On October 27th, the European Commission (EC) proposed its 2021 European banking package which centers around three key aspects which will become the focus for years to come within European legislation and supervision:
- The news a lot of financial institutions were waiting for: the EC’s position on the regulation officially known as the Basel III reforms but more colloquially known as Basel IV in the market (and in this commentary) due to the sheer extent of the changes proposed. The EC’s announcement outlines that financial institutions have an additional two years (until 2025) to implement these rules.
- A second aspect is around another hot topic: sustainability and the transition to ‘green’. The first element of environmental, social, and governance (ESG) practices.
- The last aspect is an increasingly pressing topic following the pandemic - stronger supervision and better protecting financial stability in the EU.
So why is an announcement like this so important? It’s worth taking a quick visit down memory lane to remind ourselves.
The path to Basel IV
The ‘07-‘08 global financial crisis (GFC) clearly revealed that a more resilient framework was needed around the different risks that banks manage. This is exemplified in banks’ modeling practices, specifically credit risk modelling, which have deep roots. Models can sometimes be so complex and refined that it can take a quantum physicist just to make a required judgement call.
Of course, there was a reason why complex mathematical models became common practice for so many. With sophisticated, approved models, banks could take more risk without holding back a big chunk of capital – a very large cost of funding for banks. However, politicians, regulators and public discourse strongly suggested that there should be stricter capital requirements for banks, and the excessive use of models for the sake of more risk-taking should be more controlled. Enter Basel IV - first agreed in 2017 and initially due for implementation in January 2023.
However, given the COVID19 pandemic, the subsequent pivot towards the ‘new normal’, and new credit risk models, the financial sector collectively called out for the deadline to be postponed. So, while there is no doubt that the EC will implement Basel IV to its full extent eventually, a political breakthrough was needed, and an extension of two years was granted.
Compassionate compromise or competitive disadvantage?
Not everyone will feel relief with this news. Just a month ago, the governors of the central banks in Europe wrote a letter reinforcing the different prudential reasons why their jurisdiction should stick to the original date. International competitiveness probably cited as one of the reasons which both regulators and banks have indicated.
The regulators have clearly focused on getting a stable economic system – it is one of the cornerstones of the economy in the EU. The banking federations highlighted the same argument but more as a competitive disadvantage as the nature of banking Europe is generally different to Anglo-Saxon economies such as the US. In the EU, credit portfolios in banks are large compared to their competitors in the rest of the world, and when the Basel IV ‘output floor’ is applied, it would limit the amount of impact an internal model has on the level of capital requirements. According to the EC, the effect is estimated to have less than 9% impact on capital levels.
The EC is also resolute in its ‘single stack’ approach in which methodologies used for the capital requirements will be consistent over all regulations whether they are Pillar I or Pillar II requirements. The belief of the EC here is to keep the logic consistent over the different measurements and metrics to avoid confusion.
Repercussions of the deadline shift
The knock-on effect of the recent EC postponement of the Basel IV implementation date also means the impact of this output flow will be gradually implemented until five years after the 2025 application date. This should then give financial institutions not only time to implement a robust system to deal with these new regulations but also to adapt their business model towards the capital levels that will be required.
Of course, any informed reader already knows that compared to banks caught up in the GFC in 2008, banks today have significantly higher levels of capital and buffers, so they should be (at least principle) much more resilient when similar crises hit. So, does the postponement mean that the banking lobby won? Or are we seeing politics at play, with the EC allowing enough room for banks to make sure they can finance the necessary funds for corporates, so the economy grows? Given higher capital levels in the EU, it is probably a bit of both.
One note that also needs to be made is that the Fundamental Review of the Trading Book (FRTB) measures which are related to the Basel IV framework, were part of Data Point Model (DPM) 3.1. in the EU and will have already been applicable since September 2021, so nothing will change there for the time being.
It seems Australia has also decided to delay Basel IV application to 2024 for one component and 2025 for the remainder. The effect of this however is that universal banks across the region will not be to relax or to make any plans. Even as this article goes live, Canada is continuing to apply their Basel IV rules set for 1st of January 2023 despite what the EC decides or whether other knock-on effects happen. Only time will tell how this plays out.
Emphasizing the E of ESG
So far in this commentary we have focused on Basel IV, however ample time should also be spent on the other two topics announced by the EC including the explicit rules on the management and supervision of ESG risks in line with the EU’s sustainable finance strategy.
Events such as the recent volcanic eruption in La Palma, flooding in Belgium and the Netherlands, and melting glaciers in the alps – as well as highlighting the obvious need for humanitarian intervention – from a financial perspective it also draws attention to the need for climate risks to be considered and translated into financial risks. For example, catastrophic effects like these will impact some financial institutions in terms of the insurer’s products and the credit portfolio for assets in these regions.
A lot is written about ESG in the financial sector, but to quickly revisit our previous topic, little is known about how ESG impacts Basel IV. This is important to consider as the EC also declared that it is exploring a framework in which capital requirements are adjusted for green or brown assets. There is no conclusion yet, but we could of course observe that the further development of ESG is not necessarily completely independent from the Basel IV topic and its capital requirements. The main message however remains that the EC wants to enforce explicit rules regarding ESG within its banking package.
A level playing field for supervisors
The final topic within the EC banking package focuses on the creation of more enforcement tools for supervisors. The major change in this context is that the EC wants to create a level playing field across Europe regarding supervision by not only ensuring the powers given to supervisors are equal within nations, but that they are also enforced in a more coordinated way.
This change will also mean harmonized sanctioning powers for supervisors as well. The EC writes that:
“In order to ensure that the framework remains proportionate, procedural safeguards have been introduced for the effective application of penalties, namely in the case where administrative and criminal penalties would apply cumulatively for the same breach. Under the Capital Requirements Directive, Member States are required to provide for rules on the cooperation between competent authorities and judicial authorities in cases of accumulation of criminal and administrative proceedings and penalties on the same breach.”
Enforcement around member states is one thing - but third country branch reporting is getting focus too. The EC is proposing more extended rules around third country branch reporting because growth in that space forms a significant risk on the financial stability of the EU.
What to focus on now
If are a regulatory addict, there is a lot of food for thought with the latest EC announcement. And if you are banker in a finance, risk, or compliance department you certainly have your work cut out. If you are treasurer, front office staff or salesperson – well, things will change, and you better change with them or else you could be left with costly and risky low-margin products.
But the text released by the EC will still need to go through parliament and be voted on, which should give financial institutions somewhat of a head start. The most important thing is that you stay updated with progress, so stay tuned for our quarterly regulatory update webinars and commentaries for more.
