EN Official Journal of the European Union C 339/24

Opinion of the European Economic and Social Committee on the ‘Proposal for a Directive of the European Parliament and of the Council amending Directives 2006/48/EC and 2006/49/EC as regards capital requirements for the trading book and for re-securitisations, and the supervisory review of remuneration policies’

COM(2009) 362 final — 2009/0099 (COD)

(2010/C 339/06)

Rapporteur-General: Mr MORGAN

On 10 September 2009 the Council decided to consult the European Economic and Social Committee, under Article 47 paragraph 2 of the Treaty establishing the European Community, on the

Proposal for a Directive of the European Parliament and of the Council amending Directives 2006/48/EC and 2006/49/EC as regards capital requirements for the trading book and for re-securitisations, and the supervisory review of remuneration policies

COM(2009) 362 final – 2009/0099 (COD).

On 29 September 2009 the Committee Bureau instructed the Section for the Single Market, Production and Consumption to prepare the Committee's work on the subject.

Given the urgent nature of the work, the European Economic and Social Committee, in accordance with Rule 57 of the Rules of Procedure, appointed Mr Morgan as rapporteur-general at its 459th plenary session, held on 20 and 21 January 2010 (meeting of 20 January 2010), and adopted the following opinion by 162 votes to 4 with 18 abstentions.

1. Conclusions and recommendations

1.1 The background to this proposed Directive, hereinafter referred to as the Directive, lies in the conclusions and recommendations of the Report of the Larosière Group. The EESC has already given its opinion on that report and is broadly supportive (1). The Directive has been prepared in the context of the Basel II international framework for the capital adequacy of banks. The text has been modified by the ECOFIN Council following the G 20 meeting in Pittsburgh. The EESC supports the thrust of the Directive which will amend Directive 2006/48/EC relating to the pursuit of the business of credit institutions and Directive 2006/49/EC on the capital adequacy of investment firms and credit institutions.

1.2 This opinion explains the major part played by the banks in the financial crisis and how regulation and supervision failed. In the opinion of the EESC, the Directive will address many of the regulatory failures and help to correct the major failings in the operation and governance of the banks. In themselves, these regulations will not correct the self centred behaviour of bankers which was a major factor in the crisis. The interests of banking stakeholders still needs to be recognised and the corporate social responsibility of large banking institutions needs to become a central and not a peripheral concern.

1.3 The main factors behind the crisis were:

— The granting of credit by credit institutions to clients who were not credit worthy.

— In many cases, inappropriate remuneration and incentive schemes for the retail staff of credit institutions.

— The creation by banks of credit securities without the necessary due diligence.

— The acquisition by banks of these securities without using the necessary due diligence.

— Inadequate capital reserves, especially in the trading books of banks.

— The creation of off-balance sheet vehicles which were not adequately capitalised.

— Perverse incentives and inappropriate compensation structures which led to short-termism and excessive risk taking.

— The pro-cyclical nature of regulation.

— Systemic failures of risk management in respect of the quality of securities held, the adequacy of capital reserves and the impact of variable compensation schemes on institutional risk aggregation.

— A lack of transparency in banks affairs which prevented lenders, borrowers, counter parties, investors, analysts and even independent directors from acting as would be expected in the financial markets.

— Insufficient macro-prudential supervision and international co-ordination.

1.4 The EESC is pleased that the Commission is working in conformance with the Financial Stability Board (FSB) and the Basel committee to refine its proposals respectively on remuneration and capital requirements. Banking is a sector of fundamental economic importance for the EU but at the same time it is a potentially mobile industry. To avoid damage to the EU finance industry by regulatory arbitrage, it is essential to find global solutions and the EU may well need to take the lead in proposing them. That is as it should be. The EU cannot afford to introduce regulation which is significantly out of line with practice elsewhere.

1.5 The EESC supports the core principles proposed for the formulation and implementation of remuneration policies. Had certain of these principles been in place prior to the crisis, many scandalous and embarrassing pay-outs would have been avoided.

1.6 In most industrial sectors, the absolute quantum of executive bonus payments is defined as a maximum percentage of salary. The EESC believes that banking should apply similar concepts to its variable compensation systems since nothing in the role of bankers qualifies them for unconstrained systems of compensation. In this context, the EESC welcomes the requirement for significant credit institutions and investment firms (CIIF) to establish Remuneration Committees.

1.7 The EESC recognises that this Directive is more concerned about the structure of compensation rather than its quantum. Nevertheless, the EESC must register its concern about the quantum. The EESC expects that the effect of both the new capital requirements and the prudential analysis of remuneration policies and plans will together constrain the excessive variable compensation of the past. The EESC recognises that the EU does not have a competence on the level of pay per se.

