Including updates on CRD IV, changes to highly automated trading environments and universal access to basic bank accounts


CRD IV comes to life

More than 8,200 European banks will need to hold more and better capital to resist future shocks, as part of a package of long-awaited proposals known as Capital Requirement Directive IV (CRD IV) outlined by the European Commission’s (EC) on 20 July 2011. These proposals translate the Basel III accord into draft European legislation and will supersede the existing Capital Requirements Directive. While the introduction of CRD IV will challenge EU banks’ resources, these proposals are designed to offer “a more solid foundation to ensure financial stability” and will further level the playing field for banks across the EU.

CRD IV contains two parts: a Directive, governing deposit-taking activities, and a Regulation, containing the detailed prudential requirements for credit institutions and investment firms. The Directive covers:

  • Corporate governance: new rules aimed at increasing the effectiveness of risk oversight by boards, improving the status of the risk management function and ensuring effective monitoring by supervisors of risk governance.
  • Supervision: preparation of an annual supervisory programme for each firm, greater use of on-site supervisory assessments and more intrusive and forward-looking supervisory assessments.
  • Reliance on external ratings: reducing the reliance by credit institutions on external credit ratings by requiring institutions to:
    • base their investment decisions on their own internal credit opinion; and
    • develop internal ratings for portfolios in which they have a material number of exposures.
  • Sanctions: appropriate administrative sanctions and measures with respect to violations of EU banking legislation.

The main elements to the Regulation are:

  • Capital: increasing the amount of own funds that banks need to hold as well as the quality of those funds. The total capital requirement is 8% (CT1 4.5%) plus two supplementary layers, which each can amount to 2.5%, or even more for the counter-cyclical buffer.
  • Liquidity: introducing a Liquidity Coverage Ratio (LCR) - the exact composition and calibration will be determined after an observation and review period in 2015.
  • Leverage ratio: introducing a leverage ratio will be subject to supervisory review, and the implications will be closely monitored prior to its possible move to a binding requirement in January 2018.
  • Counter party credit risk: consistent with the EC’s policy vis-à-vis over the counter derivatives, changes are made to encourage banks to clear OTC derivatives on central counterparties.
  • Capital buffers: introducing two capital buffers on top of the minimum capital requirements: a capital conservation buffer identical for all EU banks, and a countercyclical capital buffer to be determined at national level.

The proposed Regulation reflects the introduction of a single set of harmonised prudential rules for banks and investment firms, meaning that national options and discretions will be removed and Member States only permitted to apply stricter requirements where justified by national circumstances, financial stability grounds, or a bank's specific risk profile.

However, the Regulation is flexible enough to allow national supervisors respond to their national specificities by setting additional capital requirements for banks at the appropriate levels. Michel Barnier, Member of the EC responsible for Internal Market and Services, said that national supervisors will be able to set the parameters applicable to some specific risks (e.g. real-estate credit) and the exact level of the counter-cyclical security buffer according to the local economic situation. Barnier believes that a single rule book was the only answer, as any national approach to reinforce bank stability would be - “illusory” in a Single Market.

Judgments about the impact of CRD IV on the total additional capital required by banks, and then the follow-through impacts of the rules on the volume and pricing of bank lending to non-financials, will be critical to assessing whether the Directive will achieve its stated aims.

ESMA addresses highly automated trading environments

The European Securities and Markets Authority (ESMA) is consulting on a series of guidelines, which if adopted, will clarify trading platforms and investment firms’ organisational requirements in relation to a highly automated trading environment under existing regulations. The guidelines are designed to reduce the risks that arise from highly automated trading under three areas: electronic trading systems, fair and orderly trading and market abuse.

ESMA proposes that trading platforms and investment firms should have governance arrangements to ensure effective monitoring of IT systems and trading controls in a highly automated trading environment: a clear process for accountability; communication of information and signoff for initial deployment; subsequent updates and resolution of problems identified through monitoring. To ensure markets have fair and orderly trading, trading platforms should have appropriate and proportionate organisational arrangements that reduce the possibility of orders reaching the marketplace that are unauthorised, in breach of risk management thresholds, erroneous or disruptive. Generally, trading facilities should have the ability to prevent access to their platforms and to cancel, amend or correct a transaction. For investment firms’ trading systems, ESMA’s guidance suggests that firms should generally block or cancel trades that:

  • do not meet set price or size parameters;
  • are in a financial instrument that a trader does not have permission to trade;
  • the client has insufficient funds to complete the transaction; and
  • is inconsistent with firm’s obligations under the Markets in Financial Instrument Directive (MiFID).

Trading platforms will need to put in place sophisticated systems with capacity to accommodate high frequency generation of orders and transactions, to monitor orders entered and transactions undertaken and any other behaviour which may involve market abuse. Guidelines on investment firms are centred on both monitoring the activities of individuals/algorithms trading and training staff responsible for trading and compliance on market abuse.

ESMA expects to adopt final guidelines at the end of 2011. The guidelines will sit under the existing legal framework provided by MiFID and Markets Abuse Directive (MAD) which are currently under review, and so commentators need to consider them in that context. ESMA will revisit the guidelines when MiFID and MAD are finalised to consider whether they need to be adapted in the light of the new legislative framework.

