Basel 4-driven balance sheet and capital optimisation

Moving the dial article series

January 2023

In parallel with, and in no small part due to, the significant evolutions in the capital adequacy regime since the global financial crisis, banks have been facing a growing return-on-equity challenge, particularly in Europe. Now, as they face the upcoming implementation of Basel 4, it is anticipated this challenge will be exacerbated further, which will not only require strategic shifts in capital management, but could also lead to some strategic business model shifts as a result.

In the wide-ranging Basel 4 package, the most seismic change will likely be derived from the most hotly discussed and debated topic — the aggregate output floor. There has already been a move from a pre-crisis position of a single risk-based measure for capital adequacy to a “multiple metrics” Basel 3 approach (including both risk-based and leverage measures). The output floor under Basel 4 will introduce yet another layer. Under Basel 4, banks using the Internal Ratings-Based (IRB) approach will have a new minimum threshold to pass, with capital levels ‘floored’ based on a minimum percentage of the less risk-sensitive standardised approaches. In our view, this doesn’t just increase compliance burdens, it also makes the whole capital management equation much more complex.

Indeed, in some ways the output floor doesn’t just increase the complexity — in our view, it changes the whole equation. As a result, we believe Basel 4 will be like a game of 3D chess in which banks are blending the different factors of risk-based capital, leverage and the output floor. It could be argued that it will be 4D chess because we don’t expect a single version of Basel 4 — there are likely to be slightly differing requirements in different jurisdictions that will be implemented according to differing timelines that legal entities of international banks will be subject to.

Banks must therefore consider which of the Basel 4 requirements constraints is the most binding, in which geography and at which level (legal entity versus Group). They should look at their loan books at much more of a portfolio level than they have ever had to do before, which will likely be a challenging exercise. Previously, banks could take a loan-by-loan approach, asking themselves a series of yes/no questions to arrive at the most efficient treatment. Now they should assess the impact of new loans at the portfolio level and consider how to optimise the existing balance sheet. This will involve deciding what they keep on the balance sheet and what they remove through securitisation or other risk transfer mechanisms.

In our view, banks will need to increase their focus on of active portfolio management in order to optimise returns. For many this will be a strategic, operational and cultural shift in how the balance sheet is managed.

As a result, it is likely there will be an intensification of banks’ consideration of risk-weighted asset (RWA) velocity — how quickly can they churn their portfolios and to what extent will they ‘originate to distribute’ by selling, securitising or syndicating loans to reduce their RWAs to provide capacity for further origination? This has long been an area of focus for banks, but Basel 4 makes it a critical discipline to driving capital efficiency.

Because of greater distortions and mismatches between regulatory and economic treatments (the required capital treatment under the new rules versus what banks perceive as an asset’s actual economic riskiness based on their internal models) institutions should take a more nuanced view of what risk they retain or hold to drive returns, helping to ensure that they ‘move up the risk curve’ in a controlled manner.

Of course, centralised management of the balance sheet requires a centralised balance sheet. The difficulty large institutions are expected to face is that regulators are increasingly looking for banks to atomise their assets among different legal entities, managed separately and increasingly according to separate rules. Banks may be global in life, but they are local in death, and that is the regulators’ key concern. So how do banks go about centrally managing the Group balance sheet when there are various restrictions about what can and cannot be done, what can and cannot be sold or transferred, at legal entity and regional levels? In our view, the practical necessities for centralised portfolio management means that the output floor will bring this divergence to a head.

One suggested approach to this conundrum is to look at strategic changes to the business model. Consequently, banks may be increasingly moving pockets of lending and assets outside banking entities to insurance entities or funds, as the assets are treated differently there, and it can free up balance sheet scope. Indeed, this is already being seen in product areas like equity release and long-term infrastructure finance.

The central question becomes: does a firm want to be a pure-play banking group or have a more diversified footprint where local circumstances and regulations allow? We expect to see more inter-sector movement and flows due to the differences in how products are treated in banking compared with insurance and funds. There could also be more non-bank lending. It will be interesting to see how regulators respond to that, as well as to the diversification trend.

The apparently narrow, technical question of how balance sheets and capital are optimised under Basel 4 rules could therefore lead to significant strategic and structural shifts in the banking industry.

In this fascinating game of chess, what will be the winning move? Is your institution weighing up the options and preparing its strategy?