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The revised banking package of CRD VI and CRR III contains a large number of new requirements, the implementation of which will pose major challenges for the banking industry. In addition to the adoption of the final Basel IV regulations, other topics such as crypto assets or the consideration of ESG in banking supervisory law will be addressed.
The current proposals of the EU Commission for the implementation of the Basel reform proposals are presented in the edited volume by Martin Neisen and Stefan Röth. The aim is to give the reader a comprehensive but easily understandable overview of the proposals and to work out implementation challenges in a practical way.
With the help of an international team of experts, the complexity of the topic is reduced and important assistance is offered.
Compared to the second edition of the Basel IV book, the topics already implemented in the EU as part of the CRR II have been removed and a comprehensive presentation of all content of CRD VI and CRR III has been added.
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Veröffentlichungsjahr: 2023
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Table of Contents
Cover
Title Page
Copyright
Foreword
Preface
1 Introduction
Literature
Notes
2 Revision of the Standardised Approach for Credit Risk (SA-CR)
2.1 Introduction
2.2 General aspects
2.3 Determination of the exposure value
2.4 Exposures to institutions
2.5 Exposures to corporates
2.6 Specialised lending exposures
2.7 Subordinated debt and equity exposures
2.8 Retail exposures
2.9 Exposures secured by mortgages on immovable property
2.10 Defaulted receivables
2.11 Other assets
2.12 Additional risk weights for risk positions with currency mismatches
2.13 Use of external ratings
2.14 Credit risk mitigation techniques
2.15 Summary
Literature
Notes
3 The future of the IRB Approach
3.1 Introduction to the fundamentals of the IRB approach in accordance with CRR
3.2 The implementation of the Basel Committee's initiative to improve the IRB approach in the EU
Literature
Notes
4 Supervisory treatment of market risks
4.1 Introduction
4.2 General and overarching adjustments
4.3 Revised trading book boundary
4.4 Adjustments to the requirements for reclassifications (Article 104a CRR 3)
4.5 Adjustments to the requirements for internal risk transfers (Article 106 CRR 3)
4.6 Revised treatment of investments in funds in the trading book
4.7 Adjustments to the Alternative Standardised Approach for market risk
4.8 Simplified standardised approach for market risk (S-SA)
4.9 Alternative Internal Model Approach for market risk (A-IMA)
4.10 Conclusion
Literature
Notes
5 The CVA risk capital charge framework
5.1 Introduction
5.2 Hierarchy of approaches
5.3 CVA exemptions and securities financing transactions
5.4 Standardised approach for CVA
5.5 Basic approach for CVA
5.6 Conclusion and expected impact
Literature
Notes
6 Operational risks
6.1 Background
6.2 Methods for determining OpRisk according to Basel II
6.3 Overview: From Basel II to CRR 3
6.4 Standardised approach to operational risk (BCBS 424)
6.5 Outlook
6.6 Summary and conclusion
Literature
Notes
7 The output floor
7.1 Introduction
7.2 Reasons for the introduction of the output floor
7.3 The CRR 3 output floor
7.4 Objectives and effects of the output floor
7.5 Conclusion
Literature
Notes
8 Disclosure
8.1 Introduction
8.2 Proportionality principle
8.3 Risk management objectives and policy
8.4 Scope of disclosure
8.5 Own funds
8.6 Capital requirements and risk-weighted exposure amounts
8.7 Counterparty credit risk
8.8 Countercyclical capital buffer
8.9 Indicators of global systemic importance
8.10 Credit risk
8.11 Asset encumbrance
8.12 Market risk
8.13 CVA risk
8.14 Operational risk
8.15 Disclosure of key parameters (“key metrics”)
8.16 Interest rate risk of the banking book (IRRBB)
8.17 Securitisations
8.18 Environmental, social and governance risks – ESG risks
8.19 Remuneration policy
8.20 Leverage ratio
8.21 Liquidity ratios
8.22 Conclusion and expected impact
Literature
Notes
9 MREL and TLAC as part of the resolution regime
9.1 Introduction
9.2 Key requirements for resolution capability
9.3 TLAC
9.4 MREL
9.5 Outlook and conclusion
Literature
Notes
10 ESG: Regulatory overview for dealing with sustainability risks
10.1 Sustainability risks in the financial sector
10.2 Consideration of sustainability aspects in SREP
10.3 ESG ratings – methodology and comparison
10.4 Adjustment of capital requirements to cover sustainability risks
Literature
Notes
11 Cryptoassets
11.1 Definition and types of cryptoassets
11.2 Development of a prudential framework
11.3 Classification procedure for cryptoassets
11.4 Regulatory requirements in relation to Group 1 cryptoassets
11.5 Regulatory requirements in relation to Group 2a cryptoassets
11.6 Regulatory requirements in relation to Group 2b cryptoassets
11.7 Final BCBS standard
11.8 Conclusion
Literature
Notes
12 Further requirements of CRD 6
12.1 Introduction
12.2 Supervisory powers
12.3 Branches from third countries
Literature
Notes
End User License Agreement
List of Tables
Chapter 3
Table 3.1: RW for specialised lending (except HVCRE) per category and maturi...
Table 3.2: RW for HVCRE positions per category and maturity
Table 3.3: Minimum LGD for partially collateralised exposures
Table 3.4: RW for SL items for calculating the EL
Table 3.5: Summary of the Basel Committee's reform proposals
Table 3.6: Average risk weights – EBA credit risk benchmark exercise 2021...
Table 3.7: Median risk weights – EBA transparency exercise, September 2020
Table 3.8: CRR3 Risk parameter floors
Table 3.9: Proposed changes in parameter estimation
Table 3.10: Comparison of base IRBA LGD and haircuts according to CRR and CR...
Chapter 5
Table 5.1: BA-CVA risk weights
Chapter 7
Table 7.1: Transitional arrangements
Chapter 8
Table 8.1: Disclosure of differences between accounting and regulatory posit...
