EUROPEAN COMMISSION Brussels, 23.11.2016 SWD(2016) 377 final COMMISSION STAFF WORKING DOCUMENT



IMPACT ASSESSMENT

Accompanying the document Proposal amending: - Regulation (EU) No 575/2013 on prudential requirements for credit institutions and investment firms; - Directive 2013/36/EU on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms; - Directive 2014/59/EU establishing a framework for the recovery and resolution of credit institutions and investment firms; - Regulation (EU) No 806/2014 of the European Parliament and of the Council of 15 July 2014 establishing uniform rules and a uniform procedure for the resolution of credit institutions and certain investment firms in the framework of a Single Resolution Mechanism and a Single Resolution Fund {COM(2016) 850 final}

{SWD(2016) 378 final}



Table of contents 1.INTRODUCTION 2.PROBLEM DEFINITION 2.1.Excessive reliance on short-term funding 2.2.Excessive leverage 2.3.Inadequate calibration of risk weights for exposures to SMEs 2.4.Weaknesses to the regulatory framework for loss absorption and recapitalisation capacity 2.5.Inappropriate level of capital requirements against trading activities 2.6.Problems on remuneration rules 2.7.Problems on insolvency ranking of unsecured bank debt instruments 2.8.Lack of effectiveness of the current rules on moratorium 2.9.Insufficient proportionality of the current rules 2.10.Consequences from the baseline scenario 3.OBJECTIVES 3.1.General, specific and operational objectives 3.2.Consistency of the objectives with other EU policies 3.3.Consistency of the objectives with fundamental rights 3.4.Subsidiarity

4.POLICY OPTIONS AND ANALYSIS OF IMPACTS 4.1.On excessive reliance on short-term funding 4.2.On excessive leverage 4.3.On inadequate calibration of risk weights on SME exposures 4.4.On weaknesses to the regulatory framework for loss absorption and recapitalisation capacity 4.5.On inappropriate level of capital requirements against trading activities 4.6.On problems on remuneration rules 4.7.On problems on insolvency ranking 4.8.On lack of effectiveness of the current rules on moratorium 4.9.On insufficient proportionality of the current rules 4.10.The choice of the instrument 5.The cumulative impacts of the entire package 5.1.Introduction 5.2.Quantitative assessment of benefits and costs related to FRTB and the LR 5.3.Impact of the preferred options on administrative costs 5.4.The impact on SMEs 5.5.Impact on third countries 6.MONITORING AND EVALUATION Glossary Annex 1. PROCEDURAL ISSUES AND CONSULTATION OF INTERESTED PARTIES

Possible impact of the CRR/CRD IV on financing of the economy ("CRR consultation") Call for Evidence Targeted consultations Annex 2. Partial evaluation of the existing policy framework Annex 2.1. Evaluation of rules on remuneration Annex 2.2. Impact on the bank financing of the economy, including SMEs Annex 3. ASSESSMENT OF OTHER PROPOSED AMENDMENTS TO CRR/CRD IV/BRRD Annex 3.1. Calculation of derivative exposures in the counterparty credit risk framework Annex 3.2. Disclosure Annex 3.3. Supervisory reporting Annex 3.4. Pillar 2 additional capital Annex 3.5. Equity investments into funds Annex 3.6. Bank financing of infrastructure projects Annex 3.7. Large exposure framework (alignment with Basel rules) Annex 3.8. Exemptions on large exposures Annex 3.9. Rules on exposures to CCPs Annex 3.10. Contractual recognition of bail-in (article 55 BRRD) Annex 3.11. Changes to MREL Annex 3.12. Application of IFRS 9 by the EU banks Annex 3.13. Comparative analysis of characteristics of EU G-SIIs and O-SIIs

Annex 3.14. Analysis of a leverage ratio requirement for different business models and exposure types Annex 4. Estimated impact of policy options Annex 5. Background to cumulative impact assessment Annex 5.1. Estimation of costs of FRTB and LR using the QUEST model Annex 5.2. Estimation of benefits of FRTB and LR using the SYMBOL model Annex 6. Implementation of proposed measures 1.INTRODUCTION Financial crises, particularly when they involve the banking sector, can result in huge costs, both in terms of direct fiscal costs and associated costs for the real economy. The 2007-2008 financial crisis was a case in point. Between the years 2008 and 2014 EU governments used almost €2 trillion in State aid (an amount equal to almost 14% of the 2014 EU GDP) to rescue the financial sector. The losses to economic activity due to the crisis were also significant. Some estimates show that the present value of cumulative output losses across the EU may amount to 50-100 % of annual pre-crisis EU GDP (about €6-12.5 trillion), if not more. For the euro area alone, output is now 20% below the level it would have achieved had the trend growth in the previous 15 years continued after 2007. Furthermore, according to some estimates, the present value of the total loss of output until 2030 would represent more than three times the whole economic output of the euro area in 2008 . In response to the crisis the EU implemented a substantial reform of the financial services regulatory framework in order to enhance the resilience of EU institutions (the term institution is used to refer to both credit institutions (i.e. banks) and investment firms, as both are subject to the requirements of the CRR and the CRD IV) and thus increase EU financial stability. Two legislative initiatives targeted institutions, in particular: Regulation (EU) No 575/2013, also known as the Capital Requirements Regulation (CRR) and Directive 2013/36/EU, also known as the fourth revision of the Capital Requirements Directive (CRD IV) enhanced prudential requirements for institutions by implementing global standards adopted by the Basel Committee on Banking Supervision (BCBS) in December 2010; Directive 2014/59/EU, also known as the Bank Recovery and Resolution Directive (BRRD) and Regulation (EU) No 806/2014 on the Single Resolution Mechanism introduced a new recovery and resolution framework for dealing with institutions that are failing or likely to fail, including a minimum requirement for own funds and eligible liabilities (MREL). The main objectives of the Directive are to maintain financial stability and minimise losses for society in general and tax payers in particular in case an institution fails. The new EU regulatory framework has contributed to reinforcing financial stability, restoring investor confidence and allowing institutions to play their fundamental role in supporting economic recovery. The adoption of the Basel III framework at international level, and of the legislative initiatives mentioned above at EU level, did not mark the end of the post-crisis reform. Work continued on several elements which were left outstanding at the time. For example, while Basel III introduced a requirement to calculate and disclose a leverage ratio, it did not introduce a capital requirement based on that leverage ratio; that was to be introduced in 2018. Similarly, although the BCBS had agreed on the necessity of introducing liquidity requirements, the Basel III framework actually did not provide detailed rules for those requirements; those were published later. Moreover, the BCBS has carried out a fundamental review of the trading book framework to address the flaws of the existing rules unveiled by the financial crisis. The BCBS was not the only international body involved in the post-crisis reform. Following a call from G20 Leaders, the Financial Stability Board (FSB) in November 2015 issued standards aimed at ensuring that global systemically important banks (G-SIBs) have sufficient loss-absorbing capacity to be recapitalised in case they fail. This work has led to the introduction of standards on total loss-absorbing capacity (TLAC). At EU level, the Commission carried out various initiatives in order to assess whether the existing prudential framework and the upcoming reviews of global standards were the most adequate instruments to ensure that EU institutions would continue to provide the necessary funding to the EU economy. In particular, the Commission launched in July 2015 a public consultation on the possible impact of the CRR and the CRD IV on bank financing of the EU economy with a particular focus on the financing of micro, small and medium-sized enterprises (SMEs) and of infrastructure and in September 2015 a Call for Evidence (CfE) covering EU financial legislation as a whole. The two initiatives sought empirical evidence and concrete feedback on i) rules affecting the ability of the economy to finance itself and growth, ii) unnecessary regulatory burdens, iii) interactions, inconsistencies and gaps in the rules, and iv) rules giving rise to unintended consequences. In addition, the Commission carried out specific analysis on rules relating to remuneration and on the proportionality of the rules contained in the CRR and the CRD IV. Finally, the Commission contracted a study to assess the impact of CRR on the bank financing of the economy. All the initiatives mentioned above have provided clear evidence of the need to update and complete the current rules in order i) to reduce further the risks in the banking sector and thereby reduce the reliance on State aid and taxpayers' money in case of a crisis, and ii) to enhance the ability of institutions to channel adequate funding to the economy. More specifically, the evidence that was collected demonstrates that the existing EU rules: are not able to cover all risks that institutions face; are not always sufficiently risk-sensitive and able to take into account adequately all relevant risk drivers;

