On 24 March, the European Central Bank (ECB) issued an opinion on the European Commission's October 2021 proposal for amendments to the Capital Requirements Regulation (CRR3). The amended CRR will implement the remaining Basel reforms in the EU.

The opinion broadly welcomes the Commission's proposals, which implement the Basel reforms, reinforce the EU Single Rulebook and enhance the prudential framework for credit institutions in various areas.

The ECB reiterates earlier statements on the importance of finalising the EU implementation of the final Basel reforms in a “timely, full and faithful manner”, in order to address shortcomings in the current framework swiftly and effectively, thereby ensuring that banks will continue to be resilient to future crises. And it notes that a full and faithful implementation is important, not only for financial stability, but for the international credibility of the EU.  

Pockets of risk

It is the issue of full and faithful implementation that troubles the ECB. It expresses concern that some deviations and implementation choices in the European Commission proposal may leave pockets of risk insufficiently addressed in the banking sector. The main areas of risk, it notes, arise from the proposed prudential treatment of real estate exposures, credit risk from unrated corporates, counterparty credit risk, equity exposures, and operational risk.

The following areas are called out in detail:

Output floor — the proposal for the output floor (OF) includes significant transitional arrangements, leading to lower risk weights than those from the Basel standards in specific areas including residential real estate exposures with low historical losses, exposures to unrated corporates, and the calibration of counterparty credit risk related to derivative exposures.

The ECB supports the option for the “single stack” approach (a single capital stack for risk-based capital requirements) and the application of the OF at the highest level of consolidation. However, it disagrees with the re-distribution mechanism proposed by the European Commission. From the ECB's perspective, this mechanism may incentivise banking groups to reorganise their activities in order to minimise the impact of the OF on individual parts of the group. This could have a negative impact through the misalignment of organisational structures or sound risk management, and also freeze more capital at local level, which is contrary to the objective of free movement of capital necessary for financial integration.

Credit risk framework — the standardised approach contains several new deviations from the final Basel standards that, together with the continuation of some existing deviations (e.g. for small and medium-sized enterprises (SMEs) and infrastructure), may reduce the consistency and safety of the new standardised approach and leave certain risks uncovered.

The ECB suggests that co-legislators should also reassess the current deviations. It is particularly concerned with the impact of deviations regarding specialised lending exposures, equity exposures, retail exposures and the methodology for collateral valuation for exposures secured by immovable property.

Operational risk — the ECB expresses regret that the European Commission did not opt for recognition of historical losses for the calculation of capital requirements for operational risks. Inclusion of the loss history, it judges, would enhance risk-sensitivity and loss coverage of capital requirements, providing greater incentives for institutions to improve their operational risk management.

Market risk — the CRR3 proposal allows the European Commission to change the calibration of capital requirements under the new market risk framework and to postpone its implementation by two years. This could result in reduced capital requirements, deviating from the Basel standards. The ECB opinion recommends that these powers be limited, highlighting the importance of implementation by 2025.

Credit valuation adjustment (CVA) — the ECB highlights that the proposal does not reconsider existing exemptions and that such deviations are not justified from a prudential perspective, as they leave institutions exposed to uncovered risks from derivatives transactions with exempted counterparties.

Pillar III disclosures and reporting — the ECB considers that the small and non-complex institutions' (SNCIs') approach for quantitative disclosures (which uses supervisory reporting to compile the corresponding quantitative public disclosures on the basis of a pre-defined mapping) could be applied to all institutions, regardless of their size and complexity, to reduce the reporting burden of all institutions.

Implications

The ECB's opinion may lead to non-acceptance by the European Parliament of the European Commission's proposal. This would likely lead to further, extended discussions around which deviations from the Basel standards should or should not be implemented. Should these discussions be very protracted, it could call into question the feasibility of the proposed 1 January 2025 implementation start date or, at the least, reduce the amount of time available to banks to prepare for final implementation.