Special edition on the Capital Requirements Directive IV

Regulation is the most important factor influencing strategic change at financial institutions and is the second largest threat - after economic uncertainty - to growth prospects, according to our Annual Global CEO Survey. The survey, which is in its 15th consecutive year, canvassed CEOs at over 250 financial institutions in 42 countries late last year and provides a good barometer on market sentiment. The significance of regulation as a change driver in the financial sector has grown steadily since the financial crisis. Based on our face-to-face interviews with CEOs of financial institutions, it is clear, though, that it is not simply regulatory change, but regulatory complexity and uncertainty, that are really dampening confidence in growth.

Upgrading the European Union (EU) prudential regime for banks in line with the Basel III proposals is an excellent example of both regulatory complexity and uncertainty. In October 2011, the European Commission released two proposals to introduce the new regime. The bulk of the existing EU prudential regime, with the amendments necessary to introduce Basel III, is recast into a regulation – the Capital Requirements Regulation (CRR) - amongst other things to support the parallel EU goal of harmonising and deepening the internal market through a single rule book. In addition, a Directive – Capital Requirements Directive IV (CRD IV) – sets out requirements in a limited number of areas where Member State discretion is still necessary, for example in relation to corporate governance.

In an attempt to meet the target January 2013 launch date of the new regime in line with recommendations of the Basel Committee, the two EU legislators – the Council of Economic and Finance Ministers (Council) and the European Parliament – are working furiously in parallel now to agree the amendments they each want to see to the Commission’s proposals. The European Parliament’s Economic and Monetary Affairs (ECON) Committee is scheduled to vote on the Parliamentary amendments on 26 April. The Danish Presidency is looking for clearance from the Council in early May on one key political issue prior to finalising the Council’s approach, so it can commence negotiations with the European Parliament and the European Commission on the final text of the legislation. The Danish Presidency hopes to reach agreement in trialogue before the end of its term at the end of June. The European Parliament currently plans to vote on the final agreement in plenary on 12 June, subject to completing the trialogue negotiations. But the 2,195 amendments tabled on the texts in ECON are a clear indication of the complexities involved and how ambitious this timeline may prove to be. Some fear the old adage ‘more haste, less speed’ may come into play, or worse the end result may be suboptimal from both an EU and international perspective if the legislation is rushed through.

The EU regime will reflect the transitional elements of the Basel III regime, with different rules coming into effect progressively over a five year period. However, key elements of the regime will need to be in place from the 1 January 2013 launch date. Therefore, contrary to normal practice, the European Banking Authority (EBA) is already working on some important regulatory technical standards (RTS) which will underpin the regime, while recognising that they are still working with a potentially moving target. On 4 April, EBA published the first of two sets of proposals for RTS relating to own funds. These proposals cover 14 RTS; proposals for a further 7 will be issued later. The consultation period on the first set of proposals will run until 4 July, by which time, in theory, the primary text will have been finalised. Firms considering their responses to the RTS consultation should continue to monitor ongoing negotiations on the related Level 1 text.

While some stakeholders are strongly advocating close adherence to the Basel III regime, the fact that the new regime will be applied to all 8,000 banks and investment firms operating in the EU throws up particular regional and national challenges and concerns. It is far from clear at this stage – with less than nine months to go – what the regime to be launched on 1 January 2013 will look like. The European Parliament has also picked up on the fact that this primarily micro-prudential regime needs appropriate linkage to wider crisis management and bank resolution requirements, but we are still waiting for the European Commission’s proposals for those initiatives. This is clearly not an optimal scenario for planning strategically, or for efficient and cost-effective implementation.


 

ESRB pushes for flexibility on CRD capital rules

A major political issue yet to be decided is whether EU Member States will be permitted to flex the rules when faced with specific systemic risks at the national level. Essentially, there needs to be a balance struck between ‘maximum harmonisation’ – a single consistent approach which would provide certainty to the markets – and the need for individual countries to take the additional measures to the macro-prudential requirements already incorporated in the new regime to address particular issues arising at the national level. This is particularly important to EU countries where the financial sector represents a multiple of GDP, thus posing a far greater threat to national taxpayers if something goes wrong in the system. The Financial Stability Board, the International Monetary Fund and the Basel Committee have all come out in support of additional flexibility in this regard: however, it does create considerable tension in the context of the EU because permitting individual Member States to change the rules conflicts with the goal of rule harmonisation.

The latest Danish Presidency compromise issued on 2 April shows a move in this direction. In addition to the UK, the governments of Bulgaria, Estonia, Lithuania, Slovakia, Spain and Sweden are said to support this approach.

Interestingly, also on 2 April, at a critical stage in the legislative process, the European Systemic Risk Board (ESRB) published a letter from ESRB President Mario Draghi to EU legislators which advocated the permission of “constrained discretion, with workable safeguards, for macro-prudential authorities at both Member State and Union level to tighten calibrations (while leaving definitions untouched) of commonly defined prudential requirements”.

Over and above the macro-prudential measures already embedded in the CRD IV regime, the ESRB believes that an EU macro-prudential framework should be developed which takes account of “risks from a wide range of sources: from within the financial system (given intra-system interconnections and contagion between banks, and between banks and others including nonregulated entities or 'shadow banks'); from the system to the real economy; and from strong feedback mechanisms between the two.” The ESRB believes this framework should be constructed on three principles: flexibility, scope to act early and effectively, and efficient coordination.

According to the letter, in terms of flexibility, national and EU macro-prudential authorities should be empowered to tighten Pillar 1 calibrations temporarily, or mandate additional disclosures when the need arises. They should also have the power to be proactive, stepping in before significant imbalances or unstable interconnections can build up. However, to ensure that such constrained discretion does not create distortions, macro-prudential authorities need to ensure efficient ex-ante coordination “to limit possible negative externalities or unintended effects for the sustainability of the single market in financial services or for the economies of other Member States”. According to the ESRB, as the EU macro-prudential overseer, it would be best placed amongst the EU institutions to orchestrate this coordination.


 

EBA issues first RTS on own funds

Overall, to implement CRD IV/CRR, the EBA will have to prepare over 30 regulatory technical standards and 13 implementing technical standards on the CRD IV before the regime takes effect on 1 January 2013. Further implementing measures will follow in relation to subsequent milestones in the process.

The EBA issued its first consultation on 4 April, grouping several RTS on Own Funds together for consistency reasons. Where appropriate, EBA has built on guidelines from its predecessor, the Committee of European Banking Supervisors (CEBS) to draft some aspects of the RTS (e.g. hybrids and core capital). The EBA is planning a public hearing in June.

The draft RTS covers the following areas:
  • foreseeable charges or dividends: a firm is required to deduct all ‘reasonable’ foreseeable charges and dividends from profits before it can count as eligible Common Equity Tier 1 (CET 1).
  • other deductions from CET 1 capital and from Own Funds: the EBA presents how deductions will work against CET 1 and Own Funds for capital instruments of financial institutions and insurance/reinsurance undertakings, losses of the current financial year, deferred tax assets, defined benefits pension fund assets and foreseeable tax charges.
  • capital instruments of mutuals, cooperative societies or similar institutions: the EBA outlines certain legal and contractual features (e.g. it must not require the institution to make payments to the holder of an instrument during periods of market stress) that must be satisfied for capital instruments from other types of financial institutions to consider as CET 1
  • indirect funding of capital instruments: tight restrictions on the applicable forms and nature of indirect funding of capital instruments to count towards CET 1 are laid down by the EBA. To be considered as indirect funding, the investor or external entity should not be included within the scope of prudential consolidation of the applicable institution.
  • limitations on redemption of own funds instruments: the competent authority will have power to issue further redemptions on CET 1 instruments in addition to those included in the contractual or legal provisions governing the firm.
  • general requirements: this covers provisions related to indirect holdings arising from index holdings, supervisory consent for reducing own funds, and various associated disclosure requirements to holders/supervisors. The EBA provides some further details on how the supervisor may waive deductions from own funds during times of stress.
  • grandfathering of own funds: the EBA outlines that reclassifying an own funds instrument grandfathered into the new regime will not affect a firm’s capital calculation.
The second set of draft RTS will be released for consultation in the second half of 2012, probably in June.

It is worth highlighting that EBA is required to submit its final draft RTS to the European Commission by 1 January 2013. However, these will only become law once the Commission has endorsed them, the Council and European Parliament have raised no objections, and the RTS are published in the Official Journal in the form of delegated acts. This ‘sign-off’ procedure will take at least six months.


