AECM Position Paper: European Commission services staff working document on possible further changes to the Capital Requirements Directive (CRD) Brussels, 5 th April 2010 General Comments and background to mutual guarantee societies: AECM, the European Association of Mutual Guarantee Societies, is pleased to be able to provide the European Commission with its position regarding its Staff Working Document on possible further changes to the Capital Requirement Directive (CRD). AECM will also supply a position paper in the parallel consultation process undertaken by the Basel Committee, which is also has the 16 April as deadline for comments. AECM has 34 Member organizations in 17 countries (see map) that either are mutual or cooperative entities, or public institutions, providing credit default guarantees for SMEs, who for lack of sufficient collateral could not otherwise access bank loans. They have been set up with this exclusive aim in mind by their founders, i.e. beneficiary companies, banking groups, SME organizations and/or public authorities. Their legal statute, composition of own funds, operating procedures, fields of activity, etc. are very different from country to country, responding to specific market needs as well as legal and economic framework conditions. Their activity is limited to the national or regional territory. According to provisional figures for 2009, AECM members issued over 853.000 guarantees with a value of over 33 billion over the year. On 31 st December 2009, AECM members held in their portfolios more than 2 million guarantees for a value of 70 billion to over 1,8 million customers, which represent about 8% of all SMEs in the European Union; in some countries (for example in Italy) this percentage is even higher (about 25%). This underlines the important contribution guarantee societies have made to fostering SME access to credit and their efficiency in acting as a facilitator to match demand and supply of SME loans. The guarantee provides the following benefits for all parties involved: 1
The SME obtains access to needed loan finance, often at a much reduced interest rate, less collateral requirements and for financing needs going from short term working capital loans to long term investment projects. The bank in turn gets a high quality collateral in form of a guarantee. The guarantee provides a high degree of risk sharing as well as lower own funds requirements, designed to encourage the bank to issue loans to SMEs. In many countries guarantee societies also provide a wide range of qualitative information about SME customers, which provides additional information items to the balance sheet analysis performed by the banks and helps overcoming potential information asymmetries and further improving the risk assessment. Guarantee societies are usually financial intermediaries and as such subject to the Capital Requirements Directive (CRD) in the different Member States. Therefore, the changes proposed in the Commission s Staff Working Paper will have a direct impact on their guarantee activity and capacity. Specific comments: Introductory Remarks AECM understands the rationale behind the need of reviewing the supervisory framework against the background of the recent banking crisis. Nevertheless AECM reminds the Commission that not all credit and financial institutions have had the responsibility of causing the recent banking crisis. In particular the European Guarantee banks and financial institutions have by granting guarantees to SMEs played a significant part in the attenuation of the crisis. Therefore we hope that the Commission will apply the Principle of Proportionality for such credit and financial institutions in the final Directive proposals. This is not yet the case in the current Working Document. AECM encourages both the Basel Committee and the European Commission to consider that in particular mutual guarantee societies present some distinctive elements which make them very different from banks: they are mainly limited to issuing guarantees and almost only towards their member companies, their range of activities is limited and their risk is not comparable to that of banks. In consideration of this, AECM suggests that the prudential requirements applied to guarantee societies should be equivalent to the ones applied to banks, however adapted according to the actual basis of activity, and proportionate to the risk incurred. Furthermore a very important point for all revisions considered will be an adequate transitional provision regarding grandfathering arrangements. The grandfathering arrangements, namely the time horizon, in the latest amendments of the recognition of hybrid capital, could be an example also for the introduction of the respective changes resulting from the Working Paper. Core Tier 1 capital As state above, guarantee societies dispose of own funds, which are provided either by their shareholders (State, banks, industry associations, companies) or by the beneficiaries of the loans that they guarantee (companies). 2
