Basel Framework

The Basel 4 proposals are intended to make the capital positions and capital requirements of banks more comparable internationally: how much capital do banks have as a 'buffer' and does that amount of capital match the risks of their exposures?

The international supervisory framework that consists of a package of measures taken after the credit crisis in 2008 to strengthen banks' capital buffers. These measures are since 2014 anchored in European legislation (Capital Requirements Directive (CRD IV) and Capital Requirements Regulations (CRR);

The Capital Requirements Directive (CRD IV) has been published in the Official Journal of the European Union. This publication is a milestone in the development of the supervisory framework after years of discussions, negotiations and preparations. At the same time this publication is merely one step in a continuing process of amending the supervisory framework. Significant changes to national law, supervisory policy and institutions behavior and ultimately an increased soundness of the financial system are expected to be the consequences of the CRD IV. More can be found on the ECB website here;

Basic principle of Basel 4 is that banks will make more use of standardized approaches for calculating the amount of capital and the operation of internal - own - risk models will be limited;

An important new core measure is a capital floor of 72.5%, although banks may use an internal risk model under Basel 4 to determine the necessary buffers, but that buffer may never be lower than 72.5% of the Basel 4 standardized approach.That standard model is part of Basel IV and is a lot more conservative than the models of the banks themselves. "In the crisis we saw that some parties were using internal models in an undesirable way to reduce the need for capital," said Mario Draghi. of the European Central Bank when presenting the Basel 4 agreement. That percentage of 72.5% has been the subject of considerable debate for years. After all, the higher that percentage, the higher the capital buffers must be. Dutch banks suffered relatively little loss on the mortgage portfolio during the crisis, mainly due to the high payment morality among Dutch people. The internal models have ensured that Dutch - and many other Northern European - banks have maintained relatively low capital buffers;

That percentage of 72.5% has been the subject of considerable debate for years. After all, the higher that percentage, the higher the capital buffers must be. Dutch banks suffered relatively little loss on the mortgage portfolio during the crisis, mainly due to the high payment morality among Dutch people. The internal models have ensured that Dutch - and many other Northern European - banks have maintained relatively low capital buffers;

Many European banks will have Basel 4 impact, especially Northwestern European banks, including Dutch banks. They often work with internal models and also have relatively many low-risk mortgages on the balance sheets. Starting in 2022, Dutch banks will have to maintain additional capital because the mitigating impact of the internal models will be limited due to the fact that the Dutch Central Bank decided certain Basel 4 regulations come into force from January 1st onwards. This regulation is called Regeling Risicoweging hypothecaire leningen 2022 and can be found here. DNB legitimates the new regulation as follows: De minimum vloer neemt toe naarmate de LTV-ratio’s van de onderliggende leningen hoger zijn. Hierdoor moet meer kapitaal worden aangehouden voor risicovollere hypothecaire leningen portefeuilles. Juist de hoge LTV-ratio’s van nieuwe hypothecaire leningen vormen immers een belangrijke bron van systeemrisico;

The output floor is one of the central elements of the Basel III reform. As the name suggests, it is a measure that sets a lower limit (“floor”) on the capital requirements (“output”) that banks calculate when using their internal models. The main aim of the output floor is to address model risk, which in this specific case is the risk that a bank's internal model incorrectly estimates the bank's capital requirements. The main concern is that internal models might underestimate the amount of capital needed by banks. Studies conducted at EU and international level showed that capital requirements calculated by internal models can vary quite significantly, even for the same risk exposure. Some of this variability cannot be explained by the characteristics of the exposures. The output floor aims to reduce this unwarranted variability and therefore to increase the comparability of capital ratios of banks using internal models.

Banks and their supervisors have diverging views on how to implement the output floor: banks argue for a “parallel stack” approach, while supervisors argue for a “single stack” approach. What is the difference between those two approaches? Each bank is subject to several types of capital requirements: minimum capital requirements (socalled Pillar 1), additional capital requirements imposed by the bank's supervisors (so-called Pillar 2) for risks not covered or not sufficiently covered by minimum capital requirements, and capital buffer requirements. The total capital requirement of a bank is simply the sum of all these requirements. The consequences of breaching each of the individual requirements are different. For example, breaching a minimum requirement can lead to the bank's license being withdrawn, whereas breaching a buffer leads to limitations on dividend and bonus payments. It is important how each of these capital requirements is positioned compared to the others. Therefore, the prudential rules set out the order in which the different requirements “stack” on top of each other, hence the name “capital stack”. Under the “single stack” approach for risk-based capital requirements, there would be one capital stack with all the requirements in the stack expressed in terms of the risk-weighted assets. They would be calculated in accordance with the additional step explained above. In contrast, the “parallel stack” approach would create a new stack standing alongside (“parallel” to) the existing one. Under this approach, like in the case of the existing single stack approach, the capital requirements in the parallel stack would be calculated using the risk-weighted assets calculated in accordance with the procedure outlined above. However, unlike in the case of the single stack approach, the parallel stack would not contain all necessary requirements. For example, this approach could exclude the Pillar 2 requirement and the systemic risk buffer requirement, which are important aspects of the B4 framework. With the banking package of October 2021, the European Commission clearly chose for the single stack approach.

EU banks will have enough time for implementation. The final set of Basel III standards were agreed at international level by BCBS in December 2017. In response to the COVID-19 crisis, the Basel Committee decided in March 2020 to postpone the implementation deadline by one year to 1 January 2023, followed by a five-year phasing-in period of certain elements of the reform. The Commission proposes to give banks and supervisors additional time to properly implement the reform in their processes, systems and practices, and start applying the new rules from 1 January 2025. The extended implementation period will allow banks to focus on managing financial risks stemming from the COVID-19 crisis and on financing the recovery, and give them enough time to adjust before the reform reaches its full effect. Please note that the stricter capital requirements already became partly in effect for Dutch banks from the 1st of January 2022 onward due to Regeling Risicoweging hypothecaire leningen 2022 (which can be found here.).