Basel IV or what is it all about: A short US-EU banks comparison

I know this might not be the most glamorous topic, but financial regulation does deserve attention, especially now, as we enter a pivotal phase for the implementation of the latest overhaul of the international banking rulebook, widely referred to as Basel IV. In the United States, this framework was officially scheduled to take effect on July 1, 2025, but uncertainty has crept in, particularly following the return of a more deregulatory posture under the Trump administration. Moreover, US banks have already scored a notable win last year: the projected increase in capital requirements was revised down from 16% to just 9%, a reduction that significantly softens the intended impact of the new rules. In contrast, Europe has formally begun the rollout of Basel IV under the Capital Requirements Regulation III (CRR III) as of January 2025. However, even here, delays are not absent: the implementation of the Fundamental Review of the Trading Book (FRTB) - the new standard for market risk capital requirements - has been deferred until January 2026. This partial delay reflects both the operational complexity of aligning trading desks with the FRTB’s revised sensitivities-based approach and the political compromises embedded within the EU legislative process (otherwise put, we want to implement this new regulation, but we would like to start close to or even after US banks).

Whether implementation has formally begun or is still in flux, one thing is certain: this new regulatory framework (regardless of its final form) will be enacted. Therefore, to grasp the magnitude of what is at stake, we need to return to the foundations of modern international banking regulation: the Basel Accords.

Born in the late 1970s out of the Bank for International Settlements in Basel, Switzerland, the Basel Committee on Banking Supervision was created in response to a series of high-profile bank failures, including the well-known collapse of Bankhaus Herstatt in 1974. It became clear that the cross-border nature of modern banking required more than national oversight, it required a shared understanding of how much capital banks needed to absorb losses and how that capital should be measured. The first Basel Accord, finalized in 1988, was a watershed moment. It introduced the now-familiar concept of risk-weighted assets: the idea that a bank’s minimum capital requirements should be tied not just to the size of its balance sheet, but to the relative riskiness of its loans and investments.

That was Basel I. Since then, the rulebook has evolved through successive iterations, Basel II, which in 2004 introduced more sophisticated modeling techniques for calculating risk, and Basel III, a sweeping post-2008 overhaul that raised capital thresholds, added liquidity requirements, and sought to constrain leverage (basically one thousand pages of banking regulations). Basel III was, in effect, the response of the global regulatory community to a system that had nearly collapsed under the weight of the so-called opaque securitizations and a dangerous over-reliance on internal risk models that often underestimated the possibility of systemic failure (these internal risk models are touched several time in Basel IV).

Now, nearly two decades later, Basel IV represents the final leg of that reform effort. It is not technically a new accord - the Basel Committee insists that it is simply the finalization of Basel III - but its scope and ambition are broad enough to warrant a new name. What Basel IV does is recalibrate the entire structure of risk calculation. It does not so much raise capital requirements across the board as it changes the methodology through which those requirements are determined. And in doing so, it subtly reshuffles the incentives that shape how banks lend, invest, and basically organize their internal models.

As such, this post does not aim to cover every component of the new regulatory framework - that would be nearly impossible - but instead focuses on several key elements, such as the output floor, standardized risk approaches, internal ratings-based (IRB) models, and, crucially, the divergences in implementation and impact between US and European banks.

Source: GIS Reports Online

The heart of the reform lies in a measure called the output floor. Under previous iterations of the Basel framework, large banks - especially in advanced economies - were permitted to use internal models to calculate the capital they needed to hold against various types of risk. These models allowed them to assess the probability of default, loss given default, and other key variables based on their own historical data. In theory, this promoted risk sensitivity. In practice, it often resulted in aggressive capital optimization: banks using models to generate the lowest plausible risk weights, and therefore the lowest capital requirements, consistent with regulatory compliance. As such, Basel IV seeks to diminish the “excessively variable” risk sensitivity of capital requirements by imposing a floor of 72.5%.

As such, Basel IV does not eliminate internal models, but it reins them in. With the new output floor, the total risk-weighted assets (RWAs) that a bank reports under its internal model cannot fall below 72.5% of the amount that would be calculated using the standardized approach, a fixed formula defined by regulators. In plain terms, banks now face a hard floor beneath which their modeled capital cannot fall, regardless of how sophisticated or benign their model inputs may appear. Moreover, Basel IV introduces a significant recalibration of the Advanced Internal Ratings-Based (A-IRB) approach for specific exposures, particularly to large corporates and equities. In the case of equity exposures, the IRB approach has been entirely eliminated, based on the argument that internal models fail to produce sufficiently reliable estimates for regulatory capital purposes. In parallel, Basel IV also tightens the standardized approach for credit risk, aiming to reduce reliance on external credit ratings while enhancing the consistency between IRBs and the new output floor. This alignment is crucial, as it narrows the gap between banks using internal models and those using the standardized approach, thereby limiting the potential for regulatory arbitrage, as they say.

