The finalized Basel III framework, which is now in force in the European Union, is reshaping how banks calculate their capital requirements. In this interview, our financing experts Yassine El Ouazzane and Muriel Nahmias discuss some of the key principles of the framework and touch upon its practical implications for corporates.
What is the output floor rule?
The output floor, which is part of the finalized Basel III regulations for the banking sector, limits the extent to which banks can rely on internal models to calculate their risk-weighted assets (RWA).
Its main objective is to reduce what is seen as excessive variability in RWAs between banks with similar portfolios. Several studies by the Basel Committee have highlighted that some banks’ internal models produce overly optimistic outputs, especially with respect to the Loss Given Default parameter – the percentage of an asset’s value that would be lost if a borrower defaults on a loan or other obligation.
The output floor requires that RWA calculated using internal models cannot be below 72.5% of the RWA calculated using the standardized approach. As such, it represents a regulatory minimum for the output of internal models. It’s important to note that the 72.5% figure is the final target – implementation of the output floor began this year at a level of 50%, and it will increase in increments every year until the 72.5% figure is reached in 2030.
Let’s consider an example of how the output floor works. If a bank calculates its RWA are €100 million using its internal models, but the standardized approach results in a figure of €160 million, the output floor in 2030 would be 72.5% × €160 million = €116 million. The bank would therefore be required to increase its capital by €16 million.
The output floor is accompanied by minimum thresholds for Loss Given Default (such as 25% for senior unsecured exposures) and Probability of Default – 5%. The finalized Basel III rules also eliminate the advanced internal ratings-based risk measurement approach for large corporates. Now, only one internal method (fundamental) remains.
Can you explain the difference between internal models and the standardized approach in calculating capital requirements for lending?
Internal models rely on banks’ own credit ratings and enable a more granular assessment of credit risk (including the Probability of Default and Loss Given Default measures).
The standardized approach, by contrast, uses a risk-weighting grid based on whether or not a counterparty has an external credit rating, and on the level of that rating if one is available.
What is the expected impact of the new rules on banks’ lending capacity?
Unsurprisingly, the new rules are expected to weigh on the profitability of banks whose internal models are seen to significantly underestimate Loss Given Default values. However, the impact will be gradual given the output floor is being increased incrementally up to 2030.
In Europe, Japanese banks have already begun scaling back their operations in response to their regulator’s decision to rely exclusively on the standardized approach. By contrast, US banks – some of which are expected to face significantly higher capital requirements under the finalized Basel III rules – have not yet received a timeline they must follow to implement them.
It’s worth noting that European banks have known the broad outline of the changes to how they can use internal models since 2017, even though the new EU regulation only took effect in January 2025. Banks whose Loss Given Default estimates were previously seen as inconsistent have had time to adapt their internal models.
What steps can a corporate borrower take to mitigate the impact of finalized Basel III?
It’s always a good idea for companies to demonstrate that they understand the new constraints facing their banking partners as this helps foster better dialogue and enables the parties to co-develop appropriate solutions.
Depending on a company’s credit profile, its finance team might consider obtaining an external credit rating. An investment-grade rating would enable banks to apply more favorable risk weightings under the standardized approach. Conversely, some unrated companies may find that remaining unrated may actually be more advantageous.
Some companies may turn to the private debt, securitization or factoring markets to reduce their reliance on traditional bank loans and diversify their sources of funding. Finally, by providing additional guarantees to lenders, a company can improve its risk profile and access better credit terms – even in a more stringent regulatory environment.