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Basel III finalisation comes undone: A proposal that lets down citizens and backtracks on global agreements

Finance Watch regrets that the so-called “draft Banking Package 2021” (finalising the implementation of the Basel III prudential framework for banks in Europe) leaves European banks insufficiently capitalised, and taxpayers exposed. This article sums up Finance Watch’s detailed analysis of the package

Overview

The global regulatory framework agreed by the Basel Committee on Banking Supervision in December 2017 (Basel III), was created to address the insufficient capitalisation and inadequate risk controls of the banking sector that led to the financial crisis of 2008/09. The Commission’s legislative proposal, also known as the ‚Banking Package 2021‘, aims to complete the post-crisis reforms and to ‘faithfully implement the outstanding elements of the Basel III reform in the EU, while taking into account EU specificities and avoiding significant increases in capital requirements’.[1]

Contents of the legislative proposal

The Commission’s legislative proposal comprises:

  • a regulation amending the Capital Requirements Regulation (CRR II)[2] as regards requirements for credit risk, credit valuation adjustment risk, operational risk, market risk and the output floor;[3]
  • a regulation amending the Capital Requirements Regulation (CRR II) and the Capital Requirements Directive (CRD V)[4] as regards the prudential treatment of global systemically important institutions (G-SIIs) with a multiple point of entry (MPE) resolution strategy and a methodology for the indirect subscription of instruments eligible for meeting the minimum requirement for own funds and eligible liabilities (MREL);[5]
  • a directive amending the Capital Requirements Directive (CRD V) as regards supervisory powers, sanctions, third-country branches, and environmental, social and governance risks, and amending Directive 2014/59/EU.[6]

Regulatory objectives

The final instalment of the Basel III standards, agreed and published for the most part in December 2017[7], aims at (i) completing the post crisis reform of the prudential framework for banks at the global level; and (ii) correcting flaws that have become apparent since the first Basel III standards came into force in 2014.[8] In particular, the finalisation of Basel III comprises measures to

  • reduce the excessive variability of risk-weighted assets (RWA) calculated by banks under the internal ratings-based approach (IRB) by limiting its use for certain categories of credit risk and removing it altogether for operational risk and off-balance sheet exposures;
  • improve the granularity and risk-sensitivity of calculating capital requirements under the Standardised Approach (SA) for credit risk, and introduce a new, standardised framework to cover operational risk and risk related to off-balance sheet exposures;
  • introduce an ‘output floor’ for banks using the internal-ratings based approach (IRB) to limit the divergence between risk-weighted assets calculated under the different approaches (SA and IRB); and
  • introduce a ‘leverage ratio buffer’ to further limit the leverage of global systemically important institutions (G‑SIIs).

Proposed measures

The Banking Package is intended to complete the implementation of the Basel III framework into EU law. The Commission’s explanatory notes set out four main objectives:

  • strengthen the risk-based capital framework, without significant increases in capital requirements overall;
  • enhance the focus on environmental, social and governance (ESG) risks in the prudential framework;
  • further harmonise supervisory powers and tools; and
  • reduce institutions’ administrative costs related to public disclosures and to improve access to institutions’ prudential data.

In its implementation, the Commission is proposing a number of deviations from the original Basel III standards. These ‘EU-specific adjustments’ are designed, according to the Commission, to balance a number of political objectives:

  • implement the Basel III agreement faithfully;
  • take into account European specificities;
  • avoid a significant increase in capital requirements;
  • prevent competitive disadvantages;
  • reduce compliance costs further; and
  • balance the concerns of home/ and host member states in line with the logic of the Banking Union.

General observations

Finance Watch welcomes the initiative of the EU co-legislators to proceed with the implementation of the final instalment of the Basel III standards. We note, however, that the primary and overarching objective of the Basel III process – to restore financial stability and protect EU citizens and society at large from excessive risk-taking in the banking sector – is no longer mentioned as a policy objective in the Commission’s list of trade-offs that shaped its legislative proposal, which merely commits, rather tersely, to “implement the Basel III agreement faithfully”. Judging by its content, the legislative proposal seeks to do justice, just about, to the letter rather than the spirit of the agreement. The largest EU banks, G-SIIs and major O-SIIs[9], would be allowed to continue operating with lower levels of capital, on average, than their global peers and with a competitive advantage over smaller and mid-sized banks in the EU domestic market. EU citizens, and society at large, would remain exposed to the systemic risk emanating from a poorly capitalised banking sector and liable to underwriting the losses of underperforming banks. If policymakers agree to cementing the unsatisfactory status quo in this way, they will, by the same token, have abandoned any pretence of completing the Banking Union. This circle does not square.

