EXPLANATORY MEMORANDUM

1. Context of the proposed act 1.1. Reasons for and objectives of the proposal

The extent of the financial crisis has exposed unacceptable risks pertaining to the current regulation of financial institutions. According to IMF estimates, crisis-related losses incurred by European credit institutions between 2007 and 2010 are close to €1 trillion or 8% of the EU GDP.

In order to restore stability in the banking sector and ensure that credit continues to flow to the real economy, both the EU and its Member States adopted a broad range of unprecedented measures with the taxpayer ultimately footing the related bill. In this context, by October 2010 the Commission has approved €4.6 trillion of state aid measures to financial institutions of which more than €2 trillion were effectively used in 2008 and 2009.

The level of fiscal support provided to credit institutions needs to be matched with a robust reform addressing the regulatory shortcomings exposed during the crisis. In this regard, the Commission already proposed a number of amendments to banking legislation that entered into force in 2009 (CRD II) and 2010 (CRD III). This proposal contains globally developed and agreed elements of credit institution capital and liquidity standards known as Basel III and harmonises other provisions of the current legislation. The regulatory choices made are explained in detail in Section 5 below.

Directive 2006/48/EC of the European Parliament and of the Council of 14 June 2006 relating to the taking up and pursuit of the business of credit institutions and Directive contains provisions closely related to the access to the activity of the business of credit institutions (such as provisions governing the authorisation of the business, the the exercise of the freedom of establishment, the powers of supervisory authorities of home and host Member States in this regard, and the supervisory review of credit institutions). These elements are covered by the proposal for a Directive on the access to the activity of the business of credit institutions and the prudential supervision of credit institutions and investment firms with which the present proposal forms a package. However, Directive 2006/48/EC and in particular its annexes also set out prudential rules. In order to approximate further the legislative provisions that result from the transposition of Directives 2006/48/EC and 2006/49/EC into national law and in order to ensure that the same prudential rules directly apply to them, which is essential for the functioning of the internal market, these prudential rules are subject of this proposal for a Regulation.

For sake of clarity, this proposal also unifies prudential requirements on credit institutions and investment firms, the latter of which are dealt with by Directive 2006/49/EC.

1.1.1. Problems addressed – new elements under Basel III

The proposal is designed to tackle regulatory shortcomings in the following areas:

Management of liquidity risk (Part Six): Existing liquidity risk management practices were shown by the crisis to be inadequate in fully grasping risks linked to originate-to-distribute securitization, use of complex financial instruments and reliance on wholesale funding with short term maturity instruments. This contributed to a demise of several financial institutions and strongly undermined financial health of many others, threatening the financial stability and necessitating public support. While a number of Member States currently impose some form of quantitative regulatory standard for liquidity, no harmonised sufficiently explicit regulatory treatment on the appropriate levels of short-term and long-term liquidity exists at EU level. Diversity in current national standards hampers communication between supervisory authorities and imposes additional reporting costs on cross-border institutions.

Definition of capital (Part Two Title I): Institutions entered the crisis with capital of insufficient quantity and quality. Given the risks they faced, many institutions did not posses sufficient amounts of the highest quality capital instruments that can absorb losses effectively as they arise and help to preserve an institution as a going concern. Hybrid Tier 1 capital instruments (hybrids), which had previously been considered to be loss absorbent on a going concern basis were found not to be effective in practice. Tier 2 capital instruments were not able to perform their function of absorbing losses once an institution became insolvent because institutions were often not permitted to fail. The quality of capital instruments required to absorb unexpected losses from risks in the trading book was found to be as high as that for risks in the non-trading book, and Tier 3 capital instruments we found not to be of sufficiently high quality. To safeguard financial stability, governments provided unprecedented support to the banking sector in many countries. Insufficient harmonisation in the EU of the definition of capital was a catalyst for this situation, with different Member States taking significantly different approaches to the elements of capital that should be excluded or excluded from own funds. In combination with the fact that regulatory ratios did not accurately reflect an institution's true ability to absorb losses, this undermined the ability of the market to assess accurately and consistently the solvency of EU institutions. This in turn amplified financial instability in the EU.

Counterparty credit risk (Part Three Title II Chapter 6): The crisis revealed a number of shortcomings in the current regulatory treatment of counterparty credit risk arising from derivatives, repo and securities financing activities. It showed that the existing provisions did not ensure appropriate management and adequate capitalisation for this type of risk. The current rules also did not provide sufficient incentives to move bilaterally cleared over-the-counter derivative contracts to multilateral clearing through central counterparties.

Options, discretions and harmonisation (entire Regulation): In 2000, seven banking directives were replaced by a single Directive. This directive was recast in 2006 while introducing the Basel II framework in the EU. As a result, its current provisions include a significant number of options and discretions. Moreover, Member States have been permitted to impose stricter rules than those of the Directive. As a result, there is a high level of divergence which is particularly burdensome for firms operating cross-border. It also gives rise to the lack of legal clarity and an uneven playing field.

1.1.2. Objectives of the proposal

The overarching goal of this initiative is to ensure that the effectiveness of institution capital regulation in the EU is strengthened and its adverse impacts on depositor protection and pro-cyclicality of the financial system are contained while maintaining the competitive position of the EU banking industry.

1.2. General context

The financial crisis prompted a broad EU and international effort to develop effective policies to tackle the underlying problems. A High Level Group chaired by Mr. de Larosière proposed recommendations for reforming European financial supervision and regulation. They were further elaborated in a Commission Communication in March 2009. This proposal contains numerous policy revisions that are listed in the detailed action plan included in this Communication.

On a global level, the G-20 Declaration of 2 April 2009 conveyed the commitment to address the crisis with internationally consistent efforts to, improve the quantity and quality of capital in the banking system, introduce a supplementary non-risk based measure to contain the build-up of leverage, develop a framework for stronger liquidity buffers at financial institutions and implement the recommendations of the Financial Stability Board (FSB) to mitigate the pro-cyclicality.

In response to the mandate given by the G-20, in September 2009 the Group of Central Bank Governors and Heads of Supervision (GHOS), the oversight body of the Basel Committee on Banking Supervision (BCBS)[1], agreed on a number of measures to strengthen the regulation of the banking sector. These measures were endorsed by FSB and the G-20 leaders at their Pittsburgh Summit of 24-25 September 2009.

In December 2010, BCBS issued detailed rules of new global regulatory standards on credit institution capital adequacy and liquidity that collectively are referred to as Basel III. This proposal directly relates to the regulatory standards included in Basel III.

The Commission, in its capacity of an observer to the BCBS, was working very closely with the BCBS on developing these standards, including on assessing their impact. Consequently, the proposed measures faithfully follow the substance of the Basel III principles. In order to achieve the dual objective of improving the resilience of the global financial system and ensuring a level playing field, it is imperative that the more robust set of prudential requirements be applied consistently across the world.

At the same time, in the process of developing this legislative proposal, the Commission has made particular efforts in making sure that certain major European specificities and issues are appropriately addressed. In this context, it is worth recalling that in the EU, unlike some other major economies, the application of the regulatory principles agreed globally under the auspices of the BCBS is not restricted to only international active banks. These standards are in the EU applied across the whole banking sector, covering all credit institutions and in general also investment firms. As explained further in section 4.2, the EU has always considered that only such approach would provide for a true level playing field in the EU, while maximising the associated financial stability benefits.

This is one of the reasons why certain adaptations of the Basel III principles, which would appropriately address the European specificities and issues, appear to be warranted. However, these adaptations remain consistent with the nature and objectives of the Basel III reform.

In a wider context, it should be noted that one of the priorities of the Commission in the reform of EU financial services regulation has been to ensure that the banking sector is able to fulfil its fundamental purpose, namely lending to the real economy and providing services to citizens and businesses in Europe. In this respect, the Commission has adopted on 18 July a Recommendation on access to a basic payment account[2].

2. Results of the consultations with the interested parties and of the impact assessments 2.1. Consultation with interested parties

The Commission services have closely followed and participated in the work of international forums, particularly BCBS, which was in charge of developing the Basel III framework. The European Banking Committee (EBC) and the Committee of European Banking Supervisors (CEBS), and its successor from 2011 the European Banking Authority (EBA), have been extensively involved and consulted. Their views have contributed to the preparation of this proposal and the accompanying impact assessment.

2.1.1. CEBS

CEBS conducted a comprehensive quantitative impact study (QIS) on the impact of this legislative proposal on the EU banking industry. 246 credit institutions participated in the study. CEBS also conducted extensive public consultations and in October 2008 submitted a technical advice in the area of national options and discretions.

2.1.2. CRD Working Group

In the area of national options and discretions, between 2008 and 2011 the Commission services held six meetings of the Capital Requirements Directive Working Group (CRDWG), whose members are nominated by EBC. In addition, sub-groups of the CRDWG in the areas of liquidity, capital definition, leverage ratio and counterparty credit risk have also conducted work at an even more technical level.

2.1.3. Other public consultations

The Commission conducted four public consultations in 2009, 2010 and 2011, covering all elements of this proposal. In April 2010 the Commission services conducted an open public hearing on this proposal that was attended by all the stakeholder groups.

Responses to the public consultations and views expressed at the public hearing are reflected throughout the accompanying impact assessment report. Individual responses are available on the Commission's website.

