Explanatory Memorandum to COM(2004)486-1 - Proposal for DIRECTIVES OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL Re-casting Directive 2000/12/EC relating to the taking up and pursuit of the business of credit institutions and Council Directive 93/6/EEC on the capital adequacy of investment firms and credit institutions - Main contents
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| dossier | COM(2004)486-1 - Proposal for DIRECTIVES OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL Re-casting Directive 2000/12/EC relating to the ... |
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| source | COM(2004)486  |
| date | 14-07-2004 |
A single financial market in the EU will be a key factor in promoting the competitiveness of the European economy and the lowering the capital cost to companies. The Financial Services Action Plan announces a directive on new capital adequacy rules for credit institutions and investment firms in 2004, in step with progress at G-10 level in the Basel Committee on Banking Supervision i.
The agreement by the G-10 Basel Committee on Banking Supervision of the so-called Basel Accord in 1988 (Basel I) led to the adoption of minimum capital requirements across over 100 countries i. It was broadly contemporaneous to the adoption of key EU directives (Directive 89/299/EEC of 17.4.1989 on own funds, Directive 89/647/EEC of 18.12.1989 on a solvency ratio, consolidated in Directive 2000/12/EC of the European Parliament and of the Council of 20.3.2000 relating to the taking up and pursuit of the business of credit institutions).
These directives addressed credit institutions’ risks arising from credit-granting activities. Directive 93/6/EEC of 15.3.1993 on the capital adequacy of investment firms and credit institutions extended both the credit risk and market risk rules to investment firms.
1) The need for improved European requirements.
The existing rules have made a significant contribution to the single market and high prudential standards. However, various important shortcomings have been identified.
1. Crude estimates of credit risks result in an extremely crude measure of risk and is in danger of falling into disrepute.
2. Scope for capital arbitrage: innovations in markets have enabled financial institutions to effectively arbitrage the mismatch between institutions’ own allocation of capital to risks and minimum capital requirements.
3. Lack of recognition of effective risk mitigation: the present Directives do not provide appropriate levels of recognition for risk mitigation techniques.
4. Incompleteness of the risks covered under the existing directives, including operational risk, which are not subject to any capital charges.
5. Absence of requirement for supervisors to evaluate the actual risk profile of credit institutions to satisfy themselves that adequate capital is held having regard to that risk profile.
6. Absence of requirement for supervisory cooperation: in an increasingly cross-border market authorities must cooperate effectively with each other in the supervision of cross-border groups to reduce regulatory burdens.
7. Absence of proper market disclosures: the present Directives do not facilitate effective market discipline for reliable information for market participants to make well-founded assessments.
8. Lack of flexibility in the regulatory framework: the current EU system the lacks the flexibility to keep pace with rapid developments in financial markets and risk management practices, and with improvements in regulatory and supervisory tools.
What would happen under a “no policy change” scenario?
There is strong consensus that the present situation is unsustainable. Capital requirements and risks would continue to be misaligned resulting in limited effectiveness of the prudential rules and increased risks to consumers and financial stability. The full extent of the risks that some financial institutions are undertaking would still not be captured. In addition, the newest and most effective risk management techniques would not be actively encouraged or recognised and financial services groups operating in more than one Member State would continue to be subject to disproportionate burdens resulting from multiple layers of regulation and supervision. Finally, the EU would be unable to benefit appropriately from future developments, given the difficulty in speedily updating the current EU regulatory framework. In view of the proposed global implementation of the new Basel Accord the EU financial services sector would be significantly disadvantaged compared with its overseas competitors.