Priorities and trade-offs

It is worth noting that the Commission’s trade-offs, which inform the majority of the proposed deviations from Basel III standards, are (i) guided expressly by political rather than prudential and financial stability considerations; and (ii) reflect, for the most part, the concerns of the banking sector rather than those of European bank customers and citizens at large. Financial stability does no longer appear to be a priority – a reflection of the (questionable) assumption that EU banks are already adequately capitalised (see 1.4.3).

In its legislative proposal, the Commission invokes, time and again, its commitment to avoid any significant increase in capital requirements, particularly for the largest EU banking groups. That commitment was indeed made by the Basel Committee, upon instructions from the G‑20 governments, but it was made at the global level, not at the level of individual jurisdictions or even institutions. The stated purpose of the final instalment of Basel III was to rebalance capital requirements, not to increase them. European G-/O-SIIs, traditionally among the most avid users of internal modelling, have long been beneficiaries of the variability in RWAs facilitated by flaws in the original design of the ’risk-sensitive’ internal ratings-based (IRB) approach to determining capital requirements. It is not surprising, therefore, that they should be more affected by the Basel Committee’s proposed realignment, too.

A number of ‘EU-specific adjustments’ were introduced already as part of the so-called ‘CoVid-19 CRR Quick Fix’ regulation[10], which was put into place in April 2020 to provide regulatory relief for EU banks during the Covid-19 crisis. They include, in particular, (i) the postponement, by two years, of the requirement for EU banks to adjust their capital requirements for loan loss provisions in line with the adoption of the IFRS 9 standard for classifying non-performing exposures (NPEs); (ii) the postponement, by one year, of the introduction of the leverage ratio buffer; (iii) the accelerated introduction of a higher ‘SME supporting factor’ and an ‘infrastructure supporting factor’ on certain loan exposures; and (iv) bringing forward the decision to no longer require banks to deduct internally developed software from regulatory (CET 1) capital. These measures already provide significant levels of capital relief for EU banks.

Capitalisation and impact

Finance Watch does not agree with the Commission’s general assessment that “the overall level of capital in the EU banking sector is now considered satisfactory”.[11] Various studies by EU and international bodies demonstrate that the level of capitalisation of major EU banks continues to lag behind their global peers. As of December 2020, leverage ratios (fully phased-in) continued to be lower in Europe (5.5%) as compared to the Americas (7.0%) and the rest of the world (7.3%).[12] In other words, the capital ratios of major EU banks were between 27% and 33% lower than their global peers’.

In particular, EU G‑SIIs and O‑SIIs continue to make liberal use of internal modelling and, as a result, apply significantly lower risk weights, on average, to their exposures. As a result, EU banks face significantly higher incremental capital requirements from the implementation of the final Basel III standards than their global peers: for a sample of 33 EU banks analysed by the BCBS the average total capital shortfall was estimated at 17.6%, compared to 2.5% for the Americas and -5.8% for the rest of the world. Nearly half of that shortfall (42%) was attributable to the output floor.[13]

In its December 2020 impact study[14], the EBA estimated that capital requirements for EU banks would have to increase, on average, by ca. 18.5% by 2028 to comply with the final Basel III standards (without EU-specific adjustments). In this ‘base case’ scenario, the total capital shortfall for a sample of 100 of the largest EU banks was estimated at ca. EUR 52.2 bn. A small number of banks (8 G-SIIs) accounted for virtually all (83%) of the estimated shortfall. In the same study, the EBA also calculated a ‘EU-specific’ scenario, taking into account a number of ‘EU-specific adjustments’, some of them already applied in CRR I[15] and in the so-called ‘CoVid-19 CRR Quick Fix’ regulation[16], as well as the ‘alternative approach’ of calculating the output floor (see l.l). On this basis, the estimated increase in capital requirements by 2028 declined to 11.9%, equivalent to EUR 26.3 bn for the entire EBA sample. Again, the eight G-SIIs accounted for the majority (82%) of the shortfall. In all instances the output floor was the single most significant factor, accounting for 36% to 48% of the total impact.

In its impact study accompanying the legislative proposal[17], the Commission provides its own estimates of the quantitative impact of additional ‘EU-specific adjustments’ that were not considered in the EBA’s analysis but are included in the legislative proposal. These adjustments further reduce the incremental capital requirements by another 30% to 45% from the EBA’s ‘EU-specific’ scenario, primarily by neutralising the impact of the output floor. Compared to the undiluted implementation of the Basel III standards, ‘EU-specific adjustments’ foreseen in the legislative proposal would decrease the total capital shortfall by ca. 50% to 75%. As before, the main beneficiaries would be a small number of EU G‑SIIs and major O‑SIIs.

