An overview of the EU Commission's Banking Reform Package
Frankfurt am Main
05 December 2016
On 23 November 2016 the EU Commission published its Banking Reform Package, which proposes fundamental changes to CRDIV and the Bank Recovery and Resolution Directive and is likely to have a profound impact on financial groups across the spectrum of size and complexity.
On 23 November 2016 the EU Commission published a comprehensive package of proposed amendments (hereafter, the Banking Reform Package), primarily centred around the CRDIV Directive and Regulation (Directive 2013/36/EU (the CRD) and Regulation 575/2013 (the CRR)) and the Bank Recovery and Resolution Directive (Directive 2014/59/EU (the BRRD)). The Banking Reform Package is part of the on-going upgrade of CRDIV from Basel III to what some in the industry are calling ‘Basel IV’ and seeks to bring the EU’s existing minimum requirement for own funds and eligible liabilities (MREL) under the BRRD in line with the Financial Stability Board's (FSB) Total Loss-Absorbing Capacity (TLAC) standard for global systemically important institutions (G-SIIs).
The main areas of impact are:
New financial holding company regime: the Banking Reform Package will require financial holding companies in the EU to become authorised for the first time and subject to direct supervision under the CRDIV. This will place formal direct responsibility on holding companies for compliance with consolidated prudential requirements for financial groups.
Intermediate EU holding company for non-EU financial groups: Third-country groups above a certain threshold and with two or more credit institutions or investment firms in the EU will be required to establish an intermediate EU holding company. This is likely to have a profound impact on non-EU banking groups who operate on an unconsolidated basis in the EU in terms of the additional costs, governance requirements and complexity of operations.
‘Basel IV’ upgrades: The Banking Reform Package introduces the first round of ‘Basel IV’ upgrades. Whilst most of these changes will have long been anticipated, the new market risk rules, the standardised approach to counterparty credit risk, the leverage ratio, net stable funding requirements and the tightening of the large exposures limit will have a profound impact on credit institutions and large investment firms.
Total loss absorbing capacity (TLAC): the Banking Reform Package will amend the CRR and BRRD to bring the MREL requirements in line with the FSB's final TLAC term sheet standards. G-SIIs are already in the process of restructuring their regulatory capital and debt stacks in light of the FSB TLAC standards, so there are unlikely to be any unexpected impacts in this regard.
Features of MREL eligible liabilities and a new stack in bank insolvency hierarchy: in order to ensure investor certainty and uniformity of application the proposal creates a new category of claim in bank insolvency hierarchy which is the subordinated senior debt. This offers certainty of treatment and is a welcome improvement on the piecemeal approach adopted by different member states to achieve eligible liability compliance with the FSB TLAC term sheet standards on subordination to certain prescribed liabilities.
BRRD Article 55 waiver: Article 55 of the BRRD requires banks to include in contracts that are governed by the law of a third country a clause by which the creditor recognises the bail-in power of the EU resolution authorities. The Banking Reform Package proposes allowing resolution authorities to grant a waiver from compliance with the rule for certain types of liabilities where authorities determine that it is legally, contractually or economically impracticable for banks to include the bail-in recognition clause and that such waiver would not impede the resolvability of the bank. Given the compliance difficulties otherwise created by such impracticalities, this waiver will be welcome by many.
Proportionality: the Bank Reform Package introduces a lighter regime and/or exemptions for smaller institutions around, for example, regulatory reporting, disclosure, and remuneration. Importantly, non-systemic investment firms will not need to comply with the proposed changes and can apply the existing CRR regime (to the extent that it currently applies to them) pending development of their own prudential regime (the Commission intends to adopt a legislative proposal for a specific prudential framework for non-systemic investment firms by the end of 2017).
SME and infrastructure exposures: there will be preferential treatment for exposures to SMEs and infrastructure projects which are seen as enabling economic prosperity and growth in areas where there is no associated systemic risk and subject to certain safeguards.
