The Basel regulation’s TP implications for banking institutions: yesterday, today, and tomorrow

The Basel regulation’s TP implications for banking institutions: yesterday, today, and tomorrow

Since the introduction of the first Basel accord in 1988, these standards on banking regulation have evolved continuously. The next accord, Basel II, was introduced in 2004. Then, in response to the global financial crisis, the Basel III accord was published in 2010. While Basel III was scheduled to be phased in from 2013 to 2015, its full implementation was extended repeatedly, initially to January 1 2022 and then until January 1 2023 due to the COVID pandemic.

Now, without much delay, the regulatory reform process continues with the introduction of a new Basel framework that is set to take effect under transitional rules from 2025. The Basel Committee on Banking Supervision refers to the new rules as finalising the Basel III post-crisis reforms. Former European Central Bank president Mario Draghi also named the new accord “the Basel III endgame”, while others refer to it as “Basel 3.1”. In the EU, it is referred to as the Capital Requirements Regulation III and extends into the Capital Requirements Directive VI.

This article will refer to it as “Basel IV”. Basel IV aims to address certain shortcomings in the pre-crisis regulatory framework and provide a foundation for a resilient banking system to manage the build-up of systemic vulnerabilities.

Beyond its core measures of reinforcing approaches for risk valuation, exposure management and leverage limits, capital determination, and regulatory reporting, Basel IV will further increase banks’ regulatory capital requirements and reduce their free capital.

Basel IV will have a material impact for banks and other financial institutions. This article will analyse the key impacts of the new Basel IV rules on transfer pricing policies and practices in the banking sector.

As one could expect, the impact of Basel IV will vary between geographies, bank types, and business models of international banking groups. It remains unclear to what extent, and by which date, the new Basel IV rules will be fully transposed by different regulators. As an example, implementation in the Asia-Pacific region is especially uneven, with different regulators pushing back on timing, introducing extra rules, or applying a two-track system for banks that are subject to higher standards.

Nonetheless, we can determine four key implications that should be on the agenda for tax and transfer pricing functions in the banking sector:

  • Business strategy and operating models;

  • Capital and funding;

  • Booking models and trading books; and

  • Risk allocation and risk transfers.

Business strategy and operating models

The increase in capital requirements will likely lead to the need for all banking institutions to reassess their business strategy and product offerings. Initially, this may prompt reviews of product-level profitability and capital utilisation, with tax and transfer pricing functions being brought in (e.g., where these interact with cross-border transfer pricing charges or product-level taxes vary).

We may see exits from businesses and clients with low profitability, and a revision to product offerings. From a transfer pricing perspective, such exits could necessitate an assessment on potential exit taxes and the treatment of closure-related costs where these exits are in the cross-border context. Tax functions will also need to consider how to treat synergies and cost savings in the context of their transfer pricing policies.

Furthermore, we are likely to witness a further review of the legal entity set-up of international banking groups, questioning the number of separately regulated legal entities. In response, the authors expect more banking groups to operate under harmonised regulatory regimes, such as the single European rulebook and ‘passport’ system in the EU. This will likely lead to a further wave of ‘branch-ifications’ in the EU – i.e., the conversion of legal banking entities into branches – given that branches are more capital efficient as they can rely on the regulatory capital of their head office.

This is also expected to create further ripple effects given that local supervisors have historically preferred subsidiaries in their jurisdictions to better control risk exposure and balance sheets.

Basel IV introduces a revised capital floor, constraining internal models by ensuring capital meets a percentage of the standardised approach, with phased implementation gradually increasing risk-weighted assets. This increase in capital requirements would feed into tax and transfer pricing models that rely on risk-weighted asset calculations (e.g., profit split attributions for regulatory capital, or interest expense deductions/adjustments). Equally, these adjustments would feed into the attribution of capital between head offices and branches under the authorised OECD approach (AOA) rules.

To meet increased capital requirements, there are two options: banking groups can inject more capital or use hybrid debt instruments and subordinated term debt that can be included in the tier two capital base for regulatory purposes, while meeting the earmarks of debt for tax purposes.

Hybrid debt instruments and subordinated term debt are more challenging to support from a transfer pricing perspective, as they lack market comparables and rely on banks’ internal pricing models. They also contain features that are rather alien to tax authorities, such as loss-absorbing features.

In addition, banking groups will also likely increase the use of guarantees from highly rated counterparties and funded guarantee schemes aimed at managing large exposure risks. The pricing of guarantees and funded guarantee schemes is complex from a transfer pricing perspective, especially when defending their deductibility vis-à-vis the option realistically available of increasing the capital base.

Booking models and trading books

One of the new requirements of Basel IV is that banks must review their policies, procedures, and documentation to determine the correct allocation of financial instruments to the respective trading books, ultimately leading to more technical discussions and potential scrutiny on booking locations.

Regulators tend to focus on approvals by senior management and the supervisory position (based on a new set of functional requirements) for the allocation of financial instruments, both between legal entities and between a head office and branch. This is in contrast to the guidance of the OECD in the 2010 Report on the Attribution of Profits to Permanent Establishments, where the attribution primarily follows the so-called key entrepreneurial risk-taking (KERT) functions. There could be situations where the regulatory position is different from the transfer pricing position, especially in the context of banking branches, as the attribution principles for tax purposes based on the AOA focus purely on so-called risk acceptance as KERT functions (which might be different from the notion of approvals and oversight by senior management).

Furthermore, there will be more discussions from a regulatory perspective around the allocation between trading books and banking books, as well as between different trading books. While regulators focus on the overall banking entity, the view from a tax perspective could be different where it involves cross-border business or jurisdictions where tax rates differ by product.

Risk allocation and risk transfers

Lastly, considering increased capital requirements and risk limits, banking institutions will likely make more use of market and credit risk transfers given that the return on capital to booking entities will increase while the return on the trading location will decrease. Such risk transfers can be towards third-party investors, as well as off-balance sheet entities within the same banking group.

While Basel IV introduces stricter rules for risk transfers between a trading book and a banking book or between trading books, internal or external risk transfers are likely to increase. This will raise the question of related-party status, as well as the consistency of pricing in view of internal comparables.

The regulatory and tax dimensions for international banking groups are becoming more complex and intertwined. With the introduction of a new Basel framework set to take effect from 2025, tax departments will need to work with the business and regulatory side to address the four key implications from the new Basel IV accord.

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