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Document 52011SC0950
COMMISSION STAFF WORKING PAPER EXECUTIVE SUMMARY OF THE IMPACT ASSESSMENT
COMMISSION STAFF WORKING PAPER EXECUTIVE SUMMARY OF THE IMPACT ASSESSMENT
COMMISSION STAFF WORKING PAPER EXECUTIVE SUMMARY OF THE IMPACT ASSESSMENT
COMMISSION STAFF WORKING PAPER EXECUTIVE SUMMARY OF THE IMPACT ASSESSMENT /* SEC/2011/0950 final - COD 2011/0202 */
1.
Background
The extent of the financial crisis has
exposed unacceptable risks pertaining to the current regulation of financial
institutions. According to the IMF estimates, crisis-related losses incurred by
European banks between 2007 and 2010 are close to €1 trillion or 8% of the EU
GDP. In order to
restore stability in the banking sector and ensure that credit continues to
flow to the real economy, both the EU and its Member States adopted a broad
range of unprecedented measures with the taxpayer ultimately footing the related
bill. In this context, by October 2010 the European Commission (Commission) has
approved €4.6 trillion of state aid measures to financial institutions of which
more than €2 trillion were effectively used in 2008 and 2009. The level of
fiscal support provided to banks needs to be matched with a robust reform
addressing the regulatory shortcomings exposed during the crisis. In this
regard, the Commission already proposed a number of amendments to bank
regulation in October 2008 (CRD[1] II) and July 2009 (CRD
III). The legislative package that this report accompanies contains globally
developed and agreed elements of bank capital and liquidity standards known as
Basel III. The Commission services actively participated in the process of their
development on behalf of all EU Member States. The package is extended to
include a proposal for harmonisation of other provisions of CRD with a view to
deepening the Single Market and strengthening the effectiveness of supervision.
This report pertains only to the assessment of impacts of the measures
described below.
2.
Stakeholder consultation
Throughout the project the Commission
services have participated in the work of international forums, particularly
the Basel Committee on Banking Supervision (BCBS) that was in charge of
development of new policy measures in the areas of liquidity and counterparty
credit risk management, definition of regulatory capital and pro-cyclicality.
The European Banking Committee and the Committee of European Banking Supervisors
(CEBS) have been extensively involved and consulted throughout the project. To support the analysis of impacts of this
legislative package on the EU banking industry, CEBS conducted a quantitative
impact study. 246 banks from 21 member countries of CEBS participated in the
study, including 50 Group 1[2] banks and 196 Group 2
banks, together representing some 70% of the consolidated EU banking sector in
terms of capital. CEBS also provided a technical advice to the Commission in
the area of harmonisation of national options and discretions. The Commission services organised a public
hearing in April 2010 and conducted four public consultations in 2009-2011 on
the policy measures comprised by the legislative package[3].
Responses to the consultations constitute an important source of data and
stakeholder views as regards the impacts and effectiveness of potential
measures. In addition, the Commission services
conducted separate extensive consultations with the industry, including the
Group of Experts in Banking Issues, various EU banking industry associations
and individual banks.
3.
Problem definition
3.1.
Management of liquidity risk
The global financial crisis has brought to
light shortcomings in the current liquidity risk management of institutions,
including stress testing exercises and asset and liability maturity mismatches.
More specifically, existing liquidity risk management practices were shown to
be inadequate in fully grasping risks linked to originate-to-distribute
securitisation, use of complex financial instruments and reliance on wholesale
funding with short term maturity instruments. Assumptions pertaining to asset
market liquidity and interaction between market liquidity and funding liquidity
turned out to have been erroneous while behavioural aspects of financial
institutions also played an immense role in the course of the crisis. These
factors contributed to a demise of several financial institutions[4]
and strongly undermined the health of many others, threatening the financial
stability and necessitating unprecedented levels of public sector and central
bank liquidity support. Between September and December 2008, ECB loans to the
euro area credit institutions increased by some 70% to over €800 billion. While a number of Member States currently
impose some form of quantitative regulatory standard for liquidity, no
harmonised sufficiently explicit regulatory treatment on the appropriate levels
of short-term and long-term liquidity exists at the EU level. Diversity in
current national standards hampers communication between supervisory
authorities and imposes additional reporting costs on cross-border
institutions.
3.2.
Definition of capital
The EU banking system entered the crisis
with capital of insufficient quantity and quality. More specifically, certain
capital instruments and, particularly, hybrid capital instruments[5]
(hybrids), did not meet expectations of markets and regulators with regard to
their loss absorption[6], permanence[7]
and flexibility of payments[8] capacity on a
going-concern basis. In fact, compliance of hybrids with the above three
criteria in the EU was enforced by the Commission policy of 'burden sharing',
when assessing national bank recapitalization measures. Also, the list of adjustments to regulatory
capital proved to be incomplete as a number of balance sheet items such as
minority interests and deferred tax assets, whose loss absorption potential is
less certain on a going-concern basis in times of stress, have been effectively
removed by market participants from capital ratios reported by institutions. Differences
in application of regulatory adjustments across Member States further obstructed
comparability and reliability of Tier 1 capital measure. As a result, reported
Tier 1 capital ratios were not reflective of institutions’ capacity to absorb
mounting losses. This necessitated governments to provide support to the
banking sector in many countries and on a massive scale.
