Relevant to: Board members, executives, risk and finance leads, heads of capital planning, heads of Basel implementation programmes at banks operating in the EU.
At a glance:
- The European Parliament and the Council of the European Union are nearing the finishing line in finalising the EU’s flagship Banking Package that implements the revised Basel 3 framework. In early March 2023, both institutions began trilogue negotiations to produce a final version of the law.
- We expect these negotiations to run until the second half of 2023. Provided that the final package is adopted by the end of 2023, banks will have roughly one year to implement the new rules ahead of an expected 1 January 2025 implementation deadline.
- The positions of the Council and the Parliament both largely maintain the European Commission’s original “EU specific adjustments” approach of including several long transitional periods and other Basel framework deviations that cumulatively will have a substantial mitigating effect on the package’s overall capital impact.
- There are, nevertheless, many important differences between the two positions that will have to be addressed in the upcoming negotiations. The application of the Basel Standardised Output Floor (OF) remains a key open issue, as well as the design of several transitional periods including the one for exposures to unrated corporate entities. The treatment of specialised lending, exemptions to the large exposure regime, and the prudential treatment of exposures to cryptoassets will also receive attention. Agreements reached on these issues could have implications for the capital impact on certain business lines in banks when they are implemented.
- We believe that banks should make careful use of the rest of 2023 to enhance their RWA calculation and risk modelling capabilities. Moreover, most of the operational capabilities that banks will require to support implementation will be unaffected by where negotiations on many of the remaining points of difference end up. This means that there is little reason to delay the work to enhance these capabilities. Taking early action will put banks in a better position to be ready for a short implementation period.
Part I – Background to the EU Banking Package
The “Banking Package” is the most important piece of bank prudential legislation proposed in the EU in the last decade. It includes revisions to the Capital Requirements Directive and Regulation (known as CRD6/CRR3) that implement the finalised Basel 3 reforms (known in the UK as Basel 3.1) in the EU.
The legislative process began in October 2021 with a legislative proposal from the European Commission. Since then, the Council of the European Union (hereafter “the Council”) and the European Parliament (hereafter “the Parliament”) worked to develop their own internal position on the texts. The Council agreed on its General Approach (GA) on 8 November 2022 (you can read our analysis here, comparing the GA with the Commission’s original proposal). More recently, the European Parliament’s ECON Committee voted to adopt the Parliament’s proposed amendments to the Commission’s proposal, setting out its position in two reports (on CRD6 and CRR3).
Interinstitutional negotiations (known as “trilogues”) began in early March 2023. Trilogues are the final stage of the EU legislative process, in which the Council and Parliament (with input from the Commission) negotiate a common position. We expect trilogues to last until the second half of 2023, with legislators potentially adopting the final text by the end of the year. This timeframe would give the banking sector about a one-year period to adapt to the new package, the core elements of which are due to apply on 1 January 2025.
Although negotiations will primarily focus on the existing content of the Council and Parliament’s proposals, the Commission is expected to introduce additional elements during the trilogues process relating to the review of the macroprudential framework and the securitisation framework.
Part II – Key issues in the Banking Package’s forthcoming negotiations
Trilogue negotiations on the Banking Package are likely to focus mostly on a limited set of issues on which the Parliament and Council’s positions differ materially. In this section, we list the key areas of difference:
- The Council GA proposed that the OF should apply at all levels of consolidation, with host supervisors having some discretion to waive its application at the sub-consolidated level (CRR art. 92).
- The Parliament, however, proposes to apply OF on a consolidated basis only. If a National Competent Authority (NCA) acting as host supervisor concluded that this would lead to an inappropriate distribution of capital within the consolidated group (CRR art. 92a), it would be allowed to submit a capital redistribution proposal to the consolidating supervisor, which could then issue a joint decision with the host NCA on the application of the OF at the subsidiary level. Where no agreement can be reached between home and host NCAs, the European Banking Authority (EBA) would have a binding mediation role. The EBA would receive a mandate to issue an opinion by end-2027 considering the potential financial stability concerns of this approach, taking into account a more uniform degree of deposit insurance coverage across Member States as the Banking Union develops (CRR art. 518c).
