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Basel IV and its Impact on Ship Financing

By March 12, 2024 March 27th, 2024 No Comments

Bank for International Settlements (BIS) | Overview

Established in 1930, the Bank for International Settlements (BIS) is an international financial institution which is owned by member Central Banks. From its inception until today, the BIS has played a number of key roles in the global economy. Its primary goal is to foster international monetary and financial cooperation while serving as a bank for Central Banks. The BIS carries out its work through its meetings, hosting international groups pursuing global financial stability and facilitating their interaction. It also provides banking services, but only to Central Banks and other international organizations. 

The BIS is based in BaselSwitzerland, with representative offices in Hong Kong and Mexico City. It is governed by a board elected by the 63 central banks with ownership stakes, with permanent seats reserved for the U.S., U.K., Germany, France, Italy, and Belgium. 

Basel Committee

The Basel Committee on Bank Supervision (BCBS) was formed to address the problems presented by the globalization of financial and banking markets in an era in which banking regulation remains largely under the purview of national regulatory bodies. Primarily, the BCBS serves to help national banking and financial markets supervisory bodies move toward a more unified, globalized approach to solving regulatory issues. The BCBS is responsible for the Basel Accords, which recommend capital requirements and other banking regulations widely adopted by national governments.

The Basel Committee was established in 1974 by the central bankers from the G10 countries, who were at that time working towards building new international financial structures to replace the recently collapsed Bretton Woods system. Since its inception, the Basel Committee has expanded its membership from the G10 to 45 institutions from 28 jurisdictions. Member countries include Australia, Argentina, Belgium, Brazil, Canada, China, France, Germany, Hong Kong, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom, and the United States. 

Starting with the Basel Concordat, first issued in 1975 and revised several times since, the Committee has established a series of international standards for bank regulation, most notably its landmark publications of the accords on capital adequacy which are commonly known as Basel I, Basel II and, most recently, Basel III. 

Basel Accords | Overview

Starting in 2001, the BCBS has developed a series of highly influential policy guidelines known as the Basel Accords to address the risk management practices for active financial institutions in the international arena. These are essential recommendations and as such are not binding and must be adopted by national policymakers in order to be enforced. Nevertheless they have generally formed the basis of banks’ capital requirements in countries represented by the committee and beyond. 

Known as Basel I, II, III, and IV, the Basel Accords consist of four sequential banking regulations set by the BCBS. As part of its mandate, it provides recommendations on banking and financial regulations, specifically those pertaining to capital risk, market risk, and operational risk.

Basel I

The first Basel Accord, or Basel I, was finalized in 1988 and implemented in the G10 countries, at least to some degree, by 1991. It prescribes minimum capital requirements for financial institutions with the goal of minimizing credit risk. Basel I is now considered too limited in scope, but it laid the framework for the subsequent Basel Accords. With the advent of Basel I, bank assets were classified according to their level of perceived risk, and risk weighted accordingly by the so-called standardized approach. Banks are required to maintain emergency capital based on that classification. Under Basel I, banks were required to keep capital of at least 8% of their determined risk profile on hand. 

Basel II

In 2004, the committee released an update, Basel II. The Basel II Accord makes it mandatory for financial institutions to use standardized measurements for credit, market risk, and operational risk. Basel II refined Basel I’s way of calculating

the minimum ratio of capital to risk weighted assets (RWAs), dividing bank assets into tiers based on liquidity and risk levels, with Tier 1 capital being the highest quality. Under Basel II, banks still had to maintain a reserve of 8%, but at least half of that (4%) now had to be Tier 1 capital. 

Basel III

When the Global Financial Crisis (GFC) hit, two opposing schools of thought emerged. One said that the crisis demonstrated that Basel II was too lenient; the other claimed that Basel II itself worsened the crisis by incentivizing bad business practices. The Basel III Accords were designed as the 2008 crisis unfolded and attempted to correct the miscalculations of risk that were believed to have contributed to the crisis by requiring banks to hold higher percentages of their assets in more liquid forms and to fund themselves using more equity, rather than debt.  Among other changes, Basel III increased the Tier 1 capital requirement from 4% to 6%, while also requiring that banks maintain additional buffers, raising the total capital requirement to as much as 13%.

