EU regulators warn Basel III deviations could last forever

CRR III allows European Commission to extend transitional rules for SA-CCR

European Commission
European Commission transitional measures differ from the Basel III text

European regulators and a key lawmaker are wary of proposed powers for the European Commission that could lead to temporary capital relief for banks instead becoming permanent. That would also cause the European Union to deviate from capital rules agreed at the Basel Committee on Banking Supervision.

“It would be problematic in our view to open long transitions that we know are not easy to close in Europe, which would in the end become permanent exemptions,” said Isabelle Vaillant, director of prudential regulation and supervisory policy at the European Banking Authority (EBA), speaking during a public hearing in Brussels on February 8. “So this is a very risky area, which I would say has never had high value for the banks.”

On October 27, 2021, the EC published a package of amendments to the EU’s bank capital laws, known as the Capital Requirements Regulation (CRR). These amendments include measures to implement the final elements of post-crisis Basel III capital standards that were agreed in December 2017.

Within the third version of the CRR is the floor of 72.5% on risk-weighted assets measured by internal models, as compared with the same measurement using regulator-set standardised approaches. Some European banks are expected to be hit hard by this so-called output floor due to their heavy use of internal models, which tend to result in lower risk-weight density than standardised approaches.

The EC’s proposals look to soften the blow from the output floor by introducing transitional measures that differ from the Basel III text, designed to temporarily reduce the amount of RWAs that would be generated under standardised approaches.

Although the last of these transitional measures should expire on December 31, 2032, CRR III allows the EC to put forward further legislative proposals “where appropriate”, following reports by the EBA examining the use of the transitional treatment.

“It is true that the ‘temporary’ is not completely clear, because the European Commission will have the possibility to analyse the evolution of the implementation of this transitional arrangement and maybe to propose in the future any other postponement of the transitional arrangement,” said Jonás Fernández, a member of the European Parliament and rapporteur for the CRR III package, speaking on the same panel as the EBA’s Vaillant.

He later stated: “I would like to insist European regulation has to be Basel compliant as much as possible, so with the transitional arrangements I have some doubts as rapporteur and for sure [that] will be an element for the debate in the Parliament.”

Strictly temporary

Those deviations include lowering the multiplier used in the standardised approach to counterparty credit risk (SA-CCR) for derivatives trades from 1.4 to 1. This change will last until December 31, 2029, but the EC can permanently modify the multiplier through level two legislation that the Parliament and Council of the EU must accept or reject, but cannot modify.

Most other transitional arrangements should last until December 31, 2032. However, the EC has powers to submit new legislation on them to the Parliament and Council, which those lawmakers would be able to make amendments to.

The longer transitional measures include relief on standardised risk-weights assigned to corporates that have no external credit rating. These would be set to 65% in the output floor calculation if banks can prove the corporate has a probability of default below a certain level. This is lower than the risk weights for unrated corporates assigned in the final Basel III rules for jurisdictions such as the EU, which include external ratings in their capital framework. The Basel risk weights are set at 85% for small and medium-sized enterprises and 100% for other unrated corporates.

Pablo Hernández de Cos
Photo: Banco de España
Pablo Hernández de Cos

The transitional arrangement also includes lower standardised risk weights in the output floor calculation for mortgage exposures secured by residential property that are deemed to be low-risk. A risk weight of as low as 10% on the first 55% of the secured loan on otherwise unencumbered residential property can be applied until 2032, compared with a risk weight of 20% under the Basel III standards. Again, the EC has the option to propose an extension.

“These adjustments should be avoided, as in my view, they present a deviation from Basel III, are unfounded from a prudential financial stability perspective, and could trigger a race to the bottom,” said Pablo Hernández de Cos, governor of the Bank of Spain. “So I should emphasise: even considering arguments that call for these adjustments to facilitate implementation, any such deviation should be strictly temporary in nature and should not be extended.”

Hernández de Cos is also chair of the Basel Committee, but emphasised that he was speaking only in his capacity as a national regulator.

Progress on CRR III isn’t expected soon. Member of the European Parliament Fernández said he expects to submit a draft report with his amendments on the package in mid-May. Other MEPs usually release their own amendments some weeks afterwards, followed by a negotiation to reach a CRR III draft text that can secure a majority vote in the parliament.

Meanwhile, Guillaume Primot, a representative for the French government to the Council of the EU, said the French presidency – responsible for organising the Council agenda until July 2022 – has set a provisional date to “debate” the package in “May or June” before trying to find a compromise between all member states. That raises the possibility of the Council discussions continuing after the presidency rotates to the Czech Republic in the second half of the year.

All three legislators – the Parliament, Council and the European Commission – will then need to come together to negotiate a final version of CRR III.

Editing by Philip Alexander

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