CRR III – A long road, many goals
The recent amendments1 to the Capital Requirements Regulation (EU) 575/2013, aka the CRR text, marked the end of a long process started by the European Commission in 20202 and aimed at transposing the last batch of Basel III3 reforms at EU-level.
Not an easy task, given the complexity of the topic (risk-weighted assets and the prerequisite to address the worrying levels of variability observed by the BCBS4), coupled with the necessity to tailor the set standards for the specific corporate forms, structures and business models existing across the European Union.
Looking ahead, the official date when most amendments will come into force5 is getting closer and closer – with 1st January 2025 now just around the corner.
While the CRR III changes6 span across multiple areas (from credit risk to operational risk and market risk), the article wants to focus specifically on some fundamental changes in the Standardised Approach to Credit Risk (CR-SA) – putting the exposures secured by real estate assets under the magnifying glass.
Why? (I hear you say…)
Because real estate, as an asset class, at a global level represents the “biggest store of wealth” according to research by Savills7. Yet, Luxembourg has been the subject of ESRB warnings8 due to vulnerabilities9 identified in its residential real estate sector, and the ECB recently released lessons learned10 on Commercial Real Estate (CRE) valuation from its on-site inspections. Given that the changes introduced by CRR III are extensive, the intersection between prudential requirements, banking sector and financial stability is ever more interesting.
While the link between changes in risk-weights and behaviour of credit institutions is generally not linear in the short-term, it is not farfetched to assume that increased risk sensitivity of the CR-SA could lead to the prioritisation of certain lending products at the detriment of others, which the regulators are keen to ‘disincentivise’ via higher capital requirements. At the same time, it will be interesting to see how real estate funds – especially those investing in Special Purpose Vehicles (SPVs)/corporates specialised in property development – and the real estate markets will be impacted by the new wave of regulations.
1 Formally endorsed by the European Parliament on 24 April 2024 and by the Council on 30 May 2024.
2 The review of the capital requirements framework for credit institutions was part of the policy Work Programme of the European Commission.
3 The second batch of Basel reforms in Europe is also referred to as ‘Basel IV’.
4 The BCBS is the Basel Committee on Banking Supervision, an international committee that develops standards for banking regulation. It is based at the Bank for International Settlements (BIS) in Basel.
5 Some of the new provisions have already entered into force 20 days after the publication of the text (ie, on 09 July 2024). However, changes to the market risk chapter will not need to be implemented until 01 January 2026 – as decided by the European Commission on 24 July 2024.
6 The amended text adopted by the European Parliament and Council on 31 May 2024 was published on the Official Journal of the EU on 19 June 2024.
7“Total Value of Global Real Estate: Property remains the world’s biggest store of wealth” – published in September 2023.
8 A first set of warnings was issued in 2016, when the ESRB identified medium-term vulnerabilities in the residential real estate sector. This was followed in 2019 by country-specific recommendations. Another ESRB report published in February 2022, confirmed that the previously-identified vulnerabilities remained high in the Luxembourgish residential real estate market.
9 The ESRB identified vulnerabilities mainly related to the level of households’ indebtedness and their ability to withstand negative economic shocks, which could translate into financial stability risks.
10 In August 2024, the ECB published its insights on CRE valuation focusing specifically on: (1) the concept of market value; (2) validation of comparable evidence; (3) documentation of special assumptions; (4) appropriateness of valuation methodologies; (5) extent of collection of ESG data on factors affecting the assets; (6) reliance on valuers’ work; (7) timely reflection of market trends and (8) use of AVMs.
Real estate exposures – what’s the fuss all about?
On the back of the regulators’ attempt to make CR-SA more risk-sensitive, the changes to the prudential treatment of exposures secured by real estate11 are wide-ranging and multifaceted, reflecting the different stages in the construction process (finished vs. under construction) as well as the funding models (dependent or not on the income generated by the underlying property).
11 Under the CR-SA, real estate exposures are addressed in Articles 124-126a, while collateral valuation requirements are addressed in Article 208 and 229.
Building strong foundations – the features of a qualifying real estate property
CRR III adds new requirements for the classification of ‘qualifying real estate property’ – whether for residential or commercial purposes. The property must be finished, or the property is forest/agricultural land, or the lending is to a natural person (as opposed to corporates and SPVs12) and the property is either residential property13 under construction or land where Residential Real Estate (RRE) will be built. Furthermore, the exposure must be secured by a first lien, or the institution must hold the first lien as well as any lower ranking lien. Not meeting these requirements will have a direct impact on the applicable risk-weight treatment, outlined later on.
