Patrick Pearson Head of Banking Unit DG Markt, European Commission 10 June 2008

Transcription

1 LIBA LONDON INVESTMENT BANKING ASSOCIATION ISDA International Swaps and Derivatives Association, Inc. Patrick Pearson Head of Banking Unit DG Markt, European Commission 10 June 2008 Dear Patrick Public Consultation on Possible Changes to th e Capital Requirements Directive ( CRD ) The BBA, LIBA, ISDA and the ESF ( the Associations ) are responding jointly to the European Commission consultation on proposed amendments to the CRD. The attached response comprises an executive summary, addressing the key issues in each of the main areas of the consultation, and a series of appendices covering our detailed comments on those main areas. Overall, the Associations support many of the proposals made. Many of our detailed comments reflect our need for international consistency and clarity of regulatory intent. Our priority areas, listed below as they appear in the consultation document, are where we seek revision from the Commission before the proposals are finalised:? Large Exposures: connected clients [Article 4 (45)]: we disagree with the introduction of the funding criterion within the definition of connected clients. This requirement will be extremely hard to implement and will merely identify concentrations more appropriately dealt with under Pillar 2.? Large Exposures: Inter-bank [Article 111 (1)]: We strongly oppose the removal of the under 1 year exemption, because this artificial restriction on liquidity is likely to exacerbate firm failure rather than prevent it. There is no evidence to suggest that this exemption has caused problems in the last 15 years or more.? Large Exposures: Intra-group [Article 113(f)]: We strongly support the proposed introduction of a conditional exemption (subject to Art 80.7 criteria) for Intra-Group Large Exposures. These transactions are essential to firms liquidity and risk management. However, a number of changes to the text need to be made to make it operational.? Supervisory Arrangements: Supervisory arrangements must be efficient and meet the needs of worldwide financial groups, not only the EU entities. We support the concept of Colleges of Supervisors but this needs to be clearly distinct from the concepts of consolidating supervisor and of financial stability groups.? Securitisation: Retention of 15% of capital requirement [Article 95]. This proposal will not deliver the improvements in risk management relating to the 'originate to distribute' model that regulators are seeking. A flat capital charge can provide no incentive to firms to improve their underwriting standards or target their contingent liquidity risks. As with the other market turbulence related securitisation issues, we believe that this amendment should be deferred pending a wider global assessment of a package of improvements.? Securitisation: Significant Risk Transfer (SRT). [Annex IX, Part 2, 1.1]. Defining SRT in the absence of global agreement will put EU firms at a competitive disadvantage. If a local approach must be found, it should focus on the principle that regulatory capital reduction should be broadly commensurate with risk reduction. Taken together, these and the more detailed comments are driven by the following core principles, which we believe are shared by the Commission: International Dimension - Alignment with Basel Global markets require global solutions. To deliver a functional, high quality regulatory framework, and consistent with the principle on which the CRD was designed, the Commission should continue to align its current and future proposals and timescales with the Basel Committee.

2 A proportionate policy response: we share the objectives of improving market confidence in the current environment. However, we believe that any proposals, now more than ever, should:? Maintain the principles of better regulation, including market failure analysis and impact assessments.? Ensure that there is full consideration of the consequences, both intended and unintended. Taking both the principle of international dimension and proportionate policy development into account we note that the proposals being debated in Basel, including Securitisation, Liquidity Risk Management, Incremental Event Risk in the Trading Book and Definition of Capital must be subject to due policy process both in Basel and the EU. The impact of these proposals will be considerable but the Consultation Paper offers little hint of how these work streams will be taken forward in the EU. The resilience of the international financial system and the robustness of individual firms rests on the quality of these proposals which must not therefore be rushed through without proper exposure and analysis. Industry is able and willing to participate in policy development but two factors must be taken into account:? Capital: potential future proposals, such as the suggestion (on page 22 question iii) of setting a minimum proportion of requirements to be met by core capital (which might disqualify current levels of Tier 2 and 3) could lead to considerable systemic impact as firms would have to reduce business or increase capital levels by some magnitude. This would have consequences for market liquidity, capital costs and economic activity.? Implementation: major systems changes cannot be delivered overnight, so implementation timetables need to be realistic. Limit unnecessary change: some changes are very minor and do not, on initial investigation, pass a cost-benefit test. In the small details as well as big picture, the Commission should consider the impact of its proposals on the resources and competitive status of the EU financial services system. Clarity: in a number of instances, we do not understand what is being proposed. We know the Commission has recognised this concern in the past and we have suggested changes where possible. Without clarity there is a danger of unintended consequences, to the detriment of the EU financial services sector. Lamfalussy structure: In addition, we ask that the Commission reviews and updates the CRD, according to the Lamfalussy structure, including greater use of Level 2 measures than at present. This revision will ensure the CRD can evolve efficiently and effectively with continued changes in the market. The Associations would be happy to discuss all these issues in more detail and are committed to working with the Commission and other EU stakeholders to achieve a speedy acceptance and satisfactory resolution of the issues. Please do not hesitate to contact Katharine Seal (Katharine.seal@liba.org.uk), Diane Hilleard (diane.hilleard@liba.org.uk), Simon Hills (simon.hills@bba.org.uk), Ed Duncan (eduncan@isda.org) or Rick Watson (rwatson@sifma.org). Yours sincerely Katharine Seal Diane Hilleard Simon Hills Edward Duncan Director, LIBA Director, LIBA Executive Director, BBA Head of Risk and Reporting, ISDA Rick Watson Managing Director, ESF 2

