Deregulation on Horizon for US Financial Institutions

Deregulation is likely to be a significant theme for US financial institutions (FIs), with the Trump administration and Republican leaders in Congress indicating broad support to limit and simplify the regulatory regime, says Fitch Ratings. Fitch does not believe that the Dodd-Frank Act will be repealed in full; however, select provisions are potentially subject to substantial revision.

Determining the aggregate ratings or credit impact of a major deregulation initiative without specific policy proposals would be premature. It remains unclear which, if any, deregulation policies will be the focus of the administration and ultimately be passed.

However, Fitch believes that the Financial Choice Act (FCA), proposed by House Financial Service Committee Chairman Representative Jeb Hensarling, R-TX, in 2016, may serve as a blueprint for some of the changes ahead. The FCA is broad in scope and includes proposals to change FI activities, modify and potentially reduce financial regulators’ authority, limit regulatory burdens for certain FIs, add greater congressional oversight of regulators and propose reform to market infrastructure.

In determining the potential impact of such regulatory changes, both the direct impact of the change and the responses from individual banks will be key in determining the ultimate issuer credit effect. The extent to which the reforms could lead to a reduction or changes to the quality of capital and/or liquidity, or weaken governance, will be particularly important for ratings over time.

Several parts of the FCA target regulatory relief for strongly capitalized and well-managed banks, such as a proposal to exempt banks from many regulations should they exceed a 10% or higher financial leverage ratio. Smaller banks meeting the requirements would most likely benefit. For large global systemically important banks, Fitch estimates that the $400 billion in incremental Tier I capital necessary to achieve the minimum leverage ratio – the calculation would likely be similar to the Basel III supplementary leverage ratio – would outweigh any potential cost benefits of regulatory relief.

Limiting regulatory authority is another key plank of the FCA. The most significant change for the markets would be the proposed restructuring of the Federal Reserve, including how it sets interest rates, as well as its authority as a central bank. The proposed rule also calls for restructuring the Consumer Financial Protection Bureau (CFPB), adding congressional review of financial agency rulemaking and subjecting agencies’ rulemaking to judicial review, among others.

Overall, Fitch believes that such reviews could hamper agencies’ effectiveness and significantly impede their ability to issue new rules, which could have an overall negative effect on the system. Fitch believes that restructuring the CFPB with a Consumer Financial Opportunity Commission, as stipulated in the FCA, would lower compliance costs and reduce potential fines for consumer finance, but lead to weakening control frameworks.

US Protectionism Tops TPP Demise as Threat to APAC Growth

The rising possibility that the US will shift towards trade protectionism – beyond the likely collapse of the Trans-Pacific Partnership (TPP) – has become a credible downside risk to the economic outlook for the Asia-Pacific (APAC) region, says Fitch Ratings.

There is a growing risk that APAC economies will be negatively affected by a US shift toward trade protectionism. President Donald Trump has threatened to label China a currency manipulator and to place large tariffs on Chinese imports, and has criticised the US-Korea FTA. Some Republicans are also pushing for tax reforms that would impose a levy on US imports from all countries. Fitch would expect China to respond with counter-measures including, but not necessarily limited to, tariffs on US imports. A ‘trade war’ would have adverse spillovers for APAC economies, particularly those that are closely connected to regional supply chains and that are most dependent on exports.

We believe this could potentially be more relevant to the APAC economic outlook than US withdrawal from TPP. The TPP, had it been implemented, would have set important foundations for economic integration in APAC, and delivered a significant long-term boost to some economies. That said, US Congressional approval of the TPP was unlikely even before President Trump’s formal withdrawal this week; TPP was not directly factored into Fitch’s baseline growth forecasts or ratings. We also did not view the agreement as a potential game-changer for members’ short-term economic prospects.

The TPP would have lowered tariffs among its 12 member countries. It also aimed to address other wide-ranging barriers to trade by setting rules governing intellectual property rights, business competition policies – including those related to state-owned enterprises and public procurement policies – and labour standards. The TPP therefore had the potential to help drive structural reforms that could have raised productivity and lifted foreign investment in a number of economies, particularly those with weaker business environments.

