EUROPEAN COMMISSION 
Brussels, 20.7.2011 
SEC(2011) 949 final 
  
COMMISSION STAFF WORKING PAPER 
IMPACT ASSESSMENT 
  
Accompanying the document 
Regulation of the European Parliament and the Council  
on prudential requirements for the credit institutions and investment firms 
{COM(2011) 452 final} 
{SEC(2011) 950 final} 
 
 
 This document commits only the Commission's serv ices involved in its  preparation and does 
not prejudge the final form of any de cision to be take n by the Commission 
TABLE OF CONTENTS 
1. Introduction................................................................................................................ .. 3 
2. Procedural issues and stakeholder consultation ........................................................... 3 2.1. Stakeholder consultation .............................................................................................. 3 2.1.1. CEBS.................................................................................................................... ........ 4 
2.1.2. CRD Working Group ................................................................................................... 4 2.1.3. Other public consultations............................................................................................ 4 2.2. Consultation with other se rvices of the Commission................................................... 5 
2.2.1. Inter-service Steering Group........................................................................................ 5 2.2.2. Impact Assessment Board............................................................................................ 5 3. Problem definition........................................................................................................ 6 3.1. Background ................................................................................................................ .. 6 
3.2. Management of liquidity risk....................................................................................... 7 3.3. Eligibility of capital inst ruments and application of regulatory adjustments .............. 9 
3.4. Counterparty credit risk.............................................................................................. 11 3.5. Pro-cyclicality of lending........................................................................................... 11 3.6. Options, discretions and minimum harmonisation..................................................... 13 3.7. Risks inherent in baseline scenario ............................................................................ 14 3.8. Is action necessary at EU level?................................................................................. 15 4. Objectives.................................................................................................................. . 17 
5. Policy options: analysis and comparison ................................................................... 20 5.1. Liquidity risk............................................................................................................ .. 21 
5.1.1. Liquidity Coverage Ratio........................................................................................... 21 5.1.2. Net Stable Funding Ratio........................................................................................... 26 5.2. Eligibility of capital inst ruments and application of regulatory adjustments ............ 28 
5.3. Counterparty credit risk.............................................................................................. 33 5.4. Leverage.................................................................................................................. ... 36 
5.5. Capital buffers........................................................................................................... . 38 
5.6. Single rule book in banking ....................................................................................... 41 
 
 5.7. Choice of policy instrument....................................................................................... 43 
5.8. Cumulative impact of the package............................................................................. 45 5.8.1. Package of preferred options and relevant transitional provisions ............................ 45 
5.8.2. Cumulative impact on the industry ............................................................................ 47 
5.8.3. Administrative costs................................................................................................... 4 8 
5.8.4. Economic impact in transitional period ..................................................................... 49 5.8.5. Long-term economic impact ...................................................................................... 51 5.9. Impacts on SMEs ....................................................................................................... 52 6. Monitoring and evaluation ......................................................................................... 54 Glossary....................................................................................................................... ............. 56 
Annex I: Extended impact analysis.......................................................................................... 60 Annex II: Take-up of national options and discretions analysed by CRDWG ...................... 148 
Annex III: Economic and financial importan ce of the banking sector in Europe.................. 167 
Annex IV: Liquidity Coverage Ratio as speci fied in February 2010 public consultation ..... 174 
Annex V: Net Stable Funding Ratio as specifi ed in February 2010 public consultation....... 176 
Annex VI: Eligibility criteria fo r core Tier 1, non-core Tier 1 and Tier 2 regulatory capital as 
specified in February 20 10 public consultation ....................................................... 178 
Annex VII: Regulatory adjustme nts as specified in Februa ry 2010 public consultation....... 181 
Annex VIII: Assessment of admi nistrative costs and burdens............................................... 183 
Annex IX: Quantitative impact of  the CRD IV: QUEST model............................................ 186 
Annex X: Overview of quantitative models........................................................................... 192 
 
 
 1. INTRODUCTION  
The extent of the financial crisis has expos ed unacceptable risks pert aining to the current 
regulation of financial institutions. These risks proved substantial and systemic in times of 
serious turbulence. According to the IMF1 estimates, crisis-related losses incurred by 
European banks between 2007 and 2010 are close to €1 trillion or 8% of the EU GDP. The 
crisis did not stay limited to the financial sector but spread to the real economy as well: it 
plunged the EU economy in a se vere recession, with the EU GDP  contracting by some 6% in 
2009. 
In order to restore confidence and stability in the banking sector and ensure that credit 
continues to flow to the real  economy, both the EU and its Member Stat es (MS) adopted a 
broad range of unprecedented measures with the taxpayer ultimately footing the bill. In this 
context, between October 2008 and October 2010 the European Commission (Commission) 
has approved €4.6 trillion (equivalent to 39%  of the EU GDP) of state aid measures2 to 
financial institutions of which more than €2 trillion were effectively used in 2008 and 2009. 
Combined with fiscal measures aimed at  pulling EU economies out of the recession, 
supportive measures to the banking industry co ntributed to higher budge t deficits and pushed 
sovereign indebtedness levels up. This intens ified markets' perception of rising sovereign 
risks, imposing second-round costs on the MS. 
The unprecedented level of fiscal support to bank s needs to be matched with a robust reform 
addressing the regulatory shortcomings exposed during the crisis. In recognition of this, the 
Commission already proposed certain amendmen ts to bank regulation in October 2008 (CRD 
II3) and July 2009 (CRD III4). However, to prevent recent problems from occurring in the 
future and ensure that risks linked to the br oader issues of financ ial instability and pro-
cyclicality are more effectively contained, ad ditional internationally coordinated changes to 
the EU capital and liquidity re gulation of banks are needed.  
2. PROCEDURAL ISSUES AND STAKEHOLDER CONSULTATION  
2.1. Stakeholder consultation 
Throughout the project the Commission services ha ve closely followed and participated in the 
work of international forums, particularly the Basel Committee5 in charge of developing the 
                                                 
1 IMF, Meeting New Challenges to Stability and Building a Safer System , April 2010 
2 Measures comprise €3 trillion of guarantees, €138 billion of liquidity and bank funding support, €546 billion of 
approved state recapitalisations an d €349 billion of asset relief 
3 Consisting of a Directive 2009/111/EC of the European Parliament and of the Council of 16 September 2009 
amending Directives 2006/48/EC, 2006/49/EC and 2007/64/EC as regards banks affiliated to central institutions, certain own funds items, large expo sures, supervisory arrangements, and crisis 
management, Commission Directive 2009/27/EC of 7 April 2009 amending certain Annexes to 
Directive 2006/49/EC, and Commission Directive 2009/83/EC of 27 July 2009 amending certain Annexes to Directive 2006/48/EC  
4 Directive 2010/76/EU of the European Parliament and of the Council of 24 November 2010 amending 
Directives 2006/48/EC and 2006/49/ EC as regards capital requirements for the trading book and for re-
securitisations, and the supervisor y review of remuneration policies 
5 The Basel Committee on Banking Supervision consists of central bank and supervisory authority 
representatives from twenty seven countries. Nine EU MS are represented: BE, FR, DE, IT, LU, NL, ES, SE, and UK. The Commission participates as an  observer in the Committee and in its working 
groups. 
 
 Basel III framework. The European Banki ng Committee (EBC) and the Committee of 
European Banking Supervisors (CEBS, as of 2011 replaced by the European Banking Authority) – the committees of the Lamfalussy process - have been extensively involved and 
consulted throughout the project. Their views have contributed to the prepara tion of this 
impact assessment and the proposal that it a ccompanies. Consultative work with other 
stakeholder groups has been conducted in part through these committees.  
2.1.1.  CEBS 
In November 2009, the Commission invited CEBS to conduct a comprehensive quantitative 
impact study (QIS) on the impact of the CRD IV legislative proposal that this impact 
assessment accompanies on the EU banking industr y. 246 banks from 21 member countries of 
CEBS participated in the study, including 50 Group 1
6 banks and 196 Group 2 banks, 
representing some 70% of the consolidated Eu ropean banking sector in terms of capital. 
A significant share of total assets of  EU credit institutions of €42 trillion7 is owned by Group 
1 banks (for more on the economic and financia l importance of the banking sector in Europe, 
see Annex III). Given differences as regards thei r size, nature of activi ties, risk profile and 
risk management approaches, results from  the EU QIS for Group 1 and Group 2 banks 
throughout this report are analysed separately. Th e results have been anonymised to preserve 
confidentiality of MS-level indicators (on request of the participating MS). 
In response to the Commission's calls for a dvice, CEBS also conducted extensive public 
consultations and in October 2008 submitted a tec hnical advice in the area of national options 
and discretions.8  
2.1.2.  CRD Working Group 
In the area of national options and disc retions, between 2008 and 2011 the Commission 
services held six meetings of the CRD Working Group (CRDWG), whose members are 
nominated by the EBC. The group worked on preparing a 'single rule book' in banking, on the basis of CEBS' technical advice. For a detaile d list of provisions analysed by the CRDWG, 
please refer to Annex II.  Other parts of the proposal were discusse d by the CRDWG four times in 2010 - 2011. In 
addition, sub-groups of the CRDWG in the areas of  liquidity, capital definition, leverage ratio, 
counterparty credit risk and capit al buffers have also been established to conduct work at an 
even more technical level and to develop le gislative drafts in the respective areas. 
2.1.3.  Other public consultations 
The preparatory work related to the CRD IV  proposal started already in 2009 when the 
Commission services conducted a first public consultation
9 on the latest wave of possible 
amendments to the CRD. This was followed by a c onsultation that ran in February - April of 
201010 and included questions on pot ential policy measures pert aining to liquidity and 
counterparty credit risk management, capital defi nition, leverage ratio, capital buffers, and the 
                                                 
6 Group 1 banks are those that have Tier 1 capital in  excess of €3 billion, are well diversified, and are 
internationally active. All other ba nks are considered Group 2 banks. 
7 ECB, EU Banking Structures , September 2010 
8 See http://www.c-ebs.org/getdoc/354c6e4c-f22a-46a0-9025-0c55f460a5a6/2008-17-10-Final-Advice-on-
options-and-national-di.aspx   
9 See http://ec.europa.eu/internal_market/consultati ons/2009/capital_requirements_directive_en.htm   
10 See http://ec.europa.eu/internal_market/consultations/2010/crd4_en.htm   
 
 'single rule book'. A third consultation elaborati ng on the possible design of a countercyclical 
capital buffer ran in October - November 2010.11 A fourth consultation on capital 
requirements for certain types of counterparty cr edit risk was conducted in February - March 
2011.12 
In April 2010 the Commission services condu cted an open public hearing on the CRD IV 
proposal. The event was actively attended by  all the stakeholder groups, including the 
industry, regulators, supervisors, non-financial companies, and intern ational organisations. 
Responses to the four public consultations and views expressed at the public hearing 
constitute an important source of stakehol der views on effectiven ess of potential policy 
measures and are reflected throughout the report.  
In addition, the Commission services conducted separate extensive consultations with the 
industry, including the Group of Experts in Banking Issues (GEBI), various EU banking 
industry associations and individual banks. 
2.2. Consultation with other s ervices of the Commission 
2.2.1.  Inter-service Steering Group 
An Inter-Service Steering Group (ISSG) was set up to follow progress and feed in views from 
other services of the Commission, including Direct orates-General for Ente rprise and Industry, 
Economic and Financial Affairs, Taxation an d Customs Union, Health and Consumers, 
Competition, Legal Service, and Secretariat General. Experts from the Directorate-General for 
Economic and Financial Affairs contributed to this  impact assessment with analyses of 
implications of the proposal for the macro-fina ncial stability and of macro-economic impacts 
during a transitional period (see Annex IX). Th e ISSG met four times in 2009 and five times 
in 2010. 
2.2.2.  Impact Assessment Board 
The draft impact assessment was discussed with  the Impact Assessment Board (IAB) of the 
Commission on 10 November 2010. On  the basis of the IAB comments, a new simplified and 
shortened report for non-expert read ers has been prepared. The initial draft, with a number of 
amendments, has been maintained to provide fo r a more detailed assess ment of impacts (see 
Annex I: Extended Impact Anal ysis). These amendments, ma de in response to the IAB 
recommendations, included: 
- changes to the presentation of policy options related to February 2010 public consultation of 
the Commission services; - clarification on which preferre d policy options are a ligned with Basel III and which ones are 
not (and if so, how they differ from Basel III);  - inclusion of references to the work of th e Basel Committee underpinning the calibration of 
new capital requirements and an explanation for why some 3
rd countries indicated their 
intention to opt for higher thresholds; - elaboration on the impact of the package on banks with different business models, costs for bank clients, and the probabil ity of next banking crisis; 
- more extensive overview of stakeholders' views expressed during public consultations; 
                                                
 
11 See http://ec.europa.eu/internal_market/consultations/2010/capitalbuffer_en.htm   
12 See http://ec.europa.eu/internal_market/consultations/2011/credit_risk_en.htm   
 
 - clarification on the scope of the initiative conc erning the single rule book, application of the 
preferred option in practice, a nd assessment of effectiveness of  policy options considered in 
this area with respect to enhancing financial stability; and - explicit linking of policy options to  identified problems (see Table 1). 
The IAB examined the above revisions and su bsequently issued a dditional recommendations 
that have been reflected as appropriate in th is impact assessment. More specifically, further 
clarifications have been introduced as regard s differences between the preferred options and 
Basel III, presentation of policy options in  the area of the single rule book, proposals for 
higher capital thresholds in certain jurisdictions  and impact on small and medium sized banks 
and their clients.  
Note:  Annex I (Extended Impact Analysis) follows the structure of this report in terms of 
section numbering. Therefore, for additional background and more in-depth analyses 
pertaining to individual sections of this report the reader should refer to respective sections of 
Annex I. 
3. PROBLEM DEFINITION  
3.1. Background 
The current EU bank capital framework is represented by the Capital Requirements Directive 
(CRD) comprising Directives 2006/48/EC and 2006/ 49/EC and reflecting the proposals of the 
Basel Committee for the Basel II Framework13 (Basel II) and Trading Book Review14. It 
covers both credit institutions  and investment firms and stipulates the minimum amounts of 
own financial resources that banks  must have in order to cove r the risks to which they are 
exposed.  
The financial crisis has unveil ed a number of shortcomings of Basel II and necessitated 
unprecedented levels of public support in order to restore confidence and stability in the 
financial system. In the EU, the effective level of public support for the banking sector 
reached, on average, 11% of GDP as of Oc tober 2010 with the corresponding metric for a 
number of MS well in excess of the EU average. This prompted a broad EU and international 
effort to identify the reasons behind the problem s and to develop effective policies to tackle 
them head-on. In this context, already in  November 2008, the Comm ission mandated a High 
Level Group (HLG) chaired by Mr. Jacques de  Larosière to propose recommendations for 
reforming European financial supervision a nd regulation. The thirty one recommendations15 
of the HLG represented a comprehensive set of concrete possibilities for regulatory, 
supervisory and global repa ir action and were elaborated in the Commission's 
Communication16 for the spring European Council of  4 March 2009. Most of the proposals 
that this impact assessment accompanies are listed  in the detailed action plan included in the 
Communication.  
Given the level of integration within the gl obal financial system, however, reaching an 
international consensus on measures that w ould be effective in containing the problems 
                                                 
13 See http://www.bis.org/publ/bcbs107.htm   
14 See http://www.bis.org/publ/bcbs116.htm   
15 See http://ec.europa.eu/internal_market/fin ances/docs/de_larosiere_report_en.pdf   
16 See http://ec.europa.eu/commission_barroso/president/pdf/press_20090304_en.pdf   
 
 identified is crucial. In this regard, the G-20 Declaration of 2 April 200917 conveyed the 
commitment of the global leaders18 to address the crisis with in ternationally consistent efforts 
to, among others, improve the quantity and quality  of capital in the banking system, introduce 
a supplementary non-risk based measure to c ontain the build-up of leverage, develop a 
framework for stronger liquidity buffers at financial institutions and implement the 
recommendations19 of the Financial Stability Board (FSB)20 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, 
agreed21 on a number of measures to strengthen the regulation of the banking sector. These 
measures were endorsed by FSB and the G-20 l eaders at their Pittsbu rgh Summit of 24-25 
September 200922 and were fleshed out in detail and made available for stakeholder 
comments in two consultation documents of the Basel Committee in December 200923. In 
February – April 2010 the Commission conducted a parallel public consultation within the 
EU, going beyond the set of measures covered by the documents of the Basel Committee. 
In December 2010, the Basel Committee issued detailed rules of new global regulatory 
standards on bank capital adequacy  and liquidity that collectivel y are referred to as Basel III.24 
The proposal that this impact  assessment accompanies direc tly relates to the regulatory 
standards included in Basel III.  
The following sub-sections present the analysis of the main problems a nd drivers underlying 
them for the CRD areas under review. A 'problem tree' is included at the end of the section. 
3.2. Management of liquidity risk 
Problem Drivers Problems 
- Shortcomings in liquidity risk 
management, including stress testing 
- Asset and liability maturity 
mismatches 
- No harmonized and 
sufficiently explicit regulatory 
treatment at EU level - Existing liquidity risk management approaches and supervisory regimes 
inadequately captured risks inherent to the underlying market practices and trends, contributing to bankruptcy of several institutions and strongly 
undermining financial health of many others, threatening the financial stability 
and necessitating unprecede nted levels of central bank liquidity and 
government support 
- Differences in national liquidity regimes give rise to level-playing field 
issues for cross-border firms and hamper effectiveness of supervision as well 
as cooperation between supervisory authorities 
Funding liquidity risk arises because inflow s and outflows of funds at banks are not 
synchronised. A bank is deemed to be liquid as l ong as at each point in time outflows of funds 
                                                 
17 See http://www.g20.org/Documents/Fin_Deps_Fin_Reg_Annex_020409_-_1615_final.pdf   
18 European leaders expressed their support for these m easures at the European Co uncil of 19-20 March 2009 
19 The report of FSB on Addressing Procyclicality in the Financial System (see 
http://www.financialstabilityboard.org/publications/r_0904a.pdf ) set out fifteen recommendations to 
mitigate mechanisms that amplify procyclicality by  covering three areas: bank capital framework, bank 
loan loss provisions, and leverage and valuation issues. The proposal that this impact assessment 
accompanies directly relates to a number  of recommendations issued by FSB.  
20 FSB promotes international financial stability through information exchange and international co-operation in 
financial supervision and surveillance. It brings together national authorities responsible for financial 
stability in international financial centres, international financial institutions, sector-specific international groupings of regulators and supervisors, and committees of central bank experts.  
21 See http://www.bis.org/press/p090907.htm   
22 See http://www.g20.org/Documents/pittsburgh_ summit_leaders_statement_250909.pdf   
23 See http://www.bis.org/publ/bcbs164.htm  and http://www.bis.org/publ/bcbs165.htm   
24 See http://www.bis.org/publ/bcbs189.htm  and http://www.bis.org/publ/bcbs188.htm   
 
 are smaller or equal to the sum of inflows and its stock of liquid assets. Therefore, it should 
manage its liquidity risk with a view to ensure  that the above constraint is never breached. 
The global financial crisis that started in summer of 2007 has brought to light various 
shortcomings in current liquidity risk manageme nt approaches that inca pacitated a number of 
financial institutions to comply with this constraint.  
Existing bank liquidity risk management appr oaches, including liquidity stress tests, and 
supervisory regimes were shown to be inadequa te in fully grasping ri sks inherent to the 
underlying market practices, such as originate- to-distribute securitiz ation, use of complex 
derivative instruments and reliance on whol esale funding with short-term maturity 
instruments. In the run-up to the crisis, many fi nancial institutions have increasingly turned to 
the capital markets for funding their operations with instruments of shorter maturity and 
became reliant on wholesale funding sources such as commercial paper, repurchase 
agreements ('repos'), and interbank markets.25 Events of the crisis clearly illustrated that 
during times of market stress investors exhibit heightened ri sk aversion by demanding higher 
compensation for risk, requiring banks to roll over liabilities at consider ably shorter maturities 
or refusing to extend financing altogether.26 
Also, banks' assumptions pertaining to asset liq uidity in secondary markets as well as its 
interaction with funding liquidity turned out to had been erroneous. If asset markets are liquid, 
assets can be sold at their fair value or hypot hecated at low haircuts. However, bank assets 
have a potential to become illiquid, in particular in stressed conditions when market participants withdraw from the relevant markets.  Then they can only be sold at a discount or 
hypothecated at much higher haircuts. Moreover, many fi nancial institutions also 
underestimated the extent of th e interaction between market liquidity and funding liquidity. 
Rising arrears on US sub-prime mortgages that were extensiv ely packaged in residential 
mortgage backed securities caused investors to  lose faith in ratings of these and other 
structured products and led to heightened concer ns about accuracy of th eir valuation. The loss 
of investor confidence was transmitted through a fall in their price, as market liquidity for 
such securities evaporated, to an increase in f unding risk as margins a nd haircuts related to 
them increased. In turn, this forced additiona l deleveraging and selli ng, effectively creating a 
vicious feedback loop between deterioratin g market liquidity a nd disappearing funding 
liquidity.  
As of August 2007, money markets also tightened because banks started hoarding liquidity to 
better position themselves against possible fundi ng shortfalls. Such be haviour was further 
intensified due to a lack of understanding about the level of exposure to difficult-to-value and 
potentially impaired assets and, in relation to this, financial health of other institutions. 
The above factors were not properly captured by the bank liquidity risk management and 
contributed to a demise of several financial institutions and strongly undermined health of 
                                                
 
25 According to Barclays Capital, over decade leading to  the crisis, European bank wholesale funding as % of 
balance sheet has increased from 40% to 70%. 
26 Bear Sterns failed in March 2008 once it found itself unable to secure funding on the repo market and was 
subsequently taken over JPMorgan Chase. Lehman Brothers, another US investment bank, filed for 
bankruptcy in September 2008, in part because of difficulties in addressing similar funding liquidity-
related problems. UK mortgage lender Northern Rock collapsed in September 2007, following a first wave of illiquidity in the interbank market. Failure s of Bradford & Bingley and HBOS in September 
2008 were also partially driven by thei r reliance on wholesale funding markets. 
 
 many others, threatening the financial stabi lity and necessitating unprecedented levels of 
public sector and central bank liquidity support.27 
While currently a number of MS impose some fo rm of quantitative regulatory standard for 
liquidity, no harmonised sufficientl y explicit regulatory treatmen t on the appropriate levels of 
short-term and long-term liquidity exists at th e EU level. Differences in national liquidity 
regimes arise from different degrees  of resilience to li quidity stress that di fferent MS aim at as 
well as certain nationally determined factors su ch as insolvency regimes, deposit insurance 
arrangements, central bank credit and collateral policies. As regards supervisory reporting, 
diversity in current national approaches ha mpers effective communication and cooperation 
between supervisory authorities and imposes additional costs on cross-border institutions, 
causing potential level-pl aying field issues.  
3.3. Eligibility of capital instruments and application of regulatory adjustments 
Problem Drivers Problems 
- Certain capital instruments did not 
fulfil loss absorption, permanence and flexibility of payments criteria  
- List of regulatory adjustments 
incomplete or applied not to a relevant layer of regulatory capital  
- Lack of harmonization in 
application of regulatory adjustments - Tier 1 capital ratios reported by banks and, thus, their capital were not 
reflective of their capacity to absorb losses on a going-concern basis. As 
the crisis deepened and banks faced growing losses and writedowns, their fundamental solvency was called into question, leading to broader 
financial instability and necessitating extensive public sector support 
- Variations in the definition of Tier 1 capital stemming from differences 
in application of adjustments across the MS obstructed its comparability and reliability, leading to market participants' and regulators' focus on 
alternative measures 
The EU banking system entered the crisis wi th capital of insufficient amount and quality. 
Mounting losses forced banks to rebuild their cap ital bases at the time when it was most 
difficult to do so, in turn, necessitating governme nts to provide support to the banking sector 
in many countries and on a massive scale and co ntributing to the onset of economic downturn.  
The crisis has shown that certain capital instru ments did not meet the expectations of markets 
and regulators with regard to their loss abso rption, permanence and flexibility of payments 
capacity on a going-concern basis.  This in particular pertains to hybrid capital instruments 
(hybrids) and certain types of non-hybrid instrument s that make part of banks' Tier 1 capital.  
When these instruments included a possibility to  defer or cancel a co upon (i.e., criterion of 
flexibility of payments) to enable banks to conserve resources during difficult times28, such 
possibility was not widely ex ercised. This was in part dr iven by a stigma of dividend 
cancellation being interpreted by the market as a signal of distress. Effectively, the outflow of 
dividends and coupons contributed to the weaken ing of the banking sector  at the time when 
capital was most needed. As regards the crite rion of permanence, there were instances of 
banks redeeming hybrids despite th e higher cost of replacing them  at the time of crisis. This 
was in particular true when market expectati ons were based on instrument's contractual terms 
that provided for an incentive to redeem the in strument by increasing the interest rate to be 
paid if redemption is not executed.29 Instances of hybrid capital instruments absorbing losses 
                                                 
27 Between September and December 2008, ECB loans to the euro area credit institutions increased by some 
70% to over €800 billion. For public sector support, please see footnote #2.  
28 According to CEBS, in 2006 some 80% of hybrids reported by EEA banks as Tier 1 capital had a right for 
issuers to suspend payments in case of solvency difficulties and in other situations 
29 According to CEBS, in 2006 42% of hybrids (mostly innovative instruments) reported by EEA banks as Tier 1 
capital had such feature at the time of their issue 
 
 during the crisis have also been rare. As a result,  the crisis effectively delineated those capital 
instruments that acted as a 'going-concern' capit al from those that acted rather as a 'gone-
concern' capital. In fact , skipping options to redeem30 and cancelling / deferring coupon 
payments31 on hybrid capital became more prevalent only later in the crisis, in the context of 
state aid to financial institutions, and was in part due to the Commi ssion policy that included 
the objective of 'burden sharing'.32  
Another problem lied in the fact that the list of adjustments to regulatory capital proved to be 
incomplete as certain balance shee t items such as minority interests33 and deferred tax assets 
(DTAs)34 whose loss absorption potential is less cer tain on a going-concer n basis in times of 
market distress have been effectively remove d by market participants  and regulators from 
capital ratios as reported by indi vidual institutions. The crisis also showed that regulatory 
adjustments when applied were not applied to  the appropriate layer of regulatory capital. 
Under the CRD, the current adjustments are gene rally applied on a 50%-50% basis to Tier 1 
and Tier 2.35 This allowed banks to report high Tier 1 ra tios, despite the fact that they had low 
levels of Tier 1 capital (as perceived by th e markets) when entirely excluding adjustments 
such as for investments in other financial inst itutions in excess of 10% of the common stock 
of such institutions.36  
Currently, regulatory adjustments in the EU ar e not harmonised, as MS have discretion to 
apply additional adjustments.37 As regards minority interests, MS have discretion to include it 
in the regulatory capital.38 The resultant variations in the definition of Tier 1 capital across 
MS obstructed the comparability and further compromi sed the reliability of this measure. This 
led to the loss of confidence in Tier 1 as measure of capital adequacy prompting market 
participants and regulators to instead focus on alternative measures, mostly based on common 
equity, net of balance sheet elements whose lo ss absorption potential proved to be uncertain 
during market distress.   
The above shortcomings contributed to the ba nking sector entering the crisis with reported 
Tier 1 capital ratios that were not reflective of  institutions' effective capacity to absorb losses 
on a going-concern basis. As the crisis deepened and banks faced growing losses and 
                                                 
30 This was the case for RBS, Bradford & Bingley, KBC Group 
31 This was the case for BayernLB, Commerzbank, Lloyds, RBS, Allied Irish Banks, Bank of Ireland, Cajasur 
32 Commission communication on the return to viability and the assessment of restructuring measures in the 
financial sector in the current crisis under the State aid rules; see http://eur-
lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:C:2009:195:0009:0020:EN:PDF   
33 Minority interest represents shares issued by a group entity and is available primarily to absorb losses which 
occur in that entity. However, minority interest may not  necessarily be readily available to absorb losses 
elsewhere in a group, including the consolidating entity. Therefore, in cases where a group entity is 
overcapitalised, inclusion of minority interest at the consolidated entity level may represent an artificial 
enhancement to its capital ratios. According to HSBC,  at the end of 2009 minority interests contributed 
€95 billion to European bank capital. 
34 DTAs can be defined as the amounts of income taxes that may be recovered by a company in the future. 
However, DTAs whose realisation th rough reduced future tax payments is contingent on a bank's ability 
to generate profits raise prudential concern as they may not provide protection to depositors in case of 
insolvency.  
35 Article 66 
36 A deduction from Tier 1 capital only in this case is wa rranted to prevent a reduction in capital as a result of 
loss absorption in one financial institution from being immediately reflected as a loss of capital in the 
investing financial institution. 
37 Article 61 
38 Article 65 
 
 writedowns which directly redu ced their retained earnings, th eir fundamental solvency was 
called into question.  
3.4. Counterparty credit risk 
Problem Drivers Problems 
- Current provisions do not adequately capture CCR 
- Shortcomings in risk management practices as 
regards back testing, stress testing and collateral 
management 
- Current provisions do not entail sufficient 
incentives to move bilaterally cleared OTC instruments to central counterparties and to post adequate initial margin - Existing provisions did not ensure appropriate risk 
management of financial institutions as well as adequate and non-cyclical regulatory requirements against CCR that materialised during the crisis 
- Calibration of provisions did not provide sufficient 
incentives to clear bilateral OTC instruments through 
central counterparties, leading to lack of confidence and 
exacerbating instability in times of market stress 
The crisis revealed a number  of shortcomings in the cu rrent regulatory treatment of 
counterparty credit risk (CCR) exposures aris ing from derivatives, repos and securities 
financing activities. For instance, while the CRD covers the risk of counterparty default, it 
does not address the credit valuat ion adjustment (CVA) risk, asso ciated with deterioration in 
the creditworthiness of a counterparty. Yet,  during the crisis ro ughly two-thirds of 
counterparty credit losses were due to CVA losses with the remainder due to actual defaults. 
Current provisions also do not recognize the unique, syst emic risk associated with exposures 
associated with over-the-counter (OTC) deriva tives given the extent to which they are 
concentrated at large financial institutions, whose counterparties gene rally are other large 
financial institutions. Given such interconnectedness, financial institutions' credit quality deteriorated simultaneously proving them to be rela tively more sensitive to systemic risk than 
non-financial firms. Under current rules, th e CCR capital requirement was too low during the 
period preceding the crisis, but increased rapidly as the financial turmoil started, making the 
requirement pro-cyclical. The crisis also rev ealed a number of significant shortcomings in 
institutions’ risk management of counterparty credit  exposures, including in particular the 
areas of back-testing, stress tes ting, and collateral management. 
The existing framework did not provide sufficient incentives to move bilaterally cleared OTC 
derivative contracts to multilate ral clearing through central c ounterparties (CCPs). Even 
though CCPs can play an important role in the effo rts to reduce the systemic risk arising from 
the intricate web of exposures formed by holdi ngs of derivative products by banks, they were 
not widely used to clear trades. Regulatory cap ital requirements for bila terally cleared trades 
were not sufficiently high to offer an attrac tive incentive to clear OTC derivative trades 
through a CCP. Instead, the need to post initia l margin when clearing trades with a CCP 
apparently more than offset the fact that no regulatory cost was involved for such trades.  
3.5. Pro-cyclicality of lending 
Problem Drivers Problems 
- Market failures, including limitations 
in risk measurement, information asymmetries and inappropriate responses to risk and changes in 
economic conditions 
- Irresponsiveness of regulatory 
requirements to risk build-up at the macro level 
- Lack of explicit limits to leverage of - Inappropriate responses to risk an d other market failures contribute 
to leverage build-up and a concomitant overextension of credit in the economic upturn and cause banks to maintain generous discretionary distributions during periods of stress, when capital should be 
conserved 
- Lack of a limit to leveraging capital and irresponsiveness of capital 
requirements to the build-up of risk at the macro level led to accumulation of financial imbalances which precipitated steep credit-related losses and, once the economic cycle turned, prompted a de-
 
 Problem Drivers Problems 
credit institutions leveraging spiral 
Pro-cyclical effects can be defi ned as those which tend to follow the direction of and amplify 
an economic cycle. In this regard, bank lendi ng also can contribute to amplification of 
business fluctuations, which in turn may exacerba te financial instability. The cyclical nature 
of bank lending has many, often interconnected  sources that include both market and 
regulatory failures.39  
While financial institutions fare  better at assessing relative risk, they have difficulties in 
assessing absolute level of risk especially over a prolonged period, and so rarely identify 
booms with consequences for systemic risk. Th e misperception of risk may be exacerbated by 
a strong industry-wide drive for profit and mora l hazard of implicit safety nets. Hence, when 
macro-economic conditions were favourable, banks engaged in a rapid expansion of their 
balance sheets without due consideration ab out implications for system-wide financial 
stability.  
When economic conditions became depressed a nd collateral values declined, information 
asymmetries with respec t to the quality of clients’ bala nce sheets impeded access to funding 
even for borrowers with profita ble projects. Such pro-cyclical  effects proved to be more 
pertinent to borrowers which are more prone to asymmetric information, including small and 
medium-sized enterprises not subject to ex ternal ratings and extensive disclosure 
requirements. 
Inappropriate responses of financial institutions to changes in economic  conditions in some 
cases could be explained by short-term bias of  remuneration structures  or herding behaviour. 
While, given the difficulties to ra ise capital, banks should have ma de greater efforts to rebuild 
regulatory capital (to limit its depletion due to  accumulating losses), many of them maintained 
generous discretionary distri butions to their shareholders , providers of other capital 
instruments and employees.40  
One feature of current risk-based minimum cap ital requirements is that they vary over the 
economic cycle. Provided credit institutions co uld meet them, there is no explicit regulatory 
constraint on leverage of institutions. The lack of a limit to their leverage and irresponsiveness of regulatory capital requirements to the build-u p of risk at the macro level enabled banks to 
recklessly grow their balance sheets.
41 Increases in leverage combined with investment in 
more risky products allowed many banks to seek higher returns, as high levels of available 
liquidity resulted in risk premia falling to histor ically low levels. When financial asset prices 
started to fall, assets had to be marked-to-ma rket for losses incurred  and banks had to de-
                                                 
39 For a thorough description of the main sources of pro-cyclicality please see: 
 BIS, Addressing financial system procyclicality: a possible framework , Note for the FSF Working 
Group on Market and Institutional Resilience, September 2008; and  
 Masschelein, N., Monitoring pro-cyclicality under the capita l requirements directive: preliminary 
concepts for developing a framework , NBB Working Paper Document No. 120, 2007 
40 Dividends of 21 large banks from the US and Europe increased from 0.4% of their assets in 2000 to 1.1% in 
2007 and were still at 0.7% through the first three qu arters of 2008, in spite of a deepening financial 
crisis. Acharya, V., I. Gujral, and H. S. Shin, Bank Dividends in the Crisis: A Failure of Governance , 
March 2009 
41 ECB’s analysis of credit-to-GDP gap from 1995 to 2009 in 19 MS showed that credit  in the years preceding 
the financial crisis grew at a fast pace in a nu mber of them (e.g., IE , LV, LT, HU), signalling 
accumulation of risk at the systemic level and immi nence of significant credit -related losses for their 
banking sectors. 
 
 leverage by selling them in order to minimi ze regulatory capital requirements and meet 
margin calls from their counterparties, prompti ng further asset price d eclines (see section 3.2 
for the interaction between ma rket liquidity and funding liqui dity). According to the IMF 
estimates, between 2007 and 2010 crisis-relat ed writedowns and loan provisions on bank 
assets originated globally reach $2.3 trillion, $1.3 tr illion of which is attributable to European 
banks, equivalent to 8% of the EU GDP. 
Policy measures42 adopted by the Commission so far address only some specific aspects of 
the above-listed market and regulatory failures a nd, therefore, may not be  entirely effective in 
limiting the extent of leverage build-up in the balance sheets of financial institutions and the 
concomitant overextension of credit. In June 2010 the Commission adopted a report43 on 
effects of the CRD on the economic cycle noting th at it would examine a dditional measures to 
mitigate the pro-cyclicality. These measures i)  should limit the build-up of leverage in the 
banking sector, thus, helping to c ontain the risk of de stabilising deleveragi ng processes and ii) 
should curb the excessive risk-taking in times  of economic growth but  could be drawn down 
during economic downturns to incr ease resilience of the banking sector and support the credit 
flow to the economy.44  
3.6. Options, discretions and minimum harmonisation 
Problem Drivers Problems 
- Diverging national rules due to the 
inclusion in the CRD of a number of national options and discretions 
- Gold-plating of the current 
provisions 
- Lack of detail within certain CRD 
provisions that allow for supervisory 
judgement and / or choice to be made - Diverging national rules allow for competitive distortions in the 
internal market and lead to a frag mented and inconsistent financial 
supervision, impeding legal clarity and resulting in excessive 
administrative burden for cross-border banks.  
- Mutual recognition of 'host' MS treatment at consolidated level 
creates opportunities for regulatory arbitrage whereas application of 'home' MS discretions at 'host' level hinders supervisory cooperation and level playing field 
Over the recent years the EU banking market  has become highly integrated: currently around 
70% of EU banking assets is in the hands of  some 40 banking groups with substantial cross-
border activities. However, efficiency of the in ternal market in whol esale and retail banking 
services is undermined by dive rgences in national rules on cap ital and liquidity requirements. 
The CRD is a recast of the Consolidated Banki ng Directive (2000/12/EC), resulting in some 
150 national options and discretions. The CRD is  also a 'minimum harmonisation' directive.45 
This means that MS may 'add' st ricter prudential rules, which gi ves rise to a practice known as 
'gold-plating'. Divergences in national rules st emming from the possibili ty of application of 
national options, discretions and gold-plating are exacerbated by the process of transposition itself. Finally, national rules transposing the CRD are interpreted in accordance with local traditions and approaches thereby deepening the divergences in application of the CRD across 
the MS further.  
                                                
 
42 For instance, the CRD III proposal included provisions on an express obligation for financial institutions to 
establish and maintain remuneration policies and prac tices that are consistent  with effective risk 
management. The Commission also proposed to set up a European Systemic Risk Board to oversee the 
stability of the financial system, identify systemic risk s at the European level and issue risk warnings.  
43 See http://ec.europa.eu/internal_market/bank/docs/regcapital/monitoring/23062010_report_en.pdf   
44 Analysis of the Basel Committee showed  that ‘severely stressed’ banks entere d the crisis with a higher degree 
of balance sheet leverage. This analysis was based on leverage ratios for 117 banks from 19 countries in 
2006 and 2007, of which 27 banks were identified as 'severely stressed' during the financial crisis. See 
http://www.bis.org/publ/bcbs180.pdf  
45 Recital 15 of Directive 2006/48/EC 
 
 Where the legal text does not include criteria  on which judgements or choices are made by 
supervisors, some options and discretions may re sult in a lack of legal clarity. While all MS 
have a supervisory treatment that appears to be legally compliant, any given exposure might 
receive different treatment from one MS to anot her. Effects of disparate approaches have a 
direct effect on a firms' ability to properly a nd fairly compete in another MS, leading to an 
unlevel playing field. 
Diverging application of the CRD undermines th e reform of the EU supervisory architecture 
and, therefore, may impair effectiveness an d efficiency of supe rvision. From 2011, the 
European Banking Authority (EBA) replaced CEBS , taking over CEBS’ responsibilities as 
well as receiving additional powers. In partic ular, it has been entrus ted with developing 
technical standards in areas of bank regulation that concern issu es of highly technical nature 
where uniform conditions for implementing EU acts are needed. For such standards to be best 
developed and most effective, na tional requirements should not diverge, i.e., there should be 
no possibility to apply stricter rule s, different options or discretions. 
Different application of legislation in different MS is particularly burdensome for firms 
operating cross-border. They have to report on their compliance with different sets of 
requirements at consolidated and subsidiary le vels which gives rise to additional reporting 
costs. In order to allow cross-border banks to  minimize these costs, the CRD II introduced a 
requirement for supervisors to apply a uniform  reporting format by the end of 2012, which is 
under development by EBA. However, work on common reporting format represents only a 
partial solution from the industry's perspectiv e, as aforementioned divergences mean that 
differently defined data would need to be reported from one MS to another. 
Consequences of regulatory divergences are pa rticularly pertinent when considering the 
treatment of banking groups. Under the CRD, as a general rule, the consolidating supervisor 
should apply 'home' MS rules at consolidated level, unless otherwise provided for in the 
directive. Where rules are not ha rmonised, this may resu lt in banking groups with subsidiaries 
in other MS having to apply dive rging rules at solo (‘host’ MS) level and consolidated level. 
Mutual recognition of the host MS national discretion provides some degree of flexibility by 
allowing the use of local rules46 at consolidated level but may also create opportunities for 
regulatory arbitrage. The CRD al so provides the possibi lity to apply 'home' discretions at 
'host' level. This is discussed, on a case by case  basis, in colleges of supervisors involving all 
relevant supervisors of banking gr oups. In this context, superv isors may decide to apply any 
blend of 'home' and 'host' discretions. Due to the number of options and discretions, positions 
of national authorities with regard to suitability  of specific prudential measures vis-à-vis parts 
of the group may diverge, hindering efficiency and effectiveness of supervisory cooperation. 
Moreover, as practices may va ry from one college to a nother, banking group-specific 
outcomes are delivered, which may have negative  implications for the level playing field.  
3.7. Risks inherent in baseline scenario 
There is a broad international consensus th at problems outlined in sections 3.2 - 3.6 
individually, and even more so when taken toge ther, played a significant  contributing role in 
exacerbating the economic cycle and in precipitati ng the extreme financial instability that in 
turn evoked the global economic recession, damaging soundness and international competitiveness of the EU banking sector and subjecting a wide range of stakeholders, 
                                                
 
46 The CRD provides 18 cases of explicit reference to mu tual recognition of national discretions implemented by 
another national authority 
 
 including bank creditors, shareholders, employ ees, borrowers and taxpayers, to unprecedented 
economic costs. If no action in th ese areas is taken, the risk that systemic shocks of a similar 
scale occur in the future will not be addressed.  
3.8. Is action necessary at EU level? 
Based on the nature of problems outlined in the above analysis, several major justifications 
that meet the principle of subsidiarity for action at the EU level become apparent. They 
include a need to enhance th e integration of EU internal  banking market (by removing 
national options, discretions and possibilities to 'gold-plate'), address several market (e.g., in 
the area of countercyclical pol icy measures) and regulatory fa ilures (e.g., capital definition 
and liquidity risk management ru les, capital requirements for CCR) that were brought to light 
by the financial crisis, correct for regulatory arbitrage opportunities which are made possible 
by the current legislation (due to the availabil ity of certain national options and discretions) 
and ensure a consistent EU appr oach for tackling various issues  covered by the scope of this 
report, which would do away with the need for MS to pursue in dividual approaches that risk 
fragmenting the internal market.  
Most importantly, only a common EU-level approach  could be expected to effectively provide 
for financial stability and tame excessive financ ial pro-cyclicality, as currently policies that 
are directed toward these key systemic  aspects are either geared to national needs or are 
absent altogether. With respect to the latter, th e crisis clearly demonstrated the ineffectiveness 
of the national liquidity ri sk supervision approaches. 
As regards the proportionality of proposed EU acti ons, it is implicitly assessed in section 5 in 
the process of comparison of potential policy op tions in terms of their effectiveness and 
efficiency vis-à-vis the relevant policy objectives. 
 
  
                 
 
      
 
Opportunities for regulatory 
arbitrage 
 
Increased pro-cyclicality of 
the financial system  Current provisions do not capture all the 
risk adequately: 
 
9 Generalised / specific wrong way risk 
9 Systemic risk related to large financial 
institutions 
9 No capital requirement for mark-to-market 
l osses du e to credi t v alu e adju stments Shortcomings in liquidity risk 
management, including stress testing 
Implications for 
international 
competitiveness of EU 
bankin g industr yLack of legal clarity 
 
Lack of detail within certain provisions 
that allow for supervisory judgement and / 
or choice to be made   
PROBLEM DRIVERS  
Prudential capital and 
liquidity requirements 
inadequate in relation to 
undertaken risks  GENERAL 
PROBLEMS  
Current provisions leave room for 
diverging rules across MS through: 
 
9 National options 
9 National discretions 
9 Additions above minimum harmonisation due 
to possibility to gold-plate  
Increased risks to financial 
stability  
 
Creditor protection not 
optimised  Cyclicality of bank lending  
Increased compliance 
burden for cross-border 
institutions  
Unlevel playing field 
Sub-optimal level of 
supervisory co-operation 
and convergence  
Sub-optimal level of risk 
management 
Current provisions do not entail 
incentives to: 
 
9 Move bilateral OTC to clearing through 
central counterparties 
9 Post ade quate initial mar gin L
I
Q
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DI
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Y 
 
P
R
O 
-
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Y
C
L
I
C
A
L
I
T
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Y 
SI
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G
L
E
 
R
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E
 
B
O
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C
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I
T
A
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D
E
F
. 
 
C
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T
E
R
P
A
R
T
Y
  
C
R
E
D
I
T 
 
R
I
S
K Asset and liability maturity mismatches 
No harmonised and sufficiently explicit 
regulatory treatment at EU level  
Certain capital instruments did not fulfil 
loss absorption, permanence and 
flexibility of payments criteria  
List  of prudenti al adjust ments i ncomplete 
or applied not to a relevant layer of 
institutions' regulatory capital  
Lack of harmonization in application of 
prudential adjustments  
Cyclical nature of bank lending due to market failures such as: 
 
9 Limitations in risk measurement 
9 Information asymmetries 
9 Inappropriate responses to risk and 
changes in economic conditions Shortcomings in risk management 
practices: 
 
9 Back testing 
9 Stress testing 
9 Coll ateral manag em ent  
Irresponsiveness of regulatory 
requirements to risk build-up at the macro 
level
Lack of explicit limit to leverage build-up  Inadequate prudential 
requirements for 
systemically important 
institutions  PROBLEM TREE  
 
 4. OBJECTIVES  
The overarching goal of this initiative is to en sure that the effectiv eness of bank capital 
regulation in the EU, represented by the CRD, is strengthened and its adverse impacts on 
depositor protection and pro-cy clicality of the financial system are contained, while 
maintaining the competitive position of the EU banking industry. This translates into the 
following four general  policy objectives to:  
- Enhance financial stability (G-1); - Enhance safeguarding of depositor interests (G-2); - Ensure international competitiveness of EU banking sector (G-3); - Reduce pro-cyclicality in the financial system (G-4). In light of the problems presented in sections 3.2 - 3.6, five sets (in the areas of liquidity risk 
management, definition of capital, counterparty cr edit risk, pro-cyclicality, and single rule 
book) of operational
 objectives have been identified to address the applicable  problem drivers. 
Effective realization of such operational objec tives should contribute to the achievement of 
the following longer-term specific  policy objectives to:  
- Enhance adequacy of capital and liquidity requirements (S-1); 
- Enhance bank risk management (S-2); - Prevent regulatory arbitr age opportunities (S-3); 
- Enhance legal clarity (S-4); 
- Reduce compliance burden (S-5); - Enhance level playing field (S-6); - Enhance supervisory cooperation and convergence (S-7) - Align prudential requirements for systemically important financial institutions (SIFIs) with 
the risks that they pose (S-8); 
- Reduce cyclicality of bank lending (S-9); and, in turn, should facilitate the attainment of the four  general policy objectives. 
Table 1 provides an overview of the linkages between:  - identified problems and drivers underlying them; 
- operational, specific and ge neral objectives to addre ss the problem drivers; and 
- policy options to achieve the objectives.  
 
 18   Table 1:  Summary of problems, objectives and policy options 
Specific Objectives General Objectives 
S-1 S-2 S-3 S-4 S- 5 S-6 S-7 S-8 S-9 G-
1 G-
2 G-
3 G-
4 
Problems Problem Drivers Operational Objectives 
Enhance adequacy of 
capital and liquidity 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 
bank lending 
Enhance financial 
stability 
Enhance safeguarding of 
depositor interests 
Ensure international 
competitiveness of EU banking sector 
Reduce pro-cyclicality 
in the financial system 
Policy Options 
Shortcomings in liquidity risk 
management, including stress tests Ensure that institutions have 
sufficient high quality liquid assets 
to withstand an acute stress scenario lasting for 30 days √ √        1.1-
1.3 
Asset and liability maturity mismatches  Ensure that institutions fund their 
activities with more stable sources 
of funding on an ongoing structural basis √ √        2.1-
2.3 Liquidity risk management  
- Existing liquidity risk management approaches and supervisory regimes inadequately captured risks inherent to the underlying market practices and trends, contributing to bankruptcy of several institutions and strongly undermining 
financial health of many others, threatening the financial 
stability and necessitating unpr ecedented levels of central 
bank liquidity and government support.  
- Differences in national liquidity regimes give rise to level-
playing field issues for cross-border firms and hamper 
effectiveness of supervision as well as cooperation between supervisory authorities. No harmonized and sufficiently 
explicit regulatory treatment at EU 
level Develop appropriately explicit and 
harmonized EU level regime for management of liquidity risk √    √ √ √   √ √ √ √ 
1.1-
2.3 
Certain capital instruments did not 
fulfil loss absorption, permanence and 
flexibility of payments criteria  Enhance loss absorption, 
permanence and flexibility of 
payments of going-concern capital instruments √ √       √ 
List of regulatory adjustments 
incomplete or applied not to a relevant 
layer of institutions' regulatory capital  Enhance loss absorption of 
regulatory capital by appropriate 
application of regulatory adjustments from the relevant layers of capital √ √      √ √ Definition of capital 
- Banking sector – due to the drivers outlined - entered the 
crisis with reported Tier 1 capital ratios and, thus, capital 
that were not reflective of banks' capacity to absorb losses on a going-concern basis. As th e crisis deepened and banks 
faced growing losses and wr itedowns, their fundamental 
solvency was called into question, leading to broader financial instability and necessitating extensive public 
sector support 
- Variations in the definition of Tier 1 capital stemming 
from differences in application of regulatory adjustments 
across the MS obstructed its co mparability and reliability, 
leading to market participants' and regulators' focus on alternative measures Lack of harmonization in application 
of regulatory adjustments  Develop a harmonised set of 
provisions in the area of definition of capital    √  √ √ √   √ √ √ √ 3.1-
3.5 
Current provisions do not adequately 
capture counterparty credit risk Enhance adequacy of capital 
requirements for the counterparty 
credit risk √ √      √  
Current provisions do not entail 
incentives to move bilateral OTC to 
clearing through central counterparties and to post adequate initial margin Provide incentives to move bilateral 
OTC to clearing through central 
counterparties and to post adequate 
initial margin  √       √ Counterparty credit risk  
- Existing CRD provisions did not ensure appropriate risk 
management of financial institutions as well as adequate 
and non-cyclical regulatory  requirements against the 
counterparty credit ri sk that materialised during the crisis  
- Calibration of provisions does not provide sufficient 
incentives to clear bilateral OTC instruments through 
central counterparties, leading to lack of confidence and exacerbating instability in  times of market stress  Shortcomings in risk management 
practices as regard s back testing, 
stress testing and collateral Enhance bank risk management 
practices  √        √ √ √ √ 4.1-
4.3 
 
 19   Specific Objectives General Objectives 
S-1 S-2 S-3 S-4 S- 5 S-6 S-7 S-8 S-9 G-
1 G-
2 G-
3 G-
4 
Problems Problem Drivers Operational Objectives 
Enhance adequacy of 
capital and liquidity 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 
bank lending 
Enhance financial 
stability 
Enhance safeguarding of 
depositor interests 
Ensure international 
competitiveness of EU banking sector 
Reduce pro-cyclicality 
in the financial system 
Policy Options 
management 
Introduce an explicit limit on banks 
capacity to leverage their capital √ √       √ 5.1-
5.3 
Improve banks' capacity to absorb losses over periods of stress and still meet the minimum regulatory 
capital requirement √ √       √ 6.1-
6.4 Procyclicality of lending 
- Lack of a limit to leveragi ng capital and irresponsiveness 
of regulatory capital requirements to the build-up of risk at the macro level led to accumula tion of financial imbalances 
which, once the economic cy cle turned, prompted a de-
leveraging spiral and precipitat ed steep credit-related losses  
- Inappropriate responses to ri sk and other market failures 
contribute to leverage build-up and a concomitant 
overextension of credit in th e economic upturn and cause 
banks to maintain generous discretionary distributions during periods of stress, when capital should be conserved  Market failures, including limitations 
in risk measurement, information asymmetries and inappropriate responses to risk and changes in economic conditions 
Irresponsiveness of regulatory 
requirements to risk build-up at the 
macro level 
Lack of explicit limits to leverage of 
credit institutions Protect banking sector from 
excessive credit growth and build-
up of risks at the macro-level while ensuring credit flow to the economy in the economic downturn  √ √       √ √ √ √ √ 
5.1-
6.4 
Diverging national rules due to the 
inclusion in the CRD of a number of 
national options and discretions Remove national options and 
discretions in the CRD    √  √ √ √   
Gold-plating of the current provisions Remove regulatory additions above 
the agreed minimum standards   √  √ √ √   Options, discretions a nd minimum harmonisation 
- Diverging national rules allow for competitive distortions 
in the Internal Market and lead to a fragmented and 
inconsistent financial supervision, impeding legal clarity and resulting in excessive admi nistrative burden for cross-
border banks 
- Mutual recognition of 'host' MS treatment at consolidated 
level creates opportunities for regulatory arbitrage; 
application of 'home' MS discretions at 'host' level hinders supervisory cooperation and level playing field Lack of detail within certain CRD 
provisions that allow for supervisory 
judgement and / or choice to be made Make provisions allowing for 
supervisory judgement and / or 
choice more specific     √ √ √ √   √ √ √  7.1-
7.4 
 
 20  5. POLICY OPTIONS : ANALYSIS AND COMPARISON  
This section presents the policy options and th eir impacts for each policy area individually. 
Due to the number of the areas covered, the analysis of policy options and the comparison thereof have been combined for each area. Cumu lative impacts of all preferred options are 
discussed at the end of the section.  
Presentation of options in each policy area includes a 'retain cu rrent approach' scenario. While 
this usefully serves as a baseline for assessi ng impacts of alternative policy options, it needs 
to be kept in mind that sections 5.1-5.5 pert ain to proposals linked to Basel III that were 
developed by the Basel Committee with the acti ve participation of th e Commission services, 
on behalf of all 27 EU MS. Hence, 'retain curren t approach' options should be evaluated also 
bearing in mind the damage that their adopti on would inflict on the credibility of the 
Commission in the context of setti ng global bank regulation standards. 
Most policy option sets also include an opti on based on the Commission services' February 
2010 public consultation. As such, it represen ts a policy option whose development was 
underpinned by a tremendous amount of preparat ory work and which was subjected to an 
extensive consultation process in the EU. Importantly, the f eedback received from EU 
stakeholders was key for the Commission se rvices' negotiating positions at the Basel 
Committee, shaping the final policy solutions of Ba sel III. Inclusion of th is option also serves 
to enhance the transparency of the Basel III process, by showing how the thinking on 
individual parts of the new framew ork evolved over the course of 2010. 
Details of the new framework were fleshe d out by the Basel Committee in December 2010. 
Policy options pertaining to the new liquidity m easures are analysed in section 5.1. As regards 
the new capital requirements, respective policy op tions are discussed in  sections 5.2-5.5. The 
calibration, including phase-in and grandfathering arrangements,  of Basel III is shown in 
Tables 2 and 3 below. However, EU MS will be allowed to 'gold-plate' the new minimum 
requirements during the phase-in period, which means that they can apply already in 2013 the 
level of capital requi red by Basel III in 2019. 
Table 2:  Calibration of Basel III, in % of RWAs 
 Common Equity 
(after deductions) Tier 1 Capital Total Capital 
Minimum requirement 4.5 6.0 8.0 
Conservation buffer 2.5   
Minimum requirement plus conservation buffer 7.0 8.5 10.5 
Countercyclical buffer range 1 0-2.5   
Notes : 1 Common equity or other fu lly loss absorbing capital 
Source : Basel Committee  
Table 3:  Transitional arrangements for Basel III fr amework (all dates are as of January 1 ) 
Policy measure 2011 2012 2013 2014 2015 2016 2017 2018 2019 
Leverage ratio Supervisory monitoring Parallel run                                        
Disclosure starts on 1/1/2015  Migration 
to Pillar 1  
Minimum common equity (CET1) 
capital ratio    3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5% 
Capital conservation buffer      0.625% 1.25% 1.875% 2.5% 
Minimum common equity plus capital conservation buffer   3.5% 4.0% 4.5% 5.125% 5.75% 6.375% 7.0% 
Phase-in of deductions from CET1    20% 40% 60% 80% 100% 100% 
Minimum Tier 1 capital   4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0% 
 
 21  Policy measure 2011 2012 2013 2014 2015 2016 2017 2018 2019 
Minimum total capital   8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 
Minimum total capital plus capital 
conservation buffer   8.0% 8.0% 8.0% 8.625% 9.25% 9.875% 10.5% 
Capital instruments no longer qualifying as non-core Tier 1 
capital or Tier 2 capital   Phased out over a 10 year period beginning 2013 
Liquidity Coverage Ratio Observation 
period 
begins    Introduce 
minimum 
standard     
Net Stable Funding Ratio Observation 
period 
begins       Introduce 
minimum 
standard  
Source : Basel Committee  
It needs to be stressed that the calibrat ion of the new minimum capital requirements was 
determined by taking into account the impact th at the new policy measures would have on the 
numerator (i.e., definition of eligible capital) and the denominator (i.e., measures affecting risk weighted assets) of the ratios. Th erefore, analyses underpinning the phase-in 
arrangements and the calibrati on of the new rules are presente d after preferred policy options 
relevant for the calculation of the ratios ha ve been identified (in line with the approach 
followed by the Basel Committee). 
5.1. Liquidity risk 
To address the problems in the area of liquidity risk manage ment, in its February 2010 the 
Commission services consulted on the two key pot ential policy measures: Liquidity Coverage 
Ratio and Net Stable Funding Ratio. 
5.1.1.  Liquidity Coverage Ratio 
To address shortcomings in liquidity risk mana gement and to improve short-term resilience of 
the liquidity risk profile of financial institutio ns by ensuring that they have sufficient high 
quality liquid assets to withstand an acute st ress scenario lasting for 30 days, the Commission 
services proposed to introduce a Liquidity Coverage Ratio (LCR). Main policy options in this area are as follows: 
- Policy option 1.1:  Retain current approach; 
- Policy option 1.2:  Introduce LCR as specified in th e February 2010 public consultation; 
- Policy option 1.3:  Introduce LCR adopted by the Basel Committee subject to observation 
period. 
Policy option 1.1: Retain current approach
 