Basel IV

Basel IV, also sometimes known as Basel 3.1, is the latest in a set of banking reforms developed in response to the 2008-09 financial crisis. In 2017, the Basel Committee agreed on changes to the global capital requirements as part of finalising Basel III. The changes are so comprehensive that they are increasingly seen as an entirely new framework, commonly referred to as “Basel IV”.  It extends the earlier Basel Accords to put in place greater standardization and stability to the worldwide banking system. Basel IV began implementation on January 1, 2023, although banks will have five years to fully comply, with requirements for implementation varying across countries. Its principal goal, the committee says, is to “restore credibility in the calculation of Risk Weighted Assets (RWAs) and improve the comparability of banks’ capital ratios”. 

In order to achieve this, there are specific obligations around capital and risk, including:

  • harmonizing the earlier Basel Accords with a standardized approach to credit and operational risk.
  • tightening the way in which banks use their internal models to assess their capital requirements; and
  • further limiting the ability of systemically important banks to leverage by forcing them to keep additional capital in reserve.

The new rules propose a number of changes, some highly technical. They include:

  • Improving the earlier accords’ standardized approaches for credit risk assessment, credit valuation adjustment (CVA) risk, and operational risk. These rules lay out new risk ratings for various types of assets, including bonds and real estate. Credit valuation risk refers to the pricing of derivative instruments.
  • Constraining the use of the internal model approaches used by some banks to calculate their capital requirements. Banks generally will have to follow the accords’ standardized approach unless they obtain regulatory approval to use an alternative model. Internal models have been faulted for allowing banks to underestimate the riskiness of their portfolios and how much capital they must keep in reserve.
  • Introducing a leverage ratio buffer to further limit the leverage of global systemically important banks (banks considered so large and important that their failure could endanger the world financial system). The new leverage ratio requires them to keep additional capital in reserve.
  • Replacing the existing Basel II output floor with a more risk-sensitive floor. This provision refers to the difference between the amount of capital that a bank would be required to keep in reserve based on its internal model rather than the standardized model. The new rules would require banks by the start of 2027 to hold capital equal to at least 72.5% of the amount indicated by the standardized model, regardless of what their internal model suggests.

Basel IV | Implementation Status

Although the BIS introduced the Basel Accords to be implemented globally, different global regions, for example, United States, European Union and countries within regions, are allowed to customize the BIS regulations to comply with their own regulator(s) individual requirements, if these customizations are within the BIS Accord scope.

However, Basel IV is expected to impact banks unevenly. The effects stemming from the implementation will vary not only between members of each jurisdiction but also between financial institutions within the same jurisdiction, due to the nuanced rulesets that exist.

The Basel Committee has explained that Basel IV will help reduce the variability in how banks treat risk-weighted assets (RWAs), which will improve cross-bank comparability and raise confidence in the risk models being used. It represents a fundamental change in how banks will need to calculate regulatory capital. As European banks adjust to a new standardized approach (SA) to assess portfolio risks, they could face a larger increase in capital requirements than their global peers.

As we have seen, even though many details are yet to be finalized, markedly different implementations of Basel IV are emerging. These will likely combine with the inherent differences in capital requirements to create significant inconsistencies in the ways that risks are treated between jurisdictions, resulting in globally different capital requirements, skewed incentives and pricing.

Ship Financing Landscape | Implications 

The implementation of the Basel IV framework by financial institutions is a remarkable challenge for the banking landscape as methodologies for the determination of capital requirements are to be revised. In doing so, capital calculations across all risk types will be fundamentally amended. 

Specifically for the shipping industry, the focus on increased capital requirements and adjusted risk-weighted assets is expected to prompt a retreat by banks, reshaping their risk modelling and potentially impacting the shipping industry’s financing landscape. 

Banks lending to the shipping industry, in particular the larger institutions with bespoke and well-developed internal risk models, will be considering their future lending strategy carefully as a result of the standardization on models required by Basel IV. Standard key considerations such as reputation, track record, quality of technical and commercial management, employment coverage, charterer counterparty risk, asset marketability and residual value will have reduced impact on risk assessment. To a large extent, by implementing Basel IV banks will be targeting larger shipping companies that offer the best credit ratings (according to the standardized approach) and an opportunity for the cross-selling of other banking products.