Various studies suggested that Vietnam would have been among the biggest beneficiaries of TPP. One study by the US-based Peterson Institute estimates that it would have delivered an 8% boost to Vietnam’s GDP by 2030 – relative to the baseline. Malaysia and Singapore were also expected to be significant beneficiaries – because of their export exposure to TPP members – while Japan was expected to benefit from the agreement serving as a catalyst for domestic structural reform, particularly in the agricultural sector, under the third arrow of Abenomics.

Member countries will miss out on potential benefits, but non-participants will be spared the potentially damaging effects that could have ensued from trade and investment being diverted to TPP participants. China, Indonesia, the Philippines and Thailand were notable non-participants in APAC, although some may have come under pressure to join later on (Indonesia had recently signalled an eagerness to join at TPP’s outset).

China is pushing its own Regional Comprehensive Economic Partnership (RCEP) as an alternative to the TPP. However, of the other participants – ASEAN, Japan, India and Korea – ASEAN and Korea already have free trade agreements (FTA) with China. Moreover, with its narrow focus on tariffs, the RCEP is unlikely to be the catalyst for structural reform that TPP could have been. Furthermore, it is unclear to what extent RCEP, without the participation of the US and its strong import demand, can replicate the same boost to regional economic growth prospects that was expected under TPP.

Chinese banks to issue more bad loan-backed securities in 2017: Fitch

From South China Morning Post

China may permit more commercial banks to sell bad loan-backed securities in 2017 to help lenders cope with surging sour loans and deepening economic slowdown, according to global ratings agency Fitch Ratings.

Under the government’s regulatory support, China’s nascent structured finance market has seen a strong growth in 2016, with the total issuance of asset-backed securities up 42 per cent year-on-year to 865 billion yuan (HK$975.9 billion), according to recent statistics from Fitch.

Asset-backed securities are bonds or notes backed by financial assets, including loans, leases, company receivables etc. China’s asset-backed securities market was restarted in 2012 after three years of suspension. After a flattish start in 2012 and 2013, it gained strong momentum in 2014 and has expanded at a rapid pace since then.

In 2016, six Chinese commercial banks become pilot banks for issue of asset-backed securities products backed by non-performing loans, with a total quota of 50 billion yuan. These banks include the Industrial and Commercial Bank of China, China Construction Bank, Bank of China, Agricultural Bank of China, Bank of Communications, and China Merchants Bank.

The six pilot banks issued a combined 15.6 billion yuan of non-performing loans’ asset-backed securities products in 2016, according to recent data from China Government Securities Depository Trust & Clearing Company.

“We expect further issuances in 2017,” said Hilary Tan, director of Non-Japan Asia Structured Finance for Fitch Ratings.

Tan said the government is likely to expand approval to more commercial banks to help them deal with rising bad loans.

The bad debt ratio of Chinese banks has risen to 1.81 per cent by the end of 2016, the highest since the second quarter of 2009, according to recent data from the China Banking Regulatory Commission, the China’s banking regulator.

Statistics from Fitch also showed that 53 per cent of the asset-backed securities issuance in 2016 was under the asset-backed specific plan, regulated by the China Securities Regulatory Commission. These asset-backed specific plan products reached 459 billion yuan, representing a 134 per cent year-on-year increase.

About 45 per cent of the total issuance was under the credit asset securitization scheme, governed by the People’s Bank of China and China’s banking regulator. These issued credit asset securitization scheme products reached 391 billion yuan in 2016, slightly down 5 per cent year-on-year.

Fitch said the asset-backed specific plan attracted more corporate issuers due to the diversified underlying asset-classes it issued in the bond exchange market.

Fitch puts Australian banks on negative watch

From Business Insider.

Fitch Ratings has revised its outlook on Australia’s banking for 2017 to negative from stable.

In its 2017 outlook report, the agency says the change reflects an increase in macroeconomic risks and pressure on profit growth.

