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Four key questions around the EU's implementation of Basel III

The Basel Committee on Banking Supervision (BCBS) agreed the final elements of the Basel III framework in December 2017 (often referred to by industry as 'Basel IV'), but the timing and nature of its implementation in the EU is subject to a complex legislative negotiation that has yet to begin.

That said, 2020 will give us a much better idea of how the EU intends to proceed.

The European Commission is now preparing its next bank capital legislative package, the sixth Capital Requirements Directive and third Capital Requirements Regulation (CRD6/CRR3). This legislative proposal is expected to be published in mid-2020 and will implement the final Basel III framework in EU law.

In preparation for this proposal, the Commission asked the European Banking Authority (EBA) to conduct a thorough impact assessment of the new Basel standards and provide detailed policy recommendations. The EBA’s first and second reports to the Commission, published this year, found that the Basel III revisions could lead to a 23.6% increase in minimum capital requirements (MRC) for EU (excl. UK) banks, if implemented faithfully to the international standards.

The Commission has also issued a public consultation on its approach to implementing Basel III, which shows that the CRD6/CRR3 package will be wide-ranging, and is likely to go beyond core Basel III components and include measures on market risk, regulatory reporting, and potentially even climate risk and accountability regimes.

From our understanding of the early discussions around the upcoming proposal, we believe that the answers to the following four questions will determine how the EU proceeds with the adoption of the Basel framework.

Four questions to consider

Will it be implemented on time? The Commission and other regulators (such as the EBA) say they are committed to implementing the revised Basel III rules on time, according to the 1 January 2022 target set by the BCBS, with a five-year implementation period for the standardised output floor (running to 1 January 2027). Despite this, and as we have noted previously, there are growing doubts over whether the legislative negotiations can conclude in time for the BCBS implementation deadline.

Given the precedent set by the EU’s earlier negotiations of CRR2 and the original CRR, a legislative package of CRR3’s complexity and importance will likely take at least two years of negotiations at the political level. This will have to be followed by an appropriate implementation period before new rules can be brought into force.

While the length of any potential delay is unclear at this stage, it seems likely that globally active firms will face inconsistent timing in the implementation of Basel III across different jurisdictions.

Will it be implemented faithfully according to the Basel standards? Potentially one of the most controversial points in the CRD6/CRR3 debate. EU regulators (led by the EBA and the Single Supervisory Mechanism (SSM)) have emphasised the importance of the EU not deviating from the rules agreed by the BCBS in December 2017. There is, however, increasing pressure from industry groups for the EU to modify its Basel III implementation to mitigate the likely capital impact. This is driven by the expectation that the capital increases arising from Basel III will have a disproportionate impact on European banks relative to their global peers and could lead them to face even greater competitive pressures in an environment of already weak profitability and thin margins.

‘European specificities’ have been watch-words in previous CRD/CRR negotiations for structural market characteristics that justify the EU’s deviations from global standards. The desire to assess where these specificities might exist, and to devise a tailored policy response to them, is heightened by the commitment of EU finance ministers that Basel III would not lead to an increase in aggregate capital for EU banks.

Perhaps the most discussed of the EU’s potential deviations is the calibration of the standardised output floor by the BCBS at 72.5%, which was a critical element of the overall Basel III agreement reached in 2017. Regulators have cautioned that modifying the calibration in the EU’s adoption of the framework may put at risk the international consensus around the post-crisis rulebook for bank capital. EU officials are concerned that such a breakdown in consensus might provide justification for some jurisdictions not to proceed with the implementation of key parts of the regulatory framework.

Another area of significant debate is the treatment of exposures to unrated corporates under the revised standardised approach for credit risk. Industry associations and a number of EU Member States have argued that this penalises European banks, as the EU’s small and medium-sized enterprises are much less likely than their US counterparts to have a credit rating.

Can more be done on proportionality? Whether the EU should apply the full BCBS bank capital framework to all banks (as it has traditionally done), or whether a more proportional or tiered approach to implementation could be pursued is a question that featured prominently in discussions ahead of the proposal of CRR2 in 2016 and led to some streamlining of reporting requirements for small and medium-sized banks.

Opinion on further proportionality measures is mixed, with officials at the Commission arguing that since smaller banks are not inherently less risky – particularly when considered collectively – they cannot justify applying lower prudential standards to them. As a result, the current discussion appears focused on finding ways to reduce the complexity of capital calculations or the administrative burden of regulatory implementation for smaller banks.

In addition, some industry and Member State representatives have pointed out that because 99% of the EBA’s projected Basel III capital shortfalls were found in large banks, measures targeted at small and medium-sized banks would do little to mitigate the overall impact on the EU banking sector. They argue that proportionality needs to be interpreted more broadly to include the proportionate treatment of different risk types and different business models.

Can EU banking market fragmentation be addressed? There is continued concern about fragmentation of the EU banking market and the implications that this may have for cross-border consolidation and the financial efficiency of groups. We expect the Commission to make another attempt in CRD6/CRR3 to allow home supervisors to unilaterally waive sub-consolidated capital and liquidity requirements for Eurozone subsidiaries of Eurozone parent entities. This was proposed in CRR2, but ultimately failed due to concerns on the part of host Member States.

There is also debate over the appropriate level of application of new capital requirements, most notably the standardised output floor. The EBA’s advice to the Commission in August was that the floor be applied at both group and subsidiary levels. This has been opposed by many stakeholders because they see it significantly increasing capital requirements for banking groups. The Commission has asked the EBA to produce further analysis assessing the pros and cons of sub-consolidated application, which is expected in Q1 2020.

Where we go from here

All of these questions will be important in the run-up to the Commission’s legislative proposal of CRD6/CRR3 next year, but potentially even more so once the proposal is made public and enters political negotiations in the Parliament and Council. Where the EU lands on these questions will affect the requirements that banks are eventually asked to implement, and the cross-border consistency of requirements that international banking groups will face.

Many in the banking sector feel that finalising Basel III has already been a long and complex journey; contemplating these four questions should give bank boards, executives and investors a guide to how that journey will ultimately conclude. Banks that can discern how the most likely scenarios will affect their business models and competitive environment will be best placed to react appropriately.

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