The EU Banking Package is a significant part of bank prudential legislation introduced in the European Union in recent years. This package features amendments to the Capital Requirements Directive and Regulation, also known as CRD6/CRR3. The primary purpose of these revisions is to implement the finalized Basel 3 reforms, commonly referred to as Basel 3.1, within the EU jurisdiction. These reforms aim to strengthen the regulation, supervision, and risk management within the banking sector.
Capital requirements Regulations: Banking Package Integration to Basel 3.1
The EU Banking Package is a decisive shift in the European banking sector, integrating the Basel 3.1 reforms, also known as the finalized Basel 3 reforms, into the EU's regulatory framework. This integration is critical in strengthening regulation, supervision, and risk management within the industry. The primary motivation behind these reforms is to prevent the reoccurrence of financial crises and to mitigate the effects when they do occur.
Experience from recent disturbances in the US and Swiss banking sectors has highlighted the critical role of robust regulation and supervision. These incidents served as significant reminders of the vital importance of abiding by established standards. There are a multitude of lessons to be learned from these instances, but some are particularly pertinent to the implementation of our new banking framework.
Primarily, a robust regulatory framework is not an onerous imposition, but a shield that can safeguard against potential financial distress. This fact was made evident during the global pandemic and the Russian conflict, where Euro area banks have displayed remarkable resilience. The average common equity tier one capital ratio for significant banks stood at 15.3%, which indicates a healthy liquidity position that is significantly above regulatory minimums. Moreover, there's been substantial progress in diversifying funding sources and enhancing bank profitability.
However, this resilience should not engender complacency. While we have seen how a robust regulatory framework can cushion against financial shocks, we have also observed how a weakened regulatory framework can amplify systemic risks. The latter is especially true when standards are not implemented fully or are prematurely relaxed, leading to the development of financial vulnerabilities that can quickly morph into larger financial stability risks.
An example of this is the debate surrounding the Liquidity Coverage Ratio (LCR), a key part of the Basel framework that ensures banks maintain an adequate level of unencumbered high-quality liquid assets that can be converted into cash to meet their liquidity needs for a 30 calendar day liquidity stress scenario. The LCR has proven its worth during periods of financial stress, and any deviation from this crucial safeguard can potentially lead to severe liquidity problems.
Capital requirements Regulations(CRD6/CRR3) Framework
While implementing the EU Banking Package, two significant areas require attention. First, robust rules are the backbone of a resilient banking system. There are concerns that the legislative proposals for the capital requirements regulation (CRR3) might deviate from Basel III, particularly concerning risk-weights for loans to unrated corporates.
These deviations could significantly undermine the impact of the output floor on banks' required capital:
- Output Floor's Effectiveness: There are concerns that certain deviations could greatly affect the impact of the output floor on banks' required capital. The output floor is crucial as it limits the degree to which banks can minimize their capital requirements by utilizing internal models over standardized approaches. Neglecting these deviations could inadvertently result in unjustified variability in regulatory capital requirements and exaggerated capital reductions, something institutions using internal models could potentially exploit.
- Prudential Filters on Government Bonds: A potential issue on the horizon is the possibility of reinstating prudential filters for the accounting of unrealised losses on government bonds. Previously, the EU had these filters in place until the end of 2022 due to an exemption during the pandemic crisis. The use of these filters should be confined strictly to periods of exceptional crises, and reinstating them at this time could warp the risk landscape.
- Empowering Prudential Authorities: To effectively execute their mandates, prudential authorities need to be sufficiently empowered and trusted. Rigorous scrutiny is essential for strong supervision, and can only be achieved if regulatory bodies are given adequate authority.
- Role Expansion for ECB: Concerns exist regarding the apparent reluctance to allow the European Central Bank (ECB) a broader role in ensuring that competent and experienced individuals occupy leadership roles within banks, particularly the larger ones. This hesitancy needs addressing, as the "fit and proper" requirement for bank managers is a fundamental prerequisite for maintaining strong and effective governance.
Looking ahead, the proposed changes in the EU Banking Package aim to strengthen financial stability and spur the financing ofthe economy, with an increasing focus on environmental, social, and governance (ESG) risks. In this regard, there is a growing need for financial institutions to adapt to the evolving landscape of financial risks, especially those associated with climate change and other environmental risks.
As we move forward, it is essential to enhance the sustainability of the banking sector. In pursuit of this objective, the EU Banking Package suggests the integration of ESG risks into the risk management frameworks of financial institutions. Specifically, banks will be required to incorporate these risks into their internal capital adequacy assessment processes. This means that they will need to assess their exposure to these risks and ensure they have sufficient capital to cover potential losses.
Furthermore, the EU Banking Package proposes to simplify the existing regulatory framework for market risk. This would involve implementing binding capital requirements for market risk, based on the final Fundamental Review of the Trading Book (FRTB) standards in Union law. Under these reforms, institutions with medium-sized trading books would have the option to employ a simplified standardised approach to calculate their own funds requirements for market risk.
On the operational risk front, the Basel Committee on Banking Supervision (BCBS) has revised the international standard following the 2008-2009 financial crisis. The new standard aims to provide a more risk-sensitive approach by replacing all existing methodologies with a single non-model-based method for estimating operational risk capital requirements. This measure aims to streamline the operational risk framework, diminishing the likelihood of disparities in capital requirements across various institutions.
On the disclosure front, the proposal also seeks to reduce the compliance burden for institutions and enhance the comparability of disclosures. To achieve this, the EU Banking Package proposes the establishment of a centralised, web-based platform for the disclosure of information and data submitted by institutions. This platform will serve as a single point of access for all institutional disclosures, thereby improving transparency and facilitating comparison across different institutions.
Overall, the EU Banking Package represents a significant step forward in strengthening the resilience of the European banking sector. Through the enactment of these reforms, the EU endeavors to construct a resilient and sustainable banking sector, capable of fostering economic recovery and growth in the aftermath of the pandemic. These changes will also play a crucial role in promoting financial stability and preventing future financial crises.
It is clear that the path forward requires a balance between maintaining financial stability and fostering economic growth. This will require the ongoing commitment of all stakeholders - including regulatory bodies, financial institutions, and policymakers - to ensure the successful implementation of these reforms. With these efforts, the EU can build a banking sector that is not only resilient but also capable of supporting long-term sustainable growth.
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