ALMForum. Final EU - LCR provisions in the finishing straight. December 2014 No. 10

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Darrell McGee
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1 Final EU - LCR provisions in the finishing straight December 2014 No. 10

Contents Executive Summary...3 1 Extensive consideration of covered bonds (Pfandbriefe) as liquid assets...5 2 Broader consideration of securitized exposures as liquid assets.

2 Contents Executive Summary Extensive consideration of covered bonds (Pfandbriefe) as liquid assets Broader consideration of securitized exposures as liquid assets Adapted caps / floors in the calculation of eligible liquid assets Changes in the weighting factors regarding inflows and outflows Consideration of the effects of liquidity networks and IPS Conclusion...11 Available online at 2

3 Executive Summary The in June 2013 published CRR (EU Regulation No 575/2013) has determined, among other things, a general liquidity coverage ratio (LCR) and the regular reporting of the liquidity buffer. On 10 October 2014, the EU Commission has published after the appropriate consultation period its delegated regulation to implement the liquidity coverage requirement under the Capital Requirements Regulation (CRR). The rules substantiate these requirements for the LCR which are included in the CRR. In Article 460 of the CRR, the Commission was given the task to specify the LCR in details. In the Commission s view, the LCR is one of the main innovations of the CRR, since it is assumed that the lack of international liquidity standards was one of the main reasons why some European institutions were able to put their business policy too heavily on short-term refinancing of long-term assets and thus lead to a drying out of liquidity in the crisis. The main objective of the LCR is to reduce the short-term refinancing risk of banks, and thus to make financial institutions less dependent on short-term funding and central bank liquidity. The liquidity coverage requirement (LCR) requires the maintenance of a liquidity buffer that covers the net cash outflows of at least 30 days under market-wide and idiosyncratic stress conditions. Since the HQLAs have a significant share on the total assets of a bank, there is also a consequence on the income of the banks. The EBA expects that approximately 10% of total assets are High Quality Liquid Assets (HQLA). Accordingly the calibration of the LCR is essential. Although the EBA s analysis assumes that the average LCR over the entire banking system lies around 115% (111% for Tier 1 banks, 134% for non tier 1 banks), the differences between individual countries and operations of banks are large, so EBA estimates a shortfall of 263 billion Euro of HLA. While the Basel proposal for a LCR standard was developed especially for large internationally active banks, the additional challenge for the European Commission is to operationalize the LCR requirements to the extent that it is a meaningful ratio to all 8,000 European credit institutions both on individual and consolidated basis. Thus, the present proposal is a balancing act. On the one hand, the differences have to be taken into account, and on the other hand, a general bank-wide LCR ratio should be introduced. After the publication of the regulation, now the review by the European Parliament and the European Council is done. In the further process, thus, only a consent or refusal is possible. Amendments to the Regulation can at this stage not any longer be performed on the document. Due to the delay in announcing the regulation, the date of application is shifted from 01 January 2015 to 01 October The positions of the LCR under CRR already have to be declared monthly since 31 March 2014 and will be replaced on 1 October 2015 by the regulatory reporting requirements of the delegated act. In order to permit institutions to adjust gradually to the new minimum requirement, the LCR is first introduced in 2015 with a performance level of 60%, which is then gradually increased: 2016 to 70%, 2017 to 80%, and 2018 to 100%. 3

4 The main changes with respect to the proposed Basel LCR are 1. Extensive consideration of covered bonds (Pfandbriefe) as liquid assets 2. Broader consideration of securitized exposures as liquid assets 3. Adapted caps / floors in the calculation of eligible liquid assets 4. Changes in the weighting factors regarding inflows and outflows 5. Consideration of the effects of liquidity networks and IPS (Institutional Protection Scheme) agreements in the decentralized sectors 4

