EUROPEAN COMMISSION Brussels, 27.10.2021 SWD(2021) 320 final COMMISSION STAFF WORKING DOCUMENT



IMPACT ASSESSMENT REPORT

Accompanying the documents Proposal for a REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL amending Regulation (EU) No 575/2013 on prudential requirements for credit institutions as regards requirements for credit risk, credit valuation adjustment risk, operational risk, market risk and the output floor

Proposal for a DIRECTIVE OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL amending Directive 2013/36/EU as regards supervisory powers, sanctions, third-country branches, and environmental, social and governance risks, and amending Directive 2014/59/EU











{COM(2021) 663 final} - {SEC(2021) 380 final} - {SWD(2021) 321 final}



Table of contents 1. Introduction: Political and legal context 5 2. Problem definition 12 2.1. What are the problems and problem drivers? 12 2.1.1. Deficiencies in the current framework for calculating risk-based capital requirements 12 2.1.2. No dedicated capture of ESG risks in the prudential framework 18 2.1.3. Inconsistency of powers and tools made available to supervisors across the Union 19 2.1.4. Fragmentation and inefficiency in the disclosure of banks’ prudential information 21 2.2. How will the problems evolve? 23 3. Why should the EU act? 26 3.1. Legal basis 26 3.2. Subsidiarity: Necessity of EU action 26 3.3. Subsidiarity: Added value of EU action 27 4. Objectives: What is to be achieved? 27 4.1. General objectives 27 4.2. Specific objectives 28 5. What are the available policy options? 29 5.1. What is the baseline from which options are assessed? 29 5.2. Description of policy options 30

5.2.1. Improve the current framework for calculating risk-based capital requirements 30 5.2.2. Dedicated capture of ESG risks in the prudential framework 40 5.2.3. Improve the consistency in the application of supervisory powers 42 5.2.4. Reduce disclosure costs and improve market access to bank prudential information 43 6. What are the impacts of the policy options and how would they compare? 44 6.1. Improve the current framework for calculating risk-based capital requirements 45 6.2. Dedicated capture of ESG risks in the prudential framework 53 6.3. Improve the consistency in the application of supervisory powers 55 6.4. Reduce disclosure costs and improve market access to bank prudential information 58 7. Preferred policy options 59 7.1. Effectiveness 59 7.2. Efficiency 60 7.3. Coherence 61 7.4. REFIT (simplification and improved efficiency) 62 8. How will actual impacts be monitored and evaluated 63 Annex 1: Procedural information 65 1. Lead DG, Decide Planning/CWP references 65 2. Organisation and timing 65 3. Consultation of the RSB 66 4. Evidence, sources and quality 71

Annex 2: Stakeholder consultation 72 Annex 3: Who is affected and how? 77 Annex 4: Evaluation 89 Annex 5: Additional information about policy options 90 1. Improve the current framework for calculating risk-based capital requirements 90 1.1. Credit risk framework – Standardised approach 90 1.2. Credit risk framework – Internal model approach 107 1.3. Market risk framework 117 1.4. Operational risk framework 124 1.5. Credit valuation adjustment risk framework 130 1.6. Minimum haircut floor framework for SFTs 135 1.7. Standardised approach for counterparty credit risk 143 1.8. Output Floor 147 Annex 6: Specific impacts of preferred policy options 156 1. Impact on administrative and operational costs 156 2. Impact on competitiveness 158 3. Impact on SMEs 169 4. Macro-economic costs and benefits analysis 172 Annex 7: Analytical methods 178 1. EBA impact analysis 178

2. ECB macroeconomic costs and benefits analysis 183 List of abbreviations Term or acronym Meaning or definition AIRB Advanced IRB BA-CVA Basic Approached for Credit Valuation Adjustment BCBS Basel Committee on Banking Supervision CCB Capital Conservation Buffer CCyB Countercyclical Capital Buffer CfA Call for Advice CIU Collective Investment Undertaking CMU Capital Markets Union CRR Capital Requirements Regulation CRD Capital Requirements Directive CVA Credit Valuation Adjustment EAD Exposure At Default EBA European Banking Authority ECB European Central Bank EGD European Green Deal ESMA European Securities Markets Authority EU European Union EUCLID European Centralised Infrastructure for Supervisory Data FRTB Fundamental Review of the Trading Book GaR Growth-at-Risk GFC Great Financial Crisis GDP Gross Domestic Product GI Gross Income ILM Internal Loss Multiplier IRB Internal Ratings Based LDP Low Default Portfolio MRC Minimum Required Capital MS Member State OF Output Floor PD Probability of Default QIS Quantitative Impact Study RW Risk Weight RWA Risk-Weighted Asset SA-CCR Standardised Approach for Counterparty Credit Risk SA-CR Standardised Approach for Credit Risk SA-CVA Standardised Approach for Credit Valuation Adjustment SFT Security Financing Transaction SFTR Securities Financing Transactions Regulation SME Small and medium-sized enterprise SSM Single Supervisory Mechanism SREP Supervisory Review and Evaluation Process TLAC Total Loss-Absorbing Capacity TRIM Targeted Review of Internal Models



1.Introduction: Political and legal context The Great Financial Crisis of 2008-09 (GFC) had its origins in various deficiencies of the financial sector, in particular in the banking sector. According to the ‘Report of the de Larosière Group’, the origins of the GFC emanated from the combination of several factors, mainly the low cost of borrowing prevailing before the GFC, the financial market search for ever–higher returns and the emergence, and widespread use, of complex financial products created by bundling up new tradable securities from existing underlying risky loans. The deterioration of the credit quality of a large number of these loans triggered a rapid contagion of financial difficulties across the banking sector, highlighting its various deficiencies, including the failure of credit agencies and financial institutions to appropriately assess the risks of these new securities, the excessive interconnectedness of financial institutions worldwide, the inadequacy of banks’ prudential framework to impose sufficient loss-absorbing own funds and liquid assets requirements and the insufficiency of supervisory oversight. The consequences of the GFC on the financial sector resulted in major costs for governments as they had to support the financial sector, and also in a massive contraction of economic activity in the Union and across the world. In response to the GFC, the Union implemented substantial reforms of the prudential framework applicable to banks in order to enhance their resilience and thus help prevent the recurrence of a similar crisis. Those reforms were largely based on international standards adopted since 2010 by the Basel Committee on Banking Supervision (BCBS) . The standards are collectively known as the Basel III standards, the Basel III reforms or the Basel III framework . A summary of the content and timelines of those reforms, as well as their implementation in the Union, is provided at the end of this Section (see Figure 3 ). The global standards developed by the BCBS have become increasingly important due to the ever more global and interconnected nature of the banking sector. While a globalised banking sector facilitates international trade and investment, it also generates more complex financial risks. Without uniform global standards, banks could choose to establish their activities in the jurisdiction with the most lenient regulatory and supervisory regimes. This might lead to a regulatory race to the bottom to attract bank businesses, increasing at the same time the risk of global financial instability. International coordination on global standards limits this type of risky competition to a large extent and is key for maintaining financial stability in a globalised world. Global standards also simplify the life of internationally active banks – among which are a good number of EU banks – as they guarantee that broadly similar rules are applied in the most important financial hubs worldwide. The EU has therefore been a key proponent of international cooperation in the area of banking regulation In the Union, the first set of post-crisis reforms that are part of the Basel III framework have been implemented in two steps: ·in June 2013 with the adoption of Regulation (EU) No 575/2013, also known as the Capital Requirements Regulation (CRR) , and Directive 2013/36/EU, also known as the fourth Capital Requirements Directive (CRD IV) ; ·in May 2019 with the adoption of Regulation (EU) 2019/876 , also known as the second Capital Requirements Regulation (CRR II), and Directive (EU) 2019/878, also known as the fifth Capital Requirements Directive (CRD V) . The reforms implemented so far focused on increasing the quality and quantity of regulatory capital that banks have to hold to cover potential losses. Furthermore, they aimed at reducing banks’ excessive leverage, increasing banks’ resilience to short-term liquidity shocks, reducing their reliance on short-term funding, reducing banks’ concentration risk, and addressing too-big-to-fail problems . As a result, the new rules strengthened the criteria for eligible regulatory capital, increased minimum capital requirements, and introduced new requirements for credit valuation adjustment (CVA) risk and for exposures to central counterparties . Furthermore, several new prudential measures were introduced: a minimum leverage ratio requirement, a short-term liquidity ratio (known as the liquidity coverage ratio), a longer-term stable funding ratio (known as the net stable funding ratio), large exposure limits and macro-prudential capital buffers . Thanks to this first set of reforms implemented in the Union, the EU banking sector has become significantly more resilient to financial shocks. One key indication of this increased resilience is the overall increase in regulatory capital EU banks have: between the end of 2014 and mid-2020, the average Common Equity Tier 1 (CET1) capital ratio of EU banks improved by 2.5 percentage points (pp) to 15%, as shown in Figure 1 . Source: Risk Assessment of the European banking system, EBA, December 2020.