These funds are either joint common stock shares, normally admitted in core Tier 1 capital, or cooperative and mutual shares, whose treatment under the current CRD status has been unclear hitherto and handled differently by supervisory authorities in the respective Member States. The most common forms of shares issued by cooperative or mutual societies are on one hand the shares issued by cooperative or mutual societies underwritten by the beneficiary companies themselves and on the other hand certain forms of mutual guarantee funds paid in by the same companies or the shareholders. They have specific features: the subscription of cooperative or mutual shares by the beneficiary is directly linked to the issuance of the guarantee as well as the proper execution of the loan obligations and the termination of the credit agreement; their reimbursement is also subject to the withdrawal of the beneficiary from the guarantee society. The individual paid in shares directly cover the corresponding individual loan guarantee commitments. These shares cannot be compared to shares issued by cooperative banks, which do not directly cover the individual assets, i.e. loans risks, of the bank. Rather, in the case of the cooperative banks, the capital ensures the institutions overall solvency. The mutual guarantee funds paid in by the shareholders or beneficiary companies work the same way: they are paid in directly as the individual guarantee is issued and they cannot be reimbursed for the duration of the loan; moreover these funds cover the asset side of the guarantee society. They are in no way to be equated to normal deposits of banks, for which the depositant may ask for reimbursement at any time. These shares represent the most important item to determine the volume of guarantees they may issue both shares and mutual funds (or grant). Taking into consideration that they are directly linked to individual loan operations and that they are subject to strict reimbursement rules regarding the loan covered, other assets, liquidity situation, and that they involve the withdrawal of the beneficiary from the guarantee society, they should be treated as Tier 1 capital. In annex IV on page 75, the Commission provides 14 detailed criteria for the inclusion of instruments that are not common stock shares, in Core Tier 1 capital. In their current wording, many of these criteria would not be fulfilled in the case of mutual or cooperative shares. However, AECM noted that that footnote 19 on page 17 of the Commission s Staff Working Paper states that original own funds referred to in Article 57 (a) or Directive 2006/48/EC should also include any other instrument under a credit institution s statutory terms taking into consideration the specific constitution of mutuals, cooperatives and similar institutions and which are deemed equivalent to ordinary shares in terms of their capital qualities in particular as regards loss absorption. While from the Staff Working Paper, it does not appear clear, how the 14 criteria would be interpreted for the benefit of mutuals or cooperatives, AECM welcomes in this context the clarification as to their recognition as Tier 1 capital in the recent CEBS CP33 consultation paper. In our view, the 10 criteria listed as guidelines for the interpretation of Article 57 (a), in particular as regards the conditions to be fulfilled by cooperative or mutual shares to be considered as own funds instruments are generally measured and adequate. However, with regard to the CEBS paper, there is one comment to be made regarding the conditionality of redemption of cooperative and mutual shares (Criterion 4, page 11). The CP33 states that the owner 3
of the instrument shall not have a put option or any other right to require unconditional redemption. In some countries, the holder does have a redemption right for his cooperative share, however only: after the specific guarantee for which the share has been issued has come to term at face value after deduction of pro-rata losses with no rights to reserves and/or dividends after the holder has required and has got the withdrawal from the guarantee society. As explained above, the share is directly linked to a specific financial asset s risk. Therefore, this case would warrant recognition of this type of own funds instrument, since it is directly and fully lossabsorbant for the time of the existence of the specific underlying risk over the time of its existence. Furthermore we attract the Commission s and CEBS attention to the fact that in some countries, the shareholder of a limited company has the right to leave the company by a formal cancellation of the company with a perennial period of termination. In practice, the remaining shareholders decide the continuation of the company and have the option to take over the stake or not. We are convinced that this right of a shareholder of cancelling a limited company is no case of redemption or buy-back in the meaning of Criteria 3 or 4, even if the share has to be assigned to another shareholder or a third party or has to be in case of need collected by the company. Even in the cases described the capital will be adhered to in the original amount. The other provisions and interpretation in the case of cooperatives and mutuals as regards in particular the conditionality of redemption rights and pari passu treatment of loss absorbency corresponds to the legal and operational reality of our cooperative and mutual members. In particular with regard to the new definition of capital items AECM pleads for adequate grandfathering clauses like already done in our general remarks. This will be especially important with a view to the proportion of Core Tier 1 capital to the total of Tier 1 capital in case that the proportion should be raised above the current level of 50 %. In general AECM pleads for the retention of the current level. Should the Commission come to the conclusion that Core Tier 1 capital should be raised above this level, perennial