Regulatory Complexity and Uncertainty: The Capital Requirements Directive IV

The following post comes to us from Vincent O’Sullivan, member of the FS Regulatory Centre of Excellence, PwC, UK, and Stephen Kinsella, Lecturer in Economics at the Kemmy Business School, University of Limerick.

Regulation is the most important factor influencing strategic change at financial institutions and is the second largest threat – after economic uncertainty – to growth prospects, according to PwC’s Annual Global CEO Survey [1]. The survey, which is in its fifteenth consecutive year, canvassed CEOs at over 250 financial institutions in 42 countries late last year and provides a good barometer on market sentiment. The significance of regulation as a change driver in the financial sector has grown steadily since the recent crisis. Based on PwC’s face-to-face interviews with CEOs of some of the world’s largest financial institutions, it is clear, though, that it is not simply regulatory change, but regulatory complexity and uncertainty that are really dampening confidence in growth.

Upgrading the European Union (EU) prudential regime for banks in line with the Basel III proposals is an excellent example of both regulatory complexity and uncertainty. In July 2011, the European Commission [2] released two proposals to introduce the new regime. The bulk of the existing EU prudential regime, with the amendments necessary to introduce Basel III, is recast into a regulation – the Capital Requirements Regulation (CRR) – amongst other things to support the parallel EU goal of harmonising and deepening the internal market through a single rule book. In addition, a Directive – Capital Requirements Directive IV (CRD IV) – sets out requirements in a limited number of areas where Member State discretion is still necessary, for example in relation to corporate governance.

In an attempt to meet the target January 2013 launch date of the new regime in line with recommendations of the Basel Committee, the two EU legislators – the Council of Economic and Finance Ministers (Council) and the European Parliament– are working furiously in parallel to agree the amendments they each want to see to the Commission’s proposals.

European financial ministers (the ECOFIN Council [3]) made “huge progress” in finalising their position on the CRD IV on 2 May, according to the Danish Presidency [4]. Although full and final agreement eluded ministers during the meeting which endured through to the early hours of 3 May, clear progress was made on a number of fundamental issues, leaving only some technical details to be resolved. This paves the way for a final agreement on a text on which to begin negotiations with the European Parliament (EP) at the next ECOFIN meeting on 15 May 2012.

The EP’s Economic and Monetary Affairs (ECON) Committee has deferred its own vote until 14 May to enable further debate which, given the 2,195 amendments to the text introduced in the EP, appears warranted. In spite of these delays, the commitment of both the Council and the ECON committee to finalise the regime – in line with the Basel III deadlines – holds firm.

There are a couple of critical issues which, regardless of the outcome of the debates in ECOFIN and the ECON vote, are likely to engender ongoing discussion as the negotiations enter the next stage.

Michel Barnier [5], Internal Market and Services Commissioner, emphasised in his opening comments on 2 May that the EU is committed to a “faithful, complete and prompt” adoption of the Basel III regime. However he also reiterated that certain European specificities need to be addressed, given that the regime will be applied to all the EU’s 8,300 or some banks, arguing that this did not go against the Basel regime overall. Some ministers are worried about the nature of some of these specificities. For example, George Osborne, the UK Chancellor, is concerned about the requirements for bancassurers, seeing the possibility for banks to include holdings in insurance companies (in the same group) in own funds as watering down the regime overall.

The other key issue relates to the flexibility to be awarded to individual countries to increase capital requirements in face of emerging national or cross-border systemic risks. Ministers generally understood the need for countries whose banking industry constitutes a large proportion or multiple of GDP to have such a facility – a concept supported by the Basel Committee, the International Monetary Fund, the Financial Stability Board and the European Systemic Risk Board (ESRB) (see below) in recent months – questions remain about the level of additional capital that can be applied by national regulators without consultation with the European Banking Authority (EBA) or other national regulators, as a crucial issue is the potential knock-on effect cross-border, and the relative power of home and host country regulators in determining additional capital requirements.

Worth noting, on 2 April, the ESRB published a letter from its President Mario Draghi [6] to EU legislators which advocated the permission of “constrained discretion, with workable safeguards, for macro-prudential authorities at both Member State and Union level to tighten calibrations (while leaving definitions untouched) of commonly defined prudential requirements”.

