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  • The Supervision Blog

Mind the gap, close the gap – the ECB’s views on the banking package reforms

Blog post by Frank Elderson, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB

Frankfurt am Main, 28 April 2022

Today, the ECB published its opinion on the European Commission’s proposed revisions to the Capital Requirements Directive (CRD VI)[1]. Together with the proposed amendments to the Capital Requirements Regulation (CRR III), published in March 2022, the reforms comprise the EU’s latest “banking package”.

One of the main goals of the banking package is to implement in EU law the Basel III international standards which were developed in response to the great financial crisis. The Basel III standards bring key improvements to global financial regulation. They aim to ensure that banks throughout the world are better capitalised and more resilient to economic downturns, so that in times of crisis they can ultimately act as a shield for the economy, rather than a shock amplifier.

The Basel III standards have not yet been fully implemented in European banking regulation. The Commission’s CRR III proposals aim to achieve this full implementation, which the ECB very much supports. However, there are some differences – or gaps – between the Basel III standards and the CRR III proposals. This is why our advice to legislators is to “mind the gap” that will open up if Basel III standards are not implemented as originally designed. We believe that deviations from Basel standards will leave European banks exposed to pockets of unaddressed risks.

The CRD VI proposals, in turn, are aimed at further strengthening the EU prudential framework, tackling emerging risks to banks (especially those stemming from the climate crisis), and closing loopholes in regulation. The ECB greatly welcomes these proposals. In the current set up, certain supervisory rules and powers are decided unilaterally by each country, and not covered by European regulation. The CRD VI proposal now includes provisions on these rules and powers, so that they are finally harmonised across the EU, and implemented equally to all banks, regardless of the EU country in which they are headquartered.

In sum, reducing the riskiness of banks’ exposures and achieving greater harmonisation in rules will make the ECB’s banking supervision more effective, and in turn deliver a banking sector that is more integrated and more resilient.

This blog post summarises the ECB’s opinion on some of the key areas of the CRD VI. The ECB’s opinion on the CRR III[2], published earlier this year, is also briefly discussed.

Capital Requirements Directive (CRD VI) – closing the gap

Managing the risks from the green transition

Environmental, social and governance (ESG) risks have far-reaching implications for the stability of both individual banks and the financial system as a whole. We welcome the Commission’s decision to include these risks more explicitly in banking regulation, as this will grant supervisors more adequate tools to require banks to address ESG risks more rapidly and effectively.

This is particularly important in light of recent findings from an ECB benchmark showing that 90% of banks deem their own practices to be only partially or not at all compliant with the ECB’s supervisory expectations for the management and disclosure of climate-related and environmental risks[3]. Significant progress towards meeting our expectations is therefore urgently needed.

The Commission’s proposal includes a new legal requirement for banks to prepare prudential plans to address climate-related and environmental risks arising from misalignment with EU policy targets. The proposal mandates supervisors to check these plans and to require banks to implement mitigating measures if misalignment between these EU goals and a bank’s strategy leads to inadequate management of these risks.

It is important to note that these EU targets serve as a benchmark to measure banks’ deviations and to assess the associated risks. Misalignment with the EU transition pathway leads to financial, legal and reputational risks for banks. This explicit new competence to supervise transition plans should not be interpreted as stretching beyond the current risk-based focus of supervision. In fact, the opposite is true: it helps supervisors to ensure banks adequately manage climate-related risks.

For instance, a bank that finances companies which breach EU standards on carbon emissions will in the future face significant transition risks. The CRD VI obliges this bank to devise a plan for how to measure and address this increase in risk, as well as how to mitigate it by supporting the transition and adaptation of clients, especially those from the most exposed sectors.

It follows that a bank choosing to finance a non-green sector client to support this client’s transition to alignment with the EU transition pathway may be perfectly acceptable – so long as this bank adequately deals with the risks that financing these companies poses to its balance sheet.

Strengthening the governance of banks

For banks, one of the key success factors for timely and effective risk mitigation is having strong, state-of-the-art governance. This is true not only for ESG risks or risks that are more acute in times of crisis, but for all risks at all times. Well-governed banks are more resilient to adverse market developments. They manage their risks better and contribute to making our financial system safer and stabler. That is why it is paramount that banks are led by people who are highly qualified (“fit and proper” in supervisory parlance) for the job.