The Banking Reform Package
On 23 November 2016, the European Commission published the following proposals:
Regulation amending the CRR as regards the leverage ratio, the net stable funding ratio, requirements for own funds and eligible liabilities, counterparty credit risk, market risk, exposures to central counterparties, exposures to collective investment undertakings, large exposures, reporting and disclosure requirements and amending EMIR (Regulation 648/2012) (COM(2016)850).
Regulation amending the Regulation for the single resolution mechanism (Regulation 806/2014) (the SRM Regulation) (COM(2016)851) as regards the loss-absorbing and recapitalisation capacity of credit institutions within the scope of the SRM (this will be less relevant to clients headquartered in the UK as the UK has opted out of the SRM).
Directive amending the BRRD on loss-absorbing and recapitalisation capacity of credit institutions and investment firms and amending Directive 98/26/EC, Directive 2002/47/EC, Directive 2012/30/EU, Directive 2011/35/EU, Directive 2005/56/EC, Directive 2004/25/EC and Directive 2007/36/EC (COM(2016)852).
Directive amending the BRRD (COM(2016) 853) as regards the ranking of unsecured debt instruments in insolvency hierarchy.
Directive amending the CRD as regards exempted entities, financial holding companies, mixed financial holding companies, remuneration, supervisory measures and powers and capital conservation measures (COM(2016)854).
The EU's press release with a summary of the proposed changes (and links to the relevant proposals) is accessible here.
New Financial Holding Company Regime
Where a group is subject to consolidated supervision under CRDIV and headed by a Financial Holding Company (FHC) or Mixed Financial Holding Company (MFHC) at EU level, that FHC or MFHC is currently unregulated irrespective of the fact that consolidated supervision applies at such level. The Banking Reform Package proposes to require EU FHCs and MFHCs to be formally regulated under CRDIV which would see an authorisation requirement under a new Article 21a of the CRD and amendments to Articles 11, 13 and 18 of the CRR to clarify that it will be the holding company which is directly responsible for compliance, not the credit institutions and/or investment firms that are subsidiaries of such entities.
Although the PRA and the FCA already have broad powers under section 192C of the Financial Services and Markets Act 2000 (the FSMA) to give directions to a ‘qualifying parent undertaking’ (i.e. unregulated holding companies in the UK), the Banking Reform Package is likely to lead to increased operational and governance burdens for parent holding companies and increased regulatory scrutiny of their governance and risk management functions and an ability to discipline persons occupying senior positions of responsibility.
Intermediate EU holding company for non-EU financial groups
A new Article 21b of the CRD would require third-country groups which (i) have two or more (i.e. banks or investment firms) institutions in the EU and (ii) either are non-EU G-SIIs or have assets of EUR 30 billion or more in the EU to establish an intermediate EU holding company subject to authorisation under CRDIV. This is likely to have a profound impact on third country financial groups who currently operate on an unconsolidated basis in the EU in terms of the additional costs, governance requirements and complexity of operations. The quantitative threshold assessment takes account of any subsidiary credit institutions and investment firms (on a consolidated basis) and EU branches of a third country group entity and is therefore likely to be triggered by a number of non-G-SII designated groups. Holding companies of non-EU G-SIIs will have to comply with internal TLAC requirements representing 90% of the requirement applicable to the G-SII on a consolidated basis (and on a solo basis as well if they are themselves authorised credit institutions/investment firms).
‘Basel IV’ upgrades
The Banking Reform Package is part of a piecemeal rather than a full-scale upgrade of Basel III. This is because certain areas, notably those on credit and operational risk, are still being finalised by the Basel Committee. Nonetheless, the Banking Reform Package does introduce a fundamental set of changes (see below).
Most of these changes will have long been anticipated: e.g. the leverage ratio and the net stable funding requirement, market risk rules, the standardised approach to counterparty credit risk, and the tightening of the large exposures limit. In accumulation, these will have a profound impact on our credit institutions and investment firms across the spectrum of size and complexity.
Firms will need to recalibrate, and implement new operational requirements around, their trading book. Additionally, those who are currently taking into account Tier 2 capital in the calculation of their large exposures limit or have exposures to G-SIIs that are above 15% (but still within the current 25% limit in the banking book) might find themselves caught out by the new limits.
