Almost four years after the final publication of the Basel Committee on Banking Supervision (BCBS), the EU Commission published the first draft of CRR III on October 27, 2021. The draft of the banking regulation package was the official starting signal for the implementation of the final Basel III framework ("Basel IV") at EU level. After the Council of the European Union published its negotiating position on November 8, 2022, the European Parliament presented its proposals for the revision of the CRR three months later, on February 9, 2023. Based on the implementation proposals that are now available, nothing stands in the way of the start of the interinstitutional negotiations (so-called "trilogue") and the finalization of the CRR III.

The negotiating positions differ significantly on individual points, so it remains to be seen which point of view will prevail in the end. In view of the planned entry into force of the CRR III on January 1, 2025 and the expected far-reaching implications for the banking sector, however, it is advisable to start preparing for implementation as soon as possible. In our international "Deloitte CRR III Survey" we provide you with current insights into the status of the legislative process, the main differences between the CRR III drafts and the CRR III effects on the banking market.

The following summary provides an overview of the main proposed changes from the EU Commission's CRR III draft, which include in particular the credit risk standardized approach (CRSA), the internal ratings-based approach (IRBA) and the capital requirements for operational risks. In addition, the so-called output floor will be introduced in the EU over a period of several years, which will limit the use of internal ratings and risk models in the future. On the basis of their drafts, the trilogue parties agree on the start of application and are currently proposing entry into force on January 1, 2025.

The new rules relate to all types of risk and affect all banks, regardless of whether they currently use standardized approaches or internal models to determine their risk-weighted assets (RWA). With the implementation of the output floor, all banks with internal models must implement the RWA calculations according to the standard approaches for their entire portfolio. For institutions or groups of institutions that use an internal model but are also restricted by the output floor, the effective capital requirements are regularly determined according to the RWA based on the standard approaches. Some of these banks do not yet or no longer have the necessary prerequisites to determine the RWA according to standard approaches in a regular process and have to make the corresponding investments.

The modifications that have been decided not only result in challenges in relation to the concrete implementation of the new requirements in the context of risk assessment. Rather, with a view to the changed capital requirements, the focus should also be on strategic issues, e.g. with regard to existing business areas or the usefulness of further developing internal models. This requires an early analysis of the innovations.

The EU draft of the new CRSA largely adapts the proposals of the BCBS, which should also result in a more risk-sensitive capital base in the standard approach at EU level in the future: the abolition of the country of domicile rating for unrated institutions, the extensive innovations in the derivation of risk weights for real estate financing and the privileged risk weighting of certain commitments in retail business (so-called "transactors").

In addition to the existing Basel resolutions, the CRR III draft contains numerous new proposals that should contribute to additional risk differentiation in the CRSA at EU level:

• CCF: While the conversion factors (CCF) of 10 percent and 40 percent proposed by the BCBS are adopted for loan commitments, the EU is making use of the Basel resolutions' discretionary leeway. Commitments to small and medium-sized enterprises (SMEs) can continue to receive a CCF of 0 percent under certain conditions.
• Specialized lending: In addition to the new risk weighting of specialized lending in the CRSA already decided by the BCBS, a more granular risk weighting for property financing is to be applied at EU level. In addition to the improvement of qualifying infrastructure projects already implemented in the CRR II, the CRR III should also allow privileges for "high quality" object financing.
• Exposures secured by real estate:
  • In addition to the innovations in deriving risk weights for real estate financing that have also been adopted at EU level, the Commission proposes that banks in the EU continue to have the option of using the current real estate value to determine the loan-to-value ratio, with some restrictions. The BCBS, on the other hand, is based on the real estate value at the time the loan was granted. The final implementation at EU level remains to be seen at this point.
  • In addition, the risk weighting of income producing real estate (IPRE), should be equated with the risk weighting of "non IRPE". The prerequisite for this is that losses in real estate in a member state do not exceed certain thresholds and that the losses for the member state as a whole are demonstrably low (so-called hard test).

The EU proposals regarding the revision of the IRBA confirm the decisions of the BCBS regarding the narrowing of the scope of the IRBA. This applies in particular to the discontinuation of the advanced IRBA for receivables from banks and large companies (consolidated sales > EUR 500 million) and the general discontinuation of the IRBA for equity investments. In addition, the introduction of lower limits for the estimation of the institution's own risk parameters (so-called input floor for PD, LGD and CCF) is also planned at EU level.

As a consequence of these restrictions, the EU Commission's proposal envisages the following fundamental changes for existing and future IRBA approvals:

• Opt-out clause for IRBA institutions: In the CRR III draft, IRBA banks are given the option, under certain conditions, to return all or selected IRBA approvals over a period of three years after the introduction of CRR III.
• Increased flexibility for future IRBA approvals: On the other hand, IRBA approval should also be made possible at the level of individual exposure classes in the future, so that a "more selective" use of the IRBA will be possible. The current regulation for the transfer of all portfolios to the IRBA (with a few exceptions) and the associated compliance with the so-called IRBA degree of coverage at the overall bank level are therefore becoming less relevant.