are too complex or too burdensome and create excessive compliance costs for smaller institutions; are not always formulated in a sufficiently clear way and can give rise, in places, to different interpretations and applications; and do not always support economic growth. In order to enhance the resilience of EU institutions and thereby increase financial stability, this impact assessment considers various options for incorporating the remaining elements of the regulatory framework recently agreed by the BCBS and for enhancing legal certainty, especially in the area of resolution. The options considered in this impact assessment aim at: better addressing the long-term funding risk; reducing excessive leverage; increasing the loss absorption and recapitalisation capacity of global systemically important institutions (G-SIIs); better addressing market risks by increasing the risk sensitivity of the existing rules; and increasing legal certainty and enhancing convergence among Member States (MS) in the area of insolvency law and restructuring proceedings, particularly in the area of creditor hierarchy and the use of the moratorium tool. Many of the measures considered in this impact assessment are included in the roadmap developed by the Commission in response to a request from the Council to complete the Banking Union. These measures are seen as flanking measures in the context of the establishment of the European Deposit Insurance Scheme (EDIS). When contemplating the introduction of the above measures, a number of options contained in this impact assessment explore the possibility of adjusting the calibration of some of the new/revised Basel standards (e.g. the leverage ratio, the market risk rules) to reflect better the specificities of EU institutions and the EU economy. The aim of those adjustments is to avoid situations in which the strengthening of prudential requirements could lead to insufficient lending to the economy. Furthermore, some of the other options related to the above measures explore potential adjustment aimed at mitigating potential disincentives for certain activities carried out by institutions which are important for the efficient functioning of capital markets. This is necessary because, in addition to their fundamental role of providing finance to the economy, institutions are also important actors on capital markets, as issuers of or investors in securities and other financial instruments (e.g. covered bonds, securitisations). They also play an important role in facilitating the efficient functioning of those markets by providing essential services, such as underwriting or market making. The Commission has already tabled a proposal to increase the efficiency and soundness of the EU securitisation market including measures to enhance the role of institutions in this market, both as investors and as issuers. The abovementioned options consider additional ways in which to foster the creation of a Capital Markets Union (CMU). Specifically, they are looking at how the measures would need to be adjusted in order to: avoid disproportionate capital requirements for trading book positions, including those related to market making activities; reduce the costs of issuing/holding certain instruments (covered bonds, high quality securitisation instruments, sovereign debt instruments, derivatives for hedging purposes); avoid an increase in the costs of providing services to clients for trades cleared by central counterparties (CCPs). Lastly, some of the options related to the abovementioned measures contemplate adjustments aimed at preventing any potential unfavourable treatment for business areas which are particularly important for cross-border trade. Specifically, they explore the possibility of introducing a more risk-sensitive treatment for trade finance instruments within the contemplated rules on the net stable funding ratio (NSFR) and on the leverage ratio. In addition to the abovementioned measures aimed at enhancing the resilience of EU institutions, this impact assessment also contemplates measures aimed at: enhancing the risk-sensitivity of capital requirements for exposures to SMEs; reducing the administrative costs linked to some rules in the area of remuneration (namely those on deferral and pay-out in instruments); and

making the rules contained in the CRR and CRD IV more proportionate and hence less burdensome for smaller and less complex institutions. Finally, in addition to all the measures described above, which would constitute the main building blocks of a potential proposal by the Commission and which are expected to have the largest impact on EU institutions in case they would be introduced, this impact assessment also considers the possibility of introducing several other measures. These measures are included in the impact assessment for reasons of completeness, as their introduction is seen as largely uncontroversial and straightforward and would generally have a limited impact. These measures would: implement a number of changes, most of them agreed at international level, to better specify the technical aspects of certain existing rules (calculation of the exposure value of derivatives in the counterparty credit risk framework, disclosure requirements, capital requirements for equity investments in funds, large exposures limits, rules on exposures to CCPs, changes to MREL, application of International Financial Reporting Standard 9 (IFRS 9)); clarify existing rules on the basis of the outcomes of the CfE or other consultations with stakeholders (Pillar 2 requirements, exemptions from large exposures limits, supervisory reporting, contractual recognition of bail-in); or enhance the overall consistency of the treatment of investments in infrastructure projects between the CRR and CRD IV on one side and Solvency II on the other. This would increase the contribution of the banking sector to the goal of mobilising additional private finance in the context of the Commission's Investment Plan for Europe . For all the measures listed above the review at global or EU level has been already completed. In addition, there is widespread acceptance among stakeholders about the need to introduce those measures. In view of this, it is imperative to introduce these measures now in the interest of legal certainty and for the creation of a robust financial sector. This would allow the EU to meet the deadline agreed at global level for certain standards (e.g. on TLAC, leverage ratio, NSFR) and fulfil the timeline requested by the Council for the risk-reduction measures included in the roadmap for the completion of the Banking Union. Continuing work on risk-reduction in the Banking Union remains a top priority for the Commission. In order to give institutions sufficient time to adapt to the new regulatory framework it is of the outmost importance to provide them with the necessary legal certainty regarding the exact shape of the new rules as quickly as possible. Institutions should also benefit without delay from the alleviations of the compliance burden envisaged by some of the measures, especially given the current economic context in the EU. The list of preferred options responding to the problems analysed in the impact assessment as well as the indicative list of legislative amendments is presented in annex 6. This impact assessment does not include measures stemming from a strategic review of Basel III on the methods used to calculate the risk-based capital requirements for credit risk and operational risk as those changes are still under discussion at the BCBS level. The review is expected to be completed by the end of 2016. The Commission will consider whether and how to implement those measures once they are adopted at international level. 2.PROBLEM DEFINITION Given the limited time elapsed since its entry into force, a fully-fledged evaluation of the CRR, the CRD IV and the BRRD could not be carried out yet. Nevertheless, the need of amending these instruments in order either to introduce new provisions or to review the existing ones has emerged as a result of the work carried out by the BCBS, obtaining evidence on the national implementation of the Directives or as an outcome of specific consultations and studies, solicited by the Commission (for more details see annexes 2 and 6). The following issues have been identified in relation to the existing rules contained in the CRR and the CRD IV: they do not cover all risks that institutions face (e.g. the CRR currently does not foresee specific capital requirements to limit the leverage of institutions or specific funding requirements to limit the maturity mismatches between assets and liabilities); they are not always sufficiently risk sensitive (e.g. one of the simpler approaches used by institutions to calculate the size of their derivatives exposures does not fully take into account the risk reduction benefits of netting agreements); some of them are too complex or too burdensome for institutions (e.g. reporting and calculation methods), create in some cases excessive compliance costs (remuneration rules on deferral and pay-out in instruments), or may disproportionately affect certain activities or business models (including for new measures introduced to cover existing risks such as the leverage ratio); some of them are not formulated in a sufficiently clear way and give rise to different interpretations (e.g. there are different interpretations on the way in which the capital requirements in the CRR and the institution-specific capital and buffer requirements in the CRD IV interact). As regards the BRRD existing rules, the following issues have been identified: certain MREL eligibility criteria are loosely defined, leaving room for interpretation (e.g. inclusion of large corporate deposits and certain types of structured notes);

the adoption of the FSB's TLAC standard for global systemically important banks (G-SIBs) would create a misalignment with the existing MREL calibration conditions and a parallel standard for G-SIBs in the EU; regarding the insolvency ranking of unsecured debt, the requirement for subordination of certain unsecured senior claims is missing from the current text; Lack of clarity on supervisory reporting and public disclosure of items that meet MREL eligibility criteria; implementation issues with Article 55 BRRD on recognition of bail-in in third countries which was too prescriptive and led to the withdrawal of EU banks from business contracts with certain third countries; on moratorium powers, BRRD already contains provisions allowing the suspension of payment obligations but these have been implemented in very different ways at national level and may not provide a sufficiently consistent application with respect to important elements such as the scope, phase of application, trigger conditions and duration of the suspension. Sections 2.1 to 2.9 present the most important problems addressed by this impact assessment and concern the following areas: stable funding of institutions; capital requirements for risk of excessive leverage; capital requirements for exposures to SMEs; remuneration; insolvency ranking and moratorium in relation to the BRRD; proportionality. For areas for which the solution to the identified problem is seen as largely straightforward and uncontroversial and as having limited impact, are presented in annex 3. They concern: capital requirements for derivative exposures; disclosure and supervisory reporting to primarily address proportionality issues; institution-specific (Pillar 2) capital requirements; equity investments into funds; capital requirements for specialised lending exposures (infrastructure); large exposure limits; capital requirements for exposures CCPs;