In addition, the Commission conducted separate consultations with the industry, including the Group of Experts in Banking Issues (GEBI) set up by the Commission and various EU banking industry associations and individual institutions.

2.2. Impact assessment

Altogether, 27 policy options have been assessed and compared with a view to addressing the various issues identified[3]. The below table lists the individual options considered within each policy set and ranks them in terms of their relative effectiveness[4] and efficiency[5] with regard to achieving relevant longer term policy objectives. Preferred options, identified on the basis of this ranking, are highlighted and discussed in the rest of this section.

Policy Option Set || Policy Options || Policy Option Comparison Criteria

Effectiveness || Efficiency

Enhance adequacy of capital requirements || Enhance bank risk management || Prevent regulatory arbitrage opportunities || Enhance legal clarity || Reduce compliance burden || Enhance level playing field || Enhance supervisory cooperation and convergence || Align prudential requirements for SIFIs with the risks they pose || Reduce cyclicality of provisioning and capital requirements

Liquidity -Liquidity Coverage ratio || Retain current approach || 3 || 3 || || || || || || || || 3

Introduce LCR as specified in Feb 2010 public consultation || 2 || 2 || || || || || || || || 1

Introduce LCR adopted by Basel Committee subject to observation period || 1 || 1 || || || || || || || || 2

Liquidity - Net Stable Funding ratio || Retain current approach || 3 || 3 || || || || || || || || 3

Introduce NSFR as specified in Feb 2010 public consultation || 2 || 2 || || || || || || || || 2

Introduce NSFR adopted by Basel Committee subject to observation period || 1 || 1 || || || || || || || || 1

Eligibility of capital instruments and application of regulatory adjustments || Retain current approach || 5 || 5 || 5 || || || 5 || || 5 || 5 || 5

Modify only the eligibility criteria as specified in Feb 2010 public consultation || 4 || 4 || 4 || || || 4 || || 4 || 4 || 4

Modify eligibility criteria and regulatory adjustments as specified in Feb 2010 public consultation || 1-3 || 1-3 || 1-3 || || || 2-3 || || 1 || 1-3 || 3

Modify eligibility criteria and regulatory adjustments based on Basel approach || 1-3 || 1-3 || 1-3 || || || 2-3 || || 2-3 || 1-3 || 2

Modify eligibility criteria and regulatory adjustments based on Basel approach with some adjustments for EU specificities || 1-3 || 1-3 || 1-3 || || || 1 || || 2-3 || 1-3 || 1

Counterparty credit risk (CCR) || Retain current approach || 3 || 3 || || || || || || 3 || 3 || 3

Enhance CCR requirement || 2 || 2 || || || || || || 2 || 2 || 2

Enhance CCR requirements and differentiate treatment of exposures to Central Counterparties || 1 || 1 || || || || || || 1 || 1 || 1

Leverage ratio || Retain current approach || 3 || 3 || || || || || || || 3 || 3

Introduce leverage ratio as specified in Feb 2010 public consultation || 2 || 2 || || || || || || || 2 || 2

Conduct extensive monitoring of leverage ratio || 1 || 1 || || || || || || || 1 || 1

Capital buffers || Retain current approach || 4 || 4 || || || || || || || 4 || 4

Conservation capital buffer || 1-2 || 1-3 || || || || || || || 3 || 2-3

Countercyclical capital buffer || 3 || 1-3 || || || || || || || 1-2 || 2-3

Dual capital buffer || 1-2 || 1-3 || || || || || || || 1-2 || 1

Single rule book || Retain current approach || || || 4 || 4 || 4 || 4 || 4 || || || 4

Minimum harmonization || || || 3 || 3 || 1-3 || 3 || 3 || || || 1-3

Maximum harmonization || || || 1-2 || 1 || 1-3 || 1 || 1 || || || 1-3

Maximum harmonization with some exceptions || || || 1-2 || 2 || 1-3 || 2 || 2 || || || 1-3

Choice of policy instrument || Amend the CRD || || || 2 || 2 || 2 || || 2 || || || 2

Limit scope of the CRD and propose a regulation || || || 1 || 1 || 1 || || 1 || || || 1

Scale of option ranking: 1=most effective / efficient, 5=least effective / efficient

2.2.1. Individual policy measures

Management of liquidity risk (Part Six): To improve short-term resilience of the liquidity risk profile of financial institutions, a Liquidity Coverage Ratio (LCR) will be introduced after an observation and review period in 2015. LCR would require institutions to match net liquidity outflows during a 30 day period with a buffer of 'high quality' liquid assets. The outflows covered (the denominator) would reflect both institution-specific and systemic shocks built upon actual circumstances experienced in the global financial crisis. The provisions on the list of high quality liquid assets (the numerator) to cover these outflows should ensure that these assets are of high credit and liquidity quality. Based on the LCR definition included in Basel III, compliance with this requirement in the EU is expected to produce net annual GDP benefits in the range of 0.1% to 0.5%, due to a reduction in the expected frequency of systemic crises.

To address funding problems arising from asset-liability maturity mismatches, the Commission will consider proposing a Net Stable Funding Ratio (NSFR) after an observation and review period in 2018. The NSFR would require institutions to maintain a sound funding structure over one year in an extended firm-specific stress scenario such as a significant decline in its profitability or solvency. To this end, assets currently funded and any contingent obligations to fund would have to be matched to a certain extent by sources of stable funding.

Definition of capital (Part Two): The proposal builds upon the changes made in CRD2 to strengthen further the criteria for eligibility of capital instruments. Furthermore, it introduces significant harmonisation of the adjustments made to accounting equity in order to determine the amount of regulatory capital that it is prudent to recognise for regulatory purposes. This new harmonised definition would significantly increase the amount of regulatory capital required to be held by institutions.

The new requirements for going concern regulatory capital - Common Equity Tier 1 and Tier 1 capital - would be implemented gradually between 2013 and 2015. The new prudential adjustments would also be introduced gradually, 20% per annum from 2014, reaching 100% in 2018. Grandfathering provisions over 10 years would also apply to certain capital instruments in order to help to ensure a smooth transition to the new rules.

Counterparty credit risk (Part Three, Title II, Chapter 6): Requirements for management and capitalisation of the counterparty credit risk will be strengthened. Institutions would be subject to an additional capital charge for possible losses associated with the deterioration in the creditworthiness of a counterparty. This would promote sound practices in managing this risk and recognise its hedging which would allow institutions to mitigate the impact of this capital charge. Risk weights on exposures to financial institutions relative to the non-financial corporate sector will be raised. This amendment is expected to encourage diversification of counterparty risk among smaller institutions and, overall, should contribute to less interconnectedness between large or systemically important institutions. The proposal would also enhance incentives for clearing over-the-counter instruments through central counterparties. These proposals are expected to affect mostly the largest EU institutions, as counterparty credit risk is relevant only for banks with significant over-the-counter derivative and securities financing activities.

Leverage ratio (Part Seven): In order to limit an excessive build-up of leverage on credit institutions' and investment firms' balance sheets and thus help containing the cyclicality of lending, the Commission also proposes to introduce a non-risk based leverage ratio. As agreed by BCBS, it will be introduced as an instrument for the supervisory review of institutions. The impacts of the ratio will be monitored with a view to migrating it to a binding pillar one measure in 2018, based on appropriate review and calibration, in line with international agreements.

Single rule book (entire Regulation): The proposal harmonises divergent national supervisory approaches by removing options and discretions almost altogether. Some specific well defined areas, where divergences are driven by risk assessment considerations, market or product specificities and Member States' legal frameworks, are exempted, allowing Member States to adopt stricter rules.

2.2.2. Policy instrument

This proposal effectively separates prudential requirements from the other two areas of Directive 2006/48/EC and Directive 2006/49/EC, i.e. authorisation and ongoing supervision that would continue to be in the form of a directive with which this proposal forms a package. This reflects differences in subject-matter, nature and addressees.

2.2.3. Cumulative impact of the package

To supplement its own assessment of the impact of Basel III, the Commission reviewed a number of studies prepared by both public and private sectors. Their main results can be summarised as follows:

This proposal together with CRD III is estimated to increase the risk-weighted assets of large credit institutions by 24.5% and of small credit institutions by a modest 4.1%. The need to raise new own funds due to the new requirement and the conservation buffer is estimated to be €84 billion by 2015 and €460 billion by 2019.

There are clear net long term economic benefits of an annual increase in the EU GDP in the range of 0.3%-2%. They stem from a reduction in the expected frequency and probability of future systemic crises.

It is estimated that the proposal would reduce the probability of a systemic banking crisis in seven MS within the range of 29% to 89% when credit institutions recapitalise to a total capital ratio of at least 10.5%.

In addition, higher capital, including the countercyclical capital buffer, and liquidity requirements should also reduce the amplitude of normal business cycles. This is particularly relevant to small and medium enterprises that are relatively more dependent on credit institution financing throughout the economic cycle than large companies.

2.2.4. Administrative burden

Institutions with more cross-border activity would benefit from harmonisation of the current national provisions the most as the ensuing administrative burden savings are expected to reduce their burdens related to Basel III measures.

