The road to implementing the final Basel agreements

The road to implementing the final Basel agreements

Mon 27 Sep 2021

The unveiling of the new banking package “CRR3 – CRD6” on 27 October 2021 presents a further landmark on the road to implementing the final Basel III agreements. The regulatory scheme will also focus on the revision of the market risk framework from January 2019, as well as the latest developments in pillar 3 requirements.

As for the previous banking package “CRR2-CRD5”, this forthcoming legislative proposal should contain specific EU topics in connection with the European Committee’s (EC) current agenda. The Basel Committee called for implementation by 1 January 2023 at the very latest, a date which already includes a one-year deferral due to the Covid-19 pandemic.

Issue of the EU transposition

The industry has continuously been opposed to the new rules, in particular the minimum capital requirement. Known as the “output floor”, it shall limit banks’ ability to optimise capital requirements offered by internal model approaches.

Supervisors have repeatedly reaffirmed that the latest Basel agreements must be implemented in a full, reasonable, and fair manner while respecting the commitment “not to significantly increase capital requirements.” However, the industry disputed this last point since these agreements could increase capital requirements by 18.5% at EU bank level, as evidenced by the latest estimates from the EBA. Therefore, the industry claims that the output floor would be particularly binding, as well as burdensome.

In this regard, the industry has proposed an alternative approach to implementing the latter to EU policymakers. The so-called “parallel stack approach” would make it possible to calculate minimum capital requirement by comparing different ways of determining own funds requirements instead of applying solvency requirements on the sole floored-RWA, calculated with standardised approaches.

However, regulators and supervisors consider this approach to be deviating from the objectives of the Basel agreements, and the ECB and the EBA have demonstrated this opinion in a recent letter sent to Commissioner McGuinness.

Future state of EU-UK Equivalence on Prudential Regulation

Following the UK’s departure from the EU, the Prudential Regulation Authority (PRA) is transitioning from primarily a “rule taker” to a “rule maker”.  In doing so, understanding the PRA’s adoption of Basel guidelines is critical for European regulators, European firms with UK operations and UK firms with a presence in the EU in the context of equivalence and supervisory relationships. 

European Regulators are required to understand regulatory regimes of foreign countries where European banks operate or where there are European branches or subsidiaries of banks headquartered in foreign countries.  The intrusiveness of banking supervision in the EU depends heavily on the level of equivalence that exists between the EU supervisory regime and those in foreign countries. So it’s critical for EU regulators, European banks with UK operations, and UK banks with a presence in the EU to understand the UK’s adoption of CRD5 in light of Brexit.

Spotlight on the PRA’s version of CRR

In accordance with the EU Withdrawal Agreement Act 2020, the version of the CRR applied in the UK at the inception of Brexit on 11 pm on 31 December 2020  became ‘retained EU law’ through the operation of the EU Withdrawal Act 2018.  The PRA has since consulted on the proposed state of its version of the CRR, which will come into force in January 2022.  Our review of this consultation and the PRA’s assessment of responses, signals the UK regulator’s intention to make regulations more prescriptive in requiring regulated firms to conform to more defined legal requirements where they might have previously been ambiguous or discretionary. For example, in the calculations used for the Basic Indicator Approach (BIA) and in the context of intra-group exposures and Collective Investment Undertakings (CIU)

A further intention is to be more proportionate by allowing smaller firms to take a simplified approach to compliance on some matters, as indicated by the introduction of sSA-CCR, sNSFR, simplifications to capital requirements calculations, and tailored disclosure requirements. 

The latter intention is designed to progress the delivery of the PRA’s secondary objective on competition, and make the country’s financial services sector more marketable. However, these simplifications may not necessarily imply a weakness in the context of EU-UK equivalence.  The PRA’s primary objective is to promote the safety and soundness of regulated firms. Indeed, one might be forgiven for expecting the UK regulator needing to be more thorough in their general liaison with smaller firms to ensure that simplified regulatory requirements do not compromise the delivery of the PRA’s primary objective.  The regulator’s determination to promote a safe and sound financial system has been evident in their stance of maintaining their position on matters such as the treatment of intangible assets and equities in the context of capital and liquidity calculations, despite clear opposition from those who responded to the consultation. 

What’s next?

In terms of the PRA’s approach: Notwithstanding the proposed allowances, small and medium-sized firms should carefully approach the following two areas of regulatory interest. First regulatory reporting where several reporting changes are due to take effect on 1 January 2022.  These include the quarterly reporting of G-SII indicator data, amended Capital+ reporting templates, and the supersedure of historic liquidity reporting formats such as the C60 and C61 forms. The PRA has been firm in responding to calls to reconsider the frequency, granularity and timing of such reporting changes. This means that regulated firms will need to mobilise resources to adapt, comply with and monitor these changes in the very near future.

Second, the spill-over of the Basel guidelines into governance obligations: It is clear that the PRA sees the quality of governance as a key mitigant to the risk that firms pose to the UK’s financial stability.  As such, senior management should be prepared for questions beyond the specifics of the granular rule changes, and for those that are within the broader scope of the Basel guidelines. For instance, CROs and Heads of Treasury might be held accountable for their approach to identifying major stock indices in third countries and their consideration of relevant public authorities’ views, in the context of liquidity risk management;  CEOs and Branch managers might have to explain the rationale for their lending decisions, especially where loans are backed by software assets; and Heads of Compliance might need to affirm the organisation’s ability – both in terms of people and systems – to interpret, implement, and monitor compliance with the new rules.  

In terms of EU transposition of the final Basel III agreements, given the recent public position taken by key regulators, including representatives from the EU Commission, it seems unlikely that the output floor will not be transposed.

However, some EU specificities should be included in the package to better cope with the European macro-environment. In particular, specific treatment is likely to be introduced for unrated exposures to take into account the fact that ratings are much less widespread than in other markets like the US. In addition, some EU adjustments are also expected in the field of specialised lending or operational risks. 

Overall, the EU will need to be very careful to ensure a level playing field with other countries, particularly the US, where the extent and the way of fulfilling Basel requirements will be meticulously scrutinised.

Key EU clarification points
•   To possibly apply the output floor at the highest level of consolidation.
•   To reduce the requirements of pillar 2, since the risks covered by pillar 1 will be broader and better captured;
•   To what extent maintaining the supporting factors for SMEs and infrastructure;
•   To ensure a level playing field with other jurisdictions, in particular for the treatment of unrated corporates and specialized lending;
•   To calibrate operational risk capital requirements through the Internal Loss Multiplier;
•   To decide on whether maintaining current exposures exempted from CVA risk charge.
•   Although largely reflected in CRR2-CRD5, another important issue will be to better take account of the principle of proportionality.