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EU bank capital negotiations

Full legislative agreement reached between parties

A full technical agreement has now been reached on the EU’s bank capital legislative package, the fifth Capital Requirements Directive and second Capital Requirements Regulation (CRD5/CRR2), plus changes to the Bank Recovery and Resolution Directive (BRRD2). In late-February of this year, both the European Council and European Parliament endorsed the deal on the legislation reached by negotiators and full draft texts have now been published for the first time.

While the legislation is not yet final and a ratification vote is not expected to take place until April, the draft law, as it is currently published, gives the clearest and most detailed picture yet of the rules that banks will have to comply with once this is applied.  

The legislative package implements components of the Basel III framework, including giving effect to Total Loss Absorbing Capacity (TLAC), the Net Stable Funding Ratio (NSFR), the Standardised Approach for Counterparty Credit Risk (SA-CCR), the Leverage Ratio, and the Fundamental Review of the Trading Book (FRTB) in part. But it excludes the package of Basel reforms that was agreed on 7 December 2017 by the Basel Committee on Banking Supervision (BCBS) (i.e. the standardised approach (SA) for credit risk, constraints on the internal ratings-based (IRB) approach, operational risk, and standardised output floors), often referred to as “Basel IV”.

Key aspects of the deal agreed include (please note that this does not constitute a comprehensive list):

  • Implementation of the FRTB: the FRTB will initially proceed in the EU as a reporting requirement only. New EU legislation (i.e. “CRR3”) will be required at a later date to give effect to binding capital requirements. Read our December blog for further analysis.  
  • Setting Minimum Requirements for Own-Funds and Eligible Liabilities (MREL): high minimum requirements for subordinated MREL were set for Global Systemically-Important Banks (G-SIBs) and other large banks, based around an 8% of total liabilities requirement with limited discretion for resolution authorities to set lower minimums in some cases.
  • The NSFR: more lenient Required Stable Funding (RSF) treatment of Securities Financing Transactions (SFTs) was agreed for a four-year phase-in period that can be extended by future legislation.
  • The SA-CCR: the new BCBS SA-CCR is implemented in EU law, but the EU has also developed a Simplified SA-CCR and retained the Original Exposure Method (OEM) for smaller institutions.
  • Leverage Ratio: the EU has implemented the BCBS framework with a 3% baseline Leverage Ratio, and a leverage-based G-SIB buffer calibrated at 50% of the RWA-based G-SIB surcharge. Both the baseline and buffer can be met with any Tier 1 capital.
  • Intermediate Parent Undertaking (IPU): the IPU will proceed with several amendments, including a €40Bn threshold, no automatic inclusion of G-SIBs, and the flexibility to establish two IPUs for regulatory reasons. 
  • Proportionality: A definition of “small and non-complex institutions” has been agreed to designate banks that are eligible for less frequent reporting requirements and the use of the Simplified NSFR.

Key aspects of the legislative deal

FRTB

The approach taken on the FRTB was driven largely by the BCBS’s 2018 decision to re-consult on various elements of the framework at the international level (with final changes published in January 2019 – too late to be included in political negotiations). As a result, negotiators decided to implement the FRTB initially as a reporting requirement only. The EU will now require new legislation to be proposed in order to give effect to binding FRTB capital requirements (we expect this legislation to be part of the CRR3 package and not proposed by the European Commission until mid-2020).

The reporting requirement will be made operational by a Delegated Act from the European Commission to be adopted by 31 December 2019, which will reflect missing parts of the framework only completed by the BCBS in January 2019. Banks will have to start reporting FRTB figures using the SA one year after the adoption of the Delegated Act, and may begin using the Internal Models Approach (IMA) two years after that.

During the reporting period, binding capital requirements will continue to be based on the existing market risk rules. Banks with small trading books are due to be exempt from the FRTB reporting requirement.

Potential impact: The introduction of the FRTB as a reporting requirement represents a very material change to implementation work for large banks operating in the EU. Timing could be a particular challenge, as the start-date for reporting could land a year before the BCBS-set deadline (i.e. 2021 vs. 2022, respectively), forcing many banks to have their market risk infrastructure for the SA ready by that time. Equally, shifting binding capital requirements for the FRTB to CRR3 will make it very difficult for the EU to have the FRTB fully in place by the 2022 deadline. Given this, many banks will have to consider carefully how they proceed with IMA model approvals during the reporting period. For more analysis of the FRTB reporting requirement and its implications read our December 2018 blog.

MREL (bail-inable capital)

The implementation of the TLAC standard and amendments to the existing MREL framework were perhaps the most difficult part of the negotiations, with the amount of loss-absorbing capacity required and degree of subordination being most controversial.