One way of improving bank governance is ensuring that only suitable and experienced managers are appointed to the top positions of a bank. The ECB already plays a gatekeeper role in this regard, but we have been hampered by the patchwork of different national rules.

One of the things that the Commission proposal tries to do, in a balanced way, is to close the gaps that still exist in this supervisory framework for assessing how well suited to their roles the directors of European banks are. Essentially, it aims to ensure that board members of banks are held to the same standards of conduct, experience and reputation in all EU countries. This will make our banks stronger and our supervision less complex and therefore more effective.

We have encouraged banks to notify us about prospective candidates for executive positions as early as possible. Such prior, or ex-ante, assessments will allow us to better fulfil our role as gatekeepers of the financial system. The ECB agrees that a proportionate approach is in order here. Because some banks in Europe conduct much larger or more complex operations than others, we support the Commission’s proposal to focus on directors of the largest European banks. We stand ready to explore further ways to render the new system even more proportionate. The CRD VI amendments do not affect statutory rights for appointments of individuals such as employee representatives to banks’ boards, as these remain under national law.

The Commission proposal also tries to resolve the remaining differences between European countries regarding other supervisory powers, such as sanctioning powers. For example, it grants the ECB the power to impose periodic penalty payments on banks from all countries of the banking union. The ECB can sanction a bank for engaging in misconduct, and by doing so remove incentives for other banks to engage in similar behaviour.

Keeping risks from abroad in check: common rules for third-country branches

Under the current regulation, different countries apply different supervisory practices to branches of banking groups that operate in the EU but are headquartered outside of it (the so-called third-country branches)[4]. These regulatory differences create an unlevel playing field and prevent the ECB from having a clear overview of the activities of third-country banks in the EU. The Commission proposes to address these differences, strengthening the single market and minimising supervisory blind spots, thus rendering supervision more effective.

Capital Requirements Regulation (CRR III) – minding the gaps

Finally, some words on the CRR III proposal. We are concerned that deviating from the original Basel III standards, as proposed by the Commission in some areas, will expose European banks to pockets of uncovered risks. We should not forget the rationale behind Basel III: providing regulation that attributes higher risk weights to riskier assets, and to ensure that all banks hold a minimum amount of capital safeguarding them against the risks they take.

In our view, the CRR III proposal underestimates the riskiness of some important asset classes, namely real estate exposures and unrated corporate exposures. European rules should remain in the spirit of the Basel framework – because there is more uncertainty about the creditworthiness of mortgage borrowers and the riskiness of unrated companies, banks must have more capital to back these loans.

The ECB therefore advises eliminating any gaps between the EU rules and the original Basel III standards, and that any deviations should be strictly temporary. Postponing implementation or watering down Basel III standards in European law would only prolong a situation in which some banks receive undue regulatory benefit, and this risks denting financial markets’ trust in EU banks in future crises.

European banks built up capital buffers and liquidity after the great financial crisis and demonstrated resilience throughout the pandemic crisis and the recent geopolitical headwinds. They are strong enough to play by the global rulebook without the need for deviations – and they should be eager to prove this to global markets. A full, faithful and timely implementation of Basel III standards is to the benefit of effective supervision, but is also to the ultimate benefit of banks themselves. It requires limited adjustments in the short term but will deliver sizeable and long-lasting benefits for our economies, namely a safer and sounder financial system that supports the economy, its companies and its citizens through good times and bad times.

Conclusion

In our view, the revised banking package represents very good progress. It will strengthen European banks and enable the ECB to conduct more effective supervision. The package closes key gaps in supervisory powers with the CRD VI, but it may leave European banks exposed to risks if the gaps left open in some areas by the CRR III’s implementation of the original Basel III standards are not minded.

We must preserve effective international standards, particularly in the current environment; without such standards global financial markets will not work as intended. The European Union is a key player in this regard, and it needs to act as a reliable partner in the global regulatory community.

Increasing the harmonisation of supervisory powers will ultimately render supervisory action more effective, and therefore deliver a safer, sounder and more integrated banking sector, and one that is better prepared to support our economy through the challenging times ahead.

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