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CRD III (Capital
Requirements Directive III)
From the
Basel ii Compliance Professionals Association
(BCPA)
the largest
association of Basel ii Professionals in the world
The
CRD III covers
amendments addressing capital requirements for the trading book
and re-securitisation, disclosure of securitisation exposures, and
remuneration policies.
It introduces a number of changes that in the wake of the
financial crisis warrant special attention.
CRD III is still being
negotiated.
It is expected to cover the following issues:
-
Changes to the internal models in the trading book, as well as
some technical changes
-
Stressed VaR
-
Incremental risk charge
- Changes to the
weights for
securitisation exposures in the trading book and the banking book
- Introduction of
remuneration principles.
The European Commission has put forward a further revision of
EU rules on capital requirements for banks that is designed to
tighten up the way in which banks assess the risks connected with
their trading book; impose higher capital requirements for
re-securitisations; increase market confidence through stronger
disclosure requirements for securitisation exposures; and require
banks to have sound remuneration practices that do not encourage
or reward excessive risk-taking.
Under the new rules, banks will
be restricted in their investments in highly complex
re-securitisations if they cannot demonstrate that they have fully
understood the risks involved, while national supervisory
authorities will review banks' remuneration policies and have the
power to impose sanctions if the policies do not meet the new
requirements.
The proposal, which amends the existing Capital
Requirements Directives, represents part of the EU's response to
the financial crisis, and reflects consultation with Member
States, banking supervisors and industry. It now passes to the
European Parliament and the Council of Ministers for
consideration.
Commission President José Manuel Barroso
declared:
These proposals address risks linked to two major
causes of the current crisis, securitisation and remuneration. We
are acting ambitiously to prevent lightning striking twice.
The
proposals aim to ensure that banks hold enough capital to reflect
the true risks they are taking.
In particular, banks will have to
offset risks associated with highly complex resecuritisation
products and deal with perverse incentives created by pay and
bonus schemes.
We will legally oblige banks and investment firms
to have remuneration policies consistent with effective risk
management. Supervisors will be given the powers to take measures,
including increased capital requirements, to address any failures.
I am calling on Member States and the European Parliament to back
these proposals and on other jurisdictions to act on similar
lines, in line with the common commitments made at the G20.
Internal Market and Services Commissioner Charlie McCreevy
said:
These new rules target some of
the investments and practices that lie at the root of the
financial crisis.
New rules on
re-securitisations – the highly
complex financial products that caused huge losses for banks –
will require banks to hold significantly
more capital to cover their risks when investing in these
products, while the additional disclosure rules will help to
create a climate of market confidence.
The requirements on pay and
bonuses are designed to put an end to the culture of excessive
risk-taking for short-term success at the expense of long-term
profitability and sound risk management.
This package of amendments will
strengthen the risk management, transparency and sound investment
practices that are key to a healthy and stable banking system.
Capital requirements for re-securitisations
Re-securitisations are complex financial products that have
played a role in the development of the financial crisis. In
certain circumstances, banks that hold them can be exposed to
considerable losses.
The proposal will impose higher capital
requirements for re-securitisations, to make sure that banks take
proper account of the risks of investing in such complex financial
products.
Disclosure of securitisation exposures
Proper disclosure of the level of risks to which banks are exposed
is necessary for market confidence.
The new rules will tighten up
disclosure requirements to increase the market confidence that is
necessary to encourage banks to start lending to each other again.
Capital requirements for the trading book
The trading
book consists of all the financial instruments that a bank holds
with the intention of re-selling them in the short term, or in
order to hedge other instruments in the trading book.
The proposal
will change the way that banks assess the risks connected with
their trading books to ensure that they fully reflect the
potential losses from adverse market movements in the kind of
stressed conditions that have been experienced recently.
Remuneration policies and practices within banks
The
proposal will tackle perverse pay incentives by requiring banks
and investment firms to have sound remuneration policies that do
not encourage or reward excessive risk-taking.
Banking supervisors
will be given the power to sanction banks with remuneration
policies that do not comply with the new requirements.
Frequently Asked
Questions
GENERAL
The
proposals to change the banking rules may be useful for
strengthening market confidence and the ability of banks to
withstand losses.
However, the proposed measures will only come
into effect in about two year's time - too late to address the
current financial crisis
The legislative process set down
in the Treaty is such that it is not possible for the Commission's
proposals to solve the crisis.
The proposals are intended to
strengthen the framework for the future. In terms of immediate
reaction, the ECB and Member States responded promptly by
addressing problems of liquidity or solvency, and they are
continuing to do so.
For the medium term, the Commission will
continue to strengthen the regulatory framework to prevent the
recurrence of such crises.
TRADING BOOK
Now that
banks capital requirements have responded to the increased
volatility and correlation in capital markets, why are additional
capital requirements based on stress conditions required?
Banks should be adequately capitalised for stressed market
conditions even in a more benign environment.
If they start
adjusting their capital levels only once they enter into a
stressed environment, it is likely that they will be forced to
liquidate positions in order to reduce risk, possibly further
aggravating the market stress.
Why is there a need to hold
additional capital for credit risk in the trading book, if the
main concern in relation to the trading book is short term price
movements?
Over the past decade, there has been a tendency
for banks to trade more in credit risk, in contrast to the
previous position where the risks associated with the trading book
where more equity and default free interest rate risks.
This trend
was already recognised in 2006, when the CRD required banks to
phase in a new capital charge for default risk in the trading
book, calibrated at a standard of soundness similar to the one
that applied to the banking book.
However, it became apparent that
banks may lose significant amounts simply if a debt instrument in
the trading book deteriorates in credit quality, short of actual
default.
