Home Private Equity Basel IV Is a Dramatic Global Shift for Private Credit Markets

Basel IV Is a Dramatic Global Shift for Private Credit Markets

Bloomberg Law

The Basel Committee on Banking Supervision’s latest revisions to the global regulatory capital framework represent an opportunity for alternative lenders and more innovative partnerships between private funds and banks.

The Basel guides were established in response to the 2008 financial crisis to encourage liquidity in downturns. They specify how regulators around the world should apply capital requirements to banks, and have been rolled out in phases over the years.

With the move into Basel IV, which will roll into action January 2025, lenders will feel a market change. On paper, this phase presents the prospect of deeper market penetration on top of an already booming private credit space.

Private credit funds, for example, could take a greater share of some lending markets as banks generally become less competitive lenders into those markets (and even step back from lending in those markets). The interesting flip side of this coin is that private funds are seeing different sources of funding across all their deals, as banks re-evaluate what financing they participate in and the sourcing of deal financing from alternative lenders increases.

Banks also could seek to replace their previous lending activity with something like back-financing to alternative lenders to help finance their lending (which carries a lower capital-charge for banks).

In the same way credit funds have proactively explored and offered capital-efficient structures to insurers, we could see credit funds selling their wares to banks as a new route into what had been existing bank businesses—a further retreat from and adaptation of the traditional banking model.

In response to the stream of post-global financial crisis regulation, as well as increased competition from alternative lenders, the market has become all too aware of the importance of regulatory capital calculations as a driver for both size and type of lending activities of banks.

The last full suite of Basel standards was the 2010 and 2011 Basel III, with significant changes in the form of increased minimum capital requirements and buffers, new liquidity ratios, and a backstop leverage ratio for banks. Basel IV (also known in the market as Basel III.1) was agreed in 2017 and will phase in implementation for the full set of requirements.

Several regulators such as the US and UK are consulting on their final rules, which are likely to be seen by this summer. As it stands, they may each in their own way adopt a stricter capital regime than the globally agreed standard for Basel. The rules are also being referred to as the Basel Endgame.

So what is all the fuss? Fundamentally, Basel IV is revisiting risk-weighted assets. At its most basic level, these assets are the amount of capital a bank must set aside for a particular loan it makes—the riskier a particular loan exposure appears, the higher the risk-weight, and thus the more capital a bank must hold to make that loan.

Whereas historically Basel permitted the bigger banks to use their own internal models for assessing risk-weighted assets—over standard models set by regulators—that typically resulted in the calculation of lower assets. The Basel IV rules will significantly restrict that use.

The Basel IV rules also will introduce an “output floor” for banks using internal models, basically operating as a kind of minimum risk-weighted assets. Such banks will apply their internal models as usual, but then must compare their model output with the risk-weighted assets that would be required if they had been using a regulator’s standard model for a particular type of lending.

If the risk-weighted asset produced by the internal model is less than would be required under the standard model, the bank would have to top-up its capital. This would increase capital requirements for banks across the board and reduce the scope for banks to be making low-risk loans at a lower rate of regulatory capital.

Under the US implementation, use of internal models will be disapplied for credit risk, lifting capital requirements across the board. This is alongside a new enhanced standardized approach from US regulators, which rather than replacing the existing standardized approach, will be used alongside it.

As a result, those banks subject to the standards would be required to comply with both approaches, rather than just one regulatory capital model. Basel IV also introduces an increased sophistication to the standard models, leading to a significant increase in the amount of data needed across the board by banks to run their calculations.

At a more granular level, Basel IV has outlined significant increases for regulatory capital in lending on certain kinds of real estate and corporate transactions, lending to other banks or broker-dealers, and new requirements for exposure to covered bonds and subordinated debt.

Taking commercial real estate as one example, Basel IV will introduce more differentiation between the risk weightings of loans relating to general commercial real estate, income-producing commercial real estate, and acquisition, development, and construction.

This will likely see certain kinds of acquisition, development, and construction loans attract a significant increase in the risk weight that must be applied.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Owen Lysak is partner at Simpson Thacher in London, co-leading its European financial services and funds regulatory practice and European-registered and retail funds practice.

Jacob Durkin is partner at Simpson Thacher in London, focusing on complex private credit financings.

Matthew Mears is an associate at Simpson Thacher in London.

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