June 16, Dear Sirs:

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1 David Schraa Director, Regulatory Affairs Department June 16, 2008 Mr. Elemer Tertek, Director, Financial Institutions Mr. Patrick Pearson, Head of Banking Unit Internal Market and Services Directorate-General European Commission B1000 Brussels Dear Sirs: The Institute of International Finance offers the following, high-level comments as a contribution to the very important dialogue on the proposed amendments to the Capital Requirements Directive. The Institute is an association of about 385 firms active in the international financial markets, including members from about 70 countries, including the leading EU firms. Because the Institute s primary vocation in regulatory affairs is to address issues at the international level, we will defer to the detailed comments of the European associations on the proposals, of which we have taken note. However, there are a few points of fundamental significance in those amendments that we believe require comment from our perspective. Need for International Coordination The Institute s most basic comment is that those measures contemplated in the proposed amendments that are not provided for in the new Basel Accord or other international agreements, but within their scope, ought to be deferred until a globally coordinated approach is adequately analyzed, debated and agreed. This is essential not only, from firms point of view, to assure a level playing field, but also, from the policy point of view, to avoid possible distortions in what is substantially a global securitization market. In saying this, we do not wish to minimize the need to address the lessons to be learned from the recent turmoil. The Institute s members have devoted a considerable amount of effort to analysis of the risk management, underwriting, transparency, liquidity, valuation, and other issues raised recently. A major report is scheduled to be published by mid July to address all these issues, and we hope to continue to pursue the dialogue on how to make the global system more resilient with the Financial Stability Forum, the Senior Supervisors Group, the Basel Committee, IOSCO, and IAIS, as well as with the Commission, CEBS and CESR. But in creating the basis for improvements to make the market more worthy of investors confidence, we believe that international cooperation and coordination are all the more important and it is fundamental that the CRD remain in

2 close alignment with the arrangements agreed by the Basel Committee and other international instances. Securitization Issues Despite the high-profile problems of the past several months, many in the public sector as well as the industry have noted, the economic benefits of securitization are essential to the recovery and growth of the international financial system and its ability to generate the credit necessary for global prosperity. 1 It should also be kept in mind that many securitization and conduit transactions have performed relatively well despite difficult conditions and it would be wrong to tar all such transactions with the same brush as the well known examples that have encountered major difficulties. It is therefore essential that any measures taken to strengthen risk management or the regulatory capital regime with respect to securitization be both well coordinated from a global perspective and carefully balanced to assure that the credit-generating and liquidity benefits of securitization are not stifled by measures intended to address recently emerged issues. Arbitrary Capital Charge. Particularly troubling is the proposal in Article 95 to require that "risk-weighted exposure amounts for the originator credit institution shall not be less than [15%] of the risk-weighted exposure amounts of the securitised exposures had they not been securitized", regardless of whether the risk has been transferred. Without entering into all the technicalities, this proposal raises numerous concerns, including the following: o Because it is an arbitrary charge not related to risks actually incurred, the provision is contrary to the risk-based conception of Basel II and the CRD, and therefore changes its conceptual basis. o The rationale for the proposed charge is not evident. Consistently with the Commission s better regulation principles, we respectfully request that, if the proposal is to be maintained, the argument for it (and for other proposed changes) be made public for discussion and debate. o It is a blunt instrument, not addressing the potential risks run by firms with respect to contingent liabilities or the direct risks assumed by conduits or other structures that are investors in securitization transactions. o It may create false impressions or expectations on the part of investors with respect to structures where the originators or other parties have no ongoing support obligations. o It provides no meaningful incentives to improved risk management or underwriting (issues with respect to which will be covered in the forthcoming IIF market practices report). o Exposures would be difficult to calculate and it might actually burden rather than improve risk management in many instances. 1 See, for two examples among many, the speech of Malcolm Knight, General Manager of the Bank for International Settlements to the Annual Conference of IOSCO, May 29, 2008 and the Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience (April 7, 2008). 2