3. Monitoring and evaluation

The proposed amendments are linked to the Directives 2006/48/EC and 2006/49/EC preceding this Regulation. This means that both the elements of the preceding Directive and the new elements introduced by this Regulation will be closely monitored. The monitoring of the leverage ratio and the new liquidity measures will be subject to particular scrutiny on the basis of statistical data collected according to provisions in this proposal. The monitoring and evaluation will take place both at EU (EBA/ECB – European Central Bank) and international level (BCBS).

4. Legal elements of the proposal 4.1. Legal basis

Article 114(1) TFEU provides a legal basis for a Regulation creating uniform provisions aimed at the functioning of the internal market. Whereas the proposal for Directive [inserted by OP] governs the access to the activity of businesses and is based on Article 53 TFEU, the need to separate these rules from the rules on how these activities are carried out warrants the use of a new legal basis for the latter.

Prudential requirements establish criteria for the evaluation of the risk linked to certain banking activities and of the funds necessary to counter-balance those risks. As such, they do not regulate access to deposit taking activities but govern the way in which such activities are carried out in order to ensure protection of depositors and financial stability. The proposed Regulation streamlines the prudential requirements for credit institutions and investment firms, which are currently set out in two different Directives (2006/48/EC and 2006/49/EC), in one legal instrument, which considerably simplifies the applicable legal framework.

As pointed out above (sections 1.1.1 and 2.2.1), the current provisions include a significant number of options and discretions and allow Member States to impose stricter rules than those of Directives 2006/48/EC and Directive 2006/49/EC. This results in a high level of divergence which can not only be problematic for financial stability purposes as set out in section 1.1.1 above, but also hampers the cross-border provision of services and the establishment in other Member States since each time an institution wishes to take up operations in another Member State it has to assess a different set of rules. This creates an unlevel playing field impeding the internal market and also hampers legal clarity. Since the previous codifications and recasts have not led to a reduction of divergence, it is necessary to adopt a Regulation in order to put in place uniform rules in all Member States with the aim of ensuring the good functioning of the internal market.

Shaping prudential requirements in the form of a Regulation would ensure that those requirements will be directly applicable to institutions. This would ensure a level-playing field by preventing diverging national requirements as a result of the transposition of a Directive. The proposed Regulation would clearly demonstrate that institutions follow the same rules in all EU markets, which would also boost confidence in the stability of institutions across the EU. A Regulation would also enable the EU to implement any future changes more quickly, as amendments can apply almost immediately after adoption. That would enable the EU to meet internationally agreed deadlines for implementation and follow significant market developments.

4.2. Subsidiarity

In accordance with the principles of subsidiarity and proportionality set out in Article 5 TFEU, the objectives of the proposed action cannot be sufficiently achieved by the Member States and can therefore be better achieved by the EU. Its provisions do not go beyond what is necessary to achieve the objectives pursued. Only EU action can ensure that institutions and investment firms operating in more than one Member State are subject to the same prudential requirements and thereby ensure a level playing field, reduce regulatory complexity, avoid unwarranted compliance costs for cross-border activities, promote further integration in the EU market and contribute to the elimination of regulatory arbitrage opportunities. EU action also ensures a high level of financial stability in the EU. This is corroborated by the fact that prudential requirements set out in the proposal have been set out in EU legislation for more than 20 years.

Article 288 TFEU leaves a choice between different legal instruments. A Regulation is therefore subject to the principle of subsidiarity in the same manner as other legal instruments. Subsidiarity must be balanced with other principles in the Treaties such as the fundamental freedoms. Directives 2006/48/EC and 2006/49/EC are formally directed at Member States but eventually addressed towards businesses. A Regulation creates a more level-playing field since it is directly applicable and there is no need to assess legislation in other Member States before starting a business since the rules are exactly the same. This is less burdensome for institutions. Delays with regard to the transposition of Directives can also be avoided by adopting a Regulation.

4.3. Role of EBA and compliance with Articles 290 and 291 TFEU

In more than 50 provisions of this proposal, EBA is requested to submit regulatory and implementing technical standards to the Commission in order to specify the criteria set out in some provisions of this Regulation and in order to ensure its consistent application. The Commission is empowered to adopt them as delegated and implementing acts.

On 23 September 2009, the Commission adopted proposals for Regulations establishing EBA, EIOPA (The European Insurance and Occupational Pensions Authority (EIOPA), and ESMA (European Securities and Markets Authority)[6]. In this respect the Commission wishes to recall the Statements in relation to Articles 290 and 291 TFEU it made at the adoption of the Regulations establishing the European Supervisory Authorities according to which: "As regards the process for the adoption of regulatory standards, the Commission emphasises the unique character of the financial services sector, following from the Lamfalussy structure and explicitly recognised in Declaration 39 to the TFEU. However, the Commission has serious doubts whether the restrictions on its role when adopting delegated acts and implementing measures are in line with Articles 290 and 291 TFEU."

4.4. Interaction and consistency between elements of the package

This Regulation forms a package with the proposed Directive [inserted by OP]. This package would replace Directives 2006/48/EC and 2006/49/EC. This means that both the Directive and the Regulation would each deal with both credit institutions and investment firms. Currently, the latter are merely 'annexed' to Directive 2006/48/EC by Directive 2006/49/EC. A large part of it merely contains references to Directive 2006/48/EC. Joining provisions applicable to both businesses in the package would therefore improve the readability of provisions governing them. Moreover, the extensive annexes of Directives 2006/48/EC and 2006/49/EC would be integrated into the enacting terms, hereby further simplifying their application.

Prudential regulations directly applicable to institutions are set out in the proposal for a Regulation. In the proposal for a Directive remain provisions concerning the authorisation of credit institutions and the exercise of the freedom of establishment and the free movement of services. This would not concern investment firms, as the corresponding rights and obligations are regulated by Directive 2004/39/EC ('MiFiD'). General principles of the supervision of institutions, which are addressed to Member States and require transposition and the exercise of discretion, would also remain in the Directive. This encompasses in particular the exchange of information, the distribution of tasks between home and host country supervisors and the exercise of sanctioning powers (which would be newly introduced). The Directive would still contain the provisions governing the supervisory review of institutions by the competent authorities of the Member States. These provisions supplement the general prudential requirements set out in the Regulation for institutions by individual arrangements that are decided by the competent authorities as a result of their ongoing supervisory review of each individual credit institution and investment firm. The range of such supervisory arrangements would be set out in the Directive since the competent authorities should be able to exert their judgment as to which arrangements should be imposed. This includes the internal processes within an institution notably concerning the management of risks and the corporate governance requirements that are newly introduced.

5. Detailed explanation of the proposal and comparison with Basel III

To ensure a balanced application of Basel III to EU institutions, the Commission had to make several regulatory choices, which are explained in this chapter.

5.1. Maximum harmonisation (Entire Regulation)

Maximum harmonisation is necessary to achieve a truly single rule book. Inappropriate and uncoordinated stricter requirements in individual Member States might result in shifting the underlying exposures and risks to the shadow banking sector or from one EU Member State to another.

Moreover, the impact assessments conducted by the Basel Committee and the European Commission are based on the specific capital ratios adopted. It is uncertain what the potential impact in terms of costs and growth would be in case of higher capital requirements in one or more Member States, potentially expanded through a "race to the top" mechanism across the EU.

If there is a need for more stringent prudential requirements at the EU level, there should be ways to temporarily modify the single rule book accordingly. The Commission could adopt a delegated act increasing for a limited period of time the level of capital requirements, the risk weights of certain exposures, or impose stricter prudential requirements, for all exposures or for exposures to one or more sectors, regions or Member States, where this is necessary to address changes in the intensity of micro-prudential and macro-prudential risks which arise from market developments emerging after the entry into force of this Regulation, in particular upon the recommendation or opinion of the ESRB.

This proposal and the accompanying proposal for the Directive contain already three possibilities for competent authorities to address macro-prudential concerns at national level:

– for lending secured by immovable property, Member States could adjust the capital requirements;

– Member States could impose additional capital requirements to individual institutions or groups of institutions where justified by specific circumstances under the so called 'Pillar 2';

– Member States set the level of the countercyclical capital buffer, reflecting the specific macroeconomic risks in a given Member State. This would actually modify the capital requirements to a significant extent.

Member States would furthermore be allowed to anticipate some of the new stricter rules based on Basel III during the transitional period, i.e. implement them faster than the pace set out in Basel III.

5.2. Definition of capital (Part Two) 5.2.1. Deductions of significant holdings in insurance entities and financial conglomerates

Basel III requires internationally active banks to deduct from their own funds significant investments in unconsolidated insurance companies. This is aimed at ensuring that a bank is not permitted to count in its own funds the capital used by an insurance subsidiary. For groups which include significant banking or investment business and insurance business, Directive 2002/87/EC on Financial Conglomerates, provides specific rules to address such 'double counting' of capital. Directive 2002/87/EC is based on internationally agreed principles for dealing with risk across sectors. This proposal strengthens the way these Financial Conglomerates rules shall apply to bank and investment firm groups, ensuring their robust and consistent application. Any further changes that are necessary will be addressed in the review of Directive 2002/87/EC, due in 2012.