5 Ad 1: Extensive consideration of covered bonds Covered bonds are classified in the Regulation under certain conditions as Level 1 assets, but are subject to restrictions in this case, which is why they can be seen as Level-1B Assets. Other Covered Bonds may be recognized under certain conditions as Level-2A or 2B-level assets. By preferential treatment as Level-1B assets, the European Commission is significantly differing from the EBA recommendation, that though considering the liquidity of covered bonds similarly high as government bonds, finally proposed a Level 2 classification. Level 1 Level 2A Level 2B Capital requirements EU Directive 575/2013 Article 129 Point 4&5 Transparancy rules Minimum information requirements of issuers according to EU Directive 575/2013 Article 129 Point 7 Maximum portion of total issue Maximum 15% portion of issue according to EU Directive 575/2013 Article 129 Point 1c Volume of issue Minimum 500 mio EUR Minimum 250 mio EUR Minimum rating S&P AA- or 10% RWA S&P A- or 20% RWA 35% RWA Over-collateralisation 2% 7% 10% Haircut 7% 15% 30% Cap Maximum 70% of Maximum 40% of Maximum 15% of Level 1 Level 1 Liquid Assets For all of the issued covered bonds in the EU the following requirements and assignments apply: Covered bonds issued in non EU countries are also eligible as Level2A assets in case they meet the EU requirements for covered bonds according to Article 129 of the CRR and qualifiy for a 10% capital adequacy according to Article 129 Paragraph 4 of the CRR. As a consequence the possibilities for the use of covered bonds in order to cover the LCR have significantly improved in the final version compared to the initial proposal. EU-covereds can now be up to 70% of the LCR-portfolio. Furthermore, issues can now be used with a lower rating than A-. Although this leads only to a qualification as Level 2B, a share of 15% is nevertheless still possible. However, the classification of the individual issues is linked to the fulfillment of various criteria that must be examined individually and is therefore not particularly intuitive. Particularly worth mentioning is that non-eu covereds can be used in LCR portfolio and no minimum issue size is necessary which favors local smaller issues in contrast to EUpapers. However, due to the requirement of an EU equivalent legislation also various issues, such as Swiss covered bonds that are issued on a contractual basis, are rejected. 5

6 Ad 2: Broader consideration of securitised exposures as liquid assets The list of Level 2b assets has been extended by securitized receivables, mortgages, car loans and leasing loans as well as securities that are collateralized by SME and consumer loans. However, the securiticed exposures must meet among others the following criteria: Minimum Rating S&P AA- Position must be the highest senior tranche No resecuritisation and no synthetic securitisations No derivatives(except of hedges) and no marketable receivables contained Minimum issue volume 100 mio EUR Maximum 5 years remaining maturity Homogeneous assets in accordance with one of the defined asset classes Thus, the Level 2B assets are extended to the following asset categories with the appropriate haircuts: RMBS (haircut 25%) Car loans and Leasings (haircut 25%) SME securitications (haircut 35%) Consumer loans (haircut 35%) The predetermined cap of a maximum of 15% for the Level2B assets, however, means that the proportion of Level 2B assets is strongly limited and the LCR portfolio of banks will continue to consist mainly of government bonds and covered bonds. Therefore, the possibilities in terms of portfolio management to reduce the liquidity buffer costs by applying an optimized portfolio mix keep very limited. 6

7 Ad 3: Adapted caps / floors in the calculation of eligible liquid assets The Annex of the delegated regulation contains formulas for the calculation of the eligible liquid assets under the LCR. the Level 1 Assets (exclusive of covered bonds which are included in Level 1) must be at least 30% of the total High Liquid Assets the covered bonds which are eligible as Level 1 can be 70% of Level 1 assets at a maximum the Level 2A assets must not exceed 40% of the Level 1 assets the Level2B assets must not exceed 15% of total HLA Thus, the calculation of the High Liquid Assets takes place in the following steps: Step 1: market value minus repo (incl. Initial margin) Step 2: minus Haircut according to CRR Step 3: consideration of CAPs for the different instruments Step 4: Cap according to the Annex In the Annex the following calculation steps regarding the eligibility in the LCR are given: Eligibility (according to Annex CRR): a) Level 1 (without Covered) b) Level 1 covered c) Level 2 A d) Level 2 B 7

8 Example of calculation: High Liquid Assets Volume Repo Volume minus repo Haircut Volume minus haircut Cap After cap HLA eligibility acc. Annex LEVEL 1 Government bonds (0%RWA) 1.000,0 10,0 990,0 0% 990,0 990,0 a. 990,0 Covered Bonds 1.100,0 0, ,0 7% 1.023,0 70% 1.023,0 b.1.023,0 Sum Level , , , , ,0 LEVEL 2A Liquidity reserve 1.500, ,0 25% 1.125, ,0 Govern. bonds (20%RWA) 500,0 50,0 450,0 15% 382,5 382,5 Covered bonds 500,0 30,0 470,0 15% 399,5 40% 399,5 Corp. bonds (AA- or better) 200,0 0,0 200,0 15% 170,0 170,0 30% Sum Level 2A 2.700, , , ,0 c.1.287,0 LEVEL 2B Covered Bonds 200,0 0,0 200,0 30% 140,0 15% 140,0 RMBS 100,0 0,0 100,0 25% 75,0 15% 75,0 Car securitisations 100,0 0,0 100,0 25% 75,0 15% 75,0 SME securitisations 100,0 0,0 100,0 35% 65,0 15% 65,0 Consumer securitisations 100,0 0,0 100,0 35% 65,0 15% 65,0 Shares 100,0 0,0 100,0 50% 50,0 15% 50,0 Sum 2 B 700,0 470,0 470,0 d. 55,0 Sum , , ,0 C+d 1.342,0 Sum 5.500, , ,0 Sum:3.355,0 As can be seen from the example, for this portfolio composition, especially the caps on Level 2A and Level 2B take effect. Only of the available High Liquid Assets of 4,560 in this example are therefore eligible according to the LCR. In addition, the portfolio would not be compliant with the requirement that at least 30% of the eligible liquid assets have to be Level 1 papers (3 355*30%=1.006,50), because only 990 Level 1 assets are available. 8

