how Basel output floor could tilt bank lending – Bank Underground

Marzio Bassanin

The 2017 finalisation package of the Basel III reforms to bank capital regulation aims to make capital requirements more robust and consistent across banks. One of its most significant changes is the introduction of the ‘output floor’, which limits how far capital requirements calculated using internal models can fall below those based on standardised approaches. But the output floor is not just about capital levels. We find that it may tilt lending towards corporate loans and some riskier mortgages, and away from the safest mortgages. And if banks’ responses to past reforms are any guide, banks won’t wait until its full implementation in 2030 to start reacting.

What’s the output floor?

The Basel framework for bank capital regulation aims to align capital requirements with risks: banks should hold more capital against riskier assets. The framework does this through risk weights, which determine how much capital banks must maintain against different types of lending for their own safety and soundness and to ensure financial stability. Because capital is costly, changes in risk weights can affect which loans banks find most attractive. Across banks, decisions about which assets to hold can, in aggregate, affect the type of credit supplied, including higher-risk loans that support productive investment, as well as the costs of that credit.

Banks can estimate risk weights using approved internal models or apply standardised approaches set by regulators. The case for internal models is that banks with the right expertise and capabilities are often best places to assess the risks on their balance sheets. Internal models let them turn detailed information about their borrowers, such as the probability that they default and the losses that would follow, into estimates of risks. But internal models have long raised concern: they can generate different risk weights for portfolios that look similar in terms of the underlining risks. This is not just a theoretical concern – empirical studies have shown it. That kind of variability raised questions about how robust the system really is.

The 2017 Basel III finalisation package responded with the output floor, a backstop that limits how much banks can reduce risk-weighted assets (RWAs) using internal models. Under the output floor, banks’ RWAs cannot fall below 72.5% of those implied by the standardised approaches. When internal models generate lower RWAs, the output floor becomes binding. In Chart 1, the RWAs calculated using internal models (green bar) fall below the floor and therefore are replaced by the 72.5% of those calculated with standardised approaches (blue bar, right). By underpinning internal models with a common benchmark, the output floor aims to reduce unwarranted differences in RWAs across banks with similar portfolios.

Chart 1: The output floor at work

Standardised approaches aren’t perfect – they apply fixed risk weights which have relatively limited risk-sensitivity – but they do offer something models often struggle to deliver: consistency. Because those weights are set by regulators and applied the same way to all banks in each jurisdiction, they help reduce unwarranted dispersion in capital requirements.

The output floor won’t bite all at once. In the UK, it will be phased in gradually from 1 January 2027, starting at 60% and rising to 72.5% on 1 January 2030. As the floor approaches its final level, it is expected to become a binding constraint for more banks – especially those with concentrated exposures to assets where the gap between internally modelled and standardised RWAs is largest – shaping how they measure and manage risks.

This post examines the incentives created by the output floor. But banks do not operate under a single regulatory constraint. They also face a leverage ratio, a simple risk-insensitive backstop based on capital and total exposures. Their choices will reflect which constraint dominates. Our findings speak more to those banks that are not constrained by the leverage ratio.

How are banks expected to react when the output floor is fully implemented?

In a new Bank of England staff working paper – Acosta-Smith et al (2026) – we study how banks are likely to respond to the implementation of the output floor over the cycle. To explore these effects, we use an extension of the macroeconomic model developed by Angelini et al (2014) which features banks that lend to households through mortgages and to nonfinancial corporates. We compare two regulatory regimes: one based solely on internally modelled risk weights (RWs) and another that incorporates the output floor.

We simulate an economic expansion driven by a positive technology shock. Results in Chart 2 suggest that the output floor moderates the rise in the credit-to-GDP ratio during economic expansions by preventing RWAs from falling too far hence keeping capital requirements tighter.

Chart 2: RWAs, credit-to-GDP and lending

Notes: The chart compares the impulse responses functions (deviation from the steady state values – percentage point deviation for RWAs and credit-to-GDP, per cent deviation for mortgages and corporate loans) to a positive technology shock with and without the output floor. After the shock, both mortgages and corporate loans increase but the magnitude depends on the prudential framework in place. With the output floor, the increase in mortgages is milder – at the end of the simulation period mortgages are 0.4 percentage point lower – while the increase in the corporate loans higher – around 0.2 percentage point higher. Differences seem to be persistent over the simulation period.