The change follows Moody’s which in August last year changed the outlook for the banking system in Australia to negative from stable.

Profits at Australia’s banks are under pressure. The combined cash profits of the big four banks didn’t make last year’s record $30 billion.

Fitch now says Australia’s household debt is high and rising relative to disposable incomes, making borrowers sensitive to changes in the labour market and interest rates.

“Profit growth is likely to continue to slow in 2017, reflecting low interest rates, slow asset growth, competition for assets and deposits, higher funding costs, and a rise in loan-impairment charges,” Fitch says.

Fitch expects improvements in cost management to be offset by increased investment in technology.

The agency says the ongoing rise in household debt and house-price growth heightens the banking system’s sensitivities to a sharp correction if labour market conditions and interest rates changed.

“In addition, a worse-than-expected slowdown in China’s growth would negatively impact Australia’s economy given the countries’ strong economic ties,” the agency says.

“These scenarios — although not our base case — could jeopardise the banks’ strong asset quality and profitability, and weaken capitalisation.

“A prolonged global funding market disruption could place significant pressure on the banks’ balance sheets despite the improvements in liquidity.”

Standard and Poor’s in July last last year placed Australia’s sovereign rating on credit watch negative from its previously stable outlook.

EU Covered Bond Liquidity Buffer Could Be Rating Positive

Fitch Ratings says the introduction of liquidity buffers as recommended by the European Banking Authority (EBA) could in some cases increase the difference between the Issuer Default Rating (IDR) and covered bond rating determined by Fitch.

The potential for rating upgrades would apply to legislative covered bonds secured by standard assets such as mortgages and public sector exposures issued in jurisdictions with no mandatory liquidity protection such as Austria, Slovakia and Spain.

The proposed liquidity buffer forms part of step one of the EBA’s three-step recommendations on harmonisation of covered bonds frameworks in the European Union, published in December. Step one aims to provide a definition of covered bonds for regulatory recognition.

While many covered bonds include liquidity protection, requiring it as a basic feature would mark a departure from the historical concept of this type of secured bank debt. Without liquidity buffers, investor protection primarily rests on the prospect of higher recoveries from the segregated cover pool if an issuer defaults. Adding liquidity protection may also lower the probability of default on a covered bond relative to that of the issuing institution. This would depend on the length of the protection, and whether alternative refinancing can be found during this time at a cost which can be met through over-collateralisation.

The EBA proposes a buffer of liquid assets covering net outflows between cover assets and covered bonds at least over the next 180 days following an issuer default. It does not distinguish between interest and principal payments. The same timeframe would apply irrespective of the cover asset type. The proposed minimum protection of 180 days is less than the market standard for mortgage programmes, which is a 12-month extension. Fitch does not expect legislation or programmes with longer liquidity protection mechanisms to revert to the proposed minimum, and as a result we do not expect negative rating impact.

Unlike the EBA recommendation, Fitch differentiates between interest and principal payment interruption risk. For interest payments, Fitch expects at least three-month coverage on a rolling basis plus a buffer for senior expenses to assign rating uplifts for payment continuity of four or more notches. Fitch generally expects this protection to be provided on a gross basis, ie disregarding scheduled incoming cash flows. This is to mitigate disruption stemming from operational hurdles such as redirecting cash flows or setting up alternative management after an issuer default.

Regarding principal payments, the recommended six-month protection would be eligible for a maximum five notch payment continuity uplift if the cover pool consists of public sector exposure in developed banking markets, and a lower uplift of three or four notches if the cover pool consists of residential or commercial real estate mortgage loans in developed banking markets. A six-month protection is unlikely to lead to any payment continuity uplift for programmes secured by ship mortgages or aircraft financing, as Fitch views these asset classes as too illiquid, and a limited number of programmes offer an alternative refinancing option.

