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Basel Rules and their European Counterparts

By Silvio Santarossa, Partner - Risk Advisory Services

and  Kristian Lajkep, Regulatory Compliance Officer

Foreword on the Basel committee

The Basel Committee on Banking Supervision (BCBS) has a pivotal role in setting the regulation, supervision and practices standards for large internationally active banks worldwide.

As the BCBS is not a supranational or sovereign authority, the prudential rules it proposes are not intrinsically legally binding. It however has de facto (but not de jure) a profound influence on subsequent legislative processes all across the globe: its members are committed to implementing the standards and other countries tend to follow suit, even if they are not explicitly bound to.

Basel III and CRD IV

Basel III

Agreed upon by BCBS in 2010-2011, Basel III addresses problems of previous regulatory frameworks that (at the very least) allowed the 2007 financial crisis to take place. It introduced more rigorous rules regarding capital adequacy, stress testing, and liquidity risk. However, as Basel III is not a legal requirement, it needs to be translated to the legal systems of any given country.

CRD IV/CRR

The Capital Requirements Directive IV (CRD IV) and Capital Requirements Regulation (CRR), published in June 2013, are jointly implementing the Basel III agreement to the EU legislation. As a regulation, CRR is the first instance of the implementation of the Basel standards directly on EU level; This reflects an effort to create a single set of rules for all jurisdictions, a “single rulebook”.

Differences between Basel III and CRD IV/CRR

CRD IV/CRR are not exactly carbon copies of Basel III; some leeway had to be made to avoid conflict with European and member states law. Some differences however are more than just formal or cosmetic; the CRD IV encompasses some additional elements:

  • Remuneration practices, setting the ratio of variable (or bonus) component of remuneration to the fixed component (or salary) to the maximum of 100%, in exceptional cases 200%;
  • Corporate governance arrangements and processes;
  • Measures to increase the effectivity of the risk oversight by boards, particularly by increasing diversity therein;
  • Increasing transparency with regards to profits, taxes and subsidies in different jurisdictions. In the European environment, this transparency is essential, given the large loss of public trust towards the financial sector;
  • Reduced reliance on external credit ratings. Institutions are required to base their decisions on the internal credit opinions;
  • Systemic risk buffer.

CRD IV/CRR also expand the scope of Basel III. Basel III applies to internationally active banks only, but EU makes a habit of applying the same set of rules to all banks and credit institutions (as was already done with the transposition of Basel 2 agreement). The treatment of all banks as internationally active is necessary given the openness of the single European Market. However, EU firms concerned with investment advice or executing brokerage services, which do not hold client money, are not covered by CRD IV.

There are ways in which CRD IV/CRR are more lenient than Basel III as not to worsen the persistent under-investment within the EU.

In December 2014 the prudential regulatory framework in the EU was evaluated to be “materially non-compliant” with the minimum Basel III standards. The assessment conceded that the EU framework is in several areas more rigorous than the Basel framework, yet the overall grade was sealed by deviations regarding the Internal Ratings-Based (IRB) approach for credit risk and the counterparty credit risk component.

Further developments

Additions to Basel III

The implementation of Basel III did not mark the end of post-crisis consolidation of the financial regulation. A number of new sets of rules were released by the Basel committee in order to patch Basel III whenever something was lacking, though the scope and focus of some of them (FRTB in particular) make them brand new regulations in their own rights. These patches include:

  • New standards regarding the counterparty risk and the CCP’s (in July 2012);
  • Specification of rules for liquidity coverage ratio (LCR) requirement and specification of the requirement on capital, that would be based on leverage ratio (in January 2013).

Because European Regulators implemented Basel III as late as June 2013, the abovementioned rules are already incorporated in the CRD IV/CRR; the following BCBS proposals were published later and thus are yet to be implemented in EU legislation:

  • Revisions to the Standardised Approach for counterparty risk (in March 2014);
  • Net stable funding ratio, ensuring that banks have a stable funding profile in relation to their on- and off-balance sheet activities (in October 2014);
  • Fundamental review of the trading book (FRTB) - a revised market risk capital framework (in January 2016).
  • Revisions to the Standardised Approach for credit risk (in March 2016);
  • The new standard on the interest rate risk in the banking book (IRRBB) that reflects changes in market and supervisory practices due to the current exceptionally low interest rates (in April 2016).

To further see the timeline of Basel III, its amendments and its incorporation in the EU, please consult the timeline below.

Implementation in the European Environment

The Commission made a bid to incorporate all of the above to the EU law in November 2016 by proposing Amended CRR and CRD IV (also referred to as CRR 2 and CRD V) as well as BRD/SRM. However, the Commission seeks to adjust some of the new Basel standards, (i.e. the leverage ratio (LR), the net stable funding ratio (NSFR), the market risk rules in its implementation, in order to make sure that the new rules do not impede the level of lending in the European Union. These adjustments are limited in scope or are temporary – until lending increases to the desirable level. Some of the adjustments are to prevent a potential unfavourable treatment of the areas that are particularly important to cross-border trade.

Probably most important of all, the European rules include various amendments that make the requirements of CRR 2/CRD V more proportionate to the size and complexity of institutions, as not to be disproportionally costlier for very small banks (which also are subject to the regulation in the EU) compared to the larger institutions that can benefit from the economies of scale.

Some amendments are incorporated to the EU framework almost without change. IRRBB for instance is implemented with only cosmetic changes: the more pronounced role of EBA and more proportionality. In a persistently low interest rate environment, IRRBB is a necessity and there are no two ways about it. However, the timing is different; whereas BCBS suggests that IRRBB should be implemented during 2018, the IRRBB is packaged into CRR2, which has not been formally agreed upon yet and is certain not to be implemented (at the EU level) before January 2019, missing the implementation deadline set by the Basel Committee (though that may also be extended).