Over and above the macro-prudential measures already embedded in the CRD IV regime, the ESRB believes that an EU macro-prudential framework should be developed which takes account of “risks from a wide range of sources: from within the financial system (given intra-system interconnections and contagion between banks, and between banks and others including nonregulated entities or ‘shadow banks’); from the system to the real economy; and from strong feedback mechanisms between the two.” The ESRB believes this framework should be constructed on three principles: flexibility, scope to act early and effectively, and efficient coordination.

According to the letter, in terms of flexibility, national and EU macro-prudential authorities should be empowered to tighten Pillar 1 calibrations temporarily, or mandate additional disclosures when the need arises. They should also have the power to be proactive, stepping in before significant imbalances or unstable interconnections can build-up. However, to ensure that such constrained discretion does not create distortions, macro-prudential authorities need to ensure efficient ex-ante coordination “to limit possible negative externalities or unintended effects for the sustainability of the single market in financial services or for the economies of other Member States.” According to the ESRB, as the EU macro-prudential overseer, it would be best placed amongst the EU institutions to orchestrate this coordination.

Further clarity on these issues will be forthcoming soon but the debate will continue. The Danish Presidency is committed to achieving political agreement on the CRD IV package before the end of its term on 30 June 2012, so we should have a much clearer picture of the way forward in a matter of weeks. But the 2,195 amendments tabled on the texts in ECON are a clear indication of the complexities involved and how ambitious this timeline may prove to be. Some fear the old adage more haste, less speed may come into play, or worse the end result may be suboptimal from both an EU and international perspective if the legislation is rushed through.

EBA starts filling in the gaps

The EU regime will reflect the transitional elements of the Basel III regime, with different rules coming into effect progressively over a five year period. However, key elements of the regime will need to be in place from the 1 January 2013 launch date. To implement CRD IV/CRR, the European Banking Authority (EBA), the pan-European banking regulator, will have to prepare over 30 regulatory technical standards and 13 implementing technical standards on the CRD IV before the regime takes effect on 1 January 2013. Further implementing measures will follow in relation to subsequent milestones in the process.

Therefore, contrary to normal practice, the EBA is already working on some important regulatory technical standards (RTS) which will underpin the regime, while recognising that they are still working with a potentially moving target. On 4 April, the EBA [7] published the first of two sets of proposals for RTS relating to own funds. These proposals cover 14 RTS; proposals for a further 7 will be issued later. The consultation period on the first set of proposals will run until 4 July, by which time, in theory, the primary text will have been finalised.

Where appropriate, EBA has built on guidelines from its predecessor, the Committee of European Banking Supervisors (CEBS) to draft some aspects of the RTS (e.g. hybrids and core capital). The EBA is planning a public hearing in June on this consultation.

The draft RTS covers the following areas:

  • Foreseeable charges or dividends: a firm is required to deduct all “reasonable” foreseeable charges and dividends from profits before it can count as eligible Common Equity Tier 1 (CET 1).
  • Other deductions from CET 1 capital and from Own Funds: the EBA presents how deductions will work against CET 1 and Own Funds for capital instruments of financial institutions and insurance/reinsurance undertakings, losses of the current financial year, deferred tax assets, defined benefits pension fund assets and foreseeable tax charges.
  • Capital instruments of mutuals, cooperative societies or similar institutions: the EBA outlines certain legal and contractual features (e.g. it must not require the applicable institution to make payments to the holder of an instrument during periods of market stress) that must be satisfied for capital instruments from other types of financial institutions to consider as CET 1.
  • Indirect funding of capital instruments: tight restrictions on the applicable forms and nature of indirect funding of capital instruments to count towards CET 1 are laid down by the EBA. To be considered as indirect funding, the investor or external entity should not be included within the scope of prudential consolidation of the applicable institution.
  • Limitations on redemption of own funds instruments: the competent authority will have power to issue further redemptions on CET 1 instruments in addition to those included in the contractual or legal provisions governing the firm.
  • General requirements: this covers provisions related to indirect holdings arising from index holdings, supervisory consent for reducing own funds, and various associated disclosure requirements to holders/supervisors. The EBA provides some further details on how the national supervisor may waive deductions from own funds during times of stress.
  • Grandfathering of own funds: the EBA outlines that reclassifying an own funds instrument grandfathered into the new regime will not affect a firm’s capital calculation.

EBA is required to submit its final draft RTS to the European Commission by 1 January 2013. However, these will only become law once the Commission has endorsed them, the Council and European Parliament have raised no objections, and the RTS are published in the Official Journal in the form of delegated acts. This “sign-off” procedure will take at least six months so time is not on the EBA’s side.