Why is it important? Because it effectively curtails the capital advantage that internal models once conferred and moves the system closer to a more standardized, comparably risk-insensitive baseline.

But Basel IV does not stop there. It also overhauls the standardized approaches themselves, those formulas that determine the capital weightings for mortgages, corporate loans, real estate exposures, and more. For instance, the treatment of unrated corporates is now more conservative, and the capital requirements for commercial real estate loans have risen (the risk weight of these mortgage loans will increase from under 10%, based on internal risk approaches, to standard risk weights ranking from 20% to 70%). Moreover, under this new rule, banks must calculate operational risk using a formula that blends historical losses with income-related metrics, regardless of whether internal models suggest a more benign profile. And nowhere is the impact of Basel IV more visible than in the transatlantic contrast between the United States and Europe.

In the United States, the Federal Reserve has announced its intent to implement Basel IV via what it calls the “Endgame” proposal, targeting banks with more than $100 billion in assets. That means the rule will apply not only to Wall Street giants like JPMorgan and Goldman Sachs, but also to large regional institutions. Those that, in the wake of the Silicon Valley Bank collapse, have already come under heightened scrutiny. However, US banks are significantly less affected than their European counterparts, particularly because they already operate under a 100 percent standardized floor (mandated by Section 171 of the Dodd-Frank Act). This provision, also known as the Collins Amendment, requires that large US banking organizations calculate their capital requirements based on the standardized approach, effectively setting a floor below which capital requirements cannot fall, even if internal models would suggest a lower capital charge. In other words, internal models can no longer be used to arbitrarily lower capital buffers.

At the same time, the US benefits from a well-functioning capital market, which allows corporations to finance themselves through bond issuance or equity markets. This stands in stark contrast to the situation in Europe, where the lack of a fully integrated Capital Markets Union (CMU) means that banks remain the primary channel of financing.

Moreover, government-sponsored enterprises such as Freddie Mac and Fannie Mae serve as key institutional buyers of mortgage assets, acting as counterparties for banks that wish to offload mortgages from their balance sheets. This matters because, as previously discussed, under a traditional IRB approach, banks assign very low risk weights, sometimes as low as 5–10%, to asset classes such as retail mortgages. These IRB-based capital calculations typically fall under Category I or II capital standards. With Basel IV, however, these IRB approaches are increasingly being replaced or constrained by risk-sensitive standardized requirements, which will be divided into four capital standards.

The introduction of the new output floor forces banks to apply standardized risk weights, often as high as 70%, even on exposures that internal models previously treated as low risk. But because US banks have more flexibility to reduce their exposure to such asset classes or shift them off balance sheet (e.g., through securitization), the overall impact is expected to be more moderate compared to European banks, which lack similar institutional mechanisms (of course, there are already ongoing efforts to develop further the securitization market in Europe - essentially as a means to mitigate some of the adverse effects of Basel IV - but, as I discussed previously, this market continues to suffer from persistent structural deficiencies).

Another challenge introduced by Basel IV lies in the requirement to include unrealized gains and losses in regulatory capital reports. As discussed here last week, US banks still report high levels of unrealized losses. While this already impacts funding costs by making banks appear riskier to certain investors, Basel IV would institutionalize the effect by incorporating these unrealized losses directly into regulatory capital calculations. This means banks will not only face higher capital charges but may also see their Tier 1 capital eroded during periods of market volatility.

Moreover, the European banking system remains far more bank-centric than its American counterpart. As we discussed, in the US, capital markets and shadow lenders dominate credit intermediation. In Europe, banks still play the central role in financing households and businesses. This is precisely why it has been argued that European banks - particularly those in the Nordic region - are likely to be disproportionately impacted, as they rely more heavily on internal risk models to calculate capital requirements. Because these banks typically report low historical losses on certain asset classes, such as mortgage portfolios, they also tend to produce relatively low Loss Given Default (LGD) estimates under the IRB approach (as highlighted by McKinsey). Under Basel IV, however, such favorable assumptions translate into a higher capital burden due to the binding output floor, which limits the extent to which internal models can reduce risk weights. In fact, a December 2023 report by the European Banking Authority (EBA) projected that the minimum Tier 1 capital requirement will increase by an average of 8.6% for large internationally active European banks.

The impact will be even more pronounced for banks in Germany, Spain, Portugal, and Ireland, largely due to Basel IV's recalibration of risk weights applied to sovereign exposures, an area where banks in these countries are typically overexposed. Further compounding the pressure is the treatment of operational risk. An analysis from 2016 by the Operational Riskdata eXchange Association (ORX) shows that while US banks may face only a modest 3–4% capital requirement increase for operational risk, European banks could see their operational risk capital charges surge by more than 60% (!), reflecting the shift from internal measurement approaches to the more conservative standardized measurement approach (SMA) under Basel IV. This is why analysts expect the average return on equity (ROE) for European banks to decline from 8% to approximately 7.4%, assuming that there are no further delays in the implementation of other key components of Basel IV. This anticipated drop reflects the rising capital requirements and the associated costs of compliance, particularly for institutions heavily reliant on internal models or those with concentrated exposure to asset classes now facing higher risk weights.

