On 27 October 2021, the European Commission published a proposal for implementing the final Basel III rules within the European Union. The two primary instruments for doing so are the Capital Requirements Regulation (CRR) and Capital Requirements Directive (CRD). Most of the proposed amendments are due to come into force on 1 January 2025. The EU regulations aim to strengthen banks for the future by improving risk management and making them more resilient. The new regulations focus on amendments and recommendations impacting many different areas of business. But the new regulations also represent a huge implementation overhead for the banking sector.
The introduction of the “output floor” sets a threshold for the risk weighting of assets held by banks that use internal models to calculate their capital requirements. The floor is calculated as a regulatory percentage of the risk-weighted assets. To minimise the knock-on effects for banks that use internal models to a significant extent, the proposed regulations envisage a gradual increase of the percentage to be applied over a phase-in period of several years. Furthermore, the banks affected will benefit from temporary relief when using the standard approach to calculate risk-weighted assets.
The Credit Risk Standard Approach (CRSA) will also be adjusted. Among other things, the proposals include the introduction of a mandatory “due diligence” requirement in the CRSA when using external ratings to determine risk weightings. Where this due diligence process results in a lower rating of the borrower’s creditworthiness than the external rating, the risk weighting should be adjusted accordingly. In addition, the proposals envisage changes to the way risk exposure classes are structured, adjustments to individual risk weightings, and changes to the methods used to calculate the capitalisation of off-balance-sheet exposures.
The proposals also limit the applicability of the internal ratings-based (IRB) approach, in particular the “Advanced IRB” (AIRB) approach used by financial institutions to assess all risk parameters for themselves. In addition, they introduce or increase the “input floor” for certain parameters estimated by the institutions themselves. The amendments also include adjustments to the way risk exposure classes are structured, as well as the parameterisation of the IRB formula for calculating applicable risk weightings.
Whereas the current boundary is essentially based on the existence of an intention to trade under certain exposures, in the future exposures should be assigned to the trading or non-trading books according to the strictly prescribed criteria defined by the Basel Committee as part of their “Fundamental Review of the Trading Book (FRTB)”. In most cases, exemptions from these criteria will only be possible with the approval of the relevant supervisory authority. To implement the FRTB rules for calculating the regulatory capital requirements for financial institutions exposed to major market risks, the existing standardised approach to market risk has been recalibrated. Even if these institutions do not meet the requirements for applying FRTB, they are nevertheless exposed to significant market risks.
The proposals also include three new approaches to calculating capital requirements for Credit Valuation Adjustment (CVA) risk. These include a standard approach, a basic approach, and a simplified approach, and replace the previous standardised and advanced methods for CVA risks. Compared to the existing regulations, the standard approach also expands the eligibility of hedging transactions when determining the capital requirements for CVA risks. Other standards cover the following approaches:
These regulatory proposals are currently passing through the usual European legislative process. Following the publication by the European Parliament and ECB of opinions containing numerous suggested amendments in spring 2022, the French presidency recently presented a preliminary compromise proposal. However, we should expect to see further significant adjustments to this text as the legislative process follows its due course.
In short, we may conclude that in view of the dynamic development of, extensive changes to and relatively short time remaining before these regulations come into force, an in-depth understanding of and regular knowledge updates on current developments as they impact banks – especially for professionals working in regulatory reporting, risk management and business banking – are essential to ensure compliance with the new regulations by 2025.