transitional periods are however necessary. Furthermore, it would be helpful to obtain more information about the future role and weight of hybrid capital elements, especially as regards subordinated loans from shareholders. In AECM s view, subordinated capital (as shareholders contribution) should also be considered as playing a role for loss absorption during periods of stress. Taking these requests into account, AECM encourages the European Commission to take the interpretation of the application of Article 57 (a) to cooperative and mutual shares, as proposed by CEBS, into consideration for its work regarding the review of the CRD. Tier 2 capital The Working Document does furthermore not comment explicitly the future treatment of funds for general banking risks within the meaning of Article 38 of the Directive 86/635/EEC (as Tier 1 capital) and value adjustments within the meaning of Article 37 (2) of the Directive 86/635/EEC (as Tier 2 capital). In the current Banking Directive 2006/48/EC these positions are accepted as own funds (cp. Article 57 c) and e)). AECM strongly argues to maintain these positions as Tier 1 resp. Tier 2 capital without reviewing the respective eligibility criteria. 4
With respect to the proposed tightening of the items which should be deducted from own funds AECM is of the opinion that the deduction should follow the current system of Article 66 of the Directive 2006/48/EC. Therefore deductions shall not as considered in the Working Document in general made only from Core Tier 1capital, but according to the current regime from the total of Tier 1 capital resp. half of Tier 1 and half of Tier 2 capital. In addition to that AECM sees no need for a deduction of pension fund assets if special and separate reserves for pension fund liabilities exists which are not part of retained earnings resp. reserves with own fund character. Leverage ratio AECM has taken note of the introduction of a new regulatory requirement in form of a maximum leverage ratio, the exact size of which will be maybe determined only after having conducted a Quantitative Impact Study. Generally AECM is of the opinion that the leverage ratio considered in the working paper is even in the meaning of a supplementary measure contradictory to the risked based approach of the current capital regime and could therefore in particular with regard to Guarantee institutions result in a undesirable discrimination of their comparatively low risk portfolios counterguaranteed by states. Furthermore, both the Commission and the Basel Committee suggest that no netting resp. the use of credit risk mitigation techniques should be possible when establishing the exposure level used in the calculation of the ratio. Guarantee societies are looking at this new rule from the following perspective: Many guarantee institutions do historically operate with a high leverage ratio, Guarantee exposures are mostly off-balance sheet Most guarantee institutions receive public counterguarantees, which counterguarantee either individual guarantee exposures (with a counter-guarantee rate ranging from 30 to 80%) or portfolios of guarantees. This public counterguarantees is contractually defined, fixed and mostly automatic. AECM has the following concerns: Limiting the leverage excessively would force guarantee institutions to either reduce their guarantee activity (resulting in a reduction of access to finance for SMEs) or increase their capital base (rendering the guarantee instrument much less sustainable cost-wise). It is unclear to what extent guarantee commitment will have to be included in the calculation of the leverage ratio. If such an inclusion is planned, we plead for a netting of guarantees and counterguarantees resp. the use of credit risk mitigation techniques, as these are individually and contractually linked, before the guarantee exposure is recognised for the calculation of the leverage ratio. We are aware that this goes against the fundamental thinking stated above, however, not netting the guarantees with the corresponding and directly linked counterguarantees resp. the use of credit risk mitigation techniques would grossly overstate the actual risk exposure of guarantee institutions, considering the relatively high counterguarantee rate. Barring such a provision, it is hard to see, how the business model of guarantee institutions could be maintained. As an alternative, the credit conversion factor of publicly counterguaranteed guarantees could at least been lowered. 5
It is necessary to differentiate between banks speculative activities (i.e. securities trading, securitization underwriting) and activities which are meant to support the real economy (providing credit to manufacturing firms). The leverage ratio should be part of Pillar II of the current capital framework (Supervisory Review Process). Putting the leverage ratio in Pillar II would allow the national supervisor to recognize specialities of the above-mentioned business activities of Guarantee institutions, AECM opposes a fixed size leverage ratio under Pillar I of the current capital framework (Minimum Capital Requirements) which would make it impossible to recognize the specifics of the business activities of Guarantee institutions. As already mentioned under the section on Tier 1 capital, it would be helpful to obtain more information about the future role and weight of hybrid capital elements, especially as regards subordinated loans from shareholders. In AECM s view, subordinated capital (as