Table 8.2: Disclosure of own funds
Table 8.3: Composition of own funds and TLAC
Table 8.4: Key parameters and overview of risk-weighted position amounts
Table 8.5: Disclosure on counterparty default risk
Table 8.6: Disclosures on credit risk, dilution risk and credit quality
Table 8.7: Disclosure of CVA risk
Table 8.8: Operational risk disclosure
Table 8.9: Disclosure of key parameters
Table 8.10: Disclosure requirements in relation to IRRBB
Table 8.11: Disclosure of risk from securitisation positions
Table 8.12: Disclosure of remuneration policy
Table 8.13: Disclosure of leverage ratio
Table 8.14: Disclosure of liquidity requirements
Chapter 9
Table 9.1: Requirements for equity instruments in accordance with Articles 5...
Table 9.2: TLAC capability
Table 9.3: Reasons for exclusion in exceptional cases
Chapter 10
Table 10.1: Examples of sustainability criteria
Table 10.2: Common challenges of ESG ratings based on market analysis
Table 10.3: Exemplary allocation of Sustainability Factors to ESG rating
List of Illustrations
Chapter 2
Figure 2.1: Procedure for quantifying credit risk
Figure 2.2: Elements of the determination of the risk-weighted assets under t...
Figure 2.3: Risk weights for exposures to central governments and banks, publ...
Figure 2.4: Risk weights for exposures to rated institutions
Figure 2.5: Risk weights for exposures to unrated institutions
Figure 2.6: Risk weights for corporate exposures
Figure 2.7: Risk weights for specialised lending
Figure 2.8: Risk weights of subordinated debt exposures and equity positions...
Figure 2.9: Risk weights for retail exposures
Figure 2.10: Loan splitting for exposures secured with residential properties...
Figure 2.11: ETV-based approach for exposures secured with residential proper...
Figure 2.12: Loan splitting for exposures secured with commercial properties...
Figure 2.13: ETV-based approach for exposures secured with commercial propert...
Figure 2.14: Applicable rating in the case of multiple external ratings
Figure 2.15: Use of issue-specific ratings
Figure 2.16: Determination of the haircut based on the holding period and rev...
Chapter 3
Figure 3.1: Comparison of EL and UL of a portfolio
Figure 3.3: Change in the hypothetical capital ratio when adjusting the risk ...
Figure 3.4: CRR 3 risk weighting for a hypothetical wholesale portfolio
Figure 3.5: Impact of IRBA implementation for a single portfolio with the hig...
Figure 3.6: CRR 3 RWA expressed as a percentage of CRR RWA for different coll...
Figure 3.7: Reconciliation of the average risk weights from CRR to CRR 3 for ...
Figure 3.8: Reconciliation of the average risk weights from CRR to CRR 3 for ...
Chapter 4
Figure 4.1: High-level view of the FRTB framework.
Figure 4.2: Trading book delimitation in accordance with CRR 3
Figure 4.3: Conditions for the reclassification of a position
Figure 4.4: Overview of the revised treatment of investments funds
Figure 4.5: Technical adjustments to the alternative standard approach (A-SA)...
Chapter 5
Figure 5.1: CVA framework according to CRR 3
Figure 5.2: SA-CVA at a glance
Figure 5.3: Differences between SBM and SA-CVA
Chapter 6
Figure 6.1: Delimitation of operational risk
Figure 6.2: Comparison of existing approaches
Figure 6.3: Overview of AMA requirements
Figure 6.4: Requirements for the new SA
Figure 6.5: Composition of the business indicator
Figure 6.6: The BIC in SA
Figure 6.7: Sample income statement of a model bank
Figure 6.8: Capital requirements according to CRR
Figure 6.9: Calculation of the BIC according to CRR 3
Figure 6.10: Requirements for the operational risk assessment and management ...
Chapter 7
Figure 7.1: Variation of risk weights within the IRBA
Figure 7.2: Floor and leverage ratio
Figure 7.3: Output floor
Figure 7.4: Optimization of the standard approach
Figure 7.13: Elimination of the IRBA option and the new output floor
Chapter 8
Figure 8.1: Disclosure requirements in three phases
Figure 8.2: Proportionality principle
Figure 8.3: Disclosure requirements according to the proportionality principl...
Figure 8.4: ESG risk disclosure schedule
Figure 8.5: Qualitative and quantitative data
Chapter 9
Figure 9.1: Supervisory and resolution authorities in the EU
Figure 9.2: TLAC requirements within a group
Figure 9.3: Principles for internal TLAC requirements
Figure 9.4: Overview CRR, BRRD, CRD
Figure 9.5: MREL calibration
Figure 9.6: MREL-eligible liabilities
Figure 9.7: MREL requirements within a group
Figure 9.8: External MREL vs. internal MREL
Figure 9.9: Overview MREL reporting requirements
Figure 9.10: Example evaluation of data points for an ad hoc data request
Chapter 10
Figure 10.1: Qualitative assessment on the 11 thematic areas in module 1
Figure 10.2: Bottom-up stress test – module 3 at a glance
Chapter 11
Figure 11.1: Framework for the prudential treatment of cryptoassets
Figure 11.2: Redeemer, member, holder
Chapter 12
Figure 12.1: Requirements for the suitability assessment by the competent aut...
Figure 12.2: Classification of third country branches and implications for su...
Guide
Cover
Title Page
Copyright
Table of Contents
Foreword
Preface
Begin Reading
End User License Agreement
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Foreword
Unimpressed by John M. Keynes' motto “I would rather be roughly right than precisely wrong”, the Basel Committee on Banking Supervision is putting in motion the most comprehensive reform package in its entire supervisory history under the term “Basel IV”. The banking and financial market is a highly interconnected and dynamic system in which the strong connections make it almost impossible to assess the risks of the system under certain conditions. Moreover, supervision keeps pace with the financial sector's increasing complexity by penning more and progressively detailed rules for determining the minimum capital requirement for a bank's risk positions.
