It has been nearly four years since the implementation of CRR/CRD IV which cover prudential rules for banks, building societies and investment firms with the main aim of reducing the likelihood that these financial institutions will become insolvent. To an extent, this reflects the Basel III rules on capital measurement and capital standards which is set to be fully phased-in by 2019.
The EU banking sector is now set to face new rules – the proposals were published last November by the European Commission (EC) – which implement some of the key elements of the Basel III rules. The proposal introduces the Net Stable Funding Ratio (NSFR) and the Leverage Ratio as binding requirements for EU banks as well as the Financial Stability Board’s (FSB) Total Loss Absorbing Capacity (TLAC) requirement for Global Systemically Important Banks (G-SIBs) which is the FSB’s plan to end the “too big to fail.”
CRR /CRD IV and Basel III
There is a strong overlap between the EU’s proposals on CRR/CRD IV and the rules set out under Basel III. This is primarily because, after the G20 summit in April 2009, the European Commission developed the rules to strengthen the regulations of the banking sector using Basel III as a basis. As such, many of the initiatives that are in force under CRR/CRD IV are a direct reflection of Basel III rules. For example, under Basel III the NSFR (which requires banks to maintain a stable funding profile in relation to the composition of their assets) limits financial institutions’ overreliance on short term wholesale funding, which would otherwise threaten the liquidity of a bank and potentially lead to broader systematic stress. Similarly, under CRR/CRD IV the NSFR is improving funding profiles and establishing a harmonised standard for how much stable, long term sources of funding an institution needs to weather a period of market and funding stress. Another similarity is the minimum leverage ratio. The European Commission has proposed a 3% leverage ratio as a harmonised binding minimum requirement on Member States. Under Basel III, the established minimum requirement is also 3%, however, this threshold is increased for G-SIBs. The EC’s proposal to implement the Financial Stability Board’s total loss absorbing capacity, which is designed to provide home and host authorities with confidence that G-SIBs can be resolved in an orderly manner without putting public funds at risk, is an important key feature of the proposals set by the EC as, during the financial crisis of 2007-08, there was a lot controversy around financial institutions who were deemed as ‘too big to fail’. The similarities between Basel III and CRR II/CRD V convey the EC’s priority to ensure a harmonised financial framework is implemented throughout the EU.
From CRR/CRD IV to CRRII/CRD V: what are the differences?
So far, we have discussed the similarities between CRR II/CRD V and the current Basel III framework. But what are the differences between the current European framework under CRR/CRD IV and the proposed framework which is due to be implemented in early January 2019? Firstly, the key areas under the current framework and proposed framework differ greatly. When CRD IV was implemented on 1 January 2014, the main key areas were:
- Leverage requirements
- Rules for counterparty risk
- Macroprudential standards, such as the counter cynical buffer and systematically high-risk institutions.
The key developments under the proposed framework are much broader and, in some ways, more specific to the EU in terms of the areas the legislation intends to affect, for example the proposals introduce:
- A fundamental review of the trading book (FRTB)
- A new standardised approach for counterparty credit risk
- A binding net stable funding ratio
- A binding leverage ratio
- Standards on the total loss absorbing capacity
- Increased proportionality of EU rules
- Promotion of investment in the economy through encouraging SME lending and infrastructure.
This is because there have been significant amendments to the legislation some of which are not based on the Basel committee standards. In March 2016, the European Parliament produced a report on the existing framework and it was found that, under the current legislation, the increase in capital requirements beyond a certain threshold may limit the ability of small and medium sized enterprises to lend efficiently. As a result, the new framework will only apply to systematically important investment firms, whilst the current framework applies to banks and all MiFID firms. Additions to the legislation also include new financial holding companies’ authorisation requirements, which will require non-EU based banks that operate more than one subsidiary in the EU to form a new Intermediate Holding Company and seek a banking licence within the EU. The rationale of this is to facilitate the implementation of the new TLAC standard for non-EU G-SIBs and to also simplify the resolution process of third country financial institutions that operate within the EU. This means that third country groups, which historically could escape or mitigate the scope of EU consolidated supervision, may in future have to comply with EU wide prudential rules.
So, what are the aims of CRR II/CRD V?
It is argued that CRR II/CRD V will allow financial institutions to efficiently address long term funding risk and reduce excessive leverage. It will help financial institutions effectively address market risk by increasing the risk sensitivity of existing rules and enhancing the proportionality of the prudential framework for institutions. For example, banks with medium sized activities, who are currently subject to the market risk capital requirements, may, under the new framework, use a simplified standardised approach such as exemptions to the fundamental review of the trading book and a simplified approach for measuring counterparty credit risk. There are also rumours that the EC intends to deliver separate proposals for non-systematic investment firms. The proposal is also set to increase the loss absorption and recapitalisation capacity of G-SIBs and increase legal certainty amongst Member States in insolvency law and restructuring proceedings, in particularly around creditor hierarchy. Thus, it is viewed that the current legislative framework does not comprehensively tackle all the problems that were presented during and in the aftermath of the crisis and, as such, the EC believes that the proposals will further strengthen the resilience of the European banking system and restore market confidence – whilst protecting and enhancing competition between financial institutions operating within the EU.
Overall, CRR II/CRD V arguably give banks greater clarity over the future shape of capital regulation. The commission has clarified that it wants to minimise the impact of capital requirements on the real economy. It will be fascinating to see how the new proposals will impact the shape of the European financial system, especially in the UK post Brexit. In the meantime, it is important to note that the implementation date for the measures is 2019 and the main priority for firms at this point is to engage with the present legislative process and start their preparations for implementation now.
JWG will be following the development of CRRII/CRD V and will publish further articles when additional information is released. To receive these updates and all the latest financial regulation, you can subscribe to our newsletter and follow us on Twitter and LinkedIn.