Basel IV: A political turning point?
During 2016 we heard and read about the often unclear and unrealistic expectations and implementation deadlines for banking regulation. Moving into 2017, Basel IV was expected to be no exception.
Basel III, which imposed significant extra capital, liquidity, leverage and regulatory disclosure requirements, is still two years away from full implementation (2019). Yet already the Basel Committee on Banking Supervision (BCBS) have turned their attention to its successor, the so-called Basel IV package of banking reforms, which in-turn are likely to place significant additional capital demands on banks.
But crucially, and unlike its predecessors, Basel IV may prove politically infeasible.
Already, and in a departure from past-precedent, the Bank for International Settlements (BIS) led proposals have faced substantive criticism from EU regulators and political figures.
Valdis Dombrovskis, European Commissioner for financial markets, made it clear in September 2016 that Brussels would not accept any reforms that “lead to a significant increase in the overall capital requirements shouldered by Europe’s banking sector.” Furthermore Felix Hufeld, the president of Germany’s Bafin, was emphatic in November that “from a German perspective, what we have on the table so far is not acceptable.”
Their concern relates primarily to a move away from internal modelling and towards standardised risk weighting approaches for calculating Risk Weighted Assets (RWAs). This unease is amplified by the fact that the risk weightings used in these standardised RWA calculations are expected to become more onerous. Consequently, in certain asset classes banks will need to hold more capital to service the same amount of lending. Faced with these harsher requirements, banks may face a stark choice to avoid breaching regulatory capital ratios: restrict lending, or raise more capital.
For Europe in particular, restricting bank lending is a red line. European businesses rely more heavily on bank lending than their US equivalents, with non-bank lenders issuing only around 20% of corporate loans. By comparison, US non-bank lenders account for approximately 85% of the corporate lending market.
Furthermore, proposed Basel IV changes to credit risk weightings, and the introduction of ‘floors’ (i.e. minimum values) to certain RWA calculation input parameters (primarily Probability of Default, or ‘PDs’), would substantially increase the capital intensiveness of retail loan books and, more importantly, mortgage portfolios. US banks may remove mortgages from their balance sheets by trading Mortgage Backed Securities, or offload them to state agencies such as the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). However, European banks are not as heavily engaged in the former, nor do they have access to the latter, and thus will feel the impact of such changes on their ability to lend more acutely.
At a time of prolonged and ongoing post-crisis European economic stagnation, it’s not surprising that European bodies are unwilling to countenance any measures that may force banks to reduce their lending to households and businesses.
The second option, to raise more capital, is also particularly unpalatable. Italy’s problems are well documented, so anything requiring them to raise further capital at a time of crippling vulnerability will understandably be vociferously protested. But aside from Italian woes, the sector is underperforming across the continent. In particular, Eurozone banks are struggling to deliver the expected double digit returns on equity (the main component of regulatory capital) demanded by shareholders, particularly in comparison to competitors in alternative jurisdictions. Joint Bloomberg and ECB analysis in 2016 forecast an average 2017 Eurozone bank Return on Equity (net income as a percentage of shareholder equity – ‘RoE’) of less than 7%. This is marginally behind Japan, far below the 8.5% estimate for US institutions, and significantly below the pre-crisis 10%+ RoE expectations of shareholders.
With some analysis estimating that European banks would need to raise between 30 to 50% more capital as a result of the Basel IV proposals, the journey back towards acceptable shareholder returns would only become more painful and prolonged.
The Basel IV rules are not yet finalised and so the magnitude of their impact cannot yet be fully known. Yet despite this, EU figures are already making their objections heard. So much so, that the long-awaited 8th January meeting, expected to finalise the Basel IV rules, was postponed at the 11th hour in the face of heavy opposition. As of yet, there has been no reschedule.
So it is important to remember that whilst we are in the midst of a prolonged period of governmental anti-bank sentiment, it hasn’t always been this way. In the timeless back and forth of political sympathies with banks or their supervisors, opposition to Basel IV may represent one of a number of events, including the rise of Donald Trump, beginning to signal a shift of political favour in the industry’s direction.
Perhaps, even, a turning point.