The agreement requires G-SIBs and “Top Tier” banks (those with assets > €100Bn) to hold TLAC or MREL equal to 8% of their total liabilities in owns funds and subordinated debt as a Pillar 1 resolution capital requirement. As an alternative, under certain conditions, resolution authorities can choose to require these banks to hold a minimum MREL of 27% of risk-weighted assets (RWA) in own funds and subordinated debt (potentially beneficial for banks with low risk-weight densities).

For Pillar 2 purposes, it has been agreed that minimum subordination requirements can be set for smaller banks. For G-SIBs and Top Tier banks, however, MREL levels in addition to their Pillar 1 minimum requirements can only be imposed under certain conditions.

The agreement also includes a number of investor protection measures controlling retail investors’ holdings of MREL. This was in part due to concern that retail holdings of bail-inable instruments can form an impediment to the orderly resolution of an institution. In particular, provisions have been included that oblige sellers of MREL instruments to check that retail investors with an investment portfolio of less than €500k do not invest more than 10% of their total portfolio in MREL, and that their minimum investment size is €10k. As an alternative to this mechanism, Member States can simply opt to impose a €50k minimum denomination for MREL instruments.

TLAC requirements for G-SIBs are due to be applied immediately upon the entry-into-force of CRR2. The MREL requirements are due to apply from 1 January 2024, but can be extended by resolution authorities on a case-by-case basis.

Potential impact: The minimum subordinated MREL levels agreed by the negotiators are a significant gold-plating of the existing framework and of the international TLAC standard for G-SIBs that CRR2 was meant to implement. This may mean that G-SIBs and other large banks operating in Europe will face greater subordinated debt raising needs over the implementation period. There is therefore the potential price impact of a large number of banks issuing subordinated debt to the market simultaneously over the implementation period. Regulators may consider ways of minimising the effect of the new rules creating a sprint to the market.

NSFR

The implementation of the NSFR is one of the most prominent areas in CRR2 where the EU has demonstrated that it is willing to depart from BCBS standards. The European Council declaration states that it sees this as a necessary step in order to prevent “undue market disruption” in the EU.

The NSFR agreement provides favourable stable funding treatment compared to BCBS standards for short-term SFTs. RSFs for SFTs secured with high-quality collateral are set at 0%, and 5% for those secured with other collateral. Derivatives exposures are given a 5% RSF on the gross exposure amount, which is at the lowest end of the range of national discretion granted by the BCBS. The favourable RSF treatment for SFTs, however, will revert to BCBS-set minima (10% and 15% for SFTs secured with HQLA and non-HQLA, respectively) four years after the application of the NSFR unless the preferential treatment is made permanent by new legislation. The Commission is consequently asked to assess the impact of the NSFR on capital markets and consider proposing legislation to set permanent RSFs three years after application.

At the insistence of the European Parliament, the agreement also includes a Simplified NSFR that small and non-complex institutions (see proportionality section) will be eligible to use at the discretion of their competent authority. The Simplified NSFR is meant to be just as prudentially sound as the normal NSFR, but will allow for a less complex calculation process to reduce the operational cost of the framework for smaller banks.

If the finalisation of CRR2 proceeds as expected, the NSFR is due to apply two years after the entry-into-force of CRR2 (i.e. mid-2021 is finalisation proceeds as expected).

Potential impact: The outcome of the NSFR debate on reduced RSFs for securities financing confirms that the EU is prepared to diverge substantially from BCBS standards in order to safeguard the functioning of EU capital markets. Although the SFTs divergence is time-limited, we expect this debate to recur if CRR3 proposes that they be made permanent. The agreement of a Simplified NSFR for small and non-complex institutions also takes the EU prudential framework a step closer to being tailored for banks of different sizes. The less-than-equivalent approach to BCBS standards taken by negotiators here may be indicative of how they choose to deal with yet-to-be-implemented parts of the Basel III framework that will be included in CRR3.

Leverage Ratio

The agreement retains an implementation of the Leverage Ratio that is very similar to the BCBS framework. A 3% baseline ratio will be applied to all banks, and a leverage-based buffer for G-SIBs will be calibrated at 50% of the G-SIB’s RWA-based G-SIB buffer. The European Commission has been asked to report, by 2022, on whether the leverage-based buffer should be extended to other large banks beyond G-SIBs.

Despite a push by the European Parliament to include a mandatory CET1 component in the capital composition, the parties have agreed that the Leverage Ratio can be met with any Tier 1 capital.

The agreement also mandates the EBA to enhance its monitoring of banks’ leverage reporting to assess the extent to which they engage in the practice of “window dressing” where leverage requirements are only met on the day of reporting rather than throughout the period.