Under this policy option, problems related to short-term liquidity risk management, as 
outlined in section 3.2 may not be entirely addressed. Given the recently agreed Basel liquidity standards, it may be expected that under this policy option certain MS would adopt 
these sounder standards. Other MS may pursue different alleys for strengthening liquidity 
regimes and others may not act at all. This would lead to further divergence of standards 
within Europe, creating opportuni ties for regulatory arbitrage and un-levelling the playing 
field. 
Policy option 1.2: Introduce LCR as specified in the Fe bruary 2010 public consultation
 
LCR would require credit institutions to matc h net liquidity outflows during a 30 day period 
of acute stress with a buffer of 'high quality' liquid assets, i.e., to maintain LCR of at least 100%. The net liquidity outflows (the denominator) during th e period of stress would be 
 
 22  completely defined in the CRD, detailing inter alia what percentage of a given source of 
funding a credit institution has to assume woul d be withdrawn from it. The outflows covered 
would reflect both institution-specific and sy stemic shocks built upon actual circumstances 
experienced in the global fina ncial crisis and discussed in section 3.2. The provisions on the 
list of high quality liquid assets (the numerato r) to cover these outflows should ensure that 
these assets are of high credit and liquidity quality.47 For more detailed sp ecifications of both 
the numerator and the denominator of the ratio please see Annex IV.  
As regards the buffer of high quality liquid asse ts, the Commission services consulted on the 
impact of both a narrow  regulatory definition of the buffer composed of cash, central bank 
reserves and high quality sovereign de bt, as well as a somewhat broader  definition which 
included non-financial corporate bonds and co vered bonds of high quality up to 50% of the 
buffer.48 
The standards would apply at the level of individual legal entities.  This is desirable as long as 
constraints on the transferability  of assets, mutual support co mmitments and central liquidity 
risk management within groups continue to ap ply. However, application to individual firms 
could be waived by supervisors provided that it is possible to identify a set of institutions belonging to the same group with  centrally managed liquidity risk, legally binding mutual 
commitments for liquidity support between the re levant institutions an d freely transferable 
assets between legal entities even when under stress. Where these conditions are met, the 
requirements would be applied on a consolidated  level only to the en tities belonging to a 
group. Individual legal entity leve l application would be complemented by application at the 
consolidated level to ensure a sound liqui dity position of the overall banking group.  
Because in this area different MS currently apply different standards, banks were not familiar 
with standardised data requests included in the QIS. While this points in the direction of possibly significant one-off compliance cost s related to information provision, i.e., 
administrative costs, when migrating to the ne w standards, it may be expected that there 
would be important ongoing cost savings for cross- border groups that currently typically have 
to report on individual legal entity basis (and even  separately at the level of branches that do 
not have a legal personality) according to very diverse national  regimes and, in addition, on a 
consolidated basis according to their home country  regime. Hence, administrative costs due to 
EU legislation, as discussed in section 5.8.3, s hould be offset by savings of administrative 
costs due to national  reporting requirements. On top of  that, harmonised reporting would 
facilitate communication between supervisors of the different legal entities of a group.  
EU QIS showed that as of  December 2009 under the narrow
 definition of liquid asset buffer, 
average LCR was 52.4% and 74.1% for Group 1 and Group 2 banks, respectively. Group 1 
banks from only two countries and Group 2 banks  from 9 countries had average LCR above 
100%. Under the broader  definition of liquid asset buffer,  average LCR improved by some ten 
percentage points for both groups.  
Feedback from numerous public consultations s howed that the 'narrow' liquid asset buffer, 
however, does not address the situation of ju risdictions such as DK that may not have 
sufficient supply of eligible asse ts. Most respondents to the consultations also claimed that the 
'narrow' buffer definition entails the concentratio n risk of specific asset classes while labelling 
                                                 
47 They should have low credit and mark et risk, ease and certainty of valuati on, low correlation with risky assets, 
active and sizeable market, low market concentratio n, presence of committed market makers, be listed 
on developed exchange market, and be likely to attract investors in stressed market situations 
48 Those rated AA and above with a 20% haircut an d those rated A- up to AA- with a 40% haircut 
 
 23  bank (covered) bonds as illiquid would hamper ba nk ability to raise funds. Refinements were 
deemed to be necessary also as regards assumptions used to estimate several categories of net liquidity outflows (the denominator), for instance, to recognize that central bank-eligible assets that are not part of the liquid asset buffer and retail deposits consti tute a better source of 
liquidity than assumed by this option. Public authori ties of certain MS, on contrary, were in 
favour of a 'narrow' asset buffer on the grounds of financial stability. 
Policy option 1.3: Introduce LCR adopted by the Basel Committee subject to observation 
period  
Policy option 1.3 reflects the specification of  LCR announced by the Basel Committee in its 
Basel III rules text in December 2010. It takes into account the above mentioned concerns and 
recalibrates the LCR requirement by building on the 'narrow' definition of liquid asset buffer 
under policy option 1.2. 
'Narrow' liquid asset buffer under this option is broadened to include: i) non-financial 
corporate and covered bonds not issued by the bank itself of high credit  and liquidity quality 
with a 15% haircut and ii) exposures to sovere ign and public sector entities, central banks, 
that are risk-weighted at 20% under the CRD, w ith a 15% haircut. The inclusion of these 
assets (termed 'Level 2' assets) is capped at 40%  of the liquid asset buffer. Level 2 assets are 
also of very high liquidity, but possess the properties of high quality liqui d assets included in 
the 'narrow' definition to a somewhat lesser exte nt. The limit on these assets would ensure that 
assets of the very highest qua lity make up the majority of the buffer while allowing banks 
some flexibility to improve the profitability of their liquid asset holdings. This option entails three alternatives to accommodate the specific situation of jurisdictions which do not have a sufficient supply of Level 1 assets in their domes tic currency to meet the aggregate demand of 
banks with significant exposures in this currency. However, its Level 2 cap of 40% is lower 
than that of the broader
 buffer definition under option 1.2. 
This option foresees that before 2015, a range  of qualitative and quan titative criteria to 
determine high credit and liquidity quality and to  determine to which of the two levels in the 
buffer individual assets should be  assigned will be tested by EBA with a view to advising the 
Commission on the appropriate set and calibration of  such criteria. Prelim inary criteria that 
put particular emphasis on assets' external ratin gs have been set by the Basel Committee, but 
the testing of alternative criter ia should allow by 2015 to identify final criteria that place more 
emphasis on experienced liquid ity and less on such ratings. 
This option also elaborates on the expected outfl ow assumptions of a number of bank liability 
categories.49 For operational activities with financia l institution counterparties, it creates a 
25% outflow bucket for custody, clearing and settlement, and selected cash management 
activities. Importantly to the EU, a similar treatment is given to mutual deposits of 
cooperative and other ty pes of bank networks. 
In line with the general desire to introduce harmonised standards and be less dependent on 
individual banks' ability to model risks and a ssumptions that banks would make, this option 
also establishes a harmonised trea tment of net inflows rather than leaving their determination 
                                                 
49 Categories such as retail deposits; secured and unsecure d deposits from sovereign, public sector entities and 
central banks; undrawn committed credit and liquidity lines to retail and SME customers; undrawn 
committed credit lines to sovereign, public sector entities and central banks 
 
 24  to bank discretion.50 Importantly, to ensure a minimum level of liquid asset holdings, the 
amount of inflows that can offset outflows is capped at 75% of total expected cash outflows 
as calculated in the standard. This effectively requires that a bank must maintain a minimum 
amount of stock of liquid assets  equal to 25% of th e outflows in order to cover potential 
timing mismatches between in- and outflows during the 30 days and possible delays of 
inflows under stress. 
The above revisions to option 1.2 have been  determined based on the current data. The 
foreseen observation period will confirm whether any further changes are required. 
Similarly to policy option 1.2, the standards would apply at the level of individual legal and 
consolidated entities.51 The Commission will, based on a report from EBA and taking into 
account the contribution of ESRB, review befo re 2015 whether the ratio has any unintended 
consequences on the business and risk profile of European institutions, trade finance, financial 
markets and the economy. The Commission should be  able to modify the ratio accordingly as 
appropriate via a delegated act. A mechanis m would be built into the CRD IV proposal 
ensuring that the ratio will only apply after the Commission ha s concluded its review and has 
made the necessary modifications, if any.  
Under this policy option, average EU LCR is  66.5% for Group 1 banks and 87.1% for Group 
2 banks, comparable to the LCR averages of the broader  buffer definition under option 1.2. In 
terms of distributional impacts with respect to bank size, under this option the impact of 
having LCR of 100% is less pronounced for smalle r (i.e., Group 2) banks in most of the MS. 
In terms of implications of this policy opt ion on banks from other major international 
jurisdictions that are large and active abroad, the EU Group 1 LCR average is lower than that of a sample of 84 large international banks  from twenty members of the Basel Committee 
(including eight EU MS) that as of December 2009 stood at 82.9%.
52 
On the basis of the QIS, shortfall of liquid asse ts for the entire EU banking sector is estimated 
at about €1.6 trillion.53 As regards the aggregate supply of  liquid assets in the economy, when 
the above purchases of liquid assets are financed  by new equity of banks, this may effectively 
represent a switch between the direct holdings of  such assets by ultimate investors with the 
indirect ones (through holding bank equity). Yet there may not necessarily  be a big effect on 
the aggregate assets in the economy, as ultimately all securities would continue to be held - directly and indirectly – by the ultimate inve stors, including bank shareholders. Liquid asset 
shortfalls shall also not be confused with related bank cost s which stem from the foregone 
return on assets, i.e., the difference between average return on loans and average return on 
assets included in the buffer.  
LCR could lead to a contraction of the interbank market for short-term maturity. There is also 
the risk of a potential reduction in the liquidity  – and therefore maybe an increase of costs – of 
instruments excluded from the buffer, such as ABS or foreign currency swaps, as they would 
be relatively disregarded by banks. Neverthele ss, incentivising banks to find alternative 
                                                
 
50 Banks are assumed to realise inflows of 100% from their lending to other financial institutions, but should, due 
to the need to continue providing lending to firms and households, only assume 50% of the inflows 
contractually due from these counterparties.  
51 This is in alignment with Basel III rules since they outline treatment at the consolid ated group level while 
leaving the implementation at the sub-group and stand-alone bank levels to discretion of its members, in 
order to ensure greater consistency and level playing field between domestic and cross-border banks 
52 Source: QIS on the impact of Basel III reforms on the BCBS' countries 
53 Sources: EU QIS, Commission services' calculations 
 
 25  sources of funding is a key step to enhance financial stability, reduc e the reliance of the 
banking industry on such (wholesale) markets  and limit the contagion channels. 
The introduction of LCR is estimated to reduce the EU GDP by 0.11% four and a half years 
since the start of implementation, compared to th e baseline trend, if its benefits are not taken 
into account.54 However, the new framework should be  understood as an insurance scheme 
securing the stability of individual institutions and eventually of the financial system as a 
whole. Complying with the LCR requirement as  defined under this option is expected to 
reduce the probability of a systemic crisis by so me 40%, equivalent to annual GDP benefits in 
the range of 0.1% to 0.5%.55 The new measures should be able  to address the pro-cyclicality 
and volatile patterns of banks' unregulated  liquidity management: on the one hand, 
underestimated risks when liquid ity is cheap and easily availabl e and, on the other hand, rapid 
contagion and loss of confidence in crisis situation due to the asymmetry of information and 
insufficient liquidity reserves.  
Comparison of policy options  
Retaining the current scenario (option 1.1), implies that problems related to short-term 
liquidity risk management, as  outlined in section 3.2, may not  be addressed effectively, 
depending on the actions taken in this area by national supervisors and/ or the industry. While 
tightening of national liquidity regimes may provide for a degr ee of increased effectiveness 
with respect to regulation (objective S-1) a nd bank management (objective S-2) of risks 
discussed in this section, there is no guara ntee that necessary progress would be achieved 
quickly enough and evenly across the EU. 
While both policy options 1.2 (LCR as specified  in the February 2010 public consultation) 
and 1.3 (LCR developed by the Basel Committee subject to observation period) entail 
effective approaches with respect to contributin g to the achievement of relevant objectives S-
1 (Enhance adequacy of capital and liquidi ty requirements), S-2 (Enhance bank risk 
management) and G-1 (Enhance financial stability ), option 1.3 is more effective due to its 
more precise calibration of a number of elements  relevant for the calculation of LCR. While 
these two options are comparable in terms of  compliance costs for the industry, option 1.2 
(i.e., its version of the broade r buffer definition) is more effi cient than option 1.3 in terms of 
achieving the above objectives. Op tion 1.2 has a higher cap for addi tional assets eligible for 
the liquid asset buffer and genera lly could be better tailored to  the EU specificities both in 
terms of the numerator and the denominator given that they would be entirely defined in the 
CRD. As such, it would impose lower adjustment costs on both the industry, and via indirect 
impacts, on other economic agen ts. Given its superior effectiveness as regards the relevant 
policy objectives, however , option 1.3 is identifie d as a preferred option. 
Table 4:  Summary of policy option e ffectiveness and efficiency 
Policy Option Comparison Criteria 
Effectiveness 
Policy Option Enhance adequacy 
of capital and 
liquidity 
requirements [S-1]  Enhance bank 
risk 
management 
[S-2 ] Enhance 
financial 
stability 
[G-1]  Efficiency 
1.1 Retain current approach 3 3 3 3 
1.2 Introduce LCR as specified in the February 2010 public consultation 2 2 2 1 
1.3 Introduce LCR adopted by the Basel Committee subject to observation period 1 1 1 2 
                                                 
54 Sources: EU QIS, Basel Committee (MAG report, s ee section 5.8.4), Commission services' calculations 
55 Sources: EU QIS, Basel Committee (LEI report, se e section 5.8.5), Commissi on services' calculations 
 
 26  Scale of option ranking: 1=most effective / efficient, 3=least effective / efficient 
Effectiveness measures extent to whic h options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources 
5.1.2.  Net Stable Funding Ratio 
To address shortcomings in the management of  funding structure over a one year horizon, the 
Commission services propose to introduce a Net Stable Funding Ratio (NSFR). Main policy 
options in this area are as follows: 
- Policy option 2.1:  Retain current approach; 
- Policy option 2.2:  Introduce NSFR as specified in the February 2010 public consultation; 
- Policy option 2.3:  Introduce NSFR adopted by the Basel Committee. 
Policy option 2.1: Retain current approach  
Under this policy option, funding problems arising from asset - liability maturity mismatch, as 
outlined in section 3.2, may not be entirely ad dressed. While tightening of national liquidity 
regimes may provide for a degree of increased effectiveness with respect to management and 
supervision of risks discussed in this section, there is no gu arantee that necessary progress 
would be achieved quickly e nough and evenly across the EU.  
Policy option 2.2: Introduce NSFR as specifie d in the February 2010 public consultation  
NSFR would require credit inst itutions to maintain a sound funding structure over the one-
year horizon 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, depending on their liquidity profile at a one year horizon 
(reflected in the so-called 'requi red stable funding factors'), w ith sources of funding that can 
be considered stable over the same one year ho rizon. Annex V contains specifications of both 
sources of available  stable funding (the numerator) and required  stable funding for various 
asset types (the denominator) of the ratio, as outlined in February 2010 public consultation.  
In terms of level of applica tion, NSFR would apply at the level of individual legal and 
consolidated entities in line w ith the approach envisaged for application of LCR. For the 
reasons outlined in the discussion of LCR, costs related to inform ation provision, i.e., 
administrative costs, under this policy option are expected to be significant (see section 5.8.3).  
EU QIS showed that as of December 2009 the average NSFR for Group 1 banks was 79.8%. 
No country was, on average, able to meet th e requirement under this policy option, with MS 
observing ratios in the range of 60.6% to 97.2%. A wider range of results across countries was 
observed for Group 2 banks (43.4% - 155.7%), while  its average NSFR of 83.7% was slightly 
higher than that of Group 1.  
Feedback from numerous public consultations  showed that this policy option, however, 
requires further refinements with respect to calib ration of available stab le funding factors (the 
numerator) and required stable funding factor s as regards certai n asset types (the 
denominator) and that it may unfairly  penalise certain business models.56 With respect to the 
                                                 
56 Respondents claimed that banks being dependent on capital markets would be given a better ratio than retail 
deposit banks which have been stable. It was also recognised that NSFR might favour broker / dealers 
while penalising the universal banking model. 
 
 27  latter, some respondents called for the phasing in of th e ratio to allow banks for adjusting their 
business models. 
Policy option 2.3: Introduce NSFR adopted by the Basel Committee  
Policy option 2.3 reflects the spec ifications of NSFR announced by the Basel Committee in its 
Basel III rules text in December 2010. It takes into account the abovementioned concerns by 
recalibrating certain available stable f unding and required stable funding factors.57  
As a result, average NSFR is higher for most countries when compared to policy option 2.2, 
and the EU average rises to 91.1% for Group 1 banks and to 93.9% for Group 2 banks, while 
MS averages continue to be wide ly dispersed. In terms of distri butional impacts, smaller (i.e., 
Group 2) banks tend to have highe r NSFR ratios. EU banking sect or's shortfall to meet the 
NSFR requirement of 100% as of December 2009 is estimated in the vicinity of €3.2 trillion.58  
As regards implications of this policy op tion on banks from other major international 
jurisdictions that are large and active abroad, the EU Group 1 NSFR average is comparable to 
that of a sample of 85 large international banks from twenty members of the Basel Committee (including eight EU MS) that as of December 2009 stood at 92.7%.
59  
Given the above impact and acknowledging the novelty  of this requirement, this policy option 
entails an observation period that starts in 2012. The observation period would allow for the 
assessment of any unintended implications of the ratio for institutions of different size and 
business model, trade financing, financial ma rkets and credit provisi on to the real economy. 
The establishment of the actual regulatory re quirement, subject to appropriate revisions 
relative to its preliminary form, would be left  to another legislativ e proposal before 2018. 
This policy option would be less costly fo r the industry than option 2.2, as in effect, 
compliance with NSFR would start only in se ven years from 2010, giving institutions ample 
time to make necessary adjustments to their f unding structure, asset a nd liability maturity 
mismatch and activities which are the most vulnera ble to liquidity risk in periods of stress. 
Institutions would still be s ubject to the costs related to provision of information to 
supervisors during the observat ion period (see section 5.8.3). 
Comparison of policy options  
Retaining the current scenario (option 2.1) implies that problems related to longer-term 
funding liquidity risk management may not be  addressed. While bot h policy options 2.2 
(NSFR as specified in the February 2010 public  consultation) and 2.3 (NSFR adopted by the 
Basel Committee) entail an effective approach w ith respect to contributing to the achievement 
of relevant objectives S-1 (Enhance adequacy of capital and liquidity requirements) and S-2 
(Enhance bank risk management) as well as G-1 (Enhance financial stability) and other 
relevant general objectives, option 2.3 is more effective due to its more precise – from a 
                                                 
57 Available stable funding factors for retail and SME depos its are raised, while required stable funding factors 
for i) residential mortgages and other loans that qualify for the 35% or better risk weight under Basel II 
standardised approach for credit risk, ii) government and public sector entity securities with risk-weight 
of 20% under the CRD, and iii) certain of f-balance sheet commitments are lowered 
58 Sources: EU QIS, Commission services ' calculations. Expected shortfall shall not be confused with related 
bank costs which may stem (depending on actions taken by banks to comply with the requirement) from 
substituting sources of funding with lower available stable funding factors with those with higher 
available stable funding factors. 
59 Source: QIS on the impact of Basel III reforms on the BCBS' countries 
 
 28  prudential angle – calibration. Po licy option 2.3 is the most efficient option in terms of 
achieving the above policy objectives as it w ould impose lowest adjustment costs on the 
industry and, via the reduced likelihood of unwel come side effects for the industry and the 
financial markets, on other economic agents. Policy option 2.3 is iden tified as a preferred 
option. 
Table 5:  Summary of policy option e ffectiveness and efficiency 
Policy Option Comparison Criteria 
Effectiveness 
Policy Option Enhance adequacy 
of capital and 
liquidity 
requirements [S-1]  Enhance bank 
risk 
management 
[S-2 ] Enhance 
financial 
stability 
[G-1]  Efficiency 
2.1 Retain current approach 3 3 3 3 
2.2 Introduce NSFR as specified in the February 2010 
public consultation 2 2 2 2 
2.3 Introduce NSFR adopted by the Basel Committee 1 1 1 1 
Scale of option ranking: 1=most effective / efficient, 3=least effective / efficient 
Effectiveness measures extent to whic h options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources  
5.2. Eligibility of capital instruments and application of regulatory adjustments 
In the process of preparing the legislative propos al, a number of policy alternatives on various 
individual aspects of the defi nition of regulatory capital have been examined. They could be 
sensibly grouped in the following key policy options: 
- Policy option 3.1:  Retain current approach; 
- Policy option 3.2:  Modify only the el igibility criteria for own funds, as specified in the 
February 2010 public consultation; 
- Policy option 3.3:  Modify both eligibility criteria a nd regulatory adjustme nts as specified 
in the February 2010 public consultation; 
- Policy option 3.4:  Modify both eligibility cr iteria and regulatory ad justments as adopted by 
the Basel Committee; 
- Policy option 3.5:  Modify both eligibility cr iteria and regulatory ad justments as adopted by 
the Basel Committee, adjusted in certain ar eas to take account of  EU specificities. 
Policy option 3.1: Retain current approach  
Under this policy option, problems related to th e definition of capital an d outlined in section 
3.3 will not be entirely addr essed. While CRD II harmonised the criteria and established 
explicit limits for different types of Tier 1 hybrid capital, further amendments were shown by 
the crisis to be necessary in order to enha nce quality of regulatory capital. As regards 
regulatory adjustments, current CRD provisi ons allow for national discretion to make 
additional adjustments, however, this does not guarantee that a necessary progress would be 
achieved quickly enough and in a uniform manner across the EU.  
Policy option 3.2: Modify only the eligibility criteria fo r own funds as specified in the 
February 2010 public consultation  
This policy option would tighten eligibility crit eria for the different layers of regulatory 
capital. The Commission services' public consu ltation of February 2010 outlined such criteria 
with respect to core Tier 1, non-core Tier 1 and Tier 2 capital (see Annex VI). As regards 
core, or, Common Equity Tier 1 (CET1), the resultant ineligibility of certain capital 
 
 29  instruments would have a varying eff ect on institutions from different MS.60 Impacts on non-
core Tier 1 capital would be  mainly driven by eliminati on of innovative and dated hybrid 
instruments.61 As regards Tier 2 capital instrument s, EU banks that are organised as 
cooperative networks / societies would no longer be permitted to include in it commitments of 
their members (e.g., uncalled capital and co mmitments to make further non-refundable 
payments), based on the prudential rationale that capital should be paid up in order to ensure 
that it may be relied upon when required. 
However, the above amendments would address only issues relating to the eligibility of 
capital instruments. They would not address th e regulatory adjustments necessary to ensure 
that the amount of regulatory capital recognised adequately reflects the amounts that would be 
available to absorb losses on a going concer n or in insolvency.  A lack of further 
harmonisation of regulatory adjustments would result in the maintenance of the current 
divergent approaches in the EU to adjusting re gulatory capital. Therefore, this policy option 
would only be partially effective in ach ieving the relevant policy objectives. 
Policy option 3.3: Modify both eligibility criter ia and regulatory adjustme nts as specified in 
the February 2010 public consultation  
This policy option builds on option 3.2 by addressing additional problems that pertain to 
application of regulatory adjustments. To this  end, it lengthens the list of these adjustments 
and makes their application more appropriate w ith respect to tiers of regulatory capital, 
proposing to apply most of them entirely to the CET1 capital (see Annex VII).   
As a result of stricter capital eligibility requirements and re-allocation of regulatory 
adjustments to CET1 capital, under this policy op tion the CET1 ratio to risk-weighted assets 
(RWAs) declines in all countri es, while its average for the EU falls from 11.1% by some 7 
percentage points for Group 1 ba nks and from 11.5% by some 5 pe rcentage points for Group 
2 banks.62 Majority of this impact comes from th e new regulatory adjust ments: QIS showed 
that total adjustments under this option reduce eligible CET1 capital by some 60% for Group 
1 banks, and some 40% for Group 2 banks.63 In terms of distributi onal effects, impacts of 
individual regulatory adjustment s on CET1 capital vary from one MS to another, while CET1 
ratios of smaller (Group 2) ba nks are affected less than thos e of large and internationally 
active banks.  
In their responses to the cons ultation on the eligib ility of instruments for CET1 capital, 
several public authorities and many industry respondents stated that greater onus should be 
placed on the substance of a capital instrument, e .g. its ability to absorb losses effectively, 
than on its legal form. As regards eligibility of Additional Tier 1 cap ital instruments, there 
was a significant support among public authority re spondents for all such  instruments to be 
required to have a principal write-d own or conversion feat ure with an objective trigger, in line 
with the approach taken in CRD II, in order to ensure that su ch instruments absorb losses 
effectively and help an inst itution to remain as a going concern. Views of industry 
                                                 
60 Impact is relatively more pronounced in several MS due to the exclusion of some classes of shares, silent 
partnerships, participation capital, preferred shares and supplementary cooperative shares 
61 According to CEBS, as of end of 2006 almost 50% of Tier 1 hybrid instruments in the EEA were innovative 
hybrids. At the same time, such innovative hybrid s constituted a majority of dated hybrid instruments 
62 Current CET1 ratio calculated accordin g to the predominant form of Tier 1 capital (gross of deductions) as 
applied by the bank or the relevant national supervisor 
63 In terms of individual deductions, at the EU level the most material impact comes from deductions for material 
holdings of financial institutions, goodwill, DTAs, other intangibles and minority interests 
 
 30  respondents on this topic were mixed. With respect  to regulatory adjust ments, a significant 
number of public authority re spondents and many industry re spondents expressed concern 
about the appropriatene ss of the proposed non-recognitio n of minority interest and full 
deduction of DTAs and investments in certain other unconsolidated financial entities.   
Policy option 3.4: Modify both e ligibility criteria and regulatory adjustments as  adopted by 
the Basel Committee  
This policy option reflects the new definition of capital appro ach outlined in the Basel III 
rules text. Importantly, compared to option 3.3 this option entails a number of changes with 
respect to certain regulatory adjustments, improving upon the underlying prudential rationale 
and taking account of the impact  of the proposals on the indust ry and potential impact on the 
economy.  
More specifically, it provides some recognition in CET1 to the minority interest in a 
subsidiary that is a credit institution, investment firm, or firm subject to the same prudential requirements and supervision as credit institutions and investme nt firms, by deducting only 
the part of such minority interest that relates to capital above the regulatory minimum plus the 
capital conservation buffer (please s ee section 5.5) of such subsidiary.
64 It also allows the 
netting of long and short positions in capital instruments of other unc onsolidated financial 
entities, under specific circumst ances, and includes an exemp tion for underwriting positions 
held for five working days or  less. The treatment of significant investments in the common 
shares of unconsolidated financial institutions  (i.e., more than 10% of their issued share 
capital), mortgage servicing rights, and DTAs  from timing differences is also modified by 
giving these items limite d recognition in CET1.65 As a result, regulatory adjustments of Group 
1 banks as a percentage of eligible CET1 capita l, compared to option 3.3, decline by one third 
to some 40%, while Group 2 banks experience a less pronounced decline.66 
Impacts of other individual adjustments at the MS level continue to vary and, when taken 
together, exert a major albeit less pronounce d, than under option 3.3, impact on the CET1 
capital ratios. As a result and without consider ing the impact of othe r proposals included in 
the legislative proposal, average EU CET 1 capit al ratio for Group 1 ba nks increases by some 
2 percentage points to 5.8% whereas that of Group 2 banks improves slightly to 7.1%.  
As regards eligibility of Additional Tier 1 capi tal instruments, this option would entail a less 
stringent treatment than unde r options 3.2 and 3.3, as it woul d require only instruments 
classified as liabilities to be required to ha ve a principal loss absorption mechanism, which 
would effectively have a positive impact on th e EU banking sector's Tier 1 capital of an 
estimated €89 billion.  
QIS also showed that under this policy option, combined current CET1 capital for 208 Group 
1 and Group 2 banks would decline by some €490 billion67, Tier 1 capital by €370 billion and 
total capital by some €420 billion. Actual capital shortf all for the EU banking sector, 
                                                 
64 Equivalent treatment of minority interest has been proposed for Tier 1 and total capital 
65 For each of these adjustments, such recognition is capped at 10% of a bank’s common equity after application 
of all other adjustments. Also, banks have to deduct the amount by which the aggregate basket of the three items exceeds 15% of their CET1 capital,  calculated after all regulatory adjustments 
66 In terms of individual deductions, at the EU level the most material impacts are due to goodwill, material 
holdings of financial institutions and DTAs 
67 Change between current predominant form of Tier 1 capital without any deductions and CET1 capital as 
defined under option 3.4 
 
 31  however, would depend on the leve l of calibration of the new minima, implications of other 
parts of the proposal on the RWAs , and capital buffers that banks  hold in excess of current 
regulatory minima. These aspects are assessed cu mulatively in section 5.8 of this report.  
Most importantly, it is expected that the ne w capital definition rule s should significantly 
impact the stability of the financial system by enhancing its capacity to effectively absorb 
economic and financial shocks thereby preserving  the viability of fina ncial institutions.  
Policy option 3.5: Modify both e ligibility criteria and regulatory  adjustments as adopted by 
the Basel Committee, adjusted fo r certain EU specificities  
Under this policy option, a number of modifications have been c onsidered to the approach of 
the Basel Committee outlined under option 3.4 in or der to align it better  with EU regulatory 
and banking sector specificities. The modifica tions reflect certain f eatures of option 3.3 
(Modify both the eligibility crite ria and regulatory adjustments as specified in February 2010 
public consultation) as well as  stakeholder feedback rece ived in relation to public 
consultations. They include: 
- restricting CET1 to instruments that qualify under national law as equity capital68 and meet 
the CET1 criteria, rather than to ordinary shar es that meet the CET1 criteria – this approach 
places greater onus on the substance of a CET1 in strument. It recognizes the fact that some 
EU institutions issue instrume nts other than ordina ry shares having the loss absorbency 
equivalent to that of ordinary shares;  
- derogations from specific CET1 eligibility criteria for institutions that are mutuals, 
cooperative societies or similar in stitutions – this will  help to ensure th at the potential for 
general derogation from the CET1  criteria afforded by Basel III is applied appropriately and 
consistently in the EU;   
- rather than recognition in CET1 only where a ssociated with an instrument that qualifies as 
CET1, recognition in CET1 also of share premia  that qualified as original own funds under 
Article 57(a) of Directive 2006/48/EC prior to 31 December 2010 – the purpose of this 
approach is to provide recognition of the loss ab sorbing nature and role of such share premia, 
while also restricting the treatment to instrument s issued prior to the entry into force of the 
stricter definition of capit al introduced by CRD II;  
- a requirement for all Additional Tier 1 capital instruments, rather than only liabilities, to 
have principal write dow n or conversion feature69 - this approach takes account of the raising 
of capital quality in CRD II and ensures that th e principal amount of both equity instruments 
and liabilities are able to absorb losses  effectively on a going concern basis;   
- full, rather than limited, deduction from CET1 of mortgage servicing ri ghts, as for all other 
intangible assets - such an approach takes account of the relative illiquidity and uncertain 
value of mortgage servicing rights, and the pot ential difficulty of real ising significant amounts 
of them in a stressed or emergency situat ion. EU banks have limited amounts of mortgage 
servicing rights - by virtue of their US subsidia ries – and therefore impact of this adjustment 
is expected to be very small;  
                                                 
68 This represents a 'substance over form' approach, as it allows instruments other than common shares that meet 
all the eligibility criteria of Basel III to be included in CET1 
69 This addresses the issue that pref erence shares, while not being effec tive at absorbing losses on a going 
concern basis, would not be required to have a write-down or conversion 
 
 32  - a restriction on the recognition of hedging for th e purposes of determining the amounts to be 
deducted for investments in other unconsolidat ed financial entities to the trading book. The 
purpose of this approach is to limit the potential  for double counting of ca pital in the financial 
system through the provision of hedges by entitie s that are not subject  to an equivalent 
deduction requirement, and to reflect the fact  that such holdings in the non-trading book 
continue to the maturity of the instrument  and are difficult to hedge effectively;  
- an alternative approach for deduction of si gnificant holdings in unconsolidated insurance 
entities combined with enhancements to the cu rrent approach to applying the methods laid 
down in the Financial Conglomer ates Directive (FICOD). The pur pose of this is to take 
account of, and to enhance, the cross sector trea tment laid down in the FICOD of holdings of 
capital instruments in banking and insurance;  
- recognising minority interest – and certain regulatory capital issued by subsidiaries - to the 
extent that those subsidiaries are credit institutio ns or investment firms and the capital is used 
to meet minimum capital requirements, capital co nservation buffer and countercyclical capital 
buffer (see section 5.5). This rec ognises the importance of the countercyclical capital buffer, 
the capital used to meet it, and it aims at  avoiding any disinc entives to its use; 
- clarification of the tr eatment of DTAs that automatically  convert into a claim on the state 
when a firm makes a loss. Where their ability to absorb losses when needed is ensured, such 
DTAs would not have to be deducted.  
The overall net impact of these modifications  on the CET1 ratios of Group 1 and Group 2 
banks presented under option 3.4 is assumed not to be of major significance, as some of them 
would make the new capital requirements more st ringent while others would have an opposite 
effect. Most importantly, the adju stments have been developed with  a view to ensure that the 
relevant policy objectives are attained in th e most effective manner and that Basel III 
framework is meaningfully and flexibly appl ied to a diverse spectrum of the EU banking 
firms. 
Comparison of policy options  
Retaining the current scenario (option 3.1) implies that problems related to quality of capital, 
may not be addressed effectively, depending on the actions taken in this area by national 
supervisors and/or the industry. Of the remaining policy options, option 3.2 would be the least 
effective with respect to contributing to the ac hievement of the relevant policy objectives due 
to its focus on eligibility crit eria only. Policy options 3.3, 3.4 and 3.5 are perceived to be 
rather effective although they va ry in terms of treatment of individual regulatory adjustments 
and, additionally, options 3.3 and 3.5 are more aligned with certain EU regulatory and banking sector–specific aspects. In this regard , option 3.5 is more deve loped as it reflects 
outcomes of extensive public consultations. He nce, policy option 3.5 is the most efficient 
option and is identified as a preferred option. 
Table 6:  Summary of policy option e ffectiveness and efficiency 
Policy Option Comparison Criteria 
Effectiveness 
Policy Option Enhance 
adequacy of 
capital and 
liquidity 
requirement
s [S-1] Enhance 
bank risk 
managem
ent 
[S-2] Prevent 
regulatory 
arbitrage 
opportunit
ies [S-3] Enhance 
level 
playing 
field [S-6] Align 
prudential requireme
nts for 
SIFIs with 
the risks 
they pose 
[S-8] Reduce 
cyclicality 
of bank 
lending 
[S-9] Efficie
ncy 
3.1 Retain current approach 5 5 5 5 5 5 5 
 
 33  Policy Option Comparison Criteria 
Effectiveness 
Policy Option Enhance 
adequacy of 
capital and 
liquidity 
requirement
s [S-1] Enhance 
bank risk 
managem
ent 
[S-2] Prevent 
regulatory 
arbitrage 
opportunit
ies [S-3] Enhance 
level 
playing 
field [S-6] Align 
prudential requireme
nts for 
SIFIs with 
the risks 
they pose 
[S-8] Reduce 
cyclicality 
of bank 
lending 
[S-9] Efficie
ncy 
3.2 Modify only the eligibility criteria as specified 
in the February 2010 public consultation 4 4 4 4 4 4 4 
3.3 Modify both eligibility  criteria and regulatory 
adjustments as specified in the February 2010 
public consultation 1-3 1-3 1-3 2-3 1 1-3 3 
3.4 Modify both eligibility  criteria and regulatory 
adjustments as adopted by the Basel Committee 1-3 1-3 1-3 2-3 2-3 1-3 2 
3.5 Modify both eligibility  criteria and regulatory 
adjustments as adopted by the Basel Committee, 
adjusted for certain EU specificities 1-3 1-3 1-3 1 2-3 1-3 1 
Scale of option ranking: 1=most effective / efficient, 5=least effective / efficient Effectiveness measures extent to whic h options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources 
5.3. Counterparty credit risk 
To address problems related to current rule s on the counterparty credit risk (CCR) the 
Commission services considered a number of revisions in this area with the main policy 
options as follows: 
- Policy option 4.1:  Retain current approach; 
- Policy option 4.2:  Enhance  adequacy and minimize cyclicality of CCR capital 
requirement  and enhance incentives for clearing OTC instruments through central 
counterparties (CCPs); 
- Policy option 4.3:  Enhance  adequacy and minimize cyclicality of CCR  capital 
requirement , enhance incentives for clearing OTC instruments through CCPs and 
differentiate  the treatment of exposures to CCPs . 
Policy option 4.1: Retain current approach  
Under this policy option, probl ems outlined in section 3.4 would not be addressed. The 
capitalisation for CCR would remain to be  insufficient and the corresponding risk 
management standards inadequate.  
Policy option 4.2: Enhance CCR requirement  
This policy option amends the CCR framework in  several areas in order to ensure a more 
appropriate capitalisation for CCR. Credit inst itutions would be subject to an additional 
capital charge for mark-to-market losses, i. e., credit valuation ad justment (CVA) risk, 
associated with deterioration in the creditwor thiness of a counterparty. The new CVA capital 
charge would promote sound practic es in managing this  risk and recognise its hedging which 
would allow banks to mitigate the impact of this capital charge. As far as financial markets are concerned, the recognition of hedging is like ly to cause an increase of demand for both 
single-name and index credit de fault swaps (CDS) and contribute to further growth of the 
corporate CDS market.  
To address the systemic risk within the financia l sector, this option suggests raising the risk 
weights on exposures to financial institutions re lative to the non-financial corporate sector, as 
 
 34  financial exposures are more highly correlated than non-financial ones.70 This amendment is 
expected to encourage diversif ication of counterparty risk among smaller institutions and, 
overall, should contribute to less interconnected ness between large or systemically important 
institutions and, possibly, limit the propagation of a shock originati ng in a default of a large or 
systemically important financial institution (S IFI). This option would also mitigate the 
cyclicality of CCR capital requirement by requiri ng to calculate it base d on data that includes 
a period of stress and would strengthen sta ndards for CCR management, including collateral 
management, stress testing and model back-testing.  
This option would also consider ably reinforce the existing incentives for institutions to use 
CCPs for OTC derivatives as it would increase th e assessed capital requirements against such 
exposures if completed on a bilateral basis ra ther than through a CCP . Assuming that most 
institutions dealing with OTC derivatives move to CCP clearing, a number of the derivatives 
currently traded on the OTC markets woul d have to become more standardized. 
Standardisation can be a powerful tool of raising market efficien cy and liquidity, however, as 
regards hedging, it might in certain instances weaken the relationshi p between a derivative 
and underlying risk/instrument and can theref ore not be extended to the entire OTC 
derivatives market.  
Due to proposals under this policy option, RWAs  of EU Group 1 banks on average increase 
by some 10%71, with the increase concentrated in 3 MS . Most of the increase is driven by the 
proposed CVA charge. The average increase in  RWAs of Group 2 ba nks is negligible, 
illustrating that these banks have typical ly less exposure to OTC derivatives. 
Policy option 4.3: Enhance CCR requirement and differentiate treatmen t of exposures to 
CCPs   
This policy option reflects the new CCR fram ework adopted by the Basel Committee that was 
outlined in the Basel III rules text in D ecember 2010. It builds on the policy option 4.2 and 
entails a recalibration and differentiation of th e treatment of exposures to CCPs depending on 
the type of the exposure a credit institution ha s vis-à-vis a CCP (i.e., collateral & mark-to-
market exposures versus default fund contributions72) and whether the respective CCP 
complies with a set of stringen t risk management standards.73 Compared to the existing 
regime, these changes would lead to an increas e of capital requirement for exposures to CCPs. 
However, institutions would still be expected to use CCPs for OTC derivative clearing as the 
increase in capital requirement for exposures arising from bilaterally  cleared transactions 
would be significantly greater. 
The overall increase in regulatory capital under this policy option would be greater than that 
under option 4.2. Importantly, it is expected to limit th e scope for contagion (banks should be 
less affected by a default of counterparty) and contribute to strengthen ing of the financial 
                                                 
70 For regulated financial institutions with assets in ex cess of $100 billion and unregulated financial institutions 
regardless of their size 
71 Not including capital charges for exposures to CCPs 
72 The default fund contributions are designed to cover losses, over and above initial margin, following a clearing 
member default 
73 As CCPs also concentrate risk, a CCP with insuffici ently robust risk management processes can actually 
increase the systemic risk. To addr ess this, in 2010 the Commission adopted a proposal for a Regulation 
on OTC derivatives, central counterparties and trad e repositories, which envisages subjecting CCPs to 
stringent business conducts and harmonised organisational and prudential requirements such as internal governance rules, audit checks, great er requirements on capital etc; see 
http://ec.europa.eu/internal_market/financial -markets/derivatives/index_en.htm#proposals
 
 
 35  stability, which may further translate into lower risk premia banks have to pay for obtaining 
funds and better availability of financing for the economy. 
In the context of this option, the Commission services publicly consulted on the capitalisation 
of exposures to CCPs and the treatment of incurred CVA in February-March 201174.  
The latter deals with the issue of how to tr eat losses against the C VA risk which a bank in 
question writes down upfront. Given that incurre d CVA has been recognized in the Profit & 
Loss account, and thus effectively represents an amount that cannot be lost again were the counterparty to default, the Basel Committee suggested a treatment where incurred CVA 
could be deducted from the exposure amount (Expos ure at Default) in the calculation of the 
capital requirements for the default component of CCR.  
A vast majority of respondents to the Comm ission services' consultation nevertheless 
expressed serious concerns about such an approach, arguing that it is conceptually inadequate 
and that the degree of the recognition of incurred CVA is disproportionately low.  
The Commission services have extens ively analysed the comments received
75 and as 
subsequently suggested an alternative treatmen t, which would allow for a greater, however 
still prudent, degree of recognition of incurred CVA. In essence, such treatment would allow 
institutions applying the IRB a pproach to offset the regulato ry expected loss for CCR by the 
amount of incurred CVA, but this offset would be capped at the level of expected loss on the 
trade/netting set to which it relates. Institutions  applying the Standardised Approach would be 
subject to the same treatment as proposed by the Basel Committee. 
The Commission services consider the above al ternative treatment for institutions applying 
the IRB approach conceptually sounder, consiste nt with the rest of the regulatory framework 
applied to those institutions and more effectiv e in eliminating the double count referred to 
above. The benefits of such approach would nevertheless be somewhat diminished by the 
possible costs implied for internationally activ e banks by divergence from the treatment 
proposed by the Basel Committee, provided that such treatment is confirmed and implemented as announced in the Basel III framework published in December 2010.  
However, in the view of the Commission serv ices any such diverg ences would not have 
material implications for the EU industry overall and therefore are not elaborated further in this assessment. 
Comparison of policy options
 
Policy option 4.1 entails possible significant co sts in terms of inadequate management 
standards for CCR. In contrast, policy opti on 4.2 is effective in addressing all key 
shortcomings outlined in section 3.4. It ensures more adequate and less cyclical capital requirements for CCR, thus, helping to reduce the systemic risk across the financial system.  
Additional measures proposed unde r policy option 4.3 contribute to the effectiveness of this 
option with regard to enha ncing capital requirements ( objective S-1) and bank risk 
management (objective S-2) and reducing the systemic risk as they ensure an appropriate 
capitalisation for exposures to CCPs and provide  incentiv es to move OTC derivative 
                                                
 
74 http://ec.europa.eu/internal_market/bank/regcapital/index_en.htm#consultation_credit_risk   
75http://circa.europa.eu/Public/irc/markt/markt_consultations/library?l=/financial_services/credit-
risks&vm=detailed&sb=Title   
 
 36  contracts to CCPs with the highe st risk management standards.  As a result, policy option 4.3 
is identified as a pr eferred policy option. 
Table 7:  Summary of policy option e ffectiveness and efficiency 
Policy Option Comparison Criteria 
Effectiveness 
Policy Option Enhance adequacy 
of capital and 
liquidity 
requirements [S-1] Enhance bank 
risk 
management 
[S-2] Align prudential 
requirements for 
SIFIs with the risks 
they pose [S-7] Reduce 
cyclicality of 
bank lending [S-
9] Efficien
cy 
4.1 Retain current approach 3 3 3 3 3 
4.2 Enhance CCR requirement  2 2 2 2 2 
4.3 Enhance CCR requirement and 
differentiate treatment of exposures to CCPs  1 1 1 1 1 
Scale of option ranking: 1=most effective / efficient, 3=least effective / efficient 
Effectiveness measures extent to whic h options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources 
5.4. Leverage 
To address the build-up of exce ssive leverage on banks' and i nvestment banks' balance sheets 
and to contain the cyclicality of bank lendi ng, the Commission services investigated a 
possibility of introducing a non risk -based leverage ratio.  The main  policy options in this area 
are as follows: 
- Policy option 5.1:  Retain current approach; 
- Policy option 5.2:  Introduce  supplementary non-risk based leverage ratio as specified in 
the February 2010 public consultation ; 
- Policy option 5.3:  Conduct extensive monitoring  of different types of supplementary 
non-risk based leverage ratio . 
Policy option 5.1: Retain current approach  
Under this policy option the ri sk of excessive leverage du ring the next economic upturn 
would not be addressed other than by increas ed capital requirements, once adopted. Also, 
there would be no overall backstop against mo del. In addition, supervisors may introduce 
various national treatments in this area, which could undermine the level playing field within 
the EU and internationally. 
Policy option 5.2: Introduce leverage ratio as specified in the February 2010 public 
consultation  
This policy option would introduce a leverage ratio  as per the definition included in the public 
consultation of February 2010. In the process of th e EU QIS, several possi ble variations of the 
ratio were assessed.76 For the principal variant of the ratio77 QIS showed that smaller EU 
banks are less leveraged: the average Group 2 bank leverage ra tio of 3.1% is almost double 
that of 1.6% of Group 1 banks. This is mostly explained by larger Group 1 banks being more 
impacted by the new definition of Tier 1 capit al (see section 5.2) and the proposed treatment 
for non-traditional banking assets  such as derivatives.  
                                                 
76 For example, both Tier 1 and total capital for the num erator of the ratio were considered, while for the 
calculation of the exposure base (the denominator) a possibility of excluding high quality liquid assets from the on-balance sheet exposure amount was examined 
77 Numerator defined as the new definition of Tier 1 capital, while denominator defined as both on- and off-
balance sheet exposures. As regard s off-balance sheet exposures, cred it conversion factor of 100% was 
used, written credit derivatives were measured at 100% of their notional value, other derivatives 
measured at potential future exposure, and no netting of financial derivatives was recognised 
 
 37  Feedback to the public consultati ons indicated that the exposure base (i.e., denominator of the 
ratio) under this option in some cases ma y give a too wide capture of leverage.78 Furthermore, 
both national authorities and the i ndustry expressed concerns that  institutions with lower risk 
business models would be affected disproportio nately as low capital requirements of such 
institutions would result in highe r leverage ratios. Given that these institutions are critical for 
providing credit to the real economy (including to SMEs) a wrong calibration of the leverage 
ratio might therefore have unintended c onsequences for the economic recovery. 
Policy option 5.3: Conduct extensive monitoring of leverage ratio  
While a non risk-based supplemen tary leverage ratio (although differently defined) already 
exists in the US, Canada and Switzerland, experi ence with this measure in the EU is very 
limited. Therefore, both its definition and its calibration need to be chosen very carefully to avoid any unintended adverse impacts. Importan tly, discussions on the design of the ratio at 
the level of the Basel Committee also confirmed many of these concerns. Therefore, Basel III 
rules text foresees a review period of a full cr edit cycle to assess the effectiveness of this 
policy measure. Such review would assess impa cts on lower risk busin ess models; lending to 
SMEs and trade financing; intera ction of the ratio with the ri sk based capital requirements and 
other aspects. The review of th e leverage ratio would also consider the impact that differences 
in financial reporting frameworks may have on comparability and the international level 
playing field for the EU credit institutions.  
The Commission services intend to conduct such m onitoring for several alternative definitions 
of the numerator and the denominator of the ratio, including the definitions outlined in Basel III rules and in February 2010 public consultation, which would feed into the development of the most effective variant of this policy meas ure. Prior to making it a binding measure from 
2018, on the basis of the review the Commission se rvices will prepare a report and a proposal 
on the final design and calibrati on of the leverage ratio.  
Comparison of policy options
 
Effectiveness of the current scen ario (option 5.1) depends on the actions taken in  this area by 
national supervisors and/or the industry which is no guarantee that necessary progress would 
be achieved quickly enough and evenly acro ss the EU.  While mo st of alternative 
formulations of the ratio examined under opt ion 5.2 would provide for a certain degree of 
effectiveness as regards contributing to the ach ievement of objectives  S-1 (Enhance adequacy 
of capital and liquidity requirements), S-2 (Enha nce bank risk management), and S-9 (Reduce 
cyclicality of bank lending), they also entail a risk of unintended consequences. Policy option 
5.3 is expected to be more effective and effici ent than option 5.2 due to its more appropriate – 
from a prudential angle - design and calibra tion following the monitoring exercise and, 
therefore, is chosen as a preferred option.  
Table 8:  Summary of policy option e ffectiveness and efficiency 
Policy Option Comparison Criteria 
Effectiveness 
Policy Option Enhance adequacy 
of capital and 
liquidity 
requirements [S-1]  Enhance bank 
risk 
management 
[S-2 ] Reduce 
cyclicality of 
bank lending 
[S-9]  Efficiency 
5.1 Retain current approach 3 3 3 3 
                                                 
78 These cases include application of proposed conversion factors of 100% for unconditionally cancellable off-
balance sheet exposures such as credit cards and of gross nominal values of derivatives without 
allowing for netting under the Basel II framework 
 
 38  Policy Option Comparison Criteria 
Effectiveness 
Policy Option Enhance adequacy 
of capital and 
liquidity 
requirements [S-1]  Enhance bank 
risk 
management 
[S-2 ] Reduce 
cyclicality of 
bank lending 
[S-9]  Efficiency 
5.2 Introduce leverage ratio as specified in the February 2010 public consultation 2 2 2 2 
5.3 Conduct extensive monitoring of leverage ratio 1 1 1 1 
Scale of option ranking: 1=most effective / efficient, 3=least effective / efficient 
Effectiveness measures extent to whic h options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources  
5.5. Capital buffers 
In line with the conclusions of its report on th e effects of the CRD on the economic cycle, the 
Commission services examined a possibility of  policy instruments that would move in a 
counter-cyclical fashion to bank capital levels , i.e., would increase in  economic upturns and 
decrease in downturns.  The key policy options in this area are as follows: 
- Policy option 6.1:  Retain current approach; 
- Policy option 6.2: Introduce a capital buffer to enhance individual banks’ ability to 
absorb losses over prolonged periods of market stress, i.e., capital conservation buffer ; 
- Policy option 6.3:  Introduce a capital buffer to protect banks from periods of risk build-
up at the macro level, i.e., countercyclical capital buffer ; 
- Policy option 6.4:  Introduce a dual capital buffer , comprising both a capital 
conservation buffer and a count ercyclical capital buffer. 
Policy option 6.1: Retain current approach  
Under this policy option the pro-cyclicality woul d be addressed only with the policy measures 
that have been already adopted by the Commission or new measures adopted by MS. 
However, since the pro-cyclicality is driven by a number of drivers, additional measures are 
necessary, in particular, to address market failu res of behavioural nature which contribute to 
building up of systemic risk and weaken financ ial resilience of individual firms in times of 
stress. Moreover, tackling of th e problem of a systemic nature requires certain macro-level 
and / or cross-border arrangements which are feasible only with th e EU level action.  
Policy option 6.2: Capital conservation buffer  
The design of a capital conservation buffer was laid out in the Commission services’ public 
consultation of February 2010. The buffer woul d have a fixed target  over the regulatory 
capital minimum to absorb losses in 'stressed' periods that may span a number of years. Banks 
would be expected to build up such capital  in good economic times. Those banks that fell 
below the target would face constraints on disc retionary distributions of earnings (i.e., 
dividend payments, share buybacks, discreti onary payments on other Tier 1 capital 
instruments and discretionary bonus payments to staff) until conservation capital buffer target 
is reached.79 These rules would be applied at the c onsolidated group level, however, in order 
to conserve resources in specific parts of the group national supervisors would have an option 
to apply the regime at the 'solo' level.  
Such approach would be effective at ensuri ng that the banking sector accumulates capital 
buffers when it has the earnings capacity to  do so. This should e nhance resilience of 
                                                 
79 The further from the target (within the range between th e minimum and the target) the level of capital falls, the 
higher percentage of its earnings in the subsequent year a bank would be required to conserve 
 
 39  individual institutions in periods of stress  by positioning them to absorb related losses. 
However, this approach does not ensure that  retention of capital to cover risks at the 
individual bank level would coincide with the pe riods of excessive credit growth at the macro 
level and a concomitant build-up of systemic ri sks which need to be prevented to protect 
banks (as well as other economic agents) from consequences of ensuing systemic crises.  
Policy option 6.3: Counter cyclical capital buffer  
The design of a countercyclical capital buffer was laid out in the Commission services’ public 
consultations of February 2010 and Octobe r 2010. The buffer would take account of the 
macro-financial environment in which banks operate. National supe rvisors would set the 
buffer for credit exposures in their jurisdic tion. The buffer would be subject to an upper 
bound and would only be imposed when there is ev idence that the excess credit growth results 
in a build-up of the system-wide risk.80 Banks with exclusively domestic credit exposures 
would only be subject to the buffer determined by their national supervisors. In relation to 
exposures located in other MS , banks providing services by m eans of a branch or free 
provision of services would apply the buffer as determined by the host MS supervisors, when 
the buffer is set between 0% and 2.5% of risk weighted assets.81 When the buffer determined 
by host MS exceeds 2.5%, home MS authorities w ould be allowed, but not obliged to apply a 
buffer rate higher than 2.5%.  
Banking groups having subsidiaries in other MS  for the purposes of calculating the buffer on 
the consolidated basis would have to apply the buffer add-ons determined by the competent 
authorities of the subsidiaries. In practice, th is means that cross-border credit institutions 
would have to look at the geographic location of their credit exposures and calculate their 
countercyclical capital buffer according to the buffers prevailing in those MS where their 
exposures are located. For groups, decisions on th e level of the counter-cyclical buffer could 
take place in the context of the joint decision process of Article 129(3) of the CRD whereby 
the consolidating supervisor a nd the other relevant competent authorities would consult each 
other and decide on the applica tion of the buffer at consolidated  level and at th e level of each 
subsidiaries. The consequences of not meeting the countercyclical capi tal buffer would be the 
same as those of not meeting the capital conser vation buffer (i.e., constr aints on discretionary 
distributions of earnings). 
This policy option would be effec tive at ensuring that bank capit al regulation is responsive to 
macro-financial environment and, in turn, would protect the banking sector  from systemic risk 
linked to excessive cred it growth. At the level of individua l institutions, however, it may not 
be entirely effective at ensuring that banks have sufficient capital buffers to absorb losses 
incurred during protracted turbulent periods. 
 
                                                 
80 The size of the buffer would be linked to aggregate priv ate sector credit/GDP gap. When credit/GDP is near or 
below its long-term trend, the buffer would be set to zero and when credit/GDP exceeds its long term 
trend by an amount which suggests there could be excess credit growth, the buffer would be greater than 0. Analysis of the credit/GDP gap showed that it does not always work well in all jurisdictions at 
all times. Thus, rather than relying mechanisti cally on the credit/GDP guide, supervisors would be 
expected to apply judgment in setting of the buffer in their jurisdiction. In this context, ESRB may provide guidelines to national supervisors on how to apply the buffer.  
81 The corresponding treatment applies to exposures located in 3rd countries. In cases where banks have 
exposures to jurisdictions that do not operate and publish buffer decisions, national supervisors would have to set buffers for such exposures. Also, ESRB may issue recommendations on level of buffers set 
at home MS and for 3
rd countries. 
 