Levelling the playing field

A large number of smaller and mid-sized EU banks would remain either largely unaffected or even benefit from the combined effect of (i) the modifications of the standardised approach (SA) introduced by Basel III, and (ii) the output floor, which caps the ‘cost of capital’ advantage of banks using the internal-ratings based approach (IRB). As of today, the EU banking sector is already very polarised: on average, the Top-5 banks in each member state hold more than half of all banking assets in that market.[18] Finance Watch has argued for a long time that a diverse and well-integrated banking sector, comprising banks of different sizes and business models, is demonstrably beneficial, both for financial stability (at the macro-level) and for corporate and retail customers (at the micro-level). By seeking to cement the status quo in favour of the very largest institutions the EU is missing a rare opportunity to ‘re level the playing field’, improve the competitiveness for small and mid-sized banks, and enhance the quality of financial services offered to EU citizens and businesses (see also 2.1.3 below).

Addressing risks related to climate change

A large, and rapidly growing, body of scientific evidence, along with a relentless stream of news events, testify to the urgency of decisive political action to address climate change. Increasing numbers of financial policymakers, regulators and supervisors acknowledge that the financial system, including banking, requires significant changes to adapt to, let alone facilitate the necessary transition to a ‘net zero’ environment. ECB economists seem to agree that the current framework for capital does not adequately provide for climate risk.[19] Nonetheless, the Commission’s legislative proposal relies on a combination of ‘Pillar 3’ disclosures and ‘climate stress tests’ – which could, over time, serve as the basis for Pillar 2 measures – but stops well short of considering concrete ‘Pillar 1’ measures. In its pilot exercise on quantifying climate risk exposures in May 2021[20], the EBA identified significant data gaps and divergences in the approaches used by banks to calculate exposures, which suggests that meaningful and reliable ‘climate stress tests’ could still be a long time off. Given the need for urgent action this approach appears slow, and dangerously complacent.

A long and risky transition

Based on the current proposal, the implementation of Basel III in the EU would be completed when the last transitional arrangements expire, i.e. in 2033. This is more than ten years from now and five years after the deadline agreed by the BCBS member jurisdictions, including the EU, expires. Even then, ‘EU-specific adjustments’ that compensate for one-half to two-thirds of the capital impact of the Basel III package could remain in place, in particular if the proposed legislative review results in perpetuating the disapplication of certain Basel III standards. This extended transition does not only dilute the benefits of the Basel III reforms, leaving the European public exposed for even longer to the risk of another financial crisis, but also diminishes the EU’s global status as a principled and reliable partner who abides by its international commitments.

Recommendations

In order to faithfully implement the Basel III framework, and achieve its original objectives, the EU co-legislators should take a long, hard look at the Commission’s ‘EU-specific adjustments’ and

  • reject the so-called ‘transitional arrangements’ for the preferential treatment of certain exposures (unrated corporates and residential mortgages) and the review clauses in Art. 465 CRR, which pave the way for a permanent, material, and unjustified deviation from the Basel III standards;
  • apply the higher risk weights for equity exposures in accordance with the Basel III standards, in line with the original deadline and phasing-in arrangements agreed by the Basel Committee;
  • apply the ‘output floor’ to all elements of the capital stack, including Pillar 2 and the Combined Buffer Requirement, with adjustments strictly limited to the elimination of double-counting for ‘model risk’;
  • accelerate the adoption of a specific, and binding, prudential framework to address environmental, social and governance (ESG) risks in general, and climate-related risks in particular; and
  • respect the original implementation deadline of 01 January 2023, as it was agreed between the EU and its international partners on the Basel Committee, and the five-year transition period to 01 January 2028.

Christian M. Stiefmüller

Footnotes:

[1]  European Commission, Banking Package 2021: new EU rules to strengthen banks’ resilience and better prepare for the future, IP 21-5401, 27 October 2021; (https://ec.europa.eu/commission/presscorner/detail/en/IP_21_5401)

[2]  Regulation (EU) 2019/876 of the European Parliament and of the Council of 20 May 2019 amending Regulation (EU) No. 575/2013 as regards the leverage ratio, the net stable funding ratio, requirements for own funds and eligible liabilities, counterparty credit risk, market risk, exposures to central counterparties, exposures to collective investment undertakings (CIU), large exposures, reporting and disclosure requirements, and Regulation (EU) No. 648/2012, OJ L 314, 05 December 2019, pgs. 1–63

