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Resilience and Resolution

Resilience and Resolution

February 2019

The EU has reached political agreement on the “banking package” of measures, first proposed by the European Commission in November 2016.

The banking package covers extensive amendments to the Capital Requirements Regulation (CRR), the Fourth Capital Requirements Directive (CRD), the Bank Recovery and Resolution Directive (BRRD) and the Single Resolution Mechanism Regulation (SRMR). The Commission’s proposals to amend the hierarchy of unsecured creditors in insolvency, to introduce a new class of non-preferred senior debt, and to align capital requirements with the introduction of IFRS 9, were fast-tracked and have already been implemented.

The banking package:

  • Introduces a binding leverage ratio and a binding net stable funding ratio;
  • Copies out the January 2016 version of the Basel Committee’s revised market risk framework;
  • Implements other Basel Committee revised standards, including for large exposures, counterparty credit risk, exposures to central counterparties, exposures to collective investment undertakings, interest rate risk in the banking book, and Pillar 3 disclosure requirements;
  • Reduces the reporting and disclosure requirements on smaller and less complex banks; and 
  • Aligns the EU’s loss absorbing capacity requirements (“MREL”) with the international standards (“TLAC”) for global systemically important banks (G-SIBs).

Following legal review the European Parliament and Council will be asked to adopt the proposed legislation, following which it will be published in the Official Journal.

However, this package does not cover the Basel Committee’s revised standards (finalised in December 2017) on credit risk, operational risk and the output floor. That will require further amending legislation, the timing of which remains uncertain (so the EU may miss the Basel Committee implementation date of 1 January 2022).

Implications for firms

The end of the lengthy political negotiations on the banking package provides firms with some certainty on the wide range of revisions. The timetable for the implementation of the revised market risk framework will be particularly helpful, since this now extends beyond the Basel Committee’s 1 January 2022 implementation date.

Eventually, the EU implementation of Basel 4 is expected to increase significantly the capital requirements on many European banks, as a result of both the new market risk framework and the revised Basel Committee standards on credit risk (standardised and internal ratings-based approaches), operational risk and the capital floor. However, the full EU implementation of Basel 4 remains a somewhat distant prospect, although as with market risk banks will need to allow sufficient time to plan carefully for these significant changes.

Larger credit institutions – especially global systemically important banks (G-SIBs) – will face significantly higher capital, loss absorbency, liquidity, reporting, and internal systems and controls requirements.

The EU-specific adjustments to some of the relevant Basel Committee standards – in particular the leverage ratio – will generally have a downward, albeit modest, impact on banks’ capital requirements.

Moves towards greater proportionality should reduce significantly some of the reporting, disclosure and additional capital requirement burdens on smaller credit institutions.

Banks should also take note of the direction of travel on a tougher approach to anti-money laundering, gender neutral remuneration and the assessment of Environmental, Social and Governance risks.

Further insights: Key elements of the banking package 

1. Market risk

The amended CRR “CRR2” largely copies out the Basel Committee’s January 2016 revised market risk framework. As a result, it does not include subsequent changes to the market risk framework introduced by the Basel Committee, culminating in the final Basel Committee market risk standards issued in January 2019. However, the implementation timetable for the market risk elements of CRR2 allow for these changes to be introduced next year:

a) The EBA should report by end-September 2019 on the impact of the revised market risk framework on banks, and on developments in international standards.

b) By end-June 2020, the Commission should if necessary put forward a legislative proposal (probably in the form of a Delegated Regulation to amend CRR2) to refine further the EU implementation of the market risk framework, taking into account the EBA report and the final Basel Committee standards. Since the Basel Committee’s final market risk standards published in January 2019 were themselves based on an impact analysis the Commission’s proposals are likely to follow the Basel Committee’s final standards, with perhaps some EU-specific adjustments.

c) Meanwhile, the Commission should introduce by end-December 2019 a separate Delegated Regulation to require banks to report to their supervisors on the basis of the final Basel Committee market risk standards.

d) Banks should begin reporting their revised standardised approach market risk calculations to their supervisors no later than one year after the CRR2 is amended as in (c) above (so from end-2020).

e) Banks that obtain approval to use the revised internal model approach (IMA) for market risk should report their IMA calculations to their supervisors from three years after the CRR2 is amended as in (c) above (so from end-2022).

f) The revised capital requirements for market risk should apply from four years after the date of entry into force of CRR 2 (so from mid-2023, although this may be pushed back to the beginning of 2024).

