On 16 April, the European Parliament formally ratified the EU’s Risk Reduction Measures (RRM) package on bank capital and liquidity, clearing the way for the finalisation of one of the most significant pieces of EU-level banking regulation in years.

This has been more than two-and-a-half years in the making, with a long period of difficult political negotiations following the RRM’s proposal by the European Commission in November 2016. The RRM is a combination of the EU’s fifth Capital Requirements Directive (CRD5), the second Capital Requirements Regulation (CRR2), and the second Bank Recovery and Resolution Directive (BRRD2).

The RRM contains a number of important additions to the EU regulatory framework for banks, including the introduction of Total Loss Absorbing Capacity requirements (TLAC), the Net Stable Funding Ratio (NSFR), the binding Leverage Ratio, and a partial introduction of the Fundamental Review of the Trading Book (FRTB), among several other initiatives.

While this is undoubtedly an important milestone in the EU’s adoption of post-crisis standards on bank capital and liquidity from the Basel Committee on Banking Supervision (BCBS), it is far from the end of the line. Several more years of secondary rulemaking lie ahead before the RRM can be fully implemented, and EU-level work is already underway to propose legislation to implement the remaining elements of the finalisation of Basel III (referred to by some as Basel IV).

Taking all of these into consideration, there is a lot for EU banks to keep track of as they consider the financial and operational demands of implementing new capital rules over the coming years. When facing the implementation work that will arrive most immediately from CRD5, CRR2 and BRRD2, banks should assess how their planning and regulatory work driven by this can also put them in a better position to deal with implementation demands that will arrive later, both from this legislative package and from those still on the way.

Finalising and implementing the RRM package

Now that the final legislative agreement has been ratified, the RRM package is expected to enter the Official Journal of the European Union in May or June. Twenty days after that, it will enter into force. This is the point at which these files become fully-fledged EU laws.

Entry-into-force, however, does not mean that the rules will apply straight away. Indeed, in the RRM’s case, most of the regulatory initiatives it contains will only apply several years later. TLAC is the most prominent exception here, as it will apply immediately, almost in line with the January 2019 implementation target originally set by the Financial Stability Board when it completed the global standards.

Many other key components of the RRM will be subject to a two-year implementation period whose clock will only begin ticking once the package enters into force. For this reason, EU banks will have to implement the NSFR, the baseline Leverage Ratio and the Standardised Approach to Counterparty Credit Risk (among others) from the summer of 2021.

Our earlier blog discussed how the EU ultimately decided to use CRR2 to implement the FRTB as a reporting requirement only and to require new legislation (i.e. CRR3) to make it a binding capital requirement. In order to make the reporting requirement work, the Commission will adopt a Delegated Act by 31 December 2019, updating CRR2 to reflect revised international standards for the FRTB that were only agreed by the BCBS in January 2019 (too late in the negotiation process to be reflected in CRR2). Firms will be expected to begin reporting market risk using the FRTB’s standardised approach one year after the Delegated Act is adopted, and they will be able to begin using internal models approaches two years after that.

In CRD5, the Intermediate Parent Undertaking (IPU) rules requiring non-EU banks of a certain size to establish an EU IPU to house their EU activities will apply after three years (so, mid-2022). And in BRRD2, the revised Minimum Requirements for Own Funds and Eligible Liabilities (MREL) on loss-absorbing debt must be met by banks, in most cases, by 1 January 2024.

Underpinning much of this implementation work will be a significant amount of secondary rulemaking that will see the Commission and European Banking Authority (EBA) draft detailed standards to specify the way in which many of the RRM’s initiatives should be applied. Initial analysis shows that there are something in the order of 65 mandates for secondary legislation contained within the RRM’s text. These are a mix of binding Regulatory and Implementing Technical Standards to be developed by the EBA, Delegated and Implementing Acts that will come directly from the Commission, and non-binding EBA Guidelines aimed at clarifying implementation challenges. Many of these secondary standards could nevertheless have significant sway over how challenging these new rules will be for banks to put in place and operate under.

What’s next on the EU bank capital agenda?

Despite the success of completing the RRM package at the political level, and notwithstanding the immense implementation task that authorities and banks alike now face, there is little time for the EU authorities to pause for breath before taking the next steps in the bank capital agenda.

On their plate now is the EU’s adoption of the BCBS’s December 2017 agreement on the final elements of the Basel III framework. This will include, inter alia, the introduction of revisions to the standardised and internally modelled approaches for credit risk, a new approach for operational risk, and the adoption of an output floor for risk weighted assets calibrated at 72.5% of the notional output derived from standardised approaches. As mentioned earlier, the EU will also have to review the FRTB as it considers how best to introduce it as a binding capital requirement. Aspects of these BCBS standards have been particularly contentious in EU policy and industry circles given the perception that these rules would affect European banks disproportionately relative to international, and particularly US, peers. In fact, the EBA’s March 2019 preliminary assessment of the impact of Basel III predicted that it could raise the Tier 1 capital needs of globally-systemic European banks by as much as 28.4%.

As a result, EU authorities are giving very careful consideration to how the final elements of Basel III can be adopted in the EU in a more proportionate way while taking into account ‘European specificities’. To kick-start this work, the Commission issued a Call for Advice to the EBA in May 2018, requesting a detailed impact assessment and policy recommendations on the adoption of the new standards. The EBA is due to respond to this call with two reports in July (on most of the package) and September (looking specifically at the FRTB). Once these are completed the Commission will begin drafting a new legislative proposal that we expect to be called CRD6/CRR3. This, like its predecessor, will then have to go through multi-year negotiations in the European Parliament and Council before it can become law.

And so the cycle starts again, as EU policymakers take the next steps in their long post-crisis journey of determining how best to use capital regulation to strengthen the resilience of European bank balance sheets. From a bank’s perspective, important clarity is now available with the finalisation of the RRM, but several more years of policy development still lie ahead, both in Level 2 work and in preparing for the next legislative cycle. In the near-term, the sector should pay particular attention to the EBA’s detailed assessment of the effect of Basel III on European banks, due in July. This report should provide an even more complete picture of the capital impact banks can expect to face, but could also contain important clues about where EU authorities may ultimately decide to diverge from a strict application of the BCBS standards.