The EBA’s recommended definition of liquid assets is slightly wider than Fitch’s, in particular regarding LCR Level2A assets. In our programme analysis, we take the respective definition of liquid assets into account and may reduce payment continuity uplift if the discrepancy to our criteria is material. However, we expect this to be the case for a limited number of programmes, as we generally see liquid assets defined as cash in combination with an account bank replacement provision.

Fitch says Australia’s public debt likely to peak later – and higher

Australia’s public debt ratios are likely to peak later – and at a higher level – than previously expected by the government and Fitch Ratings as the economic outlook weakens. However, the debt trajectory remains consistent with our ‘AAA’/Stable sovereign rating on Australia, most recently affirmed in September.

The government increased its budget deficit forecasts for the underlying cash balance by a cumulative AUD10.3bn (0.6% of GDP) for the next four years, largely owing to lower expectations for real GDP growth and wage inflation, according to its Mid-Year Economic and Fiscal Outlook (MYEFO), released on Monday. It also projected gross and net debt ratios would peak in FY19 (12 months to end-June), a year later than forecasted six months ago in the 2017 budget. That said, revisions were smaller than those that have been made in recent years, mainly in response to sharp falls in commodity prices.

Fitch still expects the government to reduce its deficit at a slower rate than official forecasts. The MYEFO abandons the practice of assuming commodity prices will remain at recent averages; instead, it factors in a steady decline from current levels, though using price assumptions that are still higher than our own. We also believe the government will find it hard to deliver on hitherto unlegislated spending cuts assumed in the MYEFO, worth a cumulative AUD13.2bn (0.8% of GDP) by FY20, given that the coalition government lacks a majority in the Senate. The government has made some progress on budget repair through the legislature since the July election, saving AUD6.3bn in the Omnibus Savings Bill and raising AUD4.7bn in revenues through increasing tobacco excise. However, forming a political consensus over the remaining measures will be considerably more challenging.

General government debt is now likely to peak at a level slightly higher than the 40.4% of GDP that we forecast for FY18 at the time of our September review. This would still be broadly in line with the median public debt/GDP ratio for ‘AAA’-rated sovereigns, of 42%. However, the deterioration since 2007 – when general government debt was less than 10% of GDP – has eroded the sovereign’s buffer against shocks. A housing market downturn or another slowdown in the global economy, for example, could weigh on Australia’s rating if it resulted in further significant deterioration in public finances.

Australia’s fiscal outlook is sensitive to economic performance, a risk highlighted by the -0.5% qoq fall in Australia’s GDP in 3Q16, the first contraction in five years. Some of the factors behind the decline are likely to prove temporary – public investment fell sharply after a strong second quarter, construction activity was hampered by poor weather, and coal-mine disruption held back exports. Furthermore, the drag from falling mining investment should continue to fade in coming quarters, while real exports will be boosted by LNG projects reaching the production stage. However, last quarter’s data also showed a slowdown in consumer spending growth – in keeping with subdued wage gains – and continued weakness in non-mining investment. Fitch had previously expected the economy to expand 2.9% in 2016 and 2017, but those forecasts now face a higher risk of downside adjustments

Fed Rate Increase Heralds a Step Up in Normalization

The US Federal Reserve’s decision to increase interest rates heralds a more rapid normalisation of US monetary policy in 2017 and 2018, Fitch Ratings says. A changing macroeconomic and policy backdrop means that the Fed is less likely to delay further increases, although it will still move gradually by historical standards, and its monetary stance remains loose.

The Fed’s decision to raise the target range of the Federal Funds rate by 25 bp to 0.5%-0.75% comes one year after it began normalisation at the end of 2015. Our latest forecast is for two 25 bp hikes next year but there are risks of a faster pace of increase. US core inflation is now above 2% by some measures, wage inflation has picked up over the last 18 months, and unit labour cost growth has remained steadily above 2%. Unemployment is below most measures of the natural rate and this seems to be garnering greater attention in the Fed’s thinking.

