Relevant to: Board members, executives, investors and senior leadership in EU banks and EU-based subsidiaries of global groups responsible for regulatory affairs, risk and capital planning

At a glance: 

  • The European Commission is soon due to publish its proposal for a revised Capital Requirements Directive and Capital Requirements Regulation (the CRD6/CRR3 package). These will implement the Basel 3.1[1] framework in the EU. We believe five key questions are likely to dominate the political debate that will follow this publication.
  • Understanding the timing of implementation in the EU will be crucial for banks. Based on past precedent, there are real doubts over whether the package can apply in the EU before the BCBS’ 1 January 2023 deadline. While we recognise that the start date will likely be late, we expect the EU to commit to finalising implementation according to the BCBS 1 January 2028 fully phased-in deadline.
  • Regulators worldwide will be watching to see how faithfully the EU adheres to the Basel 3.1 standards agreed in 2017. Any new EU-specific deviations from the Basel 3.1 framework such as the treatment of corporate lending, and in particular, the EU’s implementation of the output floor, will receive considerable attention.
  • Divergence in the way that the EU implements Basel 3.1 relative to other major jurisdictions will make global banks’ implementation more complex and costly. It will also raise some important strategic and competitive issues for banks inside and outside the EU.
  • The Commission is also likely to include some initiatives in its proposal that are not directly related to the BCBS framework. In our view, the three most important are likely to be: (1) requirements that integrate ESG risks into the prudential framework; (2) measures to strengthen the accountability of senior management, and; (3) measures to harmonise the supervision of third country branches in the EU.

This blog explains the five key questions we identify in more detail and why they should matter to bank boards and senior executives.

The Basel Committee on Banking Supervision (BCBS) agreed the final elements of the Basel 3.1 framework in December 2017, but the timing and nature of its implementation in the EU are subject to a complex legislative negotiation that has yet to begin.

The Commission is now preparing its next bank capital legislative package, setting out its proposed approach to implementing the final Basel 3.1 framework in EU law. The package will comprise the sixth Capital Requirements Directive and third Capital Requirements Regulation (CRD6/CRR3) which are expected to be published in late October.

In preparation for this proposal, the Commission asked the European Banking Authority (EBA) to conduct an impact assessment of the new Basel standards and provide detailed policy recommendations. The EBA’s latest assessment, published in December 2020, found that the Basel 3.1 revisions could lead to an 18.5% increase in minimum capital requirements (MRC) for EU banks[2], if implemented faithfully to the international standards, or a 13.1% increase if the EU retains a number of EU-specific amendments to the framework.

We have set out below five questions to look out for in the Commission’s proposals:

1. Will the EU implement Basel 3.1 on time?

The Commission and other regulators (such as the EBA) maintain they are committed to implementing the Basel 3.1 rules in time for the 1 January 2023 target set by the BCBS, with a five-year implementation period for the standardised output floor running to 1 January 2028. Despite this, we remain highly sceptical about whether the EU’s legislative negotiation process can be concluded by 1 January 2023.

Precedent suggests that a legislative package of CRR3’s complexity and importance will likely take at least two years of negotiations at the political level. This would normally be followed by an implementation period before new rules are brought into force. In the case of CRR2, the implementation period for most provisions was two years.

Why does this matter? Divergent timing between different BCBS jurisdictions will create challenges for cross-border banks, whose entities will likely end up working to different deadlines. This will complicate group-wide regulatory change programmes.

2. What "EU-specificities" will be included in the package?

EU regulators (led by the EBA and the Single Supervisory Mechanism (SSM)) have emphasised the importance of the EU adhering to the Basel rules. There is, however, pressure from industry groups for the EU to tailor its Basel 3.1 implementation to mitigate the likely capital impact, particularly in the wake of the COVID-19 pandemic. This is driven by the expectation that capital increases arising from Basel 3.1 will have a disproportionate impact on European banks and could lead to even greater competitive pressures against a backdrop of already weak profitability and thin margins.

In previous CRD/CRR negotiations, the term “EU-specificities” has been used to describe structural market characteristics that justify the EU’s deviations from global standards. The commitment by EU finance ministers that Basel 3.1 would not lead to an increase in aggregate capital for EU banks will likely be used as a justification to identify EU-specificities and propose consequent changes to the Basel 3.1 framework in CRD6/CRR3.

