Questions and Answers on the Banking Package 2021 - Main contents
Introduction
Why is the Commission proposing this package?
Following the financial crisis, the EU embarked on wide-ranging reforms of its banking rules to increase the resilience of the EU banking sector. One of the main elements of the reforms consisted of implementing the international standards the EU and its G20 i partners agreed in the Basel Committee for Banking Supervision (BCBS), specifically the so-called “Basel III reform”. Thanks to these post-crisis reforms, the EU banking sector entered the COVID-19 crisis on a much more resilient footing. However, while the overall level of capital in EU banks is now on average satisfactory, some of the problems that were identified in the wake of the financial crisis have not yet been addressed.
The main outstanding elements of the reform, included in today's package, aim to constrain the ability of banks to excessively reduce capital requirements when using internal models. This will increase the comparability of risk-based capital ratios across banks and will restore confidence in those ratios and the soundness of the sector overall. At the same time, the reform is intended to simplify the risk-based framework thanks to better standardisation in the calculation of capital requirements.
Beyond the need to complete the Basel III reforms agreed at international level, several other shortcomings have also been identified in the current banking prudential framework, which today's package also tackles.
What are the key elements of the package?
The package contains a number of significant improvements to existing EU rules for banks:
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-First, it faithfully implements the outstanding elements of the Basel III reform in the EU, while taking into account EU specificities and avoiding significant increases in capital requirements. It also increases proportionality, notably by reducing compliance costs, in particular for smaller banks, without loosening prudential standards.
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-Second, it introduces explicit rules on the management and supervision of environmental, social and governance (ESG) risks, in line with the objectives set out in the EU Sustainable Finance Strategy, and gives supervisors the necessary powers to assess ESG risks as part of regular supervisory reviews. This includes regular climate stress testing by both supervisors and banks.
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-Third, it increases harmonisation of certain supervisory powers and tools. Supervisors will be given more powers to check if transactions are sound and bank managers are fit and proper. They will have enhanced sanctioning powers to enforce rules, while also having better oversight of complex banking groups, including fintechs. Today's proposals also introduce minimum standards for the regulation and supervision of branches of third-country banks in the EU.
Do the new rules cater to the specificities of the EU economy?
Today's package takes into account the specificities of the EU's banking sector and economy.
For example, structural features of the EU's economy, such as the significant economic contribution of SMEs - most of which are currently not rated -will be taken into account. Another example is that EU banks' long-term and strategic equity holdings will not be treated as speculative investments. In addition, the ability of EU banks to finance strategic industries, such as aircraft manufacturing and infrastructure, and to provide hedging services to European clients will be preserved. Lastly, the proposal introduces transitional arrangements for low-risk residential mortgages amongst other things.
What will be the impact on EU banks' capital requirements and the wider EU economy?
The impact of the package on the EU banking sector's overall capital requirements is not significant and will be phased in over a long period. The proposed measures implementing the outstanding elements of the Basel III reform are expected to lead to an increase in EU banks' capital requirements of less than 9% on average at the end of the envisaged transitional period in 2030 (compared to 18.5% if European specificities were not taken into account). Importantly, the capital increase would be below 3% at the beginning of the transitional period in 2025.
The macroeconomic analysis carried out by the European Central Bank shows that the Basel reforms will have a positive effect on the EU economy over the long-term. They will further restore market confidence in the EU banking sector, which will contribute to its profitability and competitiveness.
Implementing the final elements of the Basel III reforms
Which principles underpin the Commission's proposal on Basel III?
The Commission carried out extensive preparatory work leading up to today's proposal. During that process, several objectives and guiding principles were identified:
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-The implementation of the rules in the EU should be faithful to the Basel III international standards to provide legal certainty and signal the EU's commitment to its international partners in the G20.
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-Implementation should avoid a significant increase in the overall capital requirements of EU banks.
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-Where the international standards would result in unintended or disproportionate effects on the EU banking sector and the wider economy due to its specificities, adjustments should be proposed. Where possible, these adjustments should apply on a transitional basis.
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-Implementation should avoid competitive disadvantages for EU banks, in particular in the area of trading activities, where EU banks directly compete with their international peers.
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-The proposed approach should be coherent with the logic of the Banking Union and not cause fragmentation in the Single Market for banking.
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-It should ensure proportionality and aim to further reduce compliance costs, in particular for smaller banks, without loosening prudential standards.
Is your market risk framework proposal consistent with implementation in other jurisdictions? How will you ensure a level playing field?
Ensuring a level playing field is particularly important for banks' trading activities, as trading activities can be easily conducted across borders (including between Member States and third countries). The implementation of the Basel III rules should therefore converge as much as possible across jurisdictions, in order to prevent potential distortions to the global level playing field.