3 JOINT ASSOCIATIONS RESPONSE TO EUROPEAN COMMISSION CONSULTATION ON CRD POTENTIAL CHANGES EXECUTIVE SUMMARY LIBA ISDA British Bankers Association Pinners Hall Old Broad Street London EC2N1EX T +44(0) E info@bba.org.uk W LONDON INVESTMENT BANKING ASSOCIATION 6 Frederick's Place London, EC2R 8BT Tel: 44 (20) liba@liba.org.uk website: International Swaps and Derivatives Association, Inc. One Bishops Square London E1 6AO United Kingdom Tel: 44 (20) isdaeurope@isda.org website: da. St Michael s House 1 George Yard, 2 nd Floor London EC3V 9DH Great Britain Tel:

4 EXECUTIVE SUMMARY Introduction This section of our response outlines the major points from each of the Annexes to our response and provides further explanation of the six key priorities identified in the cover letter. As with the cover letter, the executive summary follows the order of the consultation. Large Exposures Large exposures is a very important part of the CRD amendment package for Members. We remain very disappointed that the review has not led to a significant revision of the Large Exposure Framework, as we continue to believe that the Internal Limits Based Approach, using the tools available to supervisors under Pillar 2, is the most appropriate regulatory response for those with the requisite systems and controls. As a result we think that there should be a sunset clause inserted into the Directive to allow it to be reconsidered once supervisors have gained more experience, and also to take account of other reviews that are currently ongoing but which have implications in this area. However, Members are prepared to accept a supervisory backstop regime, providing that it operates as such. Our four policy concerns (inter-bank, intra-group, connected clients and CRM) are therefore predicated on the proposals operating on this basis. Connected Clients. We do not support the inclusion of the funding criterion within the definition of connected clients. Funding is only one issue that might result in concentrations of defaults that would more naturally be picked up as part of the Pillar 2 process. In addition, this criterion will be extremely difficult to make operational within firms, because of the difficulty of obtaining data. We also do not think that the connected client definition is the appropriate place to address liquidity and concentration risks arising from liquidity facilities. Inter-bank. Members strongly believe that the existing exemption for inter-bank exposures of less than one year should be retained. We do not think that a 25% limit is the appropriate tool for addressing supervisory concerns identified by market failure analysis. Moreover it disincentives good risk management behaviour, by increasing liquidity and credit risk. It appears to be addressing post insolvency issues, which we do not believe are the primary objective of the regime (although we 2

5 acknowledge they are of concern to regulators), but in a way that is actually likely to exacerbate firm failure because it will restrict liquidity, which is a major factor in firm failure. Firms will need to increase the number of inter-bank counterparties thereby increasing the complexity of unwinding a large complex firm. The removal of the exemption is also not supported by any empirical evidence (this exemption has operated for over 15 years without problems). Intra group exposures. We strongly support the introduction of a conditional exemption for intra-group exposures (subject to Article 80(7) criteria) and the riskfocused basis of the approach, but think that there are drafting changes that are necessary to make these proposals workable. Intra-group exposures are the main channels for liquidity to flow around the group and for the ability to manage risk on a global, centralised basis. The exemptions for intra-group and inter-bank are closely related and if it is not possible to make these proposals work then impact on firms is likely to be significant. Credit Risk Mitigation. It should be clarified that exposure value, for the purposes of determining whether an exposure is large or not, should be calculated after taking account of credit risk mitigation. The current proposal is unclear on this point, as in some areas this is explicitly taken into account (e.g. in respect of the limit), in others implicitly (IMM will automatically integrate mitigants). Clarity of text. We believe that there is much that can be done to improve the clarity of the proposed text both drafting and re-ordering. Lamfalussy. We believe that further consideration should be given to reviewing the large exposures material and structuring its provisions in accordance with the principles of a Lamfalussy Directive which would be in keeping with much of the rest of the content of the CRD. Definition of Capital Quality of Capital. Embedded within the section on Hybrid Capital Instruments is a proposal that core capital be higher than a pre determined proportion of minimum capital requirements. We do not believe that the CRD Amendments consultation is the appropriate place to deal with this and nor do we agree that the section on Hybrid Capital Instruments section is the appropriate location to discuss this question. 3