 40  Policy option 6.4: D ual capital buffer  
The design of a dual ca pital buffering approach was laid out in the Commission services’ 
public consultations of Februa ry 2010 and October 2010. The appr oach effectively entails a 
combination of policy options 6.2 and 6.3 and is  broadly aligned with the approach of the 
Basel Committee.82 Combining the two buffers means that  application of the countercyclical 
buffer would take effect by adjusting the size of the bu ffer range established by the 
conservation buffer. Other key modalities of operating such a dual capital buffer would remain as presented in discus sion of its individual component s. The key advantage of this 
policy option over the other two a lternatives is that by combining them it addresses their 
respective shortcomings discussed above.  
The calibration of this policy option is presen ted in Table 2 while its impact on the EU 
banking industry is assessed in section 5.8 (cumulatively with new minimum capital 
requirements). Capital buffers are expected to protect banks in the dow nturn period thanks to 
the release of the buffer and limit the risks of negative spill-overs on th e real economy. They 
may, however, entail a risk of negative impact  on credit volume in 'catching up' countries. 
While the financial stability implications of this rapid credit growth  should certainly be 
addressed, a balance must be struck in or der not to unnecessarily slow down the growth 
acceleration.
83  
Comparison of policy options  
As discussed above, policy option 6.1 is largel y ineffective in tack ling relevant problem 
drivers. Policy option 6.2 is more effective than option 6.3 in terms of enhancing banks' 
capacity to absorb losses over protracted periods of 'stress' (objective S-1) but is less effective 
than option 6.3 in terms of operating in a count ercyclical manner, which is a precondition for 
minimizing the cyclicality of bank lending (S-9 ). Policy option 6.4 addresses the above 
concerns by combining the two types of capital buffers into one buffering approach. In terms 
of compliance costs for the banki ng industry, option 6.2 would be the most costly and option 
6.3 would imply the least complia nce costs, as the countercycl ical buffer would be applied 
only in times when credit growth at the aggr egate level becomes excessive, whereas costs 
related to option 6.4 would fall in  between the two extremes. However, when effectiveness of 
policy options is considered simultaneously, opt ion 6.4 is identified as the most efficient 
alternative, and, in turn, as a preferred policy option. 
Table 9:  Summary of policy option e ffectiveness and efficiency 
Policy Option Comparison Criteria 
Effectiveness Policy Option Enhance adequacy of 
capital and liquidity 
requirements [S-1]  Enhance bank risk 
management 
[S-2 ] Reduce cyclicality of 
bank lending 
[S-9]  Efficiency 
6.1 Retain current approach 4 4 4 4 
6.2 Conservation capital buffer 1-2 1-3 3 2-3 
6.3 Countercyclical capital buffer 3 1-3 1-2 2-3 
6.4 Dual capital buffer 1-2 1-3 1-2 1 
Scale of option ranking: 1=most effective / efficient, 4=least effective / efficient 
Effectiveness measures extent to whic h options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources 
                                                 
82 Proposals foresee the EU-specific in volvement of ESRB to fost er macro-prudential supe rvision and integration 
of 'capital conservation plans' whereby banks that operate in the buffer zone would have to present such plans to their supervisor for approval of capital conservation measures. 
83 This is addressed by allowing for supervisory judgement  on the buffer level and on the timing of its activation 
 
 41  5.6. Single rule book in banking 
The options regarding the deletion of option and national discretions will be referred to in the 
rest of the analysis as follows: 
- Policy option 7.1:  Retain current approach; 
- Policy option 7.2: Minimum harmonization  of national supervisory approaches; 
- Policy option 7.3:  Maximum  harmonization  of national supervisory approaches; 
- Policy option 7.4: Maximum harmonisation of national supervisory approaches with 
some exceptions .  
Policy option 7.1: Retain current approach  
Under this option, national options and discretions  will be kept in the CRD together with a 
'minimum harmonisation' approach allowing MS to  lay down stricter prude ntial rules, leaving 
the problems outlined in section 3.6 unaddressed.  
Policy option 7.2: Minimum harmonization  
Under this approach, options and discretions would be removed, but th e CRD would be kept 
as a minimum harmonisation directive. The rem oval of other options and discretions would 
take place in the framework of the existin g CRD rules via mutual recognition, deletion, 
granting choice to institutions and making an option a general ru le. Supervisors would still be 
able to require compliance with  stricter rules, because of the possibility of gold-plating. 
Because of gold-plating, the option might be part ially effective with re spect to objectives of 
enhancing supervisory cooperation and level playi ng field, as certain degree of differences in 
national supervisory approaches would be preserved. 
The option should not represent a significant incremental change to capital requirements and 
in the long run may result in compliance cost sa vings, particularly for institutions with cross-
border activities.84 In the short term, the removal of options and discretions would imply 
increase in compliance costs with a new set of rules, however.85  
Policy option 7.3: Maximum harmonization  
The deletion of national options needs to be coupled with a maximum harmonisation 
approach to fully deliver on the objectives of  reducing compliance burden, enhancing level 
playing field, legal clarity and supervisory c onvergence. This option would also maximize the 
role of EBA in ensuring a cons istent set of harmonised rules.86 The scope of 'maximum 
harmonisation' would be limited to Pillar 1 (minimum capital requirements, large exposures 
rules, liquidity, own funds) and Pillar 3 (disclosur e) provisions of the CRD. Other areas of the 
directive do not lend themselves to maximum harmonisation because of specific risk assessments (e.g., Pillar 2) or th e absence of full harmonisation.  
                                                
 
84 Based on the exercise to measure th e baseline administrative costs and burden of the EU legislation, which 
included the CRD and was conducted in 2008, total annual administrative costs related to the CRD are 
roughly €851 million with the ensuing administrative burden of €333 million. See EU Project on 
Baseline Measurement and Reduction of Administrative Costs , Report on the Financial Services Priority 
Area, March 2009 
85 This holds true in particular in relation to banks su bject to the IRB approach, wh ere internal systems would 
have to be slightly changed 
86 As a result, EBA will be expected to develop some 50+  technical standards in various policy areas which will 
have an impact on its human resources requirements and related costs. 
 
 42  Downside to this approach is that maximu m harmonisation may limit the ability of MS to 
require stricter rules on the financial stabil ity grounds. This shortcoming should not be over-
estimated given that supervisors may resort to  Pillar 2 to tailor capital requirements to the 
risks to which a bank is exposed. In addition, to this end Basel III provides for a macro-
prudential capital buffer, discussed under se ction 5.5, whereby, if necessary, national 
supervisors would be able to set a countercyclical buffer level in excess of 2.5%.87 
Importantly, by ensuring that firms follow th e same rules in all EU markets, maximum 
harmonisation is intended to boos t confidence in the stability of  credit institution across the 
EU, especially in time of stress, and thus enhance the financial stability.  
It should also be noted that  under options 7.1 and 7.2 the appl ication at national level of 
stricter rules for reasons of the financial stab ility would only be applicable to domestic banks 
and subsidiaries of foreign banks in that country. Such regulatory changes would create 
regulatory arbitrage opportunities for branches  in those MS, partly  invalidating macro-
prudential policy actions. Under this option, a regulation would enable the Commission to 
adopt temporary increases in minimum standa rds, preventing regulatory arbitrage and 
contributing to the effectiveness of macro-prudential policy actions. 
Nevertheless, there are circumstances where gold-plating is rooted in market / product 
specificities or the le gal framework of a MS.88 Thus, consideration of some flexibility to the 
maximum harmonisation approach seems to be warranted. 
Policy option 7.4: Maximum harmonization with some exceptions  
Under this option, the single rule book would provi de for some flexibility to resort to gold-
plating in areas rooted in mark et/local product specificities or  the legal framework of MS.  
Analysis of CEBS' advice and discussions with  stakeholders suggest that areas for the 
application of stricter rules ma y include the preferen tial treatment of r eal estate exposures, 
lending in foreign currency and 'high risk items' identified by EBA guidelines. In addition, in 
order to enhance national and EU  financial stability, this polic y option foresees  a possibility 
for MS to 'gold-plate' the ne w minimum requirements that woul d otherwise be phased in from 
2013 to 2019 as outlined in Table 3. This means th at MS would be allowed to apply in 2013 
the level of capital required by Basel III in 2019. 
This approach would be similar to the one adopt ed in other legislative texts (e.g., the MiFID), 
which provide for a full harmonisation while a llowing MS to adopt stricter rules in well 
identified areas of the text.  
Comparison of policy options  
Retaining the current scenario (policy option 7.1)  implies that the relevant problems are not 
addressed and effectiveness of EBA is comp romised. Maximum harmonization (policy option 
7.3) is more effective than minimum harm onization (policy opt ion 7.2) and maximum 
harmonisation with some exceptions (policy option 7.4) with respect to a ttaining objectives of 
                                                 
87 Such level should apply only to institutions that are in corporated in their jurisdictions. The buffer should be 
capped at 2.5% for the purposes of calculating the institution specific countercyclical capital buffer of 
all other institutions that have credit exposures in the jurisdiction in question. 
88 During the public consultations, some supervisors stressed the need of being able to apply stricter quantitative 
limits (e.g., lower LTV ratios for a preferential treatme nt of real estate) given the specificities of their 
local market 
 
 43  enhancing supervisory cooperation and convergen ce (S-7), enhancing legal clarity (S-4) and 
enhancing level playing field (S-6 ) as it contains both the dele tion of national options and the 
removal of the possibility to supplement the CRD provisions with nati onal legislation. Option 
7.3 is perceived to be less effective than opt ion 7.4 in terms of achieving the objective of 
enhancing financial stability in national MS as it does not cater for specificities of local markets (G-1). In this regard, option 7.4 en tails a harmonised and transparent regulatory 
framework that is intended to enhance the fina ncial stability together with a possibility of 
applying stricter rules in certain cases. From the efficiency angle, option 7.3 appears to be the 
most efficient for banking groups with cross-bord er operations (due to the greater expected 
savings of administrative costs), whereas for banks with domestic operations, options 7.2 and 
7.4 may be more efficient (lower costs due to fewer changes in na tional rules as a result of to 
their harmonisation at the EU level).  
In summary, policy option 7.4 (Maximum harmoni zation with some exceptions) is identified 
as a preferred option, as it entails  the most balanced trade-off between expected effectiveness 
in terms of contributing towards relevant policy objectives, includ ing the objective of 
financial stability, and the net administrative co st implications for the EU banking industry.  
Table 10:  Summary of policy option e ffectiveness and efficiency 
Policy Option Comparison Criteria 
Effectiveness 
Policy 
Option Prevent 
regulatory 
arbitrage 
opportunities 
[S-3]  Enhance legal 
clarity [S-4]  Reduce 
compliance 
burden 
 [S-5]  Enhance 
level playing 
field [S-6]  Enhance 
supervisory 
cooperation 
and 
convergence 
[S-7]  Enhance 
financial 
stability   
[G-1]  Efficien
cy 
7.1 Retain current 
approach 4 4 4 4 4 2-4 4 
7.2 Minimum harmonisation  3 3 1-3 3 3 2-4 1-3 
7.3 Maximum harmonisation  1-2 1 1-3 1 1 2-4 1-3 
7.4 Maximum 
harmonisation 
with some exceptions 1-2 2 1-3 2 2 1 1-3 
Scale of option ranking: 1=most effective / efficient, 4=least effective / efficient 
Effectiveness measures extent to whic h options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources  
5.7. Choice of policy instrument 
This section discusses the options as regards the most appropriate way of implementing the 
preferred policy choices discussed in sectio ns 5.1-5.6. The key altern atives that were 
considered are as follows: 
- Policy option 8.1:  Amend the CRD  to integrate the proposed provisions; 
- Policy option 8.2: Limit the scope of the CRD  to authorization and arrangements for 
ongoing supervision and propose a regulation  on prudential requirements for credit 
institutions. 
Policy option 8.1: Amend the CRD  
The policy options retained in the sections  above could be implemented by amending the 
CRD. This would maintain coherence of rule s in the three areas of authorisation, ongoing 
supervision, and prudential requi rements in one single text. This  option would le ave MS with 
a certain degree of flexibility to maintain divergen t rules at the stage of their transposition into 
 
 44  national law. It would give MS the option of imposing stricter rules on matters which are not 
fully harmonised under the preferred policy opt ion 7.4 (Maximum harmonisation with some 
exceptions). Finally, MS could continue to in tegrate the rules into national legal texts. 
Policy option 8.2: Limit the scope of the CRD and propose a regulation  
The policy options retained in the sections a bove could also be implemented by two separate 
instruments: an amendment of the CRD concer ning authorisation of cr edit institutions and 
arrangements for their supervision, and a new regulation on prudential requirements. 
Separating prudential requirement s from the other two areas w ould reflect differences in 
subject-matter, nature and addressees. Prudential requirements establish criteria for the evaluation of the risk linked to certain banking activities a nd 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.  
Shaping prudential requirements in the form  of a regulation woul d ensure that those 
requirements, which already today are worded as  obligations for credit institutions ("credit 
institutions shall…"), will in fact be directly  applicable to them. This would prevent the 
transposition from producing diverging nation al requirements. At the same time, this 
instrument could cater for the flexibility needed under option 7.4 (M aximum harmonisation 
with some exceptions) as rules on authorisation and ongoing superv ision would continue to be 
in the form of a directive. As regards prudential requirements, if in some limited areas flexibility would be needed for MS to lay down stricter rules, this could be accommodated by 
an appropriate wording in the regulation.  
A regulation would clearly demons trate that credit institutions fo llow the same rules in all EU 
markets, which should boost confidence in the st ability of credit inst itutions across the EU, 
especially in times of stress. Being direct ly applicable across the EU, it would reduce 
regulatory complexity and firms' compliance cost s, especially for credit institutions operating 
on a cross-border basis, and w ould contribute to the elimina tion of regulatory arbitrage 
opportunities. 
Comparison of policy options
 
Policy option 8.2 (Limit the scope of the CRD and propose a regu lation) is more effective 
than option 8.1 (Amend the CRD to integrat e the proposed provisions) with regard to 
contributing to the achievement of objectives  of preventing regulatory arbitrage opportunities 
(S-3), enhancing legal clarity (S-4), reducing compliance burden (S-5),  enhancing supervisory 
convergence (S-7), enhancing financial stabil ity (G-1) and safeguard ing depositor interests 
(G-2), as outlined above. It also entails a more efficient alternative since a regulation on 
prudential requirements would enable the EU to implement any changes faster, as they would 
not require transposition by national legislators.89 On this basis, option 8.2 is identified as a 
preferred policy option. 
  
                                                
 
89 This would enable the EU to meet internationally ag reed deadlines for implementation and to react quicker 
when market developments require changes to the rules  
 
 45  Table 11:  Summary of policy option e ffectiveness and efficiency 
Policy Option Comparison Criteria 
Effectiveness 
Policy 
Option Prevent 
regulatory 
arbitrage 
opportunities 
[S-3] Enhance legal 
clarity [S-4]  Reduce 
compliance 
burden 
 [S-5]  Enhance 
supervisory 
cooperation 
and 
convergence 
[S-7]  Enhance 
financial 
stability [G-
1] Enhance 
safeguardin
g of 
depositor 
interests [G-
2] Efficien
cy 
8.1 : Amend the 
CRD 2 2 2 2 2 2 1 
8.2 Limit scope of the CRD and 
propose a 
regulation 1 1 1 1 1 1 1 
Scale of option ranking: 1=most effective / efficient, 2=least effective / efficient Effectiveness measures extent to whic h options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources 
5.8. Cumulative impact of the package 
This section discusses the cumulative impact of  preferred options with in individual areas as 
presented in the preceding sub-sections. It look s at the cumulative impact of proposals in 
terms of additional capital that EU banking indust ry needs to raise in order to meet the new 
minimum capital requirements. Next, impact of  the proposal on costs related to information 
provision to supervisors and thir d parties is discussed. Finally, impacts of tighter capital and 
liquidity requirements on the EU economy in the transitional period an d in the long-term are 
assessed. 
5.8.1.  Package of preferred options and relevant transitional provisions 
The following table summarizes the twenty seven policy options analyse d. Individual options 
within each policy set are ranked in terms of their relative effectiveness90 and efficiency91 
with regard to achieving appli cable longer term policy (specifi c) objectives. Preferred options, 
where identified in the impact assessment, are highlighted.  
Table 12:  Summary of policy option e ffectiveness and efficiency 
Policy Option Comparison Criteria 
Effectiveness 
Policy 
Option  
Set Policy 
Options 
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  
Effici
ency 
1.1 Retain current approach 3 3        3 
1.2 Introduce LCR as specified in Feb 2010 PC 2 2        1 Liquidity 
Coverage ratio 1.3 Introduce LCR adopted by Basel 
Committee subject to observation period 1 1        2 
2.1 Retain current approach 3 3        3 
2.2 Introduce NSFR as specified in Feb 2010 PC 2 2        2 
Net Stable 
Funding ratio 
2.3 Introduce NSFR adopted by Basel 
Committee 1 1        1 
3.1 Retain current approach 5 5 5   5  5 5 5 
3.2 Modify only the eligibility criteria as 
specified in Feb 2010 PC 4 4 4   4  4 4 4 Eligibility of 
capital 
instruments and 
application of 
regulatory 
adjustments 3.3 Modify eligibility criteria and regulatory 
adjustments as specifi ed in Feb 2010 PC 1-3 1-3 1-3   2-3  1 1-3 3 
                                                 
90 Measures extent to which options achieve relevant objectives 
91 Measures extent to which objectives can be achieved for a given level of resources   
 
 46  Policy Option Comparison Criteria 
Effectiveness 
Policy 
Option  
Set Policy 
Options 
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  
Effici
ency 
3.4 Modify eligibility criteria and regulatory 
adjustments based on Basel approach 1-3 1-3 1-3   2-3  2-3 1-3 2 
3.5 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 
4.1 Retain current approach 3 3      3 3 3 
4.2 Enhance CCR requirement  2 2      2 2 2 Counterparty 
credit risk 4.3 Enhance CCR requirements and 
differentiate treatment of exposures to CCPs 1 1      1 1 1 
5.1 Retain current approach 3 3       3 3 
5.2 Introduce leverage rati o as specified in Feb 
2010 PC 2 2       2 2 Leverage ratio 
5.3 Conduct extensive monitoring of leverage 
ratio 1 1       1 1 
6.1 Retain current approach 4 4       4 4 
6.2 Conservation capital buffer 1-2 1-3       3 2-3 
6.3 Countercyclical capital buffer 3 1-3       1-2 2-3 Capital buffers 
6.4 Dual capital buffer 1-2 1-3       1-2 1 
7.1 Retain current approach   4 4 4 4 4   4 
7.2 Minimum harmonization   3 3 1-3 3 3   1-3 
7.3 Maximum harmonization   1-2 1 1-3 1 1   1-3 Single rule book 
7.4 Maximum harmonization with some 
exceptions   1-2 2 1-3 2 2   1-3 
8.1 Amend the CRD   2 2 2  2   2 
Choice of policy 
instrument 8.2 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 
The proposed calibration, including phase-in a nd grandfathering arrangem ents, of the package 
is aligned with the Basel III rules text and is shown in Tables 2 and 3 above.92 To set the new 
level of minimum capital requirement and capital buffers, the Basel Committee conducted a number of supporting analyses.
93 In terms of the new minimu m going-concern capital, it 
found that, for instance, the median of the 99th percentile distributions  of historical annual 
risk-weighted returns across six jurisdictions of the Committee is about -5%.94 With some 
adjustments for the impact that Basel III is ex pected to have on RWAs  and eligible capital, 
this served as a basis for the new leve l of CET1 and T1 capital requirements. 
As regards calibration of capital buffers, cumulati ve net income of 73 banks from 14 countries 
over the financial crisis period (from Q3 2007 to Q4 2009) as a share of year-end 2006 RWAs 
was analysed. This analysis showed that mean losses95 of banks with negative cumulative net 
income over this period equalled 5% of RW As. During major crises, when access to capital 
                                                 
92 It needs to be noted that Switzerland has announced its intention to proceed with more stringent requirements 
than agreed by the Basel Committee. However this pertains to requirements for its two systemically important financial institutions. Similarly, the Independent Commission on Banking of the UK in its 
interim report of April 2011 suggested that large UK retail banking operations hold equity capital of 
10% of their RWAs and that such capitalization should become the international standard for systemically important financial institutions. However, the prudential requirements for such institutions 
at both the international and the EU level have not been finalised.  
93 See http://www.bis.org/publ/bcbs180.pdf   
94 Risk-weighted return measured by RORWA and cal culated as the ratio of net income to RWAs 
95 When measured with pre-tax,  pre-distribution net income 
 
 47  markets is limited, cumulative losses of such extent can be absorbed only by those banks that 
have adequate capital buffers, accumulated during more favourable economic conditions.  
The rationale for the proposed transitional provis ions as well as impacts on the industry, other 
economic agents and financial stability are discussed in the remainder of section 5.8. 
5.8.2.  Cumulative impact on the industry 
When estimating capital shortfall due to th e CRD IV package, the impact of new CET1 
minimum requirement and capital buffers is assessed together. Table 13 shows estimated 
impact on capital ratios separately for Group 1 and Group 2 banks afte r application of the 
CRD III and IV proposals, assuming a full implementation of both proposals as of December 2009.  
Table 13 : Capital ratios for Group 1 and Group 2 banks, in %:  
Gross 1New 2O l dN e wO l dN e w
Group 1 10,7 4,9 10,3 5,6 14,0 8,1
Group 2 11,1 7,1 10,3 7,6 13,1 10,3CET1 T1 TotalGroup
 
Notes : 1 'Gross' is the ratio of new gross CET1 (without deductions) relative to old 
RWA. 2 New CET1 shows net CET1 (with dedu ctions) relative to new RWA. 'New' 
ratios do not reflect the effect of transitional and grandfathering provisions which will 
mitigate the effective impact on banks' capital ratios in the period up to 2023 
Source : CEBS  
In terms of impact on the CET1 ratio, large EU banks (average CET1 ratio of 4.9%) are 
affected more than a sample of 74 large international banks from eighteen Basel Committee countries whose average CET1 ratio as of  December 2009 stood at 5.7% upon application of 
equivalent rules.  
Changes in capital ratios are driven by the cha nges in capital definition rules and RWAs. The 
preferred policy options outlined in this report are expected to increase the RWAs of Group 1 
banks on average by 24.5%, and the RWAs of Group 2 banks – by a modest 4.1%. The extent 
of capital shortfalls that the EU banking indus try would face due to the proposals is estimated 
in the range of €370 billion as of December 200 9, at CET1 of 7% (consisting of a minimum 
requirement of 4.5% and capital conservation buffer of 2.5%).
96 Under the proposal, the 
existing public sector injections estimated at some €90 billion would be grandfathered until 1 
January 2018.97 In the long run they would add to the CET1 capital shortfall, raising it to 
some €460 billion or 2.9% of the EU banking sector's RWAs.98 However, the estimate should 
be viewed as the high end of the capital shortfall because: 
- it is based on bank capitalisation levels as of December 2009 which most likely will have 
increased in response to supervisory and market pressure even if the CRD were not amended,  
- estimates do not incorporate the impact of pha sing-in and grandfathering  provisions that will 
spread the impact for most banks during im plementation period. More specifically, capital 
shortfall that the EU banking industry would face at CET1 of 3.5%, effective from 2013, is 
                                                 
96 Of this figure, some €37 billion is attributable to the CRD III proposal (in terms of Tier 1 capital, as definition 
of CET1 did not exist prior to CRD IV proposal) 
97 The figures on state aids were not available for all participating MS  
98 Expected shortfall shall not be confused with related cost  of capital. On the implications of the proposal on the 
expected cost of equity please see section5.8.5. 
 
 48  immaterial, whereas capital shortf all at CET1 of 4.5%, effective from 2015, is estimated at 
€84 billion99, 
- it does not capture the inte raction between liqui dity and capital pr oposals (i.e., larger 
proportion of liquid assets that banks will hold in order to comply with LCR will reduce the 
amount of their RWAs relative  to total assets), and  
- only the minimum capital requirement is a critical requirement whose breaching would 
trigger supervisory intervention, whereas cons equences of falling behind the capital buffer 
target are confined to banks' curtailing th eir discretionary distributions of earnings.100  
The industry is not expected to raise the entire  shortfall amount in the capital markets. For 
instance, combined net profit of some 100 biggest EU banks in 2009 was around €33 billion 
and bank profits are likely to rise as ec onomic situation improve s and provisions for non-
performing loans decline.101  
As regards the impact of new liquidity requireme nts, the implications of LCR are discussed in 
section 5.1.1., while those of NSFR - in secti on 5.1.2. It should be noted that the estimated 
shortfalls to comply with LCR and NSFR ar e not additive since depending on the actions 
taken to minimize them, decreasing the shortfal l in one standard may result in a decrease in 
the shortfall of the other.  
5.8.3.  Administrative costs 
Implementation of legislation entails costs for businesses. Costs that are linked to providing 
information either to public or private partie s are called administrative costs. The share of 
these costs that is specifically linked to in formation that businesses would not collect and 
provide in the absence of a legal obligation is called administrative burdens. The 
Commission's Better Regulation strategy is aime d at measuring administrative costs and 
reducing administrative burdens. In the area  of prudential banking  regulation, certain 
information requirements are necessary to provid e for the desired level of financial stability 
and creditor protection and, hen ce, should be set at a level that ensures an equilibrium 
between ensuing administrative burdens and the be nefits that they yield. With regard to the 
legislative changes brought forward with this in itiative, it has to be noted that they were 
undertaken with a view to achieving multiple op erational, specific and general objectives (see 
section 4 of the impact assessment) and had to be designed accordingly.  
In August-September 2010, the Commission services  distributed a questi onnaire to the GEBI 
members about the impacts of CRD IV proposal  on administrative burdens (see Annex VIII). 
Analysis of replies showed that, overall, the biggest impacts on both the on-going burdens and the related one-off implementation costs are e xpected due to new measures in the area 
liquidity risk management, co mprising roughly 70% of all ad ministrative burdens. Proposals 
for the counterparty credit risk were also identi fied as a source of significant administrative 
burdens for Group 1 banks. As regards proposal for the 'single rule book', the number and, 
particularly, the diversity of re plies received were insufficient to assess its varying impact by 
                                                
 
99 This estimate assumes full deductions, i.e., does not acc ount for phase-in arrangements for deductions (40% in 
2015) 
100 Counter-cyclical capital buffer is not considered in the above calculation as it would only be in effect when 
there is an excess credit growth that is resulting in a system wide build-up of risk, but would stay at zero at all other times 
101 Source: Bloomberg, Orbis, Commission services' calculation 
 
 49  MS (which depends on the degree to which opti ons and discretions are exercised) and bank 
type. In this regard, banks w ith 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.  
5.8.4.  Economic impact in transitional period 
A key factor determining banks' re sponses to new capital and liquidity standards is the length 
of the period during which the new requirements will be phased in. If the transition period is short, banks may choose to curtail credit supply or adjust capital compos ition in order to lift 
capital ratios. A longer transition period coul d substantially mitigate the impact, allowing 
banks to retain more of their profits (by reducing dividend pa yments or improving operational 
efficiency), issue new equity, reduce fixed cost s or take other necessa ry steps to adjust.  
To inform the policy question of appropriate transitional provisions, the Basel Committee and 
the FSB set up a Macroeconomic Assessm ent Group (MAG) whose members were 
macroeconomists and econometricians from central banks, regulatory agencies and 
international institutions. For the full analys is of MAG please see its Interim and Final 
Reports that were published  in August and December 2010.
102 When applying MAG's key 
findings in the EU context, it is important to note that its work was based on a high number of 
macroeconomic models developed and used for policy analysis in central banks and 
international organisations, with  a high representation of models  pertaining to MS or broader 
regions of the EU. The group's Interim Report was based on the results of 89 individual macroeconomic models, of which 51 models relate to the EU
103, whereas its Final Report 
used 97 modelling simulations, of which 49 relate to the EU.104  
MAG modelled implementation scenarios of 2, 4, 6, and 8 years. The key findings as regards 
transitional periods of 4 and 8 years - as they  were given more cons ideration in Basel III 
deliberation process - are compared in Table 14. The table also shows the outcomes of the 
macroeconomic modelling conducted by ECB and the Commission (for more details on the 
Commission model please see Annex IX).105 Overall, it shows that shorter implementation 
scenarios have a greater impact  on annual GDP growth rates since the projected decline in the 
level of GDP relative to baseline would take place over a shorter time. This implies sharper 
adjustment costs for the industry and the m acro-economy. A longer imp lementation period 
shall minimize any potential transitory effects on GDP and credit availabili ty. This is in part 
because the maximum GDP loss is estimated to occur around the end of the transition period, which could be at a more mature and re silient stage of the current recovery.  
 
   
                                                
 
102 See http://www.bis.org/publ/othp10.htm , http://www.bis.org/publ/othp12.pdf   
103 Of them, 6 models relating the euro area, 9 to FR, 7 to DE, 8 to IT, NL and ES each, and 5 to the UK. 
104 Of them, 20 models relating the euro area, 7 to NL an d IT each, 5 to the UK, 4 to FR and 3 to DE and ES 
each. 
105 For a comparison of various public and private sector quantitative models, please see Annex X 
 
 50   
Table 14 : Overview of the implementation period scenarios for new capital standards 
Timing of 
estimated decline 
in GDP since start of implementation Decline in GDP 
below baseline per 
percentage point 
increase in capital 
requirement, % Estimated decline 
in the EU GDP 
below baseline due 
to capital shortfall, 
% Estimated annual 
decline in the EU 
GDP growth below 
baseline, % Implemen
tation 
period Result / Model Source 
A B C=B*2.9 D=(1+C)^(1/(A/4))-1 
Median of 89 
models MAG 18 quarters 0.19 0.55 0.10 
Median of 16 
models with impact 
on lending standards MAG 18 quarters 0.32 0.93 0.16 
Median of 11 
models with impact 
on lending standards 
and endogenous 
monetary policy MAG 18 quarters 0.17 0.49 0.09 
Multi country model 
(with impact on 
lending standards) ECB 18 quarters 0.19 0.55 0.10 
Christiano-Motto-
Rostagno model ECB 18 quarters 0.29 0.84 0.15 Four years 
      
Median of 97 
models MAG 35 quarters  0.17 0.49 0.05 
Median of 12 
models with impact 
on lending standards MAG 35 quarters  0.23 0.67 0.06 
Median of 14 
models with impact 
on lending standards 
and endogenous 
monetary policy MAG 35 quarters  0.16 0.46 0.04 
Multi country model 
(with impact on 
lending standards) ECB 35 quarters 0.08 0.25 0.03 
Christiano-Motto-
Rostagno model ECB 35 quarters 0.39 1.12 0.09 Eight 
years 
DSGE bank-
augmented model European 
Commission 36 quarters 0.14 0.42 0.04 
Sources : Basel Committee, ECB, European Commission  
Lengthening of the implementation period would also give banks more time to adjust their 
business models and cost structures, reduce the severity of the impact of lending cuts on bank-
dependent sectors, allo w more time for stable non-bank cha nnels of credit intermediation to 
develop, and give markets more time to absorb th e asset sales, debt issu es and equity issues 
that might accompany banks' balance sheet adjustments. Hence, the transitional phase-in and grandfathering provisions for the capital requirements agreed by the Basel Committee and outlined in Table 3 are likely to accommodate the above adjustment processes the most as 
they effectively imply an eight-year  transition period from 2011 to 2018.  
As regards the optimum implementation timing fo r the new liquidity requ irements, given their 
novelty and the related possibility of unintende d consequences on financial institutions of 
different sizes and business lines, observation  periods coupled with  review clauses are 
justified. LCR, including any revisions will be introduced on 1 January 2015, while NSFR, 
with appropriate revisions, will move to the minimum standard on 1 January 2018.
106  
In summary, work of the Basel Committ ee's MAG, ECB and the Commission on the 
assessment of macroecono mic costs show that the transition to  stronger capita l and liquidity 
standards is likely to have a  limited impact on the aggregate output .  
                                                 
106 The increased holding of liquid assets due to LCR is expected to reduce the EU GDP by 0.11% below the 
baseline after four and a half years from the st art of implementation (Sources: the Basel Committee 
(MAG), EU QIS, Commissi on services' calculations) 
 
 51  5.8.5.  Long-term economic impact 
It shall be emphasised that the above analyses measured only transitional costs without 
considering benefits from enhanced financial stability and mitigated pro-cyclicality which 
would start to accrue immediately, and which ha ve been assessed by the Basel Committee in a 
separate analysis of the l ong-term economic impact (LEI).107 By examining the historical data 
and a number of studies on the economic costs of systemic crises, it concluded that there are 
clear net long term economic benefits from increasing the minimum capital and liquidity 
requirements from their current levels . LEI analysis implies annual net benefits of increase in 
the EU GDP in the range of 0.3%-2% which stem  from a reduction in the expected frequency 
of systemic banking crises108 and are optimized when CET1 cap ital is calibrated in the range 
of 6% to 9%. It needs to be  noted that the approach adopt ed by the Committee was rather 
conservative and that actual net economic bene fits can be expected to be higher. The 
quantification of benefits did not include those stemming from a reduced severity of future 
crises and reduced pro-cyclicality in the system . On the cost side assumptions were equally 
conservative, including a full pass through of  costs to customers via lending rates, no 
reduction in cost of debt and equity (with an ROE assumption base d on a high historical 
average). According to the Modigliani-Miller (MM) propositions109, however, increases in 
banks' capital levels as a result  of Basel III shall reduce their leverage and, by making returns 
to their investors less volatile, the cost of equity. In this respect, macro-economic modelling 
of the Commission services showed that wh en the MM propositions are assumed to hold at 
least partially (50%), economic costs of the new rules in term s of their impact on the GDP are 
reduced in half by 2020-2030 (see Annex IX).110 The cost of debt may go down as well 
because of better cap italization levels. 
In addition to the benefits from reducing output  losses associated with reduced frequency of 
banking crises, higher capital and liquidity requirements may al so reduce the amplitude of 
normal business cycles. When considering a po ssibility of introduci ng a counter-cyclical 
capital buffer, which causes the capital requirement to increase in step with the credit-to-GDP 
ratio111, LEI analysis showed that the volatility of output would be reduced substantially, with 
the standard deviation d eclining by almost one fifth with re spect to a baseline in which no 
countercyclical capital ru les are implemented.  
Another model developed jointly by th e Commission services and academics112 looked at the 
long term macro-economic impact of Basel I II in seven MS. Regarding the effects on the 
probability of a systemic banking crisis, the re search finds that its reduction depends on how 
much banks will recapitalize unde r Basel III. Results show th at when banks recapitalize to 
10.5%113 level, the probability of a systemic banking crisis is reduced within the range of 29% 
                                                 
107 See http://www.bis.org/publ/bcbs173.htm   
108 Based on LEI analysis, the Commissi on services estimate that complying with the LCR requirement and the 
new capital requirements can be expected to reduce the probability of a systemic crisis by some 70% 
109 Modigliani, F., and M. Miller, The cost of capital, corporation finance and the theory of investment , The 
American Economic Review, 48, 1958 
 Miller M., Do the M&M propositions apply to banks? , Journal of Banking & Finance, 19, 1995 
110 When MM propositions are assumed to hold entirely (i.e., 100%), the scenario of regulatory change in terms 
of economic costs (measured as impact on the GDP) by 2020-2030 does not differ from the baseline 
scenario.  
111 Based on the simulations that increase the capital requ irement in the neighbourhood of ±2 percentage points 
around the steady state 
112 Marchesi M., S. Zedda, F. Campolongo, R. De Lisa, J. Cariboni, M. Petracco Giudici, Basel III: a macro-
economic cost-benefit analysis , 2010, JRC EUR Report 61485, EUR 24603 EN (mimeo, forthcoming) 
113 Consisting of total capital requirement of 8% and conservation buffer of 2.5% 
 
 52  to 89%. The analysis found substantial net econ omic benefits of the new framework for two 
MS and a more neutral net economic effect in the remaining five MS analysed. 
5.9. Impacts on SMEs 
A recent study114 launched by the Commission found that bank credit constitutes the most 
significant external source of SM E financing. In this respect, the study found that there is a 
significant positive effect of the business cycle on  bank loans to medium-sized firms, with the 
effect on small firms also significant but smaller.  This effect might be  explained by a number 
of regulatory and market fa ilures, including the problem of asymmetric information.115 When 
economic conditions become depressed and collateral values decline, information 
asymmetries with respect to the quality of cl ients’ balance sheets make obtaining the bank 
credit difficult even for clients with profita ble projects. When economic conditions improve 
and collateral values rise, the opposite situation tends to occur. In this regard, lending to 
SMEs is affected more than lending to large co mpanies as SMEs are not subject to external 
ratings and extensive disclosure requirements. 
Therefore, SMEs, to the extent that they are credit rationed by banks, ar e expected to be the 
primary beneficiaries of smoothened pro- cyclicality brought a bout by the enhanced 
countercyclical properties of the EU bank ca pital regulation, including capital buffers, 
improved adequacy and quality of regulatory cap ital and the leverage ratio. These changes 
will allow SMEs to engage in projects that are profitable and vital for the economic growth 
and prosperity not only during an  expansionary leg of the cycl e, but, more importantly, when 
the economic climate turns sour.  As importantl y, the proposals will benefit SMEs and their 
workforce further by smoothening th e cyclicality of demand for the products and services that 
they generate, given that SMEs contribute some  60% of the total valu e added of the EU's non-
financial business economy.116   
According to the Commission macroeconomic  model, compliance with the new capital 
framework is expected to reduce the stock of  loans on average by 1.8% and increase loan 
rates on average by some 29 basis points by 2020-2030.117 However, it needs to be stressed 
that costs of a comparable extent most likely would arise even in the absence of a regulatory reform, due to the market pressure and expectatio ns with respect to enha nced post-crisis bank 
capital levels and liquidity management.  
                                                
 
114 EIM, Cyclicality of SME Finance , March 2009 
115 The drivers behind such cyclicality are outlined in section 3.5 
116 Eurostat, European business facts and figures , 2009 
117 Specification of the Commission's QUEST model and more detailed presentation of modelling of the Basel 
III impacts on the EU economy are provided in Annex IX. It needs to be noted that modelling outputs in 
Annex IX are expressed as a change in a variable for 2.5 percentage point increase in Tier 1 capital 
ratio. For this reason, estimates have to be rescaled to  assess the impact of a shortfall of CET1 capital of 
2.9% of risk-weighted assets. In this calculation, it was assumed that capital shortfalls expressed as 
percentage points of Tier 1 and CET1 capital are comparable, given that CET1 is part of Tier 1. Hence, impact of the proposal on loan rates is derived as follows: 0.25 (average increase in loan rate by 2020-
2030, 0% MM offset, expressed in percentage points) / 2.5 (increase in Tier 1 ratio, expressed in 
percentage points) x 2.9 (regulatory capital shortfa ll in percentage points expressed as CET1 capital 
over risk weighted assets) = 0.29 percentage points. Using the same rationale, impact of the proposal on 
the stock of loans is derived as follows: -1.51 (average decrease in stock of loans by 2020-2030, 0% 
MM offset, expressed in %) / 2.5 (increase in Tier 1 ratio, expressed in percentage points) x 2.9 (regulatory capital shortfall in percentage points expressed as CET1 capital over risk weighted assets) = 
-1.8%.  
 
 53  While the proposals are expected to lead to a higher cost of bank credit – which is 
compensated by social benefits - across the entire spectrum of bank customers, SMEs are 
expected to be impacted less th an their large counter parts. Even though th e start of Basel III 
transitional period has been set for 2013, most banks have embarked on a de facto transition 
to complying with the new rules following the publication of the framework in late 2010 and 
early evidence (Q4 2010 and Q1 2011) on the impact of costs related to bank capital and 
liquidity position on credit standards for loans a nd credit lines shows that more euro area 
banks tightened their credit standards for large enterprises than for SMEs.118  
SMEs are expected to be affected less severely al so to the extent that they transact more with 
smaller (or Group 2) banks119, whose capital and liquidity shortf alls have been estimated to be 
smaller than those of the largest EU (or Group 1)  banks (see Table 15). In a similar vein, it is 
expected that the proposals, by accommodating certain specificities of the EU cooperative, 
mutual and similar banks (e.g., see policy options 1.3 and 3.5), will reduce the compliance costs for these institutions and in turn result in  smaller indirect costs to their customers, 
including SMEs.  
Table 15 : Overview of impacts of va rious proposals by bank group 
EU averages Policy area / proposed measure(s) Group 1 banks Group 2 banks 
Liquidity risk 1:    
Liquidity Coverage Ratio, % 66.5 87.1 
Net Stable Funding Ratio, % 91.1 93.9 
   
Rules on capital definition, CET1 capital ratio, %  5.8 7.1 
   
Rules on counterparty credit risk, % change of total RWAs  9.7 0.2 
   
Leverage ratio, % 1 2.5 3.5 
   
Combined impact of CRD III and CRD IV on:    
Total RWAs, % change 24.5 4.1 
CET1 capital ratio, % 4.9 7.1 
Notes: 1 Based on Basel III definitions, in the EU will be subject to monitoring periods and follow-on re-calibration  
Source : CEBS  
The extent to which costs of Basel III implementation would be passed onto bank customers 
is also unclear given that e xposure to the new measures, as shown by the EU QIS, is not 
uniform across banks while their market power  on the lending market  may be too weak.120 In 
this regard, upon full application of CRD III and the CRD IV proposal some 25% of Group 1 banks and some 75% of Group 2 banks had CET1 cap ital ratio in excess of  7% already at the 
end of 2009 (see Chart 1). Furthermore, the distribution of CET1 ratios of Group 2 banks 
indicates that the smaller the bank the higher its CET1 ratio.
121 In competitive markets, such 
asymmetric shocks are typically much more diff icult to pass onto customers, including SMEs. 
                                                 
118 ECB, The euro area bank lending survey , April 2011 
119 Some research shows that smaller ba nks are more prone to lend to SMEs because they are better suited for the 
'relationship lending', which is primarily based on information gathered by the loan officer through continuous, personalized and dir ect contacts with SMEs, their owners and managers, and the local 
community in which they op erate. E.g., see Berger, A. , L. Klapper, G. Udell, The Ability of Banks to 
Lend to Informationally Opaque Small Businesses , Journal of Banking Finance 25, 2001 
120 ECB euro area bank lending surveys show that pressure from competition plays an important role in 
offsetting the impact of factors that drive bank s to tighten their credit standards. See ECB, The euro 
area bank lending survey , April 2011 
121 As roughly three quarters of banks in the Group 2 sample had CET1 capital ratios in excess of the sample 
mean of 7.1%. 
 
 54  Moreover, monitoring periods foreseen for LCR, NSFR and the leverage ratio in combination 
with extended phase-in and inclus ion of grandfathering provisions  are expected to give banks 
necessary time to adjust their business models  accordingly and provide lending to companies 
to support economic growth.  
Also, the proposal includes a revi ew clause on the preferential risk weight fo r exposures to 
SMEs under €1 million that is currently ava ilable for banks applying the standardised 
approach for credit risk. The preferential trea tment is retained in the proposal and EBA is 
tasked with preparing an analysis for the Comm ission on whether the curr ent level of the risk 
weight and the cap for its application are comme nsurate with the actual credit loss history of 
such exposures over a full economic cycle. 
Chart 1:  Distribution of CET1 capital ratios for Group 1 and Group 2 EU banks following 
the application of CRD III and the CRD IV proposal 122 
 
Source:  CEBS, EU QIS  
Most importantly, higher cost of credit in  the long run will be offset by important economic 
and social benefits accruing not only to SMEs but a wide range of stakeholders, including 
corporate and individual borrowers and credito rs, governments, and the EU citizens in 
general , due to the anticipated reduction in a fre quency of banking crises, the extent of net 
economic benefits whereof was assessed in the preceding section.  
6. MONITORING AND EVALUATION  
It is expected that the proposed amendments will start entering into force in 2013. The 
amendments are tightly inter-li nked with other provisions of the CRD, that are already in 
effect since 2007-2008 or that will  come into effect following the implementation of CRD II 
and CRD III. The current and recent proposal s underscore the importance of timely and 
appropriate changes of the rules in response to th e market events. Therefore, it is likely that 
individual provisions of the CRD will continue to be formally evaluated on a piecemeal basis, 
                                                 
122 In the plot, the mean is shown with the "x ", the median is shown with the red line, 25th and 75th percentiles of 
the distribution are delineated by the blue box, while the black horizontal lines mark 10th and 90th 
percentiles of the distribution. In the EU QIS, sample means were calculated on the basis of the 
'composite bank'; in this case, by dividing the sum of CET1 capital by the sum of risk-weighted assets. 
A median represents the value that separates the high er half of the sample from the lower half. An Xth 
percentile distribution represents the value that sepa rates X% of lower values from (100%-X%) higher 
values of the sample. 
 
 55  following the outcomes of various monitoring exercises both at the EU and the international 
level or a necessity to act as dictated by the markets. 
Special arrangements will be put in place by the Basel Committee and EBA to ensure that 
necessary data for the monitoring of leverage ra tio and the new liquidity measures is collected 
to allow for the calibration of these policy tools. Additionally, the Commission services will continue to participate in the working group of  the Basel Committee and the joint task force 
established by ECB and EBA, that monitor th e dynamics of bank capit al positions, globally 
and in the EU, respectively.  
 
 56   G LOSSARY  
Administrative 
burden Costs specifically linked to information provision that businesses would not collect 
and provide in the absence of a legal obligation 
Business-as-usual 
factor Expresses costs of providing the information that would be collected and processed by 
businesses even in the absence of the legisl ation as a percentage of total information 
provision-related costs 
Call option A contract between two parties, whereby the buyer of the option has the right, but not 
the obligation to buy an agreed quantity of a particular commodity or financial 
instrument from the seller of the option at a certain time (the expiration date) for a 
certain price.  
Central 
counterparty (CCP) An entity that interposes itself between coun terparties to a contract  traded within one 
or more financial markets, becoming the buyer to every seller and the seller to every 
buyer 
Consolidating 
supervisor The supervisor responsible for the supervision on a consolidated basis of a banking 
group. As a rule, this is the supervisor of  the Member State where the parent bank of 
the group is based 
Contestable market Market served by a small number of firms,  but which is characterized by competitive 
pricing because of the existence of potential short-term entrants 
Contingent capital Debt that converts into equity when there is a crisis or when certain triggers are met 
Covered bond A corporate bond with a recourse to a pool of  assets that secures or "covers" the bond 
if the originator (usually a financial institution) becomes insolvent 
Counterparty credit 
risk (CCR) The risk that the counterparty to a transaction could default before the final settlement 
of the transaction's cash flows. An economic loss would occur if the transactions or 
portfolio of transactions with the counterparty has a positive economic value at the time of default. Unlike a firm’s exposure to credit risk through a loan, where the 
exposure to credit risk is unilateral and only the lending institution faces the risk of 
loss, CCR creates a bilateral risk of loss: the market value of the transaction can be positive or negative to either counterparty to the transaction. The market value is 
uncertain and can vary over time with the movement of underlying market factors. 
Credit migration 
risk Risk that a portfolio's quality will deteriorate over time without allowing a re-pricing 
of its constituent loans or instruments to compensate for the increase in their default 
risk 
Credit risk Risk of losses in on and off-balance sheet positions resulting from the failure of a 
counterparty to perform accordin g to a contractual arrangement 
Credit risk 
mitigation Technique used by a credit institution to reduce the credit risk associated with an 
exposure which the credit institution holds 
Run-off rate 
(deposit) Rate that reflects the amount of funding maturing over a given period of time and/or 
that are expected to be withdrawn 
Expected Positive 
Exposure (EPE)  The weighted average over time of exp ected exposures where the weights are the 
proportion that an individual expected exposure represents of the entire time interval. 
When calculating the minimum capital requirement, the average is taken over the first 
year, or, if all the contracts in the nettin g set mature before one year, over the time 
period of the longest maturity contract in the netting set. 
 
 57  Flexibility of 
payments (of capital 
instruments) A criterion that requires that the capital instrument must contain features permitting 
the noncumulative deferral or cancellation of payment of coupons or dividends in 
times of stress 
Funding liquidity Ability to meet their liabilities, unwind or settle their positions as they come due 
Going concern Concept that refers to a company's ability to continue functioning as a business entity. 
Hence, 'going concern capital' instruments ar e those that are effective in maintaining a 
bank as a going concern  
Haircut A percentage that is subtracted from the par value of the assets that are being used as 
collateral 
Herding behaviour A tendency of market participants to conform in their behaviour with that of their 
peers 
Hybrid capital 
instruments 
(hybrids) Securities that contain features of both equity and debt. The ultimate purpose of 
issuing such instruments is to cover economic capital needs and to provide support in 
the event of financial stress or potential losses. Hybrids help to diversify both the 
investor and capital base of a bank, and are often structured to qualify as regulatory capital on the one hand and achieve tax deductibility on the other. 
Hypothecation A practice where a borrower pledge s collateral to secure a debt 
Innovative hybrids A specific type of hybrid instruments that in clude an incentive to redeem, like a step-
up or other feature. Non-innovative instruments are hybrid instruments with no 
incentive to redeem. Innovative instruments were assigned a limit of 15% of 'original 
own funds' by the CRD II.  
Internal Ratings 
Based (IRB) approach Advanced approach by which a bank can use its own credit assessments to calculate its 
regulatory capital requirements for credit ri sk. Depending on the risk factors the bank 
is allowed to estimate, a distinction is made between a foundation IRB and an 
advanced IRB approach 
Leverage Degree to which a credit institution's exposures exceed its capital level 
Loss absorption (of 
capital instruments) A criterion that requires that the capital instrument must be available to absorb losses, 
both on a going concern basis and in liquidation, and to provide support for depositors’ 
funds if necessary 
Loss given default 
(LGD) The loss, measured as a percentage of the ex posure at default, which is likely to occur 
in case a borrower defaults; one of the required input parameters to derive the risk 
weight under the internal  ratings-based approach 
Margin Margin is collateral that the holder of a financial instrument has to deposit to cover 
some or all of the credit risk of his counterparty. When the margin posted falls below 
the minimum margin requirement, a margin call  issued.  
Market liquidity An asset's ability to be sold without causing a significant movement in the price and 
with minimum loss of value 
Market risk Market risk is the risk of losses due to price fluctuations of financial instruments in the 
trading book 
Minority interest The share capital of an entity that is fully consolidated in the banking group's 
regulatory accounts but is not owned by the group 
Mortgage backed 
security (MBS) Securitization where underlying exposures include mortgage loans, most commonly on 
residential property, in which case securitiza tion is referred to as residential mortgage 
 
 58  backed security (RMBS) 
National discretion Discretion refers to a situation in which competent authorities or Member State are 
given a choice as to whether to apply, or not to apply, a given provision 
National option An option refers to a situation in which competent authorities or Member States are 
given a choice on how to comply with a given provision, selecting from a range of 
alternatives  
Operational risk Risk of loss resulting from inadequate or failed internal processes, people and systems 
or from external events, and includes legal risk 
Original own funds The most reliable and liquid element of a ba nk's capital that comprises share capital, 
retained earnings and hybrid capital instruments which meet the criteria agreed at G10 
level. Subject to technical differences, or iginal own funds correspond to the Basel 
Accord terminology of Tier 1 capital 
Permanence (of 
capital instruments) A criterion that requires that the capital instrument must be permanently available so 
that there is no doubt that it can support depositors and other creditors in times of 
stress 
Pro-cyclicality Procyclicality of the financial system can be defined as the tendency of financial 
activity to amplify business fluctuations which may lead or contribute to financial 
instability 
Prudential filters 
and deductions Adjustments to the accounting figures, whic h reduce or eliminate unwanted effects of 
reporting for the calculation of regulatory capital 
Required stable 
funding factor A factor that approximates the amount of a particular asset that could not be monetised 
through sale or use as collateral in a secured borrowing during a liquidity event lasting 
one year. In the context of NSFR, such amount s are expected to be supported by stable 
funding 
Re-securitization Securitization where one or more of the underlying exposures meet the definition of a 
securitization 
Securitization Transaction or scheme, whereby the credit risk  associated with an exposure or pool of 
exposures is tranched, with payments in su ch transaction or scheme being dependent 
upon the performance of the underlying exposure or pool of exposures. The subordination of tranches determines the distribution of losses during the ongoing life 
of such transaction or scheme 
Repo (repurchase 
agreement) In a repo contract, the borrower agrees to sell a security to the lender and to buy the 
same security from the same lender at  a fixed price at some later date 
Securities financing 
activities While the rationale behind a repo contract is borrowing or lending of cash, in securities 
financing, the purpose is to temporarily obtain a security for other purposes such as covering short positions 
Single rule book In the context of CRD IV, the term pertains to the removal of national options and 
discretions together with maximum harmonisation of legal provisions 
Standardized 
approach Method by which a bank can use external ratings (if available) by external credit 
assessment institutions to calculate its regulatory capital requirements for credit risk 
Sub-prime 
mortgages Mortgages that are usually granted to borrowers with lower credit ratings 
Synthetically dated Hybrids that become effectively dated as a result of exercising of the embedded call 
 
 59  hybrids option 
Tier 1 capital See Original own funds  
Tier 2 capital Regulatory capital that is used to absorb losses on a gone concern basis, i.e., when a 
company is in liquidation 
Trading book Comprises those instruments held for short-term resale or to hedge other financial 
instruments that are held for short-term resale 
Wrong-way risk, 
specific and 
generalised Specific wrong-way risk arises when the ex posure to a particular counterparty is 
positively correlated with the probability of the default of the counterparty, i.e., when 
the credit exposure and default risk increase together  
Generalised wrong-way risk relates to a situation where the probability of default of 
counterparties is adversely correlated with general market risk factors 
 
 60  ANNEX I: EXTENDED IMPACT ANALYSIS  
TABLE OF CONTENTS 
1. Introduction................................................................................................................ 62 
2. Procedural issues and stakeholder consultation ......................................................... 63 2.1. Stakeholder consultation ............................................................................................ 63 2.1.1. CEBS.................................................................................................................... ...... 63 
2.1.1.1. EU Quantitative Impact Study ................................................................................... 63 2.1.1.2. Work on national options and discretions.................................................................. 64 2.1.2. CRD Working Group ................................................................................................. 64 2.1.3. Other public consultations ......................................................................................... 65 2.1.4. Consultations with the industry.................................................................................. 65 2.2. Consultation with other se rvices of the Commission................................................. 65 
2.2.1. Inter-service Steering Group...................................................................................... 65 3. Problem definition...................................................................................................... 66 3.1. Background ................................................................................................................ 66 
3.2. Management of liquidity risk..................................................................................... 69 3.3. Eligibility of capita l instruments and regulatory adjustments ................................... 74 
3.4. Counterparty credit risk.............................................................................................. 78 3.5. Pro-cyclicality of lending........................................................................................... 80 3.5.1. Underlying market failures and systemic aspects ...................................................... 81 3.5.2. Leverage and lending cyclicality ............................................................................... 83 3.6. Options, discretions and minimum harmonisation .................................................... 85 3.6.1. Current framework..................................................................................................... 85  
3.6.2. Policy context: the new EU financial architecture..................................................... 86 3.6.3. Scope of the exercise.................................................................................................. 8 7 
3.6.4. Problems stemming from di verging national rules .................................................... 88 
3.6.5. Further problems stemming from treatment of divergences at c onsolidated level .... 89 
3.7. Risks inherent in baseline scenario ............................................................................ 91 3.8. Is action necessary at EU level?................................................................................. 91 
 
 61  4. Objectives.................................................................................................................. . 93 
5. Policy options: analysis and comparison ................................................................... 96 5.1. Liquidity risk............................................................................................................ .. 97 
5.1.1. Liquidity Coverage Ratio........................................................................................... 97 5.1.2. Net Stable Funding Ratio......................................................................................... 104 5.2. Eligibility of capital inst ruments and application of regulatory adjustments .......... 108 
5.3. Counterparty credit risk............................................................................................ 115 5.4. Leverage.................................................................................................................. . 119 
5.5. Capital buffers.......................................................................................................... 1 22 
5.6. Single rule book in banking ..................................................................................... 126 
5.7. Choice of policy instrument..................................................................................... 131 5.8. Cumulative impact of the package........................................................................... 133 5.8.1. Package of preferred options and relevant transitional provisions .......................... 133 
5.8.2. Cumulative impact on the industry .......................................................................... 134 
5.8.3. Administrative costs................................................................................................. 136  
5.8.4. Economic impact in transitional period ................................................................... 137 5.8.4.1. Four-year implementation period............................................................................. 137 5.8.4.2. Eight-year implementation period ........................................................................... 138 5.8.4.3. Optimum implementation period ............................................................................. 140 5.8.5. Long-term economic impact .................................................................................... 142 5.9. Impacts on SMEs ..................................................................................................... 144 6. Monitoring and evaluation ....................................................................................... 147 
 
 62  1. INTRODUCTION  
The extent of the financial crisis has expos ed unacceptable risks pertaining to the current 
regulation of financial institutions and markets. These risks proved substantial and systemic in times of serious turbulence. According to the IMF
123 estimates, between 2007 and 2010 crisis-
related writedowns and loan provi sions on bank assets originated globally reach $2.3 trillion, 
roughly half of which (or $1.3 trillion, equivalent to 8% of the EU GDP) is now attributable 
to European banks. The crisis which started in  the financial sector plunged the EU economy 
in a severe recession, with the EU GDP cont racting by some 5.7% or €0.7 trillion in 2009. 
In order to restore confidence and stability in  the banking sector and ensure that credit 
continues to flow to the real  economy, both the EU and its Member States (MS) adopted a 
broad range of unprecedented measures with the taxpayer ultimately footing the bill of global 
rescue and recapitalization init iatives. In this context, between October 2008 and October 
2010 the European Commission (Commission) ha s approved €4.6 trillion (equivalent to 39% 
of the EU GDP) of state aid measures124 to financial institutions of which more than €2 
trillion were effectively used in 2008 and 2009. Combined with fiscal measures aimed at 
pulling EU economies out of the recession, supportive measures to the banking industry contributed to higher budget deficits and pus hed sovereign indebtedness levels up. This 
intensified markets' percepti on of rising sovereign risks, imposing second-round costs on the 
EU Member States' fiscal stance and ultimately  constraining economic policy options in the 
medium term. 
The unprecedented level of fiscal support to ba nks needs to be matched with a robust and 
internationally coordinated reform addressing the regulatory shortcom ings exposed during the 
crisis. In recognition of thes e regulatory weaknesses, th e Commission already proposed 
certain amendments to bank regulation, revi sing capital requirements for securitization 
positions and provisions on home-host supervisory issues and crisis arrangements in October 2008
125 (CRD II) as well as amendments to cap ital requirements for th e trading book and for 
re-securitizations, and to the supervisory re view of remuneration policies in July 2009126 
(CRD III).  
However, to prevent recent and present problems from occurring in the fu ture and ensure that 
risks linked to the broader issues of financ ial instability and pro-cyclicality are more 
effectively contained, additional internationall y coordinated changes to the EU capital and 
liquidity regulation of banks are needed. Such changes would provide for restoring 
businesses' and citizens' trust in financial institu tions as reliable and resilient intermediaries 
                                                 
123 IMF, Meeting New Challenges to Stability and Building a Safer System  (Global Financial Stability Report), 
April 2010 
124 Measures comprise €3.5 trillion of guarantees, €156 b illion of other liquidity and bank funding support, €546 
billion of approved state recapitalisations and €402 billion of asset relief 
125 Consisting of a Directive 2009/111/EC of the European Parliament and of the Council of 16 September 2009 
amending Directives 2006/48/EC, 2006/49/EC and 2007/64/EC as regards banks affiliated to central 
institutions, certain own funds items, large expo sures, supervisory arrangements, and crisis 
management, Commission Directive 2009/27/EC of 7 April 2009 amending certain Annexes to Directive 2006/49/EC, and Commission Directive 2009/83/EC of 27 July 2009 amending certain 
Annexes to Directive 2006/48/EC  
126 Directive 2010/76/EU of the European Parliament and of the Council of 24 November 2010 amending 
Directives 2006/48/EC and 2006/49/ EC as regards capital requirements for the trading book and for re-
securitisations, and the supervisor y review of remuneration policies 
 
