EU bank capital negotiations

The European Commission’s ‘CRD5/CRR2’ bank capital proposal (including amendments to the BRRD) is now at an important stage in its negotiations. Although a deal has not been reached in either the Council or Parliament, the likely contours of a deal, and their implications for firms, are becoming increasingly clear. 

The proposed legislation implements components of the Basel III framework in the EU, including giving effect to TLAC, the NSFR, the leverage ratio and potentially the FRTB. 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 have emerged in the EU’s CRD5/CRR2 negotiations in the last three months, and our views on the next steps as the proposal progresses towards becoming law.  

The following points reflect our latest understanding:

• The European Council was unable to reach an agreement at its March 2018 Finance Ministers’ Summit (ECOFIN). This means that negotiations will continue at a working-level and the next opportunity for an agreement will now be in May or June.
• Important progress in the negotiations has nevertheless been made, with the likely position of the Council now emerging on the FRTB, NSFR, the leverage ratio, the subordination of loss-absorbing capacity and the EU Intermediate Parent Undertaking (IPU).
• The European Parliament is conducting parallel (but less advanced) negotiations between its political groups, and is expected to reach a position of its own on the legislation in Q2 2018.
• This means that the Council and Parliament are unlikely to begin negotiating with each other on a common position until June (a process, called ‘trilogues’ that also involve the Commission) which is expected to take 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 entered into EU law by Q2 2019

Key issues being negotiated now

Fundamental Review of the Trading Book (FRTB)

We understand that the FRTB has been the most contentious and complex area of negotiations in CRR2. Negotiators have been struggling to decide how best to respond to the recent BCBS decision to re-assess some elements of the FTRB, including the P&L Attribution Test and the Simplified Standardised Approach for banks with small trading books. Given that this work is not expected to be finalised by the BCBS until the end of 2018, which will be too late to be reflected in CRR2, we understand that most EU Member States are now leaning towards removing the binding capital requirements of the FRTB from CRR2. If this happens it will push the FRTB to an entirely new legislative proposal that, in our view, will not be made before 2020.

What now appears likely is that the FRTB may be retained in CRR2 only as a reporting requirement. The binding capital requirements that currently apply to banks for market risk would then remain unchanged by CRR2. To give full effect to the FRTB, a new legislative proposal would be requested from the Commission by end-2020, which we presume will be wrapped up into the ‘CRR3’ proposal that will also cover new Basel approaches to credit risk, operational risk and standardised floors.

While not confirmed, this approach, if eventually adopted in CRR2, will throw the EU’s implementation of the FRTB into significantly more doubt. A proposal in 2020 would likely take roughly two years to negotiate at the political level, and then be followed by a two-to-three-year implementation period. This change would therefore make it almost certain that the EU will miss the BCBS’s revised 2022 target for FRTB implementation by a number of years.

Net Stable Funding Ratio (NSFR)

The NSFR, by contrast, looks set to remain part of the CRR2 text, although it will still likely be subject to a two-year implementation period, and should therefore not come into force in the EU until 2021.   

We understand that the most significant area of debate in the implementation of the NSFR has been calibrating the Required Stable Funding (RSF) factor for gross derivative liabilities since the BCBS’s October 2017 decision to allow for national discretion to set the RSF between 5% and 20%. Despite some Member States expressing a preference for a more conservative approach,  the Council seems to have opted for a 5% calibration coupled with a report from the European Banking Authority (EBA) three years after implementation assessing the need for any increase. The European Parliament, by contrast, has proposed setting the RSF at 15% and has argued that 5% would be inadequate to maintain financial stability. This may therefore become an important difference between the Council and the Parliament when trilogue negotiations begin later this year.

Similarly, the Council is still maintaining its earlier position to deviate from BCBS rules on stable funding for repos and reverse repos, setting initial RSFs of 5% and 10% for each respectively. This will also be followed by an EBA report assessing the suitability of that calibration and recommending a long-term approach.

Leverage ratio

As expected, the Council has moved to adopt the BCBS’s December decision to include a leverage-based buffer for G-SIBs calibrated at 50% of their RWA-based G-SIB buffer and sitting on top of the 3% standard leverage requirement. We understand that a number of Member States are pushing to have this buffer extended to large non-G-SIB banks are well, but no consensus has emerged in the Council yet on this.

The Council has also amended its text to clarify that the new leverage ratio framework should come into force on 1 January 2022, in line with the BCBS target set in December.

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

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

CRR2 updates the EU’s existing MREL framework to incorporate the FSB’s Total Loss Absorbing Capacity (TLAC) as a Pillar 1 requirement for G-SIBs and re-casts MREL as a similar but separate Pillar 2 measure applicable to all banks.

Two key areas of contention that have emerged in the Council’s negotiations are: (1) the discretion of resolution authorities to set MREL levels in excess of twice a bank’s own-funds requirement, and (2) whether or not to require debt instruments be subordinated to count as MREL in order to avoid No-Creditor-Worse-Off issues in resolution (required for TLAC instruments, but not by the EU’s original MREL rule developed in the BRRD).  

We understand that the compromise currently proposed by the Council Presidency aims to preserve the discretion of national resolution authorities to set higher levels of MREL by making use of the ‘Market Confidence Buffer’ as a mandatory MREL requirement. It also proposes to extend a mandatory subordination requirement to ‘Top Tier Firms’ (with consolidated resolution group balance sheets above 75 Bn EUR) calibrated by the EBA, and grant some flexibility to resolution authorities to require subordination for other banks based on various factors, including resolvability assessments. This, however, remains very contentious between Member States and should be expected to change further before the legislation reaches a Council agreement.

There is also no agreement yet on when the new MREL framework should come into force. TLAC requirements are due to apply from 1 January 2019, in line with the FSB’s standards (even though the legislation is unlikely to be finalised by that point), but the changes to the MREL framework (including subordination requirements) are not due to apply until 2024. Various Member States, however, are pushing either for an earlier application or a grandfathering clause for debt instruments no longer eligible under the new rules.  

Intermediate Parent Undertaking (IPU)

The IPU has recently become a less contentious issue in negotiations since the Council opted to make a number of changes in order to enhance its proportionality. These included allowing for a dual-IPU structure to exist where third country banks have a regulatory requirement to separate activities, raising the scope threshold from 30 Bn to 40 Bn EUR in consolidated EU assets (including branch assets), and removing the G-SIB criteria from the scope (exempting G-SIBs whose EU operations otherwise do not meet the IPU thresholds). The earlier push by the SSM and SRB to include third country branches under the IPU structure has also been diffused by a compromise approach where national authorities will receive a mandate to exercise closer supervision of third country branches. In addition, an implementation period of four years has been added (likely delaying the application of the IPU requirements to 2023).

The Parliament’s approach has been similar to the Council’s in allowing for a dual-IPU structure for regulatory separation reasons, but it has retained the scope to apply to all banks with 30 Bn EUR in consolidated EU assets (including branch assets) and all G-SIBs irrespective of their operations in the EU. Unless this changes in the Parliament’s final position, this may become an important difference in trilogue negotiations between the Parliament and the Council when they begin later this year.