The 3% baseline Leverage Ratio is due to apply two years after the entry-into-force of CRR2, and the leverage-based G-SIB buffer is due to apply from 1 January 2022, in line with the target set by the BCBS.

Potential impact: Unlike some of the other components of CRR2, the EU’s agreed approach to the implementation of the leverage ratio stays very close to the framework set out by the BCBS at the international level. The decision to permit all Tier 1 capital to meet leverage requirements will be welcome news for banks with substantial proportions of Additional Tier 1 funding on their balance sheets (unless they are located in jurisdictions that adopt a minimum CET1 requirement in their national Leverage Ratio framework, such as the UK).

IPU

The agreement reached is largely reflective of the Council’s General Approach. The scope threshold for establishing an IPU will be set at €40Bn in EU subsidiary and branch assets. The automatic requirement for G-SIBs to form an IPU if they have two or more institutions in the EU has been removed, and the transition period has been set at three years following the entry-into-force of CRD. This means that, if Member States transpose the CRD5 Directive without significant delay, an IPU application date of mid-2022 is likely.

Given that the Council and Parliament were previously aligned on allowing banks to establish two EU IPUs where there is a regulatory requirement for the separation of investment activities in the group, it comes as no surprise that this provision is included in the agreement, which has further expanded this derogation to allow for two IPUs where a single IPU would render resolvability less efficient.

The IPU will be permitted to be a financial holding company, mixed financial holding company, or a credit institution. Institutions will be permitted to have an investment firm as the IPU where they only have investment firms in the EU, or where they have set up a second IPU due to mandatory separation requirements.

Potential impact: The higher threshold and exclusion of the automatic G-SIB requirement will be welcome news for firms which may have been included in the scope of the IPU under the Parliament’s agreement, particularly for those third country G-SIBs whose current EU assets are primarily in the UK and will no longer count towards the size-based threshold following Brexit. Likewise, UK G-SIBs are likely to welcome the removal of the automatic G-SIB requirement, given that they will be treated as third-country institutions by the end of any Brexit transition period.

Proportionality  

One of the European Parliament’s key demands in trilogue negotiations was to have a more tailored prudential regime for smaller banks compared to the current framework. The result is that a definition has been agreed for “small and non-complex institutions” that is, in general, those with assets of €5Bn or less, but subject to a number of other scope conditions (e.g. trading book size, derivatives activity, etc.).

Banks qualifying as small and non-complex will be able to benefit from less frequent reporting requirements for some supervisory data, as well as take advantage of the Simplified NSFR (described in the NSFR section above).

The agreement also includes two proportionality measures accompanying the introduction of the SA-CCR. First, a Simplified SA-CCR has been created for small and non-complex institutions, and will be less risk-sensitive than the normal SA-CCR. In addition to this, the pre-existing OEM for derivatives exposures has been retained for use by banks with limited derivatives exposures where even the Simplified SA-CCR might be too complex to implement.

The EBA has been tasked to make recommendations to the European Commission one year after the entry into force of CRR2 on measures that can be taken to reduce reporting costs for small banks by at least 10%, but ideally as much as 20%. These recommendations may then feature in future legislation or secondary acts drafted by either the Commission or the EBA.

Potential impact: This agreement goes a step further on proportionality than the Commission’s original 2016 proposal, particularly in the introduction of a Simplified NSFR and Simplified SA-CCR. It still falls short, however, of creating a multi-tier prudential regime in the EU similar to that found in the United States. As a result, small banks and trade associations are likely to maintain their calls for the Commission to go further in its forthcoming work to draft CRR3 and implement the remaining elements of Basel III. Given that CRR3 will have a much larger credit risk component than CRR2, this may provide fertile ground for an even larger proportionality debate on the treatment of small banks.

Next steps in finalising the legislation

The following points reflect our latest understanding of the general state of play in finalising the legislation. 

  • Now that a full technical agreement has been reached, the legislation has to go through a multi-week period of legal cleaning and translation. This will mean that that there will be extensive small changes to the text, although these changes should not be substantive or change the intent of any of its provisions. 
  • We understand that the European Parliament is likely to vote to ratify CRD5/CRR2 and BRRD2 in mid-April as part of its final plenary session before the Parliament dissolves for European elections.
  • Following a successful ratification, and a similar sign-off procedure from the Council, we expect that CRD5/CRR2 and BRRD2 will enter into the Official Journal of the EU in either May or June, and legally enter-into-force 20 days after.
  • The application of the rules agreed to in this legislation will, in many cases, come after a substantial implementation period during which technical standards will be created. Most provisions are due to be applied two years after entry-into-force, but several have more tailored application schedules (e.g. the FRTB reporting requirement) and some are due to apply immediately (e.g. TLAC requirements).  
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