Recalibrate, communicate and align: Capital requirements become much more complex

Moving the dial article series

October 2022

As banks around the world prepare for the implementation of Basel 4, they have come a long way compared to their capital position of previous years. Before the Global Financial Crisis of 2007-2008, banks generally held too little capital that was of too low a quality with emphasis on additional Tier 1 (AT1) and Tier 2 capital. Since then, as a result of Basel 2 and 3, they now hold much more high-quality common equity Tier 1 (CET1) capital — but the rules and requirements have also become significantly more complex with additional buffers on top of Pillar 1.

This really is just the precursor to Basel 4, through which Pillar 1 capital requirements will become more complex — and could result in a doubling in some cases of the amount of Pillar 1 capital needed.

Meeting the capital requirements is therefore expected to be a tough task that will require fully coordinated planning, communication and internal alignment between different functions in the bank (first and second lines), as well as more discussion and interaction on target levels with supervisors and investors.

As banks prepare to map out their capital plans for the next 3 to 5 years, taking them into ‘live’ Basel 4 territory, it is more important than ever that they have a comprehensive grasp of the implications of the new requirements. In our view, this will necessitate sound planning, modelling, stress testing and scenario analysis.

Complex capital stack

Let’s quickly run through the capital stack and consider how the main different elements could be affected by the Basel 4 rules (see also figure 1). Each element has its own determinants, drivers and dynamics — and, to make things more complex still, the elements could interact with each other differently in a crisis situation. And a crisis should not be regarded as a remote possibility these days — as seen through the COVID-19 pandemic and then events in Ukraine, crises can spin up unexpectedly from almost anywhere.

Source: KPMG International, 2022
 

Firstly, Pillar 1. The output floor proposal under Basel 4 for most large banks will create a new, higher minimum level of capital. The calculation will become more complex, and the output floor will be 72.5% of the sum of the risk-weighted assets (RWAs) components calculated by using only standardised approaches (SA). Thus, banks will need to compare their internal model (IM) outputs with 72.5% of SA outputs and allocate capital to meet whichever is the higher. Many credit institutions will face higher RWAs on top of their IM risk exposure calculations. Therefore, the new standards will particularly impact banks that make higher use of internal models and will affect areas such as retail portfolios, including real estate financing, corporate and leveraged finance. According to the European Banking Authority (EBA), the capital required for large European banks may increase by as much as 20 to 30%.¹ ( See EBA's Impact Study from December 15, 2020. (PDF 2.6 MB))

The proposals may also lead to some recalibration of Pillar 2 requirements which are the outcome of supervisory activities, investigations and onsite inspections. Then there are other add-ons, such as Systemic risk buffers (SRB), buffers for globally systemically important institutions (GSI) and other systemically important institutions (OSI), and countercyclical buffers which are set at a national level.

Double-counting risk

It will be important to ensure that banks’ risks are not double-counted through increased capital requirements in Pillar 1; for example, model risk, if this is also imposed in one of the other elements of the capital stack (e.g., Pillar 2 requirements). There should be an offsetting effect to alleviate this — under the CRR 3 proposals, supervisors must recalibrate their Pillar 2 requirements to reflect it. But this will not be a straightforward area, and will likely add to the current challenge to delineate micro- and macroprudential buffers (as in the case of the systemic risk buffer). Banks will therefore need to engage fully with their supervisors and be ready with robust data and qualitative evidence to argue their case and reach a fair conclusion.

This will be especially important to ensure that banks do not cross the maximum distributable amount (MDA) trigger point, hampering their ability to pay bonuses and dividends, including during simulations of adverse scenarios. The importance of this was seen during COVID-19 when, despite concessions from supervisors to allow banks to use up capital buffers to support the economy, limited use was made of them due to fears of breaching MDA. Basel 4 will not amend the MDA mechanism, instead it will add complexity to the capital stack and increase the risk of double-counting.

How to cover the cost of RWA increases?

In summary, an already complex capital regime is anticipated to become even more complex under Basel 4, and capital requirements and associated costs for many banks will likely rise. In our view, a key question for banks to resolve will be: how should additional risk-weighted assets from Basel 4 be provided for? Whether the costs are met by customers (e.g. through higher interest rates and/or increased product fees and charges), shareholders (lower return on equity) or through cost or capital optimisations — or a combination of these — we believe a clear and detailed strategy will be needed for operating with a decreased capital management buffer (see figure 2 for an illustrative example). Whichever route is taken, it is also certain that banks will need to become more operationally efficient in order to offset as much of the capital cost increases as possible.

Source: KPMG International, 2022

Banks should therefore increase functional collaboration and discussions to align internally, with extensive calculations, modelling and scenario analysis. This should be documented effectively for use in evidential discussions with supervisors. It will also be crucial to provide a clear steer for investors around what to expect. The last thing that investors welcome is surprises. So, what is the bank’s capital level ambition, and why? Showing how the bank will create a stable capital environment with a clear path ahead should be the priority.

With these significant new capital rules drawing steadily closer, the time has come for banks to get to grips with the detail. Taking a proactive approach now should help put them in a stronger position for the future.