Basel IV

A New Pain Threshold For Banks

Manhattan’s Square
Manhattan breeze: US banks will feel less pain than Germany's finance institutions from new regulations on capital. Source: Moment/Getty Images.

Ever since the financial crisis forced governments to bail out some of their banks with taxpayer money, regulators have been under pressure to come up with new global rules about how much capital banks should set aside to avoid a repeat of the disaster.

After several years of difficult negotiations, a compromise may finally have been reached at a meeting of the Basel Committee on Banking Supervision, which met in Switzerland.

The upshot of the new rules, known as Basel IV,  is that European banks may have a harder time making loans, which could hurt the economy just as it begins to recover. Because the proposed solution will hit European banks harder than American financial institutions, some countries, especially France, are still trying to make adjustments to the final wording of the regulations. The deal will be discussed later this week on the sidelines of the International Monetary Fund meeting in Washington.

“European banks would have to reduce the amount of loans they make. The result will be a clear setback for the European economy.”

Hans-Walter Peters, Association of German Banks

Almost all countries have rules about how much capital banks need to keep in order to withstand a crisis. Under previous international rules, known as Basel I and II, banks could choose between using a standardized calculation for how much capital is required or internal bank models of risk. (Basel III, a set of interim measures in the wake of the financial crisis, is still awaiting full implementation.)

Fearful that some banks might try to game the system, the United States has demanded that a capital floor be established so that if a bank uses an internal measure of risk, it is only allowed to deviate from the standardized risk mode by a fixed percentage maximum.

In the talks, the US had insisted that the percentage floor be set at 75 percent of the standardized model and Europe wanted 70 percent. Last week, they tentatively agreed to split the difference and set the floor at 72.5 percent. But France, which is supported by Germany, is still holding out for the lower number, Finance Minister Bruno Le Maire said.

Capital requirements are determined by how many assets a bank has, ranked by risk, with government bonds generally given zero risk and personal loans considered higher risk. This is where US and European banks really differ.

In the US, banks offload mortgages onto government-guaranteed agencies called Fannie Mae and Freddie Mac, while European banks keep such loans on their balance sheets. Corporate borrowing in the US is usually done by issuing bonds, whereas European companies tend to borrow from banks.

The result is that many European banks have a higher number of risk-weighted assets on their books that need to be offset by capital. By using internal models of risk, German and other northern European banks know that mortgages rarely go sour and so they assign a low risk weighting to such loans. Under the new rules, however, that weighting will have to rise.

“If the limit is set at 72.5 percent, European banks would have to reduce the amount of loans they make,” said Hans-Walter Peters, head of the Association of German Banks. “This would affect long-term real estate loans as well as corporate finance. The result will be a clear setback for the European economy.”

Johannes-Jörg Reigler, CEO of the BayernLB and head of the Association of German Public Banks, agrees about the potential damage. The compromise “will be a serious blow to European banks and economies.”

Before the compromise was adopted, consultants McKinsey & Co. calculated a 75 percent floor would cost European banks more than €100 billion. Banks could either raise new capital or reduce the amount of assets they have.

The new rules will impact German banks more than others because they tend to rely on internal models of risk rather than standardized models. French banks are even more vulnerable.

“The compromise benefits American banks,” said Martin Hellmich, a professor of risk management at the Frankfurt School of Finance and Management. “They have less credit on their balance sheets, so internal risk models are less important than for European banks. Europe must come to terms with these pain thresholds.”

Andreas Kröner is a financial correspondent for Handelsblatt. Charles Wallace is an editor for Handelsblatt Global in New York. To contact the authors: kroener@handelsblatt.com and c.wallace@extern.handelsblatt.com

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