With regard to the determination of capital requirements for operational risk, the EU proposals set the BCBS' efforts to implement a uniform approach. The methodology on which this standard approach is based is also generally adopted by the EU. The calculation formula (continues to) contain an indicator (business indicator, abbreviated: BI) based on the P&L components of the respective institution. Nevertheless, the Commission's proposal for CRR III leads to an important deviation from the proposals of the BCBS: the institution-specific loss history should not be included in the capital adequacy requirements.

At this point, the BCBS has provided the Internal Loss Multiplier (ILM), at least for larger banks.

Institutions/groups whose BI exceeds the threshold of EUR 750 million are obliged under CRR III to make their loss history public as part of the disclosure. The advanced measurement approach (AMA) as an internal approach for operational risk is no longer applicable with CRR III.

With regard to the determination of the CVA charge, the EU Commission's draft largely follows the proposals of the BCBS and its efforts for a more risk-sensitive capital backing. The main changes to the content include:

• the adjustment of delta risk weights within individual risk classes (reduction by around 50% in some cases),
• the use of blanket Vega risk weights (100% or 78%) instead of a formula-based determination, and
• the introduction of new buckets for certain indices as well as the revision of the formula for aggregating the capital requirements across the different categories of the CVA risk framework to align with the market price risk framework.

Additional need for action also results from the exclusion of some securities financing transactions from the scope of application of the CVA framework and the adjustment of the aggregated multiples in the standard and foundation approaches.

In the end, the EU Commission basically agreed with the BCBS's proposals for the long and controversially discussed output floor. Accordingly, the Commission's draft includes an aggregated floor that is to be determined across all risk types.

With regard to the level of application of the floor for groups, which has not been discussed by the BCBS to date and is therefore the subject of controversial debate in the EU, the Commission has opted for a graduated approach. In principle, the output floor is initially only to be applied at the highest consolidation level and by institutions that do not belong to any EU group of institutions. In the case of groups which parent company is based in different Member States, the floor effects are distributed proportionately at sub-consolidated or individual level. In contrast, institutions with a parent company in the same member state do not have to take the floor effects into account when determining the capital requirements at the individual institution level.

In order to cushion the effects of the output floor on own funds requirements, the Commission's draft provides for a transitional period of several years, analogous to the specifications of the BCBS. Due to the later initial application date of CRR III, the transition phase is extended until December 31, 2029. In addition to various simplifications in determining the calculation basis for the output floor in the CRSA, the transitional provisions stipulate that the capital requirements should not exceed 125 percent of the RWA before the floor. The EU Commission reserves the right to retain the latter rule beyond 2029.

In addition to the CRR, the capital guidelines are also to be revised and amended in the form of CRD VI. The EU Commission also published a negotiating position on this in October 2021, a corresponding proposal by the Council of the European Union followed in autumn 2022, and the EU Parliament agreed on its negotiating position on February 10, 2023.

In addition to the changes to the capital adequacy requirements, the CRD VI includes other new regulations, most of which have no counterpart in the Basel framework. Particularly noteworthy are the changes in the supervision of branches of institutions from third countries (Third Country Branches), which are being comprehensively revised in order to make supervisory arbitrage more difficult.
Other provisions concern i.a. the suitability of managers (“fit & proper”) as well as the regulations on the SREP and the inclusion of ESG factors in risk management. In this context, it should be emphasized that capital requirements, e.g. added as a percentage as part of the SREP, should be “frozen” in terms of amount as soon as the output floor takes effect. In this case, the competent supervisory authorities should redefine the surcharges in order to avoid double charging of model risks, for example.

While the CRR III, as described, is not to be applied until 2025, the CRD VI is expected to come into force shortly after its adoption. However, it is to be expected that the legislative process will be completed by the end of 2023 at the earliest. The CRD VI as a directive still has to be transposed into national law, so that the changes will only become relevant later.

Based on the existing negotiating positions of the EU Commission, the Council of the European Union and the EU Parliament, the "trilogue negotiations" can begin. We understand that EU negotiators aim to complete the trilogue negotiations by Q4 2023 to transpose the revised CRD VI and CRR III texts into EU law before the end of 2023. This would only allow for a one-year implementation period and underscores the importance for the banking sector to take early implementation action wherever possible – including allocating sufficient resources to implement the Basel framework such as preparing for the application of the Output Floor.

The negotiations “must” be completed by the second quarter of 2024 at the latest. Due to the new elections to the EU Parliament, the legislative period will then end. If no final document is available by then, the legislative process would have to start all over again, which would lead to a significant delay.