Including updates on pending EU reforms, CRD IV and credit rating agencies

 

Next stop, Vilnius: what FS reforms are coming down the tracks in Europe

The presidency of the EU Council (Council) moves to Vilnius next month, as the Lithuanians get their first taste of running one half of the EU legislature. It shouldn’t be a total baptism of fire, thanks to good progress made by the Irish Presidency on key dossiers. However, we are at a crucial stage in the legislative process of some big ticket reforms in Europe and there is every possibility of being blown-off course in the coming months as politicians back track on implementing tough reforms.

The European Parliamentary election next year heaps added pressure to reaching political agreement on proposals already on the table within the life span of the current European Parliament (Parliament). It will take months for newly elected parliamentarians to get up-to-speed with current debates. It is also not clear what form and construct the new Parliament will take and where its priorities will lie.

While the forthcoming Presidency hasn’t laid out its strategy on regulatory reform just yet, we will take you through the main reform areas, providing you with our best guess of what’s going to happen:

Banking union

  • Single supervisory mechanism (SSM) (transfer of prudential supervision of Eurozone banks to the European Central Bank (ECB)). The trialogue reached agreement on these proposals in May. Finalisation of the legislative procedure is expected in the Autumn with a view to the ECB taking over its new responsibilities in mid-2014. There are questions about the ECB’s operational readiness to take on such a challenge within a limited period of time, but also concerns about its willingness to take on the task without other key elements of the ‘banking union’ being in place, notably the bank recovery and resolution directive, and the Single Resolution Mechanism (see below).
  • Bank Recovery and Resolution Directive: The Irish Presidency is working hard to agree a general approach in the Council by the end of its term so that trilogue negotiations with the Parliament and the Commission can commence as soon as possible. Parliament voted on its negotiating position in the Economic and Monetary Affairs Committee on 20 May. Facilitation of the trilogue negotiations on this file is likely to be a key priority for the Lithuanian Presidency with a view to reaching political agreement by the end of the year.
  • Common deposit guarantee scheme: Although flagged as a key pillar of the ‘banking union’, recent commentary has suggested that additional legislation in this area is a medium-term priority. Obviously, there is an EU regime already in place. The proposal to further revise this regime, tabled by the European Commission (Commission) in July 2010, stalled in the Council in early 2012, primarily around issues related to the funding of Deposit Guarantee Scheme, and there are no signs that negotiations are to be resurrected in the near future. However, recent negotiations in respect of the bank recovery and resolution directive, particularly given what almost happened in Cyprus, have established that protection of deposits up to €100,000 are ‘sacrosanct’.

Single rule book

  • Capital Requirements Directive (CRD) IV: We are nearly there on CRD IV (the package of reforms that implements Basel III in Europe); there should be nothing for the Lithuanian Presidency to do on this. Parliament approved the final text in April following an end-March trialogue agreement. The final text is currently undergoing a detailed review of legal drafting and translation into other official EU languages: formal adoption by finance and economy ministers is expected soon. Provided that translation is completed in time for level 1 text to be published in the Official Journal before 1 July 2013, implementation of CRD IV will be from 1 January 2014. Otherwise the implementation date will be pushed back to 1 July 2014. Regardless of what happens, it is unlikely that all Member States will have put in place the necessary national legislative measures to implement CRD IV by 1 January 2014. So expect the implementation of the prudential single rule book for banks to be a little uneven in the first few months at least.
  • Solvency II/Omnibus II (the new prudential regime for insurers): Solvency II, as amended by Omnibus II, is a different matter. Once the European Insurance and Occupational Pensions Authority reports on its long-term guarantee assessment, it is expected that trilogue negotiations will begin again in earnest with a view to reaching agreement by the end of the year. Clearly, the onus will fall on the Lithuanian Presidency to ensure this happens, if at all possible.

Financial markets

  • Markets in Financial Instruments (MiFID II/MiFID) and Market Abuse (MAD II/MAR): Again, the Irish Presidency is looking for agreement on the general approach on MiFID II/MiFIR before the end of their term. Council negotiators have made it clear that they will not conclude their discussions on MAD II/MAR until they have resolved outstanding issues with MiFID II/MiFIR. The European Parliament has been waiting patiently for the Council to complete its negotiations on these two dossiers. Reaching political agreement on these two key measures by the end of the year is likely to be a priority for the Lithuanians. For further details on MiFID II please see our note here.
  • Central Securities Depositories Regulation (CSDR): Negotiations on the CSDR are progressing, although relatively low profile. Again, the European Parliament is waiting for the Council to reach its general approach. Trilogue negotiations on this file should, therefore, take place under the Lithuanian Presidency.

