A deep dive on CRR III changes and the impact on credit risk modelling

Written by Barend Janse Van Rensburg, Consultant

In response to the global financial crisis, the European Commission released its proposal for a new banking package on the 27th of October 2021, which was then subjected to the trilogue between the Commission, the EU Parliament and the EU Council. This trilogue has ended at the end of 2023 and the final text was published in June 2024. The regulation will enter into force on January 1st, 2025 (delayed from January 1st, 2023), with transitional arrangements over the first five years. Following 2008, the EU has already enacted large-scale modifications to its banking regulation to increase the EU banking sector's resilience and thereby prevent a repetition of the catastrophe. Thanks to these measures, the EU financial industry was considerably more stable at the outset of the COVID-19 pandemic.
 
Even though EU banks' overall capitalisation has improved, the revised CRD and CRR will address some of the additional issues identified during the financial crisis. The fundamental goal is to improve the resilience and capabilities of financial institutions to weather future economic crises.

The goals can be divided into the following categories:

1. Basel III implementation – enhancing the risk-based capital framework without considerably increasing overall capital requirements: The plan accurately implements the international Basel III agreement while accounting for the unique characteristics of the EU banking industry.
2. Sustainability - Increase the prudential framework's focus on ESG risks: The new rules will compel banks to systematically identify, disclose, and manage sustainability risks as part of their risk management.
3. Greater harmonisation of regulation and supervision authorities and techniques: The package gives supervisors more enforcement measures to keep an eye on EU banks.
4. Reducing expenses associated with public disclosures and increasing access to prudential data: The plan intends to centralise prudential information releases and decrease the administrative load on institutions.

The Basel III revisions finalised by the Committee in December 2017 add to the original enhancements to the global regulatory framework and make important proposals in several areas. Some of the significant changes are:

• Introduction of an Output Floor limiting the benefit of internal models to 72.5% of the RWA calculated under Standardised Approach (SA),
• Improving the granularity and risk sensitivity of a standardised credit risk approach;
• Limiting the use of the internal ratings-based (IRB) approach for particular asset classes, adopting "input" floors, and specifying parameter estimation practices in greater detail;
• Revisions to the credit valuation adjustment (CVA) computation to improve risk sensitivity, robustness, and consistency;
• Streamlining the worldwide operational risk framework standard; and
• Replacing the current Basel II production floor with a more risk-sensitive floor restricts the capital advantage from risk models.

The adjustments to the credit risk capital requirement calculations are the most significant changes in the new CRR III proposal. Credit risk is one of the main drivers of a bank's RWA and is one of the principal risk-taking activities for most financial institutions. 

Banks can assess their risk-based capital requirements for credit risk using one of two approaches. The first is the standardised approach (SA-CR), enabling banks to use risk weights from credit rating agencies. The second is the internal ratings-based (IRB) approach, allowing banks to model their own internal ratings to calculate risk-weighted capital.

The proposed legislation would require banks to make significant changes to both credit risk estimation methods and the conditions under which they can be used. As a result, changes in credit risk assessment will significantly impact most EU financial institutions.

Most financial institutions in the EU use the standardised approach for credit risk to establish their own fund requirements for their credit risk exposures. In various sectors, the risk sensitivity of the existing SA-CR has been found to be inadequate, resulting in inaccurate or unsuitable credit risk estimation and, as a result, inaccurate or inappropriate RWA calculation.

The Committee's revisions to the standardised approach help bolster the regulatory framework by increasing granularity and risk sensitivity, reducing mechanistic reliance on credit ratings, and, as a result, laying the groundwork for a revised output floor to internally modelled capital requirements, thereby improving bank comparability.

The key revisions are described below:

The revised Basel standards recommended several adjustments to how banks estimate the exposure value of off-balance sheet items and off-balance sheet commitments.
 
Credit conversion factors ('CCFs') for off-balance sheet exposures have been matched to Basel III criteria and made more risk-sensitive in the newly reformed CRR 3. There are two new CCFs, 40% and 10%; the 0% CCF was removed (Art. 111-2). The approach of commitments on off-balance sheet items in relation to the applicable CCFs for assessing their exposure value is further clarified.
 
