EU banking legislation to complete the Basel III recommendations in preparation

In December 2017, the Basel Committee on Banking Supervision1 published the long-prepared reforms to the Basel III standards issued by it in 2010. The reform package was followed by the reforms published by the Committee in December 2018 on disclosure obligations concerning banks’ capital adequacy information and reforms concerning capital adequacy requirements for market risk published in January 2019. The reforms made by the Basel Committee seek to improve the comparability and transparency of banks’ capital adequacy information and to restore confidence in the manner of calculation of risk-weighted assets. These also seek to reduce the risk of unfounded differences in capital requirements for different banks and in different countries.

The 2010 requirements of the Committee were primarily related to the overall level of capital requirements as well as own funds and their quality. The 2017 reforms are particularly related to the calculation of risk-weighted assets.

The updated Basel Committee recommendations are implemented in Europe by uniform EU legislation. The European Commission is currently preparing its proposal on amending the current capital requirements regulation2. The objective is to make the European legislation as harmonised as possible with the standards of the Basel Committee on Banking Supervision. However, banking in Europe involves special characteristics that may justify certain deviations from the recommendations of the Committee. Among others, the European Banking Authority has given its recommendation to the Commission on how the standards of the BCBS should be implemented in Europe.

Basel III reforms increase the risk-based nature of the standardised approaches and limit the capital benefits achieved through internal models

According to several reports, there is significant deviation among banks’ risk-weighted assets that cannot be explained by differences between their risk profiles alone. In addition, internal models have been used to ease banks’ capital requirements considerably in comparison with standardised approaches.

The Basel III reforms considerably increase the risk-based nature of the capital requirements for corporate, institutional and retail as well as equity exposures under the standardised approach to credit risk. In particular, the reforms refine the measurement of risk related to unrated corporate and institutional exposures as well as exposures secured by residential and commercial property.

The reforms concerning the internal ratings-based approach for credit risk are related to the possibility of the use of internal models and the values allowed for the key parameters of the models.

In addition, the standardised approach to market risk becomes more risk-based, and the approval and measurement of internal models is clarified. Also, the concept of the trading book is clarified in order to restrict the transfers of balance sheet items between the trading book and the banking book with the intent to reduce capital requirements.

The capital requirement for operational risk is calculated applying the standardised approach, which replaces all current calculation methods for the capital requirement for operational risk. The reformed method is more risk based than the present standardised approach. It simplifies the calculation framework for the capital requirement for operational risk, which in turn improves the comparability of risk-weighted assets for operational risk.

Besides operational risk, the option to use an internal model is removed from the credit valuation adjustment risk (CVA risk).

In addition, the leverage ratio requirement for global systemically important institutions is tightened by establishing an additional leverage ratio buffer for them.

Impacts and entry into force of Basel III reforms

In practice, the most significant reform is a minimum for risk weighted assets (output floor), set for banks applying internal models, which limits the capital benefits that can be gained from the use of internal models. The total amount of risk-weighted exposures applicable in capital adequacy calculation must be at least 72.5% of the total risk-weighted exposure amount calculated applying the standardised approach under the Basel III reforms.

Based on impact assessments made, the reforms made by the BCBS have a clearly larger impact on European banks than the average globally. The impact is targeted most strongly on banks making the most use of internal models and achieving the largest alleviations to their capital requirements relative to the standardised approach through the use of internal models. Internal models are used more than the average in, for example, the banking sectors of Belgium, the Netherlands and Nordic countries.

The reform has been assessed as reducing the capital ratios of the Finnish banking sector to a considerable extent. The impact on total capital requirements is primarily determined based on how the various capital requirements are taken into account in the calculation of the output floor, which limits the capital benefits from the application of internal models. The amount of the buffer of own funds in excess of the capital requirements would decrease significantly if the output floor were applied to all capital requirements based on EU legislation. In this case, the risk-based nature of the capital adequacy framework would weaken, since the impact on internal models on the bank's capital adequacy situation would be reduced.

The application of the output floor to all capital requirements under EU legislation would not be consistent with the BCBS standards. In accordance with the standards, the floor should only be applied to the minimum capital requirements (so-called Pillar 1 requirements), the capital conservation buffer and the countercyclical capital buffer as well as the additional capital requirements for credit institutions identified as other and global systemically important institutions (OSIIs and GSIIs).

In connection with the implementation of the Basel III reforms, special attention should be paid to not overly reducing the risk-sensitivity of the capital adequacy framework. In practice, risk-sensitivity could be fostered by, for example, excluding the the output floor from the calculation of capital requirements beyond the original Basel framework (the systemic risk buffer and discretionary additional capital requirements i.e. so-called Pillar 2 requirements). Another option would be to partly compensate for the growth of capital requirements due to the output floor by, for example, reducing the Pillar 2 requirements or macro-prudential requirements. Assessment of the feasibility of the latter alternative would require an impact assessment.

The standards of the Basel Committee for Banking Supervision concerning the reform of Basel III will enter into force on 1 January 2022. The output floor will be implemented gradually over a five-year transitional period. The European Commission will issue its proposal on new EU legislation during 2020. The date of entry into force of binding provisions depends, however, on timetable by which the EU member states and the Parliament reach an agreement on their content.

1 The Basel Committee on Banking Supervision (BCBS), an international cooperation body of the central banks and banking supervisors of 28 countries, provides recommendations related to the supervision and capital requirements for internationally active banks in its standards. The standards of the Committee are not binding legislation, but its members are committed to implementing the recommendations into their national regulation. In Europe, the standards of the Committee are implemented in EU legislation, which must be complied with by all banks under law.
2 So-called EU Capital Requirements Regulation 575/2013 (CRR) and its update 2019/876 (CRR2).