The package of reforms commonly known as ‘Basel III’ is a comprehensive set of measures developed by the Basel Committee on Banking Supervision (BCBS), with this framework being a central element of the response to the global financial crisis. It aims to address a number of shortcomings in the pre-crisis regulatory framework whilst providing a foundation for a resilient banking system that will help to avoid the build-up of systemic vulnerabilities. The agreement reached in 2017 relates to promoting consistency and trust in the calculation of risk-weighted assets and strikes a balance between standardised and internal model-based approaches.
The Basel III reform intends to increase the robustness and risk sensitivity of the standardised approaches for credit risk, credit valuation adjustment risk and operational risk, as well as restricting the use of bank internal models. The new framework will introduce new requirements for banks by:
- Removing loss given default modelling for low-default portfolios and credit risk modelling for equity portfolios;
- Introducing several model input floors in the area of credit risk;
- Constraining the use of the internal model approaches, by placing limits on certain inputs used to calculate capital requirements under the internal ratings-based approach for credit risk and by removing the use of the internal model approaches for CVA risk and for operational risk;
- Introducing a leverage ratio buffer to further limit the leverage of global systemically important banks; and
- Adopting an output floor, which requires that risk-weighted assets resulting from internal models not to be less than 72.5% of the risk-weighted assets deriving from standardised approaches.
A new CRR/CRD proposal, which incorporates additional changes to the Basel III framework, is in process of being developed by the European Commission with technical support from EBA.
The proposed CRD6 package is comprised of the following parts:
- Implementing Basel III – strengthening resilience to economic shocks
The package faithfully implements the international Basel III agreement, while taking into account the specific features of the EU's banking sector. Specifically, the proposal aims to ensure that “internal models” used by banks to calculate their capital requirements do not underestimate risks, thereby ensuring that the capital required to cover those risks is sufficient. In turn, this will make it easier to compare risk-based capital ratios across banks, restoring confidence in those ratios and the soundness of the sector overall
The proposal aims to strengthen resilience, without resulting in significant increases in capital requirements. It limits the overall impact on capital requirements to what is necessary, which will maintain the competitiveness of the EU banking sector. The package also further reduces compliance costs, in particular for smaller banks, without loosening prudential standards.
- Sustainability – contributing to the green transition
Strengthening the resilience of the banking sector to environmental, social and governance (ESG) risks is a key area of the Commission's Sustainable Finance Strategy. Improving the way banks measure and manage these risks is essential, as is ensuring that markets can monitor what banks are doing. Prudential regulation has a crucial role to play in this respect.
The proposal will require banks to systematically identify, disclose and manage ESG risks as part of their risk management. This includes regular climate stress testing by both supervisors and banks. Supervisors will need to assess ESG risks as part of regular supervisory reviews. All banks will also have to disclose the degree to which they are exposed to ESG risks. To avoid undue administrative burdens for smaller banks, disclosure rules will be proportionate.
The proposed measures will not only make the banking sector more resilient, but also ensure that banks take into account sustainability considerations.
- Stronger supervision – ensuring sound management of EU banks and better protecting financial stability
The package provides stronger tools for supervisors overseeing EU banks. It establishes a clear, robust and balanced “fit-and-proper” set of rules, where supervisors assess whether senior staff have the requisite skills and knowledge for managing a bank.
Moreover, the proposal equips supervisors with better tools to oversee fintech groups, including bank subsidiaries. This enhanced toolkit would ensure the sound and prudent management of EU banks.
The Commission review also addresses, in a proportionate manner, the issue of the establishment of branches of third-country banks in the EU. At present, these branches are mainly subject to national legislation, harmonised only to a very limited extent. The package harmonises EU rules in this area, which would allow supervisors to better manage risks related to these entities, which have significantly increased their activity in the EU over recent years.
Credit institutions should be aware of the capital costs to comply with this framework and the fact that raising new equity implies added costs and the need for time and resources (indirect costs). Such a framework is expected to require changes in internal processes in order to implement new standards, as well as compliance costs and operating model changes. It might be the case that some credit institutions would need to decide whether to restructure parts of their balance sheet and how to improve profitability, in order to maintain their return on equity levels. In light of this, banks are encouraged to keep abreast of these changes in order to prepare themselves accordingly and address smoothly any upcoming regulatory compliance challenges without impacting their profits and competitiveness.