However, institutions will be allowed to continue to apply a 0% CCF to certain contractual arrangements for enterprises, including SMEs, that are not classed as "commitments" under a new exemption (Art. 111-4). Furthermore, during a transitional phase until December 31, 2029, institutions may apply a 0% CCF to unconditionally cancellable promises.
 
Following this date, the CCF will steadily increase over the next three years, eventually reaching 10% at the end of the phase-in period. During this interim time, the EBA will be able to review whether a 10% CCF on these obligations might have unforeseen repercussions for particular categories of obligors that rely on these obligations for flexible finance (Art. 495d).
Under the Basel III rules, the classification of off-balance sheet items will be revised to reflect better the grouping of such items into buckets based on applicable CCFs. 

Bank exposures shall be risk-weighted using either the Standardised Credit Risk Assessment Approach (SCRA) or the External Credit Risk Assessment Approach (ECRA) under the updated Basel III requirements(Art. 119).

External Credit Risk Assessment Approach (ECRA): (Art. 120)

• To compute the applicable risk weights, banks shall employ external credit ratings given by eligible credit assessment institutions (ECAIs).
• CRR3 aligns with Basel III's completion by decreasing the risk weight for exposures to banks that have a Tier 2 credit quality assessment from a nominated ECAI.

Standardised Credit Risk Assessment Approach (SCRA): (Art. 121)

• Banks may use the SCRA to examine all their bank exposures for which no credit assessment by an ECAI is available.
• It also applies to unrated bank risks when external ratings are permitted for regulatory purposes.
• Under SCRA, a bank must assign risk weights to each of its exposures and categorise them into one of three risk-weight buckets (i.e. Grades A, B, and C).

In addition, banks must exercise due care when determining the appropriate risk weight, for which a credit assessment from a designated ECAI is provided. This is to guarantee that external ratings accurately and conservatively reflect bank counterparty creditworthiness.

To break the link between institutions and their sovereigns, Basel III standards will eliminate the current possibility of risk-weighting exposures to institutions based on their sovereign ratings.

The applicable risk weight for corporate exposures is reduced from 100% to 75% if a level 3 credit quality assessment from a nominated ECAI is available (Art. 122-1). With the implementation of the Output Floor, institutions that use internal models to compute capital needs for corporate exposures will also be required to use the SA-CR, which uses external ratings to determine the creditworthiness of the corporate borrower.
 
CRR 3 has been changed to prevent bank lending to unrated companies from being disrupted and to give time for public and/or private initiatives to expand rating coverage. A transitional rule has been established for exposures to unrated enterprises when estimating the output floor. Banks are authorised to apply a 65% risk weight to their unrated corporate exposures during the transition period if the probability of default (PD) is less than or equal to 0.5%. Whether publicly traded or not, all unrated corporations are subject to this treatment. (Art. 465-3)

Under the SA-CR and IRB approaches, the SME supporting factor is still applicable to SME Retail and SME Corporates (RW reduced to 76,19% and 85% respectively). (Art. 501). 
The EBA will keep an eye on the use of transitional treatment and the provision of credit assessments for corporate risks by nominated ECAIs. The EBA is responsible for overseeing the transitional treatment's implementation and reporting on its calibration accuracy.

A class of specialised exposures is introduced, as well as two general ways to determine the corresponding risk weights, one for externally rated exposures and the other for non-externally rated exposures, in accordance with the Basel III criteria. The SA-CR has incorporated new exposure classes, such as project finance, object finance, and commodities finance, to correspond with the internal ratings-based (IRB) methodologies (Art. 122a).
Since the new standardised approach under the Basel III framework is not risk-sensitive enough, further granularity has been added to the CRR3 version of SA-CR for unrated specialised lending risks.
 
Under the SA-CR and IRB approaches, the preferential treatment introduced in CRR to encourage bank financing and private investment in high-quality infrastructure projects ('infrastructure supporting factor') has been kept (Art. 501a). Compared to the treatment of the same instruments under Basel III this results in a lower own funds requirement for infrastructure projects. The preferred treatment for "high quality" project financing exposures, on the other hand, only applies to those exposures for which institutions have not yet applied the "infrastructure supporting factor" treatment to avoid an unwarranted reduction in own funds requirements (Art. 122a-3).

