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Updated: March 2020
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Basel III finalisation (or: “Basel IV”)​​​​: ​apply standards in a proportionate way and be mindful of the global level playing field



PROPOSED SOLUTIONS AND ACTIONS


Proportionality

Proportionality is a long-term area of interest for Europe's savings and retail banks. Proportionate regulation allows banks to abide by legal texts whilst still carrying out their daily activities, such as SME lending. ESBG and its members have long called for proportionality to achieve better regulation and supervision, under a non-detrimental regulatory framework which increases the strength of the European banking sector. ESBG argues that the implementation of the final elements of Basel III in the EU should account for factors such as an institution's size, business model, risk profile and interconnectedness.

Adaptation to the EU specificities

ESBG believes that against the background of the framework conditions of the European banking market, the EU special features already anchored in the CRR/CRR II, such as the treatment of financial equity holdings, exemption from holding capital against credit valuation adjustment (CVA) risk on corporate derivatives exposures and supporting factors for SMEs and infrastructure exposures, should be retained. This is especially important considering that the upcoming legislation will not only be about resilience but about credit supply to the economy. The focus should be on the overall impact of the reforms, as the Basel IV package is effectively a collection of various changes to existing standards; all these changes – and their interrelations – should thus be considered as a whole.

Level playing field

Moreover, from an international perspective, we believe that the implementation of the Basel IV standards in the EU might raise a level playing field issue, namely with the United States, due to the fact that European Legislators will apply the new rules to all banks in the EU, and not only to the internationally active ones. For example, the Basel IV standards are likely to increase capital requirements for lower risk-weight portfolios, such as mortgage loans. European banks generally hold larger mortgage portfolios (as there are no mechanisms, such as Freddy Mac and Fanny Mae, in the US) and would therefore be more affected than US banks.

Output floor : alignment with international standard               

The application of the output floor in Europe should take into account the interaction with EU specific capital buffers in order to avoid any undue capital increase compared to the international standards agreement. Moreover, the output floor should to be applied as designed in the Basel framework, i.e. at the highest level of consolidation to recognise diversification effect and avoid any unintended impact on specific business model. 

New internal model approach for credit risk 

We would ask for a review of internal models applications and related procedures. This could significantly reduce the administrative efforts and huge costs on both sides – the banking industry and the regulator (almost 50% of supervisory assessments focused on model specific issues during the last years) whereas the reduction of scope and the new input and output floors largely modify the modelling philosophy. ESBG proposes to replace the complex and time consuming ex-ante models applications with a new ex-post review approach for models.

New standardised approach for credit risk (SARC)

As part of the final Basel IV standards, the BCBS finalised its reforms for the Standardised Approach (CR-SA) and the Internal Ratings Based approach (CR-IRB) for the calculation of risk weighted assets for credit risk. Under Basel IV these issues are addressed by restricting what is accepted in the IRB approach, by applying a floor to the extent to which risk weights can be driven down by the use of internal models, and by making the standardised approach more risk sensitive.

We advocate for a proper implementation of the new standardised approach for credit risk and, in particular, we call the Legislators to carefully assess the treatment of the following exposure classes:

  • Corporate exposures: The new SARC should include a European specificity. Regarding the assignment of unrated corporate counterparts to an “Investment Grade” classification: we propose that the EU replaces the requirement that the corporate entity has to issue securities on a recognized exchange with an objective criterion that is relevant for the European corporate sector. 
  • Specialized Lending (SL): in order to increase the risk sensitivity for SL exposures, ESBG proposes: 1) in the standardised approach: more granular risk weight levels; and 2) In the internal ratings-based (IRB) approach: more granular loss given default (LGD) input floors and asset values haircuts.​
  • Commercial real estate: real estate market portfolios with historically low-defaults (commercial as well as residential) should be treated with a more risk-sensitive approach.  
  • Value at origination for both Commercial real estate and Residential real estate: In ESBG’s view, both the commercial real estate and the residential real estate exposure classes would much benefit if an actual value approach was used instead of value at origination.
  • Acquisition, development and construction (ADC) exposures: it is necessary to allow for more risk sensitivity regarding the treatment of these exposures in EU regulation. In order to discriminate between speculative and non-speculative exposures. Due to this it is very important that in the EU the treatment for these exposures reflects the changes incorporated to the finalisation of Basel III, thus allowing the assignation of a risk weight of 100% if certain conditions are met (e.g. significant amount of pre-sale contracts).​
  • Equity: Basel IV intends to increase the risk weights for equity to at least 250% and up to 400% from currently 100%. For intragroup exposures and those of members of an institutional protection scheme, despite them being usually long-term, low risk and not-for profit, we propose to keep the current 100% risk weight.
  • Off-balance sheet items: Unconditionally Cancellable Commitments (UCC) are essential for financing the economy. Hence, ESBG proposes to maintain the 0% credit conversion factor (CCF) to commitments that are unconditionally cancellable upon the appropriate level of justification, including for retail clients. ​

