CRR III: Credit Risk for the Internal Ratings Based Approach

Capital Requirements Regulation III (CRR III): A New Framework for EU Banks

The European Union's banking landscape is being fundamentally reshaped by the implementation of the Capital Requirements Regulation III (CRR III). This pivotal legislation is the cornerstone of the EU's strategy to bolster financial stability, enhance bank resilience against economic shocks, and fully align with the latest international prudential standards. For any financial institution operating within the EU, a deep understanding of the origins, primary objectives, and official implementation timeline of CRR III is essential for navigating the evolving regulatory environment, particularly concerning the management of credit risk.

The Genesis of CRR III: From Basel III to EU-Specific Regulation

The Capital Requirements Regulation III, formally designated as Regulation (EU) 2024/1623, serves as the EU's legislative vehicle for enacting the final elements of the Basel III international framework. These global standards, colloquially known within the financial industry as "Basel IV," were developed by the Basel Committee on Banking Supervision (BCBS) in direct response to the systemic vulnerabilities revealed by the 2008 global financial crisis. The core aim of these reforms is to fortify the global banking system by:

• Increasing the quality and quantity of regulatory capital.
• Refining the methodologies for measuring risk.
• Introducing new prudential backstops to prevent excessive risk-taking.

As the third iteration of this regulatory framework in the EU, CRR III builds upon the foundations established by its predecessors, CRR I and CRR II. It introduces significant refinements to capital requirement calculations, addresses both established and emerging risks, such as those linked to Environmental, Social, and Governance (ESG) factors, and aims to improve transparency across the sector.

Crucially, the transition from the global Basel III standards to the EU-specific CRR III is not a simple transposition. It represents a deliberate adaptation by EU legislators to tailor these principles to the unique characteristics of the Union's diverse banking sector. This process introduces specific calibrations and transitional periods that differentiate CRR III from a direct application of the Basel accords, creating distinct compliance challenges for institutions.

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Capital Requirement Regulation (CRR): EBA RTS

EBA’s consultation on the Capital Requirements Regulation (CRR) is pivotal for banks, especially in the EU. It addresses changes in risk models under FRTB, impacting risk management and capital requirements.

GrandAlessandro Micagni

Core Objectives and Key Pillars of CRR III

The CRR III framework is structured around several key objectives designed to create a more secure and competitive EU banking system. These goals directly impact how banks manage their capital and approach credit risk.

• Strengthen Financial Stability and Credit Risk Management: A primary goal is to enhance overall financial stability. CRR III champions the use of more standardized approaches for calculating risk-weighted assets (RWAs), particularly for credit risk, thereby limiting the benefits derived from internal ratings-based (IRB) models in certain portfolios. This promotes consistency, improves the comparability of capital ratios between banks, and prevents the underestimation of underlying risks.
• Enhance Supervisory Powers and Transparency: The regulation provides supervisory authorities with more potent tools to monitor and mitigate risks, including those related to ESG. This involves enhanced stress testing, more rigorous Supervisory Review and Evaluation Processes (SREP), and expanded Pillar 3 disclosure requirements. These mandates demand greater transparency from banks on their credit risk profiles, capital adequacy, and management of climate-related financial risks.
• Ensure Proportionality and Competitiveness: Recognizing the diverse nature of the EU banking sector, CRR III embeds the principle of proportionality. It seeks to limit excessive increases in capital requirements and reduce the compliance burden on smaller, less complex institutions (SNCIs). This approach helps maintain the global competitiveness of European banks by ensuring regulatory demands are appropriate for an institution's size and risk profile.

Official Timeline for CRR III and CRD VI Implementation

Adherence to the official timeline is critical for successful CRR III compliance.

• Publication: Regulation (EU) 2024/1623 (CRR III) and the accompanying Capital Requirements Directive VI (CRD VI) were published in the Official Journal of the European Union on June 19, 2024.
• Entry into Force: The regulation formally entered into force 20 days later, on July 9, 2024.
• Application Dates:
  • The majority of CRR III provisions, including many of the new rules for credit risk, will apply from January 1, 2025.
  • The implementation of the new market risk framework (Fundamental Review of the Trading Book - FRTB) is deferred by one year to January 1, 2026.
  • EU Member States are required to transpose the CRD VI directive into their national laws by January 11, 2026.

The European Banking Package: How CRR III and CRD VI Work Together

The Capital Requirements Regulation III (CRR III) is not a standalone rule but the centerpiece of a broader legislative update known as the European Banking Package. This package pairs CRR III with the Capital Requirements Directive VI (CRD VI) to comprehensively overhaul the EU's prudential rulebook. Understanding their distinct yet symbiotic roles is essential.

This dual structure uses a Regulation for directly applicable rules and a Directive for objectives requiring integration into national law.

• Capital Requirements Regulation III (CRR III): A Directly Applicable Rulebook As a regulation, CRR III applies uniformly and directly across all EU Member States. It establishes the detailed quantitative requirements for banks and investment firms. Its scope primarily covers:
  • Pillar 1 Minimum Capital Requirements: Detailed rules for calculating capital for credit risk, market risk, operational risk, and Credit Valuation Adjustment (CVA) risk.
  • The Output Floor: Sets a limit on the reduction of capital requirements derived from internal models.
  • Liquidity and Funding: Rules governing the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR).
  • Pillar 3 Disclosures: Mandates for public disclosures and supervisory reporting, enhancing market transparency.
• Capital Requirements Directive VI (CRD VI): A Framework for National Law As a directive, CRD VI sets objectives that each Member State must transpose into its own national laws, allowing for adaptation to local legal systems. It complements CRR III by covering:
• Bank Governance and Risk Management: Internal structures, board oversight, and remuneration policies.
• Supervisory Powers: The Supervisory Review and Evaluation Process (SREP), sanctions, and other corrective measures available to regulators.
• Capital Buffers: Frameworks for various capital buffers (e.g., conservation, counter-cyclical).
• Third-Country Branches (TCBs): Establishes a harmonized regime for the authorization and supervision of branches from non-EU countries.

