Banking package: European Commission publishes proposal on the revised Capital Requirements Directive and Capital Requirements Regulation

Context and objectives

On 27 October 2021, the European Commission published a proposal on the revised Capital Requirements Directive and Capital Requirements Regulation (the CRD6/CRR3 package) and the Bank Recovery and Resolution Directive. This proposal aims to finalize the EU’s implementation of the Basel III framework through the Capital Requirements Directive (CRD6) and the Capital Requirements Regulation (CRR3).

Amendments to the existing rules

Some key changes introduced by the capital requirements package are as follows:

1. Output floor

• The output floor will apply at the highest level of consolidation in the EU, but must be calculated for each EU subsidiary.
• The European Commission proposes several amendments that reduce the capital impact during the transition period:
  • An adjustment to the calculation to allow 125% of unfloored risk-weighted assets (RWAs) to be used as an option for the basis of the calculation;
  • Allowing internal ratings-based (IRB) firms to use a 65% risk weight until 31 December 2032 for unrated corporates whose probability of default (PD) is estimated as less than 0.5% when calculating their standardized RWAs; and
  • Allowing IRB banks to set the risk weights for residential mortgage to preferential values, depending on the LTV.
     

2. Capital buffers

• The Directive will include an attempt to limit an “arithmetic” increase in capital requirements caused by the output floor’s interaction with capital buffers. Therefore, a proposal will be put forward to “freeze” the systemic risk buffer and pillar 2 requirement (P2R) until competent authorities carry out reviews that assess whether there is any double-counting of risks.
   

3. Pillar I risks

• Credit risk:
  • For a period of three years from 1 Jan 2025 to 31 December 2027, the Commission proposes to permit banks with IRB permissions to move portfolios back from IRB to Standardised. This is subject to certain conditions, chiefly that the decision is not done with the intent of regulatory arbitrage
  • For residential mortgage exposures, institutions must use the “at origination” Loan-to-Value (LTV) requirements. Increases in the valuation of the underlying property are only permitted to feed into the LTV when amendments have been made to a property that increase its value. The Commission proposes that EU institutions will be permitted to revalue property assets and reflect the valuation in LTV, subject to certain constraints;
  • Increases in risk weights for equity exposures to be transitioned from 2025 to 2030 in order to mitigate the immediate effect of what is expected to be a significant relative increase in capital requirements; and
  • A preferential approach for unrated specialised lending facilities is introduced, allowing for lower risk weights for object finance exposures that meet certain criteria in relation to the quality of the collateral package. The preferential infrastructure supporting factor previously implemented in the EU is retained, allowing for lower risk weights for lending that supports specified infrastructure projects, as long as it does not overlap with the high quality specialised lending approach.
• Market risk:
  • The European Commission allows itself to publish a Delegated Act to amend the CRR3 market risk requirements or to postpone the framework’s application by 2 years to bring it in line with emerging international standards;
  • A lower risk weight for the commodity delta risk factor for carbon trading is proposed; and
  • The governance and control over the alternative standardized approach (ASA) are specified in some detail.
• Operational risk:
  • No internal loss multiplier for the operational risk framework will take place; and
  • Larger institutions will be obliged to disclose losses via pillar 3.
     

4. Environmental, social and governance (ESG) risks

• Pillar 3 disclosure requirements for ESG risks are expanded from only applying to large, listed institutions to all in the scope of the CRR.
• Supervisors have new powers to require institutions to reduce the risk of misalignment with the EU’s relevant policy objectives, and broader transition trends relating to ESG factors over the short, medium and long term.
• New, formal requirements for institutions to systematically identify, measure and manage ESG risks are added. Their supervisors must also be able to assess risks at both bank and systemic levels.
• ESG risks must be considered over short-, medium-, and long-term horizons, with the long-term duration being at least 10 years. To achieve this, institutions need to conduct internal stress tests on their resilience to the long-term negative impacts of climate-related risks and, eventually, broader ESG risks.
   

5. Crypto assets

• The Regulation mandates the European Commission to assess, by 31 December 2025, whether a dedicated prudential treatment of crypto assets is justified. The Basel Committee on Banking Supervision’s (BCBS) development of standards should be taken into account in this assessment.
   

6. Management accountability

• The Directive will include changes to the “Fit and Proper” test: institutions will be required to draw up statements setting out the roles and duties of each member of the management body, senior management and key function holders in a similar way than the requirements in the management accountability regimes of other jurisdictions.
   

7. Third-country branches (TCBs)

• All TCBs are to be subject to an authorization requirement, including a reauthorization requirement for existing TCBs.
• TCBs are to be categorized as:
  • Class 1 (individual branch): total value of assets booked by the TCB in the MS is equal to or above EUR 5 billion, or the TCB takes retail deposits, or is not a “qualifying TCB”; or
  • Class 2 (individual branch): assets below EUR 5 billion.
  • TCBs will be subject to an assessment of their systemic importance if, individually in one MS or collectively across all MS, they exceed EUR 30 billion in assets.
• TCBs are to be subject to requirements for capital endowment, liquidity, governance and controls, and specification of and adherence to booking approach.
• For systemic TCBs, several remedies are proposed:
  • Requirement to subsidiarize;
  • Requirement to restructure assets/liabilities so that it ceases to be systemic;
  • Additional requirements for branches and/or subsidiaries of the TC group; and
  • Deferral of imposing any of these requirements for a period of 12 months, subject to the supervisor conducting a reassessment within this 12-month period.
     

Next steps

Most of the CRR3’s provisions are scheduled to apply as from 1 January 2025.

The transition period for the output floor will begin on 1 January 2025 at a 50% calibration, rising to the full 72.5% calibration by 1 January 2030.
 

What does this mean for your organization?

Institutions will need to demonstrate a significant improvement in the sophistication and completeness of their approaches to ESG risk issues, as both the Directive and Regulation stress the importance of ESG risks being included in the prudential framework, both directly and indirectly.

Institutions should start reviewing their current business models and operational and risk frameworks to progressively implement operational arrangements that incorporate capital requirements factors. They will also need to note any areas that are the most controversial or could be the most susceptible to change due to the lengthy negotiation period ahead. These negotiations always result in substantial changes to the legislation, and there is considerable risk that the final CRD6/CRR3 will look very different in key areas.
 

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