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Brussels, 13 July 2009
Capital Requirements Directive - Frequently Asked Questions
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.
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.
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.
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.