Harmonizing Supervision and Driving Transparency under CRR III

A core objective of the Banking Package is to create a more consistent supervisory environment and increase transparency regarding bank risks, including credit risk.

Strengthening the Supervisory Toolkit

CRD VI equips national competent authorities (NCAs) and the European Central Bank (ECB) with stronger, more harmonized powers. This includes stricter rules for imposing sanctions and mandating corrective actions when a bank’s credit risk management or capital levels are deemed inadequate.

Enhancing Transparency Through Pillar 3 Disclosures

CRR III significantly expands the Pillar 3 public disclosure requirements to foster greater market discipline. Banks must now provide more granular and standardized information on key risk areas. Enhanced disclosures include:

• Detailed breakdowns of credit risk exposures under both standardized and internal ratings-based (IRB) approaches.
• The quantitative impact of the output floor on capital calculations.
• Exposures related to market risk, CVA risk, and operational risk.
• Comprehensive data on Environmental, Social, and Governance (ESG) risks.

The Central Role of the European Banking Authority (EBA)

The European Banking Authority (EBA) is tasked with ensuring the consistent application of the entire package. The EBA develops crucial technical standards that provide the granular details for implementation, including:

• Regulatory Technical Standards (RTS)
• Implementing Technical Standards (ITS)
• Guidelines

These standards specify the precise methodologies for calculating risk-weighted assets (RWAs) for credit risk, define reporting templates, and detail the format of Pillar 3 disclosures, driving supervisory convergence across the EU.

Table 1: Key Legislative Components of the EU Banking Package

Credit Risk Under CRR III: A Deep Dive

Credit risk, the potential for loss from a borrower's failure to repay a debt, represents the most significant risk for the majority of banks. The Capital Requirements Regulation III (CRR III) introduces profound changes to how credit risk is measured and managed, overhauling both the Standardised Approach (SA) and the Internal Ratings-Based (IRB) Approach.

The Standardised Approach (SA) for Credit Risk: A Complete Overhaul

The SA for credit risk (SA-CR) has been significantly revamped in CRR III. The primary objectives of this reform are to:

• Enhance the risk sensitivity and granularity of risk-weighted asset (RWA) calculations.
• Reduce mechanistic reliance on external credit ratings for some asset classes.
• Provide a more credible and robust benchmark for the output floor, making the SA a cornerstone of the entire capital framework.

This overhaul involves a more detailed segmentation of exposure classes and a comprehensive recalibration of risk weights.

Revised Risk Weights for Key Exposure Classes in the SA

Corporate Exposures

• Rated Corporates: Risk weights are tied to the external rating (ECAI), ranging from 20% for the highest credit quality to 150% for lower-rated entities.
• Unrated Corporates: The default risk weight is 100%.
  • Transitional Provision (Output Floor): Until December 31, 2032, a 65% risk weight may be applied to exposures to investment-grade unrated corporates (with a PD ≤ 0.5%) for the specific purpose of calculating the output floor. This measure supports lending to viable corporates without external ratings.
• SME Supporting Factor: CRR III maintains an adjustment factor that reduces the capital required for qualifying Small and Medium-sized Enterprise (SME) exposures to encourage lending to this vital sector.
• Specialised Lending: This is now a distinct sub-category.
  • Rated: Follows standard corporate risk weights.
  • Unrated:
• Object & Commodity Finance: 100%
• Project Finance (Pre-operational): 130%
• Project Finance (Operational): 80% if high-quality criteria are met; otherwise 100%. The EBA is tasked with defining these criteria in detail.

Institutional Exposures

• Rated Institutions: Risk weights are based on external ratings, ranging from 20% to 150%.
• Unrated Institutions (SCRA): CRR III replaces reliance on sovereign ratings with the new Standardised Credit Risk Assessment Approach (SCRA). Banks must classify unrated institutions based on due diligence into one of three grades:
  • Grade A: 30% risk weight (or 20% for short-term).
  • Grade B: 75% risk weight.
  • Grade C: 150% risk weight.
• Short-Term Exposures: Exposures to institutions with an original maturity of three months or less can receive preferential risk weights.

Retail Exposures

• General Treatment: A 75% risk weight applies to qualifying retail exposures (generally to individuals or SMEs where total exposure is below EUR 1 million).
• Transactor Exposures: A lower 45% risk weight can be used for low-risk revolving credit facilities (e.g., credit cards) that are regularly paid off.
• Currency Mismatch: A 1.5x risk weight multiplier is applied to retail loans where the loan currency differs from the borrower's income currency, directly addressing foreign currency lending risk. The final risk weight is capped at 150%.

Real Estate Exposures: A Granular Overhaul

This is one of the most complex reforms in the SA, introducing a more granular, risk-sensitive framework.

