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06 September 2022
Europe
Reporter Bob Currie

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Basel changes could trigger 35% decline in sec lending income for Europe’s buy-side

New EU capital rules scheduled for implementation in 2025 are likely to trigger a sharp rise in trading costs for buy-side firms in Europe, according to research from Credit Benchmark.

These changes could result in up to a five-fold increase in the capital cost for banks of engaging in securities financing trades with pension and collective investment funds, according to the report, EU Capital Rules to Increase Buy-side Trading Costs, authored by Credit Benchmark risk advisor Thomas Aubrey.

With this in mind, Credit Benchmark indicates that the securities finance industry needs to work together to ensure that European savers and investors do not lose out when these new Basel changes are implemented.

The London-based credit consensus ratings and analytics company predicts that these changes may contribute to a 35 per cent decline in the securities lending income generated by European buy-side institutions, causing lending income to contract from its current €1.2 billion to less than €800 million.

It predicts that these changes are also likely to reduce market liquidity and to widen bid-offer spreads, resulting in a potential increase in the annual cost of trading of between €20 billion and €40 billion.

Responding to these changes, Credit Benchmark questions whether the proposed increase in capital costs borne by banks under the new Basel rules are warranted on the basis of the associated risk of default.

Credit Benchmark found that the average probability of default of 27 sovereign institutions that are rated aa- and above is 2.4 bps and these institutions could continue to receive a zero per cent risk weight under the new Basel regime.

In contrast, the average probability of default for pension funds and mutual funds rated aa- and above is only marginally higher, at 3.8bps, according to the credit analytics company. Many of these 4600 or so funds currently have a IRB risk weight of less than 10 per cent, but this is destined to jump to 65 per cent risk weight under the new rules.

These developments relate to proposals advanced by the European Commission in October 2021 to revise Capital Requirements Regulation 575/2013. Critics are concerned that changes proposed under the new Basel regime will result in a sharp jump in banks' capital requirements owing to a rise in risk weights for their exposure to unrated corporates, including pension and mutual funds.

The aggregate output floor requires a bank’s risk-weighted assets using an internal ratings-based approach (IRB) to be no lower than 72.5 per cent of RWA calculated under a Basel standardised framework.

Under the revised Basel regime, highly rated corporates with no external rating would experience a large jump in risk weight to 100 per cent.

Many pension and mutual funds — which are classified as corporates under this regime — do not commission an external rating owing to the cost involved and because they have little need to raise capital in the capital markets.

Responding to these concerns, the Commission has recommended a transitional arrangement for unrated corporates and funds, where IRB institutions apply a risk weight of 65 per cent to their corporate and fund exposures that do not have an external rating, providing these have a probability of default of less than 50bps.

Despite the more favourable capital treatment under this transitional proposal, Credit Benchmark concludes that the new rules are still likely to have a dramatic effect on the buy side, resulting in reduced market liquidity and wider bid-offer spreads that will drive up costs for pension and mutual funds.

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