Audience: Senior Risk, Finance and Corporate Lending staff
At a glance:
- Basel 3.1 implementation will significantly affect EU and UK banks’ capital requirements for exposures to unrated, non-SME corporates.
- In particular, increased risk weights under the Standardised Approach for credit risk will lead to these portfolios absorbing Output Floor capacity.
- EU and UK banks’ unrated non-SME corporate exposures amount to an estimated EUR 2.7 trillion; revisions to the capital framework that make it more difficult for those corporates to access financing post-COVID-19 will be politically unpopular.
- We expect that this will be a key part of the debate over the implementation of Basel 3.1, particularly in the UK and the EU, where corporates are highly reliant on bank financing.
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Basel 3.1 will affect the capital banks must hold against corporate lending. In this blog, we examine the effect of Basel 3.1 on lending to unrated corporate borrowers in the EU and the UK.
Under the revised Standardised Approach for credit risk in the finalised BCBS framework (Basel 3.1), the treatment of corporate exposures depends on whether the use of external credit ratings for regulatory capital purposes is permitted. Basel 3.1 allows two approaches: 1) the External Credit Rating Risk Assessment approach (ECRA), where external credit ratings are used; and the Standardised Credit Risk Assessment Approach (SCRA), where external credit ratings are not used.
The primary difference between the two approaches is the risk weight applied to exposures to unrated corporate borrowers. Under both the ECRA and the SCRA, unrated corporate exposures will be assigned a risk weight of 100%, with two exceptions: firstly, unrated SME corporates (under both approaches) will have a risk weight of 85%; secondly, in SCRA jurisdictions only, unrated corporates which are identified as being ‘investment grade’ will be assigned a risk weight of 65%. In this context, an investment grade corporate is one that has adequate capacity to meet its financial commitments in a timely manner, and has securities outstanding on a recognised exchange.
What’s the issue?
In contrast with the US, which will use the SCRA when it implements the finalised BCBS framework, the EU does allow the use of external ratings, and the EBA has recommended that it continue to do so. This means that unrated, non-SME, corporate borrowers in the EU could not benefit from the ‘investment grade’ RWA discount, and would be assigned a risk weight of 100%.
This creates a potentially significant capital add-on for EU and UK banks, which arises from the Basel 3.1 Output Floor (OF). Once fully phased in in 2028, the OF will require that RWAs calculated using modelled approaches amount to at least 72.5% of RWAs under equivalent standardised approaches. Most of the largest EU and UK banks use the internal ratings based (IRB) approach to determine risk weights for their corporate lending portfolios, and the 100% risk weight assigned to unrated non-SME corporate exposures under the ECRA will, in many cases, be considerably higher than the risk weights calculated under the IRB approach – leading to these exposures being ‘captured’ by the OF. This effect of this will be most acute in the case of low risk, financially sound but unrated corporates, as shown in the chart below.
Where corporates are externally rated, the effect of the OF in relation to IRB risk weights could be relatively minimal. However, where counterparties are unrated, but assessed by IRB banks as being low risk (equivalent to investment grade external ratings), the effect of the OF is very significant.
This means that once the revised framework has been implemented, capital requirements on an Output Floor-adjusted basis will increase more for lower risk unrated corporates than for higher risk unrated corporates. Given banks’ profitability pressure, once increased capital requirements come into force, there will likely be pressure to increase interest rates on these exposures as the OF is phased in (from 2022 to 2028).
The volume of banks’ exposures which could be affected by this is significant. As of Q1 2020, EU and UK banks’ combined exposures to non-SME corporates was just under EUR 4.5 trillion, with EUR 3.6 trillion held by EU banks and 875 billion held by UK banks. In its 2019 response to the European Commission’s Call for Advice on the implementation of Basel 3.1 in the EU, the EBA calculated that almost 75% of EU banks’ non-SME corporate exposures are unrated. This would suggest that EU banks’ exposures to unrated non-SME corporates are circa EUR 2.7 trillion.
The rule change would also create an imbalance between the EU and UK and the US, given that the US will use the SCRA. As demonstrated by the chart below, financing through equity traded on public markets, and non-financial corporate debt securities, account for a considerably larger portion of total US financing than in the Euro area. This indicates that a material proportion of US banks’ corporate exposures may be able to be categorised as ‘investment grade’, and US banks would therefore be able to apply the 65% risk weight under the SCRA.
Financing structures of the euro area, US economies by type of instrument
What does this mean?
As European economies emerge from the shock of COVID-19, revisions to the capital framework that constrain corporate access to bank financing are likely to be politically unpopular, as they could slow Europe’s post-pandemic recovery. We expect this issue to be a key part of the debate when the EU negotiates CRD6/CRR3. While the UK has traditionally been a strong advocate of close alignment with the BCBS standards, the financing of corporates in a post-COVID, post-Brexit environment will make this an equally challenging policy choice for UK regulators.
One alternative approach to implementation which seems to have growing support in the EU is a so-called ‘hybrid approach’. Under this approach, the ECRA would be used for rated exposures, and the SCRA would be used for unrated exposures (allowing for the possibility of an RW discount for ‘investment grade’ unrated corporate exposures).
However: the EBA has estimated that around 70% of EU corporate exposures would not qualify as investment grade, so implementing this hybrid approach would have limited benefits for European banks at present. This is largely due to the fact that few medium-sized EU corporates have securities listed on exchanges – due to the less deep capital markets and the resulting dominance of bank financing in the EU. In order for the hybrid approach to work in the EU, some industry stakeholders have suggested the listed securities requirement would need to be removed.
Encouraging more corporates to issue listed securities and tap capital markets for their financing is a goal that is in line with the EU’s Capital Markets Union (CMU) project. However, it is unlikely that corporates could effectively do so in such a period of time without a number of other supporting CMU initiatives designed to strengthen capital markets in many of the EU’s jurisdictions. Seven years may not be long enough to meaningfully address the problem.
What should banks do in anticipation of these revisions?
The effect of the revisions in Basel 3.1, and their flow-through to financing costs for corporates is complex. Banks that develop a deep understanding of how this will affect their loan book will not only be better placed to plan their own actions before implementation, but will be better able to help regulators and policymakers consider how they should calibrate the framework during the adoption stages.
Although policymakers might amend some parts of the Basel 3.1 framework to support economic and financial conditions in a post-COVID-19 environment, banks cannot assume that policymakers will amend the treatment of unrated corporates. Banks, therefore, need to plan for faithful adoption of the unrated corporates approach.
In this case, IRB banks should consider how they could strategically deploy ‘floor capacity’ (explained in the last blog of our Basel 3.1 analysis series) to support lending to unrated corporates. This would involve using ‘capacity’ generated by standardised or capacity-generating IRB portfolios in other areas of the bank to allow lower IRB RWAs to be recognised for the corporate loan book. Banks that do so may have to make difficult trade-offs, possibly reducing the floor capacity available to support other portfolios that are challenged by the OF, such as mortgage lending.
 ‘Investment grade’ means that the entity to which a bank is exposed has adequate capacity to meet financial commitments for the projected life of the asset or exposure. Such an entity should have adequate capacity to meet financial commitments if the risk of its default is low and the full and timely repayment of principal and interest is to be expected. Although the entity’s repayment capacity may weaken during adverse economic or business conditions, it is expected to maintain its ability to meet its financial commitments. If the entity’s repayment capacity is dependent on stable or favourable economic or business conditions, the exposure is considered to be non-investment grade. BCBS CRE20, 20.46