Basel III – EU

The EU has implemented the Basel III framework through amendments to the Capital Requirements Regulation (CRR 3) and Capital Requirements Directive (CRD 6). Both proposals were published in the Official Journal of the EU in June 2024.

The Capital Requirements Regulation 3 introduces several key aspects:

• Output Floor – Introduction of the output floor which sets a floor to total RWAs calculated under internal models at 72.5% of those calculated under standardised approaches. The output floor aims to reduce unwarranted variability and increase the comparability of capital ratios of banks using internal models.
• Credit Risk – The standardised approach for credit risk (SA-CR) has being revised to increase risk sensitivity. There are also restrictions on the use of the Advanced Internal Ratings Based (A-IRB) approach.
• Credit Valuation Adjustment (CVA) Risk – Revisions to better capture CVA risk and align with several adjustments to the market risk framework.
• Operational Risk – The operational risk framework is being revised to better reflect the risks faced by banks.
• Market Risk – CRR 3 incorporates the Fundamental Review of the Trading Book (FRTB) and introduces additional measures to address market risk.

The Capital Requirements Directive 6 also introduces several key aspects that EU Member States will have to transpose into local law including:

• Supervisory Powers & Sanctions – Increased supervisory oversight for competent authorities to assess risk.
• Third Country Branches – Additional requirements for third country banks that operate within the EU.
• ESG Risks – Requirements for banks to integrate ESG and sustainability risk into their overall risk management process.

The challenge affecting the securities finance industry is the potentially significant and disproportionate increase in the amount of capital banks need to hold under the Output Floor for credit risk in relation to their securities borrowing activity. In particular, the counterparty risk weights for most principal lenders under the standardised approach used in the Output Floor increase from low numbers today (typically around 10% under IRB) to 100%, alongside other increases in RWAs for banks at the same time.

While the standardised approach applies by default, banks can obtain permission to use their internal models under the IRB approach.

• A large portion of banks, particularly larger institutions, have been using the IRB approach to assess the risk of counterparties that they are exposed to.
• Under the IRB approach, low-risk counterparties receive low counterparty risk weights (of around 10%, for example, for a low-risk fund).
• For banks with IRB permission, if the Output Floor is binding, then (72.5% of) the standardised approach RWAs applies.
• Under the standardised approach, counterparty risk weights are split into buckets set at 0%, 20%, 50%, 75%, 100% and 150%.
• Counterparties without external credit ratings default to a 100% risk weight. Pension funds, mutual/retail funds and UCITS, for example, are typically not rated by credit rating agencies and will therefore default to 100% risk weight. They fall under the ‘corporate’ bucket because they are not sovereigns or institutions (i.e., banks).
• The effect of the increased capital requirements under the new Output Floor will be most noticeable, therefore, in the case of low risk, financially sound but unrated funds, from where the majority of supply for SFTs derives (see pie chart below).

ISLA believes that the proposed treatment of exposures to unrated low-risk counterparties could have an adverse impact on the global securities lending market.

For more information on how the Basel III framework will impact Securities Lending and Borrowing participants, please see:

• Prudential Banking Rules: Explanatory Note
• Prudential Banking Rules: Basel III Endgame & the Buy Side

ISLA has been proactively engaging with the European Commission and the co-legislators to advocate for a better treatment of RWA for unrated funds which are considered in the rules in the same way as unrated corporates.

The European Union (EU) has applied a more generous risk weight rule for unrated corporates than the original Basel III rules, to the output floor, allowing banks to allocate investment grade counterparties a 65% risk weight without affecting non-investment grade unrated counterparties, which remain at 100%. This however will result in an overall risk weighting of significantly less than 100% and is one reason why the European Central Bank and the European Banking Authority (EBA) are unhappy about this approach, raising concerns this might not be compliant with the Basel guidelines. These EU arrangements have been described by the European Commission (EC) as transitional in nature, with a review expected in 2028.

ISLA has proposed that the rules identify a category of core counterparties whose stability and soundness justifies a significantly lower risk weight for the purposes of credit risk and counterparty-credit risk under the standardised approach.

One possibility would be to set a risk-weighting of 20% for such counterparties, thus placing them on a prudential footing comparable to the CRR risk weighting allocated to general unsecured loans to well-rated corporates, and as well as to loans to well-rated banks, under the standardised approach (See CRR Article 122).

If you wish to participate in discussions around Basel III – please sign up to ISLA’s Regulatory Steering group. For enquiries, please contact regtech@isalemea.org