Given that today's proposal is being adopted before some other major jurisdictions do so, the implementation of the market risk framework can be adapted at a later date, in the event of a potential uneven implementation of these rules in other jurisdictions. The Commission will continue to monitor the proposals that these jurisdictions will put forward in the coming months, and will accordingly decide whether the implementation should be postponed, or some parts should be amended in order to align the capital requirements for EU banks to those applicable to internationally active players from those jurisdictions.
Will EU banks have enough time to implement the revised rules and when will they apply in the EU?
Yes, EU banks will have enough time for implementation. The final set of Basel III standards were agreed at international level in December 2017. In response to the COVID-19 crisis, the Basel Committee decided in March 2020 to postpone the implementation deadline by one year to 1 January 2023, followed by a five-year phasing-in period of certain elements of the reform.
The Commission proposes to give banks and supervisors additional time to properly implement the reform in their processes, systems and practices, and start applying the new rules from 1 January 2025. The extended implementation period will allow banks to focus on managing financial risks stemming from the COVID-19 crisis and on financing the recovery, and give them enough time to adjust before the reform reaches its full effect.
The “output floor”
What is the output floor and what is its purpose?
The output floor is one of the central elements of the Basel III reform. As the name suggests, it is a measure that sets a lower limit (“floor”) on the capital requirements (“output”) that banks calculate when using their internal models.
The main aim of the output floor is to address model risk, which in this specific case is the risk that a bank's internal model incorrectly estimates the bank's capital requirements. The main concern is that internal models might underestimate the amount of capital needed by banks. Studies conducted at EU and international level showed that capital requirements calculated by internal models can vary quite significantly, even for the same exposure. Some of this variability cannot be explained by the characteristics of the exposures. The output floor aims to reduce this unwarranted variability and therefore to increase the comparability of capital ratios of banks using internal models.
How does the output floor work?
Under current rules, the amount of capital that a bank must hold to cover the risks it is exposed to is calculated as a product between two numbers: i) the capital requirement, expressed as a percentage, and ii) the bank's risk-weighted assets. As the name suggests, these are the bank's assets weighted by a risk weight that is meant to capture the degree of riskiness of the asset. Risk-weighted assets can be calculated by using standardised approaches (which use parameters clearly defined and calibrated in the capital rules) or by using internal models (which allow banks themselves to estimate the parameters used in the calculation of capital requirements). Standardised approaches apply by default, unless the bank obtains permission from its supervisor to use internal models.
Today's package adds an additional step in the calculation of the capital requirements. Specifically, a bank using internal models will now have to follow these steps when calculating its risk-weighted assets:
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-Calculate the risk-weighted assets using whichever model the bank is permitted to use.
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-Calculate the risk-weighted assets using the standardised approach.
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-Multiply the amount obtained with the standardised approach in step 2 by 72.5%.
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-Compare the risk-weighted assets resulting from this calculation in step 3 with the risk-weighted assets obtained with the calculation in step 1. Whichever amount is higher has then to be used to calculate the bank's various capital requirements.
Banks and their supervisors have diverging views on how to implement the output floor: the former argue for a “parallel stack” approach, while the latter argue for a “single stack” approach. What is the difference between those two approaches?
Each bank is subject to several types of capital requirements: minimum capital requirements (so-called Pillar 1), additional capital requirements imposed by the bank's supervisors (so-called Pillar 2) for risks not covered or not sufficiently covered by minimum capital requirements, and capital buffer requirements. The total capital requirement of a bank is simply the sum of all these requirements. The consequences of breaching each of the individual requirements are different. For example, breaching a minimum requirement can lead to the bank's license being withdrawn, whereas breaching a buffer leads to limitations on dividend and bonus payments. It is important how each of these capital requirements is positioned compared to the others. Therefore, the prudential rules set out the order in which the different requirements “stack” on top of each other, hence the name “capital stack”.
Under the “single stack” approach for risk-based capital requirements, there would be one capital stack with all the requirements in the stack expressed in terms of the risk-weighted assets. They would be calculated in accordance with the additional step explained above.
In contrast, the “parallel stack” approach would create a new stack standing alongside (“parallel” to) the existing one. Under this approach, like in the case of the existing single stack approach, the capital requirements in the parallel stack would be calculated using the risk-weighted assets calculated in accordance with the procedure outlined above. However, unlike in the case of the single stack approach, the parallel stack would not contain all necessary requirements.
For example, this approach could exclude the Pillar 2 requirement (P2R) and the systemic risk buffer (SyRB) requirement, which are important aspects of the prudential framework.
Which approach did the Commission choose?
The Commission chose the single stack approach. The proposed rules maintain the logic of one single capital stack for risk-based capital requirements. In the Commission's view, this approach is the one that best reflects the logic and objective of the output floor as agreed in Basel.
