EU bank capital negotiations

Negotiations in Brussels are making important progress on the European Commission’s ‘CRD5/CRR2’ bank capital and liquidity package (including amendments to the BRRD).

The proposed legislation implements important components of Basel III, TLAC, the NSFR and the FRTB into EU law, but excludes most of the package of Basel reforms that was agreed on 7 December by the Basel Committee on Banking Supervision (BCBS) (i.e. SA credit risk, IRB constraints, operational risk, and standardised output floors) sometimes referred to as ‘Basel IV’.

This note updates on the key points of debate that we understand have emerged in the EU’s CRD5/CRR2 negotiations in the last two months, and our views on the next steps as it progresses towards becoming law.

The following points reflect our latest understanding:

• Negotiations in the European Council have made significant progress such that the Council’s likely position on most components of CRD5/CRR2 are now easier to assess.
• The Council, however, has not concluded its internal negotiations this year and these will continue in Q1 2018 on a narrower set of remaining issues.
• Meanwhile, the European Parliament’s Economic and Monetary Affairs Committee (ECON) has begun its parallel negotiations on the file, and is not expected to finalise its position until Q2 2018.
• This means that the Council and Parliament are unlikely to begin negotiating with each other on a common position until Q3 2018 (a process which is expected to take 6-10 months).
• As a result, we are maintaining our projection for the finalisation of CRD5/CRR2 at Q2 2019.

Key issues being negotiated now

Fundamental Review of the Trading Book (FRTB)

These negotiations are currently some of the most complex in CRR2 given that work is still ongoing at the Basel-level to reassess some elements of the FRTB, including the P&L Attribution Test and the Simplified Standardised Approach for banks with small trading books. We understand that Member States have determined that BCBS work that may be finalised in 2018 will be too late to be reflected in CRR2. They are, as a result, considering whether to grant the European Commission delegated authority to modify CRR2 at a later date to reflect BCBS changes, or to require that new legislation (i.e. “CRR3) is needed in order to finalise the EU’s FRTB framework. This has led the Council to favour a longer implementation period for the FRTB than the two years initially proposed by the European Commission, with four years looking most likely (e.g. implementation in 2023). This would then be followed by a phased introduction of capital requirements under the new market risk approach, which would converge to 100% after two years.

Despite the above, the Basel Committee’s decision to delay the international target implementation date for the FRTB from 2019 to 2022 will undoubtedly have a significant impact on the Council’s thinking and prospective timetables. This should become clearer as negotiations resume in Q1 2018.

Net Stable Funding Ratio (NSFR)

The Council still appears to be split over whether to fully take advantage of the Basel Committee’s October statement that a 5% Required Stable Funding (RSF) for gross derivative liabilities is sufficient to comply with BCBS standards. The Council Presidency has proposed that the RSF for derivative liabilities be permanently lowered to 5% and reviewed at a later date, but many Member States and the European Parliament feel that this is not sufficiently conservative.

A similar debate has emerged around the RSFs for repos and reverse repos, with a large group of Member States seeking to introduce lower RSFs than those set out in the BCBS text, and others instead preferring to not deviate from Basel. The Council Presidency has proposed to apply lower RSFs for repos and reverse repos of 5% and 10%, respectively, and only have these converge with Basel levels after a four year period (during which, new legislation could make these discounts permanent).

Home-host balance of powers

The European Commission’s original proposal for CRR2 granted home competent authorities the ability to waive sub-consolidated capital and liquidity requirements for the subsidiaries of parents they supervise located in other EU Member States. This proposal, however, was met with stiff resistance from Member States that are primarily host jurisdictions, who argued that this would undermine their ability to safeguard financial stability. While the Commission argued that sub-consolidated capital and liquidity requirements were no longer needed within the Banking Union, these Member States countered that the Banking Union was still incomplete. Consequently, we understand that the Council has decided to remove these provisions from CRR2 altogether.

Pillar 2 capital buffers

Member States have strongly opposed the Commission’s original proposal to explicitly prevent competent authorities from setting Pillar 2 capital buffers to address macroprudential concerns. While most agree that Pillar 2 is not, in theory, meant to address macroprudential concerns, they saw this as encroaching on their toolbox without granting them more macroprudential powers elsewhere. The Council Presidency has tried to re-formulate this part of the proposal in various ways to preserve the flexibility of national authorities, but Member States have yet to reach any consensus on this issue.

Other parts of the Pillar 2 proposal in CRD5, including the introduction of a distinction between Pillar 2 requirements and guidance, remain part of the Council’s text.

Leverage ratio

Discussions on the leverage ratio are not particularly advanced in the Council as Member States took a view early on that they would wait for the finalisation of the BCBS’s framework for a leverage-based buffer for G-SIBs before starting negotiations on this. Now that the Basel Committee has agreed to calibrate a G-SIB’s leverage ratio buffer at 50% it’s RWA-based G-SIB buffer, this should now lead to more specific consideration by the Council in H1 2018.

The European Parliament, by contrast, has proposed to require all G-SIBs to meet a leverage ratio of 4% instead of 3% for other banks. If adopted, this could potentially be more onerous for G-SIB banks whose RWA-based G-SIB buffer is lower than 2% (currently 10 EU-headquartered banks).

Minimum Requirements for Own-funds and Eligible Liabilities (MREL) (bail-inable debt)

The design of the EU’s MREL framework has been discussed at length by the Council in 2017, but a number of key issues remain outstanding. These are primarily around the design of the ‘Pillar 2 MREL’ applicable to all banks and sitting on top of the ‘Pillar 1 TLAC’ requirement for G-SIBs. Member States are generally keen to preserve maximum flexibility for their resolution authorities to set Pillar 2 MREL on a bank-by-bank basis, and have opposed the Commission’s proposal to limit ‘top-ups’ to MREL through the use of a Market Confidence Buffer (MCB), or to require such a buffer to be treated as non-mandatory guidance. The Council has yet to reach a consensus on this issue, although one option we understand is being discussed is to grant resolution authorities the power to convert MCB guidance into a hard MREL requirement if it is consistently breached by banks.

There is also a parallel debate over whether liabilities used to meet MREL should be required to be subordinated in order to avoid No-Creditor-Worse-Off issues. While a group of Member State is pushing for mandatory subordination, the Council is split and it appears that the current text is unchanged (requiring subordination only for liabilities used to meet Pillar 1 TLAC)

Intermediate Parent Undertaking (IPU)

The Presidency has responded to Member State calls for a more proportional IPU regime by proposing to allow a dual-IPU structure to exist where third country banks have a regulatory requirement to separate activities and by removing the G-SIB scope criterion (exempting G-SIBs whose EU operations otherwise do not meet the other IPU thresholds). These moves appear to have the support of the majority of the Council, although the UK and Luxembourg continue to strongly oppose the IPU.

An ongoing open question in IPU negotiations is around the risk of arbitrage by third country banks using branches. The Presidency has proposed to address this through giving national authorities greater powers to oversee third country branches, but the SSM and the SRB continue to push for those branches to be included under the IPU structure.

Fast-tracking

Earlier in 2017, the Council decided to ‘fast-track’ two components of CRD5/CRR2 relating to a transitional regime for IFRS9’s impact on CET1 and the creditor hierarchy of debt instruments in insolvency. The Council secured a quick agreement from the Parliament this Autumn, and as of this week, both of these measures have been officially signed into law and will be in force by 1 January 2018. The agreed texts for both components are available here.