December 14, 2023
As we have already begun some aspects of the year-end festive season, this week's newsletter includes insights from our authors on crucial developments shaping the financial landscape.
The OCC released its Annual Report this week, and I commend it to anyone interested in the OCC’s view on the state of the condition of the federal banking system (spoiler alert: the condition of the banking system is sound, but there are improvements that can be made and stakeholders should be on guard for complacency). However, this week I cover FDIC Director Jonathan McKernan’s speech to an ISDA conference regarding the Basel III Endgame proposal’s effect on the trading book and a suggestion for a possible phased approach to finalizing the rule.
Alix Prentice delves into the UK’s Banking Regulator’s latest moves, providing a comprehensive breakdown of the Prudential Regulation Authority's publication of near-final policy statements. She explores the intricacies of the seven chapters outlined in consultation paper 16/22, shedding light on the implementation of Basel III standards and its potential impact.
Rachel Rodman brings a detailed analysis of the European Banking Authority's recent report. Focusing on the evolving landscape of environmental and social risks, she examines the EBA's insights, emphasizing the necessity for a robust prudential framework to address these emerging factors.
As we gear up for the holidays and turning the calendars to a new year, we want to express our heartfelt gratitude for your unwavering support. To rejuvenate and prepare for an exciting start to 2024, we'll be taking a brief hiatus and returning in January.
We’re always here for comments and questions. Just drop us a note here.
Daniel Meade
Partner and Editor, Cabinet News and Views
This week, Federal Deposit Insurance Corporation (“FDIC”) Director Jonathan McKernan gave remarks to the ISDA Conference on Trading Book Capital on Basel III Implementation.
As the title suggests, he focused on the interplay of the Fundamental Review of the Trading Book (“FRTB”) and the US Basel III Endgame proposal. He noted his view was that there were at least three lessons on weakness in the trading book framework:
- One lesson of the financial crisis was that the value-at-risk (VaR) measure, which had been designed to measure the risk of short-term fluctuations in market prices, did not appropriately capitalize low probability tail events, market liquidity risk, or credit risk and, more generally, was not calibrated to a period of significant stress.
- Another lesson was that regulators did not have a credible option for withdrawing approval of internal market risk models in part because the standardized approaches did not pose a credible backstop and, in part, because model approval was done at the banking organization-level instead of some subdivision, like the trading desk.
- Yet another lesson was that the boundary between the trading and banking books created opportunities for capital arbitrage by incentivizing banks to classify instruments as “held with trading intent” even where there was no regular trading so as to benefit from the reduced capital requirements on the trading book.
He noted that “ . . . the Endgame reforms offer the potential to better align capital requirements with the underlying market risks and reduce incentives to take on tail risk or arbitrage the trading book boundary. These strike me as appropriate objectives for our Endgame proposal.” Implicit, if not explicit in the speech, is that Director McKernan’s views are that the Basel III Endgame proposal falls short on this front.
He reiterated concerns he mentioned in his dissent on the Basel III Endgame proposal in July about design decisions made by the Basel Committee, and followed in the U.S. proposal, but suggested “that the Endgame debate need not be binary.” He said he was supportive of efforts to enhance the regulatory capital framework, but “I oppose efforts to reverse engineer higher capital requirements without regard to the costs and benefits or the underlying calibration framework. That does, however, seem to leave open an approach that moves to finalize the less contested aspects of the Endgame market risk reforms and then finalizes the rest through future notice-and-comment rulemakings that can rationalize our own U.S. implementations.”
Given the bipartisan pushback on the proposal, Director McKernan’s suggestion of taking a phased approach may offer a path to at least some progress of finalizing parts of the Basel III Endgame proposal.
The Prudential Regulation Authority ("PRA") has published its near-final policy statement (the "PS") setting out feedback to seven chapters of its consultation paper 16/22 (CP16/22) on implementation of the final elements of Basel III standards on the measurement of risk-weighted assets. The seven chapters are comprised of (1) scope and levels of application; (2) market risk; (3) credit valuation adjustment or CVA and counterparty credit risk; (4) operational risk; (5) interactions with the PRA’s Pillar 2 framework; (6) currency redenomination; and (7) the Interim Capital Regime, along with associated near-final policy material.
- Scope and levels of application: These remain unchanged from those set out in CP16/22, and replicate, for Basel 3.1 implementation purposes, the existing Capital Requirements Regulation ("CRR") scope except for Interim Capital Regime ("ICR") firms and ICR consolidation entities; CRR levels of application with the exception of the output floor; and CRR provisions on prudential consolidation.
- Market risk: CP16/22 proposed three new methodologies for calculating market risk, being: the simplified standardised approach or SSA; the advanced standardised approach or ASA; and the internal modelled approach or IMA. The SSA, ASA and IMA would replace existing methodologies, and are intended to improve risk sensitivity. CP16/22 also proposed a more prescriptive scope for restrictions on how firms assign positions to the trading book or non-trading book, limits on when firms can use internal hedges to transfer risks and new requirements for when firms can exempt positions used to mitigate structural foreign exchange risk.
Adjustments to the CP16/22 position in the PS include the treatment of collective investment undertakings under the ASA approach. On the IMA approach, the PRA acknowledges the inherent inconsistency with its proposals in CP16/22 to prohibit modelling of credit risk for sovereign default risk using the internal ratings based approach or IRB, and will now prohibit the modelling of sovereign exposures using the IMA for market risk.
