CRD4: Something Old, Something New…
No major surprises in content – based on the Basel 3 package.
Use of a maximum harmonisation Regulation will be welcomed by firms.
But national authorities will be concerned about the loss of flexibility and discretion in setting capital standards and using macro-prudential tools.
Challenge for firms and regulators will be to integrate the implementation of these proposals with other regulatory reform initiatives, including capital surcharges for global and national systemically important banks.
The European Commission published today a proposed Regulation and Directive to implement the Basel 3 package of enhanced risk weightings and capital and liquidity standards. The Directive also includes new material on corporate governance, minimum administrative sanctions, reliance on credit ratings, and collaboration and information sharing among national supervisors.
The Commission proposals will go to the European Council and the European Parliament for discussion and sign-off. An early agreement will be necessary to give firms (credit institutions and investment firms) time to prepare for the Regulation and Directive to come into force at the beginning of 2013 (even if full implementation is phased in between 2013 and the beginning of 2019).
Key issues for firms…
- In most respects the substance of the Regulation and Directive will not come as a surprise to firms – they largely copy the Basel 3 package on tougher capital and liquidity standards, and on higher risk weightings in the trading book and for counterparty exposures.
- The Regulation also follows the Basel 3 agreed approach to the phasing in of higher capital standards and to the initial 'observation periods' and parallel running of the new liquidity ratios and leverage ratio.
- The Directive contains some new requirements on corporate governance, including specific limits on the number of directorships that an individual may hold.
- Firms will need to keep track of, and input actively into, European Banking Authority (EBA) processes for developing the large number of binding technical standards required to implement the Regulation and Directive at the detailed level.
- More specifically, firms will need to remain alert to the significant increase in reporting requirements set out in the Regulation, and to consider whether they are able to integrate these requirements with other changes in regulatory reporting and data management.
- The use of a 'maximum harmonisation' Regulation means that national authorities will not be able to apply higher capital ratios and risk weightings across the board, although they will have some flexibility through altering the standard risk weightings for property-related lending; requiring individual firms to hold additional 'Pillar 2' capital; and applying macro-prudential tools such as the counter-cyclical capital buffer.
- Firms also need to take into account the full range of regulatory reforms. The Regulation and Directive only cover the Basel 3 package, and do not explain how this will relate to capital add-ons for global and national systemically important banks; the Basel Committee on Banking Supervision's (BCBS) fundamental review of the trading book; the use of macro-prudential tools (other than the counter-cyclical capital buffer); recovery and resolution plans; and 'bail in' debt.
Use of a Regulation...
The Regulation contains all the new and carried forward risk weightings, the tougher minimum capital ratios, and the new liquidity and leverage reporting requirements. As a 'maximum harmonisation' Regulation, these standards will take direct effect across the EU without having to be transposed into national legislation or national regulatory rules - the standards will apply in each member state with no discretion for national variation. The Commission recommends this use of a Regulation to ensure a level playing field, to achieve a true single rule book and to strengthen the functioning of the EU single market.
The Regulation does offer national authorities some limited discretion to address macro-prudential concerns at the national level, by:
- Adjusting the standard risk weights on mortgage and commercial property lending secured by real estate, where the Regulation provides greater flexibility than the existing Capital Requirements Directive (although this applies only to risk weightings under the standardised approach, whereas most major banks use their own internal models);
- Imposing additional capital requirements on individual firms under Pillar 2, and the use of dynamic provisioning;
- Setting the countercyclical capital buffer in times of excessive credit growth and using other macro-prudential tools where the Regulation does not provide for uniform rules; and
- Implementing some of the stricter standards more rapidly than the transition pace set out in Basel 3.
In addition, the EU will have to implement in due course whatever international agreement is reached on setting additional capital requirements on global and national systemically important banks.
However, these types of discretion will be constrained by technical standards to be developed by the EBA, and by principles to be developed by the European Systemic Risk Board (ESRB) and monitoring by the ESRB of their application by national authorities.
Some Member States have already argued that, even with these national discretions, the use of a Regulation will constrain their ability to set national requirements to take account of the size of their banking sectors relative to GDP and of their national preferences for the trade-off between the safety and effectiveness of the banking sector. They may therefore place tougher requirements on firms to demonstrate credible recovery and resolution plans, as a substitute for not being able to set capital and liquidity standards above the level set by the Regulation.
Role of the European Banking Authority
The EBA will play a key role in developing 'technical standards' to set out the detail of how many of the regulatory and reporting requirements in the Regulation and Directive are to be applied in practice. These technical standards will be binding on national authorities. The EBA also has powers to ensure the consistent application of EU laws by issuing binding decisions; and to undertake binding mediation in the event of disputes about the interpretation of EU laws.
The EBA will face challenges in delivering this agenda, due to its limited resources, the importance of consulting fully on its proposals, and the untested internal and external procedures for developing and agreeing binding technical standards.
