About this article
More than a decade has passed since the financial crisis of 2007-08 and almost a year since the Basel Committee for Banking Supervision published Basel IV. In this 421 Perspectives paper, we look at some of the ramifications on the banking sector in Sweden.
Background
Before we get to Basel IV, let’s rewind back to the initial phase of Basel I-III, which all aimed to enhance the stability of the financial system after the financial crisis of 2007-08 by increasing regulatory capital.
Around the time Basel III was launched, the Swedish House of Finance here in Stockholm arranged a seminar to discuss the potential impact on the Swedish banking sector.
Kerstin af Jochnick, from the Riksbank (Sweden’s central bank and one of the parties representing Sweden at the Basel Committee for Banking Supervision), discussed how, in the first directive, Basel I, the size of the capital requirements was
based on four classes of risk: loans to state, banks, housing and corporates.
“This was considered too inflexible, and in Basel II it was changed to capital requirements that are more based on risk, and where the level of risk can be calculated by the banks themselves. However, this system, with internal models for risk calculation, has led to a dramatic drop in the capital requirements,” stated af Jochnick.
Basel III introduced output floors to prevent risk weighted assets (RWA) from reaching too low levels.
The new floor would mean that no bank would be allowed to have their RWA below a certain quota of their value.
The European Banking Authority (EBA)’s October 2018 report, Basel III Monitoring Exercise, details a “five year transitional period for the implementation of the output floor, according to which the percentage of the floor, i.e. the percentage of the non‐-modelled RWA, will gradually increase from 50% in 2022 to fully phased‐ in level of 72.5% in 2027.
The impact of the output floor during the first two years of the phase ‐in period is negligible for G‐SIIs, while it is significantly above 1% for Group 2 banks. Table 11 shows that the increase in the output floor percentage has an impact on the output floor during the phase ‐in period.”
More Robust and Resilient Swedish Banking Sector
The successor, Basel IV, presented on 7th December 2017, seeks to restore credibility in the calculations of the RWA. It essentially completes the work that the Basel Committee for Banking Supervision has been undertaking since 2012 to recalibrate the Basel III framework.
Basel IV places stronger emphasis on the standardized models and to reduce the variability of the framework for RWA. The impact of Basel IV reforms is mainly concentrated in credit risk and are primarily driven by the new output floor.
Here are six things the Swedish banking sector needs to know about Basel IV to encourage a more robust and resilient banking sector here in Sweden.
1. There Are Revised Standardized Approaches for Credit Risk (BCBS 347)
The revised standardized approach mortgages risk weights depend on the loan-to-value (LTV) ratio of the mortgage, instead of assigning a flat risk weight to all residential mortgages. Risk weights for banks and companies is determined by external credit ratings.
2. There are new constraints on the use of internal models for credit risk (BCBS 362)
The constraint is made to the estimates of risk parameters used by the banks to calculate the risk-weighted assets using the internal ratingsbased (IRB) approach. The constraint implies e.g. removing the option to use the A-IRB approach for exposures to large corporations and financial institutions. Imposing loss given default, probability of default and exposure at default floors for remaining corporate and retail IRB-approaches.
3. Operational risk gets a standardized measurement approach (BCBS 355)
Eliminating the advanced measurement approach (AMA) for operational risks. Also, fines for bad behavior and cost of computer hacks are now considered in the capital requirement to cover such operational risks.
4. The output floor has been revised (BCBS 306/362)
As mentioned above, the revised output floor will limit the amount of capital benefit a bank can derive from using internal models, relative to using the standardized approaches. The output floor has been set to 72.5% but will be implemented over a five-year period, starting from 50 % on 1st of January 2022. This will help ensure reasonable and orderly transition to the new standards.
5. There’s a new framework for market risk (FRTB) (BCBS 352)
Strengthening capital standards for market risk. The new framework will better be capturing tail and liquidity risks. New boundary between exposures in the trading book and the banking books. This becomes effective by 2022.
6. There are additional requirements for G-SIBs
The leverage ratio framework includes a leverage ratio surcharge for the largest banks, introducing a leverage ratio buffer of 50% of the risk-based capital buffer. E.g. a bank with a 4% risk-based buffer will have a 2% leverage ratio buffer and hence will be expected to maintain a leverage ratio of at least 5%.
The Basel IV Effect
In late 2016, a study disclosed that the four largest Swedish banks might need as much as 65 billion SEK in additional CET1 capital under the new regulatory requirements. This can be compared to the four largest banks’ total profit of 105.7 billion SEK during 2017.
The reason why Swedish banks are more exposed to the new changes compared to others, can be found in their low losses in mortgage portfolios, and to the extent which they have chosen to use the internal models. Since Swedish banks have relatively low loss given default (LGD) estimates, there will be a need for more regulatory capital under the new rule.
What can Swedish banks do?
There are different ways of how to bolster the balance sheets with more equity, hence increasing the regulatory capital:
• Raise new equity
• Reduce lending volumes
• Lower dividend pay-outs
• Increase interest rates on lending and adjust the price of their product offering.
Banks might also consider lifting exposures from the balance sheet. This could be especially interesting for those banks that have a higher proportion of assets covered by the IRB approach.
European banks have historically not used securitization to reduce funding costs or lower capital requirements, the new regulations might change that.
Are the shock absorbers thick enough?
The new Basel framework will increase the thickness of banks’ shock absorbers. It will also facilitate the possibility to compare the risks between banks better, since the output floors will limit impact of differences in the internal models.
But the trillion-kronor question is if the shock absorbers are thick enough when put to real use in an economy where ultra-low interest rates has left the central banks out of ammunition. Only time will tell…