Consumer protection

  • Packaged Retail Investment Products (PRIPS) / Insurance Mediation Directive (IMD)/ Undertakings for Collective Investment in Transferable Securities (UCITS) V: The ‘retail package’ launched by the Commission last July is travelling at different speeds. Controversial amendments proposed in relation to UCITS V and PRIPs in the European Parliament (on remuneration for UCITS V and on scope for PRIPs) suggest difficult and extended negotiations further down the line, if they remain in place. IMD2 is moving, but slowly, and it is not clear that there is sufficient momentum on this file to ensure its timely adoption.
  • Bank accounts: On 8 May, the Commission tabled a proposal designed to ensure the provision of basic banking services to all EU citizens, to facilitate switching accounts and to ensure comparability of fees. This proposal, like the other proposals focusing on consumer protection, is unlikely to be seen as a key priority for the forthcoming Presidency but, if not too contentious, may nevertheless see progress.

This summarises what is actually on the table so far. But Michel Barnier, speaking to the European Parliament on the 27 May, outlined further proposals due to be tabled before the end of the year:

  • Single Resolution Mechanism: The Commission is expected to table legislation on a Eurozone specific resolution mechanism this summer. This proposal is likely to be fast-tracked, taking precedence over other proposals in the Lithuanian priority list, to ensure agreement before the ECB takes up its prudential role.
  • Bank structure: A legislative proposal addressing issues raised by the Liikanen report will be issued after the summer: the proposal will take into account feedback from the recently launched consultation plus the Own Initiative report of Parliament.
  • Institutions for Occupational Retirement Provision (IORPs): The Commission recently announced that the forthcoming proposal on IORPs will not deal with solvency requirements, pending further research. Due for publication again in the Autumn, it will focus on governance and transparency requirements.
  • Long term investments: The Commission will come out shortly with a proposal on long-term investment funds. It has suggested that these funds should be a similar tool to the recently approved EU Social Entrepreneurship Funds and EU Venture Capital Funds.

In his comments to the European Parliament, Commissioner Barnier also flagged upcoming proposals on financial benchmarks and money market funds, without indicating precise timing for these proposals.

But that’s not all. Having made progress in all the above areas, the Commission intends to turn its attention to means designed to ‘base the EU economy on productive capital rather than financial capital’, as outlined in its Green Paper issued on 25 March. Clearly, we will not see any relaxation, in the short-term, of the legislative onslaught. The Lithuanian Presidency comes as a crucial juncture overall, given the Parliamentary and Commission elections next year, and the challenges it will face are significant, not least juggling the priorities. Progress in the coming six months will depend on sustained political good will and energy amongst EU legislators. But there are already clear indications that not all of the stuffed legislative agenda will be finalised before the end of the year or progressed sufficiently for the next holders of the Presidency (the Greeks) to finalise them. The question is which ones will slip through the cracks.

 

Are you still relying on credit ratings?

The third iteration of the Credit Rating Agencies Regulation (CRA III) was published in the Official Journal on 31 May 2013. Financial institutions will have until 20 June 2013 to improve their own credit risk assessment capabilities to ensure they no longer have to rely solely or mechanically on ratings from third parties.

National supervisors will be mandated to monitor the adequacy of firms’ internal credit risk procedures (based on the proportionality principle), assess the use of contractual references to credit ratings and, where appropriate, encourage them to mitigate the impact of such references. Firms should also empower customers to undertake their own due diligence before making investment decisions.

Migrating from relying solely on credit ratings is an arduous, but necessary, task. Clearly, financial firms placed too much reliance on credit ratings, in the run up to the crisis, that were evidently flawed. But regulators (and regulatory regimes) and central banks were also overly dependent on the work of credit rating agencies. Like firms, regulators and central banks will need to start using their own judgement when determining what financial instruments they will accept for regulatory purposes. Given limited resources, they are also going to have to begin to rely again on the judgements on credit risks made by the firms they regulate.

Regulators have already started preparing for the latter by strengthening firms’ internal credit risk assessment processes. Along with CRA III, a Directive amending UCITS IV and the Alternative Investment Fund Managers Directive was also published in the Official Journal on 31 May 2013. The changes are aimed at limiting the reliance on external ratings by fund managers subject to those directives.

The Capital Requirements Directive (CRD) IV requires banks to further strengthen their own risk analysis of the assets they hold. CRD IV will require banks with material credit risk exposures to develop and use internal risk models rather than relying solely on ratings from CRAs. The European Banking Authority (EBA) will monitor banks’ progress against these parameters and will disclose, on an annual basis, information on the steps taken by institutions to reduce their overreliance on external credit ratings and on the degree of supervisory convergence in Europe.