Ship Financing Landscape | The Evolution of Ship Financing

The ship financing scene has been changing over the years but historically it has been dominated by Western Banks. Until the mid-80s the main lenders were American Banks and to a lesser extent European Banks. Then in the mid 80s, during and in the aftermath of the 7-year long shipping crisis, American Banks started disappearing from the scene and by early 90s they were almost totally gone. European Banks took over and for more the 20 years they were running the show in the West and had also made serious inroads in the East. Up until very recently, Asian lenders were predominantly active in their respective countries, occasionally venturing to countries nearby. 

The GFC of 2008 marked a new era for the ship financing. All European Banks reduced their exposure to shipping and some of the biggest players left the market altogether. Then a little over 10 years ago, Chinese Leasing started appearing on the scene partly to support China’s shipbuilding industry but also because they saw an opportunity to fill the gap left by the departure of the traditional lenders. Now more Asian lenders are waking up to the opportunity of doing more lucrative business away from home and started looking with greater interest to the West. It is not, as yet, a stampede, but Asian banks currently sit on a lot of liquidity, and they are under increasing pressure to find ways to put it to work.

Global portfolios of Top 30 lenders to shipping by region

Source: Marine Money

After the Global Financial Crisis (GFC) and the subsequent withdrawal of many European banks from shipping, Asian lenders seem to have filled the gap as a prominent source of financing for the industry, as seen above. This trend is set to intensify as Basel IV influences traditional ship-financing models, pushing smaller and medium sized operators towards alternative financing structures. The evolving credit landscape is also expected to create opportunities for private equity and other alternative capital providers.

Ship Financing Landscape | The Impact of Basel IV to Ship Financing 

Come 1st January 2025 all Eurozone Banks will have to comply with the Basel IV guidelines. No Eurozone member will be given any respite. The European Stability Mechanism (ESM) was quite clear about it. Outside the Eurozone compliance will depend on the local regulator. Most Asian banks are lagging behind their European peers in the implementation of Basel IV Guidelines (indicatively we have been told that banks, in some Asian countries, have yet to comply fully with Basel II).

What does this mean for shipping loans? 

Asset backed lending will be penalised by Basel IV which favours corporate loans to large corporate entities. Shipping, a supreme example of asset-backed lending, and furthermore because of its cyclicality, has always been considered a higher risk business by regulators. Under the standardized approach, the Basel IV minimum liquidity requirement for banks will increase to at least 15% from the 13% presently under Basel III. Some Banks that have opted for the internal model approach to calculate Risk Weighting of Shipping Loans, may even result to having to accept a higher minimum liquidity than 15 %. 

In essence, after January 1st, 2025, in order for European Banks to meet their minimum return thresholds, they will have to increase margins for shipping loans. The extent of the increase may differ slightly from bank to bank but the consensus of opinion amongst shipping bankers is that it will be somewhere 20 to 40 bps. This may come as a shock to some shipowners who over the past few years have been enjoying steadily reducing margins. 

This effectively means that come January 1st next year Asian lenders would not be under the same pressure to increase margins as their European counterparts. Of course, for syndicated facilities led by European Banks, all lenders will have to follow the European pricing. One, however, cannot rule out that little by little, there will also be an increase of syndicated loan facilities involving exclusively Asian lenders. 

One should also bear in mind however, that the approval process for a loan from an Asian lender is longer than that of their traditional European Banks (particularly to onboard a new client). With the exception of Chinese Leasing companies that have been visiting Europe for many years and 2 or 3 big Japanese lenders that have had offices in Europe, most other Asian lenders have had limited exposure to European shipowners. This lack of familiarity with the European markets also means that most Asian lenders would give priority to deals with companies that have a corporate structure, a strong balance sheet and, ideally, some employment coverage.

The question is what shipowners will do, in this new world order. Would they stay with their traditional lenders even if it will cost more or will they try to explore new and more competitively priced sources of funding? It remains to be seen! 

Anthony Zolotas
Chief Executive Officer of Eurofin Group
Katerina Galanou
Manager

Eurofin International Ltd

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