The EU becomes the first jurisdiction implementing the international Basel III agreement. This should improve its legitimacy when negotiating and leading the other banking reforms expected of the global leaders who will be meeting at the G20 meeting in France in October 2011.
The CRD IV Proposal and Commission’s implementation of the Basel III rules take the form of a Regulation (for the Single Rulebook) and a Directive (complementary components such as defining competent authorities, supervision, corporate governance etc.). This was mostly to give jurisdictions like the UK and Spain (and the six other countries that formally complained of the draft regulation) more flexibility to impose additional demands on particular parts of their banking sectors to improve financial stability).
The Regulation requires banks to hold the same capital ratios as Basel III (4.5% of Minimum Tier 1 Capital in 2013, which will be gradually increased until it reaches 6% in 2019). The additional capital buffers (2.5% in the Capital Conservation Buffer to prevent future taxpayer bailouts, plus a possible 0%-2.5% Countercyclical Capital Buffer to stabilise the supply of credit) banks will need to hold will depend on national supervisors. Unlike previous drafts, the calculation of the two capital buffers has in fact been included into the Directive (and not the Regulation).
Also, some minor modifications to the Basel III rules were seen as inevitable in order to take the diversity of the EU banking sector into account. In the EC FAQ, the proposal is described as respecting the balance and level of ambition of Basel III but gives two reasons why the Commission could not simply copy/paste Basel III into its legislative proposal: 1) Basel III needs to be subjected to democratic control and; 2) While the Basel capital adequacy agreements apply to 'internationally active banks', in the EU the CRD has always applied to all banks (more than 8,300) as well as investment firms.
The proposal departs slightly from the Basel III definition of capital: 1) As opposed to Basel III, CET1 capital instruments must not only be made up of ordinary shares (i.e. the EU will treat as eligible capital all instruments issued by non-joint stock companies (mutuals, cooperative banks and savings banks) that meet the criteria listed. Under the Commission's proposal, silent partnerships will only qualify as CET1 if they respect all the conditions laid out in Article 26 of the regulation (which in turn translates the 14 Basel III criteria). The CRD IV proposal follows the same approach as Basel III by imposing 14 strict criteria that any instrument would have to meet to qualify, however, the EC approach focuses more on the substance of a capital instrument than on its legal form.
The conditions for eligibility are laid down in Article 26 of the proposal for a regulation (a-m, EC Regulation Part1: p.61) (for the original list see 2010 Consultation document, Annex IV-VII pp75-81). For comparison the Basel III rules are listed here: Basel III A global regulatory framework for more resilient banks and banking systems (BIS, Dec 2010, revised June 20111): p. 12-29 (or see http://www.bis.org/publ/bcbs189.htm (capital standards) color:black;">and http://www.bis.org/publ/bcbs188.htm (liquidity standards)
The differences between the CRD IV Proposal with Basel III include:
The differences are related to “taking into account European specificities and the financing needs of its economy” e.g. the fact that 13% of the European banking sector is made up of mutual or cooperative banks, and that bank and insurance groups are significant players (the bancassurance model).
Recognition of instruments including silent partnerships as Common Equity Tier 1: Silent partnership' has been especially used in the beginning of the financial crisis by the German government when rescuing Commmerzbank. It is a form of particiaption in basic capital without the rights usually connected to shareholding. It is a generic term covering also contracts where a silent partner is implicated in the operations of another firm by means of a capital contribution allowing the silent partner to share in the profit and loss. It is a generic term covering instruments with widely varying characteristics in terms of e.g. ability to absorb losses. Whether or not silent partnerships would qualify as CET1 depend on these characteristics. To warrant recognition in the highest quality category of regulatory capital, a capital instrument – silent partnerships included – must be of extremely high quality and must absorb losses fully as they arise. This was the case for the German silent participation in Commerzbank. The 14 criteria for Common Equity Tier 1 capital agreed in Basel III are extremely strict by design. Only instruments of the highest quality would be capable of meeting them. Provided an instrument met those strict criteria - including in respect of its loss absorbency – the Commission believes it should qualify as Common Equity Tier 1 capital.
Recognition of minority interests: Minority interests are capital in a subsidiary that is owned by other shareholders from outside the group. They are particularly important in the EU, as EU banking groups often have subsidiaries that are not fully owned by the parent company but have several other owners. Basel III recognises minority interests and certain capital instruments issued by subsidiaries (e.g. hybrids and subordinated debt) to be included in the capital of the group only where those subsidiaries are banks (or are subject to the same prudential requirements) and up to the level of the new minimum capital requirements and the capital conservation buffer. The EC proposal recognises minority interests also up to the level of the new countercyclical buffer, as it would in practice be used to absorb losses within a group. Furthermore, it also recognises the importance of the countercyclical buffer as an EU macro-prudential tool and removes a potential disincentive for regulators to use it.
