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Basel III in the European Union

by internationalbanker

By John Berrigan, Director-General in DG FISMA (Directorate-General for Financial Stability, Financial Services and Capital Markets Union), European Commission

 

 

 

Banks play key roles in financing our economy, providing households and firms with credit. At the same time, they are exposed to risks through their vulnerability to credit losses and related deposit runs. This is why it is so important to have sound regulation and supervision of banks, together with adequate industry-funded safety nets. The need for such a prudential framework for banks became particularly evident following the banking turmoil of last spring, as highlighted by the Basel Committee on Banking Supervision’s (BCBS’s) recent report1(“Report on the 2023 banking turmoil”) on lessons learnt. The report stressed the importance of international regulatory standards and effective bank governance and supervision.

In response to the Global Financial Crisis (GFC) of 2008-09, the European Union (EU) invested heavily in better regulating and supervising banks in line with international standards. Two key choices made by the EU in the last 10 years have proven particularly justified. The first was to apply the international Basel standards to all banks within the EU jurisdiction, avoiding any distinction between different categories of banks. As a consequence, we now have a banking system that is overall much more stable and robust than it was 15 years ago. The second was to put supervision in the hands of the Single Supervisory Mechanism (SSM) to ensure sound and consistent supervision across the EU (currently covering banks in 21 of the 27 EU Member States).

On October 27, 2021, the European Commission (EC) published its proposals for an amended Capital Requirements Regulation (CRR III) and an amended Capital Requirements Directive (CRD VI), grouped under the name of the “banking package”. These pieces of legislation aim to implement in the EU the last part of the agreements published in 2017 by the Basel Committee, the so-called Basel III finalisation. The Council of the European Union—representing the 27 Member States—and the European Parliament finally reached a political agreement on the text last June. Discussions on the legal wording at the technical level are still ongoing, but this timetable should allow publication of the final text in the Official Journal of the European Union in 2024 and “entry into application” of the new rules in 2025, subject to confirmation by legislators.

In the previous banking packages of 2013 and 2019, the EU significantly tightened the regulations of capital, liquidity, leverage and large exposures in banks. As a result of these measures, EU banks’ capital ratios doubled between 2009 and 2022. With this final package, we aim to improve the simplicity, comparability and risk sensitivity of banks’ regulatory frameworks and to raise confidence in risk-based capital requirements further. This implies many changes in how banks calculate their fund requirements for credit, market and operational risks.

The key plank is a technical measure called the “output floor”. The output floor sets a lower limit (floor) on the capital requirements that banks calculate when using their internal models (output) and is introduced to reduce the excessive variability of banks’ capital requirements and possible capital gains arising from the banks’ use of internal models. Internal models are risk-sensitive measurement tools that bring many benefits. Supervisors allow them so that banks can set their capital based on the data they have on their counterparties and their counterparties’ default risks. After the efforts and resources put in by European legislators and supervisors over the years to monitor, enhance and harmonise internal models, the EU chose to maintain internal models and apply the output floor. With the introduction of the output floor, the gap in capital requirements between banks using standardised approaches and those using internal models has narrowed. This impacts a relatively small number of banks, particularly large banks, which are the ones using internal models. However, we shouldn’t underestimate the impacts it may have, especially on mortgages and corporate lending, and we have introduced temporary measures to reduce those impacts and allow banks time to adapt their business models.

We have also included in the package a number of new requirements on the supervisory aspects of ESG (environmental, social and governance) risks—for instance, requiring banks to put in place green-transition plans and empowering supervisors to ensure banks are organised when managing risks related to climate change to foster orderly green transitions. The new package also includes rules to improve fit and proper assessments of banks’ managers and rules on supervisory features such as prudential consolidation as well as sanctioning powers. Provisions to better frame non-EU—or “third-country”—branches and operations in the EU have also been introduced.

The Basel III agreements were designed and approved by the Basel Committee, bringing together supervisors from 28 countries. It is, therefore, essential that the member countries of the Committee respect their commitments. Consistent implementation of regulations across countries is necessary—first, to deal with the systemic challenges of the banking sector and second, to ensure a level playing field. The United Kingdom and the United States published their Basel III implementation plans in November 2022 and August 2023, respectively, and entry into application will not occur before mid-2025. Although it is too early to make a detailed comparison, it is possible to see some differences between the EU and the US Basel implementations. The EU has chosen to transpose the Basel III rules very broadly while adopting transitional provisions to take EU specificities into account. It will continue to apply all Basel prudential rules to the approximately 4,500 credit institutions active in the 27 Member States, which is an additional layer of prudence compared to Basel III requirements. The US, while enlarging the scope, will apply international standards to fewer than 40 banks. Also, the US seems to have made more marked choices, for example, by completely banning the use of internal models for credit risks. However, the US may deviate more from the Basel standards elsewhere, such as in capital requirements for market risk. In this regard, the EU still has the possibility to adapt or delay the EU requirements linked to market risk if this proves necessary to maintain an international level playing field. It will be essential to analyse carefully, in due time, the differences in regulations and their consequences on banking activities.

Technical discussions are now taking place with the Member States and the European Parliament to finalise the legal text that will enact the Basel III agreements in EU law. A long implementation phase will follow, including significant work to specify the new rules through numerous future technical standards, which will be prepared by the European Banking Authority (EBA). The EBA’s technical assessments of specific provisions will reveal whether the new framework is well calibrated. Going forward, we will also focus on the risks linked to certain non-bank financial intermediaries, which must receive the full attention of policymakers and supervisors.

Banks have an essential role in the recovery, and it is in all our interests that EU banks are resilient going forward. We will continue working to ensure that the EU banking sector is fit for the future and can continue to be a reliable and sustainable source of finance for the EU economy.

 

Reference

1 Bank for International Settlements (BIS)/Basel Committee on Banking Supervision (BCBS): “Report on the 2023 banking turmoil,” October 2023.

 

 

ABOUT THE AUTHOR
John Berrigan is the Director-General of DG FISMA (Directorate-General for Financial Stability, Financial Services and Capital Markets Union) of the European Commission. John represents the European Commission on the Economic and Financial Committee and the Financial Services Committee, which report to European Union finance ministers. He also represents the Commission on the Financial Stability Board, which reports to G20 finance ministers.

 

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