The Impact of the Basel IV Output Floor on Danish SIFIs

Emil Øllegaard & Magnus Skovbo

Student thesis: Master thesis

Abstract

The upcoming finalisation of the Basel III framework also called Basel IV is expected to have a large impact on the Danish banking sector. This is in contrast to the G20 objective that the Basel IV framework should not bring an extensive increase in the overall capital requirements for banks. This new regulatory reform includes e.g. an output floor that defines a minimum level of capital for different types of portfolios. The purpose of this thesis is to offer a comprehensive analysis of the output floor’s potential impact on the Danish SIFIs. For the assessment of the implementational impact of the output floor, we develop an analytical framework relying on a static balance sheet assumption. We estimate that the out-put floor could result in an average increase of 38.9% in the risk-weighted assets if front-loaded to end-2019 figures. This would lead to an average reduction of 6.2 percentage points in the capital ratios assuming no mitigations. To comply with the minimum capital requirements, we estimate a capital raise of DKK 51bn as a consequence of the output floor. Our estimations show that the significant impact of the output floor stems from heightened risk weights due to the high concentration of low-risk exposures within the credit portfolios of the Danish SIFIs. More specifically, we find that a large proportion of mortgages and low-risk corporate exposures will lead to constraining risk weights for the majority of the SIFIs loan portfolios. We assess that the estimated increase in risk-weighted assets would imply a 2-7.3 bps in-crease in funding costs when including M&M effects and an imposed increase of 7.3-10.5 bps when no M&M effects are included. In addition, we assess that the banks will face in-creasing pressure on profitability which may lead to higher lending rates. These impacts may result in a larger emphasis on high-risk exposures in the hunt for return, an even higher focus on capital efficiency, and a shift to more market-based funding. In addition, we relate our findings to COVID-19 and the new potential challenges due to the current economic landscape.

EducationsMSc in Finance and Investments, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2020
Number of pages134