The oversight body of the Basel Committee, GHOS (Governors and Heads of Supervision), has agreed today after several years of work on key supplements to complete the global standards for banks’ capital adequacy. Finansinspektionen (FI) is a member of the Basel Committee and has participated in this project.
“It is positive for financial stability that there is now international agreement in the Basel Committee. From a Swedish perspective, it is valuable to have global financial markets standards in place,” says FI Director General Erik Thedéen.
“FI would like to offer to the greatest extent possible a high degree of predictability in how capital requirements for Swedish banks could change, even if we need to wait for new EU regulations before we can decide on new requirements. We do not intend to let the capital requirements increase automatically as a result of the new Basel standards. However, FI continues to view large capital buffers in banks as a key component of financial stability, and capital levels of the Swedish banks may need to rise once the agreement is implemented,” says Erik Thedéen.
Background and objective of the Basel agreement
The objective of the new standards is to improve comparability and reduce the risk for unjustified differences in capital requirements between banks and across countries. In addition, a need has been identified to simplify and clarify the regulations.
The new global standards have been updated in several important areas. The standardised approaches for determining banks’ capital requirements for credit risk, operational risk and market risk1 have been revised. The standards specifying how banks can use internal models to calculate their capital requirements have also been revised. New limitations will be implemented regarding both the parameters the banks can use in their internal models and for the types of risks for which the banks are allowed to use internal models. It will no longer be possible to use internal models for operational risks. In terms of credit risks to other financial institutions and large corporates, only the foundation IRB approach will remain, in which the probability of default for the banks’ credit risk exposures is the only parameter that is calculated using internal models.
The new global standards also contain limitations on how low the banks’ total capital requirements may be. This is in part related to the leverage ratio, which in simplified terms can be described as a lowest level of capital corresponding to three per cent of the banks’ assets2. In addition, an output floor for risk-weighted assets will be introduced for banks that apply internal models. According to the floor, the total risk-weighted assets must be at least 72.5 per cent of what they would have been if the bank had calculated them using only the standardised approaches, i.e. without internal models.
The Basel Committee’s new standards will go into effect as of 1 January 2022. The floor for the risk-weighted assets will be phased in from 50 per cent in 2022 up to 72.5 per cent as of 1 January 2027. The new standards also require the banks to publish the development of their risk-weighted assets during the entire phase-in period. The objective of the greater transparency is to make it easier for external assessments of the effect of the floor.
In parallel to the new Basel standards, the capital adequacy regulations in the EU are currently under review3. Among other measures, they introduce a leverage ratio requirement4 and modify how the capital requirements are designed in the EU and how they can be applied by supervisory authorities. The Commission’s proposal is now being negotiated within the EU and may result in a limitation in how national supervisory authorities can use additional requirements under Pillar 2.
From a Swedish perspective, the new Basel standards must first be introduced into EU legislation before they can serve as a basis for new decisions on capital requirements. It is not yet clear when these new revisions can be introduced into the EU and in which manner this will occur. It is therefore important to monitor the combined effect of both the changes in the ongoing EU negotiations and the forthcoming changes from the new Basel standards. FI therefore needs to carefully monitor the effects of the legislation at the EU level when new capital requirements are decided.
Consequences for Swedish banks
The Basel Accord refers primarily to large, internationally active banks, but in practice it also affects smaller banks. Almost all banks will need to apply the new approaches to calculate their capital requirements (new standardised approaches). In general, the approaches have been updated in that they have new definitions and are more detailed than before.
The new standards will primarily impact banks that have received permission to use internal credit risk models (internal ratings-based (IRB) approach) as a basis for their capital requirements. Around ten banks will be affected in Sweden, including the four major banks. The new floor for risk-weighted assets means that the total capital requirement could increase significantly if FI does not simultaneously adjust the parts of the capital requirements that are expressed as a per cent of the risk-weighted assets.
FI will adapt the design and application of the capital requirements for the Swedish banks when the Basel standards become binding EU regulations. FI will not allow the buffer requirements to increase automatically as a result of the Basel floor. The need for capital buffers, however, means that the capital levels in the banks may need to increase once the agreement has been implemented.
FI considers it to be important to keep the buffer function in the banks’ capital. The buffer function is the difference between the amount of capital an individual bank holds and the capital level below which the bank risks becoming subject to intervention from FI or where the bank does not meet its obligations to its financiers. Capital buffers make it possible to better handle situations where the capital level falls as a result of temporary losses. Buffers are important for FI because they enable banks to provide important functions for the economy even when a bank is experiencing temporary problems.
Compared to today, the new Basel floor means that capital requirements for the major Swedish banks will be determined more by standardised approaches. This means that there will be a weaker link between the capital requirement and the risk level in a bank. On the one hand, this limits the risk that the banks’ credit risk models will result in excessively low risk weights, but on the other hand banks may face incentives to take higher risks. One consequence of more standardised rules for capital requirements is therefore the greater importance of supervision and analysis of the banks’ credit risk management.
1 A new Basel standard for capital requirements for market risks was published already in January 2016.
2 Global systemically important banks will also be a required to hold a capital buffer.
4 The leverage ratio requirement in the EU review is based on a previous Basel standard.