1.8 The EESC is pleased to note that the provisions on remuneration are without prejudice to the provisions of Article 137(5) of the Treaty, general principles of national contract and labour law as well as the rights, where applicable, of social partners in collective bargaining.

1.9 The EESC gives its full support to the increased capital requirements detailed in this Directive. These involve, in particular:

— Provisions to reinforce capital requirements for assets which banks hold in the trading book for short term resale.

— Upgraded capital requirements for complex securitisations, both in the banking and in the trading book.

1.10 The Committee notes that the proposal no longer includes a strengthened supervisory process for re-securitisations that are particularly complex. However, the EESC would expect supervisors to be diligent in this respect and it notes that supervisors retain the full range of corrective measures.

1.11 The perspective of the EESC is influenced by the facts which came to light (2) following the SEC investigation into the collapse in value of retail backed mortgage securities, collateralised debt obligations and other such assets. Credit rating agencies (CRA) were party to the irresponsible creation of these toxic assets, which have cost the developed world hundreds of billions of dollars. Investment banks are guilty of aiding and abetting the CRA while most banks failed to understand the risks inherent in holding these securities. As the Larosière Group observed, ‘It is crucial that these regulatory changes (in respect of CRA) are accompanied by increased due diligence and judgement by investors and improved supervision’. The EESC endorsed this recommendation in its CRA opinion and it now endorses the proposed Directive because it will require banks and supervisors to act accordingly.

1.12 Point 4 in Annex I of the Directive outlines a new and extensive set of disclosure requirements. The EESC supports these. Had they been in place before the crisis, much of the ensuing grief could have been avoided. In Annex II the focus on liquidity and event risk is equally welcome. Without a technical analysis of the provisions, the EESC has received comfort from the Commission that the market liquidity crisis at the heart of the banking crisis will be averted by these measures.

1.13 The EESC understands that it is intended that liquidity issues at the level of the firm will be addressed in the next Capital Requirements Directive (CRD4). Following the crisis, this is a fundamental requirement.

1.14 The EESC notes that while nothing in the draft directive addresses the issue of off-balance sheet SPV, this had, in effect, been covered by Commission Directive 2009/83/EC issued in July 2009. Article 95 of the CRD already establishes that a bank has to calculate capital requirements for assets it originates unless it achieves ‘significant risk transfer’. The July Directive tightens up the interpretation of this provision in two important ways. Had this clarification been operative before the crisis, the contribution of SPVs to the crisis would have been considerably reduced.

1.15 The EESC is concerned that the miss-selling of credit to consumers played an important part in the build up to the crisis. The Communication on ‘packaged retail investment products’ (PRIP) (3) does appear to address the problem in that it aims to regulate selling conditions and, in particular the control of conflicts of interest that arise in that process. This builds upon the conditions imposed by the Markets in Financial Instruments Directive (2004)/39/EC.

1.16 Disclosure is key to the restoration of financial markets. The EESC is satisfied that the scale of the disclosures proposed and the access available for stakeholders is sufficient for them to obtain the information they need to do business with an institution. The disclosures required by the proposed Directive need to be understood in the context of Article 147 of CRD 2006/48/EC which directs credit institutions to publish the required disclosures.

1.17 In November 2009 the heads of HSBC and Standard Chartered Bank expressed concern that the capital requirements being proposed by regulators are excessive and damaging and will hold back both recovery and development. One might expect this view from bankers, but these are no ordinary bankers. Neither is in receipt of government support. Executives from Standard Chartered actually helped devise the UK bank support scheme. The EESC urges the Commission to ensure that when balanced by necessary due diligence and appropriate risk controls, the proposed capital requirements are proportionate to risk.

1.18 The EESC believes that an analysis should be performed by the Commission to understand the impact of the draft directive now under consideration not just on banks’ capital holdings but also on economic growth, job creation and the recovery in general.

2. Introduction

2.1 A brief explanation of the crisis in the banking system will put the Directive into perspective. Further perspectives on the crisis are provided in the report of Lord Turner, chairman of the UK Financial Services Authority (4).

2.2 The business of retail banks involves making long term loans on the basis of short term deposits. This is called maturity transformation and it is risky. If all the depositors decided to withdraw their money, a bank would have insufficient liquid assets. Similarly, if borrowers defaulted on their obligations, bank capital would be reduced, risking insolvency. To guard against this, retail banks keep reserves of liquid assets on the balance sheet and make back up arrangements with other banks while the central bank can be the lender of last resort. Banking regulation prescribes the amount of capital to be held against the bank's obligations to guard against the possibility of borrower default.

