THINK ACT BEYOND MAINSTREAM January 2016 2017

MasteringImplications the of ongoing Transformation"Basel IV" debates Journey ASignificant comprehensive new constraints guide to reinventing to come for companies banks, with expected ramifications for European economy financing 2 THINK ACT Implications of ongoing "Basel IV" debates

THE BIG 3

76% vs. 27% for European vs. US companies of all financing reliant on bank funding. Page 3 +80% of aggregated CET 1 capital for largest banks in Europe and US over the 2009-15 period reaching ~1,500 EUR Bn in 2015. Page 4 +20-40% estimated range of RWA increase in Europe (before finalization of revisions and with strong discrepancies across banks). Page 9 THINK ACT 3 Implications of ongoing "Basel IV" debates Despite some favorable conditions, European economic growth remains limited and fragile

Eurozone economies are proving fairly resilient to any In a working paper from August 2016, economists from post-Brexit vote shock but implications, such as a po- the IMF consider that further monetary accommoda- tential drop in foreign investments, are still uncertain tion may need to rely more on credit easing and an ex- and will take time to materialize. pansion of the ECB’s balance sheet rather than any Europe is continuing to battle unprecedented low additional reductions in the policy rate. growth and low inflation, with growth remaining at 0.3% in the second and third quarter of 2016, while Need to encourage European banks in their inflation is just above zero. intermediation role in the financing of the economy So far, ECB monetary policy has shown little tangi- Banks, in their fundamental intermediation role, are a ble effect even after nearly two years of negative interest critical contributor to the growth of corporations, first rates1 and unprecedented bond buying. ECB has revised and foremost for small and medium-sized enterprises. downwards its forecasts for Eurozone GDP growth for This is especially true in Europe where companies are 2017-18 to 1.6%. Interest rates have been left unchanged reliant on bank funding for 76% of all financing, where- so far and are expected to remain globally low despite as US companies, by comparison, use banks for only potential soft increase. around 27%. The high contribution of bank funding in European banks, particularly those in Germany, Europe is the result of global banks activities (G-SIBs), have long criticized negative rates in the single curren- which account for around half of total assets, and of cy area, arguing that their practice has a detrimental many regional players, banking being highly local across impact on the already fragile profitability of the sector. much of Europe, especially in Germany. A Indeed, in countries with large external trade surpluses Several proposals are emerging with the objective to (particularly Germany and the Netherlands), banks are reduce the gap between banks and markets funding in struggling to recycle their deposits and are, therefore, Europe. The recent initiative by the European Commis- particularly penalized by the negative rate of the ECB. sion to create a Capital Market Union (CMU) in Europe

1 Since June 2014, ECB applies a negative interest rate for day to day deposits that exceed mandatory reserves 4 THINK ACT Implications of ongoing "Basel IV" debates

REPARTITION OF COMPANIES FUNDING OVER THE PAST DECADE IN EUROPE AND US

24% 27%

EUROPE US

76% 73%

Non-bank funding Bank funding Source: ECB, BIS, Federal Reserve

is intended to reduce the barriers that are impeding has increased by over 24% (driven mainly by US). B cross-border investments within the European Union In addition to capital measures, all large banks and businesses access to finance. Nonetheless, these have changed the structure of their balance sheets in a initiatives will take time to produce their effects. Laws context of accommodative monetary policy to meet and regulations like the rules on securitization, or the short-term liquidity requirements (Liquidity Coverage cross-border investing framework, may have effect Ratio, LCR) and medium-long term (Net Stable Funding upon adoption of the new rules, but the success of the Ratio, NSFR). CMU will rely on individual investment decisions. In According to the Basel Committee, banks have on the absence of significant pension funds and consider- average continued to expand their lending, though ing constraints of Solvency II for insurance companies, lending growth was slower among "mature" markets. it is paradoxically banks, and especially investment Lower dividend payouts contributed to banks ability to banks, that should play an increasing role in the ani- use retained earnings to further build capital. mation of this market in the short-term. This period of strengthening of capital and liquidity ratios has been marked by opposite trajectories for Looking back, as a result of financial crisis and banks profitability in Europe and the US. Over 2009-15, tightening regulation, banks carried out significant the average ROAE4 of the 8 US G-SIBs has increased by measures to strengthen their resilience – with ~10% per year while the average ROAE of the 15 Euro- limited impact on credit volumes so far pean G-SIBs has decreased by ~9% per year. The As a result of the 2007 financial crisis, unprecedented profitability gap is emphasized for European G-SIBs financial reforms were adopted. In particular, the Basel as some of them have experienced in recent years Committee, in the context of Basel III agreements, has exceptional losses (e.g. Unicredit, Royal Bank of significantly strengthened capital requirements for Scotland) or fines (e.g. BNP Paribas). C credit institutions and created two new liquidity ratios. This drop in profitability poses a real challenge for To comply with these Basel rules, banks have enhanced European banks considering the current combination their capital and started to reduce the size of their of low economic growth, negative interest rates and balance sheets in recent years. As an illustration, the increasing regulatory pressure. It explains recent average CET12 capital ratio of the 15 European G-SIBs3 concerns regarding discussions at Basel Committee and 8 US G-SIBs has increased by ~7% per year over the level that could further increase the competition gap period 2009-15. Their aggregated CET1 capital has with US banks and have negative effects on their increased by 80% over this period reaching ~1,500 EUR capacity to finance economy. Bn in 2015. In parallel, total risk-weighted assets (RWA)