Contents
- 2) The approach of the Directive
- 2. Consultation and impact assessment
- Less complex institutions
- Flexibility of the new directive
- Investment firms
- Complexity
- b) Impact assessment
- 3. legal basis
- 4. Comments on the articles
- A. Directive 2000/12/EC
- B. Directive 93/6/EEC on the Capital Adequacy of Investments Firms and Credit Institutions
- Article 3: Definitions
- Article 11: Trading book capital treatment
- Article 28: Large exposures
- Article 33: Valuation of positions for reporting
- Article 22: Consolidated requirements
- Article 34: Risk management and capital assessment
- Article 37: Supervision
- Article 42
The Commission’s 1998 Financial Services Action Plan stated that the EU needed accurate, internationally consistent, up to date prudential standards. They should also be proportionate recognising the reduction in risks arising from the context in which exposures are incurred, and in particular lending to consumers and to small- or medium-sized entities. Rules should apply to both credit institutions and investment firms (level playing field) but also need to be proportionate and take fully into account the ‘biodiversity’ of EU financial institutions.
a) Consultation of stakeholders and interested parties
The Commission has been engaged in consultation with stakeholders and interested parties since November 1999. Three full consultation papers have been issued on 22.11.1999, 5.2.2001 and 1.7.2003. A full and structured dialogue with stakeholders was organised on 18.11.2002. Consultation papers on specific technical issues have been published (real estate and covered bonds on 7.4. 2003; ‘expected losses and unexpected losses´ on 26.11.2003; collective investment undertakings on 3.2.2004).
Commentators have generally been very supportive of the major objectives of the project. Enhanced risk-sensitivity leading to greater financial stability is supported and there is now a pressing need for the rules to be updated, to respond to the significant advances in techniques for risk measurement and management in financial services, and to reflect increased regulatory and supervisory sophistication. There is strong support for the Commission’s approach that the EU capital framework should be revised consistent with the new international framework but differentiated where necessary for EU specificities.
There is broad and significant support for the application of the new rules in Europe – to all credit institutions and investment services providers whatever the legal nature and complexity of the institution, also to avoid ‘second class’ institutions that would be likely to result if some were excluded. This reflects the perception that the proposed new framework has been well designed for the purposes of broad application.
There is continued wide and strong support for the approach proposed to ensure that the new framework is responsive to market and supervisory innovation to maintain an optimally efficient and competitive EU financial services sector. Stakeholders support the approach where enduring principles and objectives are set out in the articles and provide the mandate for the more detailed and technical provisions contained in the annexes. The procedure for amending the annexes must ensure full and effective consultation with interested parties.
Significant modifications have been introduced to address concerns expressed by some from the investment firm sector about being subject to capital requirements which they perceive to be more appropriate for credit institutions.
Some respondents asked for simplification and less prescription. The Commission has increased the clarity and user-friendliness of the text. The design will be attractive to those institutions seeking simple rules to apply or wishing to progress gradually to more complex capital rules. The proposed new framework contains a range of options and approaches of different degrees of sophistication.
Since 1999 there have also been several consultations on detailed issues. The proposal has been taken account of very detailed and useful comments from interested parties, in particular the banking and investment firm industry.
An extended impact assessment has been carried out to identify whether there is a need for action at EU level and, if so, the action required.
The Basel Committee published a quantitative impact study (QIS3) involving credit institutions across 40 countries to assess the impact of the new Basel proposals on banks' minimum capital requirements. The Commission assisted in extending this study to EU countries not represented in Basel. The key conclusions were that the new rules will in general reduce capital requirements for EU credit institutions by around 5% compared to present levels. Furthermore, the outcomes for the different approaches are in line with objectives – particularly combining capital neutrality with appropriate incentives for institutions to move towards more sophisticated approaches. Finally, smaller domestic credit institutions adopting the simple approach will face slightly reduced capital charges; larger internationally active credit institutions adopting the more advanced approach will face substantially unchanged capital charges; smaller but specialised and sophisticated EU credit institutions adopting the advanced approach might face substantially lower capital requirements than at present. Importantly, the main source of reduction in capital requirements is the ‘retail’ portfolio, which is mostly composed of loans to Small and Medium Enterprises (SMEs) below EUR 1 million and residential mortgage loans. The new operational risk capital charge is the main source of offset of this decrease in capital requirements for credit institutions.