If you introduce bail-in debt, will creditors bail-out?

Consistent with the Basel III framework, all forms of Additional Tier 1 capital under CRD IV require a permanent write-down feature to enable banks to replenish themselves in times of crisis. In the RTS discussed above, the EBA indicates that the amount to be deducted should at least be equal to the amount needed to immediately return the institution’s CET 1 ratio to the desired regulatory level. The write-down must apply on a pro rata basis to all holders of Additional Tier 1 instruments and firms can only institute write-ups after meeting strict profitability conditions.

Michel Barnier [8], EU Commissioner responsible for internal market and services, provided details on the forthcoming EU crisis management and resolution framework in a speech on 2 April 2012. The framework is designed to mitigate the need for public bail-out in the future. In this regard, the possibility of forcing losses automatically on more types of creditors than is currently envisaged in CRD IV through debt write-down is one of the “central” proposals being considered by the EC, according to Barnier.

In a draft discussion paper [9] on 30 March 2012, the European Commission’s Directorate General for Internal Market and Services outlined that debt write-down tools should be designed to give resolution authorities the power to write-off all shareholder equity and either write-off all types of subordinated liabilities or convert them into equity claim. The debt write-down tools can be used both in a going concern scenario and a liquidation scenario, according to the discussion paper. The power would be exercised when an institution triggers the conditions (not yet specified) for entering into resolution.

Paul Tucker [10], Deputy Governor of the Bank of England, and the man leading the Financial Stability Board’s recovery and resolution work programme, believes that banks have “nowhere to hide” in the post crisis era and must take the necessary steps to enable them to survive stress in the future without relying on Government support. In a speech given at the Institute for Law and Finance Conference, Frankfurt 3 May 2012, Tucker believes that the intense focus on bail-in by financial institutions is “mistaken”. All resolution tools, whichever ones are chosen, place losses on to debt holders and creditors “because that is the only place they can go”. The Bail-in only differs from other tools in that it applies losses up front based upon a valuation rather than at the end when assets are liquidated. As such, it “prospectively avoids an unnecessary destruction of value”, according to Tucker.

The new EU framework will also seek to give national resolution authorities a common and effective set of measures and powers to deal with banking crises at the earliest possible stage, including:

  • preparatory and preventative measures: including requirements for firms to prepare recovery and resolution plans
  • powers to take remedial action early on in the process: such as replacing management, implementing a recovery plan or requiring a firm to divest itself of activities or business lines that pose an excessive risk to its financial soundness
  • resolution tools: such as powers to effect the takeover of a failing bank or firm by a sound institution, or to transfer all or part of its business to a temporary bridge bank.

The European Commission believes that a properly functioning resolution regime, with robust bail-in tools, could bring a number of benefits to public finances, the financial system, the entities in difficulty and the creditors themselves. The bail-in tools in particular would have minimized the impact of the current crisis on public finances, according to the Commission. The resolution regime is an essential complement of both the CRD IV prudential regime, and the macro-prudential toolbox being developed by the ESRB. It is hoped that it will enable the smooth resolution of individual banks which get into trouble without causing negative reverberations throughout the financial system, either nationally or internationally.

Raising capital

Clearly, banks are going to need to raise even more capital with the arrival of CRD IV and, in due course, the new resolution regime. Analysts have estimated that European banks must roll-over around €1.7 trillion of senior debt of more than a year’s maturity during the next two years which could leave little room to raise additional capital from new debt issuance, even without new restrictions relating to permanent write-down features making certain forms of debt less attractive to investors. So, with opportunities to raise additional capital restricted, selling assets is an alternative. Research [11] shows that European banks have already unveiled plans to slash a total of €1.2 trillion of assets this year: British and French banks taking the lead in deleveraging.

The complexities increase when taken in a global context. Despite assurances to the contrary, it is not clear when, or even if, the United States (US) will adopt the Basel III regime. The recently introduced Collins Amendment seems to be gaining little traction in the US legislature. If introduced the regime will not be applied to all US banks, just the twenty or so largest. However, US banks are being challenged by the rigours of the Volcker Rule, which is also leading to deleveraging by US and non-US banks.

