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.

Reading time: 7-10 minutes 

At a glance: 

  • The design of the Standardised Output Floor (OF) will be a key part of the forthcoming negotiations on the EU’s implementation of Basel 3.1.  

  • The EU’s proposed implementation of the OF is materially different from the Basel 3.1 standards in both its timing and substance, which lowers its expected capital impact. The OF will still, however, become a binding capital constraint for some EU banks and introduce a new layer of complexity in capital planning and strategic decision-making for all. 

  • The level of application of the OF (either at the group-level or at all levels of consolidation) is shaping up to be a major area of contention in the EU’s negotiations. The outcome will have important consequences for the capital demands and complexity that banking groups will face.  

  • Banks should prepare now for the introduction of the OF, even while its design is still being debated by EU policymakers. Banks should, in particular, be analysing the implications of the OF for internal capital allocation (understanding what we call “floor capacity”). Many banks will also need to invest in the data and calculation infrastructure necessary to determine accurate revised Standardised risk weights, which will be the basis for calculating the OF.  

CRD6 and CRR3 – what they say about the OF 

On 27 October 2021, the European Commission published a major set of legislative proposals to implement Basel 3.1 in the EU, consisting of amendments to the EU Capital Requirements Directive and Capital Requirements Regulation (known as CRD6/CRR3 or "the Banking Package"). One of the most significant – and controversial – elements is the approach to the OF.  

The OF is one of the key components of the finalised Basel 3.1 framework agreed by the Basel Committee on Banking Supervision (BCBS) in 2017. It is designed to resolve the BCBS’s concerns about the variability of modelled risk weighted assets (RWAs) and will narrow the gap in RWA outcomes between the Standardised approaches and internally modelled approaches, which typically generate a lower overall RWA number. Once the framework is fully phased-in, banks will have to base their capital requirements on the higher of modelled RWAs or 72.5% of Standardised RWAs (see Figure A). This means that the OF is likely to lead to higher RWAs for banks that use internal models today. Banks using Standardised approaches only will not be affected but should take the OF into account when considering a potential move to internally modelled approaches. 

Figure A: The calculation of the Output Floor 

 

The Commission proposes banks should apply the OF at the consolidated group-level only. While this is consistent with the BCBS approach, the Commission’s proposal differs from the European Banking Authority’s (EBA) view that banks should apply the OF at solo level because that is how all other prudential requirements are applied in the EU.  

Under the Commission’s proposals, banks that are subsidiaries in a group will have to calculate their contribution to the overall group-level OF, but subsidiaries will not face a capital requirement if the OF does not capture the overall group. Banks will be expected to reflect the subsidiary-level OF calculation in their internal allocation of capital. 

The Commission has proposed an implementation date of 1 January 2025 for the CRD6/CRR3 package, instead of 1 January 2023. The Commission also proposes to postpone the full phasing-in of the OF at the 72.5% calibration to 1 January 2030, two years later than the BCBS’s 1 January 2028 target. 

The Commission’s proposal also includes a number of transitional periods relating to the implementation of the OF that go beyond the BCBS transition arrangements, and are designed to extend and limit the potential capital impact of the OF. The transitional treatment of exposures to unrated corporates and low risk residential mortgages, in particular, are proposed to run until at least the end of 2032. 

The implementation of the OF will be an important balancing act for EU legislators: the Basel rules are designed to apply at the consolidated level in internationally active banking groups, and are calibrated by the BCBS with this scope in mind. However, the EU has traditionally applied prudential requirements at both subsidiary and consolidated levels. This mismatch led to a significant debate around the OF’s implementation in the run up to the proposal of CRR3, which looks set to continue for some time. 

What should banks be doing now? 

The implementation of the OF will be a significant operational and strategic challenge for banks, irrespective of its final scope and form. Preparing for it will take time and, in many cases, the work that banks must do needs to be well underway before CRR3 is agreed. While the EU’s delay to the start-date of Basel 3.1 and to the full phasing-in of the OF will give banks more time to implement, they should already be planning for how they will incorporate the OF into their capital management, portfolio planning and stress testing processes.  

Key to this will be investing in implementing the revised Standardised approach for all exposures, which many internal models banks will be doing for the first time.  As we have written previously, for some banks it will be a substantial (and costly) undertaking simply to source or restructure the data and calculation infrastructure required to calculate Standardised RWAs across the whole group. An important “no-regret” action that bank boards and senior leadership can take while CRD6/CRR3 is still being decided is to invest appropriately in the systems, controls and data needed for a robust Standardised calculation.  

However the OF is implemented in the EU, it will be vital for bank management teams to understand how their bank is affected by the floor, where “floor capacity”1 is generated, and how it can be most effectively used. They should also seek to understand how the OF is likely to affect their competitors.  

The OF will add a further layer of complexity to strategic decision making, and to how management chooses to organise group structure. Internal analysis of the implications of the OF debate, and building likely scenarios for its outcome into strategic decision making, is a key task for banks in the near term. 

We see three parts to this analysis: 

  1. Understanding the effect of the OF on the group at subsidiary, business and portfolio level; 

  1. Understanding how effects on the bank differ under OF implementation at either the consolidated or sub-consolidated level; and 

  1. Developing action plans to mitigate the effect of the OF in the event that the finalised regulation implements the OF at all levels of consolidation. These could include subsidiary re-organisation, portfolio sales or changes in portfolio emphasis. 