The EBA report should also review the calibration of capital requirements for market risks for banks with medium-sized trading books. Meanwhile, those banks (and banks with small trading activities) should be exempted from the reporting requirements in (d) and (e) above.

2. Leverage ratio

CRR2 makes a 3 percent leverage ratio a binding minimum requirement for banks, and introduces the leverage buffer for G-SIBs (at half the capital surcharge applying to each G-SIB). The Commission will also consider whether to subject D-SIBs to similar leverage buffer requirements.

The leverage ratio is adjusted downwards for, or not applied to, certain entities (public development banks, central counterparties, and Central Securities Depositories holding a banking license) and exposures (officially guaranteed export credits, the initial margins on centrally cleared derivative transactions received by banks from their clients and that they pass on to central counterparties, and some exposures to central banks).

3. Net stable funding ratio (NSFR)

CRR2 also makes the NSFR a binding requirement. This amends the Basel Committee specification of the NSFR to include some EU-specific preferential treatments for sovereign bonds, reverse repos collateralised by sovereign bonds, pass-through models (in particular for covered bonds), trade financing, centralised regulated savings, residential guaranteed loans, credit unions, and central counterparties and central securities depositories not undertaking any significant maturity transformation.

The NSFR also introduces a 5 percent stable funding requirement for gross derivative liabilities, in line with the discretion provided by the Basel Committee standards.

Small non-complex banks will be subject to a simplified version of the NSFR to reduce their administrative burden (fewer data collection points), although this version will remain at least as conservative as the full NSFR.

4. Other Basel Committee standards

CRR2 and CRD5 introduce a range of other Basel Committee standards developed in recent years, including for:

  • Large exposures – a higher quality of capital as the capital base for the calculation of the large exposures limit; exposures to credit derivatives to be calculated using the standardised approach to counterparty credit risk (SA-CCR); and exposures between G-SIBs are reduced to 15 percent.
  • Counterparty credit risk – introducing the SA-CCR (and a simplified version of the SA-CCR for smaller, less complex banks, while also allowing some banks to use the even simpler Original Exposure Method).
  • Exposures to central counterparties.
  • Exposures to collective investment undertakings.
  • Interest rate risk in the banking book.
  • Pillar 3 disclosure requirements.

5. Other EU-specific measures (in CRR2 and CRD5)

SMEs – the 23.81 percent reduction in the risk weighted exposure amount for SMEs is extended to SME exposures of up to €2.5 million (an increase from €1.5 million) and the part of an SME exposure exceeding EUR 2.5 million will be subject to a 15% reduction in capital requirements.

Infrastructure finance – extend the coverage of the preferential capital treatment to additional types of infrastructure projects such as those conducted by consortiums of firms.

Salary and pension backed loans – lower capital requirements (down from 75 percent to 35 percent under certain conditions) are introduced for pension and salary-backed loans.

Own funds – exemption of certain intangible software assets from deduction from own funds, where these assets are prudently valued and loss absorbing in a gone concern situation.

Pillar 2 – the bank-specific nature of additional capital requirements should prevent its use as a tool to address macro-prudential or systemic risks. Pillar 2 requirements should be met by at least 75 percent tier 1 capital, and within this at least 75 percent common equity tier 1 (CET1) capital.

Intermediate parent undertakings (IPU) – large non-EU banking groups with two or more subsidiary institutions in the EU will be required to establish an IPU to consolidate all their activities in the EU. The threshold for this will be set at €40 billion of balance sheet assets in the EU, including those held by third country branches. G-SIBs will not be automatically captured by this requirement if they do not meet the threshold. There is a three-year transition period before the IPU requirement comes into force.