6 There is no justification that core capital be higher than a pre determined proportion of minimum capital requirements. We are concerned that such changes will have significant unintended consequences on the composition of firms capital. Requiring a certain proportion of capital to be covered by Tier 1 is inconsistent with the Tier 2 and Tier 3 limits that exist currently in the CRD. Such changes will disqualify very significant amounts of Tier 2 and Tier 3 capital that are currently used to meet market risk and large exposure requirements. Hybrid Capital Instruments. The joint trade associations support a principles based approach to implementing a hybrid capital regime in the EU that mirrors the Sydney Press Release. We are delighted that in the future firms will be able to issue dated instruments as long they have a minimum maturity of 30 years. We appreciate the inclusion of Alternative Coupon Settlement Mechanisms but have included words that will permit the most commonly used form of ACSM, which is based on the sale of shares to raise funds to pay for a distribution rather than the direct issuance of shares to hybrid holders, who may not be able to hold equities by their investment rules. Supervisory Arrangements Firms seek an efficient, non-duplicative set of supervisory arrangements. Arrangements must be suitable for all groups, whether global or regional and regardless of the nature, scale and complexity of their business. Arrangements cannot cater merely for groups whose activities are based only in the EU. In order to achieve this, the Commission proposals must separate out the concepts of (1) Consolidating Supervisor, which is valid for purely EU activities, and that of (2) Colleges of Regulators, which entails participation by and cooperation with the wider international community, where no single legislative authority has complete jurisdiction. It is important to note that the clarification and separation of these two concepts requires very little amendment to the substance of the existing draft text proposals. What is required is mainly, although not wholly, a re-ordering of the textual provisions. The text needs to deliver: supervisory arrangements that are efficient and which meet the needs of worldwide financial group. We support the concept of Colleges of Supervisors. The concept of consolidating supervisor is different and needs to be separately addressed. Additionally the concept of emergency and normal supervisory arrangements need to be treated distinctly. 4

7 Securitisation Securitisation is an important funding and risk transfer tool for the market. We strongly support efforts by the international regulatory community aimed at increasing confidence in the financial system, although this cannot be addressed by changes to the capital framework only. However, we are concerned by the lack of proper consultation in relation to the changes proposed. The absence of discussion on the market failure analysis, regulatory objectives, policy options and cost benefit analysis has made it extremely difficult to respond constructively. Therefore while we might support the concepts that we think lie behind the proposed changes there needs to be a full review and proper dialogue with the industry before changes are made. We agree that risk management, implications of the originate to distribute model and the capital charges for liquidity facilities are appropriate areas for consideration. We also think that the review should also take account of the industry initiatives that are currently ongoing. As the Basel Committee has already started such a review, we believe that it is appropriate to wait and make amendments once the outcome is known. This would have the added benefit of ensuring that a global standard is maintained. The securitisation market is global and many of our Members have significant operations beyond the bounds of the EU. Therefore it is vital that the regulatory framework here does not put them at a competitive disadvantage. There are two issues that are of particularly high priority to Members in the current proposals the retention of a flat minimum capital charge (Article 95) and the treatment of Significant Risk Transfer (Annex IX, Part 2, 1.1 and 2.1). Flat minimum capital charge Article 95. We oppose the imposition of a minimum capital charge (15%) on firms that have originated the assets that are securitised. We assume that this proposal arises out of perceived failings in the originate to distribute model. We agree that there are areas where this model requires strengthening (as identified in the Financial Stability Forum report), however, we do not believe the amendment will provide an incentive to achieve the desired outcome. As the proposal is for a flat capital charge members believe that it will encourage holdings of the positions that offer least value if transferred (i.e. senior pieces) and therefore will not encourage improvements in underwriting or risk management standards. It will not address the leverage and liquidity risk run by conduits and SIVs. Nor does the proposal target the contingent risks to such schemes to which firms were exposed. It will serve to undermine incentives to reduce reputational risks embodied in the significant risk transfer and implicit support requirements. 5

8 Furthermore the proposal may even encourage investors to expect firms to support their schemes. It will not address issues relating to the reliance of firms on active and liquid securitisation markets in their business models. Finally it is likely to create perverse incentives around the boundary of the securitisation framework or encourage assets to be originated outside the regulated community. Significant Risk Transfer - Annex IX, Part 2, 1.1 and 2.1. We do not agree with the current proposal to amend the significant risk transfer requirements. As a point of principle we do not believe that the significant risk transfer requirement is necessary if the capital framework is appropriately and prudently calibrated. The QIS exercises and firm implementation of the framework would appear to us to demonstrate that this is the case. However, we acknowledge the supervisors concern that the securitisation rules should not re-create the flaw in Basel I that resulted in transactions purely for regulatory purposes that undermined the capital framework as a whole. Ideally we would prefer a global solution to the definition of significant risk transfer. However, if a local solution must be agreed, we think that the focus should be on the regulatory failure identified, i.e. to ensure that the capital reduction is broadly commensurate with the reduction in credit risk. We do not support an approach based on arbitrary numerical limits or consider that it is necessary to take a case by case approach to determining if capital released is proportionate. We propose drafting recommendations in the securitisation annex this response. 6