shareholders contribution) should also considered as playing a role for loss absorption during periods of stress. Liquidity standards AECM encourages the Commission to consider that there are different liquidity needs, depending on the specific type of financial products and services involved. The situation of guarantee institutions for instance cannot be compared to retail financial institutions. For the former, liquidity needs concern the pay-out of liabilities arising from the guarantee activity to the extent that partner banks experience defaults in their loan portfolios. It also should be restated that most Guarantee schemes rely on state counter guarantees. The liquidity requirements of retail banks in turn have a different dimension linked to the potential mass withdrawal of customer deposits (bank run). Guarantee institutions will never face a cash outflow comparable to that of a bank run, because their member companies, which are at the same time both the beneficiaries of the guarantees and the very subjects that provide their own funds, cannot ask for the restitution of their funds until they have given the proper execution of the loan obligation. Therefore the liquidity requirements should be completely differentiated from the ones of banks for this type of specialized mono-line financial intermediary and the Principle of Proportionality should be observed. The liquidity requirements also need to be differentiated since the own funds of the guarantee societies may be liquidated immediately, as they are deposited on a bank account or mostly invested into public bonds. AECM would also like to state that although this kind of condition might allow for greater banking system stability, firms might ultimately suffer from more limited credit availability. While it is necessary to better define the banking institutions own funds and liquidity requirements, it is at the same time crucial to continue to ensure that the banking system will provide adequate access to finance to companies that represent the productive tissue of our economy. If we look at the experience from the year 2008, during which the financial crisis has reached a particularly critical level with tensions within the European banking system, we found phases of high rigidity in the interbanking market, expressed by eurribor rates of above 5% and a situation of illiquidity. This problem was only solved by the massive interventions by the ECB. 6
Consequently, the new regulation should not only ensure proper own funds and liquidity levels of credit institutions (while avoiding an undue restriction of access to finance for the productive economy), but also deal with the necessity to ensure le full efficiency of the interbank market. Countercyclical measures (capital buffer) The proposed treatment of countercyclical measures should give scope for specifics of the guarantee business of AECM members. To some extent Guarantee schemes have for example non-profit character where distributions could never be made to the shareholders. Furthermore we see no need to constrain next to distributions or dividend payments also discretionary bonus payments to the staff within the proposed measures. In the last months several initiatives on international level (Financial Stability Board FSB) and the G20 countries had been launched and already implemented in national law. Inadequate compensation should therefore no longer be possible, further backstops are not mandatory. Overall impact of measures on availability of SME financing Taking all measures proposed by the European Commission and the Basel Committee together, AECM cannot help by voicing concerns with regard to the availability of SME access to loan finance over the medium and long term. Countercyclical measures, the restriction of Tier-1 capital and the Leverage ratio can all potentially lead to a severe restriction of credit finance, especially in a context of interest rates that are set to rise over the next years. AECM acknowledges that interest rates have been particularly low in the period leading up to the crisis. Also, reforms are necessary in the long term to guarantee a certain level of stability on the financial markets. On the other hand, the Commission must not lose sight of the fact that bank loans are the main source of finance for European SMEs and that they represent over 70% of employment and GDP contribution. This means any amendment to the current regulatory framework need to be carefully considered from this perspective and that the introduction of those measures needs to be appropriately spread over time, via staggered introduction or grandfathering clauses, over the longer term if needed. Finally, with a view of improving SME access to credit and subject to fulfilling certain conditions, the counterguarantees provided by privately-owned guarantee institutions, such as in Italy, could be given due recognition and qualification, under a set of carefully considered conditions (eg. in terms of capital supply, access to public counterguarantee etc), to be considered equivalent to public counterguarantee institutions from the regulatory standpoint. In this way, they could also benefit from a 0% riskweighting and enjoy the same favourable conditions which currently apply to public counterguarantors. The application of 0-weighting to counterguarantees has proven to be a strong advantage to motivate banks to issue more SME loans. AECM remains at the Commission s entire disposal for any further comments on its position. 7