Proportionality – in addition to the proportionality elements of the market risk and NSFR requirements, small, non-complex banks will be subject to reduced reporting and disclosure requirements. The EBA will be mandated to develop targeted reporting standards for such banks, with the objective of lowering their reporting costs by at least 10 percent.

Anti-money laundering (AML) – the European Banking Authority is called on to publish guidelines to enhance cooperation and exchange of information between prudential supervisors, financial intelligence units (FIUs) and other competent authorities; and to strengthen the AML dimension in authorisation, fit and proper checks and supervisory review and evaluation (SREP).

Remuneration – remuneration practices should be gender-neutral.

Environmental Social and Governance Risks (ESG) – the EBA is called on to publish a report within two years on how supervisors might review and evaluate ESG risks. The report should cover the development of a uniform definition of ESG risks including physical risks and transition risks; the development of appropriate qualitative and quantitative criteria for the assessment of the impact of ESG risks on the financial stability of banks in the short, medium and long term (including stress testing processes and scenario analyses); the arrangements, strategies, processes and mechanisms that banks should implement to identify, assess and manage their ESG risks; and how the impact of ESG risks on banks’ lending and financial intermediation activities might be assessed.

6. Resolution

CRR2 applies the Financial Stability Board’s total loss absorbing requirement to EU G-SIBs. The transitional requirement (the higher of 16 percent of risk weighted assets or 6 percent of the leverage ratio exposure measure) will apply as soon as CRR2 enters into force, with the higher requirement (18 and 6.75 percent respectively) from 1 January 2022.

90 percent of this TLAC requirement will apply to the material EU subsidiaries (that are not themselves resolution entities) of non-EU G-SIBs.

CRR2 also sets out the definition of eligible liabilities to be applied to all banks subject to a resolution strategy for the purposes of setting bank-specific MREL requirements under the BRRD2. This definition applies a corresponding deduction of holdings of other banks’ MREL instruments (which is more generous than the Basel Committee version, where holdings have to be deducted from at least tier 2 capital instruments).

Meanwhile the BRRD 2:

  • Requires MREL to be set on a bank-by-bank basis as a percentage of both the total risk exposure amount and of the leverage ratio exposure measure. 
  • Establishes the concepts of resolution entities and resolution groups under single and multiple point of entry resolution strategies. Banks that are failing or likely to fail, but not subject to resolution, should be wound up in an orderly manner in accordance with the applicable national law (using the fast-tracked harmonised insolvency hierarchy).
  • Allows structured notes to be included within MREL, and provides limited scope for MREL to include unsubordinated debt instruments. 
  • Requires MREL-eligible instruments issued under third country law to be subject to the contractual recognition of bail in. 
  • Sets a maximum period of two days for the suspension of contractual obligations, which cannot include obligations to central banks, central counterparties and payment and settlement systems.
  • Where there is no statutory cross-border recognition framework, requires banks to include a contractual term in relevant financial contracts recognising that the contract may be subject to the exercise of powers by resolution authorities to suspend or restrict rights and obligations.
  • Limits the purchase of MREL-eligible instruments by retail investors by requiring an issuing bank to perform and document a suitability test to satisfy itself that the instrument is suitable for a retail client. Moreover, where the financial instrument portfolio of a retail client does not exceed €500,000, the issuer has to ensure that the retail client does not invest an aggregate amount exceeding 10 percent of that client’s financial instrument portfolio, and that the minimum initial investment is at least €10,000. 
  • Requires banks to report to their supervisors and resolution authorities and to disclose regularly to the public their MREL requirement, the levels of eligible and bail-inable liabilities and the composition of those liabilities, including their maturity profile and ranking in normal insolvency proceedings.

Resolution authorities will have flexibility to address and remedy breaches of MREL requirements (including TLAC for G-SIBs), including prohibiting certain distributions and requiring banks to restore the level of eligible instruments.

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