CRR 3 links the classification of retail exposures under SA-CR with IRB methodologies to achieve consistency in applying risk weights to the same category of exposures. Furthermore, revolving retail exposures that meet a series of repayment or usage conditions that may improve their risk profile by being characterised as "transactor" exposures under Basel III now have a preferable risk-weight of 45 per cent. Exposures to one or more individuals that do not match all the criteria for retail exposures are given a risk weight of one hundred per cent (Art. 123).

When the loan currency and the borrower's source of income do not match, a new risk weight multiplier requirement is applied for unhedged retail and residential real estate exposures to individuals. The final Basel III standards set the multiplier at 1.5, with a maximum ultimate risk weight of 150 per cent. If the currency of the exposures differs from the local currency of the obligor's place of residence, entities can use any unhedged exposures as a proxy (Art. 123a).

Following the adoption of the final Basel III rules, the real estate exposure class will be reclassified to provide greater granularity in terms of the inherent risk associated with various forms of real estate transactions and loans.
The new risk-weighting treatment keeps the distinction between residential and commercial mortgages. Still, it adds more granularity depending on the type of exposure (whether the guaranteed property generates income streams) and the stage of the property (construction phase vs completed property) (Art. 124).
 
What is new is the provision of special treatment for income-producing real estate mortgage loans (IPRE), loans whose repayment is heavily reliant on the cash flows generated by the property that backs them up. According to evidence gathered by the Basel Committee, such loans are inherently riskier than mortgage loans, whose repayment is dependent mainly on the borrower's underlying ability to repay the loan. However, there is no special treatment for such higher-risk exposures under the existing SA-CR, even though the reliance on cash flows supplied by the property guaranteeing the loan is a substantial risk element. Because of the lack of specific treatment, there may not be enough money to cover unexpected losses on this sort of real estate risk.
 
As a result, new definitions are updated, replaced, or inserted in CRR3 to clarify the meaning of the various forms of real estate exposures secured by mortgages, including IPRE mortgages, by clearly separating exposures secured by mortgages on residential and commercial real estate (residential and commercial).
 
In terms of secured mortgage exposures on residential real estate, CRR3 is in line with Basel III rules. While the loan-splitting technique, which divides mortgage exposures into a secured and unsecured portion and applies the appropriate risk weight to each of these two portions, will be preserved, its calibration will be changed in accordance to Basel III criteria. The risk-weighted exposure of up to 55 per cent of the property value is 20 per cent. Furthermore, for residential mortgages, when the property is not suitable for a loan split, CRR 3 provides a more risk-sensitive exposure-to-value (ETV) ratio-based endorsement treatment (e.g. because it is not yet completed).
 
Commercial real estate risks are treated similarly to residential real estate exposures. For properties with a value of up to 55 per cent, the tried-and-true loan-split method is preserved and adjusted to Basel III criteria, with the secured half of the exposure carrying a 60 per cent risk weight. Additionally, if loan-splitting is not an option, CRR 3 offers a risk-sensitive alternative strategy based on the ETV ratio for commercial mortgages (Art. 126-1).
 
While maintaining the "hard test," which allows institutions to apply the same preferred risk weights to income-generating and other real estate exposures secured by property located in markets with annual loss rates that do not exceed certain thresholds, a specific

and more risk sensitive treatment for IPRE exposures is also introduced with variable risk weights based on the ETV ratio. (Art. 125-2 & 126-2)

When a list of operational requirements are not met (finished property, legal enforceability and rank of the claim over the property, prudent valuation, effective documentation…), the risk weight of the obligor is applied for non-IPRE exposures and a fixed risk weight of 150% is applied for IPRE exposures (Art. 124-1).

Exposures pertaining to the new class Land Acquisition, Development and Construction (ADC) receive a new specific treatment under the CRR3. This new ADC exposure class comprises loans to corporates or SPV financing land acquisition, development and construction of residential or commercial immovable properties. The RW for ADC is 150% except residential ADC loans respecting certain risk-mitigating conditions that receive a RW of 100% (Art. 126a). 

Equity and subordinated debt exposures have a more diversified risk-weighting treatment. Unless such subordinated debt must be deducted, a risk weight of 150 per cent is imposed (Art. 128).

