Basel III is an internationally agreed set of measures developed by the Basel Committee on Banking Supervision in response to the financial crisis of 2007-09.

The European Commission’s (EC) legislative Banking Package (including CRDVI and CRRIII) was published on the 27th of October 2021. This was the first step in the finalisation of the Basel standards in the EU. The Council of the European Union and European Parliament have subsequently published their own amendments to the existing CRR and CRD legislation and trilogue discussions are underway to determine the content of the final changes to be published in the European Union Official Journal.

This Banking Package (CRRIII and CRDVI) is due to be implemented on the 1st of January 2025.

This will be at the forefront of the CFO agenda across the Financial Services sector in the coming years. We’ve pulled together a summary of the legislation, highlighting the recent changes and additions, looking also at what firms should be thinking about right now to meet the deadline.

IRB (Internal Ratings Based Approach)

• The financial crisis highlighted important deficiencies in the existing IRB approaches. The new proposals aim to address issues such as the wide variation in capital requirements across institutions, which hinders the comparability of ratios
• Amendments introduced limit the exposure classes for which internal models can be used to calculate own funds requirements for credit risk
• There is a restriction in the use of Advanced IRB for certain exposure types (Banks and other financial institutions, large and mid-sized corporates)
• The IRB approach is no longer available for equity exposures
• Input floors applicable to corporate exposures will apply in the same manner to exposures belonging to public sector entities (PSEs) and regional government and local authorities (RGLAs)
• Introduction of minimum values for institutions’ own estimates of IRB parameters used as inputs for the calculation of RWAs
• Scaling factor of 1.06 in calculation of Risk Weights removed
• Removal of the double default method applicable to some guaranteed exposures, leaving only one general formula for the calculation of risk weights
• Revised scope and calculation for own estimates of credit conversion factors

Capital Output Floor

• The output floor limits the capital benefit arising from the use of risk models across all risk types by establishing minimum risk weighted assets (RWAs) at 72.5% of the standardized (i.e., non-modelled) level
• The revised proposals aim to improve the reliability and comparability of capital ratios and reduce model risk overall
• Amendments aim to specify which Total Risk Exposure Amount (TREA) is to be used for the calculation of minimum own funds requirements
• The output floor is incorporated in CRR III and CRD VI at 72.5%. This is to be phased-in over 5 years to a level of 72.5%
• Although individual group entities below the EU parent will likely not be subject to the output floor, there is an approach specified to apportion floored RWAs at the consolidated level to subsidiary parent companies in each EU country. This will result in the impact of the consolidated floor being distributed across the countries in which an EU group operates
• The EC notes that the Pillar 2 Requirement and the systemic risk buffer can be used to address risks that are similar in nature to those addressed by the output floor and these may need to be amended to avoid double counting
• Acts as an additional back-stop to the risk-based approach to determining capital

CVA (Credit Valuation Adjustment)

• Revised definition introduced to capture both the credit risk spread of an institution’s counterparty and the market risk of the portfolio of transactions traded with that counterparty
• New approaches were introduced for calculating own funds requirements for CVA risk (the standardised approach, basic approach, and simplified approach)
• Amendments provide clarity on which securities financing transactions are subject to the own funds requirements for CVA risk
• Under the standardised approach (SA-CVA), risk sensitivity depends on credit spreads and market risks factors, driven by values of derivatives, i.e. offers the highest level of risk sensitivity and more detailed calculations and inputs.
• Introduction of basic approach for calculating own funds requirements with simpler formulas and supervisory factors.
• Simplified approach, least complex method, for calculating the own funds requirements for CVA risk introduced, along with eligibility criteria for its use
• Amendments to reflect new requirements applicable to eligible hedges for the purposes of the own funds’ requirements for CVA risk
• New mandates for the EBA to develop guidelines to help identify excessive CVA risk

Legislation Timelines

The Banking Package (CRRIII and CRDVI) has an implementation date of 1st January 2025.  We’ve charted out the key milestones in the below graphic.

What are the key changes to this legislation?

While the draft proposals from the Council, Commission and Parliament are broadly aligned, there are some key areas of divergence
Let’s look at a selection of these in more detail:

1. Property Revaluation:
   European Commission Proposal: allows for upward adjustment of property valuation beyond the value at origination to an upper limit of the average value over the previous three years for commercial real estate and six years for residential.
   Council of the European Union Proposal: Broadly aligned to EC proposal however it increases the average value period to six years for both residential and commercial exposures.
   European Parliament Proposal: Broadly aligned to EC proposal however it increases the average value period to four and eight years for residential and commercial exposures respectively.
2. Specialised Lending Exposures:
   European Commission Proposal: Introduces 80% risk weight for unrated object finance and project finance exposures that meet the definition of ‘high quality’.
   Council of the European Union Proposal: Removes preferential risk weight of 80% for ‘high quality’ object finance and project finance exposures and mandates an EBA report on the impact of implementing these lower risk weights
   European Parliament Proposal: Maintains the 80% risk weight for object finance and project finance exposures deemed ‘high quality’ with some changes to the conditions required for project finance exposures to qualify as ‘high quality’
3. Trade Finance
   European Commission Proposal: Increases CCF for trade finance exposures to 50% and requires a 2.5 year maturity to be used where an institution has not received permission to calculate its own LGD estimates
   Council of the European Union Proposal: Reintroduces the 20% CCF for technical guarantees and proposes the use of effective maturity for trade finance instruments as an alternative to the 2.5 year maturity proposed by the EC
   European Parliament Proposal: Aligned to the Council’s proposal
4. Level of Capital Output Floor
   European Commission Proposal: The capital output floor at a consolidated level but requires subsidiaries in separate member states to calculate their own output floor
   Council of the European Union Proposal: The capital output floor will apply at an individual license level as well as a consolidated level but provides member states with the power to apply the output floor at a consolidated level only
   European Parliament Position: Application at a consolidated level but with some allowances for host and consolidated home supervisors to apply output floor in separate member states to individual licenses

How can EY help

Our team are highly experienced in working with clients on the requirements and business impacts of regulation. Working with us, we can offer you:

• A blended organisational chart where EY will take accountability but in a way that works with you. Our multi-competency team have the key skills to help you navigate each stage of the process e.g. Data and business analysts, subject matter resources, regulatory reporting testing and implementation experts
• Panel of EMEIA SMRs across a range of competencies on hand to provide support as and when required, with local leadership providing area focused expertise and acting as central point of contact with global team
• Support in starting and accelerating the journey, challenging our processes and ongoing identification of the next set of opportunities
• Invest in tools and methodologies for delivering and implementing process and system changes in response to changing regulatory requirements
• Facilitated sessions at one of EY’s innovation centres where we collaborate on use cases with the latest technology.

For more information, contact our team today