Explanatory Memorandum to COM(2008)602 - Amendment of Directives 2006/48/EC and 2006/49/EC as regards banks affiliated to central institutions, certain own funds items, large exposures, supervisory arrangements, and crisis management - Main contents
Please note
This page contains a limited version of this dossier in the EU Monitor.
| dossier | COM(2008)602 - Amendment of Directives 2006/48/EC and 2006/49/EC as regards banks affiliated to central institutions, certain own funds ... |
|---|---|
| source | COM(2008)602  |
| date | 01-10-2008 |
A single financial market in the EU is a key factor in promoting the competitiveness of the European economy and the lowering of the capital cost to companies. The Financial Services Action Plan 1999-2005 (FSAP) aimed at laying the foundations for a strong financial market in the EU by pursuing three strategic objectives:
- ensuring a Single Market for wholesale financial services;
- open and secure retail markets and
- state-of-the-art prudential rules and supervision;
In this context, based on the Basel II G-10 agreement, a new capital requirements framework was adopted in June 2006 as the Capital Requirements Directive (CRD); this comprises Directives 2006/48/EC and 2006/49/EC. The overarching goal of the current proposal is to ensure that the effectiveness of the Capital Requirements Directive is not compromised. The revision relates to:
- Revisions of rules that were brought forward from previous directives, such as the large exposures regime and derogations for bank networks from prudential requirements;
- Establishing principles and rules that had not been formalised at the EU level such as the treatment of hybrid capital instruments within original own funds;
- Clarifying the supervisory framework for crisis management and establishing colleges for enhancing both efficiency and effectiveness of supervision.
The revision of certain other areas has been prompted by the financial market turbulence that started in 2007 and is aimed at ensuring adequate protection of creditor interests and overall financial stability.
Inconsistencies that have been identified during the transposition phase of the CRD need to be addressed to ensure that the effectiveness of the underlying goals of the CRD is not compromised. The majority of these are of a technical nature and have been covered by separate comitology measures.
An open Internet consultation was conducted from 16 April to 17 June 2008. The Commission received 118 responses. With the exception of those declared confidential by the respondents, all responses are available under:
circa.europa.eu/Public/irc/markt
Three issues have been raised by many respondents and therefore merit particular attention.
The Commission believes that inter-bank exposures are not risk-free and should be prudently managed. The Commission proposes to limit all inter-bank exposures to 25% of own funds or an alternative threshold of EUR 150 million, whichever is higher.
The consultation paper included a requirement that originators must hold a certain percentage of capital for the exposures that they securitize. In response to the consultation, it is now proposed to require that originators and sponsors retain a share of the risks and that investors ensure that this has indeed been respected. Considering the responses to a further public consultation, the Commission maintains its imperative for a demonstrable measure of due diligence and rigour in the case of the originate to distribute business model.
The consultation paper introduced the need to establish colleges of supervisors for all cross-border banks and required supervisors participating in those colleges to discuss and agree on specific issues with a non-binding mediation mechanism via the Committee of European Banking Supervisors (CEBS) without changing the allocation of responsibilities between home and host supervisors.
This proposal was seen as unsatisfactory by most stakeholders for different reasons.
It is key that colleges remain effective and efficient for the supervision of banking groups. Therefore, the Commission considers that the increased information flows should be accompanied by the eventual decision for two key aspects being entrusted to the consolidating supervisor (Pillar 2 capital requirements and reporting requirements).
From 2005 to 2007, the Commission issued several calls for advice to CEBS on hybrid capital instruments and large exposures. As to hybrid capital instruments, CEBS proposed conditions that any hybrid instrument should meet in order to be considered to be eligible Tier 1 capital in the EU. Concerning large exposures, CEBS made suggestions on definitions, the scope of application of the large exposures regime, exposure limits and the calculation of exposure values. The principles set out in their responses were broadly taken into account. CEBS' advice is published on the following web site:
www.c-ebs.org/Advice/advice
The Commission services also established a working group with members nominated by the EBC, which in 2007 and 2008 conducted meetings that stretched over nine days. The EBC endorsed a draft of this proposal at its meeting on 20 June 2008.
The impact assessment report is accessible on the following web site:
ec.europa.eu/internal_market/bank/regcapital
Altogether, over 60 different policy options have been assessed. The below summary describes the preferred policy options in each of the six issue areas covered by the impact assessment and their expected impact on key stakeholders.