9 JOINT ASSOCIATIONS RESPONSE TO EUROPEAN COMMISSION CONSULTATION ON CRD POTENTIAL CHANGES EXECUTIVE SUMMARY LIBA ISDA British Bankers Association Pinners Hall Old Broad Street London EC2N1EX T +44(0) E info@bba.org.uk W LONDON INVESTMENT BANKING ASSOCIATION 6 Frederick's Place London, EC2R 8BT Tel: 44 (20) liba@liba.org.uk website: International Swaps and Derivatives Association, Inc. One Bishops Square London E1 6AO United Kingdom Tel: 44 (20) isdaeurope@isda.org website: da. St Michael s House 1 George Yard, 2 nd Floor London EC3V 9DH Great Britain Tel:

10 EXECUTIVE SUMMARY Introduction This section of our response outlines the major points from each of the Annexes to our response and provides further explanation of the six key priorities identified in the cover letter. As with the cover letter, the executive summary follows the order of the consultation. Large Exposures Large exposures is a very important part of the CRD amendment package for Members. We remain very disappointed that the review has not led to a significant revision of the Large Exposure Framework, as we continue to believe that the Internal Limits Based Approach, using the tools available to supervisors under Pillar 2, is the most appropriate regulatory response for those with the requisite systems and controls. As a result we think that there should be a sunset clause inserted into the Directive to allow it to be reconsidered once supervisors have gained more experience, and also to take account of other reviews that are currently ongoing but which have implications in this area. However, Members are prepared to accept a supervisory backstop regime, providing that it operates as such. Our four policy concerns (inter-bank, intra-group, connected clients and CRM) are therefore predicated on the proposals operating on this basis. Connected Clients. We do not support the inclusion of the funding criterion within the definition of connected clients. Funding is only one issue that might result in concentrations of defaults that would more naturally be picked up as part of the Pillar 2 process. In addition, this criterion will be extremely difficult to make operational within firms, because of the difficulty of obtaining data. We also do not think that the connected client definition is the appropriate place to address liquidity and concentration risks arising from liquidity facilities. Inter-bank. Members strongly believe that the existing exemption for inter-bank exposures of less than one year should be retained. We do not think that a 25% limit is the appropriate tool for addressing supervisory concerns identified by market failure analysis. Moreover it disincentives good risk management behaviour, by increasing liquidity and credit risk. It appears to be addressing post insolvency issues, which we do not believe are the primary objective of the regime (although we 2

11 acknowledge they are of concern to regulators), but in a way that is actually likely to exacerbate firm failure because it will restrict liquidity, which is a major factor in firm failure. Firms will need to increase the number of inter-bank counterparties thereby increasing the complexity of unwinding a large complex firm. The removal of the exemption is also not supported by any empirical evidence (this exemption has operated for over 15 years without problems). Intra group exposures. We strongly support the introduction of a conditional exemption for intra-group exposures (subject to Article 80(7) criteria) and the riskfocused basis of the approach, but think that there are drafting changes that are necessary to make these proposals workable. Intra-group exposures are the main channels for liquidity to flow around the group and for the ability to manage risk on a global, centralised basis. The exemptions for intra-group and inter-bank are closely related and if it is not possible to make these proposals work then impact on firms is likely to be significant. Credit Risk Mitigation. It should be clarified that exposure value, for the purposes of determining whether an exposure is large or not, should be calculated after taking account of credit risk mitigation. The current proposal is unclear on this point, as in some areas this is explicitly taken into account (e.g. in respect of the limit), in others implicitly (IMM will automatically integrate mitigants). Clarity of text. We believe that there is much that can be done to improve the clarity of the proposed text both drafting and re-ordering. Lamfalussy. We believe that further consideration should be given to reviewing the large exposures material and structuring its provisions in accordance with the principles of a Lamfalussy Directive which would be in keeping with much of the rest of the content of the CRD. Definition of Capital Quality of Capital. Embedded within the section on Hybrid Capital Instruments is a proposal that core capital be higher than a pre determined proportion of minimum capital requirements. We do not believe that the CRD Amendments consultation is the appropriate place to deal with this and nor do we agree that the section on Hybrid Capital Instruments section is the appropriate location to discuss this question. 3