This is also why, just a few days ago, Deutsche Bank publicly warned that the new regulations would constrain its ability to provide loans to SMEs and medium-sized companies, particularly firms involved in defence-related industries. While the focus on defence spending may appear overstated, after all, Europe is not operating under wartime economic conditions and this is hardly the sole relevant sector, the broader point is clear: the bank anticipates a reduced corporate lending capacity overall. This is easier to understand when considering that Basel IV, in practice, functions in some respects like a supplementary leverage ratio (SLR): it imposes a flat 100% risk weight on unrated corporates, irrespective of their actual credit risk. This blunt treatment of credit exposures introduces a structural bias against companies without formal ratings, despite many of them being financially robust.

That’s why several analysts, including those at Nordea, have argued that large corporates with annual revenues exceeding €500 million but lacking a credit rating will be among the most adversely affected. In response, banks may decide, based on ROE considerations and capital efficiency metrics, to reallocate lending away from such firms in favor of more profitable segments, such as fee-based services or capital-light activities. This is essentially the core of Deutsche Bank’s argument. In contrast, other European banks have adopted a more constructive stance. For instance, BNP Paribas SA expects a manageable Basel IV impact of around 90 basis points in 2025 but maintains that its capital position will remain solid, forecasting a Common Equity Tier 1 (CET1) ratio of approximately 12% even after full implementation. Similarly, UniCredit SpA projects a 60 basis-point impact, which it believes can be offset through active portfolio management. In such cases, lending to corporates, particularly larger or more strategically important firms, may continue largely uninterrupted (that said, the trajectory of this market remains uncertain, and relying too heavily on these models introduces significant risk, especially in the current macro-financial environment, where corporate lending has already contracted in core economies like Germany and France, as discussed here).

Anyway, this occurs because certain banks with more diversified balance sheets, or with limited exposure to asset classes deemed relatively riskier (such as Deutsche Bank), can partially offset RWA shortfalls introduced by the output floor through excess RWAs in other asset categories (an example in the figure below). In other words, if a bank already holds assets that are risk-weighted above the new standardized floor, these can effectively act as a buffer, reducing the marginal capital impact of the new requirements. As a result, these banks can continue their core activities with only a modest increase in capital costs compared to the Basel III regime. This dynamic highlights how the overall impact of Basel IV is not just a function of size or geography, but of portfolio composition and internal capital allocation strategies.

Source: Moody’s

But it's not just unrated corporates that will be affected, markets traditionally considered low-risk, such as European mortgage portfolios, will also come under pressure. It is widely expected that under the CRR3, the risk weighting of mortgages to be increased by a factor of 5 (!). In this environment, banks are expected to increasingly rely on synthetic risk transfer (SRT) mechanisms, a topic I’ve analyzed in more detail here. Through SRTs, banks can synthetically offload the credit risk of specific asset pools to third-party investors, thereby achieving capital relief without removing the assets from their balance sheets. However, a critical development under Basel IV is the introduction of the output floor to the senior retained tranches of securitizations (a shift from the previous regulatory framework, where these exposures often benefited from relatively low risk or even zero weights). This change will require the creation of thicker risk transfer tranches in order to achieve meaningful capital reduction. More specifically, banks will need either to enlarge the mezzanine tranches or introduce new layers - such as senior mezzanine tranches - to ensure a sufficient portion of risk is offloaded. But this strategy faces a potential constraint: the viability of such structures hinges on the continued availability of counterparties willing to absorb these tranches, particularly in an environment of rising risk aversion and tightening spreads.

However, when it comes to Europe, the conversation is not solely about banks. Wealth management firms may also be significantly affected, particularly those operating in the Lombard lending segment. If such firms rely on retail security-based lending - typically backed by diversified, low-risk-weighted collateral - they could still face higher capital charges. This is because, under Basel IV, these exposures may be subject to the capital floor applied to other retail exposures, even though they were originally structured for low-risk consumer finance. The result is that even secured lending practices, long considered conservative, could be penalized by a more rigid standardization of risk weights.

The divergent timelines and structures of Basel IV implementation may create friction between US and European banks, with possible implications for global capital flows. A European bank lending to an SME in Italy will face different capital pressures than a US bank funding a private equity deal in Texas. Over time, these discrepancies could shape the geography of risk and the dynamics of competition in the transatlantic financial system.

To synthetize, the global system, long organized around the idea of universal banks using models to fine-tune their risk weights and optimize capital, is being reshaped into a more standardized, rule-bound order. But that does not mean a more stable one. In narrowing the room for flexibility, Basel IV may push risk outward, into the shadow banking world, into jurisdictions less enthusiastic about implementation, into corners of the system where leverage can grow unchecked (especially through the SRTs and private credit). That’s the paradox at the heart of modern financial regulation: the more rigorously we measure risk, the more it seeks out the places where no one is looking.