Given the crucial role played by this initial classification, credit institutions will be forced to routinely and consistently collect new information about the underlying property as well as the borrower, setting up adequate processes/policies to capture them on internal systems at the time of loan origination. Failure to do this could result in higher capital requirements either due to misclassification or inability to take advantage of various preferential treatments available for exposures that meet certain criteria.
The translation on real estate markets could be easier lending conditions (eg, attractive rates) for borrowers that intend to take out mortgages against qualifying properties, and for retail customers that are purchasing a property under construction (as long as it does not exceed four housing units).
12 The distinction of whether the loan is to a natural person or not is important because it impacts the assessment of an exposure as ADC or not.
13 CRR limits the immovable property to four residential housing units and must be the primary residence of the obligor. The lending cannot be used to indirectly finance ADC exposures.
IPRE or not IPRE? This is the question.
CRR ‘introduces’14 the concept of Income Producing Real Estate (IPRE) to recognise the higher risks associated with exposures where the repayment of the loan outstanding is materially dependent on the income generated by the property itself (eg, rental income or lease payments).
For institutions currently using the SA, this will likely require the identification of new information about their counterparties to form part of their credit assessment, as well as new flags on internal systems to correctly classify different types of exposures.
In practice, institutions will face the challenge of putting in place the right policies and procedures to decide at loan origination (and then throughout the monitoring cycle) how to correctly classify the exposures. While for corporate/SPV counterparts this could be quite clear-cut (eg, both servicing and prospect of recovery in case of default depend materially on the income generated by the property), for retail customers a generic rule of thumb15 could be where a borrower’s ability to service a loan depends for more than 50% on income generated by the property itself.
For real estate funds with investment property portfolios (ie, income generating), more attractive lending conditions may be found in jurisdictions with stable and mature real estate markets where the hard test is likely to be fulfilled.
14 While this is a new concept under the CR-SA, it already existed under the Internal Ratings Based Approach (IRBA) to Credit Risk. This further aligns the two approaches and it is useful in light of the Output Floor – which effectively forces IRB institutions to calculate their Risk-Weighted Assets (RWAs) under the SA too.
15 This rule of thumb does not take into account instances where the property is the borrower’s main residence, nor where a borrower has mortgaged less than 50% of IPRE housing units in a certain development.
Exposure-to-Value (ETV) and collateral (re)valuation
Another important concept related to immovable property is that of Exposure-to-Value16 (ETV), which conditions the applicable risk-weight under the whole loan approach (more on this later).
The Exposure is to be calculated on a gross basis (ie, accounting value of the asset item related to the exposure secured by immovable property + undrawn but committed amounts without considering any credit mitigation), while the Value is based on prudent valuation of the underlying asset.
At first glance, one could assume that the only change in the ratio is in the numerator, but a closer look at the amendments shows that the regulators have introduced more conservative requirements for the valuation of real estate collateral17 aimed at reducing its inherent cyclical features.
The main challenge faced by institutions will be the monitoring of collateral values, which not only need to be adjusted for potential material declines in value but also must be capped for upwards revaluations using the higher of average values18 or the value at origination. Unlike the Basel text, upwards revaluations are allowed but only where the property is subject to modifications that unequivocally increase its value (eg, renovation works to improve energy efficiency).
And how to forget those pesky Environmental Social and Governance (ESG) factors to be considered in monitoring material decline in collateral value? This, together with the other changes, could incentivise investments in real estate properties for tangible improvements, with an eye firmly on ‘greener’ features to future-proof immovable assets.
16 Unlike the calculation of Loan-To-Value (LTV), CRR III lays out in Article 124 (6) how to compute the gross exposure. This is in contrast to the LTV ratio, where institutions used own definitions – as reported on the EBA website. In Luxembourg, the CSSF’s Technical FAQ on Regulation CSSF No. 20-08 on borrower-based measures for residential real estate credit specified how own funds were to be calculated for the purpose of LTV requirement.
17 The valuation requirements are covered in the Credit Risk Mitigation Chapter, in Articles 208 and 229.
18 For RRE, the average value is measured over the last six years. For CRE, the timeframe is eight years.
Whole loan approach vs. Loan Splitting
The approach to assign risk-weights has also been completely overhauled to take into consideration not only the relative riskiness of the IPRE vs non-IPRE exposures, but also to better reflect the lower credit risk associated with lower ETV-ratio loans.
