Public consultation on the Capital Requirements Directive ('CRD IV')

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1 MEMO/10/51 Brussels, 26 February 2010 Public consultation on the Capital Requirements Directive ('CRD IV') General How do the suggested measures fit with the ongoing work of the Commission to strengthen the regulatory framework for EU banks and investment firms to prevent the recurrence of financial crises? The suggested measures, which form an integral part of the Commission's response to the financial crisis, will be the third set of amendments to the Capital Requirements Directive ('CRD IV'). They will supplement the two sets of revisions adopted by the Commission in October 2008 ('CRD II') and July 2009 ('CRD III'). CRD II, covering amendments related to own funds, large exposures, supervisory arrangements, qualitative standards for liquidity risk management and securitisation, was adopted by Member States and the European Parliament in September 2009 and will enter into force on 31 December CRD III, covering amendments addressing capital requirements for the trading book and re-securitisation, disclosure of securitisation exposures, and remuneration policies, is currently being negotiated in the European Parliament and the Council. How do the suggested measures relate to the proposals currently being consulted by the Basel Committee on Banking Supervision? In 2009, G-20 leaders committed in London and Pittsburgh to build high quality capital, strengthen liquidity risk requirements, mitigate pro-cyclicality, discourage excessive leverage as well as to strengthen liquidity risk requirements and forwardlooking provisioning for credit losses. To respond to these commitments, the Commission and the Basel Committee on Banking Supervision have been working together on developing the respective amendments to the Basel II framework and the new global liquidity standards, including on assessing their impact. Consequently, the possible changes to the CRD set out in the Commission's consultation document are closely aligned with the expected amendments to the Basel II framework and the introduction of a global liquidity standard as suggested by the Basel Committee in its December 2009 consultation. The Commission strongly supports the work of the Basel Committee in these areas. In order to achieve the dual objective of improving the resilience of the global financial system and ensuring a level playing field, it is imperative that the more robust set of prudential capital requirements be applied consistently across the world.

2 CRD IV will be the third amendment to the CRD in the space of two years, and if the proposals are adopted, banks and investment firms will be required to secure substantial amounts of additional capital and liquidity in difficult economic conditions. Is the Commission considering the cumulative impact of all these changes? Would the Commission consider delaying their application if the economic conditions do not improve quickly? The Commission is well aware that the cumulative effect of the various contemplated measures might be substantial, and that this could have implications for the capacity of banks to provide lending to the real economy. So although tighter prudential rules are needed, as clearly demonstrated by the crisis, there is a risk that imposing higher capital requirements and new liquidity standards while the system is still weak could slow recovery in the real economy. The Commission is therefore attaching the utmost importance to assessing both the micro- and macro-economic effects of the suggested measures, and their potential impact on economic and financial recovery. In this respect, the Commission has invited the Committee of the European Banking Supervisors (CEBS) to carry out a European Quantitative Impact Study to aid the assessment of the aggregate effect of the suggested measures. The feedback to the Commission's consultation paper will considerably facilitate this exercise. Depending on the outcome of this study, it may need to be assessed whether the application of any of the new measures should be postponed until recovery is further advanced and assured. This would be consistent with Declaration by the G20 Leaders on Strengthening the Financial System made at the meeting in London on 2 nd April 2009 and in Pittsburgh on th September 2009, which stated that the new prudential regulatory standards should be phased in "as financial conditions improve and economic recovery is assured, with the aim of implementation by end- 2012". Liquidity standards Why liquidity standards for credit institutions and investments firms? There is currently no harmonised approach to liquidity standards in Europe. It is not sufficient to rely on national approaches - where they exist - or to focus exclusively on a few large banks: the integration of the European banking system is already well advanced and even medium-sized banks have significant activities in other Member States. Prior to the crisis, liquidity did not receive sufficient management and supervisory attention. The crisis illustrated how quickly and severely liquidity risks can materialise for credit institutions and investment firms of all sizes. The impact of the proposed liquidity standards on all types of institutions (including specialised banks issuing covered bonds, small investment firms) will be thoroughly assessed by the Committee of European Banking Supervisors as part of a European-specific impact assessment that will be carried out in parallel with the Quantitative Impact Study currently being conducted by the Basel Committee on Banking Supervision. 2

