Including updates on CRD IV's progress and the Legal Entity Identifier

 

CRD IV close to completion?

EU policymakers still hope to reach political agreement on the revised bank capital requirements (CRD IV/CRR) by the end of year and thus, in theory, meet the Basel Committee's 1 January 2013 deadline for the implementation of Basel III. However, the reality is that it could still take some months for the Level 1 text to come into force.

Intensive work during the trilogue negotiations has whittled down the list of issues to be addressed. The European Commission's communication suggests that two key issues remain: capital treatment for systemically important banks and the question of bankers' remuneration. On the first, the ECOFIN Council expressed the view on 13 November that the final agreement needs to adhere to the compromise position battled for in the Council marathon meeting on 2 May and agreed on 15 May.

According to this position, the adopted approach would leave flexibility for Member States to impose different additional capital requirements on systemically important banks headquartered in their jurisdictions, recognising the varying threat they pose to national economies. The European Parliament's position, however, would introduce a standardised capital surcharge. On this issue, something very close to the Council's initial position would need to be adopted for political agreement to be reached.

On remuneration, the European Parliament is the more intransigent, entering the trilogue debate with the view that a 1:1 ratio should be set for fixed to variable remuneration. The Council had not focused on this issue prior to trilogue, adopting essentially a position which reflected the initial proposal from the Commission. Throughout the trilogues, the Commission has stressed that the responsibilities of shareholders should not be undermined.

In the most recent negotiations, we understand that the Cypriot Presidency proposed:

  • a 100% cap on up-front variable pay as a percentage of fixed pay
  • a 300% cap on total variable pay as a percentage of fixed pay. This cap will be a higher amount if the shareholders or owners agree to do so, but in any case shall not exceed a maximum of 500% of fixed pay.

Our view of the most likely outcome is that the 100% cap on up-front variable pay will endure, but that the caps relating to total variable pay are likely to be reduced (to, say, 200% and 300% respectively).

Of course, there will be a number of critical technical issues that will need to be resolved relating to the definitions of fixed and variable pay. In addition, the nature, frequency and timing of the shareholder vote will also need to be addressed; in particular the question arises whether EU regulated entities owned by foreign parents (e.g. the subsidiary of a US bank in London) are able to gain the approval of the parent company for an increased cap, rather than have to obtain a resolution of parent company shareholders.

Should the trilogue agree the terms of the "bonus cap" along the above lines, the resulting relaxation from the European Parliament's proposals for a strict 1:1 ratio is to be welcomed. However, the new regulations would still have a major impact on compensation structure in the European banking sector, and firms will need to analyse the potential impact and develop a workable solution for their businesses. CRD IV/CRR is scheduled to be discussed at the upcoming ECOFIN meeting on 4 December. The Presidency hopes that all outstanding issues in the trilogue will be resolved by then and political agreement will be reached. The vote in the European Parliament plenary has now been postponed to the 11 December. Should this vote take place on the basis of a political agreement, the ECOFIN Council would subsequently adopt the text, following review by legal services and translations, in early 2013. It will come into effect after publication in the Official Journal.

On this basis the Level 1 text should be in place relatively soon after the 1 January 2013 deadline. However, this leaves open the issue of the implementing measures that need to be developed. According to the Commission's initial proposal, the European Banking Authority (EBA) was due to submit to the Commission draft technical standards covering issues in some 35 articles of the CRD IV/CRR text. Over the past year or so, EBA has undertaken preparatory work covering a number of the key issues. Finalisation of its proposals, however, is dependent on publication of the final Level 1 text. Consequently, there are still many questions yet to be answered from a practical perspective in terms of when the new regime's requirements will actually come into effect.

The EU will definitely introduce the new regime before the US. On 9 November, the US agencies announced that they were "indefinitely delaying" the implementation of Basel III. The delay came in response to pressure from bankers and Congress who wants the agencies to thoroughly address the more than 2,000 comment letters filed after the comment period was extended.