New methods for market risk
New requirements for the trading book may lead to a situation where existing non-trading book institutions will possibly be classified as trading book institutions, even though maintaining a trading book would be disproportionate for those institutions. Especially specialised credit institutions, with a limited investment range, with no intention to trade, might be affected. Therefore, an allocation of an instrument or product to the trading book should be required only if there is an intention to trade.

The implementation of a new capital framework for the market risk will be very burdensome not only for the entities but also for the authorities and the impacts are still not known yet. For that reason, it is important to ensure that transposition of this standard to the European framework will include a transitional period which provide entities with time to develop new models and authorities with time to validate such new models. During this period, the entities should be allowed to use the current models.

Some refinements of technical elements of the framework would also be needed to account for the features of the trading activity of EU banks and better serve the goal of the growth and integration of the EU capital market.


IDENTIFIED CONCERNS​

The Basel standards are designed for internationally active banks and as such they do not take into consideration the nature, scale and complexity of the activities of all individual credit institutions.  

ESBG believes that:

  • Those medium-sized and small banks that use the SACR will face significant administrative burden and additional cost due to the increased complexity of the new SACR.
  • The output floor might interfere with EU-specific capital buffers and EU-systematic application of banking regulation at individual level.
  • The new SACR as basis for the calculation of the output floor is not risk sensitive enough for EU franchises.​


CONCLUSIONS

Committed to global standards, Europe should strive for a balanced implementation that simultaneously avoids potential negative effects on the availability of bank finance to the European economy.

The package of reforms to finalise the Basel III framework is, in fact, designed for internationally active banks and its indiscriminate application to the highly diversified European banking market could seriously hamper the ability of European banks to provide finance to the real economy and to foster economic growth.

A recent survey of the same Basel Committee has revealed that many jurisdictions have simplified Basel requirements in order to take into account the proportionality principle.

Without hampering the level playing field, we believe that the implementation of the final part of Basel III should therefore avoid imposing overly complex rules or create a disproportionate administrative burden, taking into account to the extent possible the specificities of the European Union. 


WHY POLICYMAKERS SHOULD ACT

As European decision-makers have so far transposed the Basel standards to all institutions in Europe, it will be crucial for them to act carefully and with the diverse European banking sector in mind. Almost half of European banks are, in fact, locally focused and would therefore need proportionate rules in order to properly finance the economy and compete on a level playing field. 

BACKGROUND​​

The Basel committee on banking supervision (BCBS) sets the standard for international banking prudential regulation. It is a forum for regular cooperation between the national banks and supervisory authorities from 28 countries.

On 7 December 2017, the BCBS agreed on the final elements of Basel III (this deal is commonly referred to as “Basel IV") to be implemented by 2022.

The general outline of the deal is the following:

  • Output floor: target set at 72.5%; transitory implementation until 2027, including a special treatment for low risk mortgages;
  • Fundamental Review of the Trading Book (FRTB): implementation postponed until 2022 – recalibration of some aspects (including P&L attribution and modellability of risk factors);
  • Operational Risk: new standardised approach, removal of internal model;
  • Credit Risk: changes to standardised approach and internal model approach (including limitation of use of models for low default portfolios, large corporates); 
  • Credit Valuation Adjustment (CVA): revised standardised approach, removal of internal models.

The implementation within the EU is still at the very early stages. The Commission's legislative proposal is expected in the first half of 2020.​