Analysis of the Council and Parliament positions in trilogues
EU Bank Capital Negotiations
Negotiations on the EU’s bank capital legislation, the fifth Capital Requirements Directive and second Capital Requirements Regulation (CRD5/CRR2), plus changes to the Bank Recovery and Resolution Directive (BRRD), are now in their final phase. The European Council and Parliament have both now reached their respective positions on the files, and have begun ‘trilogue’ talks aimed at finding a common position between them.
What we are seeing at this stage of the talks is a number of very important differences between the Council and Parliament on key issues for banks. The outcome of these negotiations will determine how and when a broad range of regulatory standards are implemented in the EU and have direct implications for banks’ financial resources, perhaps most notably through the calibration of the Minimum Requirements for Own-funds and Eligible Liabilities (MREL) rules.
The proposed legislation implements components of the Basel III framework, including giving effect to Total Loss Absorbing Capacity (TLAC), the Net Stable Funding Ratio (NSFR), and the leverage ratio. It is also likely to implement 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’.
We expect the most critical issues in trilogues to be:
- Implementation of the FRTB: the Council and the Parliament both support asking for another legislative proposal (i.e. CRR3) to implement the FRTB in full, but disagree on when to phase-in parts of the FRTB retained in CRR2 (potentially as a reporting requirement) using standardised and internal model approaches.
- Setting MREL: the Parliament and Council disagree on whether MREL requirements should be capped at a certain level, with the Council arguing for higher levels and more discretion for resolution authorities.
- The NSFR: the Parliament is seeking a more lenient treatment of securities financing transactions (SFTs) than the Council and wants to introduce a simplified NSFR for small and non-complex banks.
- Leverage ratio: the Parliament wants to include a minimum Common Equity Tier 1 (CET1) requirement while the Council’s text requires only Tier 1 capital to be used.
- Intermediate Parent Undertaking (IPU): the Parliament is proposing a lower threshold for the scope of the IPU as well as one that automatically includes non-EU Global Systemically-Important Banks (G-SIBs).
- Intragroup Eurozone capital and liquidity waivers: the Council has deleted these from their text but the Parliament is keen to keep them, seeing them as an important step in strengthening the Banking Union.
Although, at an earlier stage in negotiations, it appeared that the Parliament and Council would disagree on key issues such as the leverage ratio buffer for G-SIBs and the treatment of derivatives exposures under the NSFR, their positions on these are now largely aligned.
The rest of this note provides further detail on the key points of debate that we understand will be critical in trilogue negotiations between the Parliament and the Council, and our views on the next steps as this proposal progresses towards becoming law.
Key issues at stake in trilogues
Both the Council and the Parliament have taken stock of the BCBS’s decision this year to re-consult on some elements of the FRTB, and both now agree that new legislation will be needed in order to implement the FRTB as a binding capital requirement at a later date. Both also retain a requirement in CRR2 for banks to begin calculating and reporting market risk based on the revised framework. To facilitate this, the Council asks the European Commission to modify the requirements in CRR2 with a Delegated Act by end-2019 in order to reflect any changes made by the BCBS following its consultation.
While the Parliament, like the Council, calls on the Commission to propose new legislation by June 2020 to make FRTB capital requirements binding, it adds a further provision that in the absence of such a proposal by that deadline, the FRTB should be considered a binding capital requirement from January 2022, and be phased-in linearly from 60% of the full requirement in 2022 rising to 100% in 2026.
There is also a difference in sequencing between the two institutions. The Council wants banks to begin reporting using the SA one year after the adoption of the Commission’s Delegated Act (potentially as early as January 2021) and using internal models two years after that (i.e. in 2023). The Parliament, by contrast, has proposed that reporting (and potentially binding capital requirements) using both the SA and internal models approach (IMA) should come into force in line with the BCBS target of January 2022.
Potential impact: Although the Parliament takes a simpler approach to the introduction of the full FRTB framework (SA and IMA in January 2022) than the Council, some banks may find it difficult to obtain IMA approvals by that date. Since some regulators may need up to three years from when the rules are finalised to complete the market risk model approvals process, they may face a compressed timeline if a Delegated Act from the Commission responding to this year’s BCBS revisions only comes at the end of 2019.
MREL (bail-inable debt)
The calibration of MREL looks set to be one of the most challenging parts of trilogue negotiations. The Parliament’s key position is that resolution authorities may not set a MREL loss-absorbency requirement for non-G-SIBs that is higher than the levels set for G-SIBs in the Financial Stability Board (FSB) TLAC Term Sheet (18% RWAs or 6.75% in total liabilities). For G-SIBs, in line with FSB standards, the loss absorbency requirement will be whichever of the two measures is higher.
