Basel 4

The debate around the implementation of the final Basel reforms (Basel 4) in the EU rumbles on. It is now over eight months since the European Commission published its proposals for amendments to the Capital Requirements Regulation (CRR3) which would implement the Basel requirements from 1 January 2025.

The proposals have been working their way through the legislative process but continue to encounter obstacles and differing points of view, notably from the ECB which is concerned that CRR3 may stray too far from the desired “full and faithful implementation” of the Basel standards and, more recently, from the outgoing French presidency which put forward potential compromises as it left the building.

Meanwhile in the UK, detailed implementation proposals are expected from the PRA in Q4, a full year behind the EU. However, the PRA has written to firms setting out the expected timeline for internal model application submissions under the new market risk framework (FRTB).

Given that much is still to be finalised in terms of implementation across the EU and UK, banks are at varying stages of their preparations for Basel 4. However, there is still a strong case for starting on no-regrets actions now so as not to run out of road once the final rules are delivered.

In March, the ECB issued an opinion on the Commission's October 2021 CRR3 proposals. While broadly welcoming the Commission's approach, the ECB expressed concern that some deviations and implementation choices put forward might leave pockets of risk insufficiently addressed, notably:

• Output floor (OF) — the ECB supports the option for a “single stack” approach (a single capital stack for risk-based capital requirements) and the application of the OF at the highest level of consolidation. However, it disagrees with the redistribution mechanism proposed by the Commission, noting that this mechanism may incentivise banking groups to reorganise their activities in order to minimise the impact of the OF on individual parts of the group. This could have a negative impact through the misalignment of organisational structures or sound risk management, and also freeze more capital at local level, which is contrary to the objective of free movement of capital necessary for financial integration.
  
• Credit risk framework — the CRR3 standardised approach contains several new deviations from the final Basel standards that, together with the continuation of some existing deviations (e.g. for small and medium-sized enterprises and infrastructure), may reduce the consistency and safety of the new standardised approach and leave certain risks uncovered. The ECB suggests that co-legislators should reassess both the new and existing deviations. It is particularly concerned about potential impacts relating to specialised lending exposures, equity exposures, retail exposures and the methodology for collateral valuation for exposures secured by immovable property.
  
• Operational risk — the ECB is unhappy that the Commission did not opt for recognition of historical losses for the calculation of capital requirements for operational risks. In its view, inclusion of the loss history would enhance risk-sensitivity and loss coverage of capital requirements, providing greater incentives for institutions to improve their operational risk management.
  
• Market risk — the ECB recommends that the Commission's proposed powers to change the calibration of capital requirements under the new market risk framework and delay its implementation by two years be limited as this would effectively reduce capital requirements and deviate from Basel standards.
  
• Credit valuation adjustment (CVA) — the ECB notes that the proposal does not reconsider existing exemptions, and that deviations from Basel standards are not justified from a prudential perspective as they leave institutions exposed to uncovered risks from derivatives transactions with exempted counterparties.
  
• Pillar III disclosures and reporting — the ECB considers that the small and non-complex institutions' (SNCIs') approach for quantitative disclosures (which uses supervisory reporting to compile the corresponding quantitative public disclosures on the basis of a pre-defined mapping) could be applied to all institutions, regardless of their size and complexity, to reduce the reporting burden of all institutions.

For more on the ECB's concerns, see our article.

At the end of May, the ECON Committee published a draft report on the CRR3 proposal, setting out amendments proposed by the rapporteur, Jonás Fernández. The amendments include:

• Removal of the preferential treatment provided in the new Article 122a for “high quality” specialised lending exposures (reduced risk weight of 80% for unrated specialised lending if defined as “high quality”). Instead, a risk weight of 100% would be applied to all exposures. 
• A risk weight of 100% for retail exposures above €1 million, instead of the 75% proposed.
• Rejection of the proposed reduction of the risk weight for exposures from institutions and corporates with a short-term credit assessment. Instead, the actual values would be maintained.
• Exclusion of unrated corporates with annual sales above €500 million from the transitional regulation of applying a risk weight of 65% until 2032.
• Removal of the possibility to increase the value of immovable property used to secure an exposure above the value it had at origination.
• Removal of powers for the Commission to adopt delegated acts to amend the approaches to calculate the own funds requirements for market risk, and to amend the date of entry into application of these approaches.
• Addition of a limitation for the use of transitional arrangements for exposures secured by immovable property. Property must be certified as energy efficient level  A or A+.
• Deletion of several EBA and other mandates.

The ECON Committee is tabled to vote on the amendments in December 2022.

Before handing over the to the Czech Republic in June, the outgoing French Presidency filed its own amendments in the form of a compromise text, which would walk back some of the Commission's proposals and give national, rather than EU-wide authorities, greater discretion. While the compromise will have pleased some banks, it likely antagonised further the parties who are pushing for a more stringent application of the Basel standards. Among other things, the compromise would:

• Apply the final reforms across a banking group. The Commission proposes to apply the output floor at consolidated level, with a second calculation to distribute any capital increase down the chain. In contrast, the French suggest applying the reforms across the group but with an option for countries to apply at the consolidated level if they wish.
• Remove the cross-border ban on banking services.
• Not apply EU-wide rules which would determine when foreign banks must convert branches into subsidiaries. The threshold would instead be decided at country level.
  
• Give responsibility for fit-and-proper checks on bank directors to each country instead of standardising rules across the EU.
  

The new Czech Presidency will now need to manage the various proposals and amendments and guide all parties towards an agreement in order to be able to sensibly meet the proposed 1 January 2025 deadline. Final EU text is ecxpected towards the end of 2022 or in early 2023.

The PRA will consult on the UK implementation of the final Basel reforms in Q4 2022 with a planned implementation from 1 January 2025, aligning it, at least in terms of timing, with the EU. In the meantime, the PRA has written to firms regarding the Fundamental Review of the Trading Book (FRTB), setting out the expected timetable for submitting new market risk internal model approach (IMA) applications for review.

The PRA does not intend to consult on any temporary extension of the existing modelling regimes or permissions. Instead, current IMA firms will automatically move to the new standardised approach (SA) when the new rules are implemented, unless they have been granted a new IMA permission under FRTB.

Final IMA pre-application materials should be submitted by 1 January 2024, 12 months in advance of the proposed implementation date. Firms submitting after this date should expect to use the SA for an initial period, pending their model review, which they have been warned may take “significantly longer” than 12 months. In the run-up to the deadline, the PRA will use firms' existing quarterly FRTB implementation meetings for in-depth reviews on the following topics, with firm-specific and industry-wide feedback after each review:

• Q4 2022: Default Risk Charge (DRC)
• Q1 2023: Risk factor eligibility test (RFET)
• Q2 2023: Non-modellable risk factors (NMRF)
• Q3 2023: P&L attribution test (PLAT) and back testing

The PRA intends to conduct a further round of benchmarking on all SA in-scope firms in 2023/2024. The methodology is not expected to deviate significantly from the most recent round of ISDA FRTB-SA benchmarking.