Fitch Ratings: Operating Risk Capital May Rise for EU Banks, Fall in US

EU banks may need to hold significantly more capital for operational risk under the final version of Basel III reforms than under current requirements, while US banks may see a reduction in requirements, Fitch Ratings says. This would bring operational risk-weighted assets (RWA) as a proportion of total RWAs more into line between EU and US banks. Currently, the average ratio for large EU banks is less than 15%, compared with about 30% for large US banks.

For large EU banks (those with Tier 1 capital of more than EUR3 billion), capital requirements for operational risk would, on average, be about 35% higher than currently, adding 4.7% to their overall Tier 1 minimum required capital, according to analysis this month from the Basel Committee on Banking Supervision. The step-up is mainly due to a requirement for some EU banks to reflect their history of operational risk losses as an add-on when calculating how much capital to hold for potential future losses. The impact is significant because several banks' recent history includes large fines for mis-selling and other regulatory breaches.

The new standardised approach for operational risk capital was introduced in the launch of the final version of the international Basel III framework, but the decision on whether to factor in historical losses is left to the discretion of regulatory authorities in each jurisdiction. While EU authorities have opted to include historical losses, the US authorities appear to have decided against this in the latest round of impact analysis.

As the largest US banks currently determine capital for operational risk using internal models heavily influenced by past losses, a decision to ignore past losses could significantly reduce these requirements. According to the Basel Committee's analysis, capital requirements for operational risk under the new rules would be about 17% lower for large US banks, reducing their overall Tier 1 minimum required capital by 4.2%. The impact could be less significant than this, depending on the effect of a capital floor that applies - the so-called Collins Amendment floor.

The US stance is consistent with recent comments from the Federal Reserve questioning the use of past losses as a predictor of future losses, particularly when a bank's risk profile is changing. The resulting operational RWA metrics will therefore not be directly comparable between EU and US banks unless the approaches are aligned. The final version of Basel III is scheduled to be phased in over 2022-2027.

Higher capital requirements tend to lead banks to hold more capital, making them stronger on an economic basis, which is credit positive. Capital for operational risk is just one element of a bank's overall capital position. The US currently has a more conservative capital approach than the EU in several respects, including higher Tier 1 leverage ratio requirements for the largest US banks. A step-up in operational RWAs for EU banks and a reduction for US banks would narrow the gap in capital requirements - both for operational risk and overall.

This month's Basel Committee analysis confirms that large banks worldwide have made strong progress towards building the capital they will need under Basel III. The combined capital shortfall for large banks amounted to common equity Tier 1 capital of just EUR5.2 billion at end-2017, compared with EUR27 billion at end-2015. The main drivers of this were profit retention, particularly by US and Chinese banks, and capital raising, particularly by EU banks. The shortfall in additional Tier 1 and Tier 2 capital also reduced significantly, to EUR20.6 billion from EUR63.1 billion.