 63  for translating their deposits into productive invest ment that is key for the long-term health of 
the EU economy.  
2. PROCEDURAL ISSUES AND STAKEHOLDER CONSULTATION  
2.1. Stakeholder consultation 
Throughout the project the Commission services ha ve closely followed and participated in the 
work of international forums, particularly the Basel Committee127 and its various working 
groups in charge of developing policy propos als in individual ar eas of the proposal. 
The European Banking Committee (EBC) and the Committee of European Banking 
Supervisors (CEBS) – the committees of the La mfalussy process - have been extensively 
involved and consulted throughout the project as well and their views have contributed to the 
preparation of this impact assessment and the proposal that it accompan ies. Consultative work 
with other stakeholder groups has been c onducted in part through these committees.  
2.1.1.  CEBS 
2.1.1.1.  EU Quantitative Impact Study 
In November 2009, the Commission invited CEBS to conduct a comprehensive quantitative 
impact study (QIS) on the impact of the legislative prop osal that this impact assessment 
accompanies on the EU banking industry. 246 ba nks from 21 member countries of CEBS 
participated in the study, including 50 Group 1128 banks and 196 Group 2 banks (see Table 1). 
The analyses were performed based on data at consolidated group level as of 31 December 2009, i.e., subsidiaries of European banks we re excluded to avoid double counting. The total 
capital of participating banks  amounted to €1,464 billion wh ich represents approximately 
70% of the consolidated European banking sector. In total, a ll 50 EU Group 1 banks 
participated in the QIS. The coverage of Gr oup 2 banks was lower: 4%, or 196 of more than 
4,500 Group 2 banks participated, representing 38% of the risk weighted assets (RWAs) of 
Group 2 banks of the participatin g countries. Importantly for th e interpretation of the data, 
almost all participating countries indicated th at the submitted Group 2 data is representative 
of their Group 2 bank population.  
Table 1:  Participation of Group 1 and Group 2 banks in the EU QIS 
 AT BE DK FI FR DE EL HU IE IT LU NL NO PL PT SI ES SE UK EU 
Bank 
count 18 4 5 14 11 78 4 3 9 22 1 22 8 5 7 2 7 6 13 246 
Note:  Due to confidentiality concerns data for CY and CZ have been omitted while the number of their banks reflected in the 
EU total. 
Source : CEBS 
                                                 
127 The Basel Committee on Banking Supervision consists of central bank and supervisory authority 
representatives from twenty seven countries. Nine  EU Member States are represented – Belgium, 
France, Germany, Italy, Luxembourg, the Netherlands, Spain, Sweden, and the UK. The other countries 
represented are Canada, Japan, Switzerland, the US and, from 2009, Argentina, Australia, Brazil, China, Hong Kong, India, Indonesia, Korea, Mexi co, Russia, Saudi Arabia, Singapore, South Africa 
and Turkey. The European Commission, along with the European Central Bank, participates as an 
observer in the Committee and in its working groups. 
128 Group 1 banks are those that have Tier 1 capital in  excess of €3 billion, are well diversified, and are 
internationally active. All other banks are considered Group 2 banks 
 
 64  According to ECB129, in 2009, total assets of credit in stitutions in the EU27 reached €42,144 
billion (for more on the economic and financia l importance of the banking sector in Europe, 
see Annex II). A significant share thereof is  owned by Group 1 banks. Given differences as 
regards their size, nature of activities, risk profile and risk management approaches, results 
from the EU QIS throughout this impact asse ssment report are used separately for Group 1 
and Group 2 banks, and cumulative impact on the EU industry, where necessary, is estimated 
by applying extrapolation. Please note that EU-level averages130 and totals, when quoted in 
the impact assessment, may include NO banks. Importantly, MS-level averages and totals 
have been anonymized randomly on request of th e MS participating in the QIS in order to 
preserve confidentiality of results, yet still presen ted in the report to illustrate distributional 
effects of the new rules. 
2.1.1.2.  Work on national options and discretions 
In the area of national options and discretion s, CEBS played a key role as a source of 
technical expertise. The committee's work was carried out in response to the Commission's 
calls for advice of March 2007. CEBS' tec hnical advice was received in October 2008131, 
following extensive public consu ltation of the draft advice.  
The industry was consulted by CEBS as part of the preparation of its technical advice, which 
included an ad hoc joint CEBS-industry expert group.132 The position of the industry on all 
national options and discretions is available on CEBS web site.133 Twenty responses were 
received to the public consulta tion. In the view of most res pondents of the industry, in line 
with the objective of a single ma rket, all national options and di scretions should be removed. 
However, certain respondents stressed that there are also some cases where the existence of local market conditions or legisl ative specificities justify the a doption of different approaches 
so that certain options and national discretions should be maintained.  
2.1.2.  CRD Working Group 
In the area of national options and discretions, the Commission services held six meetings of 
the CRD Working Group (CRDWG), whose me mbers are nominated by the EBC, in 
December 2008, March and April 2009, October 2010, and February and March 2011. The group worked on preparing a single rule book in the EU, considering the technical advice of 
CEBS and the potential removal of the remaining options which was not suggested by CEBS. 
For a detailed list of provis ions analysed by the CRDWG, please refer to Annex II.  
Other parts of the proposal were discussed by the CRDWG in June and October 2010, and 
February and March 2011. It sh all be noted that working s ub-groups of the CRDWG in the 
areas of liquidity, capital definition, leverage ra tio, counterparty credit risk and capital buffers 
have also been established in 2010 to conduct work at even more technical level and to 
develop legislative drafts in the respective areas. 
                                                
 
129 ECB, EU Banking Structures , September 2010 
130 Unless noted otherwise, av erages were calculated by creating a co mposite bank at a country and a total 
sample level which means that all country and total sample averages effectively are weighted averages 
131 See http://www.c-ebs.org/getdoc/354c6e4c-f22a-46a0- 9025-0c55f460a5a6/2008-17-10-Final-Advice-on-
options-and-national-di.aspx   
132 See http://www.c-ebs.org/getdoc/1d48fde8-6672-4df5-a526-b406472c6af2/National-Discretions.aspx   
133 See http://www.c-ebs.org/getdoc/5d174851-eb98 -4a34-a542-6ab9b6f89eaa/CP18.aspx   
 
 65  2.1.3.  Other public consultations 
The preparatory work related to the CRD IV legi slative proposal started already in summer of 
2009 when the Commission services c onducted a first public consultation134 on the latest 
wave of possible amendments to the CRD. Th is was followed by anot her public consultation 
that ran from February to April of 2010135 that included a second round of questions on the 
'single rule book' as well as consulting on a lis t of potential policy measures pertaining to 
liquidity and counterparty credit risk manageme nt, definition of cap ital, leverage ratio, 
conservation and countercyclica l capital buffers and appropriate treatment of systemically 
important financial institutions. A third public  consultation elaborating on the possible design 
of the countercyclical capital buffer ran from October to November 2010.136 A fourth public 
consultation on capital requirements for certai n types of counterpart y credit risk was 
conducted in February – March 2011.137 
Responses to these consultations constitute an important source of data and key stakeholder 
views as regards the impacts a nd effectiveness of potential pol icy measures outlined in the 
consultation. Feedback to the public consultations included calls for assessing implications of certain important aspects of the proposal. Th ese aspects include implementation dates and 
phase-in of new rules, grandfathering of ex isting provisions and cumulative impact of 
individual measures of the package on the i ndustry, the economy and the financial stability. 
Also, on 26 April 2010 the Commission services  conducted an open public hearing on the 
CRD IV proposal. The event was open to all stakeholders who have responded to the 
consultation of February 2010 and actively atte nded by all the stake holder groups, including 
industry, regulators, supervisors, non-financia l companies, international organisations. 
2.1.4.  Consultations with the industry 
In addition, the Commission se rvices conducted separate exte nsive consultations with the 
industry, including the Group of Experts in Banking Issues (GEBI), various EU banking 
industry associations and individual banks. 
A number of policy measures with a potentially  material impact on the industry, such as 
treatment of deferred tax assets and of mino rity interests, and design of new liquidity 
requirements, as well as industry's assessment of costs and benefits of the entire package were 
discussed by the GEBI members at the Group 's meetings in April and October 2010. In 
August – September 2010, the GEBI was invited to provide input into assessment of 
administrative burdens related to the CRD IV (see Annex VIII). 
2.2. Consultation with other s ervices of the Commission 
2.2.1.  Inter-service Steering Group 
An Inter-Service Steering Group (ISSG) was set up to follow progress and feed in views from 
other services of the Commission, including Direct orates-General for Ente rprise and Industry, 
Economic and Financial Affairs, Taxation an d Customs Union, Health and Consumers, 
Competition, Legal Service, and Secretariat General. Experts from the Directorate-General for 
                                                
 
134 See http://ec.europa.eu/internal_market/consultati ons/2009/capital_requirements_directive_en.htm   
135 See http://ec.europa.eu/internal_market/consultations/2010/crd4_en.htm   
136 See http://ec.europa.eu/internal_market/consultations/2010/capitalbuffer_en.htm   
137 See http://ec.europa.eu/internal_market/consultations/2011/credit_risk_en.htm  
 
 66  Economic and Financial Affairs contributed to this impact assessmen t by conducting analysis 
of implications of the propos al on the macro-financial st ability and of macro-economic 
impacts during a transitional period (see Annex IX). The ISSG met four times in June - 
September 2009 and five times in January – October 2010. 
3. PROBLEM DEFINITION  
3.1. Background 
Capital requirements rules stipulate the mini mum amounts of own financial resources that 
banks must have in order to c over the risks to whic h they are exposed. The aim is to ensure 
the financial soundness of these institutions and, in  particular, to ensure that they can weather 
difficult periods and that thei r depositors are protected.  
In the EU, harmonised capital requirements ar e a key component in the single market in 
financial services: mutual rec ognition of requirement s is the basis for banks’ and investment 
firms’ 'single market passport', meaning that they can operate throughout the EU on the basis 
of approval by the appropriate re gulatory authority in their own MS. The current EU bank 
capital framework is represented by the Cap ital Requirements Directive (CRD) comprising 
Directives 2006/48/EC and 2006/49/EC and refl ecting the proposals of the Basel Committee 
for the Basel II Framework138 (Basel II) and Trading Book Review139. It covers both credit 
institutions and i nvestment firms. 
With the adoption of the CRD, capital re quirements became more comprehensive140 and risk 
sensitive141. The CRD also enhanced the role of th e ‘consolidating supervisor’ by assigning it 
responsibilities and powers in coordinating the supervision of cross- border groups and laid 
out a three-pillar structure (s ee Box 1) representing additiona l marked differences from a 
predecessor legislation.  
Box 1:  Three pillar structure of the CRD: 
Pillar 1 covers the minimum capital required for cr edit risk, operational risk and market risk; the 
minimum capital requirements became much more ri sk-sensitive and comprehens ive than in the past, 
facilitating improved coverage of the real risks run by the institution.  
Pillar 2 covers the review and evaluation of the cred it institution's fulfilment of the requirements of the 
CRD by the supervisor and any resulting action; new rules include requirements for an ‘internal 
capital assessment’ by financial institutions, whereb y they would need to assess their capital needs 
considering all the risks they face.  These rules also require supervisor s to evaluate institutions’ overall 
risk profile to ensure that they hold adequate capital. 
Pillar 3 covers the disclosure by institutions and f acilitates a better understanding of the soundness and 
stability of financial institutions. 
                                                 
138 See http://www.bis.org/publ/bcbs107.htm   
139 See http://www.bis.org/publ/bcbs116.htm   
140 Rules were expanded to cover 'operational' risk, e.g., the risk of systems breaking down 
141 Rules include a possibility for institutions to adopt ap proaches to determining regulatory capital that are 
appropriate to their situation and to the sophistication of their risk management. For instance, the 
Internal Ratings Based approach enabled institutions to determine capital requirements for credit risk of 
their portfolios, by using their own ‘risk inputs’ such as probability of default and loss given default. The calculation of these risk inputs was made subject to a strict set of operational requirements to 
ensure that they are robust and reliable. 
 
 67  The financial crisis has unveiled a number of  shortcomings of Basel II and necessitated 
unprecedented levels of public support in order to  restore confidence and stability (see Chart 
1). This prompted a broad EU and internationa l effort to identify the reasons behind the 
problems and to develop effective po licies to tackle them head-on.  
As part of its efforts to deal with the fi nancial crisis, already in November 2008, the 
Commission mandated a High Level Group (HLG) chaired by Mr. Jacques de Larosière to 
propose recommendations for reforming the Eur opean financial supervision and regulation. 
The thirty one recommendations142 of the HLG represented a comprehensive set of concrete 
possibilities for regulatory143, supervisory and global repair ac tion and were elaborated in the 
Commission's Communication144 for the spring European Council of 4 March 2009.  
Most of the proposals that this impact asse ssment accompanies and th e amendments to the 
CRD (CRD III) already adopted by the Commissi on in July 2009 are listed in the detailed 
action plan included in the Comm unication. Such 'phased' appr oach to revising the current 
rules reflects the balance betw een, on the one hand, a necessity to swiftly tackle the problems 
that transpired during the crisis and restor e the financial stability, and, on the other hand, 
given the level of integration within the globa l financial system, reaching an international 
consensus on measures that would be effec tive in containing the problems identified (see 
Table 2 for more details on the three waves of the CRD amendm ents). With respect to the 
latter, the G-20 Declaration of 2 April 2009 on Strengtheni ng of the Financial System145 
conveyed the commitment of the global leaders146 to address the crisis with internationally 
consistent efforts that are ai med at strengthening transparen cy, accountability and regulation 
by, among others, improving the quantity and quali ty of capital in the banking system once 
the economic recovery is assured, introducing a supplementary non-risk based measure to 
contain the build-up of leverage in the banki ng system, developing a framework for stronger 
                                                 
142 See http://ec.europa.eu/internal_market/fin ances/docs/de_larosiere_report_en.pdf   
143 Recommendations called for the Base l Committee to urgently amend rules with a view to gradually increase 
capital requirements, reduce their pro-cyclical imp acts and tighten norms for liquidity management. 
They also called for EU to adopt and confirm w ith the Basel Committee a common definition of own 
funds clarifying whether and to what extent hybrid capital instruments should be counted as Tier 1 
capital. 
144 See http://ec.europa.eu/commission_barroso/president/pdf/press_20090304_en.pdf   
145 See http://www.g20.org/Documents/Fin_Deps_Fin_Reg_Annex_020409_-_1615_final.pdf   
146 European leaders expressed their support for these m easures at the European Co uncil of 19-20 March 2009 Chart 1:  Public capital injections in the banking sector, in % of 2009 GDP 
012345678
IE LU BE NL UK DK DE AT LV EU EL FR IT SE HU PT FI PL SKTotal approved injections
Effective capital injections 
Source:  European Commission  
 
 68  liquidity buffers at financia l institutions and charging FSB147, the Basel Committee and 
CGFS148, while working with accounting rule se tters, to implement the recommendations149 
of 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, 
agreed150 on a number of measures to strengthen the regulation of the banking sector. These 
measures were endorsed by the FSB and the G- 20 leaders at their Pittsburgh Summit of 24-25 
September 2009151 and were fleshed out in detail and made available for stakeholder 
comments in two consultation documents in December 2009152. In February – April 2010 the 
Commission conducted a parallel public consultation within the EU, going beyond the set of 
measures covered by the documents of the Basel Committee.  
In December 2010, the Basel Committee issued detailed rules of new global regulatory 
standards on bank capital adequacy and liquidity that collectively are referred to as Basel 
III.153 The proposal that this impact assessment accompanies directly relates to the standards 
covered by Basel III.  
The following sub-sections present analysis of  main problems and drivers underlying them for 
the CRD areas under review in  this proposal. Problem drivers are identified in italics  and a 
'problem tree' is included at the end of the section. 
Table 2:  Three 'waves' of the CRD amendments by the Commission 2008 - 2011 
Timing of 
proposals Major CRD provision areas 
changed Justification / key objectives 
Revision of large exposures regime Area 'left op en' at the time of the CRD adoption in 2006 
Establishing a more harmonized treatment 
of hybrid capital instruments within original own funds Area 'left open' at the time of  the CRD adoption in 2006 
Revision of home-host supervisory  and 
crisis arrangements Change in response to the financial crisis, to provide for attainment of long-term policy 
objectives of bank capital regulation 
Derogations for bank networks from certain prudential requirements Area 'left open' at the time of  the CRD adoption in 2006 October 2008 
Revision of treatment of life insurance as 
eligible collateral Inconsistency identified in the CRD transposition process 
                                                 
147 The Financial Stability Board was convened in April 1999 to promote international financial stability through 
information exchange and international co-operation in  financial supervision and surveillance. It brings 
together national authorities responsible for financial stability in significant international financial 
centres, international financial institutions, sector-specific international groupings of regulators and 
supervisors, and committees of central bank experts. FSB seeks to co-ordinate the efforts of these various bodies in order to promote international financial stability, improve the functioning of markets, 
and reduce systemic risk. 
148 The Committee on the Global Financial System (CGFS), monitors developments in global financial markets 
for the central bank Governors of the G10 countries  
149 The report of the FSB on Addressing Procyclicality in the Financial System 
(http://www.financialstabilityboard.org/publications/r_0904a.pdf  ) set out fifteen recommendations to 
mitigate mechanisms that amplify procyclicality by  covering three areas: bank capital framework, bank 
loan loss provisions as well as leverage and valuation issues. The proposal that this impact assessment accompanies directly relates to a number of  recommendations issued by the FSB.  
150 See http://www.bis.org/press/p090907.htm   
151 See http://www.g20.org/Documents/pittsburgh_ summit_leaders_statement_250909.pdf   
152 See http://www.bis.org/publ/bcbs164.htm , http://www.bis.org/publ/bcbs165.htm   
153 See http://www.bis.org/publ/bcbs189.htm , http://www.bis.org/publ/bcbs188.htm   
 
 69  Timing of 
proposals Major CRD provision areas 
changed Justification / key objectives 
Revision of capital requirements for 
Collective Investment Undertakings under the IRB approach Inconsistency identified in the CRD transposition process 
Revision of capital and risk management 
requirements for securitization positions Change in response to the financial crisis, to provide for attainment of long-term policy 
objectives of bank capital regulation 
Revision of capital requirements for the trading book 
Revision of capital requirements for re-securitization positions in the banking 
book 
Enhancing disclosure requirements of securitization risks July 2009 
Enhancing supervisory review of 
remuneration policies Changes in response to the financial crisis, to provide for attainment of long-term policy 
objectives of bank capital regulation, including enhancing stability and limiting 
procyclicality of the financial system 
Enhancing and harmonizing requirements 
for liquidity risk management  
Revision and harmonization of definition of capital rules, regulatory adjustments 
Revision of capital requirements for the 
counterparty credit risk 
Introduction of a supplementary non-risk 
based measure to contain leverage 
Introduction of capital buffers  Change in response to the financial crisis, to provide for attainment of long-term policy 
objectives of bank capital regulation, including enhancing stability and limiting 
procyclicality of the financial system June 2011 
Single rule book in banking  Making supervisory rules more consistent by reducing number of national options and 
discretions to provide for reduction of compliance burden and enhanced level playing field 
3.2. Management of liquidity risk 
The global financial crisis that started in su mmer of 2007 has evidenced the crucial role of 
interacting market and funding liquidity fo r the banking sector. It brought to light 
shortcomings of current liquidity risk manage ment, including stress testing exercises of 
institutions  and asset and liability maturity mismatches , and evidenced the need to review 
banking supervisors' approach to liquidity risk management. Structured products and 
interbank market operators suffered liquidity cons traint, eventually leading to drying out of 
liquidity, resulting in choking ba lance sheets of banks. The inability to mobilize resources led 
to a severe liquidity constraint  on some banks, pre ssing central banks in  providing emergency 
liquidity support. The propagation of the crisis  from certain structured products to mature 
financial markets through the interplay of balance sheets and exposure to credit risk 
highlighted the connection between market liqui dity risk and funding liquidity risk, and the 
vulnerability of banks' balance sheet to liquidity risks.  
Funding liquidity risk arises because inflow s and outflows of f unds at banks are not 
synchronised. A bank is deemed to be liquid as  long as at each point in time outflows of 
liquidity are smaller or equal to the sum of  inflows and the bank’s stock of liquidity. 
Therefore, it should manage its liquidity risk with a view to ensure that the above constraint is 
never breached. However, the existing liquidity risk management approaches, including stress 
tests, and supervisory regimes were shown to be inadequate in fully grasping risks inherent to 
the underlying market practices such  as (i) originate-to distribute securitization; (ii) reliance 
on wholesale funding with short term maturity instruments; (iii) prol iferation of complex 
financial instruments with underestimated underl ying risks. Also, assu mptions pertaining to 
(iv) asset market liquidity, as  well as (v) intera ction between market liquidity and funding 
liquidity turned out to had been erroneous while (vi) behavioural aspects of financial 
institutions played an immense role in the course  of the crisis. These f actors contributed to a 
demise of several financial institutions and strongly undermin ed health of many others, 
threatening the financial stability and necessita ting unprecedented levels of public sector (see 
 
 70  Chart 1) and central bank liquidity support (for the extent of the ECB liquidity support since 
2007 see Chart 2). They are analys ed in more detailed below. 
Chart 2:  ECB loans to the euro area credit instit utions and deposits of euro area credit 
institutions with the ECB, 10-day moving average in € billion, January 2007 – June 2010 
2004006008001.000
01/2007
04/2007
07/2007
10/2007
01/2008
04/2008
07/2008
10/2008
01/2009
04/2009
07/2009
10/2009
01/2010
04/20100125250375500
Loans to banks (lhs) Deposits by banks (rhs)
 
Sources:  ECB, European Commission services' calculation  
 
 i. Securitization was used widely by fina ncial institutions to expand funding sources and 
create additional balance sheet capacity. As the process of pooling assets, selling them to a 
special purpose vehicle, obtaini ng credit ratings and issuing s ecurities takes time, market 
stress during this timeframe resulted in ba nks having to warehouse and, therefore, fund 
assets for longer than planned: according to the ESF, in 2008, 95% of all European 
securitization issuance was retained by banks (a nd used for repo with the ECB and the Bank 
of England) with primary issuance market effe ctively closed due to significantly diminished 
investor appetite for these instruments.154  
 ii. In the run-up to the crisis, many financial institutions have increasingly turned to the 
capital markets for funding their own operations as well as those of related entities with 
instruments of shorter maturity and became mo re reliant on wholesale funding sources such 
as commercial paper, repurchase agreements ('repos'), and interbank markets. Events during the crisis illustrated clearly that during times of market stress invest ors exhibit heightened 
risk aversion by demanding higher compensati on for risk, requiring  banks to roll over 
liabilities at considerably shorter maturities or refusing to extend fina ncing altogether. Some 
forms of securitization such as off-balance sheet structured inve stment vehicles and 
conduits raised funds by selling asset backed commercial pa per (ABCP) of average maturity 
of 90 days while the assets b acking it typically comprised pools of loans, mainly mortgages. 
To ensure funding liquidity of such off- balance sheet vehicles, 'sponsoring' banks 
                                                
 
154 European Securitisation Forum, ESF Securitization Data Report, Q4 2008 
 
 71  committed to provide a credit line, the so-cal led 'liquidity backstop', effectively exposing 
themselves to liquidity risk pertaining to maturity mismatch of these entities. When 
investors, following the spike in sub-prime mortgage defaults became concerned about the value of structured products and lost confid ence in the reliability of their ratings, their 
appetite for ABCP evaporated  and banks sponsoring these ve hicles were called upon to 
provide liquidity. As banks had to fulfil such  contingent asset funding commitments, some 
of them ran into funding difficulties. In July 2007, IKB, a German bank was unable to 
service a liquidity guarantee of €8.1 billion it  had provided to its Rhineland Funding conduit 
and the state-owned development bank that ow ned 38% of the IKB took over the liquidity 
facility committed to Rhineland Funding.
155 Other European banks had also to provide 
liquidity to their ABCP c onduits to varying degrees.156 Additional liquidity needs were also 
created when institutions felt compelled to prov ide support to affiliated investment vehicles 
even when there was no contractua l obligation to do so, since they perceived that a failure to 
do so would impact their reputation adversely. For instance, in June 2007 Bear Stearns, a 
large US investment bank, in order to protect its reputation, injected $3.2 billion into two of 
its hedge funds that had trouble meeting ma rgin calls due to lo sses on asset backed 
securities (the two funds filed for ba nkruptcy protection shortly thereafter).  
 In addition to the commercial paper, financial institutions extensively used other wholesale 
funding sources such as repo and interbank ma rkets. Repos allow institutions to obtain 
typically short-term funding, under the conditi on of periodic margin calls, mobilizing 
resources entailing opportunity costs.157 Recent changes in risk ma nagement practices made 
such transactions more sensitive to liquidity  risk: margin calls were made on a daily or 
intraday basis compared to weekly or monthl y ten years ago and re-use of collateral had 
notably increased. While the use of collateral  was aimed at mitigating counterparty credit 
risk, it gave rise to funding liquidity risk when counterparties had to provide additional 
collateral on short notice due to changes in market price and in response to increased haircuts, reflecting deteriorated  market liquidity, asset quality and their own counterparty 
risk. Moreover, financial institutions and invest ment banks in particul ar increasingly relied 
on overnight repos, effectively requiring them to  roll over a significant part of their funding 
on a daily basis. Bear Sterns failed in March 2008 once it found itself unable to secure 
funding on the repo market and was subsequently taken over JPMorgan Chase, in a deal that 
effectively wiped out its shar eholders value. Lehman Brot hers, another investment bank, 
filed for bankruptcy in September 2008, in part  because of difficulties in addressing similar 
funding liquidity-related problems. 
 iii. The use of derivative instruments of ever increasing complexity created additional 
challenges for management of liquidity risk. Predicting their cash flows and correlations 
with other financial assets in times of stress proved to be difficult. AIG, largest insurer in 
the world, suffered from a liquidity crisis wh en its credit ratings were downgraded below 
"AA" levels in September 2008.
158 As AIG was active in underwriting derivatives insuring 
mortgage backed securities, the credit rati ng downgrade imposed that it posts additional 
                                                 
155 IKB also received a rescue package of some €3.5 billion from German government and private and state 
sector banks to cover potential losses from structured investments it had made 
156 E.g., HBOS provided liquidity support to its Grampian programme that had some $36 billion commercial 
paper outstanding 
157 Formally, the collateral is sold to the lender, subject to an agreement to repurchase it at an agreed price and 
moment in time 
158 This risk materialised once on September 15, 2008 S&P and Moody's downgraded AIG long-term credit 
ratings by three and two notches, respectively, among other justifications citing 'reduced flexibility in 
meeting additional collateral needs'. 
 
 72  collateral. Fearing contagion to  the rest of the market thro ugh balance sheet interplay, the 
US government bailed AIG out with suppor t reaching some $180 billion by end-2009.  
 iv. Assumptions pertaining to asset market li quidity were another source behind the recent 
funding shock. Financial institutions can satisf y their liquidity needs by selling assets or 
hypothecating them. If asset market s are liquid, assets can be so ld at their fair value or 
hypothecated at low haircuts. However, because of their nature, banks’ assets have to a 
large extent a potential to become illiquid, in particular in stressed conditions, when they 
can only be sold at a discount or hypothecated at much higher haircuts. This is in particular 
true for complex instruments that were not  actively traded among a large number of 
participants which made assessi ng their price and secondary market liquidity challenging as 
more and more parties withdrew from the releva nt markets. Financial institutions had made 
overly optimistic assumptions about the asse t market liquidity of  certain structured 
products, such as asset backed securities  and loan books. They had often assumed 
continuous high liquidity of thes e markets, and indeed some ha d treated loan securitisation, 
asset backed securities held on balance sheet and ABCP programs as very resilient sources of liquidity in the event of funding difficulties, not anticipati ng that the liquidity of such 
markets may disappear.  
 v. Many financial institutions al so underestimated th e extent of a vici ous feedback loop 
between market liquidity and funding liquidity . Rising arrears on US sub-prime mortgages 
that were extensively packaged in residentia l mortgage-backed securities caused investors 
to lose faith in the ratings of structured s ecurities and led to heig htened concerns about 
accuracy of their valuati on. The loss of investor confidence  in a wide range of structured 
securities was transmitted through a fall in their price as market liquidity for such securities 
evaporated. This led to an increase in funding ri sk as margins and haircuts related to these 
securities increased, which, in turn, forced additional deleve raging and selling, effectively 
creating a vicious circle betw een deteriorating market liqui dity and disappearing funding 
liquidity. Also, as long as the institution's solvency is unques tioned, it will fi nd it relatively 
easy to obtain credit on a secured or even unsecured basis. However, as many banks held 
large positions in difficult-to-value and potentially impaired securities,
159 concerns about 
their solvency arose that aggr avated further banks funding diffi culties, as discussed below. 
 vi. The flow of funds between banks was dete rmined not only by contra ctual relationships, 
which have been formed prior to the crisis, but also by endogenous behavioural reactions of 
banks. In stressed conditions, in stitutions with a liquidity surplus tend to refrain from 
lending in the interbank market because of precautionary hoardi ng of liquidity for their own 
potential liquidity needs. In  fact, as of August 2007 money markets tightened as banks 
started hoarding liquidity, as explained above, to  meet contingent claims with respect to 
their off-balance sheet vehicles and conduits , meet margin calls on repo and derivative 
transactions, or to better position themselv es against possible funding shortfalls. Such 
behaviour was further intensified due to a l ack of understanding about the level of exposure 
to difficult-to-value and potential ly impaired assets and, in rela tion to this, financial health 
of other institutions. The combination of these factors made banks reluctant to lend funds to 
each other, as evidenced by TED160 spread (see Chart 3). These concerns prompted banks in 
                                                 
159 Notably, structured securities the value of which depends on underlying assets that may not be fully 
transparent to the public 
160 The difference between the three-m onth London interbank offered rate (LIBOR) and the interest rate on the 
three-month US Treasury b ill; TED is an acronym formed from T-Bill and ED, the ticker symbol for 
the Eurodollar futures contract. It is a widely used proxy to measure the liquidity in the interbank 
market because, at times of uncertain ty, it reflects both the fact that bank s charge higher interest rate to 
 
 73  the euro area to park their shor t term liquidity with the ECB ra ther than engage in inter-bank 
lending  admittedly at higher rates (for dynamics  of the euro zone banks' deposits with the 
ECB see Chart 2). Absent liquidity on the inte rbank market, several financial institutions 
relying on wholesale funding f aced liquidity tightening. Mort gage lender Northern Rock 
collapsed in September 2007, following a first wave of illiquidity in the interbank market that started a month before. Failures of Br adford & Bingley and HBOS in September 2008 
were also partially driven by thei r reliance on wholesale funding markets.
161  
The nature, magnitude and duration of the liqui dity shock were not fully anticipated by the 
financial sector and, particular ly, by banks that had been a ggressive in leveraging their 
balance sheets and reliance on inter-bank f unding. The shock underscored shortcomings in 
liquidity risk management, including stress te sting exercises, of institutions as risk 
management had focussed predominantly on firm -specific constraints and not enough on the 
implications of market-wide disruptions or co mbinations of firm-specific and market-wide 
shocks. While higher capital leve ls had been thought to allow banks to absorb unexpected 
losses and provide reassurance to markets, ev ents of 2007-2008 demonstrated that even well 
capitalised banks faced serious liquidity problems,  that had been precipitated in part by asset 
and liability maturity mismatches. These events illustrated how quickly and severely liquidity 
risks can materialise and cer tain sources of funding can disappear, compounding concerns 
related to the valuation of assets, capital ad equacy and financial st ability in general.  
Chart 3:  TED spread in percentage points, January 2007 – December 2008  
0,001,002,003,004,005,006,00
01/2007 04/2007 07/2007 10/2007 01/2008 04/2008 07/2008 10/2008
Sources:  US Federal Reserve, European Commission calculation  
While interventions of central banks and depos it guarantee schemes can limit the impact of 
liquidity shocks, they raise the problem of mo ral hazard wherein banks may be insufficiently 
prudent in managing their liquidi ty risk ex-ante, expecting the central bank to provide the 
                                                                                                                                                         
each other for unsecured loans but al so a reduction in T-bill rate as institutions increase their demand 
for collateral of the highest quality. 
161 According to Barclays Capital, over decade leading to  the crisis, European bank wholesale funding as % of 
balance sheet has increased from 40% to 70%, while the simple funding gap expressed as loans less 
deposits has tripled from approxima tely $1 trillion to over $3 trillion. 
 
 74  necessary liquidity in times of stress. Moreov er, the crisis also co nfirmed the perceived 
‘stigma’ of borrowing from the central bank which led some institutions to withdraw lines and 
cut exposures, thus exacerbati ng rather than easi ng of funding pressure and compromising 
effectiveness of central bank intervention. 
In recognition of the need for credit institutions  to improve their liquidity risk management, 
the CRD was amended in 2009 to include minimum qualitative standards for institutions' liquidity risk management and the superv isory review of that  risk management.
162  However, 
these amendments fell short of providing fo r harmonised quantitative standards, thereby 
leaving regulatory standards in this important field un-harmonised while in the area of capital 
requirements, both a quantitative standard and qualitative requirements on the internal 
management exist in European legislation. While a number of MS impose some form of 
quantitative regulatory st andard for liquidity, no harmonised sufficiently explicit regulatory 
treatment on the appropriate levels  of short-term and long-term liquidity exists at the EU 
level . There are differences in national liquidity re gimes that arise from different degrees of 
resilience to liquidity stress that different  MS aim at. Linkages to certain nationally 
determined factors such as insolvency regimes,  deposit insurance arrangements, central bank 
credit and collateral policies or structure of the banking se ctor also play a role.  
Such differences in national liquidity regimes ma y give rise to potential level-playing field 
issues, particularly, for firms that have cr oss-border operations. As regards supervisory 
reporting, diversity in current national approa ches imposes additional costs on cross-border 
institutions and hampers effective communi cation and cooperation between supervisory 
authorities. In addition to the lack of co mparability of nationa l reporting frameworks, 
effectiveness of supervision was impacted ad versely by inadequate tim eliness and content, 
e.g., missing off-balance sheet items, of supe rvisory reports. Finally, the absence of a 
harmonised liquidity regime leads to liquidity supervision being carved out from the principle 
of home country supervision over branches of cr edit institutions within the EU, whereas in all 
other areas of prudential rules,  a level of harmonisation has b een reached that allows credit 
institutions to exercise their freedom of establishment without their branches being subject to 
host country rules and supervision. 
3.3. Eligibility of capital instruments and regulatory adjustments 
The EU banking system entered the crisis with  capital of insufficient amount and quality. 
Mounting losses forced banks to rebuild their capital bases at the time when it was most 
difficult to do so, in turn, necessitating governme nts to provide support to the banking sector 
in many countries and on a massive scale (see Chart 1) and contributing to the onset of 
economic downturn. More specifically, the exis ting CRD provisions on definition of capital 
were shown to suffer from the following shortcomings: 
i. Certain capital instruments did not meet the expectations of mar kets and regulators with 
regard to their loss absorption, permanence and flexibility of payme nts capacity on a going-
concern basis . This in particular pertains to the e ffectiveness in relation to the above three 
criteria of hybrid capital in struments (hybrids) a nd certain types of non -hybrid instruments 
that make part of 'original own funds'. The original CRD as adopted back in 2006 did not 
establish an EU framework for the recogni tion of hybrids within banks' Tier 1 capital 
despite the fact that the criteria of loss abso rption, flexibility of payments and permanence 
which are critical for determining an instrument's  inclusion as a compone nt of Tier 1 capital 
                                                 
162 Directive 2009/111/EC amending Directive 2006/48/EC 
 
 75  had been agreed at the G10 level and announced in the Sydney Press Release163 in 1998. As 
a result, several MS (non-members of G10) did not have a regime for including hybrids 
within Tier 1 capital, while supe rvisors in jurisdictions with su ch a regime had discretion to 
assess whether instruments satisfy  the criteria agreed at the G10 level. This shortcoming 
was largely addressed with the adoption of th e CRD II that established a harmonised set of 
stringent criteria for Tier 1 hybrid capital164 and introduced explicit limits165 on different 
types of Tier 1 hybrid capital, such as c onvertible capital, innovative hybrids and other 
hybrids. However, these provisions take effect only as of end 2010.  
 As regards the flexibility of payments, the crisis has shown that when these instruments 
included a possibility to defer or cancel a di vidend (coupon) to enable  banks to conserve 
resources during difficult times166, such possibility was not widely exercised. This was in 
part driven by a stigma of dividend cancellation  being interpreted by the market as a signal 
of distress. In fact, since banks  routinely paid dividends on their common shares, they had 
to pay them on hybrids as well (so called 'dividen d pusher' clause), as in most cases issuers 
of both bonds and equities mu st pay coupons on bonds before they pay dividends on shares. 
While supervisors have the authority under certa in conditions to restrict dividend payments 
by banks, they not always exercised this optio n because of the consideration that banks 
would find it difficult to raise additional capital  if they cancelled or cut dividends/coupons. 
Also, bank creditors did not  exercise an appropriate level of market discipline as they fully 
expected that due payments would be cont inually made. Effectively, the outflow of 
dividends and coupons contributed to the weaken ing of the banking sector at the time when 
capital was most needed.  
 As regards permanence, there were instan ces of banks calling hybrids despite the higher 
cost of replacing them at the time of crisis.167 This was in particular true when market 
expectations were based on instrument's contr actual terms that provide for a step-up in the 
interest rate if call is not exercised whic h effectively made such hybrids synthetically-
dated.168 Even though seemingly in the interest of banks' shareholde rs, skipping the call 
options (e.g., RBS, Bradford & Bingley, K BC Group) or cancelli ng/deferring coupon 
payments (e.g., BayernLB, Commerzbank, Lloyds, RBS, Allied Irish Banks, Bank of 
Ireland, Cajasur) on hybrid capital – where bank s had the discretion to suspend payments - 
became more prevalent only later in the crisis , in the context of state aid to financial 
                                                 
163 See http://www.bis.org/press/p981027.htm   
164 Article 63a 
165 Article 66; CRD II admits hybrids up to 50% of Tier 1 capital. 
166 According to CEBS, in 2006 only 19% of hybrids reported by EEA banks as Tier 1 capital did not have a 
right for the issuer to suspend payments, while as regards the remaining instruments, issuers had a right to do so in case of solvency difficulties, breach  of regulatory solvency or other limits fixed by 
supervisors and in other situations 
167 In fact, the markets were caught by surprise when in December 2008 Deutsche Bank broke this convention by 
announcing that it would not buy back €1 billion of subordinated lower Tier 2 bonds. Its decision was 
based on economic grounds: accepting the step-up allowe d the bank to pay annual interest of about 4% 
versus 7% if it tried to replace it with a new debt. As a result, credit default swaps on the Markit iTraxx 
Financial Index linked to subordinated bonds of 25 European banks and insurers jumped 20 basis 
points, reflecting investors' concern that Deutsche Bank's decision would encourage other borrowers to skip a call on all hybrids – whether Tier 2 or Tier 1 hybrids (sources: Bloomberg, Financial Times). 
Other instances of skipping a call on hybrid securities had been rare: in April 2008, Italian bank Credito 
Valtellinese Scrl chose not to call bonds of €150 million. 
168 According to CEBS, in 2006 42% of hybrids (mostly innovative instruments) reported by EEA banks as Tier 
1 capital had a step-up featur e at the time of their issue 
 
 76  institutions, and was in part due to the Co mmission policy that included the objective of 
'burden sharing'.169  
 In relation to loss absorption, the CRD II provisions170 require hybrid securities to provide 
'for principal, unpaid interest or dividend to be such as to absorb losses and to not hinder 
recapitalisation of the credit institutions'.171 According to CEBS172, in 2006 for 39% of 
hybrids reported by EEA banks as Tier 1 cap ital, issuers had a right to write down a 
principal on a going concern basis either perm anently or temporarily, while 1% of hybrids 
had a possibility of conversion  to ordinary shares. For inst ance, payment of principal and 
interest on Bradford & Bingley's hybrid capita l was deferred until af ter its repayment of 
liability to the UK government that was prov ided to the bank in the process of its 
nationalisation.173 However, such instances of hybrid  capital instrument s absorbing losses 
during the crisis have been rare. More importantly, as in case with flexibility of payments and permanence criteria, events of the crisis demonstrated that majority of Tier 1 hybrids 
met the three criteria of Ti er 1 capital only once bank recapitalization by governments 
commenced.  
 As a result, the crisis effectively delineated those capital instruments that acted as a 'going-
concern' capital from those that acted rather  as a 'gone-concern' capital. This made both 
market participants
174 and regulators175 to consider using much stri cter definitions of capital, 
which among other elements also excluded hybr ids, to measure banks' strength on a going-
concern basis.   
ii. The list of regulatory adjustme nts proved to be incomplete  as a number of balance sheet 
items whose valuation and/or loss absorption potential is less cert ain on a going-concern 
basis in times of market distress (such as mi nority interests, deferred tax assets, pension 
fund assets) have been effectively removed by  market participants and regulators from 
regulatory capital ratios as reported by individu al institutions. This list is not harmonised 
                                                 
169 Commission communication on the return to viability and the assessment of restructuring measures in the 
financial sector in the current cr isis under the State aid rules, http://eur-
lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:C:2009:195:0009:0020:EN:PDF   
170 Article 63a  
171 When a credit institution incurs huge losses it may need to be recapitalised. Availability of the hybrid 
principal and flexibility to stop the payment of coupons on hybrid may not be sufficient to attract new 
share capital as investors would be concerned that new capital provided to recapitalise the institution is 
used directly to benefit existing hybrid holders. To address this, hybrids must contain a mechanism that 
makes the recapitalisation easier by limiting the poten tial future outflows to the holders of hybrids. 
172 CEBS, Report on a quantitative analysis of the characteristics of hybrids in the European Economic Area 
(EEA), March 2007 
173 See http://corporate.bbg.co.uk/media-centre/latest-news/2010/2010-02-23.aspx   
174 For instance, Standard & Poor's calculates an individual bank 'total adjusted capital' (TAC) with a definition 
different from that of regulatory requirements. The credit rating agency limits the inclusion of Tier 1 
hybrid instruments for most banks to 25%. When combined with additional adjustments to TAC (such 
as for pension deficits, intangibles) as well as adjustments to risk weighted assets under Basel II, 
Standard & Poor's risk adjusted capital ratio for a global sample of 45 banks in mid 2009 was equal to 
6.3%, markedly below their average regu latory Tier 1 ratio of 9.7%. S&P, S &P Ratio Highlights 
Disparate Capital Strength Among The World's Biggest Banks , November 2009, 
http://www.standardandpoors.com/ratings /articles/en/us/?assetID=1245195414308   
175 For instance, in early 2009, the US conducted a stress test on 19 largest banking groups by measuring their 
financial health on the basis of 'Tier 1 common capital', effectively excluding hybrids. 'Tier 1 common 
capital' was calculated as Tier 1 capital (that excludes certain intangible assets, including goodwill and 
deferred tax assets) less non common elements, including qualifying perpetual preferred stock, qualifying minority interest in subsidiaries, and qualifying trust preferred securities; for more 
information please see  http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20090507a1.pdf
  
 
 77  across the EU, as Article 61 of the CRD pr ovides MS with a discretion as regards 
deductions of items that are not included in Article 57. 
 Minority interest represents shares issued by a group entity and is available primarily to 
absorb losses which occur in this entity. Currently, national practices as regards the 
inclusion of minority interest, in cluding extent thereo f, in 'original own funds' across the EU 
differ, as Article 65 of the CRD provides fo r a discretion. According to estimates of 
HSBC176, at the end of 2009 minority interests c ontributed €95 billion to European bank 
capital (or 46% of the global total of €206 b illion) of which €75 billion were included in 
Tier 1 and €60 billion in  core Tier 1. Over 65 European banks had capital contribution from 
minority interests, of which 15 had minority interest in excess of €1 billion that in some 
cases constituted over 20% of their Tier 1 capital. However, minority interest may not 
necessarily be readily availa ble to absorb losses elsewh ere in a group, including the 
consolidating entity. Therefore, in cases where a group entity is  overcapitalised, inclusion of 
minority interest at the consolidated entity le vel may represent an artificial enhancement to 
its capital ratios. For this reason it may be warranted to subject minority interest to a haircut and regulators in some EU MS  (e.g., IT) and intern ational jurisdictions have been already 
following this rationale.  
 Deferred tax assets (DTAs) can be defined as the amounts of income taxes that may be 
recovered by a company in the future. They may arise due to (i) temporary timing differences between statutory and tax accounting prof its (e.g., limitations to deductions for 
tax purposes in the current period ), (ii) unused tax losses that can be carried forward to use 
against future taxable profits, or (iii) tax credit ca rry forwards which ar e unused tax credits 
that can be used against future taxable prof its. However, DTAs whos e realisation through 
reduced future tax payments is contingent on a financial institution's ability to generate profits raise prudential concern as they may not  provide protection to depositors in case of 
insolvency. Moreover, DTAs can be written down in a period of  stress when banks' future 
profitability becomes less certai n. As a result, as crisis evolved market participants, 
including investors, industry analysts and credit rating agencies, grew increasingly 
concerned about the impact of DTAs on the quality of regulatory capital measures of 
banks.
177 According to the CEBS, regulators in se veral MS (e.g., SE, DK), already require 
that DTAs be deducted from banks' Tier 1 capita l while in AT tax losses carried forward are 
not allowed under national GAAP.  
iii. The crisis also showed that regulatory adjustments when applied were not applied to the 
appropriate layer of regulatory capital . Under the CRD, the current adjustments are 
generally applied on a 50%-50% ba sis to Tier 1 and Tier 2 (alt hough in some cases solely to 
Tier 1 capital).178 This allowed banks to report high Tier 1 ratios, despite the fact that they 
had low levels of Tier 1 capital when consid ered 100% net of the adjustments such as 
adjustment for investments in other financial institutions in excess of 10% of the common stock of such financial institutions. A deducti on in this case is warranted to prevent a 
reduction in capital as a result of loss absorpti on in one financial institution from being 
immediately reflected as a loss of capital in the investing fina ncial institution. Furthermore, 
current provisions of the CRD enabled some  banks to circumvent this requirement 
                                                
 
176 See http://ec.europa.eu/internal_market/bank/docs/gebi/hsbc_en.pdf   
177 According to Fitch Ratings, DTAs of US banks rated by the agency increased by 300% over the 12 month 
period ending June 2009, which, given the uncertainty surrounding certain banks' operating 
performance, increases the risk that they woul d need to write down their DTAs; Fitch Ratings, US 
Banks' Deferred Tax Assets , September 2009 
178 Article 66 
 
 78  altogether by virtue of a national discretion al lowing to treat the above  investments in other 
financial institutions as equity and debt inst ruments as part of banks' trading book in cases 
where they acted as market makers in these securities.179 
The above shortcomings contributed to the ba nking sector entering the crisis with reported 
Tier 1 capital ratios that were not reflective of institutions' effective capacity to absorb losses 
on a going-concern basis. As the crisis deep ened and banks faced growing losses and 
writedowns which directly redu ced their retained earnings, th eir fundamental solvency was 
called into question. Moreover, variations in the definition of  Tier 1 capital stemming from 
differences in application of regul atory adjustments across the MS obstructed the 
comparability and reliability of this measure. Th is led to the loss of confidence in Tier 1 as 
measure of capital adequacy by market particip ants and regulators who instead focused on 
alternative measures mostly based on common equity and adjusted for the balance sheet 
elements whose value and loss absorption poten tial proved to be uncer tain during market 
distress, such as tangible common eq uity or core Tier 1 capital.   
As importantly, the crisis has confirmed the importance of banks having sufficient capital 
buffers in good times to enable them to weat her difficult times, as accessing private equity 
and hybrid capital markets for mo st European banks during the crisis proved to be rather 
difficult, which made the taxpayers provide the funding for the resultant shortfall of capital 
and impeded the flow of bank credit the real s ector of the EU economy (please see section 3.5 
for more detailed discussion of the es calation of pro-cyc lical effects).  
3.4. Counterparty credit risk 
According to the data of the International Swaps and Derivatives Association (ISDA), the 
total outstanding notional amount of the over-t he-counter (OTC) derivatives from 2001 to 
2007 on average grew at the annual rate of 37%, reaching $454 trillion globally in 2007180 
whereas according to the International Capita l Markets Association (ICMA), the value of 
outstanding repo contracts on the books of 68 Eur opean institutions reached some €6.4 trillion 
in 2007. The crisis revealed a number of shortcomings in the current regulatory treatment of counterparty credit risk (CCR)  exposures arising from deri vatives, repos and securities 
financing activities. It showed that the exis ting CRD provisions did not ensure appropriate 
management and adequate capitalisation of financial institutions against the CCR that 
materialised during the crisis which was driven  by a number of factor s, of which the most 
material are the following:  
i. The current framework  did not adequately capture specifi c and generalised wrong-way risk . 
Specific wrong-way risk arises when the exposur e to a particular counterparty is positively 
correlated with the probability of  the default of the counterparty
181, i.e., when the credit 
exposure and default risk in crease together. Generalised wrong-way risk relates to a 
situation where the probability of default of counterparties is  adversely correlated with 
general market risk factors.182 During the crisis, a key obser vation was that defaults and 
deteriorations in the creditworthiness of trad ing counterparties occurre d precisely at the time 
when market volatilities, and therefore count erparty exposures, were  higher than usual. 
                                                 
179 Directive 2006/49/EC, Annex VII, part D 
180 According to ISDA, of 500 biggest global companies in 2008 (based on 2008 Fortune Global 500) 471 used 
some type of the OTC derivatives. 
181 Annex III, Part 1, point 28 
182 Annex III, Part 1, point 27 and Part 6, point 34 
 
 79  Although the current rules183 require monitoring of specifi c wrong-way risk, no standard 
practice has been developed by in stitutions and many of them ente red into transactions with 
substantial exposure to this type of risk. A particular example of  such transactions related to 
the purchase of credit protection from the so-called 'monoline'184 insurers. Monolines such 
as AMBAC, MBIA and ACA provided insuranc e on mortgage-backed securities and other 
structured products. When defaults on sub-prim e mortgages soared and monolines' ability to 
make payments on all the insurance cont racts signed became less certain, their 
creditworthiness was downgraded by the credit rating agencies, leading to a tsunami of margin calls and subsequent demise of severa l monolines on one side and mark-to-market 
losses combined with increased capital charges in relation to the insured securities for banks 
that held them, on the other.
185  
 The framework also did not directly require ca pital for mark-to-market losses due to credit 
valuation adjustments  (CVA). Roughly two-thirds of count erparty credit losse s were due to 
CVA losses and only one third were due to actual defaults.186 The current framework 
addresses CCR as a default and credit migration risk, but does not fully account for market 
value losses short of default. 
ii. The calculation of CCR associated with a deri vative contract or credit guarantee between 
financial institutions accounts for a degree to wh ich the market values of their assets are 
correlated. An increase in probability of default at one institution is likely to coincide with 
deterioration in asset quality at the counterpart y, implying an increased probability that the 
counterparty will default on the derivative or guarantee contract. U nder the current CRD 
provisions, counterparty exposur es associated with OTC deri vatives are assigned the same 
asset value correlation (AVC) as that which is used for a direct loan to a counterparty.187 
However this approach does not recognize the uni que, systemic risk associated with such 
exposures given the extent to which they are concentrated at large financial institutions, 
whose counterparties generally ar e other large financial institutions . The crisis confirmed 
that large financial institutions were more interconnected than reflected in the capital 
framework. As a result, when markets ente red the downturn, institutions' counterparty 
exposures to other fina ncial firms also increased. During th e crisis, financial institutions 
proved to be relatively more sensitive to sy stemic risk than non-financial firms and their 
credit quality deteriorated simultaneously. Evid ence suggests that asset values of financial 
firms are more correlated with each other in comparison to those of non-financial firms. The 
work conducted by the Basel Committee of AV Cs between some 12,400 firms from 1995 to 
2008 showed that average AVC for financial firms with assets of at le ast $25 billion relative 
to the financial sector index was at least 25%  higher than the average AVC for non-financial 
firms relative to the overall market index. 
                                                 
183 Annex III, Part 6, points 35 and 39 
184 Monoline insurers guaranteed the timely repayment of the bond principal and interest in case an issuer of the 
debt defaulted. Essentially, monolines provided a back-up guarantee to the debt issued by lower rated 
borrowers in exchange for insurance premiums and, therefore, had to be highly rated by the credit rating agencies in order to fulf il such a role. For instance,  a borrower rated A, by paying a premium to a 
monoline could use for its debt the monoline's AAA rating which made the debt attractive to additional 
investors and reduced the interest rate to be paid on the debt. 
185 In January 2008 Barclays Capital estimated that pote ntial losses for banks globally due to downgrades of 
monoline insurers could be in the range of $48-$143 billion 
186 According to estimates of the Basel Committee 
187 After quantifying exposure at default as a multiple ( α) of the expected positive exposure (EPE) to the 
counterparty, the Basel II formula for corporate loans is applied 
 
 80  iii. The existing framework did not provide sufficient incentives to move bilaterally cleared 
OTC derivative contracts to multilateral cl earing through central counterparties (CCPs).  
CCPs can play an important role in the efforts to reduce the systemic risk arising from the 
intricate web of exposures formed by holdings  of derivatives products by banks and other 
financial institutions. However, regulatory capital requirements for bilaterally cleared trades were not sufficiently high to offer an attractiv e incentive to clear OTC derivative trades 
through a CCP. Instead, the need to post initia l margin when cleari ng trades with a CCP 
apparently more than offset the fact that no regulatory cost was i nvolved for such trades. 
iv. Calculation of capital based on Effective Expected Positive Exposure (EPE) did not provide 
sufficient incentives for posting adequate initial margins throughout the cycle.  Initial 
margining was typically very low at the start of the crisis and increased rapidly during the 
turmoil . The raising of initial margin during the cris is served to protect the institutions, but 
also triggered weakened position if not th e failure of certain counterparties, thus 
exacerbating the crisis (see section 3.2 on fundi ng liquidity problems related increase in 
margin calls on complex transactions). 
v. The crisis also revealed a number of significant shortcomings in institutions’ risk 
management of counterparty credit exposures , including in particular the areas of back-
testing, stress testing, and collat eral management. The difficulties  in statistical  interpretation 
of back-testing results for CCR suggest that many firms did not appr opriately consider 
problems that were identified by back-testing. The use of models with poor back-testing 
results contributed to an underestimation of potential losses. Stress testing of CCR was not 
comprehensive, was run infrequently, some times on an ad hoc basis; and, in many 
institutions, provided inadequate  coverage of counterparties or  the associated risks. The 
crisis also highlighted a number of areas of concern that were rela ted to the management 
and operation of the collater al management process. 
3.5. Pro-cyclicality of lending 
Pro-cyclical effects can be defi ned as those which tend to follow the direction of and amplify 
an economic cycle. Within the financial system , such effects have a significant bearing. In 
particular, bank lending could contribute to ampl ify business fluctuations, which in turn may 
exacerbate financial instability. Recent empirica l evidence confirms that shocks to credit 
supply have the potential to a ffect economic activity in the predominantly bank-based euro 
area. Other theories, such as the mo netary theory of the business cycle
188 emphasize the role 
played by an artificial credit expansion in fo stering a boom-bust cycle.  The theory underlines 
the potential for generating economic cycles by the fractional reserve banking sector when bank credit is misaligned from the intermediation of  real savings. The cyclical nature of bank 
lending has many, often interconnected sources that include both ma rket and regulatory 
failures.
189  
                                                 
188 The theory was pioneered by Ludwig von Mises and F.A. von Hayek obtained the Economics Nobel Prize in 
1974 for his contribution to it. 
189 For a thorough description of the main sources of pro-cyclicality please see: 
 BIS, Addressing financial system procyclicality: a possible framework , Note for the FSF Working 
Group on Market and Institutional Resilience, September 2008; and  
 Masschelein, N., Monitoring pro-cyclicality under the capital requirements directive: preliminary 
concepts for developing a framework , NBB Working Paper Document No. 120, 2007 
 
 81  3.5.1.  Underlying market failure s and systemic aspects 
The cyclical nature of bank lend ing is in part driv en by several market failures such as 
limitations in the measurement of risk , information asymmetries between borrowers and 
lenders and inappropriate responses of financial inst itutions to changes in the economic 
conditions : 
i. Financial institutions have difficulties in assessing absolute level of risk (while they fare 
better at assessing relative risk), especially over a prolonged period, and so rarely identify 
booms with consequences for systemic risk. Hence, when macro-economic conditions were 
favourable, banks engaged in a rapid expans ion of their balance sheets without due 
consideration about implications fo r system-wide financial stability.  
 Measures of risk may be quite low as vul nerabilities and risk accumulate during the 
expansion phase but spike once tensions arise, for example, the market risk embedded in 
banks' trading book can be easily underestimated  if measured over short holding periods. 
Such limitations to perception of risk are in part attributable to the paucity of information regarding the dynamics of system ic risk and are explained by cer tain theories of behavioural 
finance such as disaster myopia
190 and cognitive dissonance191.  
 The misperception of risk ma y be exacerbated by a strong industry-wide drive for profit and 
moral hazard of implicit safety nets. The d ecisions made by each market participant may be 
rational in their own terms to promote the su ccess of an individual  institution during a 
period of growth (or to preser ve capital or liquidity during  a downturn), but may be sub-
optimal when considering the system as a whole.192  
ii. When economic conditions are depressed and collateral values decline, information 
asymmetries with respect to the quality of clients’ balance sheets can imply that even borrowers with profitable projects find it difficult to obtain funding. When economic 
conditions improve and collateral values ri se, the opposite situation may occur. This 
reasoning suggests that pro-cyc lical effects may be more pertinent to borrowers which are 
more prone to asymmetric information, includ ing small and medium-sized enterprises not 
subject to external ratings and ex tensive disclosure requirements. 
iii. Inappropriate financial institutions' responses to changes in economic  conditions in some 
cases are explained by short-term bias of remuneration structures or herding behaviour
193. 
Remuneration policies in financial institutions had an enhancing pro-cyclical effect where they entailed disproportionate rewards on th e upside and insufficient penalties on the 
downside, e.g., bonuses based on shor t-term profits that are paid  immediately, with no risk 
adjustment or deferred payment to take account  of future performance of the business unit 
or institution as a whole.  
 The crisis also showed that while in the ab sence of raising capital by the private sector 
greater efforts should have been  made to rebuilding of regulatory capital (in order to limit 
the rate and level of its depletion due to  accumulating losses), many banks maintained 
                                                