This comes after a year-long debate in the Council over whether it is appropriate to use the BRRD to constrain the discretion of resolution authorities in setting MREL at the levels they judge necessary. The Council’s General Approach contrasts sharply with the Parliament’s position as the Council seeks to require both G-SIBs and non-G-SIB ‘Top Tier Banks’ (assets > 100Bn EUR) to hold 8% of their total liabilities in own funds and subordinated debt in order to satisfy the BRRD’s existing 8% minimum bail-in rule for banks to be eligible for financing from resolution funds.
Potential impact: In early discussions, this is being flagged as potentially the most difficult issue to be resolved in trilogues. The Council’s position would gold plate the FSB’s TLAC requirements for G-SIBs and potentially require much greater issuance of subordinated instruments by non-GIBs whose assets exceed 100 Bn EUR. The Parliament’s position, by contrast, could call into question whether EU banks could be eligible for support in resolution, which may be seen as a significant impediment to their resolvability by EU and third country resolution authorities, as well as by markets.
The Council and Parliament’s positions diverge on the Required Stabled Funding (RSF) treatment for short-term SFT lending e.g. reverse repos), where the Parliament is seeking to deviate from BCBS standards even more than the Council. Specifically, the Parliament has proposed to apply a 0% RSF to SFTs that are secured with high quality collateral and a 5% RSF for transactions that are not. The Council’s position, by contrast, has proposed higher RSFs of 5% and 10% for such transactions, respectively. This stands out as a potentially difficult issue to resolve given the number of Member States in the Council that are uncomfortable with deviating too far from the RSFs in the BCBS standards (10% and 15%, respectively).
The Parliament has also developed a ‘Simplified NSFR’ that can be used by ‘small and non-complex institutions’ (scope discussed in the proportionality section below) with much more straightforward RSF and Available Stable Funding (ASF) buckets. While the Council does not have a similar position on a simplified NSFR, the initiative is in keeping with a broader drive towards proportionality in the prudential regime for small banks and could, therefore, plausibly be taken on-board in a final agreement.
Potential impact: Wherever the Council and Parliament strike a compromise on the RSF for SFTs, it is now clear that both institutions wish to diverge substantially from the levels set by the BCBS. This will almost certainly be seen by the BCBS as materially non-compliant with the NSFR standard and may lead some non-EU authorities to modify their own implementation. In addition, internationally-active banks may face larger systems and implementation costs if they encounter inconsistent NSFR treatment of SFTs in their main jurisdictions of operation.
The Council and the Parliament’s positions are aligned on the quantum of the leverage ratio, both for the basic amount (3%) and the G-SIB buffer (set at 50% of the bank’s RWA-based G-SIB buffer). This puts both institutions mostly in line with the framework developed by the BCBS and means that the outcome on quantum is almost certain to end up here.
On the quality of capital, however, the Parliament’s position requiring banks to meet at least 50% of the leverage ratio with CET1 capital contrasts with the Council and the BCBS position that the full ratio can be met with Tier 1 capital alone.
Potential impact: Although a gold plating of the BCBS standard, the Parliament’s position on the quality of capital used to meet the leverage ratio is relatively permissive compared to the leverage framework already in place for large UK banks (requiring 75% of the basic leverage ratio and 100% of leverage-based buffers to be met with CET1). If, however, this is identified to be a constraining factor for some banks or certain kinds of banking business models it may become a more contentious part of trilogue talks.
The scope of application is where negotiations on the IPU in trilogues are most likely to be contentious. The Council’s General Approach sets the scope threshold at 40 Bn EUR in EU subsidiary and branch assets and does not include G-SIBs which do not otherwise meet the test. The Parliament sets the threshold lower, at 30 Bn EUR in EU subsidiary and branch assets, and includes subsidiaries of non-EU G-SIBs irrespective of their EU assets.
The Council and Parliament are aligned, however, on allowing banks to establish two EU IPUs where there is a regulatory requirement for the separation of activities within a group. Both also ask the EBA to report at a later date on the effectiveness of the IPU framework, with particular regard to the use of third country branches, and recommend whether any legislative amendments should be pursued at that time.
Potential impact: Given the amount of time that the Council and Parliament are proposing for the implementation of the IPU (four and three years after the entry into force of the CRD, respectively) banks that presently have EU assets between 30 and 40 Bn EUR may outgrow even the Council’s higher scope threshold. The Parliament’s automatic inclusion of G-SIBs in the scope, however, may fall hardest on 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.