3.3.
Counterparty credit risk
The crisis revealed a number of
shortcomings in the current regulatory treatment of counterparty credit risk[9]
arising from derivatives, repo[10] and securities financing[11]
activities. It showed that the existing provisions did not ensure appropriate
management and adequate capitalisation for this type of risk. The current rules
also did not provide sufficient incentives to move bilaterally cleared
over-the-counter derivative contracts to multilateral clearing through central
counterparties[12].
3.4.
Pro-cyclicality of lending
Pro-cyclical effects are defined as those
which tend to follow the direction of and amplify the economic cycle. The
cyclical nature of bank lending has a number of interconnected sources that
include both market and regulatory failures. One feature of current risk-based minimum
capital requirements is that they vary over the economic cycle. Provided that credit
institutions and investment firms could meet them, there is no explicit
regulatory constraint on the amount of risk they can take on and hence on their
leverage. The lack of such constraint and irresponsiveness of capital
requirements to the build-up of risk at the macro level led to an accumulation
of financial imbalances which precipitated steep credit-related losses and,
once the economic cycle turned, prompted a damaging de-leveraging spiral.
3.5.
Options, discretions and minimum harmonisation
In 2000, seven banking directives were
replaced by the Consolidated Banking Directive. This directive was recast in
2006 with CRD, while introducing the Basel II framework in the EU. As a result,
CRD provisions include a significant number of options[13]
and discretions[14]. CRD is also a 'minimum
harmonisation' directive which means that Member States may add stricter
prudential rules, which gives rise to a practice known as 'gold-plating'. As a result, there is a high level of
divergence in how the rules are implemented by MS and subsequently applied by
the national supervisory authorities which is particularly burdensome for firms
operating cross-border. It also gives rise to the lack of legal clarity and an
uneven playing field.
4.
Objectives
The overarching goal of this initiative is
to ensure that the effectiveness of bank capital and liquidity regulation in
the EU is strengthened and its adverse impacts on confidence in banks and pro-cyclicality
of the financial system are contained while maintaining the competitive
position of the EU banking industry. This translates into the following four
general policy objectives to: - Enhance the financial stability; - Enhance safeguarding of depositors'
interests; - Ensure international competitiveness of the
EU banking sector; - Reduce pro-cyclicality of the financial
system.
5.
Policy options: analysis and comparison
Altogether, 27 policy options have been
assessed and compared with a view to addressing the various issues identified.
This section presents expected impacts of policy measures in each area as well
as cumulative impacts of the entire proposal.
5.1.
Liquidity risk
To improve short-term resilience of the
liquidity risk profile of financial institutions, a Liquidity Coverage Ratio (LCR)
will be introduced from 2015, after an observation period and a review to apply
any necessary refinements to both its composition and calibration and to check
for any undesired impacts on the industry, financial markets and the economy.
Based on LCR definition included in Basel III, compliance with this requirement
in the EU in the long run would produce net annual GDP benefits in the range of
0.1% to 0.5%, due to a reduction in the expected frequency of systemic crises. To address funding problems arising from
asset-liability maturity mismatch, the Commission considers introducing a Net
Stable Funding Ratio (NSFR). Before deciding on its final calibration and
moving it to a minimum standard as of 2018, extensive monitoring of NSFR and
its implications will be conducted.
5.2.
Definition of capital
The proposals tighten criteria for
eligibility of capital instruments for the different layers of regulatory
capital and make extensive revisions to the application of regulatory
adjustments. For Group 1 banks, revised regulatory adjustments reduce eligible
common equity Tier 1 (CET1) capital by 42% and that of Group 2 banks by 33%. These
reductions are driven by adjustments for goodwill, material investments in
other financial institutions and deferred tax assets. The new CET1 and Tier 1 minimum
requirements will be implemented gradually from 2013 and by 2015 would reach
4.5% and 6%, respectively. Revisions to regulatory adjustments will be
introduced in 2014 – 2019. Grandfathering provisions for capital instruments
that no longer meet the new eligibility requirements are also foreseen.
5.3.
Counterparty credit risk
Requirements for management and
capitalization of the counterparty credit risk will be strengthened. The
proposals will also enhance incentives for clearing over-the-counter
instruments through central counterparties. These proposals are expected to
affect mostly the largest EU banks. The review of the treatment of counterparty
credit risk, and in particular putting in place higher own funds requirements
for bilateral derivative contracts in order to reflect the higher risk that
such contracts pose to the financial system, forms an integral part of the
Commission’s efforts to ensure efficient, safe and sound derivatives markets.
It complements other Commission’s regulatory initiatives in this area, in
particular the proposed Regulation on OTC derivatives, central counterparties
and trade repositories, adopted by the Commission on 15 September 2010.
5.4.
