Managing tomorrow’s banking risks

Thu 07 Dec 2023

While the banking sector has shown resilience over recent years, the economic environment and geopolitical situation remain tense. So, what does this mean for risks to the banking sector? More specifically, what is the impact on capital requirements for banks with the implementation of the Capital Requirements Regulation (CRR3) and the Capital Requirements Directive (CRD6), and how do environmental, societal and governance (ESG) issues influence the agenda? Also, how are regulations adapting to rising crypto-asset use?

These questions were raised by French Prudential Supervision and Resolution Authority (ACPR) Secretary General Nathalie Aufauvre at a recent talk hosted by the European Institute of Financial Regulation (AEFR).

The cost of risk remains low overall but banks are not out of the woods

Regarding risks to banks, the rise in interest rates is an issue for countries such as France, which operates a system of fixed-rate borrowing versus savings. In addition to a fall in property prices, recent interest rate rises have taken asset and liability management by surprise, with institutions having to adapt their interest-rate hedging strategies. 

In terms of cyber and climate risks, these remain a priority with clear guidelines and customer protection defined. In particular, on-site controls to monitor the fight against anti-money laundering and terrorist financing (AML-CFT) are vital. Overall, it was pointed out that the risks come from non-bank financial intermediaries (NBFIs) rather than from the traditional banking sector. 

As a central role of the supervisor, increased risks must be accompanied by increased supervision. Due to multiple interconnections and contagion effects, it’s deemed that the risks also justify applying more stringent rules to a broader range of banks.

Implementation of Basel III is key

With the transposition of Basel III standards in the EU bringing the post-financial crisis reforms to a close, the introduction of CRR3 in January 2025 and CRD6 in mid-2025 (mid-2026 for non-EU branches) are fundamental priority reforms that enhance the risk sensitivity of standardised approaches and apply more constraints on internal models.

As a result, the impact on capital requirements will be reduced to +9% of Tier 1 requirements for the EU, compared with an estimated 13.1% in 2020.

This package strikes a good balance between compliance, maintaining a level playing field and adapting to the specific characteristics of the EU market. This includes Europe maintaining transitional provisions until 2029 or 2032, depending on residential property price outcomes. The package also takes account of specific European features, such as compliance with Basel III innovations and assimilation of guaranteed loans with mortgage loans, for example. 

A number of topical issues were also dealt with, including the treatment of banks’ exposure to crypto-assets, improving access to the EU market and a new minimum regulatory regime. Mitigation of the output floor impact on the securitisation regulatory framework was also dealt with, albeit with some compromise on application. This included host country supervision at the prudential requirement application level, with an option for application at the highest level of domestic consolidation.

In conclusion, ACPR priorities remain the same. This includes a focus on strengthening financial strength, particularly regarding credit risk, the risks associated with the sharp rise in interest rates and the post-Silicon Valley Bank (SVB) environment. Liquidity risk is also an important focus, with the ACPR advocating to broaden the scope of applying international standards.

Strengthening sustainability reporting

The Corporate Sustainability Reporting Directive (CSRD) is considered vital to strengthen sustainability reporting. The initial application of CSRD is expected in 2025, and gradual compliance by companies up to 2028.

On 31 July 2023, the European Commission adopted a delegated Act setting out the European Sustainability Reporting Standards (ESRS) applicable to all companies within the EU subject to the CSRD. With the exception of transversal standards, the ESRS are subject to a materiality analysis.

There is also a quest for transparency and integrity in ESG rating activities. As such, ESG rating agencies operating within the EU and whose ratings are disclosed publicly will be subject to EU regulation on the transparency and integrity of ESG rating activities.

The transition plans for a climate-neutral economy have a high degree of interoperability. CRD6 mandates drawing up guidelines specifying the content of transition plans and ensuring consistency with other frameworks, including the CSRD.

The ACPR is actively involved in the European Banking Authority’s) work on transition plans to ensure the credibility and consistency of strategies in light of the latest scientific data as well as clarifying specific elements of the prudential framework.

In the face of the climate crisis and its consequences, the framework is evolving to consider ESG dimensions in prudential systems. This has resulted in ACPR and ECB climate stress test exercises and the publication of the supervisor’s expectations regarding climate risk management. However, a questionnaire sent to banks in 2023 showed little account taken of climate risks, with a few scattered good practices.

Monitoring the rise in crypto-assets

While the primary use of crypto-assets is currently focused on speculative investments, they offer some interesting innovations for the financial sector, particularly in the circulation and exchange of distributed ledger technology (DLTs).

However, they are likely to lead to the development of tokenised finance. For example, the financial sector is increasingly conducting experiments to test and verify the advantages of DLTs for transactions involving tokenised financial assets. The introduction of a pilot scheme in Europe provides a temporary regulatory framework.

Within the Markets in Crypto-Assets Act (MICA) regulation, stablecoin regulation is due to come into force in June 2024. The regulation includes the definition of electronic money tokens (EMT), which are crypto-assets designed to maintain a stable value by reference to an official currency. The regulation also defines asset-referenced tokens (ART), which are crypto-assets excluding EMTs intended to maintain a stable value by referencing a basket of one or more official currencies or other assets.

Regarding crypto-assets, the ACPR considers the AML-CFT risk very high. In particular, there is a know-your-customer (KYC) problem, and traceability is not always sufficient.

The MICA regulation is therefore considered only a first step towards regulating crypto-assets, with the possibility of future adaptation to be reviewed after the regulation enters into force.