Note: the above ratios are based on the prevailing rules of the prudential framework of the Union at the time, including under the prevailing transitional arrangements. As a result, the EU banking sector entered the COVID-19 crisis on a significantly more resilient footing when compared to its condition at the onset of the GFC. In addition, temporary relief measures were taken by supervisors and legislators at the outset of the COVID-19 crisis. In its Interpretative Communication on the application of the accounting and prudential frameworks to facilitate EU bank lending - Supporting businesses and households amid COVID-19 of 28 April 2020, the Commission confirmed the flexibility embedded in the prudential and accounting rules as highlighted by the European Supervisory Authorities and international bodies. In June 2020, co-legislators adopted targeted temporary amendments to specific aspects of the prudential framework – the so-called CRR “quick fix” package. Together with resolute monetary and fiscal policy measures, this helped banks to keep on lending to households and companies during the pandemic (as can be observed from Figure 2 below, which also shows some of the impacts of the relief measures for the Euro area). This, in turn, helped mitigate the economic shock resulting from the pandemic. Source: European Central Bank (ECB) Financial stability review, November 2020. Note: In the two right-hand side charts, the y-axis represents the aggregate impacts of temporary relief measures expressed in percentage points changes between the banks’ CET1 ratio between end-Q1 2020 (i.e. before the measures applied) and end-Q2 2020 (i.e. after the measures applied). In the left-hand side chart, the x-axis represents the distribution of the aggregate impacts of temporary relief measures across individual banks supervised by the ECB. In the second chart, the x-axis represents the inter-quantile distribution of the individual banks’ impacts of two specific temporary relief measures, specifically the amendments to the CRR related to transitional arrangement for the application of IFRS 9 provisions and the date of application of the SME factor. However, while the overall level of capital in the EU banking system is now considered satisfactory on average, some of the problems that were identified in the wake of the GFC have not yet been addressed. Analyses performed by the EBA and the ECB (see Section 2.1.1) have shown that the capital requirements calculated by EU banks using internal models demonstrated a significant level of variability that was not justified by differences in the underlying risks, ultimately undermining the reliability and comparability of their capital ratios. In addition, the lack of risk-sensitivity in the capital requirements calculated using standardised approaches results in insufficient or unduly high capital requirements for some financial products or activities (and hence specific business models primarily based on them). In December 2017, the BCBS agreed on a final set of reforms to the international standards to address these problems.In March 2018, the G20 Finance Minister and Central Bank Governors welcomed these reforms. In 2019, the Commission announced its intention to table a legislative proposal to implement these reforms in the EU prudential framework. In light of the COVID-19 pandemic, the preparatory work has been delayed, reflecting the BCBS’s decision of 26 March 2020 to postpone the previously agreed implementation deadlines for the final elements of the Basel III reform by one year. Beyond the temporary measures adopted to facilitate bank lending in the context of COVID-19 referred above, this delay has allowed the Commission services to reassess the impact of the planned reform in light of the potential consequences of the COVID-19 pandemic. The temporarily stressed economic conditions have not altered the Commission services’ views on the need to deliver on this structural reform. Completing the reform will address the outstanding issues highlighted above and will thus further strengthen EU banks’ financial soundness, putting them in a better position to support economic growth and withstand potential future crises. It will also give banks the necessary regulatory certainty, completing a decade-long reform of the prudential framework for banks. The Commission services consider that the reform can be carried out in a manner that will not disrupt the recovery from the COVID-19 crisis. This would also be in line with the actions of other members of the BCBS that are committed to implementing the reform timely and faithfully. Indeed, major jurisdictions, (US, UK, JP, HK, CA, AU and SG), have publically committed to adopting rules implementing the reform by 1 January 2023. Some of them, namely JP, CA, HK and SG, have already published draft rules. Those jurisdictions expect the EU to stick to its commitment to implement the reform on time. Figure 3 below provides an overview of the first and final set of Basel III reforms, as well as the timelines of their adoption in the prudential framework applicable to EU banks. Source: European Commission. Note: The dates coloured in yellow at the top are the dates of adoption of the various Basel III standards by the BCBS. The dates coloured in blue at the bottom are the dates of adoption of standards in Union law. The completion of the reform of the prudential framework for banks following the GFC is not the only important initiative related to the banking sector. Another initiative is linked to the Commission’s ongoing work on the transition to a sustainable economy. The Commission Communication on the European Green Deal (EGD) clearly set out the Commission’s commitment to transform the EU economy into a sustainable economy while also dealing with the inevitable consequences of climate change. It also announced a Sustainable Finance Strategy that will build on previous initiatives and reports, such as the action plan on financing sustainable growth and the reports of the Technical Expert Group on Sustainable Finance, but will reinforce the Commission’s efforts in this area to bring them in line with the ambitious goals of the EGD. The Taxonomy Regulation will play an important enabling role in this context, by establishing a list of environmentally sustainable economic activities. Bank-based intermediation will play a crucial role in financing the transition to a more sustainable economy. At the same time, the transition to a more sustainable economy is likely to entail risks for banks that they will need to properly manage to ensure that risks to financial stability are minimised. This is where prudential regulation can play an important role. The abovementioned Strategy acknowledged this and highlighted the need to include a better integration of climate and environmental risks into the EU prudential framework. Work in that direction has already started. In the CRR II, the co-legislators introduced a requirement for large, listed banks to disclose environmental, social and governance (ESG) risks and mandated the EBA to prepare two reports on how the treatment of ESG risks could be incorporated in the prudential framework. In October 2019, the EBA published its Action Plan on sustainable finance, outlining how it intends to achieve the three actions above. In this report, among other things, the EBA encouraged banks to integrate ESG risks, identify simple climate-risk metrics, adopt climate change related scenarios and use scenario analysis.

Work is also ongoing within the international supervisory community. In 2017, central banks and supervisors launched the Network for Greening the Financial System (NGFS). The aim of the network is to enhance the role of the financial system to manage risks and to mobilise funding for green and low-carbon investments in the broader context of environmentally sustainable development. In May 2020, it has published a handbook for supervisors on how to incorporate climate-related risks into supervision. The final area of focus is the proper enforcement of prudential rules. Both supervisors and markets play a crucial role in this respect. In order for rules to achieve their intended effect, they need to be properly enforced. For this to happen, supervisors need to have at their disposal the necessary tools and powers (e.g. powers to authorise banks and their activities, require information from them, or sanction them in case they break the rules). The Commission keeps monitoring the functioning of the supervisory framework laid down in the CRD, including through close dialogue with national supervisors, the ECB and the EBA, in order to ascertain whether the powers and tools made available to supervisors are adequate, complete and used appropriately. Market discipline is another important tool. In order to for investors to properly exercise they role of monitoring the behaviour of banks, they need to access the necessary information. This is why the CRR requires banks to disclose certain information to the markets. As in the case of the supervisory framework, the Commission keeps monitoring disclosure rules, including through dialogue with market participants, to gauge whether the information disclosed by banks is sufficient and easy to obtain. The above monitoring activity allows the Commission to identify areas where rules need to be adjusted in order to address identified issues. 2.Problem definition 2.1.What are the problems and problem drivers? 2.1.1.Deficiencies in the current framework for calculating risk-based capital requirements Banks are exposed to different types of risk as part of their day-to-day business. While the specific types of risks (as well as the intensity of those risks) a bank will be exposed to will depend on the business model of that bank, the four main types of risk that might result in financial losses for banks are credit risk, operational risk, market risk and counterparty risk. In order to ensure that banks have sufficient amounts of regulatory capital to cover unexpected financial losses caused by those risks, banks are subject to binding risk-based capital requirements under the prudential framework ( Figure 4 below shows the aggregate level of risk weighted assets (RWA) for those risks for EU banks over the last few years). Despite the wide-ranging first set of reforms implemented in the Union after the GFC, increased levels of capital (as shown in Figure 1 ) have not yet allowed to fully restore the confidence in the EU banking sector and some problems identified during the GFC remain. One important reason for this is the lack of trust in the risk-based capital requirements calculated by using internal models. Source: Risk Assessment of the European banking system, EBA, December 2020. Indeed, banks can use two types of approaches to calculate their risk-based capital requirements: the standardised approaches, which banks have to use by default, or the internal model approaches (based on banks’ own modelling assumptions), which banks may use upon the permission from their supervisors. Standardised approaches are benchmark risk measurement techniques which banks have to us by default unless they have been granted permission to use the internal model approaches. Under these approaches, banks have to calculate their risk-based capital requirements according to standard formulas and pre-defined parameters (e.g. regulatory risk weights, loss-given default parameters, market volatilities, etc.) specified in the legislation. This ensures that banks apply those approaches in a uniform manner which makes the calculation of capital requirements under those approaches largely comparable across banks for similar risks. The standardised approaches’ parameters are intended to capture a conservative estimate of the average risk of an exposure in a way that is sufficiently simple for a widespread use. The majority of EU banks relies on standardised approaches to calculate their capital requirements. Standardised approaches have shown a number of weaknesses during the GFC which prevent them from acting as solid benchmark. First, some observations of actual losses incurred by banks during the GFC showed that the existing standardised approaches do sometimes underestimate the risks of certain types of exposures leading to insufficient amounts of capital required. The opposite was also found to be true: sometimes standardised approaches overestimated risks, leading to excessive amount of capital required. This can be explained, to an important extent, by the fact that they are designed to be simple. They hence do not always properly reflect the various characteristics of financial products, especially the most complex ones. This may, in turn, have an impact on banks’ activities. For example, if the capital requirement for a certain type of loan is too low compared to the riskiness of that loan, then the bank may grant too many of those loans while having insufficient capital if those loans start defaulting (and vice versa). The lack of risk-sensitivity of standardised approaches has been observed for all types of risks, although to different extents. For example, in its 2019 benchmarking exercise of internal models for credit risk, the EBA highlighted the high variability of the ratio between the risk weights generated by banks’ internal models for credit risk and the corresponding risk weights under the standardised approaches, for different types of credit exposures. As shown in Figure 5 below, the high discrepancies of those ratios across institutions cannot be explained solely by the high variability in banks’ internal model approaches but also by the lack of risk-sensitivity in the standardised approaches.