Currently, every European bank must observe approximately 40,000 legally binding requirements of the European Union. In the field of banking supervision, four thousand and one different rules have been set down on 34,019 pages. With a reading speed of 50 words per minute and one hour reading time per working day, you would need around 32 years to read all the pages! And because the rules are constantly changing, they can never be fully read and understood. Today it is almost impossible to find any banking supervisor or bank practitioner who is able to explain exactly the supervisory rules and their consequences. The scope and complexity of the rules are just too great.
Behind this book is a highly qualified, expert team committed to a necessary reduction of regulatory complexity by providing this important companion volume to the reams of legislation. Broad knowledge is an especially crucial characteristic for dealing with complex systems. The authors come from pertinent sectors and have many years of consulting experience. The team of authors is led by Martin Neisen and Stefan Röth, two publishers whose experience and reputation are a guarantee of quality.
This book presents the innovations of the Basel IV package in a concise, understandable and practice-oriented way. It is committed to an optimised view by focusing on all relevant aspects. It is an outstanding work which, thanks to its clear structure and intellectual rigour, allows the reader to “see the wood for the trees”.
I strongly recommended this volume to all scientific readers concerned with the development of banking supervision and risk management, as well as for practitioners interested in these issues. I hope this book will be openly received and widely distributed, and that the reader will find much of interest within these pages.
Professor Dr Hermann Schulte-Mattler – Dortmund, February 2016
Preface
Three years have passed since the publication of the second edition of our book. The year 2022, for which the Basel Committee on Banking Supervision announced that the Basel IV reforms would come into force in 2017, has passed. However, the wait for Basel IV is still not over. There is no need to recount the events of the past few years here; the postponement of Basel IV is certainly one of the easiest casualties of the COVID pandemic to absorb. Now that its peak hopefully seems to have passed, supervisors and regulators can once again devote more attention to Basel requirements and less to crisis management. And so, it also seems an appropriate time to give our book a much-needed update.
This is mainly due to the proposals now being made by the EU Commission on the implementation of Basel IV in the European Union. Corresponding proposals for an amendment to the CRR and CRD were already published at the end of 2021. In the meantime, initial proposals for amendments have also been submitted by the EU Parliament and the EU Council. The most comprehensive amendment of the CRR is thus gaining massive momentum. We are happy to take this into account in the third edition of our book by eliminating the presentation of the contents of CRR 2 that have already entered into force, thus allowing us to concentrate fully on the presentation of the topics that are still outstanding. These include, above all, the Standardised Approach and IRB approach for credit risk, operational risk and the credit valuation adjustment (CVA) risk capital charge. And, of course, the floor rule, which is just as controversial in the context of EU implementation as it was at the level of the Basel Committee. Regarding these topics, it is our particular concern to present the deviations of the EU from the Basel requirements and thus also to provide clear added value for readers of the preceding editions.
In addition, however, the European Commission is using the upcoming amendment of the CRR and CRD to address a number of other topics for which there are no concrete Basel requirements, or which have only been on the supervisory agenda since the finalisation of Basel III in 2017. This is reflected in new sections, for example on ESG or cryptoassets, which were not previously covered in this book. We therefore hope that this new edition will again add value and be useful to both existing and new readers.
As always, our thanks go to the individual authors for their contributions and to Professor Dr. Schulte-Mattler for the foreword.
Martin Neisen and Stefan Röth – Frankfurt, Autumn 2022
1Introduction
Stefan Röth
When the author of this section began his first day of work after graduating from university in January 2008, he had no idea what developments the year would hold in store for the financial sector. Nor did he suspect that the reaction of regulators and supervisors would shape his working life for more than a decade.
As early as 2008 and 2009, measures were agreed at meetings of the G20 countries and the Financial Stability Board (FSB), and at the end of 2011, the first adjustment of banking supervisory requirements in response to the crisis came into force in the EU (“Basel 2.5” or CRD III).1 Also in 2011, the Basel III framework was adopted by the Basel Committee,2 which came into force in the European Union in 2014 in the form of the first Capital Requirements Regulation (CRR).3
The measures contained in the two packages were intended both to address the immediate causes of the crisis (CRD III: market risk, derivatives, securitisation) and, in principle, to ensure greater stability in the financial sector (e.g. through stricter capital adequacy requirements under the CRR). However, they were only the prelude to a series of much more far-reaching reforms that would fundamentally change the calculation of risk-weighted assets.
From the author's point of view, the starting signal for this was the first paper of the Basel Committee for the Review of the Market Risk Framework (“Fundamental Review of the Trading Book” – FRTB), which was published in 2012.4 It was followed by numerous other papers, which were intended to fundamentally change by 2017 all risks included in Pillar 1 (including credit, market and operational risk) both under the standardised and the internal model approaches. As is well known, the Basel Committee reached the preliminary endpoint of this development at the end of 2017 with the finalisation of Basel III,5 while in public and among the editors of this book the term Basel IV is used.
While the work of the Basel Committee came to an end in 2017, almost ten years after the outbreak of the financial market crisis, the work at EU level was to drag on even further. In 2016, the EU had already incorporated part of the Basel IV papers of the Basel Committee into the first major amendment of the CRR. The so-called CRR 2 was adopted by 2019, with significant parts coming into force in 2021.6 It includes, for example, new requirements in the area of counterparty credit risk and market risk as well as the finalisation of the requirements for the net stable funding ratio (NSFR) and leverage ratio (LR). Since it is already in force and has been applied by institutions for more than a year, we have deliberately decided not to describe its contents again in this book and instead to focus on those topics that have yet to come into force in the EU.
The paper published by the Basel Committee at the end of 2017, the contents of which have not yet been considered in CRR 2, essentially contains requirements for credit risk (CR SA, IRB), operational risk and the output floor, as well as further adjustments to other topics. According to the Basel Committee, these requirements should be implemented by 2022. However, under the influence of the COVID pandemic, it was decided in March 2020 to postpone the initial application date to 1 January 2023.7
At the level of the European Union, however, an initial draft amendment to the CRR (“CRR 3”) was not published until October 2021 by the EU Commission.8 It provides for the regulations to enter into force on 1 January 2025, two years later than agreed internationally. At the time of writing, a large number of amendments have already been tabled by the EU Parliament and compromise proposals have been put forward by the EU Council Presidency. Nevertheless, it is difficult to estimate by when the so-called trilogue will be concluded and the final version of CRR 3 can enter into force. January 2025 therefore currently appears to be the earliest possible date, although a postponement cannot be ruled out.
