With the publication of Regulation (EU) 2024/1623, on 31 May 2024, the final texts of Regulations No. 575/2013 ( CRR) and Directive 2013/36/EU (CRD) were approved by the Presidents of the European Parliament and the European Council, which transpose the regulatory changes contained in the final Basel III Reform (also commonly known as ‘Basel III+’ or ‘Basel IV’), promoted internationally by the Committee in 2017.
The texts published in the Official Journal of 19 June, provide for the amendment of the Capital Requirements and Own Funds Regulations with specific reference to the treatment of credit, market, CVA and operational risks, the so-called output floor and the calculation of own funds.
This further evolution and strengthening of prudential regulation derives from the results of the supervisory activities carried out over time and therefore from the need (I) to reduce the variability of capital requirements calculated using internal models, which is sometimes not justified by differences in the underlying risks; (ii) to increase the reliability and comparability of the Institutions’ capital ratios; and (iii) to introduce a dedicated supervision of the so-called ‘model risk’.
Furthermore, it has been ascertained that the standardised methods currently used by banks to calculate their capital requirements do not sufficiently take into account the risks to which they are exposed, i.e. they are not adequately risk-sensitive, resulting in capital requirements that are not correctly sized.
The entry into force of the final text of CRR 3 has been confirmed as of 1 January 2025, with the exception of some provisions that are immediately applicable and the market risk regulation that is deferred to 1 January 2026. However, also taking into account the various transitional periods and temporary provisions, the new rules will only be fully effective as of 2033.
The new text of CRR 3 amends the current regulatory framework, detailing the main changes envisaged by the European regulator in the determination of mandatory capital requirements for Credit Institutions, defining the introduction of the so-called ‘output floor’ and introducing a series of prudential provisions not strictly derived from the international framework. In the following sections we identified and discussed key modifications.
1. Standardised Credit Risk
The revision of the Standardised Approach aims to increase its risk sensitivity in relation to certain exposures in order to ensure greater adequacy in the measurement of credit risk and, consequently, in the calculation of capital requirements. CRR 3 updates the current architecture of off-balance sheet exposures, providing for five new buckets (instead of the current four) and introducing a more stringent treatment for unconditionally cancellable commitments (UCCs), to which a 10% credit conversion factor (CCF) will be applied instead of the current 0%.
The main novelty, however, is the inclusion in the prudential perimeter of offers sent to customers but not yet accepted, for which the customer’s acceptance is binding on the bank, for which the regulations do not currently provide any specific treatment, but which from 1 January 2025 will have to be weighted with the same conversion factor applicable to the associated off-balance sheet exposures and will therefore have to be included in the RWA perimeter.[1]
For retail exposures, the legislator aligns the treatment of the retail asset class with that already provided in the IRB approaches so as to ensure consistent application of the corresponding risk weights to the same set of exposures and introduces a preferential risk weight treatment of 45 % for revolving exposures (e.g. balance sheet credit cards) that meet a set of repayment or drawdown conditions that reduce the risk profile (e.g. transactional exposures).
In addition, the treatment of exposures to Supervised Intermediaries is modified by introducing the Standardised Credit Risk Assessment (SCRA) method for exposures for which a credit assessment by a selected ECAI is not available, which provides for the assignment of a specific Risk Weight at the end of a dedicated assessment activity focused on the levels assumed by specific prudential indicators (i.e. CET1, T1 and Total Capital Ratio) and leverage.
A revision of the framework also affects equity exposures where the positions falling into this asset class are further detailed, with an increase in the weighting factors applied, from the current 100% to 250% for equity exposures and 400% for unlisted exposures to venture capital and private equity firms in anticipation of significant short-term capital gains. As an exception, however, a 0% risk weight is assigned to equity exposures to central banks, which therefore no longer contribute to any capital absorption.
At the same time, the current treatment of subordinated debt exposures is revised to be consistent with the standards set forth in the Basel III Reform by applying a risk weight of 150 % to subordinated equity instruments (in the form of Tier 2 instruments) or to MREL/TLAC eligible subordinated debt instruments (such as, but not limited to, senior non-preferred instruments).