3 Why does the Commission suggest that the liquidity standards should apply to all legal entities within the group while liquidity is increasingly managed centrally in most cross-border banking group? Liquidity supervision is not currently harmonised. This means that each legal entity within a group may be subject to different and conflicting requirements. This has not prevented banking groups from centrally managing their liquidity. The consultation paper considers different options to take account of this practice, such as a waiver from the application of the standards to legal entities, while ensuring the resilience of legal entities to liquidity stress situations. In the wake of the Icelandic crisis, some have advocated further powers to host authorities of branches. Why then does the Commission propose a shift of responsibilities for liquidity supervision from the host to the home supervisor? According to the current rules of the Capital Requirements Directive (CRD), host supervisors retain responsibility for the liquidity of branches until further harmonisation is achieved. The liquidity standards will deliver that harmonisation. A branch as such cannot become illiquid: a branch does not have a distinct legal identity and, legally, all obligations of a branch are obligations of the credit institution itself. The Commission recognises that host supervisors need to be better involved in the supervision of branches and have access to the necessary information. Directive 2009/111/EC ('CRD II') has recently amended the CRD to this end. In keeping with the home country principle underpinning the Single Market, branch supervision would benefit from a more effective home country control, in cooperation with the host supervisor. More broadly, issues of potential failures of branch supervision will also be addressed in the context of a better integrated supervision and the Commission's forthcoming work on a crisis management framework. Definition of capital How will the grandfathering requirements of CRD II, which come into force from 31 December 2010, relate to the new requirements suggested for CRD IV? From 31 December 2010, amendments made by CRD II will come into force, including improvements to the definition of capital. The Commission aims to require implementation of amendments to the CRD covering the issues raised in this consultation from end The Commission will use the results of impact assessment to inform its approach to the phasing in of the new requirements on which the Commission is consulting; and to the interaction of this phasing in with the grandfathering provisions for recent changes to the CRD's definition of capital. In determining the appropriate approach, the Commission will consider the need to ensure economic and financial recovery. 3

4 Leverage ratio How will the leverage ratio interact with the risk-based capital ratio? A leverage ratio would be introduced as a supplementary measure. The precise nature and phasing in of the ratio would be determined in the light of the results of impact assessments. The leverage ratio will supplement rather than replace the riskbased minimum capital ratio. Counterparty credit risk How does the review of the treatment of counterparty credit risk in the Basel II capital framework and the CRD interact with the Commission's ongoing work to ensure efficient, safe and sound derivatives markets? This review is fully in line with the objectives of the Commission's Communications on derivatives of July and October The latest Communication of October 2009 set out a number of future policy actions the Commission intends to propose to increase transparency in the derivatives markets, reduce counterparty and operational risk in trading and enhance market integrity and oversight. The suggested amendments to the Capital Requirements Directive in the area of counterparty credit risk form an integral part of the Commission's efforts on this front. Countercyclical measures, including dynamic provisioning Will the Commission's attempts to develop dynamic provisioning inhibit international convergence of accounting standards? Would it not be better to feed into the work of the International Accounting Standards Board (IASB)? The Commission views dynamic provisioning as a potentially useful countercyclical measure that merits further exploration. It is appropriate to have a clear view of the options and their relative effect, which is the purpose of this consultation. To this end, the Commission is keen to develop its thinking on dynamic provisioning. All avenues need to be explored. At the same time, the Commission continues to work with the IASB and the Basel Committee to promote forward-looking provisioning and accounting convergence. 4

5 Dynamic provisioning addresses financial stability concerns, while the accounting framework aims to provide a true and fair view of the financial position. To what extent is it possible to use the accounting framework to address the financial stability concerns, while ensuring that investors receive the appropriate information? During the crisis it has become clear that banks had not set aside sufficient levels of provisions for credit risks on loans originated during the 'good' economic years. Dynamic provisioning aims to mitigate this by requiring banks to build up adequate provisions for expected credit losses during economic upturns and use these during downturns. Dynamic provisioning therefore addresses a broader financial stability concern. The fundamental question is to what extent the overall objective of accounting standards to provide useful information to investors should be complemented with objectives related to financial stability. According to the Commission's current thinking, it would appear appropriate to show expected credit losses "above the line", impacting the reported net income. Reducing net profits during good times will properly influence bank management behavior, limit bank bonuses and prevent an imprudent distribution of profits. Moreover, presentation of expected credit losses "above the line" better reflects the risks related to the bank's earnings and would therefore enhance the true and fair view of the bank's financial position and performance. Can the respective prudential concerns not be resolved through regulatory capital requirements rather than dynamic provisioning? Regulatory capital covers unexpected losses whereas dynamic provisioning is intended to address expected losses. Nevertheless, the consultation looks at different options in this regard. Single rule book What is the purpose of achieving a single rule book in banking? The establishment of the European Banking Authority should be accompanied by the development of a single set of harmonised rules so as to ensure their uniform application and thus contribute to a more effective functioning of the Internal Market. The Commission suggests removing national options and discretions from the CRD, and achieving full harmonisation by no longer allowing Member States to apply stricter rules, unless compelling evidence is brought that stricter rules in specific areas are needed on financial stability grounds. See also IP/10/197 5