contractual recognition of bail-in and changes to MREL; application of IFRS 9 by EU institutions. 2.1.Excessive reliance on short-term funding When an institution takes decision regarding its balance sheet structure, it does not take into account all the impacts of its choice on the rest of the economy. In addition, private incentives to limit excessive reliance on unstable funding of core (often illiquid) assets are weak. Institutions may have private incentives to expand their balance sheets, often very quickly, relying on relatively cheap and abundant short-term wholesale funding. Rapid balance sheet growth increases the likelihood that individual institutions will face funding problems in case of liquidity shocks, and weakens their ability to respond to these shocks when they occur. As shown by the examples below, this fragility can have systemic implications when institutions fail to internalise the costs associated with large funding gaps. This can have negative consequences on financial stability in case of economic shocks. During the financial crisis, institutions made use of excessive amounts of short-term wholesale funding to finance their long term activities. When short-term funding became unavailable, institutions were either forced to request emergency liquidity assistance from central banks or engage in 'fire sales' of assets, triggering a downward spiral in prices and eroding their liquidity positions, with the ultimate consequence of driving a number of them into insolvency. Some credit institutions also had to be bailed-out by their governments. For example Hypo Real Estate Holding AG (HRE) had - through a subsidiary (Depfa Bank Plc) - funded its long term public sector and infrastructure loans either on the interbank market or through other short-term wholesale funding. Following the Lehman Brothers bankruptcy, it was unable to refinance itself on the wholesale market and requested State support. Ultimately, the state guaranteed more than €120 billion of HRE's liabilities and had to inject around €10 billion of capital to nationalise it. Similarly, Northern Rock faced in the second half of 2007 substantial outflows of wholesale funds as maturing short-term loans and deposits used to fund its long-term assets were not renewed. This combined with the inability to tap the securitisation and covered bond markets led to a request for liquidity support from the Bank of England. The public announcement of this request led to a run on Northern Rock. The full year net outflow of wholesale funding amounted to £11.7 billion and by end-2007 a loan from the Bank of England amounted to approximately £28.5 billion. Ultimately, in 2008, Northern Rock was nationalised. In both cases these crisis periods were preceded by years of extensive long-term assets growth without a similar increase in stable funding sources. The CRR introduced a reporting requirement and a general requirement that long-term assets have to be adequately met with a diversity of stable funding instruments (liabilities) under both normal and stressed conditions. More detailed requirements to cover funding risk were not set at that time at EU level given that the BCBS was still in the process of completing its work to specify the NSFR requirement. Therefore, the current European regime does not provide an adequate framework to ensure that institutions’ assets are sufficiently stably funded by their liabilities. The BCBS completed its work and published the NSFR standard in October 2014. In December 2015, the EBA submitted a report to the Commission on whether and how it would be appropriate to ensure that institutions use stable sources of funding and on the impact of such a requirement. 2.2.Excessive leverage The financial crisis has shown that institutions' leverage can increase to unsustainable levels and have a pro-cyclical effect on the financial system. In the run up to the crisis, many investors, including institutions, actively sought higher yields as high levels of available liquidity resulted in risk premium falling to historically low levels. Low interest rates, combined with issues of moral hazard, pushed them to search for higher returns, whether through an increase in leverage or investment in more risky financial products. This caused a high level of financial fragility of individual institutions as well as the financial system as a whole. When prices of financial assets started to fall, institutions had to mark those assets to market thus recognising the losses incurred. This in turn forced institutions to de-leverage by selling assets in order to minimise regulatory capital requirements and meet margin calls from their counterparties. This prompted further decreases in asset prices. In short, institutions’ leverage showed a pro-cyclical pattern: significant increase of leverage in financial booms and strong de-leveraging in financial downturns. Equally important, it was observed that institutions that were severely affected by this mechanism showed strong risk-based capital ratios before the crisis. This is due to the fact that risk-based capital requirements tend to vary over the economic cycle: they decrease as borrowers' creditworthiness improves during economic expansions and increase during economic downturns as borrowers' creditworthiness deteriorates. The combination of incentives for higher leverage before the crisis on one side and the irresponsiveness of regulatory capital requirements to the build-up of risk at the macro level on the other side enabled institutions to grow their balance sheets. While the countercyclical capital buffer introduced by the CRD IV aims at addressing this pro-cyclicality to a certain extent, it is not considered sufficient as it leaves certain discretion in setting the buffer rates. Moreover, as shown by the recent crisis it is difficult to quantify systemic risk as well as to model accurately the different types of risks, in particular at the micro-level (i.e. at the level of the single institution). This makes risk-based capital measures less reliable and calls for the introduction of a simpler and non-risk-sensitive back-stop measure. The misperception of risk may be exacerbated by a strong industry-wide drive for profit, bonuses and moral hazard due to implicit safety nets. Hence during favourable macro-economic conditions, institutions would be prone to engage in a rapid expansion of their balance sheets without due consideration about implications for system-wide financial stability. As the ex-ante identification of systemic risks and formation of asset-bubbles is a very complex exercise, the introduction of a 'hard' leverage ratio would also help alleviate an excessive expansion of leverage. Figures 1 and 2 provide an indication of how leverage has evolved for a selected number of credit institutions in the years prior to the financial crisis compared to risk based capital requirements. As can be seen the leverage of European credit institutions had increased roughly by half since 1995. Had the leverage ratio requirement been in place before the onset of the financial crisis there would have been fewer failures during the crisis. Figure 1. Total assets to total equity Figure 2. Risk weighted assets to Tier 1 capital Sources: CGFS (2009) Sources: CGFS (2009) The leverage ratio framework was introduced in December 2010 by the BCBS in order to: i) restrict the build-up of leverage in the banking sector (and hence avoid destabilising deleveraging processes that can damage the broader financial system and the economy) and ii) reinforce the risk-based requirements with a simple, non-risk based “backstop” measure. The framework did not foresee an immediate introduction of a capital requirement based on the leverage ratio. Instead, it set out an expectation that such requirement would enter into force in 2018. In the EU, the leverage ratio was introduced in the prudential framework in 2013. In line with the BCBS decision, it was not introduced as a capital requirement that institutions must meet. Rather, the CRD IV included it in the Pillar 2 framework, while the CRR introduced requirements to compute it, report it to supervisors and, from January 2015, to disclose it publicly. This has set regulatory expectations for institutions which has already had a positive impact on the evolution of the leverage ratio in the EU: the average level of the leverage ratio for Group 1 and Group 2 credit institutions was above 5% and 4.5% respectively as of December 2015 (see figure 3). Figure 3. Evolution of the leverage ratio for Group 1 and Group 2 credit institutions Source: CRD IV – CRR / Basel III monitoring exercise – results based on data as of 31 December 2015 , EBA, p. 19, Figure 4.

In January 2016, members of the Basel Committee’s oversight body, the Group of Governors and Heads of Supervision (GHOS) agreed on a Tier 1 definition of capital and a minimum level of 3% for the leverage ratio with the view of making it a Pillar 1 requirement by 1 January 2018. This international agreement confirmed the market and industry expectations of a binding 3% leverage ratio. However, only when imposed as a hard capital requirement which must be met at all times the leverage ratio will be an effective measure requiring institutions to constantly manage their balance sheet in a way that will prevent excessive de-leveraging during downturns. A non-binding measure can simply not bring about the same prudential rigour. Furthermore, given the scope for discretion allowed by the current measures for Member States and supervisors in their application of the leverage ratio to institutions, the introduction of harmonised minimum binding requirements across the EU is deemed beneficial in terms of consistency, effectiveness and promoting coherence in the regulation of institutions as in principle all would have to meet the 3% requirement. 2.3.Inadequate calibration of risk weights for exposures to SMEs SMEs are the backbone of the EU economy and an important source of employment and growth for the EU economy. They remain largely reliant on bank lending (e.g., credit lines, leasing) to finance their activities. In fact, other sources of financing, such as equity finance and debt issuance (e.g. bonds), although available, are not as widely used, or are only used through special public support schemes. Following the financial crisis, bank lending to SMEs has suffered a significant drop in volumes, from a peak of €95 billion in mid-2008 to approximately €54 billion in 2013/2014 and currently hovers around €60 billion, which is still almost 20% below the level observed in 2003. Lending to larger corporates, on the other hand, after reaching a higher peak before the crisis and after experiencing a sharper drop thereafter, is roughly back to the volumes observed in 2003 – 2004 (see figure 4). Figure 4. New bank lending to SMEs and larger corporates (EUR million; three-month moving average) Note: SME loans proxied by loans up to and including €1 million; loans to large corporates proxied by loans over €1 million. Source: ECB MFI interest rate statistics. SME are more constrained in receiving external funding also because of their high sensitivity to economic cycles and shocks, which due to their greater sectorial and geographical specialisation. Moreover, the asymmetry of information which exists between SMEs and potential lenders, is particularly acute, and further limits SMEs' ability to switch sources of funding quickly. This disadvantage is reflected in higher interest rates on small loans when compared to large loans as well as in other forms of credit constraints. A comparison of the average cost of loans in the EU shows a significant gap between lending to SMEs and to large firms (see figure 5). In addition, unlike large corporations, small companies have limited access to capital markets and thus remain disproportionally reliant on banks. The smaller a firm, the more restricted the spectrum of potential non-bank funding options (see table 1). Alternative sources of financing are shown to be accessible only to larger firms, firms having high credit ratings, and firms located in countries with better developed financial markets. Ensuring that SMEs have adequate access to finance is therefore a main consideration when setting out policies. Figure 5. Yields of and spread between small and large loans, euro area Source: ECB Table 1. Use of financing instruments by non-financial corporations (percentage averages out of total sample over 2009-2014) Sources: ECB and European Commission Survey on the access to finance of enterprises; European Central Bank (2015c), Non-bank financing for euro area NFCs during the crisis, Box 6 in Economic Bulletin, Issue 4. In the light of the overall increase in capital requirements and in order to avoid disruptions to lending to SMEs in the aftermath of the financial crisis, Article 501 of the CRR introduced a 24% discount to capital requirements for exposures to SMEs, the so-called SME supporting factor, but also included a review clause and asked EBA to provide a report on the issue by June 2016. EBA published the report in March 2016. It provided evidence that the capital requirements, including the SME supporting factor, have overall been consistent with the riskiness of SMEs. The report also indicated that the €1.5 million exposure cap for the application of the SME supporting factor was not indicative of a change in riskiness of SMEs. This implies that SME exposures beyond €1.5 million exposure threshold have been subject to too high minimum capital requirements in comparison to other bank exposures classes and could have likely resulted in insufficient lending to SMEs. The issue is heightened by the current environment of low economic growth and high unemployment and thus requires to be promptly addressed.

The issue is also underpinned by the views expressed in the responses to the CRR consultation and the Call for Evidence. Some stakeholders, particularly banks, claimed that the overall increase in capital requirements had negatively affected their willingness to provide sustainable financing to the economy. They also claimed that the systematic risk stemming from exposures to SMEs was lower than for exposures to larger corporates, and asked that the SME supporting factor should be at least maintained, if not expanded. 2.4.Weaknesses to the regulatory framework for loss absorption and recapitalisation capacity The absence of adequate crisis management and resolution frameworks forced governments around the world to rescue banks following the financial crisis. The subsequent impacts on public finances as well as the undesirable incentive effects of socialising the costs of bank failures have underscored the need for a different approach. The G20 leaders have publicly committed not to use public funds anymore to bail out banks. Significant steps have been taken in international fora and at the EU level in order to reduce the systemic risks of failing banks, through – among others – effective resolution frameworks. A cornerstone tool of a robust resolution framework is the “bail-in”: a system which consists of, writing down debt or converting debt claims or other liabilities into equity according to a pre-defined hierarchy. The tool can be used to internally recapitalise an institution that is failing or likely to fail, so that its viability is restored. Therefore, shareholders and certain creditors, rather than taxpayers, will have to bear the burden of an institution's failure. In the EU, these objectives are already covered by the BRRD. The latter harmonises and improves the tools for dealing with financial crises across the EU and requires all EU institutions to meet a Minimum Requirement for own funds and Eligible Liabilities (MREL). The policy objective of MREL is to ensure that institutions have a sufficient amount of bail in-able liabilities to allow for smooth and quick absorption of losses and recapitalisation in resolution. After the agreement of the BRRD in the EU, the Financial Stability Board (FSB) has developed, in consultation with the Basel Committee on Banking Supervision (BCBS), a new international standard for G-SIBs. The standard is intended to end "too-big-to-fail" problem by ensuring the adequacy of G-SIBs' total loss-absorbency capacity (TLAC), should they fail. Indeed, absent sufficient amounts of readily bail-in-able liabilities, a failure of a G-SIB may either impose large costs on the global financial system or necessitate fiscal intervention, which is to be avoided. The possible systemic effects, in particular the possible large costs to other market players and the economy at large through the contagious effects of interbank exposures, asset fire-sales and uncertainty among holders of operating liabilities (e.g. derivative counterparties) are illustrated by the Lehman Brothers case. The MREL requirement and TLAC share the objective of ensuring that banks have sufficient loss absorption and recapitalisation capacity. TLAC addresses the particular global systemic problems posed by G-SIBs worldwide, whereas MREL is part of an EU framework to promote an orderly and feasible resolution or winding down for every bank. The BRRD framework cannot protect the EU from contagion of the collapse of a third country G-SIB. The particular global contagion risk and world-wide social costs of a G-SIB's failure by contrast require a backstop on the minimum requirement on loss absorption and recapitalisation capacity to ensure that these G-SIBs hold a sufficient amount of bail in-able liabilities so that they can absorb losses internally without worldwide societal implications or a fiscal intervention in their favour. As the MREL was designed to be applicable for all types of institutions regardless of the global systemic implications of their failure, there is no harmonised minimum requirement but the requirement is to be tailored to each institution by the resolution authority. As the failure of a third country G-SIB would impose significant costs on the EU economy through contagion effects, a global minimum standard is very much in the EU's interest. Other jurisdictions have not implemented frameworks ensuring minimum requirements for bail-in-able liabilities like the EU did in the BRRD. Even if this were the case, it would be difficult for the EU to have confidence in the practical application of a framework comparable to the MREL requirement in third countries absent a clearly quantified minimum standard. Finally, as third country G-SIBs are by definition active worldwide and compete with EU banks, from a level playing field perspective it is also desirable to hold them to a clearly quantified minimum standard in order to avoid competitive disadvantages that could result from the unilateral introduction of the EU's sound MREL requirement. However, the EU can only credibly expect third countries to implement the TLAC standard if it holds its own G-SIBs to the same requirements. 2.5. Inappropriate level of capital requirements against trading activities Financial instruments held by institutions for trading purposes (e.g. shares, bonds, derivatives), are subject to the risk of movements in their market prices, which has a daily impact on institutions' profits and losses. These market price movements can be large and sudden; sudden large drops in market prices can damage the solvency position of institutions. Because of the idiosyncrasy of this risk, the prudential framework embedded in Council Directive 93/6/EEC contains a specific regime for these financial instruments (they are often referred to as trading book exposures), which is different from that applicable to other types of exposures, such as loans (those are usually referred to as banking book exposures). During the financial crisis, the level of capital required against trading book exposures proved insufficient to absorb losses. Trading book losses in EU institutions were very substantial and some of those institutions had to be injected State aid and/or resolved as a result (e.g. Dexia, Royal Bank of Scotland). This revealed a number of weaknesses in the design of the prudential framework for the trading book, which needed to be addressed. In 2009, a first set of reforms were finalised at international level (known as the 'Basel 2.5' package of reforms) and transposed in the EU via Directive 2010/76/EU (CRD III). These reforms, subsequently retained under the CRR, sought as a main objective to increase the overall market risk capital requirements to addresses the most pressing deficiencies of the standards on market risk. However, the 2009 reform did not address the design flaws present in those standards, such as: a scope of application of the market risk capital requirements which is not sufficiently clearly defined. This allows institutions to engage in regulatory arbitrage, i.e. they can allocate some of their instruments to the regulatory book that generates the lower capital requirements. As an example, prior to the crisis, securitisation instruments were usually allocated to the trading book because of the low volatility of the securitisation markets (leading to low capital requirements under the market risk rules) even if there was no evidence of regular trading in these instruments (implying that they had little chances to be traded); lack of risk-capture. Many features of market risk are not reflected in the capital requirements. As a consequence, the amount of capital required for certain instruments is not aligned with the real risks that institutions face for these instruments. As an example, the risk of holding more illiquid instruments is not recognised since the current market risk capital requirements assume that all trading positions can be extinguished within two weeks; high variation of modelling outcomes. Internal models used by institutions to calculate capital requirements for market risk may generate very different estimates of the amount of capital required for similar portfolios. A comparative study performed by the BCBS across a sample of 15 large banks worldwide (half of them Europeans) with permission to use internal model showed that, for the same hypothetical diversified portfolio of trading assets, the bank with the highest capital requirements generated for this portfolio had capital requirements that were roughly three times higher than those of the bank with the lowest capital requirements. Consequently, the BCBS initiated the fundamental review of the trading book (FRTB) to tackle those flaws. This work was concluded in January 2016, following three public consultations in May 2012, October 2013 and December 2014. A more comprehensive overview of what went wrong during the 2007-2008 financial crisis with the trading book framework and of why the Basel 2.5 reforms did not sufficiently improve the capture of market risk was provided in the BCBS consultation paper of May 2012. 2.6.Problems on remuneration rules CRD IV contains a number of detailed rules on how institutions should determine and pay out variable remuneration of staff whose activities have a material impact on the institutions’ risk profile. Problem 1: Excessive compliance costs arising from the rules on deferral and pay-out in instruments Under CRD IV rules, institutions are not allowed to immediately pay out the full amount of variable remuneration or to pay it entirely in cash. Instead, CRD IV requires that at least 40% (or in some cases at least 60% of the variable remuneration) be paid out only after a number of years. It moreover requires that at least 50% of the variable remuneration be paid out in instruments instead of cash. These rules are applicable to all institutions, regardless of their size and complexity, and to all identified staff, regardless of the level of their variable remuneration.

Because of this broad scope of application, compliance with the above requirements entails high costs outweighing prudential benefits in the following cases: (i) small and non-complex institutions (for instance local cooperative and savings banks) need to make considerable investments in human resources (HR), information technology (IT) and advisory services and are faced with difficulties in creating instruments appropriate for remuneration purposes. According to EBA estimates, the average one-off costs for these institutions would range from €100 000 to €500 000 per institution, and ongoing costs from €50 000 to €200 000. (ii) other institutions also incur important costs resulting from the fact that they need to apply the rules to all of their identified staff, which will often include a high number of individuals with only non-material levels of variable remuneration. For instance, according to EBA estimates, a full compliance by large institutions with the above requirements in respect of all staff, even that with non-material levels of variable remuneration, would imply one-off costs ranging from €1 to 5 million, and ongoing costs ranging from €400 000 to €1.5 million. At the same time, the prudential benefits of applying the requirements on deferral and pay-out in instruments in the above cases are low. If a staff member receives only a non-material level of variable remuneration, then such variable remuneration is unlikely to provide him/her with incentives to engage in excessively risky behaviour, which would need correction through deferral and pay-out in instruments. Given that small and non-complex institutions are typically not among the institutions paying the larger portions of variable remuneration, and mostly pose lesser risks to financial stability, the prudential benefit of deferral and pay-out in instruments in their case would be limited. Problem 2: Excessive compliance costs arising from the requirement for listed institutions to pay out part of the variable remuneration in shares Under the CRD IV rules, listed institutions are always required to pay out part of the variable remuneration in shares; on the other hand, non-listed institutions have the possibility to use, in addition to or instead of shares, share-linked instruments (Article 94(1)(l)(i)). Compliance with the pay-out in shares requirement entails important difficulties and burdens for the approximately 200 institutions that are listed. They would need to either create new shares or buy them on the market. Both are cumbersome procedures for the institution. The creation of new shares would risk negatively affecting the shareholders by diluting their voting rights. The purchase of shares could trigger speculation and force the institution to pay a premium. Acquiring shares would moreover lead to reducing the own funds of the institution. Furthermore, staff remunerated in shares may not be able to sell them because of problems of insider dealing which is criminally sanctioned, lowering the perceived value of such remuneration for staff. Moreover, payment in shares in different countries can be subject to legal, accounting or tax constrains. For example, some institutions with subsidiaries in non-EU jurisdictions (Russia, US) have signalled problems they encounter with shares to remunerate staff in their non-EU subsidiaries. While these are arguably significant difficulties and burdens, it is not possible to precisely quantify the absolute costs resulting from them for listed institutions. At the same time, an equally effective yet less difficult and burdensome alternative for shares exists, namely share-linked instruments. This means that, in the case of listed institutions, the requirement to pay out part of the variable remuneration exclusively in shares entails unnecessary compliance costs compared to other available alternatives with similar prudential benefits. 2.7.Problems on insolvency ranking of unsecured bank debt instruments One of the key objectives of the BRRD is to facilitate private sector loss absorbency in the event of a bank crisis. To achieve this objective, all banks are required to meet a Minimum Requirement for Own Funds and Eligible Liabilities (MREL) to ensure that sufficient financial resources are available for write down or conversion into equity. Under the BRRD, MREL does not generally require mandatory subordination of eligible instruments for MREL. This means, in practical terms, that a liability eligible for MREL may rank in insolvency at the same level (pari passu) with certain other liabilities which are not bail-inable in accordance with the BRRD (e.g. operational liabilities, such as short-term inter-bank loans), or certain other liabilities which are bail-inable, but could be excluded from bail-in on a discretionary basis (as allowed under the BRRD) if the resolution authority can justify they are difficult to bail-in for reasons of operational execution or systemic contagion risk (e.g. derivatives, structured notes). This could lead to situations where bailed-in bondholders may claim they have been treated worse under resolution than under a hypothetical insolvency. In such case, they would need to be compensated by financial means of the resolution fund. To avoid this risk, resolution authorities may decide that the MREL requirement should be met with instruments that rank in insolvency or resolution below other liabilities that are either not bail-inable by law or difficult to bail-in (“subordination requirement”). Harmonising the ranking of unsecured bank debt holders in insolvency and resolution would provide the means to ensure an effective and transparent bail-in, especially in cross-border cases and would provide certainty and clarity to investors and resolution authorities. In addition to the MREL standard for which subordination of debt instruments could be required by resolution authorities to the extent it is needed to facilitate the application of the bail-in tool in a given case, the minimum TLAC requirement for G-SIBs, as clearly stated by the FSB Term Sheet, should be met using a certain amount of subordinated debt instruments. The results of international negotiations and the consensus among Member States indicate that the future EU TLAC standard applicable to G-SIIs will stay aligned with the FSB TLAC Term Sheet as regards the subordination condition. This means that G-SIIs will have to satisfy the TLAC level with instruments that are subordinated to other excluded TLAC instruments (e.g. operational liabilities) with the aim to enhance the operational execution and robustness of bail-in powers and to avoid legal uncertainty. The TLAC requirement to hold subordinated instruments combined with the potential discretionary request by the resolution authority to meet MREL also with subordinated instruments have driven some Member States to re-assess national insolvency ranking. A number of Member States have amended (or are in the process of amending) the insolvency ranking of certain banks’ creditors under their national insolvency law to operationalise the possible application of the bail-in tool and to ensure that banks comply with the “subordination requirement” of the international FSB standards on TLAC for G-SIBs. As the national rules adopted so far diverge significantly, they can create competitive distortions in the single market and complicate the operationalization of the bail-in tool, in particular for cross-border banks. Moreover, the national approaches have very different effects on G-SIIs’ ability to address potential shortfalls in meeting TLAC standards. Under some approaches TLAC shortfalls were addressed with immediate effect through statutory retroactive subordination of the existing stock of unsecured senior debt, possibly without the issuance of new debt instruments, meaning a limited additional cost of funding was incurred to become TLAC compliant. Under other approaches banks would likely need to issue new debt, which meets the subordination criterion, at a higher marginal cost than senior debt for the period running to and after the TLAC compliance date. The effects ultimately depend on a bank’s shortfall of TLAC eligible instruments and its liability structure, but two banks with comparable shortfalls and liability structures could face significantly different treatment depending on the insolvency ranking of unsecured debt in their respective jurisdictions. Additionally, the creditors of banks under such divergent national insolvency regimes would be treated very differently when buying the claims of banks falling under different national hierarchy of creditor regimes. There is a broad agreement among stakeholders that having divergent approaches to the statutory insolvency ranking of bank creditors provides uncertainty for issuers and investors alike and makes more difficult the application of the bail-in tool for cross-border institutions. This uncertainty could also result in competitive distortions in the sense that unsecured debt holders could be treated differently in different jurisdictions and the costs to comply with the TLAC and MREL requirement for banks may be different from jurisdiction to jurisdiction. In its conclusions of 17 June 2016, the Council invited the Commission to put forward a proposal on a common approach to the bank creditors' hierarchy. During the meeting of the experts of the European Parliament and of the Member States of 23 of June 2016, a large number of Member States communicated that they were clearly in favour of harmonisation and endorsed partially harmonised EU approach to subordination. They insisted, however, that any EU approach should provide sufficient flexibility to take account of different bank business models across the EU and reduce at minimum impacts on bank funding costs. 2.8.Lack of effectiveness of the current rules on moratorium

A moratorium tool can be broadly defined as the power to temporarily suspend payments or performance of obligations and / or temporarily prohibit contracting new obligations. Use of moratorium in a supervisory/resolution context can be useful in several scenarios: for liquidity stabilisation: in case of severe liquidity outflows, an institution could have to sell assets at a discount (“fire sale”). This creates losses which are bound to be borne by creditors and particularly those “left behind”. Even in the absence of fire sales, there might be a first mover advantage that sparks a bank run: the first creditors to redeem their claims would be repaid fully, while those who act late will face losses (due, for example, to asset discounts in an insolvency procedure). A moratorium could ensure a stabilization of the liquidity position and equal treatment of creditors and foster financial stability by eliminating the first mover advantage. Potentially this may, depending on the circumstances, also address the contagion issue; to ensure stability in the pre-resolution phase: a moratorium can help ensure the stability of an institution in the days leading up to resolution, provide ample time for the resolution authority to conduct a prudent valuation and determine, for example, the appropriate amounts for bail-in; to restore the capital position of the institution: the use of a moratorium tool in a supervisory context can be a useful tool to address temporary issues with respect to, for example, the composition of a bank's capital; to prevent increases in secured funding: an institution that is experiencing distress may not be able to issue unsecured (term) debt. Such an institution would need to attract secured funding, which may require that in order to provide safety to the new secured creditors the secured claim might have to be over-collateralised. If over-collateralised funding increases significantly, this effectively increases the loss rate for unsecured creditors as well as possibly depositors / the DGS in case of default. Stabilizing the liquidity situation through a moratorium could prevent such an effect, while ensuring the equal treatment of creditors. The issue of the harmonisation of moratorium tools was raised in the meetings of the Council Ad-hoc Working Party on strengthening the Banking Union. In that context a questionnaire was submitted to the Member States and the ECB, and the Dutch Presidency produced two non-papers on the topic, mainly summarising Member States replies to the survey. The Council conclusions of 17 June 2016 invited the Commission to conduct further work on whether and how further harmonisation of the rules and application of moratorium tools can contribute to the stabilisation of an institution in the period before, and possibly after, an intervention. Further to that, DG FISMA carried out internal analysis and consultations – including a questionnaire – with national experts to assess the most appropriate way forward. An uneven playing field resulting from the identified differences listed below would lead to detrimental consequences and could hamper the effectiveness of resolution tools in a cross-border scenario. For example, the very different duration of the suspension from one Member State would make it more difficult for a resolution authority to devise a consistent resolution strategy cross-border. Also, it would in certain cases impair the effectiveness of the moratorium tool altogether because it would create an incentive for creditors to move their investments in the bank to countries where the duration of the suspension is shorter. Similarly, the possibility allowed by certain national legislations to use the moratorium as an early intervention tool, which would allow supervisors/resolution authorities to intervene more effectively at an earlier stage when the specific situation of the bank requires, may be impaired by the different approaches at national level in this respect. An effective application of the tool in a cross-border scenario would be greatly reduced if supervisors / resolution authorities were not in a position to apply the same tools across the board at the same time. Existing provisions in CRD IV and BRRD already provide some basis for competent authorities to exercise certain moratorium powers. In particular, Member States transposed provisions on moratorium in very different manners. This can negatively impact the practical application of a moratorium and create an uneven level playing field. Therefore these provisions may be improved and further harmonised to make existing tools more effective by enhancing legal clarity and providing further certainty in a cross-border scenario. All Member States have some type of moratorium tools available in their jurisdiction. Most introduced these tools in their legislative framework as a result of the transposition of BRRD or CRD IV. The relevant national provisions however vary in terms of scope of the liabilities covered (particularly with respect to covered deposits and payment systems), means of activation (supervisory / resolution / both), and duration. With respect to the scope, in several Member States moratorium powers extend also to covered deposits (12 MS). In most Member States a moratorium intervention on covered deposits would be considered as a pay-out event and would therefore trigger the application of the Deposit Guarantee Scheme. Payment obligations to CCPs or payment settlement systems are on the other hand excluded from the scope of moratorium powers in most MS (9). Marked differences in transposition can be encountered also with respect to the duration of the payment suspension in case of moratorium. Most national legislations (16 MS) provide a predetermined maximum duration. The duration can however range widely (from one working day to twelve months). Some Member States have comparatively short durations of twenty days or one month, while the most frequent indicated maximum duration is six months. Several Member States indicated that an extension of the suspension period would be possible (although these extensions are sometimes also subject to a predetermined maximum). Moreover, with respect to the intervention phase for moratorium tools, legislative provisions at national level do not appear consistent. While more consistency can be observed with regards to moratorium powers applied under resolution, national legislative frameworks seem to follow different approaches with respect to the use of such tools in the early intervention phase. In several countries moratorium powers can be activated during the early intervention phase and in this context the precautionary powers provided by the CRD IV framework can usually be exercised. In other countries, however, a moratorium power seems to be considered eminently a resolution-related tool and can only be activated once a bank is deemed to be failing or likely to fail or put under resolution. Finally, some of the consulted stakeholders highlighted possible means to improve this tool, such as on the duration of the suspension and its scope. 2.9.Insufficient proportionality of the current rules It can be argued that the CRR and the CRD IV are already "proportionate" to a large extent, insofar as they take into account the size, complexity and business model of institutions for various purposes. The framework as a whole is formulated in a modular manner, such that institutions must only apply those requirements which are relevant to the risks they incur. Furthermore, the framework provides for specific exemptions and preferential treatments for various purposes (e.g. own funds, liquidity, covered bonds), thus reflecting the relative complexity and riskiness of institutions and the activities they undertake.