Among the main changes introduced is a specific treatment for loans financing the acquisition, development or construction (ADC) of residential or non-residential real estate by providing for a differential (pejorative) risk weight due to the fact that the source of repayment at the time the loan is made is either a planned but uncertain sale of the property or substantially uncertain cash flows. However, favourable supervisory treatment is provided where the ADC exposure relates to a residential property and certain conditions are met.[2]
Lastly, in line with what the legislature had already provided for in the internal ratings-based approaches, CRR 3 further expands the scope of regulatory asset classes for the standardised approach by providing for the introduction of exposures to corporates in the specialised lending class within the existing regulatory portfolio.
2. IRB Credit Risk
With regard to the IRB approach, the Regulator has intervened on the current supervisory framework, limiting the exposure classes for which recourse to the advanced IRB approach (A-IRB) is permissible, such as in the case of exposures to large corporates and exposures to Supervised Intermediaries or entities in other financial sectors, where only recourse to the basic IRB approach (F-IRB) will be permitted, with the possibility of estimating PD internally only, or in the case of exposures in equity instruments where the IRB approach is no longer permitted.
In order to ensure that capital absorption levels are sufficiently prudent, thereby mitigating model risk and improving the comparability of ratios, the minimum values used for internal PD estimates for retail exposures have been updated, and new limits (input floors) for LGD and CCF values have been introduced at the same time.
The new CRR 3 Regulation also modifies the scope of application and calculation methods for obtaining internal estimates of CCFs used to determine the exposure value of off-balance sheet items, providing for the use of a fixed 12-month period prior to default for the internal estimate of CCFs and allowing the use of internal estimates only for commitments for which the corresponding standardised CCF is less than 100 per cent.
Finally, it is worth mentioning the deletion of the ‘graduation factor of 1.06’ in the risk-weight formula, which simplifies the calculation and cancels out the 6 % calibration increase in risk weights based on internal ratings that apply under the current framework. From an IT perspective, in addition to incorporating the methodological interventions into the RWA A-IRB calculation engines, particular attention must be paid to system integration aspects.
3. Credit Risk Mitigation
In the area of credit risk mitigation (CRM) techniques, the haircut coefficients applicable to financial collateral under the comprehensive approach were revised, as were the guaranteed LGD values and the haircut coefficients applicable to exposures processed under the F-IRB approach.
In addition, again in relation to financial collateral, the possibility of applying the look-through approach to OICs acquired as credit protection has been made explicit, as an alternative to adopting the fall-back approach or the Management Rules. Banks that have substantial financial collateral will therefore be incentivised to define a process that allows for the adoption of the look-through because of the potential reduction in expected capital absorption resulting from a more accurate assessment of the eligibility of the instrument underlying the CIU.
Among other interventions in the CRM area, it is worth mentioning the Regulator’s intention to reduce the impact of cyclical effects on the valuation of loan-backed properties. In this context, it is provided that in the event of a revaluation beyond the value at the time the loan is granted, the value of the property may not exceed the average value measured for that property or for a comparable property in recent years, or the appraised value of the property, whichever is higher, distinguishing the reference time horizon according to the type of property (commercial or residential).
The Regulator’s objective is thus to ‘reward’, in determining the appraisal value of the property, those assets that have structural features that guarantee high standards of energy efficiency and reduce the impacts of potential extreme climatic events, as well as those that have insurance coverage that is not limited to fire and burglary events.
4. Operational Risk
With respect to the calculation of operational risk capital requirements, the final text of 19 June provides for a single ‘non-model based approach’ (SA, Standardised Approach) as defined by the Committee reform. This approach finds its genesis in the low risk-sensitivity of the current BIA/TSA approaches and the difficult comparability, breadth of observable practices and potential erratic nature of the internal AMA approaches. With regard to operational risk, therefore, the use of internal models will no longer be permitted.
The Basel Committee’s ‘plain vanilla’ proposal for the new standardised approach provided for the combination of (i) an indicator based on the size of the credit institution’s business (Business Indicator Component or BIC) with (ii) a Loss Component from which derives a so-called ILM (Internal Loss Multiplier) coefficient. Such an approach should have guaranteed a more accurate sizing of the capital requirements, ensuring a correlation with the intermediary’s risk profile, without diminishing the incentive to adopt a robust operational risk management framework and reducing the so-called sunk costs incurred to implement TSA and AMA-compliant frameworks.
