The latest revision of the EU Capital Requirements Directive and Regulation (CRD and CRR, also known as the "EU banking package") has now been endorsed by the EU Council and EU Parliament. The new measures implement the 2017 Basel III standards in the region and seek to address new emerging risks facing its banking system. But the protracted negotiations have inevitably led to compromises and tentative steps. S&P Global Ratings believes that while some aspects of the regulatory framework have improved, divergence from Basel standards has not been fully resolved. In our view, these deviations--which we also see in other regions--undermine a core ambition of Basel III: global regulatory consistency (see "The Basel Capital Compromise For Banks: Better Buffers, Elusive Comparability," published June 3, 2021).

The rollout is largely neutral for bank ratings. Many EU banks are already well-capitalized in anticipation of the increase in regulatory risk-weighted asset requirements. Therefore, we don't expect a meaningful increase in banks' capital levels. This was also confirmed by the latest impact assessment published by the European Banking Authority (EBA), which indicated that the overall Tier 1 capital requirements would increase by a relatively limited 9% by 2028 under the new rules, and that the estimated capital shortfall had been virtually eliminated already at the end of 2022.

Comparability:   The new rules include output and input floors to improve the comparability of internal model outcomes, a key objective of the global Basel III standards. The output floor sets a lower limit to the capital requirements that are produced by institutions' internal models; the floor will gradually increase to reach 72.5% of the own funds requirements that would apply under a standardized approach by 2028. The input floors set lower limits on the banks' modelling assumptions. The revised standards also mark the end of internal modelling practices for operational risk measurement, which is now subject to a new standardized approach.

Risk-sensitivity:   A series of amendments focuses on standardized risk-weights for credit risk. Examples include:

• More granularity in the risk-weighting of real estate exposures, especially those to income-producing residential and commercial real estate, for which repayment is materially dependent on cash flows generated by the property;
• New exposure classes with associated risk-weights for project finance, object finance, and commodities finance;
• Increased risk-weights for equity exposures; and
• An increase in the credit conversion factors applicable to some off-balance-sheet items.

An additional change in this area are binding requirements around market risk, based on the Fundamental Review of the Trading Book (FRTB) led by the Basel Committee. Previously, EU banks were only subject to reporting requirements based on FRTB.

The revised Banking Package will now be subject to legal revision and a final vote in the EU Parliament Plenary. It should take effect from Jan. 1, 2025, but it includes around 140 mandates for the EBA to produce various technical standards, guidelines, and reports, with a final deadline for all regulatory initiatives of the end of 2028.

EU Banking Package Also Addresses Other Prudential Objectives

As well as implementing Basel III standards, the revised banking package addresses secondary prudential objectives that are more specific to the EU.

First, the rules harmonize the regulatory framework applicable to third-country branches (TCBs), which remain supervised at the national level.   TCBs have grown in importance in the past few years as several international firms have chosen this legal structure to provide banking services in the EU, following the loss of passporting rights for their U.K. entity post Brexit. As a result, there were 106 TCBs in the EU at the end of 2020, with aggregated assets of over €500 billion.

In contrast to a subsidiary, which is a legal entity and supervised as such, a branch is a mere extension of a parent bank. A branch is therefore predominantly subject to supervision from the home (foreign) authority. Under the new rules, these TCBs will be subject to harmonized rules on authorization and minimum capital/liquidity requirements. Supervisory authorities are also now granted the power to force subsidiarization of a TCB, for instance if a TCB poses a risk to financial stability or if the total assets held by a third-country banking group in the EU (potentially via multiple branches) exceeds €40 billion.

That said, the final text carves out several exceptions. For example, it allows third-country institutions to provide interbank or investment services without necessarily triggering the requirement to establish a branch.

Second, the revised rule extends the scope of fit and proper assessment.   This includes a broader set of bank managers, known as key function holders. It also clarifies some requirements (for instance around management board diversity). Under the new rules, members of a bank's management board can also be subject to periodic penalty payments if they are deemed to be personally responsible for the bank's breach of specific prudential requirements.

Third, the revised banking package clarifies the regulatory framework around the management of environmental, social, and governance (ESG) risks by banks.   The main aspects relate to the introduction of ESG risks within the second pillar of the prudential framework. In practice, the European Banking Authority (EBA) will be mandated to develop guidelines on the inclusion of ESG risks in the Supervisory Review and Evaluation Process (SREP) and standards for the stress testing of such exposures. Banks will also be required to include ESG risks in their strategies and processes for evaluating internal capital needs and adequate internal governance.

We note that this EU approach is broadly similar to the one followed by the Bank of England (BoE). Indeed, the BoE published a report in March 2023 updating its approach to assessing climate risk within the regulatory capital framework. It identified gaps in the current regime and highlighted the use of the Pillar 2 framework, including Pillar 2A capital add-ons, to capture material risks.

