Explanatory Memorandum to COM(2009)362 - Amendment of Directives 2006/48/EC and 2006/49/EC as regards capital requirements for the trading book and for re-securitisations, and the supervisory review of remuneration policies SEC(2009) 974 final SEC(2009) 975 final - Main contents
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This page contains a limited version of this dossier in the EU Monitor.
| dossier | COM(2009)362 - Amendment of Directives 2006/48/EC and 2006/49/EC as regards capital requirements for the trading book and for ... |
|---|---|
| source | COM(2009)362  |
| date | 13-07-2009 |
A new capital requirements framework, based on the Basel-II revised international capital framework, was adopted in June 2006 as the Capital Requirements Directive ('CRD'): this comprises Directive 2006/48/EC relating to the taking up and pursuit of the business of credit institutions (recast) and Directive 2006/49/EC on the capital adequacy of investment firms and credit institutions (recast).
There is widespread recognition that further regulatory reform is needed to address weaknesses in the regulatory capital framework and in the risk management of financial institutions that contributed to the turmoil in global financial markets. As part of its response to the financial crisis, in November 2008 the Commission mandated a High Level Group chaired by Mr. Jacques de Larosière to propose recommendations for reforming the European financial supervision and regulation. The thirty one recommendations i of that Group represented a comprehensive set of proposals for regulatory and supervisory repair. With regard to remuneration structures, the Larosière Report recommends that compensation incentives should be better aligned with shareholder interests and long-term profitability by basing the structure of financial sector compensation schemes on the principles that bonuses should reflect actual performance, should not be guaranteed, and that the assessment of bonuses should be set in a multi-year framework, spreading bonus payments over the cycle. i
Building on the Group's recommendations, in its Communication 'Driving European Recovery' for the spring European Council of March 4, 2009 i the Commission set out an ambitious programme of financial services reform. The present proposal is one of the several measures that the Commission has already taken to implement that programme.
The Communication stated that a proposal for the revision of the CRD to be presented by the Commission by June 2009 would:
· include provisions to reinforce capital requirements for assets that banks hold in the trading book for short-term resale;
· upgrade the capital requirements for complex securitisations, both in the banking and in the trading book; and
· enable supervisory authorities to impose capital sanctions on financial institutions the remuneration policies of which are found to generate unacceptable risk.
Similar objectives were also agreed by leaders of the G20 at the meeting in London on 2 April 2009. The Declaration on Strengthening of the Financial System i announces an agreement to take action, once recovery is assured, to improve the quality, quantity, and international consistency of capital in the banking system; and to endorse and implement the Financial Stability Forum’s principles on pay and compensation and to support sustainable compensation schemes. i
On the same date, the Financial Stability Forum ('FSF') published a report on Addressing Procyclicality in the Financial System and Principles on Sound Compensation Practices in the financial industry, i aimed at aligning employees' incentives with the long-term profitability of the firm.
The report of the FSF on Addressing Procyclicality sets out recommendations to mitigate procyclicality which cover three areas: bank capital framework, bank loan loss provisions, and leverage and valuation. The Basel Committee on Banking Supervision has issued Recommendations intended to mitigate the risk that the regulatory capital framework might amplify the transmission of shocks between the financial and real sectors. This includes proposals to reduce the reliance on cyclical VAR-based capital estimates and enhance the risk coverage for re-securitization instruments and default and migration risk for non-securitized credit products. In support of the recommendations of the FSF and the G20, the Basel Committee is working on developing more detailed changes to the current rules to a timetable set by the G20.
The FSF Principles on Sound Compensation Practices call for effective governance of compensation, and for compensation to be adjusted for all types of risk, to be symmetric with risk outcomes, and to be sensitive to the time horizon of risks. They also recommend that implementation by firms should be reinforced through supervision.
The Commission took the first step towards addressing the problems that arise from poorly designed compensation structures when, on 30th April 2009, it adopted Recommendations on the regime for the remuneration of directors of listed companies i and on remuneration policies in the financial services sector. i The Communication that accompanied the Recommendations indicated that the CRD would be modified to bring the remuneration arrangements of banks and investment firms within prudential oversight.
The Committee of European Banking Supervisors ('CEBS') has also developed principles on remuneration policies, which were published on 20th April 2009. The scope of the principles covers remuneration policies applying throughout an organisation, and focuses on key aspects including the alignment of company and individual objectives; governance with respect to oversight and decision-making; performance measurement; and forms of remuneration.
The current proposal is intended to give effect to the commitments set out in the Commission Communication of 4 March, and is consistent with the high level international objectives agreed by G20 leaders.
