As the Basel Committee on Banking Supervision (BCBS) actively pursues a framework for calculating risk-weighted assets (RWAs), Europe's savings and retail banks have raised serious concerns that may arise for the banking sector, especially in Europe, as a result.
Published: January 2017
The BCBS's planned reforms would lead to a noticeable ratcheting-up of capital requirements. ESBG members could be hit by this on their capacity to keep lending to the real economy – namely SMEs and households. The most relevant regulatory reforms include potential constraints on the use of internal model approaches, revisions to the standardised approach for credit risk and changes to the operational risk framework.
Policy should acknowledge that the pace of world economic growth is lumpy at best. Regions of the globe have different expansion rates needs that policymakers should bear in mind when revising the banking sector capital framework. Expected to impact banks greatly, the new Basel framework will need to strike the right balance between the need for supporting economic growth and imposing tougher capital requirements. So far, the tabled reforms fail on that front. Past reforms in areas like capital, liquidity, loss absorption, have worked, providing support for financial stability all over the world. Now, when economic data show signs of growth, there is need to alow the economy to further expand instead of prescribing even stricter requirements.
Basel reforms could lead to a significant increase in capital requirements, which should be avoided by all means. Not only does the banking industry back this point, but first and foremost the Group of Central Bank Governors and Heads of Supervision (GHOS) has given this clear guidance. A hefty rise in capital requirements, coupled with regulation which is not proportionately balanced, would affect the real economy and every individual who seeks a bank loan. Banks would be hampered in financing the economy and providing liquidity to the markets. Further deleveraging would probably be needed as well by the European banking sector.
A one-size-fits-all solution would be problematic. If, for example, the real estate sector is less risky in one region than in another, risk models should be allowed to reflect this.
Risk sensitivity must not be wiped out in the Basel reforms. Stable banks focusing on traditional low-risk lending would be severely punished if risk sensitivity were erased. Banks with a considerably higher proportion of high risk assets on their balance sheet would be much less affected, meaning capital and risk would become deconnected.
The global level playing field could be endangered following the Basel reforms. G20 leaders rightly stressed in their latest Communiqué that the level playing field must be promoted. From a European banking perspective, EU banks are differently structured than those in other parts of the world, where, additionally, capital markets play a different role.
While in the United States the size of the banking sector is smaller than U.S. gross domestic product, the EU banking sector is more than three times its economy.
In Europe, corporate loans play a fundamental role. Loans make up more than 40% of GDP, bonds roughly 10%. In the US the focus is clearly with corporate bonds as loans comprise roughly 10% of GDP versus 40 % for bonds.
Increased risk weights now tabled in the proposed Basel reforms do not sit well with European banks. The main reason stems from EU residential mortgages representing 24% of bank loans, while in the US large parts of the mortgage book are transferred to government sponsored entities Fanny Mae & Freddy Mac. The mortgages resold to these GSEs consequently disappear from US banks' balance sheets, pusing up the average risk weight and making floors less binding.
Credit risk: Serious doubts have been raised by ESBG membership on whether the proposed framework would be able to improve comparability and remove unjustified differences in risk weights. The proposed framework seems too prescriptive and simplified. Furthermore, the risk weight for SMEs could be a little bit lower. If not, the combined effect of higher risk-weighted assets and higher capital requirements slash credit availability for SMEs.
Internal models: ESBG supports initiatives, such as from the European Banking Authority, aiming at enhancing the trust in IRB models as a valid tool to measure capital requirements. We believe that it would be better if supervisory authorities made efforts to improve internal models instead of imposing standardised floors for all credit institutions, regardless of their business model, or abandoning the use of certain models. Commissioner Dombrovski recently supported this point of view by stating that a standardised capital floor would not be essential. He added that latest data show that a floor would undermine risk sensitivity and lead to significant capital requirement increases, particularly for European banks.
What can be done:
There must be more flexibility. It seems too difficult to reconcile different banking systems through one global policy approach. There is need for the Basel Committee to set "global standards with local calibration".
The Basel Committee should re-consider some of its envisaged regulatory steps and re-calibrates certain elements of its proposals. Two examples are the risk weights in the corporate and retail exposure classes and due diligence requirements. These measures would ensure the European banking sector would get a fair deal, meaning not be hit disproportionately.
More thorough impact assessments are needed. The Basel Committee should conduct them in a way that better takes into account the impacts on smaller and less complex banks as well. Impact assessments should additionally take into account the interplay between the different parts of the Basel reforms as well as the existing rules framework and other recent developments such as TLAC. Only by looking at the overall picture, and the intertwined nature of the pieces, can have a more clear understanding of the probable outcome.
Internal models: It would be better if supervisory authorities make efforts to improve internal models instead of imposing standardised floors for all credit institutions regardless of their business model.
Credit risk: The risk weight for SMEs need to be a little bit lower. If not, the combined effect of higher RWAs and higher capital requirements could significantly dry up the flow of credit availabile for SMEs.