5.2.2. Highest quality own funds – criteria, phasing out and grandfathering

Under Basel III, the highest quality own funds instruments for internationally-active banks that are joint-stock companies may comprise only "ordinary shares" that meet strict criteria. This proposal implements these Basel III strict criteria. It does not restrict the legal form of the highest quality element of capital issued by institutions structured as joint stock companies to ordinary shares. The definition of ordinary share varies according to national company law. The strict criteria set out in this proposal will ensure that only the highest quality instruments would be recognised as the highest quality form of regulatory capital. Under these criteria, only instruments that are as high quality as ordinary shares would be able to qualify for this treatment. In order to ensure full transparency of the instruments recognised, the proposal requires the EBA to compile, maintain and publish a list of the types of instrument recognised.

Basel III provides a 10-year phase out period for certain instruments issued by non-joint stock companies that do not meet the new rules. Consistent with the amendments made to own funds by Directive 2009/111/EC, and the need to ensure consistent treatment of different legal forms of company, this proposal (Part Ten, Title I, Chapter 2) affords such grandfathering also to the highest quality instruments issued by joint stock companies that are not common shares, and the related share premium accounts.

Basel III allows instruments that do not meet the new rules that are issued before 12 September 2010 to be phased out of regulatory capital, in order to ensure a smooth transition to the new rules. This is known as the 'cut off date' for the transitional arrangements. All instruments that do not meet the new rules that are issued after the cut off date would be fully excluded from regulatory capital from 2013. This proposal sets the cut off date on the date of the adoption of this proposal by the Commission. This is necessary in order to avoid applying the requirements of the proposal retroactively, which would not be legally feasible.

5.2.3. Mutual societies, cooperative banks and similar institutions

Basel III ensures that the new rules are capable of being applied to the highest quality capital instruments of non-joint stock companies - e.g. mutuals, cooperative banks and similar institutions. This proposal specifies in greater detail the application of the Basel III definition of capital to the highest quality capital instruments issued by non-joint stock companies.

5.2.4. Minority interest and certain capital instruments issued by subsidiaries

A minority interest is the capital of certain subsidiaries that is owned by a minority shareholder from outside the group. Basel III recognises minority interest – and certain regulatory capital issued by subsidiaries - only to the extent that those subsidiaries are institutions (or subject to the same rules) and the capital is used to meet capital requirements and the new Capital Conservation Buffer, a new capital cushion which imposes new restrictions on the payment of dividends and certain coupons and bonuses. The other new capital buffer – the Countercyclical Buffer– is an important macro-prudential tool, which may be imposed by supervisors to moderate or bolster lending in different phases of the credit cycle. This proposal establishes robust EU processes for coordinating Member States' use of the Countercyclical Buffer. The approach set out in this proposal to minority interest and certain other capital issued by subsidiaries gives recognition of the Countercyclical Buffer where used. This recognises the importance of the buffer and the capital used to meet it, and removes a potential disincentive for the buffer to be required. .

5.2.5. Deduction of certain Deferred Tax Assets (DTAs)

A DTA is an asset on the balance sheet that may be used to reduce any subsequent period's income tax expense. Basel III specifies that certain DTAs do not require deduction from capital. This proposal clarifies that such DTAs include those that automatically convert into a claim on the state when a firm makes a loss would not require to be deducted, where their ability to absorb losses when needed was ensured.

5.3. Treatment of specific exposures (Part Three, Title II, Chapter 2) 5.3.1. Treatment of exposures to SMEs

Under current EU law, banks can benefit from preferential risk weights applied to exposures to SMEs. This preferential treatment will continue to be in place also under Basel III as well as under the draft proposal. More beneficial capital requirements for exposures to SMEs would require a revision to the international Basel framework in the first place. This question is subject to a review clause in the proposal.

It is crucial that risk weights of SME lending are carefully assessed. For this reason, the EBA is requested to analyse and report by 1 September 2012 on the current risk weights, testing the possibilities for a reduction, taking into consideration a scenario with a reduction by one third in relation to the current situation. In this context, the Commission intends to report to the European Parliament and the Council on this analysis and would put forward legislative proposals for the review of the SMEs' risk weight, as appropriate.

Moreover the Commission, consulting EBA, will, within 24 months after the entry into force of this Regulation, report on lending to small and medium-sized enterprises and natural persons and shall submit this report to the European Parliament and the Council together with any appropriate proposal.

5.3.2. Treatment of exposures arising from trade finance activities

BCBS is expected to finalise their view on whether more beneficial capital requirements for trade finance should be set only towards the end of 2011. Consequently, this is not reflected in this proposal, but a review clause on the treatment of these exposures has been provided for.

5.4. Counterparty credit risk (Part Three, Title II, Chapter 6)

In Basel III, banks will be required to hold additional capital against the risk that the credit quality of the counterparty could deteriorate. This proposal would introduce this new capital charge. However, Basel III recognises losses that a bank writes down upfront with immediate impact on the profit and loss account (incurred credit valuation adjustments) only to a very limited extent. On the basis of the feedback to a consultation by the Commission in February/March 2011 on this issue and with the support of a vast majority of Member States, this proposal would allow banks using the advanced approach for credit risk a greater, however prudent, recognition of such losses and therefore better reflect the common practice of provisioning for future losses exercised by many EU banks.

5.5. Liquidity (Part Six) 5.5.1. Liquidity Coverage Requirement

The Commission is firmly committed to reaching a harmonised Liquidity Coverage Requirement by 2015. At the same time, uncertainties about possible unintended consequences and the observation period of Basel III should be taken very seriously. The following elements ensure introducing a binding requirement only after an appropriate review:

– a general requirement to apply from 2013 for banks to keep appropriate liquidity coverage as a first step;

– an obligation to report to national authorities the elements needed to verify that they keep an adequate liquidity coverage on the basis of the uniform reporting formats developed by the European Banking Authority in order to test the Basel III criteria;

– a power for the Commission to further specify the Liquidity Coverage Requirement in line with the conclusions from the observation period and international developments. Avoiding the lengthy ordinary legislative procedure (via co-decision) would allow making the maximum use of the observation period and being able to defer calibration towards the end of this observation period.

The liquidity coverage requirement will, within groups of credit institutions or investment firms or both, in principle apply at the level of every individual credit institution or investment firm. By contrast to branches, which do not have a legal personality, credit institutions or investment firms are themselves subject to payment obligations that may lead to liquidity outflows under stress circumstances. It cannot be taken for granted that credit institutions or investment firms will receive liquidity support from other credit institutions or investment firms belonging to the same group when they experience difficulties to meet their payment obligations. However, subject to stringent conditions, competent authorities will be able to waive the application to individual credit institutions or investment firms and subject those credit institutions or investment firms to a consolidated requirement. Those stringent conditions can be found in Article 7(1) and they ensure, inter alia, that the credit institutions or investment firms are, in a legally enforceable manner, committed to support each other and have the actual ability to do so.

In the case of a group with credit institutions or investment firms in several Member States, all competent authorities of the individual credit institutions or investment firms must, in order for the waiver of individual requirements to be available, agree together that the conditions for the waiver are met. In such cross-border situations, there are, in addition to the conditions in Article 7(1), further conditions in Article 7(2). Those further conditions require that all of the individual competent authorities must be satisfied with the liquidity management of the group and with how much liquidity the individual credit institutions or investment firms of the group have. In case of disagreement, each competent authority of an individual credit institution or investment firm will decide alone about whether the waiver would apply.

There is an additional possibility for EBA to mediate in case of disagreement between the competent authorities. The result of the mediation is however only binding regarding the conditions in Article 7(1). The individual competent authorities retain the last say regarding the conditions in Article 7(2), i.e. regarding the adequacy of the group's liquidity management and regarding the liquidity adequacy of the individual credit institutions or investment firms.

5.5.2. Net Stable Funding Requirement

The Commission is firmly committed to reaching a minimum standard on the Net Stable Funding Requirement by 1 January 2018. Since Basel III sets out an observation period until 2018 in this regard, there would be sufficient time to prepare a stable funding requirement in the form of a co-decision proposal to be agreed between Parliament and Council before the end of the observation period.

5.6. Leverage (Part Seven)

The Leverage Ratio is a new regulatory tool in the EU. In line with Basel III, the Commission does not propose a Leverage Ratio as a binding instrument at this stage but first as an additional feature that can be applied on individual banks at the discretion of supervisory authorities with a view to migrating to a binding ('pillar one') measure in 2018, based on appropriate review and calibration. Reporting obligations would allow a review and an informed decision on its introduction as a binding requirement in 2018. In line with the Basel III, it is proposed that institutions publish their Leverage Ratios from 2015.

5.7. Basel I limit (Part Thirteen)

Basel II requires more capital to be held for riskier business than would be required under Basel I. For less risky business, Basel II requires less capital to be held than Basel I. This is because Basel II was designed to be more risk sensitive than Basel I.

To prevent banks from being subject to inappropriately low capital requirements, Basel II does not allow a lower capital than 80% of the capital that would have been required under Basel I. This requirement expired at the end of 2009, but Directive 2010/76/EC reinstated it until the end of 2011. Based on the extension of this requirement by BCBS in July 2009, the draft proposal reinstates it until 2015. Competent authorities may, after having consulted EBA, waive the application of the Basel I limit to an institution provided that all requirements for the use of the advanced approaches for credit and operational risks are met.

