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Critics say proposed minimum capital requirements will disadvantage EU banks and hamper eurozone’s recovery from Covid-19.

As part of the Basel III banking reforms, the European Commission (EC) is set to propose new capital requirements for EU banks in September, with the contentious issue of the output floor facing a pushback from a number of countries, including France and Germany.

The proposed rules will introduce new minimum capital requirements — the so-called output floor — which would make it difficult for banks to rely on internal models to calculate the size of their capital base and force them to follow more standardised processes to estimate risk.

“Efforts are under way to influence the commission in terms of proposals to come up with something which is workable,” says Giles Edwards, senior director, financial services ratings at S&P Global. “French and German banks have very efficient internal models that produce low risk weights, so they stand to be among the most impacted [by the new rules].”

In the aftermath of the global financial crisis in 2007-09, the Basel Committee on Banking Supervision concluded that a key shortcoming of the pre-crisis bank capital framework was excessive variability in banks’ risk-weighted assets (RWAs) because capital requirements for similar assets differed so markedly between various institutions.

There’s no reason to have the output floor from an economic perspective

Sigurd Næss-Schmidt, Copenhagen Economics

The finalised Basel III framework seeks to resolve this issue through the implementation of a standardised output floor — narrowing the gap in RWA outcomes between the standardised approach and internally modelled approaches.

Once the framework is fully phased in by 2028, risk weighting of an asset should be no less than 72.5% of regulators’ estimates generated through equivalent standardised models.

“The Basel Committee’s recommendations want to create a floor [across the banking sector] to prevent the amount of capital from falling too low,” says Conor MacManus, director, financial services risk and regulation at PwC. “But this has proved very controversial.”

Sigurd Næss-Schmidt, a partner at consultancy Copenhagen Economics, says: “Such a [standardised] system will inevitably have different impacts on different countries,” adding that unlike banks in the US, many European banks rely on internal models to calculate the risk of mortgage assets and the necessary capital requirements.

“European banks have a lot of mortgages on their balance sheets, unlike in the US,” Mr MacManus says. “The overall capital impact of the final set of reforms will be much more significant for European banks compared to US banks [which finance a lot of business through securities].”

Capital shortfalls

The European Banking Authority estimates that the output floor will lead to an 9% increase in minimum required capital for leading European banks, which would equate to a Tier 1 capital shortfall of about €30bn, according to Deloitte.

The final Basel III package will leave the EU banking sector needing to raise an extra €170bn-€230bn of capital, according to a report published this month by Copenhagen Economics and commissioned by the European Banking Federation.

“There’s no reason to have the output floor from an economic perspective,” says Mr Næss-Schmidt. Various studies show that when banks hold reserve capital of 15% or more, then the benefits of holding that increased capital are “close to zero”, he says.

Some analysts expect a compromise to be reached around the application of the output floor, perhaps allowing banks’ internal models greater leeway in the final analysis to moderate the overall increase in EU banks’ capital requirements.

“My guess is that there will be a hint of pragmatism around the output floor,” says an analyst at a leading consultancy, who asked to remain anonymous.

Opponents of a blanket interpretation of the Basel III framework argue that a significant increase in capital requirements could impair the flow of credit into the real economy, hampering the euro area’s recovery from Covid-19.

“Europe needs its banks to lend,” says Mr Edwards. “The general feeling from the regulators is that there is enough capital in the system as a whole; it’s more a case of rejigging it. Yet the completion of Basel III may require more capital in the system, so it’s just a case of finding where the common ground is.

“Hopefully, the commission will have read the tea leaves fairly well in terms of where the red lines lie, and therefore what it comes out with in September will be fairly close to what will ultimately be decided. [In the end] it will probably be to the satisfaction of almost nobody, but ultimately something everyone can live with,” he adds.

Once the EC has published the proposals, they have to ratified by the European parliament, with implementation expected between 2023 and 2028. “It’s been such a difficult negotiation that the deadline is now looking very ambitious,” Mr MacManus says, adding that further delays are looking probable.

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