Basel 3 changes in EU: CRD4

New update 26/10/2011

This page contains information on the following:

Introduction

On 20 July 2011, the European Commission published the CRD IV Proposal, its implementation of the Basel 3 changes discussed internationally. The proposals are designed to strengthen and stabilise the banking and wider financial systems.

CRD IV consists of a Regulation (CRR), establishing the prudential requirements for individual institutions, and a Directive (CRD), governing the access to deposit taking activities. The CRR and CRD are complimentary and together establish the new banking regulatory framework that will eventually replace the existing Capital Requirements Directives.

While Member States will have to transpose the Directive into national law as per usual procedures, the Regulation is directly applicable in Member States with no need for transposition. By using a Regulation, the Commission aims to remove major divergences in national interpretation of the text and speed up the implementation process.

The Commission has framed its proposal with a view to allowing a degree of flexibility in the transposition of the Basel 3 Agreement into EU Legislation. Many of the technical details have yet to be defined, with, as expected the European Banking Authority (EBA) being granted a key role in developing technical standards and parameters. This creates potential new risks for mortgage lenders as CRD IV is implemented by national authorities.

In some areas, the Commission appears to have toughened its position compared to earlier unofficial drafts, as for example, the February version which gave the impression that there was a possibility to avoid the Leverage Ratio being migrated to Pillar I. However, in the July Proposal, the eventual migration of the Leverage Ratio to Pillar I appears to be a semi-automatic measure.

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Timetable

The Commission’s CRD IV Proposal will now be passed to the European Parliament (EP) and to the Council for debate and, eventually, adoption. The Commission's aim is to see the final CRD IV Proposal being applicable as of 1 January 2013.

At this stage, it is difficult to estimate the time the EP and the Council will need to review and agree upon a final text, but the second half of 2012 is a best estimate.

The EP is understood to have prioritised the CRD IV Proposal. In the EP Economic and Monetary Affairs (ECON) Committee, the Rapporteur is Othmar Karas, MEP (EPP, Austria) and the Shadow Rapporteurs are Sharon Bowles, MEP (ALDE, UK); Vicky Ford, MEP (ECR, UK); Philippe Lamberts, MEP (Greens, BE); and Udo Bullmann, MEP (S&D, DE).

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Summary of key issues

Mortgage risk weights

In the standardised approach, there is a national discretion to increase (but not to lower) the 35% RW for residential mortgages. Competent authorities must assess the appropriateness of the mortgage RWs at least annually, based on default experience and on a forward looking review of the property market. EBA will co-ordinate these assessments, establish conditions and criteria for the reviews and publish revised RWs. Following a review, RWs can be increased or stricter criteria for eligibility for the mortgage RWs can be introduced (Articles 119-121).

The borrower’s ability to service their mortgage must not depend on the performance of the underlying property (i.e. the borrower has to have other sources of income) (Article 120, para 2 b). Financial institutions have to determine maximum LTI ratios and obtain evidence of income, when granting the loan. In order to derogate from this rule, institutions have to comply with a hard test as follows (Article 120, para 3):

The Member State's competent authority must have published evidence that the residential property market in that region is well developed and long established; and
Losses stemming from mortgage lending – with a collateral value of up to 80% of the market value or the mortgage lending value – do not exceed 0.3% of the outstanding loans in any given year; and
Overall losses stemming from residential mortgage lending do not exceed 0.5% of the outstanding loans in any given year

Exposures to ‘particularly high risks’ including ‘speculative property financing’ will face a 150% risk weight (Article 123). EBA will define ‘particularly high risks’ (no timeframe set) which includes situations where there is a high risk of loss as a result of the default of the obligor.

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Covered bonds

In the standardised approach, the risk weighting of covered bonds shall be based on the rating of the covered bond (instead of the credit institution) (Article 124 (3)). For unrated covered bonds the risk weight would be 10% if the senior unsecured exposures from the institution are 20% risk-weighted (20% RW for CBs where the senior unsecured is 50% risk-weighted). This clause is to compensate for the higher risk weights for covered bonds that could result from the removal of Option 1 from the old CRD. Article 473 grandfathers some covered bond risk weights until the end of 2014.