Notes: Each point represent one EU bank participating to the exercise. Unlike the standardised approaches, internal model approaches allow banks to estimate most or all the parameters required to compute capital requirements on their own. Since putting in place and maintaining such internal models requires significant resources, the cost of operating internal model approaches are significantly higher than the costs of using standardised approaches. This is why the number of banks that use internal models is much smaller than the number of banks using standardised approaches: according to the EBA’s 2019 study of the impact of the final elements of the Basel III reform, , only 79 banks out of 189 participating to the EBA data collection were using internal models. However, those banks tend to be the largest ones in the EU, accounting for a large proportion of the total EU assets. Hence, the capital requirements calculated under the internal model approaches by those banks represent more than half of the overall capital requirements of EU banks as shown in Figure 6 . Source: Basel III reforms: Impact study and key recommendations, August 2019, EBA. When using internal models, banks can capture risks more accurately by taking into account their own assessment of the characteristics of exposures, such as loans (e.g. the likelihood that the borrower would default and the size of the loss the bank would incur in case there is a default). Since the use of internal models is predicated on close monitoring and assessment of the risks banks are exposed to, banks have a better understanding of how to manage and mitigate those risks. However, the freedom that internal model approaches give to banks has potential downsides. Depending on how these models are built and on the modelling assumptions underpinning them, internal models of different banks can produce different estimates of risks and hence different levels of capital requirements. Given that each bank originates loans to different clients, invests in different assets and trades with different counterparties, a certain degree of variation is to be expected. However, a range of studies conducted at both international and EU levels found a level of variation in capital requirements across banks using internal models that cannot be explained solely by differences in the riskiness of banks’ exposures. In fact, those studies have shown that internal models can produce very different capital requirements for very similar or even identical exposures. In some cases, capital requirements for the exact same portfolios of exposures have shown a variation of more than 600%, as illustrated by Figure 7 below in the area of market risk. This variation makes it difficult to compare capital ratios across banks, puts in question their calculation and undermines confidence in capital ratios and distorts competition across banks. Source: EBA report - results from the 2019 market risk benchmarking exercise. Notes: The category ‘FX’ refers to trading portfolios with foreign-exchange rate risk, ‘Comm’ to trading portfolios with commodity risk (e.g. energy or agricultural goods) and ‘CTP’ to trading portfolios with subject to the specific Correlation Trading Portfolio capital requirement (e.g. collateralised debt obligations). Moreover, a recent study published by the Bank for International Settlements (BIS) illustrates that, besides a wide degree of variability in capital requirements among banks using internal models, the market perception of the financial risks that banks face is persistently higher than banks’ own assessment of risk when calculating capital requirements with internal models. As shown by Figure 8 below, this problem of perceived underestimation of risks by internal models is significant for certain banks. The reliability and robustness of the capital requirements produced by internal models is predicated on the condition that banks should not use internal models to reduce their capital requirements to levels which jeopardise the very objectives of safeguarding financial soundness and covering potential losses. For this purpose, the current prudential framework already provides a number of safeguards, most notably the need for supervisory approval to use an internal model as well as its regular monitoring and review. However, given the growing number and sophistication of models used by banks and the updates made to those models, their supervision is becoming more complex and more resource intensive. Furthermore, a reliable internal model requires sufficient data of sufficient quality to be available. This condition is not always met: in some cases the amount of available data is insufficient to allow for reliable and robust modelling of losses. This in turn produces unreliable estimates of the size of the risks a bank is exposed to and hence leads to inaccurate capital requirements.

The identified problems have raised doubts on the adequacy of internal models. Supervisory approval is required for banks to use internal models and supervisors can naturally decide not to allow a bank to use inappropriate internal models. However, the supervisors’ approval process of internal models cannot prevent in itself the variability observed across the outcomes of banks’ internal models. The supervisory authorities have already undertaken dedicated initiatives to reduce to some extent such variability. In 2016, the EBA produced a roadmap to comprehensively review the current rules for credit risk internal models and in order to issue guidelines, opinions or develop technical standards. Also since 2016, the ECB/SSM has carried out a large-scale targeted review of internal models (TRIM) for the banks under its direct supervision in cooperation with the national supervisory authorities. However, there is a limit to the number of interventions supervisors can make to address issues with individual models used by individual banks, because supervisors have limited resources at their disposal. Once that limit is reached, more structural solutions, like changes to the rules governing models, may need to be contemplated. 2.1.2.No dedicated capture of ESG risks in the prudential framework Climate change and the profound economic transformations that are needed to contain it pose significant risks to banks, primarily in the form of transition risk (whereby the transition to a sustainable economy can result in big shifts in asset values) and physical risks (whereby more frequent or more severe weather events impact banks and their customers). Climate (and, more broadly, environmental) risks are often considered together with social risks and governance risks under the heading of ESG risks, as these risks share a number of characteristics and are often intertwined. ESG risks, in turn, are closely linked with the concept of sustainability, as ESG factors represent the main three pillars of sustainability. ESG risks affect different types of banks’ exposures differently: over the longer term, exposures related to the financing of sustainable activities are most likely less risky for banks than exposures financing unsustainable activities. If these risk differentials are not adequately reflected in banks’ decision-making, banks may underestimate the overall level of risk that they face, which raises financial stability concerns. For example, Alessi, L., Di Girolamo, F., Petracco-Giudici, M. and Pagano, A. (2021) argue that transition risks might result in an increase of bank losses by 4% in a crisis. Also, banks may also underestimate the risks of unsustainable activities compared to sustainable activities and as a result may overinvest in unsustainable activities while underinvesting in sustainable activities. An adequate reflection of ESG risks in banks’ decision-making in turn would help addressing this misallocation of resources and hence make it more likely that banks finance sustainable activities, enabling the Union to reach the EGD’s goals. Against this background, it is essential that banks are able to measure and monitor their exposure to ESG risks, also to enable supervisors and market participants to appropriately assess the ESG risks faced by each bank in order for supervision and market discipline to function effectively. The current legal framework does not prevent banks from considering ESG risks in their decision-making nor from disclosing information on their exposure to such risks. While availability of relevant data for banks has been an obstacle in this context, steps have been taken to facilitate banks’ access to such data, for example by means of requirements under the Corporate Sustainability Reporting Directive (CSRD) and the Taxonomy Regulation. These measures should put banks in a better position to manage ESG risks. Also, EU co-legislators have deemed that a dedicated approach to capture ESG risks in banks’ financial activities could help address the aforementioned challenges and introduced in CRR II provisions aimed at improving the capture of ESG risks. First, large banks with publicly listed issuances will start disclosing information on ESG risks from 2022 onwards. Second, the EBA has been mandated to assess by June 2021 the potential inclusion of ESG risks in the supervisory review and evaluation process (SREP) performed by supervisors. Third, the EBA has been mandated to assess by 2025 whether a dedicated prudential treatment of exposures related to assets or activities associated substantially with environmental and/or social objectives would be justified. However, the immediate effectiveness of these provisions is limited, as a large number of banks are outside of the scope of the CRR disclosure rules, and any advice from the EBA on the other two areas under investigation would require subsequent changes to the CRR. As a result, the present legal requirements alone are insufficient to provide incentives for a systematic and consistent management of ESG risks by banks. This has also been recognised by the EBA in its aforementioned discussion paper, which states that it “sees the need for enhancing the incorporation of ESG risks into institutions’ business strategies, business processes and proportionately incorporate ESG risks in their internal governance arrangements”. The EBA considers the current legal requirements insufficient for this purpose and therefore “recommends to incorporate ESG risk-related considerations in directives and regulations applicable to the banking sector (e.g. CRD and CRR)”. 2.1.3.Inconsistency of powers and tools made available to supervisors across the Union In order to perform their duties, national and European competent authorities in charge of banking supervision have to use their powers under national laws transposing the CRD. In this regard, the CRD requires Member States (MS) to provide competent authorities with a minimum set of powers to exercise their supervisory functions (thereafter “supervisory powers“) and to impose sanctions through administrative measures and administrative penalties (thereafter “sanctioning powers”) for banks breaching regulatory requirements (as set out in the CRR rules or national laws transposing the CRD). While the CRD ensures a minimum level of harmonisation across the Union, some MS have identified a number of areas for which they considered it necessary to further elaborate the rules and/or to introduce additional powers for supervisory authorities. Consequently, these MS introduced additional provisions in their national laws, making use of the discretion allowed under the CRD. This has led to a situation where supervisors in different MS have different powers. In the area of sanctioning powers, some MS included additional provisions in order to, inter alia, sanction banks for breaches other than those contained in the minimum list provided in the CRD, and determine administrative penalties incurred by banks in case of breaches of CRD/CRR, including the maximum amount of administrative penalties. In the area of supervisory powers, some MS further specified the assessment of the prudential soundness of banks in case of acquisitions of material holdings in entities other than banks, material transfers of assets and liabilities between a bank and a third party, and mergers or de-mergers with other banks. As regards the supervision of members of a bank’s management body and of key function holders, the CRD sets a number of principles to assess their suitability (‘fit-and-proper assessment’). However, the CRD lacks details on how and when supervisors should conduct fit-and-proper assessments of board members and how to identify the key function holders and assess their suitability. While the publication of joint guidelines by the EBA and the European Securities Markets Authority (ESMA) published in 2017 and the guide to fit and proper assessments published by the SSM in 2018 improved the harmonisation of practices across MS, material divergences in national laws remain. For instance, the supervisors in some MS assess the suitability of board members only a significant period of time after their appointment while in the majority of MS supervisors perform this assessment prior to their appointment. In the case of key function holders, some supervisors do not properly identify them and therefore do not carry out an assessment of their suitability to perform their duties, while other do it in a variety of ways. This fragmented regulatory landscape in the definition of certain powers and tools available to supervisors and their application across MS undermines the level playing field in the Single Market and raises doubts about the sound and prudent management of EU banks and their supervision. This problem is particularly acute in the context of the Banking Union, as already highlighted in the Commission’s report on the SSM. Differences across 19 different legal systems prevents the SSM from performing its supervisory functions effectively and efficiently. Moreover, as a result of the diverse transposition of the CRD at national level, cross-border banking groups have to deal with a number of different procedures for the same prudential issue, unduly increasing their administrative costs. Banks as well as supervisors, in particular in the SSM, and MS have therefore acknowledged the problem (for more details see Section 6.3. and Annex 2). 2.1.4.Fragmentation and inefficiency in the disclosure of banks’ prudential information Prudential regulation requires banks to publicly disclose financial and other quantitative and qualitative information so that investors, clients, depositors and other interested stakeholders can gauge their level of risk. Banks’ disclosure of financial information also contributes to enhanced transparency and market discipline, thereby promoting sound risk management. In the Union, the CRR II implemented the revised BCBS framework on public disclosure (also known as the ‘Pillar 3’ framework), and adjusted the content and scope of bank disclosures to make them applicable to all EU banks in a proportionate manner. Under the CRR II, the amount of information that banks need to disclose depends on the size and complexity of their activities (the larger and more complex a bank is, the more information it is required to disclose). Banks are currently required to disclose all relevant prudential information in one single document or a separate section of their financial report prepared under the applicable accounting standards. Information on banks are therefore scattered on their individual websites and other media platforms. However, stakeholders (e.g. investors making investment decisions or analysts making recommendations to their clients) are interested in gathering, analysing and comparing information across several banks.

