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European prudential regulation: what does it mean for lenders?


Published: 31 July 2013 | Author: Bernard Clarke

Earlier this summer, the European Council and Parliament agreed a revision of capital requirements directive (CRD 4). Why?

The package of legislation known as CRD 4 was passed in June and sets out new bank capital requirements for financial institutions operating in the EU. The new rules are the culmination of a review of capital and other requirements started by the European authorities in July 2011.

The main conclusion from the review is that regulators and financial institutions need to build on the lessons learned from the financial crisis. In particular, they need to ensure that there are adequate measures to address the scale of potential losses in the financial sector when a period of excessive credit growth precedes a downturn. This series of events, which contributed to the financial crisis, revealed vulnerabilities in the regulation and supervision of the banking system, both at a European and global level. Institutions that entered the crisis with capital of insufficient quantity and quality were exposed. In dealing with the crisis, national governments were required to provide unprecedented support to the banking sector and financial institutions in many countries. 

The new rules seek to strengthen the resilience of the EU banking sector, so that it is better placed to absorb economic shocks, while ensuring that banks and other institutions continue to finance economic activity and growth.

What are the implications of the new rules for the UK mortgage market?

The CRD package contained very little that was specific to mortgage markets. However, some changes to the regulatory regime were suggested that could have affected UK mortgage lenders.  For example, during negotiation of the final package, there was a proposal to reduce the definition of a mortgage in material default from 180 days past the due date to 90 days. Although this would not have affected how lenders treat individual customers in arrears, or their forbearance policies more generally, it would have had implications for the amount of capital a lender needed to hold against mortgages in arrears. In the final package, however, the authorities confirmed the current status quo in the UK, with national regulators retaining the flexibility to use either 90 or 180 days. 

Proposals also included a provision to raise the risk weighting of buy-to-let (BTL) mortgages. Once again, however, the final decision on whether to impose a higher risk weighting on these mortgages has been left with national regulatory authorities (the Prudential Regulation Authority, or PRA, in the UK), so BTL mortgages could be exempted from this provision. We will work with the PRA to seek to ensure that BTL is treated proportionately in the UK.

What are the wider effects of the CRD 4 requirements?

The CRD 4 package implements international standards on bank capital requirements, recommended by the Basel Committee on Banking Supervision (BCBS). These have evolved over time and, following the financial crisis, were reviewed again by the committee. The outcome is this review is Basel III – essentially the third configuration of these standards. 

The CRD 4 package establishes a new regulatory framework and comprises two elements:

  • the CRD 4 directive, which will need to be converted into national legislation; and
  • the capital requirements regulation (CRR), which creates law that takes immediate affect in all EU member states from the implementation date, without any further action on the part of national authorities.

In creating a single prudential rule book applicable to all financial institutions in EU member states, the CRR seeks to create a level playing field on prudential regulation across Europe. It removes many of the national opt-outs and much of the discretion national regulators had when implementing earlier EU prudential regulation requirements. It does, however, allow member states to apply stricter requirements when these are justified by national circumstances, or needed on financial stability grounds because of a bank’s specific risk profile. The CRR covers a number of fundamental prudential requirements. It sets out, for example, the minimum capital lenders need to hold against their risk-weighted assets and introduces a "leverage ratio."

The CRD 4 directive imposes further requirements on lenders to hold additional capital in the form of various "buffers". These provide protection against financial shocks, reinforce the resilience of the banking system and ensure that lenders have adequate capital to absorb losses without relying on governments or taxpayers. The directive also limits bonuses in the banking sector, promotes greater diversity in the composition of boards of financial institutions, imposes requirements to strengthen corporate governance and seeks to ensure there is greater transparency.

What is the leverage ratio?

As soon as an institution’s assets exceed its capital base, it is leveraged. Leverage is, of course, inherent to banking activity, but the financial crisis highlighted that many credit institutions and other firms were too highly leveraged. The Commission does not propose to eliminate leverage; it wants to reduce excessive leverage. 

The Commission therefore proposes to start the process of introducing a leverage ratio. This is defined as tier one capital, divided by a measure of non-risk weighted on- and off-balance sheet items. The purpose of the leverage ratio is to have a simple instrument that can be applied as a safeguard against risks. The ultimate aim is also to constrain leverage and bring institutions’ assets more in line with their capital, to help mitigate the instability caused by institutions seeking to deleverage in an economic downturn.

The leverage ratio contained within the CRD 4 package follows the BCBS recommendation that the ratio of core equity to banks assets should be 3%. Within the UK, there has been considerable debate about the leverage ratio, with the parliamentary committee on banking standards suggesting a higher ratio of 4%. However, a recent announcement by the Prudential Regulation Authority (PRA) on leverage ratios for major UK lenders seeks to apply the 3% leverage ratio outlined in Basel 3 and CRD 4. Lenders below the minimum 3% ratio have until the end of 2015 to restore their balance sheet position, but the PRA can impose a tighter deadline on some firms.

How will the new regime be implemented?

CRD 4 becomes law on 1 January 2014, but there are different periods of transition for lenders until all the prudential rules are fully implemented. New capital requirements have to be adopted by the end of 2014, with the leverage ratio applied from January 2018 and requirements for the liquidity coverage ratio – intended to ensure that financial institutions have adequate access to liquid assets – phased in gradually between 2015 to 2018. In the meantime, national prudential rules will continue to apply and, in the UK, existing prudential regulation is for capital on a par with the CRD 4 requirements. In the case of the liquidity coverage and leverage ratios, UK requirements exceed those in CRD 4. The immediate impact of CRD 4 is therefore expected to be minimal for UK lenders.

As part of the implementation process, the PRA intends to hold two public consultation exercises this summer. The first focuses on changes to the PRA’s rules to reflect the CRR and the CRD 4 directive. The CRR will in essence replace the majority of rules in the PRA’s handbook (BIPRU,  the Prudential Sourcebook for Banks, Building Societies and Investment Firms, and GENPRU, the General Prudential Sourcebook). The second consultation will cover the transition process, existing waivers and other outstanding issues. On behalf of lenders, we intend to respond to both consultations.