30 May 2024
After almost three years of legal proceedings and intensive Trilogue negotiations, the Plenary of the European Parliament formally adopted on 24 April 2024 the so-called Basel III package, i.e. the implementation of the Basel III requirements in the EU Capital Requirements Regulation (CRR) and the Capital Requirements Directive (CRD) for credit institutions. Member States are expected to adopt the legislative package during one of the upcoming ECOFIN meetings.
From a mortgage lender’s and covered bond issuer’s perspective, the most relevant changes can be summarised as follows:
The current Articles 124 to 126 CRR are widely replaced by a new risk weight regime for real estate in line with the Basel III standards. The new rules are more risk sensitive than the current CRR, i.e. more granular as regards the risk weight buckets, the property types and the construction phase. The approach builds on the distinction between income-producing property (IPRE) and owner occupied property (non-IPRE), allocating higher risk weights to the former.
For mortgages secured on residential property, non-IPRE mortgages under the so-called ‘loan splitting approach’ benefit from lower risk weights for LTV-ratios below 55% (20% risk weight) compared to the current framework. IPRE residential mortgages under the ‘whole loan approach’ start with a 30% risk weight below 50% LTV and receive lower risk weights (45%) beyond 60% LTV compared to the current treatment. Overall, the new regime for residential real estate appears more favourable with respect to the current rules.
While the same logic applies to commercial mortgages, the overall SA-CR regime is less favourable compared to the current regime. Non-IPRE commercial mortgages under the loan splitting approach receive a risk weight of 60% for LTVs below 55% and for IPRE mortgages, a minimum 70% risk weight applies for LTVs up to 60%. Even higher risk weights apply to LTVs beyond 60%.
For both property types (RRE & CRE), the more favourable non-IPRE risk weights also apply to IPRE assets where loss rates pass so-called ‘hard tests’, i.e. losses of maximum 0.3% for exposures up to 55% of the property value and of maximum 0.5% for exposures up to 100% of the property value.
To conclude, only lenders that currently use the SA for credit risk focusing on owner-occupied residential mortgages with low LTV-ratios and mortgage loans in Member States which fulfil the ‘hard test’ criteria will benefit from the new SA-CR regime compared to the present treatment.
While this Article was more fundamentally revised in the context of the new EU Covered Bond legislation, it is now complemented by a comprehensive risk weight ‘ladder’ for non-rated covered bonds, thereby making the new requirements more risk sensitive.
It is furthermore clarified that competent authorities may allow that real estate cover assets continue to be valued at or at less than the Market Value or at the Mortgage Lending Value by way of a derogation from Article 229 CRR. However, this derogation only applies to property valuation for cover pool eligibility and not to risk weighting purposes in accordance with Articles 124 to 126 CRR.
The property valuation regime for capital requirements for credit risk has been significantly revised. According to the new Article 229 CRR, the principle of Market Value and/or Mortgage Lending Value valuation of real estate is replaced by a new prudential valuation approach, known as the ‘property value’, introduced by Basel III.
Accordingly, the value must be calculated using conservative valuation criteria, excluding expectations on price increases and subject to adjustments to take into account the potential for the current market price to be significantly above the value that would be sustainable over the life of the loan.
This new valuation approach not only applies to banks using the Standardised method but also to IRB-banks as regards their IRB and output floor calculations. In the current absence of any further guidance from the legislator or national authorities on how to calculate this ‘property value’, the mortgage industry is currently assessing whether an approach consisting of adjusting Market Values would comply with the new rules.
The use of advanced statistical methods for monitoring of property values and the identification of their need for revaluation stipulated by Article 208 continue to be permitted but they are now subject to a number of conditions mirroring those of the EBA Loan Origination & Monitoring (LOAM) Guidelines. These conditions were initially supposed to apply where statistical methods were used for valuation at origination. While this specific use was not retained in the final agreement, the related requirements were. Consequently, advanced statistical methods – as long as they comply with a number of strict technical criteria – can be used for monitoring purposes but not for property valuation at origination.
According to Article 229(d), upwards adjustments of property values beyond the value at loan origination are permitted, but only up to the average value over the last 8 years in case of commercial properties and over the last 6 years for residential properties. Only in case of modifications made to the property that unequivocally increase its value, such as improvements to energy performance or improvements to the resilience, protection and adaptation to physical risks of the building, can the value of the property exceed the average value referenced above.
Finally, for the existing mortgage loan book, lenders may continue to carry out property valuations as they currently do until 31 December 2027 or until a review of the property value is required, whichever date is earlier (Article 495(f) CRR).
The output floor of 72.5% for IRB-banks represents a major challenge for mortgage lenders operating internal rating models[1]. Whereas the implementation of a ‘Parallel Stacks Approach’ would have been the most efficient way to mitigate unintended and penalising impacts of the output floor, this approach was not pursued.
Instead, the European legislator has chosen a ‘fall-back’ solution providing for a specific transitional arrangement for low risk residential mortgages (only). Member States may allow lenders to apply a preferential risk weight of 10% up to 55% of the RRE value, provided certain legal requirements (dual claim on the property and on the other assets of the obligor) and strict hard tests (losses over the last 8 years below 0.25% up to 55% LTV of all RRE exposures in a given year) are met.
This regime is supposed to expire on 31 December 2032. The EBA is required to monitor the use of the transitional regime and shall report its findings on the appropriateness of the risk weights used to the Commission by 31 December 2028. Should the Commission decide to propose an extension, this will require a legislative proposal and be limited to four years. Against this background, the transformation of the proposed transitional rules into a permanent regime could prove challenging.
Notwithstanding the accumulated delays in the legal proceedings, the co-legislators have confirmed that the new CRR rules will start applying on 1 January 2025. The provisions included in the CRD will be applying after their transposition by Member States. Both CRR and CRD final versions were published on the EP and Council websites early this year.
[1] Copenhagen Economics: Impact of Final Basel III on the EU Mortgage Sector, April 2022. The Study concluded that the output floor will significantly impact low-risk business such as mortgage lending. Capital requirements for the EU mortgage portfolios of IRB banks will increase by an estimated average of 18%, leaving a total extra capital need of up to EUR 39 billion. For corporate mortgage lending, the output floor will even trigger capital requirement increases of around 40% in average.
Author :Wolfgang Kälberer, EMF-ECBC Strategic Adviser
Established in 1967, the European Mortgage Federation (EMF) is the voice of the European mortgage industry on the retail side of the business, representing the interests of mortgage lenders at European level.