How would you avoid that there is a duplication in capital requirements through a single stack?
The proposal introduces safeguards to prevent unjustified increases in the Pillar 2 requirement (P2R) and the systemic risk buffer (SyRB) requirement in case a bank becomes bound by the output floor. For example, the bank's supervisor(s) will be required to review the calibration of the P2R and the SyRB requirement, respectively, to establish whether double-counting of risk is present, and if so, to re-calibrate those requirements to avoid such double-counting.
Are there any transitional provisions for the introduction of the output floor in the EU?
Yes. In fact, there are several. The output floor itself will be gradually introduced from 1 January 2025 over a period of 5 years. In practice, this means that the abovementioned multiplier will gradually increase over this period, from a starting value of 50% to its final value of 72.5%.
In addition, there are also some targeted transitional provisions to spread out the impact of the output floor over up to 8 years, specifically in relation to exposures to unrated companies, low-risk mortgages and derivatives. Furthermore, specific transitional arrangements are provided for the new treatments of equity exposures and unconditionally cancellable commitments.
Sustainability
What are environmental, social, and governance (ESG) risks and how are you proposing to address them?
ESG risks refer to environmental, social and governance risks that banks might be exposed to. The ability of banks to identify and manage sustainability risks and absorb financial losses arising from them is key for financial stability and for the resilience of the economy as Europe transitions towards climate neutrality.
Better integrating climate and environmental risks into EU rules already started in the context of the last banking package (CRR II / CRD V). Today's proposal reinforces the need for ESG risks to be consistently included in banks' risk management systems and in supervision. To achieve this, clear requirements are set to identify, measure, manage and monitor sustainability risks in the risk management frameworks. Today's proposal also:
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-enlarges the scope of ESG disclosures to all institutions (it currently only applies to large listed ones), in a proportionate way;
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-explicitly empowers supervisory authorities to incorporate ESG in the Supervisory Review and Evaluation Process and in stress testing by authorities, and requests stress testing of ESG risks by banks;
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-asks institutions to have robust governance arrangements and concrete plans signed off by the management body to deal with ESG risks.
How does the proposal square with the Commission's Sustainable Finance Strategy?
On 6 July 2020, the Commission adopted the “Strategy for Financing the Transition to a Sustainable Economy”. Amongst other things, this Strategy aims to improve the financial sector's resilience and its contribution to sustainability. This is where the proposed amendments to the CRR/D fit in with the Strategy, by ensuring that ESG factors are consistently included in banks' governance and risk management processes, as well as in the periodic risk assessments conducted by supervisors.
Do you propose adjusting the capital requirements for green/brown assets?
As announced, we are exploring this idea. However, we do not have all the data needed at this stage.
The Commission has asked the EBA to assess if and how capital requirements could be differentiated depending on the environmental and social impact of the assets held by institutions. The final results of that analysis are expected in 2023.
To inform possible future policy proposals, the Commission will examine the EBA conclusions, as well as the ongoing work at international level, for example within the Basel Task Force on Climate-related Financial Risks (TFCR). As usual, the Commission will consult widely and publicly.
More enforcement tools
What lessons have you learnt from recent financial scandals? What are you doing to address those?
The analysis of recent financial scandals highlighted the need to further clarify the rules, for example, on group supervision of banking groups. Notwithstanding the ongoing work of the EBA on the Call for Advice on digital finance, this package contains, as a first step, a number of quick fix improvements, streamlining the scope of prudential consolidation to ensure that banking groups are always properly supervised at consolidated level irrespective of their structure.
Furthermore, it is proposed to develop the concept of “independence” of competent authorities, which already exists in the Capital Requirements Directive, by setting ambitious minimum standards applicable to competent authorities, their staff and members of their governance bodies.
Why are new powers for supervisors needed? What are you proposing?
The Capital Requirements Directive lists a set of supervisory powers made available to competent authorities under national law. However, these powers are not harmonised at EU level. This may mean that some competent authorities lack the necessary supervisory tools, with potentially negative implications for the intensity and quality of supervision across the EU. The lack of harmonisation also raises questions of the level playing field and raises issues in relation to the proper functioning of the Single Supervisory Mechanism.
To address this situation, the list of supervisory powers under the Capital Requirements Directive has been amended to provide supervisors with the necessary powers to assess certain operations (acquisition of qualifying holdings, transfer of assets or liabilities, mergers or divisions) that can be considered material from a prudential perspective insofar as they can alter the prudential profile of a credit institution.
What are you proposing on sanctioning powers for supervisors? How would they be enhanced and stay proportionate?
Several provisions are being amended to harmonise sanctioning powers at the disposal of European supervisors. To ensure a level playing field in the area of administrative sanctions, Member States will now be required to provide for administrative penalties, periodic penalty payments and other administrative measures in relation to breaches of national provisions transposing the Capital Requirements Directive and the Capital Requirements Regulation. The harmonisation of administrative penalties will take into account Member States' specific constitutional arrangements and their right to provide for and impose criminal penalties.