• Key Distinction: Income-Producing Real Estate (IPRE): A new classification for loans where repayment depends materially on the cash flow from the property itself. This requires robust internal assessment policies.
• Risk Weighting Methodologies:
  • Loan-Splitting Approach (for non-IPRE): The portion of a loan up to 55% of the property's value receives a preferential risk weight (20% for Residential, 60% for Commercial). The remaining portion is treated as unsecured.
  • Whole Loan Approach (for IPRE): The risk weight is determined by Exposure-to-Value (ETV) buckets, ranging from 20% to 70% for Residential IPRE and 60% to 110% for Commercial IPRE.
• Stricter Property Valuation Rules: Valuations must be more conservative, performed by independent valuers, and adjusted for sustainability factors. The recognized value is often capped at the lower of the current value or a multi-year historical average (6 years for residential, 8 for commercial).
• Dedicated Treatment for ADC Exposures: Land Acquisition, Development, and Construction (ADC) loans are now a distinct class, generally receiving a 150% risk weight. A lower 100% risk weight is possible for residential ADC if risk-mitigating conditions (like significant pre-sales) are met, as specified in EBA guidelines.
• Transitional Measures: Until December 31, 2032, Member States may permit a more favourable risk weight treatment for certain low-risk residential mortgages when calculating the output floor.

Equity Exposures

• General Treatment: A 250% risk weight is applied to most equity investments.
• Exceptions for Long-Term Investments:
  • Listed, long-term equity: 100% risk weight.
  • Unlisted, long-term equity: 400% risk weight, reflecting higher illiquidity and valuation risk.
• Legislative Program Exposures: A 100% risk weight may apply to equity investments made under specific government-backed programs.

Due Diligence for External Ratings

A fundamental principle reinforced in CRR III is that banks cannot mechanistically rely on external credit ratings. Even when using the SA-CR with external ratings, institutions are mandated to perform their own due diligence on the creditworthiness of the obligor or transaction. 

• Article 113 of CRR III stipulates that if an institution's internal assessment of an exposure identifies higher risk characteristics than those implied by the external credit rating assigned by a nominated ECAI, the institution must assign a risk weight that corresponds to at least one credit quality step higher (i.e., a less favorable credit quality step) than that indicated by the external rating. 
• This "use test" for external ratings applies to most exposure classes where the use of external ratings is permitted. It effectively means that external ratings act as a floor for risk assessment, not a ceiling. This requirement underscores the regulatory expectation that banks maintain adequate internal credit assessment capabilities, even if they primarily rely on the SA-CR. It introduces an element of supervisory judgment regarding the adequacy of a bank's internal due diligence processes and can be a source of dialogue with competent authorities.

Table 2: Standardised Approach - Illustrative Key Changes in Risk Weights for Selected Exposures

The Internal Ratings-Based (IRB) Approach: New Safeguards and Limitations

The Internal Ratings-Based (IRB) Approach allows sophisticated banks to use their own models to estimate credit risk parameters, Probability of Default (PD), Loss Given Default (LGD), and Exposure at Default (EAD), for calculating capital requirements. CRR III introduces major revisions to this framework, designed to curb the variability of risk-weighted assets (RWAs), improve comparability between banks, and restore credibility to internal modelling. The key changes involve restricting the use of the most advanced models, introducing hard floors for risk parameters, and providing more flexibility in the application of IRB.

Restrictions on the Advanced IRB (A-IRB) Approach

One of the most significant changes in CRR III is the restriction on the scope of the Advanced IRB (A-IRB) approach, where banks model all three risk parameters (PD, LGD, and EAD). The rationale is to reduce model risk in "low-default portfolios" where reliable loss data is scarce.

The A-IRB approach is now prohibited for the following exposure classes, forcing a move to the Foundation-IRB (F-IRB) or Standardised Approach:

• Large Corporates: Defined as those with a consolidated annual turnover exceeding €500 million.
• Institutions: This includes exposures to banks and other credit institutions.
• Other Financial Sector Entities: Encompasses a range of non-bank financial institutions.

Furthermore, the IRB approach (both Advanced and Foundation) has been removed entirely for all equity exposures. These must now be treated under the Standardised Approach, simplifying their capital treatment and removing a source of model-driven RWA variability.

Introduction of Input Floors for Key Risk Parameters

To ensure a minimum level of prudential conservatism, CRR III introduces "input floors," which are hard limits below which a bank's internal estimates for PD, LGD, and Credit Conversion Factors (CCFs) cannot fall for regulatory purposes.

Probability of Default (PD) Floors A bank's estimated PD used in its RWA calculations cannot be lower than:

• 0.05% for exposures to corporates, institutions, and central governments.
• 0.03% for exposures to regional governments and public sector entities.
• 0.10% for Qualifying Revolving Retail Exposures (QRRE) that are revolvers.
• 0.05% for all other retail exposures.

Loss Given Default (LGD) Floors The minimum LGD values are highly dependent on the exposure type and the presence of collateral.

• For Corporate and Institutional Exposures:
  • Unsecured Exposures: The LGD floor is generally 25%.
  • Secured Exposures: Floors are lower, falling to 0% for exposures fully secured by eligible financial collateral.
• For Retail Exposures:
• Unsecured QRRE: The LGD floor is 50%.
• Other Unsecured Retail: The LGD floor is 30%.
• Secured by Residential Property: The LGD floor is fixed at a conservative 5%, regardless of the level of collateralization.

Credit Conversion Factor (CCF) Floors For banks using their own CCF estimates for off-balance sheet items, the floor is generally set at 10%.