2 Common Equity Tier 1 capital — 3 Global Systemically Important Banks — 4 Return On Average Equity THINK ACT 5 Implications of ongoing "Basel IV" debates

B STRENGTHENING OF CAPITAL

Evolution of total Common Equity Tier 1 capital and total Risk-Weighted Assets for European and US G-SIBs

CET1 Ratio Europe CET1 Ratio USA +7% p.a. 12.80% 12.68% 12.32% 11.67% 12.51% 10.59% 11.60% 11.63% 11.48% 9.75% 9.05% 10.02% 9.77%

8.21% +24.4% 11,718 5,777

+80.3% 10,937 CET1 Europe USA 5,883 RWA Europe USA

10,022 9,770 5,807 9,616 5,644 9,562 9,420 5,506 5,227 5,409

5,941

5,054

4,334 4,214 4,127 4,111 4,011 1,476 1,331 723 1,111 1,147 685 954 1,028 819 632 644 550 582 490 647 753 446 480 503 329 403

2009 2010 2011 2012 2013 2014 2015

Source: SNL [EUR Bn, 2009-15] 6 THINK ACT Implications of ongoing "Basel IV" debates

New wave of stricter prudential regulations different stages of development. While revision to mar- are being considered while Basel III continues ket risk is finalized, discussions are still ongoing (c.f. last to be implemented BCBS conference in Santiago) regarding operational and While Basel III reform is not yet fully implemented, the credit risks; this latest constituting the bulk of RWA. On Basel Committee on Banking Supervision (BCBS) is average, credit risk accounts for ~82% of risk-weighted preparing a new wave of reforms, so-called "Basel IV" assets for the top 100 European banks and thus would by the banking industry due to the magnitude of the be the main driver of capital impact. D changes it would introduce. The objective is to have Strong discrepancies are expected between risk these revised rules largely finalized by early 2017, for types despite BCBS aiming at softening impacts in its an entry into force in 2018-19. latest proposals that introduced some significant (but Whereas changes introduced by Basel III so far non-public) changes. Quantitative impact studies are were mainly focused on the numerator of the solvency already available for market risk while credit and ratio, i.e. the definition of capital and the minimum operational risks are still under intense debate between level of the ratio, "Basel IV" consists of a series of re- banking federations, governments and regulatory forms focused on risk calculation in the denominator bodies. of the ratio. New standard for market risk, the so-called "Fun- "Basel IV" will affect the method of evaluation of damental Review of the Trading Book" (FRTB), has al- most Pillar I risks (i.e. credit, market and operational ready been published, where a 40% weighted-average risks), as well as interest rate risk. Broadly, three types increase of market risk RWA is expected based on a of changes are proposed: sample of 44 participating banks6. FRTB will not only →→ Revision of the standardized approaches, increase the amount of RWA, but will also increase the →→ Revision of the internal rating method approaches operational costs and complexities of calculating RWA. and limitation of their use, Final operational risk standard is expected for early →→ Introduction of several floors to limit the potential gap 2017 and is estimated to lead to a mean increase of between standardized and internal rating calculations. 60% in operational risk capital based on a sample of 54 A set of additional disclosure requirements, a revision of participating banks7. European banks would see the the leverage ratio and a treatment of sovereign risk expo- largest increase under the Standardized Measurement sures complete what is called the "Basel IV" package. Approach (SMA) with an 80% mean increase in com- Overall, Banks have expressed great concerns parison with the current regulatory approved capital. regarding the potential impact of these measures. At The SMA is supposed to completely replace the past the last G20 Summit in China5, leaders reiterated their internal model approach (IMA) as well as the past stan- support to the work of the Basel Committee and noted dardized approaches8. that it should be done "without further significantly The revision of the credit risk methodologies is still increasing overall capital requirements across the in progress. Given the large share of credit RWA and banking sector", while promoting a level playing field. the potential significant increase in RWA requirements Even if this statement was proven to be true on average, under the current consultative papers, the new ap- capital requirements will be sharply increased for proaches to credit are under particular scrutiny by the some regions and banks taken individually, especially banking sector. those who have invested in their internal models. →→ Some banking book portfolios would be particularly impacted through the combination of methodological Whilst changes to the credit risk framework are still changes (i.e. new standardized approach, limitations/ under review and calibration, the estimated impacts change to advanced models). This concerns particularly on other risk types already appear to be significant wholesale credit portfolios which are directly linked to The elements constituting the "Basel IV" package are at the financing of corporate economic activity in Europe.

