Looking ahead to the Capital Requirements Regulation version 3 (CRR3)

On 27 October 2021, the European Commission (EC) proposed amendments to the Capital Requirements Regulation (CRR) with the aim of finalizing implementation by the European Union of the Basel-III reform applicable to credit institutions and investment firms in scope. The proposal, more commonly known as CRR3, adopts a rich set of new prudential treatments in particular deploying more stringent and risk sensitive standardised approaches for credit, market and operational risk while imposing further restrictions on the use of internal models.

CRR3 will bring major changes to the way banks manage risk and will have a significant impact on the current banking industry. The proposal indeed aims at boosting the financial resilience of the EU banking sector while considering its specificities and expected role in financing economic recovery and transformation in the EU.

After months of consultations, a unified legislative package has been presented to the European Parliament and Commission for discussion. On 27 June 2023, a provisional agreement on the implementation of the Basel 3.1 finalization was reached during the Trialogue involving the EU Commission, Parliament and Council. Although many technical aspects remain to be addressed under the current Spanish Council Presidency, the core aspects of these provisions will be formally accepted by the EU with the anticipated entry into force being 1 January 2025, unless there is an alignment with UK implementation, foreseen in July 2025. 

A new standardised approach for credit risk (SA-CR)

The Simplified Standardised Approach (SA-CR) is widely used by Luxembourg institutions, and more generally across the EU, to determine the amount of own funds needed to cover credit risk. However, it was sometimes deemed as not fully capturing risk in certain areas. Hence, CRR3 aims to address this drawback by making the revised SA-CR more risk sensitive, notably by adding more granularity in specific exposure classes and reviewing the prudential risk weights, such as, inter alia: 

• On the exposures secured by real estate, distinctions have been added based on the type of financing of the exposure (whether it is dependent on income generated by the property) and the stage of development of the property (whether it is still under construction or completed). The Exposure-to-Value (ETV) ratio has been amended in this perspective for both residential and commercial mortgages.
• A risk-weight multiplier requirement has been introduced for unhedged residential real estate exposures to retail where there is a mismatch between the currency of denomination of the loan and that of the obligor's source of income.
  The determination of risk weight for exposures to institutions without a credit assessment by a nominated External Credit Assessment Institution (ECAI) is revised to align with Basel III. This method involves classifying exposures into one of three grades based on quantitative and qualitative criteria, with additional due diligence requirements outlined in the CRD.
• A new exposure class for the treatment of specialized lending exposures has been introduced.
• Off-balance sheet items and their commitments are grouped into new categories or "buckets", subject to forthcoming European Banking Authority (EBA) guidelines and leading to a broader range of Credit Conversion Factors (CCFs).

Change to Internal Ratings-Based approaches 

A key outcome of the CRR3 is certainly the reduction in the scope of  exposures eligible to Internal Rating-Based (IRB) models for credit risk. Indeed, as the EC aimed at increasing harmonization across the institutions and making IRB model outcomes more comparable, the IRB framework has been revised to establish limits to the application of IRB framework. 

• The CRR3 limits the use of the Advanced IRB (A-IRB) approach only to exposure classes where robust modelling is deemed feasible (for example, exposures to large corporates or institutions) – while other exposure classes will be migrated to less sophisticated methods (i.e., under the Foundation IRB (F-IRB) or standard method).
• The Permanent Partial Use (PPU) has also been revised to allow institutions to apply the IRB approaches selectively.
• Exposures to Public Sector Entities, Regional Governments and Local Authorities will be treated under a new “PSE-RGLA” exposure class and will be treated under the same requirements as the general corporate exposure regime.
• Input floors are introduced to establish minimum levels of own estimates (i.e., Probability of Default (PD), Loss Given Default (LGD), Exposure At Default (EAD)) within the IRB framework. Sovereign exposures are however exempted from the application of the new input floors.
• Further changes include the deletion of the scaling factor in the risk weight formula. 

A revised market risk framework

On the market risk side, the CRR3 updates are unquestionably linked to the alignment of prudential regulation with the Fundamental Review of the Trading Book (FRTB) standards. Under the current proposal, the general provisions have been amended to introduce own funds requirements according to FRTB and also lay down the conditions for the use of the different methods (namely, Alternative Standardised Approach (A-SA), Alternative Internal Model Approach (A-IMA) or Simplified Standardised Approach (SSA)).  

Furthermore, the criteria for distinguishing between the Trading Book and the Banking Book have also undergone revision. It includes a provision that forces institutions to assign certain instruments to the Trading Book, where derogations are permitted but subject to supervisory approval. 

Redefining the CVA risk charge

CRR3 will replace the internal modelled approach by a standardised or a basic approach that institutions should use to calculate their own fund requirements for Credit Valuation Adjustment (CVA) risk. 

The proposal also clarifies the conditions and criteria under which securities financing transactions will be subject to the CVA risk charge. 

Operational risk under the new BIC approach 

As part of the proposal, the current operational risk framework will be replaced by a new Standardised Approach for own funds requirement covering operational incidents. The Advanced Measurement Approach (AMA) which allowed the use of internal statistical models will hence be removed. 