Greater Flexibility: Roll-Out and Permanent Partial Use (PPU)

While restricting models in some areas, CRR III provides banks with more strategic flexibility in how they apply the IRB framework, moving away from a rigid "all or nothing" principle.

This is achieved through refined provisions for Permanent Partial Use (PPU), which allows a bank to use the Standardised Approach for certain portfolios (e.g., immaterial business units) while applying IRB to others. The regulation also provides more explicit pathways for banks to revert to less sophisticated approaches (from A-IRB to F-IRB or SA) for specific exposure classes, subject to prior supervisory permission. This flexibility, combined with the new A-IRB restrictions and the impact of the output floor, encourages banks to strategically assess where maintaining complex IRB models provides the most benefit. The EBA is mandated to develop Regulatory Technical Standards (RTS) to specify the conditions for these provisions.

EBA Guidance on CRR III: Operationalizing IRB Model Changes

To facilitate a smooth transition to the new framework, the European Banking Authority (EBA) issued a crucial statement on July 17, 2024. This guidance clarifies the practical application of CRR III for banks using the Internal Ratings-Based (IRB) Approach for credit risk. The central message underscores the need for proactive, continuous dialogue between institutions and their supervisors ahead of the January 1, 2025, application date.

Communicating the Future IRB Model Landscape

The EBA emphasizes that banks must communicate their intended IRB model strategy to supervisors well in advance. This ensures alignment and helps mitigate last-minute compliance issues. Institutions are expected to provide a detailed plan that covers:

• Scope of Application: A clear declaration of which exposure classes will be covered by the IRB Approach.
• Rating Systems: Specification of the rating systems that will be used for each class.
• Partial Use and Roll-Out: Detailed plans concerning the Permanent Partial Use (PPU) of the Standardised Approach or any roll-out of new IRB models.
• Reversion Plans: Any intention to revert from IRB to a less sophisticated approach, specifying whether it requires permission (Article 149) or notification (Article 494d).
• Mandatory Changes: An implementation plan for any mandatory reversals to the Standardised Approach and the adoption of new Credit Risk Mitigation (CRM) requirements.

Assessing and Categorizing CRR III-Induced Model Changes

A key part of the EBA's guidance is clarifying how to treat model changes under the existing materiality assessment framework (Delegated Regulation (EU) No 529/2014).

• Performance-Impacting Changes: Any CRR III-driven update that is assessed as impacting the performance of an existing rating system must be bundled and submitted to supervisors for permission (if material) or notification.
• Non-Performance-Impacting Mandatory Changes: Critically, the EBA clarifies that mandatory changes that are purely mechanical do not require a formal model change approval process. This provides significant pragmatic relief for banks. Examples include:
  • Applying the new regulatory PD, LGD, and CCF input floors.
  • Using prescribed regulatory LGD and CCF values.
  • Removing the 1.06 scaling factor previously applied to IRB RWAs.
  • While formal approval is not needed, institutions must still communicate the RWA and capital impact of these changes to their supervisor.
• Changes Due to Reduced Scope: If a model's range of application is materially reduced, an ex-ante notification is required. Banks must then review the model to ensure it remains performant and properly calibrated for its new, smaller scope.

Implementation Plans and Pragmatic Sequencing for Complex Updates

The EBA guidance encourages a forward-looking approach and provides pragmatic sequencing for the most complex model updates, allowing banks to avoid inefficient rework while awaiting final technical standards.

Credit Conversion Factor (CCF) Estimates: The implementation is sequenced. Banks must apply the new CCF input floors by January 1, 2025. However, more complex methodological changes (like the introduction of a 12-month fixed horizon) can be deferred until the final EBA Guidelines on the topic are published. Any "temporary non-compliance" during this period must be discussed and managed with the competent authority.

Definition of Default: Similarly, the EBA advises institutions not to prematurely update their models for the definition of default. They should wait until the relevant EBA Guidelines are revised and finalized. This practical stance allows banks to focus on immediate CRR III requirements first, ensuring a more orderly and efficient implementation process.

Credit Risk Mitigation (CRM) in CRR III: Adapting to New Standards

Credit Risk Mitigation (CRM) techniques are essential tools for banks to reduce their credit risk exposures and, consequently, their capital requirements. The Capital Requirements Regulation III (CRR III) introduces significant revisions to the rules governing CRM, aiming to ensure that the capital relief granted accurately reflects genuine risk reduction. These changes impact the eligibility of collateral, the recognition of guarantors, and the calculation of Loss Given Default (LGD).

Revised Eligibility and Valuation Rules for Collateral

CRR III tightens the framework for recognizing collateral, with a strong focus on prudent valuation, especially for real estate.

• Financial Collateral: The list of eligible debt securities that can be used as collateral has been updated, with continued reliance on high credit quality. Key principles include:
  • Volatility Adjustments (Haircuts): To account for potential price changes, haircuts must be applied to the value of financial collateral. These haircuts vary based on the asset type, its maturity, and are increased if the collateral is not re-valued daily.
  • Currency Mismatch: An additional haircut is applied if the collateral's currency is different from the currency of the exposure it is meant to hedge.
• Immovable Property (Real Estate): The rules for real estate collateral have been made significantly more conservative to prevent the build-up of risk from property bubbles.
  • Stricter Valuation Principles: Valuations must be performed independently by qualified experts using prudently conservative criteria. A crucial new requirement is the explicit consideration of sustainability factors and an adjustment for long-term value, excluding speculative price increases.
  • Valuation Cap: The recognized value of a property is capped. It generally cannot exceed the average value measured over the last six years for residential property or eight years for commercial property, preventing over-reliance on recent market peaks.
  • Energy Efficiency Exception: An exception to the cap is made for property modifications, such as significant energy efficiency upgrades, that unequivocally increase the property's value.
• Other Collateral: The regulation specifies LGD values and haircuts for other collateral types like receivables and other physical assets. The EBA is also mandated to develop Regulatory Technical Standards (RTS) to further specify eligibility criteria.

