7 minute read 15 Nov 2021
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How the EU’s Banking Package 2021 has started the Basel 4 endgame

Authors
Jared Chebib

Associate Partner, Financial Services Consulting, Ernst & Young LLP

Financial services enthusiast. Dedicated to helping our clients transform to manage their risks better and meet their regulatory commitments. People coach and leader.

Christopher Woolard CBE

Partner, Financial Services Consulting, EY LLP; EY Global Financial Services Regulatory Network Chair and EY EMEIA Leader, Financial Services Regulation

Experienced senior leader in regulation, strategy and innovation. Building better consumer and market outcomes in financial services.

7 minute read 15 Nov 2021

The European Commission has published new rules to strengthen banks' resilience.

In brief
  • On 27 October 2021, the European Commission (EC) published its legislative package implementing the Basel 3 Reforms, also known as Basel 4.
  • This fires the starting gun on the last leg of the journey to deploy the changes to capital standards in the region through the CRR III and the CRD VI.

With this announcement, the European Union (EU) is attempting to balance two objectives: implementing the proposals of the Basel Committee on Banking Supervision (BCBS) to enhance financial stability and supporting EU institutions’ ability to continue financing the economy.

The EU package mainly follows the Basel proposals, and the majority of the capital changes track the Basel Committee’s guidelines. The EU has – so far, at least – resisted some of the industry proposals to depart significantly from Basel: for example, by having an alternative “parallel stack” approach to Basel’s output floor. But some changes to the Basel proposals are incorporated to reflect specific EU interests, either by tweaking approaches or by providing for a transition period to adjust to specific changes. The Capital Requirements Regulation (CRR) III and the Capital Requirements Directive (CRD) VI also implement the market risk capital changes in the Fundamental Review of the Trading Book (FRTB), although the amendments include a provision that allows the EC to amend the market risk approaches if there are any major discrepancies with other major jurisdictions.

Although the Basel timetable calls for the Reforms to be implemented on 1 January 2023, the EU announcement indicates an application date of 1 January 2025, with transitional arrangements applying over a further five-year period. This seems to confirm speculation of a further delay from the Basel timetable and fits with the typical EU (and country-level) legislative processes.

The EC estimates that the impact of implementing the proposed Basel 3 Reform options is expected to lead to a weighted average increase in EU banks’ minimum capital requirements of +6.4% to +8.4% in the long term (by 2030) after the envisaged transitional period.

And the EU has taken the opportunity to include additional regulatory change in this package, including (i) environmental, social and governance (ESG) requirements, (ii) the introduction of a new framework and classification system that will require reauthorization of all existing third-country branches, (iii) amendments to the bank crisis management framework, and (iv) further measures to harmonize supervisory powers and tools.

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1

Chapter 1

Implementation of the Basel 3 Reforms

The EU is adjusting the Basel proposals to reflect specific local needs.

Output floor

Establishing an output floor has proved to be one of the most controversial Basel proposals. The output floor limits the capital benefit arising from the use of risk models across all risk types by establishing minimum risk weighted assets (RWAs) at 72.5% of the standardized (i.e., non-modeled) level. The output floor is incorporated in CRR III and CRD VI at 72.5%, but is confirmed to operate primarily at the consolidated EU level only.

Although individual group entities below the EU parent are not subject to the output floor, there is an approach specified to apportion floored RWAs at the consolidated level to subsidiary parent companies in each EU country. This will result in the impact of the consolidated floor being distributed across the countries in which an EU group operates.

In a further concession, the EC notes that the Pillar 2 Requirement and the systemic risk buffer can be used to address risks that are similar in nature to those addressed by the output floor and these may need to be amended to avoid double counting.

Standardized credit risk

The Basel proposals provide for various changes that make standardized approaches more risk sensitive. Generally speaking, the changes tend to add more tiers, categories and requirements, thereby making standardized approaches more complex.

The EC incorporates the Basel changes to standardized credit risk approaches for institutions, corporates and specialized lending. However, two EU specificities are included. These recognize concerns arising from the fact that many EU corporates and specialized lending exposures are unrated. Accordingly, for unrated corporates with a probability of default (PD) of less than 0.5%, the standardized risk weight is set at 65% rather than 100% for a transition period. And unrated object finance exposures that are assessed to be high quality will also benefit from a relatively favorable capital treatment. In addition, the current EU infrastructure supporting factor is retained.

