Implementing Basel IV in the EU
Executive Education / 21 November 2022
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On 27 October 2021, the European Commission presented proposals for implementing the new Basel IV rules in the European Union by making certain amendments to the Capital Requirements Regulation (CRR) and Capital Requirements Directive (CRD). These recommendations for CRR3 and CRD6 are currently undergoing the usual legislative process.

The main amendments include the introduction of an output floor, adjustments to the way risk exposure classes are structured, rules on the trading book/banking book boundary, new approaches for calculating the capital requirements for credit valuation adjustment (CVA) risks, and new standards for operational and sustainability risks. In addition, the requirements for third-country institutions providing banking services within the EU have been tightened up.

Relevance to all types of banking risk

The new rules apply to all types of risk and cover the entire banking sector. Professionals and specialists must tackle and satisfy these capital requirements in compliance with CRR/CRD. But further training is also recommended for bank employees working in other divisions and departments.

Most of these amendments are due to come into force on 1 January 2025. In August 2022, the European Parliament published the positions it has adopted with respect to these legislative amendments. And in October 2022, the Czech presidency presented its second compromise proposal, focusing on the following priorities:

Output floor

Originally, the Commission envisaged that an output floor would only be applied in full at the highest level of consolidation, or else by standalone institutions within the EU. It is now proposed that, among other things, the output floor should apply in full to all financial institutions. However, an exception should be made for institutions that are part of a group with a parent company based in the same EU member state, and which is itself subject to the output floor.

Credit risks and large exposure rules

Of the European Commission’s proposals, the European Parliament has essentially accepted the structural amendments to risk exposure classes, risk weightings and the eligibility of credit risk mitigation techniques. Several parliamentary groups continue to demand that certain exposures to fossil fuel-related risks should be fully capitalised (risk weighting: 1250%). Albeit only if the exploitation or extraction of the relevant energy source first started after 1 January 2022, which would result in hugely increased capital requirements for such exposures.

But institutions must also draw up a schedule for reducing any emissions which they finance to zero by 2050. If an institution exceeds the targets set out in this schedule by more than 5% in a given reporting year, the large exposure rules shall be applied to the corresponding exposures.

Conversely, lower capital requirements should be applied to risk exposures that serve to encourage or support sustainability and energy efficiency. This affects, for example, loans or mortgages for improving the energy efficiency of buildings.

Treatment of crypto assets

While the Commission’s CRR3 proposals do not contain any specific provisions relating to capital requirements for crypto assets, the European Parliament’s proposals do contain specific risk-weighting criteria. Thus crypto assets created by tokenising traditional assets (class 1 crypto assets) should be treated in exactly the same way as the reference assets. But crypto assets that are not based on traditional assets (i.e. are defined as class 2 crypto assets) should be fully capitalised. In addition, the European Parliament proposes that total class 2 crypto-asset exposures should not exceed 1% of a financial institution’s Tier 1 capital.

Boundary between trading and banking books

The CRR currently envisages a phased implementation of the Basel IV regulations governing the boundary between trading and non-trading books. For example, provisions for reclassifying positions between trading and banking books (in terms of supervisory approval, disclosure, and minimal capital requirements), as well as internal hedging transactions, are due to come into force in mid-2023, whereas all other boundary-related regulations will only come into effect in January 2025, following the introduction of CRR3.

However, certain parliamentary groups are proposing that the phased introduction in 2023 and 2025 should be replaced by a consistent implementation starting in January 2025.

CVA risk charge

The Commission’s CRR3 proposals retain the existing capital-requirement exemptions for CVA risks, but introduces mandatory reporting of exempted transactions. Some of the proposed amendments, however, aim to abolish the exemptions altogether because they deviate from the Basel Committee’s original recommendations.

Operational risk

The Basel IV text specifies that the capital requirement for operational risks should be calculated as the product of a business indicator and an “Internal Loss Multiplier” (ILM) based on historical losses. However, ILM has not been implemented in the Commission’s proposals (or else has been assigned a value of 1). To be consistent with the Basel IV text, a number of parliamentarians are suggesting that ILM should be introduced.

Restrictions on dividend payouts and variable compensation

Some parliamentarians are suggesting that the CRD should give supervisory authorities the power to suspend the payment of variable remuneration, share buybacks, and dividend and coupon payouts on capital instruments, so long as such a suspension does not constitute a credit default event. In the event of severe economic turmoil that poses a risk to the proper functioning and integrity of the financial markets and financial system within the EU, it should be possible to implement such measures for a period of (at most) 12 months, irrespective of a given financial institution’s compliance with capital-requirement legislation.

In view of the dynamic development of these regulations, as well as the relatively short time remaining until they are implemented, it is essential that banks should have an in-depth understanding of, as well as regular updates on, the very latest developments in – for example – regulatory reporting, risk management and other areas of business, so they can be sure of complying with the new regulations by 2025.