The text introduces significant changes in the calculation and management of operational risk. The potential organisational and business process impacts will be significant for banks that currently adopt the BIA method, and in particular for large banks (above the BI threshold of EUR 750 million or EUR 1 billion), which, in addition to the definition and maintenance of an operational risk management framework, will have to guarantee Loss Data Collection on the basis of articulated and high quality standards. For the Banks that today adopt the TSA, the interventions to be planned may have to concern refinements to the Loss Data Collection process (e.g. methods of collecting non-standard events, data consolidation techniques at Group level).[3] Otherwise, Banks that are currently authorised to adopt AMA methods will continue to operate their own frameworks without the need to plan evolutionary initiatives related to the introduction of CRR 3.
5. CVA and Market Risk
With a view to improving risk sensitivity and resilience, the legislator has intervened with regard to Credit Valuation Adjustment (CVA)[4] risk by introducing three new methodologies: the Standardised Approach (SA-CVA), a Basic Approach (BA-CVA) and the Simplified Approach (the latter applicable only if certain conditions as specified in the regulations are met).
The SA-CVA, for which Banks must apply to the Supervisory Authority for approval, continues to be the most risk-sensitive approach, relying on estimates of risk factor sensitivities. Although it is classified as a standard approach, Banks may only adopt this approach if they meet certain data, modelling and governance requirements.
Instead, the calculation of the capital requirement under the BA-CVA uses as input parameters the Exposure at Default (EAD) calculated for counter party risk and risk weights that depend on the counterparty sector and creditworthiness. The BA-CVA has a ‘Reduced’ and a ‘Full’ version , which involve two different calculation rules.
With regard to Market Risk, CRR 3 subjects institutions to new challenges, especially at the methodological level and with a view to updating the processes for classifying assets in regulatory portfolios and to constantly monitoring the correctness of this categorisation. Banks that decide to adopt internal models for calculating capital will have to set up adequate systems and data infrastructures in order to comply with the general quantitative and qualitative requirements of the regulations.
6. The introduction of the Output Floor
One of the main innovative elements of the new Regulation (CRR 3) is the introduction of a threshold (the so-called output floor) with the aim of counteracting the possible effect of underestimation of own funds requirements calculated using internal models due to their defects or weaknesses and indirectly guaranteeing regulatory protection against Model Risk.
Specifically, banks that use internal models to calculate risk-weighted exposures will not be allowed to reduce their Unfloored Total Risk Exposure (U-TREA) below 72.5% of the risk-weighted exposures that would have been obtained using only the Standardised Total Risk Exposure (S-TREA) approaches.[5] Thus, the output floor acts as a prudential backstop to the sizing of risk-weighted assets calculated using the internal models and is therefore complementary to the leverage ratio. In the final text of 19 June, the output calculation is provided for at the consolidated level only.
In terms of the transition to the new prudential standard, for banks adopting internal models, the introduction of the output floor is the project component that absorbs the most resources, as it requires the definition of a dedicated calculation process at the consolidated level, while at the same time requiring the involvement of subsidiaries, which will have to provide specific additional information with pre-established timelines.
7. Regulatory changes effective 9 July 2024
In the final text of CRR 3 published in the Official Journal, the legislator has also set out certain provisions that Banks are already required to implement immediately, i.e. in advance of the actual entry into force of the set of rules (1 January 2025).
Among the main regulatory changes are:
- the partial reinstatement of the so-called ‘prudential filter’ introduced with Regulation (EU) 2020/873, which allowed Banks to temporarily sterilise the effects on own funds of unrealised gains and losses in relation to government bond exposures measured at OCI fair value until 31 December 2025. For the adoption of such treatment, the requirement to inform the Supervisory Authority at least 45 days before the date of submission of supervisory reports remains in place;
- with reference to the concept of instrumental enterprise, the current perimeter is extended to include cases where the subsidiary carries out activities of operating leasing, ownership or management of assets, provision of data processing services or any other activity, to the extent that such activities are ancillary to banking activities. The change in the scope of prudential consolidation may immediately determine significant impacts also on other regulatory profiles (e.g. new definition of default, etc);
- for banks that have received authorisation to use internal models, the transitional regime on corrections to LGD estimates in the case of the massive disposal of defaulted exposures has been extended until 31 December 2024;
- finally, the transitional regime on exposures to central governments and central banks of Member States when denominated and funded in a currency of another Member State was extended until 31 December 2026.