In addition, at the request of the Barcelona European Council the Commission commissioned a study on the consequences of the draft proposed new capital requirements for credit institutions and investment firms in the EU i. The final report, prepared by PricewaterhouseCoopers, is positive about the impact (with only two areas of criticism – investment firms and venture capital - both of which have been addressed in the Commission’s proposals).[4] The key conclusions are that the new capital requirements framework should be positive for the EU, and for prudential regulation in the EU. EU credit institutions’ capital requirements should decrease by ± 5% (€ 90 billion) and translate into an annual increase in profits of ± € 10-12 billion. There is no disadvantage for smaller credit institutions and no indication that the new regime will force mergers or consolidation. The decision to cover all credit institutions in the directive will not put EU firms at a competitive disadvantage, nor is the US decision to apply only advanced approaches to some 20 big credit institutions a significant competitive factor. Implementation costs for EU credit institutions are not solely driven by Basel II and many of these investments (perhaps as high as 80%) would have happened anyway, although over a longer period. Importantly, there will be no negative impact on the availability and cost of finance for SMEs in most EU Member States (‘procyclicality’ effects are less - and less damaging - than the present rules). SME fears stem from insufficient information understanding of Basel II. The macro-economic effects of Basel II on the EU-economy are small - there could be a benign supply-side shock to the economy reducing the cost of capital to firms and generating an increase of 0.07% in EU GDP. In general the new capital framework will reduce the banking system’s vulnerability through greater awareness of risk, improved risk management, and a more efficient allocation of capital should have beneficial long-run consequences for the EU economy.
The proposals are based on Article 47 i of the Treaty, which is the legal basis to adopt Community measures aimed at achieving the Internal Market in financial services. The chosen instrument is a Directive as the most appropriate to achieve the objectives and it amends existing directives covering the same technical issues. Its provisions do not go beyond what it is necessary to achieve the objectives pursued.
The proposals apply the ‘re-casting technique’ (Interinstitutional Agreement 2002/C 77/01) enabling substantive amendments to existing legislation without a self-standing amending directive. This reduces complexity and makes EU legislation more accessible and comprehensible.
Amendments of a non-substantive nature are made to many provisions to improve the structure, drafting and readability of the directives.
Article 4: Definitions
Article 4 contains certain new definitions concerning essential concepts to clarify their meaning and contribute to a better understanding.
Article 22:
The existing wording has been amended to clarify and develop the obligation for credit institutions to have in place effective internal risk management systems. Given the diversity of credit institutions covered, these requirements will have to be met on a proportionate basis. Relevant technical provisions are in Annex V.
Articles 56-67:
A small number of amendments have been made. Although it is not intended to review the definition of ‘own funds’, as a consequence of the modified approach to expected loss in the Basel Committee (‘Madrid decision’), some limited amendments are necessary.
Articles 68-75:
Credit institutions must hold adequate own funds on an ongoing basis and state the minimum level of those own funds. The provisions specify how the requirements should be met if the credit institution is part of a group (the existing option for Member States’ authorities to waive certain requirements has been retained but with more precision). The calculation of the requirements has been clarified in the light of the introduction of Regulation (EC) no.1606/2002 on international accounting standards.
Articles 76-101:
These provisions replace the existing solvency ratio requirements for credit risk and introduce two methods to calculate risk weighted exposure amounts.
The Standardised Approach (Art. 78-83) is based on the existing framework, with risk weights determined by the allocation of assets and off-balance sheet items to a limited number of risk buckets. Risk sensitivity has been increased by the number of exposure classes and risk buckets (Art. 79). There are lower risk weights for non-mortgage retail items (75%) and residential mortgages (35%). A 150% risk weight for assets which are 90 days past due (100% for residential mortgages) is introduced. The use of credit rating agencies’ ratings to assign risk weights where these are available (‘external ratings’) is permitted (Art 81-83). Relevant technical provisions are in Annex VI.