Between the two approaches, Loan Splitting (LS) is the most risk-sensitive and, consequently, tends to result in more capital efficient results. Given these benefits, it comes without surprise that the LS applies (without restrictions) to non-IPRE loans but can only be applied to IPRE loans if the hard test19 is fulfilled.
19 While the concept of a ‘hard test’ performed at Member State level by the relevant Competent Authority is not new (CRR II Art 124(2) – empowers CAs to review annually the appropriateness of 35%/50% risk-weights for collateralised portions of RRE and CRE loans), its repercussions have changed given it can now inhibit institutions from applying the LS approach to IPRE loans.
| Residential Real Estate (RRE) Exposures | |||||||
ETV bands |
≤50% |
50%-60% |
60%-80% |
80%-90% |
90%-100% |
>100% |
If criteria not met |
| Non-IPRE & qualifying IPRE (hard test fulfilled) | Non-qualifying real estate exposure: RW of the counterparty |
||||||
Loan splitting (up to 55% of secured exposure) |
20% | RW of the counterparty | |||||
| IPRE (hard test NOT fulfilled) | Non-qualifying IPRE RW: 150% | ||||||
| Whole loan approach | 30% | 35% | 45% | 60% | 75% | 105% | |
| Commercial Real Estate (CRE) Exposures | ||||
| ETV bands | ≤60% | 60%-80% | >80% | If criteria not met |
| Non-IPRE & qualifying IPRE (hard test fulfilled) | Non-qualifying real estate exposure: RW of the counterparty |
|||
| Loan splitting (up to 55% of secured exposure) | 60% | RW of the counterparty | ||
| IPRE (hard test NOT fulfilled) | Non-qualifying IPRE RW: 150% | |||
| Whole loan approach | 70% | 90% | 110% | |
Table 1 – Risk-weight treatment for various real estate exposures under CRR III as at October 2024
Practically, the impact on credit institutions is not only linked to the change in calculation but also to the relative impact on capital requirements – though net negative or positive results will depend on individual portfolio characteristics
(Land) Acquisition, Development and Construction (ADC)
The final key change introduced by CRR III is the new exposure class for ADC20, carved-out from the so-called ‘Items associated with particular high risk’ – which captured investments of speculative nature. Unlike previous capital treatment, ADC exposures can attract either a full 150% risk-weight or a preferential treatment at 100%. The possibility to apply a lower risk-weight depends on the ability to fulfil certain criteria21 that have been vaguely included in Level 1 text but that the European Banking Authority (EBA) has been tasked to define more clearly by July 2025. Draft Guidelines22 have already been published and gone through a Public Consultation in May 2024.
The presence of a new exposure class will force credit institutions to review current classification systems and to update policies/procedures to correctly identify exposures that are eligible (or not) for the preferential treatment.
On the flip side, real estate markets and real estate funds could be gently nudged to veer towards more conservative approaches to finance their construction projects (eg, signing pre-sale contracts with substantial cash deposits or have substantial equity at risk).
20 As defined in CRR Art 4(78b), ADC are exposures to corporates or SPVs financing any land acquisition (for development and construction) or financing development and construction of any RRE or CRE property.
21 To be able to apply the preferential risk-weight, there either needs to be a legally binding pre-sale/pre-lease contract with a substantial cash deposit subject to forfeiture in case of termination or the obligor has substantial equity at risk.
Conclusions
The article highlights the key changes that will impact credit institutions from 1st January 2025, with regard to exposures collateralised by real estate property.
The main prudential amendments can be summarised as: (1) new features for qualifying real estate assets; (2) IPRE vs non-IPRE exposures; (3) ETV and collateral (re)valuation; (4) applicable risk-weight treatments; and (5) ADC exposures.
While the increased risk-sensitivity of the CR-SA represents an opportunity for institutions to optimise their capital requirements, this can only be achieved with a consistent and robust approach up-front. Adequately adapting existing systems, data collection practices, policies and procedures will be key to harnessing latent potential and achieving compliance.
If on the one side optimisation could lead to lower capital requirements for credit institutions, on the other the effects on the real estate markets (both residential and commercial) and real estate funds could be felt as more stringent conditions to meet to attract more competitive borrowing rates.
