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Basel IV is coming: What you need to know

Basel IV is coming: What you need to know

Basel IV will be a game changer not only for banks but also for corporates when it comes to access to financing. The regulation, a finalisation of Basel III that takes effect from 2023, will overhaul global bank capital requirements, changing the corporate lending landscape particularly in Europe and the Nordics.

Nordea On Your Mind is the flagship publication of Nordea Investment Banking’s Thematics team, which produces research for large corporate and institutional clients. The research does not contain investment advice and typically covers topics of a strategic and long-term nature, which can affect corporate financial performance.

Top decision makers at Nordea’s large clients across the Nordic region receive Nordea On Your Mind around eight times per year. The publication’s themes vary widely, and many are selected from suggestions by clients. Examples of covered topics include artificial intelligence, wage inflation, M&A, e-commerce, income inequality, ESG, cybersecurity and corporate leverage.

In a recent episode of the Nordea On Your Mind podcast, Johan Trocmé, Viktor Sonebäck and Kajsa Andersson from Nordea Thematics walked through the what, why and how of Basel IV, and what corporates should do to prepare for the changes to come.

Why do banks need to be regulated?

“Banks are mission critical for the functioning of the economy and modern society,” says Andersson. They provide the resources for people to be able to purchase homes and other big-ticket items as well as funding for companies to be able to expand their businesses and grow. What’s more, they are a vital part of the payments system and crucial for GDP.

Regulation is needed to ensure banks have enough capital in place to absorb potential losses in times of financial distress, she adds.

Regulation is needed to ensure banks have enough capital in place to absorb potential losses in times of financial distress.

Kajsa Andersson

How are banks regulated?

Banks are regulated at the national and regional levels, and since 1973, bank regulations have been coordinated globally by the Basel Committee for the Bank of International Settlements (BIS). The BIS is jointly owned by 63 central banks from countries that account for 95% of global GDP.

The first Basel framework was introduced in 1988, followed by Basel II in 2004, which expanded the standardised rules, including making it possible for banks to use their own internal risk models to calculate their capital requirements.

In response to the global financial crisis in 2009, the Committee introduced Basel III, which added several reforms to mitigate risk in the global banking system:

  • Capital ratio
    Basel III increased banks’ capital ratio by 2.5% compared to Basel II. That is the ratio of a bank’s capital to its risk-weighted assets. Risk-weighted assets refer to a bank’s assets, including its interest-bearing loans to customers, adjusted for certain risks, such as the probability of a default by the borrower and the loss that would result. The higher the risk in lending, the higher the bank’s risk-weighted assets, and the more equity capital reserves a bank needs to hold. The minimum reserve capital a bank needs under the Basel framework is 10.5% of its risk-weighted assets plus the countercyclical capital buffer and leverage ratio requirement described below.
  • Countercyclical capital buffer
    Basel III also added a countercyclical capital buffer, which is built up in good times and released when systemic risks materialise. This buffer varies by country and can be anywhere between 0 and 2.5%, depending on what the national regulator has decided.
  • Leverage ratio requirement
    In addition, Basel III added a leverage ratio requirement as a backstop to the risk-based capital measures. This requires banks’ Tier 1 equity capital to be at least 3% of the bank’s total exposure, referring to its equity, debt plus off-balance sheet liabilities such as derivatives exposures. The leverage ratio applies in addition to the minimum capital percentage a bank needs to comply with at all times.

The minimum reserve capital a bank needs under the Basel framework is 10.5% of its risk-weighted assets plus the countercyclical capital buffer and leverage ratio requirement.

What’s new in Basel IV?

In 2017, the Basel Committee agreed on changes to the global capital requirements as part of finalising Basel III. The changes are so comprehensive that they are increasingly seen as an entirely new framework, commonly referred to as “Basel IV,” set to take effect from 2023.

An analysis by the Basel Committee highlighted a worrying degree of variability in banks’ calculation of their risk-weighted assets. The latest reforms aim to restore credibility in those calculations by constraining banks’ use of internal risk models.

Advanced internal risk models give banks the most freedom to estimate their credit risk, often yielding a much lower risk than the regulator’s standard model. Under Basel IV, banks can no longer use these typically more sophisticated and complicated internal risk models for large corporates with a turnover of at least 500 million EUR.

In addition, Basel IV introduces a so-called output floor, which prevents a bank’s own internal measurement of its risk exposure from yielding less than 72.5% of the standardized approach.

“At a maximum, you can reduce your risk-weighted assets by 27.5%,” explains Sonebäck. “So this is a major change that affects how much benefit you can get from these internal models. It will affect banks that are using internal models the most.”

The new reforms also modify the leverage ratio, changing the definition of a bank’s total exposure. In addition, they make changes to the credit valuation adjustment (CVA) and operational risk frameworks.

How will Basel IV affect banks?

The purpose of Basel IV is to level the playing field and harmonize how banks calculate risks, not to increase the level of capital in banks on a global level, explains Sonebäck. However, the reforms will likely have a disparate impact in different regions, due to regional differences in banks’ use of internal models for calculating risk.