The Internal Ratings Based (IRB) approach (Art 84-89), permits credit institutions to use their own estimates of the risk parameters inherent in their different credit risk exposures. These parameters form the inputs into a prescribed calculation designed to provide soundness to a 99.9% confidence level. The ‘Foundation’ Approach allows credit institutions to use their own estimates of probability of default, while using regulatory prescribed values for other risk components. Under the ‘Advanced’ Approach, credit institutions may use their own estimates for losses given default and their exposure at default. Credit institutions are allowed to use pooled data in the estimation of risk parameter values. This allows smaller credit institutions to apply a more risk sensitive approach to calculating capital requirements.
The proposed ‘roll-out’ rules (Art. 85) for the IRB approach provide flexibility for credit institutions to move different business lines and exposure classes to the Foundation or the Advanced IRB Approach during a reasonable timeframe. ‘Partial’ use is allowed for non-material exposure classes and business lines (capital requirements can be calculated under the Standardised Approach even if a credit institution uses the IRB Approach for other exposure classes). The proposed EU framework recognises that, for small credit institutions the requirement to develop a rating system for certain counterparties is potentially very burdensome. Permanent partial use for these exposure classes is proposed even in cases where credit institutions’ exposures to such counterparts are material (Art. 89).
Relevant technical provisions for the IRB approach are in Annex VI.
Articles 90-93:
The rules identify common issues for mitigation techniques and treat common underlying risks or economic effects consistently. These include the recognition of a wider range of collateral and guarantee/credit derivative providers than at present. The IRB Foundation Approach gives a prudentially appropriate level of recognition to financial receivables and physical collateral. Alternative methodologies are available for credit institutions to choose between methods of different levels of complexity (a Simple Method – based on an easy-to-use ‘risk weight substitution’ approach; or a Comprehensive Method – involving the application of volatility adjustments to the value of the collateral received). To calculate volatility adjustments more and less complex approaches are made available (a simple ‘Supervisory’ approach where the amounts of the benchmark volatility adjustments are set out in a table; or a more risk-sensitive ‘Own Estimates’ approach). Relevant technical provisions are in Annex VIII.
Articles 94-101:
These articles introduce for the first time a harmonised set of rules for capital requirements for securitisation activities and investments. This provides a significantly improved capital requirements framework – allowing credit institutions to take advantage of the funding, balance-sheet management and other advantages that such transactions can deliver. It will also reduce the extent to which securitisation has been seen as an instrument of capital arbitrage. Relevant technical provisions are in Annex IX.
Articles 102-105:
These provisions introduce requirements to meet the operational risk faced by credit institutions. Three different methodologies are available. A simple approach (Art. 103) based on a single income indicator (Basic Indicator Approach - BIA). This approach provides a capital buffer against operational risk, without requiring credit institutions to develop sophisticated and costly information systems about their risk exposure. A more precise approach based on business lines (Standardised Approach - STA) (Art. 104) is more risk-sensitive as the capital requirement for operational risk is differentiated to reflect the relative risks of different business lines. This approach is likely to be attractive to a large number of smaller / less complex credit institutions. More sophisticated methodologies (Advanced Measurement Approaches - AMAs) (Art. 105) generate their own measures of operational risk, subject to more demanding risk management standards. AMAs are expected to be gradually adopted mainly by large internationally active credit institutions and smaller specialised credit institutions which have developed advanced risk monitoring systems for their main activities. Relevant technical provisions are in Annex X.
Articles 106-119:
A small number of amendments bring consistency between capital requirements and the large exposures rules, in particular to reflect the expanded recognition of credit risk mitigation techniques.
Article 123-124:
These Articles reflect the second ‘pillar’ of the Basel Committee’s capital accord. Art. 51A requires credit institutions to have in place internal processes to measure and manage their risk and the amount of ‘internal’ capital they themselves deem adequate to support those risks. Competent authorities are required (Art. 124) to review compliance by credit institutions with the various legal obligations for organisation and risk control, and to evaluate the risks taken by credit institutions. This assessment will be used by supervisors to determine whether weaknesses exist in controls and capital held. Relevant technical provisions are in Annex XIII.