Moreover, US growth is less likely to disappoint as it did in 1H16, thanks to a pick-up in private sector investment growth, tighter labour market conditions supporting consumption, and the short-term boost from the incoming Trump administration’s planned tax cuts. The President-elect’s proposals are unlikely to be enacted in full, but Fitch assumed a fiscal stimulus of 0.5%-0.75% of GDP in our November Global Economic Outlook. This saw us revise our US real GDP growth forecasts to 2.2% in 2017 and 2.3% in 2018, up from our pre-election forecasts of 2.0% and 2.2%.

More expensive funding costs and a stronger dollar could counteract fiscal stimulus to some extent. The prospect of Fed hikes and reflationary US economic policy, combined with rising oil prices, have already pushed longer-term market rates sharply higher (10-year US treasury yields are around 2.5%, from around 1.8% in the run-up to the US election), but the still gradual Fed tightening that we forecast does not pose a risk to economic expansion. Policy rates are still low relative to growth and inflation prospects and sovereign borrowing costs remain low.

Possible triggers for faster Fed normalisation might include a bigger fiscal stimulus with a greater focus on public infrastructure than we currently anticipate and further accelerations in wage growth. In addition, the effect of fiscal stimulus on US inflation would be magnified if Trump were to follow through on promises to restrict imports from Mexico and China, but the timing and scope of any such measures are unpredictable and are not incorporated in our US GDP or interest rate forecasts.

The shifting US fiscal backdrop to the Fed decision illustrates how central banks will no longer constitute the only source of macro policy stimulus in 2017. Easier fiscal policy is one reason we expect global growth to pick up in 2017 (to 2.9%, from 2.5% this year).

But the interplay of US economic, fiscal and monetary policy may create global challenges. The prospect of US rate rises has led to periodic bouts of financial market volatility in recent years. With the ECB and BOJ still pursuing ultra-loose monetary policy, Fed normalisation is likely to extend the current period of dollar strength. This could be positive for other advanced economies but may increase the cost or reduce the availability of external funding for some emerging markets. A stronger dollar and relative EM currency weakness are reasons why EM sovereign rating pressure looks likely to continue in 2017.

Fitch On China’s Banking Sector

Fitch Ratings’ outlook for the Chinese banking sector in 2017 is negative,  as weak profitability and strong credit growth will keep capitalisation under pressure. High and rising leverage in the corporate sector remains a key risk facing China’s banks.

hk-china-pic

China’s debt-resolution timeline is being pushed back by measures to lessen the debt burden on corporate borrowers – including low interest rates, loan rollovers, debt-for-equity swaps and a loosening of prudential controls. Leverage will continue to increase, especially at the corporate level, as long as there is reliance on credit to support GDP growth targets. We have revised up our estimates for growth in leverage, with Fitch-adjusted total social financing/GDP now likely to reach 258% by end-2016 and 274% by end-2017.

The authorities’ attempt to boost household lending may help to diversify risks. Household lending is relatively safe compared with corporate lending – given low LTV for mortgages, low household leverage and a high savings rate. However, rapid mortgage growth is driving sharp increases in residential property prices, and has the potential to fuel a further increase in corporate leverage since corporate borrowers use real estate as collateral to secure lending. Furthermore, policy guidance for banks to extend lending to struggling borrowers in over-capacity sectors also weighs on the banks’ risk-management and governance.

Fitch expects NPL and ‘special mention’ loan ratios to continue rising in 2017. Bank profitability will remain lacklustre and under pressure, owing to another likely cut in the benchmark one-year lending rate and further migration of deposits toward wealth management products (WMPs). WMPs now account for 17% of system deposits, and are a source of funding and liquidity risks for the banking sector.

Our forecast of flat profit growth and a double-digit increase in risk-weighted assets suggests that capitalisation will remain under pressure. The amount of announced AT1 and T2 issuance is not enough to keep pace with banks’ balance-sheet expansion, while equity-raising will be difficult in light of falling ROEs and questions over China’s medium-term growth.