Updated Rules for Unfunded Credit Protection (Guarantees & Derivatives)

The framework for recognizing guarantees and credit derivatives has been refined to ensure their reliability as risk mitigants.

• Eligible Guarantors: The list of eligible protection providers remains focused on highly-rated entities, including central governments, public sector entities, institutions, and multilateral development banks. A corporate can also be an eligible guarantor if the bank uses the IRB approach for its direct exposures to that same corporate.
• Credit Insurance: The EBA has been actively reviewing the role of credit insurance as an eligible form of CRM, signaling a regulatory focus on ensuring that all forms of credit protection are treated with appropriate prudence.
• Internal Hedges: For a bank to recognize a credit derivative from its own trading book as a hedge for a banking book exposure, the market risk of that internal hedge must be perfectly offset by another transaction with an eligible third-party provider.

The Impact of New CRM Rules on LGD Calculation

The changes to CRM directly influence the calculation of Loss Given Default (LGD), a key driver of credit risk capital requirements.

• Under the Standardised Approach (SA): For exposures covered by an eligible guarantee, banks typically use a "substitution approach." This allows the bank to substitute the risk weight of the lower-risk guarantor for the risk weight of the original, higher-risk obligor on the covered portion of the exposure.
• Under the Internal Ratings-Based (IRB) Approach: For banks with permission to model their own LGD, the effect of collateral is incorporated directly into their models. However, a critical change in CRR III is that these LGD estimates are now floored at a minimum level. This means that even with high-quality collateral or guarantees, the capital relief from CRM is capped by the new LGD input floors, ensuring a baseline level of capital is always held against the exposure.

Credit Conversion Factor (CCF) Updates for Off-Balance Sheet Items

CRR III significantly revises the Credit Conversion Factors (CCFs), which are used to determine the on-balance sheet equivalent value of off-balance sheet items like undrawn loan commitments and guarantees. These changes impact how credit risk capital is calculated under both the Standardised and IRB approaches.

Under the Standardised Approach (SA) The framework for assigning CCFs has been made more granular. Off-balance sheet items are now mapped to one of five prescribed risk buckets: 10%, 20%, 40%, 50%, or 100%. A critical consequence of this new bucketing system, detailed in Regulatory Technical Standards (RTS) from the EBA, is the effective elimination of the 0% CCF for many commitments previously considered very low risk. These items now typically attract a 10% CCF.

Under the Internal Ratings-Based (IRB) Approach For banks with supervisory permission to use their own CCF estimates (IRB-CCF), CRR III introduces a crucial safeguard: an input floor of 10%. This means a bank’s internal CCF estimate cannot fall below this regulatory minimum.

The EBA has also provided pragmatic sequencing for more complex IRB-CCF model updates. While the 10% floor is effective from January 1, 2025, the implementation of other technical changes, such as the requirement for a "12-month fixed horizon" in CCF estimation, can be deferred until the EBA finalizes its specific guidelines on the matter.

The New Treatment of Unconditionally Cancellable Commitments (UCCs)

One of the most impactful changes relates to Unconditionally Cancellable Commitments (UCCs), which were often previously assigned a 0% CCF.

The new framework introduces a baseline 10% CCF for UCCs, reflecting the risk that even these commitments cannot always be cancelled in time to prevent a loss. Recognizing the potential economic impact of this change, CRR III includes transitional arrangements that phase in this 10% CCF over time to avoid an abrupt restriction of credit.

• Definition: The definition of a UCC has been clarified. The bank must have the absolute contractual right to cancel the commitment at any time without prior notice, or the cancellation must be automatic upon the borrower's credit deterioration.
• The Rare 0% CCF Exception: A 0% CCF is still possible but only under extremely strict conditions. The arrangement must involve, among other things, no commitment fees, a full creditworthiness assessment before every single drawdown, and the bank must retain full authority over each drawdown decision.

The overall shift from a 0% to a 10% CCF for many common banking products will increase risk-weighted assets (RWAs), but the transitional provisions and EBA guidance provide a managed pathway for this implementation.

Table 3: Credit Risk Mitigation - Key Changes to Collateral and Guarantees

The Output Floor in CRR III: A New Paradigm for Bank Capital

One of the most transformative elements introduced by CRR III is the output floor. This mechanism acts as a powerful prudential backstop, fundamentally altering how banks calculate their capital requirements. Its primary goals are to reduce excessive variability in risk-weighted assets (RWAs) across banks, enhance the comparability of capital ratios, and restore credibility to internal models by ensuring they do not result in capital levels that are deemed unduly low.

How the Output Floor Works: The 72.5% Rule

The output floor operates by setting a lower limit on the capital benefits a bank can derive from using its internal models. It directly links a bank's model-based outcomes to the more conservative Standardised Approaches.