Article 478 sets out that the Commission, after consulting with EBA, must report to the EP and the Council by the end of 2015, together with any appropriate proposals, whether the risk weights for covered bonds (in Article 124) are adequate and whether the condition for covered bonds to be CRD eligible (also Article 124) should be made stricter. The review should also assess the adequacy of the preferential treatment for certain covered bonds in the trading book (see Article 375 (3)).

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Key issues in more detail

This is the EMF’s summary of the key proposals for mortgage lenders in the July 2011 CRD IV Proposal, with the timetable for each issue and changes from the draft CRD IV Proposal discussed in the EMF Economic Affairs Committee meeting held in February 2011.

Risk weights for mortgage credit

Timetable:

EBA to submit technical standards (including formats/dates/frequencies) to the Commission on loss reporting by 1 January 2013;
Institutions to report losses to national authorities as of 1 January 2013;
EBA to submit to the Commission draft technical standards for determining RWs for mortgages by 31 December 2014;
EBA to submit to the Commission draft technical standards for determining items in default by 31 December 2014.

Reporting obligations (Article 96): financial institutions will have to report data on losses stemming from residential and commercial mortgage lending to the competent authorities. Aggregate data will be published by competent authorities. The EBA will develop draft implementing technical standards for reporting and publication of this information.

Concerning the exposures secured by mortgages the following rule has been added: the part of exposures treated as fully and completely secured by mortgages on immovable property shall not be higher than the officially published amount of the market value, or in some cases the mortgage lending value of the property in question (Article 119).

Risk weight of exposures fully and completely secured by residential property is 35% (Article 120), and the regulation does not differentiate between owner occupied and rented property.

For the residential RW, the risk of the borrower must not depend on the performance of the underlying property (i.e. the borrower has to have other sources of income than rental fees from the property in question) (Article 120, para 2 b). Financial institutions have to determine maximum LTI ratios and obtain evidence of income, when granting the loan. In order to derogate from this rule institutions have to comply with a hard test as follows (Article 120, para 3):

The Member State's competent authority must have published evidence that the residential property market in that region is well developed and long established; and
Losses stemming from mortgage lending – with a collateral value of up to 80% of the market value or the mortgage lending value – do not exceed 0.3% of the outstanding loans in any given year; and
Overall losses stemming from residential mortgage lending do not exceed 0.5% of the outstanding loans in any given year.

Similar rules also apply for the IRB model (Article 195).

Risk weight of past due residential mortgages – after 90 days (Article 122 and 174) is 100%. EBA is to prepare technical standards on the definition of default (which includes being 90 days past due).

Exposures to ‘particularly high risks’ including ‘speculative immovable property financing’ will face a 150% risk weight (Article 123). EBA will define ‘particularly high risks’ (no timeframe set) which includes situations where there is a high risk of loss as a result of the default of the obligor.

The rules in the large exposure regime give the possibility to reduce residential and commercial mortgages' exposure values by up to 50% under certain conditions (Article 391).

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a. Liquidity provisions (LCR and NSFR)

Liquidity coverage requirement (LCR) (Article 401): institutions shall at all time hold liquid assets under stressed conditions:

Sum of liquidity inflows less liquidity outflows must be greater than or equal to liquid assets (under stressed conditions over a short period of time).

Timetable:

Financial institutions are required to have appropriate liquidity coverage as of 2013.

EBA to make a proposal on technical reporting standards to the Commission by 1 January 2013.

EBA to report annually to the Commission on the impact of the LCR (focusing on the impact of the LCR on different European business models, as well as the on appropriateness of the calibrations). The first of these reports should be submitted by 31 December 2013:

EBA to propose uniform definitions and standards of “high and extremely high liquidity and credit quality transferable assets” by 31 December 2013;
The Commission to publish the first Delegated Act on LCR (confirming or adjusting the LCR) by 31 December 2015 at the latest;
The Commission's Delegated Act on LCR may enter into force on 1 January 2015 at the earliest;
EBA to report to the Commission on the impacts/calibration of NSFR by 31 December 2015;
The Commission to report on the impacts/calibration of the NSFR to the EP and to submit a Proposal if appropriate by 31 December 2016;
Possible introduction of the NSFR after the observation period in 2018.