However, even if there is no postponement and CRR 3 comes into force on 1 January 2025, the proposals of the EU Commission provide for transitional arrangements. Provisions that are expected to have a major impact on the level of risk-weighted assets, such as the capital floor or the increase in the credit conversion factors in the CR SA from the current 0 percent to 10 percent in the future, are subject to long-term transitional arrangements. As things currently stand, the regulations will not take full effect until 2032.
By then, almost a quarter of a century will have passed since the outbreak of the financial market crisis. And thus, the professional life of the author of these lines will continue to be shaped by the regulatory processing of the financial market crisis for the foreseeable future.
To make it easier for the reader to understand these regulations even if he or she has not spent 25 years working with them, we have presented in the following sections the main requirements of the EU Commission's draft amendment of the CRR, CRD9 and BRRD.10 In doing so, we aim to highlight the differences that arise compared to the Basel requirements from December 2017. We also address those requirements that have found their way into the consultation on the EU's own initiative, i.e., are not based on Basel initiatives, such as the amendments to the CRD presented in section 12. Finally, the amendment also addresses issues that have evolved dramatically since 2017 and now occupy a significant place on the regulators' agenda. For this reason, section 10 on ESG and section 11 on the regulation of cryptoassets have been newly included in the book.
As in the previous editions, our aim is to present the regulations in an easy-to-read and understandable form and, in particular, to address the foreseeable challenges in future implementation.
Literature
Basel Committee on Banking Supervision; BCBS 189 (2010): Basel III: A global regulatory framework for more resilient banks and banking systems.
Basel Committee on Banking Supervision; BCBS 219 (2012): Consultative document – Fundamental review of the trading book.
Basel Committee on Banking Supervision; BCBS 424 (2017): Basel III: Finalising post-crisis reforms.
Proposal for a Directive of the European Parliament and of the Council amending Directive 2013/36/EU as regards supervisory powers, sanctions, third-country branches, and environmental, social and governance risks, and amending Directive 2014/59/EU (CRD 6 Draft of the EU Commission).
Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) No 575/2013 as regards requirements for credit risk, credit valuation adjustment risk, operational risk, market risk and the output floor (CRR 3 draft of the EU Commission).
Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) No 575/2013 and Directive 2014/59/EU as regards the prudential treatment of global systemically important institution groups with a multiple point of entry resolution strategy and a methodology for the indirect subscription of instruments eligible for meeting the minimum requirement for own funds and eligible liabilities (BRRD draft of the EU Commission).
Directive 2010/76/EU of the European Parliament and of the Council of 24 November 2010 amending Directives 2006/48/EC and 2006/49/EC as regards capital requirements for the trading book and re-securitisations, and the supervisory review of remuneration policies (CRD III).
Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 646/2012 (CRR).
Regulation (EU) 2019/876 of the European Parliament and of the Council of 20 May 2019 amending Regulation (EU) No 575/2013 as regards the leverage ratio, the structural liquidity ratio, requirements for own funds and eligible liabilities, counterparty credit risk, market risk, exposures to central counterparties, exposures to collective investment undertakings, large exposures, reporting and disclosure requirements and Regulation (EU) No 648/2012 (CRR 2).
Notes
1
Cf. Directive 2010/76/EU.
2
See BCBS 189.
3
Cf. Regulation (EU) No 575/2013.
4
See BCBS 219.
5
See BCBS 424.
6
Cf. Regulation (EU) 2019/876.
7
See Basel Committee press release, 27 March 2020:
https://www.bis.org/press/p200327.htm
.
8
Cf. CRR 3 Draft of the EU Commission.
9
Cf. CRD 6 draft of the EU Commission.
10
Cf. BRRD draft of the EU Commission.
2Revision of the Standardised Approach for Credit Risk (SA-CR)
Friedemann Loch and Frank Marinkovic
2.1 Introduction
For a typical bank, credit risk represents by far the most relevant type of risk.1 The concept for quantifying this type risk was the first one to be developed by the Basel Committee under the Basel I accord in 1988. Given that early stage in the development of regulatory rules for the quantification of risk, these rules did not have a proper level of risk sensitivity and were thus unable to distinguish adequately between low and high levels of credit risk. This lack of specificity was criticised by both the supervisory authorities and the banks and led to the first significant revision of the quantification rules from 1999 onwards, later referred to as “Basel II”.
Under Basel II, a new concept was introduced that gave banks the option to choose between a so-called “Standardised Approach” (credit risk standardised approach, hereinafter also referred to as “SA-CR” or “SA”), in which almost all parameters and rules for quantification were prescribed by the supervisory authorities, and an approach based on internal ratings (“IRB approach”, see Chapter 3), in which it was possible for banks for the first time to determine one or more credit risk parameters on the basis of internal procedures and to calculate the risk weighting based on these parameters.2
The SA-CR developed under Basel II already featured a much more granular breakdown of the risk weighting for different borrowers than under Basel I, as well as a significantly improved consideration of risk mitigation instruments.
With respect to the IRB approach, however, there were still simplifications, clearly intended by the supervisor, both in the determination of the risk weight of the individual borrower and in the form and scope of eligible risk mitigation instruments.
Since Basel II, and virtually unchanged by Basel IV, banks have the option of either using the less risk-sensitive SA-CR or the IRB approach (which requires prior supervisory approval), which generally leads to lower risk weightings. Banks may individually choose to apply the IRB approach. However, once the IRB approach is used, it has to be applied to all material positions (see section 3.2.3).
Basel II was implemented by means of several European directives, which were incorporated into German law as part of an amendment to the German Banking Act (KWG) and the introduction of the Solvency Regulation in December 2006.