At present, it is considered difficult and burdensome for these stakeholders to access and aggregate this information. For example, available information on smaller, non-publicly listed banks tends to be harder to find and is usually only available in the language of the Member State in which the bank is established. The current difficulties related to the access to prudential information deprive market participants from the information they need about banks’ prudential situations. This ultimately reduces the effectiveness of the prudential framework for banks and potentially raises doubt about the resilience of the banking sector, especially in periods of stress. In addition to having to disclose certain information, banks must also report certain information to their supervisors as part of a separate process. Two separate processes to share similar financial information imply undue administrative costs for banks; this also makes these processes more vulnerable to a certain type of operational risk (i.e. the risk of misalignment in the same type of information communicated through two different channels). Since 2018, the EBA, in cooperation with the ECB and national competent authorities, has been working on the creation of the European Centralised Infrastructure for Supervisory Data (EUCLID) to aggregate in a centralised integrated system the reporting information shared by supervisors on the largest EU banks. This system will be particularly useful to feed public reports and analysis with aggregated data and risk indicators on the overall EU banking sector. However, the prudential framework does not yet grant powers to the EBA to disclose individual bank data that is reported to supervisors. Introducing those powers would allow banks to only report information to their supervisors and the EBA which would then proceed to disclose the required parts of that information on behalf of banks. Banks, in particular small and non-complex ones, have repeatedly called to further reduce the administrative burden stemming from reporting and disclosure requirements whereas other market participants (investors, analysts) highlighted the need for a centralised and easy access to banks’ prudential information. 2.2.How will the problems evolve? As far as the deficiencies of internal models in the current framework for calculating risk-based capital requirements are concerned, confidence in the risk based capital requirements could be partially restored through the supervisory exercises run by the EBA and the ECB. Those exercises aim at ‘model repair’ by means of harmonising certain modelling assumptions across EU banks. However, the completion of those exercises could not fully resolve the issues, given the amount of flexibility the current rules still provide banks to design their individual internal models. In addition, enhanced supervisory review would not address the deficiencies identified in the standardised approaches for calculating risk-based capital requirements. In this context it has to be recalled that capital requirements calculated under the standardised approach represent a significant share of total capital requirements across the Union. In the absence of changes to address the identified deficiencies related to internal model approaches, the risk-based capital requirements calculated by banks using those models would remain incomparable across banks and in some cases may be too low in relation to the risks of certain exposures. If the deficiencies related to the standardised approaches would remain unaddressed, some financial products or activities (and hence specific business models primarily based on them) would attract either insufficient or unduly high capital requirements. In both cases the potential mispricing of risks by individual banks and consequently the inadequate capitalisation of those risks by those banks would persist. As a consequence, some mistrust in the EU banking sector would persist with negative consequences for banks’ market valuations and funding costs which could in turn undermine their ability to finance the EU economy. The lack of confidence in the EU banking sector could ultimately lead to a higher probability that future periods of stress, whatever their origins, could turn into more severe financial crises. As regards the capture of ESG risks in the prudential framework, the problems that such capture could potentially address (i.e. inadequate management of ESG risks) would become ever more pressing. Both transition risks and physical risks to banks would inevitably increase as the economic restructuring gains speed and as environmental events increase in magnitude and frequency. In the absence of timely legislative action to address these problems (in addition to the limited measures included in CRR II and elsewhere, see Section 2.1.2), banks might continue to misprice ESG risks, which would in turn lead to inadequate financing of the transition to a more sustainable economy risks. It could also lead to undercapitalisation of banks which could lead to financial stability issues. On the supervisory and sanctioning powers, in absence of a legal initiative the discrepancies observed across national laws transposing the CRD would continue to exist, maintaining the current fragmentation and the un-level playing field with regard to the application of supervisory powers and the imposition of sanctions. This would have negative consequences in two respects. On the one hand, some MS would maintain a relative low degree of supervision, allowing some of their banks to perform certain operations that could be risky, thus fuelling mistrust in the soundness of banks. Furthermore, in some MS supervisors would still not be empowered to impose sanctions for breaches of certain prudential requirements and would thus continue to lack an important supervisory tool. On the other hand, other MS would continue to exercise the legal flexibility available in the CRD in a more conservative manner. Additional supervisory and sanctioning powers in these MS could incentivise some banks to carry out certain activities in other MS without such powers. Finally, without a change, the ECB/SSM would not be able to apply the same supervisory tools and exercise the same powers to all banks under its supervision in a consistent way which would impede the effectiveness of its supervision. The existing inconsistencies and identified deficiencies of the application of fit-and-proper requirements lead to a less effective and efficient supervision regime. In a number of MS, members of the management body would continue to take up their position without having been vetted upfront by supervisors. This involves the risk that unqualified managers could contribute to key decisions for the banks’ businesses and its risk management. In the absence of proper definitions of key function holders and rules for their assessment the current un-level playing field across institutions within the Union would continue to exist, creating reputational risk for EU banks and their supervisors, undermining trust in the banking sector. Finally, in the absence of actions to address the fragmentation and the inefficiency in the disclosure of banks’ prudential information to the public, analysing and comparing information on individual banks would remain burdensome and costly for the relevant stakeholders and would continue to undermine the effectiveness of market discipline. In addition, banks’ processes to report information to supervisors and to disclose information to the public would continue to run in parallel, unduly maintaining maintaining unnecessary administrative costs.



3.Why should the EU act? 3.1. Legal basis All actions considered frame the taking up, pursuit and supervision of the business of banks within the Union, with the objective of ensuring the stability of the internal market. One of the fundamental components of the Union’s financial system, banking is currently providing the largest part of financing within the internal market. The Union has a clear mandate to act in the area of the internal market and the appropriate legal basis consists of the relevant Treaty Articles underpinning Union competences in such area. The legal basis falls within the internal market area, which is considered a shared competence, as defined by Article 4 TFEU. Most of the actions considered represent updates and amendments to Union law, and as such, they concern areas where the Union has already exercised its competence and does not intend to cease exercising such competence. A few actions (particularly those amending the CRD) aim to introduce an additional degree of harmonisation in order to achieve consistently the objectives defined by that Directive.