2.3 Banks also trade on their own account. For this they also hold capital. These capital reserves have traditionally been modest because the potential losses from the trading book were expected to be low because the traded assets which were considered to be readily marketable. Capital to support the trading book was calculated by a value at risk methodology (VaR). Banks also set up special purpose trading vehicles (SPV) off balance sheet. These were highly leveraged and potentially risky but because they were deemed to be off balance sheet the regulators treated them as independent entities. However, when the crisis broke, many SPV were brought back onto bank balance sheets for reputational reasons, although no capital reserves had previously been provided against this possibility.

2.4 The authorities played a part in the development of the banking crisis. Regulators approved the capital held by banks. Monetary authorities, with the exception of the ECB, kept interest rates too low for too long. Even in the euro-zone, rates were far too low for certain economies. In the political arena, the US government forced banks to arrange imprudent mortgages to a sub-prime clientele. Savings ratios decreased in the western world leaving the growth in borrowing to be financed by Asia. These factors stimulated risky banking.

2.5 Banks granted sub-prime mortgages, then packaged them into bundles and sold them on. This activity spread beyond the United States. With the help of the credit rating agencies, these bundles were sliced into tranches carrying differential credit ratings, many paying interest much higher than the risk free rate. Re-securitisation repackaged existing debt tranches so that the underlying securities became untraceable. An alphabet soup of credit securities ended up as a major component of the own account trading book and SPV trading. The massive risk represented by this concentration was not recognised.

2.6 The origination and distribution of credit securities became a tidal wave. As Lord Turner has shown, the scope and scale of transactions in the ‘casino’ economy dwarfed the scale of economic activity in the real economy. To go even faster, banks ceased to rely on deposits and funded their lending by very short term borrowing on the wholesale money markets. This was maturity transformation gone mad. Then the Fed started to raise interest rates and the casino closed.

2.7 Sub-prime mortgage holders began to default. The rating agencies massively down graded the ratings of credit securities. Banks everywhere tried to sell these assets and this led to systemic failure. Prices plummeted. Liquidity through marketability was no more. Banks did not know the condition of other banks so confidence evaporated and interbank trading in the wholesale markets came to a halt. For the lack of liquidity, all types of banks got into trouble. Lehman's was allowed to fail while many other banks in the USA and elsewhere needed massive government support to survive

2.8 Compensation schemes tended to reinforce risk taking in credit institutions. At all levels, the incentives drove a short term profit focus, irrespective of longer term risks. The spiral of interbank trading created an artificial economy detached from the real economy and in which rewards became detached from the norms of the real world. The quality of loan books deteriorated dramatically. Traders and others were under similar short term pressures. In some cases, even front line retail staff were highly incentivised to extend credit card and mortgage facilities to clients of dubious credit worthiness.

2.9 Regulatory reforms need to be based on the lessons learnt. The quantity and quality of bank capital needs radical improvement. Capital held against the trading book should be substantially increased and the VAR formula revised. Capital calculations need to become countercyclical. Risk assessment needs to be more cautious. The liquidity risks involved in maturity transformation need reconsideration because, in the crisis, liquidity through marketability and wholesale markets both failed.

2.10 Regulatory reforms will not be enough. Market mechanisms and greater shareholder involvement are essential. The main issue is the lack of transparency. The true nature of bank loans, assets, reserves and bank risk profiles must be public. Such transparency will allow lenders, borrowers, shareholders, directors and analysts to act as they should in the market.

2.11 Government failure - political, monetary and regulatory - needs to be corrected so that bankers must return to prudent banking and require prudence from their customers. In some Member States, retail customers need protection from promiscuous lending by credit institutions.

2.12 Corporate governance must improve. Risk management and broad oversight needs a wholly new perspective. Compensation needs a longer term horizon. It must underpin rather than undermine risk management and it should be aligned with the long term interests of shareholders and stakeholders. The compensation of all staff whose professional activities can have a material impact on the risk profile of a bank should be determined in the context of that profile.

2.13 The banking crisis has brought into focus the problem of combining retail banks and investment banks into single institutions which may be deemed too big to fail. In many ways the combination makes sense, because many investment banking activities provide necessary facilities to both retail and corporate clients. The central issue is the implicit and often explicit necessary guarantee that the state provides to those who make retail deposits. This introduces moral hazard into investment banking and may encourage excessive risk taking. After the 1929 crash, the US Glass-Steagall Act enforced the institutional separation of retail and investment banking. It was repealed in 1999 because of the extent of the overlap which had developed. If the two activities are not to be separated by, for example, a new Glass-Steagall Act, then it is essential that the capital requirements regime be tough enough to prevent the investment bank from bringing down the retail bank.

