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Brussels, 14th July 2004
European Commission proposal for a new capital requirements framework for banks and investment firms - frequently asked questions
(see also IP/04/899)
What is the purpose of EU capital requirements rules?
Capital requirements rules stipulate the minimum amounts of own financial resources that credit institutions and investment firms must have in order to cover the risks to which they are exposed. The aim is to ensure the financial soundness of these institutions – in particular to ensure that they can weather difficult periods. This is aimed at protecting depositors and clients and the stability of the financial system. In the EU harmonised capital requirements are a key component in the single market in financial services: mutual recognition of requirements is the basis for banks’ and investment firms’ “single market passport”, which basically means that they can operate throughout the EU on the basis of approval by the appropriate regulatory authority in their own Member State.
What is new about this proposal (as compared with the existing legislation)?
Capital requirements would become much more risk-sensitive. They would be far less crude than in the past and better cover the real risks run by the institution. This would enhance consumer protection and financial stability and lead to more efficient capital allocation.
Capital requirements would be more comprehensive than in the past. In particular they would be expanded to cover ‘operational risk’ (such as the risk of systems breaking down or people doing the wrong things). This is an increasingly important risk for financial institutions.
The new rules would comprise a new ‘supervisory review process’ (the so-called ‘Pillar 2’). This part of the framework would require financial institutions to have their own internal processes to assess their capital needs and call for supervisors to evaluate institutions’ overall risk profile to ensure that they hold adequate capital.
The new rules would also require credit institutions to disclose certain information publicly in order to increase the levels of ‘market discipline’ supporting the soundness and stability of financial institutions (the so-called ‘Pillar 3’).
Finally, the new framework would enhance the role of the ‘consolidating supervisor’ responsible for the top-level of supervision of an EU cross-border group – i.e. the national supervisory authority in the Member State where the group’s parent institution is authorised.
This role would now include new responsibility and powers in coordinating the supervision of cross-border financial services groups. This would include coordinating the treatment of an application by such a group for approval to use the more sophisticated capital calculation rules made available by the proposed Directive.
All supervisors concerned in such an application should reach an agreed decision on the application within six months. In the case of failure to do so, the consolidating supervisor would be empowered to make a decision.
What is the ‘Standardised Approach’?
This approach is similar to the existing rules, in that it is straightforward to use and does not require institutions to provide their own estimates of risks. It nonetheless incorporates enhanced risk-sensitivity by permitting the use of, for example, external ratings of rating agencies and export credit agencies. It also permits the recognition of a considerably expanded range of collateral, guarantees and other ‘risk mitigants’. It includes reduced capital charges for retail lending (6% as compared with 8% previously) and residential mortgage lending (2.8% as compared with 4% previously).
What is the ‘Internal Ratings Based (IRB) Approach’?
A significant step forward in prudential regulation, it allows institutions to provide their own ‘risk inputs’ – probability of default, loss estimates, etc – in the calculation of capital requirements. The calculation of these inputs is subject to a strict set of operational requirements to ensure that they are robust and reliable. They are incorporated into a ‘capital requirement formula’ which produces a capital charge for each loan or other exposure that the institution makes. The formula is designed to achieve a high level of soundness of the institution in the event of economic difficulties.
The IRB approach comes in two modes. The ‘Advanced’ mode allows institutions to use their own estimates of all relevant risk inputs. This approach is likely to be chosen by the biggest and most sophisticated institutions. The ‘Foundation Approach’ requires institutions only to provide the ‘probability of default’ risk input. This will enable a large number of less complex banks to reap the benefits of the risk-sensitivity provided by the IRB approach.
What is operational risk?
Operational risk is the risk that financial institutions suffer losses due to problems with their systems or processes or due to human error or as a result of external events. This is an important area of risk for financial institutions. The proposals introduce capital requirements to ensure that institutions are resilient to such risks.
In the proposal, three methods of calculating the capital requirements for such risks are made available ranging from the very simple based on a percentage of total gross income, through an intermediate approach which requires activities to be ascribed to eight different business lines, to an advanced approach which relies on institutions own calculations of operational risk.
Who will be covered by the new rules?
The new framework would – like the current rules – apply to all banks (or ‘credit institutions’) and investment firms in the EU.
How would investment firms be affected by the proposals?
The EU Single Market in financial services requires that the same activities giving rise to the same risks should be subject to the same capital charge.