Finally, in accordance with the undertakings set out in its Communication of 4 March, the Commission will propose further changes to the CRD in October 2009 to address liquidity risk and excessive leverage, introduce provisions for dynamic capital reserving, and remove national options and discretions to advance progress towards a common rule book.
An open internet consultation on proposed draft revisions to trading book and securitization provisions was conducted from March 25 until April 29, 2009. Eighteen responses were received.
The responses generally supported the objectives of the Commission's draft proposals. Some respondents expressed concerns that the approach to re-securitisations was not sufficiently targeted. However, such concerns arose from an assumption that the Commission intended what would in effect be a general ban by requiring the deduction from capital of all re-securitisations. This was not the Commission's intention, and that has been made clear by modifications which represent a more differentiated approach.
A separate online public consultation on a proposed draft of remuneration policy provisions ran from April 29 until May 6, 2009 on DG MARKT website. Twenty three responses were received from financial institutions and industry representatives, Member States and regulators.
The majority of respondents expressed support for the principle that remuneration policies within the banking sector should be consistent with sound and effective risk management, and that this should be brought within the scope of supervisory review under the CRD.
Some expressed concerns that because remuneration policies and practices are tailored to the structure and business model of individual institutions, the principles set out in the CRD should not be too prescriptive. The Commission believes that the text permits the necessary flexibility by requiring firms to comply with the principles in a way that is appropriate to their size, internal organisation and nature, scope and complexity of their activities. In addition, other respondents were concerned that including remuneration for employees, other than executives, within the scope of supervisory review might impact adversely on collective agreements that banks and investment firms have in place for non-management employees.
Altogether, fourteen different policy options have been assessed. The summary below describes the preferred policy option and its expected impact.
With respect to capital requirements for bank trading books, the following targeted amendments, aligned with what is envisaged by the Basel Committee, will be introduced:
– Adding an additional capital buffer based on stress scenario VAR to the ordinary VAR. This change is expected to roughly double current trading book capital requirements.
– Extending the existing charge for default risk in the trading book to capture losses short of issuer default, e.g. rating downgrades, to address the fact that recent losses on traded debt most of the time did not involve issuers actually defaulting. The impact of this change will depend on the composition of banks' portfolios in the post-crisis environment.
– Basing the charge for securitisation positions in the trading book on the existing simple risk weights for the banking book. Again, the impact of this change will depend on the composition of banks' portfolios in the post-crisis environment.
Generally, banks tend to maintain capital levels that are in line with internally developed targets, and which may lead to higher capital levels than those required by minimum capital requirements. Therefore, it is not straightforward to estimate how much additional capital banks would have to raise in order to comply with the proposed amendments. An increase in the minimum capital required might be partially absorbed by existing capital buffers. For instance, the overall solvency ratio for large euro-area financial institutions at the end of first half of 2008 was on average 11.4%, implying an average capital buffer (over the minimum capital requirements) of 3.4% of risk-weighted assets.
In line with the approach developed by the Basel Committee, re-securitization positions would be assigned a higher capital requirement than other securitisation positions to reflect the higher risk of unexpected impairment losses.
For particularly complex re-securitizations, the proposals reinforce both the due diligence requirements and the supervisory process to enforce them. For investments in re-securitizations of particularly high complexity, banks will have to demonstrate to their supervisor that necessary due diligence standards have been met. If they cannot do so, a general deduction from capital would apply. In instances where compliance with required due diligence is found to be inadequate, institutions would be debarred from future investment in such instruments.
The impact of these measures on the future credit supply – the funding of which is facilitated in part by issuance of re-securitizations such as certain collateralized debt obligations (CDOs) - should be assessed in the light of the level of their issuance in the post-crisis market environment. Evidence shows that total CDO issuance in Europe contracted from €88.7 billion in 2007 to €47.9 billion in 2008. This contraction would have been even more pronounced had the European Central Bank and the Bank of England not been accepting securitization as collateral: in 2008, 95% of all securitization issuance was retained by banks for repo purposes, with primary market remaining effectively closed due to significantly diminished investor appetite for these instruments. Against such trends, any incremental impact on the CDO issuance and credit supply would appear to be limited. However, this measure could limit recovery of the secondary market for the affected instruments.
Disclosure requirements, in line with internationally agreed standards, would be enhanced in several areas such as securitization exposures in the trading book and sponsorship of off-balance sheet vehicles.
These changes will improve investor understanding of banks' risk profile and, by enhancing transparency, reinforce banks' risk management. The incremental administrative burden for the EU banking industry is estimated at €1.3 million per year and is expected to fall mostly on larger institutions with more advanced approaches to risk management.