Fitch’s previous research estimates that a one-off resolution of the debt problem would currently result in a capital shortfall of CNY7.4trn-13.6trn (USD1.1trn-2.1trn) – equivalent to around 11%-20% of GDP. The capital gap could rise further if current rates of inefficient credit are sustained and no additional capital is raised.

The Viability Ratings (VRs) of Chinese banks range from ‘bb’ to ‘b’, which reflects Fitch’s base case of varying-but-significant risks to capital and asset quality. These risks will linger unless there is a shift to a more stable operating environment, characterised by slower credit growth and higher loss-absorption buffers. Fitch’s stable rating outlook reflects our expectation of state support, which remains the sole rating driver for Chinese bank IDRs. More corporate debt is ultimately likely to migrate towards the sovereign balance sheet beyond the local government swap programme.

 

Political Risk Looms Large for Global Sovereigns in 2017

Global sovereigns face elevated levels of political risk and uncertainty in 2017, says Fitch Ratings, embodied by the unexpected election of President-elect Donald Trump in the US and the UK’s Brexit vote in June.

panic-pic

These risks are reflected in a trend away from political orthodoxy that reduces the predictability of policy direction in advanced countries in 2017. Combined with a general trend towards looser fiscal policy and greater trade protectionism, this carries risks to sovereign creditworthiness among both advanced economies and emerging markets (EM), although the overall outlook for Fitch’s sovereign ratings in 2017 is stable.

While the large majority (82 of 114) of Fitch’s sovereign ratings retain Stable Outlooks as we head into 2017, risks are clearly tilted to the downside, given the distribution of 25 Negative and only three Positive Outlooks. The threat of increased trade protectionism and a stronger dollar will maintain downward pressure on EM sovereigns’ macroeconomic performance and ratings, with 20 remaining on Negative Outlook as we move towards year-end. Key EM sovereign rating sensitivities will include the extent to which policy responses can mitigate the negative effects of subdued commodity prices, weaker trade flows and the potential for renewed dollar strength.

Fitch expects global GDP growth to increase to 2.9% in 2017, from 2.5% in 2016, driven largely by a pick-up in the US combined with a cyclical recovery in some of the largest EMs, which should more than offset continuing weakness in the eurozone and Japan. Our forecast of an acceleration in 2017 US growth to 2.2%, from 1.5%, reflects partly our assessment of the impact of President-elect Trump’s proposed reflationary policies, including corporate and personal income tax cuts combined with a focus on infrastructure investment. We expect this fiscal stimulus (totalling 0.5-0.75% of GDP) to produce a near-term boost to growth, but the president-elect’s rhetoric on trade policy increases downside risks to growth in the medium term.

Following the seismic political shocks of 2016, Fitch expects political risk to remain a key issue for sovereign creditworthiness in advanced economies in 2017, posing risks to medium-term economic growth prospects that would likely be negative for sovereign ratings. Euroscepticism and populism could affect European cohesion in the coming months, with the Italian constitutional referendum in early December to be followed by Dutch, French and German national elections in 2017. Any further significant political shocks triggered by electoral events in Europe could prove hugely damaging for the European project, although such a scenario is not Fitch’s base case.

With advanced economies failing to regain pre-crisis growth rates, the debate on global macroeconomic policy has shifted, with commentators, policy-makers and supranational institutions all calling for a move towards fiscal loosening and away from the reliance on ultra-loose monetary policy that has become the cornerstone of macro policy in recent years. This shift in policy emphasis is likely to be led by the US in view of the proposed reflationary domestic policy agenda and the prospects for higher interest rates. While it is likely to provide a near-term boost to growth, the fiscal impact of the Trump plan would likely be negative for US sovereign creditworthiness over the medium term, as tax cuts alone cannot generate enough growth to make up for the loss in revenue, leading to a deterioration in debt dynamics.

In Europe, fiscal loosening is already being pursued to some extent as austerity fatigue and a focus on political issues such as Brexit, the migrant crisis and security concerns have diverted attention away from fiscal consolidation. This has manifested itself in many eurozone governments moving away from a strict interpretation of the European fiscal rules, typically without sanction by the European Commission. This is likely to be growth-supportive in the near term but further undermines fiscal credibility. High public debt ratios remain one of the key rating weaknesses for western European sovereigns, meaning that few have material fiscal space within their existing rating categories.