Articles 125-143:
There is an increasing degree of EU cross-border business and a trend towards centralisation of risk management within cross-border groups. This requires improved coordination and cooperation amongst national supervisory authorities in the EU. The existing and well established role of the consolidating supervisor has thus been developed further. Under Art. 136 supervisors will be provided with a minimum harmonised range of powers to require credit institutions to address any inadequacies in the requirements of the Directive.
Article 144:
A minimum set of disclosure requirements exists for Member States’ authorities to enhance convergence of implementation and introduce transparency.
Articles 145-149:
These provisions reflect the ‘third’ pillar of the Basel Committee’s new capital accord. The disclosure of information by credit institutions to market participants contributes to greater financial soundness and stability, maintains a level playing field and respects the sensitivity of certain information. Art. 147 requires disclosure on a minimum annual basis for most credit institutions - more frequent disclosure may be necessary in the light of specific criteria. Relevant technical provisions are in Annex XII.
Article 150:
The Directive needs to keep pace with market developments. The necessary degree of flexibility is provided by making a distinction between core and technical rules (particularly in the annexes to the directive) that may need adaptations in the short to medium term. Art. 150 adds new technical areas to those in Directive 2000/12/EC (introduced in 1989) and proposes that the new technical Annexes should be able to be modified following the same rapid procedure.
Article 2: Scope
Article 2 specifies how the requirements apply to individual investment firms, groups of investment firms, and mixed groups.
There are certain new and amended definitions on essential concepts to clarify their meaning and contribute to a better understanding.
There is an enhanced definition of the ‘trading book’ to increase certainty as to the capital requirements that apply and to restrict possible arbitrage between the ‘banking book’ / ‘trading book’ boundary. Relevant technical provisions are set out in Annex VII.
Articles 18 and 20:
Article 18 prescribes, for credit institutions and investment firms, the minimum capital requirements for market risk. The treatment of positions in collective investment undertakings and credit derivatives and a number of other modifications for increased risk-sensitivity are new. Relevant technical provisions are in Annexes I to VII. Article 20 extends the rules on capital requirements for credit risk and operational risk in Directive 2000/12 to investment firms, as at present. New credit risk elements include the provision of a treatment for credit derivatives and an amended measure of exposure for repurchase transactions and securities/commodities financing transactions. For operational risk there are significant modifications to take account of the specific features of the investment firm sector, with an option to continue the ‘Expenditure Based Requirement’ for investment firms falling into the low-, medium- and medium/high-risk categories.
The current situation is continued where credit institutions and investment firms are subject to the same rules, subject to modifications to large exposures for trading book transactions. A new element is an amended measure of exposure for repurchase transactions and securities/commodities financing transactions. Relevant technical provisions are in Annex VI.
Enhanced requirements for the valuation of trading book positions are prescribed for prudential soundness in the context of rules designed for trading book positions to be priced on a daily basis. Relevant technical provisions are in Annex VII.
The existing option for competent authorities to waive the application of consolidated requirements for groups consisting of investment firms is continued subject to more prudentially sound conditions.
Article 34 incorporates the obligation for credit institutions (Article 17 of Directive 2000/12), for investment firms to have in place effective internal risk management systems. Given the diversity of the institutions covered, these requirements will have to be met on a proportionate basis. It also applies the requirement in Article 51A of Directive 2000/12 to investment firms to have internal processes to measure and manage the risk they are exposed to and the amount of capital (‘internal’ capital) they deem adequate to support those risks. It adds to the existing risk management requirements for investment firms in Directive 2004/39/EC.
This Article applies the rules in Directive 2000/12 mutatis mutandis to investment firms.
As for Directive 2000/12, Directive 93/6 need to keep pace with market developments. The necessary flexibility is brought by distinguishing between core and technical rules (particularly in the annexes) that will need adaptations in the short to medium run. The technical Annexes should be able to be modified following a rapid procedure. To reflect expected further important developments in regulatory practice in the coming years, a review clause is included for the treatment of counterparty risk.
ê 2000/12/EC