Basel IV Implementation in the EU: What Does the New Banking Package Mean for Banks?

The European Commission (EC) published the long-awaited ‘Banking Package 2021’ on 27 October 2021. The package is expected to complete the post-financial crisis agenda in the European Union’s (EU) banking sector, making the EU the first major jurisdiction in the world to reach the stage of transposing the final elements of Basel IV to its law.

The package consists of proposals to amend the Capital Requirements Directive (CRD V) and the Capital Requirements Regulation (CRR VI). Τhree major objectives mark this reform, namely, the implementation of the final Basel IV standards; the management and supervision of environmental, social and governance (ESG) risks; and the harmonization of banking supervision to improve the resilience of EU banks to future economic shocks.

The main purpose of the package is to address issues around banks’ use of internal risk models to calculate their capital requirements. The proposals also introduce significant adjustments to the measurement methods for credit, market and operational risks, while taking into account proportionality and EU specificities. Although the EC’s proposals aim to limit the overall impact on capital requirements, the modified risk measurement for credit risk, credit valuation adjustment risk, operational risk, market risk and the so called ‘output floor’ (on which more below) would have a material impact on the EU banks’ risk-weighted assets (RWAs) and, therefore, capital planning and business models.

The standardized approach to credit risk (SA-CR)

In line with the Basel IV standards, the EC proposes to align the classification of retail exposures under SA-CR with those under the Internal Ratings Based (IRB) approach. It also proposes to revise the SA-CR for financial institutions, corporates and specialized lending to make it more risk sensitive. But the EC deviates from the Basel IV framework and includes a number of EU-specific provisions for defining exposure classes and assigning the respective risk weights. These include exposures to the small and medium-sized enterprises, most of which are currently not rated, and long-term and strategic equity holdings, which are not treated as ‘speculative investments’.

The EC also proposes targeted transitional provisions in relation to exposures to unrated companies, low-risk mortgages and derivatives, as well as new treatments of equity exposures and unconditionally cancellable commitments. For instance, in the case of unrated corporates with a probability of default of less than 0.5%, the proposals set the standardized risk weight at 65% until 31 December 2032 instead of 100% as set out in the Basel IV framework. Likewise, it sets a 100% risk weight for intra-group equity exposures while Basel IV treats equity exposures as standardized, applying risk weights of up to 450%. The EC proposes that the increases in risk weights for equity exposures are phased in from 2025 to 2030.

IRB approach to credit risk

In Iine with the Basel IV framework, the EC proposes to apply input floors to establish minimum levels of probability of default, loss given default (LGD) and exposure at default within the IRB framework. Here, again, there are deviations from Basel IV which, if implemented, will require larger banks to revamp their processes, systems and practices. Many banks currently using IRB approaches are likely to dismiss them completely and switch to SA-CR. Taking this into account, the EC proposes to allow banks that have permissions to use IRB approaches to carry their portfolios to SA-CR over a transition period of 3 years, subject to certain conditions.

Capital output floors

In line with Basel IV propositions, the EC introduces an ‘output floor’ to reduce the excessive unwarranted variability of banks’ capital requirements calculated using internal models. The bottom limit is set at 72.5% of the capital requirements that would normally apply under standardized approaches (SAs). While this should address model risks, it will have implications for larger banking groups that currently use internal models to calculate their risk-weighted assets.

The package introduces the total risk exposure amount only to the institution at the highest level of consolidation in the EU and does not subject the individual group entities below the EU parent to the capital output floor. Instead, it requires groups to apportion the floored RWAs across the subgroups (ie subsidiary parent companies) in other EU member states depending on their respective risk profiles. 

While the EC notes that the package does not aim to result in significant increases in banks’ capital requirements, the output floor may result in a material increase in capital requirements for some larger banks. To avoid any cliff effects the EC proposes a transitional provision to phase in the capital output floor over a period of 5 years.

Fundamental Review of the Trading Book (FRTB)

The package also introduces the FRTB, which was included in the previous banking package for reporting purposes only. This means that banks will now have to calculate their market risk capital requirements using the new alternative SA, alternative internal model approach and simplified SA subject to certain supervisory conditions. To reflect these changes large banks will have to stop using their existing internal model approaches to calculate their market risk capital requirements and, instead, use the new internal model approach. 

In addition, the proposals revise the new trading book boundary, in line with Basel Committee's revised FRTB standards, updating the criteria used to assign positions to the trading book and the banking book. These changes will require firms to develop the necessary systems infrastructure to meet substantial new data requirements, as well as additional risk sensitivity and complexity in the related risk models.

Operational risks

To simplify the calculation of operational risk capital requirements the package also replaces the current risk calculation approaches for operational risk with a single, non-model-based approach to be used by all banks. However, banks will not have to dismiss their Advanced Measurement Approach models for operational risks completely as they can still use these models as part of their internal risk management processes.

Credit Valuation Adjustment (CVA) risk

The package further amended the current risk calculation approaches for the CVA risk to include more sensitivities to ensure that standards appropriately capture banks’ actual CVA exposures. As a fair-value accounting adjustment to the price of a derivative transaction, CVA aims to provision against potential losses due to the deterioration in the creditworthiness of a counterparty. The CVA risk framework now captures both the credit spread risk of a counterparty and the market risk of the portfolio in line with Basel IV standards. The EC proposes to remove the use of internal modeled approaches and to introduce new approaches for calculating CVA risk capital requirements, allowing banks to use a combination of the alternative approaches (SA or basic approach) subject to certain conditions. The package also introduces requirements with respect to the regulatory reporting of the calculations for exempted transactions and provides clarifications as to which transactions are subject to CVA risk requirements.

Conclusion

The EU Banking Package 2021 represents the final step towards the completion of the European post-crisis regulatory reforms. The package is expected to lead to an increase in EU banks’ capital requirements of up to 3% during the initial phase and less than 9% by the end of the envisaged transitional period in 2030. But the EC estimates that this number would be 18.5% in the absence of the proposed EU-specific applications.

In addition, any capital impact will be phased in over a long transition period. What might also give some comfort to banks in the EU is that the EC proposes to grant them additional time to implement the final Basel reforms. The EC proposes to allow banks to start implementing most provisions in the package from 1 January 2025, ie two years later than the Basel Committee’s implementation schedule of 1 January 2024.

The final CRD/CRR framework is not expected to take shape before 2023 and is likely to be subject to lengthy negotiations between the European Parliament and the Council of Ministers. Previous experience has shown that these negotiations could result in substantial changes to the current proposals, particularly on the most controversial topics.

Mete Feridun is Chair of the Centre for Financial Regulation and Risk Management, and Professor of Finance at the Department of Banking and Finance, Eastern Mediterranean University in Cyprus.