Implementing Basel 4

On 27 October 2021, the European Commission published its 2021 Banking Package designed to strengthen banks' resilience and better prepare for the future.

There are three parts to the package:

Implementing the final Basel reforms (Basel 4)
Sustainability - contributing to the green transition
Stronger supervision - ensuring sound management of EU banks and protecting financial stability

The first part is covered in the Commission's proposal for key amendments to the Capital Requirements Regulation, referred to as CRR3. These relate to credit risk, credit valuation adjustment risk, operational risk, market risk and the output floor and will be the basis for implementing the remaining Basel 4 requirements in the EU.

Why are further amendments required?

While the overall level of capital in the EU banking system is now generally considered satisfactory, there were still issues to address around the use of internal models and underestimation of risk. These issues are addressed by the Basel 4 requirements.

CRR3 is intended to implement faithfully the Basel 4 requirements, while taking into account the specific features of the EU's banking sector. It aims to ensure that internal models used by banks to calculate their capital requirements do not underestimate risks, thereby ensuring that the capital required to cover those risks is sufficient. This will make it easier to compare risk-based capital ratios across banks and should, in turn restore confidence in the ratios and the soundness of the sector overall.

The proposal aims to strengthen resilience, without resulting in significant increases in capital requirements. The Commission notes that it limits the overall impact on capital requirements to what is necessary, in order to maintain the competitiveness of the EU banking sector. The package also aims to reduce compliance costs, particularly for smaller banks, without loosening prudential standards.

In line with expectations?

Perhaps most importantly, the EU has made concessions to banks' calls for more time to implement the final Basel reforms. The Commission proposes to start implementing the new rules from 1 January 2025, two years later than the (already deferred) 1 January 2023 Basel Committee timeline. This, it says, is to allow banks to focus on managing the financial risks stemming from the COVID-19 crisis and on financing the recovery, and to give them enough time to adjust before the reforms reach their full effect.

It was widely expected that the Commission would reject the “parallel stacks approach” for which some banks lobbied in relation to the output floor, and it has done so. CRR3 introduces the output floor through a “single stack” approach but with safeguards to avoid duplication in capital requirements.

In a predicted deviation from Basel 4, CRR3 introduces an amendment that the `floored' total risk exposure amount be applied at the highest level of consolidation in the EU.

The proposals also make use of flexibility elsewhere in the framework to keep capital increases to a minimum - for example to reduce the impact of historical losses feeding through to capital, through deployment of transitional regimes for loans to unrated corporates and low-risk mortgages and by maintaining regional carve-outs for small businesses, infrastructure and derivatives. For more detail, see below.

And CRR3 also introduces harmonised definitions of the different types of ESG risks (aligned to definitions proposed by the EBA). Banks are now required to identify, disclose and manage these risks at an individual level and report their exposure to the competent authorities. However, no immediate increase in capital is required.

Detailed amendments

All proposed amendments described in this section are in line with Basel 4 unless otherwise specified.

Standardised approach (SA)

Revision of the SA for credit risk to increase risk sensitivity in relation to several key aspects, including:
- Updates to the way institutions determine their exposure value of off-balance sheet items and commitments on off-balance sheet items — in particular, by amending credit conversion factors (CCFs). CRR3 uses the discretion under Basel 4 to exempt certain contractual arrangements for corporates, including SMEs, and introduces a transitional period for institutions’ unconditionally cancellable commitments until 31 December 2029 (after which incrementing CCFs will be phased in over three years)
- Basel 4’s Standardised Credit Risk Assessment Approach (SCRA) is introduced to sit alongside the existing External Credit Risk Assessment Approach (ECRA) — with implications for exposures to institutions and corporates
  - A lower risk weight now applies to institutions and corporates applying ECRA with a nominated eligible credit assessment institution (ECAI)
  - Institutions with no ECAI-applied ECRA are required to use SCRA. However, CRR3 deviates from Basel 4 by proposing a transitional arrangement for exposures to unrated corporates when calculating the output floor
General alignment to Basel 4 risk weighting amendments regarding the treatment of: specialised lending exposures (although CRR3 introduces additional granularity for object finance exposures), retail exposures, exposures with currency mismatch, subordinated debt exposures and defaulted exposures
CRR3 deviates from Basel 4 slightly in regard to exposures secured by real estate — where Basel 4 caps property value at loan origination (allowing adjustments only following extraordinary events), CRR3 maintains the EU’s use of frequent monitoring and adjustments (within certain limitations)
CRR3 deviates from Basel 4 in regard to equity exposures — by introducing specialised treatment for strategic equity investments

