North-South divide: Basel makes Nordic and Dutch banks bristle

Lobbyists confident EU policymakers can be persuaded to implement softer credit risk rules

The BIS, home to the Basel Committee on Banking Supervision

Photo: Ulrich Roth

In a report to G20 finance ministers in July 2017, the Basel Committee on Banking Supervision emphasised the importance of global prudential rules that established a level playing field for internationally active banks. The phrase was nowhere to be found in the final Basel III rules announced on December 7.

European banks have certainly not forgotten the commitment, which goes hand-in-hand with the principles of a single internal market in the European Union. Within Europe, Nordic banks bear the brunt.

“On the global level, the impact [of Basel III] in terms of capital increases is zero in aggregate, then in Europe it’s about a 15% increase and on Nordic banks it’s about a 30% increase,” says Jakob Legard, economic executive director at the Danish Banking Association.

Judging by initial reactions from Nordic and Dutch banks, lobbyists will be pushing European policymakers to deliver a level playing field even if Basel failed to do so, amid inevitable warnings about stifling the real economy in specific jurisdictions.

“Policymakers want robust growth in the EU, so we’re optimistic Basel III will end up more risk-sensitive than it is currently when implemented in Europe,” says Otto ter Haar, a Basel expert at the Dutch Banking Association.

Hans Lindberg, the chief executive of the Swedish Bankers’ Association, adds: “It is not reasonable that the Swedish banks, which are already the most capitalised in the world, will suffer more than other banks thanks to the new Basel rules. We assume the implementation in the EU and Sweden takes place in a manner that does not risk disposing of the risk-based capital requirements that are successfully used in Sweden.”

Part of the compromise between governors and heads of supervision (GHOS) was an internal model output floor set at 72.5% of the standard formula for risk-weighted assets, limiting the use of internal models because Basel had found significant unexplained variations in RWAs. The 72.5% figure was agreed after European negotiators had originally argued for a 70% floor or below and their US peers an 80% floor or above.

Comparing the quantitative impact studies (QIS) undertaken by Basel and the European Banking Authority shows capital increases for European banks, which rely heavily on internal models, would be high by global standards. Out of a global capital shortfall of €90.7 billion ($107 billion) for group 1 internationally active banks if the rules were applied today, based on end of 2015 data, more than 40% or €36.7 billion could be attributed to EU banks. This percentage rises to nearly 60% for the core equity Tier 1 capital shortfall in the EU at €16.4 billion, compared with €27.4 billion globally.

We’ll try and get rid of the floor to begin with, because we think we have a good argument as to why

Jakob Legard, Danish Banking Association

Despite the floor being touted as a globally acceptable compromise agreed by European supervisors, Legard says the Danish association’s first lobbying move will be to try to snuff it out.

“We’ll try and get rid of the floor to begin with, because we think we have a good argument as to why. We want to support the work that is already ongoing and we think the leverage ratio already offers an effective backstop and does a lot of the work of the floor,” he says. “If that’s unrealistic, then we’ll put other ideas forward such as changing the risk weights in the standard formula.”

Mortgage mayhem

The pain of increasing capital requirements is especially acute for Northern European banks’ mortgage and corporate loan portfolios. Mortgages in the Nordic and Benelux regions performed well during the 2008 financial crisis, and these portfolios produce RWA outputs using an internal model often below 10%, with some as low as 3–4%.

Under the Basel update, risk sensitivity has been partially improved by replacing a 35% standardised risk weight for residential mortgages with a weight that ranges from 20% to 70% depending on loan-to-value (LTV) ratios (see table A). But higher LTV ratios in the Nordic and Dutch mortgage market compound the output floor’s effect, further increasing capital requirements. 

 

 

Ter Haar of the Dutch Banking Association says he thinks the output floor is too central to the Basel compromise to be amended in the EU, but is pushing for more risk granularity in the standard formula. The Basel Committee has already attempted to factor in borrowers’ ability to make monthly payments on mortgages by applying a “debt service coverage ratio”, but this was rejected on the basis it would be difficult to establish levels that worked in each jurisdiction. Now lobbyists say this debt service ratio could be applied in the European context.

“I would dare to suggest that an 80% LTV ratio mortgage in the Netherlands is often less risky than an 80% LTV mortgage in, for example, Brazil. Internal models took into account legal differences, housing shortages, political stability – yet the standardised approach doesn’t take any of these factors into account. In my view, it should be up to each national authority to optimise the link between risk and risk weight in its jurisdictions. There seems to be no ‘one size fits all approach’ that can do the trick for residential mortgages. If so, don’t go for a one size fits all approach,” says ter Haar.

