modeled amounts of risk-weighted assets falling below 72.5% of the amount calculated by the Basel Committee on Banking Supervision's standardized approach. In the EU, the reforms are set to kick in from Jan. 1, 2025, with a phase-in period running until 2030.

Banks, specifically those in Denmark and the Netherlands, will start looking to streamline portfolios next year, according to Bart Joosen, professor of law at Hazelhoff Centre for Financial Law at Leiden University.

"[They] will become more active in risk transfer transactions to reduce the impact of the capital floors," he told S&P Global Market Intelligence. Significant risk transfer transactions allow banks to deleverage their balance sheets by transferring the risk of a tranche of a loan portfolio to investors.

Capital calculations

Basel capital rules were devised following the global financial crisis of 2008/09 and have already spurred a large increase in the amount of capital held by commercial banks. All of the 20 largest banks by assets in Europe hold capital at least 2 percentage points above their regulatory minimums, Market Intelligence data shows.

Fewer banks are now applying to regulators for market risk models owing to the nature of the decision-making around the output floor, according to Lars Overby, head of risk-based metrics at the European Banking Authority (EBA).

While still early and somewhat speculative, it has been suggested that banks are likely making a trade-off in their internal considerations, Overby said. On one hand, they can implement a relatively complex model and not get the capital gain due to the output floor being binding; on the other, they could use a larger share of the standardized approach on the balance sheet, which may entail a less binding output floor, he said.

The output floor is still a "wildcard" in terms of how banks are making business adjustments, optimizing around the regulatory framework and their capital structure, Overby said.

Transition period

The capital impact for European banks has steadily decreased since the EBA's first analysis, aided by recently agreed long transitional provisions mitigating the effect on the output floor, Overby said.

While the UK has opted to postpone the implementation date of Basel III to July 2025, in parallel with the US, the EBA warned in October to not delay it any further.

But the implementation time frame in Europe should mirror that of its counterparts, according to Johanna Orth, head of group regulatory affairs at Sweden's Skandinaviska Enskilda Banken AB (publ).

"Different starting dates in the large financial centers make it more difficult for the market to compare and analyze banks," Orth told Market Intelligence. "It may make the picture blurrier."

The European Banking Industry Committee also called for a delay, saying banks need time to adapt to the new calculation and reporting requirements in 2024. It also cited the issue of practical alignment between the supervisory reporting and the capital requirements as the two "cannot be decoupled" and banks cannot implement the requirements without the reporting.

Climate risk

European banks also face evolving rules around climate risk and stress testing.

Currently, the scenario analysis element of stress testing for climate risk relies heavily on backward-looking metrics that mirror exercises done for credit risk. But banks will suffer if regulators do not "think outside the box and step away" from the economic theories that support other risk analyses, Joosen said.

"Simulations based on climate science should be the new way of assessing your risks and capitalizing them," Joosen said. "Using climate science reports and models is the way forward, essentially plugging that into a credit risk assessment," he said.

The fact that Europe has not implemented transition pathways eight years after the Paris agreement is particularly worrying, and there is greater potential for systemic risk the longer it is left, said Gonzalo Gasós, senior director of prudential policy and supervision at the European Banking Federation.

Transition pathways are part of an initiative to get a more detailed look at current and future transition activities by sector. Gasós also believes banks will struggle to progress in the area in 2024 due to insufficient data on their customers.

"We need transition pathways by economic sector from policymakers in 2024," he said.

Banks can also expect the ECB to implement microprudential tools to tackle climate risk in 2024, probably in the form of Pillar 2 capital add-ons that consider the idiosyncratic circumstances of a bank, Joosen said.

Macroprudential tools have been touted as a way to manage climate risk, notably from the ECB recently as well as the European Systemic Risk Board, largely through systemic risk buffers and borrower-based measures. But a systemic buffer "will not fly" with banks, Joosen said.

Banks would struggle to come up with sufficient capital for that cumulative requirement, and such tools are not risk sensitive and ignore the individual risk profile of banks, he said.