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European banks brace for mortgage hit to capital as Basel IV deal nears


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European banks brace for mortgage hit to capital as Basel IV deal nears

With global regulators seemingly poised to end a yearlong stalemate by approving final revisions to a sweeping package of rules for banks, lenders in Europe face a capital hit, S&P Global Market Intelligence data suggests.

The Group of Governors and Heads of Supervision, or GHOS, is set to meet Dec. 7 to review proposals from the Basel Committee on Banking Supervision to finalize the reforms known as Basel III. Agreement has been delayed by a conflict over the imposition of an output floor, which would limit the extent to which banks can use internal models to calculate the riskiness of their assets, which in turn informs how much high-quality capital they must hold to meet Basel III's requirements.

European banks and regulators have been particularly strident in their opposition to the output floor, which would require the result from so-called internal ratings-based, or IRB, approach models to be no less than a set percentage of what would be produced using a standardized model. Negotiators look to have settled on a 72.5% output floor, something the influential German central bank has said is acceptable if still too high, as long as the U.S. implements the package in full, including a review of how capital is allocated against assets held in banks' trading books.

The Basel Committee's standards are not directly binding on banks and must be implemented at national and pan-national level, although the committee does monitor adherence to the norms.

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Consultant McKinsey said in a report in late November that the overall capital impact on European banks from the full set of Basel IV changes could amount to €120 billion if no mitigating actions are taken. That would translate into a drop in the crucial common equity Tier 1 ratio — which measures capital as a share of risk-weighted assets to 9.5% from 13.4%.

Of that decline, 1.3 percentage points would come from IRB output floors, McKinsey said, with a further 0.8 point from a new standardized approach to measuring operational risk. The average return on equity for European banks would drop to 7.4% from 8.0%, McKinsey added.

Concern for European banks

European banks are more affected by the output floor change than their U.S. counterparts because the latter are able to securitize much of their mortgage exposure off their balance sheets, reducing the amount of capital that must be held. American corporations also tend to get most of their financing from capital markets, whereas European corporates are generally more reliant on direct bank lending.

Mortgage exposure is a particular concern for European banks, especially those in the north of Europe. Swedish banks, for example, tend to have very low risk-weight densities, meaning that they recognize a small proportion of a loan's value in their risk-weighted assets.

Data from the European Banking Authority's 2017 transparency exercise, which examined balance sheets of the largest banks across Europe, shows that for those mortgage portfolios that are risk-weighted using an internal model, risk-weighted assets as a percentage of exposure at default (RWA/EAD) amounted to less than 20% for 12 of 13 banks either currently or recently classed as globally systemically important. The portfolios for which risk is calculated using a standardized approach represent a small share of mortgages at most of the sampled banks, but carry risk weights several times higher than those measured under IRB.

Projected impact

Exactly how much risk weights would rise after the imposition of an output floor is impossible to model, and mortgages measured under the standardized model are likely to have different characteristics than those weighted under IRB. But S&P Global Market Intelligence has calculated the impact on the key common equity Tier 1 ratio should the RWA/EAD rise to 20%, 30% or 40%.

Sweden's largest bank, Nordea Bank AB (publ), would see its CET1 ratio drop more than 5 percentage points were the RWA/EAD percentage to rise to 40%, while the CET1 ratios of ING Groep NV, Crédit Agricole Group and Royal Bank of Scotland Group Plc would all drop by more than 2 percentage points.

Any changes are likely to have a long lead time, with McKinsey suggesting a phase-in period lasting until 2027.

"Each bank will likely need to adopt a package of changes big and small to improve capital management," it said. "Proposed strategic shifts in business models will have to be tested for sustainability in the new regulatory environment. Most banks can make beneficial business changes that do not require a new strategic focus, including the application of methods to increase capital efficiency and profitability."

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Click here to view capital ratios, asset quality, leverage and profitability across 132 European banks that participated in the European Banking Authority's 2017 transparency exercise.