A closer look at the EU Banking Package

Introduction

A new legislative package aimed at implementing the final elements of the international Basel 3 standards was recently adopted in the EU. The package, which also covers other banking matters, aims to strengthen banking regulation while ensuring that European banks remain resilient and capable of operating effectively during economic shocks.

The EU Banking Package, as it is referred to, was published in the Official Journal of the European Union on 19 June 2024.

In addition to implementing global standards, the EU Banking Package introduces requirements in areas like fit and proper criteria for bank leadership, supervising third-country branches operating in the EU (TCBs), and integrating environmental, social and governance (ESG) risks into banking regulation.

 

Basel Standards

The “Basel” Framework is a shorthand description of the standards set by the Basel Committee on Banking Supervision (BCBS). Although its standards aren't legally binding, BCBS is considered a leading global standard setter for the prudential regulation of banks and constitutes a forum for regular discussions and cooperation on banking supervision. BCBS consists of 45 members from central banks and bank supervision authorities from 28 States jurisdictions (including all the major financial centres such as the US, EU, UK, and Japan).

In the last four decades BCBS has developed different sets of international regulatory and prudential standards of progressively broader scope and higher sophistication.

Basel 1 (1988) was the first internationally agreed set of standards, primarily focusing on concerned eligible capital and credit risk.

Basel 2 (2004) was of significantly larger scope. It adopted a three-pillar approach (regarding minimum capital requirements, regulatory supervision, and market discipline), and introduced the Internal Rating Based (IRB) approach, allowing banks to use their own internal risk estimates in determining credit risks.

Basel 3 is the set of standards agreed by BCBS to enhance the prudential regulation, supervision and risk management of banks prepared as a response to the 2007-2008 global financial crisis to improve banks' resilience to economic shocks. The key idea behind the reform is that long-term benefits of more robust regulation and prudential standards outweigh the short-term costs of their implementation (as shown in Chart 1¹below):

In the EU, the outstanding parts of Basel 3 are implemented (with some adjustments) through the latest Banking Package. It consists of:

• Regulation 2024/1623 of the European Parliament and of the Council of 31 May 2024 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 III); and the
• Directive (EU) 2024/1619 of the European Parliament and of the Council of 31 May 2024 amending Directive 2013/36/EU as regards supervisory powers, sanctions, third-country branches, and environmental, social and governance risks (CRD VI).

Timelines: The CRR III will apply from 1 January 2025, although some provisions have already applied since 9 July 2024. And the Fundamental Review of the Trading Book (FRTB) will be applied by 1 January 2026. EU member states have to transpose the CRD VI into national law by 10 January 2026, except for the provisions on third-country branches which will be applicable from 11 January 2027.

In this article, we summarise some of the key changes introduced in the Banking Package.

 

Credit risk

The BCBS has found the current Standardised Approach for credit risk (SA-CR) to be insufficiently risk sensitive in several areas, leading to inaccurate — either too high or too low — measurements of credit risk and hence, of own funds requirements. Against this background, SA-CR was revised to increase the risk sensitivity by reviewing the prudential risk weights and adding more detail on specific exposure classes.

CRR III introduced some key adjustments to the credit risk capital requirement calculations. CRR III aims to improve the risk sensitivity of the standardised approach including provisions relating to:

• exposure value of off-balance sheet items
• exposures to credit institutions (ie banks) and corporates
• treatment of specialised lending exposures
• real estate exposures (ie residential and/or commercial immovable properties)
• equity exposures
• foreign currency exposures

 

Market risk

An important aspect of the Banking Package is the inclusion of the FRTB. It introduces specific disclosure requirements to enhance transparency around capital requirements for market risk.

The FTRB imposes more rigid rules for banks that use their own internal models for calculating capital and secures that they capture tail risk.

The FRTB also aims to fully consolidate the regulations and requirements governing trading book activities, including revising trading book boundaries as against banking books. This will make it easier to compare risk-based capital ratios across banks and is designed to reinstate confidence in those ratios and in the banking sector overall.

 

Operational risk

An operational risk event means any event linked to an operational risk that generates a loss or multiple losses, in one or multiple financial years.