An amended limit-based backstop regime is considered to be most effective as it is specifically tailored to respond to the identified shortcomings of the current regime. Furthermore, the distribution of costs and benefits among stakeholder groups under this option is the most consistent. Banking industry is expected to see savings in administrative burden brought about by a more harmonized regime and its closer alignment with the solvency regime. Certain types of investment firms will be exempted from the scope of the regime. Importantly, financial stability will be enhanced by the certainty that a maximum exposure of a given credit institution to a third party is limited.
A common regulatory European framework would address the shortcomings of the current situation by facilitating convergence between Member States and sectors, consequently contributing to stronger level playing field conditions within the single market. Clear EU regulation will improve the quality of capital from an industry and supervisory perspective, while providing more choice and liquidity to investors.
Colleges comprising authorities supervising group entities in different Member States will address potential conflict and supervisory overlap. This will be aided by reinforced powers of the consolidating supervisor. In crisis situations, stakeholders will benefit from enhanced supervisory cooperation and a clearer allocation of responsibilities. Mediation mechanisms will ensure conflict resolution while regular exchanges will allow for early detection of financial stress.
It is appropriate to 'regularize' the situation in the Member States that have implemented the derogations under Article 3 of the CRD in their legal systems after the time limits. For other Member States, this may open a possibility for EU bank networks with assets over € 331 billion and representing more than 5 million members to qualify for the supervisory treatment under the article. Such networks typically consist of cooperative banks even though Article 3 is not limited to them.
3.5. Treatment of Collective Investment Undertakings (CIUs) under the Internal Ratings Based (IRB) Approach
Applying more targeted increases to the Standardized risk-weights would provide for a sound and risk-sensitive alternative treatment of exposures in CIUs, whereby the percentage increase in risk weights would be lower for well-rated exposures and higher for lower-rated and unrated exposures.
Potential conflicts of interest in the originate to distribute model should be addressed by making sure originators and sponsors of credit risk transfer retain some share of the risks they have underwritten. For this reason, investors will be required to ensure that originators and sponsors retain a material share of the risks and in any event not less than 5 per cent of the total so that effectively, equally originators and sponsors that are regulated by the CRD and those that are not regulated by it will have to retain a share of the risks. A stronger and more rigorous securitization framework including more rigorous due diligence should contribute towards more responsible underwriting and avoidance of a repeat of the enormous costs that have been borne by investors and financial institutions over the past 18 months.
Contents
- LEGAL ELEMENTS OF THE PROPOSAL
- BUDGETARY IMPLICATION
- DETAILED EXPLANATION
- 2. CONSULTATION OF INTERESTED PARTIES
- 2.1. Large inter-bank exposures
- 2.2. Capital Requirements for Securitisation
- 2.3. Colleges of Supervisors
- 2.4. Expertise
- 3. IMPACT ASSESSMENT
- 3.1. Large exposures
- 3.2. Hybrid capital instruments
- 3.3. Home-host issues and crisis management arrangements
- 3.4. Derogations for bank networks from certain prudential requirements
- 3.5. Treatment of Collective Investment Undertakings (CIUs) under the Internal Ratings Based (IRB) Approach
- 3.6. Capital requirements and risk management for securitization positions
- OF THE PROPOSAL
- 6.1. Hybrid capital (Chapter 2 Section 1 of Directive 2006/48/EC)
- 6.1.2. Eligibility criteria (Article 63a of Directive 2006/48/EC)
- 6.1.3. Quantitative limits (Article 66 of Directive 2006/48/EC)
- 6.1.4. Transitional provisions (Article 154 paragraphs 8 and 9 of Directive 2006/48/EC)
- 6.1.5. Disclosure provisions (Annex XII, Part 2, points 3 (a) and (b) of Directive 2006/48/EC)
- 6.2. Large exposures
- 6.2.1. Definitions (Article 4 point 45 and article 106 of Directive 2006/48/EC)
- 6.2.2. Simplification of the large exposures regime (Chapter 2 Section 5 of Directive 2006/48/EC)
- 6.2.3. Interbank exposures (Article 111 of Directive 2006/48/EC)
- 6.2.4. Waiver for certain investment firms (Article 28 of Directive 2006/49/EC)
- 6.3. Supervisory arrangements
- 6.3.2. Colleges of supervisors - Articles 42a, 129 and 131a (new) of Directive 2006/48
- 6.4. Technical amendments
- 6.4.1. Derogations for credit institutions affiliated to a central institution (Article 3 of Directive 2006/48/EC)
- 6.4.2. Capital requirements for investments in Collective Investment Undertakings (Article 87 of Directive 2006/48/EC)
- 6.4.3. Securitisation (new Article 122a of Directive 2006/48/EC)
- 6.4.4. Counterparty credit risk (Annex III and Article 150 of Directive 2006/48/EC
- 6.4.5. Liquidity risk (Annexes V and XI of Directive 2006/48/EC)
A Directive amending the current directives is the most appropriate instrument. The proposal is based on Article 47 i of the Treaty, which is the legal basis to adopt Community measures aimed at achieving the Internal Market in financial services.
