Running to 1,000 pages in length, implementing the Basel Committee on Banking Supervision’s latest, and probably final, proposals must be one of the most daunting regulatory efforts ever to hit the financial system.
‘The more you start looking into it, the more layers of the onion there are’
According to Deloitte, the EU’s ‘Banking Package’, which will implement the Basel reforms, is the most important piece of bank prudential legislation proposed in the EU in the last decade. It includes revisions to the Capital Requirements Directive and Regulation (known as CRD6/CRR3) that implement the finalised Basel 3 reforms in the EU, reforms that are known in the UK as Basel 3.1.
‘The more you start looking into it, the more layers of the onion there are,’ says Rod Hardcastle, a director and regulatory specialist at Deloitte.
Knock-on effect
However, the big question for CFOs, from large multinationals to SMEs, is whether Basel will have a knock-on effect for them as customers and borrowers. In short, could the Basel regulations increase the cost of credit? This is worth dealing with up front.
‘As a general principle,’ says Nala Worsfold, a regulation expert with UK Finance, an industry body for banking, ‘Basel 3.1 is expected to increase capital requirements across all banks. This is likely to impact their cost of capital, which may have implications for customers.’
Although the final versions for implementation have yet to be agreed, close observers believe that will come early next year, in order to hit Basel’s own implementation deadline of 1 January 2025. And it’s almost impossible to say how individual banks will react, even more so when it comes to specific asset classes and business lines, especially as the reforms will be implemented (and therefore interpreted) at a national regulatory, or supervisory, level.
EU Basel negotiations continue
The European Parliament and the Council of the European Union are nearing the finishing line in finalising the EU’s flagship Banking Package that implements the revised Basel 3 framework. In early March 2023, both institutions began trilogue negotiations to produce a final version of the law.
In a briefing, Deloitte said it expects these negotiations to run until the second half of 2023. Provided that the final package is adopted by the end of 2023, banks will have roughly one year to implement the new rules ahead of an expected 1 January 2025 implementation deadline.
The positions of the Council and the Parliament both largely maintain the European Commission’s original ‘EU specific adjustments’ approach of including several long transitional periods and other Basel framework deviations that cumulatively will have a substantial mitigating effect on the package’s overall capital impact.
There are, nevertheless, many important differences between the two positions that will have to be addressed in the upcoming negotiations. According to Deloitte, the application of the Basel Standardised Output Floor (OF) remains a key open issue. The treatment of specialised lending, exemptions to the large exposure regime, and the prudential treatment of exposures to crypto assets, will also receive attention.
Get up to speed
But as banks plan their capital needs two to three years out, CFOs might take a similar view.
‘Talk to your bank, talk to your relationship manager,’ says Hardcastle. ‘Ask them where they are on their implementation journey. What are they thinking, what are they seeing, what are they hearing in the market?
‘Make sure your bank knows you are thinking about this, you know what’s going on and that you want to be kept informed, because the best thing you can do in these situations is make sure you are getting the best information you can as early and as quickly as possible.’
‘For those that have permission to use models to calculate their regulatory capital, the capital can go up quite substantially’
The final reforms were signed off by the Basel Committee in 2017 as a landmark piece of regulation building on the Basel 3 rules introduced in 2010 two years after the global financial crisis.
National competent authorities (NCAs) are responsible for implementing the principles set out by the committee. The core tool used by Basel to protect the financial system is to ensure banks hold enough capital in reserve. In the UK, the Prudential Regulation Authority (PRA) notes in CP16, a key consultation paper: ‘As demonstrated in the global financial crisis, if a lack of confidence in risk weighted capital ratios increased in a downturn and put in doubt the adequacy of capital levels in firms, it could have implications for the resilience of the financial system as a whole.’
Risk weight calculations
The original Basel regulations set out ways for banks to calculate the risk weighting of assets, the core task for working out capital reserves. But regulators noticed ‘variability’ in the way risk weights were calculated, raising concerns of consistency and comparability.
It’s this problem that the final Basel reforms set about trying to resolve. It does this through trying to bring closer together two permitted calculation methods: the ‘model’ approach used by large institutions that are allowed to use their own internal methods for calculation, and the ‘standardised’ approach used by smaller banks.
The model approach will be hit by the introduction of the so-called ‘output floor’, effectively a limit on how much those models can reduce the amount of capital banks have to hold. But, in any case, the standardised approach, with a few caveats, will now be the main method.
That means large banks are most likely to feel the effects, even though the Basel Committee has talked much about the changes being neutral.
‘We say this is bound to be a costly move. And we don’t think any serious evidence has been provided of there being countervailing benefits’
‘In the main,’ says Hardcastle, ‘capital requirements are going to go up, particularly for the larger, more complex banks. And for those that have permission to use models to calculate their regulatory capital, the capital can go up quite substantially.’
And there is also potential trouble brewing for SME finance chiefs. As part of its consultation, the PRA proposes doing away with what’s known as the SME Supporting Factor (SSF). This measure, introduced in 2014, effectively discounts the risk weighting of loans to SMEs, making them more attractive for banks.
Increased loan rates
Removing it means lending to small and medium-sized companies instantly means holding more capital in reserve, potentially pushing up loan rates.
There is another complicating factor too. Many SME loans are backed by property as collateral. But Oxera, a consultancy commissioned by the UK’s Federation of Small businesses, says the PRA calculations would mean a higher risk weighting for SME loans that are secured rather than unsecured.
In all, Oxera estimates Basel 3.1 could reduce lending to SMEs by £44bn in the UK, driven by what it believes will be an average 32% increase in risk weighting for their loans.
Peter Andrews, a senior adviser at Oxera, says: ‘We say this is bound to be a costly move. And we don’t think any serious evidence has been provided of there being countervailing benefits, at least equal to those costs.’
This comes at a time when there are signals that the SME Supporting Factor will remain in place in the EU. This could potentially give European banks a competitive advantage over those in the UK. However, Hardcastle believes the ‘operational challenges’ involved make European banks pitching for UK SME custom unlikely.
There is another source of optimism. Capital reserves are not the only factor in how banks determine their rates. Economic conditions, industry developments and relationships all have a role to play. Banks, says Worsfold, tend to look at things ‘more realistically’ than simply hiking rates when capital requirements rise.