12 There is no justification that core capital be higher than a pre determined proportion of minimum capital requirements. We are concerned that such changes will have significant unintended consequences on the composition of firms capital. Requiring a certain proportion of capital to be covered by Tier 1 is inconsistent with the Tier 2 and Tier 3 limits that exist currently in the CRD. Such changes will disqualify very significant amounts of Tier 2 and Tier 3 capital that are currently used to meet market risk and large exposure requirements. Hybrid Capital Instruments. The joint trade associations support a principles based approach to implementing a hybrid capital regime in the EU that mirrors the Sydney Press Release. We are delighted that in the future firms will be able to issue dated instruments as long they have a minimum maturity of 30 years. We appreciate the inclusion of Alternative Coupon Settlement Mechanisms but have included words that will permit the most commonly used form of ACSM, which is based on the sale of shares to raise funds to pay for a distribution rather than the direct issuance of shares to hybrid holders, who may not be able to hold equities by their investment rules. Supervisory Arrangements Firms seek an efficient, non-duplicative set of supervisory arrangements. Arrangements must be suitable for all groups, whether global or regional and regardless of the nature, scale and complexity of their business. Arrangements cannot cater merely for groups whose activities are based only in the EU. In order to achieve this, the Commission proposals must separate out the concepts of (1) Consolidating Supervisor, which is valid for purely EU activities, and that of (2) Colleges of Regulators, which entails participation by and cooperation with the wider international community, where no single legislative authority has complete jurisdiction. It is important to note that the clarification and separation of these two concepts requires very little amendment to the substance of the existing draft text proposals. What is required is mainly, although not wholly, a re-ordering of the textual provisions. The text needs to deliver: supervisory arrangements that are efficient and which meet the needs of worldwide financial group. We support the concept of Colleges of Supervisors. The concept of consolidating supervisor is different and needs to be separately addressed. Additionally the concept of emergency and normal supervisory arrangements need to be treated distinctly. 4

13 Securitisation Securitisation is an important funding and risk transfer tool for the market. We strongly support efforts by the international regulatory community aimed at increasing confidence in the financial system, although this cannot be addressed by changes to the capital framework only. However, we are concerned by the lack of proper consultation in relation to the changes proposed. The absence of discussion on the market failure analysis, regulatory objectives, policy options and cost benefit analysis has made it extremely difficult to respond constructively. Therefore while we might support the concepts that we think lie behind the proposed changes there needs to be a full review and proper dialogue with the industry before changes are made. We agree that risk management, implications of the originate to distribute model and the capital charges for liquidity facilities are appropriate areas for consideration. We also think that the review should also take account of the industry initiatives that are currently ongoing. As the Basel Committee has already started such a review, we believe that it is appropriate to wait and make amendments once the outcome is known. This would have the added benefit of ensuring that a global standard is maintained. The securitisation market is global and many of our Members have significant operations beyond the bounds of the EU. Therefore it is vital that the regulatory framework here does not put them at a competitive disadvantage. There are two issues that are of particularly high priority to Members in the current proposals the retention of a flat minimum capital charge (Article 95) and the treatment of Significant Risk Transfer (Annex IX, Part 2, 1.1 and 2.1). Flat minimum capital charge Article 95. We oppose the imposition of a minimum capital charge (15%) on firms that have originated the assets that are securitised. We assume that this proposal arises out of perceived failings in the originate to distribute model. We agree that there are areas where this model requires strengthening (as identified in the Financial Stability Forum report), however, we do not believe the amendment will provide an incentive to achieve the desired outcome. As the proposal is for a flat capital charge members believe that it will encourage holdings of the positions that offer least value if transferred (i.e. senior pieces) and therefore will not encourage improvements in underwriting or risk management standards. It will not address the leverage and liquidity risk run by conduits and SIVs. Nor does the proposal target the contingent risks to such schemes to which firms were exposed. It will serve to undermine incentives to reduce reputational risks embodied in the significant risk transfer and implicit support requirements. 5

14 Furthermore the proposal may even encourage investors to expect firms to support their schemes. It will not address issues relating to the reliance of firms on active and liquid securitisation markets in their business models. Finally it is likely to create perverse incentives around the boundary of the securitisation framework or encourage assets to be originated outside the regulated community. Significant Risk Transfer - Annex IX, Part 2, 1.1 and 2.1. We do not agree with the current proposal to amend the significant risk transfer requirements. As a point of principle we do not believe that the significant risk transfer requirement is necessary if the capital framework is appropriately and prudently calibrated. The QIS exercises and firm implementation of the framework would appear to us to demonstrate that this is the case. However, we acknowledge the supervisors concern that the securitisation rules should not re-create the flaw in Basel I that resulted in transactions purely for regulatory purposes that undermined the capital framework as a whole. Ideally we would prefer a global solution to the definition of significant risk transfer. However, if a local solution must be agreed, we think that the focus should be on the regulatory failure identified, i.e. to ensure that the capital reduction is broadly commensurate with the reduction in credit risk. We do not support an approach based on arbitrary numerical limits or consider that it is necessary to take a case by case approach to determining if capital released is proportionate. We propose drafting recommendations in the securitisation annex this response. 6

