On 27 June 2023, EU co-legislators agreed a deal on the European Commission’s Banking Package, finalizing the implementation of the Basel III regulatory forms in the form of the third EU Capital Requirements Regulation (CRR3) and the sixth Capital Requirements Directive (CRD6).
Two of the key elements of the new regulatory framework for bank capital are the introduction of the “output floor”, intended to align more closely banks’ application of internal models (IM) and the Standardised Approach (SA), and more proportionate application of the rules for smaller, less complex institutions.
Over the past months, the International Capital Market Association’s (ICMA) European Repo and Collateral Council (ERCC) has been particularly focused on a critical feature of CRR3 related to the capital risk weighting of SFTs. One of the key provisions of the Final Basel III framework is a more granular but less sensitive recalibration of the credit risk (CR) weighting calculations under the Standardised Approach.
This is particularly punitive in the case of SFTs since it does not recognize the relatively short-term nature of SFTs in the case of exposures to non-banks. Accordingly, this results in the Risk Weighted Asset (RWA) computations for SFTs with many key market participants under the SA being multiples of those calculated under banks’ internal models. This contrasts with the treatment of short-term SFT exposures to banks for which Final Basel III recognizes their lower risk.
Furthermore, this detrimental treatment will also impact banks relying on their own IMs. There is no explanation as to why short-term exposures with non-banks are treated less favorably. Ahead of the Council and European Parliament discussions on the CRR3 proposal, the ERCC shared and discussed a position paper widely with Member States and MEPs. The ERCC recommends the introduction of a maturity adjustment under the SA-CR for short-term SFTs. This would be consistent with other aspects of CRR2 and CRR3 that take into account maturity sensitivities in the SA.
The European Council unfortunately proposed that the new calibration remain, but that the European Banking Authority (EBA), in close collaboration with the European Securities and Markets Authority (ESMA), report to the European Commission by the end of 2025 an assessment of whether a recalibration of the associated risk weights in the SA is appropriate, given the associated risks with respect to short-term maturities, specifically for residual maturities below one year.
On the basis of this report, the Commission could propose legislative changes by the end of 2027. ICMA understands that this proposal was agreed in the final trilogue process, and that the 100% RWA for SFT exposures with unrated non-bank entities will be entered into EU law.
In an interview last year, ICMA told Finadium that the difference between the RWA under the new SA and internal models can be as much as 5X-6X, which translates to additional costs of roughly 3 basis points when putting a repo on balance sheet with a non-bank counterparty. This is particularly problematic for sovereign bond repo, for which even a few basis points widening in the spread ends up in significant costs.