The core calculation is straightforward. A bank’s final Total Risk Exposure Amount (TREA), the denominator of its capital ratios, must be the higher of two figures:

1. Its Un-floored TREA (U-TREA): This is the bank's RWA calculated using its own approved internal models where permitted (e.g., the IRB approach for credit risk) and the Standardised Approaches for all other exposures.
2. 72.5% of its Standardised TREA (S-TREA): This is a benchmark figure calculated as if the bank were using only the Standardised Approaches for all of its risk types.

This means that even if a bank’s advanced models produce very low RWAs, its final regulatory capital requirement cannot be less than 72.5% of the amount calculated under the simpler, standardized framework.

Defining the Standardised TREA (S-TREA)

The S-TREA is the foundation of the output floor calculation. It must be a "pure" standardized figure, with no influence from internal models. This requires calculating capital requirements as follows:

• Credit Risk: Must use the Standardised Approach (SA-CR) for all credit and counterparty credit risk exposures.
• Market Risk: Must be calculated without using the alternative internal model approach (A-IMA).
• Operational Risk: Must use the single new Standardised Approach for operational risk.
• CVA Risk: Must use the standardised or basic approaches for CVA risk.

The Strategic Implications of the Output Floor

The introduction of the output floor has profound strategic consequences for banks that use internal models.

• Significant Operational Burden: The most immediate impact is the requirement for all IRB banks to maintain the systems and data necessary to calculate their entire portfolio's RWAs under two parallel systems: their internal models and the new, more granular Standardised Approaches.
• Reassessment of IRB Models: For banks where the output floor becomes the binding capital constraint, the economic benefit of developing and maintaining expensive IRB models for certain portfolios may be significantly reduced. This could lead institutions to strategically revert to the simpler Standardised Approach for specific asset classes where the capital benefit from modelling no longer justifies the cost and complexity.

Phased Implementation Schedule of the Output Floor (2025-2030)

To prevent a sudden "capital shock" across the banking sector, CRR III introduces the 72.5% output floor through a gradual, multi-year phase-in. This gives banks time to adapt their capital plans and business strategies. The applicable percentage of the Standardised TREA (S-TREA) used for the floor calculation will increase annually as follows:

• 2025: 50%
• 2026: 55%
• 2027: 60%
• 2028: 65%
• 2029: 70%
• From January 1, 2030, onwards: 72.5% (fully phased-in)

While the regulatory requirement is staggered, market analysts and supervisors will expect banks to manage their capital based on the "fully loaded" 72.5% impact well before 2030.

Scope of Application: Solo and Consolidated Levels

To ensure its effectiveness, the output floor is designed to be comprehensive. As a general rule, it applies at both the consolidated (group) level and the solo (individual entity) level. This dual application prevents banks from concentrating the benefits of internal models in specific subsidiaries to circumvent the floor's impact at the group level.

However, CRR III provides a National Discretion. A Member State can choose to waive the application of the output floor at the solo level for banks within a purely national group, provided the parent institution applies the full output floor at the consolidated level. This can facilitate more efficient capital management within national banking groups.

Interaction with Pillar 2 Capital Requirements

The output floor is a Pillar 1 requirement, forming the base of a bank's capital stack. On top of this floored amount, banks must still hold capital for Pillar 2 Requirements (P2R) and various capital buffers.

A key concern is the potential for "double counting" risks if a bank becomes bound by the output floor. The EBA has provided guidance on this interaction, clarifying that supervisors should review existing P2R add-ons. If an add-on was previously imposed to cover risks from "model deficiencies," and the output floor is now deemed to adequately cover those same risks, supervisors should adjust the P2R to avoid penalizing the bank twice for the same underlying risk. This supervisory review is critical to ensure the overall capital increase is not unduly punitive.

Key Transitional Provisions for the Output Floor Calculation

To further soften the impact during the phase-in period, CRR III includes several important transitional rules. These provisions allow for the use of temporarily more favorable risk weights only when calculating the S-TREA for the purposes of the output floor.

• Unrated Corporate Exposures: Until the end of 2032, a 65% risk weight (instead of the standard 100%) can be applied to exposures to unrated corporates that are deemed investment grade (with a PD ≤ 0.5%).
• Low-Risk Residential Mortgages: Member States can allow IRB banks to use a more favorable risk weight treatment for low-risk residential mortgages when calculating their S-TREA until the end of 2032.
• Unconditionally Cancellable Commitments (UCCs): The Credit Conversion Factor (CCF) for UCCs will be phased in for the S-TREA calculation, starting at 5% between 2025-2029 and gradually increasing to the final 10% by 2032.
• Specialised Lending (Object Finance): An 80% risk weight can be applied to high-quality, unrated object finance exposures until the end of 2032.

These targeted provisions are crucial for mitigating the output floor's immediate impact on lending to key sectors of the economy, though they add a layer of complexity to the S-TREA calculation during the transitional period.

Beyond Credit Risk: Other Key Frameworks in CRR III

While the changes to credit risk and the introduction of the output floor are cornerstones of the new regulation, CRR III also completes the EU's implementation of the final Basel III reforms by overhauling the frameworks for operational risk, market risk, and Credit Valuation Adjustment (CVA) risk.

Operational Risk: A Single New Standardised Approach (SA)

CRR III fundamentally reforms the capital treatment for operational risk by replacing all previous methodologies, including the Basic Indicator Approach (BIA), The Standardised Approach (TSA), and the complex Advanced Measurement Approaches (AMA), with a single new Standardised Approach (SA) for all institutions. This change is designed to dramatically improve simplicity and comparability across the sector.