Under the Basel III final standards, the new methodology merges an indicator based on an institution's business size (referred to as the Business Indicator Component or BIC) with another that considers the institution's historical loss records (the so-called “loss multiplier”). Jurisdictions can choose to exclude historical losses when determining operational risk capital for all relevant institutions or consider historical loss data for institutions below a specified business size. 

Hence, in the EU, the minimum own funds requirements for operational risk will be based on the BIC, solely. 

However, even if the use of the loss multiplier is not imposed per se, certain data collection and disclosure requirements remain under CRR3. Institutions with a business indicator of EUR 750 million or more will be asked to compute and disclose their yearly operational risk losses, save of a waiver under special circumstances. The collected data will also be available for the Supervisory Review Evaluation Process (SREP). 

Introducing the output floor 

One of the big CRR3 novelties and probably the most controversial, is the introduction of the output floor (OF). This measure has been initiated to reduce the benefits of using overly optimistic internal models and hence, to ensure that the results of internal models lead to sufficient levels of capital to cover potential losses. The floor is set as a percentage (72,5%) of the RWA calculated using the standardised approach and is phased in over a transition period spanning from 2025 until 2032. 

Debates continue regarding the scope of application of the floor. While the initial draft EC proposal imposed the OF to be met at consolidated level in the EU, with an allocation mechanism to stand-alone entities and sub-consolidated groups in the same Member State based on their contribution to the total floor impact, the draft agreement from the trialogue discussions requires the floor to be met by each institution, on individual basis, with potential derogation for sub-groups consolidated in the same Member State. 

Anyhow, it's crucial to note that regardless of the final agreement, banks should be prepared to compute their contribution to floored and unfloored exposures at individual level and, therefore, ensure they have the necessary data available.

Another step toward integrating ESG risks

As part of the transition towards a more sustainable economy, the ESG risk has been integrated in the prudential framework. Indeed, CRR3 requires banks and investment firms to integrate environmental risks into their risk management framework. They must identify, assess, and manage the risks related to climate change, natural disasters, and other environmental factors.

Extending the scope of disclosures 

The draft proposal introduces new requirements in terms of disclosures. For instance, the scope of ESG disclosures (on physical risks and transition risks) has been extended to all institutions, including the small and non-complex ones. The EBA has, however, been mandated to develop technical standards to ensure disclosures are proportionate to the size and complexity of the institution. 

Furthermore, in its ambition to increase transparency and monitoring, the EBA has been developing the Supervisory Data on the European Centralised Infrastructure platform (EUCLID) on which financial institutions will report key data and metrics with the objective to make them available to multiple stakeholders beyond competent authorities, such as other financial institutions, citizens and academia. 

Implication for institutions in Luxembourg

• Increased data requirements 

The CRR3 proposal comes with numerous challenges in terms of data, including the need for more granular data for calculating risk-weighted assets. For instance, exposures to institutions for which no credit assessment by a nominated ECAI is available may present a significant challenge for their peers on the interbank market, as they should be classified into one of three grades based on a range of qualitative and quantitative factors. 

Another challenge in terms of data collection is posed by the implementation of the output floor. Indeed, institutions using IRB models will have to collect and manage data as if they were using the standard methods in order to compute the floor. 

• New considerations for the cost of capital

With the restrictions imposed on IRB models and the introduction of the output floor, institutions could be willing to re-assess their use of advanced methods for assessing their own fund requirements. Indeed, they might be tempted to give up on the models as the gains in own funds requirements would be lessened while the cost of running internal models will increase. 

Another example is, interestingly, the new treatment of unrated institutions, which also has direct consequences on the cost of funding. Unrated institutions (commonly encountered in Luxembourg) which are dependent on inter-banking funding, will be less appealing for their lenders as their prudential cost could be higher. The efforts and potential data limitations faced by their counterparties to classify them in the ad hoc grade, may result in higher risk weights or lack of appetite for placing.

• Planning capital adequacy already

As CRR3 will directly impact the capital requirements of banking activities and products from 2025, institutions should already integrate suitably adjusted forecasts into the three-year horizon required by ICAAP for capital adequacy planning. 

• Crypto assets entering the prudential framework

Before the end of 2025, the Commission will assess the need for creating specialised prudential measures for dealings with crypto assets. After consulting EBA and taking into account international consideration, the Commission will then make a legislative proposal to the European Parliament and the Council, where applicable.

Conclusion

While CRR3 intends to refine risk-sensitivity and provide a more consistent approach to the management of risks in the banking industry, it is not without its challenges.

The use of internal models has been made more restrictive, reducing capital savings achievable inter alia under the IRB approach. At the same time, the complexity of the new standardised approaches has also significantly increased, which could pose other challenges for institutions, whether as direct users of these methods or through their inclusion in the OF. 

Furthermore, the new CRR framework introduces enhanced data and disclosure requirements, which will likely involve additional efforts and resources for collection, management and reporting. 

However, from a risk perspective, the CRR3 framework displays greater risk sensitivity, better capturing nuances between the different exposure classes and the effect of risk mitigation factors, where applicable. It will also lead to enhanced comparability of own funds requirements and make the EU financial system more resilient.