3.2.Subsidiarity: Necessity of EU action In the context of global cooperation on financial stability, supervisors and regulators meeting within the BCBS, including from several EU Member States, the ECB, the EBA and the Commission, have developed common international standards that members jurisdictions should apply to their internationally active banks. Following the GFC, the BCBS launched a fundamental review of the international standards to strengthen the resilience of the global banking system and improve comparability across banks worldwide. A number of the revised standards have already been incorporated into Union law by means of the CRR and the CRD IV, as subsequently amended by the CRR II and CRD V. However, a number of additional revisions adopted by the BCBS in December 2017 in relation to credit risk, operational risk, CVA risk, market risks and the replacement of the Basel I floor by an aggregate output floor have still to be transposed in Union law. These proposed revisions address remaining shortcomings in the international prudential framework as identified during and after the GFC. The objectives pursued by those revisions of international standards can be better achieved at Union level rather than by different national initiatives as they represent adjustments to the EU prudential framework. The identified problems (see section 2.1.1) and the underlying causes are similar across Member States and potential differences pertain to the behaviour and business model of individual institutions, not their location within the Union. No action by the Union would render the existing prudential framework outdated in relation to evolving market challenges and would create major misalignments with standards applied by other jurisdictions. This would have reputational, financial stability and market impacts. The ability of Member States to adopt national measures to address the identified issues is limited, given that the CRR and the CRD already regulate those aspects, and changes at national level would not be able to derogate from Union law currently in force. If the Union were to cease regulating those aspects, the internal market for banking services would become subject to different sets of rules, leading to fragmentation and undermining the recently built single rulebook in this area. National measures would affect the degree of cross-border service provision, capital flows and market integration across Member States. This would be detrimental to effectively ensuring financial stability in the internal market. With regard to the current rules on supervision (e.g. fit and proper rules, supervisory powers and sanctions), the current national laws supplementing the prudential framework have displayed some substantial differences. The absence of sufficient common rules does not allow for a level-playing field, potentially fuelling regulatory or supervisory competition. Also, in the context of the Banking Union, where the ECB exercises direct supervisory powers set out in national laws transposing the CRD, the ECB does not have the same range of powers with regard to all banks under its supervision. The objective of efficient and harmonised supervision throughout the Union cannot be achieved by individual MS actions. 3.3.Subsidiarity: Added value of EU action There are clear benefits from action at Union level. The Union’s prudential framework for banks would be aligned with the latest international standards, thus becoming more fit for purpose and ensuring a greater resilience of the Union’s banking sector. It is more efficient to change the current Union rules than repealing them and replacing them with national rules. EU action also allows for a more homogenous approach, taking into account all EU specificities in a comprehensive way. As regards those aspects that would supplement existing rules (e.g. fit and proper rules, supervisory powers, sanctions) additional harmonisation will contribute to a more homogenous approach and reduce the fragmentation of the internal market. At the same time EU action contributes to establishing a level playing field and a higher quality of supervision across the Union. 4.Objectives: What is to be achieved? 4.1.General objectives There are two general objectives pursued by this initiative: 1.Contributing to financial stability. Only a stable and financially sound banking system, which is well capitalised and where risks are adequately managed, will lead to a reduced probability of banking crises, and reduce the impact of such crises should they occur. This will in turn allow to maintain investors’ and depositors’ confidence in the banking system, especially in periods of stress. 2.Contributing to steady financing of the economy in the context of the recovery post-COVID-19 crisis. The EU economy is heavily reliant on financing provided by the banking sector. While initiatives are underway to develop a Capital Markets Union (CMU) that might over time reduce this reliance, the banking sector will in particular play a key role in financing the medium-to-long term recovery from the COVID-19 crisis. 4.2.Specific objectives The two general objectives pursued by this initiative can be broken down into the following four specific objectives: 1.Strengthen the risk-based capital framework, without significant increases in capital requirements. To ensure a resilient and stable banking system, it is essential to have a solid prudential framework in place which ensures that risks are accurately measured and adequately covered by capital. In particular, trust in the banking system is conditional upon trust in the reliability of the risk-based capital framework. Internally modelled approaches that EU banks use for calculating risk-based capital requirements should result in adequate capital levels and produce comparable outcomes. At the same time the prudential framework should provide robust and sufficiently risk-sensitive standardised approaches for banks using them. However, strengthening the risk-based capital framework should not come at the cost of significantly increasing capital requirements as requested by the EU Parliament and the Council. 2.Enhance the focus on ESG risks in the prudential framework. Including a sustainability dimension in the prudential framework would ensure a better management of ESG risks and a better allocation of bank funding across projects, thus helping the transition to a more sustainable economy. 3.Further harmonise supervisory powers and tools. Supervisory tools such as fit-and-proper assessments, supervisory powers and sanctioning powers play a key role in ensuring the safety and soundness of individual banks and the stability of the EU banking system as a whole. Certain tools should therefore be made available to supervisors in all Member States and applied consistently. This would also help reduce administrative costs resulting from the current fragmentation. 4.Reduce banks’ administrative costs related to public disclosures and improve access to banks’ prudential data. Public information on individual banks that is easily accessible and comparable should enhance the ability of bank clients, investors and other market participants to monitor and exert market discipline on banks’ behaviour. Banks in turn would benefit from a more efficient system that integrates supervisory reporting and disclosure, and thereby reduces their administrative burden. 5.What are the available policy options?

5.1.What is the baseline from which options are assessed? The baseline option from which the considered policy options are assessed assumes no legislative change to the prudential framework applicable at Union level. Under this option, the structural shortcomings of internal models of the current prudential framework as described in Section 2.1.1 would remain unaddressed, and the Commission would solely rely on the supervisory initiatives taken by the EBA and the ECB under their current remits to improve the situation. In addition, the EBA will continue performing its annual supervisory benchmarking exercises on credit and market risk internal models to highlight the degree of variability of EU banks’ internal models. The EBA and ECB initiatives could achieve to some extent a reduction of the variability in capital requirements calculated based on internal models for credit, counterparty and market risks. While acting as important complements, these supervisory initiatives cannot substitute for the necessary reforms of the binding requirements included in the current prudential framework. Without those reforms, the problems described in Section 2.1.1 would continue to exist. In the same vein, without changes to the standardised approaches, they would remain insufficiently risk-sensitive. Since those standardised approaches are legally binding, they are virtually identical for all banks that apply them. Therefore initiatives employed by supervisory authorities cannot be used to tackle the deficiencies identified in Section 2.1.1. Moreover, under this scenario, the only binding requirement related to ESG risks that would apply would be the requirement for large banks to disclose information on those risks from end-June 2022 onwards, as highlighted in Section 2.1.2. While competent authorities will continue to be able to exercise their Pillar 2 powers to require banks to address ESG risks, due to the lack of an explicit reference to those risks in the CRD, those powers will not be applied systematically and consistently. Any additional requirements that the EBA may propose in the reports due in 2021 and 2025 (see Section 2.1.2) would require legislative action. Not changing legislation would also mean that divergences among MS in the area of supervisory powers made available to competent authorities under the CRD, identified in Section 2.1.3, would persist. For example, the prudential framework would still not require MS to give competent authorities powers to sanction certain types of regulatory breaches. Furthermore, there would be no legal requirement for an intervention in the case of specific situations that could raise prudential concerns, such as the acquisition of material holdings in entities other than banks, material transfers of assets and liabilities, and (de-)mergers. MS would still have ample leeway to grant the competent authorities these supervisory powers at their own discretion. The CRD would also still not require competent authorities to assess the suitability of key function holders. At the same time, the prudential framework would continue to lack specifications on how competent authorities should conduct fit-and-proper assessments. As a result, the rules would remain subject to broad margins of interpretation by MS, leaving clearly identified prudential concerns unaddressed. The initiatives conducted by the EBA and the ECB/SSM (see Section 2.1.3) could help increase the harmonisation of the fit-and-proper assessment across Member States but, only if MS would empower supervisors by amending their national frameworks. In absence of such national empowerments, inadequate supervision of key function holders would persist in some MS, as associated with the risks of employing unsuitable individuals as members of the management body. Finally, under this scenario of no change to the current prudential framework, banks’ investors and other stakeholders interested in banks’ prudential information would still find it burdensome to collect such information on individual banks’ platforms. In addition, banks would continue to have to follow two separate processes to report and disclose the required information, which would continue to generate an undue administrative burden for them, as described in Section 2.1.4. 5.2.Description of policy options 5.2.1.Improve the current framework for calculating risk-based capital requirements Option 1 - Implement the Basel III reforms in full alignment with the BCBS standards and implementation timelines This option would implement in Union law the final elements of the Basel III reform (adopted by the BCBS between December 2017 and July 2020) in full alignment with the standards and the timelines agreed by the BCBS. The agreement was the result of a strategic review of the international prudential standards for banks, which was conducted by the BCBS in the wake of the GFC, with a view to improving the balance between simplicity, comparability (mainly of the internal model approaches) and risk-sensitivity (mainly of the standardised approaches) of those standards. This option would entail implementing the final elements of the Basel III reform agreed in December 2017, namely: ·the revisions to the standardised approach for credit risk (SA-CR) to improve the robustness and risk sensitivity of the existing approach; ·the revisions to the IRB approaches for credit risk to reduce unwarranted variability in banks’ calculations of RWAs; ·the minimum haircut floors for non-centrally cleared securities financing transactions (SFTs) to limit the pro-cyclicality of these transactions and the build-up of excessive leverage in the financial system; ·the revisions to the CVA risk framework consisting of the removal of the use of an internally modelled approach and the introduction of a new basic approach (BA-CVA) as well as revisions to the standardised approach for CVA (SA-CVA) to enhance the risk sensitivity, strengthen the robustness and improve the consistency of the framework; ·the new standardised approach for operational risk (SA-OR), replacing all the existing standardised and internal model approaches for this risk to simplify the framework and increase comparability; and ·the aggregate output floor (OF) to limit the unwarranted variability in the regulatory capital requirements produced by internal models and the excessive reduction in capital that a bank using internal models can derive relative to a bank using the revised standardised approaches. In addition, this option would implement the revised (i.e. January 2019) version of the original (i.e. January 2016) market risk standards, known as the ‘fundamental review of the trading book’ (FRTB), for the purpose of calculating capital requirements. Most of the revised FRTB standards have already been implemented in EU law as part of the CRR II. Following an agreement between the European Parliament and the Council, they were implemented for reporting purposes only (i.e. banks are not required to use them to determine their capital requirements). Under this option they would be converted into a capital requirement, fully aligned with the final 2019 standards. Table 1 below presents a more detailed list of the key elements of the reforms included in the December 2017 agreement, as well as the revised market risk framework adopted in 2019.

