Careers Type: About credit

Basel 4 (also known as Basel 3.1) aims to capture risk more accurately and reduce variability in risk-weighted asset (RWA) calculations, focusing on credit, market, and operational risks. ‘European Banks: Basel 4 /CRR 3 Primer’ from CreditSights provides an overview of Basel 4 alongside its implications for, and impact on, European banks.

The package of reforms within Basel 4 will be implemented in the EU from January 2025 through amendments to the Capital Requirements Regulation (CRR 3) and Capital Requirements Directive (CRD 6). The transition period extends until January 2030, with the transition period for the output floor on mortgage loans and risk weights on loans to unrated corporates extended to 2032. The UK, Switzerland, and the US will implement similar amendments with slightly different timeframes.

A significant change within Basel 4 is the introduction of an output floor, designed to limit the benefit banks can gain from using their internal models to calculate RWAs. Specifically, the output floor sets a floor for RWAs calculated by internal models at 72.5% of those calculated using the standardised approach. This measure will particularly affect residential mortgage loans.

The Danish Compromise will continue, allowing banks with insurance subsidiaries to risk-weight their holdings rather than deduct them from own funds, with risk weights reducing from 370% to 250%.

Other changes, not yet finalised in some jurisdictions, include the final implementation of the fundamental review of the trading book (FRTB) and a new standardised measurement approach for operational risk, both of which look set to increase market risk RWA and/or operational risk RWA for a number of banks.

However, generally the estimated increase in banks’ RWAs and the consequent increase in capital requirements is much lower than the initial expectations. The European Banking Authority now estimates that the Tier 1 capital requirements for EU banks will rise by 9.9%, while the UK’s Prudential Regulatory Authority now estimates an increase of less than 1% for UK banks once the reforms are fully implemented.

You can view the full primer, which includes details on the capital impact estimated by key European banks, here. Please note that a CreditSights subscription will be required to access the report.

Covenant Review’s report “EU Liability Management: Subordination and Seniority in European High Yield Bonds and Loans” provides an in-depth examination of the ranking and subordination risks prevalent in European high yield bonds and leveraged loans. It highlights the importance of understanding various forms of subordination—payment, lien, and structural—and the significance of intercreditor agreements in managing these risks.

• Payment subordination refers to a debt holder’s repayment hierarchy.
• Lien subordination concerns the relative priority of secured debt claims on collateral.
• Structural subordination happens when non-guarantor subsidiaries incur debt.

You can view the report here.

Research from Fitch Ratings has found an organization’s outlook is a stronger indication of the next rating movement that a previous rating action in negative credit developments. Issuers that were downgraded but with stable outlook were lowered again 9% of the time, whereas those affirmed with negative outlook were subsequently downgraded 24% of the time. Conversely the research found little evidence of momentum in the positive direction.

The research analyzed the momentum in corporate credit ratings, focusing on whether upgrades or downgrades signal future rating actions in the same direction. The research covered around 30,000 actions since 2013 where the previous rating was B- or above.

Below is a summary of the findings.

Negative momentum scenarios:

Rate of downgrade from a stable outlook:

• Downgrade from stable outlook is rare, occurring about 3.5% of the time after an affirmation with stable outlook. These are normally associated with a quicker deterioration than expected and for ratings at the lower end of the rating scale.
• When the previous action was a downgrade but the outlook was revised to stable, the downgrade rate increases to close to 10%.

Rate of downgrade from a negative outlook:

• The rate of downgrade is 30% following a downgrade with negative outlook.
• For issuers affirmed with a negative outlook, the downgrade rate is slightly lower at 24%.

Rate of multi-notch downgrade from a negative outlook:

• Multi-notch downgrades occur 15% of the time following a previous downgrade with negative outlook.
• This is significantly higher than the 5% rate after an affirmation with negative outlook.

Positive momentum scenario:

Upgrade rate from a positive outlook:

• Whether a positive outlook is associated with an upgrade or affirmation seems to have minimal impact on its conversion rate into an upgrade. The authors suggest this reflects the minimal incentives for issuers to halt positive credit developments, or otherwise prevent upgrades.
• New ratings with a positive outlook are less likely to receive an immediate upgrade in the following rating action. Instead, it may take several rating actions before an upgrade happens.

Implications for credit analysts:

• Monitoring indicators: Analysts should pay close attention to outlook changes as they are strong indicators of future rating actions.
  Although a less powerful signal than a negative outlook, the previous action being a downgrade is a relevant indicator of a higher likelihood of a forthcoming downgrade, especially in high yield, compared with issuers which have been affirmed.
• Regional differences: Data for regions do differ from the global average. Emerging market exposure can be a differentiator.
• Ratings actions: Whilst this research only considered two consecutive actions, it may take several ratings actions before a downgrade or upgrade happens.
• Gradual upgrades: Positive outlooks on new ratings should be seen as a long-term positive indicator rather than an immediate precursor to upgrades, requiring sustained positive credit developments.

The full article ‘Corporate Rating Momentum’ is available here. Note that a Fitch Ratings account may be required to access the document.