Beyond this, the EU banking package encourages macroprudential authorities to impose a systemic risk buffer for exposures to climate-related physical and transition risks, if not already done and if they deem it effective and proportionate. This is already possible under existing law, and in line with the outcome of the European Central Bank's (ECB) recently published work about the potential tools to embed climate-related risks into macroprudential measures for the banking sector.

What's more, banks will be subject to a new requirement to develop and monitor the implementation of specific plans and quantifiable targets to address the financial risks arising in the short, medium, and long term from ESG factors. This will strengthen banks' accountability against their transition plans and will come into force in parallel with the new framework recently launched by the United Nations for monitoring the credibility of net-zero plans by non-state actors (corporates, financial institutions, municipalities).

The deeper inclusion of ESG risks into banking regulation will provide supervisors with more effective tools and powers. We note, however, that this is only one step on the long journey to integrate climate risks in the prudential framework (see Box 2).

Fourth, the revised rules introduce disclosure and prudential requirements for crypto assets.  Banks will be subject to a new requirement to disclose their direct and indirect exposures to crypto assets, as well as any related business and risk management activities.

At the same time, banks will have to apply a 1,250% risk-weight for their exposures to crypto assets, with an exception for asset-refenced tokens whose issuers comply with the market in crypto asset (MiCA) regulation (250% risk-weight). By June 2025, the European Commission will also need to propose new legislation on the prudential treatment of crypto assets, based on the Basel framework published in December 2022.

The revised EU banking package does not address some of the risks that have materialized for banks in recent months. For instance, the prudential rules for the management of liquidity and interest rate risks are unchanged. We believe that any regulatory initiative in these fields would first need to take shape at a global level before the EU considers further changes to its own framework.

Public Policy And Industry Considerations Made Their Mark

The final text is a compromise between the EU co-legislators which, as widely expected, includes several divergences and delays compared with the Basel standards. Most of these divergences were already included in the initial draft proposal put forward by the EU Commission in 2021 (see "Basel III Bank Capital Rules In Europe: Delayed And Diluted"). In our view, these deviations, along with expected deviations in other regions, partly erode the overarching objective of global regulatory consistency for banks.

The EU delays and divergences from Basel standards mainly reflect long-standing political and industry considerations (see chart 1). Indeed, banks continue to provide the bulk of the financing to the EU economy, making any change to their capital requirements (and therefore their capacity to lend to the economy) a subject of heated political discussions.

EU banks securitize much less of their underwritten credit than do U.S. banks, most importantly mortgages, which represent around a third of total customer loans. This specific EU consideration largely explains the two main transitory deviations from Basel standards, namely the preferential risk weights under the output floor calculation for unrated corporates with a low probability of default and for low-risk mortgage exposures. EU legislators deem these measures as necessary to avoid cliff effects in the provision of credit. Taken together, the two measures will largely mitigate the effect of the introduction of the output floor, during the transition period until 2032.

Chart 1

Some historical and permanent deviations from Basel standards will continue after this revision of capital rules, namely:

• The lower risk-weights for participations in insurance subsidiaries that are within the scope of prudential supervision (the so-called "Danish compromise");
• The preferential treatment of sovereign exposures; or
• The SME and infrastructure supporting factors that allow lower related risk weights than under Basel rules.

These reflect industry considerations, in particular the importance of the bancassurance model in Europe, as well as public policy considerations, due to the importance of bank funding in the sovereign debt market and the SME and infrastructure markets. The latter has led to an assessment by the Basel Committee that EU regulations are "largely non-compliant" with Basel standards. Another temporary deviation from Basel rules that was added in the final text is a new temporary prudential filter. This allows banks to exclude from regulatory capital unrealized gains and losses on their government debt portfolios held at fair value through other comprehensive income, until the end of 2025. This is to avoid the potential volatility in reported capital due to the "extraordinary and unprecedented pace of monetary policy tightening" currently under way.

As part of the negotiations between co-legislators, some additional amendments were introduced compared with the initial draft proposal from the EU Commission, mainly upon the proposal from the Council (i.e., the finance ministers of member states). For instance, it was decided that the output floor would apply at all consolidation levels (i.e., on each entity within banking groups) with an option for member states to apply only at the highest level of consolidation within their jurisdiction. This amendment ensures that host supervisory authorities can apply the output floor to local subsidiaries operating in their countries, but it will somewhat hinder the flexible allocation of capital across member states for cross-border banking groups. The EU Commission will assess the impact of this deviation in a report due by end-2028. Another transitional measure for banks calculating their output floor relates to the risk-weighting of their securitization exposures, for which they will be allowed to apply a favorable treatment until 2032. This is to avoid the potential negative impact on the volume of securitization by banks using internal ratings-based (IRB) approaches, which would counter one of the stated policy objectives behind the deepening of a Capital Markets Union (CMU) in the EU.

Further, some proposals from the European Parliament to make limited progress on the long-standing issue of capital waivers (which cannot be granted to banks operating across borders) were also set aside during negotiations. All in all, these amendments underline that no major progress toward completion of the EU Banking Union was made in this round of reform.

Finally, an important industry consideration which emerged in multiple aspects of the revised banking package is the application of the principle of proportionality. For instance, minimum requirements are stricter for TCBs recognized as Class 1, meaning that they have more than €5 billion in assets and/or take significant retail deposits.

In the U.K., the PRA's Basel III.1 consultation adhered more closely to the Basel standards than the EU's banking package, most notably in the application of the output floor. Nevertheless, the PRA proposed to diverge from the Basel framework in certain areas. For example, in the standardized approach to credit risk, the PRA outlined a more risk-sensitive treatment of unrated corporate exposures, removed the SME support factor, and introduced a new 85% risk-weight on a "corporate SME" exposure category. In the internal ratings-based approach to credit risk, the PRA took a more conservative approach than the Basel standards in certain areas, such as by prohibiting the use of such models for sovereign exposures and doubling the probability of default floor for U.K. mortgages.

Reform Is Neutral For EU Bank Ratings

We view the EU regulatory and supervisory framework as average, meaning that it is broadly in line with international standards and that we consider banking supervision to be effective and hands-on. This is despite the deviations from Basel that we noted above, and which for some are permanently enshrined in EU law (e.g., the Danish compromise). Although the new banking package will lead to some improvements in the regulatory framework for banks, we don't see this as in and of itself changing our view of institutional frameworks in EU countries.

Most banks' capital policies already take into account the likely impact of Basel implementation, with banks maintaining large management buffers above current requirements to help absorb an expected future rise in regulatory RWAs. As of December 2022, the EBA found that, across a sample of 157 EU banks, the Tier 1 capital shortfall against the revised capital rules had been reduced to only €0.6 billion. We don't expect the implementation of the revised capital rules will lead to a meaningful increase in capital levels for EU banks overall.

Some larger banks might see an increase in regulatory RWAs, though, and therefore in capital requirements, mainly due to the introduction of the output floor. Indeed, large banks tend to use the IRB approach to calculate credit RWAs, so will take a hit if the output of their IRB model is below the output floor. According to the EBA, capital requirements would gradually increase by 7.4% by 2028 for these larger banks. We consider this impact to be relatively modest and mainly the result of the transitional measures related to low-risk mortgages and unrated corporates described above. According to the EBA, larger banks have already fully absorbed the increase in RWAs resulting from Basel III finalization, with no shortfall at the end of December 2022.

That said, higher capital needs for selected activities could lead to some business model changes over time, as banks continuously optimize their capital allocation to meet return on equity (ROE) targets. This will particularly be the case after the end of the transition period in 2032, when certain activities (such as low-risk mortgages or exposures to unrated corporates) would see a rise in required capitalization. The final text indicates that any extension of this transitional period would need to be substantiated and limited to four years at the most.

As we expect global divergences with the Basel standards to persist, we will continue to use our S&P Global Ratings risk-adjusted capital (RAC) framework as our preferred measurement for bank capital adequacy.

The change in calculations of regulatory RWAs for market risk in the trading books and credit valuation adjustments might lead to some changes in our S&P RWAs, as these are calibrated based on regulatory RWAs. As for credit RWAs, changes to the regulatory calculations might have an impact on our S&P RWAs via changes to exposure-at-default, which are the basis of our S&P credit RWAs. Overall, we don't expect these changes to have a material impact on RAC ratios, however.

If some banks increase their capital base to mitigate higher regulatory RWAs, then their RAC ratios may rise. But this is unlikely to change ratings since capital and earnings assessments tend not to be highly sensitive to small changes in RAC ratios. As for accounting changes, we wouldn't see a change in ratio, without a change in the actual underlying exposures, as affecting the creditworthiness of the bank.

Looking ahead, and beyond the end of transition periods in the next decade, EU banks could face stricter capital requirements to continue to hold low-risk mortgages and exposures to unrated corporates--unless EU legislators agree on an extension of the transition period. Given the large capital needs expected to finance the digital and green transition, which remain at the top of the EU authorities' political agenda, this calls for a deepening of the EU capital markets, over time.

As for the completion of the Banking Union, progress on a CMU is likely to be both increasingly necessary and politically challenging. A case in point is the fate of the securitization market which, despite lower past default rates than in the U.S. and a new regulatory framework, has so far failed to be re-ignited. With regard to other aspects of the CMU, a fully functioning securitization market would lead to a greater diversification of funding options for the EU economy. And that would allow banks to optimize their balance sheet by transferring risks.

Related Research

• ECB Stress Test: Eurozone Banks Need To Do More To Comprehend Climate Risk, July 11, 2022
• Capturing Environmental Risks In Banks’ Capital Frameworks Is An Ongoing Discussion In Europe, May 6, 2022
• Basel III Bank Capital Rules In Europe: Delayed And Diluted, Oct. 28, 2021
• The Basel Capital Compromise For Banks: Better Buffers, Elusive Comparability, June 3, 2021