How the EU could implement the Basel III Output Floor

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At a glance

• The Basel III Output Floor (OF), when implemented in the EU through the Capital Requirements Regulation (CRR3), will require risk weighted assets (RWAs) calculated using the internal model approach to be no less than 72.5% of the RWAs required under the standardised approach.
• There is a policy debate now in the EU over whether this should be applied to all levels of a banking group, as is the custom with EU bank capital regulations, or at the highest level of consolidation only, in line with the design of the BCBS rules. 
• If the OF is applied at the consolidated level only, the overall effect of the OF could be reduced, as the “capacity” created by standardised portfolios in one subsidiary could be used to offset OF constraints in another.

In the wake of the Great Financial Crisis, the BCBS determined that one key shortcoming of the pre-crisis bank capital framework was excessive variability in banks’ RWAs, with capital requirements for similar assets differing between institutions. This diminished the credibility of the capital framework, and consequently undermined the usefulness of banks’ reported capital ratios as a measure of their solvency.

The finalised Basel III framework seeks to resolve this issue through the implementation of a Standardised OF. The OF will narrow the gap in RWA outcomes between the standardised approach and internally modelled approaches, which typically generate a lower overall RWA number. Once the framework is fully phased-in by 2028, RWAs calculated using modelled approaches will have to amount to at least 72.5% of RWAs under equivalent standardised approaches.

For banks using internal ratings-based (IRB) models, this will have a significant effect on their minimum required capital (MRC). The EBA estimates that the OF will account for an 8.6% aggregate increase in MRC for European banks, which would equate to a CET1 shortfall of around EUR 30bn[1]. Much of this impact will be felt by large banks, which are expected to face a 9% increase in MRC. Also considering that the parallel Basel III revisions to the Standardised and IRB Approaches to Credit Risk, due to be implemented simultaneously, will change the interaction between Standardised and IRB RWAs for many banks, this challenge will likely be compounded by changing the basis on which the OF is calculated.  Given the potentially increased difficulty of raising capital in the wake of COVID-19, this could be a challenging shortfall for European banks to meet.

Generally, banks with low RWA densities (such as those with large residential mortgage portfolios) will be the most constrained by the OF:

Distribution of RWA densities of banks in EBA QIS 

Source: EBA QIS on Basel III implementation (2018), based on a sample of 77 EU banks

The current EU policy debate

European legislators will implement the OF in the EU through CRD6/CRR3, with a legislative proposal expected from the Commission by end-2020.

The implementation of the OF will be an important balancing act for legislators. On the one hand, banks must be capitalised to absorb the losses that they might reasonably expect to face, and the OF will be important to giving the market confidence that IRB banks meet this test. On the other hand, the use of IRB approaches allows banks to manage risk and allocate capital effectively, supporting their ability to provide credit to the economy.

The Basel rules are designed to apply at the consolidated level of a banking group[2], and are calibrated by the BCBS with this scope in mind. However, the EU has traditionally applied prudential requirements at both the consolidated and subsidiary levels. This mismatch between the BCBS’s design and the EU’s approach has led to a significant debate around the OF’s implementation in CRR3.  

Why does this matter?

EU policymakers are now considering whether the OF should be applied to EU banks at the consolidated level only (with the OF calculation based on the aggregate RWAs of the whole group) or at both the consolidated and subsidiary levels. The decision will have significant implications for the fungibility of capital in European banking groups.

Applying the floor at all levels of a group

Applying the OF at both group and subsidiary levels would increase overall capital requirements, leaving banks holding more capital in some subsidiaries than is necessary for reasonably foreseen loss-absorption.

The EBA, in its policy advice to the European Commission on Basel III implementation, recommends applying the floor at both group and subsidiary levels in order to be consistent with the general EU approach. The EBA argues that the rationale for the OF (i.e. to constrain undue risk weight variability, and reduce the difference between RWAs under the standardised approach and the IRB approach) applies equally at both the consolidated and subsidiary levels. It also points out that application at all levels of a group could help to level the playing field between subsidiaries of large entities, and medium-sized/small institutions that do not consist of multiple solo entities.

However, some stakeholders, including Edouard Fernandez-Bollo, Member of the Supervisory Board of the ECB, have argued that applying the OF at all levels could create a perverse incentive for banks to combine higher risk and lower risk activities in the same subsidiaries, in order to mitigate the effect of the OF. This could result in activities that had previously been managed separately being managed by teams that lack the necessary risk management capacity. 

Andrea Enria, Chair of the Supervisory Board of the ECB, has also argued that applying the OF at all levels would make EU bank M&A less attractive, as it would reduce the ability of banking groups to allocate capital flexibly within a group structure, and consequently limit the ability of universal banking groups to diversify risks at a group level.