The Commission Proposal introduces the Liquidity Coverage Requirement (LCR, Article 401). No further details are set out beyond the above definition apart from the condition that institutions cannot count double liquidity inflows and liquid assets (article 401). There are however, no such restrictions on liquidity outflows. The EMF is reviewing whether this raises an issue for the mortgage credit industry.

If a credit institution does not comply with the liquidity requirements, it will have to notify the competent authority immediately and submit a restoration plan. Until compliance is restored, the institution will have to report on a daily basis unless the authority decides differently (a national discretion is granted to competent authorities in this area, see Article 402).

If a liquid asset ceases to meet the criteria for being a liquid asset, there will be a 30 day grace period during which it can continue to be counted as a liquid asset.

Reporting: during the observation period, institutions will have to report on their liquid assets (Article 403). Institutions will have to report their LCR on a monthly basis and the items providing and requiring stable funding on a quarterly basis to the competent authorities (Article 403). The EBA will develop details and a reporting template and present these to the Commission by January 2013.

The article on the LCR reporting obligation has created a definition of liquid assets by providing four liquid asset classes:

Cash and cash equivalents;
Transferable assets that are of extremely high liquidity and credit quality;
Sovereign assets;
Transferable assets that are of high liquidity and credit quality.

At least 60% of all liquid assets, which have to be reported under the LCR, must be classified under the first three groups (i.e. extremely high liquidity and credit quality assets, cash or sovereign assets). This is in line with the Basel 3 provisions on liquidity.

Changes in the definition of liquid assets (Article 404):

Article 404 (2) sets out a list of assets which cannot be considered as liquid assets. This list includes assets issued by a credit institution. CRD compliant covered bonds are exceptions from this exclusion. In the July Proposal, an exception has also been added for UCITS compliant covered bonds (i.e. UCITS compliant covered bonds could be eligible);
Although in the present Regulation (Article 404) SSPE and ABS have been deleted from the list of assets that are not eligible for use in the liquidity buffer (i.e. they could potentially be included as eligible liquid assets), Annex III would effectively prohibit these asset classes from being eligible liquid assets;
Article 410 sets out the LCR outflow assumptions, with Article 410 (7) addressing covered bonds. This allocates a 100% outflow assumption for covered bonds, meaning that an issuer is not considered to be able to issue any covered bonds during a stress scenario. This will have a significant negative impact for covered bonds and would appear to contradict the LCR regime which recognises that covered bonds could be liquid assets.

The observation period is aimed at ensuring that there will be no unintended consequences of the new Regulation for financial markets, credit availability and economic growth taking account of different business models and funding environments across the EU.

Since the February 2011 CRD IV draft, the chapter on liquidity provisions has been restructured: the definition of liquid assets (for reporting purposes) can be found under “Title II: Liquidity reporting” and not under “Title I: Definitions and liquidity coverage requirement”. This gives the Commission the possibility to change the final rules if necessary, following the EBA review of the liquidity provisions.

The CRD IV Proposal presents the NSFR as a reporting requirement only (Articles 414-415).

LCR implementation: for the LCR, the Commission must publish a Delegated Act confirming or adjusting the LCR by the end of 2015 at the latest. The LCR cannot be brought in as a binding rule before the beginning of 2015.

NSFR implementation: during the observation period, the methodology and appropriateness of the NSFR will be reviewed by EBA by the end of 2015 (Article 481 (3)). This assessment will include reviewing the potential impact of the NSFR on lenders’ ability to support the real economy.

Based on the EBA reports, the Commission can, if appropriate, make a Proposal to the EP and Council by the end of 2016 to introduce the NSFR as a binding requirement (Article 481 (3)). The Commission is firmly committed to reaching a minimum standard on the NSFR by the beginning of 2018 (Explanatory Memorandum 5.5.2).

The Commission’s Impact Assessment estimates that the current shortfalls of the liquidity rules for all EU banks are around EUR 1.6 trillion for the LCR and EUR 3.2 trillion for the NSFR (under Basel III type rules).