However, the new framework recognises that the situation of certain investment firms is different to that of banks. Accordingly, investment firms which do not undertake the activities of dealing in securities on their own account, or underwriting the issue of securities, as a central activity, would be permitted to continue to use the existing ‘expenditure-based capital requirement’ instead of the specific operational risk requirement.
The treatment of ‘trading book’ exposures is an important aspect for investment firms. There is further work being undertaken on this area which is expected to come on stream relatively quickly.
How does the proposal benefit small-and-medium size enterprises (SMEs)?
Capital requirements are one of the factors that can affect the availability and cost of lending to (and other forms of financing of) SMEs.
The risk-sensitivity of the new framework means that it is possible to reflect the fact that it is less risky to have a large number of small loans than a small number of large loans. This results in lower capital requirements for lending to SMEs.
The proposal also recognises that for certain forms of equity financing
(venture capital) carried out as part of a sufficiently diversified portfolio
the risks are lower than in the case of individual equity exposures. Accordingly
a preferential capital charge is provided for this kind of financing.
What is the implementation date for the proposed Directive?
The implementation date is scheduled for the end of 2006. In order to allow reasonable transition arrangements, institutions would be able to continue to use the existing rules as an alternative until the end of 2007. Similarly, in order to allow sufficient time for the bringing on stream of the most sophisticated approaches while maintaining the Internal Market level playing field, the advanced approaches to credit risk and operational risk would be available at the end of 2007.
How will it be ensured that the implementation of the new framework does not give rise to differences between countries and to difficulties for cross-border groups?
The new framework incorporating harmonised state-of-the-art prudential rules means that the opportunities for regulatory arbitrage would be very significantly reduced. This would have significant beneficial effects in enhancing the level playing field within the Single Market.
The proposed Directive incorporates important requirements for supervisory authorities to work together so as to ensure an efficient and proportionate regulatory environment for cross-border groups. The Directive would also oblige supervisors themselves to publicly disclose how they implement and apply its rules in practice.
Another key example of this is that cross-border groups would only have to make one application for approval of their internal rating systems and/or models for all of the entities within the group.
This application should be channelled through the ‘consolidating supervisor’ – the supervisory authority responsible for the top-level of supervision of an EU cross-border group. The application should be determined jointly by the supervisory authorities concerned. But if they fail to reach a decision within six months, the consolidating supervisor would be empowered to make the decision.
The new Committee of European Banking Supervisors (CEBS) – recently established by a Commission decision – will have an important role to play in ensuring consistency and convergence in the application of the new framework. Such a role forms a key part of its mandate and of the reason for its establishment.
What is the Basel Committee?
The Basel Committee on Banking Supervision (‘the Basel Committee’) consists of central bank and supervisory authority representatives from the thirteen ‘G10’ countries. Nine EU Member States are represented – Belgium, France, Germany, Italy, Luxembourg, the Netherlands, Spain, Sweden, and the UK. The other countries represented are Canada, Japan, Switzerland and the US.
The European Commission, along with the European Central Bank, participates as an observer in the Committee itself and in its many working groups.
What is the Basel Accord?
The ‘Basel Accord’ is an agreement on capital requirements amongst the members of the Basel Committee. ‘Basel 1’ was agreed in 1988.
Although strictly speaking it only applies to internationally active banks in the G10, the Accord has been applied to most banks in 100 countries throughout the world.
While it has made a significant contribution to financial stability and consumer protection, Basel 1 is now viewed as outdated. Accordingly since 1998 an intensive exercise has been underway to revise the Accord (‘Basel 2) and, in parallel, the EU capital requirements legislation.
What is the link between the Basel Accord and EU legislation?
The existing European legislation (originally the Solvency Ratio Directive of 1989 – now incorporated in the Codified Banking Directive of 2000) was based on the Basel 1 Accord. It applies to all banks and investment firms in the EU.
In order to maximise consistency between the EU legislation and the international framework, the European Commission and EU members of the Basel Committee have had as a primary objective ensuring the suitability of Basel 2 for application in the EU Single Market.
Accordingly, the new Basel agreement represents the appropriate basis for the proposed EU Directive on a new capital requirements framework. At the same time the EU legislative proposal has been designed to fully reflect the specific features of the European context – in particular its application to the full range of financial institutions including banks of all sizes and levels of complexity and investment firms.
Examples of such “EU adaptations” in the proposed Directive include: