The European Commission is finalising the legislative package aimed at introducing in the European Union the prudential requirements of the ‘Basel III’ agreement which was sealed at the end of 2017 (see EUROPE 11921/20). It will present two amendment texts, a regulation and a directive, amending the ‘CRR-CRD’ regulatory framework, on Wednesday 27 October, with a one-year delay due to the Covid-19 pandemic.
According to the European institution, this legislative initiative has four main objectives: - strengthen the risk-based capital framework, without significant increases in capital requirements overall; - enhance the focus on environmental, social and governance (ESG) risks in the prudential framework; - further harmonise supervisory powers and tools; - reduce institutions’ administrative costs related to public disclosures and to improve access to institutions’ prudential data.
One of the most publicised issues concerns the gradual introduction of an ‘output floor’ to converge internal models (banks apply their own formulas under the supervision of the supervisor) and standard models (banks apply a formula defined in a regulatory manner), both of which are used to identify risks and hence calculate the capital requirements to address them (see EUROPE 12812/11).
From 2030 onwards, the result obtained by the internal model may not be less than 72.5% of the calculation obtained via the standard model. According to the draft regulation, this minimum threshold is to be gradually increased as follows: 50% in 2025, 55% in 2026, 60% in 2027, 65% in 2028, 70% in 2030.
“The decision to introduce an output floor is based on the analysis that the use of internal models makes banks likely to underestimate risks and, therefore, capital requirements”, the Commission justifies.
To balance - it seems - the impact of this new minimum threshold on banks using internal models, new supervisory provisions are introduced to make the way banks using standard models calculate their credit risk more robust. This includes exposure to ‘off-balance sheet’ assets, other financial institutions, infrastructure projects, retail operations, real estate.
Taking ESG risks into account
As the EU moves towards climate neutrality by 2050, banking institutions need to take better account of environmental, social and governance risks.
To promote proper understanding and management of ESG risks, EU-based banks need to “systematically identify, disclose and manage these risks at the individual level”, the Commission stresses, aware that understanding of these risks differs “substantially” within the banking sector.
The new provisions are based on specific recommendations of the European Banking Authority (EBA) (see EUROPE 12747/13). Banks will have to prepare concrete plans to address these risks, extend their reporting to ESG risks and will be encouraged to allocate more funding to sustainable projects. The EBA will produce guidance to standardise the supervision of ESG risks and will report in 2023 on the prudential treatment of ESG exposures.
Better supervision of branches of third country banks
The third part of the legislative reform is to further harmonise the competences and tools available for supervision.
The current regulatory fragmentation in this area weakens the rules of the game within the internal market and raises doubts about the sound and prudent management by banks of their activities and their monitoring by supervisors, especially within the Eurozone Banking Union, the Commission admits.
In particular, the legislative package will introduce specific provisions to better supervise the EU-active ‘third country branches’ of banking groups which are currently mainly subject to supervision at national level.
This includes: - a uniform authorisation procedure; - minimum capital requirements (either as a percentage of liabilities for branches with more than €5 billion in assets and/or retail activities, or as a financial package for less risky entities) for liquidity, risk management and governance; - reporting obligations on activities in the EU; - regular monitoring of these branches by national supervisors, including through colleges of supervisors for large entities operating in several Member States.
“The EU is the only major jurisdiction where the supervisor on a consolidated basis does not have a complete picture of the activities of third country groups operating in the EU via subsidiaries and branches”, the Commission notes. It observes a trend towards an increase in the number of such branches of third country groups, especially since Brexit. At the end of 2020, there were 106 such entities, 14 more than in 2019, distributed mainly in Germany, France, Luxembourg, Cyprus and Belgium.
In addition, the CRR-CRD package will aim to improve both the financial reporting of banks and access to regulatory data issued by financial institutions. For example, a proposal is expected on the EBA centralising the publication of required data, which will increase the comparability of the information collected.
For the sake of proportionality of the rules, the European authority will itself publish the data accumulated for the supervision of small financial institutions. However, they will have to be more transparent about their exposure to non-performing bank loans.
Lastly, the Commission believes that there is no need to give more powers to national supervisors on the distribution of dividends to bank shareholders, as the experience of the pandemic has shown that the existing rules work well. And it is too early, according to the EU institution, to introduce specific measures for crypto-assets into the EU’s prudential framework. It is better to wait for the results of the Basel Committee’s work, which has just begun, it states.
According to the European institution, the planned package of measures would increase capital requirements to between 0.7 and 2.7% in 2025 and between 6.4 and 8.4% in 2030. Ten large financial institutions out of a panel of 99 banking groups representing 75% of EU banking assets will be most affected by the need to raise €27 billion in capital to comply with the future rules.
To see the ‘CRR’ proposal: https://bit.ly/3vItuXx
To see the ‘CRD’ proposal: https://bit.ly/3EdKVCC (Original version in French by Mathieu Bion)