In response to the financial market crisis, the implementation of the Basel III regulations changed the structure of the regulatory requirements at European level and replaced the previous national requirements under the Solvency Regulation with a European regulation (“CRR”), which in turn has been amended several times and currently has the status “CRR 2”. The CRR and CRR 2 did not materially change the content of the SA-CR requirements. Thus, the current rules of the SA-CR correspond de facto to the requirements of Basel II from 1999.
CRR 3 leaves the basic structure of SA-CR and IRBA unchanged, but the SA-CR and IRBA rules are subject to fundamental changes and updates.
Figure 2.1 shows the main elements for quantifying credit risk.
Figure 2.1: Procedure for quantifying credit risk
Source: Own representation.
Under the current SA-CR – which has remained virtually unchanged since Basel II – external ratings play a key role in determining the risk weights and hence the regulatory capital requirement. Both the classification of exposures into individual asset classes and the process for deriving risk weights on the basis of external ratings are prescribed in full for banks by the supervisory authorities, with no scope for discretion. The scope of collateral and guarantees eligible for risk mitigation purposes is also clearly defined. Only in the case of the recognition of financial collateral are banks permitted – albeit only to a very limited extent – to use their own estimated haircuts.
In contrast to the SA-CR, it is possible under the IRBA to determine the borrower's creditworthiness using internal ratings. In addition, there are also so-called “advanced IRB approaches” in which the effect of the recognition of risk mitigation instruments (i.e. the loss given in the event of default) and the credit conversion factors can also be individually quantified by the banks (see Chapter 3 on the IRB approach).
After the adoption and European/national implementation of Basel II, it became apparent that the objectives of greater economic differentiation of credit risks pursued with the development of the SA-CR were essentially only achieved for claims on central governments and central banks. For other asset classes, in particular for claims on corporates, it became apparent that, due to the often-low number of available external ratings, a differentiation of different credit ratings – and thus risk weights – was not possible, or only possible to a very limited extent. All claims on corporates without an external rating are to be classified as “unrated” within the currently valid SA-CR and are assigned a risk weight of 100 percent, which corresponds materially to the requirements of Basel I (or Principle I /“Grundsatz I” in Germany).
In the course of the financial market crisis that began shortly after the implementation of Basel II, not only the limited extent of risk differentiation but also the appropriateness of the use of external ratings for regulatory purposes was increasingly questioned and criticised.
After the Basel Committee had made a series of adjustments to the regulatory framework known as “Basel 2.5” as an immediate reaction to the financial market crisis, which did not, however, relate to the SA-CR, the Committee devoted itself to a fundamental revision of practically all aspects of the determination of capital ratios under the heading “Basel III”.
The adoption of Basel III essentially took place in two parts. The first part involved – among other changes – a radical and fundamental revision of the rules for the definition of regulatory capital and the form and level of regulatory capital ratios. In addition the concept of capital buffer has been introduced. Regarding the rules of the SA-CR, there were practically no changes at Basel level at this time.
Since the Basel III regulations were essentially implemented for the first time at European level by means of a central regulation (“Capital Requirements Regulation/CRR”) instead of a directive to be implemented on a decentralised basis, the associated standardisation of previously existing national differences also resulted in individual changes in detail for the SA-CR in Germany.
The second part of Basel III involved a fundamental revision of virtually all methods for the quantification of risk weighted assets.
Activities regarding the revision of the SA-CR started at Basel level in December 2014 with the publication of a first consultation paper for the revision of the SA-CR.3 The objective of the revision was to increase risk differentiation and to move away (to the maximum extent possible) from the use of external ratings without increasing the complexity for the calculation of RWA. Another objective of the Committee was to increase international comparability by reducing existing national options in the implementation of the SA-CR and to improve comparability between the SA-CR and the IRBA by better aligning the asset classes in both approaches.
The first consultation paper envisaged a fundamental change in the structure of the SA-CR and included a complete move away from the use of external ratings. Since the new proposals for the quantification of credit risk contained in this consultative paper showed clear conceptual weaknesses and the resulting capital charges were also significantly higher than the previous level, the Basel Committee published a second consultative paper4 in December 2015, in which the use of external ratings was again permitted and the procedures for determining the capital charge were again more closely oriented to the previous regulations.
In the further course of the negotiations at Basel level, adjustments and refinements were made to numerous individual aspects of the SA-CR and published in December 2017 as part of a paper known as the “Finalisation of Basel III”.5
The Basel requirements relating to the SA-CR will be incorporated into European law via a further revision of the CRR (“CRR 3”). The first draft of this amendment regulation was published on 27 October 2021. As of the first quarter of 2023 discussions will take place. It is expected that the rules will be finalised and published by the end of 2023. The date of the application of the new rules is scheduled for 1 January 2025. In principle, the Basel requirements are to be implemented as precisely as possible, but the current draft of CRR 3 already shows numerous deviations and specifications in detail for the individual requirements.
A fundamental difference between the current SA-CR and the revised SA-CR under CRR 3 arises from the fact that the SA-CR in CRR 3 must be implemented in full by all banks – including all IRB banks – as the SA-CR represents the starting point for the calculation of the “capital floor” (see Chapter 7) for all IRB banks. This is fully in line with the Basel Committee's requirements.
Formally, a floor regulation already existed since the adoption of Basel II/Solvency Regulation in 2006. Due to a different wording at European level for the calculation of the capital floor compared to the original intention, the “EU floor” did not represent a real limitation for IRB banks. Since January 2018, the floor regulations at European level have expired.
Figure 2.2 contains a schematic overview of the individual steps and components for determining capital adequacy under the SA-CR. The figure shows that the individual calculation steps under SA-CR will not change significantly under CRR 3. The areas in which CRR 3 will result in changes in the SA-CR are highlighted in colour.
The individual components of the revised SA-CR for the individual asset classes are presented below. The focus is on the changes compared to the current regulations. Where the draft CRR 3 deviates from the requirements of the Basel Committee, this is explicitly mentioned.
