How the Basel 3 Reform finalization impacts Bank valuation

Banks need to adapt to the Basel 3 Reform in order to maintain profitability and growth and re-think their capital management strategies.

In brief

• Implementation of the Basel 3 Reform changes is a broad and complicated endeavor, representing a considerable investment.
• Banks that manage to optimize their RWA will better mitigate the impact on their profitability and thus their valuations.
• Next to tactical steps on e.g., classification or data management, banks may need to question more fundamentally some aspects of their business model.

There are noticeable differences in firms’ levels of readiness for the Basel 3 Reform changes, i.e. the review and proposed amendments to the capital requirements directive (CRD6) and the capital requirements regulation (CRR3). Larger, more complex firms are typically taking longer to deliver the change and therefore need to start earlier. The implementation itself is a broad and complicated endeavor, representing a considerable investment – particularly for larger firms – as we approach go-live.

Implementing the changes of the Basel 3 Reform will in most cases result into higher capital requirements, which means banks will be less leveraged, thereby leading to improved shock-absorbing capacity but also lower returns. The reform impacts banks' risk-weighted assets (RWA), which is a key determinant of a bank's capital requirement. Banks that manage to optimize their RWA are likely to better mitigate the impact on their profitability versus their peers and thus their valuations.

The impact on a bank valuation due to the Basel 3 Reform will depend upon how each bank manages to adapt to the new regulatory requirements while also maintaining its profitability and growth. Banks will have to develop capital management strategies, which may not only be tactical (e.g., adjust pricing, steer credit production towards or away from certain segments, etc.) but also potentially questioning more fundamentally some aspects of the business model (e.g., move away from business activities that consume the most capital after the Basel 3 Reform).
 

Basel 3 Reform

The Basel 3 Reform is intended to further increase the resilience of banks and the banking system. The implementation is lagging behind the timetable agreed upon in Basel, according to which the reforms were to be phased in over five years, starting from 1 January 2023. In the EU, the co-legislators reached a political agreement on Basel 3 implementation on 27 June 2023, so that the new rules can apply as of 1 January 2025 provided that the legal texts are finalized in time. Although this represents a two-year delay compared to the BCBS timetable (a delay mainly attributable to COVID-19), it is still broadly aligned with progress in other large jurisdictions.

On 26 September 2023, the European Banking Authority (EBA) published the second Basel 3 Monitoring Report which assesses the impact of the full implementation of the Basel 3 Reform on EU banks in 2028. This assessment uses a sample of 157 banks for the point-in-time analysis. Overall, the results of the Basel 3 capital monitoring exercise show that European banks' minimum Tier 1 capital requirement would increase by 12.6% at full implementation. The main contributing factors are the output floor (6.8%) and credit risk (4.3%). These impacts are partially offset by the impact of the leverage ratio which is becoming less constraining under the Basel 3 Reform, evidenced by a decrease of 3.8%, as shown here.
 

Bank valuation

As for other companies, a bank’s valuation is driven by the quality of its balance sheet and its financial performance. Key ratios include Non-Performing Loans (NPL), Loan-to-Deposit (LTD), liquidity, capital adequacy, leverage, Net Interest Income (NII), Cost-income, Return on Equity (ROE), Return on Assets (ROA) and Cost of Risk. However, there are two crucial differences that influence bank valuation compared to industrial companies.

Firstly, free cash flows are estimated differently for banks compared to other industries. The operational activity cannot be easily distinguished from the financing activity, given that debt is a crucial part of the bank’s operations. Moreover, there is no meaningful distinction between current and long-term assets and liabilities allowing for the proper definition of a net working capital. Therefore, free cash flows to the firm are not relevant for banks and EBITDA is not an appropriate valuation driver.

Secondly, banks operate under a regulatory framework that governs how they are capitalized (minimum capital ratios), where they can invest (riskier assets require more capital) and how fast they can grow (constrained by leverage). From a valuation perspective, assumptions about growth are linked to reinvestment assumptions. For banks, these assumptions must be scrutinized since free cash flows to equity are not freely distributable, as the capital requirements must be met at all times. The Basel 3 Reform adds another layer of uncertainty and complexity to this valuation, as changes in the regulatory environment can create material shifts in value.

Banks are commonly valued using a Dividend Discount Model (DDM). The DDM values a bank based on its ability to pay out dividends to capital providers while maintaining a predetermined target capital ratio. Dividends can only be paid after satisfying capital requirements and making all necessary investments in regulatory compliance (thus subject to regulatory changes). The Basel 3 Reform significantly impacts the RWA of Banks and, consequently, the expected distributable dividends and therefore valuation. This comes on top of the significant implementation costs that banks are already facing to support their digital transformation (e.g., reducing branch networks, developing cyber security, enhancing app banking services etc.). At the same time, banks face increasing funding costs as they are required to raise Minimum Required Eligible Liabilities (MREL ) instruments, while facing the competitive environment for mortgages and saving deposits, putting pressure on net interest income.
 

