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ESG in Pillar I
CRR III introduces new requirements for the consideration of Environmental, Social, and Governance risks in Pillar 1, regulatory reporting and Pillar 3. These are based on uniform definitions of E, S and G provided by CRR III and complemented by corresponding Pillar 2 requirements enclosed in the CRD VI:
- Environmental Risk definition: Environmental risk refers to the financial impact on institutions from the immediate or potential effects of environmental factors on counterparties or invested assets. This includes risks associated with climate change mitigation and adaptation, sustainable water and marine resource utilisation, transition to a circular economy, pollution prevention and control, and biodiversity and ecosystem conservation. It encompasses both physical and transition risks.
- Social Risk definition: Social risk pertains to the financial impact on institutions arising from the current or potential impacts of social factors on counterparties or invested assets.
- Governance Risk definition: Governance risk relates to the financial impact on institutions due to the present or prospective impacts of governance factors on counterparties or invested assets.
With regards to Pillar 1 capital requirements, CRR III mandates the European Banking Authority (EBA) to produce a report on ways to include ESG consideration in the Pillar 1. This report was published by the EBA in the autumn of 2023 and will inform future proposals by the EU Commission. Rather than advocating ESG risk as a separate type of risk, the report makes proposals on how to include ESG’s influence on traditional financial risks like credit-, market and operational risk in the prudential framework. Being mindful of ongoing developments in the area, the EBA report also clearly distinguishes between short term measures and measures that will need to be revisited in the future:
- Short term measures include the consideration of ESG in the valuation of collateral, requiring institutions to assess significant decreases in collateral market value due to ESG factors. This entails thorough valuation and revaluation to account for collateral deterioration or obsolescence.
- Long term measures may include green or brown factors that directly impact the calculation of risk weights
Incorporating ESG risks may lead to an increase in risk-weighted assets and minimum capital requirements, necessitating early analysis for future capitalisation and methodological revisions of risk models. Challenges include integrating ESG factors into collateral evaluation, differentiating between EU and non-EU market risks in carbon trading, identifying exposures to ESG risks, and embedding ESG considerations into business strategy, governance, risk management, reporting, and disclosure. Institutions must meticulously assess regulatory changes and treatments, ensuring coherence across the three pillars of banking regulation and effectively addressing emerging challenges.
Crypto Assets
As the financial services industry's interest in crypto assets grows, the EU is setting the stage for their prudential treatment, building on the foundation laid by the Markets in Crypto Asset Regulation (MiCA). CRR III underscores key provisions regarding the disclosure of exposures to crypto assets and related services, along with their prudential treatment.
In December 2022, the Basel Committee on Banking Supervision (BCBS) released a final standard on the prudential treatment of crypto assets. This standard categorises crypto assets into distinct groups, significantly affecting their associated risk-weighted assets. A legislative proposal by the EU Commission, due by 30 June 2025, is expected to align with BCBS and international standards, thereby introducing a dedicated prudential treatment for crypto asset exposures in the European Union.
Until this proposal becomes effective, transitional provisions for the treatment of crypto assets are as follows:
- Exposures to tokenised traditional assets will be treated as exposures to the underlying traditional assets, unless their value depends on another crypto asset, in which case a 1,250% risk weight applies.
- Exposures to asset-referenced tokens (ARTs) that comply with MiCA and reference traditional assets will have a 250% risk weight.
- Exposures to other crypto assets will carry a 1,250% risk weight.
Institutions' total exposure to crypto assets must not exceed 1% of their Tier 1 capital. Exceeding this limit requires immediate notification to the competent authority.
Further Amendments
Minimum requirements for own funds and eligible liabilities (MREL)
The Bank Recovery and Resolution Directive (BRRD) introduced the minimum requirements for own funds and eligible liabilities (MREL) in 2016 for European Union institutions. MREL's purpose is to ensure these institutions always uphold a specific ratio of their own funds and liabilities that can be bailed-in. This ensures that, during a resolution, there's an adequate bail-in capital buffer.
MREL, which is expressed as a percentage of an institution's total liabilities and regulatory own funds, is applicable to a broad spectrum of European institutions under the BRRD, irrespective of their size or systemic importance.
