On Monday 11 December, the EU co-legislators announced their final agreement on the Capital Requirements Regulation and Directive (CRR III/CRD VI), which was meant to implement the final instalment of the international Basel III accords on the adequate capitalisation of banks.
Basel III was intended to address the failings of its predecessor, Basel II, which played a critical role in the global financial crisis of 2008/09. The second important objective of the review was to address environmental, social and governance (ESG) risks in support of the objectives of the EU sustainable finance strategy.
Implementation of the Basel III international standards
Finance Watch, a non-profit association dedicated to reforming finance in the interest of citizens, expresses its disappointment at the outcome of the legislative process. Despite repeated warnings from the EU’s top financial regulators and supervisors, the chairs of the European Banking Authority (EBA) and the European Central Bank (ECB), academics and civil society representatives, the co-legislators have now settled on a text that includes material deviations from Basel III.
Particularly worrying are the deviations in the EU implementation of risk weights for exposures to residential real estate (mortgages) and unrated corporates, as well as the Basel III ‘output floor’. The objective of the ‘output floor’ is to limit the advantage large banks gain from gaming prudential rules with the extensive use of internal risk models. EU banks, who count among the most active users and main beneficiaries of internal models, have been lobbying intensely, and with obvious success, against its implementation. The deviations being introduced by EU policymakers to the ‘output floor’ will significantly weaken its impact.
In defiance of their international commitments, EU legislators have swung behind the banking sector’s argument that Basel III does not adequately reflect the specificities of the EU banking sector.
Christian M. Stiefmueller, Senior Adviser at Finance Watch, said:
“This agreement finally brings closure to a deeply disappointing chapter of prudential law-making in the EU. At a time when international cooperation is already at risk, EU policymakers have all but given up on their post-crisis commitments, which does not bode well for the future of the Basel process. CRR III/CRD VI will continue to leave major European banks poorly capitalised, and taxpayers exposed for many years to come.”
Addressing ESG risks
Finance Watch does however welcome the provisions in the CRR III/CRD VI on mandatory prudential transition plans for banks, which will be subject to prudential supervision. The transition plans will align with the EU’s climate neutrality objective, as well as its sustainability disclosure rules (CSRD).
It is important that the EBA now develops robust implementation guidelines that ensure the objectives set in transition plans properly reflect climate science and lead to the alignment of bank business models with climate neutrality objectives. The focus should be mechanisms and tools through which the banks can push the non-financial sector towards carbon neutrality.
However, provisions on transition plans do not make up for the failure by EU co-legislators to implement precautionary capital measures to address climate-related financial risks. Alongside many other civil society stakeholders, Finance Watch had repeatedly warned of the possible climate-related financial crisis that could ensue if banks fail to account for this risk.
Finance Watch proposed a “one-for-one” rule to address this issue within the CRR III/CRD VI, whereby for each euro that finances new fossil fuels, banks should have a euro of their own funds held liable for potential losses.
Rather than taking meaningful action now, EU co-legislators have asked the EBA to research possible prudential treatment of ESG risks. The EBA have until the end of 2025 to complete this exercise, after which the possibility of new prudential rules will be discussed.
Julia Symon, Head of Research and Advocacy, said:
“Failure to adopt timely capital measures to account for climate-related financial risks is irresponsible. By underpricing climate risk, prudential rules are now effectively at odds with the EU climate objectives.
That being said, we are glad to see mandatory transition plans in the final text this evening. Transition plans have the potential to become an important tool for managing climate-related risks over time. In the absence of coherent Pillar 1 measures on climate risk, transition plans will be key to spurring behavioural change.”
Recognition of risks related to crypto-assets
In recognition of new prudential risks related to the emergent market for crypto-assets the new text includes, for the first time, capital requirements for such exposures, which are broadly in line with the relevant, preliminary standards of the Basel Committee. Finance Watch welcomes these provisions to safeguard the resilience of EU banks in light of the emerging risks.
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Notes to editors
To arrange an interview with Christian M. Stiefmueller, Senior Adviser at Finance Watch or Julia Symon, Head of Research & Advocacy at Finance Watch, please contact Alison Burns at firstname.lastname@example.org or call on +32 (0)471577233
Additional details on how the agreed CRR III/CRD VI diverges from Basel III
Deviations from Basel III are found in a number of sensitive areas, including the transitional risk weights for exposures to residential real estate (mortgages) and unrated corporates, and the calibration of counterparty credit risk related to derivative exposures. The proposed transitional arrangements provide for the new framework to become fully effective only in ten years’ time, five years’ later than the agreed Basel III deadline. Numerous review clauses during that period empower the co-legislators to make these deviations permanent.
The decision to apply what remains of the ‘output floor’ at the individual bank rather than consolidated (group) level illustrates, once again, that there is little hope of achieving the EU Banking Union as long as member states do not address the ever-present ‘home-host ‘problem. The ‘home-host problem’ refers to conflicts between the interests of the ‘home’ jurisdiction where an international banking group is domiciled, and where consolidated supervision usually takes place, and the ‘host’ jurisdiction which ‘hosts’ and supervises a subsidiary. Such conflicts arise, usually, when a group is in distress and both jurisdictions vie for control of its capital and liquidity.
Moreover, the agreed CRR III/CRD VI text maintains existing deviations on the standardised approach for credit risk and introduces new ones, especially for lending to property development and construction, mortgage lending, specialised lending (commodities and project finance), certain retail exposures, and equity exposures.
For further information, please see Finance Watch’s review of the 2021 Banking Package, its 2021 report advocating for incorporating climate-related financial risk into bank and insurance prudential rules, and finally, its 2022 report outlining how finance can contribute to making the world reach its greenhouse gas net-zero target.
About Finance Watch
Finance Watch is an independently funded public interest association dedicated to making finance work for the good of society. Its mission is to strengthen the voice of society in the reform of financial regulation by conducting advocacy and presenting public interest arguments to lawmakers and the public. Finance Watch’s members include consumer groups, housing associations, trade unions, NGOs, financial experts, academics and other civil society groups that collectively represent a large number of European citizens. Finance Watch’s founding principles state that finance is essential for society in bringing capital to productive use in a transparent and sustainable manner, but that the legitimate pursuit of private interests by the financial industry should not be conducted to the detriment of society.
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