Periodic penalty payments have now been introduced as a new enforcement tool. Those daily pecuniary penalties aim to ensure that credit institutions swiftly comply with prudential rules. This harmonisation of the administrative sanctioning framework under the Capital Requirements Directive would provide effective, proportionate and dissuasive tools for supervisors to sanction breaches of the Capital Requirements Regulation and Capital Requirements Directive obligations.
In addition, the scope of the sanctioning powers will be expanded, since the list of breaches subject to administrative penalties and sanctions is supplemented with prudential requirements currently missing on this list.
In order to ensure that the framework remains proportionate, procedural safeguards have been introduced for the effective application of penalties, namely in the case where administrative and criminal penalties would apply cumulatively for the same breach. Under the Capital Requirements Directive, Member States are required to provide for rules on the cooperation between competent authorities and judicial authorities in cases of accumulation of criminal and administrative proceedings and penalties on the same breach. In particular, the EBA will be mandated to submit a report on the cooperation between competent authorities and judicial authorities regarding the duplication of administrative and criminal penalties and proceedings on the same breach.
Why are you proposing a revised framework of the rules on the “fit-and-proper”?
The “fit-and-proper” framework requires that banks' board members and managers must demonstrate a number of qualities (e.g. skills, experience and good reputation) to be able to exercise their duties within credit institutions. This is crucial to ensure the sound and prudent management of credit institutions.
However, the “fit-and-proper” framework is one of the least harmonised areas in the banking prudential framework. That is why the Commission is proposing to revise this framework to promote clear and robust standards at EU level taking into account the principle of proportionality.
Overall, the proposal is largely based on well-established ESMA/EBA guidelines on suitability.
Board members
The proposal specifies that board members will not be able to take up their positions before the institutions check if they have the qualities necessary to perform their duties. This is the first layer to ensure that the system is robust.
The second layer lies in the assessment by competent authorities. The proposal does not require Member States to change their assessment model as such. A competent authority assessing board members after their appointment will not be obliged to replace its system with assessments prior to appointment in all cases.
However, for large banking groups, the Commission's proposal puts in place a system for prior assessment of board members with roles in the top-entities of such groups. This means that board members will not be able to exercise their duties before the competent authorities have finalised their assessment.
Also, irrespective of whether the assessment is carried out before or after the appointment, the proposal sets out clear and common rules and procedures to ensure that the board members' suitability assessment is carried out properly by competent authorities within a reasonable timeframe. This will also give further legal certainty to institutions.
Key function holders
Under the proposal, credit institutions will have to assess their influential managers (“key function holders”) to ensure they have all the relevant qualities needed to carry out their functions, especially with regard to expertise.
The proposal follows a targeted approach, enabling supervisors to focus on the most relevant managers, i.e. the chief financial officer or the heads of internal control functions in systemic institutions.
Third country branches
Why is the Commission proposing new rules for third country branches (TCBs)?
According to the EBA, the largest 15 third country banking groups hold more than three quarters of their EU assets via TCBs. While TCBs have a very significant footprint in EU banking markets, their establishment is currently harmonised to a very limited extent. There are no common authorisation or prudential requirements, or appropriate cooperation arrangements between supervisory authorities to comprehensively monitor branches and subsidiaries of the same third country group. This is a source of financial stability risk for the EU.
Today's proposal addresses these financial stability concerns by laying down a comprehensive and proportionate EU prudential framework on TCBs. The framework comprises harmonised provisions on TCBs' authorisation, capital, liquidity, governance, reporting and supervision.
In relation to TCBs with assets equal to or larger than EUR 30bn in one or more Member States, the framework will require competent authorities to assess whether those TCBs are systemically important for the Member States where they are established, and the EU. Where competent authorities conclude that the assessed TCBs are systemically important, they will be able to require their third country parent group to convert its TCBs into subsidiaries or, alternatively, impose other requirements provided these are deemed sufficient to address financial stability concerns (e.g. restructuring of the TCBs' assets or activities, additional prudential requirements, etc.).
Are you going beyond what other jurisdictions do? What are you doing to keep the new framework proportionate?
Today's proposal is largely consistent with the requirements that many third countries already apply to foreign branches established in their own territories.
The obligations laid down in the framework are tailored in a proportionate manner to take into account the TCBs' size and riskiness from a financial stability perspective.
As outlined above, very large TCBs will be subject to an assessment of systemic importance. While subsidiarisation may be imposed, competent authorities will also be able to impose other requirements on the TCBs, or no requirements at all, if they deem such alternative options sufficient to address financial stability risks.
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