Why German Banks Took Stand Against Basel Capital Floors

Updated on
  • Deutsche Bank, Commerzbank would be among most affected
  • ‘Setting floors is not the right way,’ says one lobbyist

The twin tower skyscraper headquarter offices of Deutsche Bank AG, right, stand at dusk in Frankfurt.

Photographer: Alex Kraus/Bloomberg/Bloomberg

No wonder Germany is on the warpath against a proposed global standard for how banks calculate the capital they need: Its largest lenders rank among the worst when it comes to how they assess risk.

That means Deutsche Bank AG and Commerzbank AG will be affected more than most big lenders and may have to raise additional capital, if and when the Basel Committee on Banking Supervision implements a proposed floor for how much their risk-weighting of assets can veer from standardized measures. By Deutsche Bank’s own calculations, its risk-weighted assets equal just 28 percent of its balance sheet, compared with 50 percent for the six largest U.S. banks, according to data compiled by Bloomberg.

German banks say that’s because their assets are less risky, a view supported by members of the country’s central bank. But U.S. regulators and a group of economists advising the German government say European firms have gamed the system for too long and that needs to end. The Basel committee has published studies showing that the variation in risk weightings by banks can’t be explained by differences in portfolios alone.

While a final compromise was expected by Jan. 8, when the committee’s top management was scheduled to meet, Germany’s public opposition to the proposed floor and other European countries’ less conspicuous lobbying forced a delay. The meeting will be postponed until the group reaches consensus on “final calibration,” the committee said Tuesday in statement, saying it expects to complete the work “in the near future.”

“While there’s some inappropriate variation in risk weighting, setting floors is not the right way to get rid of that,” said Dirk Jaeger, a management board member at the Association of German Banks, a lobbying group in Berlin. “Because that will also eliminate the appropriate variation between the risks banks face. A mortgage in Germany isn’t as risky as a mortgage in some other country, where it takes many more years to foreclose on a house.”

Spokesmen for Deutsche Bank and Commerzbank, Germany’s two largest lenders, declined to comment. Deutsche Bank executives have publicly voiced objections similar to Jaeger’s.

Standard Weightings

The proposed floors would be calculated based on standard risk weightings determined by regulators. An AAA-rated corporate bond is assigned a certain weighting wherever it is issued, as is a residential mortgage. A compromise that looked promising last month was to set the floor at 75 percent, meaning that a bank can use its internal models to determine risk as long as it doesn’t come up with figures that fall below 75 percent of what the standard formulas give for the same assets.

In that case, the standard version would become the base for calculating how much capital the bank would need to have. While German members of the Basel committee have opposed the concept of floors, they might agree to a lower level, according to some Basel members and analysts. The range originally proposed by the committee was 60 percent to 90 percent.

See also: What Global Bank Regulators Are Fighting About: QuickTake Q&A

Sweden also has objected to the 75 percent floor because its banks have bigger holdings of mortgages than those in other countries. Sweden’s historically stable housing market makes such mortgages less risky than what standardized formulas suggest, Swedish regulators and banks have argued. So a bigger proportion of mortgages make the risk weighting look small compared with total assets. The mortgage holdings of Germany’s two biggest banks in relation to total assets are similar to those of the top U.S. firms.

Spain hasn’t been as vocal in the debate over floors, even though its banks hold larger proportions of home loans. Spanish banks have some of the highest risk weightings in Europe, which may be the result of a riskier housing market and tougher requirements by local regulators in demanding higher risk weights in internal calculations.

Japan and France initially objected to the Basel changes but muted their opposition after the compromise on setting the levels at 75 percent was proposed last month. Germany and Sweden have continued to be outspoken against the change.

The majority of the increase in risk weighting for Deutsche Bank would come from its corporate lending, according to estimates by Keefe, Bruyette & Woods. Mortgages would account for less than 10 percent of the expected increase. With a 75 percent floor, Deutsche Bank would be more than a percentage point below its targeted capital ratios by 2025, while most other large European banks would get there through earnings retention, KBW estimates.

Three Components

Risk weighting has three components: credit, market and operational. Credit measures the risk in all lending -- corporate loans, mortgages and credit cards. Market risk looks at securities held in trading portfolios and the possible impact of changing market conditions. Operational risk is supposed to estimate potential losses resulting from the failure of internal controls, such as rogue traders or violations of money-laundering regulations.

The proposals under discussion would eliminate the use of internal models for operational risk, establishing new standard calculations based on a bank’s recent history of fines and litigation costs. KBW analysts estimate that could raise risk weightings for all banks by as much as 16 percent. No changes are planned for calculating market risk, which is based only in part on standardized formulas. That means the floors matter only for credit risk, where there can be significant variation between internal and standardized models.

While some changes under consideration at the committee cover all banks, the floors apply only to the biggest firms because they’re the only ones that use proprietary models to determine risk weightings. The remainder use standard formulas set by regulators.

When the Basel committee established global capital standards in 1988, banks were required to use formulas set by regulators to calculate risk. The reversion to internal models came in 2004 under Basel II. The committee introduced a transitional floor at the time, saying the risk weights calculated by internal formulas couldn’t fall below 80 percent of those calculated under Basel I standards. The transitional floor was extended when the rules were overhauled again in 2010 as Basel III, though it hasn’t been fully adhered to in practice, according to committee members.

For U.S. banks, which are already required under the 2010 Dodd-Frank Act to use the higher of the risk weightings calculated through internal models or standard formulas, the floors would have little impact. Five of the six largest U.S. lenders could continue to rely on their internal models because they would be above the 75 percent floor, data compiled by Bloomberg show. And if the floor is set at 70 percent or lower to appease the Germans, they all would be above it.