The Package is a comprehensive re-write of the EU’s three main legislative pillars in the field of banking regulation, the Capital Requirements Regulation (CRR), Capital Requirements Directive (CRD), the Single Resolution Mechanism Regulation (SRMR) and the Bank Recovery and Resolution Directive (BRRD). It had been billed as a necessary update to incorporate the most recent international standards, in particular the latest iteration of the Basel III framework, issues by the Basel Committee on Banking Supervision, and the Total Loss Absorbing Capacity (TLAC) of the Financial Stability Board (FSB). On the whole, however, the EU legislators have gone about the adoption of these standards with a barely concealed lack of enthusiasm.
Out of Steam: Financial Stability comes second (again)
In the core area of capital requirements, policymakers have let themselves be convinced, once again, that European banks should be run on a shoestring with capital at three pence to the Pound. The adoption of a binding, risk-neutral Leverage Ratio (LR) has been a long-standing demand by Finance Watch and many other experts. At a level of 3%, however, the Leverage Ratio has become practically meaningless and will not be effective at compensating the flaws in the risk-weighted asset (RWA) calculations and bank’s internal ratings-based models (IRB) at the core of the risk-based Basel III framework, which are highly susceptible to subjectivity and manipulation. In its adoption of the Leverage Ratio, the Net Stable Funding Ratio (NSFR) and the Liquidity Coverage Ratio (LCR), two more key ratios introduced by the Basel III framework to improve the resilience of banks’ balance sheets, the EU legislators have applied a number of deviations from the original Basel III standards, which accommodate the demands of European banks but severely undermine the usefulness of these new metrics. These deviations concern, for example, the treatment of derivative transactions, of short-term transactions with financial institutions and of High Quality Liquid Assets (HQLA).
Similarly, the introduction of the TLAC standard, which governs the capacity of banks to absorb losses and recapitalise themselves without recourse to external funds, the EU legislators has been compromised by deviations, in particular regarding the requirement for liabilities that may be subject to bail-in to be subordinated to regular unsecured creditors. The lack of a clear and credible subordination regime is bound to render bail-in more difficult, even impracticable at the point of resolution, when it is most needed.
The Package also contains a number of provisions that to limit supervisory authorities’ room for applying discretionary judgment. By confirming the splitting of Pillar 2 capital requirements into a binding “requirement” and non-binding” guidance, a controversial practice applied by the ECB since 2016, large banks’ binding core equity requirements reduced by more than 20% in one fell swoop. Similarly, the new tight constraints on the discretionary autonomy of resolution authorities when setting the Minimum Requirement for Eligible Liabilities (MREL), are likely to hinder rather than help the resolvability of distressed banks.
In other areas, the Package continues and entrenches a misguided attempt to direct bank lending by tinkering with risk factors and capital charges. Lower risk weights for loans to SMEs and infrastructure projects are meant to channel loans towards parts of the economy that are considered currently underserved. In the best case, these “support factors” amount to subsidies to the banks for writing business that they would take on anyway. In the worst case, they may undermine lending standards and encourages banks with weak risk controls to lend to companies and projects of doubtful credit quality.
Paved with good intentions?
On the positive side, the European Banking Authorities (EBA) has been asked to report on a uniform definition of Environmental Social and Governance (ESG) risks and on related risk management processes. This could lead to new guidelines for the inclusion of ESG risks in a next supervisory review.
Given the systemic nature of climate risk and the expected long-term negative impacts on the economy and potentially financial stability, this step is very important. Yet, it all depends if the EBA will be able to propose an appropriate definition of ESG risks and appropriate methodologies. For example, the definition of ‘environment’ should not be limited to ‘climate’, but should include the whole range of what comprises a liveable environment: a healthy and restored ‘stock’ of natural capital providing the fundamental ecosystem services our society is based on.
Between timid progress and resolute backsliding
Overall, this Banking Package represents a missed opportunity to continue and complete the regulatory effort that took place in the first half of this decade when memories of the devastating twin crises of 2007-09 (global financial crisis) and 2010-12 (Eurozone crisis) were still fresh. The outgoing Parliament is leaving behind a very mixed bag of timid progress and resolute backsliding.