When a bank suffers losses, for example on loans that have not been repaid, it is the capital base that first absorbs the shortfall. The aim of the EU’s capital rules is therefore to guarantee the financial soundness of banks and to protect the financial system as a whole. From 1 January 2025, European banks will have to comply with new rules set out in the CRR3 regulation. This text transposes the latest Basel III international reforms into European law. We take a look at the issues involved in eight questions.

Why these rules?

Banks play a crucial role in the economy by collecting savings and redistributing them in the form of loans to businesses and individuals. A minimum level of capital, calculated on the basis of the risk taken, is therefore essential to ensure that the difficulties of one institution do not spread to the entire financial system and the real economy.

While the new rules are intended to strengthen the financial solidity of banks, they have also raised questions and criticism, particularly from banks. They point to a high cost, which weighs on their profitability and limits their ability to support the real economy.

How is it calculated?

The capital adequacy ratio is calculated by dividing the capital that the bank is required to hold by the value of its assets, adjusted for the risks it takes on. To remain within regulatory limits, this ratio must reach a minimum value, generally between 8% and 10.5%, or even higher in some cases. There are two approaches to calculating capital requirements: the standard approach and the internal model approach.

- The standard approach is a flat-rate approach that assigns a risk rate to each asset class. For example, a loan to an unrated company (with no external rating) will have a risk rate of 100%. If the bank lends a million euros to this company, with minimum requirements of 10%, it will therefore have to set aside €100,000 of capital. This simple, conservative approach is well suited to small and medium-sized banks.

- The internal model approach is more commonly used by large banks, which can estimate the risk parameters of their assets themselves. This approach is more complex, but it allows banks to take better account of the specific nature of their risks and to reduce their capital requirements. Internal models are widely used in Europe. In Luxembourg, they are used by BGL BNP Paribas, Bil and Spuerkeess.

Did you say Basel IV?

The Basel rules on bank capital requirements are drawn up by the Basel Committee on Banking Supervision, an international institution founded in 1974 and reporting to the Bank for International Settlements (based in Basel, Switzerland). Since Basel I (1988), the first version of the agreements, these rules have evolved regularly to adapt to the challenges of the global banking system.

The 2017 reform, transposed into European law by the CRR3 regulation, is called "Basel IV" by the European banking industry because it introduces new rules that have a significant impact on banks. Supervisors, on the other hand, prefer to speak of 'finalising Basel III' or 'Basel III plus', as they see these reforms as a continuation of Basel III. Many use the expression "Basel Endgame”.

How does the Basel IV 'floor' work?

Basel IV aims to bring the two approaches to calculating capital closer together, by limiting the room for manoeuvre of banks using internal models and making the standard approach more sensitive to risk. The aim is to improve the comparability of capital requirements between banks and to strengthen the credibility of the system.

One of the major changes introduced by Basel IV is the 'output floor', a capital floor that limits the capital savings achieved through the use of internal models. In concrete terms, the risk-weighted assets (RWAs) calculated using internal models may not be less than 72.5% of those calculated using the standardised approach. This mechanism was introduced because the regulators found that the internal models led to results that were too divergent between banks.

Capital or liquidity?

Capital rules do not protect banks against liquidity problems. Liquidity refers to a bank's ability to meet its short-term commitments, for example in the event of massive withdrawals of deposits. A bank may have a high level of equity capital but lack liquidity, as was the case for Credit Suisse in 2023.

Liquidity and equity are two different dimensions of a bank's financial strength. Equity is a permanent resource used to absorb losses, while liquidity is a short-term resource used to meet immediate financing needs.

More capital, less instability?

The authorities consider that the strengthening of capital requirements has contributed to the resilience of the banking system. One example: in ten years of activity, the Single Resolution Board, the central authority in charge of managing banking crises in the eurozone, . The European financial stability bodies are confident about the future: faced with unfavourable macroeconomic scenarios, the banks have on the whole demonstrated their ability to withstand them.

What about recent crises?

The banking crises of 2023 highlighted the importance of liquidity for banking stability. Weren't Silicon Valley Bank and Credit Suisse brought down by bank runs, massive withdrawals of deposits? This is a reminder that equity capital alone is not enough to guarantee a bank's stability, and that liquidity is a crucial factor to take into account.

Other recent crises, the covid-19 pandemic and the energy crisis did not originate in the financial sector. But the banks in the eurozone withstood them well, which, according to the authorities, is also testimony to the effectiveness of the capital adequacy rules.

How effective are we in the face of digitalisation?

The digitisation of financial services can amplify the risks of banking instability, particularly by speeding up capital movements and amplifying rumours and panics. Tighter capital and liquidity requirements are intended to mitigate these risks by providing banks with greater cushions against shocks.

The authorities believe that banks with solid fundamentals, high capital buffers and high liquidity buffers are better protected against shocks and market reactions. The very targeted reactions in the eurozone during the crises of 2023 are cited as evidence: the weaker the bank, the greater the market correction. This also means that, if the situation were to deteriorate further, these banks would be in a better position to resist. In this respect, capital acts as a bulwark against contagion.

Read the original French-language version of this report /