CRR3 – a More Level Playing Field Between Banks
On 1st of Jan. 2025 CRR3 came in effect in the European Union. One of the most significant changes that comes with the updated capital regulation is the new way to calculate capital requirements for credit risk under the standardised approach. Short recap: A bank can either calculate capital requirements using the standardized approach, or, subject to approval from supervisors, deploy internal models derived from internal data on behavior, portfolio features and historical losses.
Internal models usually result in lower capital requirements (higher potential to distribute capital surplus to shareholders) for credit risk compared to the standardized approach. Additionally, banks using the standardized approach might be affected by a selection bias towards poorer credit quality as, by design, the higher the credit quality, the larger the relative benefit becomes when deploying internal models (i.e. capacity to offer more attractive interest rates). This latter feature is certainly true in the Nordic region where historical losses for mortgages have been very low and where banks leverage on this fact in the models.
The updated standardized approach will reduce regulatory requirements for the safest mortgage loans by lowering the required risk weight from 35% to 20%. Additionally, it also includes reduced risk weights for commercial real estate loans with low loan-to-value ratios (high credit quality).
For these kinds of exposures, the risk-weight will be on par with the risk-weight of an internal model for comparable loans when considering the risk-weight floors imposed by Swedish and Norwegian regulators.
In addition, an output floor on capital requirements based on the output from the standardised approaches will be phased in until 2030 which makes it even less beneficial to use internal models.
The Nordic countries, except for Norway and Iceland, are part of EU where CRR3 came immediately in effect on 1 Jan. 2025. Norway and Iceland normally adopt the same capital adequacy rules as in the EU through the EEA agreement and on 6 Dec. 2024, the Norwegian Ministry of Finance adopted regulatory amendments corresponding to CRR3 in Norwegian law. CRR3 will enter into force in Norway after any constitutional reservations in the EEA Agreement in Liechtenstein and Iceland have been lifted.
Possible effects of CRR3
The changes mean, among other things, that smaller banks, which often use the standardised approach, will have lower and more risk-sensitive capital requirements for residential and commercial property loans. This means that the capital costs for those loans will be lower and more comparable to the capital cost for large banks that use internal models, hence smaller banks can offer more competitive interest rates to their clients. This could contribute to more effective competition in the banking market, which would benefit all bank customers.
An alternative scenario would be that the reduced incentive for IRB let’s larger banks move towards the standardized approach. That would also create a level playing field, but with less granularity and more coarse measurement of risk (even though, these banks would need to continue IRB for Pillar 2). Hence, the systemic risk of the whole sector could rise. A consequence contrary to the intention of regulatory authorities. For bank customers, the risk premia would probably come closer to a median, hence less risk price differential.
Apart from mortgages, exposures to corporates under the IRB approach are particularly affected by the output floor based on the standardized approach. Since the majority of corporates in the EU do not have an external rating, IRB Banks will apply a 100 % RW on unrated corporates for the purpose of calculating the output floor, while an internal rating may result in a much lower risk weight. To counter this effect, CRR3 introduces a transitional arrangement up until 2032 letting IRB banks assign a risk weight of 65 % on unrated corporates provided that the internal estimated PD of those obligors are not higher than 0,5 %.
As a consequence, lending costs for externally unrated might increase from the introduction of the output floor, although mitigated somewhat by the transitional arrangement. One of the aims with this rule is to increase the number of rated corporates in the EU. It remains to be seen if this possible increase in lending cost will push more corporates to acquire a rating.
Many banks have come far in their preparations to report CRR3 by the first quarter of 2025. However, there are various aspects of the consequences of the new regulation that will impact banks in different ways. We recommend that banks with IRB models already start to analyse the effect on capital cost and pricing when the phased in output-floor starts to take effect. Smaller banks should evaluate the effects of lower capital requirements from mortgages with low LTV and consider to adjust the offered interest rates on such loans.