6. Budgetary implications

EBA will play an important role in achieving the objective of this Regulation, as the proposals ask it to develop more than 50 binding technical standards (BTS) on various policy issues. BTS – which would eventually be endorsed by the Commission – will be key to ensure that provisions of highly technical nature are implemented uniformly across the EU and that the proposed policies work as intended. For this significant workload, EBA would need more resources than those already provided within the context of its establishment under Regulation (EU) 1093/2010. Further details are set out in the attached legislative financial statement.

Proposal for a

THE EUROPEAN PARLIAMENT AND THE COUNCIL OF THE EUROPEAN UNION,

Having regard to the Treaty on the Functioning of the European Union, and in particular Article 114 thereof,

Having regard to the proposal from the European Commission,

After transmission of the draft legislative act to the national Parliaments,

Having regard to the opinion of the European Economic and Social Committee[7],

Acting in accordance with the ordinary legislative procedure,

Whereas:

(1) The G20 Declaration of 2 April 2009[8] on Strengthening of the Financial System called for internationally consistent efforts that are aimed at strengthening transparency, accountability and regulation by, improving the quantity and quality of capital in the banking system once the economic recovery is assured. The declaration also called for introducing a supplementary non-risk based measure to contain the build-up of leverage in the banking system, and developing a framework for stronger liquidity buffers. In response to the mandate given by the G20, in September 2009 the Group of Central Bank Governors and Heads of Supervision (GHOS), agreed on a number of measures to strengthen the regulation of the banking sector. These measures were endorsed by the G20 leaders at their Pittsburgh Summit of 24-25 September 2009 and were set out in detail in December 2009. In July and September 2010, GHOS issued two further announcements on design and calibration of these new measures, and in December 2010, the Basel Committee on Banking Supervision (BCBS) published the final measures, that are referred to as Basel III.

(2) The High Level Group on Financial Supervision in the EU chaired by Jacques de Larosière invited the European Union to develop a more harmonised set of financial regulation. In the context of the future European supervisory architecture, the European Council of 18 and 19 June 2009 also stressed the need to establish a 'European Single Rule Book' applicable to all credit institutions and investment firms in the Single Market.

(3) Directive 2006/48/EC of the European Parliament and of the Council of 14 June 2006[9] relating to the taking up and pursuit of the business of credit institutions and Directive 2006/49/EC of the European Parliament and of the Council of 14 June 2006[10] on the capital adequacy of investment firms and credit institutions ("institutions") have been significantly amended on several occasions. Many provisions of Directives 2006/48/EC and 2006/49/EC are applicable to both credit institutions and investment firms. Irder to ensure a coherent application of those provisions, it would be desirable to merge these provisions into new legislation applicable to both credit institutions and investment firms. For sake of clarity, the provisions of the Annexes to those Directives should be integrated into the enacting terms of this new legislation.

(4) That new legislation should consist of two different legal instruments, a Directive and this Regulation. Together, both legal instruments should form the legal framework governing the access to the activity, the supervisory framework and the prudential rules for credit institutions and investment firms. This Regulation should therefore be read together with the Directive.

(5) Directive [inserted by OP], based on Article 53 (1) TFEU, should contain the provisions concerning the access to the activity of credit institutions and investment firms, the modalities for their governance, and their supervisory framework, such as provisions governing the authorisation of the business, the acquisition of qualifying holdings, the exercise of the freedom of establishment and of the freedom to provide services, the powers of supervisory authorities of home and host Member States in this regard and the provisions governing the initial capital and the supervisory review of credit institutions and investment firms.

(6) This Regulation should contain the prudential requirements for credit institutions and investment firms that relate strictly to the functioning of banking and financial services markets and are meant to ensure the financial stability of the operators on these markets as well as a high level of protection of investors and depositors. This directly applicable legal act aims at contributing in a determining manner to the smooth functioning of the internal market and should, consequently, be based on the provisions of Article 114 TFEU, as interpreted in accordance with the consistent case-law of the Court of Justice of the European Union .

(7) Directives 2006/48/EC and 2006/49/EC, although having harmonised the rules of Member States in the area of prudential supervision to a certain degree, include a significant number of options and discretions, and Member States are still permitted to impose stricter rules than those laid down by those Directives. This results in divergences between national rules which are such as to obstruct the fundamental freedoms and thus have a direct effect on the functioning of the internal market and cause significant distortions of competition. In particular, such divergences hamper the cross-border provision of services and the establishment in other Member since each time different rules have to be assessed and complied with by operators when doing business in another Member State. In addition, credit institutions and investment firms authorized in different Member States are often subject to different requirements, leading to significant distortions of competition. Divergent development of national laws creates potential and actual obstacles to the smooth functioning of the internal market due to unequal conditions of operation and difficulties for credit institutions and investment firms operating in different juridical systems across the Union.

(8) In order to remove the remaining obstacles to trade and significant distortions of competition resulting from divergences between national laws and to prevent any further likely obstacles to trade and significant distortions of competition from arising, it is therefore necessary to adopt a Regulation establishing uniform rules applicable in all Member States.

(9) Shaping prudential requirements in the form of a Regulation would ensure that those requirements will be directly applicable to them. This would ensure uniform conditions by preventing diverging national requirements as a result of the transposition of a Directive. This Regulation would entail that institutions follow the same rules in all the Union, which would also boost confidence in the stability of credit institutions and investment firms, especially in times of stress. A Regulation would also reduce regulatory complexity and firms' compliance costs, especially for credit institutions and investment firms operating on a cross-border basis, and contribute to eliminating competitive distortions. With regard to the peculiarity of immovable property markets which are characterised by economic developments and jurisdictional differences that are specific to Member States, regions or local areas, competent authorities should be allowed to set higher risks weights or to apply stricter criteria based on default experience and expected market developments to exposures secured by mortgages on immovable property in specific areas.

(10) Member States should have the power to maintain or introduce national provisions where this Regulation does not provide for uniform rules provided that those national provisions are not in contradiction with Union law or do not undermine their application.

(11) Where Member States adopt guidelines of general scope, in particular in areas where the adoption by the Commission of draft technical standards is pending, those guidelines shall neither contradict Union law nor undermine its application.

(12) This Regulation does not prevent Member States from imposing equivalent requirements on undertakings that do not fall within its scope.

(13) The general prudential requirements set out in this Regulation are supplemented by individual arrangements that are decided by the competent authorities as a result of their ongoing supervisory review of each individual credit institution and investment firm. The range of such supervisory arrangements should be set out in a Directive since the competent authorities should be able to exert their judgment as to which arrangements should be imposed.

(14) This Regulation should not affect the ability of competent authorities to impose specific requirements under the supervisory review and evaluation process set out in Directive [inserted by OP] that should be tailored to the specific risk profile of credit institutions and investment firms.

(15) Regulation (EU) No 1093/2010 of the European Parliament and of the Council of 24 November 2010 establishing a European Supervisory Authority,[11] established the European Banking Authority (EBA). That Regulation aims at upgrading the quality and consistency of national supervision and strengthening oversight of cross-border groups.

(16) Regulation (EU) No 1093/2010 requires EBA to act within the scope of Directives 2006/48/EC and 2006/49/EC. EBA is also required to act in the field of activities of credit institutions and investment firms in relation to issues not directly covered in those Directives, provided that such actions are necessary to ensure the effective and consistent application of those acts. This Regulation should take into account the role and function of EBA and facilitate the exercise of EBA's powers set out in that Regulation.

(17) Equivalent financial requirements for credit institutions and investment firms are necessary to ensure similar safeguards for savers and fair conditions of competition between comparable groups of credit institutions and investment firms

(18) Since credit institutions and investment firms in the internal market are engaged in direct competition, monitoring requirements should be equivalent throughout the Union.

(19) Whenever in the course of supervision it is necessary to determine the amount of the consolidated own funds of a group of credit institutions and investment firms, the calculation should be effected in accordance with this Regulation.

(20) According to this Regulation own funds requirements apply on an individual and consolidated basis, unless competent authorities disapply supervision on an individual basis where they deem this appropriate. Individual, consolidated and cross-border consolidated supervision are useful tools in overseeing credit institutions and investment firms.

(21) In order to ensure adequate solvency of credit institutions and investment firms within a group it is essential that the capital requirements apply on the basis of the consolidated situation of these institutions in the group. In order to ensure that own funds are appropriately distributed within the group and available to protect savings where needed, the capital requirements should apply to individual credit institutions and investment firms within a group, unless this objective can be effectively otherwise achieved.

(22) The precise accounting technique to be used for the calculation of own funds, their adequacy for the risk to which a credit institution or investment firm is exposed, and for the assessment of the concentration of exposures should take account of the provisions of Council Directive 86/635/EEC of 8 December 1986 on the annual accounts and consolidated accounts of banks and other financial institutions[12], which incorporates certain adaptations of the provisions of Seventh Council Directive 83/349/EEC of 13 June 1983 on consolidated accounts[13] or of Regulation (EC) No 1606/2002 of the European Parliament and of the Council of 19 July 2002 on the application of international accounting standards[14], whichever governs the accounting of the credit institutions and investment firms under national law.