Credit risk

The Basel 3 reform introduces several changes to both the Standardized (SA) and the Internal Ratings Based (IRB) approach. Under IRB, a bank calculates its capital requirements using internally developed models. The reform is expected to result in both increases and decreases of capital requirements depending on the bank’s existing regulatory approaches and portfolio quality. The changes in the final framework aim, among other things, to enhance comparability by aligning definitions and taxonomies between the SA and IRB approaches and to make the SA more risk-sensitive. In particular, the final reform introduces new asset classes or divides the existing ones, and revises the eligibility and/or the scope of the IRB approach for certain asset classes, leading to a reduced use of the IRB approach. 

Two novelties introduced in the reforms are (i) the specific treatment of Income Producing Real Estate (IPRE) mortgage loans to account for the higher risks associated with such exposures, where there is material dependence on the cash flows from the underlying properties , and (ii) the loan-splitting approach. This loan-splitting approach divides mortgage exposures into secured and unsecured. For properties ineligible for loan-splitting, a more risk-sensitive fallback treatment based on the Exposure-to-Value (ETV) ratio will be applied. Both approaches require much more data gathering and processing compared to the current SA approaches. National jurisdictions are allowed to choose either the loan-splitting approach or the whole-loan approach for residential and commercial real estate, although it is currently anticipated that most jurisdictions will opt for the loan-splitting approach.

On the opposite direction, the removal of the IRB approach for ‘equity’ exposures leads to a decrease in the RWA for this exposure class. Under the revised SA framework, the risk weight for ‘equity’ exposures is expected to drop to 250%, from the current risk weight of 370%. This is particularly interesting for banks that currently apply the Danish compromise method to risk weight participations in their insurance undertakings (rather than fully deducting them from equity).
 

Output floor

The introduction of the output floor represents one of the most significant changes under the Basel 3 Reform. It limits the capital benefits for banks using internal models to calculate the regulatory capital across all risk types. The risk-weighted exposures produced by these banks should not fall below 72.5% of the risk-weighted exposures that would apply based on standardized approaches (gradually to be phased-in, starting at 50% in 2025). This would result into an estimated impact of 6.8% on European banks' minimum Tier 1 capital requirement.

The output floor significantly impacts capital consumption of banks using internal models (IRB). However, it also requires two sets of calculations (both under IRB and SA), along with downstream controls and processes. It brings optimization to the top of the agenda while attention shifts from modelling to standardized approaches, and it has several additional implications, e.g., in terms of capital management and pricing. The output floor as a limiting factor asks for the optimization of SA to mitigate impacts, but also brings strategic questions, such as suitable allocation approaches to understand and mitigate the RWA shortfall. As the output floor is only applied to the total RWA amount, banks need to understand clearly not only which products or segments consume more capital to optimize their product mix, but also which contribute most to the difference between the floored SA and the IRB approaches. Banks may need to allocate more capital to certain portfolios, which could further impact their costs, pricing, and profitability. The impact is particularly large for high-quality portfolios (such as prime retail mortgage) which currently benefit from low IRB risk weights. This allows for strategic optimization decisions, i.e., moving away from products or business lines where the discrepancy between the IRB and the floored SA is the highest, or offsetting that discrepancy by growing the part of the portfolio where the difference is more limited.
Market insights confirm that most IRB banks deal with optimizing of SAs. First, banks should review their underwriting criteria, in terms of acceptable collateral, Loan-to-Value (LTV) limits, etc., to reduce the capital consumption under the SA approach. Specifically for Belgian banks, the effect of the output floor is magnified as banks typically also grant mortgage mandates, which don’t qualify as eligible collateral under the standardized approach (EBA Q&A 2019_4721). Additionally, the regulator already discourages Belgian banks from granting loans with high LTVs (NBB circular 2019_27).

Second, under the Basel 3 Reform, banks will have to source new data attributes. While some may opt to make minimum technology updates to meet the new requirements, we view the reform as an opportunity to launch a broader capital technology transformation. RWA calculations depend on data management, modelling, and reporting, all of which could lead to increased RWA and capital requirements if not optimally calculated and deployed. By improving accuracy and processes, banks could lower RWA requirements under either approach. This can be done across all possible dimensions, but credit risk is usually key. Banks should clearly understand their RWA drivers, the evolution over time and the critical data fields, in order to define actions to mitigate the RWA impact (e.g., by correctly registering all collaterals in the system, challenging data quality issues, etc.).
 

A comprehensive multidisciplinary approach

EY offers a comprehensive multidisciplinary approach to help organizations address the impact of Basel 3. Our EY Parthenon Strategy teams and our Risk teams work hand in hand to assess the impact of the Reform and identify optimization levers, and we support implementation with the support of our Data and Technology capabilities. The collaboration with Moody's Analytics enhances this approach, merging EY's business and risk experience with technical solutions for effective implementation and project management.