 

If you introduce bail-in debt, will creditors bail-out?

Under Basel III proposals, Additional Tier 1 capital instruments that are classified as liabilities for accounting purposes must have principal loss absorption mechanisms either through (i) conversion into shares at a pre-specified trigger point or (ii) a write-down mechanism which allocates loss to the instrument at a pre-specified trigger point. Moreover, additional Tier 1 capital instruments cannot hinder recapitalisation.

Consistent with the Basel III framework, all forms of Additional Tier 1 capital under CRD IV require a permanent write-down feature to enable banks to replenish themselves in times of crisis. In the RTS discussed above, the EBA indicates that the amount to be written down should at least be equal to the amount needed to immediately return the institution’s CET 1 ratio to the desired regulatory level. The write-down must apply on a pro rata basis to all holders of Additional Tier 1 instruments and firms can only institute write-ups after meeting strict profitability conditions.

Michel Barnier, EU Commissioner responsible for internal market and services, provided details on the forthcoming EU crisis management and resolution framework in a speech on 2 April 2012. The framework is designed to mitigate the need for public bail-out in the future. In this regard, the possibility of forcing losses automatically on certain more types of creditors than is currently envisaged in CRD IV through debt write-down is one of the ‘central’ proposals being considered by the EC, according to Barnier. In a draft discussion paper on 30 March 2012, the European Commission's Directorate General for Internal Market and Services outlined that debt write-down tools should be designed to give resolution authorities the power to write-off all shareholder equity and either write-off all types of subordinated liabilities or convert them into equity claima. The debt write-down tools can be used both in a going concern scenario and a liquidation scenario, according to the discussion paper. The power would be exercised when an institution triggers the conditions (not yet specified) for entering into resolution.

The new framework will also seek to give authorities a common and effective set of measures and powers to deal with banking crises at the earliest possible stage, including:
  • preparatory and preventative measures: including requirements for firms to prepare recovery and resolution plans
  • powers to take remedial action early on in the process: such as replacing management, implementing a recovery plan or requiring a firm to divest itself of activities or business lines that pose an excessive risk to its financial soundness
  • resolution tools: such as powers to effect the takeover of a failing bank or firm by a sound institution, or to transfer all or part of its business to a temporary bridge bank.
The European Commission believe that a properly functioning resolution regime, with robust bail-in tools, could bring a number of benefits to public finances, the financial system, the entities in difficulty and the creditors themselves. The bail-in tools in particular would have minimized the impact of the current crisis on public finances, according to the Commission. The resolution regime is an essential complement of both the CRD IV prudential regime, and the macro-prudential toolbox being developed by the ESRB. It is hoped that it will enable the smooth resolution of individual banks which get into trouble without causing negative reverberations throughout the financial system, either nationally or internationally.


 

Raising capital

Clearly, banks are going to need to raise even more capital with the arrival of CRD IV and, in due course, the new resolution regime. Analysts have estimated that European banks must roll-over around €1.7 trillion of senior debt of more than a year’s maturity during the next two years which could leave little room to raise additional capital from new debt issuance, even without new restrictions relating to permanent write-down features making certain forms of debt less attractive to investors. So, with opportunities to raise additional capital restricted, selling assets is an alternative. Research by Nomura shows that European banks have already unveiled plans to slash a total of €1,200 billion of assets this year: British and French banks taking the lead in deleveraging.

The complexities increase when taken in a global context. Despite assurances to the contrary, it is not clear when, or even if, the United States will adopt the Basel III regime. The recently introduced Collins Amendment seems to be gaining little traction in the US legislature. If introduced the regime will not be applied to all US banks, just the twenty or so largest. However, US banks are being challenged by the rigours of the Volcker Rule, which is also leading to deleveraging by US and non-US banks.

The CRD IV/CRR regime will undoubtedly change banks’ funding patterns and sources of capital in the future. Raising funds from private markets in the wake of the crisis is proving both difficult and expensive. The more institutions that deleverage simultaneously, the more price pressure comes into play so being an early mover may be critical. Creditors are requiring higher margins to hold bank debt because they have increased awareness of the inherent riskiness of banks’ operations. The funding pressures on financial institutions over the next couple years are likely to continue to increase, even if we are fortunate enough to avoid further sovereign debt shocks in Europe and the global economy begins to turn the corner.