Content of the Regulation and Directive
The new material in the Regulation and the Directive mostly reflect the Basel 3 package:
Definition of capital – much greater emphasis is placed on core tier 1 capital.
Deductions from capital – these will be more wide-ranging, more harmonised, and mostly tougher (because deducted from core tier 1 capital) than previously.
Minimum capital ratios, the conservation buffer and the counter-cyclical capital buffer – these follow the Basel 3 approach to the levels and phasing in of these ratios. This includes allowing national authorities to apply a counter-cyclical buffer of more than a 2.5 percent increase on the core tier 1 capital ratio, but any requirement above 2.5 percent will only apply to branches or cross-border lending into that country if the authorities in other countries agree to do so; and that – other than in exceptional circumstances – there should be a 12 month lag between the announcement and the implementation of any increase in this buffer, although reductions in the buffer will apply immediately.
Revisions to risk weightings – the Regulation introduces tougher risk weightings for some areas of market risk (securitisations in particular) and for counterparty credit risk exposures. On trade finance, the Regulation allows for a review to take account of the BCBS consideration (expected to be finalised later this year) of whether trade finance should be subject to more beneficial capital requirements.
Leverage ratio – this ratio will need to be reported by firms to their national supervisors from 2013, and disclosed publicly by firms from 2015. The ratio will be reviewed by supervisors as part of their Pillar 2 review and evaluation, before it becomes a binding Pillar 1 requirement from 1 January 2018.
Liquidity – the Regulation sets out reporting requirements for the new Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) during the 'observation periods' for these ratios, ahead of the LCR being implemented in 2015 and the NSFR in 2018. The Regulation also requires firms to maintain, from as soon as the Regulation comes into force, liquidity buffers which are adequate to meet net liquidity outflows under stressed conditions over a short period of time. National authorities will therefore have to apply either the LCR or similar national requirements on firms to hold a buffer of high quality liquid assets ahead of LCR implementation in 2015.
The Directive makes clear that the introduction of harmonised reporting and quantitative minimum liquidity standards across the EU will require a shift to greater home country responsibility for assessing whether a credit institution with branches in other EU countries meets these new requirements. The Directive also envisages the introduction of a Pillar 2 type regime for liquidity.
Credit ratings – as in Basel 3, the Regulation introduces only a marginal reduction in the use of credit ratings in the calculation of capital ratios, while external ratings for corporate bonds have been introduced as a component of assessing high quality liquid assets for the purposes of the LCR. The new Directive attempts to reduce the reliance on external credit ratings by requiring supervisors to ensure that firms develop and move to internal ratings based approaches if they have 'material' credit risks or debt instrument risks in the trading book; and that firms have internal methods for assessing credit risks that do not rely solely or mechanically on external ratings.
Corporate governance – the Directive includes new requirements on boards ('management body') of firms to:
- Take overall responsibility for strategy, risk appetite, internal governance and effective oversight of senior management;
- Devote sufficient time to performing the functions of the board, with specific limits imposed on the number of directorships that may be held by an individual (an upper limit of one executive directorship with two non-executive directorships, or four non-executive directorships);
- Separate the functions of Chair and Chief Executive, unless justified to and authorised by the national supervisory authority;
- Establish a risk committee and a sufficiently strong and independent risk management function;
- Establish a nomination committee which reviews periodically the composition and performance of the board and the knowledge, skills and experience of the individual members of the board; and
- Establish a remuneration committee and follow remuneration policies based on the principles developed by the Financial Stability Board.
In addition, the EBA will develop binding technical standards on the assessment of the fitness and probity of members of the board, and national supervisory authorities. The EBA will also undertake a benchmarking of board diversity practices.
The role of audit committees is not mentioned in the proposed Directive, since audit requirements are covered in other EU Directives.
Minimum administrative sanctions – the Directive establishes minimum common standards for the key violations to which sanctions should apply; the types of sanction that should be available to national authorities; the magnitude of financial penalties; the criteria to be taken into account in determining the type and level of sanction to be applied; and the publication of sanctions.
Supervision – the Directive requires national supervisory authorities to take proper account of new elements of regulation. This includes the leverage ratio and the liquidity ratios; to follow good supervisory practice such as undertaking annual assessments, stress testing and the close monitoring of firms' internal models; and to strengthen collaboration and information sharing with supervisors in other countries.
Not the end of the story…
Firms and regulators will need to integrate the implementation of the Basel 3 package with the wide range of other regulatory reform initiatives. These include capital surcharges for global and national systemically important financial institutions; the BCBS's fundamental review of the trading book; the capital, liquidity and other requirements to be imposed on central counterparties (CCPs) to take account of the systemic risks that they take and manage; macro-prudential oversight and the use of macro-prudential tools (other than the counter-cyclical capital buffer); and recovery and resolution plans and 'bail in' debt (covered in the EU's proposed crisis management Directive).