[3]  European Commission, Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) No. 575/2013 as regards requirements for credit risk, credit valuation adjustment risk, operational risk, market risk and the output floor, COM (2021) 664 (final), 27 October 2021

[4]  Directive (EU) 2019/878 of the European Parliament and of the Council of 20 May 2019 amending Directive 2013/36/EU as regards exempted entities, financial holding companies, mixed financial holding companies, remuneration, supervisory measures and powers and capital conservation measures, OJ L 314, 05 December 2019, pgs. 64–114

[5]  European Commission, Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) No. 575/2013 and Directive 2014/59/EU as regards the prudential treatment of global systemically important institution groups with a multiple point of entry resolution strategy and a methodology for the indirect subscription of instruments eligible for meeting the minimum requirement for own funds and eligible liabilities, COM (2021) 665 (final), 27 October 2021

[6]  European Commission, Proposal for a Directive of the European Parliament and of the Council amending Directive 2013/36/EU as regards supervisory powers, sanctions, third-country branches, and environmental, social and governance risks, and amending Directive 2014/59/EU, COM (2021) 663 (final), 27 October 2021

[7]  Basel Committee on Banking Supervision, High-level summary of Basel III reforms, 07 December 2017, pg. 1; (https://www.bis.org/bcbs/publ/d424_hlsummary.pdf)

[8]  The implementation of Basel III in the EU began with the adoption of the legislative package comprising Regulation (EU) 575/2013 (CRR) and Directive 2013/36/EU (CRD IV) in June 2013, which came into force on 01 January 2014

[9]  Global Systemically Important Institutions (G-SIIs) and Other Systemically Important Institutions (O-SIIs)

[10] Regulation (EU) 2020/873 of the European Parliament and of the Council of 24 June 2020 amending Regulations (EU) No. 575/2013 and (EU) 2019/876 as regards certain adjustments in response to the COVID-19 pandemic (CRR ‘quick fix’), OJ L 204, 26 June 2020, pgs. 4-17

[11] European Commission (Fn 3 above), pg. 3

[12] Basel Committee on Banking Supervision, Basel III Monitoring Report, September 2021, pgs. 5 and 36; (https://www.bis.org/bcbs/publ/d524.pdf); see also: Gambacorta, Leonardo / Shin, Hyung Song, Why bank capital matters for monetary policy, BIS Working Paper No. 558, April 2016; (https://www.bis.org/publ/work558.htm)

[13] Committee on Banking Supervision, Basel III Monitoring Report (Fn 12 above), pg. 32

[14] European Banking Authority (EBA), Basel III Reforms: Updated Impact Study, EBA/Rep/2020/34, 15 December 2020, pg. 42

[15] Regulation (EU) 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012, OJ L 176, 27 June 2013, pgs. 1–337

[16] Regulation (EU) 2020/873 of the European Parliament and of the Council of 24 June 2020 amending Regulations (EU) No. 575/2013 and (EU) 2019/876 as regards certain adjustments in response to the COVID-19 pandemic (CRR ‘quick fix’), OJ L 204, 26 June 2020, pgs. 4-17

[17] European Commission, Commission Staff Working Document: Impact Assessment Report accompanying the documents Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) No. 575/2013 as regards requirements for credit risk, credit valuation adjustment risk, operational risk, market risk and the output floor, and Proposal for a Directive of the European Parliament and of the Council amending Directive 2013/36/EU as regards supervisory powers, sanctions, third-country branches, and environmental, social and governance risks, and amending Directive 2014/59/EU, SWD (2021) 320 (final), 27 October 2021

[18] In some markets, including Belgium, the Netherlands and the Baltic member states, the five largest institutions account for between 75% and 95%, with Greece as the member state with the highest degree of concentration, at 97%. Source: European Central Bank (ECB), EU Structural Financial Indicators: End of 2020, 26 May 2021; (https://www.ecb.europa.eu/press/pr/date/2021/html/ecb.pr210526~7469dedaaf.en.html)

[19] Baranović, Ivana / Busies, Iulia / Coussens, Wouter / Grill, Michael / Hempell, Hannah, The challenge of capturing climate risks in the banking regulatory framework: is there a need for a macroprudential response?; in: European Central Bank (ECB): Macroprudential Bulletin No. 15, 19 October 2021; (https://www.ecb.europa.eu/pub/financial-stability/macroprudential-bulletin/html/ecb.mpbu202110_1~5323a5baa8.en.html)

[20] European Banking Authority (EBA), Report on Management and Supervision of ESG Risks for Credit Institutions and Investment Firms, EBA/Rep/2021/18, 23 June 2021

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