15 JOINT ASSOCIATIONS RESPONSE TO EUROPEAN COMMISSION CONSULTATION ON CRD POTENTIAL CHANGES HYBRID CAPITAL INSTRUMENTS LIBA ISDA British Bankers Association Pinners Hall Old Broad Street London EC2N1EX T +44(0) E info@bba.org.uk W LONDON INVESTMENT BANKING ASSOCIATION 6 Frederick's Place London, EC2R 8BT Tel: 44 (20) liba@liba.org.uk website: International Swaps and Derivatives Association, Inc. One Bishops Square London E1 6AO United Kingdom Tel: 44 (20) isdaeurope@isda.org website: St Michael s House 1 George Yard, 2 nd Floor London EC3V 9DH Great Britain Tel:

16 HYBRID CAPITAL INSTRUMENTS We support a principles based approach The joint trade associations support a principles based, substance over form approach to the regulatory oversight of hybrid instruments in order to drive greater convergence and the greater use of these instruments that a level playing field will bring. We were concerned that the underlying three principles of the 1998 Sydney Press Release (SPR) had been unnecessarily embellished by CEBS during its work on hybrid capital during So we are glad to see that these proposals have stepped back from overly prescriptive requirements. The ability to issue dated instruments is welcome Whilst requiring an instrument to be undated would ensure that there is no doubt about the permanent nature of a hybrid instrument we do not believe that such a requirement is absolutely necessary. After all share capital, the task of which is to absorb unexpected losses before all other forms of Tier 1 capital, can be redeemed with the approval of a court. Indeed listed entities can repurchase ordinary shares in the open market at any time. The implementation of the Basel 2 via the CRD has changed the way in which firms manage their capital. Particularly once the floors fall away it will become much more dynamic as capital requirements fluctuate in line with the economic cycle. Therefore we are pleased that long-dated instruments with a call date, subject to supervisory oversight of any repayment and suitable lock-in provisions, will be permitted in order to allow firms to manage this volatility. Hindering recapitalisation The ability of a hybrid instrument to not hinder recapitalisation will be impossible to prove before the fact, although we prefer this wording to previous CEBS s proposal that their structure should make recapitalisation more likely. Those required to give legal opinions about the possibility of a particular structure hindering recapitalisation will find this impossible to do. Therefore we have suggested the deletion of this requirement, confident that the proposed regulatory veto of payments and redemptions will in itself achieve this objective. 2

17 What matters is the temporary suspension of the rights of hybrid investors to receive payments once a certain Tier 1 capital trigger has been breached so that a breathing space is created whilst a recapitalisation plan can be developed. Requiring permanent write-down, as has been previously suggested, as a route to facilitating recapitalisation, would create an asymmetry in which ordinary shareholders, who should bear the greater proportion of the economic risks and losses, would receive all of any subsequent gain in the firm s value. This does not reflect the intended position of ordinary shareholders as the most junior stakeholders in the firm s capital structure. Suspension permits the prevention of redemption and the payment of coupons but ensures that the investment remains in the hands of the hybrid investors rather than becoming part of shareholders resources. In this way hybrid investors would fairly benefit from any potential upside once the firm had set back on the path back to good health alongside the ordinary shareholders. Mandatory write down or conversion into ordinary shares is not necessary. Alternative coupon settlement mechanisms We appreciate the inclusion of the ACSM concept but note that the most commonly used form of ACSM is based on the sale of shares to raise funds to pay for a distribution rather than the direct issuance of shares to hybrid holders. So the proposed limitation of ACSM to the substitution of ordinary or preference shares for payments in cash of coupons or dividends to the hybrid holders themselves does not reflect market practice. The majority of hybrid buyers are fixed income investors so may be prevented by their investment criteria from holding the substituted ordinary or preference shares. We have therefore suggested wording that caters for this market reality without prejudicing a firm s capital ratios. Early calls We appreciate the explicit acceptance of early calls for tax and regulatory reasons and have added further wording relating to other such circumstances, such as accounting changes that may negatively impact the economics of a hybrid and result in a firm wishing to redeem. 3

18 No further core capital limits needed We do not agree that it is necessary to improve even further the quality of capital based on a pre determined proportion of minimum capital requirements. No additional limits on core capital are needed. We do not agree that it is necessary to improve even further the quality of capital based on a pre determined proportion of minimum capital requirements as was proposed by CEBS. Any such change may conflict with existing Tier 2 and Tier 3 limits and potentially disqualify significant amounts of such capital currently used. 4