Recognition of hedging when calculating amounts to be deducted for investments in unconsolidated financial entities: Basel III allows banks to use hedging to reduce the amount of deductions they have to make from capital for investments in instruments issued by other financial institutions. The rationale is that hedging reduces the losses a bank could make from changes in the value of investments that are hedged. That approach could transfer the risk of holdings for long-term investment or trading purposes in financial institutions outside of the banking sector. Firms not subject to a similar requirement for deduction would be likely to provide hedges to banks for their investments and would not therefore be required to make a similar deduction. The proposal addresses this risk by limiting recognition of such hedging to the trading book only. The Commission believes there are strong reasons to do so: 1) it is difficult to hedge an instrument that is perpetual and held to maturity in the banking book; 2) it limits the extent to which such risk can be shifted to another sector not subject to the same treatment; 3) it reduces the difficulty of establishing who ultimately bears the risk on investments in financial institutions.
Allow significant holdings in other financial entities like insurance companies to be exempt from deduction: The accounting definition of capital must undergo some adjustments for the purposes of a regulatory objective. Such adjustments include deductions, which reduce the amount of capital that is recognised. Basel III requires banks to deduct significant investments in unconsolidated financial entities, including insurance entities, from the highest quality form of capital (CET1). The objective is to prevent the double counting of capital, i.e. to ensure that the bank is not bolstering its own capital with capital that is also used to support the risks of an insurance subsidiary. In the EU, groups that contain significant banking / investment businesses and significant insurance businesses are a common and important feature of the banking system. This so-called 'bancassurance' business model is a key feature of the EU banking landscape. The EU has a specific legal mechanism, the Financial Conglomerates Directive (FICOD), to address the risk of double counting of capital across the banking and insurance sectors. In this context, the proposal allows a more robust and consistent version of the FICOD approach to continue to be used as an alternative to a Basel III deduction approach. The fundamental review of the FICOD planned for 2012 should allow any further changes required to be made to this EU approach.
Issue of Deferred Tax Assets (DTAs) yet to be properly evaluated by Basel Committee: Deferred Tax Assets (DTAs) are assets that may be used to reduce the amount of future tax obligations. Basel III treats DTAs differently depending on how much they can be relied upon when needed to help a bank to absorb losses. Where their value is less certain to be realised, they must be deducted from capital. The proposal clarifies that DTAs that are transformed on a mandatory and automatic basis into a claim on the state when the firm makes a loss would be one of the forms of DTAs for which deduction would not be warranted. This legal instrument was not discussed explicitly at the time of the Basel III agreements since it has only been introduced thereafter. This issue is likely to become subject of further work by the BCBS.
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Extract from EC Regulation Part1: p12:
5.2. Definition of capital (Part Two)
5.2.1. Deductions of significant holdings in insurance entities and financial conglomerates
Basel III requires internationally active banks to deduct from their own funds significant investments in unconsolidated insurance companies. This is aimed at ensuring that a bank is not permitted to count in its own funds the capital used by an insurance subsidiary. For groups which include significant banking or investment business and insurance business, Directive 2002/87/EC on Financial Conglomerates, provides specific rules to address such 'double counting' of capital. Directive 2002/87/EC is based on internationally agreed principles for dealing with risk across sectors. This proposal strengthens the way these Financial Conglomerates rules shall apply to bank and investment firm groups, ensuring their robust and consistent application. Any further changes that are necessary will be addressed in the review of Directive 2002/87/EC, due in 2012.
5.2.2. Highest quality own funds – criteria, phasing out and grandfathering
Under Basel III, the highest quality own funds instruments for internationally-active banks that are joint-stock companies may comprise only "ordinary shares" that meet strict criteria. This proposal implements these Basel III strict criteria. It does not restrict the legal form of the highest quality element of capital issued by institutions structured as joint stock companies to ordinary shares. The definition of ordinary share varies according to national company law. The strict criteria set out in this proposal will ensure that only the highest quality instruments would be recognised as the highest quality form of regulatory capital. Under these criteria, only instruments that are as high quality as ordinary shares would be able to qualify for this treatment. In order to ensure full transparency of the instruments recognised, the proposal requires the EBA to compile, maintain and publish a list of the types of instrument recognised. Basel III provides a 10-year phase out period for certain instruments issued by non-joint stock companies that do not meet the new rules. Consistent with the amendments made to own funds by Directive 2009/111/EC, and the need to ensure consistent treatment of different legal forms of company, this proposal (Part Ten, Title I, Chapter 2) affords such grandfathering also to the highest quality instruments issued by joint stock companies that are not common shares, and the related share premium accounts. Basel III allows instruments that do not meet the new rules that are issued before 12 September 2010 to be phased out of regulatory capital, in order to ensure a smooth transition to the new rules. This is known as the 'cut off date' for the transitional arrangements. All instruments that do not meet the new rules that are issued after the cut off date would be fully excluded from regulatory capital from 2013. This proposal sets the cut off date on the date of the adoption of this proposal by the Commission. This is necessary in order to avoid applying the requirements of the proposal retroactively, which would not be legally feasible.
5.2.3. Mutual societies, cooperative banks and similar institutions
Basel III ensures that the new rules are capable of being applied to the highest quality capital instruments of non-joint stock companies - e.g. mutuals, cooperative banks and similar institutions. This proposal specifies in greater detail the application of the Basel III definition of capital to the highest quality capital instruments issued by non-joint stock companies.