Equity investments in funds: the Commission intends to amend the CRR to implement the Basel Committee on Banking Supervision (BCBS) standard on the treatment of equity investments in funds that was finalised in December 2013.
Standardised approach for counterparty credit risk: the Commission intends to amend the CRR to implement the BCBS standard on the calculation of the exposures value of derivatives contracts (SA-CCR) that was published in March 2014 and which will replace the current mark-to-mark method.
Exposure to CCPs: the Commission intends to amend the CRR to implement the BCBS standard on the treatment of exposures to central counterparties (CCPs) that was finalised in April 2014.
Market risk: following the BCBS’ fundamental review of the trading book (FRTB), the Commission intends to amend the CRR to implement the BCBS standards for minimum capital requirements for market risk that were finalised in January 2016.
Large exposures: the Commission intends to amend the CRR to implement the BCBS standard supervisory framework for measuring and controlling large exposures that was finalised in April 2014. The Commission intends to amend Article 395 of the CRR to limit the capital that can be taken into account to calculate the large exposures limit to Tier 1, to introduce the lower limit of 15% for G-SII exposures to other G-SIIs and to impose the use of the SA-CCR methods for determining exposures to OTC derivative transactions.
Leverage ratio: the Commission intends to introduce a binding leverage ratio requirement of 3% of tier 1 capital.
Net stable funding ratio (NSFR): as a complement to the Liquidity Coverage Ratio (the LCR), the Commission intends to introduce a binding NSFR that will require credit institutions and systemic investment firms to hold sufficient stable funding to meet their funding needs during a one-year period under both normal and stressed conditions.
Interest rate risk in the banking book (IRRBB): Articles 84 and 98 of the CRD and Article 448 of the CRR will also be amended to introduce a revised framework for capturing interest rate risks in banking book positions. The amendments include the introduction of a common standardised approach that institutions might use to capture these risks or that competent authorities may require the institution to use when the systems developed by the institution to capture these risks are not satisfactory.
Total loss absorbing capacity (TLAC)
The Banking Reform Package will amend the CRR and BRRD to bring the MREL requirements in line with the FSB's final TLAC term sheets standards. The proposals require G-SIIs to maintain a risk-based ratio of own funds and eligible liabilities at 18% of total risk exposure and a non-risk-based ratio of own funds and eligible liabilities at 6.75% of total exposure and certain provisions around eligible and excluded liabilities, as well as a requirement for internal TLAC vis-à-vis non-EU G-SIIs (the BRRD already contains a similar requirement for EU G-SIIs).
The Commission also intends to amend Article 108 of the BRRD to partially harmonise the bank insolvency creditor hierarchy relating to the priority ranking of holders of bank senior unsecured debt eligible to meet the BRRD rules and the TLAC standard on loss absorbency and recapitalisation capacity for banks, in particular the subordination requirement. The new provision keeps the existing class of senior debt while it creates a new liability class of ‘non-preferred’ senior debt that should only be bailed-in in resolution after other capital instruments, but before other senior liabilities. Firms would remain free to issue debt in both classes while only the ‘non-preferred’ senior class is eligible for the minimum TLAC requirement or any subordination requirement that could be imposed by resolution authorities on a case-by-case basis.
Additionally, the legislative package includes a clearly framed and regulated moratorium tool allowing for the suspension of certain contractual obligations for a short period of time in resolution as well as in the early intervention phase.
Article 55 bail-in waiver
Article 55 of the BRRD requires banks to include in contracts that are governed by the law of a third country a clause by which the creditor recognises the bail-in power of the EU resolution authorities. This applies to all contracts not legally excluded from bail-in, even if there is no practical possibility that these contracts will be affected by bail-in. However, an impact assessment carried out as part of the proposals identified that certain third country counterparties refuse to include a contractual recognition clause (forcing some EU banks to discontinue part of their business) and that, separately, some third country supervisors may in some cases prevent the inclusion of such a clause.