5 Held in September 2016 6 FRTB interim impact analysis, Basel Committee, November 2015, taking into account calibration refinements endorsed by the BCBS in December 2015 and considering 100% of desk approvals (otherwise, larger increase) 7 ORX (Operational Riskdata Exchange) benchmark exercise carried out in March 2016 with a sample of 54 banks 8 However, internal models will still be needed for Pillar 2 purposes THINK ACT 7 Implications of ongoing "Basel IV" debates

C OPPOSITE TRAJECTORIES

Evolution of Net Income (NI) and total Equity for European and US G-SIBs

ROAE Europe ROAE USA +10% p.a. 9.10% 8.20% 7.69% 6,82% 6.93% 6.83% 6.39%

6.89% -9% p.a. 5.27% 4.72% 4.34% 3.98% 2.26% 2.59% 2,075 1,022

NI Europe USA 1,865 966 Equity Europe USA

1,648 1,611 1,580 896 865 1,512 864 846

1,357 776 1,053

899

751 746 716 665 128 581 105 96 76 85 84 40 62 71 47 40 20 23 40 89 56 29 43 44 51 61 2009 2010 2011 2012 2013 2014 2015

Source: SNL [EUR Bn, 2009-15] 8 THINK ACT Implications of ongoing "Basel IV" debates

D KEY ELEMENTS OF BCBS PROPOSALS AND MATURITY LEVELS BY RISK CATEGORIES

Structure of RWA, 2015, in EUR Bn (Top 100 European banks)

CREDIT MARKET OPERATIONAL TOTAL RISK RISK RISK RWA

12% 100% 6% 1,108 9,424 82% 534 7,782

KEY ELEMENTS New standardized New standardized Standardized In addition, revisions approach (new approach with Measurement to the Interest Rate OF BCBS methodology, increased risk Approach (SMA) to Risk in the Banking PROPOSALS adjusted CCF and sensitivity completely replace all Book (IRRBB) has risk weights) existing models and also been finalized Clearer rules for the approaches (April 2016) Limitation of use of separation of trading internal rating based and banking books New Business Final standards on approaches for low Indicator (BI) replaces Capital floors default portfolios Methodological gross income expected for 2017 changes to internal Changes to IRB models (replacement Increased constraints methodology of SVaR by expected according to size (including PD, LGD, shortfall, movement EAD floors) from IRC to incre- mental default risk)

STATUS Consultations in Final standards Final standards progress published on January expected 2016 on Q1/2017

PD: Probability of Default, LGD: Loss Given Default, EAD: Exposure at Default, CCF: Credit Conversion Factor Source: Basel Committee on Banking Supervision (BCBS), SNL [EUR Bn, as of Dec. 2015], Top 100 banks in Europe in terms of assets THINK ACT 9 Implications of ongoing "Basel IV" debates