5.2.4. Minority interest and certain capital instruments issued by subsidiaries
A minority interest is the capital of certain subsidiaries that is owned by a minority shareholder from outside the group. Basel III recognises minority interest – and certain regulatory capital issued by subsidiaries - only to the extent that those subsidiaries are institutions (or subject to the same rules) and the capital is used to meet capital requirements and the new Capital Conservation Buffer, a new capital cushion which imposes new restrictions on the payment of dividends and certain coupons and bonuses. The other new capital buffer – the Countercyclical Buffer– is an important macro-prudential tool, which may be imposed by supervisors to moderate or bolster lending in different phases of the credit cycle. This proposal establishes robust EU processes for coordinating Member States' use of the Countercyclical Buffer. The approach set out in this proposal to minority interest and certain other capital issued by subsidiaries gives recognition of the Countercyclical Buffer where used. This recognises the importance of the buffer and the capital used to meet it, and removes a potential disincentive for the buffer to be required. .
5.2.5. Deduction of certain Deferred Tax Assets (DTAs)
A DTA is an asset on the balance sheet that may be used to reduce any subsequent period's income tax expense. Basel III specifies that certain DTAs do not require deduction from capital. This proposal clarifies that such DTAs include those that automatically convert into a claim on the state when a firm makes a loss would not require to be deducted, where their ability to absorb losses when needed was ensured.
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Further observations:
A significant reason for the discrepancy between Basel III and CRD IV lies in the fact that while the Basel agreements are only aimed to apply to internationally active banks, the EU has always applied them widely to all banks and investment firms active in the EU’s single market which by itself is cross-border in nature. Taking these particular EU circumstances into account means that: the criteria for eligible types and definitions of high quality liquid assets under the short-term 30-day Liquidity Coverage Ratio (LCR) are looser than the criteria under Basel III given the European circumstances (and thanks to the strong lobbying by the covered bonds industry that will need to demonstrate its effectiveness in terms of liquidity). The exact composition and features of the LCR and eligible assets will be determined by the European Banking Authority (EBA) after a review period ending in 2015. This would allow for other assets, such as gold, to be included. The Basel III’s long-term Net Stable Funding Ratio (NSFR) is absent from the Commission’s proposals (there is only stipulation that the EBA will evaluate the precise form of a stable funding requirement and the Commission will use the observation period until 2018 to prepare a legislative proposal); A further notable feature of the CRD IV proposal is a desire to reduce the present reliance on external credit assessments (i.e. the Regulation prescribes how banks should develop their own internal credit rating models to determine their minimum capital requirements); The Regulation also introduces supervisory checks for leverage, with a view to reconsidering the introduction of a binding leverage ratio in 2018.
The EC proposal also goes beyond Basel in terms of governance and supervision of banks and investment companies. But these new rules will depend on monitoring and enforcement (e.g. new criteria for appointment of Board members and diversity policy in members in terms of gender, also imposition of dissuasive fines and sanctions).
The CRD IV rules defining capital, and setting a firm floor of 4.5 per cent, are in a draft regulation, which is mandatory across the EU, while the rest of the capital requirement, creating an effective minimum of 7 per cent, is in a draft directive. Directives must be translated into national law by each member country, allowing for some flexibility.
The proposal foresees a much expanded use of the countercyclical buffers and as argued by the UK, member states will be able to impose higher capital levels on individual firms or if economic conditions demand it (this is separate to the issue of systemic importance of these institutions which also will carry a capital surcharge – but these recent new rules on SIFIs are not included in the European Commission’s proposal for the CRD IV).
Other issues to be resolved over the coming years include definitions of eligible liquid assets for the 2 liquidity ratios (e.g. the role of covered bonds in the composition of the liquidity buffer). Both the LCR and NSFR will enter an observation phase where the supervisor the EBA will test different measurement criteria and monitor the effects on bank ability to provide long-term funding to support the real economy. Likewise, and in accordance with Basel III, the new Leverage Ratio measure will be tested before it becomes a binding requirement (information collected, public disclosure as of 2015 leading to review and decision on potential binding measure as of 2018). Other work on the aspects outside the scope of Basel III includes assessing whether EU action on criminal sanctions is necessary, and the treatment of exposures to SMEs will be subject to further review etc...
Background and links:
The Commission's proposals have three concrete goals: Require banks to hold more and better capital to resist future shocks by themselves; set up a new governance framework giving supervisors new powers to monitor banks more closely and take action through possible sanctions when they spot risks e.g. credit bubbles; Create a Single Rule Book for banking regulation (to help improve both transparency and enforcement).
The EC proposal (made public on 20 July 2011) replaces the former Capital Requirements Directives (2006/48/EC and 2006/49/EC) with a Regulation and a Directive. It constitutes a major step towards creating a sounder and safer European financial system, and by strengthening the resilience of the EU banking sector. This will ensure that the costly bank bail-outs following the 2008-09 financial crisis are avoided in the future.
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