The Banking Reform Package therefore proposes allowing resolution authorities to grant a waiver from compliance with the rule for certain types of liabilities where authorities determine that it is legally, contractually or economically impracticable for banks to include the bail-in recognition clause and that such waiver would not impede the resolvability of the bank. Given such obstacles to compliance with Article 55, this waiver will be welcome by many.
The Banking Reform Package includes various amendments to make the overall prudential framework more proportionate to the size and complexity of firms. Notably, for smaller and non-complex institutions, there will be a relaxation of the rules and/or exemptions in the following areas:
Non-systemic firms: non-systemic investment firms will not need to comply with the proposed changes and can continue to apply the existing CRR regime (to the extent that it currently applies to them) pending development of their own prudential regime (the Commission intends to adopt a legislative proposal for a specific prudential framework for non-systemic investment firms by the end of 2017). Systemic firms will, by contrast, be subject to the amended version of the CRR. See the EBA's Discussion Paper on a new prudential regime for Investment Firms (EBA/DP/2016/02), accessible here.
Market risk: banks with small trading books (under EUR 50 million and less than 5% of the institution's total assets) will benefit from a derogation, which allows them to apply the treatment of banking book positions to their trading book. Banks with medium-sized activities subject to the market risk capital requirements (under EUR 300 million and less than 10% of the institution's total assets) may use the simplified standardised approach, which corresponds to the existing standardised approach.
Regulatory reporting/disclosure: smaller institutions will be subject to both less extensive and less frequent disclosures.
Remuneration: Article 94 of the CRD will be amended to allow for the recognition of share-linked instruments and provide an exemption for (i) institutions with assets on average equal to or less than EUR 5 billion over the four-year period immediately preceding the current financial year or (ii) a staff member whose annual variable remuneration does not exceed EUR 50,000 and does not represent more than one fourth of the staff member’s annual total remuneration (although competent authorities are given flexibility to adopt a stricter approach).
Exposures to SMEs and infrastructure projects
There will be further preferential treatment for exposures to SMEs above the current concession limit of EUR 1.5 million and infrastructure projects which are seen as enabling economic prosperity and growth in areas where there is no associated systemic risk and subject to certain safeguards.
Waivers from capital and liquidity requirements: The Commission intends to amend Articles 7 and 8 of the CRR which allow a competent authority to waive in certain circumstances the application of own funds and liquidity requirements. Given the UK has opted out of the SSM and has not implemented the Article 7 waiver (unlike the Article 8 waiver), it remains to be seen whether the PRA and/or FCA opt in on these waivers.
Exempted entities: the Banking Reform Package will clarify the scope of Articles 2 and 9 of the CRD vis-à-vis exempt institutions and the prohibition around deposit-taking business vis-à-vis persons other than credit institutions.
SREP and Pillar 2: the Banking Reform Package will clarify that the supervisory review and evaluation process (SREP) and corresponding firm-specific supervisory requirements under Pillar 2 are confined to a purely micro-prudential perspective.
IFRS 9: the Banking Reform Package will phase in IFRS 9.
Initial assessment of implications
Whilst the proposal is very extensive and requires an in depth examination for its component parts and the interrelationship between such components there are a number of observations we can make. First, there is a step change in the way the EU approaches regulation of financial groups. This applies to EU groups in the form of a new authorisation regime for financial holding companies but also in requiring non EU groups that are G-SIIs or with significant operations in Europe (EUR 30bn or above in assets) to establish a European holding structure consolidating all risk and within reach of EU regulators through direct authorisation and supervision.
The latter will likely require significant restructuring of some non EU groups operating in Europe above the threshold. It is unclear at this stage how the proposal affects branches of non-EU financial groups that help to trigger the threshold quantitative test. Undoubtedly, such operations are likely to come under more scrutiny than is currently the case.
That, coupled by the revision to the large exposure regime insofar as it relates to G-SIIs may well compound the impact of such proposals as it is likely to apply pressure on exposures resulting from financial market activities and intra-group for affected entities.
The Banking Reform Package will now go before the Council and the European Parliament for consideration. Allen & Overy's Financial Services Regulatory team will keep progress under review.