How the New Operational Risk SA Works

The new approach calculates capital based on two main elements:

1. The Business Indicator (BI): This serves as a financial-statement-based proxy for a bank's operational risk exposure. It is calculated as a sum of interest, services, and financial components, averaged over three years.
2. The Internal Loss Multiplier (ILM): For larger institutions (with a BI over €1 billion), this multiplier can adjust the capital requirement based on the bank's own historical operational loss experience over the last 10 years. However, CRR III gives national supervisors the discretion to set the ILM to 1 for all banks in their jurisdiction, effectively neutralizing the direct link to historical losses.

Key Implications for Banks

This shift has significant consequences. Most notably, the massive investments many banks made in developing and maintaining complex AMA models are now redundant for Pillar 1 capital purposes. While the insights may still inform internal risk management (Pillar 2), the move to a single SA standardizes the capital charge, making it less tailored to an individual bank's specific risk profile and control environment.

Market Risk: Implementing the Fundamental Review of the Trading Book (FRTB)

CRR III fully incorporates the Basel Committee's Fundamental Review of the Trading Book (FRTB), representing the most significant overhaul of the market risk capital framework in over a decade.

Core Elements of the FRTB Framework

The FRTB introduces several key changes to address weaknesses exposed during the global financial crisis:

• Stricter Trading Book Boundary: Implements more objective criteria for assigning instruments to the trading book versus the banking book, aiming to reduce regulatory arbitrage.
• New Standardised Approach (A-SA): This is a far more risk-sensitive standardised method based on sensitivities to a wide range of risk factors (delta, vega, and curvature).
• New Internal Model Approach (A-IMA): For banks with supervisory approval, this approach replaces the old Value-at-Risk (VaR) measure with Expected Shortfall (ES), a more robust metric that better captures tail risk. It also imposes much stricter requirements for model validation and the treatment of Non-Modellable Risk Factors (NMRFs).
• Simplified Standardised Approach (S-SA): A simpler, less punitive option is available for institutions with small or non-complex trading activities (e.g., trading book assets below €500 million and 10% of total assets).

Implementation Timeline and Challenges

The implementation of the complex FRTB rules is a highly demanding undertaking for banks, requiring substantial investment in data, IT systems, and risk modelling capabilities.

In recognition of these challenges and to better align with global timelines, the application date for the FRTB market risk rules in the EU has been postponed by one year to January 1, 2026. This deferral provides banks with additional time to prepare for the significant operational hurdles presented by the new framework.

Credit Valuation Adjustment (CVA) Risk: A Revised Framework

CRR III introduces a fully revised framework for calculating the capital required to cover Credit Valuation Adjustment (CVA) risk. CVA is the market value of counterparty credit risk, and this capital charge is designed to protect against losses when the credit spread of a counterparty changes. The new framework aims to improve risk sensitivity, consistency, and comparability.

New Methods for Calculating CVA Capital

The previous methodologies, including the internal model method (IMM), have been replaced by a new hierarchy of approaches.

• Standardised Approach (SA-CVA): This is the new default method. It is a more risk-sensitive approach based on the sensitivities of an institution's CVA portfolio to a wide range of market risk factors, including counterparty credit spreads. Its design is closely aligned with the new market risk standards (FRTB).
• Basic Approach (BA-CVA): This is a simpler, less risk-sensitive option intended for institutions with less significant derivatives activities.
• Simplified Approach: For institutions with a very small derivatives portfolio (e.g., below a €100 billion aggregate notional), CRR III provides a simple proxy. These banks can set their CVA capital requirement equal to 100% of their capital requirement for counterparty credit risk (CCR).

Key Changes and Refinements in the CVA Framework

Alongside the new methodologies, several other important changes have been implemented.

• Removal of Internal Models: In a significant move towards standardization, the ability for banks to use their own internal models to calculate CVA capital requirements has been eliminated. This aligns with the broader regulatory theme of reducing the variability in risk-weighted assets (RWAs) that stems from complex internal models.
• Refined Scope of Application: The framework clarifies which transactions are subject to the CVA risk charge. Notably, it introduces a potential exemption for Securities Financing Transactions (SFTs), provided the CVA risk from these transactions is deemed immaterial according to criteria that the EBA will specify in Regulatory Technical Standards (RTS).
• Alignment with Market Risk Standards: The new CVA framework is designed to be highly consistent with the FRTB market risk standards. This linkage is a primary reason why the implementation timelines for both frameworks are often considered in tandem.

Industry Context and Ongoing Work

The revisions to the CVA risk framework have been a subject of significant industry focus. Financial industry associations have expressed concerns that the calibration of the new approaches, particularly the SA-CVA, could increase the cost of hedging for corporate end-users, potentially impacting market liquidity.

The framework is not yet fully finalized in its most granular details. The EBA is tasked with developing several crucial RTS to specify technical elements, including the conditions for the SFT exemption and other aspects of the SA-CVA calculation.

Implementation and Strategy: Navigating the CRR III Landscape

The introduction of the CRR III package presents a formidable challenge for financial institutions. Beyond understanding the regulation itself, banks must navigate a complex web of technical standards from the European Banking Authority (EBA), assess the impact on their capital, and make strategic decisions to adapt their business models for the new environment.

The EBA's Implementation Roadmap: Key Dates and Deliverables

The European Banking Authority (EBA) is pivotal in operationalizing CRR III, with approximately 140 mandates to develop the granular rules, Regulatory Technical Standards (RTS), Implementing Technical Standards (ITS), and Guidelines, needed for consistent application. To manage this extensive workload, the EBA has published a comprehensive, phased implementation roadmap.