 
190 Tendency to underestimate the likelihood of high-loss low-probability events 
191 Tendency to interpret information in a biased way, so that it reinforces the prevailing belief entertained by the 
economic agent 
192 For a comprehensive review see Bori o, C., C. Furfine, and P. Lowe, Procyclicality of the financial system and 
financial stability: issues and policy options , BIS Paper No 1, 2001 
193 A tendency of market participants to conform in their behaviour with that of their peers 
 
 82  generous discretionary distri butions to their shareholders , providers of other capital 
instruments and employees. In some cases banks that had depleted their capital buffers used 
the distribution of capital as a way of signalling their financial strength to the markets. Such 
practices put shareholders' inte rests above those of depositors and created peer pressure on 
other banks to follow suit. As a consequence, financial institutions in aggregate ended up 
increasing distributions at the exact point in time when they should have been conserving 
their earnings and capital. According to Acharya et al. 194 dividends of 21 large banks from 
the US and Europe increased from 0.4% of th eir assets in 2000 to  1.1% in 2007 and were 
still at 0.7% through the fi rst three quarters of 2008, in spite of a deepening financial crisis.  
In light of the financial crisis, the effect of pro-cyclical feedback mechanisms on the financial 
system has been examined by a number of inte rnational groups, including the FSB, the Basel 
Committee, the G-20 and, within the EU, a wo rking group of the Economic and Financial 
Committee (EFC). Several of these groups, in cluding FSB, the Basel Committee and the G20, 
published their findings and / or  recommendations in spring 2009. In line with the above, the 
Commission in its Communication of 4 Marc h 2009, announced that it would pursue certain 
measures aimed at enhancing level of capital and introducing counter-cyclical buffers and a 
supplementary metric to better contro l leverage and li quidity risks.  
In order to address the harmful effect of poor ly designed remuneration structures, in 2009 the 
Commission adopted the CRD III proposal whic h included provisions to supplement the 
requirements of the CRD with an  express obligation for credit institutions and investment 
firms to establish and maintain, for those categor ies of staff whose profe ssional activities have 
a material impact on their risk profile, remunera tion policies and practices that are consistent 
with effective risk management.  
To improve the adequacy of bank capital requirements, the CRD III proposal also included 
provisions for increase in regul atory capital requirements fo r the trading book activities and 
re-securitizations held in th e banking book. During the financia l crisis, weakness of the 
minimum capital requirements in these areas led to additional stress on banks' capital positions which, in turn, contributed to the tight ening of bank lending standards. Importantly, 
measures to address the risk capture in the area of CCR (see section 3.4) that are part of the current CRD IV proposal shall have a positiv e effect on limiting the cyclicality of the 
minimum capital requirements. 
In 2010, the European Parliament and the C ouncil adopted the Commission's proposal to set 
up a European Systemic Risk Board (ESRB)
195 to oversee the stability of the financial system 
as a whole. ESRB would identify systemic risks at the European level and issue risk warnings. Adding a robust macro-prudential overl ay to the current micr o-prudential approach 
should help to address sources of  pro-cyclicality linked to limita tions in the risk measurement 
and inappropriate responses of market partic ipants to risk. This should support the timely 
identification of cycles and the build-up of ri sks in the system which, when accompanied by 
robust links to supervisors and policymakers, c ould enable action to be taken earlier to avoid 
excessive volatility and pro- cyclicality in a downturn.  
                                                
 
194 Acharya, V., I. Gujral, and H. S. Shin, Bank Dividends in the Crisis: A Failure of Governance , 31 March 
2009 ( http://www.voxeu.org )  
195 Regulation (EU) No 1092/2010 of the European Parliament and of the Council of 24 November 2010 on 
European Union macro-prudential oversight of th e financial system and establishing a European 
Systemic Risk Board  
 
 83  3.5.2.  Leverage and lending cyclicality 
However, the measures proposed by the Commi ssion so far were designed to address only 
some specific aspects of the above-listed market  failures and, therefore,  may not be entirely 
effective in limiting the extent of leverage build-up in the balance sheets of financial institutions and the concomitant overextensi on of credit. On 23 June 2010 the Commission 
adopted a report to the European Parliament a nd to the Council on the effects of the CRD on 
the economic cycle
196 noting that it would examine additi onal measures which i) limit the 
build-up of leverage in the bank ing sector and ii) curb the exce ssive risk-taking in times of 
economic growth but could be drawn down dur ing economic downturns  to increase the 
resilience of the banking s ector and to support the cred it flow into the economy.   
The financial crisis has shown that credit in stitutions' leverage – the degree to which their 
exposures exceed their capital levels – can incr ease to unsustainable levels and have a pro-
cyclical effect on the financial system. In the run up to the crisis, many investors, including 
banks, actively sought higher yields  as high levels of availabl e liquidity resu lted in risk 
premia falling to historically low levels. Exceptionally low interest rates, combined with issues of moral hazard and market contestabilit y, pushed banks to search for higher returns, 
whether through an increase in leverage or investment in mo re risky financial products.  
One feature of current risk-based minimum cap ital requirements is that they vary over the 
economic cycle, e.g., they decrease as borrowe rs' creditworthiness improves during economic 
expansions. Provided credit institu tions could meet their risk-bas ed capital requirements, there 
is no explicit regulatory c onstraint on their leverage. The lack of a limit to their leverage  and 
irresponsiveness of regulatory c apital requirements to the build- up of risk at the macro level  
enabled banks to grow their balan ce sheets by taking on more risks.  
In this regard, the analysis of credit growth, using credit-to-GDP gap as indicator, from 1995 
to 2009 carried out by the ECB for 19 MS showed  that credit in the years preceding the 
financial crisis grew at a fast pace in a number of them (such as IE, LV, LT and HU), 
signalling the building up of financial imbalanc es, accumulation of risk at the systemic level 
and imminence of significant cr edit-related losses for their banking sectors (see Table 3).
197 A 
corresponding calculation that has been conduc ted by the Basel Committee to measure the 
level of this metric for five years prior to the outbreak of a crisis for a sample of very severe 
banking crises, including those th at e.g. took place in Nordic c ountries in 1991 and Mexico in 
1994, showed average credit-to-GDP gaps  consistently in excess of 10%.198   
When financial asset prices started to fall, th e opposite feedback loop wa s in high gear: assets 
had to be marked-to-market for losses incurre d and banks had to de-l everage by selling them 
in order to minimize regulatory capital requi rements and meet margin calls from their 
counterparties, prompting further asset price d eclines (see section 3.2 for the interaction 
between market liquidity and funding liquidity).  
Analysis by IMF199 based on the sample of 36 large inte rnational commercial and investment 
banks showed that leverage might be a useful indicator of vulnerability  of a bank. According 
                                                 
196 See http://ec.europa.eu/internal_market/bank/docs/regcapital/monitoring/23062010_report_en.pdf   
197 In some EU-12 MS, fast pace of cred it growth can in part be attributed to their lower pre-crisis levels of 
credit/GDP  
198 See http://www.bis.org/publ/bcbs172.pdf?noframes=1   
199 IMF, Responding to the Financial Crisis and Measuring Systemic Risk  (Global Financial Stability Report), 
April 2009 
 
 84  to this analysis, in the period from January 2005 till June 2007 (before th e start of the current 
cycle and the beginning of th e sub-prime crisis), leverage200 of non-intervened201 banks was 
equal to 7.6, while leverage of  intervened commercial banks and intervened US investment 
banks was equal to 9 and 13.7, respectively. 
Table 3: Credit-to-GDP gap for selected EU  countries in %, annual averages202 
AT BE BG CZ DK EE FI GR HU IE
1995 -2.1 0.4 -24.9 0.7
1996 2.2 -0.2 3.2 -27.9 0.5 1.3
1997 -0.1 4.9 -7.0 1.5 3.9 -27.8 0.4 5.1
1998 -0.6 5.0 7.6 -3.0 7.0 -25.3 -0.3 4.5
1999 -0.3 5.8 13.3 -3.2 7.5 0.3 -18.0 0.1 10.2
2000 0.6 4.3 13.0 -3.1 7.3 0.5 -13.8 2.1 9.2
2001 -0.4 3.5 12.3 -3.8 8.8 0.5 -11.1 -0.1 1.4 4.6
2002 -2.2 0.3 12.5 -4.4 9.4 2.0 -5.3 -0.4 -3.4 -0.3
2003 -3.8 -1.0 14.1 0.7 9.4 2.2 1.1 -0.5 1.2 -2.1
2004 -3.2 0.6 15.9 5.1 9.4 4.1 5.9 0.2 5.1 6.2
2005 -3.2 -1.0 17.5 9.0 11.7 9.2 9.6 1.9 6.9 19.0
2006 -2.7 -2.0 12.5 12.4 15.7 15.4 12.5 3.2 6.6 28.4
2007 -3.4 6.1 19.2 15.0 20.3 14.5 13.0 3.6 5.5 31.6
2008 -1.8 8.7 22.7 16.8 21.4 7.3 16.1 4.4 8.2 40.2
2009 -0.2 9.1 15.7 15.9 22.0 5.1 21.5 -0.2 14.0 39.4
LT LU LV MT PL PT RO SI SK
1995 -0.6
1996 0.1 -0.2 0.1 1.9 -0.3
1997 0.5 -0.7 -0.1 6.0 -0.1 0.0
1998 1.2 -1.7 -0.3 12.6 0.1 1.3 0.4
1999 1.9 -0.5 0.6 0.4 26.0 -1.4 2.1 0.7
2000 0.7 0.3 0.3 -0.8 -0.1 32.8 -0.8 1.7 0.1
2001 0.8 0.7 1.8 -2.3 -1.1 30.6 0.8 1.1 -6.0
2002 2.0 -1.7 2.7 -6.3 -1.7 19.0 2.2 -1.1 -1.8
2003 4.3 -1.8 3.5 -5.5 -1.7 8.2 3.3 -1.5 2.4
2004 7.5 -2.7 5.1 -2.5 -1.6 -3.4 3.5 1.0 4.0
2005 9.6 -1.1 9.5 -1.1 -2.4 -8.1 3.9 4.5 7.1
2006 14.0 -1.7 14.4 1.1 -0.2 -2.1 6.5 7.4 10.1
2007 15.8 3.8 10.7 2.6 3.7 -1.5 8.9 10.9 11.4
2008 13.0 8.7 -0.3 3.1 7.6 4.4 15.5 12.4 12.5
2009 10.3 9.3 -1.0 5.4 9.2 9.3 11.5 13.2  
Note:  Green: 2%<gap<5%; Orange: 5%<gap<10%; Red: gap>10%; No colour: gap<2%. Results for 2009 are most likely 
distorted due to the impact of the financ ial crisis on macroe conomic variables. 
Sources:  Individual countries ' data, ECB calculation  
Another analysis203, conducted by the Basel Committee look ed at leverage ratios for 117 
banks from 19 countries in 2006 and 2007, of wh ich 27 banks were identified as 'severely 
stressed' during the financial cris is. The results of the analysis showed that severely stressed 
banks entered the crisis with indicators show ing a higher degree of balance sheet leverage. 
For instance, average leverage, when measured by tangible common equity as a percentage of tangible assets, for the group of severely stressed banks was equa l to 2.65% in 2006 in 
comparison to 3.81% for the group of non-stressed banks.
204 
Even though certain targeted measures to th e CRD that are expected to contribute to 
containing the build-up of excessive bank le verage have been proposed and might be 
supplemented by additional amendments in the futu re, given that leverage  is also driven by 
factors outside the bank capital framework and wo rks in a pro-cyclical fashion which - as the 
recent events have shown - has damaging conse quences for a wide range of economic agents, 
                                                 
200 Measured as a ratio of debt to common equity 
201 Intervened institutions are those that have gone bankrupt or that have received government capital injections 
or have had assets purchased by government or r eceived loans to facilitate a merger or acquisition 
202 Credit-to-GDP gaps calculated as a di fference between the ratio and its long  term trend, whereas the trend is 
derived based on quarterly data using a one –sid ed Hodrick-Prescott filte r with a choice for the 
smoothing parameter λ a value of 400,000 
203 See http://www.bis.org/publ/bcbs180.pdf   
204 Difference statistically significant at 5% level 
 
 85  it is appropriate to consider de veloping a measure that controls  the overall extent to which 
financial institutions can leverage their capital.  
The need to introduce a leverage ratio as a back-stop measure to the risk-based capital 
requirements results from the difficulty of quan tifying systemic risk, in particular at the 
micro-level of financial institutions. As the current crisis has dem onstrated, the entire 
financial sector can move into a high-gear of  balance-sheet expansio n in the boom phase, 
blurring the analysis of risk by financial institutions. As the ex-ante identification of systemic 
risks and formation of asset-bubbles is largely a probabilistic exercise , the introduction of a 
'hard' leverage ratio would help allevi ate an excessive expansion of credit. 
3.6. Options, discretions and minimum harmonisation 
3.6.1.  Current framework 
The CRD is a recast of the Consolidated Banking Directive (2000/12/EC). In 2000, seven 
banking directives and their am ending directives were replaced  by one single Directive. In 
2006, the CRD introduced the Basel II framework in European legisla tion. As a result, the 
CRD provisions include a significant number of options205 and discretions206. In particular, 
the recast of 2000/12/EC to introduce the Basel II framework has resulted in 101 options and 
discretions which have been identified by CEBS.207 To a large extent, insertion of national 
options and discretions in the CRD has been used to facilitate compromises between diverging positions of MS and the European  Parliament and to better accommodate 
specificities of local markets.  
In addition to the aforementioned availabil ity of options and discretions, the CRD is a 
'minimum harmonisation' Directive. This is explicitly acknowledged in recital 15 of Directive 2006/48/EC
208 and means that MS may 'add' stricter prudential rules, whic h gives rise to a 
practice known as 'gold-plating'.  
Divergences in national rules st emming from the possibility of application of national options 
and discretions and gold-plating are exacerbated by the process of transposition itself. Finally, 
national rules transposing the CRD are interpreted in accordan ce with local traditions and 
approaches thereby deepening the divergences  in application of the CRD across the MS 
further. 
                                                 
205 An option refers to a situation in which competent au thorities or MS are given a choice on how to comply 
with a given provision, selecting from a range of alternatives. For example, for purposes of risk-weighting institutions or local authorities, MS ma y apply either the central government risk-weight 
based method or the credit assessment based method.  Options granted to credit institutions to flexibly 
make use of prudential treatments reflecting different risk management processes are not included in this list.  
206 Discretion refers to a situation in which competent authorities or MS are given a choice as to whether to 
apply, or not to apply, a given provision. For example, a competent authority under particular 
circumstances can apply a 50% risk-weight to commerci al real estate, or waive capital requirements at 
solo level for domestic subsidiaries. 
207 Competent authorities are requ ired under Article 144 (b) of the CRD to di sclose 'the manner of exercise of the 
options and discretions available in Community legislation'. CEBS has developed a 'supervisory 
disclosure framework' for that purpose ( http://www.c-ebs.org/Superv isory-Disclosure.aspx ) 
208 "The Member States may also establish stricter rules th an those laid down in Article 9(1), first subparagraph, 
Article 9(2) and Articles 12, 19 to 21, 44 to 52, 75  and 120 to 122 for credit institutions authorised by 
their competent authorities. The Member States may al so require that Article 123 be complied with on 
an individual or other basis, and that the sub-consolidation described in Article 73(2) be applied to other 
levels within a group" 
 
 86  3.6.2.  Policy context: the new EU  financial architecture 
This accumulation of national options and discreti ons and the possibility to make 'additions' at 
national level when transposing the directive have resulted in administrative burden for firms 
operating in different MS. This has been explicitly recognised by the Ec ofin Council in the 
context of the review of the Lamfalussy proc ess. In its conclusions  of 4 December 2008, the 
Ecofin invited MS "to keep unde r review the options and disc retions implemented in their 
national legislation, limit their use (wherever possible) and report to  the Commission on these 
findings". The Ecofin also invited the Institutions  "to introduce a 'review clause' in future EU 
legislation on all options and discretions includ ed in the respective acts". When this review 
clause comes into effect after a specified ti me, the necessity and use of the options and 
discretions should be review ed and, where necessary, abolished where there is no 
demonstrated need. 
Likewise, the High Level Group on Financial Supe rvision in the EU chaired by Jacques de 
Larosière209 invited the EU to develop a more harm onised set of financial regulation. As a 
follow-up to this report, Co mmission Communication of 4 Ma rch 2009 emphasised that "key 
differences in national legisla tion stemming from exceptions, de rogations, additions made at 
national level or ambiguities contained in curre nt directives should be identified and removed, 
so that a harmonised core set of standards is defined and applied throughout the Member 
States", and called for a 'rolling' plan to deliver a singl e rule book. In the c ontext of the future 
European supervision arch itecture, the European Council also stressed the need to establish a 
European single rule book app licable to all financial inst itutions in the Single Market.210 
As a follow-up to the de Larosière report, in  2009 the Commission has proposed the creation 
of a European System of Financial Supervisor s that already became ope rational as of January 
2011. At the EU-level, the four existing Lamfalu ssy Level 3 Committees of Supervisors have 
been replaced by three new European Supervisor y Authorities (ESAs), i.e., EBA, a European 
Insurance and Occupational Pensions Authorit y (EIOPA), and a European Securities and 
Markets Authority (ESMA), each of them ha ving a legal personality and their Joint 
Committee for common issues such as anti- money laundering, financial conglomerates, 
accounting and others. These new ESAs took on all the missions of the previous Committees 
and received additional increased  responsibilities, defined lega l powers and greater authority.  
In particular, the ESAs have been entrusted with  the task of developing  technical standards in 
areas specified in their respective sectoral le gislation. The areas, wher e the Authorities are 
empowered to develop technical standards for endorsement by th e Commission, concern 
issues of a highly technical nature where uniform conditions for implementing Community 
acts are needed.  
For standards to be best devel oped, requirements of the CRD should not diverge, i.e., there 
should be no possibility to apply stricter rules, or di fferent options and na tional discretions at 
a national level. The technical standards de veloped by the new ESAs (Article 7 of the 
proposed Regulations) will be adopted by the Commission in the form of regulations (or 
decisions).  
Against this background, maximum harmonisation and the removal of options and discretions 
would be instrumental in allowing the new author ities to develop technica l standards that will 
                                                 
209 See http://ec.europa.eu/internal_market/fin ances/docs/de_larosiere_report_en.pdf  (recommendation No 19) 
210 Brussels European Council 18 and 19 June 2009 
 
 87  become legally binding once endorsed by the Commission, and, thus, in fully underpinning 
the reform of the EU supervisory architecture.211 In addition, further cl arity and consistency 
of the Community legislation would limit scope  for disagreement between supervisors, and, 
where disagreement will occur, powers granted to the Authorities will enable them to resolve 
the matter with reference to Community legi slation and, in particular, already accepted 
standards.  
3.6.3.  Scope of the exercise 
CEBS has identified 101 national options and discretions to be disclosed in its supervisory 
disclosure framework in accordance with Article 144 of the CRD. The way MS have 
implemented these options and discreti ons is disclosed on CEBS' web-site.212 Additional 
potential national discretions have been identi fied by the industry representatives in their 
responses to CEBS' questionnaire of July 2007.  In total, CEBS analysed 152 options and 
discretions.213 Annex II provides an insight  into extent to which they have been exercised by 
individual MS. Majority of the national discretions and op tions can be grouped into the 
following categories:  
i. national options and discretions reflecting the di versity of domestic market because of local 
economic or institutional conditions;214 
ii. national options and discretions reflec ting different supervisory approaches;215 
iii. provisions in the CRD under whic h supervisors shall make a supervisory judgment (based 
on criteria or some conditions) th at are not strictly speaking 'n ational options', but some MS 
have implemented these provisions as an option.216 
                                                 
211 For a presentation of technical standards, pleas e see the Commission staff working document accompanying 
the draft Council and Parliament Regulation on a European Banking Authority, draft Council and 
Parliament Regulation on a European Insurance and Occupational Pensions Authority, draft Council 
and Parliament Regulation on a European Securities and Markets Authority 
212 See http://www.c-ebs.org/Supervisory-Disclosur e/Options-and-national-discretions.aspx   
213 CEBS proposed to keep as a national discretion only 28% of them with accompanyi ng proposals, i.e., deletion 
of the option, making an option a general rule, letting the choice of the use of an option to credit 
institutions for the 65% of the provisions analyzed. Of the 28% that were proposed to be kept, about one third would expire by the end of 2011, meaning that any change in the text of the CRD would have 
no or limited validity by the time the provision would have been amended through the legislative 
process. 
214 An example of an ‘institutional condition’ would be the structure of institutions in a MS, such as local and 
regional authorities. Accounting treatment, company law,  supervisory philosophy, and so on, do not fall 
into this category. For example, in Annex VI, Part 1, point 15, the Competent Authorities may, in exceptional cases, treat exposures to public sector entities as exposures to the central government in 
whose jurisdiction they are established where, in their opinion, there is no difference in the risk between 
such exposures because of the existence of an a ppropriate guarantee from th e central government. In 
Annex VIII, Part 1, point 28, MS may also reco gnize as eligible provid ers of unfunded credit 
protection, other financial institutions authorised and supervised by competent authorities and subject to prudential requirements equivalent to those applied to credit institutions. 
215 For example, in terms of scope of application, some supervisors make use of solo-consolidation: under 
Article 70, MS may allow, on a case-by-case basis, for the purpose of the calculation of the individual requirements of the parent institution, and subject to  certain conditions, the incorporation of subsidiaries 
whose material exposures or liabilities are all to that parent institution. Another example is Article 80(3) 
that allows MS to choose between two alternative methods for risk-weighting exposures to credit institutions: (a) on the basis of the risk-weight of the corresponding central government and (b) on the 
basis of the credit assessment of the institution itself. 
 
 88  This impact assessment and the legislative prop osal that it accompanies do not tackle certain 
national options and discretions that will be addr essed in separate exercises in line with the 
review clauses specified in the legislation.217 
Part of the divergence in national rules stems fr om the fact that the CRD, as explained earlier, 
is a 'minimum' harmonisation directive, allowing MS  to establish stricter rules than those laid 
down under some of its provisions. 'Regulatory a dditions' made at nationa l level are threefold: 
i. additions in areas which are no t explicitly covered by sectoral  legislation (e.g., supervisory 
provisioning policy that is implemented in some MS); 
ii. additions explicitly allowed in the Directive in areas which lack full harmonisation (e.g., 
Article 61 on the composition of own funds), or not sufficiently harmonised (e.g., 
supervision of liquidity in accordance with Article 41); and 
iii. additions in areas which are fully harmonised:  the Commission has been informed of the 
degree to which Member States resorted to 'gol d-plating' in a report on the transposition of 
the CRD in the 27 Member States.218  
Only the third category of regulatory additions  is discussed in this section. The second 
category is discussed in the context of the pr oblem definition of bank liquidity (section 3.2) 
and capital definition framework (section 3.3). Other harmonization-related aspects will be 
tackled at the time of revision or in troduction of respective provisions.  
3.6.4.  Problems stemming from diverging national rules 
The EU banking market is becoming increasi ngly integrated: currently around 70% of EU 
banking assets is in the hands of some 40 banking groups with subs tantial cross-border 
activities. Especially  in the EU-12, banking markets are dominated by foreign (mostly 
Western European) financial groups. In these co untries, on average 65% of banking assets are 
held by foreign-owned banks; while in EE, the CZ and SK this statistic is in excess of 92%. 
However, efficiency of the internal market  in wholesale and reta il banking services is 
undermined by divergences in national rule s on capital and liquidity requirements. 
                                                                                                                                                         
216 For example, in Article 84(2) when IRB approach is used by an EU parent or financial holding company and 
its subsidiaries, the competent authorities may allo w the minimum requirements to qualify for IRB 
approach to be met by parent and subsidiaries considered together. This is a supervisory decision to be 
applied on a case basis after considering the f eatures of banks' IRB system, i.e. centralised 
system/decentralised system.  
217 These include: 
 i) options pertaining to provisions on the regulatory  treatment of 'large exposu res'. CRD II significantly 
reduced the number of options and discretions, but some options have been left as a result of 
compromises. The Parliament and the Council ag reed to review them by the end of 2011; 
 ii) options pertaining to the scope of application (i.e., application of requirements at solo, sub-
consolidated and consolidated level), subject to  a specific review clause by the end of 2011. 
218 DLA Piper UK LLP, Study on the Implementation of Directive 2 006/48/EC and Directive 2006/49/EC by the 
27 Member States , final report, February 2009.  
 Examples include the regime of past due items, risk weight of 100% instead 75% for retail exposures, 
risk-weight of 50 % instead of 35% for residential real estate, concept of loss for operational risk, 
eligibility criteria for collateral, more sophisticated definition of  dilution risk for receivables, restrictive 
transposition of the use test for IRB banks, restric tive definition of the retail exposure class under the 
IRB framework, higher capital requ irements for foreign currency risk. 
 
 89  As a result of 'gold-plating', national options and discretions available in the legislation, 
there is a high level of diverge nce in how the rules are implem ented by MS and subsequently 
applied by the national supervisory authoritie s who also have a possibility under certain 
provisions to exercise judgment or make a choice , thus expanding the scope of national 
divergences further. These diverg ences have several consequences: 
i. Where the legal text does not include criteria on which judgements or choices are made by 
supervisors, some options and national discre tions may result in a lack of legal clarity.  
ii. While all MS have a supervisory treatment that  appears to be legally  compliant, any given 
exposure might receive very diffe rent treatment from one MS to another. The lack of a 
consistent approach across the EU is a major co ncern for industry as the effects of disparate 
approaches have a direct effect on firms' abili ty to properly and fair ly compete in another 
MS, leading to an uneven playing field. 
iii. The different rules in different MS also make  it more difficult for de positors, investors and 
other stakeholders to make effective comp arisons between the financial situation and 
stability of credit institutions from different  MS, leading to increased market uncertainty 
especially in situations of financial stress. 
iv. The different application of the legislation in  different MS is particularly burdensome for 
firms operating cross-border. They have to  calculate and report different sets of 
requirements according to the rules of the cons olidating supervisor, the supervisor of the 
subsidiary (or the host supervisor) for national discretions pertaining to the features of a 
local market which gives rise to a dditional supervisory reporting costs.  
v. The presence of divergences hampers the deve lopment of a single re porting framework in 
the EU in order to allow cross-border banks to minimize their superv isory reporting costs. 
In this regard, CRD II requires competent author ities to apply a uniform reporting format by 
the end of 2012 and EBA is already developi ng a common reporting framework ('COREP'). 
However, a uniform reporting format does not m ean that the contents of the data to be 
reported are identical throughout the EU. This is  because there is no harmonisation of data 
definitions which is driven by, among other fact ors, differences in the CRD implementation 
and in supervisory approaches because of the proliferation of national options and 
discretions. 
3.6.5.  Further problems stemming from treatment of divergences at consolidated level  
Consequences of regulatory divergences are pa rticularly pertinent when considering their 
treatment at consolidated level. Under the CRD, as a general rule the consolidating supervisor (home competent authority) should apply 'home' country rules at a consolidated level, unless 
otherwise provided for in the directive. Wher e rules are not harmonised, this may result in 
banking groups with a subsidiary  in another jurisdiction having to apply diverging rules at a 
solo level (host country) and at a consolidated level (home country).  
There are legal and practical excepti ons to this general principle: 
i. Mutual recognition (possible recognition of the host treatme nt at home level). The CRD 
provides 18 cases of explicit reference to mutual recogn ition of national discretions 
 
 90  implemented by another national authority219 and the supervisory disclosure framework 
discloses the way those 18 cases of national di scretions are applied, and whether MS allow 
for mutual recognition. Mutual recognition of  the host supervisor’s national discretion 
provides some degree of flexibili ty by allowing at consolidated  level the use of local rules 
and at the same time reduces administrative bur dens incurred by the pare nt credit institution 
in relation to the subsidiaries. It also allows credit institutions to apply the 'host' treatment 
for exposures directly he ld by the credit institution, and thus ensure a le vel playing field 
between firms providing services in the same MS. The CRD contains only a limited number 
of mutual recognition-based provisions. Ho wever, mutual recognition of national 
discretions should not be seen as an optimum or definitive solution, as it might result in 
embedding national discretions in Community le gislation. Mutual re cognition only lends 
itself to national discretions justified because of  local or institutional conditions (see above). 
ii. Reporting practices vary from one country/ba nk to another. Under a 'building' block 
approach, the consolidating bank aggregates  the capital requirements calculated by each 
legal entity of the group, a nd therefore essentially base s the calculation of capital 
requirements on host country rules. This reporting practice comes down to broadly 
recognising the treatment of host countri es (i.e., mutual recognition). In certain 
circumstances, i.e., when the prudential treat ment depends on the booking of an exposure, 
this reporting practice might l ead to regulatory arbitrage.220  
iii. The CRD provides the possibility to apply 'hom e' discretions at 'host' level. This is 
discussed, on a case by case basis, in colle ges of supervisors in volving all relevant 
supervisors of banking groups. In the context of the joint decision for using advanced 
approaches to credit risk and operational risk, supervisors may decide to apply any blend of 
'home' and 'host' discretions. However, due  to the number of options and discretions 
available in the CRD, positions of national author ities with regard to suitability of specific 
prudential approaches or measures vis-à-vi s parts of the group may diverge, hindering 
efficiency and effectiveness of supervisor y cooperation. In case of disagreement, the 
consolidating supervisor may have the last say.221 Effectively, mutual recognition under 
Article 129 delivers banking gr oup-specific outcomes as practices may vary from one 
college of supervisors to another. This appro ach may lead to potential  problems of different 
treatment of different cross-border groups, and may have implications for the level playing 
field in the host jurisdiction. 
                                                 
219 For example, regarding the preferentia l treatment of commercial real estate (i.e. 50% risk weight under Annex 
VI, Part 1, section 9.2) that MS may allow under specific conditions, when this discretion is exercised 
by the competent authority of on e MS, the competent auth ority of another MS may allow their credit 
institutions to risk weight at 50% such exposures fully and completely secured by mortgages on 
commercial property.  
220 For example, if subject to mutual recognition, the option to risk-weight banks using the assessment of a 
credit rating agency or the rating of the sovereign may lead to regulatory arbitrage. The risk-weighting 
of exposures to credit institutions differs depending on whether it is determined (a) on the basis of the 
risk-weight of the corresponding central government or (b) on the basis of the credit assessment of the institution itself. If a banking group may apply option (a) at solo level in Member State X while its 
home country (Member State Y) ap plies option (b), and if option (a) results in lower capital 
requirements, the group will be incentivised to book its exposure to credit institutions in Member State 
X.
 
221 Article 129(2) 
 
 91  3.7. Risks inherent in baseline scenario 
There is a broad international consensus th at problems outlined in sections 3.2 - 3.6 
individually, and even more so when taken toge ther, played a significant  contributing role in 
exacerbating economic cycle and precipitating extr eme financial instabil ity that in turn 
evoked the global economic rece ssion, damaging soundness and inte rnational competitiveness 
of the EU banking sector and subjecting a wide range of stake holders, including bank 
creditors, shareholders, employees, borrowe rs and taxpayers, to unprecedented economic 
costs. If no action in these areas is taken, the risk that systemic shocks of a similar scale occur 
in the future will not be addressed.  
3.8. Is action necessary at EU level? 
Based on the nature of problems outlined in the above analysis, several major justifications 
that meet the principle of subsidiarity for action at the EU level become apparent. They 
include a need to enhance the integration of EU internal banki ng market (by removing 
national options, discretions and possibilities to gold-plate), a ddress several market (e.g., in 
the area of countercyclical po licy measures) and regulatory fa ilures (e.g., capital definition 
and liquidity risk management ru les, capital requirements for CCR) that were brought to light 
by the financial crisis, correct for regulatory arbitrage opportuni ties which are made possible 
by the current legislation (due to the availability of certa in national options and discretions) 
and ensure a consistent EU appr oach for tackling various issues  covered by the scope of this 
report, which would do away with the need for MS to pursue individual approaches that risk 
fragmenting internal market.  
Most importantly, only a common EU-level appr oach could be expected to effectively 
provide for financial stability and tame excessive financial pro-cyclicality, as currently policies that are directed toward these key systemic  aspects are either geared to national needs 
or are absent altogether. With respect to th e latter, the crisis clearly demonstrated the 
ineffectiveness of the national liqui dity risk supervision approaches. 
As regards the proportionality of proposed EU acti ons, it is implicitly assessed in section 5 in 
the process of comparison of potential policy op tions in terms of their effectiveness and 
efficiency vis-à-vis the relevant policy objectives. 
 
 92   
 
       
 
               
 
Opportunities for regulatory 
arbitrage 
 
Increased pro-cyclicality of 
the financial system  Current provisions do not capture all the 
risk adequately: 
 
9 Generalised / specific wrong way risk 
9 Systemic risk related to large financial 
institutions 
9 No capital requirement for mark-to-market 
l osses du e to credi t v alu e adju stments Shortcomings in liquidity risk 
management, including stress testing 
Implications for 
international 
competitiveness of EU 
bankin g industr yLack of legal clarity 
 
Lack of detail within certain provisions 
that allow for supervisory judgement and / 
or choice to be made   
PROBLEM DRIVERS  
Prudential capital and 
liquidity requirements 
inadequate in relation to 
undertaken risks  GENERAL 
PROBLEMS  
Current provisions leave room for 
diverging rules across MS through: 
 
9 National options 
9 National discretions 
9 Additions above minimum harmonisation due 
to possibility to gold-plate  
Increased risks to financial 
stability  
 
Creditor protection not 
optimised  Cyclicality of bank lending  
Increased compliance 
burden for cross-border 
institutions  
Unlevel playing field 
Sub-optimal level of 
supervisory co-operation 
and convergence  
Sub-optimal level of risk 
management 
Current provisions do not entail 
incentives to: 
 
9 Move bilateral OTC to clearing through 
central counterparties 
9 Post ade quate initial mar gin L
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R
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K Asset and liability maturity mismatches 
No harmonised and sufficiently explicit 
regulatory treatment at EU level  
Certain capital instruments did not fulfil 
loss absorption, permanence and 
flexibility of payments criteria  
List  of prudenti al adjust ments i ncomplete 
or applied not to a relevant layer of 
institutions' regulatory capital  
Lack of harmonization in application of 
prudential adjustments  
Cyclical nature of bank lending due to market failures such as: 
 
9 Limitations in risk measurement 
9 Information asymmetries 
9 Inappropriate responses to risk and 
changes in economic conditions Shortcomings in risk management 
practices: 
 
9 Back testing 
9 Stress testing 
9 Coll ateral manag em ent  
Irresponsiveness of regulatory 
requirements to risk build-up at the macro 
level
Lack of explicit limit to leverage build-up  Inadequate prudential 
requirements for 
systemically important 
institutions  PROBLEM TREE  
 
 93  4. OBJECTIVES  
The overarching goal of this initiative is to ensure that the effectiveness of bank capital 
regulation in the EU, represented by the CRD, is strengthened and its adverse impacts on 
depositor protection and pro-cy clicality of the financial system are contained, while 
maintaining the competitive position of the EU banking industry. This translates into the 
following four general  policy objectives to:  
- Enhance financial stability (G-1); - Enhance safeguarding of depositor interests (G-2); - Ensure international competitiveness of EU banking sector (G-3); 
- Reduce pro-cyclicality in the financial system (G-4). 
In light of the problems presented in sections 3. 2 - 3.6 five sets (in the areas of liquidity risk 
management, definition of capital,  counterparty credit risk, pr ocyclicality, and single rule 
book) of operational
 objectives have been identified to address the applicable problem 
drivers. Effective realizatio n of such operational objectives  should contribute to the 
achievement of the following longer-term specific  policy objectives to:  
- Enhance adequacy of capital and liquidity requirements (S-1); 
- Enhance bank risk management (S-2); - Prevent regulatory arbitr age opportunities (S-3); 
- Enhance legal clarity (S-4); - Reduce compliance burden (S-5); - Enhance level playing field (S-6); - Enhance supervisory cooperation and convergence (S-7) - Align prudential requirements for systemically important financial institutions (SIFIs) with 
the risks that they pose (S-8); 
- Reduce cyclicality of bank lending (S-9); and, in turn, should facilitate the attainment of the four  general policy objectives. 
Table 4 provides an overview of the linkage between: - identified problems and drivers underlying them (indicated in italics in the problem 
definition); 
- operational, specific and ge neral objectives to addre ss the problem drivers; and 
- policy options to achieve the objectives. 
 
 94  Table 4:  Summary of problems, objectives and policy options 
Specific Objectives General Objectives 
S-1 S-2 S-3 S-4 S- 5 S-6 S-7 S-8 S-9 G-
1 G-
2 G-
3 G-
4 
Problems Problem Drivers Operational Objectives 
Enhance adequacy of 
capital and liquidity 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 
bank lending 
Enhance financial 
stability 
Enhance safeguarding of 
depositor interests 
Ensure international 
competitiveness of EU banking sector 
Reduce pro-cyclicality 
in the financial system 
Policy Options 
Shortcomings in liquidity risk 
management, including stress tests Ensure that institutions have 
sufficient high quality liquid assets 
to withstand an acute stress scenario lasting for 30 days √ √        1.1-
1.3 
Asset and liability maturity mismatches  Ensure that institutions fund their 
activities with more stable sources 
of funding on an ongoing structural basis √ √        2.1-
2.3 Liquidity risk management  
- Existing liquidity risk management approaches and supervisory regimes inadequately captured risks inherent to the underlying market practices and trends, contributing to demise of several institutions and strongly undermining 
health of many others, threatening the financial stability and 
necessitating unprecedented leve ls of central bank liquidity 
and government support.  
- Differences in national liquidity regimes give rise to level-
playing field issues for cross-border firms and hamper 
effectiveness of supervision as well as cooperation between supervisory authorities. No harmonized and sufficiently 
explicit regulatory treatment at EU 
level Develop appropriately explicit and 
harmonized EU level regime for management of liquidity risk √    √ √ √   √ √ √ √ 
1.1-
2.3 
Certain capital instruments did not 
fulfil loss absorption, permanence and 
flexibility of payments criteria  Enhance loss absorption, 
permanence and flexibility of 
payments of going-concern capital instruments √ √       √ 
List of regulatory adjustments 
incomplete or applied not to a relevant 
layer of institutions' regulatory capital  Enhance loss absorption of 
regulatory capital by appropriate 
application of regulatory adjustments from the relevant layers of capital √ √      √ √ Definition of capital 
- Banking sector – due to the drivers outlined - entered the 
crisis with reported Tier 1 capital ratios and, thus, capital 
that were not reflective of banks' capacity to absorb losses on a going-concern basis. As th e crisis deepened and banks 
faced growing losses and wr itedowns, their fundamental 
solvency was called into question, leading to broader financial instability and necessitating extensive public 
sector support 
- Variations in the definition of Tier 1 capital stemming 
from differences in application of regulatory adjustments 
across the MS obstructed its co mparability and reliability, 
leading to market participants' and regulators' focus on alternative measures Lack of harmonization in application 
of regulatory adjustments  Develop a harmonised set of 
provisions in the area of definition of capital    √  √ √ √   √ √ √ √ 3.1-
3.5 
Current provisions do not adequately 
capture counterparty credit risk Enhance adequacy of capital 
requirements for the counterparty 
credit risk √ √      √  
Current provisions do not entail 
incentives to move bilateral OTC to 
clearing through central counterparties and to post adequate initial margin Provide incentives to move bilateral 
OTC to clearing through central 
counterparties and to post adequate 
initial margin  √       √ Counterparty credit risk  
- Existing CRD provisions did not ensure appropriate risk 
management of financial institutions as well as adequate 
and non-cyclical regulatory  requirements against the 
counterparty credit ri sk that materialised during the crisis  
- Calibration of provisions does not provide sufficient 
incentives to clear bilateral OTC instruments through 
central counterparties, leading to lack of confidence and exacerbating instability in  times of market stress  Shortcomings in risk management 
practices as regard s back testing, 
stress testing and collateral Enhance bank risk management 
practices  √        √ √ √ √ 4.1-
4.3 
 
 95  Specific Objectives General Objectives 
S-1 S-2 S-3 S-4 S- 5 S-6 S-7 S-8 S-9 G-
1 G-
2 G-
3 G-
4 
Problems Problem Drivers Operational Objectives 
Enhance adequacy of 
capital and liquidity 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 
bank lending 
Enhance financial 
stability 
Enhance safeguarding of 
depositor interests 
Ensure international 
competitiveness of EU banking sector 
Reduce pro-cyclicality 
in the financial system 
Policy Options 
management 
Introduce an explicit limit on banks 
capacity to leverage their capital √ √       √ 5.1-
5.3 
Improve banks' capacity to absorb losses over periods of stress and still meet the minimum regulatory 
capital requirement √ √       √ 6.1-
6.4 Procyclicality of lending 
- Lack of a limit to leveragi ng capital and irresponsiveness 
of regulatory capital requirements to the build-up of risk at the macro level led to accumula tion of financial imbalances 
which, once the economic cy cle turned, prompted a de-
leveraging spiral and precipitat ed steep credit-related losses  
- Inappropriate responses to ri sk and other market failures 
contribute to leverage build-up and a concomitant 
overextension of credit in th e economic upturn and cause 
banks to maintain generous discretionary distributions during periods of stress, when capital should be conserved  Market failures, including limitations 
in risk measurement, information asymmetries and inappropriate responses to risk and changes in economic conditions 
Irresponsiveness of regulatory 
requirements to risk build-up at the 
macro level 
Lack of explicit limits to leverage of 
credit institutions Protect banking sector from 
excessive credit growth and build-
up of risks at the macro-level while ensuring credit flow to the economy in the economic downturn  √ √       √ √ √ √ √ 
5.1-
6.4 
Diverging national rules due to the 
inclusion in the CRD of a number of 
national options and discretions Remove national options and 
discretions in the CRD    √  √ √ √   
Gold-plating of the current provisions Remove regulatory additions above 
the agreed minimum standards   √  √ √ √   Options, discretions a nd minimum harmonisation 
- Diverging national rules allow for competitive distortions 
in the Internal Market and lead to a fragmented and 
inconsistent financial supervision, impeding legal clarity and resulting in excessive admi nistrative burden for cross-
border banks 
- Mutual recognition of 'host' MS treatment at consolidated 
level creates opportunities for regulatory arbitrage; 
application of 'home' MS discretions at 'host' level hinders supervisory cooperation and risks delivering group-specific prudential treatment that may hamper level playing field Lack of detail within certain CRD 
provisions that allow for supervisory 
judgement and / or choice to be made Make provisions allowing for 
supervisory judgement and / or 
choice more specific     √ √ √ √   √ √ √  7.1-
7.4 
 
 
 96  5. POLICY OPTIONS : ANALYSIS AND COMPARISON  
This section presents the policy options and th eir impacts for each policy area individually. 
Due to the number of areas covered, the analysis of policy options and the comparison thereof have been combined for each area. Cumulative im pacts of all preferred options are discussed 
at the end of the section.  
While presentation of options in each policy ar ea includes a 'retain current approach' scenario 
which usefully serves as a baseline for assess ing impacts of alternative policy options (and 
reflects the standard methodol ogy of conducting impact assessments at the Commission), it 
needs to be kept in mind that sections 5.1-5.5 pert ain to proposals linked to Basel III that were 
developed by the Basel Committee with the activ e participation of the Commission services, 
on behalf of all 27 EU MS.  
Details of the new framework were fleshed out by the Basel Committee in December 2010. 
Policy options pertaining to the new liquidity m easures are analysed in section 5.1. As regards 
the new capital requirements, respective policy options are discussed in  sections 5.2-5.5. The 
calibration, including phase-in an d grandfathering arrangements, of Basel III is shown in 
Tables 5 and 6 below. However, EU MS will be allowed to 'gold-plate' the new minimum 
requirements during the phase-in period, which means that they can apply already in 2013 the 
level of capital requi red by Basel III in 2019. 
Table 5:  Calibration of Basel III, in % of RWAs 
 Common Equity 
(after deductions) Tier 1 Capital Total Capital 
Minimum requirement 4.5 6.0 8.0 
Conservation buffer 2.5   
Minimum requirement plus conservation buffer 7.0 8.5 10.5 
Countercyclical buffer range 1 0-2.5   
Notes : 1 Common equity or other fu lly loss absorbing capital 
Source : Basel Committee  
Table 6:  Transitional arrangements for Basel III fr amework (all dates are as of January 1 ) 
Policy measure 2011 2012 2013 2014 2015 2016 2017 2018 2019 
Leverage ratio Supervisory monitoring Parallel run                                        
Disclosure starts on 1/1/2015  Migration 
to Pillar 1  
Minimum common equity (CET1) 
capital ratio    3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5% 
Capital conservation buffer      0.625% 1.25% 1.875% 2.5% 
Minimum common equity plus capital conservation buffer   3.5% 4.0% 4.5% 5.125% 5.75% 6.375% 7.0% 
Phase-in of deductions from CET1    20% 40% 60% 80% 100% 100% 
Minimum Tier 1 capital   4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0% 
Minimum total capital   8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 
Minimum total capital plus capital 
conservation buffer   8.0% 8.0% 8.0% 8.625% 9.25% 9.875% 10.5% 
Capital instruments no longer qualifying as non-core Tier 1 
capital or Tier 2 capital   Phased out over a 10 year period beginning 2013 
Liquidity Coverage Ratio Observation 
period 
begins    Introduce 
minimum 
standard     
Net Stable Funding Ratio Observation 
period 
begins       Introduce 
minimum 
standard  
Source : Basel Committee  
 
 97  It needs to be stressed that the calibrati on of the new minimum capital requirements was 
determined by taking into account the impact th at the new policy measures would have on the 
numerator (i.e., definition of eligible capital) and the denominator (i.e., measures affecting risk weighted assets) of the ratios. Th erefore, analyses underpinning the phase-in 
arrangements and the calibration of the new rules are presented after preferred policy options 
relevant for the calculation of the ratios have been identifie d (in line with the approach 
followed by the Basel Committee). 
5.1. Liquidity risk 
To address the problems in the area of liquidity  risk management, the Commission services in 
its February 2010 consulted publicly on the tw o key potential policy measures: Liquidity 
Coverage Ratio and Net Stable Funding Ratio. 
5.1.1.  Liquidity Coverage Ratio 
To address shortcomings in liquidity risk mana gement and to improve short-term resilience of 
the liquidity risk profile of financial institutions by ensuring that they have sufficient high quality liquid assets to withstand an acute st ress scenario lasting for 30 days, the Commission 
services proposed to introduce a Liquidity Coverage Ratio (LCR). Main policy options in this area are as follows: 
- Policy option 1.1:  Retain current approach; 
- Policy option 1.2:  Introduce LCR as specified in th e February 2010 public consultation; 
- Policy option 1.3:  Introduce LCR adopted by the Basel Committee subject to observation 
period. 
Policy option 1.1: Retain current approach
 
Under this policy option, problems related to short-term liquidity risk management, as 
outlined in section 3.2 may not be entirely addr essed. While tightening of national liquidity 
regimes may provide for a degree of increased effectiveness with respect to management and 
supervision of risks discussed in this section, there is no gu arantee that necessary progress 
would be achieved quickly enough and evenly across the EU.  Given the recently agreed 
Basel liquidity standards, it may be expected  that under this policy option individual MS 
would adopt these sounder standards for a few of their largest banks. Other MS may pursue 
different alleys for strengthening liquidity regimes and others again may not act at all. This 
scenario is likely to lead to further dive rgence of standards wi thin Europe, creating 
opportunities for regulatory arbitrage and un-levelling the playing field. 
Policy option 1.2: Introduce LCR as specified in the Fe bruary 2010 public consultation  
LCR would require credit institutions to matc h net liquidity outflows during a 30 day period 
of acute stress with a buffer of 'high quality' liquid assets. The net li quidity outflows during 
the period of stress would be completely de fined in the CRD, detailing inter alia what 
percentage of a given source of funding a credit  institution has to assume would be withdrawn 
from it (see Annex IV). The outflows covered would also include those resulting from 
liabilities and contingent liabilities, both c ontractual and non-contractual, coming due and 
would reflect both institution-specific and sy stemic shocks built upon actual circumstances 
experienced in the global financial crisis whic h, as outlined in section 3.2, may include events 
such as: 
 
 98  - downgrade in the institu tion’s public credit rating; 
- run-off of a proportion  of retail deposits; 
- loss of unsecured whol esale funding capacity; 
- loss of secured, short-term financing transa ctions for all but high quality liquid assets; 
- increases in market volatilities that have an impact on the quality of collateral or potential 
future exposure of derivatives positions and thus require larger collateral haircuts or additional collateral; and - a need for the institution to provide fundi ng to honour non-contractual obligations in the 
interest of mitigating reputational risk. 
The regulatory list of high quality liquid assets (fo r specific definitions of the 'buffer of high 
quality liquid assets' see Annex IV) to cover th ese outflows should ensure  that these assets: 
- have low credit and market risk: assets whic h are less risky tend to have higher liquidity. As 
regards the credit risk, high cr edit standing of the issuer a nd a low degree of subordination 
increases an asset’s liquidity. As regards market risk, low duration
222, low volatility, low 
inflation risk and denomination in  a convertible curren cy with low foreign exchange rate risk 
all enhance an asset’s liquidity; - have ease and certainty of valuat ion: an asset’s liquidity increas es if market participants are 
more likely to agree on its valuation. A liqui d asset’s pricing formula must be easy to 
calculate and not depend on strong assumptions . Market participants should have similar 
views about inputs into those pric ing formula, for instance due to  public availability thereof; 
- have low correlation with risky assets: the stoc k of high quality liquid assets should not be 
subject to a wrong-way risk. For instance, assets  issued by financial firms are more likely to 
be illiquid in times of liquidity  stress in the banking sector; 
- be listed on a developed and recognised exchange market: being listed increases an asset’s 
transparency; - have active and sizable market: the asset should  have active outright sale and repo markets 
at all times (which means having a large numbe r of market participants and a high trading 
volume). Market breadth
223 and market depth224 should be good; 
- have presence of committed market makers: quot es will always be available for buying and 
selling the asset; - have low market concentration: diverse group  of buyers and sellers in an asset’s market 
increases the reliability of its liquidity; - are likely to attract flight to quality in st ressed market cond itions: historically, the market 
has shown tendencies to move into some types of assets in a systemic crisis. 
As regards the buffer of high quality liquid as sets, the Commission services consulted on the 
impact of both a narrow
 regulatory definition of liquid asse t buffer composed of cash, central 
bank reserves and high qual ity sovereign debt, as we ll as a somewhat broader  definition 
which could also include non-fi nancial corporate bonds and c overed bonds of high quality, 
i.e., those rated AA and above with a 20% haircu t and those rated A- up to AA- with a 40% 
haircut, up to 50% of the buffer. 
In order to strengthen the resilie nce of European credit institutions against liquidity risk and to 
introduce a harmonised regulatory measure at Eur opean level, the standards would apply at 
the level of individual legal entities. Applica tion at individual entity level within European 
                                                 
222 Price sensitivity of a fixed income security to changes in interest rate 
223 Price impact per unit of liquidity 
224 Units of the asset that can be traded for a given price impact 
 
 99  groups is desirable so long as constraints on the transferability of assets, mutual support 
commitments and central liquidity risk manage ment within groups continue to apply. The 
envisaged scope of application takes account of th e fact that liabilities have to be repaid by 
legal entities in principle and that the liquidi ty to meet the resulting outflows should be 
available at the legal entity level. However, application to individual firms could be waived 
by competent authorities provided that it is possi ble to identify a set of institutions belonging 
to the same group to which the requirements ca n be meaningfully applied on a consolidated 
basis because liquidity risks are managed cen trally in the group, there are legally binding 
mutual commitments for liquidity support between  the relevant institu tions and assets are 
freely transferable between legal entities even  when under stress. Where these conditions are 
met, the requirements would be applied on a co nsolidated level only to  the entities belonging 
to a group. 
Individual legal entity level application would be complement ed by application at the full 
consolidated level in order to  ensure a sound liquidity positi on of the overall group and to 
facilitate alignment with international standards that will expect internationally active banks to report their consolid ated liquidity position.  
In contrast to areas that  are related to capital, liquidity data  in a quantitative impact study were 
collected for the first time. Because in this  area different MS currently apply different 
standards, banks were not familiar with standard ised data requests. Hence, the classification 
of liquidity risk positions as required in the QIS did not necessarily match their classification 
at banks internally or for MS prudential re porting purposes which made gathering and 
splitting the data into required regulatory sub- categories for participating banks difficult. QIS 
results on liquidity, thus, should be interprete d as a directional tool to assess calibration-
driven changes rather than a precise estimate of actual quantitative impact.  
These difficulties also point in the directi on of possibly significant one-off compliance costs 
related to information provision, i.e., administrative costs (see section 5.8.3) when migrating 
to the new standards. However, given that the same type of information would be needed for 
individual legal entity level a pplication and also considering th at the standards would be for 
the first time fully harmonised across the EU, it may be expected th at there would be 
important ongoing cost savings fo r cross-border groups that currently typical ly have to report 
on individual legal entity basis (and even separately at the level of branches that do not have a legal personality) according to very diverse national  regimes and, in addition, on a 
consolidated basis according to their home country  regime. Hence, administrative costs due to 
EU legislation, as discussed in section 5.8.3 sh ould be offset by saving s of administrative 
costs due to national reporting requirements. On top of th at, harmonised reporting would 
facilitate communication between supervisors of the different legal entities of a group.  
EU QIS showed that as of  December 2009 under the narrow
 definition of liquid asset buffer, 
average LCR was 52.4% and 74.1% for Group 1 and Group 2 banks, respectively. Under the 
broader  definition of liquid asset buffer, average LCR improved by some ten percentage 
points for both groups.  
Feedback from numerous public consultations s howed that the narrow  liquid asset buffer, 
however, does not address the situation of jurisdictions su ch as DK that may not have 
sufficient supply of eligible asse ts. Most respondents to the cons ultations also claimed that the 
'narrow' buffer definition entails the concentratio n risk of specific asset classes while labelling 
bank (covered) bonds as illiquid would hamper ba nk ability to raise funds. Refinements were 
deemed to be necessary also as regards assumpti ons used to estimate several categories of net 
 
 100  liquidity outflows (the denominator), for instance, to recognize that central bank-eligible 
assets that are not part of the liquid asset buffer a nd retail deposits constitute a better source of 
liquidity than assumed by this option. Public authori ties of certain MS, on contrary, were in 
favour of a 'narrow' asset buffer on the grounds of financial stability.  
Policy option 1.3: Introduce LCR adopted by the Basel Committee subject to observation 
period  
Policy option 1.3 reflects the specification of LCR announced by the Basel Committee in its 
Basel III rules text in December 2010. It takes into account the above mentioned concerns and 
recalibrates the LCR requirement by building as follows on the 'narrow' definition of liquid 
asset buffer under policy option 1.2: 
- Narrow liquid asset buffer is broadened to in clude: i) non-financial corporate and covered 
bonds not issued by the bank itself of high credit  and liquidity quality with a 15% haircut and 
ii) exposures to sovereign and public sector ent ities, central banks that  are risk-weighted at 
20% under the CRD with a 15% haircut. The incl usion of these assets (termed 'Level 2' 
assets) is capped at 40% of the liquid asset buffer.225 Level 2 assets are also of very high 
liquidity, but possess the properties of high quality  liquid assets listed above to a somewhat 
lesser extent. However, they generally generate  higher yield and holding them is therefore 
more attractive for banks. The limit on these a ssets would ensure that  assets of the very 
highest quality make up the majority of the bu ffer while allowing banks some flexibility to 
improve the profitability of their liquid asset holdings.  
- Determination Level 2 assets: this option foresees that before 2015, a range of qualitative and quantitative criteria to determine high credit and liquidity quality and to determine to which of the two levels in the buffer individual a ssets should be assigned  will be tested by 
EBA with a view to advising the Commission on the appropriate set and calibration of such 
criteria. Preliminary criteria have been set by the Basel Committee that put particular 
emphasis on assets' external ratings, but the test ing of alternative crit eria should, before 2015, 
allow for identification of final criteria that place more emphasis on experienced liquidity and less on such ratings. - This option entails three alternatives to acco mmodate the specific situation of jurisdictions 
that do not have a sufficient supply of Level 1 assets in their domestic currency to meet the 
aggregate demand of banks with significant expo sures in this currency. However, its Level 2 
cap of 40% is lower than that of the broader
 buffer definition under option 1.2. 
- 'Stable'226 retail and SME deposit run-off rate is reduced to 5%, while that of 'less stable'227 
deposits to 10%, from 7.5% and 15% under option 1.2, respectively. It is difficult to find 
evidence of empirical run-off rates that is not very dependent on individual circumstances, not 
least relating to the deposit guarantees afforded by the public sector to re tail depositors. Given 
the further harmonisation and improvement of le gal depositor protection in the EU, lower run 
off rates appear justified in tendency, not pretending that there was a unique 'right' level of 
these run-off rates. - Roll-off for unsecured deposits fr om sovereigns, public sector entities and central banks is 
reduced to 75% as opposed to 100% under option 1.2. For secu red funding received from 
these entities, this optio n recognises that they are likely to continue to roll-over secured 
                                                
 
225 Whereas assets that qualify for the 'narrow' definition of liquid asset buffer are termed 'Level 1' assets 
226 See Annex IV for definition 
227 Less stable deposits could include deposits which are not covered by effective deposit insurance, high value-
deposits, deposits of sophisticated or high net worth individuals and deposits which can be withdrawn 
quickly and foreign currency deposits, as determined by each jurisdiction 
 
 101  funding during a time of stress, and for secured funding backed by assets that would not be 
included in the buffer of liqui d assets, assumes a 25% roll-o ff of funding. This addresses 
concerns of stakeholders that central bank-eligible assets sh ould be included in the proposal 
by allowing a bank to count the ma jority of any central bank fundi ng it has obtained as stable 
funding, and therefore to increase  its stock of liquid assets by monetising less liquid collateral 
at the central bank, to the extent that the central bank has already provided that funding.  
- Secured funding: outflow and inflow haircuts  are aligned with Level 1 and Level 2 buffer 
asset haircuts. - Undrawn committed facilities: this option assumes 5% run-off on credit and liquidity lines 
to retail and SME customers, down from 10% u nder option 1.2. It also applies a 10% run-off 
for credit lines and 100% run-off for liquidity lines to sovereigns, central banks, and public 
sector entities (in addition to  non-financial corporates).  
- This option also establishes a harmonised treatment of net inflows rather than leaving their 
determination to bank discretion, making the st andards less dependent on individual banks' 
ability to model risks and assumptions. Banks ar e assumed to realise inflows of 100% from 
their lending to other financial institutions, bu t should, due to the need to continue providing 
lending to firms and households, only assume  50% of the inflows co ntractually due from 
these counterparties. Importantly, to ensure a minimum level of liquid asset holdings, the 
amount of inflows that can offset outflows is capped at 75% of total expected cash outflows 
as calculated in the standard. This effectively requires that a bank must maintain a minimum 
amount of stock of liquid assets  equal to 25% of th e outflows in order to cover potential 
timing mismatches between inflows and outflow s during the 30 days and possible delays of 
inflows under stress. - For operational activities with financial institution counterpartie s, this option creates a 25% 
outflow bucket for custody and clearing and settle ment activities, as well as selected cash 
management activities. These activities would require specific supervisory approval before 
the funds specifically related to those activities could be considered 'operational', i.e., not all 
funds from a counterparty would qualify. The ba nk that has deposited the operational deposits 
would receive no inflow recogniti on for those deposits, as they would be expected to remain 
at the other bank during a time of  stress because for those oper ational deposits, the depositing 
bank would find it impossible to withdraw si gnificant funds without compromising its own 
ability to operate. Importantly to the EU, similar treatment is  given to mutual deposits of 
cooperative and other ty pes of bank networks. 
Similarly to policy option 1.2, the standards woul d apply at the level of  individual legal and 
consolidated entities. This is in alignment with  Basel III rules since they outline treatment at 
the consolidated group level while leaving th e implementation at the sub-group and stand-
alone bank levels to discretion of its members, in  order to ensure greate r consistency and level 
playing field between domestic  and cross-border banks.  
The Commission will, based on a report from EB A and taking into account the contribution of 
ESRB, review before 2015 whether the ratio  has any unintended consequences on the 
business and risk profile of European institutio ns, trade finance, financial markets and the 
economy. The Commission should be able to modify the ratio accordingly as appropriate via a delegated act. A mechanism would be built into the CRD IV proposal ensuring that the ratio 
will only apply after the Commi ssion has concluded its review and has made the necessary 
modifications, if any. 
Under this policy op tion, average EU LCR is 66.5% fo r Group 1 banks and to 87.1% for 
Group 2 banks, comparable to the LCR averages of the broader
 buffer definition under option 
1.2. In terms of distribu tional impacts with respect to bank size, Charts 4 and 5 show that 
 
 102  under this option the impact is less pronounced for smaller (i.e., Group 2) banks in most of the 
MS. In terms of implications of this policy option on banks from other major international 
jurisdictions that are large and active abroad, th e EU Group 1 LCR average is lower than that 
of a sample of 84 large international banks  from twenty members of the Basel Committee 
(including eight EU MS) that as of December 2009 stood at 82.9%.228 
Chart 4 : Distribution of LCR for Group 1 
banks, in %: country averages Chart 5:  Distribution of LCR for Group 2 banks, in %: 
country averages 
050100150200250300
I CHB K J F E U GDLEA               LCR of 100% 
050100150200250300
PGUJ LHFNKED E U SMRBCA               LCR of 100% 
Notes:  LCRs are capped at 400%. EU averages for both Group 1 and Group 2 banks include data for three additional 
countries that are not  shown individually. 
Source:  CEBS  
The combined shortfall of liquid assets to m eet the LCR threshold of 100%, calculated as a 
sum across individual banks wh ere a shortfall is observed, for Group 1 and Group 2 banks 
that participated in the QI S, is about €1 trillion under th is policy option (see Chart 6), 
equivalent to €1.6 trillion when extrapolated to the entire EU  banking sector. As regards the 
aggregate supply of liquid assets in the economy,  when the above purchases of liquid assets 
are financed by new equity of banks, this ma y effectively represent a switch between the 
direct holdings of such assets by ultimate inve stors with the indirect ones (through holding 
bank equity). Yet there may not necessarily be a big effect on the aggregate assets in the 
economy, as ultimately all securities  would continue to be held - directly and indirectly – by 
the ultimate investors, including bank shareholders. Liquid asset shortfalls shall also not be confused with related bank costs which stem from the foregone return on assets, i.e., the difference between average return on loans and average return on assets included in the 
buffer.  
The LCR could lead to a contraction of the inte rbank market for short-term maturity. There is 
also the risk of a potential reduction in the liquidity  – and therefore maybe an increase of 
costs – of instruments excluded from the buffer, such as ABS or foreign currency swaps, as they would be relatively disregarded by ba nks. Nevertheless, incentivising banks to find 
alternative sources of funding is a key step to enhance fi nancial stability, reduce the reliance 
of the banking industry on such (wholesale) markets  and limit the cont agion channels. 
If the averages of Group 1 and Group 2 banks are weighted based on their share of RWAs, 
EU banking industry's LCR can be approximated at 74% under this policy option, from which 
an implicit increase of 34% in the buffer of elig ible liquid assets to achieve compliance with 
the LCR of 100% can be derived.
229 The resultant impact on bank lending and the economic 
output can be assessed based on the work of the Macroec onomic Assessment Group (MAG) 
of the Basel Committee.230 In its analysis of transitional costs of the new rules, MAG 
estimated that tightening of the liquidity requirement, consisting of a 25% increase in 
                                                 
228 Source: QIS on the impact of Basel III reforms on the BCBS' countries 
229 100%/74%-1=34% 
230 See http://www.bis.org/publ/othp10.pdf?noframes=1   
 
 103  holdings of liquid assets to tota l assets ratio, produced a median  increase in lending spreads of 
14 basis points and a fall in lending volumes of 3.2%  after four and a half  years, associated 
with a median decline in the GDP of 0.08% be low the baseline. Hence, impact on the EU 
GDP due to the introduction of the LCR can be  approximated to a decline in GDP of 0.11% 
over the period of four and a half ye ars, compared to the baseline trend.231 
Chart 6 : Liquidity shortfall for Group 1 and Group 2 banks comb ined as of December 2009, in € million  
0100200300400500
EGH L J BCADKMR S PQO U I TPolicy option 1.3
Policy option 1.2, 'narrow' buffer
Notes:  Country H, L and N totals include shortfalls only for Group 2 banks (Group 1 banks removed based on request of 
national supervisors). No LCR shor tfalls estimated for countries U, I, T under both policy options.  
Source:  CEBS  
Despite the costs that the implementation of new liquidity requirements may entail for some 
institutions in a transition period, the new framework should be understood as an insurance 
scheme securing the stability of individual instit utions and eventually of the financial system 
as a whole. The new measures should be able  to address the pro-cyclicality and volatile 
patterns of banks' unregulated liquidity mana gement: on the one hand, underestimated risks 
when liquidity is cheap and easily available an d, on the other hand, ra pid contagion and loss 
of confidence in crisis situation due to the asymmetry of information and insufficient liquidity reserves.  
Analysis of the Basel Committee of the long-term  economic benefits of the new rules showed 
that increases in liquid asset holdings of 50% for the average bank reduces the estimated probability a systemic banking crisis by 1.1 per centage points (from 2% to 0.9%) when bank 
capitalisation is kept constant at 9%.
232 Therefore, estimated increase in liquid asset holdings 
of 34% by the EU banking industry can be assu med to reduce the probability of a systemic 
crisis by some 0.8 percentage points (or 40%), e quivalent to annual GDP benefits of 0.14% to 
0.48% under the 'no permanent effect' and 'moderat e permanent effect' s cenarios, respectively 
(please see section 5.8.5 for more on the analysis  of long-term economic benefits by the Basel 
Committee). 
 
