Apparent political focus on easing the impact of the Basel III output floor – as reflected in a reduction, albeit temporary, in certain residential mortgage risk weights – has been welcomed by some mortgage bankers, but concerns around CRE treatment and increased capital requirement persist.

On Wednesday of last week (27 October), the European Commission adopted and announced the Banking Package 2021, featuring amendments to the Capital Requirements Directive (CRD) and Capital Requirements Regulation (CRR) that include the implementation of outstanding elements of Basel III.

The Commission’s adoption kicks off the legislative process whereby the text and its impact will be analysed, with negotiations around potential amendments and improvements ahead of final approval by the European Council and Parliament.

“Today’s proposals ensure that we implement the key parts of the Basel III international standards,” said Valdis Dombrovskis, Commission executive vice president (pictured). “This is important for the stability and resilience of our banks.

“We do it by taking into account the specificities of the EU banking sector, and avoiding a significant increase in capital requirements.”

A key concern for banks has indeed been that the introduction of a Basel III “output floor” would lead to a significant increase in capital requirements that furthermore do not appropriately reflect low risk mortgage lending. Banks using the internal ratings-based (IRB) approach cannot set the risk weights of assets below 72.5% of those they would face under the standardised approach (SA) to credit risk, which in the case of residential mortgages would typically have set a floor of 24% based on a 33% average SA risk weight for total residential real estate exposures in Europe – far higher than the risk weights applied in many cases by EU banks, pushing up their capital requirements.

Opponents of the output floor have argued that other measures such as the leverage ratio or specific EU rules to strengthen model requirements tackle the risks of outlier banks setting risk weights that may be too low, that the measure does not recognise low risk mortgage lending, and that it could drive mortgage business towards non-bank lenders, with the Basel Committee on Banking Supervision not having adequately taken into account specificities of the European mortgage system, which is more reliant on on-balance sheet lending than areas such as the US.

With the Commission having nevertheless underlined its intention to align its approach with Basel III, several EU banking groups had lobbied for a “parallel stack” approach to mitigate the impact of the output floor. Under this proposal, the output floor would not have been used in the current overall calculation of capital requirements, but would have been used to calculate capital requirements excluding EU add-ons such as the O-SII buffer and Pillar 2 requirement, with a bank’s ultimate regulatory capital requirement being the higher of the two. The approach would have alleviated the impact of Basel III in countries where its impact could otherwise have been greatest, such as Denmark, Germany, the Netherlands and Sweden.

With supervisory authorities including the European Central Bank having spoken out against the parallel stack approach, the Commission has rejected it, citing a desire for better alignment with Basel III.

However, among other concessions, it has now proposed that during a transition period from 2025 to 2032 the risk weight applicable to output floor calculations for certain residential mortgages is lowered from 20% under the standardised approach to 10%, thereby lowering the respective output floor to 7.25%. This risk weight is only applicable to a secured part of exposures, up to 55% of the property value, subject to further conditions, including historic loss levels.

“Given the size of mortgage portfolios on European bank balance sheets, and the resilience of their performance, the output floor could have had a material impact on a number of European banks,” said S&P Global Ratings analysts. “The proposed changes to standardized risk weights for low risk mortgages could therefore materially dent the impact of the output floor.”

According to Luca Bertalot, secretary general of the European Mortgage Federation-European Covered Bond Council (EMF-ECBC), the outcome followed tough negotiations around special treatment for mortgages as it became clear the parallel stack approach was facing opposition, with the EMF-ECBC intervening to help ensure that the proposal would give concrete relief to those mortgage markets most significantly impacted, and at the same time secure a level playing field and prevent any major pro-cyclical elements.

“In terms of global level playing field, the Commission was politically open to giving some kind of recognition of the on-balance characteristic of our banking system, and ready to mitigate the impact on the mortgage portfolio of EU banks,” Bertalot told The CBR. “During the negotiations, most of the criticalities identified by our members were addressed by the technical services of the Commission.

“We are now working to analyse the impact country by country, and to prepare our campaign for the Council and Parliament, but all in all, considering the technical and diplomatic complexity of this dossier, we have landed in a safe place.”

But while the Commission gave ground on the issue of residential mortgage, it did not similarly yield on commercial mortgages, and the Association of German Pfandbrief Banks (vdp) highlighted this among outstanding shortcomings of the proposals.

“We welcome the fact that the legislative proposal now explicitly recognizes that real estate financing needs to be treated differently, after such treatment had previously been denied for years,” said vdp chief executive Jens Tolckmitt. “However, the solution that has now been found is still completely inadequate. It is incomprehensible, on the one hand, why the special treatment to be given to residential properties should only apply for a limited time and, on the other hand, why commercial properties are disregarded.

“The original goal of ‘not significantly’ increasing the capital burden on the banking industry with the Basel III reform is thus clearly missed.”

The output floor will be phased in over five years from 2025, with a starting value of 50%, while the proposals include what the Commission says are safeguards to avoid duplications in capital requirements resulting from the combination of the output floor and add-ons such as the Pillar 2 requirement.

The Commission said that the reforms are expected to lead to an increase in EU banks’ capital requirements of less than 9% on average at the end of the envisaged transitional period in 2030 – compared to 18.5% if European specificities were not taken into account – and less than 3% at the beginning of the transitional period in 2025. However, the vdp and others argue that the capital ratios banking supervisors and market participants expect to see are always higher than minimum capital requirements, with early compliance also expected, while the expiry of the transitional arrangements after 2030 is not included in the impacts mentioned by the Commission.

The 2032 end to the phase-in transition period is beyond what was previously envisaged, and there is already speculation that transitional measures such as the lower SA residential mortgage risk weight could be made permanent.

“That would be necessary,” said one industry representative, “because the actual proposal results in large increases of capital requirements, especially for banks that use internal models. The actual timeline, with transitional rules ending in about 10 years, does not prevent the adverse effects on the real and financial economy.”

Under the current proposal, the European Banking Authority (EBA) is mandated to report to the Commission on the appropriateness of the transitional treatment and associated risk weights by the end of 2028.

Implementation of Basel III in the EU had originally been envisaged at the start of 2022, but discussions around the latest Banking Package are now expected to extend well into next year. As well as the views of Council and Parliament, the finalisation of the package will be subject to a European Banking Authority report on the proposals.

The Banking Package also includes elements that are aimed at alignment with the Commission’s sustainable finance strategy. In line with the Energy Efficient Mortgages Initiative (EEMI) it leads, the EMF-ECBC had lobbied for banks to be able to reflect increases in property values resulting from energy efficiency improvements in risk weights, and the proposals allow this.

“We are very pleased to see an explicit reference to energy efficiency mortgages,” said Bertalot.

Photo credit: Aurore Martignoni/EC Audiovisual Services; Copyright: EU