19 Changes to Directive 2006/48/EC Article 57, point (a) (a) capital within the meaning of Article 22 of Directive 86/635/EEC, in so far as it has been paid up, plus the related share premium accounts, it fully absorbs losses in going concern situations, and in the event of the bankruptcy or liquidation of the credit institution, it ranks after all other claims but excluding cumulative preferential shares; a) capital within the meaning of Art 22 of Directive 86/635/EEC, in so far as it has been paid up, plus the related share premium accounts, it fully absorbs losses in going concern situations, and in the event of the bankruptcy or liquidation of the credit institution, it ranks after all other claims but excluding cumulative preferential shares; Justification Identification of loss absorbency capability The addition of these extra words in relation to loss absorbency means they need to be interpreted which could lead to inconsistency. As Art. 22 refers to the most junior form of capital possible this loss absorption capacity is not in doubt. Only the most junior instruments count Any Article 22 instrument that has preference over dividend payments should not qualify as core capital a key feature of which is the ability to share in a firm s losses. Convertible instruments As the CRD definition follows the accounting definition an instrument such as an such as a mandatory convertible which settles into common shares would not qualify as capital. As long as the number of common shares to be delivered is not fixed but subject to a future outcome the accounting standard requires such an instrument to be booked as a liability (IFRS 32 / Paragraph 21-24). The liability will be booked out against equity when the settlement with common shares of the mandatory convertible occurs. (Typically these instruments have maturities between 3 to 5 years). Despite that the funds paid in by the 5

20 investor are of a permanent quality and cannot be used differently than to pay up the nominal value of common shares and increase the share premium account such an instrument does not fulfil the definition and would be disregarded as capital as it also does not fulfil the maturity conditions of the other instruments mentioned in Articles 63. Therefore, we suggest that the Commission consider alternative formulations to the above wording. One alternative that would be worthy of wider exposure would be: a) capital within the meaning of Article 22 of Directive 86/635/EEC, in so far as it has been paid up or funds have been received to pay up, plus the related share premium accounts, it fully absorbs losses in going concern situations in the event of the bankruptcy or liquidation of the credit institution it ranks after all other creditors claims and it includes noncumulative preferential shares but excludes cumulative preferential shares. 6

21 Article 63, point (a) (a) The instrument shall be undated [or have a maturity of at least [30] years]. It may include a call option at the sole discretion of the issuer, but it shall not be redeemed before five years after the issue date. If the statutory or contractual provisions governing undated instruments provide for a moderate incentive for the credit institution to redeem as determined by the competent authorities, such incentive shall not occur before ten years after the issue date. [Dated and undated] instruments may be called or redeemed only with the prior consent of the competent authorities. The competent authorities may grant permission provided the request is made at the initiative of the credit institution and either financial or solvency conditions of the credit institution are not affected. The competent authorities may require institutions to replace the instrument by items referred to in points (a) or items of the same or better quality referred to in point (ca) of Article 57." [The competent authorities shall require the suspension of the redemption for dated instruments if the credit institution does not comply with the capital requirements set out in Article 75]. The competent authority may grant permission for an early redemption of dated and undated instruments in the event that (a) The instrument shall be undated or have a maturity of at least 30 years. It may include a call options at the sole discretion of the issuer, but it shall not be redeemed before five years after the issue date. If the statutory or contractual provisions governing undated instruments provide for a moderate incentive for the credit institution to redeem as determined by the competent authorities, such incentive shall not occur before ten years after the issue date. [Dated and undated] Instruments may be called or redeemed only with the prior approval consent of the competent authorities. The competent authorities may grant permission provided the request is made at the initiative of the credit institution. Where the instrument is wholly owned or issued by a subsidiary of the credit institution such permission may not unreasonably be withheld. and either financial or solvency conditions of the credit institution are not affected. The competent authorities may require institutions to replace the instrument by items referred to in points (a) or items of the same or better quality referred to in point (ca) of Article 57." [The competent authorities shall require the suspension of the redemption for dated instruments if the credit institution does not comply with the capital requirements set out in Article 75]. 7

22 there is a change in national tax treatment or regulatory classification which was unforeseen at the issuance date." The competent authority may grant permission for an early redemption of dated and undated instruments at any time, including prior to the fifth anniversary of the issue date, in the event that there is a change in national applicable tax or accounting treatment or rating or regulatory classification or other adverse external development. which was unforeseen at the issuance date." Justification Minimum maturity A 30 year minimum maturity mirrors US and rating agency requirements which are well understood by investors whilst being of a sufficiently long term. Requiring an instrument to be undated would ensure that there is no doubt about the permanent nature of a hybrid instrument but we do not believe that such a requirement is absolutely necessary. After all share capital, the task of which is to absorb unexpected losses before all other forms of Tier 1 capital, can be redeemed with the approval of a court. Indeed listed entities can repurchase ordinary shares in the open market at any time. So dated going concern capital would be a very beneficial development that would assist firms in managing their capital requirement, Dated capital with a lock-in would enable our members to fine tune their available capital more closely to their capital requirements which is likely to become more volatile under Basel II. This would contribute to the optimisation of their cost of capital as we expect that dated instruments would attract a different type of investor, which may have pricing benefits. Call options 8