Expected capital and operational impact 

For EU banks using internal ratings-based (IRB) models, the implementation of the OF will have an effect on their minimum required capital (MRC) - although the size of the impact has been reduced by the Commission’s policy choices, as described above. The Commission’s impact assessment, published alongside its legislative proposal, estimated that the implementation of the OF as set out in the proposal would increase banks’ MRC by 5.7% (1 percentage point lower than the EBA’s December 2019 estimate for the impact of a fully implemented OF).  

Nevertheless, even if the OF may not cause large capital shortfalls in 2030 (based on banks’ current level of capitalisation), it is still likely to become a new binding constraint for many EU banks, whose RWAs constitute a majority of the total EU banking market (see Figure B). 

Figure B: the Output Floor as a binding constraint for EU banks  

The EBA’s December 2020 impact analysis showed that, of the 62 internal model banks in its sample, under an “EU-specific approach” to Basel implementation almost half would be constrained by the OF rather than risk-based capital requirements or the leverage ratio, and that banks constrained by the OF hold more than half of the assessed internal model banks’ RWAs, despite being less than half of the number of banks in the sample. It is important to note, however, that this assessment was made by the EBA before the Commission’s proposal of CRR3.  

Characteristics of subsidiary level vs. consolidated level application of the OF 

Applying the floor at all levels (subsidiary and group) 

Applying the OF at both group and subsidiary levels would increase overall capital requirements, leaving banks holding more capital “trapped” in some subsidiaries than is necessary for reasonably foreseen loss-absorption. 

The EBA recommended applying the floor at both group and subsidiary levels in order to be consistent with the general EU approach. The EBA argued that the rationale for the OF (i.e. to constrain undue risk weight variability and reduce the difference between RWAs under the Standardised approach and internally modelled approaches) applies equally at both consolidated and subsidiary levels.  

letter addressed to the European Commission from senior central bankers and supervisors of 19 EU Member States, many of which are ”host” member states, supported the EBA’s view that the OF should apply at all levels of consolidation. 

Applying the OF at all levels was a significant contributor to the overall increase in capital that the EBA forecast in its impact analyses. The Commission’s consolidated-level-only proposal reduces this impact, and is more in line with the overall political expectation that the implementation of Basel 3.1 should not materially increase capital requirements for EU banks. 

Furthermore, some stakeholders, including senior EU banking regulators, have argued that applying the OF at all levels could create perverse incentives for banks, e.g. combining higher risk and lower risk activities in certain subsidiaries, in order to mitigate the effect of the OF.  

Applying the floor at the highest level of consolidation only 

Under both the BCBS framework and the Commission’s CRR3 proposal, the OF applies on a whole balance sheet basis, rather than to individual exposures, risk types, or portfolios. This enables “floor capacity” to be transferred between entities in a group, as Standardised portfolios can offset the effect of the OF on internally modelled portfolios whose RWAs fall below the 72.5% Standardised floor level. 

If the OF is applied at the consolidated level only, banks would be able to use this floor capacity across their subsidiary structure – in the aggregate calculation at the group level, the use of Standardised approaches in one subsidiary could offset the floor impact of another subsidiary which uses an internal model.  

Industry stakeholders, such as the EBF and AFME, support the application of the OF at the consolidated level only. For banks with specialised subsidiary structures (which have certain subsidiaries using the Standardised approach, and others which use internally modelled approaches) this could reduce the overall amount of capital required under the OF at the group level.  In addition, Andrea Enria, Chair of the Supervisory Board of the ECB, has on several occasions stated his support for implementing the OF at the consolidated level. He has also previously argued that applying the OF at all levels would make EU bank consolidation less attractive, as it would reduce the ability of banking groups to allocate capital flexibly within a group structure, and consequently limit the ability of universal banking groups to diversify risks at a group level. 

The OF is expected to have greatest impact on large banks. Given their complex group structures, for those banks OF implementation at the consolidated level only would avoid a potentially material constraint on the transfer of capital resources within the group. This fungibility of bank capital would be very useful in the EU Single Market, but banking groups will still need to anticipate how third country host supervisors might choose to apply it to subsidiaries outside of the EU. 

The EU’s forthcoming negotiations on CRR3 and the OF  

The level of application of the OF will be a prominent part of the negotiations on CRR3 that are now taking place in EU institutions. While industry stakeholders, as well as some senior figures in the supervisory community, support application at the consolidated level only, the number of EU Member States that appear to favour applying the OF at all levels of consolidation mean that banks have to take it seriously as a potential outcome in the negotiations. The decision will have potentially significant implications for the fungibility of capital in European banks. 

Prior experience tells us the EU legislative process for a file of this size, importance and complexity typically takes at least two years to complete, so we do not expect a final CRD6/CRR3 package to become law until late-2023 or early 2024. If these expectations are correct, then this will give banks about one year between seeing the final law and having to be ready for the initial implementation date of 1 January 2025. Given such a short potential window for implementation, banks must begin to consider what they can do now to prepare.  

Endnotes 

1: By floor capacity we mean the effect an exposure (or portfolio of exposures, or business unit) has on whether or not the OF becomes a binding constraint on a bank. Standardised exposures, or modelled exposures with risk weights greater than 72.5% of the equivalent Standardised risk weight for the same exposure, move a bank away from being constrained – they provide capacity against the OF.  Modelled exposures with risk weights less than 72.5% of the equivalent Standardised risk weight for the exposure move a bank toward being constrained – they absorb capacity against the OF.