This option would address the main deficiencies, identified in Section 2.1.1, with the current prudential framework for calculating risk-based capital requirements applicable to EU banks. At the same time, this option would entail no adjustments to the final Basel III standards to cater for specificities of the EU economy and would also remove some of the EU-specific rules currently in place to fully align the EU prudential framework with those standards (e.g. it would remove the exemptions from the CVA risk charge and the small and medium-sized enterprise (SME) supporting factor). Table 1: Overview of the main revisions to the Basel framework introduced by the final elements of the Basel III reform. Risk area Main revisions Credit risk – standardised approach ·For rated exposures to banks, some of the RWs have been recalibrated. In addition, the RW treatment for unrated exposures to banks is more granular than the existing flat RW, which depends on the RW applicable to the central government of the Member State in which the bank is established. ·For exposures to corporates, a more granular RW treatment has been developed. In addition, a specific treatment for exposures to project finance, object finance and commodities finance was developed. ·For real estate exposures (both residential and commercial), more risk-sensitive approaches have been developed to better reflect different funding models and stages in the construction process. ·For retail exposures, a more granular treatment was developed, which distinguishes between different types of retail exposures and reflects FX risk. ·For subordinated debt and equity exposures, a more granular and generally stringent RW treatment was developed. ·For off-balance sheet items, a more risk-sensitive treatment was developed, which is more stringent for unconditionally cancellable commitments. Credit risk – internal models approach ·The possibility to use of internal models was either limited or altogether removed for portfolios and risk parameters where the BCBS had concluded that the available data was insufficient to ensure reliable modelling (i.e. exposures to financial institutions and large corporates, equity exposures). ·New minimum values (‘input floors’) were introduced for banks’ estimates of the probability of default, loss-given default and exposure at default (EAD). ·The option for banks to pick and choose between the use of internal models and the standardised approach per asset class was introduced. Market risk (FRTB) ·More objective rules were introduced to allocate transactions either to the trading book, or to the banking book. ·Both the standardised approach and the internal model approach were be completely overhauled to better capture market risk. ·New tests were introduced to ensure the robustness of the internal models and leave less flexibility for banks to use their own modelling assumptions. CVA risk ·Internal models were replaced by standardised approaches, leaving banks with a choice between a more sophisticated and a simpler approach. ·For banks with non-centrally cleared derivatives contracts with a combined notional value of less than EUR 100 bn, a simplified approach was made available. Securities Financing Transactions ·For certain non-centrally cleared SFTs with certain counterparties, minimum haircut floors were introduced; as a result SFTs which do not meet the haircut floors must be treated as unsecured loans. Operational risk ·The current internal model approach and the three existing standardised approaches were replaced with a single risk-sensitive standardised approach to be used by all banks. ·The capital requirement under the new standardised approach depends on the size of the bank (expressed in terms of a refined measure of gross income) and the bank’s operational risk-related loss history. Output floor ·A revised output floor was introduced. The floor sets a lower limit to the capital requirements that are produced by a bank’s internal model at 72.5% of the capital requirements that would apply if the bank would calculate its capital requirements using standardised approaches. Option 2 - Implement the final Basel III reforms with EU-specific adjustments and in alignment with the BCBS implementation timelines Similar to option 1, option 2 would also implement all the final elements of the Basel III reform. Compared to option 1, this option would include a number of targeted adjustments to cater for the specificities of the EU banking sector and the funding structure of the EU economy, and taking into account the context of the recovery, with the objective to avoid disproportionate impacts or unintended consequences of the reforms on essential activities and financial services provided by EU banks. In fact, the Basel standards are designed to capture common financial risks that can be observed across the world. They are calibrated based on averages of data collected across banks and financial markets located in different regions of the world. As a result, the capital requirements under some Basel standards may not capture more specific financial risks appropriately which could lead to disproportionate impacts on the corresponding financial activities. In addition, a few other targeted adjustments under this option would help to ensure an international level playing field for trading activities. Finally, this option would also make use of the flexibility the international standards provide in order to harmonise their application across the Union, in line with the objectives set out for this legislative proposal. Specificities of the EU banking sector and EU economy EU businesses (and in particular SMEs, see also Section 3 of Annex 6) rely heavily on bank lending to finance their investment and working capital needs, much more than in other major jurisdictions. However, the international standards do not always sufficiently take into account the specific financing structures and risk management strategies used in the EU. To address this issue, option 2 includes several targeted adjustments: ·Treatment of unrated corporates: corporate lending in the EU is predominantly provided by banks using IRB models. With the implementation of the OF those banks would also need to apply the SA-CR which relies on external ratings to determine the credit quality of the corporate borrower. Most EU corporates, however, do not typically seek external credit ratings, due to the cost of establishing a rating and other factors. Given that capital requirements calculated under the SA-CR are, on average, more conservative for unrated corporates than for corporates that have a rating, the implementation of the OF could cause substantial increases in capital requirements for banks using internal models (because the standardised approach would be used to calculate the OF). To avoid disruptive impacts on bank lending to unrated corporates and provide enough time to establish public and/or private initiatives aimed at increasing the coverage of credit ratings, option 2 would introduce a transitional period. During this period banks using internal models could apply a favourable treatment when calculating their OF for exposures to unrated corporates. This transitional arrangement would be coupled with an empowerment for the Commission to further extend the length of the period, based on a report by the EBA. This would ensure sufficient access to bank funding by unrated corporates during the transition period, as banks could continue to apply lower capital requirements whilst initiatives to foster widespread use of credit ratings would be established. After the transition period banks would refer to credit ratings to calculate capital requirements for most of their exposures to corporates in accordance with the Basel III standards. More details about this specific issue and the dedicated adjustment to address it are provided in subsection 1.1.1 of Annex 5. ·SME supporting factor: Given their fundamental role in creating jobs and economic growth in the EU, EU co-legislators decided that capital requirements for SME exposures should be lower than those for large corporates to ensure appropriate bank financing of SMEs. As a result, an SME supporting factor was introduced in the CRR and its scope extended in CRR II. Option 2 would maintain this SME supporting factor in the prudential framework, which would result in lower capital requirements for SMEs than the specific treatment provided by the Basel III standards. ·Infrastructure supporting factor: bank financing of infrastructure and other specialised projects is also a defining characteristic of the EU economy, as compared with other jurisdictions where such projects are predominantly financed by capital markets. Large EU banks are major providers of funding for specialised projects, objects finance and commodities finance, in the EU and globally. They have developed a high level of expertise in those areas. A preferential treatment has been introduced in CRR II to foster bank finance and private investment in high quality infrastructure projects (‘infrastructure supporting factor’). Option 2 would maintain this treatment, which would result in lower capital requirements for infrastructure projects than the specific treatment provided by the Basel III standards. Furthermore, a new preferential treatment under the standardised approach for “high quality” object finance would be introduced. It would apply where financial risks are specifically managed. Conflicting signals to banks active in this market segment should be avoided. This option would also empower the Commission to adopt delegated acts that would adjust the internal models approach, if such adjustment would be found appropriate based on a comprehensive assessment by the EBA during the implementation period. ·Equity exposures: Many EU banks hold long-standing, strategic equity participations in financial and non-financial corporates. The final Basel III standards increase the RWs for all kinds of equity exposures over a 5-year transition period without providing a specific treatment for strategic equity investments. Applying the more conservative approach embedded in the Basel III standards to the whole stock of existing equity holdings could jeopardise the economic viability of existing strategic relationships. Option 2 would exclude equity holdings in entities within the same banking group or covered by the same institutional protection schemes (IPS) from the application of the more conservative treatment. In addition, it would grandfather existing strategic participations where banks exercise influence, including via holdings in insurance undertakings, whilst applying the new, more conservative treatment to new equity exposures. More details about this specific issue and the dedicated adjustment to address it are provided in subsection 1.1.3 of Annex 5. ·Treatment of Collective Investment Undertakings (CIUs) used for trading purposes: CIUs play a crucial role in facilitating the accumulation of personal savings, whether for investments or for retirement. The seamless provision of CIUs as investment product hinges on banks’ ability to continuously offer to their clients the possibility to buy or sell back those instruments. For that purpose, banks must keep inventories of CIUs in their trading books. The revised market risk standards adopted in 2019 rely on a number of conservative assumptions and complex operational requirements that could increase significantly the capital requirements for those instruments, therefore restricting their supply. To avoid this unintended effect on those trading activities, Option 2 would provide a number of adjustments to the treatment of CIUs under the market risk rules. More details about this specific issue and the dedicated adjustment to address it are provided in section 1.3 of Annex 5.