9 Ad 4: Changes in the weighting factors regarding inflows & outflows As in the CRR, the basis outflow rate for stable retail deposits (if covered by a DGS Deposit Guarantee Scheme) is fixed to 5% and 10% (without coverage by a DGS). Unlike the CRR, however, a lower outflow rate of 3% is intended for retail deposits after the full implementation of Directive 2014/49/EU (Deposit Guarantee Scheme Directive DGSD), due to requests of member states and after the Commission s approval. However, other retail deposits may be subject to higher outflows according to Article 25. On the basis of a catalogue of criteria, including criteria such as volume, remuneration, place of residence of the depositor/deposit currency and sales channel (eg. over the Internet), such deposits have to be classified by credit institutions in two risk pots with an outflow of 10% to 15% and 15% to 20%.rung und Vertriebskanal (bspw. über das Internet) umfasst, müssen derartige Einlagen von den Kreditinstituten in zwei Risikotöpfe mit einem Abfluss von 10% bis 15% bzw. 15% bis 20% eingeteilt werden. DGS: Deposit Guarantee Scheme Prerequisite Transaction account Established customer relationship Criteria Regular accounting entries of salary, income, payments Min 12 mo + additional product Retail deposit DGS no DGS < 500 T EUR No internet account Interest rate low No prolongation time deposit < 30 d No foreigner Minimum 2 fulfilled Otherwise Outflow Stable 5 % (3%) 10 % % % 9

10 Ad 5: Consideration of the effects of liquidity networks and IPS (Institutional Protection Scheme) agreements in the decen tralized sectors In order to take into account liquidity network and IPS constructions, the regulation contains the following special rules: For the decentralised institutes: The liquidity reserve Is eligible as Level 1 asset for decentralized institutions if it is assured by appropriate agreements within the sector that the central institute invests the liquidity reserve only in Level 1-eligible securities (Article 16, Point 1) Eligibility of liquid assets posted as collateral for unused lines in the central institution (Article 7, Point 2) Higher inflows for unused credit and liquidity facilities with the central institute possible (Article 34, Point 1b) Calculation of the net cash outflows without the inflow cap at the individual level (Article 33, Point 2, only for IPS) For the central institute: The portion of deposits from sector banks which is counted as liquid asset is represented with 100% outflow (taking account of haircuts) and offset against the corresponding HLA (Article 27, Point 3) 25% outflow of deposits of sector banks that are not recognized as HLA in the sector banks (Article 27, item 1) Lower outflows for committed and unused credit and liquidity lines to the sector banks possible (Article 29, Point 1b) In principle, it can be assumed that for the calculation of the LCR over the entire sector liquidity networks or IPS do not lead to a disadvantage for the participating banks. An advantage of the IPS structure in the current regime remains that it can be calculated in the sector banks with not capped inflows. Conclusion Compared to the Basel 3 LCR, the EU regulation thus differs mainly in the very broad recognition of covered bonds as High Liquid Assets. Because of the proposed caps for the recognition of liquid assets as Level2A and Level2B, liquid assets - which are not government bonds and covered bonds can de facto only be mixed to the portfolio in homeopathic doses. In the light of the ECB purchase program for covered bonds there is a danger that due to this combined effect the market for covered bonds will get overbought, thus, yiels will go back again and existing buyers crowded out of the market. 10

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(Text with EEA relevance)

(Text with EEA relevance) L 271/10 COMMISSION DELEGATED REGULATION (EU) 2018/1620 of 13 July 2018 amending Delegated Regulation (EU) 2015/61 to supplement Regulation (EU) No 575/2013 of the European Parliament and the Council with