In accordance with the principles of subsidiarity and proportionality as set out in Article 5 EC, the objectives of the proposed action, cannot be sufficiently achieved by the Member States and can therefore be better achieved by the Community. Its provisions do not go beyond what it is necessary to achieve the objectives pursued.
Only Community legislation can ensure that credit institutions and groups of credit institutions operating in more than one Member State are subject to the same requirements of prudential supervision, which ensures a level playing-field, avoids unwarranted compliance costs for cross-border activities and thereby promotes further single market integration. Community action also ensures a high level of financial stability within the EU.
This proposal does not increase administrative burden for Member States or economic operators. On the contrary, the large exposure regime is simplified and reporting requirements reduced. The harmonisation of the treatment of hybrid capital instruments also leads to a simplification and therefore to a reduction of administrative burden for banks operating cross-border.
The proposal has no implication for the Community budget.
Hybrid capital instruments (hybrids) are securities that contain features of both equity and debt. The purpose of issuing such instruments is to cover capital needs of banks while appealing to an investor class who is willing to take more risk than in fixed income (debt) products and who therefore also expect higher returns. These instruments are usually designed in a way aiming at ensuring their qualification as original own funds for regulatory purposes.
The lack of legislation at EU level has lead to diverging eligibility criteria and limits throughout the EU. This results in the lack of a level playing field and the possibility of regulatory arbitrage for banks operating within the single market area as the differences in treatment between Member States impact the issuance costs of hybrid capital instruments.
6.1.1. Distinction between the 'core' component of banks' own funds and hybrids eligible in banks' original own funds (Article 57 points (a) and (ca) of Directive 2006/48/EC)
To date, there is no clear terminology for describing hybrid instruments eligible as banks' original own funds ('tier 1 capital'). Since a list of specific instruments in the Directive would quickly be outdated because of constant innovation, principles have been developed, which define hybrids eligible for original own funds.
Core capital within banks' original own funds includes all instruments that are referred to in the national definition of equity capital, fully absorb losses on a going concern basis and represent the most subordinated claim during liquidation. More particularly, these instruments should represent the 'last line of defence' for any bank both during normal times and liquidation. Usually these instruments are common shares and corresponding premiums but, more generally, any type of instrument not providing preferential rights in case of negative economic performance.
However, there are also instruments not falling within this scope such as preference shares that create preferential rights for dividend payments and liquidation, which thus are included in the category of hybrids.
For hybrids to be recognised as original own funds, they need to absorb losses, permit the cancellation of payment in times of stress, be deeply subordinated during liquidation and must be permanently available so that there is no doubt that it can support depositors and other creditors in times of stress. These criteria were agreed at the G10 level and announced in a Press Release in 1998 but they have not been transposed into EU legislation. Eligible instruments meet the permanence test if they are either undated or their original maturity is longer than 30 years. They can however be callable earlier but only at the initiative of the issuer, with supervisory approval and if they are replaced with capital of the same quality, unless the supervisor determines that there is adequate capital. Supervisors should also be empowered to suspend the redemption of dated instruments depending on the solvency of the bank.
Eligible instruments should also allow to cancel payments or to redeem them so long as minimum capital requirements are complied with. Eligible instruments must not be cumulative, i.e. any unpaid amount should be forfeited and no longer due and payable. However, an alternative payment in kind mechanism should be allowed (e.g. by issuing new shares) under strict conditions set by supervisors (the relevant costs being borne by shareholders through dilution of their stakes)
Eligible instruments should absorb losses during liquidation but also help the institution to continue operations on a going concern basis and they should not hinder the recapitalisation of the issuer. Thus, hybrids should be senior only to ordinary share capital and junior to hybrids included in bank's additional own funds.
Banks and investment firms should not extensively rely on hybrid capital instruments to the detriment of 'core' components indicated in Article 57 (a). To this end, the Commission proposes a limit structure allowing for different categories.
The main criterion for distinction between categories, the convertibility of hybrids in case of need, provides an incentive to develop hybrids that lead to higher quality of capital during crises (i.e. by a higher share of core capital). Supervisory authorities may temporarily waive the limits in emergency situations.
