Growing investment opportunities amid bank deleveraging trend

The Basel III Endgame

Debate over the Basel “Endgame” rules have racked up column inches over recent months (and years) and are set to have far-reaching implications for banks in the EU, UK, and particularly the US – with the proposed US Endgame rules more punitive than the European proposals if implemented in their current form.

The Endgame represents the final phase of Basel III requirements (also known as “Basel IV”), with European regulators having agreed the additional capital rules in 2017 as part of the overarching Basel III Framework developed in response to the Global Financial Crisis (GFC). Most large European banks have increased their common equity Tier 1 (CET1) ratios since 2017 and the bloc’s biggest banks appear well positioned to navigate the implementation of the final reforms.

Although Basel has a 2028 deadline for implementation, the rules are set to be rolled out in the EU from 1 January 2025 (and from 1 July 2025 in the UK and the US), the phase-in period runs until 1 Jan 2030. While this seems a long time away the impact of the final reforms is already prompting many banks to rethink capital allocation and focus on optimising their balance sheets to adapt to major risk-weighted asset (RWA) calculation changes. As a reminder, “risk-weighted assets” measure how much capital banks need to hold against the risks they are taking.

One of the key developments of Basel IV is the introduction of an ‘output floor’ – a measure that limits banks’ use of internal models to assess the riskiness of their assets – which is expected to push up capital consumption especially for large banks. It will become more expensive for banks to keep high-quality residential mortgages and unrated corporate loans on their balance sheets once the risk weighting floors are phased in. The risk weighting of mortgages is therefore set to increase five-fold compared to Basel III¹, for example. Under current regulations, many banks have used internal modelling, rather than standardised modelling, to keep lower risk weights on such loans given their historically low default rates.

Few alternatives to asset sales and risk-sharing transactions

Over the years so-called ‘risk-sharing’ regulatory capital solutions, like Significant Risk Transfer (SRT) transactions, and core asset/portfolio sales have emerged as critical tools in enabling banks, particularly European banks, to sell junior risk (or buy protection in the case of SRT) on portfolios to address regulatory capital issues, optimise their balance sheets and boost profitability in the context of ever-growing regulatory capital requirements brought in following the GFC.

Significant Risk Transfer: SRT transactions effectively help banks to manage their RWA exposures by transferring the credit risk on a portfolio of assets to third-party investors either via a true sale securitisation or a synthetic transaction so that they obtain regulatory capital relief on that portfolio, while allowing banks to keep the loans on-balance sheet and maintain key customer relationships.

Asset/portfolio sales: With these transactions, banks are typically looking for risk limit headroom or to increase their ‘capital velocity’ and are increasingly selling whole pools of typically seasoned, and performing loans to selected institutional investors – while still servicing the loan assets for a fee and maintaining relationships with end-consumers. Structuring for full asset derecognition and/or regulatory capital relief may be the preferred solution for certain asset types that are more capital-intensive from a regulatory standpoint or where portfolio sales arise as part of a lender’s strategic pullback/exit from certain markets or geographies that are no longer core to them. These asset-backed transactions tend to be labelled as ‘Specialty Finance’ transactions or form a core part of the growing ‘Asset-Backed Finance (ABF)’ complex.

In both instances, securitisations are executed mostly privately owing to the higher barriers to entry (largely self-imposed) and inherent complexity involved in these transactions, particularly in Europe. In these markets, premiums have remained for structuring, complexity and illiquidity together with less competition for assets which has created a clear supply and demand imbalance.