The proposed amendments will impose oblige credit institutions and investment firms to have remuneration policies that are consistent with effective risk management. The relevant principles will be set out in the CRD, but will be closely aligned with those set out in Commission Recommendation C(2009) 3159 of 30 April 2009 on remuneration policies in the financial services sector.
Making the relevant principles of the Recommendation binding will increase the rate of compliance by credit institutions and investment firms.
The proposal allows firms the flexibility to comply with the new obligation and high level principles in a way that is appropriate to their size and internal organisation and the nature, scope and complexity of their activities. This approach is likely to minimise the up-front and on-going compliance costs for firms, and was therefore preferred over an alternative of requiring a strict and uniform compliance by all firms, irrespective of their size, with the principles set out in Commission Recommendation C(2009) 3159 of 30 April 2009 on remuneration policies in the financial services sector.
Contents
- Budgetary implication
- Legal elements of the proposal
- 2. public consultation
- 3. Impact assessment
- Trading Book
- Re-securitizations
- Disclosure of Securitization Risks
- Supervisory Review of Remuneration Policies
- 5. Detailed explanation of the proposal
- 5.1. Capital requirements for re-securitisation
- 5.2. Technical changes
- 5.3. Disclosure requirements
- 5.4. Market risk capital requirements for securitisations
- 5.5. Internal models based capital requirements for market risks
- 5.6 Remuneration policies
- 5.7 General clarification of supervisory review under Article 136(2)
The proposal has no implication for the Community budget.
Given that changes need to be introduced into an existing Directive, an amending Directive is the most appropriate instrument. This amending Directive should have the same legal basis as the Directive it amends. Therefore, the proposal is based on Article 47 i EC, which provides the legal basis for the harmonisation of rules relating to the taking up and pursuit of the business of, inter alia, credit institutions.
In accordance with the principles of proportionality and subsidiarity 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 operating in more than one Member State are subject to the same requirements for prudential supervision, in this case by ensuring that the already harmonised capital requirements framework for credit institutions and investment firms is further strengthened by reinforced capital requirements for trading book items, appropriate due diligence and upgraded capital requirements for complex re-securitisations, and the introduction of explicit rules and appropriate supervisory measures and sanctions with regard to remuneration structures.
(Article 1 i and i and Annex I, paragraph (3))
Re-securitisations are securitisations that have underlying securitisation positions, typically in order to repackage medium-risk securitisation exposures into new securities. They have generally been considered low credit risk by rating agencies and market participants. However, given their complexity and sensitivity to correlated losses, such re-securitisations entail higher risks than straight securitisations. Therefore, this proposal comprises a set of capital requirements that are higher than for straight securitisation positions of the same rating.
Furthermore, the proposal includes a strengthened supervisory process for re-securitisations that are particularly complex. The sample-based supervisory review that applies to securitisations and re-securitisations of normal complexity is not sufficiently rigorous for some re-securitisations, where the high level of complexity of the instrument in question casts doubt on the ability of the bank to understand fully the nature and risks of the underlying exposures. The proposal therefore requires that compliance with the applicable due diligence standards for banks that invest in such products be checked for each individual investment made. CEBS will converge supervisory practice by agreeing which types of re-securitisations are highly complex, so that the ability of institutions to perform proper due diligence in relation to such instruments can be verified by supervisors on a case-by-case basis. In exceptional cases where a bank cannot demonstrate to its regulator that it has complied with the required due diligence in respect of a highly complex re-securitisation, a risk weight of 1250% will be applied to the position in that re-securitisation. This capital treatment applies to new re-securitisations issued after 31 December 2010, and will only apply to an existing re-securitisation position after 31 December 2014 if new underlying exposures are added or substituted after that date. Accordingly, the 1250% risk weight cannot be applied to banks' legacy positions in re-securitisations (unless the underlying exposures of those positions are changed after the end of 2014).
(Article 1 i and Annex II, point i; Article 1 i; Article 2 i and i; Annex I, point i and Annex II, point (2))
In 2006 the Commission and CEBS set up the Capital Requirements Directive Transposition Group (CRDTG) in 2006 to facilitate a coherent implementation and application throughout the EU of the CRD. According to the CRDTG, certain technical provisions of that Directive need to be further specified. For instance, this directive will clarify that capital requirements for settlement risk also apply in the non-trading book.
(Article 1 i and Annex I, point (4))
The existing disclosure requirements in the CRD regarding institutions' securitisation exposures are strengthened by this proposal. In particular, the disclosure requirements will in future cover the risks not only of securitisation positions in the non-trading book, but also those in the trading book.