When someone stops paying their mortgage in the Nordics, the house is reclaimed and sold off in the market within a matter of months. You can’t do this in the same way in Southern Europe and therefore the rules need to take this into account

Julie Galbo, Nordea

Julie Galbo, chief risk officer at Nordea, says one of the reasons banks’ loss history of mortgages in Scandinavia has been so low compared with elsewhere in Europe is thanks to the insolvency regime that operates in most Nordic countries. Non-performing loans, including mortgages, in Italy and elsewhere in southern Europe are a well-known weakness in the European banking system, partly because of the difficulties of enforcing on mortgage collateral. In the Nordic and Benelux regions, the insolvency process is more straightforward, and this also discourages borrowers from defaulting in the first place.

“I think what is incredibly important when you move into the European implementation is to recognise the insolvency regimes in Europe. When someone stops paying their mortgage in the Nordics, the house is reclaimed and sold off in the market within a matter of months. You can’t do this in the same way in Southern Europe and therefore the rules need to take this into account,” says Galbo.

Corporate inequality

Another area of concern is the difference between charges for corporate lending by EU banks compared with their US peers. As previously feared, the standardised approach to credit risk punishes European banks’ lending to corporates without an external rating, although the impact has been somewhat eased in the final package.

In the updated rules, exposure to unrated corporates with sales of less than €50 million per year attract a risk weight of 85%, or down to 75% after meeting certain conditions, rather than the 100% weight previously planned. Conditions required to reach the 75% risk weight include an absolute ceiling on the maximum aggregated exposure to one counterparty of €1 million.

By contrast, US banks, which are not allowed to use external ratings, can apply a 65% risk weight to a corporate if they can show it is equivalent to investment grade. The difference between the jurisdictions will then affect internal model banks via the standardised output floor.

The fact that the US can use the investment grade classification and Europe cannot due to its market structure, creates an unlevel playing field

Otto ter Haar, Dutch Banking Association

“The Basel update makes this a bit more granular. The smallest companies that fall into the retail category get a 75% risk weight, the medium ones could benefit from 85%, but for the larger companies without an external rating this will still shoot to 100%. The Netherlands has many companies without an external rating, so there will still be missed opportunities to finance the real economy,” says ter Haar at the Dutch Banking Association.

“The fact that the US can use the investment grade classification and Europe cannot due to its market structure, because very few companies have their debt listed on an exchange, creates an unlevel playing field: externally unrated investment grade companies get a 65% risk weight in the US and a 100% risk weight in the EU,” he adds.

Lobbyists say the argument that the US has more risk granularity than Europe should have a powerful effect on EU policymakers as they consider the impact of the rules.

Overstated?

Although all the Nordic banking associations are preparing to push hard for a softer implementation of the Basel rules in the EU, there are differences between countries in the region that mean Basel III will increase capital requirements to a varying degree in each jurisdiction. As such, some think certain lobbyists’ claims are overstated.

The Swedish regulator Finansinspektionen has raised the average risk weight floor for housing loans using a Pillar 2 supervisory add-on capital requirement, initially to 15%, and then to 25% in 2016. In Norway, meanwhile, regulators increased the minimum value of the loss given default parameter (LGD floor) used in the calculation of risk weights from 10% to 20%. As such, while Basel may increase Pillar 1 requirements, the aggregate capital impact is reduced by input and output floors already enforced in these countries.

“Our view is that Swedish banks are going to be fine, in terms of the output floor. There’s likely to be an element of recycling, by removing that Pillar 2 risk weight requirement, because we’ve seen a corresponding increase in Pillar 1,” says Monsur Hussain, senior director in the financial institutions group at Fitch Ratings.

“Where we do see the risk of RWA inflation is at the Danish banks, because they don’t have the same domestic Pillar 2 adjustments. It’s a similar story in the Netherlands, and perhaps even more so [there], because they typically have low risk weight densities combined with high LTVs mainly due to past tax incentives to maximise mortgage debt.”

Furthermore, Hussain cautions against reading too much into the Basel impact analysis, because the data used for the impact assessments by Basel is from 2015 and focuses mainly on the impact of credit and operational risks. What is made less clear by this is the impact of market risk rules, he says, under the Fundamental Review of the Trading Book, which has yet to be finalised. The impact of new rules on securitisation and credit valuation adjustments was also excluded.