23 The opportunity for call options should not be limited to one time only. Only undated instruments to have a step up The proposed requirement that the instrument containing a step up must be undated is super-equivalent to the Sydney Press release and removes flexibility. Approval or consent We prefer the word approval, rather than consent as we believe acceptance of a firm s capital plan as part of the Pillar 2 process is sufficient seeking of consent after the presentation of the capital plan has been reviewed as part of the SREP is not necessary and will duplicate regulatory and firm effort unnecessarily. Intra-group instruments Other than in exceptional circumstance the competent authority should automatically approve the redemption of intra-group instruments. Reference to financial and solvency conditions A redemption will always have an impact on financial & solvency conditions of the institution. Financial & solvency conditions are not defined so these terms should be deleted. Dated instruments but subject to lock-in We welcome the ability to issue dated instruments and recognise that the quid pro quo for this is that regulators may suspend redemption at the initial maturity date if capital requirements are unlikely to be met as a result. Replacement with same or better quality capital The prior regulatory approval that is referred to at the start of this sub paragraph could be made conditional on replacement. So this sentence is superfluous. 9

24 National or applicable tax law? The tax law that is relevant is the one applicable to the instrument, not the national law of the competent authority our proposed wording is clearer. 10

25 Article 63a, point (b) (b) The statutory or contractual provisions governing the instrument shall allow the credit institution to cancel, when necessary, the payment of interest and dividends for an unlimited period of time, on a non-cumulative basis. Notwithstanding the above, the credit institution shall be obliged to cancel such payments if it does not comply with the capital requirements set out in Article 75. The competent authorities may require the cancellation of such payments based on the financial and solvency situation of the credit institution. Such cancellation shall not prejudice the right of the credit institution to substitute the payment of interest or dividend by a payment in the form of an instrument referred to in Article 57 point (a), provided that any such mechanism allows the credit institution to preserve financial resources. Such substitution may be subject to specific conditions required by the competent authorities. (b) The statutory or contractual provisions governing the instrument shall allow the credit institution to cancel, when necessary, to waive or defer the payment in cash of interest and or dividends for an unlimited period of time, on a non-cumulative basis. Notwithstanding the above, the credit institution shall be obliged to cancel waive such payments if it does not comply with the capital requirements set out in Article 75. The competent authorities may require the waiver cancellation of such payments based on the financial and solvency situation of the credit institution. Such waiver cancellation shall not prejudice the right of the credit institution to substitute the payment in cash of interest or dividend by a payment using the proceeds of the sale of an in the form of an instrument referred to in Article 57 point (a) Article 22 of Directive 86/635/EEC, provided that any such mechanism allows the credit institution to preserve financial resources. Such substitution may be subject to specific conditions required by the competent authorities. Justification Cancellation Use of the word cancel may cause tax problems in some jurisdictions. We prefer the use of 11

26 the words waive as used in the Sydney Press Release. Payments in cash Payments in cash should be prevented. Payments in other forms, including raising cash through the issue of some form of Tier one capital: (not only strictly defined common shares) that are sold in the market, should be permitted. 12

27 Article 63a, point (c) (c) The statutory or contractual provisions governing the instrument shall provide for principal, unpaid interest and dividend to be such as to absorb losses and to not hinder the recapitalisation of the credit institution. (c) The statutory or contractual provisions governing the instrument shall provide for principal, unpaid interest and or dividend to be such as to absorb losses and to not hinder the recapitalisation of the credit institution.. Justification Hindering recapitalisation Experience suggests that hybrids do not hamper recapitalisation but the inclusion of this wording would require the production of a legal opinion, which would be virtually impossible to draft. Whether or not an instrument will hinder recapitalisation may be impossible to assess at the issue date and will depend on the facts at the time such recapitalisation is required. We believe that Tier 1 capital other than equity is also loss absorbing on an ongoing basis as:? the institution has full control over the cash raised from the point of issuance? in the UK at least, the issuer has full discretion over coupon payments at all times? in the UK at least, the absence of any obligation to make any payment (both coupons and repayment of principal) means that UT2 and T1 are excluded from the calculation of liabilities for legal insolvency purposes, thus providing economic support (cash) for the institution while also not impeding its board's flexibility to continue trading to "operate" its way out of trouble? a restriction on making cash payments (e.g. upon breach of regulatory ratios) can be achieved contractually without also needing to write down or convert principal? a hybrid Tier 1 instrument by definition already counts as Tier 1 - writedown/conversion only increases one type of Tier 1 while decreasing another - it 13