CRD IV and Basel III: The Story so Far

The fourth Capital Requirements Directive (CRD IV) in Europe and the associated Capital Requirements Regulation (CRR) promise to completely change the regulatory landscape in the European financial sector. These are the legal and regulatory instruments that will finally bring into force the Basel III accord, which itself is a far reaching package of measures developed in direct response to the 2008 financial crisis. Basel III itself has of course since been delayed and the Liquidity Coverage Ratio (LCR) stipulations have been changed. 

As Arnold Bennett (1867-1931), the English novelist said, however, ‘any change, even for the better, is always accompanied by drawbacks and discomforts’ and this can certainly expect to be the case for the CRDIV/Basel III implementation procedure. 

CRD IV will deliver Basel III to the European Union (EU). Legislators also have the opportunity to add items that were not in the original Basel III accord, inserting European ‘tweaks’. In addition, the introduction of CRD IV/CRR has been used to further European harmonisation and create a single rule book for prudential regulation; the regulation has wider aims than just Basel III implementation. In effect this means there is much much more to CRD IV than just a ‘how to’ guide to implementing Basel III. First, I’d like to look at the policy items that are included as part of CRD IV. 

The amount of capital required to be held will be increased in terms of quality of capital, with common equity being required to make up at least 4.5% of a firm’s risk weighted assets (RWAs). In addition deductions to capital will be made directly against equity capital, and the number of items that must now be deducted from capital has increased. Additionally, there are more items to which capital will be charged. For example, credit exposures to clearing houses will be charged in a way not previously seen before, impacting banks and other players on the financial markets which will ultimately impact corporate treasurers and others who rely on them for hedging. We also have seen a reduction in the number of capital exemptions that will apply under CRD IV. Firms will find for instance that the treatment of intercompany exposures is less generous than under previous regimes. Further, higher risk weights will be charged for certain exposures. The overall impact of this will be to force many to significantly increase the value of the risk weighted assets (RWAs) used to conduct business, and so further increase the capital requirement. 

CRD IV: OTC and CCP changes

CRD IV introduces charges for central counterparties (CCPs); it also encourages financial market participants to use CCPs in the clearance of most over-the-counter (OTC) derivative classes, in accordance with the G20’s wishes after the 2008 financial crash to effectively force OTC trading and hedging ‘on exchange’ in future to increase transparency and enable trades to be unwound more easily in future – avoiding the fiasco of trying to sort out Lehman Brothers’ trades after the firm collapsed. From this spring onwards, firms will now have incentives to clear OTC derivatives via CCPs in the form of reduced capital charges. There are also margining requirements that are applied against OTC derivatives, forcing these instruments to have cash flow characteristics that resemble its exchange traded counterpart more. 

Capital buffers have been introduced with the capital conservation buffer, and the countercyclical buffer. The capital conservation buffer is set at 2.5% of a firm’s RWAs. This buffer is in addition to the 8% minimum capital amount – larger for bigger systemically important financial institutions (SIFIs) – and may be used, with the permission of the appropriate regulator, in times of financial stress. However the use of this buffer will result in restrictions on the amounts of dividends and bonuses that can be paid. 

The countercyclical buffer differs from the capital buffer in that it is to be varied by jurisdiction. It is a variable requirement that can normally range between 0 and 2.5%. The purpose of this buffer is to allow the authorities in each jurisdiction to change capital levels in response to their individual credit cycles and conditions. In other words, regional authorities will be able to raise capital levels as the pace of lending in their economy rises. Conversely if the pace of lending falls authorities will be able to lower the countercyclical buffer requirement. 

Systemic Risk

Uniquely as part of CRD IV there will also be a third buffer, a systemic risk buffer. This will be under the discretion of each country jurisdiction, although the EU will set the ground rules for Europe, and it will be allowed to rise in excess of 2.5%. This buffer has been put in place to allow authorities to cater for systemic issues of capital that are not related to the credit cycle. This buffer may, for example, be used to implement the ring fencing requirements raised in some EU countries, such as the UK, where investment and retail bank operations are being placed behind ‘chinese walls’. 

