CRR3 opens a new chapter in EU financial regulation

The third revision of the Capital Requirements Regulation (CRR3), which will come into force at the beginning of 2025, represents a major change in European banking regulation. Developed by the Commission and recently adopted by the European Parliament in response to the international reforms carried out by the Basel Committee, CRR3 aims to strengthen the resilience and stability of the banking sector.

The Capital Requirement Regulation was initiated in 2013. As early as 2019, CRR2 made adjustments in response to lessons learned from the 2008 financial crisis. The CRR3 reform (also known as “Basel IV”) is a continuation of the Basel III Accords; It establishes a set of rules aimed in particular at improving the comparability of prudential ratios between banks and preventing possible abuses that could result from the use of internal models that are sometimes considered “aggressive”.

CRR3 aims at:

• Strengthening banks’ resilience to economic shocks by increasing capital requirements (improving the level and quality of capital)
• Harmonising international regulations while ensuring that European banks remain competitive,
• Considering emerging risks, such as climate risks and cyber risks, that were not truly covered by previous regulatory frameworks.

CRR3 increases capital requirements

Input floors: a limit to optimization by internal models

Regardless of the quality of the risks underwritten, the probabilities of default (PD) and the level of losses given default (LGD) modelled by banks based on their historical data may not be lower than certain thresholds which depend in particular on the nature of the obligor or the nature of the collateral that guarantees each exposure.

The ban on internal LGD models for certain asset classes

CRR3 now requires banks to use regulatory LGDs (IRB-Foundation approach) for very large companies and financial institutions; however, these “low-risk” clienteles generally benefited from very favourable RWA in the IRB-Advanced approach

The Output Floor: a vector for harmonization between banks

One of the most discussed reforms of CRR3 is the introduction of the Output Floor. Under the new rules, the bank’s total RWA, calculated using internal models, cannot be less than 72.5% of the RWA calculated using the standardised approach. This measure aims to reduce excessive differences between banks using internal models, thereby increasing comparability and transparency.

One of the most discussed reforms of CRR3 is the introduction of the Output Floor. Under the new rules, the bank’s total RWA, calculated using internal models, cannot be less than 72.5% of the RWA calculated using the standardised approach. This measure aims to reduce excessive differences between banks using internal models, thereby increasing comparability and transparency.

Some “beneficial” measures

Among the few measures that make it possible to mitigate the increase in RWA under CRR3, we note the disappearance of the Scaling Factor, which increased RWA by 6% in IRB under CRR2, but also the maintenance of the Supporting Factor, which had been abolished in the B3F standard (Basel III Finalized). The Supporting Factor encourages banks to continue financing SMEs, which are a key sector of the European economy. However, while SME lending offers growth opportunities for banks, it also poses increased risks that banks need to manage carefully.

Major impacts beyond credit risk…

But beyond the expected increase in RWA on credit or counterparty risk, the consequences of CRR3 could be even more significant for other types of risks, and in particular:

• Market risk with the implementation of FRTB, which will lead to strong increases in RWA in certain activities, in particular Derivatives and Securities Lending
• Operational risk, with RWA that are now, under CRR3, very directly correlated with the bank’s NBI

Stricter capital requirements

With CRR3, banks will have to maintain a higher level of high-quality capital, mainly consisting of Common Equity Tier 1 (CET1). With mechanisms such as the IRB Shortfall or the Backstop (for defaulted exposures) requiring direct deductions from capital, many banks (especially those that make extensive use of internal models) will certainly have to increase the level of their risk provisions and review their capital structure by issuing new shares or limiting the distribution of dividends over the next few years.

The consequences are potentially serious for European banks

Increased pressure on profitability

This increase in capital requirements could put additional pressure on banks’ profitability, especially in a low interest rate environment where margins are already under pressure.

Strategic reorientations to be planned

Whether to limit RWA or to reduce their exposure to carbon-intensive industries, some banks could be forced to revise their pricing strategy, their risk appetite, or even give up developing in certain businesses, customer segments or geographical areas to refocus on the least exposed and most profitable activities.

Possible distortions of competition at international level

CRR3, by aligning European rules with international standards, aims to maintain the competitiveness of European banks. However, increased capital and liquidity requirements could put European banks in a difficult position vis-à-vis their non-European competitors. Indeed, the normative framework that will be imposed on US banks could prove to be less restrictive than the European standard in some respects, especially if the 2024 presidential elections revive the protectionist policy advocated by Donald Trump. Depending on the strict positions that supervisors may adopt, European banks could be heavily penalised, or even taken out of the game in certain areas (such as medium and long-term guarantees, which the ACPR seems to consider to be excluded from the scope of Trade Finance, which would multiply by 2.5 the capital requirements on these products).

A factor accelerating the consolidation of the sector

Compliance with CRR3 could also support the consolidation of the banking sector. Some medium-sized banks may find it difficult to make the investments needed to adapt their internal systems and processes or may not be able to cope with the increase in capital requirements. This consolidation could lead to the formation of larger banks, but it could also reduce diversity and competitiveness within the sector.

In conclusion…

CRR3 therefore represents a major turning point in European banking regulation. Its reforms aim to strengthen the resilience of the banking sector while encouraging better management of emerging risks. While these changes may impose additional costs on banks, they also provide opportunities to enhance transparency, competitiveness, and innovation. European banks must therefore adapt quickly to this new framework and take advantage of it to “reinvent themselves” in order to continue to thrive in an increasingly complex and regulated environment.