The Basel III reforms implemented by CRR 2 (Regulation (EU) 2019/876) and CRD 5 (Directive (EU) 2019/878) include an overhaul of the market risk regime, new capital rules for derivatives and securities financing transactions, a binding leverage ratio and supplemental leverage requirement. Although the changes ostensibly apply to Capital Requirements Regulation (CRR) investment firms as well as Credit Institutions, the majority of the EU investment firms will soon be removed from the scope of the CRR with the introduction of the new Investment Firms Regulation (‘IFR’) and Directive (‘IFD’). Moreover, CRR 2 and CRD 5 amend the CRR and Capital Requirements Directive (CRD 4), providing the legal framework for the prudential regulation of banks within the European Union. The agreed rules will reduce risks in the banking sector by further reinforcing banks’ ability to withstand potential shocks.
Implementation Timeframe
The new prudential regime on capital requirements was published in the Official Journal of the European Commission on 7 June 2019 and entered into force on 27 June 2019. Most amendments of the new framework will be applicable from mid-2021. The majority of the provisions in CRR 2 will apply on 28 June 2021 and the deadline for the national transpositions of the provisions of CRD 5 is 28 December 2020.
Own Funds
As a general rule, banks are required to deduct the value of software assets identified as intangible assets from their capital. This increases their capital needs. The co-legislators have agreed to exclude certain software assets from the scope of assets that need to be deducted from own funds. In order to ensure a level-playing field at international level and to foster the investments in software in the context of an even more digital environment, the European Banking Authority will be mandated to draft technical standards to define those software assets that do not need to be deducted.
New Leverage Ratio
The new rule requires institutions to maintain a leverage ratio of at least 3% at all times. Moreover, the leverage ratio shall be calculated as the Tier 1 capital divided by the institutions overall credit exposure. An additional leverage ratio buffer will be applicable to institutions classified as Global Systemically Important Institutions (G-SIIs). Moreover, CRR 2 will allow the initial margin to reduce the overall exposure when applying the leverage ratio to derivatives transactions.
Liquidity Risk
The Net Stable Funding Ratio (NSFR) requires credit institutions to ensure that their overall exposures are matched with stable funding sources in order to avoid any possible liquidity crises. The NSFR standard has been agreed by the Basel Committee and will enter into force together with adjustments recommended by the EBA’s NSFR report in order to ensure that the NSFR does not prevent the financing within the European economy. The aforementioned adjustments are related mainly to specific treatments such as pass-through models in general and covered bonds issuance in particular, whose funding risk can be considered as low when assets and liabilities have the same maturity. The proposed specific treatments broadly reflect the preferential treatment granted to these activities in the EU Liquidity Coverage Ratio (LCR). As the NSFR complements the LCR, these two ratios need to be consistent in their definition and calibration.
Market risk
Instruments that banks hold for trading (trading book), such as shares, bonds, or derivatives, are usually subject to volatility, which has a daily impact on banks’ profits and losses. Sudden drops in the value of these instruments may damage the solvency position of banks.
CRR2’s new approach to market risk reflects the Basel Committee’s Fundamental Review of the Trading Book (FRTB) which was completed in January 2016. The FRTB set out what level of capital was needed to absorb trading losses but due to time constraints, CRR II has only addressed the reporting requirement. The capital elements of FRTB will be implemented at a later point but, until then, banks will still need to use current CRR for calculating market risk capital.
The new market risk rules will introduce significant changes to internal model-based approach, and a revised standardised approach. Banks with “medium-sized” market risk-related activities will be able to remain on a simplified standardised approach, corresponding to the existing standardised approach.
The revised capital requirements for market risk should apply four years after the date of entry into force of CRR 2 (so from mid-2023, although this may be pushed back to the beginning of 2024).
Revised Counterparty Credit Risk
CRR 2 constitutes the EU’s implementation of the new Basel standardised approach to counterparty credit risk (SA-CCR). The legislators agreed a) to provisions that would help banks with high-levels of non-performing loans to sell them with a limited impact on their capital requirements and b) a more favourable treatment for pensions and salary-backed loans. The new approach is more risk-sensitive, providing better recognition of hedging, netting, diversification and collateral.
Large Exposures
One of the key changes under the new prudential framework is that the 25% exposure limit will be calculated on the capital base of Tier 1 capital instead of eligible capital (which includes the Tier 2 capital). This will result in more stringent limits in order to further mitigate the concentration risk that the institutions are exposed to. In addition, the exposure limit is reduced to 15% for exposures between Global Systemically Important Banks G-SIBs, in order to mitigate systemic risk. As regards the calculation of exposures, CRR 2 removed the use of the Internal Model Method (IMM) and imposed the use of the Standardised Approach for calculating the exposure value of derivatives and other instruments subject to counterparty credit risk.
Proportionality
Firstly, the text renders requirements for banks to publically disclose certain information more proportionate for smaller and less complex banks. A mandate is also given to the European Banking Authority with the aim to streamline reporting requirements. Secondly, where new prudential standards are introduced, simple and conservative alternatives are proposed for smaller, less complex banks, notably for market risk, the net stable funding ratio, counterparty credit risk and interest rate risk in the banking book. Finally, the agreed rules introduce simplified obligations on remuneration and on the net stable funding ratio for smaller and less complex banks.
Pillar 2
The proposal of European Commission provided that Pillar 2 capital add-ons should be confined to a purely micro-prudential perspective, to avoid overlaps with the existing macro-prudential tools which aim to address systemic risk. The adopted text confirms this separation and provides additional flexibility for the application of the existing macro-prudential tools in order to ensure that authorities have sufficient means to address systemic risk.
Pillar 3 disclosures
CRR2 implements the revised Basel Pillar 3 requirements published in 2015. As part of the proportionality framework introduced in CRR 2, the frequency and content of required disclosures depends on the classification of each institution as a large institution, small and non-complex institution or other institution. The original proposals included a requirement for market risk to be disclosed at trading desk level which would have revealed information about banks’ trading strategies. Moreover, CRR 2 requires institutions to disclose some additional new key prudential metrics such as the amount of the additional own funds related to the ICAAP add-on decided by the Competent Authority as a result of the Supervisory Review and Evaluation Process conducted.
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