CRR III includes a new Standardised Measurement Approach (SMA) for measuring the minimum capital requirements for operational risk, applicable to banks. The new SMA provides a specific formula that calculates the business indicator (BI), which determines the own funds requirement for operational risk. The BI is derived from the following primary components: the interest, leases and dividend component, the services component and the financial component. As indicated in the regulation, each of the above components is further broken down into several sub-components.

 

Output floor

Introducing the output floor is one of the key regulatory measures of the Basel 3 reform.

Following lengthy deliberations, the BCBS decided to continue to permit internal models. By setting a minimum threshold for capital requirements calculated using internal models, it aims to limit the risk of excessive reductions in capital.

If internal models are used, the threshold is set as a percentage (72.5%) of RWAs calculated using the standardised approach and is phased in over a transitional five-year period.

Figure 1 - Output Floor phase-in period

Pursuant to CRR III, the output floor requirements should generally apply at all levels of consolidation. But if a member state decides that this objective can be achieved by different means, particularly for certain groups, like cooperative groups with a central body and affiliated institutions within that member state, it can choose not to apply the output floor requirement at the individual level or at a sub-consolidated level for institutions within its jurisdictions. This is permitted as long as the parent institution, at the highest level of consolidation within the member state, adheres to the output floor based on its consolidated situation.

 

Third-country branch regime

Branches established by companies from third countries to provide banking services in a member state are regulated primarily by national laws, and only harmonised to a non-exhaustive extent by Directive 2013/36/EU.

Although these third-country branches have a growing role in EU banking, they're subject only to general information requirements, lacking uniform prudential standards or supervisory cooperation at the EU level. This fragmented regulatory approach creates diverse standards across member states, limiting authorities’ ability to monitor risks effectively. To address these challenges, a harmonized framework for third-country branches was suggested, focusing on shared standards for authorization, prudential measures, governance and reporting.

CRD VI provides for minimum harmonizing conditions for establishing branches of third-country banks in the EU, including capital requirements, liquidity requirements, internal governance obligations, outsourcing management, and booking requirements. 

CRD VI introduces that third-country branches must apply for authorisation so they can provide core banking services (eg taking deposits and other repayable funds, lending, guarantees and commitments)² in a member state.

Article 48c of CRD VI sets out minimum requirements for authorisation in the member states. For example, the activities that the head undertaking seeks authorisation for in the member state have to be covered by the authorisation that the head undertaking holds in the third country where it's established. And they're subject to supervision in that third country. Article 48d of the directive sets out the grounds for the refusal or withdrawal of an authorisation.

The authorisation requirements will generally also apply to the existing branches of third-country banks that already fully licensed, if they want to continue to provide core banking services in the EU.

However, national competent authorities have the discretion to exempt such branches, for instance, if the branches are already subject to at least equivalent requirements.

 

Environmental, Social and Governance risks

The unprecedented scale of transition to a sustainable, climate-neutral and circular economy has significant impact on the financial system. And institutions are having to make major changes to their business models. Businesses have to manage climate-related and other environmental risks, for example those arising from environmental degradation and biodiversity loss, in terms of both transition and physical risks.

In line with EU's sustainability goals, the banking sector should take ESG risks into account in its risk assessments and disclosures. The Banking Package integrates Environmental, Social and Governance risks into banking framework.

• The Banking Package includes new disclosure requirements and management requirements (eg regular climate stress testing) of ESG risks.
• Banks will have to draw up a prudential transition plan that's consistent with the sustainability commitments banks undertake under the Corporate Sustainability Reporting Directive.
• The Banking Package extends disclosure of ESG risks to all banks, with a proportional approach for smaller institutions.
• Systemic risks related to climate change can be addressed through the Systemic Risk Buffer.
• Institutions will need effective and comprehensive strategies and processes to assess and maintain the amounts, types and distribution of internal capital they consider adequate to cover the nature and level of the risks to which they are or might be exposed. Institutions have to explicitly take into account the short, medium and long term for the coverage of ESG risks.
• The Banking Package introduces a sustainability dimension in the prudential framework to identify, measure, manage and monitor ESG risks.
• The Banking Package integrates ESG factors and risks into the Supervisory Review and Evaluation Process, and it develops standards and methodologies to identify, measure, manage and monitor ESG risks.