Figure 2.2: Elements of the determination of the risk-weighted assets under the SA-CR
Source: Own representation.
Figure 2.3: Risk weights for exposures to central governments and banks, public sector entities and multilateral development banks
Source: Own representation.
Due to the ongoing consultation process on CRR 3 and the ongoing trilogue negotiations, it is not yet possible to estimate the areas in which detailed changes will be made to the requirements.
2.2 General aspects
In the individual asset classes, there will no longer be any “risk positions associated with particularly high risks” in the future. In the future, this asset class will essentially be included in the asset classes “immovable property” and “special financing”, which was newly introduced as a sub-category of corporate receivables.
In addition to special financing, there will also be a new asset class “subordinated debt securities”.
The following exposure classes will (probably) not be changed under CRR 3:
exposures to central governments or central banks
exposures to regional or local authorities
exposures to public sector entities
exposures to multilateral development banks
exposures to international organisations.
In the case of central governments, it should be noted that the use of external ratings for this exposure class has not been uncontroversial in the past. However, as part of the finalisation of Basel III described above, no majority could be found at the level of the Basel Committee for an adjustment of the regulations. Consequently the status quo for this asset class will be maintained both in the SA-CR and in the IRBA. The extent to which changes will be made in this area cannot be estimated at the present time.
The current regulations in Basel and thus also in the CRR allow the use of recognised external ratings without further internal review or plausibility checks. It is therefore possible that a bank can apply a comparatively good external rating even though it has arrived at a less favourable result in the course of an internal assessment.
In future, with the exception of exposures to central governments or central banks, regional or local authorities, public sector entities and international organisations, such a reconciliation will be required for all exposures. If the bank arrives at a more conservative result or a lower credit rating in its internal assessment, this must be used. In the opposite case, however, the external rating is used. The content of this regulation corresponds to the requirements for due diligence developed in Basel.
Regarding the design of a “due diligence”, the Basel Committee has only developed general criteria that correspond to a risk classification – without requiring the level of detail of an IRB approach. The draft CRR 3 does not contain any detailed requirements in this respect, but merely refers in the newly worded Article 113 (1) to Article 79 lit. b) of the CRD (Directive 2013/36/EU), which in turn provides that banks should have implemented internal methods by which they can assess the credit risk of individual debtors. This CRD requirement was transposed into national law as part of MaRisk and therefore does not constitute a new material requirement. Since MaRisk has long included the requirement that banks have appropriate risk classification systems in place, this is not a material change with respect to due diligence. The only new requirement is the need to compare the external rating and the internal assessment and, in cases where the bank's internal assessment is more negative than the external rating, to assign a rating that is at least one notch higher than the rating according to the external rating.
Regarding the comparison of the internal assessment with the external rating and the risk weighting to be derived from it, the present draft text of CRR 3 deviates from the Basel requirements. The regulation adopted in Basel provides for a comparison of the internal assessment with the external rating on the basis of the resulting risk weight. For example, if the external rating would result in a risk weight of 20 percent, but the internal assessment (translated into the external rating system) would result in a risk weight of 50 percent, the 50 percent risk weight is to be used. In cases where the internal assessment comes to a “slightly worse” result (for example, internally “AA” instead of externally “AAA”), but the resulting risk weight is not higher, no adjustment is made.
The current CRR 3 draft text, on the other hand, only provides for a comparison between the risk characteristics on the basis of the internal assessment and the external rating, without reference to the risk weight. As soon as the internal assessment arrives at a worse result than the external rating, a higher credit quality step is to be applied, irrespective of whether the worse rating would lead to this in the individual assessment. The internal rating of “AA” would lead to an increased credit quality step (from 1 to 2) for an external rating of “AAA”, although a rating of “AA” on its own would lead to a credit quality step of 1.
It is expected that a corresponding adjustment will be made in the context of the consultation currently underway by comparing the internal and external ratings at the level of the resulting credit quality step.
2.3 Determination of the exposure value
Unchanged from the current requirements, the assessment basis for on-balance sheet assets is the respective book value after deducting existing individual and general credit risk adjustments. However, the current draft contains a restriction to non-trading book positions when considering additional valuation adjustments in accordance with Article 34 CRR.
A credit equivalent amount must be calculated for derivative positions. This continues to be carried out in accordance with the regulations already implemented under CRR 2 using the so-called standardised approach for counterparty risk or the simplified standardised method (“SA-CCR”). A separate calculation of the capital charge is required for repurchase agreements and similar transactions (see separate section on risk mitigation techniques).
For off-balance sheet items, there will be a total of five different conversion factors in future instead of the previous four levels:
100 percent for positions from category 1
50 percent for positions from category 2
40 percent for positions from category 3
20 percent for positions from category 4
10 percent for positions from category 5.
The items that previously had to be provided with a conversion factor of 100 percent will (essentially) also be weighted at 100 percent in the future. For the remaining off-balance sheet items, there will be new weighting factors in many cases. In particular, the weighting of loan commitments is subject to significant changes.
In line with the Basel requirements, there will be no conversion factor of 0 percent, but transitional provisions in Article 495d CRR 3 provide for the generally applicable conversion factor of 10 percent to be multiplied by a further – staggered – factor for credit commitments that are revocable at any time, which will gradually increase from 0 percent in 2025 and will not expire until 2032. This measure is intended to cushion a sudden increase in capital requirements for banks that have large amounts of revocable loan commitments on their books.
In addition, Article 5 No. 8 CRR 3 allows certain contractual arrangements with corporate customers or SMEs that do not fall under the definition of commitments to lend to be assigned a conversion factor of 0 percent.
Depending on the respective asset class, the individual risk position values are multiplied either by a flat risk weight (e.g., 75 percent for “retail business”) or by a risk weight determined on the basis of external ratings (e.g., “loans and advances to corporates”, “loans and advances to sovereigns”) in order to determine the risk-weighted assets. The risk exposure values or risk weights and thus the risk-weighted assets can be reduced by applying risk mitigation techniques.