- Credit valuation adjustment and counterparty credit risk: CP16/22 proposes three new CVA capital requirements, or calculation methodologies to replace those already in place, being: the alternative approach (AA-CVA), the basic approach (BA-CVA) and the standardised approach (SA-CVA). The PS now offers an additional and optional transitional arrangement for transactions for which existing exemptions are being removed so that those transactions can use the new CVA methodologies immediately.
- Operational risk: CP16/22 proposed to replace all the existing approaches for calculating operational risk capital requirements with a single standardised approach ("SA"), and the PS is making certain amendments to exclude divested activities from the calculation of the Business Indicator or BI in the SA.
- Pillar 2: While CP16/22 did not set out any policy proposals for changes to Pillar 2, it did set out the principle that capital requirements will not be double counted for the same risks in Pillars 1 and 2A. In order to address concerns about timing challenges, the PS proposes to conduct a separate review of Pillar 2A methodologies after the finalisation of its Basel 3.1 rules.
- Currency redenomination: The PS maintains CP16/22’s proposal to redenominate monetary values expressed in EUR and USD into GBP using average daily spot rates rounded to two significant figures.
- Interim capital regime: CP16/22 deals with Small Domestic Deposit Takers which are not required to apply Basel 3.1 standards by introducing a Transitional Capital Regime or TCR that would allow these firms to remain subject to the existing CRR until a permanent tailored capital framework can be implemented. The PS leaves this approach broadly unchanged, though now named the Interim Capital Regime.
Next Steps
Q2 2024 will see the publication of a near-final policy statements with feedback to the remaining chapters of CP16/22, including on credit risk and the output floor. While final rules cannot be made until HM Treasury has first revoked the relevant parts of the CRR, the implementation date for the policy material in this PS and the subsequent publication due in Q2 remains 1 July 2025 with a transitional period of 4.5 years giving full implementation by 1 January 2030.
In October 2023, the European Banking Authority (EBA) published a report addressing the need for a comprehensive prudential framework that adequately considers emerging environmental and social risks. The report is a response to Article 501c of Regulation (EU) No 575/2013 (the Capital Requirements Regulation 2013 (CRR)) and Article 34 of Regulation (EU) 2019/2033 (the Investment Firms Regulation (IFR)), and the EBA initiated its publication through a discussion paper on May 2, 2022. This report signals a series of upcoming reports in line with the CRR.
To address environmental and social risks, the report advocates a holistic approach, suggesting short-term enhancements to the current Basel Pillar 1 framework. These modifications aim to swiftly integrate environmental and social risks, emphasizing risk management/supervision (Pillar 2) and market transparency (Pillar 3). The proposed changes cover both standardized and idiosyncratic approaches, recognizing the efficacy of internal models in capturing new risks. Pillar 1, 2 and 3 requirements were established by Basel II. Pillar 1 establishes minimum capital requirements based on market, credit and operational risks, including environmental risks, and a minimum leverage ratio. Pillar 2 applies in addition to Pillar 1, where this underestimates certain risks. Pillar 3 focuses on transparency through prescribed public disclosures.
Recognizing the link between environmental and social factors and traditional financial risks, the report emphasizes institutions' need to develop techniques for identifying and quantifying these risks. The EBA plans to monitor the incorporation of environment-related information into models and accounting, proposing amendments to supervisory reporting frameworks for enhanced data collection on environmental risks.
Considering data challenges, the EBA explores scenario analysis to enhance the forward-looking elements of the prudential framework. The report acknowledges ongoing developments in the sustainable finance regulatory framework, highlighting the need for future prudential treatments to align with emerging policy tools.
Final Thoughts
We reported in December 2022 on the EBA’s publication of its roadmap on sustainable finance, which outlined the “objectives and timeline for delivering mandates and tasks in the area of sustainable finance and environmental, social and governance (ESG) risks.” The roadmap set out the EBA’s plan for the next three years to “integrate ESG risks considerations” into the banking framework and to “support the EU’s efforts to achieve the transition to a more sustainable economy.” The roadmap followed various legislative acts and initiatives that have allocated to the EBA “new mandates and tasks in the area of sustainable finance and ESG risks.”
As elements of the European sustainable finance regulatory framework are still evolving, the EBA is set to continue integrating environmental and social risks across all regulatory pillars. This aligns with broader initiatives outside of the prudential framework that aim to contribute to the transition towards a sustainable economy while ensuring the resilience of the banking sector. As we previously reported on June 1, 2023, the EBA articulated a common, high-level definition of greenwashing and outlined greenwashing risks, impacts, proposed mitigation efforts and challenges for the industry. We also reported on the EBA’s release of its opinion on the first set of European Sustainability Reporting Standards, in which the EBA stated that the ESRS promoted “significant improvement” in climate-related disclosures and demonstrated “overall consistency with international standards and relevant EU Law.” Notably, the EBA recognized how the ESRS “better align[ed] with the disclosure requirements under [the] EBA’s Pillar 3 Framework.”
(This article originally appeared in Cadwalader Climate, a weekly newsletter on the ESG market.)
Cabinet readers, as the holiday season approaches, we want to take a moment to express our gratitude for your continuous support throughout the year. In celebration of the festivities and to recharge for an exciting new year, we'll be taking a short break. Wishing you all a joyful and safe holiday season filled with warmth and cheer. We eagerly anticipate reconnecting in the new year.