Enria: no reason for EU to deviate from Basel output floor

ECB supervision chief urges lawmakers to implement contentious Basel III model constraints

Andrea Enria - 2019 - ECB.jpg
Andrea Enria: “The bulk of the proposals… are perfectly aligned with the analysis done by the EBA”

The European Central Bank’s chair of its single supervisory mechanism, Andrea Enria, has told European legislators there is no reason for the European Union to deviate from controversial rules set by international standard-setters.

“The bulk of the proposals, which are on the table of international standards, are perfectly aligned with the analysis done by the EBA [European Banking Authority] and the findings of our own analysis of internal models,” said Enria, speaking at a hearing of the European Parliament in Brussels on September 4. “So they are definitely a repair process, which is necessary and important. I don’t see any reason for deviation.”

In December 2017, the Basel Committee on Banking Supervision agreed the last part of reforms to the post-crisis capital requirements framework, known as Basel III. Within those proposals was a floor that would prevent the capital requirements calculated using banks’ own internal models from falling below 72.5% of the regulator-set standardised approaches. This change will potentially curb the capital incentives to use internal models.

European politicians, banks and industry bodies have long been critical of the output floor, which is expected to have a more marked impact on European banks than on their US peers.

One member of the European Parliament described the 72.5% Basel floor as a “rotten compromise” shortly before the final Basel III package was agreed.

Nordic and Dutch banks have also been extremely critical of the floor, because a standardised formula for credit risk will result in a significant increase in risk-weighted assets (RWAs), especially on their mortgage books.

I think it has been calibrated in a reasonable way and I don’t think it will be excessively burdensome for banks
Andrea Enria, European Central Bank

Since the December 2017 Basel standards were published, European banks have been hoping they could lobby local lawmakers to dilute the rules when they are implemented in the EU. But Enria stressed the output floor should be implemented with no deviation from Basel III, even though it may potentially penalise low-risk business.

“Although there are some issues [with the output floor], I think we should be loyal to our negotiations,” said Enria. “I think it has been calibrated in a reasonable way and I don’t think it will be excessively burdensome for banks.”

Enria pointed to recent research published by his former employer, the EBA, on August 2, which found only large banks would see their capital requirements increased significantly by the output floor (see table A).

In a document providing advice to the European Commission on the implementation of the output floor, the EBA found Basel III would cause a shortfall of €135 billion in total capital, based on the full implementation of the package, which will only happen in 2027. Of this shortfall, the output floor alone contributed €56.7 billion. Large institutions – including global systemically important banks – saw an overall increase of 25% in their minimum capital requirements, whereas medium-sized and smaller banks face far lower increases.

Reasons to push ahead

Enria said the large banks facing the biggest shortfalls have generally been asked to adjust their internal models already, meaning the actual capital shortfall is likely to be significantly smaller than forecast.

The ECB launched its targeted review of internal models (Trim) used by eurozone banks in 2016, to assess whether the models are fit for purpose and align with applicable regulations. Trim has already led to hefty increases in capital requirements for some of Europe’s lenders. Spanish lender BBVA had to increase RWAs by €7.3 billion as a result of Trim, while Dutch bank ABN AMRO disclosed a €1.3 billion rise in RWAs for the same reason.

Enria also pointed out to MEPs that part of the reason why Europe faces a disproportionate increase in capital requirements from the output floor when compared with other jurisdictions, particularly the US, is because the EU was “more lenient” in implementing the floor included in the Basel II Accords agreed in 2006.

The Basel II capital floor was supposed to prevent capital requirements from falling below 80% of the total capital that banks would have had to hold under Basel I. The EU’s banking law, the Capital Requirements Regulation, which entered into force in 2014, included the floor but allowed national authorities to waive the requirement if an institution met all the criteria for internal model approval held within the CRR. And, under Article 500 of the CRR, the Basel II floor expired altogether in the EU in December 2017. 

By contrast, the use of internal models by US banks has been constrained by a local rule known as the Collins floor. This was created by the Collins Amendment to the 2010 Dodd-Frank Act, and it stops overall RWAs calculated by internal models from falling below 100% of the standardised outputs, but excludes operational risk and credit valuation adjustments from the calculation. Depending on the size of operational RWAs, research by Risk.net found the Basel floor might still be a tougher framework than Collins for some banks.

Enria also said the output floor would have the advantage of providing a more level playing field between banks using internal models and those relying on standardised approaches.

Models face the chop

Europe’s banks are already eyeing up the potential implications of the output floor and the models that will possibly cease to have value once their capital benefits are curtailed.

One source at a bank says the output floor is now weighing particularly heavy on their bank’s decisions to invest in internal models needed for Basel’s revamp of market risk capital requirements, known as the Fundamental Review of the Trading Book.

Many European banks concentrate their balance sheet on lending, so much of their investment is in credit risk models. This does not leave much room for them to develop their own models for other parts of their business, such as market risk. In addition, since credit RWAs account for a large portion of total bank balance sheets, internal model outputs for credit exposures that are significantly below the standardised approach will soak up most of the 72.5% floor for the bank as a whole.

Moreover, changes finalised by the Basel Committee in January this year lowered the punitive risk-weight used in the FRTB standardised approach, consequently narrowing the capital difference between the standardised and internal model outputs. This further dilutes the incentive to invest in internal models, although it may also make the output floor less of a binding constraint for market risk.

“There used to be a capital incentive to invest in internal models for the FRTB, but now and in the future there will not be a capital incentive because of the small difference between internal models and the standardised approach,” says an FRTB specialist at a European bank. “Once you have built the internal model for credit risk, there is not much room left [under the output floor] for the other internal models. It is not very clear what you will get as capital relief if you invest in internal models now.”

Finalising the Basel III reforms, however, will at least give European banks certainty about the amount of capital they will have to maintain. Equity analysts say the constantly evolving post-crisis regulation makes it hard for them to forecast banks’ earnings, as well as complicating banks’ own capital management processes.

“It is essential to complete the last chapter of the post-crisis reform agenda, and to give banks and markets certainty that the regulatory requirements have achieved a stable configuration,” Enria told MEPs. “This is something the industry asks a lot – to have a stabilisation of the capital requirements. I think it is a reasonable objective and we need to finalise this package first.”

The European Commission is due to adopt draft proposals to implement Basel III by June 2020.

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