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Update: Basel IV deal sets capital floor for risk models, European banks protest

The Basel Committee on Banking Supervision has completed its post-crisis capital framework with new rules limiting the use of internal risk modeling, but European banks say they give U.S. banks an unfair advantage.

Banks will have to hold at least 72.5% of the capital against risky assets recommended by standard models, the BCBS said, but they will have until 2027 to comply, with the 'output floor' being phased in incrementally starting at 50% in 2022.

The updated rules, dubbed 'Basel IV' by the banking industry, also prevent banks from using internal models to calculate certain credit risks like equity exposures, and introduce a single standardized approach for modeling operational risk.

In all, the changes mean a €40 billion capital shortfall for European banks, mainly shouldered by Europe's global systemically important institutions, whose capital requirements will rise by 15.2% on average, according to the European Banking Authority.

"The aggregate output floor is the strongest driver of the increase, whereas the revisions to the credit risk and operational risk frameworks have a more moderate impact," said the EBA, in a report released shortly after the BCBS decision.

'Not reasonable'

The completion of the post-crisis Basel III framework is nearly a year behind schedule, having been held up by a critical disagreement between U.S. and European regulators over the output floor.

Many European banks have huge mortgage and corporate loan books compared to their U.S. peers, and use historically low default rates to assign these exposures minimal risk weightings in their internal models, which U.S. regulators say is gaming the system.

European regulators argue their banks are being treated unfairly, as bank lending is far more important to the region's economy than in the U.S., which has a much bigger bond market.

Lobbyists at the European Banking Federation reacted to the news by calling for a thorough assessment of its potential impact.

"We should not lose sight of the fact that the output floor may do significant harm to our European economy and to the global competitiveness of European banks," said EBF CEO Wim Mijs in a statement. "The output floor could impair the benefits of the finalized Basel III package and endanger the balance, so it is important that all parts of the world introduce the new requirements in a harmonized way."

Sweden's banking sector is one of the hardest hit by the output floor, and the Swedish Banking Association expressed its disagreement.

"It is not reasonable that Swedish banks, which are already among the best capitalized banks in the world, will suffer harder than other banks by the new Basel regulatory framework," said its CEO Hans Lindberg. "We assume that the implementation in the EU and Sweden takes place in a manner that does not jeopardize the risk-based capital requirements that are successfully used in Sweden."

Initial reaction from the U.S. was more restrained.

"It’s important that U.S. regulators implement those standards and write the implementing regulations in a manner that’s consistent with our country’s interests and financial conditions," said Wayne Abernathy, executive vice president of financial institutions policy and regulatory affairs at the American Bankers Association. He called for regulators to seek public comment before drafting implementing rules, "so that the public can provide input on the new standards that will improve their effectiveness and support economic growth in the U.S."

Go it alone?

During the dispute over Basel IV, a number of European politicians and regulators have threatened to simply ignore the global Basel standards if the final outcome was too negative and introduce a European framework instead.

Markus Ferber, vice chairman of the European Parliament’s Economic and Monetary Affairs Committee, struck that familiar tone in response to the BCBS' decision.

"This deal will make corporate financing in Europe more expensive and this is bad news for the real economy," Ferber said by email. "Once again, Europe loses out because they failed to stand united in the negotiations. Given the poor implementation record of Basel packages in other jurisdictions, the European Union will have to have a close look if all provisions should really be implemented one-to-one into European law."

However, Sam Theodore, head of financial institutions at Germany-based Scope Ratings, told Market Intelligence the decade-long implementation period was "very generous" and the final rules were a "good thing for transparency."

"I don't think it's such a big deal for profitability but banks like to make noise," he said. "For a long time the discrepancy in risk-weighted assets and [CET1] calculations was a major complaint of analysts, basically saying they are comparing apples with pears. The output floor should make for a level playing field ... I believe it strengthens the investment case for European banks."