“The QIS does exclude quite a few things – it excludes the new CVA and securitisation frameworks and doesn’t reflect FRTB, so really it’s only focused on core credit, op risk changes and the impact of the floor. So it’s not surprising the bulk of the capital increase for group 1 banks is down to European players,” he says.

Some very sensible adjustments have been made, which indicates regulators have listened

Julie Galbo, Nordea

A report published by the Austrian Central Bank on December 13 offers colour on the risk weight variability of European jurisdictions between 2013 and 2016 and suggests regulators should attempt greater harmonisation across the EU.

“The effects are large in Denmark, Sweden and Italy, with low RW due to the HQ of the bank being in these countries, whereas the opposite is true for Ireland, the UK and Portugal,” the paper states, suggesting Danish and Swedish risk weights are relatively low compared with the European average and that the final Basel III implementation could bring them into line.

This would be in the spirit of comments made by Basel chairman Stefan Ingves at the Basel III press conference on December 7, who said the new rules are designed “to catch the outliers.” However, as banks have pointed out, focusing the capital impact on outliers is scant consolation if one of those outliers is a key provider of liquidity and finance in a specific market.

Nonetheless, there were some clear wins for European banks when the final compromise was thrashed out at Basel. Galbo at Nordea says the package was “better than expected”. This was reflected in banks’ share prices immediately after the December 7 agreement, with Nordea’s stock trading around 3–4% higher, along with other large banks including Deutsche Bank, which rose 3%, and BNP Paribas by more than 4%. 

“Some very sensible adjustments have been made, which indicates regulators have listened,” Galbo says. “The standard approach seems to have been made less punitive; we’ve been allowed to rely on probability of default models for large corporates and financial institutions, and if you look at the way central bank reserves are treated, they are no longer penalised under the leverage ratio which is good for monetary policy transmission.”

All in the implementation

The accuracy of Nordic and wider European banking lobbyists’ claims will not become entirely clear until further impact assessments are undertaken, as promised by the European Commission in a press release that welcomed the Basel deal. Nevertheless, key European policymakers have already shown deep scepticism towards globally agreed Basel rules. In November, German MEP Markus Ferber said Basel was heading for a “rotten compromise”. He now says the final text confirms his fears.

“The final Basel compromise was pretty much in line with what has been publicly discussed over the past months and therefore in line with expectations. Hence, my mind about the compromise has not changed,” he tells Risk.net.

“On the issue of the floor, we have moved far too far towards the US position, which will only harm large European banks. When it comes to implementing the Basel package, the first criterion for me would be if other jurisdictions actually do fully implement the package, too. The second point would be that we have to make sure to apply a certain degree of proportionality to the package to make it a decent fit to the EU banking system and especially to the many smaller banks in the EU.”

Basel has already opened the door to national discretion, to a limited extent, when it comes to implementing the output floor. As expected, the floor will be phased in over five years from 50% in 2022 to the full 72.5% in 2027. But it will also be at the national discretion of supervisors to cap the annual increase in a bank’s total RWAs at 25% during that phase-in period.

Many want EU policymakers to go further. They are hoping the long period of time needed for impact assessments, debate and implementation will play to their advantage. The two approaches that seem to be finding most favour among lobbyists are to persuade regulators to allow certain portfolios (rather than the whole balance sheet) an exemption from the output floor, or to make standardised risk weights sensitive to a greater number of factors.

I think issues like non-performing loans can be dealt with over the next 10 years in a very pragmatic way

Julie Galbo, Nordea

Galbo at Nordea says she is confident the European implementation of Basel III will be sympathetic to Nordic banks’ concerns about the impact of the output floor on mortgages and corporate lending and will not want to penalise banks that manage their risks effectively and finance the real economy.

“I think two things are in the minds of European policymakers. [The] first is to create a level playing field in the EU, including the Nordic region, and [the] second is ensuring the measures in place are risk sensitive. The more risk sensitive they are, the more you drive the right incentives for credit institutions,” she says.

“I think issues like non-performing loans can be dealt with over the next 10 years in a very pragmatic way and that should hopefully allow European policymakers to implement the rules in a way that is more risk sensitive than the Basel rules as they stand.”

One European official, who spoke on condition of anonymity, says it is unlikely any banks will be given an exemption from an internal model output floor, because it is the very largest banks that use internal models. He also says that if greater national discretion were offered it would be likely that capital requirements could be increased in certain circumstances, but not decreased. He adds, however, that it is always “a balancing act” between remaining consistent with globally agreed rules and measuring the impact on the European economy.