The most subordinated instruments of a credit institution that does not have proprietors or shareholders under national law, such as the members' certificates of some cooperative banks, should be treated like convertible hybrids insofar as the respective capital has been paid up and ranks after all other claims .
The Commission acknowledges the importance of hybrids as a major source of funding and the need to limit the impact of the new regulation. To this end, the proposal allows firms not complying with the new set of quantitative limits to gradually adjust to the new rules over a period of 30 years.
Following the establishment of criteria for hybrid capital instruments to be eligible for original own funds, Annex XII needs to be amended accordingly. These changes shall be included in this proposal. Banks are required to disclose specific information on hybrids, particularly on those eligible only within the transitional period.
The current CRD provisions are based on the general assumption that banks spread their exposures to their clients. However despite this, institutions could still be exposed to the same client or a group of connected clients. In extreme situations, this can lead to the loss of the full exposure or of its part. The aim of the large exposures regime is to prevent an institution from incurring disproportionately large losses as a result of the failure of an individual client (or a group of connected clients) due to the occurrence of unforeseen events. To address this, the European Commission issued a recommendation i in 1987, followed by a directive i in 1992. Given their limited number and extent of changes made at the time of the CRD adoption, the large exposures regime has not been reviewed for 16 years. In recognition of this fact, Article 119 of 2006/48/EC and Article 28 i of 2006/49/EC require a more in-depth review of the existing requirements 'together with any appropriate proposals' to be submitted to the European Parliament and to the Council.
The current CRD provisions show several shortcomings: high costs for the industry including unwarranted compliance costs for certain types of investment firms, lack of clarity and a level playing field. In addition, the current regime does not effectively address market failure pertaining to certain exposure types (e.g. exposures to institutions), implying a higher burden for taxpayers and capital inefficiencies. These shortcomings are addressed by deleting national discretions where possible, exempting certain types of investment firms from the regime, aligning applied methods closer to methods applied for capital adequacy purposes, strengthening legal certainty by clarifying definitions and adjusting the treatment of certain types of exposures, (e.g. exposures to institutions).
As to the concept of connected clients defined in Article 4, until now, the supervisory authorities have focused only on the asset side of the entities in question in order to identify whether one entity may encounter repayment difficulties because of the financial problems of the other entity. The recent market developments have shown that two or more undertakings can be financially dependant (and pose significant risks) because they are funded by the same vehicle. As a result, this proposal takes into account not only the risk that derives from the business and assets of two entities but also from their liability or funding side.
6.2.2. Simplification of the large exposures regime (Chapter 2 Section 5 of Directive 2006/48/EC)
Reporting requirements in Article 110 have been simplified and harmonised. This was one of the major industry complaints about the current regime. The requirement for interim reporting has been removed and institutions making use of the IRB approach have to report their 20 largest, not exempted, exposures on a consolidated basis.
The current limits for large exposures are manifold. This structure is simplified in Article 111 into a single limit of 25%.
The list of exemptions in Article 113 is currently long and creates burdensome differences across member states and the lack of a level playing field. The only exemptions which remain are exposures to sovereigns and regional governments and local authorities, those reflecting the typical nature of cooperative banks, intra-group exposures if exempted under the solvency regime, exposures secured by certain collateral and exposures arising from undrawn credit facilities provided that the credit facility actually drawn does not exceed the prescribed limit.
The current use of different calculation methods and risk mitigation methods has not enhanced the transparency of the results to be assessed by financial firms and their supervisors. In Articles 114, 115 and 117 the methods are clarified and aligned as much as possible to the methods applied for the capital adequacy regime. In order to increase firms' flexibility, the current national discretions to apply the respective methods have been transformed into options for the institutions themselves.
Inter-bank exposures pose a significant risk as banks, although regulated, can fail. A failure of one institution can cause a failure of other institutions with the possibility of causing systemic crisis. For this reason, large inter-bank exposures require very prudent management. As a traumatic loss from an exposure to an institution can be as severe as from any other exposure, the Commission has concluded that the current regime, based on a complex mix of risk weights and differentiation on maturity, is not sufficiently prudent. Against this background, the Commission, having reflected on the outcome of the analysis investigating costs and benefits of several available regulatory approaches, has concluded that there is a merit to treat inter-bank exposures as any other exposures, regardless of their maturity. The Commission has addressed specific concerns by allowing an alternative threshold of EUR 150 million and waivers for banks operating in networks, savings banks under certain conditions and certain types of exposures related to clearing and settlement transactions.