2.4 Exposures to institutions
In the asset class for institutions, a fundamental distinction must be made between exposures with an external rating and unrated exposures. This corresponds to the distinction provided for in Basel between an external credit risk assessment approach (ECRA) and a standardised credit risk assessment approach (SCRA).
If risk positions have an external rating from a recognised rating agency, CRR 3 provides for a link between the credit quality step derived on the basis of the external rating and a risk weight, analogous to the current regulations. It must be taken into account that a comparison between the external rating and an internal assessment is required as part of the allocation (see above).
As in the current regulations, the risk weights range from 20 percent to 150 percent, although a risk weight of 30 percent instead of the previous 50 percent is envisaged in future for credit quality step 2.
In future, there will be no preferential risk weighting for exposures with a residual maturity of up to three months.
Figure 2.4: Risk weights for exposures to rated institutions
Source: Own representation.
For receivables with an original maturity of up to three months, there are no changes in the risk weighting. Receivables from cross-border trade in goods with an original maturity of six months will in future be treated in the same way as short-term receivables of up to three months and will receive the same reduced risk weighting.
If no external rating is available for the institution or the exposure, the current rules allow for the use of the external rating of the home country. Based on the home country principle, unrated exposures to banks are assigned the risk weight of the home country increased by one notch. In Germany, these exposures thus receive a risk weight of 20 percent (credit quality step 1 / 0 percent for the Federal Republic of Germany). This system is deliberately discontinued in CRR 3 in order to resolve the “bank-sovereign link” that existed previously.
In the future, the SCRA developed in Basel will be applied in these cases.
Under the SCRA, borrowers are to be classified into one of three grades (“Grade A”, “Grade B”, “Grade C”) on the basis of flat-rate specifications. Separate risk weightings of 40 percent for Grade A, 75 percent for Grade B and 150 percent for Grade C are provided for each grade. Reduced risk weightings of 20 percent, 50 percent and 75 percent apply to short-term exposures. Analogous to externally rated receivables, all positions with an original maturity of three months and receivables from cross-border trade in goods with an original maturity of six months are considered short-term positions.
A further reduced risk weight of 30 percent is applied to Grade A exposures that meet other criteria (“Grade A+”).
The risk weightings correspond in principle to those in Basel, but in contrast to the Basel requirements, CRR 3 does not provide for a risk weight of 150 percent for short-term receivables in Grade C, but only for a risk weight of 75 percent.
Assignment to Grade A is possible provided all the following requirements are met:
The debtor has adequate capacity to meet its existing financial obligations in a timely manner and regardless of economic conditions.
The debtor meets its regulatory capital requirements, including buffer requirements, and any other locally applicable comparable capital requirements, as applicable.
Information regarding compliance with regulatory capital requirements is publicly available.
The bank's internal assessment (analogous to the process for externally rated exposures) also concludes that the borrower has adequate capacity and complies with regulatory capital requirements.
If a debtor has a Tier 1 capital ratio of more than 14 percent and a leverage ratio of more than 5 percent and the exposure is not a short-term exposure, a risk weight of 30 percent is assigned.
Assignment to Grade B is possible if the following requirements are met:
The debtor does not have adequate capacity for repayment, but is subject to substantial credit risk and can only meet its obligations when economic conditions are stable or favourable.
The debtor meets its regulatory capital requirements (excluding buffer requirements) and, where applicable, any other locally applicable comparable capital requirements.
The information regarding the fulfilment of the regulatory capital requirements is publicly available.
The bank's internal assessment (analogous to the procedure for externally rated positions) does not produce any deviating results with regard to the institution's capacities and compliance with the capital adequacy requirements.
All exposures not classified in grades A/A+ or B are to be assigned to Grade C. Although Grade C is intended to be the residual for all exposures not to be assigned to the other grades, the CRR 3 draft additionally lists the following criteria for assignment to Grade C:
The debtor has a significant credit risk.
Unfavourable economic conditions can lead/have led in the short term to the debtor no longer being able to meet his financial obligations.
In the course of audits of the financial statements, the auditor expressed considerable doubts about the debtor's ability to meet its financial obligations.
Figure 2.5: Risk weights for exposures to unrated institutions
Source: Own representation.
When deriving risk weights on the basis of the three grades, it must also be taken into account that for debtors whose exposures are denominated in currencies other than that of the debtor's home country and are not short-term exposures arising from commodity transactions, the applicable risk weight may not be lower than the risk weight of the debtor's home country (determined on the basis of external ratings). This floor shall cover transfer, conversion or currency risks.
In summary, the provisions of the CRR 3 draft largely correspond to the Basel requirements. Compared to today's requirements for exposures to institutions, there will be slightly reduced capital requirements for externally rated institutions due to the slightly reduced risk weighting in credit quality step 2 and the inclusion of certain exposures with an original maturity of 6 months.
Due to the elimination of the home country principle for unrated exposures and the use of the SCRA with the classification into individual grades, significantly higher capital charges are to be expected in some cases, as many of the institutions that are currently not externally rated have their domicile in countries with a very good external rating, which currently leads to a risk weight of only 20 percent for these institutions. In the future, such exposures will have to be assigned a risk weighting of 40 percent or, at best, 30 percent.
2.5 Exposures to corporates
For exposures to corporates, a comparison of the rating to be used externally with an internal credit assessment will be necessary in future, analogous to exposures to institutions (see section 2.2). The risk weights for externally rated companies remain unchanged at between 20 percent and 150 percent. In future, however, a risk weight of 100 percent will no longer apply to companies with a rating in credit quality step 3, but only a reduced weight of 75 percent.
Unrated exposures to corporates continue to receive a risk weight of 100 percent. In these cases, the internal rating is not taken into account.
A significant change with regard to claims on corporates will result from the fact that in future, in addition to “regular corporate claims”, there will also be special financing transactions with a separate asset class (see section 2.6).
Figure 2.6: Risk weights for corporate exposures
Source: Own representation.
