After a year’s delay, October 2021 saw the European Commission publish its proposal for the final implementation of Basel III — also known as Basel IV. The Banking Package 2021 makes Europe the first major jurisdictions to set out a vision and timetable for implementing the Basel Committee’s latest global reforms.
The package seeks to enhance financial stability, while also facilitating the flow of finance to the economy as Europe recovers from the pandemic and transitions to carbon neutrality. Its main components are revisions to the Capital Requirements Regulation (CRR III), the Capital Requirements Directive (CRD VI) and the “daisy chain” proposal (to amend CRR in the area of resolution). The proposed application date is January 2025.
Expected high-level impacts
The EU package adopts the bulk of the Basel Committee’s proposals but makes some specific changes. These have been largely welcomed by the European banking industry. In particular, the package proposes a lengthy transition period, with reduced risk weights under the standardised approach for residential mortgages and loans to unrated corporates. These will significantly reduce the potential increase in many banks’ risk-weighted assets by limiting the impact of the output floor (OF) — a minimum capital requirement for banks using internal models. The OF is set at 72.5% of the own funds requirement that would apply under the standardised approach.
The Commission estimates that the full implementation of its proposals would lead to a weighted average increase in minimum capital requirements of between 6.4% and 8.4% by 2030. According to the EBA, 10 of the 99 banks covered by its impact study (which collectively represent 75% of EU banking assets) would need to raise a total of less than €27bn to meet the package’s capital requirements. This equates to approximately 2% of the €1,414bn of total regulatory capital held by the 99 sampled banks at the end of 2019.
More time to adjust
The EC proposes CRR III and CRD VI to be applied from January 2025. Several phasing-in periods are planned, with full implementation anticipated by 2032:
- Application of the OF will be phased in from 2025 until 2030, meaning that internal ratings-based (IRB) banks will not need to hold the full 72.5% of the own funds requirement under the standardised approach until the end of that period.
- Unrated corporates with a probability of default below or equal to 0.5% will receive a reduced risk weight of 65% in the standardized approach at least until 2032, compared to 100% in the Basel Committee’s proposals (if not “investment grade” or SME).
- A transitional pattern has also been included for real estate mortgages. Low risk exposures secured by mortgages on residential property can apply a favourable risk weight until 2032 or 2029, depending on certain defined conditions.
Going beyond Basel
In some areas, the package goes beyond the final implementation of Basel III. It proposes a number of enhancements to existing EU banking rules, including:
- ESG requirements. The package expects banks to identify, disclose and manage environmental, social and governance (ESG) risks at an individual level. Management bodies are also required to factor these risks into banks’ strategies and develop plans to address them. In line with the objectives set out in the Strategy for Financing the Transition to a Sustainable Economy, the proposals give supervisors the power to address ESG risks through the prudential framework, such as the Supervisory Review and Evaluation Process (SREP) or climate stress testing.
- Fit and proper assessments. The package proposes a more harmonized approach to fit-and-proper frameworks in the EU. It sets out minimum requirements for key function holders and proposes a common assessment framework to verify compliance by board members.
- Third Country Branches (TCBs). The package defines a new common framework for TCBs requiring all branches from non-EU countries to go through a new authorisation process. National competent authorities are empowered to evaluate the systemic importance of TCBs, which could lead to requirements for subsidiarisation or restructuring, or the imposition of Pillar 2 requirements.
What does this mean for banks?
The proposals set out in the package need to be discussed in the European Parliament and could still undergo changes. Even so, banks should start preparing for the new regulatory framework now. As a first step, institutions can consider the six following actions:
- Conducting an impact assessment regarding the effects on capital planning.
- Understanding areas of vulnerability and exposure to any idiosyncratic impacts.
- Optimising risk-weighted assets (RWA) calculations, starting with the standardised approach for credit risk.
- Performing a gap analysis (or updating previous Basel III analyses), including key changes to IT infrastructure and data.
- Using the results of this analysis to adjust risk appetites, credit risk frameworks or business model decisions — including product design — to mitigate the effects of the package.
- Stepping-up “ESG culture” and ensuring that exposure to ESG risks can be identified, managed and disclosed.
The EU’s banking package raises many challenges for European banks. Although institutions have been granted more time to adjust, the new rules remain a concern for many, especially considering how their impact varies across countries and business models.
However, some developments have already been observed. For example, some lenders have already started to adjust their pricing to reflect the new regulations, such as charging more to unrated corporate borrowers. These actions are generating pressure to expand the availability of rating scores for corporates.
In short, banks should do their homework on the banking package, helping to ensure they can meet changing supervisory and regulatory expectations right up until the implementation date.
Image: Floriane Vita via Unsplash