                                                 
231 Assuming liquid asset share is increas ed while total assets do not change. However, if meeting the LCR did 
not affect the amount of assets not eligible for the LCR buffer, then the above effect would be smaller, 
as the liquid to total asset ratio would increase by less than 34%. 
232 When measured as tangible common equity (TCE) to RWAs under Basel I and II definitions. This is 
equivalent to the average of some 6% CET1 ratio that the EU banks would have after the application of 
Basel III provisions 
 
 104  Comparison of policy options  
Retaining the current scenario (option 1.1), implies that problems related to short-term 
liquidity risk management, as  outlined in section 3.2, may not  be addressed effectively, 
depending on the actions taken in this area by national supervisors and/ or the industry. While 
tightening of national liquidity regimes may pr ovide for a degree of increased effectiveness 
with respect to regulation (objective S-1) an d bank management (objective S-2) of risks 
discussed in this section, there is no guara ntee that necessary progress would be achieved 
quickly enough and evenly across the EU. 
While both policy options 1.2 (LCR as specified in the February 2010 public consultation) 
and 1.3 (LCR developed by the Basel Committ ee subject to observation period) entail 
effective approaches with respect to contributin g to the achievement of relevant objectives S-
1 (Enhance adequacy of capital and liquidity  requirements) and S- 2 (Enhance bank risk 
management) as well as G-1 (Enhance financia l stability) and other relevant general 
objectives, option 1.3 is more e ffective due to its more precise  calibration of a number of 
elements relevant for the calculation of LCR.  While these two options are comparable in 
terms of compliance costs for the industry, polic y option 1.2 (i.e., its version of the broader 
buffer definition) is more efficient than option 1.3 in terms of achievi ng the above objectives. 
Option 1.2 has a higher cap for additional assets eligible for the liquid asset buffer and generally could be better  tailored to the EU specificities both in terms of the numerator and 
the denominator given that they would entire ly be defined in the CRD. As such, it would 
impose lower adjustment costs on both the i ndustry, and via indirect impacts, on other 
economic agents. Given its superior effectivene ss as regards the relevant policy objectives, 
however, policy option 1.3 is iden tified as a preferred option. 
Table 7:  Summary of policy option e ffectiveness and efficiency 
Policy Option Comparison Criteria 
Effectiveness 
Policy Option Enhance adequacy 
of capital and 
liquidity 
requirements [S-1]  Enhance bank 
risk 
management 
[S-2 ] Enhance 
financial 
stability 
[G-1]  Efficiency 
1.1 Retain current approach 3 3 3 3 
1.2 Introduce LCR as specified in the February 2010 public consultation 2 2 2 1 
1.3 Introduce LCR adopted by the Basel Committee subject to observation period 1 1 1 2 
Scale of option ranking: 1=most effective / efficient, 3=least effective / efficient Effectiveness measures extent to whic h options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources 
5.1.2.  Net Stable Funding Ratio 
To address shortcomings in funding liquidity ri sk management by requiring institutions to 
achieve and maintain a sound funding struct ure over a one year horizon, the Commission 
services propose to introduce a Net Stable Fund ing Ratio (NSFR). Main policy options in this 
area are as follows: 
- Policy option 2.1:  Retain current approach; 
- Policy option 2.2:  Introduce NSFR as specified in the February 2010 public consultation; 
- Policy option 2.3:  Introduce NSFR adopted by the Basel Committee. 
Policy option 2.1: Retain current approach  
 
 105  Under this policy option, funding pr oblems arising from asset - liability maturity mismatch, as 
outlined in section 3.2, may not be entirely addr essed. While tightening of national liquidity 
regimes may provide for a degree of increased effectiveness with respect to management and 
supervision of risks discussed in this section, there is no gu arantee that necessary progress 
would be achieved quickly enough and evenly across the EU.  Given the recent agreements by the Basel Committee in this area, it may be exp ected that under this policy option individual 
MS would pursue these sounder standards for a few of their largest banks. Other MS may 
follow different alleys for strengt hening liquidity regimes and othe rs again may not act at all. 
Thus, this scenario would likely lead to fu rther divergence of standards within Europe, 
creating opportunities for re gulatory arbitrage and un-le velling the pl aying field. 
Policy option 2.2: Introduce NSFR as specifie d in the February 2010 public consultation
 
The NSFR would require credit institutions to  maintain a sound funding structure over the 
one-year horizon in an extended firm-specific st ress scenario where an institution encounters 
and investors and customers become aware, fo r instance, of a significant decline in its 
profitability or solvency, a pot ential downgrade in its debt, counterparty credit or deposit 
rating or a material effect that calls into  question its reputation or credit quality.  
To the above end, the assets currently f unded and any contingent  contractual and non-
contractual obligations to f und would have to be matched to a predetermined extent, 
depending on their liquidity profil e at a one year horizon (reflect ed in the so-called 'required 
stable funding factors'), with so urces of funding that can be c onsidered stable over the same 
one year horizon.233 The required stable funding factors a nd the degree to which sources of 
funding can be considered stable would be  set out in the CRD. Annex V contains 
specifications of both sources of stable fundi ng (the numerator) and the required stable 
funding for various asset types (t he denominator) of the ratio, as outlined by the Commission 
services in its public consu ltation of the February 2010.  
In terms of level of applicati on, the approach envisaged for the LCR above would pertain to 
the NSFR as well, i.e., the NSFR  would apply at the level of individual legal and consolidated 
entities. 
As already mentioned in the analysis of the L CR, liquidity data were collected for the first 
time in a QIS which meant that banks were not fam iliar with standardised data requests in this 
area. Hence, QIS results as regards the NSFR should be seen as a directional tool to assess calibration-driven changes rather than a precise  estimate of actual quantitative impacts of the 
new standard. This may also contribute to pos sibly significant compliance costs related to 
information provision, i.e., administrative cost s (see section 5.8.3) under this policy option.  
EU QIS showed that as of December 2009 th e average NSFR for Group 1 was 79.8%. No 
country was, on average, able to meet the re quirement under this polic y option, with the MS 
observing ratios in the range of  60.6% to 97.2%. A wider range of results across countries 
was observed for Group 2 banks (43.4% - 155.7%),  while the average NSFR of 83.7% was 
slightly higher than that of the sample of Group 1 banks. The combined shortfall of stable 
funding to meet the NSFR threshold of 100%, calculated as a sum across individual banks 
                                                
 
233 The required stable funding factors assigned to various types of assets are parameters intended to approximate 
the amount of a particular asset that could not be monetised through sale or use as collateral in a secured borrowing on an extended basis during a liquidity event lasting one year. Such amounts are expected to 
be supported by stable funding. 
 
 106  where a shortfall was observed, for Group 1 a nd Group 2 banks participating in the QIS was 
about €3.4 trillion under this scenario (see Chart 9).234  
Feedback from numerous public consultations  showed that this policy option, however, 
requires further refinements with respect to defi nition of available stable funding factors (the 
numerator of the ratio) and requi red stable funding factors as re gards certain asset types (the 
denominator of the ratio) and that it may also  distort incentives acro ss business models, in 
particular, as regards reta il versus wholesale banking.235 With respect to the latter, some 
respondents called for the phasing in of the ratio to allow banks  for adjusting their business 
models. As a result, while this policy option may be effective in  achieving relevant specific 
objectives, such as S-1 (Enhance adequacy of capital and liquidity requirements) and S-2 
(Enhance bank risk management), it would do so with certain unwelcome distributional 
effects across banking business models and with  overall higher than warranted compliance 
costs for the industry and, through indire ct effects, other economic agents. 
Policy option 2.3: Introduce NSFR adopted by the Basel Committee  
Policy option 2.3 reflects the specifications of NSFR announced by the Basel Committee in 
its Basel III rules text in December 2010. It ta kes into account the above mentioned concerns 
and recalibrates the NSFR requirement by raising  the available stable funding factor  for 
'stable' and 'less stable' retail and SME deposits and lowering  the required stable funding 
factors  for i) residential mortgages and other loan s that qualify for the 35% or better risk 
weight under Basel II standardised approach for credit risk, ii) government and public sector 
entity securities with risk-weight of 20% unde r the CRD, and iii) certain off-balance sheet 
commitments.236  
Under this policy option, averag e NSFR is higher for most countries when compared to policy 
option 2.2, and the EU average NSFR rises to  91.1% for Group 1 banks (with four MS on 
average meeting the requirement) and to 93.9% for Group 2 banks. In terms of distributional 
impacts with respect to bank size, Charts 7- 8 show that under this  option the impact is 
generally less pronounced for sm aller (i.e., Group 2) banks.  
In terms of implications of this policy option on banks from other major international 
jurisdictions that are large and active abroad, the EU Group 1 NSFR average is comparable to 
that of a sample of 85 large international banks from twenty members of the Basel Committee (including eight EU MS) that as of December 2009 stood at 92.7%.
237 
 
                                                 
234 Expected shortfall shall not be conf used with related bank costs which may stem (depending on actions taken 
by banks to comply with the requirement) from substituting sources of funding with lower available 
stable funding factors with those with hi gher available stable funding factors. 
235 Respondents claimed that banks being dependent on capital markets would be given a better ratio than retail 
deposit banks which have been stable. It was also recognised that NSFR might favour broker / dealers 
while penalising the universal banking model. 
236 The available stable funding factors fo r 'stable' and 'less stable' retail and SME deposits are raised from 85% 
and 70% to 90% and 80%, respectively, in comparison to policy option 2.2. The required stable funding 
factor for residential mortgages and other loans that qualify for the 35% or better risk weight under Basel II standardised approach for credit risk is lowered to 65% from 100%. The extent to which 
conditionally revocable and irrevocable credit and liqui dity facilities would need  to be pre-funded is 
lowered to 5% from the requirement of 10%. The required stable funding for government and public sector entity securities with risk-weight of 20% unde r the CRD is reduced to 20%, down from 100%.  
237 Source: QIS on the impact of Basel III reforms on the BCBS' countries 
 
 107  Chart 7 : Distribution of NSFR for Group 1 
banks, in %: country averages Chart 8:  Distribution of NSFR for Group 2 banks, in %: 
country averages 
0255075100125150175200
HB I KDG E U C J F ELA            NSFR of 100% 
0255075100125150175200
EFQDHUP J E U NCB MKRSOLGA               NSFR of 100% 
Notes:  EU averages, in addition to countries shown in the charts, include three add itional countries for Group 1, and one for 
Group 2.  
Source:  CEBS  
The combined shortfall of stab le funding to meet the NSFR th reshold of 100%, calculated as a 
sum across individual banks where a shortfal l is observed, for Group 1 and Group 2 banks 
that participated in the QI S as of December 2009 was about €1.8 trillion under this policy 
option (see Chart 9), equivalent to €3.2 trillion when extrapolat ed to the entire EU banking 
sector.  
Chart 9 : Liquidity shortfall for Group 1 and Group 2 banks comb ined as of December 2009, in € million  
02004006008001000
ELGJCABKDH MPRSOUIQTPolicy option 2.3
Policy option 2.2
Notes:  Country F, L and M totals include shortfalls only for Group 2 banks (Gr oup 1 banks removed based on request of 
national supervisors). No NSFR shor tfalls estimat ed for countries U, I, Q, and T under option 2.3.  
Source:  CEBS  
Given the novelty of this requirement, this  policy option acknowle dges a possibility of 
unintended consequences across business models and / or funding structur es. In this regard, 
this option entails an observation period that st arts in 2012 before making further appropriate 
revisions to the NSFR calibra tion and moving it to a regulator y requirement as from 2018. 
The observation period would allo w for the assessment of any uni ntended implications of the 
ratio not only for the industry, but also trade financing, financial mark ets and credit provision 
to the real economy. In practice, this woul d be implemented by introducing appropriate 
reporting requirements for credit institutions as part of the present legislative proposal in 
order to provide for a sound basis for the obs ervation period and a monitoring of such a 
requirement across business models. The establis hment of the actual regulatory requirement, 
subject to appropriate re visions relative to its preliminar y form, would be left to another 
legislative proposal before 2018. This policy option would be le ss costly for the in dustry than option 2.2, as in effect, 
compliance with the eventual NSFR would st art only in seven years from 2010, giving the 
 
 108  institutions ample time to make  necessary adjustments to thei r funding structure, maturity 
mismatch and activities which are the most vulnera ble to liquidity risk in periods of stress. 
Institutions would still be s ubject to the costs related to  provision of information to 
supervisors during the observat ion period (see section 5.8.3). 
Comparison of policy options  
Retaining the current scenario  (option 2.1) implies that pr oblems related to longer-term 
funding liquidity risk management, as outlin ed in section 3.2, may not be addressed 
effectively, depending on the actions taken in this area by national supervisors and/or the 
industry. While tightening of national liquidity regimes may provide for a degree of increased 
effectiveness with respect to regulation (objec tive S-1) and bank management (objective S-2) 
of risks discussed in this sect ion, there is no guarantee that ne cessary progress would achieved 
quickly enough and evenly across the EU. While both policy options 2.2 (NSFR as specified  in the February 2010 public consultation) 
and 2.3 (NSFR adopted by the Basel Committee) enta il effective approaches with respect to 
contributing to the achievement of relevant ob jectives S-1 (Enhance adequacy of capital and 
liquidity requirements) and S-2 (Enhance bank risk management) as well as G-1 (Enhance 
financial stability) and other relevant general obj ectives, option 2.3 is more effective due to its 
more precise calibration – from a prudential angl e - of a number of elements relevant for the 
calculation of the NSFR and a possibility of a further fine-tuning of the ratio and 
minimization of undesired destabil ising effects for the industry a nd in the financial markets.  
Policy option 2.3 is the most efficient option in  terms of achieving the above policy objectives 
as it would impose lowest adjustment cost s on both the industry and, via the reduced 
likelihood of unwelcome side effects, on other economic agents. Policy option 2.3 is 
identified as a preferred option.    Table 8:  Summary of policy option e ffectiveness and efficiency 
Policy Option Comparison Criteria 
Effectiveness 
Policy Option Enhance adequacy 
of capital and 
liquidity 
requirements [S-1]  Enhance bank 
risk 
management 
[S-2 ] Enhance 
financial 
stability 
[G-1]  Efficiency 
2.1 Retain current approach 3 3 3 3 
2.2 Introduce NSFR as specified in the February 2010 public consultation 2 2 2 2 
2.3 Introduce NSFR adopted by the Basel Committee 1 1 1 1 
Scale of option ranking: 1=most effective / efficient, 3=least effective / efficient Effectiveness measures extent to whic h options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources 
5.2. Eligibility of capital instruments and application of regulatory adjustments 
To address shortcomings in the area of definitio n of capital, including issues pertaining to the 
loss absorption, permanence and flex ibility of payments of capita l instruments that shall be 
counted towards the regulatory going-concern capital as well as issues regarding the 
completeness, appropriateness and lack of harmon ized application of re gulatory adjustments, 
the Commission services considered wide-ranging adjustments in this area. In the process of 
preparing the legislativ e proposal, a number of policy alte rnatives on various individual 
aspects have been examined; they could be  sensibly grouped in the following key policy 
options: 
- Policy option 3.1:  Retain current approach; 
- Policy option 3.2:  Modify only the eligibility criteria  for own funds, as specified in the 
February 2010 public consultation; 
 
 109  - Policy option 3.3:  Modify both eligibility criteria a nd regulatory adjustments as specified 
in the February 2010 public consultation; 
- Policy option 3.4:  Modify both eligibility criteria and regulatory adjustme nts as adopted by 
the Basel Committee; 
- Policy option 3.5:  Modify both eligibility criteria and regulatory adjustme nts as adopted by 
the Basel Committee, adjusted fo r certain EU specificities. 
Policy option 3.1: Retain current approach  
Under this policy option, problems related to eligibility of capit al instruments and application 
of regulatory adjustments that are outlined in section 3.3 will not be entirely addressed. The 
CRD II already harmonised the criteria and estab lished explicit limits for different types of 
Tier 1 hybrid capital and these provisions took effect as of end 2010. However, further 
amendments were shown by the crisis to be n ecessary in order to e nhance the loss absorption, 
flexibility of payments and permanence of common equity and hybrid Tier 1 capital. As 
regards regulatory adjustments,  current CRD provisions allow for national discretion to make 
additional adjustments. While revision of thes e adjustments by individual MS may lead to 
improved quality of capital, there is no guarant ee that a necessary progress would be achieved 
quickly enough and in a uniform manner across the EU, thus, hampering the functioning of 
the single banking market and undermining the financial stability.  
 
 Policy option 3.2: Modify only the eligibility cr iteria for own funds as specified in the 
February 2010 public consultation  
This policy option would entail ti ghtening of criteria for eligibili ty of capital instruments for 
inclusion in the different layers  of regulatory capital, as specif ied in the Commission services' 
public consultation of February 2010. The consul tation document outlined such criteria with 
respect to core Tier 1, non-core Tier 1 and Ti er 2 capital, which are listed in Annex VI.  
As regards core, or, common equity Tier 1 (C ET1), the ineligibility  of some types of 
instruments would have a relatively more pr onounced impact in several MS due to the 
exclusion of instruments such as some classes of shares, silent partnerships, participation 
capital, preferred shares and suppl ementary cooperative shares.   
Impacts on non-core Tier 1 capital would be dr iven by elimination of innovative and dated 
hybrid instruments. According to CEBS analys is, as of end of 2006, almost 50% of Tier 1 
hybrid instruments in the EEA were innovative hybrids (mostly prevalent in UK, FR, DE, NL 
and IT); at the same time, such innovative hyb rids constituted a majority of dated hybrid 
instruments.238  
As regards Tier 2 capital inst ruments, the CRD provisions239 permit the commitments (e.g., 
uncalled capital and commitments to make furt her non-refundable payments) of the members 
of credit institutions set up as cooperative societies to be included within lower Tier 2 capital 
provided they may be included in capital under national law.240  The approach proposed in 
criterion 1 as regards the eligibility for Tier  2 capital (see Annex VI) would exclude such 
commitments from Tier 2 based on the prudentia l rationale that capital should be paid up in 
order to ensure that it may be relied upon when  required. This would have an impact on those 
EU banks that are organised as c ooperative networks / societies. 
However, the above amendments would address only issues pertaining to  the eligibility of 
capital instruments. They would not address th e regulatory adjustments necessary to ensure 
                                                 
238 CEBS, Report on a quantitative analysis of the characteristics of hybrids in the European Economic Area 
(EEA) , March 2007 
239 Articles 57(g) and 64(1) 
240 An identical treatment is afforded to the joint and several commitments of borr owers for credit institutions 
organised as funds 
 
 110  that the amount of regulatory capital recognized adequa tely reflects the am ounts that would be 
available to absorb losses on a going concern basis or in insolvency. A lack of further 
harmonization of regulatory adjustments would re sult in maintenance of the current divergent 
approaches in the EU to adjusting regulatory capital. Therefore, this  policy option would only 
be partially effective in terms of achieving the relevant policy objectives. 
Policy option 3.3: Modify both el igibility criteria and regulatory adjustments as specified in 
the February 2010 public consultation  
This policy option builds on opti on 3.2 by addressing problems id entified in section 3.3 that 
pertain not only to capital eligibility but also to regulatory adjustments.  To this end, this 
policy option entails lengthening the list of these adjustments as well as making their 
application more appropriate with  respect to layers of regulator y capital. As specified in the 
consultation of February 2010 (see Annex VII), most of modified adjustments would be 
applied to the core, or, common equity Tier 1 (CET1) capital.  
EU QIS showed that under this  policy option, total deductions amount to some 60% of CET1 
capital prior to deductions for Group 1 banks, and some 40% for Group 2 banks. In terms of 
individual deductions, at the EU level the mo st material impact on banks' eligible CET1 
capital would come from deduc tions for material holdings of  financial institutions and 
goodwill. Other significant reductions in eligible  CET1 capital would be driven by deductions 
for DTAs, other intangibles and minority interests in countries where minority interests are 
included in the current predomin ant form of Tier 1 capital.  
February 2010 public consultation of the Co mmission services included a proposal for 
deduction of only those DTAs that are subject to future profitab ility (i.e., tax losses carried 
forward). However, CEBS analysed the imp act of deducting various types of DTAs. The 
analysis showed that DTAs related to future profitability comprise r oughly one third of total 
DTAs in the EU, although in six MS they repr esent more than the half of existing DTAs.  
Overall, the impacts of indivi dual regulatory adjustments on C ET1 capital vary from one MS 
to another, and taken together have  a major impact on CET1 capital ratio. 
As a result of stricter capital eligibility  requirements and re-allocation of regulatory 
adjustments to CET1 capital, unde r this policy option the CET1 ratio would decrease for all 
countries as shown in Charts 10 and 11. Averag e EU CET1 ratio falls from 11.1% by some 7 
percentage points for Group 1 banks and from  11.5% by some 5 percentage points for Group 
2 banks, with considerable variation in the magnitude of the decline between and within 
countries. In terms of distribu tional effects, smaller (i.e., Gr oup 2) banks are less severely 
affected by the definition of capital proposals than large and interna tionally active banks. 
Chart 10 : Change in CET1 capital ratios 
for Group 1 banks due to capital definition proposal, in %: country averages Chart 11:  Change in CET1 capital ratios for Group 2 banks due 
to capital definition proposal, in %: country averages 
048121620
LHJ E U FBCGDAENew CET1
Current CET1
New EU average
048121620
SK FRO L J HEM E U GDAC TBNew CET1
Current CET1New EU average
Notes:  Current CET1 ratio calculated on a smaller sample of banks and according to the predominant form of Tier 1 capital 
as applied by the bank or the relevant na tional supervisor; and is gross of deductions . New CET1 ratios capture the effects of 
proposals for eligibility to CET1 capital and deductions from it  as well changes to RWAs related to definition of capital 
proposal. New CET1 ratios are understated to the extent that they reflect a full DTA deduction (as opposed to deduction of 
DTAs related to future profitability onl y). EU Group 1 'Current CET1' and Group 2 'New CET1' averages each include one 
additional MS that is not shown individually, while Group 1 'N ew CET1' and Group 2 'Current CET1' averages each include 
two additional MS. 
Source:  CEBS  
 
 111  In their responses to the consultation as rega rds the eligibility of instruments for CET1 
capital, several public authori ties and many industry respondents stated that greater onus 
should be placed on the substance of a capital in strument, e.g., its ability to absorb losses 
effectively, than on its legal form. As regard s eligibility of Add itional Tier 1 capital 
instruments, there was a signi ficant support among public authorit ies for all such instruments 
to be required to have a principal write-down or conversion feature with an objective trigger, 
in line with the approach taken in CRD II, in order to ensure that such instruments absorb 
losses effectively and help an institution to remain as a going concern. Views of the industry 
on this topic were mixed. With respect to re gulatory adjustments, a significant number of 
public authority respondents and many industr y respondents expressed concern about the 
appropriateness of the proposed non-recognition of  minority interest and full deductions of 
DTAs and investments in certain other unconsolidated financial institutions. 
Policy option 3.4: Modify both el igibility criteria and regulatory adjustments as adopted by 
the Basel Committee  
This policy option reflects the new definiti on of capital approach adopted by the Basel 
Committee that was outlined in the Committee’s Basel III rules text in December 2010. This 
option, compared to option 3.3, entails a number of  changes with respect to certain regulatory 
adjustments, improving upon the underlying pruden tial rationale and taki ng into account of 
the impact of the proposals on the industry and potential im pact on the economy. The key 
changes are as follows: - Minority interests: this option provides some  recognition in CET1 to  the minority interest 
supporting the risks of a subsidiary  that is a credit in stitution, investment firm, or firm subject 
to the same prudential requirements and superv ision as credit institut ions and investment 
firms in the CET1.
241 For this, minority interest should m eet the criteria of common stock of 
the consolidating bank. Howeve r, capital above the regulat ory minimum and a capital 
conservation buffer (please see section 5.5) of a subsidiary would be deducted in proportion 
to the minority interest share. - Investments in capital instruments of other financial institutions: this option includes an 
exemption for underwriting positions held for five working days or  less and, under specific 
circumstances, allows the netting of long and s hort positions in other unconsolidated financial 
entities. - The treatment of significant investments in the common shares of unconsolidated financial 
institutions (i.e., more than 10% of their issu ed share capital), mortgage  servicing rights, and 
deferred tax assets from timing differences is  modified by giving these deductions a limited 
recognition when calculating the CET1, with such recognition capped at 10% of a bank’s 
common equity component for each of the above  deductions. At the same time, banks would 
have to deduct the amount by which the aggreg ate basket of the three items above exceeds 
15% of their CET1 capital, calculated after all regulatory adjustments, while the items 
included in the 15% aggregate limit would be s ubject to full disclosure . Amounts that are not 
deducted from the CET1 as per the above appr oach, however, are risk weighted at 250%. 
EU QIS showed that CET1 deductions as % of new CET1 capital gross of deductions for 
Group 1 banks compared to option 3.3 decline markedly, while Group 2 banks experience a less pronounced decline (see Table 9). In terms of  individual deductions, at the EU level the 
most material impacts are due to goodwill, material holdings of financial institutions and DTAs.  For both bank groups, deduction of surplus of items included in the basket has a low 
impact while deduction of mortgage servicing ri ghts has no impact at all. Impacts of other 
individual adjustments continue  to vary from one MS to an other and, when taken together, 
exert a major albeit less pronounced, than under option 3.3, impact on the CET1 capital ratios. 
                                                
 
241 Equivalent treatment of minority interest has been proposed for Tier 1 and total capital. 
 
 112  Table 9 : CET1 deductions and minority interest as a percentage of new CET1 capital gross of deductions: 
comparison of policy option 3.3 and 3.4 for Group 1 and Group 2 banks 
Total
Goodwill
Intangibles
Financials
DTAs
Mortgage servicing rghts
Basket exceeding 15%
Other 2
Minority interest 3
Total
Goodwill
Intangibles
Financials
DTAs
Mortgage servicing rghts
Basket exceeding 15%
Other 2
Minority interest 3
A -69 -70 -11 -8 -14 -8 0 0 -28 -3 -34 -34 -3 -1 -20 -1 0 -2 -9 0
B -74 -68 -39 -9 -4 -10 0 -5 -2 -3 -67 -69 -35 -5 -7 -10 0 -4 -8 -1
C -71 -55 -34 -4 -2 -12 0 -4 -1 -3 -38 -37 -15 -3 -11 -2 0 -1 -5 -10
D -80 -47 -5 -2 -14 -4 0 -5 -17 -8 -32 -24 -1 -3 -3 -2 0 -3 -11 -10
E -93 -47 -23 -4 -7 -7 0 -2 -4 -2 -26 -28 -3 -6 -14 -1 0 0 -3 0
F - 5 4 - 4 3 - 2 3 - 4 - 3 - 9 0 - 2 - 2 - 1 - 6 - 8 0 - 2 0000 - 6 0
G -80 -43 -12 -4 -8 -10 0 -3 -6 -1 -111 -22 -1 0 -19 0 0 -1 -2 0
H -42 -37 -16 -4 -6 -5 0 -1 -6 -6 -12 -9 -1 -3 0 -3 0 0 -2 0
I -28 -25 -13 -4 0 -1 0 0 -6 -7
J- 3 3 - 2 4 - 7- 4- 3- 3 0 0 - 8- 3 - 1 4 - 1 3 - 5- 3 0 - 2 0 0 - 4 0
K -24 -20 -12 -4 0 0 0 0 -3 -23 -47 -19 -6 -3 -8 0 0 0 -1 -15
L -18 -16 -10 -2 -1 -1 0 0 -2 0 -6 -9 0 -4 0 -2 0 0 -3 0
M - 4 1 - 3 5- 3 - 2- 2 2 0 0 0 - 8 0
N - 1 0 - 3 1 - 2 5 - 5 - 1 0000 - 2
O - 1 6 - 1 6 0 - 1 3 0000 - 3 - 1
P - 1 6 - 1 4 - 2 - 1 - 5 000 - 6 0
Q - 2 9 - 1 3 - 6 - 5 - 1 000 - 1 0
R -8 -10 -4 -2 -1 0 0 0 -2 0
S - 1 2 - 1 0 - 1 000000
EU 4-62 -42 -20 -4 -5 -6 0 -2 -5 -4 -45 -33 -12 -3 -9 -3 0 -1 -5 -3Country
Policy option 3.3 (total)  1Policy option 3.3 (total)  1Group 1 banks
Policy option 3.4Group 2 banks
Policy option 3.4
Notes:  1 Deductions for DTAs are based on full DTA deduction whereas the Commi ssion services consulted only on 
exclusion of DTAs relating to future  profitability of an institution; 2 'Other' includes deductions related to investments in 
own shares, shortfall of provision to expected losses, cash flow hedge reserve, cumulative changes in own credit risk, 
pension fund assets and securitisation gains on sale; 3 It is assumed that minority interest was already excluded from the 
current predominant form of Tier 1 capital.  Therefore, minority interest is not incl uded in the sum of deductions from CET1, 
and is shown for information purposes; 4 Group 1 EU average includes 3 more coun tries that are not shown individually 
while Group 2 EU average includes 2 additional countries.  
Source:  CEBS  
As a result and without considering the impact  of other proposals included in the CRD IV, 
average EU CET 1 capital ratio for Group 1 banks , compared to option 3.3, increases by some 
2 percentage points to 5.8% whereas that of Group 2 banks improves slightly to 7.1%, 
representing lower reductions fr om the current levels of predom inant form of Tier 1 capital 
(see Charts 12 and 13 for dist ribution of CET1 capital ra tios by country for Group 1 and 
Group 2 banks).  As regards eligibility of Additional Tier 1 cap ital instruments, this option would entail a less 
stringent treatment than the policy options 3.2 and 3.3 discussed above since those options 
would require all such instruments,  irrespective of them being rega rded as equity or liabilities 
for accounting purposes, to contai n a meaningful statutory or  contractual loss absorption 
mechanism, whereas only instruments classified  as liabilities must have principal loss 
absorption under the Basel approach, which eff ectively would increase Tier 1 capital under 
this option by an estimated €89 billion. Nota bly, treatment under policy option 3.4 would not 
be in line the provisions of CRD II in conj unction with CEBS' guidelines on hybrid capital 
instruments which is reflected under options 3.2 and 3.3. As a result certain MS would be 
affected less severely unde r option 3.4 in terms of its impact on Tier 1 capital. 
  
Chart 12 : CET1 capital ratios (country 
averages) for Group 1 banks due to capital definition proposal, in % Chart 13:  CET1 capital ratios (country averages) for Group 2 
banks due to capital definition proposal, in % 
 
 113  048121620
LK I J HE E U CGBDFANew EU average
048121620
S FQOL J RMEHPNAG E U DKCBNew EU average
 
Notes:  CET1 ratios capture the effects of proposals on eligibility fo r CET1 capital and deductions from it as well changes to 
RWAs related to definition of capital proposal. Group 1 EU av erage ratio includes 3 more countries that are not shown 
individually while Group 2 EU averag e includes 2 additional countries. 
Source:  CEBS  
It can be estimated that under this policy opt ion, combined current CET1 capital for 208 
Group 1 and Group 2 banks would decline by some €490 billion242, Tier 1 capital by €370 
billion and total capital by some €420 billion. Actual capital shortfall for the EU banking 
sector, however, would depend on the level of cali bration of the new minima, implications of 
other parts of the proposal on the RWAs, and ca pital buffers that banks hold in excess of 
current regulatory minima (as can be seen fr om Charts 12 and 13). These aspects are assessed 
cumulatively in section 5.8.2 of this report.  It is expected that the new capital definition and regulatory ad justments should significantly 
impact the stability of the financial system, by not only increasing the level of capital, but 
more importantly by increasing its quality, i.e ., its capacity to effectively absorb economic 
and financial shocks thereby preserving the viab ility of financial inst itutions. In addition, 
some specific deductions, such as for unconsolid ated investments in financial institutions, 
should have the effect of  reducing systemic risk. 
Policy option 3.5: Modify both el igibility criteria and regulatory adjustments as adopted by 
the Basel Committee, adjusted fo r certain EU specificities  
Under this policy option, a number of adjustment s have been considered to the approach of 
the Basel Committee outlined under option 3.4 in or der to align it better with EU regulatory 
and banking sector specificities. These adjust ments reflect certain features of option 3.3 
(Modify both the eligibility criteria and regulat ory adjustments as specified in February 2010 
public consultation) as well as  stakeholder feedback rece ived in relation to public 
consultations. They include: - restricting CET1 to inst ruments that qualify under na tional law as equity capital
243 and meet 
the CET1 criteria, rather than to ordinary shar es that meet the CET1 criteria – this approach 
places greater onus on the substance of a CET1 in strument. It recognizes the fact that some 
EU institutions issue instruments other than ordinary shares having the loss absorbency 
equivalent to that of ordinary shares;  - derogations from specific CET1 eligibility criteria for institutions that are mutuals, cooperative societies or similar in stitutions – this will help to ensure that the potential for 
general derogation from the CET1 criteria affo rded by Basel III is applied appropriately and 
consistently in the EU;   - rather than recognition in CET1 only where associated with an instrument that qualifies as 
CET1, recognition in CET1 also of share prem ia that qualified as or iginal own funds under 
Article 57(a) of Directive 2006/48/EC prior to 31 December 2010 – the purpose of this 
approach is to provide recogniti on of the loss absorbi ng nature and role of such share premia, 
while also restricting the treatm ent to instruments issued prior to the entry into force of the 
stricter definition of capit al introduced by CRD II;  
                                                
 
242 Change between current predominant form of Tier 1 capital without any deductions and CET1 capital as 
defined under option 3.4 
243 This represents a 'substance over form' approach, as it allows instruments other than common shares that meet 
all the eligibility criteria of Basel III to be included in CET1 
 
 114  - a requirement for all Additional Tier 1 capital in struments, rather than only liabilities, to 
have principal write down or conversion feature244 - this approach takes account of the raising 
of capital quality in CRD II and ensures that th e principal amount of both equity instruments 
and liabilities are able to absorb losses  effectively on a going concern basis;   
- full, rather than limited, deduction from CET1 of  mortgage servicing ri ghts, as for all other 
intangible assets - such an approach takes account of the relative illiquidity and uncertain value of mortgage servicing right s, and the potential difficulty of realising significant amounts 
of them in a stressed or emergency situati on. EU banks have limited amounts of mortgage 
servicing rights - by virtue of their US subsidia ries – and therefore impact of this adjustment 
is expected to be very small;  
- a restriction on the recognition of hedging for the purposes of determining the amounts to be 
deducted for investments in other unconsolidated  financial entities to the trading book. The 
purpose of this approach is to limit the potenti al for double counting of ca pital in the financial 
system through the provision of hedges by entiti es that are not subject to an equivalent 
deduction requirement, and to re flect the fact that such hol dings in the non-trading book 
continue to the maturity of the instrument  and are difficult to hedge effectively;  
- an alternative approach for deduction of significant holdings  in unconsolidated insurance 
entities combined with enhancem ents to the current approach to applying the methods laid 
down in the Financial Conglomerates Directiv e (FICOD). The purpose of  this is to take 
account of, and to enhance, the cross sector tr eatment laid down in the FICOD of holdings of 
capital instruments in banking and insurance;  - recognising minority interest – and certain regu latory capital issued by subsidiaries - to the 
extent that those subsidiaries are credit institut ions or investment firms and the capital is used 
to meet minimum capital requirements, capital conservation buffer and c ountercyclical capital 
buffer (see section 5.5). This rec ognises the importance of the countercyclical capital buffer, 
the capital used to meet it, and it aims at  avoiding any disinc entives to its use; 
- clarification of the treatment of DTAs that automatically convert into a claim on the state 
when a firm makes a loss. Where their ability to absorb losses when needed is ensured, such 
DTAs would not have to be deducted.  The overall net impact of the above adjustme nts on the CET1 ratios of Group 1 and Group 2 
banks presented under option 3.4 is assumed not to be of major significance, as some of them 
would make the new capita l requirements more stringent wh ile others would have an opposite 
impact. Most importantly, the adjustments have b een developed with a view to ensure that the 
relevant policy objectives are attained in th e most effective manner and that Basel III 
framework is meaningfully and flexibly appl ied to a diverse spectrum of the EU banking 
firms. 
Comparison of policy options
 
Retaining the current scenario (o ption 3.1) implies that problems re lated to quality of capital, 
as outlined in section 3.3 may not be addresse d effectively, depending on the actions taken in 
this area by national supervisors and/or the i ndustry. While tightening of national approaches 
may provide for a degree of increased effec tiveness with respect to capital adequacy 
(objective S-1) and bank management of risks (o bjective S-2) discussed in this section, there 
is no guarantee that necessary progress would be achieved quic kly enough and evenly across 
the EU. Of the remaining policy options, option 3.2 woul d be the least effective with respect to 
contributing to the achievement of the relevant policy objectives due to its focus on eligibility 
criteria only. Policy options 3.3, 3.4 and 3.5 are perc eived to be rather e ffective although they 
vary in terms of treatment of individual re gulatory adjustments and, additionally, options 3.3 
                                                
 
244 This addresses the issue that pref erence shares, while not being effect ive at absorbing losses on a going 
concern basis, would not be required to have a write-down or conversion 
 
 115  and 3.5 are more aligned with certain EU regulat ory and banking sector–specific aspects. In 
this regard, option 3.5 is more developed as  it reflects outcomes of extensive public 
consultations. Hence, policy option 3.5 is the most efficient option and is identified as a 
preferred option. Table 10:  Summary of policy option e ffectiveness and efficiency 
Policy Option Comparison Criteria 
Effectiveness 
Policy Option Enhance 
adequacy of 
capital and 
liquidity 
requirement
s [S-1] Enhance 
bank risk 
managem
ent 
[S-2] Prevent 
regulatory 
arbitrage 
opportunit
ies [S-3] Enhance 
level 
playing 
field [S-6] Align 
prudential requireme
nts for 
SIFIs with 
the risks 
they pose 
[S-8] Reduce 
cyclicality 
of bank 
lending 
[S-9] Efficie
ncy 
3.1 Retain current approach 5 5 5 5 5 5 5 
3.2 Modify only the eligibility criteria as specified 
in the February 2010 public consultation 4 4 4 4 4 4 4 
3.3 Modify both eligibility  criteria and regulatory 
adjustments as specified in the February 2010 public consultation 1-3 1-3 1-3 2-3 1 1-3 3 
3.4 Modify both eligibility  criteria and regulatory 
adjustments as adopted by the Basel Committee 1-3 1-3 1-3 2-3 2-3 1-3 2 
3.5 Modify both eligibility  criteria and regulatory 
adjustments as adopted by the Basel Committee, adjusted for certain EU specificities 1-3 1-3 1-3 1 2-3 1-3 1 
Scale of option ranking: 1=most effective / efficient, 5=least effective / efficient 
Effectiveness measures extent to whic h options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources  
5.3. Counterparty credit risk 
To address problems related to current rules on the counterparty credit risk (CCR), discussed 
in section 3.4, the Commission services propose a number of revisions in this area with the 
main policy options as follows: 
- Policy option 4.1:  Retain current approach; 
- Policy option 4.2:  Enhance  adequacy and minimize cyclicality of CCR capital 
requirements  and enhance incentives for clearing OTC instruments through central 
counterparties (CCPs); 
- Policy option 4.3:  Enhance  adequacy and minimize cyclicality of CCR  capital 
requirements, enhance incentives for clearing OTC instruments through CCPs and adjust  
the treatment of exposures to CCPs . 
Policy option 4.1: Retain current approach  
Under this policy option, problems outlined in section 3.4 would not be addressed. The 
capitalisation for CCR would remain to be insufficient and the corresponding risk 
management standards inadequate . Credit institutions would con tinue to lack incentives to 
move their bilaterally cleared OTC derivative co ntracts to multilateral clearing through central 
counterparties (CCPs). No consid eration would be given to the degree of cyclicality of the 
capital requirements.  
Policy option 4.2: Enhance CCR requirements  
This policy option would entail amending the C CR framework in several areas in order to 
ensure a more appropriate capitalisation for CCR. This would include the following 
amendments: - Capital requirements for credit valuation adju stment (CVA) risk: cred it institutions would be 
subject to an additional capital charge for mark -to-market losses (i.e., CVA risk) associated 
with deterioration in the cr editworthiness of a counterpart y. As mentioned in section 3.4, 
while the current regulatory sta ndards cover the risk of a count erparty default, they do not 
address such CVA risk, which has been a greate r source of losses than outright defaults. The 
new CVA capital charge has been designed in a risk sensitive manner. It would also allow 
 
 116  recognising both single name a nd index hedges of the CVA ri sk and thus promote sound 
practices in managing this risk. Such approach  would allow banks to considerably mitigate 
the impact of the new CVA capital charge and, in  turn, largely address concerns of the end 
users of derivatives - expressed in the public consultations - about the possible 
disproportionate impact of this measure on non-fi nancial institutions usin g derivatives for risk 
mitigating purposes, in case banks' hedging of the CVA risk were not adequately recognised.
245 As far as financial markets are concer ned, the recognition of hedging is likely 
to cause an increase of demand for both singl e-name and index Credit Default Swaps (CDS) 
and contribute to further growth  of the corporate CDS market.  
- Adjustment of the asset value correlations: to address the systemic risk within the financial 
sector, this option suggests rais ing the risk weights on exposur es to financial institutions 
relative to the non-financial co rporate sector, as financial exposures are more highly 
correlated than non-financial on es. Specifically, it suggests ap plying a multiplier of 1.25 to 
the asset value correla tion of exposures to regulated fina ncial firms (with assets above $100 
billion) and to all exposures to unregulated fi nancial firms (regardless of  size). The measure is 
expected to encourage diversif ication of CCR among smaller institutions and, overall, should 
contribute to less interc onnectedness between larg e or systemically impor tant institutions and, 
possibly, limit the propagation of a shock originating in  a default of a large or systemically 
important financial institution (SIFI). To the extent that wholesale financial markets are 
characterised by a hub and spoke structure, rela tionships between hubs will be weakened and 
banks in spokes will have an incentive to increase the number of their relationships. This could reduce the scope to benefit from s cale economics and therewith reduce overall 
efficiency. On the other hand, it also imp lies stronger competition among hubs and possibly 
lower margins in wholesale financing, which coul d have beneficial effects for the economy at 
large as well as in terms of a reduc tion of systemic risk as a whole. 
- Calibration of the exposure at default fo r CCR exposures: credit institutions would be 
required to calculate the Effective Expected Positive Exposure metric based on data that 
includes a period of stress to address general wrong-way risk. The amendments would also 
explicitly determine the treatment of exposures  with counterparties where specific wrong-way 
risk has been identified. These amendments w ould dampen the cyclicality of the respective 
capital requirements. The resultant increase in  regulatory capital would limit the scope for 
contagion (banks should be less affected by a default of count erparty) and should contribute 
to strengthening of the financial stability, which may further translate into lower risk premia 
banks have to pay for obtaining funds and better availability of financing for the economy.    
- Strengthening standards for collateral manageme nt and initial margining, stress testing and 
back-testing (model validation). - Clearing of OTC instruments through CCPs: this  option would also considerably reinforce 
the existing incentives for inst itutions to use CCPs for OTC derivatives as the proposed 
amendments would increase the assessed capit al requirements agains t such exposures if 
completed on a bilateral basis rather than th rough a CCP. Assuming that most institutions 
dealing with OTC derivatives move to CCP cl earing, a number of the derivatives currently 
traded on the OTC markets would have to b ecome more standardized, which is one of 
requirements to be cleared and also a necessa ry condition to achieving the counterparty risk 
reduction benefits of central clea ring. Standardisation can be a pow erful tool of raising market 
efficiency and liquidity. As regards hedging, standardisation might in certain instances 
                                                
 
245 Specifically, end users of derivatives (including non-financial institutions) feared that banks would pass the 
additional costs resulting from the new CVA charge on to their counterparties by increasing the price of 
the respective derivative products, which are being us ed by end users for risk mitigation purposes. End 
users claimed that this would disincentivise them to enter into such derivative transactions and thus 
mitigate the risk accordingly. 
 
 117  weaken the relationship between a derivative an d underlying risk/instrum ent and can therefore 
not be extended to the entire OTC derivatives market. As market participants (including non-
financial institutions / end users of derivatives) have an interest in tailor-made contracts, the 
strengthening of CCPs may lead to higher cost s for them as liquidity will suffer in the non-
standardised segments. The number of banks included in the CCR analysis  in the EU QIS was considerably smaller 
than the overall number of particip ating banks. This can be primarily  attributed to the fact that 
this type of risk is relevant only to banks  with significant OTC derivative and/or SFT 
activities as well as insufficien t data quality which led to th e exclusion of 17 of the 50 Group 
1 banks from the analysis.  
Due to proposals under this policy option, th e remaining 33 Group 1 banks had an average 
increase in their RWAs of some 10%
246; most of it due to the proposed CVA charge. Capital 
increases related to other meas ures, including the rise in the asset value correlation, were by 
comparison modest. Across EU MS, above-average  increases in the RWAs were observed in 
banks from MS H, E and J. Notably, the av erage increase in RWAs of Group 2 banks was 
significantly smaller at 0.2%, il lustrating that these banks have  typically less exposure to OTC 
derivatives, and that proposals with regard to CCR have major implications only for the 
largest EU banks. 
Policy option 4.3: Enhance CCR requirements and adjust treatment of exposures to central  
counterparties  
This policy option reflects the new CCR framew ork adopted by the Basel Committee that was 
outlined in the Committee’s Basel III rules text in December 2010. It builds on the policy option 4.2 and entails, in addition, a recalibra tion and differentiation of the treatment of 
exposures to CCPs
247 depending on the type of the exposure the credit institution has vis-à-vis 
a CCP and whether the respective CCP complies with a set of stringent risk management 
standards.248  
More specifically, this proposal  would differentiate between (i ) collateral and mark-to-market 
exposures to CCPs and (ii) the default fund contributions249:  
- The collateral and mark-to-market exposures wo uld attract a very low (e.g., 1%) risk weight, 
reflecting the low (however, non-zero) risk that such exposures entail.250 Such treatment 
would, however, be allowed, only if a given CCP  meets a set of robust risk management 
standards. The collateral and mark-to-market e xposures to CCPs that are not compliant with 
these standards would be treate d like any other bilateral counte rparty. Such approach would 
                                                 
246 Not including capital charges for exposures to CCPs 
247 Currently, banks’ exposures to CCPs generally attract  a zero EAD; few requirements are placed on CCPs in 
order for banks to use a zero EAD in calculating their exposures to such entities. 
248 A CCP is an entity that interposes itself between coun terparties to a contract traded within one or more 
financial markets, becoming the buyer to every seller and the seller to every buyer. A CCP can play an 
important role in the efforts to reduce the systemic risk arising from the web of exposures formed by 
holdings of derivatives products by banks and other financial institutions However, a CCP also concentrates risk, which means that a CCP with in sufficiently robust risk management processes can 
actually increase the systemic risk. In  order to avoid such a situation, supervisors need to ensure that a 
CCP has in place strong risk management procedures and is, more generally, subject to and complies 
with strict rules/standards governing all aspects of its operations. In this context, on 15 September 2010, 
the Commission adopted a proposal for a Regulation on OTC derivatives, central counterparties and trade repositories, which envisages subjecting CCPs to stringent business conducts and harmonised 
organisational and prudential requirements such as internal governance rules, audit checks, greater 
requirements on capital etc; see http://ec.europa.eu/internal_market/financial-
markets/derivatives/index_en.htm#proposals  
249 The default fund contributions are designed to c over losses, over and above initial margin, following a 
clearing member default 
250 Collateral held by an entity acting as a custodian will,  provided such collateral will not form part of the 
custodian's estate in a bankrupt cy, receive a zero risk weight.  
 