The CRD IV/CRR regime will undoubtedly change banks’ funding patterns and sources of capital in the future. Raising funds from private markets in the wake of the crisis is proving both difficult and expensive. The more institutions that deleverage simultaneously, the more price pressure comes into play so being an early mover may be critical. Creditors are requiring higher margins to hold bank debt because they have increased awareness of the inherent riskiness of banks’ operations. The funding pressures on financial institutions over the next couple years are likely to continue to increase, even if we are fortunate enough to avoid further sovereign debt shocks in Europe and the global economy begins to turn the corner.

While some European stakeholders are strongly advocating close adherence to the Basel III regime, the fact that the new regime will be applied to all banks and investment firms operating in the EU throws up particular regional and national challenges and concerns. It is far from clear at this stage – with less than eight months to go – what the regime to be launched on 1 January 2013 will look like. The European Parliament has also picked up on the fact that this primarily micro-prudential regime needs appropriate linkage to wider crisis management and bank resolution requirements, but we are still waiting for the European Commission’s proposals for those initiatives. This is clearly not an optimal scenario for planning strategically, or for efficient and cost-effective implementation.

Endnotes

[1] PwC (2012) 15th Annual Global CEO Survey, London http://www.pwc.com/gx/en/ceo-survey
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[2] European Commission (2011) New proposals on capital requirements, European Commission: Brussels, http://ec.europa.eu/internal_market/bank/regcapital/index_en.htm#crd4
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[3] European Commission (2012) Revised rules on Capital Requirements (CRD IV), European Commission: Brussels, http://ec.europa.eu/commission_2010-2014/barnier/headlines/news/2012/05/20120503_en.htm
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[4] As quoted in Wall Street Journal (G. Smith, V. Mock and L. Norman), Future Bank-Capital Rules Clearer After EU Meeting, 3 May 2012, http://online.wsj.com/article/SB10001424052702303877604577382020185698622.html
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[5] Michel Barnier (2012) Statement by Commissioner Barnier (in French), European Commission, Brussels, http://europa.eu/rapid/pressReleasesAction.do?reference=MEMO/12/301&format=HTML&aged=0&language=EN&guiLanguage=en
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[6] Draghi, M. (2012) Principles for the development of a macro-prudential framework in the EU in the context of the capital requirements legislation, European Systemic Risk Board: Frankfurt, http://www.esrb.europa.eu/pub/pdf/2012-03-29_CRR-CRD_letter.pdf?dafdc180851e9f99b38d4678f4cc5c74
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[7] European Banking Authority (2012) Consultation paper on Draft Regulatory Technical Standards on Own Funds, European Banking Authority: London, http://www.eba.europa.eu/News–Communications/Year/2012/Consultation-paper-on-Draft-Regulatory-Technical-S.aspx
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[8] Barnier, M. (2012) Bank crisis resolution – Commission engages in final technical discussion with stakeholders, European Commission: Brussels, http://ec.europa.eu/commission_2010-2014/barnier/docs/speeches/20120330/statement_en.pdf
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[9] European Commission (2012) Discussion paper on the debt write-down tool –bail-in, DG Internal Market Working Paper, European Commission: Brussels, http://ec.europa.eu/internal_market/bank/docs/crisis-management/discussion_paper_bail_in_en.pdf
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[10] Paul Tucker (2012), “Resolution: a progress report”, Speech given at the Institute for Law and Finance Conference, Frankfurt 3 May 2012, http://www.bis.org/review/r120507b.pdf
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[11] O’Sullivan, V. and S. Kinsella (2011) 2012: the year of deleveraging in Europe?, Financial Regulation International, 15 (1) pp 1-6, http://www.i-law.com/ilaw/doc/view.htm?id=280280
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4 Trackbacks

  1. […] and I write on this topic, applied to the case of the Capital Requirments Directive IV, on the Harvard Law School Forum on Corporate Governance and Financial Regulation here. A related talk I gave at the IIEA is […]

  2. By Regulatory Complexity and Uncertainty | Stephen Kinsella on Sunday, May 20, 2012 at 6:05 pm

    […] and I write on this topic, applied to the case of the Capital Requirments Directive IV, on the Harvard Law School Forum on Corporate Governance and Financial Regulation here. A related talk I gave at the IIEA is here. This entry was posted in Rants by Stephen. Bookmark […]

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  4. By Regulatory Complexity and Uncertainty | Vincent O'Sullivan on Thursday, May 24, 2012 at 12:40 pm

    […] and I write on this topic, applied to the case of the Capital Requirments Directive IV, on the Harvard Law School Forum on Corporate Governance and Financial Regulation here. A related talk that Stephen gave at the IIEA […]

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