(23) For the purposes of ensuring adequate solvency it is important to lay down capital requirements which weight assets and off-balance-sheet items according to the degree of risk.

(24) On 26 June 2004 the BCBS adopted a framework agreement on the international convergence of capital measurement and capital requirements ('Basel II framework'). The provisions in Directive 2006/48/EC and 2006/49/EC that this Regulation has taken over form an equivalent to the provisions of the Basel II framework agreement. Consequently, by incorporating the supplementary elements of the Basel III this Regulation forms an equivalent to the provisions of the Basel II and III agreements.

(25) It is essential to take account of the diversity of credit institutions and investment firms in the Union by providing alternative approaches to the calculation of capital requirements for credit risk incorporating different levels of risk-sensitivity and requiring different degrees of sophistication. Use of external ratings and credit institutions and investment firms' own estimates of individual credit risk parameters represents a significant enhancement in the risk-sensitivity and prudential soundness of the credit risk rules. There should be appropriate incentives for credit institutions and investment firms to move towards the more risk-sensitive approaches. In producing the estimates needed to apply the approaches to credit risk of this Regulation, credit institutions and investment firms should enhance credit risk measurement and management processes of credit institutions and investment firms to make methods for determining credit institutions and investment firms' regulatory own funds requirements available that reflect the sophistication of individual credit institutions and investment firms' processes. In this regard, the processing of data in connection with the incurring and management of exposures to customers should be considered to include the development and validation of credit risk management and measurement systems. That serves not only to fulfil the legitimate interest of credit institutions and investment firms but also the purpose of this Regulation, to use better methods for risk measurement and management and also use them for regulatory own funds purposes.

(26) The capital requirements should be proportionate to the risks addressed. In particular the reduction in risk levels deriving from having a large number of relatively small exposures should be reflected in the requirements.

(27) In line with the decision of the BCBS, as endorsed by the GHOS on 10 January 2011, all Additional Tier 1 and Tier 2 instruments of an institution should be fully and permanently written down or converted fully into Common Equity Tier 1 capital at the point of non-viability of the institution.

(28) The provisions of this Regulation respect the principle of proportionality, having regard in particular to the diversity in size and scale of operations and to the range of activities of credit institutions and investment firms. Respect of the principle of proportionality also means that the simplest possible rating procedures, even in the Internal Ratings Based Approach (‘IRB Approach’), are recognised for retail exposures.

(29) The ‘evolutionary’ nature of this Regulation enables credit institutions and investment firms to choose amongst three approaches of varying complexity. In order to allow especially small credit institutions and investment firms to opt for the more risk-sensitive IRB Approach, the relevant provisions should be read as such that exposure classes include all exposures that are, directly or indirectly, put on a par with them throughout this Regulation. As a general rule, the competent authorities should not discriminate between the three approaches with regard to the Supervisory Review Process, i.e. credit institutions and investment firms operating according to the provisions of the Standardised Approach should not for that reason alone be supervised on a stricter basis.

(30) Increased recognition should be given to techniques of credit risk mitigation within a framework of rules designed to ensure that solvency is not undermined by undue recognition. The relevant Member States' current customary banking collateral for mitigating credit risks should wherever possible be recognised in the Standardised Approach, but also in the other approaches.

(31) In order to ensure that the risks and risk reductions arising from credit institutions and investment firms' securitisation activities and investments are appropriately reflected in the capital requirements of credit institutions and investment firms it is necessary to include rules providing for a risk-sensitive and prudentially sound treatment of such activities and investments.

(32) Operational risk is a significant risk faced by credit institutions and investment firms requiring coverage by own funds. It is essential to take account of the diversity of credit institutions and investment firms in the Union by providing alternative approaches to the calculation of operational risk requirements incorporating different levels of risk-sensitivity and requiring different degrees of sophistication. There should be appropriate incentives for credit institutions and investment firms to move towards the more risk-sensitive approaches. In view of the emerging state of the art for the measurement and management of operational risk the rules should be kept under review and updated as appropriate including in relation to the charges for different business lines and the recognition of risk mitigation techniques. Particular attention should be paid in this regard to taking insurance into account in the simple approaches to calculating capital requirements for operational risk.

(33) The monitoring and control of a credit institution's exposures should be an integral part of its supervision. Therefore, excessive concentration of exposures to a single client or group of connected clients may result in an unacceptable risk of loss. Such a situation can be considered prejudicial to the solvency of a credit institution.

(34) In determining the existence of a group of connected clients and thus exposures constituting a single risk, it is also important to take into account risks arising from a common source of significant funding provided by the credit institution or investment firm itself, its financial group or its connected parties.

(35) While it is desirable to base the calculation of the exposure value on that provided for the purposes of own funds requirements, it is appropriate to adopt rules for the monitoring of large exposures without applying risk weightings or degrees of risk. Moreover, the credit risk mitigation techniques applied in the solvency regime were designed with the assumption of a well-diversified credit risk. In the case of large exposures dealing with single name concentration risk, credit risk is not well-diversified. The effects of those techniques should therefore be subject to prudential safeguards. In this context, it is necessary to provide for an effective recovery of credit protection for the purposes of large exposures.

(36) Since a loss arising from an exposure to a credit institution or an investment firm can be as severe as a loss from any other exposure, such exposures should be treated and reported in the same manner as any other exposures. However, an alternative quantitative limit has been introduced to alleviate the disproportionate impact of such an approach on smaller institutions. In addition, very short-term exposures related to money transmission including the execution of payment services, clearing, settlement and custody services to clients are exempt to facilitate the smooth functioning of financial markets and of the related infrastructure. Those services cover, for example, the execution of cash clearing and settlement and similar activities to facilitate settlement. The related exposures include exposures which might not be foreseeable and are therefore not under the full control of a credit institution, inter alia, balances on inter-bank accounts resulting from client payments, including credited or debited fees and interest, and other payments for client services, as well as collateral given or received.

(37) It is important that the misalignment between the interest of undertakings that ‘re-package’ loans into tradable securities and other financial instruments (originators or sponsors) and undertakings that invest in these securities or instruments (investors) be removed. It is also important that the interests of the originator or sponsor and the interests of investors be aligned. To achieve this, the originator or sponsor should retain a significant interest in the underlying assets. It is therefore important for the originators or the sponsors to retain exposure to the risk of the loans in question. More generally, securitisation transactions should not be structured in such a way as to avoid the application of the retention requirement, in particular through any fee or premium structure or both. Such retention should be applicable in all situations where the economic substance of a securitisation is applicable, whatever legal structures or instruments are used to obtain this economic substance. In particular where credit risk is transferred by securitisation, investors should make their decisions only after conducting thorough due diligence, for which they need adequate information about the securitisations.

(38) There should be no multiple applications of the retention requirement. For any given securitisation it suffices that only one of the originator, the sponsor or the original lender is subject to the requirement. Similarly, where securitisation transactions contain other securitisations as an underlying, the retention requirement should be applied only to the securitisation which is subject to the investment. Purchased receivables should not be subject to the retention requirement if they arise from corporate activity where they are transferred or sold at a discount to finance such activity. Competent authorities should apply the risk weight in relation to non-compliance with due diligence and risk management obligations in relation to securitisation for non-trivial breaches of policies and procedures which are relevant to the analysis of the underlying risks.

(39) Due diligence should be used in order properly to assess the risks arising from securitisation exposures for both the trading book and the non-trading book. In addition, due diligence obligations need to be proportionate. Due diligence procedures should contribute to building greater confidence between originators, sponsors and investors. It is therefore desirable that relevant information concerning the due diligence procedures is properly disclosed.

(40) When a credit institution or investment firm incurs an exposure to its own parent undertaking or to other subsidiaries of its parent undertaking, particular prudence is necessary. The management of exposures incurred by credit institutions and investment firms should be carried out in a fully autonomous manner, in accordance with the principles of sound management, without regard to any other considerations. In the field of large exposures, specific standards, including more stringent restrictions, should be laid down for exposures incurred by a credit institution to its own group. Such standards need not, however be applied where the parent undertaking is a financial holding company or a credit institution or where the other subsidiaries are either credit or financial institutions or undertakings offering ancillary services, provided that all such undertakings are covered by the supervision of the credit institution on a consolidated basis.

(41) In view of the risk-sensitivity of the rules relating to capital requirements, it is desirable to keep under review whether these have significant effects on the economic cycle. The Commission, taking into account the contribution of the European Central Bank should report on these aspects to the European Parliament and to the Council.

(42) The capital requirements for commodity dealers, including those dealers currently exempt from the requirements of Directive 2004/39/EC, should be reviewed.

(43) The goal of liberalisation of gas and electricity markets is both economically and politically important for the Community. With this in mind, the capital requirements and other prudential rules to be applied to firms active in those markets should be proportionate and should not unduly interfere with achievement of the goal of liberalisation. This goal should, in particular, be kept in mind when reviews of this Regulation are carried out.