Nevertheless, several Member States and Members of the European Parliament have raised the concern that the current EU regulatory framework does not sufficiently differentiate between the very large systemic institutions and very small local institutions. Moreover a sizable number of respondents to the CRR consultation and the Call for Evidence submitted that, in their view, some of the prudential requirements in the CRR and CRD IV may impose a disproportionate burden on smaller and less complex institutions. Respondents to the Call for Evidence singled out complexity of rules, administrative burden and compliance costs as the most pressing concern for smaller institutions. They argued that costs resulting from complex prudential rules create a competitive advantange for larger institutions insofar as these can benefit from economies of scale to allocate more resources to compliance functions. In particular, respondents pointed to costs resulting from current CRR and CRD IV requirements on: EU harmonised (Pillar 1) reporting, whose volume and frequency was regarded as disproportionate for smaller institutions, as well as reporting required by supervisors under Pillar 2 on an ad hoc basis, over and above Pillar 1 reporting; disclosure of capital and liquidity requirements, which applies to all institutions in largely the same fashion, as a result of which it was regarded as too detailed and frequent for smaller institutions and of little practical use for institutions with no publicly traded securities; and the complexity and large volume of rules that respondents have to deal with and the inability to keep up with all the changes in the legislation. Section 4.9 below discusses various potential policy options to address undue burden on smaller institutions resulting from reporting and disclosure requirements. Whilst these measures address proportionality issues related to the size of a credit institution, other measures proposed in the impact assessment address proportionality concerns related to credit institutions' business model (e.g. the types of activities carried out). More precisely, where relevant, each section in this impact assessment discusses specific policy options and limited exceptions tailored to simpler or less risky business models or activities undertaken by any institution, including for these purposes smaller institutions (see sections on TLAC, lending to SMEs, trading book, leverage ratio, NSFR and remuneration). This approach has been chosen taking into account the specificities of the banking sector in the EU, where the market is highly polarised (i.e. there is a very large gap between the biggest and the smallest banks) and the composition (i.e. size and type of business models of banks) of the banking sector across Member States is highly different. The possibility of developing a 'lighter regime' across the board for small/less complex EU credit institutions would be very complex since solutions that could work for a certain type of credit institutions might not work for others. Instead, the introduction of tailored measures for different metrics (e.g. TLAC, lending to SMEs, trading book, leverage ratio, NSFR and remuneration) ensure a degree of flexibility able to cover credit institutions with different sizes and business models in all Member States. 2.10.Consequences from the baseline scenario Not dealing with the problems described above would have several broad potential consequences: from the safety point of view they include mispricing of risk, inadequately capitalised or funded individual institutions and too-big-to-fail institutions. All of these would ultimately lead to a higher probability of financial crises in the future and to higher economic and social costs of those crises, both in terms of foregone output and unemployment; from the point of view of smaller institutions, they include a continued high level of administrative costs; from the point of view of the services provided by institutions to the EU economy - to the extent that the current regulatory framework imposes capital requirements which are disproportionate to the actual risks faced by those institutions - they include an insufficient supply of those services (e.g. lending to SMEs or client clearing services). Looking at the individual areas, more detailed consequences would likely materialise. On stable funding of banks, while the LCR ensures that banks will be able to withstand a severe stress on a short-term basis it does not ensure that they will have a sustainable stable funding structure on a longer-term horizon. General requirements on stable funding and market discipline would likely mitigate some of risks related to insufficiently stable funding, but are unlikely to prevent banks from relying on too-high amounts of short-term funding. Banks would therefore be more prone to liquidity problems in situations where markets for short-term funding were disrupted. This would likely lead to the failure of those banks and potentially even to a new financial crisis. On the loss absorption of systemically important institutions, there would be no backstop on the minimum loss absorption and recapitalisation capacity in G-SIIs, the level playing field between G-SIIs could be difficult to assess and there would be no incentive for other jurisdictions to impose a similar framework on third country G-SII. Each of these elements would impose significant costs on the EU economy in case of failure of a G-SII.

On the leverage ratio, not implementing a capital requirement based on this ratio would mean that the risk of excessive leverage would continue to be monitored by supervisors during the supervisory review process and institutions would have to calculate, report and disclose the leverage ratio. However, the combination of market discipline and supervisory review would not serve as an effective deterrent against excessive leverage of institutions compared to a binding leverage requirement and thus risks to financial stability would remain. Furthermore, there would be no backstop to risk-based capital requirements calculated using institutions' internal models (as the existing backstops expire will expire at the end of 2017). Finally, the effects of economic cycles would not be addressed properly as risk-based capital requirements alone are insufficient to deal with this issue. On market risks, the weaknesses and design flaws of the current prudential framework for trading book transactions will remain unaddressed. As the result, the allocation of capital requirements across those transactions may still be inadequate as compared to the true risks faced by the institutions. For certain transactions in the trading book, institutions subject to the CRR would therefore not have sufficient amounts of capital to absorb the potential losses that may arise from adverse changes to the market conditions for those transactions. Institutions with very concentrated portfolios in those transactions would suffer significant losses, potentially requiring State aid and/or be resolved as a result. Other transactions of the trading book may suffer from an excess of capital requirements which would continue negatively affecting the market liquidity and transactions costs. On the SME supporting factor, leaving the existing rules unchanged would ensure the continuity of the current regulatory framework with no new compliance burden. Maintaining the status quo would be also in line with EBA's findings, which demonstrated that the SME SF had been found to be consistent with actual systematic riskiness of EU SMEs, except for retail exposures of banks using the Internal Ratings-Based (IRB) approach. This option would also address numerous calls from banks to the CRR consultation and the Call for Evidence for retaining the SME SF in the CRR. The stability of the regulatory framework would ensure the consistency in monitoring of the use of the SME SF in accordance with Article 501(3). Moreover, the EBA report provides evidence showing that additional capital reduction for SME exposures above the current €1.5 million exposure threshold could still be consistent with the riskiness of these exposures. Not providing further capital reduction for SME exposures above €1.5 million would thus likely result in a sub-optimal level of bank financing of these SMEs. On remuneration, the application of the rules on deferral and pay-out in instruments to small and non-complex institutions, as well as towards staff with low, non-material levels of variable remuneration would trigger for the institutions concerned important compliance costs and burdens. This would also translate into non-negligible supervisory burden for competent authorities. At the same time, the prudential benefits of applying those requirements to small and non-complex institutions and towards staff with non-material levels of variable remuneration would be low. Moreover, listed institutions would have to sustain important compliance difficulties resulting from the requirement to use shares in fulfilment of the requirement under Article 94(1)(l)(i) of the CRD IV, while the prudential benefit would not be any higher than in case of the use of share-linked instruments. On insolvency ranking, the current heterogeneity of approaches would lead to a confusing and unclear situation for investors and create an uneven playing field for both banks and investors which could be detrimental for the European debt market or even lead to regulatory arbitrage. This fragmentation would likely lead in some countries, to a less liquid and more expensive market for European TLAC eligible debt which could have a negative impact on banks’ funding costs and their ability to roll-over debt. This could arise for instance in cases where creditors, who have been statutorily subordinated by law, could be incentivised to limit their exposures to that particular market potentially impacting liquidity and driving funding costs up. Along a similar line, banks whose unsecured debt has been statutorily subordinated would be potentially incentivised to move into riskier funding (e.g. derivatives, structured products) rather than roll-over subordinated debt that is in excess of their TLAC holding. With regards to transparency and clarity, it is expected that investors would be able and willing to evaluate the insolvency laws of Member States with sizable capital markets, but might be reluctant to do so for 28 different regimes. This could be to the detriment of Member States with less developed capital markets. Furthermore, the heterogeneity of approaches would increase the complexity for resolution authorities to set the minimum requirements for bail-inable liabilities and might impede the effectiveness of the bail-in tool, especially for cross-border groups. Most Member States and stakeholder groups acknowledge these risks associated with divergent national insolvency regimes and are clearly in favour of a partial harmonisation of creditor claims on unsecured liabilities. On moratorium, the diversity of national approaches to the implementation of the tool as well as the lack of clarity of certain elements may reduce the effectiveness of this tool and result in undesired consequences such as bank runs or reduction of liquidity in a supervisory/resolution context. On proportionality, costs resulting from complex prudential rules and high administrative burden would maintain the current competitive advantange of larger institutions insofar as these can benefit from economies of scale to allocate more resources to compliance functions. Failure to embed more proportionality in the prudential rules in an adequate fashion would result in excessive compliance costs for institutions, an uneven playing field for smaller institutions and barriers to entry for potential new market players. The transmission mechanism is shown in the problem tree below.





