The EU proposes delaying the implementation of Basel III by 2 years

The European Commission (EC) today?published draft legislation?implementing the international?Basel III?reforms on credit and market risk that were finalised in January 2019. In response to COVID-19, Basel postponed the implementation to 1 January 2023, followed by a five-year phasing-in period for elements of the reform.

The EC proposes giving EU banks two additional years to implement the reforms so they start applying from 1 January 2025, to allow for the outcome of the EU legislative process. The EC claim this will allow banks to focus on managing financial risks stemming from COVID-19 and on financing the recovery and give them enough time to adjust before the reforms reach full effect.

Several major jurisdictions (Australia, Hong Kong, Canada, Japan, Singapore, the UK and the USA), have already publicly committed to adopting rules implementing the reform by 1 January 2023 with a number having published draft rules. How other jurisdictions react to the EU’s unilateral decision to postpone implementation will be interesting. Some might publicly chastise the EU for the delay, but privately might be pleased with the outcome.

?The tone of the proposal gives a clear intention that EU banks should not be disadvantaged versus global peers. How times change.

That said, European banks were unsuccessful in lobbying for a softer adoption of the 72.5% output floor, the so-called “parallel stacks” approach.

Deviations from the Basel framework: Something?Old, Something Borrowed, Something New

The EC is proposing to maintain several existing deviations, such as the?SME and infrastructure supporting factors?that result in lower capital requirements for exposures to SMEs and infrastructure projects. The existing exceptions from capital requirements for?CVA risks?also remain, but banks will be now be required to report the capital requirements calculations for CVA risks of exempted transactions to their supervisors.

The proposal also takes advantage of flexibility within the Basel III Accord not to disadvantage EU banks. Proposals include introducing the?output floor?at the consolidated rather than solo level, temporarily?lowering the existing calibration of SA-CCR for all derivatives transactions?when calculating the output floor, disregarding the inclusion of banks’ own historical losses related to operational risk through the?Internal Loss Multiplier?(ILM) indicator in calculations of capital requirements for operational risk.

New proposed deviations include transitional arrangements on exposures to?low-risk mortgages?for the Output Floor until 2032, as well as for exposures to?unrated corporates?until the end of 2029 to avoid disruptive impacts on bank lending to unrated corporates and to provide time for EU public and/or private initiatives to appear to increase the coverage of credit ratings. The EBA will advise at the end of 2028 whether there are sufficient external ratings available on EU corporates.

?Long-dated strategic equity exposures?(including insurance holdings) are proposed to be grandfathered and then given further temporary capital relief. There are new preferential capital treatments for the treatment of?Collective Investment Undertakings (CIUs)?under the market risk rules, preferential prudential treatment for credit insurance, leasing activities?and?“high quality” project finance.

To support EU?Emissions Trading System (ETS),?the EC proposes introducing a specific category for ETS allowances, calibrated to reflect the price volatility in the EU ETS market.

It is proposed the EU holds back on introducing the?minimum haircut floor framework for non-centrally cleared Securities Financing Transactions (SFTs)?until the EBA and ESMA provide a joint report assessing the impact and subsequently recommend the most appropriate approach.

Other issues outside of the Basel framework

The proposal looks to ensure?ESG risks?are consistently included in banks' risk management systems and have robust governance and accountability arrangements to deal with ESG risks. It expands the existing scope of ESG disclosures to all EU banks (currently it only applies to large listed banks) and ensures ESG is incorporated in the Supervisory Review and Evaluation Process (SREP) and stress testing by supervisors.

The proposal is silent on banks holding of crypto assets, but the requires legislation before December 2025.

Finally, there are proposals for new rules for?third-country branches (TCBs)?harmonising provisions on TCBs' authorisation, capital, liquidity, governance, reporting, and supervision. TCBs with assets greater than EUR 30bn in one or more Member States, will trigger a supervisory assessment whether those TCBs are systemically important with the possibility to require their third country parent group to convert its TCBs into subsidiaries or, restructure the TCBs' assets or activities, or face add additional prudential requirements. In essence, this is similar to what the US prudential regulators required of foreign branches under their Foreign Banking organisation (FBO) requirements.