EU-specificities are likely to be incorporated into the Commission’s proposal in two ways:

  • Deviations from the BCBS text: The treatment of exposures to unrated corporates under the revised standardised approach for credit risk is one area where the Commission may propose the adoption of a more flexible “hybrid” approach. We covered the policy considerations in relation to unrated corporates in our previous blog: The unrated corporate exposure conundrum: Basel 3.1, capital and pricing.
  • Retaining existing deviations from the BCBS text: These include CVA exemptions for corporate exposures and the EU’s supporting factor for exposures to SMEs. While the EBA has called for these deviations to be rolled back in CRD6/CRR3, we believe EU legislators are likely to opt to retain them.

Why does this matter? Divergence in the substance of the rules will create a more complex regulatory landscape for cross-border groups that could have implications for pricing and strategy as well as compliance. It could also affect the cross-border competitiveness of EU banks relative to their global peers.

3. How will the EU implement the output floor?

We wrote about EU options for the standardised output floor in our 2020 blog: How the EU could implement the Basel III output floor. This has been the subject of considerable debate given the EBA’s assessment that it will be the single largest contributor to capital increases for EU banks. 

Some have called for the EU to modify the output floor to reflect EU-specificities, including through measures such as adopting the “parallel stacks” proposal[3]. The Commission, however, has come under significant pressure from most EU Member States not to diverge from the Basel 3.1 text in this area. As a result, we believe the CRD6/CRR3 proposal is likely to put forward an output floor framework that adheres carefully to the BCBS standards. Nonetheless, we believe the likelihood of the European Parliament and Council proposing modifications to the output floor is high. Interestingly, the ECB has recently reported that the gap between EU banks’ standardised and IRB numbers has narrowed due to their targeted review of internal models (TRIM) exercise which has increased RWAs by EUR 275 Bn.[4] This will reinforce supervisors’ arguments against changing the output floor.

Why does this matter? Output floor calibration will determine much of the capital impact of CRD6/CRR3 for EU banks. In addition, the design choices for the output floor that the EU will have to make will affect banks’ ability to allocate capital efficiently across the group, as explored in our 2020 blog, linked above. 

As negotiations on the output floor progress, we believe banks should focus on ensuring that they are ready to implement accurately and comprehensively the new standardised approaches that will determine the overall effect of the floor. Where banks are calculating standardised approaches for portfolios for the first time (as in the case of some IRB banks), making sure accurate standardised numbers are available will help to manage the challenge of implementing the output floor, regardless of its eventual calibration. You can read more of our views on this in our recent blog: Basel 3.1 and standardised RWAs: time to get serious. 

4. Will the Commission incorporate sustainable finance?

The Commission’s recently refreshed sustainable finance strategy states that it will use CRD6/CRR3 to integrate ESG fully and formally into the EU prudential framework. Currently, a “green supporting factor” appears unlikely – the EBA is due to publish a report on a dedicated prudential treatment for climate risks in 2023, and we do not expect the Commission to pre-judge that report.[5] Instead, we expect the Commission’s proposal to set formal requirements for the integration of ESG into firms’ risk management frameworks, set requirements for internal climate risk stress testing, and empower national supervisors to incorporate ESG risks into the Supervisory Review and Evaluation Process.

However, that is unlikely to be the end of the story. Many in the European Parliament will be keen to push the EU’s climate agenda forward as far as possible, and will advocate stronger action – potentially through the inclusion of a green supporting factor, or higher risk weights for banks’ fossil fuel exposures. Given the 2023 deadline for the EBA report, it is possible it will be published before the CRD6/CRR3 text is finalised. This could leave room for inclusion of a dedicated prudential treatment in the final legislative text.

At present, EU supervisors feel the existing framework provides sufficient flexibility to manage ESG risks. In the near term, instead of contemplating the prospect of a green supporting factor, banks should focus on improving their climate risk management capabilities and organisational arrangements.