(44) Credit institutions and investment firms investing in re-securitisations should exercise due diligence also with regard to the underlying securitisations and the non-securitisation exposures ultimately underlying the former. Credit institutions and investment firms should assess whether exposures in the context of asset-backed commercial paper programmes constitute re-securitisation exposures, including those in the context of programmes which acquire senior tranches of separate pools of whole loans where none of those loans is a securitisation or re-securitisation exposure, and where the first-loss protection for each investment is provided by the seller of the loans. In the latter situation, a pool- specific liquidity facility should generally not be considered a re-securitisation exposure because it represents a tranche of a single asset pool (that is, the applicable pool of whole loans) which contains no securitisation exposures. By contrast, a programme-wide credit enhancement covering only some of the losses above the seller-provided protection across the various pools generally would constitute a tranching of the risk of a pool of multiple assets containing at least one securitisation exposure, and would therefore be a re-securitisation exposure. Nevertheless, if such a programme funds itself entirely with a single class of commercial paper, and if either the programme-wide credit enhancement is not a re-securitisation or the commercial paper is fully supported by the sponsoring credit institution or investment firm, leaving the commercial paper investor effectively exposed to the default risk of the sponsor instead of the underlying pools or assets, then that commercial paper generally should not be considered a re-securitisation exposure.

(45) The provisions on prudent valuation for the trading book should apply to all instruments measured at fair value, whether in the trading book or non- trading book of credit institutions and investment firms. It should be clarified that, where the application of prudent valuation would lead to a lower carrying value than actually recognised in the accounting, the absolute value of the difference should be deducted from own funds.

(46) Credit institutions and investment firms should have a choice whether to apply a capital requirement to or deduct from Common Equity Tier 1 items those securitisation positions that receive a 1 250 % risk weight under this Regulation, irrespective of whether the positions are in the trading or the non-trading book.

(47) Originator or sponsor institutions should not be able to circumvent the prohibition of implicit support by using their trading books in order to provide such support.

(48) Directive 2006/48/EC introduced a preferential risk weight under the standardised approach for exposures to small or medium sized enterprises or natural persons and the possibility for institutions to apply internal ratings based approaches where they themselves estimate the risk weight, reflecting the soundness of their own particular underwriting criteria. The preferential risk weights should continue to be in place also under this Regulation. However, the possible merits of lowering the risk weights or expanding their application to more exposures should be reviewed within 24 months after the entry into force of this Regulation. Such review should be evidence-based and take into account reliable data on credit losses on exposures to small or medium sized enterprises or natural persons during a full economic cycle. The impact on lending to consumers should be given particular attention in the context of this review.

(49) Without prejudice to the disclosures explicitly required by this Regulation, the aim of the disclosure requirements should be to provide market participants with accurate and comprehensive information regarding the risk profile of individual institutions. Credit institutions and investment firms should therefore be required to disclose additional information not explicitly listed in this Regulation where such disclosure is necessary to meet that aim.

(50) Where an external credit assessment for a securitisation position incorporates the effect of credit protection provided by the investing institution itself, the institution should not be able to benefit from the lower risk weight resulting from that protection. This should not lead to the deduction from capital of the securitisation if there are other ways to determine a risk weight in line with the actual risk of the position, not taking into account such credit protection.

(51) Given their recent weak performance, the standards for internal models to calculate market risk capital requirements should be strengthened. In particular, their capture of risks should be completed regarding credit risks in the trading book. Furthermore, capital charges should include a component adequate to stress conditions to strengthen capital requirements in view of deteriorating market conditions and in order to reduce the potential for pro-cyclicality. Credit institutions and investment firms should also carry out reverse stress tests to examine what scenarios could challenge the viability of the institution unless they can prove that such a test is dispensable. Given the recent particular difficulties of treating securitisation positions using approaches based on internal models, the ability of credit institutions and investment firms to model securitisation risks in the trading book should be limited and a standardised capital charge for securitisation positions in the trading book should be required by default.

(52) This Regulation lays down limited exceptions for certain correlation trading activities, in accordance with which an institution may be permitted by its supervisor to calculate a comprehensive risk capital charge subject to strict requirements. In such cases the institution should be required to subject those activities to a capital charge equal to the higher of the capital charge in accordance with that internally developed approach and 8 % of the capital charge for specific risk in accordance with the standardised measurement method. It should not be required to subject those exposures to the incremental risk charge but they should be incorporated into both the value-at-risk measures and the stressed value-at-risk measures.

(53) In light of the nature and magnitude of unexpected losses experienced by credit institutions and investment firms during the financial and economic crisis, it is necessary to improve further the quality and harmonisation of own funds that credit institutions and investment firms are required to hold. This should include the introduction of a new definition of the core elements of capital available to absorb unexpected losses as they arise, enhancements to the definition of hybrid capital and uniform prudential adjustments to own funds. It is also necessary to raise significantly the level of own funds, including new capital ratios focusing on the core elements of own funds available to absorb losses as they arise.

(54) For the purposes of strengthening market discipline and enhancing financial stability it is necessary to introduce more detailed requirements for disclosure of the form and nature of regulatory capital and prudential adjustments made in order to ensure that investors and deposits are sufficiently well informed about the solvency of credit institutions and investment firms.

(55) The new definition of capital and regulatory capital requirements should be introduced in a manner that takes account of the fact that there are different national starting points and circumstances, with initial variance around the new standards reducing over the transition period. In order to ensure the appropriate continuity in the level of own funds, existing public sector capital injections will be grandfathered for the extent of the transition period.

(56) Directive 2006/48/EC required credit institutions to provide own funds that are at least equal to specified minimum amounts until 31 December 2011. In the light of the continuing effects of the financial crisis in the banking sector and the extension of the transitional arrangements for capital requirements adopted by the BCBS, it is appropriate to reintroduce a lower limit for a limited period of time until sufficient amounts of own funds have been established in accordance with the transitional arrangements for own funds provided for in this Regulation that will be progressively phased in from 2013 to 2019. For groups which include significant banking or investment business and insurance business, Directive 2002/87/EC on Financial Conglomerates, provides specific rules to address such 'double counting' of capital. Directive 2002/87/EC is based on internationally agreed principles for dealing with risk across sectors. This proposal strengthens the way these Financial Conglomerates rules shall apply to bank and investment firm groups, ensuring their robust and consistent application. Any further changes that are necessary will be addressed in the review of Directive 2002/87/EC, due in 2012.

(57) The financial crisis highlighted that credit institutions and investment firms massively underestimated the level of counterparty credit risk associated with over-the-counter (OTC) derivatives. This prompted the G20 Leaders, in September 2009, to call for more OTC derivatives to be cleared through a Central Counterparty (CCP). Furthermore, they asked to subject those OTC derivatives that could not be cleared centrally to higher own funds requirements in order to properly reflect the higher risks associated with them.

(58) Following the G-20 Leaders' call, the BCBS, as part of Basel III, materially changed the counterparty credit risk regime. Basel III is expected to significantly increase the own fund requirements associated with credit institutions' and investment firms' OTC derivatives and securities financing transactions and to create important incentives for credit institutions and investment firms to use CCPs. Basel III is also expected to provide further incentives to strengthen the risk management of counterparty credit exposures and to revise the current regime for the treatment of counterparty credit risk exposures to CCPs.

(59) Institutions should hold additional own funds due to credit valuation adjustment risk arising from OTC derivatives. Institutions should also apply a higher asset value correlation in the calculation of the own fund requirements for counterparty credit risk exposures arising from OTC derivatives and securities-financing transactions to certain financial institutions. Credit institutions and investment firms should also considerably improve measurement and management of counterparty credit risk by better addressing wrong-way risk, highly leveraged counterparties and collateral, accompanied by the corresponding enhancements in the areas of back-testing and stress testing.

(60) Trade exposures to CCPs usually benefit from the multilateral netting and loss-sharing mechanism provided by CCPs. As a consequence, they involve a very low counterparty credit risk and should therefore be subject to a very low own funds requirement. At the same time, this requirement should be positive in order to ensure that credit institutions and investment firms track and monitor their exposures to CCPs as part of good risk management and to reflect that even trade exposures to CCPs are not risk-free.

(61) A CCP's default fund is a mechanism that allows the sharing (mutualisation) of losses among the CCP's clearing members. It is used in case the losses incurred by the CCP following the default of a clearing member are greater than the margins and default fund contributions provided by that clearing member and any other defence the CCP may use before recurring to the default fund contributions of the remaining clearing members. In view of this, the risk of loss associated with exposures from default fund contributions is higher than the one associated with trade exposures. Therefore, this type of exposures should be subject to a higher own funds requirement.

(62) The “hypothetical capital” of a CCP should be a variable needed to determine the own funds requirement for a clearing member’s exposures from its contributions to a CCP’s default fund. It should not be understood as anything else. In particular, it should not be understood as the amount of capital that a CCP is required to hold by its competent authority.

(63) The review of the treatment of counterparty credit risk, and in particular putting in place higher own funds requirements for bilateral derivative contracts in order to reflect the higher risk that such contracts pose to the financial system, forms an integral part of the Commission’s efforts to ensure efficient, safe and sound derivatives markets. Consequently, this Regulation complements the Commission proposal for a Regulation on OTC derivatives, central counterparties and trade repositories, of 15 September 2010[15].