·Treatment of financial products based on the EU emission trading scheme (ETS): banks play an important role in providing liquidity to the EU market for carbon emissions allowances. Banks typically fill their clients’ estimated demand for allowances at a future date via derivatives (‘forward’) transactions. Under the revised market risk rules, the exposures to carbon emission allowances are assimilated to electricity contracts, and therefore get allocated to the same risk weight (60%). In light of the historical price volatility of EU ETS, this risk weight appears excessively high. Furthermore, in its Communication on fostering openness, strength and resilience of the European economic and financial system, the Commission announced its intention to support further ETS trading activity in the EU, notably as part of the ‘green’ transition. Option 2 would therefore introduce a specific category for ETS allowances, distinct from electricity, for which RWs would be calibrated to reflect the actual price volatility of this commodity in the EU ETS market. More details about this specific issue and the dedicated adjustment to address it are provided in section 1.3 of Annex 5. ·Exemptions from capital requirements for CVA risk: When implementing the initial Basel III reforms in Union law through the CRR, the EU co-legislators exempted certain transactions from the calculation of capital requirements for CVA risk. These exemptions were agreed to prevent a potential excessive increase in the cost of some derivative transactions triggered by the introduction of the capital requirement for CVA risk, particularly when banks could not mitigate the CVA risks of certain clients. While the introduction of the revised capital requirement for CVA risks adopted as part of the final elements of the Basel III reform would improve to some extent the risk-sensitivity of the standardised approaches for CVA risks, the level of capital requirements would still remain very high for the exempted transactions, notably due to the removal of the internal model approach for CVA risk. In this context, Option 2 would maintain the existing CRR exemptions. To help supervisors monitoring the CVA risks arising from the exempted transactions when they are excessive, option 2 would require institutions to report to their supervisors the calculation of capital requirements for CVA risks of the exempted transactions. In addition, option 2 would introduce EBA guidelines to help supervisors to identify excessive CVA risk. More details about this specific issue and the dedicated adjustment to address it are provided in section 1.5 of Annex 5. ·Introduction of the minimum haircut floor framework for non-centrally cleared SFTs: SFT markets play an essential role in the EU financial system by allowing financial institutions to manage their own liquidity position and support their securities market-making activities, as well as central banks to transmit, via financial institutions, their monetary policy plans to the real economy. However, SFTs can also enable market participants to recursively leverage their positions by reinvesting cash collateral and re-using non-cash collateral, respectively. To address some concern with respect to the risk of build-up of excessive leverage outside the banking sector, the Financial Stability Board (FSB) published in 2013 a recommendation to its member jurisdictions to introduce minimum collateral haircuts for some non-centrally cleared SFTs traded between banks and non-banks, either, at the discretion of each jurisdiction, directly via a market regulation or indirectly via a more punitive capital requirement that was later developed by the BCBS. Presently there is still a lack of certainty about the impact of implementing this FSB recommendation on the EU SFTs market and whether its prudential objective could be attained without creating undesirable consequences. In this context, option 2 would propose to delay its implementation in the EU until the EBA and ESMA provide in the coming years a joint report to the Commission assessing its impact and recommending the most appropriate approach. More details about this specific issue and the dedicated adjustment to address it are provided in section 1.6 of Annex 5. International level playing field for trading activities. Banks trading activities in wholesale markets can easily be carried out across borders (for certain activities, even between the EU and non-EU countries). The capital requirements applied to these activities should therefore converge as much as possible across jurisdictions to avoid a potential competitive advantage for those banks for which the domestic rules are more lenient. In this context, option 2 would turn the existing reporting requirement for market risk based on the BCBS FRTB framework into a capital requirement, as proposed under option 1. However, option 2 would contain a safeguard that would allow addressing disruptions to the playing field for EU banks’ trading activities that could materialise if other major jurisdictions would delay the implementation of the FRTB framework or adjust its calibration. Specifically, option 2 would introduce an empowerment for the Commission to delay, if necessary, the application of the capital requirement based on the FRTB framework and/or to adjust its calibration considering international developments. More details about this specific issue and the dedicated adjustment to address it are provided in section 1.3 of Annex 5. A second adjustment under option 2 would address the conservative calibration of the standardised approach for counterparty credit risk (SA-CCR) currently applied to derivative transactions and already transposed in Union law by means of the CRR II. At the time of adoption, the EU co-legislators requested the EBA to report by June 2023 on the current SA-CCR calibration. Subsequently, in the Capital Market Recovery Package they requested the Commission to review the appropriateness of the SA-CCR calibration by June 2021. Considering that at least one major jurisdiction has already lowered the calibration of SA-CCR for certain types of derivatives transactions, option 2 would temporarily lower the existing calibration of SA-CCR for all derivatives transactions when calculating the OF. This would provide sufficient time to further discuss this issue at international level. More details about this specific issue and the dedicated adjustment to address it are provided in section 1.7 of Annex 5. Flexibility in the Basel III standards The Basel standards usually leave some flexibility for their local implementation, either by explicitly allowing jurisdictions to choose between different implementation options at their own discretion or by implicitly not providing all the technical details for the operationalisation of the standards. Option 2 proposes to make use of this flexibility and would implement those discretions in a harmonised manner. First, the introduction of the OF in the prudential framework represents one of the key elements of the final Basel III reform, aimed at reducing the excessive variability of banks’ capital requirements calculated with internal models and thereby enhancing the comparability of capital ratios. The Basel III standards arguably leave some room for interpretation as regards the requirements to which the OF should apply and, in case of banking groups, the level at which it should apply. Under option 2, the OF would include all the existing capital requirements in scope of Union law, including the specific SRB and P2R capital requirements imposed to EU banks by supervisors and competent authorities. This is coherent with the current prudential framework and consistent with the objective of the OF. In order to avoid disproportionate capital impacts, while still strengthening financial stability and complying with the Basel III standards, option 2 would also prescribe that any overlap between the risks captured by the OF and the risks captured by any of the these specific capital requirements imposed by supervisors and competent authorities must be avoided . Moreover, the Basel standards, including the OF, apply foremost at the level of a banking group (consolidated level). In the EU prudential framework, capital requirements usually apply both at the level of individual banks/subsidiaries (individual/solo level) and at consolidated level. Some concerns have been raised that certain EU banking groups would incur an excessive increase in capital requirement due to the introduction of the OF if it were applied at solo level, in addition to its application at consolidated level. In this context, option 2 would introduce the OF at consolidated level only. However, to adequately capture the risks of both parent entities and their subsidiaries, whilst remaining consistent with the logic of the Single Market, option 2 would require any additional capital resulting from the application of the OF at consolidated level to be distributed fairly across the various entities of the group according to their risk profile as if the OF was applied at individual level. More details about the impacts of the output floor and the different implementation options are provided in section 1.8 of Annex 5. In addition, the revised standardised approach for operational risk (SA-OR) introduced a discretion to allow jurisdictions to disregard the inclusion of banks’ own historical losses related to operational risk through the Internal Loss Multiplier (ILM) indicator in their calculations of capital requirements for operational risk under this approach. While there is empirical evidence showing that banks experiencing greater operational risk losses historically are more likely to experience operational risk losses in the future, the events that have led to the largest operational losses are less amenable to prediction based on historical loss data than for other types of risks. For this reason, option 2 would exercise the discretion provided by the Basel III standards and set the ILM to 1. More details about this specific issue and the dedicated adjustment to address it are provided in section 1.4 of Annex 5. Finally, option 2 would also exercise the flexibility provided in the Basel III standards to clarify that holdings of unlisted equities with a holding period of at least 3 years would not be considered as speculative holdings and would therefore not be subject to the most conservative treatment. Option 3 - Implement the Basel III reforms with EU-specific adjustments and transitional arrangement adapted to the COVID-19 crisis This option would mirror option 2, but with a later date of application of the reform. Instead from 1 January 2023, the reform would apply from 1 January 2025, followed by a 5-year transitional period as proposed by the BCBS. This would lead to the full application of the reform by 1 January 2030. Option 3 would fulfil EU’s commitment to implement the international standards, and provide certainty for banks’ capital planning and lending decisions, whilst at the same time leaving them more time to comply with the revised capital requirements. The extended implementation period would allow banks to focus on managing their financial risks stemming from the COVID-19 crisis and financing the recovery and give them enough time to adjust before the reform would reach its full effect. In addition, to reinforce the signal that banks would have ample time throughout the recovery phase to adjust to the new rules and thereby help avoid that other market participants would put pressure on banks (in particular the few most impacted banks) to frontload the new requirements, this option would entail dedicated communication efforts to explain the additional implementation period. 5.2.2.Dedicated capture of ESG risks in the prudential framework