The current regime imposes unwarranted compliance cost burdens on investment firms without delivering any apparent societal benefits. Therefore, it is proposed to waive investment firms with limited license and limited activities from the large exposure regime in Directive 2006/49/EC.
6.3.1. Information exchange and cooperation – Articles 40, 42a, 42b, 49 and 50 of Directive 2006/48
In emergency situations, smooth and unfettered multilateral exchange of information is of particular relevance. This is why it is proposed to improve information rights of host country supervisors of systemically relevant branches in Article 42a and to specify in Article 49 and 50 the legal framework for transmitting information to ministries of finance and central banks.
The proposal provides for a definition of systemically relevant branches in Article 42a. Access to relevant information would be facilitated by the involvement of supervisors of systemically relevant branches in colleges of supervisors. This participation will be decided by the consolidating supervisor depending on the issues to be discussed.
By requesting authorities to have regard to the implication of their decisions on the financial stability in other Member States, Article 40 i outlines a European dimension in supervisory decisions which is key to underpinning cooperation between authorities.
The suggested amendments aim at reinforcing the efficiency and effectiveness of supervision of cross-border banking groups by requiring:
- the establishment of colleges of supervisors to facilitate the tasks of the consolidating supervisor and host supervisors,
- a joint decision on two key supervisory aspects for group supervision (Pillar 2 and reporting requirements) with a last say for the consolidating supervisors. This is coupled with a mediation mechanism in case of disagreement.
- the competent authorities involved in the supervision of a group to consistently apply within a banking group the prudential requirements under the Directive.
The consolidating supervisors will be required to inform CEBS on the activities of colleges to develop consistent approaches across colleges. Colleges will also be required for supervisors overseeing cross-border entities that do not have subsidiaries in other Member States but that do have systemically important branches.
6.4.1. Derogations for credit institutions affiliated to a central institution (Article 3 of Directive 2006/48/EC)
In Article 3 of Directive 2006/48/EC, it is proposed to delete the time limits (dates of 15 December 1977 and of 15 December 1979) that restrict its application. The recent accession of new Member States revealed the need to make the derogations in this Article available to all Member States and not only to those that have joined the EU three decades ago.
6.4.2. Capital requirements for investments in Collective Investment Undertakings (Article 87 of Directive 2006/48/EC)
Credit institutions felt that the capital requirements for investments in Collective Investment Undertakings (CIU) such as mutual funds were too strict under the IRB approach in those cases where banks cannot or do not want to provide internal rating for the exposure held by the CIU. The proposal considerably lowers the capital requirements for less risky assets held by the CIU but maintains high capital charges where the assets are either high risk or the actual risk is not known. This also continues to provide a disincentive to hide unknown risks on a bank's balance sheet behind investments in CIU without adequate capital requirements.
Potential conflicts of interest in the 'originate to distribute' model must be addressed by making sure that originators and sponsors of the more opaque credit risk transfer instruments retain a proportion of the risk that is being transferred to investors. For this reason, it should be required from investors to make sure that originators and sponsors retain a material share (not less than 5 per cent) of the risks so that effectively, equally originators and sponsors that are regulated by this directive and those that are not regulated by this directive will have to retain a share of the risks for their own account. This requirement should be complemented by ensuring that investors have a thorough understanding of the underlying risks and the complex structural features of what they are buying. To enable informed decisions, detailed information has to be available to investors.
This Annex lays out the details of the methods to calculate capital requirements for counterparty credit risk. The technical amendments proposed aim at ironing out a number of difficulties identified during the transposition phase of the CRD. The changes do not materially alter the content of the annex but clarify and streamline its application.
Future technical amendments of Annex III should be adopted under the comitology procedure. Currently, the powers of execution do not explicitly refer to this annex.
The current market turmoil has highlighted the fact that liquidity is a key determinant of the soundness of the banking sector.
The proposed changes implement the work conducted by CEBS and the Basel Committee on Banking Supervision to develop sound principles for liquidity risk management. The proposed changes to Annex V highlight the need for the board of directors to set an appropriate level of liquidity risk tolerance. The proposed changes to Annex XI aim at ensuring a proper incentive for banks to better understand their liquidity risk profile. It requires national supervisors to facilitate firms' understanding of their liquidity risk profiles, and does not exclude the possibility of relying to some extent on internal methodologies for supervisory purposes.
Given the significant changes introduced by these modifications, it is appropriate to include these amendments in this proposal.