The completion of Basel III on the revised treatment of equity exposures is consistent with CRR3. The definition of equity and what additional instruments are classed as equities to calculate risk-weighted assets for credit risk help to clarify the breadth of the equity exposure class.
 
To increase the risk sensitivity of the SA-CR, the enhanced risk weights reflect the larger risk of equity losses relative to debt securities with a 250% risk weight and differentiate between longer-term and riskier speculative investments with a 400% risk weight. To prevent unnecessary complications, long-term exposures are classified using the holding period allowed by the institution's senior management as a critical factor.
 
Equity exposures taken under legislative programs designed to promote specific sectors of the economy that provide significant investment grants and involve some form of government oversight may be subject to a 100 per cent risk weight, subject to a 10% threshold of the institution's own funding and supervisory approval.
Central bank equity investments are still subject to a risk weight of 100 per cent.
Finally, the CRR3 sets a floor for equity exposures that are booked as loans but result from a debt/equity swap performed as part of debt completion or orderly debt restructuring: the applicable risk weight under Basel III cannot be lower than the risk weight that would apply if the holdings remained in the debt portfolio (Art. 133).

When purchasing non-performing exposures (NPEs), CRR3 defines the risk weighting of discounts. The revised text states that when assessing the appropriate risk weight for a defaulted exposure, organisations can consider the discount on purchased defaulted assets (Art. 127-1).

Another slight evolution regarding the definition of default is the removal of the 180 days tolerance for RRE or SME CRE (Art. 178-1)

CRR 3 is revised to direct the European Supervisory Authorities (ESAs) to prepare a study on the barriers to the provision of external ratings by ECAIs, particularly for corporates, and alternative solutions as a foundation for future public or private rating systems efforts.

In a nutshell, the proposed SA-CR amendments are as follows:

As previously stated, the financial crisis exposed numerous flaws in the assessment of regulatory capital using internal modelling, including the IRB credit risk approaches. The lack of robustness in the modelling of particular asset classes, the overcomplexity of IRB methodologies, and the lack of comparability of banks' internally estimated IRB capital requirements are all examples of these flaws.
The IRB's approaches have been altered to address these issues via:

• Limiting the application of the advanced IRB (A-IRB) approach to specific asset classes;
• Introducing "input" floors for risk parameters in asset classes where IRB techniques are still accessible to provide a minimal level of conservatism in model parameters; and
• Adding more details to parameter estimation methods to reduce RWA variability.

The key revisions are described below:

CRR 3 limits the A-IRB approach for asset classes that cannot be robustly and prudently modelled. Therefore, the application of the A-IRB approach for exposures to large companies, as well as exposures to banks and financial institutions, is no longer available – only F-IRB will be possible for these exposures (Art. 151-8).

In addition, the IRB approach will be completely phased out for equity exposures – the SA-CR should be used for these exposures (Art. 151-4, 155, 165 & 167 deleted).

Public sector entities (PSEs) and regional governments, and local authorities (RGLAs) can currently be classified as either exposures to central governments or exposures to institutions.  

All exposures to such entities would be allocated to a new exposure class called "PSE-RGLA" (regardless of their current treatment as sovereign or bank exposures) (Art. 147-2

The final version of CRR3 deviates from Basel III standards, which mandate that the F-IRB approach is applied to PSE-RGLA exposures, as it allows banks to apply A-IRB with advantageous input floors for PD (3bps – Art. 160-1a) & LGD (5% - Art. 161-5). PSE/RGLA equivalent to sovereigns in SA are also treated as sovereigns in IRB, that is with no input floors (Art. 147-3a).

In CRR3, minimum floor values are introduced for the bank's estimated IRB parameters, which are utilised as inputs to the computation of RWAs ('input floors'). These input floors serve as a safety net to ensure that own funds requirements do not fall below reasonable levels, to offset model risk, measurement error, and data restrictions, and to improve capital ratio comparability among institutions.
 
For both F-IRB and A-IRB, the PD risk parameter's values will change. Entry floors for corporates and retail assets have been raised to 0.05%, and QRPE revolvers have been raised to 0.1% (Art. 160.1 & 163.1). The input floors for LGD and CCF are new requirements for the A-IRB approach. The LGD for corporate unsecured loans is set at 25%, and the LGD for general retail unsecured loans is set at 30% (Art. 161-4 and 164-4), while the IRB-specific CCF entry level is set at 50% of the applicable CCF standardised approach for the revolving exposures where IRB-CCF are still authorized (Art. 166-8c).
Sovereign exposures are exempt from the PD, LGD, and CCF entry floors; nevertheless, the portion of the exposure not covered by collateral is subject to the appropriate PD, LGD, and CCF entry levels.