Intra-group capital and liquidity waivers
In its initial version of CRR2, the Commission proposed to allow consolidating supervisors of Eurozone banking groups to waive sub-consolidated capital and liquidity requirements for Eurozone subsidiaries of those groups. This was seen as a key step in completing the Banking Union and reducing cross-border ring-fencing of financial resources. This, however, was controversial enough with a group of primarily host country Member States for the Council to delete this proposal in its General Approach.
The Parliament, however, has decided to retain the intra-group waivers for liquidity, and the waivers for capital with some limitations on the amount of sub-consolidated capital that can be waived. This has been identified by the Parliament as one of its key priorities going into trilogues, which will be difficult for the Council to compromise on given how internally divided it is on the matter.
Potential impact: If the Council ultimately prevails in keeping these waivers out of CRR2 then the CRR status quo of national supervisors having powers to ring-fence sub-group capital and liquidity within the Banking Union will continue. The enduring inefficiency of this ring-fencing from a balance sheet management perspective, however, may reduce the incentive for Eurozone-based banks to pursue cross-border mergers and acquisitions activity that might otherwise be attractive.
European Parliament priorities
The Parliament has passed a number of amendments to the legislative package that do not have any clear counterparts in the Council’s text. In trilogues, some amendments of this nature are often adopted in the final law as they do not necessarily conflict with the Council’s position and they allow the Parliament to see its priorities reflected in the final deal. In the CRD5/CRR2, these include:
Capital treatment of software: MEPs are enthusiastically backing an amendment they made to remove software from the intangible assets that are deducted from CET1 under the CRR. Their amendment asks the European Banking Authority (EBA) to draft Regulatory Technical Standards to define the term “software” in a way that allows a prudentially sound approach to be taken. The purpose of the amendment, however, is to give favourable capital treatment to IT investment and Fintech acquisition by banks in order to help them more readily undergo digital transformations.
Small and non-complex banks: As widely expected, the Parliament backed putting a greater degree of proportionality into the CRR for small banks. It does this by defining a ‘small and non-complex institution’ as one meeting a number of thresholds including having less than 5 Bn EUR in assets (as well as other trading book and derivatives thresholds) and granting those institutions more lenient reporting and disclosure requirements in some areas. In addition, the Parliament also backs a simplified NSFR for these banks (discussed in the NSFR section above).
SME supporting factor: The Parliament raised the threshold at which SME exposures can benefit from the 23.81% reduction in RWAs from 1.5M EUR to 3.0M EUR. This amendment appears to be politically well founded as the Council has also called for raising this threshold (but not specified to what level) and the original SME supporting factor in CRR has proven to be very popular in EU policy circles.
Gender neutral remuneration: The Parliament unexpectedly passed an amendment by a narrow margin requiring banks to adopt gender neutral remuneration policies based on Guidelines that the EBA will be asked to draft. Competent authorities will also be asked to gather data and report regularly to the EBA on gender pay gaps. Two years after the entry-into-force of CRD5, the EBA will draft a report on the effectiveness of the application of gender neutral pay policies.
How negotiations will unfold from here
The following points reflect our latest understanding of the general state of play in negotiations:
- There are material points of difference between the Council and the Parliament on a wide range of issues, although the difference in the BRRD text (around MREL calibration) appears to be more difficult to resolve than those in CRD5/CRR2.
- The Council has stated that it has very little room to compromise on its position on the files, given how politically difficult it was to reach a deal between EU Member States. This will do little, however, to deter the Parliament from seeking to reflect its priorities in the final agreement.
- The areas where the Parliament has decided to diverge from BCBS standards more substantially than the Council (e.g. in the NSFR) will be a challenging part of negotiations. These deviations will be difficult for the Council to accept, as a large group of Member States is already uncomfortable with the degree of divergence from the BCBS in the Council’s own text.
- The first round of trilogue negotiations for CRD5/CRR2 took place on 5 July, and the first for BRRD on 11 July. These are likely to have been largely scene-setting meetings to identify priorities for the negotiations, with the most substantial talks not kicking-off until after the summer break.
- The Commission is adamant that negotiations should conclude with an agreement before the end of the year. This is possible, but would require negotiations on such a complex file to progress unusually quickly in the autumn. We therefore continue to see a reasonable likelihood of negotiations spilling over into 2019. After an agreement is reached, translation, legal cleaning and ratification may also take several months.
- As a result, we are maintaining our projection for CRD5/CRR2 to enter into EU law by Q1 or early Q2 2019.