Internal ratings-based approach (IRB)
New limitations to the exposure classes for which internal models can be used to calculate own funds requirements:
- Exposures to corporates with total sales greater than EUR 500 million can only use Foundation IRB (F-IRB) and no longer use Advanced IRB (A-IRB)
- Equity exposures can only use SA-CR and no longer use IRB
Introduction of an input floor under A-IRB to include minimum values for institutions’ own estimates of IRB parameters that are used as inputs to the calculation of RWAs — however, this is not applicable to sovereign exposures
General alignment to other Basel 4 amendments relating to IRB risk weights — with CRR3 applying only the following deviations:
- Creation of a new exposure class for regional governments and local authorities as well as public sector entities
- ‘Phase in’ of parameter floors for specialised lending exposures under the A-IRB approach, and including certain transitional arrangements over a 5 year period
The EBA is tasked with assessing the appropriateness of enabling clauses for leasing exposures and credit issuance

Credit risk mitigation techniques
Rules implemented to account for collateral and guarantees under both the SA-CR and F-IRB approaches

Amendments to ensure that standards appropriately capture banks’ actual CVA risk. Specifically:
- CVA risk is updated to include both the credit spread risk of a counterparty and the market risk of the portfolio
- Clarification on which transactions are subject to CVA risk requirements
- Requirement for institutions to report the results of their calculations for exempted transactions (accounting for any eligible hedges)
- Description of new approaches for calculating own funds requirements for CVA risk, as well as conditions for using a combination of these approaches

All existing approaches for the calculation of the own funds requirements for operational risk are replaced by a single non-model-based approach to be used by all institutions. However, the EBA has been mandated to report on the use of insurance in this context, following concerns of arbitrage
Basel 4’s new standardised approach combines an indicator based on an institution’s business size (Business Indicator Component) with an indicator based on loss history. CRR3, however, allows EU jurisdictions to disregard the historical loss indicator
As a matter of proportionality, data collection and governance rules are split into those applying to all institutions and those only relevant for institutions that also have to disclose historical loss data (i.e. those with a business indicator equal to or above EUR 750 million)

In line with Basel 4’s revised FRTB standards, binding own funds requirements for market risk are introduced. FRTB approaches — alternative standardised approach (A-SA), alternative internal model approach (A-IMA) and simplified standardised approach (SSA) — are introduced along with their conditions for use, and the frequency of calculation of the own funds requirements
Most notably, existing internal model approaches to calculate own fund requirements are replaced with the FRTB A-IMA

An output floor is introduced to reduce the variability of own funds requirements calculated using internal models. This floor sets a lower limit to the capital requirements produced by internal models — once fully implemented, this will be 72.5% of the own funds requirements that would apply under standardised approaches
In a deviation from Basel 4 however, CRR3 introduces an amendment that the ‘floored’ total risk exposure amount (TREA) be used only by the institution at the highest level of consolidation in the EU. Nonetheless, any consequent increase in the own funds required must be distributed fairly across the subgroups which are located in other member states, according to their risk profile

Adjustment of the total exposure measure to align the treatment of client-cleared derivatives with the treatment envisaged under the standardised approach for counterparty credit risk
Removal of minimum conversion factor of 10% for certain off balance-sheet items
Clarification that certain provisions (related to regular-way purchases and sales awaiting settlement) apply to financial assets, rather than only securities

Basel 4 proposes the introduction of minimum collateral haircuts for some non-centrally cleared SFTs, and that these haircuts be introduced indirectly via a punitive capital requirement
Before including this in CRR3, the EBA and ESMA have been tasked with reporting on the implications of the haircuts and whether they should be implemented punitively or as a blanket market regulation