The impact of Basel IV capital rules on business lending

After more than a decade of evolution, the Basel III bank capital standards are edging closer to their full implementation, with the final version called “Basel III Endgame” or “Basel IV” by some experts due to come into effect from July 1, 2025, with a three-year phase-in period. The standards were drawn up to help stabilise the world’s banking industry in the wake of the global financial crisis of 2007-09 and may have far-reaching implications, not least for lending practices.

The rules have been created by the Basel Committee on Banking Supervision, which was established in 1974 to become the primary global standard-setter for the prudential regulation of banks as well as a forum for regular co-operation on banking supervisory issues. Its 45 members comprise representatives of central banks and bank regulators from 28 jurisdictions.

The Basel III rules, which follow the Basel I standards issued in 1988 and Basel II in 2004, aim to build resilience into the global banking system and avoid a repeat of the financial crisis. Covering the regulation, supervision and risk management of banks, they are intended to apply to all internationally active banks, though rule-making has been led by Europe and there is some variation in how the standards have been implemented around the world.

In particular, the rules govern the amount of capital banks need to hold against the risks they are taking. In practical terms, this influences how much banks are able and willing to lend, and under what conditions.

Steady increase in capital ratios

The implementation of the framework may have been slow, but in many areas the Basel III framework is largely in place already. Under pressure from legislators and prudential regulators, large European banks have been increasing their common equity tier 1 capital ratios for several years. Many of the biggest banking groups, especially those directly supervised by the European Central Bank, already have capital ratios above or close to the Basel IV (or Basel III Endgame) requirements, so little immediate change in their lending patterns or practices is likely.

Other factors will also affect lending decisions, such as the prevailing level of interest rates, the relative indebtedness of borrowers, and the vigour of national and European economies.

In any case, the new standards are being phased in over a lengthy period – up to January 1, 2030. Any rethinking of capital allocation and optimisation of balance sheets required in response to the new rules will take place gradually. Meanwhile, other factors will also affect lending decisions, such as the prevailing level of interest rates, the relative indebtedness of borrowers, and the vigour of national and European economies.

However, the new rules do increase the amount of capital banks need to hold against their lending. This involves calculation of each institution’s risk-weighted assets, assessing the minimum amount of capital that banks must hold depending on the risk profile of its lending activities, as well as other assets on its balance sheet. For example, mortgage lending secured against residential property is viewed as lower risk than credit card lending, and therefore entails fewer capital constraints. The greater the risk a bank is taking, the more capital it must hold to protect depositors in the event that borrowers are unable to repay.

Thus, an increase in the amount of capital banks must hold is highly likely to have at least some impact on their willingness to lend, particularly to small businesses, which are seen as being at the riskier end of the borrower spectrum.

Lessons from the past

There are already some indications from the past on how institutions may respond. In a report for the Banca d’Italia on the early stages of Basel III implementation in Italy, Valerio Vacca and Maddalena Galardo of the central bank’s Financial Stability Directorate identified differences between different types of banks.

“After Basel III was enforced in Italy in 2014, lowly-capitalised banks slowed down credit to firms and raised interest rates compared with capital-strong lenders. They also rebalanced portfolios towards safer borrowers,” they wrote. The report found the same was true regarding lending to micro- and small businesses – after 2014 weaker banks became more cautious in extending credit to small companies as opposed to better capitalised institutions.

The new rules will not inevitably result in reduced lending to small businesses – the reality is more nuanced.

However, that does not mean the new rules will inevitably result in reduced lending to small businesses – the reality is more nuanced. Vacca and Galardo wrote: “Large capital buffers enhance bank resilience, including against black swans (i.e. unforeseeable events) and this should secure more stable lending flows.” It is possible that an increase in capital requirements might, under some circumstances, result in a reduction in a bank’s overall funding costs, increasing rather than diminishing its lending capability.

It is likely that Basel IV will affect banks differently. Institutions facing stricter requirements may experience an increase in the cost of funding, which they are likely to pass on to borrowers, at least in part. This may result in less availability of loans in the market, particularly from weaker banks. Vacca and Galardo said: “Banks that had lower accumulated capital buffers at the moment the new rules entered into force might have modified their lending behaviour more clearly than their capital-richer peers.” However, while overall lending conditions may change, it is likely to be a slow process.

Alternative lenders

There are likely to still be options for borrowers elsewhere in the financial system as alternative lenders move in to take advantage of any pullback by traditional banks. Asset manager M&G argues that banks are “increasingly selling whole pools of typically seasoned, and performing loans, to selected institutional investors – while still servicing the loan assets for a fee and maintaining relationships with end-consumers”.

The installation in Washington of an administration seemingly committed to business deregulation has cast further doubt on how the US will implement the standards.

There is also the question of whether the Basel IV standards will be implemented uniformly across major market economies. Already in 2024 the US Federal Reserve pulled back from some of its original proposals in the face of a concerted campaign by the US banking industry to water down its so-called Basel Endgame requirements. Since then, the installation in Washington of an administration seemingly committed to business deregulation has cast further doubt on how the US will implement the standards.

The post-crisis capital rules have been known and understood for some time. While they may to some degree restrict the availability of loans from banks with weaker capitalisation, and potentially reduce the options available to borrowers categorised at higher risk, a major shift in the banking industry’s lending strategy appears for now unlikely, although greater co-operation and interaction with other types of lender such as credit funds may well be part of institutions’ response.