Moreover, resolution authorities determine MREL individually for each institution, allowing for adjustments based on each institution's unique characteristics and ensuring proportionality.
MREL is composed of a loss absorption amount (LAA) and a recapitalization amount (RCA):
- The LAA for calculating MREL is composed of the minimum capital requirement (i.e. total capital ratio of at least 8% RWA), the surcharge set by the supervisory authority for each individual institution and the capital buffer requirement, or consists of the future leverage ratio requirement if this should be higher.
- For institutions for which the resolution authority does not provide for regular insolvency proceedings in the resolution plan but for resolution because the former would not be suitable for achieving the resolution objectives, the provision of a RCA is also required in addition to the loss absorption amount. This is determined for an institution depending on the resolution strategy listed in the resolution plan.
The adequate recapitalization of a successor institution is particularly important for its acceptance, so that the market classifies such an institution as solvent.
The requirement is determined by the resolution authority on the basis of various criteria (e. g. size, business model, refinancing model and risk profile of the entity).
Changes with BRRD and impact for banks
When determining the minimum MREL ratios, it is important to note at which level they must be complied with. Currently, institutions have to meet the MREL requirements at the individual level. In addition, EU parent companies must comply with a minimum ratio on a consolidated basis.
As a result of the amendments to BRRD, the requirements at the individual level of the winddown unit no longer apply. For subsidiaries that are not defined as a wind-down unit, the minimum requirement at individual level must be met as an internal MREL ratio. The level of the requirement is determined jointly by the group resolution authority and the resolution authority of the subsidiary as part of the resolution strategy.
The national resolution authority responsible for a subsidiary may waive the minimum requirements for eligible liabilities. BRRD will remove the link to the existence of an own funds waiver. In return, conditions for the granting of the MREL waiver are defined that are comparable to the capital waivers.
For subsidiaries, BRRD results in some clarifications regarding the instruments that can be recognized. The MREL requirements must be covered by instruments included within the group. In addition, own fund items raised from entities outside the resolution group may be eligible, provided that a write-down or conversion of these instruments does not impair the resolution entity's control over the subsidiary.
Changes to the SA-CCR and impact for banks
Introduced by CRR II in 2021, the standardised approach for counterparty credit risk (SA-CCR) is one of the more complex variations of a standardised approach. Taking into account the lessons learned since then, CRR III includes some detailled changes to the SA-CCR framework:
1. Creation of netting sets for the case of multiple margin agreements
CRR provides guidelines for calculating exposure values when multiple margin agreements are applied to the same netting set. CRR III revises this approach, introducing a distinct logic for the formation of netting sets to calculate the exposure value:
- Transactions under the same margin agreement and margin period (MPOR) are to be grouped into a (hypothetical) sub-netting set.
- Transactions under a margin agreement but with different MPORs should be allocated to distinct (hypothetical) sub-netting sets based on their respective MPORs.
- Transactions not covered by a margin agreement are to be allocated to a separate (hypothetical) sub-netting set.
Under CRR III, the approach for calculating replacement costs (RC) and potential future exposure (PFE) has been revised. The individual components of replacement costs – CMV, NICA, VM, TH, MTA – should be aggregated across (hypothetical) sub-netting sets. The multiplier for PFE is to be calculated at the netting-set level, while the Addon is computed separately for each hypothetical sub-netting set and then aggregated.
The significance of this change depends on the bank's business model. For banks where this is relevant, the impact can be substantial, as it alters the methodology for calculating exposure value and its input factors. Additionally, banks are required to establish hypothetical sub-netting sets, fundamental for calculating the exposure value.
2. Splitting of digital vanilla options
CRR requires the split of finite linear combinations of bought or sold long or short positions for Caps, Floors, Collars and Straddles. CRR III expands this requirement to include digital vanilla options, necessitating their segmentation into sold/bought vanilla call/put options (collar combination).
The impact of this change hinges on a bank's business model. If digital options are absent from a bank's portfolio, the impact is minimal. However, for banks holding such positions, this alteration is significant. Banks must now divide these options into collar combinations of sold/bought vanilla call/put options. This necessitates a review and modification of data delivery into current regulatory reporting systems and the integration of this new data into the existing data model. Banks should ensure that their collar combinations comply with CRR III conditions and re-evaluate them as necessary.