While the original CRD framework required banks and large investment firms to have their own sound internal risk models, the Commission believes that “basing credit decisions solely on external credit rating agency ratings does not fulfil this requirement under EU-banking legislation”. In the Commission’s view, the CRD IV rules in this regard simply reinforce an existing requirement which failed to effect any meaningful change in how banks assess risk.

In the insurance space, EU commissioner Michel Barnier, said that the Commission intends to include measures relating to reliance on credit ratings in the delegated acts for Solvency II in the coming months.

CRA III focuses on other issues beyond reducing over dependence of credit ratings. CRAs are required to adopt a specific and rigorous methodology for rating sovereign debt and be subjected to additional transparency and accountability requirements. Some are sceptical about these requirements, claiming that CRA importance in respect of sovereign ratings is overblown. Downgrades usually lag behind market sentiment, in part because the CRAs need more time to carry out detailed analysis. For example, yields on Greece and Irish debt rose long before credit rating agencies downgraded their debt. While CRA’s rating of complex derivatives was exposed as being flawed during the financial crisis, their track record on rating sovereign debt is generally viewed as stronger.

The Regulation also attempts to spur competition in the highly concentrated CRA market by encouraging the use of smaller rating providers. Where issuers are seeking credit ratings from two or more CRA’s, the issuer “should consider appointing at least one credit rating agency which does not have more than 10% market share” according to the Regulation. Moreover, the Regulation mandates a regular rotation of CRAs issuing credit ratings on re-securitisations. Multiple and different views, perspectives and methodologies applied by CRAs should produce more diverse credit ratings and ultimately improve the assessment of the creditworthiness of re-securitisations.

Finally, politicians want to make CRAs more liable and accountable for the ratings they issue. Where a CRA has committed, intentionally or through gross negligence, any of the infringements that have an impact on a credit rating, an investor or issuer may claim damages from that CRA. However, rating financial products is a risky business and CRAs ensure that their contracts reflect this fact and limit liability. Moreover, CRAs negligence is likely to be difficult to prove in court.

 

It’s raining RTSs

The EBA published a raft of consultations on draft regulatory technical standards (RTS) and implementing technical standards (ITS) on CRD IV last month as we gear-up to a potential start date of 1 January 2014 for the new prudential regime. We expect two dozen further CRD IV consultations from the EBA this year as the final t’s are crossed and the i’s dotted.

The RTS and ITS are narrow in focus and technical in nature, but important nonetheless:

  • Draft RTS on the own funds: The EBA is seeking to harmonise the calculation of deductions, and make the calculation more conservative. This additional RTS was required by the most recent amendments to the draft CRR text and follows two previous draft RTS on own funds last year. The consultation closes on 18 July 2013.
  • Draft RTS on the risk retention rule: The risk retention rule was originally introduced in CRD III and it requires the originator, sponsor or original lender to a securitisation deal to hold an economic interest in 5% of the securities issued (i.e. having skin in the game). The proposed RTS confirms the different approaches that may be used to identify an appropriate ‘slice’ of 5% of the securities concerned. Most of the RTS does not differ significantly from the current practice under Basel 2.5 and associated guidance. The consultation closes on 22 August 2013.
  • Passport notifications: In the associated draft RTS, the EBA specifies the information financial institutions should provide to its home regulators when passporting a branch or services. The information includes details about the programme of operations, governance arrangements, and a three year financial plan. The templates, forms and procedures associated with these notifications are presented in the draft ITS. Both consultations close on 24 August 2013.
  • Draft ITS on joint decisions on institution-specific prudential requirements: The draft ITS outlines the protocol in reaching joint decisions on prudential matters between the consolidating supervisor and other relevant supervisors under CRD IV. They address issues including planning the joint decision process, the group risk assessment report, reaching agreement on the joint decision document, and monitoring the application of the joint decision. The consultation closes on 16 August 2013.
  • Draft RTS on the definition of market risk: The definition of market has to be defined for the purpose of calculating the general market risk component for equities under the standardised rules. The RTS on the definition of market need to be submitted to the EC by 31 January 2014.
  • Draft RTS on the definition of material risk takers for remuneration purposes: The draft RTS greatly expands the definition of banks’ material risk takers subject to the cap to include all employees whose total remuneration is greater than €500,000

In May the EBA also published draft guidelines on capital measures for foreign currency lending to unhedged borrowers under the Supervisory Review and Evaluation Process (SREP) on 23 May 2013, following a recommendation from the European Systemic Risk Board. The guidelines will form a part of the suite of EBA guidelines setting out common procedures and methodologies for the SREP being developed under Article 102(3) of CRD IV. They are subject to the finalisation of the SREP guidelines and may therefore be revised in due course.