→→ For low default portfolios, i.e. financial institutions, significant impact in terms of capital adequacy. large corporate, commercial real estate, and specialized For example, considering an aggregated increase of lending (object and project finance), impact is also ex- 25% on RWA across the top 100 banks in Europe, they pected to be severe as they will be excluded from the would have to increase their capital by a total of 300 present internal rating based scope. Paradoxically, EUR Bn or deleverage their assets by 7.000 EUR Bn to those assets would attract risk weights much beyond maintain their current CET1 ratio at ~12,5%. what their "low default" profile would suggest, which is In this context, Valdis Dombrovskis (European Com- particularly counter-intuitive and difficult to reconcile missioner for financial markets, financial stability and with the risk sensitivity principle also promoted by the capital markets) expressed late September 2016 criti- GHOS (Group of Governors and Heads of Supervision), cism of the latest proposals, notably regarding capital the BCBS and financial authorities. floors and the aim to limit the flexibility of internal →→ For corporate and most retail portfolios that remain modelling. According to Commissioner Dombrovskis, eligible to internal rating based approaches, a series of significant increases in capital requirements are not ac- methodological changes will lead to an increase in RWA ceptable in current circumstances in the EU. They risk (though more modest). With the introduction of PD, putting European banks at a disadvantage – in particu- LGD and EAD floors, changes to risk-weights and credit lar vis à vis their US counterparts. conversion factors (CCFs), internal models will become Similarly, Felix Hufeld, Head of BAFIN, stated in less risk sensitive and overall more conservative. November: "Discussions are not over the finish line yet. On top of these fundamental changes for each risk From a German perspective, what we have on the table so types, the introduction of an aggregate output floor far is not acceptable. (...) We are trying to develop a global will create additional challenges. While the final cali- standard. But if part of the industry would be eliminated, bration of this floor is still unknown (75% according to that is not acceptable for us". latest debates9), this would further increase RWA requirements and reduce the overall risk sensitivity of Expected unfavorable impact on the financing of the capital measures. European economy, questioning its funding model In order to meet the new prudential ratios in a world of Final calibrations of these reforms are still uncertain scarce resources, European credit institutions will but will add significant new constraints, especially have to adjust their balance sheets, either by reducing for European banks considering structural the size of their assets (e.g. through limiting business specificities vs. other jurisdictions activity, adjusting business mix, increasing assets sales The overall impact of "Basel IV" on the aggregated or reinforcing distribution to the market), or by raising banking sector remains uncertain as it will largely de- additional capital, or both. pend on banks individual capital adequacy framework Given current market conditions (banks being and on the finalization of discussion on all areas of valued below their book value) credit institutions are credit risk and on capital floors in particular. However, more likely to meet their solvency requirements through it is clear that the impact will considerably differ from a reduction of their balance sheet. This would inevitably one bank to another and across jurisdictions. drive a new wave of bank deleveraging, which would Large European internationally active banks will be directly affect the funding of European companies the most significantly impacted by the revisions as they (while the first stage of deleveraging in 2009-11 impacted have invested more on internal models (for credit and mainly the non-European international business of market risks in particular), they hold larger "low de- European banks). Such an impact on banks' lending is fault portfolios" and since new rules introduce pro- in contradiction with the monetary policy currently gressivity related to size for operational risk. pursued by the European Central Bank. Based on BCBS revised proposals, bank experts A part of this is already visible in the markets, e.g. confirmed a RWA average increase in the rangeof through efforts to strengthen originate-do-distribute 20% to 40%. Such an increase of RWA would have a models or to sell non-performing loans (NPLs) and

9 The Basel Committee proposes a gradual entry into force of this floor: from 55% on 1 January 2021, it would then increase by 5 percent per year until reaching 75% by 2025. 10 THINK ACT Implications of ongoing "Basel IV" debates

non-core assets (NCAs). As an example, completed and such as Fanny Mae, Freddie Mac and Ginnie Mae and ongoing deals of these assets in first half of 2016 corporates relying less on bank credit), European banks amount to 112 EUR Bn, already exceeding the figure of hold more exposures to counterparties which would be 104 EUR Bn for all of 2015. Loan sale transactions in negatively impacted by the recent proposals (in particu- continental Europe are particularly important in Italy lar residential mortgages and large corporates). and Central Eastern Europe. Overall, "Basel IV" could favor a move towards a Moreover, banks could have to pass on the increase more capital-market based financing model as in the of the capital charge to the price of their financing. US but this would take time to materialize in Europe The additional operational costs for implementing the considering that CMU is not already in place. More new "Basel IV" regulatory changes are also likely to be generally, beyond requirements to strengthen the supported by the clients, as will be the additional costs resilience of banks (even if they degrade their from other ongoing reforms such the Total Loss-Ab- profitability), it is of course essential to work in parallel sorbing Capacity (TLAC) for G-SIBs. on measures to support and develop European Contrary to business practices observed in US economies in the present (political and economic) (federal guaranty granted to mortgages by agencies environment.

APPENDIX — List of the 23 G-SIBs (Global Systemically Important Banks) in Europe and US as of Nov. 2016

MARKET COUNTRY BANK TOTAL

EUROPE France BNP Paribas 4 Crédit Agricole Société Générale Groupe BPCE Germany Deutsche Bank 1 Netherlands ING 1 Italy UniCredit 1 Spain Santander 1 Sweden Nordea 1 Switzerland UBS 2 Credit Suisse United Kingdom HSBC 4 Barclays Royal Bank of Scotland Standard Chartered

USA JP Morgan Chase 8 Bank of America Wells Fargo Citigroup Goldman Sachs Morgan Stanley Bank of New York Mellon State Street

TOTAL 23

Source: Financial Stability Board (FSB) THINK ACT 11 Implications of ongoing "Basel IV" debates ABOUT US Roland Berger, founded in 1967, is the only leading global consultancy of German heritage and European origin. With 2,400 employees working from 34 countries, we have successful operations in all major international markets. Our 50 offices are located in the key global business hubs. The consultancy is an independent partnership owned exclusively by 220 Partners.