The Key differences

Leverage Ratio

The purpose of the regulation:

The leverage ratio is an additional capital requirement determined on the basis of non-risk weighted assets so as to prevent possible excessive leverage during economic booms and to act as a backstop to internal model based capital requirements.

European setting:

The commission wishes to maintain its January 2015 delegated act on the leverage ratio that sets the requirement at 3% of Tier 1 capital. This flat rate will however have a different impact on businesses of different sizes and different business models, and some adjustments to address this will be needed. These adjustments allow institutions to reduce the leverage ratio exposure measure:

  • By the amount of pass-through promotional loans and officially guaranteed export credits;
  • By the initial margin received from clients for derivatives cleared through qualifying central counterparties, as not to disincentive client clearing by institutions;
  • (If they are public development banks) by the amount of lending they provide to finance public sector investments.

Most of these changes predominantly affect the institutions that would normally fall outside of the Basel framework and therefore for the most part, the proposal is in line with the leverage ratio agreed by the Basel Committee.

Net Stable Funding Ratio (NSFR)

The current state of affairs:

The CRR already obliges banks to adequately meet the long-term assets with a diversity of stable liabilities.

Proposed improvements:

The proposal of CRD V/CRR 2 attempts to address the problem that this rule still allows the institutions to be financed to a too excessive degree, through short-term wholesale funding.

How does this improvement differ from Basel committee’s proposal?

The European Rules on NSFR imitate the Basel standard with a few notable adjustments requested by the EBA in order to prevent this regulation from impacting the investments in the EU too negatively and, in the case of the last three points, in order not to hinder the functioning of EU capital markets and sovereign bond markets. The differences relate mainly to the specific treatment of:

Pass-through models and covered bonds issuance, whose funding risk can be considered as low when assets and liabilities are matched funded:

  • Trade finance activities, whose short-term transactions are less likely to be rolled-over than other types of loans to non-financial counterparties;
  • Centralised regulated savings, whose scheme of transfer renders the client deposits and claims on the state-controlled fund interdependent;
  • Residential guaranteed loans, whose specific characteristics make them similar to mortgage loans;
  • Credit unions, whose statutory constraints on investment of their excess of liquidity entail a funding risk similar to that of non-financial corporates
  • for the institution receiving the deposits;
  • Derivative transactions;
  • Short term transactions with financial institutions;
  • High Quality Liquid Assets.

The EU liquidity coverage ratio treatment of these activities is much more favourable compared to the Basel LCR, giving them almost preferential treatment.

Capital Requirements for the market risk – trading book

What is the purpose of the regulation?

Following the implosion of capital held against trading book positions during the financial crisis, Basel 2.5 and its European counterpart, the CRD III attempted to address some of the most glaring weaknesses in the trading book requirements. Basel committee’s Fundamental Review of the Trading Book (FRTB) tries to address what was left via:

  • Establishing clearer and more easily enforceable rules on the scope of application to prevent regulatory arbitrage;
  • Making requirements proportionate to reflect the actual risks to which banks are exposed;
  • Strengthening the conditions to use internal models to enhance consistency and risk-weight comparability across banks.

How does the European proposal differ from the FRTB?

In order not to reduce the financial markets ability to invest throughout Europe and as not to limit the ability of end-users, such as corporates, to hedge their risks, FRTB has undergone some changes when translated to the European law. These include:

  • Reflecting specific EU regulatory environment, characterised by simple, transparent and standardised securitisations, covered bonds and the treatment of sovereign exposures to ensure the consistency of EU regulation;
  • Phasing-in the overall level of the requirement, to prevent a disproportionate immediate impact on banks' capital requirements.

The European Union is currently set to implement CRR 2 (and thus its version of FRTB) before January 2019. It is however considering postponing the implementation deadline to January 2020, but this would mean not meeting the BCBS deadline for implementing FRTB, which is March 2019.

Most importantly however FRTB does not adequately take into account the size of the institution. This raises again a concern about proportionality, as these rules could be just too complex and costly for small and even medium sized companies to implement.Consequently:

  • Banks with trading books below EUR 50 million and less than 5% of the institution's total assets can benefit from a derogation which allows them to apply the treatment of banking book positions to their trading book.
  • Banks with activities under EUR 300 million and less than 10% of the institution's total assets may use the simplified standardised approach which is the current version of standardised approach.

Both of these standards would increase the regulatory burden and would introduce potentially unnecessary capital and liquidity requirements on top of the existing ones. The Federal Reserve has not announced how they plan to implement the FRTB.

A Note on the US

In the US the new standards are received somewhat coldly. The US treasury report recommends delaying the domestic implementation of the NSFR and FRTB until they can be appropriately calibrated and assessed. The treasury feels that US banks are already subject to sufficiently rigorous rules regarding those areas of trading book and liquidity risk that NSFR and FRTB address.

Looking to the future

Some of the most complex changes to the Basel III framework, for example changing the perception of the credit and operational risks, are still under discussion at the Basel Committee and as such do not as yet enter the drafts of CRD V and CRR 2 at the European level. However, when the Basel committee reaches its decision and after they inevitably go through a series of consultations, the European Union is sure to adopt them, or something very close to these standards.

Please note:

During the editing stage leading up to the release of the RegBrief, BCBS has released an important report on finalisation of Basel III reforms that may or may not render some parts of this expert input obsolete. Please find it here if you are interested.

Annex: The implementation timeline