 118  considerably promote the use of the CCPs with high risk management standards with all the 
related positive impact on financial stability.  
- The default fund contributions would attract hi gher capital charge (compared to collateral 
and mark-to-market exposures) that would be  derived on the basis of a risk sensitive 
approach, reflecting the financial resources waterfall of a CCP in  question. The capital charge 
applied to the default fund contributions woul d therefore vary according to the financial 
resources (such as initial  margins or CCP own capital) availa ble to support any possible losses 
before the default fund contributions are use d. Such approach would considerably increase 
incentives for firms to post higher initial margins,  which would in turn increase the robustness 
of CCPs and enhance the financial stability. The treatment of default fund contributions 
posted with a CCP that does not comply with th e enhanced standards would be significantly 
more conservative.  The above described approach would, compared to  the existing regime, lead to an increase of 
capital requirement for exposures to CCPs. Th is increase however would only be marginal 
and not significantly affect the effectiveness of the goal to reinforce the incentives for 
institutions to use CCPs for OTC derivatives ou tlined in the discussion of policy option 4.2 as 
the increase in capital requirement s for exposures arising from b ilaterally cleared transactions 
would be significantly greater. In the context of this option, the Commission se rvices publicly consu lted on the capitalisation 
of exposures to CCPs and the treatment of incurred CVA in February-March 2011
251.  
The latter deals with the issue of how to treat loss es against the CVA risk which a bank in 
question writes down upfront. Give n that incurred CVA has been recognized in the Profit & 
Loss account, and thus effectivel y represents an amount that ca nnot be lost again were the 
counterparty to default, the Basel Committee suggested a treatment where incurred CVA 
could be deducted from the exposure amount (Ex posure at Default) in the calculation of the 
capital requirements for the default component of CCR.  A vast majority of respondents to the Co mmission services' consultation nevertheless 
expressed serious concerns about such an approa ch, arguing that it is co nceptually inadequate 
and that the degree of the recognition of incurred CVA is disproportionately low.  
The Commission services have extens ively analysed the comments received
252 and as 
subsequently suggested an alternative treatm ent, which would allow for a greater, however 
still prudent, degree of recognition of incurred CVA. In e ssence, such treatment would allow 
institutions applying th e IRB approach to offset the regul atory expected loss for CCR by the 
amount of incurred CVA, but this offset would be capped at the level of expected loss on the 
trade/netting set to which it relates. Institutions  applying the Standardised Approach would be 
subject to the same treatment as proposed by the Basel Committee. The Commission services consider the above a lternative treatment for institutions applying 
the IRB approach conceptually sounder, consiste nt with the rest of the regulatory framework 
applied to those institu tions and more effective in eliminating the double count referred to 
above. The benefits of such approach would nevertheless be somewhat diminished by the 
possible costs implied for internationally ac tive banks by divergence from the treatment 
proposed by the Basel Committee, provided that such treatment is confirmed and implemented as announced in the Basel III framework published in December 2010.  However, in the view of the Commission serv ices any such divergences would not have 
material implications for the EU  industry overall and therefore are not elaborated further in 
this assessment. 
Comparison of policy options
 
                                                 
251 http://ec.europa.eu/internal_market/bank/regcapital/index_en.htm#consultation_credit_risk   
252http://circa.europa.eu/Public/irc/markt/markt_consultations/library?l=/financial_services/credit-
risks&vm=detailed&sb=Title   
 
 119  Policy option 4.1 entails possible si gnificant costs in terms of inadequate capital and risk 
management standards for CCR, with its resu lting negative consequences for financial 
stability. This option can be therefore di scarded from any further considerations.  
In contrast, policy option 4.2 is effective in addressing all key shortcomings outlined in 
section 3.4 – it ensures more adequate and less cyclical capital requirements for CCR, 
strengthens risk management standards and provides additional incentives to move OTC derivative contracts to CCPs, thus, helping to reduce the systemic risk across the financial 
system.  Measures proposed under policy option 4.3 (on to p of those proposed under policy option 4.2) 
enhance capital requirements (objective S-1) an d bank risk management (objective S-2) and 
reduce the systemic risk even further by ensu ring an appropriate capita lisation for exposures 
to CCPs and providing additional important incen tives to move OTC derivative contracts to 
CCPs with the highest risk management standard s. As a result, policy option 4.3 is identified 
as a preferred policy option. Table 11:  Summary of policy option e ffectiveness and efficiency 
Policy Option Comparison Criteria 
Effectiveness 
Policy Option Enhance 
adequacy of 
capital and 
liquidity 
requirements [S-
1] Enhance bank 
risk 
management 
[S-2] Align 
prudential 
requirements 
for SIFIs with 
the risks they 
pose [S-7] Reduce 
cyclicality of 
bank lending 
[S-9]  Efficiency 
4.1 Retain current approach 3 3 3 3 3 
4.2 Enhance CCR requirements  2 2 2 2 2 
4.3 Enhance CCR requirements and adjust 
treatment of exposures to CCPs  1 1 1 1 1 
Scale of option ranking: 1=most effective / efficient, 3=least effective / efficient 
Effectiveness measures extent to whic h options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources  
5.4. Leverage 
To address excessive build-up of leverage on ba nks' and investment banks' balance sheets and 
help contain the cyclicality of bank lendi ng, the Commission services investigated a 
possibility of introducing a non risk -based leverage ratio.  The ma in policy options in this area 
are as follows: - Policy option 5.1:  Retain current approach; 
- Policy option 5.2:  Introduce  supplementary non risk based leverage ratio as specified in 
the February 2010 public consultation ; 
- Policy option 5.3:  Conduct extensive monitoring  of different types of supplementary non 
risk based leverage ratio . 
Policy option 5.1: Retain current approach
 
Under this policy option the bui lding up of excessive levera ge during the next economic 
upturn would not be addressed other than by increased minimum capital requirements, once 
adopted. Also, there would be no overall backstop  against model risk. In addition, there would 
be a risk that supervisors may introduce various national treatmen ts in this area, which could 
undermine the level playing field wi thin the EU and internationally. 
Policy option 5.2: Introduce le verage ratio as specified in the February 2010 public 
consultation  
This policy option would introduce a leverage ratio as per the definition included in the public 
consultation of February 2010, which was closely aligned with the consultative document of 
the Basel Committee of December 2009.  In the process of the EU QIS, several vari ations of a possible ratio were assessed. For 
example, both Tier 1 and total capital for the nume rator of the ratio were considered, while for 
 
 120  the calculation of the exposure base (the denom inator) a possibility of excluding high quality 
liquid assets from the on-balance sh eet exposure amount was examined.  
The distributions of average leverage ratios for Group 1 a nd Group 2 banks of different 
countries for the principal variant of the ratio are shown in Charts 14 and 15. Notably, at the 
EU level, the average Group 2 bank leverage ra tio of 3.1% (representing a multiple leverage 
of 32 times Tier 1 capital) is almost double that  of 1.6% (representing a multiple leverage of 
63 times Tier 1 capital) of Group 1 banks, indica ting that smaller EU banks are less leveraged. 
This outcome is mostly explained by the fact th at larger Group 1 banks are more impacted by 
i) the new Basel definition of Tier 1 capital (s ee section 5.2) and ii) the proposed treatment for 
non-traditional banking assets. In  particular, the proposed deduc tions from CET1 capital were 
considered to be fully and dire ctly applicable without  recognising the mitigating effects of the 
agreed phasing-in regime, which has a signifi cant impact on the Tier 1 capital base. Non-
traditional banking assets constitute a relativ ely larger portion of Group 1 bank business 
(compared to Group 2 banks) and their treatmen t had an important impact on the exposure 
base by not allowing netting of derivatives, valu ing written credit deriva tives at 100% of their 
notional value and capturing off-ba lance sheet exposure at 100%. 
Feedback to the public consulta tions showed that the exposure base (i.e., denominator of the 
ratio) under this option is broadly defined and in  some cases may give a too wide capture of 
leverage. These cases include application of  proposed conversion factors of 100% for 
unconditionally cancellable off- balance sheet exposures such as credit cards and of gross 
nominal values of derivatives without allo wing for netting under the Basel II framework. 
Furthermore, both national authorities and the industry expressed concerns that institutions 
with lower risk business models would be affected disproportionately as low capital 
requirements of such institutions would result in higher leverage ratios. Given that these institutions are critical for pr oviding credit to th e real economy (incl uding to SMEs) a wrong 
calibration of the leverage ratio might ther efore have unintended consequences for the 
economic recovery.     
Chart 14 : Leverage ratios (country averages) 
for Group 1 banks, in % Chart 15:  Leverage ratios (country averages) for Group 2 
banks, in % 
012345678
IL D JC H B E U E FA G           EU average 
012345678
QSA M RPKCD H E U J FEBG               EU average 
Notes:  Leverage ratio using the new definition of Tier 1 capital in the numerator, and both on- and off-balance sheet 
exposures in the denominator. More specifically, in the denom inator credit convers ion factor of 100% for all off-balance 
sheet exposures was used, including for unconditionally cancella ble commitments, written credit derivatives were measured 
at 100% of their notional value, other derivatives measured at potential future  exposure, and no netting of financial 
derivatives was recognised. Group 1 EU average includes 4 add itional countries that are not shown individually while Group 
2 EU average includes 2 additional countries. 
Source:  CEBS  
Policy option 5.3: Conduct extens ive monitoring of leverage  
While a non risk-based supplementary leverage  ratio (although differen tly defined) already 
exists in the US, Canada and Switzerland, experi ence with this measure in the EU is very 
 
 121  limited. Hence, both its definition and calibration need to be chos en very carefully to avoid 
any unintended adverse impacts. Discussions in  this regard at the level of the Basel 
Committee also confirmed these concerns. Therefor e, Basel III rules text foresees a review 
period of a full credit cycle to assess the eff ectiveness of this policy measure. Such review 
would assess, among others:  - impacts on lower risk business models versus  higher risk business models, and effects of 
possible migration from the former to the la tter (the EU QIS did not provide sufficient 
information on the distribution of leverage rati os across different banki ng business models);  
- changes in overall balance sheet st ructure due to securitisation;   
- interaction of the ratio with the risk-based capital requirements;  
- impacts on markets for specific financial products such as repos and covered bonds;  
- its effectiveness of mitigating pro-cy clicality throughout an economic cycle;  
- impacts on lending to SMEs and trade financing; and  - impacts that differences in financial repor ting frameworks may have on comparability and 
the international level playing field for the EU institutions.  Until a more extensive monitoring of the leverage ratio has been carried out it is not possible to define the most effective design and absolute  minimum level of the leverage ratio for all 
types of EU credit instituti ons and investment firms. The Commission services intend to 
conduct such monitoring for several alternat ive definitions of the numerator and the 
denominator of the ratio (including the definition s outlined in Basel III rules and in February 
2010 public consultation), which would feed into  the development of the most effective 
variant of this policy measure. On the basis of  this review and prior to making it a binding 
measure from 2018, the Commission services wi ll prepare another proposal on the final 
design and calibration of the leverage ratio.  
 
 Comparison of policy options
 
Retaining the current scenario (option 5.1), implies that problem s related to excessive build-
up of leverage, as outlined in  section 3.5.2, may not be addre ssed effectively, depending on 
the actions taken in this area by national supervisors and/or th e industry. While tightening of 
national regimes may provide for a degree of  improved effectiveness with respect to 
regulation (objective S-1) and ba nk management (objective S-2) of risks discussed in this 
section, there is no guarantee that necessary progress would be achieved quickly enough and 
evenly across the EU. Under policy option 5.2 steps were taken to examin e a number of alternative formulations of 
the leverage ratio. While most of alternativ e formulations examined would provide for a 
certain degree of effectiveness as regards c ontributing to the achievement of relevant 
objectives S-1 (Enhance adequacy of capital a nd liquidity requirements), S-2 (Enhance bank 
risk management), and S-9 (Reduce cyclicality of bank lending), they may also entail a risk of 
unintended consequences (which can be onl y ascertained following a more extensive 
monitoring exercise) which makes this option less  attractive from the efficiency standpoint. 
Policy option 5.3 is marginally more effective an d efficient than option 5.2 due to its more 
appropriate – from a prudential angle - even tual design of both the numerator and the 
denominator of the ratio as well as its eventu al calibration following the monitoring exercise. 
Policy option 5.3 therefore is iden tified as a preferred option.  
Table 12:  Summary of policy option e ffectiveness and efficiency 
Policy Option Comparison Criteria 
Effectiveness 
Policy Option Enhance adequacy 
of capital and 
liquidity 
requirements [S-1]  Enhance bank 
risk 
management 
[S-2 ] Reduce 
cyclicality of 
bank lending 
[S-9]  Efficiency 
 
 122  Policy Option Comparison Criteria 
Effectiveness 
Policy Option Enhance adequacy 
of capital and 
liquidity 
requirements [S-1]  Enhance bank 
risk 
management 
[S-2 ] Reduce 
cyclicality of 
bank lending 
[S-9]  Efficiency 
5.1 Retain current approach 3 3 3 3 
5.2 Introduce leverage ratio as specified in the February 
2010 public consultation 2 2 2 2 
5.3 Conduct extensive monitoring of leverage ratio  1 1 1 1 
Scale of option ranking: 1=most effective / efficient, 3=least effective / efficient 
Effectiveness measures extent to whic h options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources  
5.5. Capital buffers 
The Commission has already adopte d certain policy proposals aime d at tackling some of the 
market failures outlined in section 3.5 and mitig ating the pro-cyclical ity in the financial 
system. However, additional policy measures are needed to address the outstanding yet 
significant problem drivers. To this end, the Commission services, in line with the 
conclusions of the report on the effects of the CRD on the economic cycle of June 2010, 
examined a possibility of implementing instru ments that would move in a countercyclical 
fashion to bank capital levels, i.e., would increase in economic upturns and decrease in 
downturns. Such measures would smooth the cyclicality of bank lending by providing for 
supplementary capital buffers that would ensu re financial soundness of banks throughout the 
economic cycle and protect the sector from peri ods of systemic risk build-up. The key policy 
options in this area are as follows: 
- Policy option 6.1:  Retain current approach; 
- Policy option 6.2: Introduce a capital buffer to enhanc e individual banks’ ability to 
absorb losses over prolonged periods of market stress, i.e., capital conservation buffer ; 
- Policy option 6.3:  Introduce a capital buffer to protec t banks from periods  of risk build-
up at the macro level, i.e., countercyclical capital buffer ; 
- Policy option 6.4:  Introduce a dual capital buffer , comprising both a capital 
conservation buffer and a count ercyclical capital buffer. 
Policy option 6.1: Retain current approach  
Under this policy option, drivers of pro-cyc licality discussed in section 3.5 would be 
addressed only with the policy measures that  have been already adopted by the Commission 
or new measures adopted by MS. However, since the pro-cyclicality is driven by a number of 
such drivers, additional measures are necessary, in particular, when it comes to dealing with 
market failures of behavioural nature, e.g., limita tions in risk measurement at the absolute 
level (which, among other factors, contribute to building up of syst emic risk and incapacity to 
sustain losses evoked by crises that  follow) or inappropriate res ponses to risk and changes in 
economic conditions (which have been shown to  weaken financial resilience of individual 
firms in times of stress). Hence, this policy option is largel y sub-optimal in terms of its 
effectiveness vis-à-vis attainment of relevant  policy objectives. Furthermore, supplementary 
policy measures to address the problem of a sy stemic nature may require certain macro-level 
and / or cross-border arrangements which are fe asible only with the EU  level legislation.  
Policy option 6.2: Capital conservation buffer  
The design of a capital conservation buffer was laid out in the Commission services’ public 
consultation of February 2010. The buffer would be based on a fixed buffer target over the 
regulatory capital minimum to absorb losses in 'stressed' periods that may span a number of 
quarters / years. Banks would be expected to build up such capital in  'good' economic times. 
Those banks that fell below the target would face  constraints on discreti onary distributions of 
earnings (i.e., dividend payments, share buyback s, discretionary payments on other Tier 1 
 
 123  capital instruments and discreti onary bonus payments to staff)  until conservation capital 
buffer target is reached.  
More specifically, a buffer range would be established above the new regulatory minimum 
capital requirement and capital distribution co nstraints would be imposed on those banks 
whose capital levels fall in this range. It is  important to emphasize, that in such instances, 
banks would be able to conduct business as norm al; the constraints impo sed would relate only 
to discretionary distributions, and not operations of banks. Th e restriction on distributions 
would depend on a distance to the target level – the further from the target (within the range 
between the minimum and the target) the level of  capital falls, the higher percentage of its 
earnings in the subsequent year a bank would be  required to conserve. These rules would be 
applied at the consolidated group level, i.e., restric tions would be imposed  on distributions out 
of the consolidated group, however , in order to conserve resour ces in specific  parts of the 
group national supervisors would have an option to apply the regime at the 'solo' level.  
Such approach would be effective at ensuri ng that the banking sector accumulates capital 
buffers when it has the earnings capacity to  do so. This should enhance resilience of 
individual institutions in periods of stress in the financial markets, as they would be better 
positioned to absorb related losses. However, this approach does not ensure that cumulating the additional capital to cover risks at the in dividual bank level woul d coincide with the 
periods of excessive credit growth at the macr o level and a concomitant build-up of systemic 
risks which need to be prevente d to protect banks (as well as  other economic agents) from 
consequences of ensuing systemic crises. Indus try representatives, in their responses to the 
public consultation, argued that effectiveness of  this policy option in terms of containing the 
cyclicality of bank lending would be limited du e to their unwillingness to skip dividends, 
which would effectively lead to their perception of a target of  the conservation capital buffer 
as a new regulatory minimum capital re quirement (which it will not be).  
Policy option 6.3: Counter cyclical capital buffer
 
The design of a countercyclical capital buffer was laid out in the Co mmission services’ public 
consultations of February 2010 and October 2010. The buffer would ensure that bank capital 
requirements take account of the macro-financia l environment in which banks operate and, in 
turn, to achieve the broader macro-prudential goal of protecting the banking sector and the 
real economy from the system-wide risk s stemming from the boom-bust evolution in 
aggregate credit growth. Importantly, the counter cyclical capital buffer would also help to 
lean against the build-up phase  of the cycle which would o ccur through the capital buffer 
acting to raise the cost of cr edit, and therefore dampen its demand, when there would be 
evidence that the stock of credit has grown to excessive  levels relative to its long term trend.  
Competent authorities in each MS would be  responsible for setting the buffer add-on253 
applicable to credit exposures to counterparties locat ed in their jurisdic tion. The add-on would 
                                                 
253 The methodology for calculating buffer add-on has been developed by the Basel Committee and has been 
subject to public consultation conducted by the Commission services. The methodology transforms the 
aggregate private sector credit/GDP gap into a sugge sted buffer add-on. It i ndicates a zero guide add-on 
when credit/GDP is near or below its long-term trend and a positive guide add-on when credit/GDP 
exceeds its long term trend by an amou nt which, on the basis of available historical data, suggests there 
could be excess credit growth that may be associated  with a build up of system-wide risk. Analysis of 
the credit/GDP gap showed that while it would often have  been a useful guide in taking buffer decisions 
in the past, it does not always work well in all jurisdictions at all times. Thus, rather than relying 
mechanistically on the credit/GDP guide, authorities would be expected to apply judgment in setting of the buffer in their jurisdiction after using the best information available to gauge a build-up of the 
system-wide risk. 
 
 124  be subject to an upper bound and would only be imposed when there is evidence that the 
excess credit growth results in  a build-up of the system-wide risk. Credit institutions with 
exclusively domestic credit expos ures would only be subject to the add-on determined by the 
competent authorities of the home MS, whereas institutions providing services in other MS by means of a branch or free provisi on of services in relation to exposures located in those MS 
would apply the buffer add-on as determined by the host MS competent authorities, when the buffer is set between 0% and 2.5%  of risk weighted assets.
254 When the buffer determined by 
host MS exceeds 2.5%, home MS authorities woul d be allowed, but not obliged to apply a 
buffer rate higher than 2.5%. 
Banking groups having subsidiari es in other MS for the purpos es of calculating the buffer 
add-on on the consolidated basi s would have to apply the bu ffer add-ons determined by the 
competent authorities of the subsidiaries. In practice, this means that cross-border credit 
institutions would have to l ook at the geographic location of  their credit exposures and 
calculate their countercyclical capital buffer acc ording to the add-ons pr evailing in those MS 
where their exposures are located. For banking groups, decisions on the level of the counter-
cyclical buffer could take place in the context of the joint decision pr ocess of Article 129(3) 
of the CRD whereby the consolidating supervisor  and the other relevant competent authorities 
would consult each other and reach a joint decision on the application of the buffer at 
consolidated level and at the level of each subsidiaries. In case of a disagreement, the 
respective competent authorities would make their own decision in accordance with their 
responsibilities, i.e., consolidated requirement would be determined by the consolidating 
supervisor whereas 'solo' requirements - by competent authorities responsible for the 
supervision of subsidiaries.  
Countercyclical buffer add-on decisions would be  pre-announced by 12 months to give banks 
time to meet the additional capital requirements before they take effect, while reductions in the buffer would take effect immediately to help  reduce the risk of the supply of credit being 
constrained by regulatory capital requirement s. The consequences of not meeting the 
countercyclical capital buffer would be the same as those of not meeting the capital 
conservation buffer (i.e., constraints on di scretionary distributions of earnings). 
In cases where banks have exposures to jurisd ictions that do not operate and publish buffer 
add-ons, the competent authorities would have  to set their own buffer add-ons for such 
exposures. This could be done by using cred it and GDP data and other information on 
economic and financial conditions for those jurisdictions availa ble from BIS, IMF and other 
sources. In the European context, this option allows for the involvement of the European 
Systemic Risk Board (ESRB) to foster m acro-prudential supervision, e.g., by recommending 
buffer add-ons for third country jurisdictions.  
This policy option would be effec tive at ensuring that bank capit al regulation is responsive to 
macro-financial environment and, in turn, would protect the banking sector from the systemic 
risk linked to excessive credit  growth. At the level of indi vidual institutions , however, this 
policy may not be entirely effective at ensuring  that they have sufficient capital buffers to 
absorb losses incurred during protracted turbulent periods, especially cons idering the fact that 
credit growth in aggregate is used to  gauge the need for buffer adjustments. 
Policy option 6.4: D ual capital buffer
 
                                                 
254 The same applies to exposures located in third countries, i.e., the competent authorities would have to use the 
buffer add on calculated by the third country in which the credit institution operates through a 
subsidiary or a branch. 
 
 125  The design of a dual capital buffering approach  was laid out in the Commission services’ 
public consultations of February 2010 and Oc tober 2010. The approach effectively entails a 
combination of policy options 6.2 and 6.3. In terms of its  key structural feat ures, it is aligned 
with the approach of the Basel Committee. Comb ining the two buffers means that application 
of the countercyclical buffer would take eff ect by adjusting the size of the buffer range 
established by the conservation buffer. As di scussed under option 6.3, the countercyclical 
element would be 'turned on' when there are sign ificant risks that stock of credit has grown to 
historically high levels. Simila rly, other key modalities of oper ating such a dual capital buffer 
would remain as presented in discus sion of its individual components.  
The key advantage of this policy option over the other two alternatives is that by combining 
them it addresses their respective shortcomings in relation to relevant policy goals, i.e., inclusion of the capital conservation buffer wo uld cover risks on the individual bank level 
while inclusion of the countercy clical capital buffer w ould cover risks at the macro level and 
would make the capital buffers of banks move in a more countercyc lical fashion to the 
economic cycle.  
The calibration of this policy option is presen ted in Table 5 while its impact on the EU 
banking industry is assessed in section 5.8 (cumulatively with new minimum capital 
requirements). Capital buffers are expected to have a positive impact on financial stability by design of the measures. By creating an addi tional buffer when excess credit growth is 
observed, they should protect banks in downturn periods thanks to a release of the buffer, 
thereby limiting the risks of  negative spill-overs to the real economy. The pro-cyclical effects, 
therefore, would be mitigated. There may be, however, a risk of negative impact on credit volume in 'catching up' countries. The pro cess of economic catching up is very often 
accompanied by a deepening of the financial sect or and a rapid increase in credit growth. 
While the financial stability im plications of this rapid credit growth should certainly be 
addressed, a balance must be struck in order not to unnecessarily slow down the 
recovery/growth acceleration. This concern is  addressed by allowing for a supervisory 
judgement when deciding on the buffe r level and timing of activation. 
Comparison of policy options
 
As discussed above, policy option 6.1 is largel y ineffective in tack ling relevant problem 
drivers and achieving relevant policy objectives. Policy option 6.2 is more effective than 
option 6.3 in terms of enhancing banks' capacity to absorb losses over protracted periods of 
'stress' in the markets (objective S-1) but is le ss effective than option 6.3 in terms of operating 
in a countercyclical manner, which is a prec ondition for minimizing the cyclicality of bank 
lending (S-9). Policy option 6.4 a ddresses the above concerns by combining the two types of 
capital buffers into one buffering approach.  In terms of compliance costs for the banking in dustry, option 6.2 would be the most costly 
and option 6.3 would imply the l east compliance costs, as the c ountercyclical buffer would be 
applied only in times when credit growth at the aggregate level becomes excessive, whereas 
costs related to option 6.4 would fall in between the two extremes, depending on its 
calibration. However, when eff ectiveness of policy options is  considered simultaneously, 
option 6.4 is identified as the most efficient al ternative, and, in tur n, as a preferred policy 
option. Table 13:  Summary of policy option e ffectiveness and efficiency 
Policy Option Comparison Criteria 
Effectiveness 
Policy Option Enhance adequacy 
of capital and 
liquidity 
requirements [S-1]  Enhance bank 
risk 
management 
[S-2 ] Reduce 
cyclicality of 
bank lending 
[S-9]  Efficiency 
6.1 Retain current approach 4 4 4 4 
 
 126  Policy Option Comparison Criteria 
Effectiveness 
Policy Option Enhance adequacy 
of capital and 
liquidity 
requirements [S-1]  Enhance bank 
risk 
management 
[S-2 ] Reduce 
cyclicality of 
bank lending 
[S-9]  Efficiency 
6.2 Conservation capital buffer 1-2 1-3 3 2-3 
6.3 Countercyclical capital buffer 3 1-3 1-2 2-3 
6.4 Dual capital buffer 1-2 1-3 1-2 1 
Scale of option ranking: 1=most effective / efficient, 4=least effective / efficient 
Effectiveness measures extent to whic h options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources 
5.6. Single rule book in banking 
The options regarding the deletion of option and national discretions will be referred to in the 
rest of the analysis as follows: 
- Policy option 7.1:  Retain current approach; 
- Policy option 7.2: Minimum harmonization  of national supervisory approaches 
through removal of options and discretions an d specification of crit eria for supervisory 
judgments and / or choices; 
- Policy option 7.3:  Maximum  harmonization  of national supervisory approaches 
through removal of options and discretions an d specification of crit eria for supervisory 
judgments and / or choices combined with removal of a possibility to supplement the 
CRD provisions with national rules in harmonised areas of the CRD; 
- Policy option 7.4: Maximum harmonisation of national supervisory approaches  
through removal of options and discretions an d specification of crit eria for supervisory 
judgments and / or choices combined with removal of a possibility to supplement the 
CRD provisions with some exceptions  in specific areas where gold plating is justified.  
Policy option 7.1: Retain current approach  
Under this option, national options and discretions  will be kept in the CRD together with a 
'minimum harmonisation' approach allowing MS  to lay down stricter prudential rules.  
In prudential terms, stricter prudential rules ar e usually driven by financ ial stability concerns. 
Some MS have decided not to impl ement certain provisions of the CRD255, or to provide for 
stricter rules256. 'Gold-plating' applies to all banks irre spective of the risk to which a given 
credit institution is or might be exposed. As part of this impact assessment, the Commission 
services asked CEBS to provide an analysis  on areas where MS already 'gold-plates' the 
directive. Views of European supervisors were  mixed as to whether existing 'gold-plating' 
provisions should be kept. On the one hand, so me stressed that 'gold-plating' may prove 
useful for financial stability in the future. On the other hand, others emphasised that a full 
harmonisation was crucial in specific areas of the Directive, e.g., ow n funds, liquidity.  
Some MS have set the minimum solvency ratio at, e.g., 10% instead of the 8% required by the 
Directive, on macro-prudential grounds. Under Ba sel II, however, harmonised Pillar 1 capital 
requirements are complemented by a Pillar 2 capital requirement. Supervisors shall determine whether banks' own funds ensure a sound manageme nt and coverage of their risks, and shall, 
where appropriate, require highe r capital requirements. In cont rast, gold-plating – as a means 
to ensuring financial stability by providing hi gher minimum capital requirements – does not 
lend itself to a proportionate a nd thorough analysis of the risk s that banks run. Under Basel 
III, banks would still be expected to operate above the minimum level of capital requirements 
as determined by supervisors under Pillar 2. In addition, it must be noted that Basel III would 
                                                
 
255 For the treatment of equity under the CRD, certain MS  have not transposed the "PD/LGD" approach, arguing 
that this leads to less conservative capital requirements as opposed to other methods.  
256 For example, strict LTV requirements for exposures secu red by real estate, or high risk weight for speculative 
real estate programs  
 
 127  considerably increase the level of minimum capital requirements and provide for a macro-
prudential tools (e.g., cap ital buffers) to increase levels of  capital when needed for macro-
economic reasons. This means that gold-plati ng the level of minimum capital requirements 
for reasons of financial stability does not  seem to be necessary under Basel III. 
Downside to the current gold-plating approach  and the existence of  national options and 
discretions is the conflicting requirements at solo and consolidated level that increase 
compliance burden for groups. This is less of a problem for local banks  without entities in 
other MS. In terms of supervisory converg ence, gold-plating and options and national 
discretions may be detrimental to effective supe rvisory cooperation in colleges of supervisors 
as diverging supervisory approaches will not only be driven by different interpretations of a 
common rule book, but also by different rules la id down by MS to implement the same rule 
book. EBA would not be fully able to ensure a consistent implementation of Community 
legislation by providing interp retative guidelines (Article 16 of the EBA Regulation), by 
contributing to compliance with Union law (A rticle 17 of the EBA Regulation), and by 
developing technical standards (Art icle 18 of the EBA Regulation).  
Assuming that the consolidating supervisor 'imp oses' the use of a national discretion at group 
and at local level – as authoris ed under Article 129(2) – reta ining the current  approach may 
also have implications for the level playing field in the host jurisdiction as explained under 
section 3.6.5.  
Policy option 7.2: Minimum harmonization  
Under this approach, options and discretions would be removed, but the CRD would be kept 
as a minimum harmonisation directive.  Removing options and discretion in isolation is  only partially effective in achieving the 
objectives of reducing compliance burden a nd enhancing supervisory convergence. In 
particular, when an option currently allo ws for a stricter prudential requirement
257, removing 
this option by defining a clear set of criter ia could be circumvented by the ability of 
supervisors to require stricter rules. Minimum harmonisation is not fully effective in meeting 
the objective of ensuring a level playing field. Capital requirements fall within the responsibility of the home supervisors. Banks pr oviding services in a host country – either by 
free provision of services or through a branch – are not subject to the requirements of the host 
country which may differ from the requirement in the home country.  Where the exercise of an option currently lead s to a less stringent treatment, e.g., 50% risk 
weight for commercial real es tate, its generalisation may be at odds with the objective of 
financial stability. In keeping with this obj ective, harmonisation shoul d be done – under this 
policy option – upwards towards the most pr udent standard. In the above example of 
commercial real estate, this could mean pr oposing a lower level of  loan-to-value (LTV) 
requirement. Downside to this approach is that harmonisation towards the most prudent 
standard does not always accommodate  differences in local markets. 
Under this option, the mutual recognition of na tional options would be made 'binding' - and 
not only 'optional' - where options are strictly rooted in local specificities and where mutual 
recognition would not give rise to regulatory arbitrage. This is in particular the case for 
country specific exposures
258 where assets are country-specific and cannot be moved around 
across different entities of a bank.  Because of gold-plating, the option might be par tially effective with respect to objective of 
enhancing supervisory cooperation, because ce rtain degree of differences in national 
supervisory approaches would be preserved. 
                                                
 
257 For example, competent authorities may require a risk-w eight of 150% for 'high risk items'. The CRD does 
not provide for clear criteria. 
258 For example, Finnish residential housing companies attracting a preferential treatment under Annex VI, Part 
1, point 45 of the CRD 
 
 128  This option would entail compliance costs as bank s would have to comply with revised rules. 
This holds true in particular in relation to banks subject to the IRB approach, where internal 
systems would have to be slightly changed. For small banks subject to the Standardised 
approach, the suggested changes would not entail material cost s. Their reporting obligations 
would be affected slightly by the revised rules.  At the same time, this option also is expected to result in compliance co st savings, particularly 
for institutions with cross-bor der activities. Such savings ar e recognised by the industry, but, 
based on its feedback, are highly difficult to assess, because: 
– Reduction of compliance costs would only be of relevance over time. In the short term, the 
removal of options and discretions would impl y compliance with a new single set of rules; 
– A uniform reporting would entail a reduction of  compliance costs, but it would only be 
effective by the end of 2012; 
– For banks subject to the IRB approach, signi ficance of the reduction of compliance costs 
depends on whether currently supervisors ha ve come to an agreement regarding the 
application of a single set of  rules across a banking group.  
The impact on banks' capital requirements might be significant only in relation to 
requirements for exposures secured by real es tate where harmonizati on of the currently 
diverse national rules is suggested, if such harmonization takes place towards the most 
prudent standard. This impact  would vary by MS, depending on whether their current 
treatment is less or more stringent vis-à-vis th e new harmonised treatment, however, overall it 
is not expected to be material. The removal of other options and di scretions (via mutual 
recognition, deletion, granting choice to institu tions and making an option a general rule) 
would take place in the framew ork of the existing CRD rules, and therefore would not 
represent a significant incremental change to capital requirements.  Both home and host supervisors would be aff ected simultaneously by the removal of options 
and national discretions. The impact would vary depending on how options have been 
exercised in various MS. Annex II provides an insight into how national options are used.  
Policy option 7.3: Maximum harmonization 
 
Under this option, option 7.2 (Removal of options  and national discretion) is complemented 
by a maximum harmonisation approach. As discu ssed above, the deletion of national options 
needs to be coupled with a maximum harm onisation approach to fully deliver on the 
objectives of reducing compliance burden, enhanc ing level playing fiel d, legal clarity and 
supervisory convergence. The role of EBA in ensuring a consistent set of harmonised rules 
would be maximised under this approach.259 
Under this option, the scope of 'maximum harmonisation' would be clearly circumscribed to 
Pillar 1 (minimum capital requirem ents, large exposures rules, liquidity, own funds) and Pillar 
3 (disclosure).260 Other areas of the Directive do not lend themselves to maximum 
harmonisation, either i) because of the abse nce of a full harmonisation (e.g., internal 
governance), or ii) because the decisions are ba sed on specific risk assessments (e.g., Pillar 2).  
Downside to this approach is that maximum harmonisation may limit th e ability of MS to 
require stricter rules on the financial stabil ity grounds. However, as explained under option 
                                                 
259 As a result, EBA will be expected to develop some 50+  technical standards in various policy areas which will 
have an impact on its human resources requirements and related costs. 
260 I.e., Title V, Chapter 2, section 2 – subsection 3 (minim um level of own funds), Title V, Chapter 2 – sections 
3 to 6 (i.e. Articles 76 to 122 covering minimum own funds requirements for credit and operational risk, 
large exposures and qualifying holdings outside the financial sector) of 2006/48/EC, Title V, Chapter 5 (disclosure by credit institutions) of 2006/48/EC, and Chapter V, section 1 (provisions against risks) 
and section 4 (large exposures) of Directive 2006/49/EC. 
 
 129  7.1, this shortcoming should not be over-estimated given that supervisors may resort to Pillar 
2 to tailor capital requirements to the risks to which a bank is or may be exposed and that 
Basel III provides for a macro-prudential capital buffer, discussed under section 5.5.261 
Importantly, this option would ensure that firms follow the same rules in all EU markets. This 
should boost confidence in the stability of credit  institutions across the EU, especially in time 
of stress, and thus enhance the financial stabilit y. The crisis has demonstr ated that a clear and 
transparent regulatory framework was critical to maintain confidence in the market in 
liquidity stress situations.  It should also be noted that under options 7.1 and 7.2 the application at national level of 
stricter rules for reasons of th e financial stability would only be  applicable to domestic banks 
and subsidiaries of foreign banks in that c ountry. Such regulatory changes would create 
regulatory arbitrage opportunities for branches  in those MS, partly invalidating macro-
prudential policy actions. Under this option, a re gulation (see section 5.7) would enable the 
Commission to adopt temporary increases in minimum standards. By doing so, the new rules 
would be applicable to all EU banking in stitutions, preventing  regulatory arbitrage 
possibilities and contributing to the effectiveness of m acro-prudential policy actions. 
Nevertheless, in stressed situati ons, stricter rules may be inst rumental in ensuring financial 
stability. For example, additional requirements in terms of disclosure for securitised exposures have been recommended by CEBS an d the Commission to re -establish confidence 
in the inter-bank market. However, recent expe rience has proved that Community legislation 
could be modified on short not ice. In addition, implementati on of prudential rules by means 
of a regulation (see section 5.7) would shorten implementation timelines as there would be no 
need for MS to transpose EU legislation into national law. In addition, there are circumstances where gold-plating is rooted  in market/product 
specificities or the legal fram ework of a MS. During public co nsultations, some supervisors 
stressed the necessity of being able to intr oduce stricter quantitativ e limits (e.g., lower LTV 
requirements for real estate) in  order to make requirements e ffective given specificities of 
their local market.  Against this background, there is a merit in considering wh ether some flexibility in 
implementing the maximum harmonisation appr oach under option 7.3 would not benefit the 
objective of financial stability while effectivel y contributing to achieve ment of the remaining 
specific objectives. 
Policy option 7.4: Maximum harmonization with some exceptions
 
Under this option, option 7.3 (Maximum harmonisation) is modified to allow for some 
flexibility. In its analysis of  the scope of full harmonisation in the CRD, CEBS emphasised 
that a certain degree of flexibili ty would be needed. It was stre ssed that a 'single rule book' 
does not necessarily mean a 'uniform' rule book, and should provide for differences in national treatment where market specificities or specific local products call for a different 
treatment.  Analysis of CEBS' advice and further discussion with stakeholders suggest that the following 
areas lend themselves to the a pplication of stricter rules: 
- qualifying criteria for applying a preferential tr eatment of real estate exposures, in addition 
to or that are stricter than those provided in  EU legislation and / or  higher risk weights 
depending on local specificities;  
- treatment of lending in foreign currency; - higher risk weights for 'high risk items' identified by EBA guidelines. 
                                                
 
261 Whereby, if necessary, national supervisors would be able to set a countercyclical buffer in excess of 2.5%. 
Such level should apply only to institutions that are incorporated in their jurisdictions. The buffer should be capped at 2.5% for the purposes of calculating the institution specific countercyclical capital 
buffer of all other institutions that have credit exposures in the jurisdiction in question. 
 
 130  In addition, in order to enhance national and EU  financial stability, this policy option foresees 
a possibility for MS to 'gold-plate' the new minimum requirements that  would otherwise be 
phased in from 2013 to 2019 as outlined in Table 6. This means that MS would be allowed to 
apply in 2013 the level of capita l required by Basel III in 2019. 
This approach would be similar to the one adopt ed in other legislativ e texts (e.g., the MiFID), 
which provide for full harmonisation while allo wing MS to adopt stricter rules in well 
identified areas of the text.  
Comparison of policy options  
Retaining the current scenario (policy option 7.1), implies that the problems described in 
sections 3.6.4 and 3.6.5 are not addressed and ef fectiveness of the ne wly created EBA is 
compromised. Maximum harmoniza tion (policy option 7.3) is mo re effective than minimum 
harmonization (policy option 7.2) or maximum harmonisation with some exceptions (policy 
option 7.4) with respect to at taining objectives of enhanci ng supervisory cooperation and 
convergence (S-7), enhancing legal clarity (S-4) and enhancing level playing field (S-6) as it 
contains both the deletion of national options and the removal of the possibility to supplement 
the CRD provisions with nationa l legislation. However, option 7.3 is perceived to be less 
effective than option 7.4 in terms of achiev ing the objective of enhancing the financial 
stability in national MS as it does not cater for specificities of local ma rkets (G-1). In this 
regard, option 7.4 entails a harmonised and transp arent regulatory framework that is intended 
to enhance the financial stability together with a possibility of applying st ricter rules in certain 
cases.  From the efficiency angle, opti on 7.3 appears to be the most efficient for banking groups with 
cross-border operations (due to the greater expe cted savings of administ rative costs), whereas 
for banks with domestic operations, options 7.2 and 7.4 may be more efficient (lower costs 
due to fewer changes in national rules due to their harmonisation at the EU level).  
In summary, policy option 7.4 (Maximum harmoni zation with some exceptions) is identified 
as a preferred option, as it entail s the most balanced trade-off between expected effectiveness 
in terms of contributing to wards relevant policy objectiv es, including the objective of 
financial stability, and the net administrative co st implications for the EU banking industry.  
 Table 14:  Summary of policy option e ffectiveness and efficiency 
Policy Option Comparison Criteria 
Effectiveness 
Policy 
Option Prevent 
regulatory 
arbitrage 
opportunities 
[S-3] Enhance legal 
clarity [S-4]  Reduce 
compliance 
burden 
 [S-5]  Enhance 
level playing 
field [S-6]  Enhance 
supervisory 
cooperation 
and 
convergence 
[S-7]  Enhance 
financial 
stability   
[G-1]  Efficien
cy 
7.1 Retain current 
approach 4 4 4 4 4 2-4 4 
7.2 Minimum harmonisation  3 3 1-3 3 3 2-4 1-3 
7.3 Maximum 
harmonisation  1-2 1 1-3 1 1 2-4 1-3 
7.4 Maximum harmonisation 
with some 
exceptions 1-2 2 1-3 2 2 1 1-3 
Scale of option ranking: 1=most effective / efficient, 4=least effective / efficient Effectiveness measures extent to whic h options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources 
 
 131  5.7. Choice of policy instrument 
This section discusses the opti ons as regards the most approp riate way of implementing the 
preferred policy choices discussed in secti ons 5.1-5.6. The key alternatives that were 
considered are as follows: 
- Policy option 8.1:  Amend the CRD  to integrate the proposed provisions 
- Policy option 8.2: Limit the scope of the CRD  to authorization and arrangements for 
ongoing supervision and propose a regulation  on prudential requirements for credit 
institutions 
Policy option 8.1: Amend the CRD  
The policy options retained in the sections  above could be implemented by amending the 
existing directives of the CRD: 2006/48/EC a nd 2006/49/EC. This would maintain coherence 
of rules in the three areas of: -authorisation,  -ongoing supervision, and  -prudential requirements  in one single text which MS would have to transpose. Maintaining such coherence would 
reflect the fact that, in spite  of differences as regards s ubject matter (i.e., authorisation 
procedures, procedures for ongoing supervision, prudential requirements applicable to the 
provision of credit) and a ddressees (i.e., MS, competent author ities, credit institutions), all 
three areas of rules are interrelated.  Maintaining the form of a directive would enab le the EU in all these areas to impose binding 
requirements on MS but to give them the choi ce of form and method to achieve them. It 
would leave MS with a certain degree of flexibili ty to maintain divergent rules at the stage of 
transposition of the rules into national law. It  would give MS the option of imposing stricter 
rules than is foreseen in the EU legal act on matters which are not fully harmonised under the 
preferred policy option 7.4 (Max imum harmonisation with some exceptions). Finally, MS 
could continue to integrate the rules into national legal texts. 
To the extent a directive give s MS the choice of form and me thod to achieve a result, it 
enables MS to continue exercising legislativ e actions on matters where EU action does not 
provide added value, and thereby reflects the pr inciple of subsidiarity. However, this only 
applies to matters which are not fully ha rmonised under the preferred policy option 7.4. 
Policy option 8.2: Limit the scope of the CRD and propose a regulation
 
The policy options retained in the sections a bove could also be implemented by two separate 
instruments: an amendment of the CRD concer ning authorisation of cr edit institutions and 
arrangements for their superv ision by competent authoritie s, and a new instrument on 
prudential requirements for credit institutions in th e form of a regulation. 
Separating prudential requirements from the othe r areas would reflect differences in subject-
matter, nature and addressees. Prudential requirements are rules applicable to credit institutions on an ongoing basis whic h establish criteria for the ev aluation of the risk linked to 
certain banking services and of the funds nece ssary 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 orde r to ensure protection of depos itors and financial stability.  
Shaping prudential requirements in the form  of a regulation would ensure that those 
requirements, which already today are worded in the form of obligations applicable to credit 
institutions ("credit institutions shall…"), will in fact be dire ctly applicable to them. This 
would prevent the transposition from producing diverging national requirements, interpreted 
according to diverging cultures, and provide for a harmonised set of core rules applicable in 
the EU.  At the same time, this instrument could cater for the flexibility needed under the preferred 
policy option 7.4. First, rules on authorisation and ongoing supervis ion would continue to be 
 
 132  in the form of a directive. Second, as to the pr udential requiremen ts, if in some limited areas 
flexibility is needed for MS to  lay down stricter requirements or implementing provisions, this 
can be accommodated by an appropriate word ing of the regulation. For example, the 
regulation can explicitly allow MS to impose additional requirements, or it can require and 
empower MS to lay down implementing provisions in certain limited areas. A regulation would make the requirements applicab le to credit institutions more accessible to 
entities operating on a cross-bor der basis, EU citizens, and third country investors and 
regulators. Moreover, it would clearly demonstrate that credit institutions follow the same 
rules in all EU markets, which should boost confid ence in the stability of  credit institutions 
across the EU, especially in times of stress. 
A single regulation directly app licable across the EU would redu ce regulatory complexity and 
firms' compliance costs, especially for credit institutions operating on a cross-border basis as 
they could rely on identical rule s applying throughout the Union.  
A harmonised set of rules in a regulation woul d also contribute to the elimination of 
regulatory arbitrage opportunities and would reas sure depositors that protection standards are 
equal, encouraging them to benefit from the internal market in banking services. 
 
 Comparison of policy options
 
Policy option 8.2 (Limit the scope of the CRD a nd propose a regulation) is more effective 
than option 8.1 (Amend the CRD to integrate the proposed provisions ) with regard to 
contributing to the achievement of objectives  of preventing regulator y arbitrage opportunities 
(S-3), enhancing legal clarity (S-4), reducing compliance burden (S-5),  enhancing supervisory 
convergence (S-7), enhancing financial stabil ity (G-1) and safeguarding depositor interests 
(G-2), as outlined above. It also entails a more efficient alternative si nce a regulation on prude ntial requirements would 
enable the EU to implement any changes require d by market developments more quickly, as it 
is usually immediately applicable after adoption by the legislator. Any future modifications of 
the regulation could be implemented more  quickly too, as they would not require 
transposition by national legislators.
262 That would enable the EU to meet internationally 
agreed deadlines for implementation, respond sw iftly to delays in the implementation of 
internationally agreed reforms in key third c ountry jurisdictions, and also to react quicker 
when market developments require changes to th e rules. On this basis,  option 8.2 is identified 
as a preferred policy option. Table 15:  Summary of policy option e ffectiveness and efficiency 
Policy Option Comparison Criteria 
Effectiveness 
Policy 
Option Prevent 
regulatory 
arbitrage 
opportunities 
[S-3] Enhance legal 
clarity [S-4]  Reduce 
compliance 
burden 
 [S-5]  Enhance 
supervisory 
cooperation 
and 
convergence 
[S-7]  Enhance 
financial 
stability [G-
1] Enhance 
safeguardin
g of 
depositor 
interests [G-
2] Efficien
cy 
8.1 : Amend the 
CRD 2 2 2 2 2 2 1 
8.2 Limit scope 
of the CRD and 
propose a 
regulation 1 1 1 1 1 1 1 
Scale of option ranking: 1=most effective / efficient, 2=least effective / efficient Effectiveness measures extent to whic h options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources 
                                                 
262 However, at the stage of a switch from a Directive to a Regulation MS would need to be given a certain 
minimum period to adapt their national rules. 
 
 133  5.8. Cumulative impact of the package 
This section discusses the cumulative impact of preferred options within  individual areas as 
presented in the preceding sub- sections. It looks at the cumu lative impact of proposals in 
terms of additional capital that EU banking industry needs to raise in order to meet the new minimum capital requirements. Next, impact of the proposal on costs related to information 
provision to supervisors and third parties is discussed. Finally, impacts of tighter capital and 
liquidity requirements on the EU economy in th e transitional period and in the long-term are 
assessed. 
5.8.1.  Package of preferred options and relevant transitional provisions 
The following table summarizes the twenty seve n policy options analysed. Individual options 
within each policy set are ranked in terms of their relative effectiveness
263 and efficiency264 
with regard to achieving applicab le longer term policy (specific)  objectives. Preferred options, 
where identified in the impact assessment, are highlighted.  Table 16:  Summary of policy option e ffectiveness and efficiency 
Policy Option Comparison Criteria 
Effectiveness 
Policy 
Option  
Set Policy 
Options 
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  
Effici
ency 
1.1 Retain current approach 3 3        3 
1.2 Introduce LCR as specified in Feb 2010 PC 2 2        1 Liquidity 
Coverage ratio 1.3 Introduce LCR adopted by Basel 
Committee subject to observation period 1 1        2 
2.1 Retain current approach 3 3        3 
2.2 Introduce NSFR as specified in Feb 2010 
PC 2 32        2 Net Stable 
Funding ratio 
2.3 Introduce NSFR adopted by Basel 
Committee 1 1        1 
3.1 Retain current approach 5 5 5   5  5 5 5 
3.2 Modify only the eligibility criteria as specified in Feb 2010 PC 4 4 4   4  4 4 4 
3.3 Modify eligibility criteria and regulatory 
adjustments as specifi ed in Feb 2010 PC 1-3 1-3 1-3   2-3  1 1-3 3 
3.4 Modify eligibility criteria and regulatory 
adjustments based on Basel approach 1-3 1-3 1-3   2-3  2-3 1-3 2 Eligibility of 
capital 
instruments and 
application of 
regulatory 
adjustments 
3.5 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 
4.1 Retain current approach 3 3      3 3 3 
4.2 Enhance CCR requirement  2 2      2 2 2 Counterparty 
credit risk 4.3 Enhance CCR requirements and 
differentiate treatment of exposures to CCPs 1 1      1 1 1 
5.1 Retain current approach 3 3       3 3 
5.2 Introduce leverage rati o as specified in Feb 
2010 PC 2 2       2 2 Leverage ratio 
5.3 Conduct extensive monitoring of leverage 
ratio  1 1       1 1 
6.1 Retain current approach 4 4       4 4 
6.2 Conservation capital buffer 1-2 1-3       3 2-3 
6.3 Countercyclical capital buffer 3 1-3       1-2 2-3 Capital buffers 
6.4 Dual capital buffer 1-2 1-3       1-2 1 
Single rule book 7.1 Retain current approach   4 4 4 4 4   4 
                                                 
263 Measures extent to which options achieve relevant objectives 
264 Measures extent to which objectives can be achieved for a given level of resources   
 
 134  Policy Option Comparison Criteria 
Effectiveness 
Policy 
Option  
Set Policy 
Options 
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  
Effici
ency 
7.2 Minimum harmonization   3 3 1-3 3 3   1-3 
7.3 Maximum harmonization   1-2 1 1-3 1 1   1-3 
7.4 Maximum harmonization with some 
exceptions   1-2 2 1-3 2 2   1-3 
8.1 Amend the CRD   2 2 2  2   2 
Choice of policy 
instrument 8.2 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 
The proposed calibration, including phase-in a nd grandfathering arrangem ents, of the package 
is aligned with the Basel III rules text and is shown in Tables 5 and 6 above.265  
To set the new level of minimum capital requirement and capital buffers, the Basel Committee conducted a number  of supporting analyses.
266 In terms of the new minimum 
going-concern capital, it found that, fo r instance, the median of the 99th percentile 
distributions of historical annual risk-weighted returns across six jurisdictions of the 
Committee is about 5%.267 With some adjustments for the impa ct that Basel III is expected to 
have on RWAs and eligible capital,  this served as a basis for the new level of CET1 and T1 
capital requirements.  As regards calibration of capital buffers, cu mulative net income of 73 banks from 14 
countries over the financial crisis period (f rom Q3 2007 to Q4 2009) as a share of year-end 
2006 RWAs was analysed. This analysis showed that mean losses
268 of banks with negative 
cumulative net income over this period equalled  5% of RWAs. The same analysis found that 
'peak' losses, defined as losses over whatever sub- period of the financial crisis that produced 
the largest negative net income figure, were larger  than those incurred for the 'fixed' period of 
Q3 2007 to Q4 2009. During major crises, when access to capital markets is limited, cumulative losses of such extent can be abso rbed only by those banks that have adequate 
capital buffers, accumulated during mo re favourable economic conditions.  
The rationale for the proposed calibration as well as its impacts on the industry, other 
economic agents and financial stability are discussed in the remainder of section 5.8. 
5.8.2.  Cumulative impact on the industry 
When estimating capital shortfall due to the CRD IV package, the impact of new minimum 
CET1 requirement and capital buffers is assessed t ogether. This approach reflects the fact that 
the most demanding capital requirement and thus largest capital shortfall for most EU countries relates to CET1 capital: if banks rais e eligible capital to m eet the new regulatory 
CET1 requirement, they will largely meet the new T1 and total capital ratios. This can be seen from Table 17 which under columns labelled 'new ' shows capital ratios afte r application of the 
CRD III and IV proposals, assuming a full impl ementation of both proposals as of December 
2009. Columns that contain ratios labelled 'old' s how capital ratios as of December 2009, i.e., 
before implementation of both the CRD III and the CRD IV legislative proposals. The 'new' 
                                                
 
265 It needs to be noted that Switzerland has announced its intention to proceed with more stringent requirements 
than agreed by the Basel Committee. However this pertains to requirements for its two systemically important financial institutions, whereas treatment of such institutions at both the Basel and the EU 
level has not been finalised. 
266 See http://www.bis.org/publ/bcbs180.pdf   
267 Risk-weighted return measured by RORWA and cal culated as the ratio of net income to RWAs 
268 When measured with pre-tax,  pre-distribution net income 
 
 135  ratios do not reflect the effect of transitional and grandfathering provisions outlined in Table 
6, which will mitigate the effective impact on banks' capital ratios in the period up to 2023.   
Changes in capital ratios are driven by the ch anges in capital definition rules and RWAs. The 
preferred policy options outlined in this report are expected to increase the RWAs of EU Group 1 banks on average by 24.5% and RWAs of Group 2 banks – by a modest 4.1%. The 
extent of capital shortfalls
269 that the EU banking industry would face due to the proposals is 
estimated to fall in the range of €370 billion or approximately  2.3% of EU banking sector's 
RWAs as of December 2009, at CET1 of 7% (consisting of a minimum requirement of 4.5% 
and capital conservation buffer of 2.5%). Of this figure, some €37 billion is attributable to the 
CRD III proposal270 and the remainder is driven by th e CRD IV amendments. However, the 
estimate should be viewed as the high  end of the capita l shortfall because: 
- it is based on bank capitalisation levels as  of December 2009 which most likely will have 
increased in response to supervisory and market pressure even if the CRD were not amended,  
- estimates do not incorporate the impact of phasing-in and grandf athering provisions that will 
greatly reduce the extent of capital shortfall in  the short run and will spread the impact for 
most banks during implementation period. More specifically, capital sh ortfall that the EU 
banking industry would face at CET1 of 3.5% , effective from 2013, is immaterial, whereas 
capital shortfall at CET1 of 4.5%, effec tive from 2015, is estimated at €84 billion271, 
- it does not capture the inte raction between liquidity and capital proposals (i.e., larger 
proportion of liquid assets that banks will hold in order to comply w ith LCR will reduce the 
amount of their RWAs relative  to total assets), and  
- it is estimated on the combin ed impact of the proposed calibration for the minimum 
requirement of 4.5% and the conservation cap ital buffer of 2.5%; yet only the minimum 
capital requirement is a critical requirem ent whose breaching would trigger supervisory 
intervention, whereas consequen ces of falling behind the capital buffer target are confined to 
banks' curtailing their discretionary distributions  of earnings. Countercycl ical capital buffer is 
not considered in the above calculation as its ad d-on would only be in effect when there is an 
excess credit growth that is resu lting in a system wide  build-up of risk, but would stay at zero 
at all other times. 
Table 17 : Capital ratios for Group 1 and Group 2 banks, in %:  
Gross 1New 2Old New Old New Gross 1New 2Old New Old New
L 12,7 9,4 12,7 9,8 15,9 10,5 14,5 13,2 12,2 13,2 13,8 15,2
J 9,4 5,8 12,0 8,7 14,2 10,8 14,5 12,2 14,7 12,2 17,2 12,8
H 11,2 5,1 10,7 5,9 14,7 8,0 10,8 9,2 12,2 9,2 16,4 10,5
E 11,8 4,7 10,7 4,9 14,3 8,0 13,2 9,4 11,4 9,7 12,9 10,7
D 7,4 4,4 8,1 4,8 11,9 6,8 7,7 5,7 9,1 6,1 11,7 7,5
C 10,5 4,4 9,2 5,4 12,6 9,6 9,0 5,4 9,5 5,7 11,2 9,9
G 6,3 3,6 8,6 4,4 12,4 9,2 9,7 8,2 9,8 8,2 14,7 12,4
B 13,1 3,6 8,5 3,8 12,4 4,7 12,0 3,4 8,4 4,7 12,0 6,8
F 7,1 3,4 11,3 3,8 14,0 6,7 18,2 16,9 18,9 18,0 25,2 24,3
A 4,6 1,3 8,3 1,4 11,9 4,6 11,9 7,6 9,4 7,6 12,4 11,5
S 22,7 20,0 14,4 20,0 23,0 22,7
Q 16,1 13,4 13,8 13,4 15,0 14,3
O 16,2 13,3 13,3 13,5 14,3 13,8
R 14,2 11,3 15,5 11,6 16,9 12,4
M 15,5 9,7 12,6 10,9 13,4 13,7
P 10,6 8,8 10,7 8,8 12,7 8,8
N 11,9 7,9 9,0 10,1 12,1 11,9
K 7,4 5,8 9,3 6,8 13,0 10,1
Total 3 10,7 4,9 10,3 5,6 14,0 8,1 11,1 7,1 10,3 7,6 13,1 10,3CountryGroup 1 banks Group 2 banks
CET1 T1 Total CET1 T1 Total
Notes : Countries sorted based on average net CET1 ratio  
                                                 
269 Estimated as the sum of capital shortfalls in order to meet the new required CET1 ratio across individual 
banks participating in the EU QIS,  and where capital shortfall was observed, and then extrapolating the 
figure to cover 100% of the EU banking sector. 
270 In terms of Tier 1 capital, as definition of  CET1 did not exist prior to CRD IV proposal 
271 This estimate assumes full deductions, i.e., does not account for phase-in arrangements for deductions (40% 
in 2015)  
 
 136  1 'Gross' is the ratio of new gross CET1 (without deductions) relative to old RWA. 2 New CET1 shows net CET1 (with 
deductions) relative to new RWA. 3 EU averages for both Group 1 and Group 2 banks include data for two additional 
countries that are not  shown individually. 
Source : CEBS  
Impacts on individual MS banking sectors will var y, as could be seen be seen from Table 17 
that shows country average CET1 ratios  separately for Group 1 and Group 2 banks. 
Additionally, as of December 2009 there were some €87 billion of state aids in common 
equity capital in five MS.272 Under the proposal, existing public  sector injections would be 
grandfathered until 1 January 2018. In the long run, however, they would add to the CET1 
capital shortfall, raising it to some €460 bill ion or 2.9% of the EU banking sector's RWAs. 
Given the length of suggested phasing-in period, the above capital shortfal ls shall be assessed 
against the possibility of banks  running profitable operations and subsequently retaining their 
profits. The banking sector is not expected to raise the entire shortfall amount in the capital 
markets. For instance, combin ed net profit of some 100 biggest EU banks in 2009 was around 
€33 billion and bank profits are likely to rise as economic situation im proves and provisions 
for non-performing loans decline.273  
In terms of impact on the CET1 ratio, large EU banks  (average CET1 ratio of 4.9%) are 
affected more by the CRD III and the CRD IV proposals than a sample of 74 large 
international banks from eighteen274 Basel Committee countries whose average CET1 ratio as 
of December 2009 stood at 5.7% upon a pplication of equivalent rules.  
As regards the impact of new liquidity requireme nts, the implications of LCR are discussed in 
section 5.1.1, while those of NSFR – in secti on 5.1.2. It should be noted that the estimated 
shortfalls to comply with LCR and NSFR ar e not additive since depending on the actions 
taken to minimize them, decreasing the shortfall in one standard may result in a decrease in 
the shortfall of the other.  
5.8.3.  Administrative costs 
Implementation of legislation entails costs for businesses. Costs that are linked to providing 
information either to public or private partie s are called administrativ e costs. The share of 
these costs that is specifically linked to info rmation that businesses would not collect and 
provide in the absence of a legal obligati on is called administrative burdens. The 
Commission's Better Regulation strategy is aimed at measur ing administrative costs and 
reducing administrative burdens.275 In the area of prudential banking regulation, certain 
information requirements are necessary to provid e for the desired level of financial stability 
and creditor protection and, hen ce, should be set at a level that ensures an equilibrium 
between ensuing administrative bu rdens and the benefits  that they yield. With regard to the 
legislative changes brought forward with this in itiative, it has to be noted that they were 
undertaken with a view to achieving multiple op erational, specific and general objectives (see 
section 4 of the impact assessment) and had to be designed accordingly.  
In August-September 2010, the Commission services  distributed a questio nnaire to the GEBI 
members about the impacts of CRD IV proposal  on administrative burdens. Analysis of 
replies showed that, overall,  the biggest impacts on both th e on-going administrative burdens 
and the related one-off implementation costs are expected due to new measures in the area 
                                                 
272 The total sum of state aids is not representative for the entire QIS sample as data was not available for all 
participating MS  
273 Source: Bloomberg, Orbis, Commission services' calculation. It needs to be pointed out that this figure is not 
distributed evenly across banks but reflects significant crisis-related losses for a number of large European banking groups 
274 Australia, Belgium, Canada, China, France, Germany, Italy, Japan, Korea, the Netherlands, Saudi Arabia, 
Singapore, South Africa, Spain, Sweden, Switzerland, the UK, the US. 
275 For more on the Commission's approach towards dealing with administrative costs and burdens please see: 
http://ec.europa.eu/governance/better_regulation/admin_costs_en.htm   
 
 137  liquidity risk management, comprising roughly 70% of all administra tive burdens. Proposals 
for the counterparty credit risk were also identif ied as a source of significant administrative 
burdens for Group 1 banks. The Commission serv ices conducted a r ough estimation of 
administrative burdens for each area of proposal s linked to Basel III (see Annex VIII). As 
regards proposal for the 'single rule book', the number and, particular ly, the diversity of 
replies received were insufficient to assess it s varying impact by MS (which depends on the 
degree to which options and disc retions are exercised) and bank type. In this regard, banks 
with more cross-border activity  would benefit from harmonisa tion of the current national 
provisions the most as the ensuing administra tive burden savings are expected to reduce 
administrative burdens of the Basel III-related policy measures.  
5.8.4.  Economic impact in transitional period 
A key factor determining banks' responses to ne w capital and liquidity st andards is the length 
of the period during which the new requirements will be phased in. If the transition period is short, banks may choose to curtail credit supply or adjust capital composition in order to lift 
capital ratios. A longer transition period coul d substantially mitigate the impact, allowing 
banks to retain more of their profits (by re ducing dividend payments or improving operational 
efficiency), issue new equity, reduce fixed cost s or take other necessa ry steps to adjust.  
To inform the policy question of appropriate tr ansitional provisions, the Basel Committee and 
the FSB set up a Macroeconomic Assessment Group (MAG) whose members were macroeconomists and econometricians from  central banks, regulatory agencies and 
international institutions. This section overvie ws its main conclusions as well as those of 
certain macro-models pertaining to  the EU countries or the euro zone.  For the full analysis of 
MAG please see its Interim and Final Reports that were published in  August and December 
2010.
276 
When applying the MAG's key findings in the EU context, it is important to note that  its 
work was based on a high number of macroeco nomic models developed and used for policy 
analysis in central banks and in ternational organisations, with a high representation of models 
pertaining to MS or broader re gions of the EU. The group's In terim Report was based on the 
results of 89 individual macroeconomic models277, of which 51 models relate to the EU278, 
whereas its Final Report used 97 modelling si mulations, of which 49 relate to the EU.279  
MAG modelled implementation scenarios of 2, 4, 6, and 8 years. The transitional periods of 4 and 8 years are presented below in more detaile d, as they were given more consideration in 
Basel III deliberation process. 
5.8.4.1.  Four-year implementation period 
Macro-economic impacts of the new standards ov er an implementation period of four years 
were estimated using 89 indivi dual models. The median esti mate showed that for each 
percentage point increase in capital requirement s that is implemented gradually over 4 years, 
                                                
 
276 See http://www.bis.org/publ/othp10.htm , http://www.bis.org/publ/othp12.pdf   
277 The key results are reported based on 89 'standard' models, i.e., standard semi-structural and DSGE models 
used for policy analysis and forecas ting.  In addition, M AG's members used 15 'satellite' models that 
estimate changes in lending spreads and volumes resulting from specified changes in target capital and 
liquidity ratios, 13 bank-augmented DSGE models, i.e., dynamic stochastic general equilibrium models incorporating banking sectors and financial frictions, and 8 reduced form models (vector auto-
regression and other reduced-form models). 
278 Of them, 6 models relating the euro area, 9 to FR, 7 to DE, 8 to IT, NL and ES each, and 5 to the UK. 
279 Of them, 20 models relating the euro area, 7 to NL an d IT each, 5 to the UK, 4 to FR and 3 to DE and ES 
each. 
 