3. Gist of the Commission's Directive

Changes to the text of the Directive added after the Pittsburgh meeting and pertinent to the EESC perspective are added in italics.

3.1 Excessive and imprudent risk-taking in the banking sector has led to the failure of individual financial institutions and systemic problems in Member States and globally, there is agreement by supervisors and regulatory bodies, including the G20 and the Committee of European Banking Supervisors, that the inappropriate remuneration structures have been a contributory factor. In this context the internationally agreed and endorsed principles and standards established by the Financial Stability Board are of particular importance.

3.2 In order to address the potentially detrimental effect of poorly designed remuneration structures, there should be an express obligation for credit institutions and investment firms (CIIF) to establish and maintain, remuneration policies and practices that are consistent with effective risk management.

3.3 It is important that the new obligation concerning remuneration policies and practices should be implemented in a consistent manner. It is therefore appropriate to specify core principles to ensure that the structure of remuneration does not encourage excessive risk-taking and is aligned with the risk appetite, values and long-term interests of the institution.

3.4 The following are some of the core principles:

— The remuneration policy is consistent with and promotes sound and effective risk management and does not encourage risk-taking that exceeds the level of tolerated risk of the credit institution.

— The remuneration policy is in line with the business strategy, objectives, values and long-term interests of the credit institution.

— The assessment of performance is set in a multi-year framework in order to ensure that the assessment is based on longer term performance and that the actual payment of performance based remuneration is spread over a period which takes account of the underlying business cycle of the firm and its business risks.

— Payments related to the early termination of a contract reflect performance achieved over time and are designed in a way that does not reward failure.

— Guaranteed variable compensation is exceptional and occurs only in the context of hiring new staff and is limited to the first year of employment.

— At least 50 % of variable compensation should be paid in shares or in appropriate non-cash instruments, which should be subject to an appropriate retention policy.

— Payment of the major part of a significant bonus is deferred for an appropriate period and is linked to the future performance of the firm. At least 40 %, at least 60 %in the case of senior management, to be deferred over not less than 3 years, vesting on a pro rata basis.

— Variable remuneration, including the deferred portion, is paid or vests only if it is sustainable according to the financial situation of the institution.

3.5 ‘Significant’ CIIF are required to establish a Remuneration Committee. ‘Significant’ CIIF are defined in terms of their size, internal organisation and the nature, the scope and the complexity of their activities.

3.6 Competent authorities should also have the power to impose either financial or non-financial measures or penalties for the breach of a requirement to have remuneration policies that are consistent with sound and effective risk management. Those measures and penalties should be effective, proportionate and dissuasive.

3.7 In order to promote supervisory convergences in the assessment of remuneration policies and practices, the Committee of European Banking Supervisors should ensure the existence of guidelines on sound remuneration policies in the banking sector.

3.8 Since poorly designed remuneration policies and incentive schemes are capable of increasing to an unacceptable extent the risks to which CIIF are exposed, it is appropriate that competent authorities impose qualitative or quantitative measures on the relevant entities as required. Qualitative measures include requiring CIIF to reduce the risk inherent in their activities, including structures of remuneration. Quantitative measures include a requirement to hold additional own funds.

3.9 In order to ensure adequate transparency to the market of their remuneration structures and the associated risk, CIIF should disclose information on their remuneration policies and practices for those staff whose professional activities have a material impact on the risk profile of the institution.

3.10 There should be a separate capital treatment for securitisations which re-package other securitisations and are subject to a higher credit risk than normal securitisations and provide CIIF with clear disincentives against investment in securitisations of particularly high complexity and risk.

3.11 Re-securitisations repackage medium-risk securitisation exposures into new securities. They have generally been considered low credit risk by rating agencies and market participants. However, given their complexity and sensitivity to correlated losses, such re-securitisations entail higher risks than conventional securitisations. Therefore, this proposal comprises a set of capital requirements that are higher than for straight securitisation positions of the same rating.

3.12 Given 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.

3.13 Without prejudice to the disclosures explicitly required by this Directive, the aim of the disclosure requirements should be to provide market participants with accurate and comprehensive information regarding the risk profile of individual institutions. Therefore institutions should be required to disclose additional information not explicitly listed in this Directive if necessary to meet this objective.

3.14 In the field of securitisation, disclosure requirements of institutions should be considerably strengthened. They should in particular also take into account the risks of securitisation positions in the trading book.

Brussels, 20 January 2010. The President of the European Economic and Social Committee Mario SEPI

(1) OJ C 318, 23.12.2009, p. 57.

(2) OJ C 277, 17.11.2009, p. 117.

(3) COM(2009) 204 final.

(4) The Turner Review, UK Financial Services Authority, March 2009.