Basel III finalisation and overall impact of the reforms
Speaking points by Edouard Fernandez-Bollo, Member of the Supervisory Board of the ECB, at the Working Group Financial Services hosted by Kangaroo Group on "Is the Basel agreement compatible with strengthened financing of the European economy?"
Brussels, 21 January 2020
The ECB supports the full, timely and consistent implementation in EU legislation of the global standards agreed by the Basel Committee on Banking Supervision.
As the discussion evolves on the overall impact of the reforms, it is worth underlining their benefits, such as increased bank resilience, financial stability and international consistency. In the long term, banks will be better capitalised and better able to withstand shocks, thus better protecting depositors and citizens from bank failures. Ultimately, the reforms will enhance the resilience and stability of the financial system, supporting economically productive lending in future downturns. Let me also emphasise the importance of having internationally consistent standards. Banks have significantly stepped up their cross-border activities with increasing global reach. European banks are among the most internationally active and benefit from this consistency in their international activity.
According to a macroeconomic impact assessment prepared by ECB staff, full Basel III implementation will bring substantial long-run economic benefits. Specifically, the finalisation of Basel III was found to significantly reduce the severity of economic downturns as well as the probability of future banking crises on a permanent basis. These medium to long-term benefits are judged to outweigh the modest short-term transitional costs of the reform.
Looking at individual banks, we acknowledge that the reforms will require some banks to make adjustments; nevertheless, we believe that the benefits will outweigh the costs. For example, evidence shows that banks with higher capital ratios enjoy a better trade-off between risk and profits. In other words, they generate the same level of profits with lower risk. Moreover, given the long transition period, banks will have time to adjust to capital changes.
The new set of standards aims to repair flaws and weaknesses in the use of internal models. Higher capital requirements for some individual banks are a natural consequence. The reforms will have a very significant impact on some banks and a much lower one on others. A few banks could even see their overall requirements go down.
Finally, we must keep in mind that the EBA’s impact assessment rests on quite conservative assumptions. It assumes, for instance, that neither banks nor supervisors will adjust their behaviour once the new rules have been introduced and that balance sheets will remain static.
The impact of the output floor
The output floor is a core element of the reform package. It ensures that risk-weighted assets calculated with internal models do not fall too far below those calculated under standardised approaches.
The output floor should be applied at the highest level of consolidation only. This is essential in ensuring an equilibrium in the application of Basel III as it would establish the output floor as a simple limit to the regulatory capital relief that can be achieved by using internal models, while avoiding potentially adverse side effects. For example, applying the output floor at the individual level would incentivise banks to minimise the impact of the output floor on individual subsidiaries. Banks might restructure by shifting risky activities into subsidiaries that normally specialise in lower-risk activities and may therefore lack the necessary risk management capacity.
Some stakeholders have pointed to the relationship between the output floor and Pillar 2 requirements. Pillar 2 is defined as a measure to buffer risks that are not covered by Pillar 1. Any increase in actual capital caused by a purely arithmetic effect arising from the output floor would not be justified as it would not reflect additional risk. Banks that are bound by the output floor will see an increase in their risk-weighted assets that leads to higher Pillar 1 requirements. This is an intended effect of the reform package. At the same time, the increase in risk-weighted assets would also push up the euro amount of Pillar 2 capital add-ons. This effect is purely arithmetic and does not reflect an actual increase in risks that would necessitate additional Pillar 2 capital. Supervisors should therefore sterilise this increase by calibrating the risk charge accordingly. We are fully committed to doing so. More generally, the ECB will seek to avoid double counting between Pillar 1 and Pillar 2, for instance by eliminating charges under Pillar 2 if risks are covered by the new output floor or by other limitations to the use of internal models.
Finally, the output floor will be phased in over a long transition period to give banks sufficient time to smoothly adapt to the new requirements.