In summary, it is expected that there will be no material changes for loans and advances to corporates – with the exception of specialised lending. The capital charge will decrease slightly due to the lowering of the risk weight for credit quality step 3. Other changes envisaged by the Basel Committee relate to the preferential weighting of exposures to SMEs and have already been incorporated into the CRR. Only the comparison between external rating and internal rating required in future for externally rated companies is to be assessed as an additional burden – with potentially higher risk weights. However, the extent of this burden depends on the number of corporate exposures actually externally rated.
2.6 Specialised lending exposures
In the case of specialised lending exposures, in accordance with Article 122a of the CRR 3, lending is generally made to a special purpose vehicle (SPV) which has been established specifically to refinance a particular tangible asset, commodity or – subject to specified conditions – project (“investment”). It does not itself hold any significant assets other than the investment. It is also a prerequisite that the risk position vis-à-vis the special purpose entity is not secured by real estate or otherwise linked to the real estate financing.
Typically, the special purpose vehicle only has the function of taking out loans and collecting the income from the investment, which at the same time serves as the main refinancing source for the debt service incurred. The lending institution, on the other hand, has considerable control over the underlying assets and the income generated from them.
The CRR 2 rules of the SA do not distinguish between special financing and other risk positions vis-à-vis corporates, so there is no separate regulatory treatment. The increasing relevance is due to the pronounced business practice of specialized lending in the European Union, e.g. in the form of infrastructure and special projects. In particular, the amended regulation aims to create a convergence with the requirements of the internal ratings-based approach (IRB) for unrated risk exposures. For this purpose, the SA builds on a subset of the categories of its credit risk peers (cf. Article 147 (8) CRR 3), namely:
project finance (e.g., factories, infrastructure projects, wind turbines)
object financing (e.g., ships and aircraft)
commodity finance (e.g., crude oil and metals).
The further IRB classification for revenue-generating real estate (IPRE, cf. section 2.9) is found as a separate category in the exposure class “exposures secured by real estate”. Hence, there are therefore no material differences with regard to the scope of the separately treated specialised lending positions within the SA.
Given that there is no external issue-specific rating for the special financing under consideration, a risk weighting of 100 percent is generally provided for property and commodity financing. However, in order to make the SA more risk-sensitive, the possibility of a privilege is opened up in the form that a risk weighting of 80 percent can be applied for “high-quality” property financing. The quality can be measured, among other things, by criteria which prove that the borrower can meet its financial obligations even under considerable stress conditions. These include, for example, an appropriate ratio of the amount of the receivable to the value of the collateral or a conservative repayment profile. In addition, the contractual structure from the perspective of the lending institution, in particular the handling of the assets, must be assessed in order to determine the quality. Finally, the operational experience of the management must be assessed, e.g., the existence of all necessary permits and licences.
For project finance, i.e., those used to finance a project for the development or acquisition of large, complex and expensive construction assets, the risk weight depends on the project phase. A risk weight of 130 percent is applied during the pre-operating phase; in the operating phase, however, it is generally 100 percent. Similar to the aforementioned financings, privileged treatment can be obtained under certain circumstances. Among other things, sufficient cash reserves must be available. In addition, the contract partner of the special purpose vehicle is decisive for the assessment of the quality. This partner must meet certain supervisory standards, e.g., it may be a European national bank or a public body.
As with corporate receivables, specialised lending with an issue-specific rating receives a risk weighting of between 20 percent and 150 percent, depending on the external assessment.
Figure 2.7 summarises the risk weights for specialised lending:
Figure 2.7: Risk weights for specialised lending
Source: Own representation.
In practice, it is often difficult to make a clear distinction between corporate loans and specialised lending or within specialised lending. This is particularly true with regard to the economic and legal criteria, for example in the case of loans to hospitals, sports stadiums or multifunctional halls. This type of financing can involve both project financing and receivables secured by real estate; in this respect, a detailed case-by-case analysis may be necessary. The precise delimitation and classification of special financing is a new challenge for the SA, although it already exists in analogous form within the IRB. In order to enable a uniform assessment, the EBA is mandated by CRR 3 to present corresponding specifications by the end of 2025.
Under CRR 2 requirements, unrated property, project and commodity financings receive a risk weight of 100 percent as normal corporate exposures. Therefore, an RWA saving in the CRR 3 context can only be realized from a high-quality rating of the financing. It is to be expected that the privilege for existing specialised lending activities will hardly be used, as experience shows that the current constructs or projects rarely meet the strict requirements. Accordingly, the classification is relevant for new special financing in the future, so timely consultation is indispensable.
2.7 Subordinated debt and equity exposures
Currently, the CRR does not contain a separate exposure class for subordinated debt under the standardised approach. With CRR 3, Article 128 CRR is revised and an explicit risk weighting is applied to subordinated debt. The requirements for particularly high-risk exposures previously contained in Article 128 CRR are no longer applicable. The positions previously included in this asset class will be allocated to other asset classes – in particular special financing.
In the future, subordinated debt instruments will include all debt instruments that are subordinated to claims of other creditors as well as own funds instruments unless they are classified as equity exposures. In addition, these items include all liabilities pursuant to Article 72b CRR 3 (TCAL or MREL instruments).
For these risk positions, a risk weight of 150 percent is generally to be applied, unless the positions must be deducted directly from equity.
This new asset class may require considerable effort with regard to the identification of these positions. As the affected instruments receive a risk weight of 100 percent under the current CRR regulations, the capital burden for banks will increase significantly.
The risk weightings applicable to equity exposures change in a similar way. Currently, a risk weighting of 100 percent is applied to equity exposures (unless they are to be deducted from equity). In future, a risk weighting of 250 percent is envisaged for equity exposures. However, if speculative equity exposures are involved, e.g., equity exposures with trading intentions or equity exposures in venture capital firms, a risk weighting of 400 percent must be applied in the future.
The significantly higher risk weighting takes into account the significantly higher economic risk of an investment position compared to a regular receivable. The previous rule with a risk weighting of 100 percent does not adequately reflect the risk.