Option 1 - Introduce measures for a better management of ESG risks by banks Under this option, several measures would be introduced to improve the management of ESG risks by banks and to reinforce the specific review by bank supervisors as well as the degree of market discipline, without directly targeting banks’ minimum capital requirements. These measures would aim to improve the resilience of banks to ESG risks and increase bank funding of sustainable activities by means of an improved understanding of the risks involved and an anticipation of expected market pressures. As regards risk management, there is currently no explicit requirement for banks to have in place internal processes to manage ESG risks, nor an explicit requirement for ESG risks to be part of the supervisory review and evaluation process (SREP). Under this option, the current CRD V mandate for the EBA to issue a report to assess the inclusion of ESG risks in the SREP would be reinforced by explicitly requiring supervisors to ensure that banks manage ESG risks adequately. To the same end, the EBA's mandate would be clarified to require an assessment of how such risks should be included in the SREP via guidelines. Finally, the EBA would be mandated to specify further how ESG risks should be identified, measured, managed and monitored. This would include internal stress tests on banks’ resilience to climate change risks and long-term negative impacts. The annual stress tests performed by supervisors are an important tool to gauge the viability of banks under adverse conditions. At present, the CRD requires supervisors to perform annual stress tests on the banks they supervise, while the EBA is mandated to define a common stress test methodology via guidelines. Under this option, this requirement would be extended to include regular climate change stress tests and to mandate the EBA together with the other ESAs to develop a methodology for that purpose. In the area of disclosure, the disclosure requirements related to the disclosure of ESG risks would be extended to a larger universe of banks (i.e. beyond large, listed banks to whom the existing requirement will apply from 2022) while respecting the proportionality principle. As the EU economy is transitioning towards a sustainable economic model, while at the same time being exposed to sustainability risks, exposures due to the financing of sustainable activities might be expected to be less risky for banks than exposures financing unsustainable activities. While this option would not include comprehensive adjustments to capital requirements for these exposures, it would contain a specific review clause that would allow such adjustments to be made in the near future, once sufficient evidence would be available. In addition, the deadline for the EBA to deliver its report on the prudential treatment of these exposures would be advanced from 2025 to 2023 in order to ensure greater timeliness of any changes to the prudential rules that may be needed. Option 2 - Adapt minimum capital requirements to reflect ESG risks Option 2 would adapt the minimum capital requirements under so-called “Pillar 1” of the prudential framework for the financing of certain activities and/or products where specific evidence exists that they are more or less risky than comparable exposures as a result of ESG factors. For the exact delimitation of environmentally sustainable activities deemed to be of lower risk based on such evidence, the Taxonomy Regulation and its delegated acts would be used. Under this option, capital requirements for sustainable exposures would be lowered, while capital requirements for unsustainable activities would be increased, to reflect the differences in ESG risks inherent in the two types of exposures. As under option 1, the deadline for the EBA to deliver its report would be advanced from 2025 to 2023. 5.2.3.Improve the consistency in the application of supervisory powers Option 1 - Clarify and complement certain provisions on supervisory and sanctioning powers while leaving ample flexibility to Member States Under option 1, several elements of the prudential framework related to supervisory and sanctioning powers would be clarified compared to the status quo in order to ensure a more consistent application of the supervisory toolkit. However, this option would still grant flexibility to MS to detail certain supervisory and sanctioning powers in national laws. As regards supervisory powers, this option would introduce harmonised obligations for banks to notify competent authorities ahead of specific events with prudential relevance (acquisitions of holdings, transfers of assets and liabilities, mergers and demergers). To avoid placing an unnecessary burden on competent authorities and banks alike, the notification obligation would be subject to a materiality threshold. This option would abstain from specifying relevant related powers or obligations for the competent authorities. This means that MS would be left with the discretion to grant competent authorities ex ante supervisory powers to oppose or to approve these events. As regards sanctioning powers, this option would introduce a generic sanctioning provision, giving competent authorities a general power to sanction all possible breaches of the regulatory framework. This option would also include a clarification of the distinction between the enforcement dimension (e.g. compelling entities to comply with the rules) and the punitive dimension (sanctioning a breach or a misconduct) of sanctioning powers. Lastly, this option would mandate the EBA to harmonise the basis for the calculation of pecuniary sanctions applicable to EU credit institutions (e.g. the total annual net turnover) by means of regulatory technical standards. Concerning the fit-and-proper framework, this option would introduce harmonised rules for banks by requiring them to carry out an assessment of members of the management body and of key function holders before they take up their positions. This would be mandatory for all the banks in the group in which those persons are supposed to hold their functions. In addition, the option would address the assessment procedure in order to make it more reliable. This would include a specification of competent authorities’ powers and processes for the assessment of members of the management body but not for key function holders as this category comprises very different roles. Option 2: Ensure a greater level of harmonisation of the provisions on supervisory and sanctioning powers by narrowing down the flexibility of Member States This option would go a step further compared to option 1. It would frame the current flexibility of Member States in determining which powers and tools to grant supervisors in national laws. As regards supervisory powers, based on the notification requirement already foreseen in option 1, option 2 would introduce in the CRD explicit powers for competent authorities to ex ante oppose or approve events with prudential relevance (e.g. acquisitions of material holdings, material transfers of assets and liabilities, mergers and demergers). As regards sanctioning powers, compared to option 1, the list of key CRD/CRR breaches subject to administrative sanctions would be completed based on a risk-based approach. The list of sanctionable breaches would be expanded (e.g. breaches of additional reporting requirements and capital requirements would be included). In this regard, this option would ensure that the breaches to these important regulatory requirements would fall under the scope of the sanctioning regimes of all Member States. Like option 1, this option would introduce a clarification between enforcement and punitive dimension of sanctioning powers. But in addition to that it would grant an additional enforcement tool (periodic penalty payments) to competent authorities in order to reinforce their ability to ensure a strict application of prudential requirements. Furthermore, this option would include a harmonisation of the definition of total annual net turnover by using the indicator currently used in the calculation of capital requirements for operational risk in order to foster a comprehensive and consistent application of administrative penalties across the EU and ensure comparability of sanctions. Finally, under this option, the obligation for competent authorities to assess members of the management body and key function holders before they would occupy their positions would be limited to positions in the parent entity and material subsidiaries of large banks only (i.e. those powers would not be extended to small banks) following a risk-based approach. This would allow both supervisors and banks to focus their resources on the most important appointments. As with option 1, EU law would specify the procedural requirements for the fit-and-proper assessment, irrespective of whether the assessment is done ex ante or ex post.

5.2.4.Reduce disclosure costs and improve market access to bank prudential information Option 1 - EBA provides a single electronic access to EU banks’ quantitative disclosures Under this option, the EBA would provide investors and other stakeholders with a single electronic web-based access to quantitative information that EU banks are required to disclose. Specifically, the EBA would publish this information on its website. The data would be sourced directly from the supervisory data that banks are required to report to their competent authorities, with the frequency determined by the disclosure rules. Specifically, they would be sourced from the EUCLID platform which is expected to be launched in 2021. This would be similar to what the EBA does as part of its EU-wide Transparency Exercises. It is important to highlight that the EBA would only provide the platform for the centralised disclosure; the ownership of the data and the responsibility for its accuracy would remain with the banks that produce it. Under this option, any qualitative information that banks have to disclose would not have to be published on the centralised platform; the disclosure of that information would be left to banks to manage. Option 2 - EBA provides a single electronic access to EU banks’ quantitative and qualitative disclosures. Under this option, the EBA would provide investors and other stakeholders with a single electronic web-based access to both quantitative and qualitative information that EU banks are required to disclose. As under option 1, the quantitative information would be sourced from the EUCLID platform. Conversely, the qualitative information would be sent to the EBA by banks. The qualitative information could be simply sent in the format that institutions currently use (e.g. in the form of a pdf document; that document would then be published on the centralised platform). Subsequently, the format could be amended in line with developments related to other initiatives, e.g. the European Single Access Point (ESAP). As under option 1, the ownership of the information and the responsibility for its accuracy would remain with the banks that produce it. 6.What are the impacts of the policy options and how would they compare? In this section, the policy options identified to address each problem in Section 5 are assessed against three criteria: ·effectiveness: the extent to which the different policy options would achieve the objectives; ·efficiency: the analysis of the costs versus the benefits of the different policy options; and ·coherence: the coherence of the different policy options with the overarching objectives of EU policies Based on the analysis provided, a score is assigned to each policy option for each criterion. This helps to understand the selection of the preferred policy option, i.e. the policy option with the highest overall score. 6.1.Improve the current framework for calculating risk-based capital requirements As explained in Section 5.2.1, option 1 would address the main outstanding deficiencies of the prudential framework identified after the GFC, by strengthening the calculation of risk-based capital requirements and ensuring more comparability in this calculation across banks. Despite the ongoing COVID-19 crisis, these reforms are still needed since they address structural shortcomings of the prudential framework. Those shortcomings undermine the reliability of banks’ risk measurement and calculation of capital requirements. This can, in turn, have negative consequences on financial stability