3 o It may encourage firms to hold more paper from securitizations, quite possibly the most senior tranches, artificially affecting business and risk-management decisions. Experience has shown that certain tranches that firms have retained, rather than those distributed, have caused the most challenging valuation and loss problems in recent months. o It would distort competition with non-regulated or offshore entities, especially in lower-margin businesses, and would distort competition between the EU and non- EU markets. o It would likely increase the cost of securitization across the board, to the detriment of investors and market efficiency. This would be particularly unfortunate in sectors such as automobile or credit-card transactions, where securitization is an essential source of funding. o It may create misaligned incentives or other unintended consequences. o There is no such provision in Basel II, nor are we aware of any proposal to include anything of the kind. The foregoing is not an exhaustive list, but member firms will be making clear their concerns both directly and through the more-detailed comments of the European associations. Significant Risk Transfer. Provisions regarding significant risk transfer are another area where we would urge that any changes deemed necessary be deferred until the Basel Committee has had the chance to deliberate, consult, and issue any new standard that is ultimately judged to be necessary. Moreover, provisions with respect to significant risk transfer may be affected by developments on the accounting issues of derecognition and consolidation, which the IASB has an urgent project to reconsider pursuant to the mandate of the April, 2008 Financial Stability Forum report. Any changes should be coordinated though not directly linked. The forthcoming IIF report will address in some detail the issues around significant risk transfer and derecogntion/consolidation. The thrust of that discussion is that, unless carefully calibrated (and issued on a global basis), inappropriate restrictions could burden economic and financial recovery and put unnecessary burdens on securitization which, as already said, has become an essential part of the global financial machine. This is an area where, on the one hand, the debate on serious problems in the market has tended to eclipse the fact that there are many transactions that continue to perform reasonably well despite difficult market conditions and, on the other, where there is a serious danger of overreaction in correcting the real issues that have come to light. It is, of course, important to address the many issues that came to light after July, 2007, but arbitrary and draconian risk-transfer requirements are not the way to do so. The IIF report will have a number of recommendations of industry action and considerations for the official sector, and, of course, the Financial Stability Forum, Senior Supervisors Group and other international official groups are addressing those issues. It should be noted that there appears to be a consensus in the official as well as private sectors that Basel II has already addressed the specific problems of Basel I with respect to 3

4 securitization. The Interim Report of the Institute s Committee on Market Best Practices (April 2008, available at has already noted the extent to which Basel II would have mitigated some of the recent problems of the securitization markets. Again without going into a highly detailed discussion, we are concerned that the proposed quantitative tests of 50% of mezzanine tranches and 90% for equity tranches may prove to be arbitrary and unrelated to the real risks of many transactions; moreover, the aspect of the proposed test requiring case-by-case regulatory analysis may well prove to be burdensome for firms and regulators alike. We do agree that it is appropriate for the Basel Committee to reassess the specifics of the current securitization framework, including significant risk transfer; however, we do not think that the proposed approach in the CRD amendments is an appropriate response to those concerns. The thresholds proposed appear to be arbitrary. Particularly with respect to mezzanine tranches, the requirement could create a disincentive to originators acting as market-makers, and therefore harming liquidity. Large Exposures A number of detailed changes in the large-exposure regime are proposed. without attempting to delve into the details, which have been addressed extensively by the European associations, we would encourage the Commission to ensure that: o The changes do not restrict the ability of banks to provide liquidity to one another in times of particular problems in the financial and settlement systems, such as when stress events occur and there is a need for banks to remain in the market and support one another for the benefit of the continued smooth operation of the entire system; and o The changes assure the ability of banks to move liquidity between subsidiaries or, where relevant, between branches, with flexibility to manage short-term liquidity requirements without unnecessarily trapping liquidity in ways that artificially interfere with the ability to manage liquidity on a group-wide basis subject to integrated risk management, as recommended by the Financial Stability Forum report cited above. 2 Own Funds/Definition of Capital We have been following with interest the debates on own funds through CEBS and the various documents published. We do not propose here to enter into that debate now, deferring to the European associations with respect to the discussion in the EU. We do, however, urge that any substantive final actions be kept consistent with global standards and definitions coordinated through the Basel Committee. As many in both the official 2 For a further discussion of this point see the IIF s Principles of Liquidity Risk Management (March 2007) especially pp

5 and private sectors have noted, the new Basel Accord (and of course the CRD) will be critical to recovery and mitigating future market stresses. This makes it all the more important that both the numerator and the denominator of capital requirements be kept consistent globally. Supervisory Arrangements Without entering into the specifics of a complex debate, the Institute has long been concerned about the need to engender more efficient as well as more effective regulation and supervision at the international level. As the recent FSF and SSG reports indicate, there appears to be widespread recognition in the international level on this point. The Institute published its general views on this subject in its Proposal for a Strategic Dialogue on Effective Regulation (December, 2006) and its Special Committee on Effective Regulation is working actively on ways to reinforce the international supervisory and regulatory architecture in light of the recent turmoil. Among the special concerns of firms is the well coordinated, efficient, and nonduplication management of cross-border supervision, especially with respect to the Basel/CRD capital requirements and Pillar 2. The Institute has long advocated international coordination through colleges of supervisors, and we have separately communicated a paper done for the Basel Accord Implementation Group on this subject. We intend to continue this dialogue with that group this Summer. For present purposes, we make two comments. First, that any augmentation of the colleges process at the European level must make due allowance for participation of third-country supervisors. This is clearly the mandate of the recent FSF report, but the point bears emphasis. Second, European procedures for colleges should be coordinated with those of the Accord Implementation group, subject to necessary adjustments for the European legal structure, such as Article 127. Should you have any questions about this letter, please contact the undersigned (dschraa@iif.com; ) or Caitríona O Kelly (cokelly@iif.com; ), Very truly yours, 5