It was decided to eliminate the 1.06 scaling factor currently applied to RWA calculations due to enhancements to the IRB framework and the inclusion of an aggregated output floor (Art. 153 & 154). 

The double default technique for some secured exposures is omitted in the modified CRR3, leaving only one general formula for calculating risk weights and simplifying the framework (Art. 153-3 deleted). The updated formula ensures that RWAs are more comparable between companies and that there are less unjustified variations.

For senior unsecured corporate exposures, the CRR3 uses recalculated LGD values. The LGD is cut to 40% for non-financial organisations, while it remains at 45 percent for banks, securities firms, and other financial institutions (Art. 161-1).

The scope of the computation of own estimations of CCFs has been revised, as have the calculation methodologies. The new regulations mandate the use of a fixed 12-month period before default for estimating own CCF estimates (Art. 182) and only permit the use of own estimates for specific undrawn revolving commitments for which the corresponding standardised CCF is less than 100%. For all others off-balance sheet items, the SA-CCF must be applied (Art. 166-8b).

IRB approaches to specialised credit exposures are hampered by the new modelling limits imposed by the Basel III regulations. While the parameter floors do apply, unlike the treatment for other corporate exposures, the A-IRB approach is applicable regardless of obligor size (Art. 151-8c). The new minimum requirements for corporate loans, on the other hand, apply to specific lending risks without considering specific lending procedures that include credit risk mitigation mechanisms. Consequently, new floors have been phased in over the course of five years, starting with a 50% discount and progressively escalating to 100% (Art. 495b).

In a nutshell, the proposed IRB changes are as follows:

Implementing CRR 3 credit risk-related provisions will be a challenge for all financial institutions and will confront various issues.
 
The reforms will force banks to examine capital use throughout their whole operation and maybe revise their pricing and product offerings as a result. As a result, the new framework will impact company strategy and business strategies. The BCBS anticipates that this will result in a capital reallocation within the system. Larger banks will need to concentrate on capital floors, but smaller banks will need to carefully assess what infrastructure and technology changes are required to handle the greater amount and granularity of data required by the most advanced standardised techniques.
 
The new reforms will no doubt be one of the most significant difficulties facing the financial sector in the future. The potential increase in RWA poses a problem for financial institutions, as do implementation issues deriving from scope constraints, limiting estimating procedures, and new input floors. Furthermore, recalibration of impacted models would necessitate extra resources. Models that have been re-calibrated must be re-validated, and large changes may necessitate further supervisory permission.

According to the European Commission, the package will have a minor impact on the EU banking sector's overall capital needs, which will be phased in overtime. At the end of the projected transitional phase in 2030, the proposed actions implementing the outstanding aspects of the Basel III reform are estimated to result in an average increase in EU banks' capital requirements of less than 9% (compared to 18.5 per cent if European specificities were not considered). Importantly, at the start of the transitional phase in 2025, the capital growth would be less than 3%.
 
Furthermore, the European Central Bank's macroeconomic study indicates that the Basel reforms will have a long-term positive impact on the EU economy. They will contribute to the profitability and competitiveness of the EU banking sector by restoring market confidence.
 
Additionally, all capital effects will be phased in over a long period of time. The European Commission plans to allow EU banks more time to comply with the final Basel III standards may also reassure them. Banks will begin implementing most of the package's provisions on January 1, 2025, two years after the Basel Committee's implementation deadline of January 1, 2023.
The CRR's full structure is unlikely to emerge before 2023, and it will almost certainly be the subject of protracted talks between the European Parliament and the Council of Ministers. In the past, these conversations have resulted in significant revisions to the current proposals, especially on the most contentious subjects.
 
While banks now have assurance regarding the new regulations, it is apparent that they will need to dedicate significant time, effort, and resources to understanding not only the technical components of the reforms but also their influence on the specific tactics of enterprises entering the market.