Figure 6. Problem tree 3.OBJECTIVES 3.1.General, specific and operational objectives There are three broad general objectives behind the initiative: contributing to financial stability, reducing the likelihood and the extent of taxpayers' support in bank resolution as well as contributing to sustainable financing of the economy. These can be broken down in the following, more specific objectives: enhance risk-capturing (incl. risk-sensitivity) of the prudential framework so that it better reflects all the different risks embedded in the banking activity (S-1); increase proportionality of rules that lead to unnecessary administrative burden and compliance costs (S-2); enhance the level playing field and reduce risk arbitrage opportunities (S-3); enhance capacity of loss-absorption and recapitalisation of G-SIBs worldwide (S-4); enhance legal certainty and coherence (S-5). Table 2. Mapping of problems and objectives Field Problems Problem Drivers Operational Objectives Specific Objectives S-1 S-2 S-3 S-4 S-5 Funding risk Fragility of banks which excessively use short-term wholesale funding to finance long term activities Un-level playing field Shortcomings in banks' risk management on maturity matching between assets and liabilities Lack of explicit pan-EU regulatory measures mitigating the funding risks Introduce regulatory measures ensuring a more stable funding structure for EU banks √ √ √ √ Inadequacy of the current regulatory framework to address funding risks over the long term and to ensure that banks finance their long term activities with stable sources of funding Develop and implement appropriate methodology/metrics to measure the degree of stability of liabilities and of liquidity of assets over a one-year horizon √ √ √ √ Excessive leverage Overextension of credit in the economic upturn resulting in excessive de-leveraging spiral during the economic downturn Generous discretionary distributions during periods of stress, when capital should be conserved A too favourable picture of the financial robustness of the financial institutions leading to further leverage and reduced the resilience of the financial sector to future shocks Banks' incentive to increase leverage in order to maximise their return on equity without taking into account externalities Limitations in risk measurement, information asymmetries and inappropriate responses to risk and changes in economic conditions Risk-based capital requirements cannot fully ensure that all risks are adequately captured. Lack of explicit regulatory limits to leverage of credit institutions Provide a backstop to the risk sensitive capital requirement √ √ √ √ SME exposures Banks' ability to provide adequate funding to EU SMEs could be hampered, particularly by the most capital-constrained banks Capital requirements for SME exposures beyond €1.5 mio threshold do not reflect sufficiently systematic risk stemming from SMEs and consequently are too high in comparison to other exposures classes Re-calibrate Risk Weights for exposures to SME loans so that they better reflect risks of SME exposures √ √ √ √ Loss absorption and recapitalisation capacity Distress or disorderly failure of a G-SIB anywhere in the world would create significant disruption to the wider financial system and economic activity Lack of G-SIBs' capacity to absorb losses from major financial crisis without the taxpayer support Introduce a minimum requirement on the loss absorbing and recapitalisation capacity of systemically important institutions √ √ Un-level playing field G-SIBs worldwide are not subject to a clear minimum standard Introduce a minimum requirement on the loss absorbing and recapitalisation capacity of systemically important institutions √ √ Market Risk Possible bank failures resulting from: -inadequately captured risks inherent to banks' trading book resulting from: -regulatory arbitrage between banking and trading books -high risk of a sudden and severe impairment of market liquidity across asset markets Lack of consistency and comparability among banks using models to calculate their capital requirements for some trading book positions Lack of clarity with regard to the boundary between the trading and the banking book Establish a more objective boundary between the trading and the banking book √ √ √ √ Lack of risk sensitivity of the whole framework to addressee certain risks (e.g. tail risk or liquidity risk) Provide a more prudent capture of “tail risk” and capital adequacy; Incorporate varying liquidity horizons into the revised SA and IMA √ √ √ √ Lack of consistency between standardised and internal approaches Make a standardised approach more risk-sensitive to serve as a credible fall-back for, as well as a floor to, the Internal Models Approach √ √ √ √ Lack of rigour in the model approval by supervisors, of more consistent identification and capitalisation of material risk factors across banks Constraints on the capital-reducing effects of hedging and diversification Introduce a revised internal models-approach (IMA) √ √ √ √ Insolvency ranking Fragmented framework for insolvency ranking for unsecured bank debt: Possible competitive distortions due to differences in cost of funding and different treatment for investors, as well as investor uncertainty and asymmetry of information costs. Probability that claims arise due to a breach of the no-creditor-worse off principle differs from MS to MS. Bank's ability to use unsecured debt to meet TLAC and MREL may also differ. This could lead to possible competitive distortions in the EU debt markets. Divergent approaches for ranking unsecured debt holders in insolvency creating debt market fragmentation and uneven playing field. Different investor treatment and cost of funding impact for banks which need to issue TLAC eligible instruments to satisfy shortfalls. Pari passu ranking of unsecured bank debt with liabilities that are more likely to be excluded from bail-in for operational reasons, increasing the risk of legal challenge and likely to hinder the operational execution of bail-in. Enhance clarity for investors and issuers, by partially harmonising the hierarchy of unsecured claims in insolvency. Enable banks to meet TLAC/MREL shortfalls in due time, with a tailor-made solution and more clarity on costs, under fairer competitive conditions, Enable banks to maintain flexibility in adequately choosing the funding mix. Avoid competitive distortions that result from different treatment of unsecured bank debt holders under various national insolvency laws. Increase the robustness of the bail-in tool. √ √ √ Moratorium Lack of a level playing field in the application and implementation of moratorium tools Potential lack of clarity with respect to important issues such as duration, intervention phase, scope Variety of approaches at national level Enhance consistency across EU Member States and improve clarity for supervisors and resolutions authorities as well as creditors and provide an effective tool to be used when assessing banks' liquidity in a supervisory/resolution tool √ √ Remuneration Excessive compliance costs arising from the rules on deferral and pay-out in instruments The existing CRD IV rules on deferral and pay-out in instruments are applicable to all institutions, regardless of their size or complexity, and to all of their identified staff, regardless of the level of their individual variable remuneration Eliminate excessive costs related to compliance with the rules on deferral and pay-out in instruments, without posing risks to financial stability √ Excessive compliance costs arising from the requirement for listed institutions to pay out part of the variable remuneration in shares The existing CRD IV rules require listed institutions to pay out a part of the variable remuneration in shares Eliminate excessive costs for listed institutions related to compliance with the rules on payment in shares, without posing risks to financial stability √ Proportionality Disproportionate compliance and administrative costs Overall framework too complex and burdensome Disclosure and reporting requirements are burdensome and disproportionate for smaller institutions Prudential requirements need to take into account the risk profile and complexity of institutions and the activitities they undertake Reduce administrative burden and compliance costs for smaller institutions Enhance the modular approach of the CRR/CRD IV to take into account risk profile and complexity of institutions and the activitities they undertake Maintain overall consistency of the prudential framework for all institutions √ √ √ √ 3.2.Consistency of the objectives with other EU policies Four years after the European Heads of State and Governments agreed to create a Banking Union, two pillars of the Banking Union – single supervision and resolution – are in place, resting on the solid foundation of a single rulebook for all EU banks. While important progress has been made, further steps are needed to complete the Banking Union. The CRR/CRD IV review is part of this effort and the overall objective of this initiative, as described above, are fully consistent and coherent with the EU's fundamental goals of promoting financial stability, reducing the likelihood and the extent of taxpayers' support in bank resolution as well as contributing to a harmonious and sustainable financing of economic activity, which is conducive to a high level of competitiveness and consumer protection (Article 169 TFEU). These overall objectives are also in line with the objectives set by major EU initiatives such as the Juncker investment plan (EFSI), a proposal for European Deposit Insurance Scheme (EDIS) and its focus on risk reduction as well as with the objective of moving towards a Financial Union, with the completion of the Economic and Monetary Union and the creation of a Capital Markets Union. Some of the proposed provisions on leverage, liquidity and loss-absorbance capacity in particular are also consistent with internationally agreed standards (Basel Committee and FSB) to which the EU has actively contributed and committed to implement. 3.3.Consistency of the objectives with fundamental rights