(64) The years preceding the financial crisis were characterised by an excessive build up in credit institutions' and investment firms' exposures in relation to their own funds (leverage). During the financial crisis, losses and the shortage of funding forced credit institutions and investment firms to reduce significantly their leverage over a short period of time. This amplified downward pressures on asset prices, causing further losses for both credit institutions and investment firms which in turn led to further declines in their own funds. The ultimate results of this negative spiral were a reduction in the availability of credit to the real economy and a deeper and longer crisis.

(65) Risk-based own funds requirements are essential to ensure sufficient own funds to cover unexpected losses. However, the crisis has shown that these requirements alone are not sufficient to prevent credit institutions and investment firms from taking on excessive and unsustainable leverage risk.

(66) In September 2009, G-20 leaders committed to developing internationally-agreed rules to discourage an excessive leverage. To this end, they supported the introduction of a leverage ratio as a supplementary measure to the Basel II framework.

(67) In December 2010, the BCBS published guidelines defining the methodology for calculating the leverage ratio. These rules foresee an observation period that will run from 1 January 2013 until 1 January 2017 during which the leverage ratio, its components and its behaviour relative to the risk-based requirement will be monitored. Based on the results of the observation period the BCBS intends to make any final adjustments to the definition and calibration of the leverage ratio in the first half of 2017, with a view to migrating to a binding requirement on 1 January 2018 based on appropriate review and calibration. The BCBS guidelines also foresee the disclosure of the leverage ratio and its components starting from 1 January 2015.

(68) A leverage ratio is a new regulatory and supervisory tool for the Union. In line with international agreements, it should be introduced first as an additional feature that can be applied on individual institutions at the discretion of supervisory authorities. Reporting obligations for institutions would allow appropriate review and calibration, with a view to migrating to a binding measure in 2018.

(69) When reviewing the impact of the leverage ratio on different business models, particular attention should be paid to business models which are considered to entail low risk, such as mortgage lending and specialised lending with regional governments, local authorities or public sector entities.

(70) In order to facilitate the review, credit institutions and investment firms should during an observation period monitor the level and changes in the leverage ratio as well as leverage risk as part of the internal capital adequacy assessment process (ICAAP). This monitoring should be included in the supervisory review process.

(71) Restrictions on variable remuneration are an important element in ensuring that credit institutions and investment firms rebuild their capital levels when operating within the buffer range. Credit institutions and investment firms are already subject to the principle that awards and discretionary payments of variable remuneration to those categories of staff whose professional activities have a material impact on the risk profile of the institution have to be sustainable, having regard to the financial situation of the institution. In order to ensure that an institution restores its levels of own funds in a timely manner, it is appropriate to align the award of variable remuneration and discretionary pension benefits with the profit situation of the institution during any period in which the combined buffer requirement is not met.

(72) Good governance structures, transparency and disclosure are essential for sound remuneration policies. In order to ensure adequate transparency to the market of their remuneration structures and the associated risk, credit institutions and investments firms should disclose detailed information on their remuneration policies, practices and, for reasons of confidentiality, aggregated amounts for those members of staff whose professional activities have a material impact on the risk profile of the credit institution or investment firm. That information should be made available to all stakeholders.

(73) Directive 95/46 of the European Parliament and of the Council of 24 October 1995 on the protection of individuals with regard to the processing of personal data and on the free movement of such data[16] and Regulation (EU) No 45/2001 of the European Parliament and of the Council of 18 December 2000 on the protection of individuals with regard to the processing of personal data by the EU institutions and bodies and and on the free movement of such data[17], should be fully applicable to the processing of personal data for the purposes of this Regulation

(74) Credit institutions and investment firms should hold a stock of liquid assets that they can use to cover liquidity needs in a short term liquidity stress. When they use the stock, they should put in place a plan to restore their holdings of liquid assets and competent authorities should ensure the adequacy of the plan and its implementation.

(75) The stock of liquid assets should be available at any time to meet the liquidity outflows. The level of liquidity needs in a short term liquidity stress should be determined in a standardised manner so as to ensure a uniform soundness standard and a level playing field. It should be ensured that such a standardised determination has no unintended consequences for financial markets, credit extension and economic growth, also taking into account different business models and funding environments of credit institutions and investment firms across the Union. To this end, the liquidity coverage requirement should be subject to an observation period. Based on the observations and supported by EBA, the Commission should confirm or adjust the liquidity coverage requirement by means of a delegated act.

(76) Apart from short-term liquidity needs, credit institutions and investment firms should also adopt funding structures that are stable at a longer term horizon. In December 2010, the BCBS agreed that the NSFR will move to a minimum standard by 1 January 2018 and that the BCBS will put in place rigorous reporting processes to monitor the ratio during a transition period and will continue to review the implications of these standards for financial markets, credit extension and economic growth, addressing unintended consequences as necessary. The BCBS thus agreed that the NSFR will be subject to an observation period and will include a review clause. In this context, EBA should, based on reporting required by this Regulation, evaluate how a stable funding requirement should be designed. Based on this evaluation, the Commission should report to Council and European Parliament together with any appropriate proposals in order to introduce such a requirement by 2018.

(77) Weaknesses in corporate governance in a number of credit institutions and investment firms have contributed to excessive and imprudent risk-taking in the banking sector which led to the failure of individual institutions and systemic problems.

(78) In order to facilitate the monitoring of institutions' corporate governance practices and improve market discipline, credit institutions and investment firms should publicly disclose their corporate governance arrangements. Their management bodies should approve and publicly disclose a statement providing assurance to the public that these arrangements are adequate and efficient.

(79) In order to ensure progressive convergence between the level of own funds and the prudential adjustments applied the definition of own funds across the Union and to the definition of own funds laid down in this Regulation during a transition period, the phasing in of the own funds requirements of this Regulation should occur gradually. It is vital to ensure that this phasing in is consistent with the recent enhancements made by Member States to the required levels of own funds and to the definition of own funds in place in the Member States. To that end, during the transition period the competent authorities should determine within defined lower and upper limits how rapidly to introduce the required level of own funds and prudential adjustments laid down in this Regulation.

(80) In order to facilitate smooth transition from divergent prudential adjustments currently applied in Member States to the set of prudential adjustments laid down in this Regulation, competent authorities should be able during a transition period to continue to require institutions, to a limited extent, to make prudential adjustments to own funds that are a derogation from this Regulation.

(81) In order to ensure that institutions have sufficient time to meet the new required levels and definition of own funds, certain capital instruments that do not comply with the definition of own funds laid down in this Regulation should be phased out between 1 January 2013 and 31 December 2021. In addition, certain state-injected instruments should be recognised fully in own funds for a limited period.

(82) In order to ensure progressive convergence towards uniform rules on disclosure by institutions to provide market participants with accurate and comprehensive information regarding the risk profile of individual institutions, disclosure requirements should be phased in gradually.

(83) In order to take account of market developments and experience in the application of this Regulation, the Commission should be required to submit to the European Parliament and the Council reports, as appropriate together with any legislative proposals, on the possible effect of capital requirements on the economic cycle of minimum, own funds requirements for exposures in the form of covered bonds, large exposures, liquidity requirements, leverage, exposures to transferred credit risk, counterparty credit risk and the original exposure method, retail exposures, on the definition of eligible capital, and the level of application of this regulation.

(84) In order to specify the requirements set out in this Regulation, the power to adopt acts in accordance with Article 290 of the TFEU should be delegated to the Commission in respect of technical adjustments to this Regulation to clarify definitions to ensure uniform application of this Regulation or to take account of developments on financial markets; to align terminology on, and frame definitions in accordance with, subsequent relevant acts; ; to adjust the provisions of that Regulation on own funds to reflect developments in accounting standards or Union legislation, or with regard to the convergence of supervisory practices; to expand the lists of exposure classes for the purposes of the Standardised Approach or the IRB Approach to take account of developments on financial markets; to adjust certain amounts relevant to those exposure classes to take into account the effects of inflation; to adjust the list and classification of off- balance sheet items; and to adjust specific provisions and technical criteria on the treatment of counterparty credit risk, the Standardised Approach and the IRB Approach, credit risk mitigation, securitisation, operational risk, market risk, liquidity, capital buffer, leverage and disclosure in order to take account of developments on financial markets or in accounting standards or Union legislation, or with regard to the convergence of supervisory practices and risk measurement and account of the outcome of the review of various matters relating to the scope of Directive 2004/39/EC.

(85) The power to adopt acts in accordance with Article 290 of the TFEU should also be delegated to the Commission in respect of prescribing a temporary reduction in the level of own funds or risk weights specified under that Regulation in order to take account of specific circumstances; to clarify the exemption of certain exposures from the application of provisions of that Regulation on large exposures; to specify amounts relevant to the calculation of capital requirements for the trading book to take account of developments in the economic and monetary field; to adjust the categories of investment firms eligible for certain derogations to required levels of own funds to take account of developments on financial markets; to clarify the requirement that investment firms hold own funds equivalent to one quarter of their fixed overheads of the preceding year to ensure uniform application of this Regulation; to determine the elements of own funds from which deductions of an institution's holdings of the instruments of relevant entities should be made; to introduce additional transitional provisions relating to the treatment of actuarial gains and losses in measuring defined benefit pension liabilities of institutions; to temporarily increase in the level of own funds; and to specify liquidity requirements.

(86) It is of particular importance that the Commission carry out appropriate consultations during its preparatory work, including at ex