Applying the floor at the highest level of consolidation only

Industry stakeholders, such as the EBF and AFME, support the application of the OF at the consolidated level only. For banks with specialised subsidiary structures (which have certain subsidiaries using the standardised approach, and others which use the IRB approaches) this could reduce the overall amount of capital required under the OF at the group level.

Under the BCBS framework, the OF applies on a whole balance sheet basis, rather than to individual exposures, risk types, or subsidiaries. This enables ‘floor capacity’[3] to be transferred between entities in a group, as standardised portfolios can offset the effect of the OF on IRB portfolios whose RWAs fall below the 72.5% standardised floor level.

If the OF is applied at the consolidated level only, banks would be able to use this floor capacity across their subsidiary structure – in the aggregate calculation at the group level, the use of the standardised approach in one subsidiary could offset the floor impact of another subsidiary which uses an internal model.  

The OF is expected to have greatest impact on large banks. Given their complex group structures, for those banks OF implementation at the consolidated level only would remove a material potential constraint on the transfer of capital resources within the group.

The question over the level of application of the OF will be a prominent part of negotiations at the EU level, both before and after the Commission makes its legislative proposal for CRD6/CRR3 later this year. While industry stakeholders, as well as some prominent figures in the supervisory community, support application at the consolidated level only, the EBA’s proposed approach is supported by a number of Member States, and is being considered equally seriously. The implications of the decision need to be clearly understood by banks.

The BCBS has delayed its timeline for Basel III implementation by one year; however the EU was unlikely to meet the original 2022 deadline and, in practice, implementation programmes at European banks will need to continue apace. Whichever way the OF is adopted in the EU, implementation will be a significant operational and strategic challenge for EU and UK banks.

The BCBS delay will give banks more time to get to grips with the practical challenges created by implementation of the OF. But just as importantly, it will give some banks an added opportunity to form a more strategic view of Basel III compliance.

Where do we go from here?

Managing and minimising the effect of the OF will require accurate Standardised RWAs across the whole firm; but the way Standardised RWAs are calculated, particularly in respect of collateral allocation and the effect of riskiness on RWAs, is very different to the IRB approaches. For some banks it will be a substantial (and costly) undertaking to put in place the infrastructure and data feeds to calculate standardised RWA across the whole group.

Nonetheless, whether the OF is implemented at all levels or at the consolidated level only, it will be vital for bank management teams to have access to high-quality data from across their whole group structure in order to understand how the group is affected by the floor

The OF will require a shift in management’s understanding of – and approach to – capital optimisation. Previously, portfolios that generated the highest returns on the lowest RWAs would have been viewed as the most desirable. In future Standardised portfolios that create floor capacity to allow a firm to support a larger, higher return IRB portfolio may become more appealing – subject to other return, leverage, liquidity and capital constraints.

Markets for those exposures or portfolios that generate floor capacity (and acceptable returns) may become more competitive. Banks that react fastest to the outcome of the EU policy debate will be best placed to develop a ‘first mover’ advantage over their competitors.    

Particularly if implemented at the subsidiary level, the OF will add a further layer of complexity to strategic decision making, and to how management chooses to organise their group structure. IRB portfolios which are of strategic importance could become inefficient from a regulatory capital point of view. Where this is the case, banks will need to assess whether and how certain entities need to be restructured, and how risk management capabilities may need to be improved in some areas as a result.

What should banks be doing now?

Internal analysis of the implications of the OF debate, and building it into strategic decision making, is a key task for banks in the near-term.

We see three parts to this analysis in the immediate term:

1. Understand the effect of the OF on the firm at subsidiary, business and portfolio level;
2. Understand the implications of OF implementation at both consolidated and subsidiary levels; and
3. Develop plans for actions to mitigate the effect of implementation of the OF, such as subsidiary re-organisation, portfolio sales or changes in portfolio emphasis.

[1] EBA, Basel III reforms: Impact study and key recommendations, December 2019

[2] https://www.bis.org/fsi/fsisummaries/scope_app.htm

[3] By floor capacity we mean the effect an exposure (or portfolio of exposures, or business unit) has on whether or not the OF becomes a binding constraint on a bank. Standardised exposures, or modelled exposures with risk weights greater than 72.5% of the equivalent Standardised risk weight for the same exposure, move a bank away from being constrained – they provide capacity against the OF.  Modelled exposures with risk weights less than 72.5% of the equivalent Standardised risk weight for the exposure move a bank toward being constrained – they absorb capacity against the OF.