The EU is committed to high standards of protection of fundamental rights and is signatory to a broad set of conventions on human rights. In this context, the proposed measures as discussed above are not likely to have a direct impact on these rights, as listed in the main UN conventions on human rights, the Charter of Fundamental Rights of the European Union which is an integral part of the EU Treaties, and the European Convention on Human Rights (ECHR). 3.4.Subsidiarity Following the liberalisation of international capital flows in the 1970s and 1980s, banks have provided an increasing amount of cross-border services. To ensure that banking regulation remains effective, regulators have developed internationally agreed principles and standards that large cross-border banks have to respect irrespective of their location. Those standards are developed by the Basel Committee on Banking Supervision (BCBS). Several EU Member States and the European Commission take part in those discussions and the Basel standards form the backbone of the prudential requirements set out in EU banking legislation. Following the financial crisis, the BCBS fundamentally revised the international standards leading to the Basel III regulatory framework, which sought to improve banks' ability to absorb shocks, improve risk management and governance; and, strengthen transparency and disclosures. These were incorporated into EU law by means of the CRR and the CRD IV. The prudential requirements for institutions are accordingly already dealt with at EU level. The legal bases are Article 114 TFEU for the CRR, BRRD and SRMR, and Article 53(1) TFEU for the CRD IV. The BCBS has since the adoption of the CRRIV and CRD IV finalised a number of additional standards, including a binding leverage ratio; a NSFR requirement to ensure that banks have adequate funding structures on a long-term horizon; and following a fundamental review, revised capital requirements for the trading book. The objectives pursued by these measures as discussed above can be better achieved at EU level rather than by different national initiatives. National measures aimed at e.g. reducing bank’s leverage, strengthening bank’s stable funding and trading book capital requirements would not be as effective in ensuring financial stability as EU rules, given the freedom of banks to establish and provide services in other Member States and the resulting degree of cross-border service provision, capital flows and market integration. On the contrary, national measures could distort competition and affect capital flows. Moreover, adopting national measures would be legally challenging, given that the CRR already regulates banking matters, including leverage requirements (reporting), liquidity (LCR) and trading book requirements. The amendment of existing CRR and CRDIV legal instruments is thus considered to be the best alternative striking the right balance between the single rules for banks and maintaining national flexibility, such as on some macro prudential measures, for competent authorities to address risks to financial stability. Therefore the amendments would further promote a uniform application of banking regulatory standards, the convergence of supervisory practices and ensure a level playing field throughout the EU banking system (see annex 6 for the indicative list of parts of legislation to be amended). These objectives cannot be sufficiently achieved by Member States alone. This is particularly important in the banking sector where many banks operate across the EU single market. Full cooperation and trust within the single supervisory mechanism (SSM) but also within the colleges of supervisors and competent authorities outside the SSM is essential for banks to be effectively supervised on a consolidated basis. National rules would not achieve these objectives. 4.POLICY OPTIONS AND ANALYSIS OF IMPACTS 4.1.On excessive reliance on short-term funding Policy options 1. No policy change 2. A single NSFR requirement as per Basel for all banks 3. A single NSFR requirement as per Basel with some adjustments for all banks Option 1: No policy change The Basel III framework, implemented through the CRR and the CRD IV, already comprises minimum capital requirements and a liquidity requirement, the LCR. As mentioned in the problem definition, capital requirements are useful to ensure the solvency of banks but they do not capture the liquidity and maturity of off- and on-balance sheet items. Furthermore, the LCR takes account of the liquidity of assets, liabilities and off-balance sheet items but focuses on a 30 days horizon in stressed conditions. As such, the LCR increases the resilience of banks in case of severe short-term liquidity stresses but does not capture the risk of excessive maturity mismatches on a longer term horizon. As a consequence, the LCR ensures that banks will be able to withstand a severe stress on a short-term basis but does not ensure that banks will have a sustainable stable funding structure on a longer term horizon. Banks would then continue to be prone to funding risks and, if short-term bank funding dries-up, they will not be able to maintain their funding structure on a longer term horizon, which could lead to a new banking crisis. A fast-growing body of literature has developed in the past few years, which assesses for a sample of banks considered in various countries and time periods, whether the existence of a stable funding requirement would have significantly diminished the number of failures relative to what happened in the absence of such a requirement. E.g. the IMF working paper “Bank Funding Structures and Risk: Evidence from the Global Financial Crisis” finds a significant impact of the stable funding ratio: higher levels of the stable funding ratio decrease the probability that a bank will subsequently fail. The most recent EBA Basel III monitoring exercise report of 13 September 2016, based on a different sample of EU banks than the sample of the EBA NSFR report, shows that during 2015 these banks in aggregate terms have already reduced their NSFR shortfall. This is likely to be a result of supervisory monitoring, market discipline, implementation of other prudential requirements that help improving the NSFR and anticipation of EU implementation of international rules. However, only when imposed as hard requirements which shall be met at all times, stable funding requirements will be effective in preventing excessive maturity mismatches between assets and liabilities and overreliance on short-term wholesale funding. This would advocate for the introduction of a detailed stable funding requirement at EU level. Option 2: A single NSFR requirement as per Basel for all banks A complementary binding detailed NSFR would ensure that banks adequatly fund their activities with more stable sources of funding on an ongoing structural basis. It would provide an effective requirement of more stable longer term funding sources for banks’ obligations on a one-year horizon in normal and stressed conditions compared to the current situation where banks have to ensure that long term obligations are adequately met with a diversity of stable funding instruments without it being a detailed requirement. The advantage of this option would also be the full compliance with the Basel NSFR for all banks established in the EU. However, this approach may unduly penalize some activities or specific business models that are not or not adequately recognised by the Basel NSFR framework. This could lead to difficult adjustments for some banks that could have important unintended consequences on the European economy. Indeed, as of end-December 2014, 30% of the banks participating in the data collection for the EBA Report on NSFR, representing 75% of total assets in the EU, did not meet the Basel NSFR requirements. The stable funding shortfall for these non-compliant banks was estimated at 595 billion EUR, representing 3,5% of the available stable funding amount for all the banks in the sample. As the way to comply with the NSFR requires deep restructuration of the balance sheet’s structure, the adjustments to the shortfall could be difficult to implement for non-compliant banks. This NSFR shortfall could mean that non-compliant banks have to find additional stable funding (equity, medium/long term bonds/loans or retail deposits), which would typically incur some compliance costs, or to restructure their activities (the exact amount would depend on the RSF factor applied to the banks' assets) or to undertake a combination of both. Table 3. NSFR shortfalls

NSFR shortfall (as of end-December 2014): No. of banks Number of compliant banks NSFR NSFR shortfall (bn. Euro) NSFR shortfall (% available funding) Total banks in the sample 279 196 (70%) 103.6 594.7 3.5 Consolidated results (removing identified subsidiaries of banks included in the sample) 234 169 (72%) 103.6 522.7 3.2 Source: EBA report on the NSFR , data as of end-December 2014 Option 3: A single NSFR requirement as per Basel with some adjustments for all banks Using the Basel framework as a basis for the definition of a European NSFR would ensure a level playing field for European banks, especially for the ones undertaking cross-border activities. Moreover, as the Basel NSFR has been subject to an extensive observation period and public consultation (apart from the treatment of derivative transactions) and has been thoroughly discussed, its calibration is broadly satisfactory. However, the necessity to take specific account of some European specificities in order to ensure that the NSFR does not hinder the financing of the European real economy would justify adopting some adjustments to the Basel NSFR for the definition of the European NSFR. This mirrors the feedbacks received from the industry through the NSFR targeted public consultation and the call for evidence. The industry indeed widely accepts the introduction of the NSFR which is deemed as being a useful complementary supervisory measure but criticizes the miscalibration of some specific banking activities that could have an important impact on these activities and on the real economy. These adjustments to the European context are recommended by the EBA NSFR report and relate mainly to specific treatments for: pass-through models in general and covered bonds issuance in particular, whose funding risk can be considered as low when assets and liabilities are matched funded; trade finance and factoring activities, whose short-term transactions are less likely to be rolled-over than other type of loans to non-financial counterparties; centralised regulated savings, whose scheme of transfer renders the client deposits (liabilities) and claims on the state-controlled fund (assets) interdependent; residential guaranteed loans, whose specific characteristics make them similar to mortgage loans; credit unions, whose statutory constraints on investment of their excess of liquidity entail a funding risk similar to that of non-financial institutions for the institution receiving the deposits. These proposed specific treatments reflect the preferential treatment granted to these activities in the European LCR compared to the Basel LCR. Such treatment was widely supported by Member States during the expert group meeting and by the industry during the NSFR targeted consultation. Beyond these European specificities, the EBA NSFR report does not advocate for other adjustments to the Basel NSFR for its implementation at EU level. However, the conclusions of the EBA NSFR report should be taken with caution, mainly because of the limitation of data underlined in the report (data only cover a single point in time (data as of end-December 2014) representing 75% of total assets held by credit institutions in the EU; 40% of credit institutions in the sample are from DE and IT). The stringent treatment of derivative transactions in the Basel NSFR could have an important impact on banks’ derivatives activities and on the access to some operations (e.g. hedging of currency risk, interest risk, exposure to a commodity etc.) for end-users (e.g. corporates, pension funds, public sector entities, insurance companies, retail banks etc.). Additional data gathered from the EBA show that the stable funding requirement linked to derivatives transactions for banks included in the sample of the EBA NSFR report amounts to more than €615bn (data as of end-December 2014), with €260 billion due only to the 20% stable funding requirement on gross derivatives liabilities. The disproportionate impact the NSFR could have on derivatives activities and, consequently, on European financial markets and on the European economy is one of the main concern expressed quite unanimously by the industry, including end-users, through the call for evidence and the NSFR targeted consultation.. The treatment of derivative transactions and of some interlinked transactions (e.g. clearing activities) could be unduly and disproportionately impacted by the introduction of the NSFR without having been subject to extensive quantitative impact studies and public consultation. The additional requirement to hold 20% of stable funding against gross derivatives liabilities is very widely seen as a rough measure that overestimates additional funding risks related to the potential increase of derivative liabilities over a one year horizon. The rules underpinning the calculation of NSFR derivative assets and liabilities and in particular the asymmetric treatment between variation/ initial margins received and posted is also cited as detrimental to derivatives markets. According to a first impact study of the industry, the treatment of derivatives liabilities and variation and initial margins in the NSFR could lead to an additional funding requirement of €750 billion for the entire world-wide industry (not limited to the European industry). On the basis of available data and of Member States’ opinions expressed during the expert group meeting, it seems reasonable to slightly adjust the Basel treatment of derivatives, in particular the 20% RSF factor that applies to gross derivatives liabilities, not to hinder the good functioning of EU financial markets and the provision of risk hedging tools to credit institutions and end-users, including corporates, to ensure their financing as an objective of the Capital Market Union. Furthermore, regarding short term transactions with finan