At the same time, the ability of banks to liquidate these
instruments may be compromised when markets are stressed – as is
likely to be the case at times when the credit risk is highest.
Accordingly, this proposal would require banks to hold capital for
credit related losses short of an instrument's default, taking
into account medium-term price movements in view of an impaired
market liquidity for such instruments.
RE-SECURITISATIONS
Rating agencies have downgraded huge outstanding amounts of
structured products, including many re-securitisation positions.
This has led to much higher capital requirements already. Why is
there a need to raise capital requirements even further?
The credit ratings assigned by credit rating agencies reflect the
expected default frequency of an instrument, treating the
instrument in isolation and not in the context of a portfolio.
Bank capital requirements however aim at capturing the
contribution that an instrument makes to worst-case scenario
losses (i.e. given a high confidence level) in a bank's well
diversified portfolio of credit risks.
In this context, the
potential contribution of a re-securitisation of several
underlying securitisations to a bank's loss would be higher than
that of a normal securitisation, even if both have the same
expected default frequency.
REMUNERATION POLICIES
What categories of financial institutions and staff are covered by
the proposed rules in the CRD?
The new rules will apply to
all EU credit institutions and investment firms.
However, they
cover only staff whose activities have material impact on the risk
profile of the financial institution.
This is intended to target
the rules effectively at remuneration structures that have are
most likely to have an impact on the management of risk within the
institution.
One of the main problems identified was that
remuneration policies in the banking sector were not sufficiently
aligned with the risk tolerance of the financial institutions.
Bonus structures induced excessive economic and financial
risk-taking not only by executives and senior management, but also
by individuals engaged in activities such as sales and trading.
It
is therefore important that the new rules should focus on the
remuneration of those staff members who perform activities which
have a material impact on the risk profile of the financial
institution.
Applying the same principles to staff whose functions
do not have any impact on the risk profile of the financial
institution is not necessary in order to achieve the objective and
could result in an unjustified administrative burden for financial
institutions.
It has been suggested that regulators
can
impose 'capital add-ons' where the remuneration policies of an
institution fail to comply with the new rules. An imposition of
additional own funds seems an excessive and unduly punitive way of
dealing with risk arising from remuneration structures.
Capital add-ons are only one of the measures available to
supervisors to address problems identified in the course of the
supervisory review, and we recognise that a requirement for
additional own funds is likely to a last resort, used in the more
extreme cases.
Supervisors also have other measures at their
disposal under the CRD, such as requiring the institution to
reduce the risk inherent in particular systems. In addition, they
may impose sanctions such as fines.
The intention is that
supervisors should have at their disposal a range of measures to
address any problems that they might identify in the course of
their supervisory review.
Will these initiatives lead to
higher fixed component of remuneration?
The proposed
principles on sound remuneration in the CRD simply recommend that
there should be an appropriate balance between fixed pay and
bonuses.
It is true that employment contracts are likely to be
renegotiated and that the fixed component awarded could be higher.
However, a high fixed component should reduce excessive
risk-taking by removing perverse incentives for individual to
increase his or her total remuneration by boosting short-term
financial results.
Furthermore, the Recommendations do not
prohibit bonuses.
There has been a lot of public concern
about the level of severance pay and 'rewards for failure'. How
does the proposal address this?
One of the principles for
sound remuneration to be included the CRD states that payments
related to the early termination of a contract should reflect
performance achieved over time, and should be designed in a way
that does not reward failure.
This is intended to prevent
excessive awards of severance pay where it is not justified by
performance. Policies that permit such awards may encourage
excessive risk-taking.
Supervisors will examine the terms in
remuneration policies governing severance pay, and may take
measures where those terms are not consistent with sound and
effective risk management.
Is there a risk that binding
requirements on remuneration policies may interfere with
contractual freedoms and with collective agreements and labour law
in Member States?
The scope of the new provisions of the
CRD will – like the Recommendation – be restricted to the
remuneration structures for staff whose activities have a material
impact on the risk profile of the bank or investment firm – this
is likely to include directors, senior management and traders.
This means that the requirements will not cover more junior staff
and those who do not commit the firm's capital.
These latter staff
are more likely to be covered by collective agreements.
Moreover, the amendments are not intended to prescribe the amount
and form of remuneration, and institutions remain responsible for
the design and application of their particular remuneration
policy.
Firms have flexibility as to how the principles are
applied in a way that is appropriate to their size, internal
organisation and the nature, scope and complexity of their
activities, provided that they can demonstrate that the required
outcomes are achieved. Freedom of contract should not, therefore,
be inappropriately restricted.
How do the new rules on
remuneration relate to the Recommendation on remuneration policies
in the financial services sector that was adopted by the
Commission in April, and to the principles on remuneration
policies published by the Committee of Banking Supervisors
('CEBS')?
The proposed new rules on remuneration policies
in the CRD will complement the Recommendation and give teeth to
the Commission's policy on remuneration.
The principles on sound
remuneration policies proposed for the CRD are entirely consistent
with those in the Commission Recommendation and those elaborated
by CEBS.
The proposal will introduce a binding obligation
for banks and investment firms to have in place remuneration
policies that are consistent with and promote sound and effective
risk management.
Those policies will be subject to the supervisory
review carried out by regulators, who have at their disposal a
range of measures to ensure that financial institutions comply
with this requirement.
In this context, the principles set
out in the Recommendation and those elaborated by CEBS will be
highly relevant.
They will provide guidance to financial
institutions as to how this binding obligation could be met, and a
framework for supervisors when assessing firms' remuneration
structures.
In addition, the proposal requires CEBS to
maintain its principles, so that they will be updated where
necessary to ensure that evolving remuneration practices are
consistent with the rules in the CRD.
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