8. Concluding remarks
The current supervisory framework has revealed shortcomings with respect to the variability of estimates of capital absorption calculated using internal models, comparability and risk sensitivity of standardised metrics. The provisions adopted by the new regulatory framework on Credit, CVA, Market and Operational Risk do so by revising the current capital requirement quantification framework.
The impact of the regulatory changes has been periodically monitored for several years now by the Basel Committee at the global level and by the EBA at the European level. The understanding of the impact on capital ratios has been taken care of over time by most of the intermediaries that adopt internal models also because of these analyses conducted through numerous Quantitative Impact Studies (QIS).
The most recent analysis published by the EBA in September 2023, conducted on a sample of about 160 banks,[6] estimated a weighted average increase in minimum capital requirements for European banks adopting internal models, when fully implemented, of about 13% of Tier 1 capital. These estimates do not take into account further potential impacts resulting from the regulatory adjustments published in the most recent regulatory versions and those that will be included in the final version of the Regulation. Moreover, it is worth highlighting how the impacts are subject to significant variability depending on the characteristics of each institution.
In relation to capital requirements on operational risk, it is possible to foresee a wide dispersion of impacts among Banks at the domestic level, with different directionality between small and medium-sized Institutions and large Banking Groups, as well as between Banks adopting the BIA/TSA methods and Banks with internal models. However, the exercise of discretion regarding the sterilisation of ILM effects has significantly reduced variability. It is reasonable to foresee for small and medium-sized banks adopting the BIA methods a potential capital saving resulting from the use of a beta coefficient of 12% instead of the current 15%. For larger banks, differently due to the prevalent use of the TSA and AMA approaches, an increase in capital requirements is expected.
In this context, it should be noted that many Institutions that adopt internal models to calculate capital requirements have already activated specific multi-year projects to guide the transition to the new Basel III rules. For other Institutions, the activation is progressive and also depends on the complexities that each Institution will be called upon to manage for the transition to the new requirements.
References and Endnotes
- With regard to off-balance sheet exposures, the EBA published the ‘Consultation paper on draft RTS on the allocation of off-balance sheet items and UCC considerations under CRR 3’ aimed at defining criteria for the allocation of ‘other off-balance sheet items’ not already included in Annex I of the CRR and identifying factors that could potentially limit the ability of institutions to write off freely cancellable commitments. The consultation on this RTS closed on 4 June. ↑
- On this topic, the EBA published ‘Draft Guidelines on ADC exposures to residential property under Article 126a of Regulation (EU) 575/2013’ which set out the criteria and thresholds to be considered for the assignment of a 100% favourable risk weight to residential ADC exposures. The document is still under consultation (deadline 19 August). ↑
- On this topic, the EBA published the ‘Consultation paper on draft RTS on operational risk loss’, which defines criteria for the collection and recording of operational losses. ↑
- With regard to CVA, the EBA published the ‘Consultation Paper on draft RTS on CVA risk of SFTs’ which defines the criteria and the scope of exposures arising from securities financing transactions at fair value that can be classified as ‘material’ for CVA purposes. ↑
- As already noted in the Credit Risk area, CRR 3 envisages the adoption of a transitional regime for the output floor that will allow, over the period 2025-2029, for the gradual application of the defined floor value, potentially allowing banks to reduce the impact of recalculating exposures to standard. ↑
- European Banking Authority (2023) The EBA second mandatory exercise on Basel III full implementation shows a significantly reduced impact on EU banks with shortfalls nearly fully absorbed. Press Release. Available at: https://www.eba.europa.eu/publications-and-media/press-releases/eba-second-mandatory-exercise-basel-iii-full-implementation ↑
