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Internal model-reliant European banks face Basel IV capital hit

Banks in Europe's northern countries could face a significant rise in requirements for capital against business and mortgage loans if new Basel IV rules curtailing the use of in-house models to calculate risk are imposed, data shows.

Banks in Finland included in the European Banking Authority's recent transparency exercise calculate risk weightings for nearly 100% of their mortgage loans using internal ratings-based models, which allow banks to slash their capital requirements compared to those that result from the standardized models provided by the Basel Committee for Banking Supervision.

Banks in Belgium, the Netherlands and Norway used internal models for about 90% of their mortgage loans by risk-weighted assets. More than 90% of corporate loan RWAs in Sweden, Denmark and Finland are the result of internal calculations.

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A preliminary deal struck in December on reworking global risk-weighting rules could force banks using internal models to boost their capital against the loans to 75% of what would be called for under the standard model, it is understood. The new requirements, which could also include higher standard model risk weights and would be phased in by 2025, could be announced by the Basel Committee as soon as January.

A 75% capital floor with a seven-year operational loss history could knock an average 272 basis points off common equity Tier 1 capital at a group of nine European banks studied by Hari Sivakumaranat, an analyst at Keefe Bruyette & Woods, with Svenska Handelsbanken AB (publ) losing as much as 910 basis points. Lloyds Banking Group Plc, with a heavy mortgage portfolio, would lose 309 basis points, and ING Groep NV 212.

The Basel Committee says an overhaul of risk weighting is needed to complete post-crisis Basel III reforms and to stop banks gaming the system to reduce their capital charges, arguing that the overall effect on the financial system's capital will not be significant. But banks in Europe, which unlike U.S. institutions have large corporate and mortgage loan books, say they could be forced to raise billions of euros in capital and have dubbed the changes "Basel IV."

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Internal model risk weights can often be a fraction of those resulting from the standard model. ­The average risk weighting of Swedish mortgages included in the EBA's transparency exercise was 6.7% when using internal models, compared to nearly 43% using the standard model. U.K. banks' internal model mortgages were weighted at just under 15%, barely a third of the weighting on the same banks' mortgage portfolios using the standard model.

Banks in Sweden and elsewhere argue that they can assign low weightings to mortgages because they have decades of data to help them accurately calculate risk of default and because their customers have track records of reliability in economies with historically low levels of volatility. They and many European officials say limiting leeway on risk calculations could backfire by increasing incentives for lenders to use scarce capital for bets on riskier assets.

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While Dutch and Scandinavian banks in particular look set to pay a heavy price in capital for Basel IV, many in the center and south of the continent may escape more lightly. Banks from Austria, Greece and Spain all had less than half of their mortgage RWAs in internal model portfolios, while the proportion was only 25% for Portuguese banks. There was also less of a disparity in these countries between standard and internal model asset density, with the average internal model weighting for Portuguese mortgages of 19.9% being slightly more than half the level for the standard portfolio.

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Click here to view SNL's profile of individual European banks.