Globally, the impact on banks’ required capital will be limited, he says. The impact will be larger in Europe and the Nordics, where banks tend to be heavier users of internal risk models. The European banking system, for example, will need an estimated 19% of additional Tier 1 capital in their capital buffer, while Swedish banks will need an additional 28%. That compares to an estimated 2% additional Tier 1 capital for US banks.

For the European banking system, that means having to find an additional 52 billion EUR of capital, based on current lending volumes.

How will Basel IV affect banks’ lending to corporates?

The return on capital in the banking sector has dropped by around one-third since the global financial crisis of 2008-2009. The big question is whether banks will take the latest hit from the increased cost of capital related to Basel IV or pass that along to customers, according to Trocmé.

He points to a study by Copenhagen Economics, which estimates that the expected borrowing costs for corporates in the EU will increase by around 25 basis points on the back of the additional capital needs of Basel IV. In Sweden, the increase in corporate borrowing costs is likely to be twice as high, at over 50 basis points, according to the study.

Large corporates, with revenues over 500 million EUR, that don’t have a credit rating and rely on bank loans for funding today are likely to be hardest hit.

What can corporates do to prepare?

Trocmé encourages companies in this category to review all of the potential funding options available to them, including potential new funding sources, so they are not caught off guard when the changes arrive.

Companies will need to have “maximum flexibility to be able to choose between different funding options to find what suits them best,” he says.

Having a credit rating is likely to become more important, he adds, given that unrated large corporates will be grouped at a higher risk level regardless of their actual credit risk history.

Large corporates, with revenues over 500 million EUR, that don’t have a credit rating and rely on bank loans for funding today are likely to be hardest hit.

A Basel glossary:

  • Basel Committee on Banking Supervision: An international committee formed in 1974 to develop global standards for banking regulation. Its 45 members represent central banks and bank supervisors from 28 jurisdictions.
  • Basel I: A set of international banking regulations adopted by the Basel Committee in 1988, requiring banks to hold capital of at least 8% of their risk-weighted assets. Basel I and the subsequent II, III and “IV” comprise the Basel Accords.
  • Basel II: The second set of global banking regulations adopted by the Basel Committee in 2004. They expanded the rules for minimum capital requirements under Basel I, allowing banks to use their own internal models to assess credit risk when determining capital requirements. Basel II also established a framework for regulatory review and disclosure requirements.
  • Basel III: The third instalment of global banking regulations, adopted by the Basel Committee in 2009 in response to the global financial crisis. The reforms increased banks’ capital ratio to 2.5% and introduced a countercyclical capital buffer, leverage ratio and liquidity requirements.
  • Basel IV: Changes to the global capital requirements the Basel Committee agreed to in 2017 as part of the finalisation of Basel III, set to take effect from 2023. They prevent banks from using internal risk models to assess the credit risk of large corporates with a turnover of at least 500 million EUR. They also constrain banks’ use of internal models via an output floor and modify the leverage ratio, credit valuation adjustment (CVA) and operational risk frameworks. The reforms aim to harmonise how banks calculate credit risk when determining their capital requirements.
  • Capital requirement: The amount of capital a bank has to hold, as required by regulators. The Basel Accords are the main set of international rules governing banks’ capital requirements, which are designed to shore up banks’ resiliency so they can absorb losses in times of financial distress.
  • Capital ratio: A bank’s available capital expressed as a percentage of its risk-weighted assets. That minimum ratio is 10.5% under the Basel framework.
  • Countercyclical capital buffer: A capital buffer introduced under the Basel III reforms, designed to be built up in times of economic expansion and released during recessions. The buffer varies by country and is set by the national regulator anywhere between 0 and 2.5%.
  • Leverage ratio: A requirement added under Basel III as a backstop to the risk-based capital measures. It requires a bank’s Tier 1 capital to be at least 3% of its total exposure, which includes its equity, debt, derivative exposure and off-balance sheet liabilities.
  • Risk-weighted assets: Risk-weighted assets are used to determine the minimum amount of capital banks must hold under the Basel Accords. Risk-weighted assets refer to a bank’s assets, including its interest-bearing loans to customers, adjusted for certain risks, such as a the probability of a default by the borrower and the loss that would result. Under Basel III, a bank’s capital ratio must be at least 10.5%, referring to the ratio of the bank’s capital to its risk-weighted assets.

Podcast: Basel IV – A game changer for bank lending to corporates

Did you think you would find drama in a podcast on bank regulations? Think again. Johan Trocmé, Viktor Sonebäck and Kajsa Andersson from Nordea Thematics talk about what Basel IV is, why the Basel Committee for Banking Supervision is involved in regulations to begin with, and what they are hoping to achieve with this finalisation of Basel III. Most importantly, they explore what this will mean for corporate borrowers, based on findings in their recent NOYM report.

Johan Trocmé and Viktor Sonebäck

If you are a corporate client and want to access the full Nordea On Your Mind report, please contact Viktor Sonebäck.

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