Long awaited, the EU is finally about to update its common banking rulebook. In this post, I provide an overview of the most important changes the regulatory community will have to consider in the coming months.
The current EU legislative package consisting of Capital Requirements Directive and the Capital Requirements Regulation was introduced to implement the post-crisis Basel III reforms. The EU is revising this package, adopting new prudential rules to make the financial system more resilient and stable.
The revised package (‘the banking package’) which was first proposed in November 2016 introduces significant revisions to capital, funding, and liquidity requirements. The final package agreed in February 2019 represents an important step towards the finalisation of the Banking Union and the Capital Markets Union in the EU. The package comprises the Capital Requirements Directive V (CRD V) and the Capital Requirements Regulation II (CRR II), as well as the revised Bank Recovery and Resolution Directive and the Single Resolution Mechanism Regulation.
This post highlights the key revisions under CRD V and CRR II, focusing on the implementation of the Standardised Approach for Counterparty Credit Risk (SA-CCR), leverage ratio, the net stable funding ratio (NSFR), the intermediate EU parent undertaking (IPU) rule and the fundamental review of the trading book (FRTB).
To complement the EU Liquidity Coverage Ratio (LCR), the package introduces the NSFR standard agreed by the Basel Committee. But the EU implementation includes with some adjustments including specific treatments such as pass-through models in general and covered bonds issuance broadly reflecting the preferential treatment granted to these activities in the EU LCR to ensure two ratios are consistent in their definition and calibration. The package also allows small and non-complex institutions to use a simplified and less granular version of the NSFR subject to supervisory approval by their supervisors based on factors including the size of assets, trading book and derivative positions. It also includes adjustments to the Basel standard with respect to the treatment of short-term transactions with financial institutions. The package introduces these adjustments only transitionally for a period of four years, after which the calibration of the Basel standard would apply unless the Commission submit a legislative proposal to amend the treatment of these short-term transactions.
The IPU rule
The package requires third-country groups with significant EU activities of at least EUR 40bn including EU branches, regardless of whether they are G-SIBs or not, to set up an IPU in the EU to allow for a more holistic supervision of the EU activities and to facilitate resolution within the EU. The package permit the establishment of two intermediate parent undertakings taking into account the structural separation requirements in certain third countries, as long as such separation would not hinder effective resolution. While the IPU rule does not require branches to be organised under an IPU, it subjects them to enhanced reporting and tighter supervision to avoid their use for regulatory arbitrage. The IPU rule will take effect 3 years after CRD5, i.e. by early 2024.
Given the risk-weighted measures of capital adequacy are also susceptible to errors that are inherent in assigning risk weights, the banking package introduces a binding leverage ratio requirement for all institutions subject to the CRR. It sets the ratio at 3% of Tier 1 capital in line with the internationally-agreed Basel level. The package also requires global, systemically important banks to hold an additional leverage ratio buffer on top of the 3% leverage ratio. This buffer is set at 50% of their G-SIB capital buffers, which should also be met by Tier 1 capital. The Commission is expected to consider extending the application of this supplementary buffer to other systemically important institutions and to submit a report to the EP and the Council by 31 December 2020. These are less relevant for the UK banks, as the Prudential Regulation Authority already applies a more stringent leverage regime.
The package adopts a new SA-CCR, which is a more risk sensitive measure of counterparty risk reflecting netting, hedging and collateral benefits, as well as being better calibrated to observed volatilities. The package also introduces a simplified approach to calculation of counterparty risks for firms with the size of the on-and off-balance sheet derivative business less than 10% of their total assets and €300m. It also keeps the Original Exposure Method as an alternative approach for firms with very limited derivatives exposures, subject to certain eligibility criteria with respect to contract netting agreements.
The EU FRTB introduces a more precise market risk framework with respect to the proportionate treatment of market risk exposures, permitting firms with trading book size of under €50m and less than 5% of their total assets to apply the credit risk framework for banking book positions for their trading books instead of the market risk rules. It also permits firms with trading books size of less than €300 m and less than 10% of their total assets, to use a simplified standardised approach. However, given the Basel Committee decided to delay the implementation deadline of the FRTB to 1 January 2022, the package introduced FRTB only as a reporting requirement. All large firms are required to start reporting the calculation derived from the revised standardised approach within one year after the adoption of the Commission delegated act, which is currently expected to take place by 31 December 2019. The Commission is also expected to submit a legislative proposal by June 2020 as part of new CRD VI and CRR III.
So what’s next?
The Banking Package is expected to enter into force May 2021, with the transposition deadlines of 18 months and 2 years, for CRD V and CRR II, respectively. While the banking package includes the elements of the Basel III framework already agreed at international level at the time of the Commission’s proposal, it does not adopt all of the more recent changes including those on credit and operational risk agreed by the Basel Committee in December 2017, which are often referred to as ‘Basel IV’ – with the exception of the rules on the revised leverage ratio and the leverage ratio buffer. Basel IV framework, which is expected to be implemented via the forthcoming CRD VI and CRR III framework, includes changes to the standardised and internal models approach to credit risk, operational risk, leverage ratio, capital floors and credit valuation adjustment, and will complement the initial phase of Basel III reforms.
Mete Feridun is a Manager in PwC’s Financial Services Risk and Regulation practice, where he focuses on the prudential regulation of banks and investment firms. Prior to joining PwC, he worked at the Financial Conduct Authority as a Senior Supervisor, where he was in charge of overseeing the implementation of the retail banking ring-fencing structural reform by a major UK banking group. He also worked at the Bank of England as a Senior Supervisor at the Prudential Regulation Authority, where he was in charge of the microprudential supervision of a portfolio of global systemically important banks. Mete Feridun is also a professor of Finance and have held recent visiting academic posts at the University of Oxford, University of Cambridge and LSE Systemic Risk Centre.
Disclaimer: The views and opinions expressed in this blog are those of the author and do not necessarily reflect the official views and opinions of PwC.