Implications of CRR3 for the 2025 EU-wide stress test

With the introduction of the updated Capital Requirements Regulation (CRR3), which has entered into force on 9 July 2024, the European Union's financial landscape is poised for significant changes. The 2025 EU-wide stress test will be a major assessment to measure the resilience of banks under these new regulations. This article summarizes the estimated impact of CRR3 on banks’ capital requirements for credit risk based on the results of a monitoring exercise executed by the EBA in 2022. Furthermore, this article comments on the potential impact of CRR3 to the upcoming stress test, specifically from a credit risk perspective, and describes the potential implications for the banking sector.

The CRR3 regulation, which is the implementation of the Basel III reforms (also known as Basel IV) into European law, introduces substantial updates to the existing framework [1], including increased capital requirements, enhanced risk assessment procedures and stricter reporting standards. Focusing on credit risk, the most significant changes include:

• The phased increase of the existing output floor to internally modelled capital requirements, limiting the benefit of internal models in 2028 to 72.5% of the Risk Weighted Assets (RWA) calculated under the Standardised Approach (SA), see Table 1. This floor is applied on consolidated level, i.e. on the combined RWA of all credit, market and operational risk.

• A revised SA to enhance robustness and risk sensitivity, via more granular risk weights and the introduction of new asset classes.¹
• Limiting the application of the Advanced Internal Ratings Based (A-IRB) approach to specific asset classes. Additionally, new asset classes have been introduced.²

After the launch of CRR3 in January 2025, 68 banks from the EU and Norway, including 54 from the Euro area, will participate in the 2025 EU-wide stress test, thus covering 75% of the EU banking sector [2]. In light of this exercise, the EBA recently published their consultative draft of the 2025 EU-wide Stress Test Methodological Note [3], which reflects the regulatory landscape shaped by CRR3. During this forward-looking exercise the resilience of EU banks in the face of adverse economic conditions will be tested within the adjusted regulatory framework, providing essential data for the 2025 Supervisory Review and Evaluation Process (SREP).

The consequences of the updated regulatory framework are an important topic for banks. The changes in the final framework aim to restore credibility in the calculation of RWAs and improve the comparability of banks' capital ratios by aligning definitions and taxonomies between the SA and IRB approaches. To assess the impact of CRR3 on the capital requirements and whether this results in the achievement of this aim, the EBA executed a monitoring exercise in 2022 to quantify the impact of the new regulations, and published the results (refer to  the report in [4]).

For this monitoring exercise the EBA used a sample of 157 banks, including 58 Group 1 banks (large and internationally active banks), of which 8 are classified as a Global Systemically Important Institution (G-SII), and 99 Group 2 banks. Group 1 banks are defined as banks that have Tier 1 capital in excess of EUR 3 billion and are internationally active. All other banks are labelled as Group 2 banks. In the report the results are separated per group and per risk type.

Looking at the impact on the credit risk capital requirements specifically caused by the revised SA and the limitations on the application of IRB, the EBA found that the median increase of current Tier 1 Minimum Required Capital³ (hereafter “MRC”) is approximately 3.2% over all portfolios, i.e. SA and IRB approach portfolios. Furthermore, the median impact on current Tier 1 MRC for SA portfolios is approximately 2.1% and for IRB portfolios is 0.5% (see [4], page 31). This impact can be mainly attributed to the introduction of new (sub) asset classes with higher risk weights on average. The largest increases are expected for ‘equities’, ‘equity investment in funds’ and ‘subordinated debt and capital instruments other than equity’. Under adverse scenarios the impact of more granular risk weights may be magnified due to a larger share of exposures having lower credit ratings. This may result in additional impact on RWA.

The revised SA results in more risk-sensitive capital requirements predictions over the forecast horizon due to the more granular risk weights and newly introduced asset classes. This in turn allows banks to more clearly identify their risk profile and provides the EBA with a better overview of the performance of the banking sector as a whole under adverse economic conditions. Additionally, the impact on RWA caused by the gradual increase of the output floor, as shown in Table 1, was estimated. As shown in Table 2, it was found that the gradual elevation of the output floor increasingly affects the MRC throughout the phase-in period (2023-2028).

Table 2 demonstrates that the impact is minimal in the first three years of the phase-in period, but grows significantly in the last three years of the phase-in period, with an average estimated 7.5% increase in Tier 1 MRC for G-SIIs in 2028. The larger increase in Tier 1 MRC for Group 1 banks, and G-SIIs in particular, as compared to Group 2 banks may be explained by the fact that larger banks more often employ an IRB approach and are thus more heavily impacted by an increased IRB floor, relative to their smaller counterparts.  The expected impact on Group 1 banks is especially interesting in the context of the EU-wide stress test, since for the regulatory stress test only the 68 largest banks in Europe participate. Assuming that banks need to employ an increasing version of the output floor for their projections during the 2025 EU-wide stress test, this could lead to significant increases in capital requirements in the last years of the forecast horizon of the RWA projections. These increases may not be fully attributed to the adverse effects of the provided macroeconomic scenarios.

Conversely, it is good to note that a transition cap has been introduced by the Basel III reforms and adopted in CRR3. This cap puts a limit on the incremental increase of the output floor impact on total RWAs. The transitional period cap is set at 25% of a bank’s year-to-year increase in RWAs and may be exercised at the discretion of supervisors on a national level (see [5]). As a consequence, this may limit the observed increase in RWA during the execution of the 2025 EU-wide stress test.

In conclusion, the implementation of CRR3 and its adoption into the 2025 EU-wide stress test methodology may have a significant impact on the stress test results, mainly due to the gradual increase in the IRB output floor but also because of changes in the SA and IRB approaches. However, this effect may be partly mitigated by the transitional 25% cap on year-on-year incremental RWA due to the output floor increase. Additionally, the 2025 EU-wide stress test will provide a comprehensive view of the impact of CRR3, including the closer alignment between the SA and the IRB approaches, on the development of capital requirements in the banking sector under adverse conditions.

References:

1. final_report_on_amendments_to_the_its_on_supervisory_reporting-crr3_crd6.pdf (europa.eu)
2. The EBA starts dialogue with the banking industry on 2025 EU-Wide stress test methodology | European Banking Authority (europa.eu)
3. 2025 EU-wide stress test - Methodological Note.pdf (europa.eu)
4. Basel III monitoring report as of December 2022.pdf (europa.eu)
5. Basel III: Finalising post-crisis reforms (bis.org)