The Dutch banks will meet the new requirements in good time
The framework will increase the capital requirements for the Dutch major banks. Given their strong capital and profit positions, they are expected to be able to comply with these tightened requirements in good time. The new requirements will be phased in during an extensive transition period. On a global scale, the framework will contribute to a more level playing field and improve the banks' resilience to shocks.
Level playing field
The Basel Committee, the international forum of banking supervisors, has been responsible for setting global standards for capital requirements for banks since 1974. In the wake of the financial crisis, the 2010 Basel III accord laid down agreements about an overall increase of the amount and quality of the capital that banks are required to hold.
These agreements were soon found in need of review due to deficiencies in the calculation method for risk-weighted assets – the banks' exposures adjusted for risks, for which they are required to hold capital. The deficiencies mainly related to the internal models used by large banks to calculate their risk-weighted assets and capital ratios. The Committee believes that banks have had too much leeway in calculating their ratios.
The Committee also proposes to review the Standardised Approach, a model for calculating risk-weighted assets prescribed by the supervisory authorities which is mainly used by smaller banks. The revised Standardised Approach model should better reflect the actual risks that banks are exposed to. By more accurately defining the rules for risk-weighting in both the Standardised Approach and the internal models method, the banks' capital ratios will become more mutually comparable – creating a more level playing field at a global scale.
Review of internal models
The most important changes for the major Dutch banks involve the tightened rules for the internal models method. The new accord sets stricter rules for risks that are more difficult to quantify. For example, it will no longer be permitted to use internal models for operational risk (i.e. losses due to internal process deficiencies, human errors, system faults or external events). A standardised approach will have to be applied instead. For credit risk, banks will have to apply standardised probability of default (PD) ratios and loss given default (LGD) percentages if insufficient data are available to accurately estimate risks. In other cases, floors have been set for the internal PD and LGD estimates.
With regard to internal models the rules are tightened even further, with two additional backstops that are to be applied to the risk-weighted capital requirements. The largest banks (globally significant banks or G-SIBS) will be subject to a higher leverage ratio requirement in the form of an add-on on top of the current 3% international standard. Moreover, an output floor for capital requirements will be set for banks: when applying the internal models method, the banks' capital requirements may never fall below 72.5% of the capital requirements under the Standardised Approach. This further limits the risk of banks being overly optimistic in estimating their capital requirements.
The new framework is expected to significantly increase the capital requirement for the Dutch major banks, which will have to strengthen their capital in order to meet the new requirement. The main reason for the increased requirement is the introduction of the output floor. The impact of this output floor is substantial, due to the size of the Dutch banks' mortgage portfolios. The Basel Standardised Approach leads to a significantly higher risk weighting compared to the internal models method, the outcomes of which are based on the structurally low losses on Dutch mortgage portfolios.
On the whole, the capital requirements for smaller banks remain virtually the same, although for individual banks the impact can be significant – upward as well as downward. Most smaller banks apply the Standardised Approach rather than the internal models method. The main changes for smaller banks involve the requirements related to the risk-weighting of mortgages, for which a loan splitting system is introduced. Mortgages are split into a covered and an uncovered component. A lower risk-weighting is applied to the covered component – with a loan-to-value (LTV) ratio of up to 55% – while a higher risk-weighting is applied to the remaining uncovered component. The loan splitting system better reflects the underlying risk attached to mortgages, which strongly depends on the ratio between the amount of the loan and the value of the underlying collateral.
Time to prepare
The Dutch major banks have had sufficient time to prepare for the tightened capital requirements. As early as 2015, DNB urged the banks to factor in higher requirements (see ‘Banks must factor in higher mortgage capital requirements). And in 2016, the banks participated in a Quantitative Impact Study analysing the impact of the Basel Committee's proposals.
In the Basel Committee, DNB has argued in favour of improving banks' resilience while maintaining the capital framework's risk sensitivity. Compared to the proposals that were put up for market consultation in 2015, the impact of the new framework is markedly lower. In addition, the banks have been given an extensive transitional period (until 2027) to implement the necessary changes into their operational management.
Given the Dutch banks' strong capital and profit positions, we expect them to be able to comply with the new requirements by means of profit retention until 2027. The impact on lending and economic growth depends on the banks' behavioural responses. The Basel agreements also affect the minimum requirement for own funds and eligible liabilities (MREL) that is eligible for bail-in, since this is a percentage of risk-weighted assets, just like the capital requirements. This is still the subject of debate at European level.
The new framework provides for global standards that will be incorporated into legislation. For the Netherlands, this will be done within the European Union, based on a European Commission proposal. This process is expected to take several years.