CRD IV will also include the measure to bring the Basel III liquidity regime into force, including the LCR in a reduced form at the end of 2015 after the delay and the Net Stable Funding Ratio (NSFR) in 2018/9. Firms will need to hold amounts of highly quality liquid assets required to ensure cash flow over 30 days while under liquidity stress. They will also be required to ensure that one year stable cash inflows will adequately cover expected cash outflows. These and other requirements bring liquidity to a level comparable to capital in terms of importance of the prudential health of a firm. 

From 2019, Basel III and CRD IV will also bring a 3% leverage ratio into force, meaning that Tier 1 capital will not be allowed to be less than 3% of on-balance RWAs. Unlike other Basel III calculations on-balance sheet loans and deposits will not be allowed to be netted. This will introduce a third prudential metric that banking firms will have to adhere to. It will be logical in future for financial firms to forego business opportunities because they dislike the potential impact on its liquidity or leverage, despite having adequate capital. The consequences for corporate treasurers seeking bank funding will be profound, with smaller players likely to struggle still further and large corporations becoming even more attractive. 

European v Country-specific Requirements

As alluded to previously CRD IV/CRR significance is not only related to the policy initiatives being introduced. Previously the CRD was implemented by requiring national authorities to incorporate the CRD in their national rule book. Interpretations of what was meant or required by any part of the directive were also under the auspices of the national authorities. The CRR, however, introduced to the 27 member states of the EU a single rule book, with interpretation being the responsibility of the European Banking Authority (EBA). There is also a single reporting mechanism in the form of Common Reporting (COREP) and Financial Reporting (FINREP) stipulations, and a common data point model for delivery of information to the EBA, although this latter requirement will be done through the national authorities. This should not be interpreted as all prudential reporting being the same across Europe. Where there is information required by the national authority, but not included in the COREP/FINREP reporting, the national regulators will be able to request the reporting information. 

Another issue that has been resolved is that the CRD IV/CRR represents a ‘minimum’ standard throughout the EU – not an ‘absolute’ standard. As such the rule book is written in a form that will allow national supervisors to request more strenuous capital, liquidity and leverage terms if required. 

European governing bodies have taken the creation of a single rule plus overall public concern regarding the financial sector and the impact of the 2008 crisis to include measures that were not already included in the Basel III accord. These include an EU cap on banker bonus payments to be no greater than 200% of salary, an agreement that banks will publish details of profits, taxes and subsidies received by operating jurisdiction, and the inclusion of an additional capital charge for SIFIs. These measures will add to the reporting requirements on EU banks, as well as change the remuneration structures. More importantly, for treasurers it may cause banks to seek to increase salaries and find the profits to fund them from elsewhere. The separate capital adequacy Basel III rules under the CRD IV are already likely to squeeze bank lending for corporate treasurers. 

Conclusion

One ought not to forget however that the CRD IV has not yet been finalised. All the above is the results of agreements and pronouncements to date between European governments via the European Council (EC), the European Parliament (EP), and the European Commission (EC). The fact is that CRD IV should have been already been agreed last year and implemented from 1 January 2013. Like Basel III, it too has been delayed therefore, with the delayed start dates likely to impact concluding dates too. As a result Europe has not met its G20 obligations. At present the official websites indicate that CRD IV will be finally considered and adopted in April 2013, this date has however moved from October 2012 to March and now to April 2013, with other dates also being discussed, so there is no certainty. One regulator has indicated that CRD IV/CRR will probably come into effect on 1 January 2014, and of course certain elements – such as Basel III – will be on-going anyway. This 2014 start date would appear to be a solid date, but CRD IV has been dogged by delay after delay so it’s best to keep checking. 

Overall observers cannot be completely certain of what the final CRD IV package will be although the industry has a very good idea. What is clear, however, is that financial firms are not likely to have the requisite amount of implementation time. 

The financial industry has been considering the impact of Basel III measures on their business for some time. CRD III had already forced firms to make some adjustments and many of the changes had been flagged long in advance. However, there is a big difference between planning and considering change and effectively implementing it. The likelihood is that all firms will be calling on the same skills and resource, both internal and external at around the same time in order to effectively implement it; perhaps causing a ‘resource crunch’. This will mean that firms have to now consider the impact of what is known and make as many preparations as humanly possible. 

 

 

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