Economic recovery in the largest EM countries should gain momentum in 2017 as crises in Brazil and Russia ease. Meanwhile, we expect the slowdown in China’s growth rate to continue on a gradual path, reducing to 6.4% in 2017 from 6.7% in 2016. In Fitch’s view, China will remain committed to its growth target of approximately 6.5%, particularly given the political transition of five of the seven members of the Politburo Standing Committee scheduled for 2H17.

The threat of less open trade relationships between the US and key trading partners, including China, combined with a stronger dollar would be generally negative for EM countries, and particularly so for smaller open economies. A “trade war” between the US and China would have adverse consequences for GDP growth and inflation in both countries, and could lead to depreciation of the RMB and financial market risk aversion, which would likely spill over to other emerging markets.

Basel IV Proposals May Lead to EU/US Divergence

Basel Committee discussions on “Basel IV” at the end of November may expose deep divisions between national members and could lead to further differentiation between the EU and internationally agreed Basel standards, Fitch Ratings says. This would exacerbate challenges for market participants attempting to compare the capital strength of banks globally and could undermine confidence in a framework aimed at promoting a level playing field.

risk-pic-2

The latest Basel III amendments (sometimes referred to as “Basel IV”) seek to restrict the use of internal risk models, which are associated with wide divergences in risk-weighted measures, and potentially set overall capital requirements using the revised standardised approaches. EU politicians have expressed significant concerns in their parliamentary submissions ahead of a vote on the EU’s finalisation of Basel III on 24 November. Meanwhile, regulators such as Thomas Hoenig of the US FDIC recently warned against the dilution of the reforms and support tougher equity-based requirements.

If enacted the proposals are likely to increase capital requirements for lower risk-weight portfolios, such as mortgage loans, despite the committee’s intention not to significantly raise capital requirements for banks globally. European banks generally hold larger mortgage portfolios and would be more affected. EU regulators seek to balance the economic consequence of any increase in capital requirements against the challenges banks face to boost capital internally in light of negative yields and low growth prospects. EU lawmakers say they are aiming for “global standards with local calibration”.

In contrast, US banks would be less affected as they typically sell their mortgage loans to US government agencies and larger firms already hold capital on the higher of the standardised and internal ratings-based (IRB) approaches. US supervisors also might be more willing to set higher capital standards due to the more supportive operating environment and lower reliance on loan-based finance than the EU.

These tensions are likely to be reflected in two key areas in the 28-29 November Basel discussions. The proposal for a capital floor based on a certain percentage of the standardised approaches has the greatest potential for EU divergence. Whether the committee sets an overall floor or one for each risk category is important. EU lawmakers have publicly protested that a floor would severely punish stable banks focused on traditional low-risk lending, while banks with higher-risk assets would be less affected. The impact on European mortgage banks may be a key consideration here as residential mortgage loans are potentially most vulnerable, especially if a permanent capital floor were to be applied on a risk-category basis.

We believe outright elimination of internal ratings models for certain credit exposures is unlikely. The speech by Stefan Ingves, chair of the Basel Committee on 10 November did not mention this. EU lawmakers are concerned about the impact on credit flow to the real economy and have argued that working to enhance trust in IRB models is preferable to abandoning them for portfolios such as large corporates. We believe there would be a generous transitional phase-out period even if the committee does move away from using models for these portfolios.

We think it is more likely that specific constraints will be introduced to reduce risk-weight variability, as proposed for modelling mid-sized corporate and retail exposures, and to ensure a minimum level of conservatism, for example through the introduction of specific loss given default floors in models for residential and commercial real estate exposures. But other measures, such as a model floor for unconditionally cancellable commitments, which may effectively increase capital charges for these exposures, face opposition from both sides of the Atlantic due to concerns it would constrain banks’ lending capacity.