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b. Leverage ratio

Timetable:

EBA to develop technical reporting standards to be submitted to the Commission by 1 January 2013 (for adoption by means of a Delegated Act);
Competent authorities to start LR data gathering in 2013;
EBA to submit draft implementing technical standards for public disclosure to the Commission by 30 June 2014;
Public disclosure of the LR from 2015;
Review of the LR starts as of mid 2016;
EBA to report to the Commission on the impact of the LR by 31 October 2016;
The Commission to report to the EP/Council on the impact of the LR, suitability, and if appropriate proposes one or more levels for the LR and their calibration by 31 December 2016;
Final decision on calibration and whether the LR should be migrated to Pillar I by 2018.

Reporting to competent authorities: EBA will develop technical reporting standards by January 2013 (Article 417), to be adopted by the Commission through a Delegated Act. This is for reporting the LR and its components to the competent authority. The Commission’s FAQ states that reporting is to start from the beginning of 2013.

Credit institutions will have to calculate a quarterly LR based on the simple average of each of the previous three month’s LRs (Article 416).

Financial institutions will have to calculate the LR based on Tier 1 and on a transitional (broader) Tier 1 capital base (they can choose which one they disclose) between 2013 and 2021 (Article 475, transitional Tier 1 rules are from Articles 463 to 474).

Public disclosure: EBA will develop public disclosure standards by June 2014, which the Commission can adopt by a Delegated Act. Institutions must disclose their LR, a breakdown of the total exposure measure, a description of their management of the risk of excessive leverage and factors which have impacted on the LR (Article 436). The Regulation does not set a start date for public disclosure, but the Commission’s FAQ sets this as 2015. Public disclosure should be on an annual basis (or more frequently in some circumstances, Article 420).

Institutions can choose to disclose their LR either based on Tier 1 or the transitional Tier 1 basis or both (Article 475).

LR as a binding requirement: by October 2016, EBA shall review the impact of the LR and suggest any changes to the Commission (Article 482). This review should pay particular attention to the impact on low risk business models such as mortgage lending (Introduction, para 69, page 27).

The Commission will have to report to the EP and Council on the impact and effectiveness of the LR by the end of 2016 (Article 482), and if appropriate, make a legislative proposal to introduce one or more levels for the LR as a binding requirement.

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c. Covered bonds

Article 124 covers CRD compliant covered bonds.

In the standardised approach, the risk weighting of covered bonds shall be based on the rating of the covered bond (instead of the credit institution) (Article 124 (3)). For unrated covered bonds the risk weight would be 10% if the senior unsecured exposures from the institution are 20% risk-weighted (20% RW for CBs where the senior unsecured is 50% risk-weighted etc.). This clause is to compensate for the higher risk weights for covered bonds that could result from the removal of Option 1 from the old CRD. Article 473 grandfathers some covered bond risk weights until the end of 2014.

For substitute assets, the 15% limit for credit quality step 1 assets still applies. In addition, where there would be concentration problems with this, competent authorities will have the option to permit up to 10% credit step quality 2 exposures (Article 124 (1c)).

CRD compliant credit quality step 1 covered bonds are granted preferential treatment in the trading book (Article 325 (3)). For example, a covered bond with a maturity over two years that is rated at least AA- would have a specific own fund requirement of 0.8% instead of 1.6%.

Member States or competent authorities will have the option to fully or partially exempt CRD compliant covered bonds from the large exposure limits (Article 389 (2)), however, the exemption will be reviewed by the Commission before the end of 2013 and if necessary a Proposal will be submitted to the Council and EP (Article 479).

The waiver for the use of intra-group MBS is extended to the end of 2014. The Commission will have to review the appropriateness of this waiver by the end of 2012 and if appropriate the Commission can convert it to a general rule (using a Delegated Act) or extend it to other forms of covered bonds (via legislative proposals) (Article 473).

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d. Level playing field

International level playing field: in its published document on CRD IV FAQ, the European Commission stated that the EU has an interest in increasing the resilience of the banking sector, which has a long term benefit even though in the short term it might create regulatory arbitrage if other jurisdictions do not implement the Basel 3 rules. Therefore the Commission is closely monitoring the consistent implementation of Basel 3.

European level playing field: the role of the transition period is to take into account the differences across Member States' business models and banking systems when introducing the new requirements and provisions.