- OF transitions: the Parliament modified the transition period for the application of the OF to unrated corporate exposures (CRR art. 465(3)). A 65% risk weight (RW) for firms with a probability of default of less than 0.5% would apply until the end of 2030. From 2031 up until the end of 2032, the RW would rise to 70%. The Parliament’s proposal is stricter than that proposed by the Commission and retained by the Council (RW at 65% until December 2032), although it introduces the possibility of extending the differentiated treatment by four additional years, subject to a new law.
- The Parliament introduced an additional derogation for standardised RW securitisation exposure amounts (SEC-SA) valid until the completion of the Capital Markets Union (CMU). The proposal differentiates the applicable probability level “p” depending on whether the position is in an STS securitisation (p=0.25) or not (p=0.5). There is no fixed date for completion of the CMU.
- Other transitions: for equity exposures, the Council and Parliament agree on applying the higher of the RW prior to the entry into force of CRR3 (capped at 250%) or the transitional RW. For specialised lending exposures, positions are aligned, except for a Parliament clause introducing a mandate for the Commission to consider the Basel standards when drafting a legislative proposal on the extension of the transitional arrangement. The Council GA introduced three further transitions (external ratings for banks, property revaluation requirements, and public guarantee schemes) not included by the Parliament.
- The Council introduced additional exemptions from large exposure limits (CRR art. 400) that were not included in the Parliament’s text, proposing that certain off-balance sheet items, such as unconditionally cancellable commitments, should be exempted from the large exposure regime (CRR art. 395). The Council proposes to allow NCAs (at least until end-2028) to exempt certain exposures fully or partially from the large exposure regime (including covered bonds, 50% of trade finance off-balance sheet documentary credits and 50% of off-balance sheet undrawn credit facilities).
New prudential treatments
- Cryptoassets: the Parliament introduced new provisions for the prudential treatment of cryptoassets, mandating the Commission to submit a legislative proposal. The Commission’s proposal should consider the recently finalised Basel standards, due to be implemented in jurisdictions by 1 January 2025. The proposal is expected to cover areas including criteria for assigning cryptoassets to different categories based on their risk characteristics, specific own funds requirements for each category, liquidity requirements for crypto exposures, and disclosure requirements. As an interim measure, the new CRR art 461b would require firms to apply a RW of 1250% to crypto exposures until the end of 2024. We understand that the Commission may respond to this by introducing amendments on the crypto prudential treatment during the upcoming trilogues.
- Securitisation and securities financing transactions: the Parliament introduced a mandate for the EBA and ESMA to report to the Commission on the prudential treatment of securitisation transactions, by end-2025, with the Commission potentially then submitting a legislative proposal by end-2026 (CRR art. 506ca). Both the Council and Parliament introduced similar amendments for securities financing transactions (Parliament CRR art. 506cb – Council CRR art. 506e).
Credit risk capital requirements
- Object finance exposures: (unrated specialised lending exposures – CRR art. 122a). The Parliament proposed to apply a preferential RW for certain “high-quality” object finance exposures (RW of 80%), whereas the Council proposed that a 100% RW would apply (with no differentiation for high-quality object finance), in line with the Basel standards.
- Revaluation of immovable property collateral: property revaluation based on advanced statistical methods would not be allowed under the Council’s proposal. The Parliament, on the other hand, would allow the use of statistical methods for the monitoring of the property value and the identification of immovable properties in need of revaluation (not for the revaluation per se) (CRR art. 208(3)).
Market risk capital requirements
- The Council would allow the use of a combination of A-IMA and A-SA, only if own funds requirements calculated using A-IMA are at least 10% of total market risk own funds requirements (CRR art 325(4)).
- Internal default risk models (CRR art 325bp). The Council and Parliament propose different default probability floors for covered bonds (Council 0.02%, Parliament 0.03%).
- Carbon trading (CRR art. 325as). The Council proposed a commodity delta risk factor RW of 40%, compared to 60% in the Parliament’s (and Commission’s) proposals.
- For further insight on the implementation of the Fundamental Review of the Trading Book, please refer for our earlier analysis here.
There are also points of difference between the Council and Parliament’s positions on ESG risks and third-country branches (TCB) rules. These will be covered in subsequent blogs.
Part III – What the differences between the Council and Parliament mean for the likely impact of the Banking Package
A key conclusion from analysing the positions on the Banking Package taken by the Council and Parliament is that both institutions have largely maintained an approach to implementing the Basel standards that makes extensive use of transitional periods, such as those for unrated corporate exposures. Both also maintain existing deviations from the standards, including the SME and Infrastructure supporting factors and the CVA exemption for transactions with corporates. Taken together, the two positions still reflect many aspects of the “EU specific adjustments” approach that the European Commission signalled was a core part of its original proposal in 2021.
The EBA has previously assessed that these adjustments are likely to have a significant mitigating effect on the capital impact of the revised rules. In its September 2022 Basel III Monitoring Report, the EBA estimated that the full implementation of the “EU specific adjustments” approach (at the end of all transitional periods in 2033) would lead to an increase in Minimum Required Capital (MRC) for all EU banks of 10.7% (and 20% for G-SIBs), compared to a 15% (and 24.7% for G-SIBs) forecast increase in MRC for all banks if the EU implemented the Basel framework faithfully. The fact that both institutions have maintained much of the EU specific adjustments approach means that the EU is now very likely to adopt a version of the revised Basel 3 rules that mitigates the impact of the Basel standards substantially.
Among the components of the Basel 3 framework, the OF is forecast to be the largest driver of MRC increases (6.8% for all EU banks and 7.7% for G-SIBs). One of the key issues for the OF in trilogues will be whether it should apply at the consolidated or sub-consolidated levels. We have written before about how applying the OF at the sub-consolidated level could have a constraining effect on cross-border banking groups that use internal models. The European Commission’s 2021 impact assessment for the Banking Package estimated that applying the OF at the consolidated level only would be more capital efficient for cross-border banks, although an EBA analysis noted that this would vary heavily from bank to bank depending on the cross-border distribution of their activities.
The Parliament’s proposal for a higher risk weight for unrated corporate exposures from 2031 would dampen the positive capital effect of the transition slightly. A potential additional four-year transition proposed by the Parliament would reduce the risk of a “cliff effect” in 2032, but continued uncertainty over the timing of the end of the transition period will complicate capital and strategic planning.
Outside of the OF, transitional provisions in the credit risk area introduced for equity exposures are likely to reduce the MRC by 0.6%. The Council’s exemption from the large exposure regime of unconditionally cancellable commitments (UCCs) could further mitigate the impact of applying the Basel 3 10% credit conversion factor for those exposures, with EU legislators having previously signalled their concern over the impact on corporates that rely on UCCs to manage seasonal or unexpected short-term changes in working capital needs.
Part IV: Next steps for firms
We expect that trilogue negotiations on the Banking Package will run until the second half of 2023, and likely conclude before the end of the year.
If this is the case, then a final text of CRD6/CRR3 should be available roughly one year before the EU’s expected implementation deadline of 1 January 2025. Given that the Council and Parliament’s position on the implementation timing are aligned (both on the 1 January 2025 initial implementation and the five-year OF phase-in running to 1 January 2030), this is unlikely to be pushed back by negotiators during trilogues unless the negotiations themselves end up taking much longer than expected.
This will create a relatively short implementation timeframe for the banking sector to prepare for and comply with the new rules. While the issues at stake in trilogues could have an important capital impact on certain business lines in banks, the operational capabilities needed to support implementation of the Basel framework will be little affected.
A decision to apply the OF at the sub-consolidated level would mean a larger operational burden for some cross-border groups, as well as potential capital inefficiencies. Beyond this, however, all IRB banks will still need to put new infrastructure in place to operationalise the OF and calculate standardised and internal models RWAs in a robust and controlled way. IRB and standardised banks alike will face significant pressure to improve the accuracy of their RWA calculations, and putting in place the required systems, governance, controls and reconciliation capabilities to support this will take time and investment.
It is critical, therefore, that banks take early action to implement the framework where it is possible to do so. Taking stock of the likely capital and operational implications of the Banking Package as its negotiators near the finishing line provides them with that opportunity,