Why does this matter? Our view is that, while the implementation of a climate scaling factor could have a significant impact on banks’ RWAs, at present it is a sufficiently remote prospect that it should not be EU banks’ near term focus when it comes to climate change. The integration of climate risk into banks’ risk assessment, including the ICAAP, will mean that climate risks have an impact on RWAs and capital in the nearer term. In-scope banks should therefore focus on meeting supervisory expectations for climate risk and understanding the capital implications of doing so

This will be particularly pertinent to smaller, non-SSM, banks that will be brought into the scope of climate risk management requirements for the first time by CRR3. For them, the EBA’s report on management and supervision of ESG risks, as well as feedback from the ECB on compliance with their Guide on climate-related risks will serve as a useful reference for industry practice and supervisory expectations.

For more information, read our blog: Climate-related financial risk in banking | The state of play on capital requirements.

5. Will the Commission include non-Basel measures in CRD6/CRR3?

We know from the Commission’s 2019 consultation on implementing Basel 3.1[6] that it sees the CRD/CRR as an opportunity to consider bank accountability and governance. The consultation specifically sought views on “…benefits and drawbacks of designing an accountability regime whereby the management body of each institution would be required to draw up a statement of responsibilities of each of its members clearly identifying the activities for which they are responsible…”.  This, together with the increasing global prevalence of executive accountability regimes, makes it reasonable to expect the Commission to include such an initiative.  Any such measures will probably be included in the Directive, rather than the Regulation, as it seems likely that different Member States may prefer the discretion to take varying approaches to this issue.

The Commission may also choose to respond to the EBA’s recent report on the harmonisation of EU law applicable to third country bank branches[7] by including some of the recommended measures in the legislation. If this is included, new measures could focus on the reduction of discrepancies in the supervision of third country branches by National Competent Authorities, enhanced reporting requirements for branches and additional measures that supervisors could take if a branch is considered systemically important.  

Why does this matter? The Commission has always used CRD/CRR proposals as a vehicle to include some non-Basel initiatives, many of which have become important regulatory requirements for banks – this time is likely to be no exception.

On accountability, the Commission observed that defining the roles and responsibilities of members of the management body and key function holders “could also help to make fit and proper assessments by firms and competent authorities more informed and targeted”. This indicates that the Commission may see its proposals for accountability as an enhancement to the fit and proper regime rather than a regime modelled on the UK’s SM&CR. Nevertheless, if the Commission advances proposals to enhance accountability, boards and senior executives will need to transform some of their governance and management arrangements.

On the approach to third country bank branches, banks will need to assess how any proposal might affect their group structure. Any indication that significant third country branches might need to subsidiarise would be an important structural reform initiative that would require significant planning and work and entail significant costs.

Where we go from here

Where the EU lands on these questions will affect the requirements that banks must implement, and the cross-border consistency of requirements that international banking groups will face.

Many in the banking sector feel that finalising Basel 3.1 has already been a long and complex journey; considering these five questions will help bank boards, executives and investors assess where that journey will conclude. Banks that most accurately anticipate how the outcome of the legislative process will affect their business models and competitive environment will have a first mover advantage.

--


[1] We use “Basel 3.1” to describe the December 2017 BCBS publication Basel III: Finalising post-crisis reforms

[2] The EBA’s assessment did not include any UK banks.

[3] The parallel stacks approach to the output floor is a proposed approach where bank capital requirements are defined as “the higher of the floored requirements excluding Pillar 2 and SRB and the un-floored requirements including Pillar 2 and the SRB”, https://www.ecb.europa.eu/pub/financial-stability/macroprudential-bulletin/html/ecb.mpbu202107_1~3292170452.en.html

[4] The final leap: implementing the Basel III reforms in Europe, speech by Elizabeth McCaul, European Central Bank, https://www.bankingsupervision.europa.eu/press/speeches/date/2021/html/ssm.sp210908_1~2f82d84760.en.html

[5] A green supporting factor would reduce the risk weight on lending that meets a specified “green” assessment. Another option might be a brown penalising factor, which would increase risk weights on lending that fails a specified “green” assessment.

[6] European Commission consultation document - Public consultation: Implementing the final Basel III reforms in the EU.

[7] European Banking Authority document - The EBA proposes to further harmonise EU law applicable to branches of third country credit institutions.