Countercyclical policy measures
Proposals for capital buffers comprise a
capital conservation buffer and a countercyclical capital buffer. The (CET1) capital
conservation buffer of 2.5% of risk-weighted assets (RWA) is aimed at ensuring
banks' capacity to absorb losses in stressed periods that may span a number of
years. Banks would be expected to build up such capital in good economic times.
Those banks that fall below the buffer target will face constraints on
discretionary distributions of earnings (i.e., dividend payments) until the
target is reached. The countercyclical capital buffer is
intended to achieve the broader macro-prudential goal of protecting the banking
sector and the real economy from the system-wide risks stemming from the
boom-bust evolution in aggregate credit growth. It will be applied by adjusting
the size of the buffer range established by the conservation buffer by additional
2.5%. In order to limit an excessive build-up of
leverage on credit institutions' and investment firms' balance sheets and thus help
containing the cyclicality of lending, the Commission also proposes to
introduce, as an element of the supervisory review, a non-risk based leverage
ratio. Implications of the ratio will be monitored prior to it possibly
becoming a generally binding requirement on 1 January 2018.
5.5.
Single rule book
The proposals harmonise divergent national
supervisory approaches by removing options and discretions. Some
specific areas, where gold-plating is driven by risk assessment considerations,
market or product specificities and Member States legal framework, remain
exempted.
5.6.
Cumulative impact of the package
To supplement their own assessment of the
impact of Basel III, the Commission reviewed a number of studies prepared by
both public and private sectors. This package and CRD III together are
estimated to increase RWA of Group 1 banks by 24.5% and RWA of Group 2 banks by
a modest 4.1%. The extent of CET1 shortfall to meet the new minimum requirement
and the conservation buffer, based on the EU bank capital levels in 2009 is
estimated to be immaterial by 2013, at €84 billion by 2015 and €460[15]
billion by 2019, equivalent to 2.9% of the banking sector's RWA. To give banks time to retain more of their
profits, improve operational efficiency, issue new equity and take other
necessary steps to adjust, the new capital requirements entail an eight year
transition period. Based on analyses of the Basel Committee, ECB, and the
Commission services, transition to stronger capital and liquidity standards
will have only a limited impact on the aggregate output. In terms of long-term economic impact,
analysis conducted by the Basel Committee found clear net long term economic
benefits of Basel III. This analysis implies net economic benefits of annual
increase in the EU GDP in the range of 0.3%-2%. They stem from a reduction in
the expected frequency of future systemic crises and are optimised when CET1 is
calibrated in the range of 6% to 9%. Another model developed by the Commission
and academics found that the proposals would reduce the probability of a
systemic banking crisis in seven Member States within the range of 29% to 89%
when banks recapitalise to a total capital ratio of at least 10.5%. In addition, analysis of the Basel
Committee showed that higher capital, including the countercyclical capital
buffer, and liquidity requirements should also reduce the amplitude of normal
business cycles. This is particularly relevant to SMEs who are dependent on
bank financing throughout the economic cycle.
6.
Monitoring and evaluation
It is expected that the proposed amendments
will enter into force in 2013. Measuring the progress of reaching specific
policy objectives will be aided by the working groups of the Basel Committee
and the European Banking Authority (EBA), that monitor the dynamics of bank
capital positions, globally and in the EU, respectively. Special arrangements
will be put in place by EBA to ensure that necessary data for monitoring of
leverage ratio and the new liquidity requirements are collected to allow for
the finalization of these policy measures in due time. [1] Capital Requirements Directive. [2] Group 1 banks are those that have Tier 1 capital in
excess of €3 billion, are well diversified, and are internationally active. All
other banks are considered Group 2 banks. [3] See http://ec.europa.eu/internal_market/bank/regcapital/index_en.htm. [4] Bear Sterns, Lehman Brothers,
Northern Rock, HBOS, Bradford and Bingley. [5] Hybrids are securities that contain features of both
equity and debt. [6] The instrument must be available to absorb losses,
both on a going concern basis and in liquidation, and to provide support for
depositors’ funds if necessary. [7] The instrument must be permanently available so that
there is no doubt that it can support depositors and other creditors in times
of stress. [8] The instrument must contain features permitting the
noncumulative deferral or cancellation of payment of coupons or dividends in
times of stress. [9] The risk that the counterparty to a transaction could
default before the final settlement of the transaction cash flows. [10] In a repo (repurchase agreement) contract, the borrower
agrees to sell a security to a lender and to buy the same security from the same
lender at a fixed price at some later date. [11] While the rationale behind a repo contract is borrowing
or lending of cash, in securities financing, the purpose is to temporarily
obtain a security for other purposes such as covering short positions. [12] An entity that interposes itself between counterparties
to contracts traded within one or more financial markets, becoming the buyer to
every seller and the seller to every buyer. [13] A choice given to competent authorities or MS on how to
comply with a given provision, selecting from a range of alternatives. [14] A choice given to competent authorities or MS as to
whether apply a given provision. [15] Of this figure, €37 billion (measured in Tier 1
capital) is attributable to CRD III proposal.