Banking, Finance & CM

New Capital Requirements for European Banks – Grandfathering for Existing Equity Instruments

As recent developments have shown, it is highly unlikely that the EU Capital Requirements Regulation (CRR) on credit institutions and investment firms, which aims to put in place a comprehensive and risk-oriented regulatory framework throughout the EU, will enter into force on 1 January 2013 in the whole European Union (even though some EU Member States would be ready to implement Basel III as at 1 January 2013). Still, the implementation of Basel III is imminent. The goal is a sounder and safer European financial system. As the global financial crisis revealed the shortcomings of the current regulatory environment as to the prudent operation of the European credit institutions, the CRR envisages stricter rules for institutions’ own funds, liquidity and leverage.

The impact of the CRR on the own funds is shown in the graph below.

Basel III – impact of the CRR on the own fund

© Deutsche Bun­des­bank Basel III – Leit­faden zu den neuen Eigenkap­i­tal- und Liq­uid­ität­sregeln
für Banken (2011) (avail­able only in Ger­man).

More and better-quality own funds

The CRR aims to increase both the qual­i­ty and quan­ti­ty of the insti­tu­tions’ own funds by increas­ing the ratio of own funds insti­tu­tions must hold and by restrict­ing which instru­ments count as core equi­ty. Under the cur­rent Basel II rules as intro­duced into Euro­pean law, insti­tu­tions and invest­ment firms must hold a min­i­mum of aggre­gate own funds of 8% of the risk weight­ed assets. The CRR will request sig­nif­i­cant­ly high­er ratios of tru­ly loss shar­ing and loss absorb­ing cap­i­tal. Cred­it insti­tu­tions will need to hold own funds of the high­est qual­i­ty – com­mon equi­ty tier 1 (CET1) – of 4.5%. Hybrid instru­ments that proved to be not tru­ly loss absorb­ing in the finan­cial cri­sis will not count as CET1 (but may still be eli­gi­ble as Addi­tion­al Tier 1 if they con­tain cer­tain fea­tures or are amend­ed accord­ing­ly). In addi­tion, each cred­it insti­tu­tion will need a 2.5% CET1 cap­i­tal con­ser­va­tion buffer. Even though the for­mal own funds require­ment remains at 8%, it will in fact be 10.5%: 6% Tier 1, 2.5% cap­i­tal con­ser­va­tion buffer and 2% Tier 2 (such as sup­ple­men­tary cap­i­tal). Banks of sys­temic impor­tance will even need 9% CET1.

The Commission’s impact assess­ment1 shows that the short and medi­um term dis­ad­van­tages to the insti­tu­tions’ prof­itabil­i­ty and to pay div­i­dends is expect­ed to be bal­anced by the long-term eco­nom­ic ben­e­fits that stem from the reduc­tion in the expect­ed fre­quen­cy of future sys­temic crises.

Grandfathering

To enable the insti­tu­tions to pre­pare for the new set of rules, and to take all steps nec­es­sary to adjust (ie, increas­ing their cap­i­tal by issu­ing new equi­ty and/or retain­ing prof­its and/or reduc­ing their risk-weight­ed assets), the new cap­i­tal require­ments envis­age a tran­si­tion peri­od. This grand­fa­ther­ing also means that the neg­a­tive effects of the new reg­u­la­tion on the prof­itabil­i­ty of the insti­tu­tions will build up dur­ing a longer peri­od instead of hit­ting them at once.

The grand­fa­ther­ing sec­tion of the CRR applies only to the instru­ments that were issued pri­or to 20 July 2011, which is the date of adop­tion of the CRR pro­pos­al by the Com­mis­sion. Such instru­ments qual­i­fy as own funds, as in the past, but the amount of such instru­ments by which they may be tak­en into account will be lim­it­ed to a cer­tain per­cent­age, as stip­u­lat­ed by the com­pe­tent author­i­ties with­in the ranges as set forth in the CRR, and decreas­es grad­u­al­ly over time. The Euro­pean Bank­ing Author­i­ty will devel­op draft reg­u­la­to­ry tech­ni­cal stan­dards to spec­i­fy the con­di­tions for treat­ing the “old regime” instru­ments as the respec­tive cap­i­tal type under the CRR dur­ing a 10-year peri­od from 1 Jan­u­ary 2013 to 31 Decem­ber 2022 (the CRR con­tains in a num­ber of arti­cle-spe­cif­ic man­dates for the Euro­pean Bank­ing Author­i­ty to devel­op such tech­ni­cal stan­dards cov­er­ing spe­cif­ic issues).

