Sabine Lautenschläger of ECB Speaks on the Finalization of Basel III

Sabine Lautenschläger mentioned that many banks claim that Basel III throws risk-sensitivity overboard and penalizes low risk exposures. She explained, "....we all know how challenging it is to measure and model risks. Much depends on the quality of the models; much depends on the data and the assumptions that feed into those models and much depends on supervisors’ capacity to act. If there are errors along the way, banks might end up undercapitalized and vulnerable. This, in turn, might lead markets to question the reliability of risk-based capital requirements in general, which would undermine trust in banks more generally. Therefore, we need to balance risk- sensitivity with some safeguards. And this is exactly what we aim to do with Basel III. It preserves risk-sensitivity. It retains internal models for most asset classes. And it enhances the risk-sensitivity of the standardized approaches. But, at the same time, Basel III adds a few safeguards."

First, Basel III aligns the degree of risk-sensitivity with the extent to which it is possible to measure and model risks. Second, there are some more conservative haircuts on collateral and some input floors. These input floors lie beneath the parameters for probability of default and loss given default. There will be floors beneath the exposure at default calculation also. These floors work bottom-up; they will keep banks from feeding their internal models with excessively low inputs. This serves as a safeguard because it prevents capital requirements from being set too low. Third, there is the output floor, which ensures that risk-weighted assets calculated with internal models do not fall too far below those calculated with standardized approaches.

Sabine Lautenschläger also discussed the impact of final Basel III package on banks and on their business models and their capital. The rules are not neutral. The bottom-up safeguards in Basel III, including the input floors, will impact risk-weights in some business areas. Certain retail credit card exposures are one example. The top-down output floor affects overall capital requirements, depending on the overall portfolio composition of a bank. She stated that it is hard to predict how business models will evolve. This depends not only on regulation, but also on many other factors, including the future path of profitability in different business areas, the pricing power of banks and, eventually, how banks will adapt their business models. With respect to the about additional capital requirements, she mentioned that the transition period will be long to give banks and legislators time to implement the changes introduced by Basel III. Further she stated, "... EBA estimates that, for EU banks, the final Basel III package will lead to an aggregate Tier 1 capital shortfall of EUR 34.4 billion. Is that a lot? In 2016, the largest banks in the euro area earned EUR 50 billion—net, after taxes, and in a difficult environment. Also, the capital shortfall refers to the end of the transition period, which is nine years away. Most banks should be able to earn their way out of potential shortfalls." She concluded that Basel III preserves risk-sensitivity. Banks will be able to handle its impact and, in the long run, benefit from a more stable banking system.

Related Link: Speech

Keywords: Europe, Banking, Basel III, Risk Sensitivity, Output Floor, Capital Requirements, ECB