How is the new Basel IV framework going to impact banks? In this article we will discuss how Basel IV will affect banks’ risk-weighted assets (RWA) and capital requirements. In addition, we will explore the use of Significant Risk Transfer (SRT) transactions, particularly synthetic securitizations, as a mechanism for banks to manage their balance sheets more actively.
Finally, we will discuss the treatment of synthetic excess spread (SES) and how recent updates from the European Banking Authority (EBA) have lowered the exposure value of SES, making synthetic transactions more attractive for banks.
Impact of Basel IV on banks’ RWA
The Basel Committee on Banking Supervision (BCBS) set January 1, 2023 as a global deadline for “Basel IV”. However, the actual implementation timeline varies based on local jurisdiction. In the European Union, a phased approach has been set, which requires banks to adapt progressively to the new framework between 2025 and 2030.
One of the biggest impacts the new framework is expected to have is represented by the so-called output floor that will limit the benefit of the internal rating model (IRB). Banks’ RWA calculated with IRB will have a floor of (i.e. can not be lower than) 72.5% of the capital requirement that would have been calculated under the Standardized Approach (SA).
The impact on this is huge as banks using IRB methodologies benefit from reduction in RWA (compared to SA peers) that can range from 50 to 80% which removal would increase the Tier 1 capital requirement for EU banks by some 14%, based on their lending books as of the end of 2020. Based on an assessment made by the EBA the impact on European banks total capital will be north of €120bn.
How Banks can use Significant Risk Transfer transactions to manage their balance sheets
Increasing capital requirements will therefore push banks to manage their balance sheet more actively, selling or transferring risk through various mechanisms, among which a lion’s share is expected to be represented by Significant Risk Transfer (SRT) transactions.
After being in the spotlight for many regulators, the shadows on SRT are progressively fading away and they are becoming more and more accepted. This has been proven by the possibility of labeling synthetic securitizations as simple, transparent and standardized (STS) as per Capital Markets Recovery Package implying lower capital absorption for banks.
Synthetic securitizations do not imply a transfer of assets while providing protection on the bank risk, therefore allowing a reduction in RWA allocated to e.g. loans and mortgages, enabling the same benefit of a traditional securitization but with lower costs and less operational overheads.
Until very recently one of the main pieces of legislation representing an obstacle to the development of synthetic transactions has been represented by the treatment of the so-called synthetic excess spread.
Synthetic Excess Spread
A synthetic excess spread (SES) is an amount that is contractually designated by the originator to absorb potential losses of the securitised exposures in a synthetic securitisation. The SES acts as credit enhancement and can be considered a form of insurance for investors, as it provides a cushion against potential losses on the underlying assets.
The SES is typically generated from the excess spread of the transaction, which is the difference between the income generated by the securitized assets and the cost of funding the transaction. SES is then used to reduce the payments that investors in synthetic securitizations have to make in case of default, therefore lowering their risk and ensuring the originator maintains skin in the game.
In order to avoid the use of SES to obtain a so-called regulatory arbitrage (1), CRR considers it as a securitization position for the originator has to allocate regulatory capital. Such a treatment was considered excessively punitive by the market and potentially meaning the cost of synthetic transactions becoming unsustainable.
RTS on the calculation of the components that should be included in the exposure value of SES
EBA has recently further sweetened the cost of SRT for banks. On Apr 24, 2023 the European Banking Authority released draft regulatory technical standards (RTS) that lower the exposure value of Synthetic Excess Spread. The draft RTS specifies the calculation of the components that should be included in the exposure value of SES, taking into account the relevant losses expected to be covered by SES.
Reference to relevant expected losses substantially exempts anything already received up to one year of expected losses, while including anything above that level.
Although the approach of EBA still remains conservative, the foregoing updates – which were well received by market participants – demonstrate that the regulator is getting more and more comfortable with synthetic transactions.
Conclusion and Key Takeaways
In conclusion, Basel IV represents a significant change for banks and their operations. The new framework’s output floor will limit the benefits of internal rating models, requiring banks to manage their balance sheets more actively and transfer risk through mechanisms such as Significant Risk Transfer transactions.
Synthetic securitizations have emerged as an effective way for banks to achieve this goal, and recent updates from the EBA have made them more attractive to market participants. While the regulatory environment for synthetic transactions is still evolving, the updates from the EBA suggest that regulators are becoming more comfortable with these instruments.
Overall, Basel IV and its impact on the banking industry will continue to be an important topic for the following years.
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(1) – Regulation (EU) 2021/558 explains that the regulatory arbitrage ‘occurs when an originator institution provides credit enhancement to the securitization positions held by protection providers by contractually designating certain amounts to cover losses of the securitized exposures during the life of the transaction, and such amounts, which encumber the originator institution’s income statement in a manner similar to an unfunded guarantee, are not risk-weighted’.