Dur­ing the 10-year tran­si­tion peri­od the applic­a­ble per­cent­age will be low­ered year by year, forc­ing the insti­tu­tions to grad­u­al­ly sup­ple­ment the cap­i­tal fall­en out with instru­ments that qual­i­fy as the respec­tive cap­i­tal type under the CRR. Dur­ing the tran­si­tion peri­od, the insti­tu­tions may take into con­sid­er­a­tion such “expired” cap­i­tal (ie, those parts exceed­ing the applic­a­ble per­cent­age) in the low­er ranks to the extent that the inclu­sion of that cap­i­tal qual­i­fies under the new rules (eg, for­mer Tier 1 cap­i­tal as Addi­tion­al Tier 1 or Tier 2 cap­i­tal) does not exceed the per­cent­age lim­it applic­a­ble to such low­er rank.

Hybrid capital

As to hybrid cap­i­tal (ie, forms of cap­i­tal instru­ment that have fea­tures of both debt and equi­ty instru­ments), such instru­ments are not con­sid­ered to be suf­fi­cient­ly loss absorbent; thus, the CRR set forth a very detailed set of con­di­tions and stricter cri­te­ria for their inclu­sion in the Addi­tion­al Tier 1 cap­i­tal. Instru­ments that do not meet the cri­te­ria will qual­i­fy as Tier 2 cap­i­tal. To qual­i­fy as Addi­tion­al Tier 1 cap­i­tal, all such instru­ments must absorb loss­es by being writ­ten down or con­vert­ed into “true” CET1 instru­ments, when the key mea­sure of the institution’s sol­ven­cy falls below 5.125%.

Instru­ments sub­scribed for by gov­ern­ments as cap­i­tal dur­ing the finan­cial cri­sis have dif­fer­ent tran­si­tion peri­ods. Those instru­ments will ful­ly count as own funds of the same qual­i­ty as at present until 31 Decem­ber 2017 if the rel­e­vant instru­ment was con­sid­ered by the Com­mis­sion as com­pat­i­ble with the pro­vi­sions of the EU Treaty. The CRR again sets forth detailed cri­te­ria for cat­e­go­riz­ing such instru­ments accord­ing to the cat­e­gories cre­at­ed by the CRR.

Conclusion

The pur­pose of the CRR is to ensure that finan­cial insti­tu­tions, being the core of the EU finan­cial sys­tem, are safe, sound and resilient to adverse mar­ket events. It is the clear­ly artic­u­lat­ed goal of the EU Com­mis­sion that the gov­ern­ments (and their tax­pay­ers) will not have to bail out finan­cial insti­tu­tions in the future. The cri­sis pro­vid­ed grounds for such changes to the cap­i­tal require­ments reg­u­la­tion as envis­aged in the CRR, which places more bur­den­some cri­te­ria on the reg­u­lat­ed insti­tu­tions. Thus, the ques­tion may arise whether the ten­den­cy of mov­ing the risk to oth­er less reg­u­lat­ed areas (eg, “shad­ow banks”) will be strength­ened by the intro­duc­tion of the CRR. If so, what will be the con­se­quences for the finan­cial sys­tem?

The pur­pose of Basel III is to ensure that finan­cial insti­tu­tions, being the core of the EU finan­cial sys­tem, are safe, sound and resilient to adverse mar­ket events. Still, exist­ing own funds instru­ments that do not meet the stricter Basel III and CRR cri­te­ria will be phased out only over a (gen­er­al­ly) 10-year peri­od.

The purpose of the CRR is to ensure that financial institutions, being the core of the EU financial system, are safe, sound and resilient to adverse market events.

1
Exec­u­tive Sum­ma­ry of the Impact Assess­ment (PDF);
Impact Assess­ment (PDF).