The EC also incorporates the Basel changes to standardized credit risk for retail exposures. However, there is an EU-specific concession in real estate lending. Instead of the proposed Basel approach of requiring the value of the property to be based on the value at the time of the loan origination, the EC approach permits the property value to be adjusted upward, but only to the average of the property’s value over the last three (for commercial) or six (for residential) years.

Under the Basel changes, equity exposures can only be treated as standardized, and the risk weights are set at levels up to 450%. The EC incorporates these changes but proposes two concessions: the first sees intra-group equity exposures remain at a 100% risk weight, and the second provides for a transition period of adjustment to the new Basel risk weights.

Internal ratings-based (IRB) credit risk

The EC incorporates the Basel changes to remove the Advanced-IRB (A-IRB) approach option for exposures to large corporates and financial institutions, and remove all IRB approach options for equity. However, in an EU-specific change, exposures to public sector entities, regional governments and local authorities are exempted and can remain on the A-IRB approach.

Basel proposes input floors to establish minimum levels of PD, loss given default (LGD) and exposure at default (EAD) within the IRB framework. Further changes include the removal of the 1.06 scaling factor and a reduction of the LGD component in Foundation-IRB from 45% to 40%. The EC incorporates these changes to IRB; however, for specialized lending and leasing exposures, the input floor is subject to a transitional phase-in.

Credit valuation adjustment (CVA)

The EC incorporates the Basel changes to CVA to remove the use of internal modeled approaches and require a standardized approach or a basic approach.

Operational risk

The Basel changes to operational risk remove the advanced measurement approach (AMA) and replace it with a non-modeled standardized approach. This is based on a business indicator component (BIC) that the EC incorporates. However, the EC approaches do not further consider historical operational losses. Hence, as a much-anticipated development, the operational risk internal loss multiplier (ILM) element is effectively set at 1.

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Chapter 2

Full implementation of FRTB

The EU has also included market risk capital changes in the FRTB.

The EC had originally planned for inclusion of binding FRTB standards as part of CRR II. However, following the revision of the standards published by the BCBS in 2019, combined with updated timelines, FRTB was only included in CRR II for reporting purposes. The CRR is now amended to reflect the revised FRTB standards from 2019, with a proposal to move to binding capital requirements for market risk and CVA, which would come into force on 1 January 2025. This timeline diverges with the BCBS proposal of 1 January 2024.

Additionally, the amendments include a provision that allows the EC to amend the market risk capital calculation approaches if there are any major discrepancies with other major jurisdictions, by 31 March 2024.

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3

Chapter 3

Highlights of other CRD/CRR amendments

New requirements and technical elements are also clarified through the CRR and CRD updates.

ESG requirements

CRR III and CRD VI include considerable new ESG requirements for banks and require the EBA to accelerate the publication of recommendations on capital requirements to June 2023. In addition, the suitability of the macro-prudential framework for dealing with these risks will be reviewed by 2022.

Third-country branches (TCBs)

The EC has introduced a new framework incorporating a classification system and accompanying requirements for the authorization, regulation, reporting and supervision of TCBs in the EU.

Updates to bank crisis management and deposit insurance framework

The EC proposal incorporates some technical elements related to the resolution regime, aimed at clarifying some aspects of the total loss-absorbing capacity (TLAC)/minimum requirement for own funds and eligible liabilities (MREL) regime both under a single point of entry (SPE) and a multiple point of entry (MPE) resolution strategy. These reforms relate to technical issues that do not alter the essence of the approach to resolution but, rather, contribute to operationalizing the implementation of TLAC.

Summary

As the first major jurisdiction to show its hand, the EU has started the Basel 4 endgame. Other leading regulators, notably in the US and the UK, will need to respond, both with their versions of the Reforms and views on the timing of implementation.

About this article

Authors
Jared Chebib

Associate Partner, Financial Services Consulting, Ernst & Young LLP

Financial services enthusiast. Dedicated to helping our clients transform to manage their risks better and meet their regulatory commitments. People coach and leader.

Christopher Woolard CBE

Partner, Financial Services Consulting, EY LLP; EY Global Financial Services Regulatory Network Chair and EY EMEIA Leader, Financial Services Regulation

Experienced senior leader in regulation, strategy and innovation. Building better consumer and market outcomes in financial services.