Phase 1 Deliverables: Targeting the January 1, 2025 Deadline

This initial phase prioritizes the technical standards essential for the core Basel III implementation, which takes effect on January 1, 2025. Key deliverables include:

• ITS on Supervisory Reporting: These standards update the regulatory reporting framework (e.g., COREP templates) to incorporate the new requirements for the output floor, credit risk (both SA and IRB), market risk (FRTB), CVA risk, and the new operational risk SA. The final draft was published on July 9, 2024.
• ITS on Pillar 3 Disclosures: To enhance market discipline, these standards align the public disclosure formats with the new CRR III requirements, covering the same risk areas as the reporting ITS. The final draft was published on June 21, 2024.
• Other Key Technical Standards (RTS): This phase also includes crucial RTS detailing the materiality assessment for IRB model changes and the classification criteria for off-balance sheet items.

Phase 2 and Beyond: Addressing EU-Specific Mandates

Later phases of the roadmap will address requirements not directly linked to the initial Basel III rollout or those with longer implementation timelines. These deliverables, expected throughout 2025 and beyond, will cover topics such as:

• Expanded ESG risk reporting and disclosure requirements.
• Rules for exposures to shadow banking entities.
• Other EU-specific regulatory mandates.

The Technical Toolkit for Implementation

To help banks prepare their systems, the EBA provides a critical technical package, typically in the fourth quarter following the finalization of an ITS. This package includes the Data Point Model (DPM), XBRL taxonomy, and validation rules that are essential for IT departments to update their reporting systems.

Furthermore, the EBA is developing a Pillar 3 Data Hub, an initiative designed to centralize institutions' public disclosures. This will provide investors, analysts, and other stakeholders with a single electronic access point for EU-wide bank prudential data, greatly improving accessibility and comparability.

The sheer volume of these EBA deliverables means that CRR III implementation is not a single event but a continuous, multi-year process. Banks must maintain vigilant oversight of the EBA's roadmap and be prepared to adapt their systems and processes iteratively as new standards are finalized.

CRR III: Impact, Challenges, and Strategic Imperatives for EU Banks

The introduction of the CRR III package is more than a compliance update; it is a transformative event that requires banks to conduct a deep and strategic reassessment of their business models, operational capabilities, and capital planning. Navigating this new landscape successfully will be a key determinant of competitive positioning in the coming years.

Capital Adequacy: Quantifying the RWA Increase

Regular monitoring exercises by the European Banking Authority (EBA) and national supervisors provide insight into the expected capital impact.

• Overall Capital Impact: EBA analysis projects a material increase in the EU banking sector's Tier 1 minimum required capital once the framework is fully implemented. While estimates vary, figures have suggested an average increase in the mid-teens percentage-wise for the largest banks, with the output floor being a primary driver.
• Key Drivers of RWA Increases:
• Output Floor: Consistently identified as the most significant factor for banks using internal models, especially those with large, low-risk portfolios like residential mortgages.
• Credit Risk (SA & IRB): Changes to the Standardised Approach for real estate and unrated corporates, combined with new input floors and restrictions on the IRB approach, will directly increase credit risk RWAs.
• Operational Risk: The new single Standardised Approach is expected to increase capital requirements for some banks, particularly those with a high Business Indicator (BI).
• CVA and Market Risk: The revised frameworks for CVA risk and market risk (FRTB) are also expected to contribute to higher capital needs.

Influence on Lending and Business Strategy

The new capital incentives will inevitably influence lending decisions and portfolio allocation.

• SME Lending: While the SME supporting factor is retained, higher capital requirements for unrated corporates (which are often SMEs) could impact loan pricing and availability.
• Real Estate Lending: This sector faces extensive changes. The granular new rules for commercial and residential property, combined with the binding effect of the output floor on low-risk mortgage books, will likely increase the capital cost of property lending.
• ESG & Green Finance: CRR III formally integrates ESG risk into the prudential framework. Over time, this will increasingly influence risk assessments and capital allocation, likely favouring sustainable investments.

The Core Pillars of CRR III: A Summary of Key Changes

The regulation introduces several transformative changes that will redefine how banks manage risk and capital.

• A Revamped Standardised Approach (SA) for Credit Risk: The SA is no longer a simple benchmark but a more granular and risk-sensitive framework in its own right. Key changes include the detailed new rules for real estate exposures (distinguishing Income-Producing Real Estate), the due-diligence-based SCRA for unrated institutions, and a more stringent treatment for ADC exposures.
• New Safeguards for the Internal Ratings-Based (IRB) Approach: The use of internal models is now subject to significant new constraints. These include restricting the use of the most advanced models (A-IRB) for large corporates and financial institutions and introducing hard input floors for key risk parameters like Probability of Default (PD) and Loss Given Default (LGD).
• The Output Floor: A New Capital Paradigm: Arguably the most impactful change, the output floor sets a lower limit on the risk-weighted assets (RWAs) that banks can report. Phased in to reach 72.5% by 2030, it ensures that the capital benefits from internal models cannot fall below a set percentage of the capital required under the Standardised Approaches, fundamentally linking the two frameworks.
• Harmonization of Other Risk Frameworks: Beyond credit risk, CRR III introduces a new single Standardised Approach for operational risk and implements the Fundamental Review of the Trading Book (FRTB) for market risk (effective 2026), creating a more consistent prudential regime.