Update on the European Council's Agreement of a General Approach
EU Bank Capital Negotiations
The European Council has reached an agreement on the ‘CRD5/CRR2’ bank capital proposal (including amendments to the BRRD). This is a very important milestone in EU negotiations on the bank capital framework and, although further negotiations now need to occur with the European Parliament, we now have a much better sense of what to expect in the final deal.
The proposed legislation implements components of the Basel III framework in the EU, including giving effect to TLAC, the NSFR, and the leverage ratio. 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. SA credit risk, IRB constraints, operational risk, and standardised output floors), often referred to as ‘Basel IV’.
This note updates on the key points of debate that we understand were critical in reaching an agreement in the Council, and our views on the next steps as the proposal progresses towards becoming law.
The following points reflect our latest understanding:
- The European Council reached a compromise agreement (known as a ‘General Approach’) at its 25 May Finance Ministers’ Summit (ECOFIN). This means that the Council is now ready to begin negotiations with the Parliament.
- The Council’s agreement hinged on compromises being struck on the implementation of the FRTB, the ability of resolution authorities to require the subordination of MREL instruments, and the methodology for identifying G-SIBs.
- In order to overcome longstanding disagreements, the Council designed some creative compromise solutions, including introducing the FRTB as a reporting requirement without immediate binding capital requirements, and introducing the concept of a “Top tier bank” to be subject to special MREL subordination rules more similar to G-SIBs.
- Given the delicate political balance that has been struck in the Council with these compromises, it will be very difficult for these positions to change significantly in upcoming negotiations with the Parliament.
- Although other important elements of the CRD5/CRR2 package were not part of the final deal-making at the ECOFIN meeting (e.g. the NSFR, SA-CCR, IPU and leverage ratio) they will still likely be the subject of significant negotiations in the coming months as there are some emerging points of difference between the two institutions (the leverage ratio buffer for G-SIBs and the treatment of gross derivatives liabilities under the NSFR being two examples).
- The European Parliament is making slower progress towards reaching its own position, but MEPs are expected to vote on a draft report in June or July.
- The Council can only begin negotiations with the Parliament once this happens (a process called ‘trilogues’ that also involves the Commission). When this begins, we anticipate that it will be another 8-10 months before a final deal can be reached.
- As a result, we are maintaining our projection for CRD5/CRR2 to be agreed and enter into EU law by Q1 or early Q2 2019.
Key issues in the Council deal
Fundamental Review of the Trading Book (FRTB)
The FRTB has been one of the most contentious parts of the CRR2 negotiations since its inception. Negotiators struggled to decide how best to respond to the BCBS decision in March to re-consult on some elements of the FRTB including the P&L Attribution Test and the Simplified Standardised Approach for banks with small trading books.
As expected, Council negotiators decided that the BCBS work would be finished too late in 2018 to include in CRR2. As a result, the Council’s General Approach retains the FRTB in the form of a reporting requirement only. If this approach survives, the binding capital requirements for market risk under the FRTB will have to be established separately in new legislation that the Council has asked the Commission to propose in mid-2020. We assume that this legislation will be ‘CRR3’ and will contain other elements of the Basel III package, including new approaches to credit risk, operational risk and the introduction of standardised floors.
It is important to note that a mid-2020 legislative proposal implementing the FRTB and the residual elements of the Basel III package (which would normally take two years to negotiate and a further two-to-three years to implement) will make it almost certain that the EU will miss the BCBS’s revised 2022 target date for the implementation of FRTB capital requirements. Instead, the Council is looking to signal its seriousness about implementing the FRTB by proceeding with the reporting requirement beforehand.
In order to operationalise the reporting requirement, the Council asked the Commission to adopt a Delegated Act by 31 December 2019 that can be used to amend CRR2 to reflect any changes made by the BCBS to those elements of the market risk framework currently under consultation. The reporting requirement using the revised standardised approach would then come into force one year after the Delegated Act is adopted (i.e. by end 2020). This approach would likely require EU banks to implement the FRTB for reporting purposes a full year earlier than the 2022 BCBS implementation target. Banks wishing to report using the revised internal model approach, after obtaining approval, could begin doing so three years following the adoption of the Delegated Act (theoretically by end 2022).
While this deal has broken a longstanding deadlock in the Council’s negotiations, it arguably creates more questions than it answers about what happens to the FRTB in the EU. The FRTB is expected to be part of the impact assessment the EBA has recently been asked to conduct on the Basel III framework and the Commission will have another opportunity to amend the standards with its new proposal in 2020.
Minimum Requirements for Own-funds and Eligible Liabilities (MREL) (bail-inable debt)
CRR2 and the BRRD incorporate the FSB’s Total Loss Absorbing Capacity (TLAC) standard into the EU’s existing MREL framework as a Pillar 1 mechanism for G-SIBs. The existing MREL framework will be retained as a Pillar 2 mechanism to determine the entire loss absorbency requirement for non-GIBs and potentially to top-up the requirement for G-SIBs beyond the harmonised TLAC level. A key point of debate during negotiations was the level at which banks would be required to subordinate MREL instruments in order to avoid No-Creditor-Worse-Off (NCWO) issues in resolution. To resolve this, the Council’s General Approach introduces the concept of “Top-tier banks”, or institutions other than G-SIBs (with assets greater than 100 Bn EUR) which are important from a financial stability point of view. Both Top-tier banks and G-SIBs will be required to ensure that 8% of their total liabilities are held as either own funds or subordinated debt in order to meet the BRRD’s existing minimum bail-in requirement.
The General Approach retains discretion for resolution authorities to set the level of subordination below 8% of total liabilities based upon an agreed prudential formula. Resolution authorities also retain the discretion to require even higher levels of MREL subordination, though they can only do so for up to 30% of the G-SIBs and Top-tier banks for which they set MREL levels. While the General Approach does not require banks that are neither G-SIBs nor Top-tier to subordinate MREL instruments, resolution authorities are given the discretion to require these banks to hold up to 8% of total liabilities as own funds and subordinated debt based on an assessment that identifies NCWO concerns.
G-SIBs and Top-tier banks will be required to comply with minimum TLAC and MREL requirements by 2022. The target date for compliance with both external and internal MREL has been set at 1 January 2024, though an intermediate target will be set for 1 January 2022. Interim targets and deadlines for compliance with internal MREL have been aligned with those for external MREL. Resolution authorities retain the discretion to extend the 2024 deadline on a bank-by-bank basis.
Global Systemically-Important Bank (G-SIB) score
The General Approach makes changes to the G-SIB scoring methodology, which determines the capital buffers G-SIBs must hold based on systemic importance. Competent authorities will be able to calculate an additional score for G-SIBs which discounts cross-border activity taking place within the Banking Union. This new methodology reflects the aim of the Banking Union project – to treat the Eurozone as a single banking jurisdiction – and has been justified by the degree of oversight that the Single Resolution Board has over cross-border activity in the Eurozone during a resolution scenario. However, the new methodology does not yet re-categorise any existing G-SIBs as non-G-SIBs, though it may allow certain G-SIBs in upper capital surcharge ‘buckets’ to drop down into lower buckets.
This decision contrasts with the one made earlier this year by the Council to delete the Commission’s originally-proposed waivers on sub-consolidated capital and liquidity requirements for Eurozone-headquartered groups with subsidiaries located in other Eurozone countries. Although this decision was driven by ‘host’ jurisdiction Member States concerned about the impact such waivers could have on their capacity to maintain financial stability, the logic cited at the time was that the current progress of implementing Banking Union was not sufficiently advanced to justify a change in the existing rules.