New requirements are set for ETFs as UCITS

In response to concerns about the risks of Exchange Traded Funds (ETFs), ESMA published a discussion paper on 22 July 2011, looking at the way to reduce the risks for retail investors and highlighting the potential systemic risk caused by ETFs and their impact on financial stability.

ESMA is seeking feedback on the following policy orientations for UCITS ETFs:

  • Title or identifier - ETFs should use an identifier, in their name, rules or instrument of incorporation, prospectus and marketing material, which identifies them as an ETF.
  • Index-tracking issues - The prospectus of index-tracking ETFs should include a clear and comprehensive description of the index to be tracked and the mechanism used to gain exposure to the index.
  • Synthetic ETFs - The information provided to investors in the prospectus of synthetic ETFs should at least include information on the underlying investments of the investment portfolio or index, the type of collateral that may be received from the counterparty, the risk of counterparty default and the effect on investor returns. Annual returns should contain information about underlying exposures, counterparties and collateral.
  • Securities lending activities - Among other things, collateral received should comply with the criteria for OTC derivative transactions set out by ESMA (formerly CESR) in its July 2010 guidelines on risk measurement and calculation of global exposure and counterparty risk for UCITS. Investors should also be informed about the policy relating to collateral (e.g. permitted types of collateral and the level of collateral required).
  • Actively managed ETFs - Investors should be clearly informed of the fact that a fund is actively managed and of the main sources of risks arising from its investment strategy.
  • Leveraged ETFs - The prospectus of leveraged ETFs should disclose the leverage policy and the risks associated with it, as well as a description of how the daily calculation of leverage impacts on investors' returns over the medium to long term.
  • Secondary market investors - ETFs should be required to give all investors the right to redeem their units directly from the fund, including those who acquire units on the secondary market.

In relation to structured UCITS, ESMA sets out proposals on total return swaps and strategy indices.

Comments can be made on the discussion paper until 22 September 2011.

FSB advances recovery and resolution plans

Systemically important financial institutions (SIFIs) will need to complete the first drafts of their recovery plans in less than five months and their resolution plans in less than 11 months, according to proposed timelines set by the Financial Stability Board (FSB). Supervisors and SIFIs are currently working closely together to create appropriate recovery and resolution plans for each firm. By December 2012, both the recovery plans and the resolution plans should be completed by firms and approved by supervisors.

Currently, resolution arrangements for firms vary greatly across jurisdictions. According to the FSB, an effective resolution regime should be built on a number of interdependent components:

  • a tailored national resolution regime for SIFIs;
  • a resolution authority with the necessary expertise, resources and statutory powers;
  • a broad range of resolution options for failed firms;
  • bail-in powers to write-down or convert a firm’s equity into debt;
  • legal capacity to enable cross-border coordination of resolution; and
  • an agreed framework where losses are borne by shareholders and unsecured creditors and not taxpayers.

The resolution authority should prevent any unnecessary losses in the value of assets and contagion across the financial system. This may require the difficult and time consuming task of extracting and preserving systemically important operations.

The FSB believes that an interim solution, such as a “bridge bank”, may be required in such cases, where the resolution authority could tap in to additional powers necessary to operate and resolve the firm including powers to terminate contracts and replace management and directors if necessary.

The Basel Committee on Banking Supervision produced a consultation report detailing the assessment methodology underpinning calculations on additional capital SIFIs will be required to hold under FSB proposals. The methodology for SIFIs is based on an indicator approach and comprises of five board categories:

  • size;
  • interconnectedness;
  • lack of substitutability;
  • global activity; and
  • complexity.

The additional loss absorbency requirements range from 1-2.5% of Common Equity Tier 1, depending on the bank’s importance. The higher capital requirements will be introduced in parallel with Basel III capital conservation and countercyclical buffers and will be fully effective on 1 January 2019.

EC argues for universal access to basic bank accounts

The EC wants every EU citizen to have access to a basic, affordable bank account irrespective of their financial position. Currently, Member States do not guarantee the availability of essential banking services and an estimated 30 million EU citizens over the age of 18 have no bank account. The EC is seeking to reduce this figure by establishing EU-wide principles giving customers the right to open and use a bank account with a number of basic features, such as ability to withdraw and lodge money and execute payment transactions. Access to such accounts will not be conditional on the purchase of additional services and the EC is quite explicit that banks should not offer any overdraft facilities in connection with these accounts.

At least one bank will be required to offer these basic payment accounts in each jurisdiction and the application process must be “transparent, fair and reliable”. Fees associated with the account should either be free or at a “reasonable charge”. Member States must ensure that appropriate and effective complaints and redress procedures are in place for the out-of-court settlement of disputes concerning rights and obligations and a competent authority is made responsible for monitoring effective compliance with these principles.

The financial industry generally opposes a binding EU instrument in this field, arguing that each country should develop its own solutions in light of its individual circumstances. However, the Commission believes that pan-European regulation is justified on social and financial grounds.

At present, ten EU countries have either regulatory codes (Belgium, France, Finland, Denmark, Sweden, and Netherlands) or voluntary codes (Germany, Slovenia, Italy, and UK) in place.