Chart 2 also shows how the introduction of the output floor affects banks’ allocation of lending. When the output floor is in place and it becomes binding, banks expand corporate lending more than mortgages relative to the regime based solely on internal models.

The key driver is the gap between internally modelled and standardised risk weights (IM-SA gap) and how the size of this gap varies across different asset classes. Standardised risk weights are generally higher than those produced by internally modelled ones, but the size of the IM-SA gap varies considerably across asset classes. Assets with a large IM-SA gap see the biggest increase in capital requirements (because the output floor is higher than modelled RWs). By contrast, assets with a small gap are affected much less and, in some case, the required regulatory capital reduced (because the output floor is equal to or lower than modelled RWs).

For UK banks, data show that mortgages tend to have lower RWAs than corporate loans but have a larger IM–SA gap – so the output floor is generally more binding for mortgages than for corporate loans. Chart 3 illustrates the implications: over the simulated period, the output floor-implied risk weights (72.5% of standardised RWs) are higher than the internally modelled risk weights for mortgages, but lower for corporate loans. As a result, once the output floor binds, mortgages become more ‘expensive’ in terms of capital requirements, while corporate loans become ‘cheaper’. Banks therefore are incentivised to expand more corporate loans than mortgages, to mitigate the costs of the output floor.

Chart 3: Assets’ contributions to capital requirements

Notes: The chart reports the difference (in percentage points) between the output floor implied risk weight (72.5% * SA risk weight) and the SA risk weight over the simulation of a positive technology shock. The difference is positive for mortgages and negative for corporates loans, meaning that the former become more expensive, while the latter cheaper for banks. The magnitude is higher for corporate loans compared to mortgages.

Models tidy up a world that’s anything but tidy. Ours boils banks’ balance sheets down to just two asset types. But mortgages, for instance, span a huge range of risks. Bigger IM–SA gaps tend to show up for safer mortgages, while smaller gaps point to riskier ones. Put simply, once you drop this back into the real world, the output floor is expected to push UK banks towards riskier mortgages and corporate loans and away from the safest mortgages – assuming everything else constant.

What can we say today about banks’ reactions?

The output floor won’t fully take effect until 2030. But that doesn’t mean banks which will see the output floor binding in 2030 will wait until then to react. Whether we see early behavioural changes depends on how much banks anticipate the future regime – and history suggests they often move well before formal implementation.

A study by Fritsch and Siedlarek (2022) at the Federal Reserve Bank of Cleveland looks back at the Basel III reforms. They find that banks started adjusting their regulatory capital positions shortly after the proposed rules were announced in 2012. That was years before the new regime actually came into force. They find that the effect was especially clear for US regional banks, which are typically more sensitive to supervisory scrutiny and have stronger incentives to stay comfortably above regulatory thresholds.

Early reactions aren’t limited to capital ratios. Hendricks et al (2023) document strategic changes in reporting, lobbying and business models that reduced banks’ exposure to the proposed Basel III rules before they were finalised. And looking at a different policy change, Guillaume et al (2020) show that UK banks eligible for Pillar 2A capital relief started altering their asset composition after the relevant policy statement was published, not when the relief formally applied.

Taken together, these studies suggest a clear pattern: when regulatory rules change but are not yet in effect, banks tend to react early.

What can we conclude?

Once the output floor is fully in place, banks are likely to rebalance their portfolios towards corporate loans and some riskier mortgages, and away from the safest mortgages. All else equal, these incentives point towards a reallocation of credit toward relatively higher-risk finance that may support productive investment.

Past experience suggests that banks will not wait until the output floor is fully implemented in 2030 to respond. Banks most likely to be affected by the output floor may already be adapting their strategies, with early signs of portfolio shifting emerging well before 2030. That makes this an area where timely empirical work could add real value.

As we noted at the start, the post sets aside the leverage ratio, the other backstop sitting alongside risk-weighted capital rules. A natural next step for future research will be to test whether a binding leverage ratio dampens the impact of the output floor.

Marzio Bassanin works in the Bank’s Prudential Framework Division.

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