US banks are particularly concerned about:

  • New risk-weighted assets rules: the new residential mortgage risk-weighting requirements under Basel III require much more complex and granular risk treatment which could significantly impair community banks' ability to conduct a viable and robust residential lending business when combined with other mortgage rules under the Dodd-Frank Act.
  • Subjecting Basel III rules to thrift holding companies with significant insurance activities: Basel III requirements are not calibrated to the insurance business model and does account for the longer-term nature of their liabilities and their practice of matching asset and liability maturities.
  • The inclusion of unrealized losses and gains on available-for-sale debt securities in regulatory capital: this could result in large and volatile changes in a bank's capital level, especially when interest rates begin to rise from their current historical lows.

A common thread running through all comment letters is a concern about complexity. This is a growing concern amongst policymakers. Andrew Haldane, Executive Director for Financial Stability at the Bank of England, believes that "modern finance is complex, perhaps too complex". He suggests "as you do not fight fire with fire, you do not fight complexity with complexity." Overall, Haldane suggests that "the tower of Basel is at risk of over-fitting - and over-balancing" and it may be time to "rethink its architecture."

Thomas Hoenig, Director, Federal Deposit Insurance Corporation, believes its "time for international capital rules to be simple, understandable and enforceable". Hoenig believes that Basel III is built on a flawed architecture that uses "highly complex modeling tools that rely on a set of subjective, simplifying assumptions to align a firm's capital and risk profiles."

So roll on Basel IV/CRD V? There are clearly issues in introducing these requirements at a time of ongoing economic upheaval in the US and Europe but another revision (or simplification) of the regime is not on the cards. The Basel Committee argues that the long transitional period for key elements of the regime gives time the economic conditions to stabilise.

Jaime Caruana, General Manager of the Bank for International Settlements, recently rejected suggestions from some quarters that the timelines associated with Basel III should be slowed-down in light of the precarious economic conditions banks face, suggesting instead that the faster banks rebuild and repair their balance sheets, the faster that market confidence will be restored, funding lines re-opened and capital costs to normalise. Additionally, Wayne Byres, BIS Secretary General, recently made clear that, while BIS' finalization of the LCR requirements would have to be postponed to 2013 instead of end 2012, "implementing Basel III is essential, but it must be accompanied by other measures and reforms" such as the treatment of securitisation within the Basel framework.

Basel III clearly aimed to restore market confidence but how are policy makers' going to sell a regulation they can't agree on?


 

Harnessing the Legal Entity Identifier

Market participants often view new regulations with a healthy dose of scepticism. However, regulations can be widely beneficial if they address specific market failures. Work on developing a global legal entity identifier (LEI) could be a case in point and may prove a 'win win' for both supervisors and the markets. Widespread adoption of the LEI should lower the cost of managing counterparty and operational risks. It would also help supervisors assess interconnectedness within the markets, curb market abuse and, of course, facilitate orderly resolution should this prove necessary.

In economic parlance, there has been a public good market failure in this regard. The benefits of the LEI will accrue collectively to users and a wider array of stakeholders but no one private operator could envisage investing the time and effort to design a system.

So the work now being driven by the Financial Stability Board (FSB) is addressing a fundamental market weakness. The standard setter aims to launch the system, developed through 'a high degree of federation', by March 2013. Adopting a pragmatic approach, All FSB members have signed up to the concept but there are still challenges in making it operational. The FSB is still mulling over the location and exact legal form of the foundation underpinning the system-which will influence its overall governance framework. A number of potential locations has been analysed and detailed assessments of a narrower set of options is now underway. The results of these assessments will facilitate the drafting of the necessary legal documents to establish the various bodies that are part of the system.

Elsewhere, the FSB, its Implementation Group (IG) and the LEI Private Sector Preparatory Group (PSPG) have made good progress in their planning and development work. The IG prepared a recommendation for the technical specification of the LEI code structure which was endorsed by the FSB. The IG has also prepared a draft Charter for the Regulatory Oversight Committee (ROC), the body which will have ultimate responsibility of the governance of the system, which was submitted to the G20 Finance Ministers and Central Bank Governors this month.

In terms of populating the initial board of Directors of the ROC, the PSPG has finalised the selection criteria in terms of fitness, experience, regional and sectoral balance etc. It has also undertaken detailed work on operational aspects of the new system, such as data quality, localisation, ownership and corporate hierarchies, as well as finding the best way to take advantage of existing local infrastructures.