(Article 1 i, i and i; Article 2 i; Annex II, point (1))
Capital requirements for securitisations in the trading book are currently calculated as if these instruments were normal debt positions. This contrasts with the banking book, where there is a separate, more differentiated and risk sensitive set of capital requirements. This proposal envisages that the trading book capital requirements be based on those for equivalent securities in the banking book.
(Annex II, point (3)
Institutions may currently calculate their capital requirements for market risks in the trading book using their own models that estimate the potential losses from future adverse market movements. Over 2007-2008, it became clear that internal models systematically underestimated the potential loss in stressed conditions. This led to inadequate capital requirements and cyclical volatility of banks' capital as the market environment deteriorated. Accordingly, this directive will strengthen the capital requirements based on internal models in several respects:
· there will be a requirement to estimate separately the potential losses in a protracted period of adverse circumstances, thereby enhancing the resilience of models under stress conditions and reducing their potential for pro-cyclicality;
· institutions will be required to estimate not only the risk of losses from default of debt items in the trading book, but also the potential losses from deterioration in credit quality short of default;
· to address doubts about the ability of internal models to adequately capture the particular risk profile of securitisation positions, institutions will be required to assess a separate standardised capital charge for the risks of securitisation positions in the trading book.
(Article 1 i and i; Annex I, point i and point (4)(iii))
Under the current European supervisory framework, there is no express requirement that the remuneration policies of financial institutions should be subject to supervisory oversight. As a result, supervisory authorities have generally not focused on the implications of remuneration policies for risk and effective risk management.
The purpose of this proposed amendment to the CRD is:
· to impose a binding obligation on credit institutions and investment firms to have remuneration policies and practices that are consistent with and promote sound and effective risk management, accompanied by high level principles on sound remuneration;
· to bring remuneration policies within the scope of the supervisory review under the CRD, so that supervisors would be able to require the firm to take measures to rectify any problems that they might identify;
· to ensure that supervisors may also impose financial or non-financial penalties (including fines) against firms that fail to comply with the obligation.
The proposed requirement will apply to credit institutions and, by virtue of Article 34 of Directive 2006/49/EC, to investment firms that are authorised and regulated under Directive 2004/39/EC on markets in financial instruments.
The scope of the proposed obligation is restricted to remuneration for staff whose professional activities have a material impact on the risk profile of the bank or investment firm. This targets the remuneration policies for those individuals who take decisions that may affect the level of risk assumed by the institution.
The proposed high-level principles on sound remuneration are not intended to prescribe the amount and form of remuneration, and institutions remain responsible for the design and application of their particular remuneration policy. Firms have flexibility as to how the principles are applied in a way that is appropriate to their size, internal organisation and the nature, scope and complexity of their activities. Credit institutions and investment firms carry out different activities and have different levels of tolerated risk: remuneration structures and application of the principles will vary accordingly.
Prudential oversight in the course of the supervisory review would focus on whether the remuneration policies and practices are consistent with sound risk management given the nature of the firm's business. In order to align supervisory assessments, and to assist firms in complying with the principles, the proposal requires CEBS to ensure the existence of guidelines on sound remuneration policies.
If a supervisor identifies problems it may require the credit institution or investment firm to take qualitative or quantitative measures to address those problems. Those measures may include a ('qualitative') requirement for the firm to rectify the situation by changing its remuneration structure to reduce the inherent risk and – in appropriate cases – a ('quantitative') requirement for the firm to hold additional own funds against the risk.
In addition, competent authorities must also have the power under the CRD to impose penalties for a breach of any requirement of the Directive (including the proposed requirement in relation to remuneration policies). This sanctioning power is separate from the power to require firms to take qualitative or quantitative measures. The proposed amendment to Article 54 CRD is intended to ensure that supervisors have both financial and non-financial sanctions at their disposal, and that such sanctions are effective, proportionate and dissuasive.
This proposed amendment of the CRD complements the Commission Recommendation on remuneration policies in the financial services sector. The more detailed principles set out in the Commission Recommendation, along with the CEBS guidelines, will be relevant to compliance with the obligation under the CRD. They should provide further guidance as to how the obligation might be met, and a framework for regulators when assessing firms' remuneration structures.
The proposed new sub-paragraph of Article 136 i is intended to clarify that, when carrying out the supervisory review, competent authorities should take into account both the quantitative and the qualitative aspects of credit institutions' assessment of internal capital under Article 123, and credit institutions' arrangements, processes, mechanisms and strategies under Articles 22. This clarification applies to the entire review process, and is not restricted to the review of the new requirement relating to remuneration policies and practices. The objective is to facilitate further convergence of supervisory practices across the EU.