 138  after 4.5 years (18 quarters)280 from the start of implementation the GDP would decline by 
0.19% relative to a baseline scenario, consisti ng of a 0.16% decline as estimated by national 
authorities and an additional drop of 0.03% due to international spill-over effect that was 
estimated separately by the IMF.281 As regards the estimation results of national authorities, 
the vast majority of them are clustered around the median and within the range of 0.07% - 
0.31% when the top and bottom fifth of distri bution are excluded (s ee the bottom panel of 
Chart 17). Therefore, for a 2.9 percentage point increase in required capital (see section 5.8.2) 
such median estimate results in a GDP declin e of 0.6% after 4.5 year s from the start of 
implementation.282 The 51 models relating to the EU MS  or MS groups produced a median 
which is similar to that of the overall sample of models. The projected impacts arise mainly 
from banks passing on higher costs to borrowers with a median estimated increase in lending 
spreads of 15 basis points after 4.5 years (for  each percentage point  increase in capital 
requirements), which results in  a slowdown in investment.  
A sub-set of models that account for the cr edit supply effects, i. e., tightening lending 
standards (in addition to effects of increasi ng lending spreads) for each percentage point 
increase in capital requirements produced a median decline in th e GDP of 0.32% after 4.5 
years from the start of implementation. For a 2.9 pe rcentage point increase  in required capital 
this is equivalent to a GDP decline of 0.9%. Easing of the monetary policy may reduce such 
estimated output losses. In this respect the MAG estimated that such offsets are especially pronounced in models that incor porate credit supply constraint s, reducing the GDP loss from 
0.32% to 0.17%, for each percentage point increase in capital. MAG also assessed impact of tig htening liquidity requirement consisting of 25% increase in 
holding of liquid assets, i.e., impact of LCR.  This produced a median fall in the GDP of 
0.08% below the baseline over 4.5 years. This estimat e is equivalent to a decrease in the GDP 
of 0.11% below the baseline for th e EU, given the estimated increas e in holdings of eligible 
liquid assets of 34% for the EU's banking industry (see section 5.1.1) . Notably, impacts of 
tighter capital and liquidity requirements by MAG were assessed separately whereas some 
positive offsetting effects between holding of liquid assets and capital requirements are expected, i.e., a higher share of more liquid and le ss risky assets to total assets will result in a 
decline in banks' RWAs relative to their total assets.  Among the models considered by MAG were t hose used routinely by the Commission and 
ECB. ECB's multi-country model of five larg est EU MS (DE, FR, IT, ES, NL) for each 
percentage point increase in capital ratio, c onsidering effects on both credit spreads and 
lending standards, estimated a GDP reducti on of 0.19% 4.5 years af ter the start of 
implementation. For a 2.9 percenta ge point increase in required  capital this produces a GDP 
decline of 0.6%. ECB's Christ iano-Motto-Rostagno DSGE model,  used for policy analysis, 
for each percentage point increase in capital  requirements produced a decline of 0.29% over 
4.5 years, or, a 0.8% decline for 2.9 percentage  point increase in capital requirement. 
5.8.4.2.  Eight-year implementation period 
Macro-economic impacts of the new standards ov er an implementation period of eight years 
were estimated using 97 indivi dual models. The median esti mate showed that for each 
percentage point increase in capital requirement s that is implemented gradually over 8 years, 
after roughly 9 years (35 quarters)
283 from the start of implementation the GDP would decline 
                                                 
280 The largest GDP impact for the four-y ear implementation scenario is realised  after 4.5 years from the start of 
the implementation. 
281 Reflecting exchange rates, commodity prices, shifts in global demand. 
282 The GDP-impact estimates produced by MAG were in  most cases linear to ch anges in bank capital 
283 The largest GDP impact for the eight -year implementation scenario is r ealised after 35 quarters (almost 9 
years) from the start of the implementation. 
 
 139  by 0.17% relative to a baseline scenario, c onsisting of a 0.15% decl ine as estimated by 
national authorities and an addi tional drop of 0.02% due to intern ational spill-ove r effect (see 
the bottom panel of Chart 17). Therefore, for a 2.9 percentage point in crease in required 
capital such median estimate results in a GDP decline of 0.5% after 9 ye ars from the start of 
implementation. The projected impacts result fr om a combination of wider lending spreads 
(median increase of 15.5 basis points after 9 year s, for each percentage point increase in 
capital requirements) and reduced  lending volumes (median declin e of 1.4% after 9 years, for 
each percentage point increase in capital requirements). 
Models that seek to take acc ount of effects of tightening le nding standards (in addition to 
effects of increasing lending spreads) generate  a stronger macroeconomic impact that those 
without such effects. For each percentage point increase in capital requirements, these models 
produced a median decline in the GDP of  0.23% after 9 years from the start of 
implementation.284 For a 2.9 percentage point increase in required capital this is equivalent to 
a GDP decline of 0.7%. Easing of the moneta ry policy may reduce output losses from 0.23% 
to 0.16%, for each percentage point increase in capital. According to the Commission's bank-augmen ted DSGE model (QUEST III) calibrated to 
cover all 27 MS, the GDP declines by 0.14% 9 y ears after start of implementation of the new 
proposals for each percentage point increase in Tier 1 capital ratio.
285 This translates in a 
cumulative decline of the GDP of 0.42% fo r an increase in re gulatory capital of 2.9 
percentage points (for more details on the Commission's model as well as a comparison of 
industry and public sector modelling outcomes, please see Annexes IX and X).     
Chart 17: Aggregate impact of one percentage point increase in the target capital ratio: distribution of GDP 
deviation across all models, in %  
                                                 
284 Including international spill-over effect of 0.02% 
285 Under the conservative assumption that Modigliani-Miller (MM) theorem does not hold which was also 
assumed by MAG. For more on MM see section 5.8.5 and Annex IX. Note that QUEST III is modelled on the basis of Tier 1 capital ratio. Given that C ET1 capital is part of Tier 1, QUEST III modelling 
results presented in Annex IX are applied in the cont ext of CET1 ratio shortfalls. The calculation is as 
follows: -0.36% deviation in GDP from baseline by 2019 divided by 2.5 percentage point increase in capital ratio = -0.144% deviation in GDP from baseline by 2019 for one percentage point increase in 
capital ratio. 
 
 140  
Notes:  1 Distributions are computed across the 89 cases used in the MAG Interim Report, excluding those designed to 
measure the impact of international spill-overs. 2 Distributions are computed across th e 97 cases contributed for the MAG 
Final Report, excluding those designed to meas ure the impact of international spill-overs. 3 The shaded areas indicate the 
range between the 20th and 80th percentile . The vertical line indicates the unweighted median at the quarter indicated 
(measured from the start of implementation). 4 The vertical lines indicate  the 18th and (for the eight-year case) 35th quarters.  
Source:  Basel Committee   
5.8.4.3.  Optimum implementation period 
In addition to the above transition scenarios, MAG also examined implementation alternatives 
of two and six years. For instance, a two y ear implementation period led to the largest 
reduction from the baseline path with the trough occurring after tw o and a half years: the GDP 
would fall a maximum 0.22% relative to the base line, including international spill-over effects 
for a one percentage point increase in capital. Overall, shorter implementation scenarios have 
a greater impact on annual GDP growth rates since the projected decline in the level of GDP 
relative to baseline would take pl ace over a shorter time (see Table 18). 
Table 18 : Overview of the implementation period scenarios for new capital standards 
Timing of 
estimated decline 
in GDP since start of implementation Decline in GDP 
below baseline per 
percentage point 
increase in capital 
requirement, % Estimated decline 
in the EU GDP 
below baseline due 
to capital shortfall, 
% Estimated annual 
decline in the EU 
GDP growth below 
baseline, % Implemen
tation 
period Result / Model Source 
A B C=B*2.9 D=(1+C)^(1/(A/4))-1 
Two years Median of 89 MAG  10 quarters 0.22 0.64 0.22 
 
 141  Timing of 
estimated decline 
in GDP since start of implementation Decline in GDP 
below baseline per 
percentage point 
increase in capital 
requirement, % Estimated decline 
in the EU GDP 
below baseline due 
to capital shortfall, 
% Estimated annual 
decline in the EU 
GDP growth below 
baseline, % 
models 
Median of 89 
models MAG 18 quarters 0.19 0.55 0.10 
Median of 16 
models with impact 
on lending standards MAG 18 quarters 0.32 0.93 0.16 
Median of 11 
models with impact 
on lending standards 
and endogenous 
monetary policy MAG 18 quarters 0.17 0.49 0.09 
Multi country model 
(with lending 
standards) ECB 18 quarters 0.19 0.55 0.10 
Christiano-Motto-
Rostagno model ECB 18 quarters 0.29 0.84 0.15 Four years 
      
Median of 97 
models MAG 35 quarters  0.17 0.49 0.05 
Median of 12 
models with impact 
on lending standards MAG 35 quarters  0.23 0.67 0.06 
Median of 14 
models with impact 
on lending standards 
and endogenous 
monetary policy MAG 35 quarters  0.16 0.46 0.04 
Multi country model 
(with impact on 
lending standards) ECB 35 quarters 0.08 0.25 0.03 
Christiano-Motto-
Rostagno model ECB 35 quarters 0.39 1.12 0.09 Eight 
years 
DSGE bank-
augmented model European 
Commission 36 quarters 0.14 0.42 0.04 
Sources : Basel Committee, ECB, European Commission  
A longer implementation period shall minimize a ny potential transitory effects on GDP and 
credit availability. This is in part becaus e the maximum GDP loss is estimated to occur 
around the end of the transition period, which could be at a more mature and resilient stage of 
the current recovery. Lengthening of the implementation period would also: 
- give banks more time to adjust their business models and cost structures;  
- allow more time for stable non-bank channe ls of credit intermediation to develop; 
- reduce the severity of the impact of le nding cuts on bank-dependent sectors, and  
- give markets more time to absorb the asset sale s, debt issues and equ ity issues that might 
accompany banks' balance sheet adjustments.  Hence, the transitional phase-in and grandfat hering provisions for th e capital requirements 
agreed by the Basel Committee and outlined in Table 6 are likely to accommodate the above 
adjustment processes the most as they effectiv ely imply an eight-year transition period from 
2011 to 2018. As regards the optimum implem entation timing for the new liquidity 
requirements, given their novelty and the relate d possibility of unint ended consequences on 
financial institutions of different sizes and business lines, observation periods coupled with 
review clauses are justified. LCR, including a ny revisions will be introduced on 1 January 
2015, while NSFR, with appropria te revisions, will move to the minimum standard on 1 
January 2018.  In summary, work of the Basel Committ ee's MAG, ECB and the Commission on the 
assessment of macroeconomic costs show that the transition to stronger capital and liquidity 
standards is likely to have a lim ited impact on the aggregate output . It shall be emphasised 
that the above analyses measured only transitio nal costs without consid ering benefits from 
enhanced financial stability and mitigated pro-cyclicality which would start to accrue 
immediately, and extent of which can be infe rred from a discussion of long-term economic 
effects presented in section 5.8.5 below. 
 
 142  5.8.5.  Long-term economic impact 
Assessment of the long-term implications of the CRD IV proposal is based on the work 
conducted by the Basel Committee and the Co mmission together with the academics. 
The Basel Committee's assessment of the long-ter m economic impact (LEI) is summarised in 
the report published in August 2010.286 By examining the historical data and a number of 
studies on the economic costs of systemic crises, the report fi nds that there are clear net long 
term economic benefits from increasing the mi nimum capital and liquidity requirements from 
their current levels in orde r to raise the safety and s oundness of the global banking system .  
Charts 18 and 19 illustrate expected net economic benefits for a range of  CET1 capital ratios, 
separately for meeting new capital requirement s, and capital and liquidity requirements 
together. 
Chart 18 : Long-run expected annual net economic 
benefits of increases in capital requirements for a range of CET1 ratios, in % of GDP  Chart 19 : Long-run expected annual net economic 
benefits of increases in capital requirements and meeting liquidity requirements for a range of CET1 
ratios, in % of GDP  
0,00,51,01,52,0
5% 6% 7% 8% 9% 10% 11%Moderate permanent effect
No permanent effect
0,00,51,01,52,0
5% 6% 7% 8% 9% 10% 11%Moderate permanent effect
No permanent effect
Notes:  LEI working group's assessment of ne t benefits was done on the basis of the ratio of tangible common equity 
(common equity net of goodwill and intangibles) to RWAs under Basel I and II definitions. These ratios were adjusted by 
70% to arrive at CET1 ratio equivalents for the EU banking sector which reflect a 17% increase in RWAs and additional 
deductions on top of goodwill and intangibles of 18% under th e capital definition proposals (adjustments based on the 
results of the EU QIS data). Vertical lines indicate capitalizat ion levels at which marginal ne t economic benefits cease being 
positive. 
Source:  Basel Committee, European Commission calculation  
Considering the impact of meeting only new cap ital requirements (Cha rt 18), net economic 
benefits are positive for the range of CET1 ratios up to 11%, however, they stop increasing marginally at 9.1% CET1 under the 'moderate pe rmanent effect' scenario (annual benefit of 
increase in GDP of 1.96%) and at 7% CET1 unde r the 'no permanent effect' scenario (annual 
benefit of increase in GDP of 0.33%).
287 Similar dynamics is observed when meeting of new 
liquidity requirement is considered, with th e marginal net economic benefits rising up to 
CET1 levels of 6.3% and 9.1% under the 'no permanent effect' and 'moderate permanent 
effect' scenarios, respectively. This implies th at optimum calibration of the new requirements 
might be in the range of CET1 ratios of 6%-9%,  or higher, given the conservative approach 
undertaken, as explained below. The above benefits of higher capital and liqui dity requirements accrue from reducing the 
probability of financial crisis and the output  losses associated with such crises.
288 It needs to 
be noted that the approach adopted by the working group was rather conservative: above 
quantification of economic benefi ts did not include those stemmi ng from reduced severity of 
                                                 
286 BCBS, An Assessment of the Long-Term Economic Impact of Stronger Capital and Liquidity Requirement s, 
August 2010; http://www.bis.org/publ/bcbs173.htm   
287 Under "large permanent effect" scenario net benefits keep rising beyond the 11% CET1 ratio, reaches the 
level of annual increase in GDP of 5.9% (t his scenario is not sh own in the chart).  
288 Based on LEI analysis, the Commissi on services estimate that complying with the LCR requirement and the 
new capital requirements can be expected to reduce the probability of a systemic crisis by some 70% 
 
 143  future crises and reduced pr o-cyclicality in the system, given anticipated effects of 
countercyclical policy measures that are in cluded in the proposal. On the cost side, 
assumptions were equally conservative, includin g a full pass through of costs to customers via 
lending rates, no reduction in cost of debt a nd equity with an ROE assumption based on a 
high historical average (15%). According to  the Modigliani-Miller  (MM) propositions, 
increases in banks' capital leve ls shall reduce their leverage and, by making retu rns to their 
investors less volatile, the cost of equity.289 In this respect, macro-economic modelling of the 
Commission services showed that when the MM propositions are assumed to hold at least 
partially (50%), economic costs of the new ru les in terms of their impact on the GDP are 
reduced in half by 2020-2030 (see Annex IX).290 The cost of debt may decline as well 
because of enhanced bank capitalization leve ls. This would further reduce the impact on 
lending rates and, via them, on th e GDP. Therefore, actual net economic benefits could be 
higher across the CET1 ratios shown in Charts 18 and 19.  In addition to the benefits from reducing output  losses associated with  reduced frequency of 
banking crises, higher ca pital and liquidity requirements ma y also reduce the amplitude of 
normal business cycles. Higher capital and liquid ity ratios permit banks to absorb losses in 
downturns and restrain lending in an expansi on, thereby smoothing th e supply of credit over 
the cycle, and, as a consequence, also i nvestment and consumption. BCBS' working group on 
LEI assessed this impact by using dynamic stoc hastic general equilib rium (DSGE) models 
that explicitly integrate bank capital and m easures of liquidity. The group found that a 2 
percentage point increase in capital ratio reduces the standard de viation of output by 2 
percentage points, based on the median estimate  across the models used. When considering a 
possibility of introducing a counter-cyclical  capital buffer, which causes the capital 
requirement to increase in step with the credit-to-GDP ratio
291, the analysis showed that the 
volatility of output would be re duced substantially, with the st andard deviation declining by 
almost one fifth with respect to a baseline in which no counter-cyclical capital rules are 
implemented.  Another macro-economic cost-benefit analysis  of Basel III has been conducted by the 
Commission services and academics
292 by coupling the SYMBOL model293 with a framework 
proposed by the Bank of England to estimate th e impact of tightening capital requirements on 
the GDP294. This analysis looked at the long-term economic impact of the new framework in 
seven EU MS.  Regarding the impact on the probability of a systemic banking crisis
295, the analysis found 
that it depends on how much banks will recapita lize under Basel III. Results showed that 
                                                 
289 Modigliani, F., and M. Miller, The cost of capital, corporation finance and the theory of investment , The 
American Economic Review, 48, 1958 
 Miller M., Do the M&M propositions apply to banks? , Journal of Banking & Finance, 19, 1995 
 Miles, D., Yang, J., and G. Marcheggiano, Optimal bank capital , Bank of England Discussion Paper 
No. 31, January 2011 
290 When MM propositions are assumed to hold entirely (i.e., 100%), the scenario of regulatory change in terms 
of economic costs (measured as impact on the GDP) by 2020-2030 does not differ from the baseline 
scenario.  
291 Based on the simulations using a prudential rule that increases the capital require ment when the credit-to-
GDP ratio increases so as to generate movements of the capital ratio in the neighbourhood of ±2 percentage points around its steady state 
292 M. Marchesi, S. Zedda, F. Campolongo, R. De Lisa, J. Cariboni, M. Petracco Giudici, Basel III: a macro-
economic cost-benefit analysis , 2010, JRC EUR Report 61485, EUR 24603 EN (mimeo, forthcoming) 
293 The SYMBOL model ( SYstemic Model of Banking Originated Losses) 
294 Bank of England, Financial Stability Report , Box7, 2010; see 
http://www.bankofengland.co.uk/pu blications/fsr/2010/fsr27.htm   
295 The probability of occurrence of a systemic banking cr isis is derived from the distribution of liquidity 
shortfalls of the banking system on the basis of the definition that a systemic banking crisis occurs 
 
 144  when banks recapitalize to 10.5%296 level, the probability is re duced within the range of 29% 
to 89%. Given the estimated reduction in the pr obability of a systemic banking crisis, the 
analysis found substantial net economic benef its of the new framework for two MS and a 
more neutral net economic effect in the remaining five MS analysed.  
5.9. Impacts on SMEs 
A recent study297 commissioned by the Commission finds th at internal financing is the most 
common source of SME financing, and includes owner investment, funding through retained 
profits and sale of assets. As regards the fina ncing from external sources, bank credit is the 
most significant.298 In this respect, the st udy found that there is a signi ficant positive effect of 
the business cycle on bank loans to medium-sized firms, with the effect on small firms also 
significant but smaller.299 This effect might be explaine d by a number of regulatory and 
market failures, including the problem of asymmetric information.300 When economic 
conditions become depressed and collateral values decline, information asymmetries with 
respect to the quality of clients’ balance sheets  make obtaining the bank credit difficult even 
for clients with profitable projects. When ec onomic conditions improve and collateral values 
rise, the opposite situatio n tends to occur. In this regard, lending to SMEs is affected more 
than lending to large companies as SMEs are not subject to external ratings and extensive disclosure requirements.  Therefore, SMEs, to the extent that they are credit rationed, are expected to be the primary 
beneficiaries of smoothened pr o-cyclicality (see s ection 5.8.5) brought about by the enhanced 
counter-cyclical properties of the EU bank capital regulation, including capital buffers, 
improved adequacy and quality of regulatory capital and the leverage  ratio. These changes 
will allow SMEs to engage in projects that are profitable and vital for the economic growth 
and prosperity not only during an expansionary leg of the cycle, but, more importantly, when 
the economic climate turns sour.  As importan tly, the proposals will benefit SMEs and their 
workforce further by smoothening th e cyclicality of demand for th e products and services that 
they generate, given that SMEs contribute some  60% of the total value added of the EU's non-
financial business economy.
301  
According to the Commission macroeconomic model, compliance with the new capital 
framework is expected to reduce the stock of  loans on average by 1.8% and increase loan 
rates on average by some 29 basis points by 2020-2030.302 However, it needs to be stressed 
                                                                                                                                                         
where losses or liquidity shortfalls are higher than a certain threshold, beyond which public authorities 
find it difficult to avert the spreading of a crisis. In particular, it is assumed that the threshold for a systemic banking crisis in any country corresponds to 3% of its GDP. 
296 Consisting of total capital requirement of 8% and conservation buffer of 2.5% 
297 EIM, Cyclicality of SME Finance , March 2009 
298 According to this study, for a sample of 10 EU countri es the share of short- and long-term bank loans in total 
SME capital were in the range of  3-17% and 7-31%, respectively 
299 The first report of the Commission on the effects of th e CRD on the economic cycle also notes that SMEs 
were less successful than large enterprises in obtaining a bank credit for which they had applied in 
October 2008 – September 2009 (i.e., economic recession in most EU Member States) and that among 
those companies that have been adversely affected by bank credit availability, obtaining the needed 
funds from other sources was also more difficult for SMEs; see 
http://ec.europa.eu/internal_market/bank/do cs/regcapital/monitoring/23062010_report_en.pdf  . 
300 The drivers behind cyclicality of bank lending are discussed in section 3.5.1 
301 Eurostat, European business facts and figures , 2009 
302 Specification of the Commission's QUEST model and more detailed presentation of modelling of the Basel 
III impacts on the EU economy are provided in Annex IX. It needs to be noted that modelling outputs in 
Annex IX are expressed as a change in a variable for 2.5 percentage point increase in Tier 1 capital 
ratio. For this reason, estimates have to be rescaled to  assess the impact of a shortfall of CET1 capital of 
2.9% of risk-weighted assets. In this calculation, it was assumed that capital shortfalls expressed as 
percentage points of Tier 1 and CET1 capital are comparable, given that CET1 is part of Tier 1. Hence, 
 
 145  that costs of a comparable extent most likely would arise even in the absence of a regulatory 
reform, due to the market pressure and expecta tions with respect to e nhanced post-crisis bank 
capital levels and liquidity management.  While the proposals are expected to lead to  a higher cost of bank credit – which is 
compensated by social benefits - across the en tire spectrum of bank customers, SMEs are 
expected to be impacted less than their large counterparts. Even though the start of Basel III 
transitional period has been set for 2013, most banks have embarked on a de facto transition 
to complying with the new rules following the publication of the framework in late 2010 and 
early evidence (Q4 2010 and Q1 2011) on the imp act of costs related to bank capital and 
liquidity position on credit standards for loans and credit li nes shows that more euro area 
banks tightened their credit standards for large enterprises than for SMEs.
303  
SMEs are expected to be impacted less severely al so to the extent that they transact more with 
smaller Group 2 banks304, whose capital and liquidity shortf alls are estimated to be smaller 
than those of Group 1 banks (see Table 19). In a si milar vein, it is expected that the proposals, 
by accommodating certain specificities of the EU  cooperative, mutual and similar banks (e.g., 
see policy options 1.3 and 3.5), will reduce the co mpliance costs for these institutions and in 
turn result in smaller indirect costs to their customers, including SMEs.  
Table 19 : Overview of impacts of va rious proposals by bank group 
EU averages Policy area / proposed measure(s) Group 1 banks Group 2 banks 
Liquidity risk 1:    
Liquidity Coverage Ratio, % 66.5 87.1 
Net Stable Funding Ratio, % 91.1 93.9 
   
Rules on capital definition, CET1 capital ratio, %  5.8 7.1 
   
Rules on counterparty credit risk, % change of total RWAs  9.7 0.2 
   
Leverage ratio, % 1 2.5 3.5 
   
Combined impact of CRD III and CRD IV on:    
Total RWAs, % change 24.5 4.1 
CET1 capital ratio, % 4.9 7.1 
Notes: 1 Based on Basel III definitions, in the EU will be subject to monitoring periods and follow-on re-calibration  
Source : CEBS  
The extent to which costs of Basel III impl ementation would be passed onto bank customers 
is also unclear given that exposure to the ne w measures, as shown by the EU QIS, is not 
uniform across banks while their market power on the lending market may be too weak. In 
this regard, upon full application of CRD III a nd the CRD IV proposal some 25% of Group 1 
                                                                                                                                                         
impact of the proposal on loan rates is derived as follows: 0.25 (average increase in loan rate by 2020-
2030, 0% MM offset, expressed in percentage points ) / 2.5 (increase in Tier 1 ratio, expressed in 
percentage points) x 2.9 (regulatory capital shortfa ll in percentage points expressed as CET1 capital 
over risk weighted assets) = 0.29 percentage points. Using the same rationale, impact of the proposal on 
the stock of loans is derived as follows: -1.51 (average decrease in stock of loans by 2020-2030, 0% 
MM offset, expressed in %) / 2.5 (increase in Tier 1 ratio, expressed in percentage points) x 2.9 (regulatory capital shortfall in percentage points expr essed as CET1 capital over risk weighted assets) = 
-1.8%.  
303 ECB, The euro area bank lending survey , April 2011 
304 Some research shows that smaller ba nks are more prone to lend to SMEs because they are better suited for the 
'relationship lending', which is primarily based on information gathered by the loan officer through 
continuous, personalized and direct contacts with  SMEs, their owners and managers, and the local 
community in which they operate. E.g., se e Berger, A., L. Klapper, G. Udell, The Ability of Banks to 
Lend to Informationally Opaque Small Businesses , Journal of Banking Finance 25, 2001 
 
 146  banks and some 75% of Group 2 banks had CET1 capital ratio in excess of  7% already at the 
end of 2009 (see Chart 20).  Chart 20:  Distribution of CET1 capital ratios for Group 1 and Group 2 EU banks following 
the application of CRD III and the CRD IV proposal 
305 
 
Source:  CEBS, EU QIS  
Furthermore, the distribution of CET1 ratios of Group 2 banks indicates that the smaller the 
bank the higher its CET1 ratio.306 In competitive markets, such asymmetric shocks are 
typically much more difficult to pass onto customers.307  
Moreover, monitoring periods foreseen for LCR, NSFR and the leverage ratio in combination 
with extended phase-in and inclus ion of grandfathering provisions  are expected to give banks 
necessary time to adjust their business models  accordingly and provide lending to companies 
to support economic growth. Also, the proposal includes a review clau se on the preferential 
risk weight for exposures to SMEs under €1 million that is currently available for banks applying the standardised approach for credit risk . The preferential treatment is retained in the 
proposal and EBA is tasked with preparing an  analysis for the Co mmission on whether the 
current level of the risk weight and the cap for its application are commensurate with the 
actual credit loss histor y of such exposures over a full economic cycle. 
Most importantly, higher cost of credit in the long run will be offset by important economic 
and social benefits accruing not only to SMEs but a wide range of stakeholders, including 
corporate and individual borrowers and credit ors, governments, and the EU citizens in 
general , due to the anticipated reduction in a freq uency of banking crises, the extent of net 
economic benefits whereof was assessed in the preceding section.  
                                                
 
305 In the plot, the mean is shown with the "x", the median is shown with the red line, 25th and 75th percentiles of 
the distribution are delineated by the blue box, while the black horizontal lines mark 10th and 90th 
percentiles of the distribution. In the EU QIS, sample means were calculated on the basis of the 
'composite bank'; in this case, by dividing the sum of CET1 capital by the sum of risk-weighted assets. A median represents the value that separates the hi gher half of the sample from the lower half. An X
th 
percentile distribution represents the value that se parates X% of lower values from (100%-X%) higher 
values of the sample. 
306 As roughly three quarters of banks in the Group 2 sample had CET1 capital ratios in excess of the sample 
mean of 7.1%. 
307 ECB euro area bank lending surveys show that pressure from competition plays an important role in 
offsetting the impact of factors that drive bank s to tighten their credit standards. See ECB, The euro 
area bank lending survey , April 2011 
 
 147  6. MONITORING AND EVALUATION  
It is expected that the proposed amendments  will start entering into force in 2013. The 
amendments are tightly inter-linked with othe r provisions of the CRD, that are already in 
effect since 2007-2008 or that will come into effect following the implementation of CRD II 
and CRD III (see Table 2).  Normally, the practice at the Commission is to  conduct an evaluation of  a legislation some 
four years after its implementation, however, give n the three waves of re visions that the CRD 
will have undergone in 2008-2011 (which may be  followed by additional amendments in the 
near future) it might be sensible to conduct a comprehensive evaluation of the CRD that 
would be based on the entirely overhauled capit al framework, which complicates setting of 
such target date.  At the same time, the current and recent pr oposals underscore the im portance of timely and 
appropriate changes of the rules in response to the market events. Therefore, it is likely that 
individual provisions of the CRD will continue to be formally evaluated on a piecemeal basis, following the outcomes of various monitoring exer cises both at the EU and the international 
level or a necessity to act as dictated by the markets. Special arrangements will be put in place by th e Basel Committee and EBA to ensure that 
necessary data for the monitoring of leverage ra tio and the new liquidity measures is collected 
to allow for the calibration of these policy tool s. The Commission services will continue to 
participate in the working group of the Basel Committee and the joint task force established 
by ECB and EBA, that monitor the dynamics of bank capital positions
308, globally and in the 
EU, respectively.  
                                                 
308 Indicators that are monitored includ e capital adequacy ratios,  capital buffers, parameters used as inputs in 
minimum capital requir ement calculation for the credit risk, etc. 
 
 148  ANNEX II: TAKE-UP OF NATIONAL OPTIONS AND DISCRETIONS ANALYSED BY CRDWG 
Exercise of options and national 
discretions by Member States 
Area Directive 
2006/48 
(unless 
indicated 
2006/49) Denominati
on Description Yes 
(with 
provis
o) No Not 
yet 
decide
d N/A 
OWN 
FUNDS Article 57 
(second last 
paragraph) Inclusion 
of interim 
profits Member States may permit the inclusion of 
interim profits before a formal decision has 
been taken on the accounts, subject to 
conditions. 80 %  
(7 %) 13 %     
OWN 
FUNDS Article 58 Waiver on 
certain deductions Shares in another credit institution, financial 
institution, insurance or reinsurance undertaking may not be deducted if held 
temporarily for the purposes of a financial 
assistance operation designed to reorganise 
and save the entity. 73 % 
(3 %) 23 %     
OWN 
FUNDS Article 59 Alternativ
es to 
deductions As an alternative to deductions of 
participations and capital instruments held 
in other financial institutions, credit 
institutions may be allowed to apply, with 
the necessary changes, any of the 
methodologies set out in Annex 1 to the 
Conglomerates Directive. 57  % 
(0 %) 43 %     
OWN 
FUNDS Article 60 Deduction
s for 
stand-
alone 
requireme
nts 
purposes For the purposes of the calculation of their 
stand alone requirements, institutions may 
not be required to deduct holdings and 
participations in institutions included in the 
scope of their consolidation. 57 % 
(7 %)  37 %     
OWN 
FUNDS Articles 61, 
63.1, 64.3 
and 65 List of 
own funds The list of own funds elements in the 
Directive is a maximum, both in items and 
amounts. Member States may choose not to 
admit certain elements or to apply lower 
ceilings. They can add further deductions. 
Member states may choose to accept other 
elements of own funds different from those 
in article 57, subject to conditions. Finally 
they can decide on the possible inclusion of 
cumulative preferential shares and 
subordinated loan capital and on the 
inclusion of certain elements normally 
accounted for as assets, when they bear a 
credit ('negative') sign. 72 % 
(21 
%) 3 %   3 % 
OWN 
FUNDS Article 13.2 
Dir. 
2006/49/EC Alternativ
e form of 
calculation 
for 
investment 
firms not 
providing 
certain 
services 
and 
applying 
Article 21 Investment firms that, in view of the 
services they provide, are allowed to 
calculate their own funds  as a percentage of 
the turnover of the previous year (Article 
21), may be also authorised to apply a 
definition of own funds other than that 
prescribed by the directive 2006/48/EC. 47 % 
(3 %) 3 % 7 % 13 % 
OWN 
FUNDS Article 13.5 
Dir. 2006/49/EC Flexibility 
in the compositio
n of own 
funds for 
investment 
firms 
making If an institution is cal culating its own funds 
in accordance with the alternative offered in Article 13.2 of directive 2006/49/EC, it can 
be allowed to substitute subordinated loans 
by other elements described in Article 57 of 
directive 2006/48/EC, mainly as Tier 2. 27 % 6 %   13 % 
 
 149  Exercise of options and national 
discretions by Member States 
Area Directive 
2006/48 
(unless 
indicated 
2006/49) Denominati
on Description Yes 
(with 
provis
o) No Not 
yet 
decide
d N/A 
use of the 
option in 
Article 
13.2 
OWN 
FUNDS Article 14 
Dir. 2006/49/EC Excess of 
subordinated capital The Competent Authorities may allow 
investment firms to hold subordinated capital in excess of ordinary thresholds, up 
to certain limits. 27 % 
(7 %) 5 %   17 % 
SCOPE 
OF 
APPLIC
ATION Article 69.1 Individual 
waiver for 
subsidiarie
s Member States may grant individual 
institutions which are s ubsidiaries within a 
group, subject to the fulfilment of certain 
conditions, an exemption from individual 
requirements. The same applies where the 
parent company is a financial holding 
company. 40 % 57 % 3 %   
SCOPE 
OF 
APPLIC
ATION Article 69.3 Individual 
waiver for 
parent 
credit institutions Member States may grant individual 
institutions which are the parent company 
within a group, subject to the fulfilment of 
certain conditions, an exemption from individual requirements.  30 % 77 % 3 %   
SCOPE 
OF 
APPLIC
ATION Article 70 Solo 
consolidati
on Member States may allow, on a case-by-
case basis, for the purpose of the calculation 
of the individual requirements of the parent 
institution, and subject to certain conditions, 
the incorporation of subsidiaries whose 
material exposures or liabilities are all to 
that parent institution. 33 % 
(3 %) 60 % 3 %   
SCOPE 
OF 
APPLICATION Article 72.3 Exemption 
from Pillar 
III The Competent Authorities may decide to 
exempt, fully or partially, a credit institution 
from Pillar III requirements provided such institution is included within a group 
complying with comparable disclosures on 
a consolidated basis in a third country. 50 % 
(7 %) 43 %     
SCOPE 
OF 
APPLIC
ATION Article 73.1 Exemption 
from 
consolidati
on Member States may decide that, if certain 
conditions are met, some subsidiaries need 
not be included in consolidation. 73 % 
(17 
%) 7 % 3 %   
SCOPE 
OF 
APPLIC
ATION Articles 22, 
24 & 25 Dir. 
2006/49/EC Consolidat
ed waiver 
for 
investment firms A group of investment firms may be 
exempted from consolidated capital 
requirements, on a case-by-case basis, 
provided conditions are met. 25 % 
(4 %) 54 % 4 % 14 % 
COUNT
ERPAR
TY 
RISK 
IN 
DERIV
ATIVE
S  Annex III, 
Part 3 Alternativ
e template 
for the 
calculation 
of 
potential 
future 
value in 
certain 
cases For institutions complying with certain 
requirements in their trading activities in 
commodities, gold and other products, 
Member States may allow percentages for 
the calculation of potential future value 
other than the general ones. 30 % 63 % 7 %   
COUNT
ERPAR
TY 
RISK 
IN 
DERIV
ATIVE
S  Annex III, 
Part 6, Para. 
7 Higher 
value of 
coefficient 
Alpha 
(multiplier 
to 
calculate 
the 
exposure Member States may set a value for 
coefficient Alpha higher than 1.4. 60 % 37 % 3 %   
 
 150  Exercise of options and national 
discretions by Member States 
Area Directive 
2006/48 
(unless 
indicated 
2006/49) Denominati
on Description Yes 
(with 
provis
o) No Not 
yet 
decide
d N/A 
value of 
certain 
contracts) 
COUNT
ERPAR
TY RISK 
IN 
DERIV
ATIVE
S  Annex III, 
Part 6, Para. 
12 Internal 
determinat
ion of the value of 
coefficient 
Alpha 
(multiplier 
to 
calculate 
the 
exposure 
value of 
certain 
contracts) Member States may allow institutions to 
calculate Alpha internally, subject to a floor 
of 1.2. 67 % 
(7 %) 23 % 3 %   
COUNT
ERPAR
TY 
RISK 
IN 
DERIV
ATIVE
S  Annex III, 
Part 7c (ii) Calculatio
n 
(separate/a
ggregate) 
of 'net-to-
gross ratio' At the discretion of Competent Authorities, 
credit institutions may use either separate 
calculation or aggregate calculation when 
calculating the 'net-to-gross ratio'. If 
Member States permit credit institutions a 
choice of methods, the method chosen is to 
be used consistently. 63 % 30 % 7 %   
STAND
ARDIS
ED 
APPRO
ACH Article 80.3 
& Annex VI, 
Part 1, Para. 
24 Risk-
weighting 
exposures 
to credit 
institutions Member States may choose between two 
alternative methods for risk-weighting 
exposures to credit institutions: (a) on the 
basis of the risk-weight of the 
corresponding central government and (b) 
on the basis of the credit assessment of the 
institution itself. (a) 
((b)) 37 % 53 %   
STAND
ARDIS
ED 
APPRO
ACH Article 80.7 Exemption 
of intra-
group 
exposures 
from risk-
weighted 
exposures If certain conditions are met, the Competent 
Authorities may assign a 0% risk-weight on 
exposures not forming part of "own funds" 
of a credit institution to its parent 
undertaking, its subsidiary, a subsidiary of 
its parent undertaki ng or an undertaking 
linked by a relationship within the meaning 
of Article 12(1) of  Directive 83/349/EEC. 60 % 
(10 
%) 30 %     
STAND
ARDIS
ED 
APPRO
ACH Article 80.8 Treatment 
of 
exposures 
to a 
counter-
party 
which is 
member of 
the same 
institution
al 
protection 
scheme. If certain conditions are met, the Competent 
Authorities may assign a 0% risk weight on 
exposures not forming part of "own funds" 
to counterparties which are members of the 
same institutional protection scheme as the 
lending institution. 23 % 77 %     
STAND
ARDIS
ED 
APPRO
ACH  Article 81.3 Mutual 
recognitio
n of an 
ECAI If an ECAI has been recognised as eligible 
by the competent authorities of a Member 
State, the competent authorities of other 
Member States may recognise that ECAI as 
eligible without car rying out their own 
evaluation process         
STAND
ARDISArticle 82.2 Mutual 
recognitioWhen a competent authorities of a Member 
State have made a determination under § 1         
 
 151  Exercise of options and national 
discretions by Member States 
Area Directive 
2006/48 
(unless 
indicated 
2006/49) Denominati
on Description Yes 
(with 
provis
o) No Not 
yet 
decide
d N/A 
ED 
APPRO
ACH  n of an 
ECAI (ECAI  assessment associated with credit 
quality step), the competent authorities of 
other Member State may recognise that 
determination without carrying out their 
own determination process 
STAND
ARDIS
ED 
APPRO
ACH Article 83.2 Permission 
to use 
unsolicited 
ratings In order to use unsolicited ratings, credit 
institutions must get permission from the 
Competent Authorities. To make this 
possible, that alternative should be 
incorporated to legislation (implicit 
discretion). 67 % 
(17 
%) 17 %     
STAND
ARDIS
ED 
APPRO
ACH Annex VI, 
Part 1, Para. 
5 Recognitio
n of a third 
country's 
treatment 
of central 
governme
nt and 
central 
bank 
exposures When a third country with 
supervisory/regulatory arrangements at least 
equivalent to those in the Community, 
assigns for the exposures to its own central 
government and central bank denominated 
and funded in the domestic currency a lower 
risk weight than the one applicable in 
principle, a member state may allow the 
risk-weight of such exposures in the same 
manner. 80 % 
(7%) 13 %     
STAND
ARDIS
ED 
APPRO
ACH Annex VI, 
Part 1, Para. 
11 Recognitio
n of a third 
country's 
treatment 
of regional 
governme
nts and 
local 
authorities When a third country with 
supervisory/regulatory arrangements at least 
equivalent to those in the Community treats 
exposures to regional government and local 
authorities as exposures to its central 
government, a Member State may allow the 
risk-weight of such exposures in the same 
manner. 90 % 
(3 %) 7 %     
STAND
ARDIS
ED 
APPRO
ACH Annex VI, 
Part 1, Para. 
14 Treatment 
of public 
sector 
entities as 
institutions Exposures to public s ector entities may be 
treated as exposures to credit institutions, 
without applying the preferential weights 
applicable to short term exposures to 
institutions.  70 % 
(7 %) 23 %     
STAND
ARDIS
ED 
APPRO
ACH Annex VI, 
Part 1, Para. 
15 Treatment 
of 
exposures 
to public 
sector 
entities 
guaranteed 
by central 
governme
nts The Competent Authorities may, in 
exceptional cases, treat exposures to public 
sector entities as e xposures to the central 
government in whose jurisdiction they are 
established where, in their opinion, there is 
no difference in the risk between such 
exposures because of the existence of an 
appropriate guarantee from the central 
government. 67 % 
(13 
%) 20 %     
STAND
ARDIS
ED 
APPRO
ACH Annex VI, 
Part 1, Para. 
17 Recognitio
n of a third 
country's 
treatment 
of public 
sector 
entities When a third country with 
supervisory/regulatory arrangements at least 
equivalent to those applied in the 
Community treats expos ures to its public 
sector entities as expos ures to institutions, a 
Member State may allow the risk-weight of 
exposures to such public sector entities in the same manner.  77 % 
(10 
%) 13 %     
STAND
ARDIS
ED 
APPRO
ACH Annex VI, 
Part 1, Para. 
29 Exposures 
to rated 
institutions 
with an 
original 
effective 
maturity 
of more "Exposures to institutions with an original 
effective maturity of more than three 
months for with a credit assessment by a 
nominated ECAI is available shall be 
assigned a risk weight according to Table 4 
in accordance with the assignment by the 
competent authorities (...)         
 
 152  Exercise of options and national 
discretions by Member States 
Area Directive 
2006/48 
(unless 
indicated 
2006/49) Denominati
on Description Yes 
(with 
provis
o) No Not 
yet 
decide
d N/A 
than three 
months 
(quality 
steps) 
STAND
ARDISED 
APPRO
ACH  Annex VI, 
Part 1, Para. 
31 Preferentia
l RW treatment 
for claims 
on 
institutions 
with an 
original 
maturity 
of 3 
months or 
less under 
Option 2 
(qulaity 
steps) "Exposures to an institution with an original 
effective maturity of three months or less for with a credit assessment by a nominated 
ECAI is available shall be assigned a risk 
weight according to Table 5 in accordance 
with the assignment of the competent 
authorities.         
STAND
ARDIS
ED 
APPRO
ACH Annex VI, 
Part 1, Para. 
37 Treatment 
of short 
term 
exposures 
to EU 
institutions 
in their 
national 
currency A Competent Authority may allow short 
term exposures to Member States' 
institutions denominated and funded in the 
national currency a risk weight that is one 
category less favourable than the 
preferential risk weight applicable on 
exposures to EU central governments. 63 % 
(3 %) 33 %     
STAND
ARDIS
ED 
APPRO
ACH Annex VI, 
Part 1, Para. 
40 Treatment 
of 
exposures 
in the form 
of 
minimum 
reserves 
held by an 
intermedia
ry credit 
institution. Provided that certain conditions are met, a 
Member State may permit exposures in the 
form of minimum reserves required by the 
ECB or by the central bank of a Member 
State to be held by a credit institution, in 
accordance with the relevant ECB 
regulation on the application of minimum 
reserves, to be risk weighted as exposures to 
the central bank of the member state 
concerned. 70 % 30 %     
STAND
ARDISED 
APPRO
ACH  Annex VI, 
Part 1, Para. 41 Treatment 
of exposures 
to  
corporates 
(quality 
steps) Exposures for which a credit assessment by 
a nominated ECAI is available shall be assigned a risk weight according to the 
following table in accordance with the 
assignment by the competent authorities of 
the credit assessments of eligible ECAIs to 
six steps in a credit quality assessment 
scale.         
STAND
ARDIS
ED 
APPRO
ACH  Annex VI, 
Part 1, Para. 
49 Definition 
of 
Residentia
l Real 
Estate: 
wave to 
independe
nce 
condition 
on any 
cash flow 
generated 
by the 
underlying Waiver eligibility criterion residential real 
estate (RRE): "compe tent authorities may 
dispense with the condition contained in § 
45(b) for exposures fully and completely 
secured by mortgages on residential 
property which is situated within their 
territory, if they have evidence that a well-
developed and long-esta blished residential 
real estate market in present in their 
territory with loss rates which are 
sufficiently low to justify such treatment".         
 
 153  Exercise of options and national 
discretions by Member States 
Area Directive 
2006/48 
(unless 
indicated 
2006/49) Denominati
on Description Yes 
(with 
provis
o) No Not 
yet 
decide
d N/A 
property 
serving as 
collateral. 
STAND
ARDIS
ED APPRO
ACH  Annex VI, 
Part 1, Para. 
50 Mutual 
recognitio
n of the 
waiver Recognition of the treatment in §46 within 
EU: "when the discretion contained in §46 
is exercised by the competent authorities of a Member State, the competent authorities 
of another Member State may allow their 
credit institutions to apply a risk weight of 
35% to such exposures fully and completely 
secured by mortgages on residential 
property".         
STAND
ARDIS
ED 
APPRO
ACH  Annex VI, 
Part 1, Para. 
51 RW 50% 
for CRE 50% RW for commercial real estate (CRE): 
"Subject to the discretion of the competent 
authorities, exposures fully and completely 
secured, to the satisfaction of the competent 
authorities by mortgages on offices or other 
commercial premises s ituated within their 
territory may be assigne d a risk weight of 
50%"         
STAND
ARDIS
ED 
APPRO
ACH  Annex VI, 
Part 1, Para. 
52 50% RW 
for Finnish 
Housing 
CRE Subject to the discretion of the competent 
authorities, exposures fully and completely 
secured, to the satisfaction of the competent 
authorities, by shares in Finnish housing 
companies operating in accordance with the 
Finnish Housing Company Act of 1991 or 
subsequent equivalent le gislation, in respect 
of offices or other commercial premises 
may be assigned a risk weight of 50%         
STAND
ARDIS
ED 
APPRO
ACH  Annex VI, 
Part 1, Para. 
53 + Art 153 Exposures 
related to 
property 
leasing 
transaction
s Property leasing transactions: "Subject to 
the discretion of competent authorities, 
exposures related to property leasing 
transactions concerning offices or other 
commercial premises situated in their 
territory and governed by statutory 
provisions whereby the lessor retains full 
ownership of the rented assets until the 
tenant exercises his option to purchase, may 
be assigned a risk weight of 50%. " Art 153: 
(...) the competent authorities may until 31 
December 2012  allow a 50% risk weighting to be applied without the 
application of Annex VI, Part 1, § 55 & 56.          
STAND
ARDIS
ED 
APPRO
ACH  Annex VI, 
Part 1, Para. 
58 Waive on 
definition 
of the 
CRE Waiver eligibility criterion CRE: 
"competent authorities may dispense with 
the condition contained in § 51 (b) for 
exposures fully and completely secured by 
mortgages on commercial property which is 
situated within their territory if they have 
evidence  that (...) with loss rates do not 
exceed the following limits (...)         
STAND
ARDIS
ED 
APPRO
ACH Annex VI, 
Part 1, Para. 
63 Risk-
weighting 
past due 
exposures 
secured by 
non 
eligible 
collateral A risk weight of 100% may be assigned on 
past due exposures which are fully secured 
by non eligible collateral when value 
adjustments reach 15% of the exposure 
gross of the value adjustments, if strict 
operational criteria exist to ensure the good 
quality of the collateral. 17 % 83 %     
STAND
ARDISAnnex VI, 
Part 1, Para. Risk-
weighting The applicable risk weight on past due 
exposures secured by mortgages on 67 % 33 %     
 
 154  Exercise of options and national 
discretions by Member States 
Area Directive 
2006/48 
(unless 
indicated 
2006/49) Denominati
on Description Yes 
(with 
provis
o) No Not 
yet 
decide
d N/A 
ED 
APPRO
ACH 64 of past due 
exposures 
secured by 
mortgages 
on 
residential 
property residential property net of value 
adjustments may be reduced to 50%, if 
value adjustments are no less than 20% of 
the exposure amount gross of the value 
adjustments.  
STANDARDIS
ED 
APPRO
ACH Annex VI, 
Part 1, Para. 
66 Risk-
weighting 
items 
belonging 
to 
regulatory 
high risk 
categories The Competent Authorities have the 
discretion to assign a risk weight of 150% 
on exposures associated with particularly 
high risks. 70 % 
(3 %) 27 %     
STAND
ARDIS
ED 
APPRO
ACH Annex VI, 
Part 1, Para. 
67 Regulatory 
high risk 
categories 
- lower 
risk 
weight due 
to value 
adjustment
s The risk weight on non past due exposures 
receiving a 150% risk weight may be 
reduced to (a) 100% if value adjustments 
exist which are no less than 20% of the 
gross exposure and (b) 50% if value 
adjustments are no less than 50% of the 
gross exposure. 53 % 
(7 %) 40 %     
STAND
ARDIS
ED 
APPRO
ACH Annex VI, 
Part 1, Para. 
68(e) Loans 
secured by 
commercia
l real 
estate as 
collateral 
for 
covered 
bonds The Competent Authorities may recognise 
loans secured by commercial real estate as 
eligible collateral for covered bonds where 
the required loan to value ratio of 60% is 
exceeded up to a maximum level of 70%, if 
certain defined criteria and conditions are 
met. 43 % 57 %     
STAND
ARDIS
ED 
APPRO
ACH Annex VI, 
Part 1, Para. 
85 Risk-
weighting 
institutions 
specialisin
g in the 
inter-bank 
and public 
debt market Member States may allow a risk weight of 
10% for exposures to institutions 
specialising in the interbank and public debt 
markets in their home member states, if 
such institutions are subject to close 
supervision and the exposures are 
adequately secured. 27 % 70 % 3 %   
STAND
ARDIS
ED 
APPRO
ACH Annex VI, 
Part 3, Para. 
17 Exceptions 
to the non-
use of 
domestic 
currency 
ratings for 
foreign-
currency 
exposures The Competent Authorities may allow the 
domestic currency rating of an obligor to be 
used for its foreign currency exposures 
provided such exposures arise from 
institutions' participation in a loan extended 
by a Multilateral Development Bank. 77 % 23 %     
IRB Article 84.2 Requireme
nts for 
IRB 
standards 
for parent 
and EU 
subsidiarie
s 
altogether When IRB approach is used by an EU 
parent or financial hoding company and its 
subsidiaries, Member States may allow the 
minimum requirements to qualify for IRB 
to be met by parent and subsidiaries 
considered together. 70 % 
(13 
%) 17 %     
IRB Article 85, Roll-out "(1): Subject to  the approval of the         
 
 155  Exercise of options and national 
discretions by Member States 
Area Directive 
2006/48 
(unless 
indicated 
2006/49) Denominati
on Description Yes 
(with 
provis
o) No Not 
yet 
decide
d N/A 
1+2 possibility competent authorities, implementation may 
be carried out sequentially across the 
different exposure classes (…) (2) 
Implementation as referred to §1 shall be 
carried out within a reasonable period of 
time to be agreed by the competent 
authorities." 
IRB Article 89.1. Partial use 
of the 
standardis
ed 
approach  Subject to the approval of the competent 
authorities, credit institutions permitted to 
use the IRB approach (…) for one or more 
exposure classes may apply Subsection 1 
(standardised approach) for the following 
exposures (…)         
IRB Article 89 
last sentence Mutual 
recognitio
n within 
EU of the 
use of 
standardis
ed 
approach 
for the 
exposures 
listed : Mutual recognition within EU of the use of 
standardised approach for the exposures 
listed : 'this paragraph shall not prevent the 
competent authorities of other Member 
States to allow the application of the rules 
of Subsection 1 (standardised approach) for 
equity exposures which have been allowed 
for this treatment in other Member States'         
IRB Annex VII, 
Part 1, Para. 
6 Lower rate 
for 
specialized 
lending The Competent Authorities may authorise a 
credit institution to generally assign a 50% 
risk weight to SL-Category 1 and 70% to 
SL-Category 2 (regardless of maturity) if 
certain conditions are met. 60 % 
(13 
%) 27 %     
IRB Annex VII, 
Part 1, Para. 
13 (last 
sentence) Special 
treatment 
for 
revolving 
retail 
exposures 
secured by 
a link to a 
wage 
account The requirement that retail revolving 
exposures be unsecured (Annex VII, Part 1, 
Para. 13 b)) may be waived by the 
Competent Authorities in respect of 
collateralised credit facilities linked to a 
wage account. 73 % 27 %     
IRB Annex VII, 
Part 1, Para. 
18 Treatment 
of 
ancillary 
banking 
services Exposures to ancillar y banking services 
undertakings (equity) can be treated as non-
credit obligation assets. 90 %  10 %     
IRB Annex VII, 
Part 2, Para. 
5, 7 & Annex 
VIII, Part 1, 
Para. 26 Possibility 
to extend 
the list of 
unfunded 
protection 
providers 
for the 
purposes of 
recognitio
n of 
unfunded 
credit 
protection 
in PD For the purposes of the recognition of 
unfunded credit protection in PD by 
institutions, the Competent Authorities may 
extend the list of unfunded credit protection 
providers further than those included in 
Annex VIII, Part 1, Para. 26. 40 % 
(3 %) 57 %     
IRB Annex VII, 
Part 2, Para. Alternativ
es for the The Competent Authorities may require all 
institutions in their jurisdiction to use 33 % 
(3 %) 64 %     
 
 156  Exercise of options and national 
discretions by Member States 
Area Directive 
2006/48 
(unless 
indicated 
2006/49) Denominati
on Description Yes 
(with 
provis
o) No Not 
yet 
decide
d N/A 
12 & 13 calculation 
of 
maturity maturity (M) for each exposure in 
accordance with formulae instead of using 
values by default (0.5 years for repos and 
2.5 for other exposures). 
IRB Annex VII, 
Part 2, Para. 15 Maturity 
for EU-firms (< 
EUR 500 
mio.) The Competent Authorities may allow 
maturity of exposures to European corporates with consolidated assets of less 
than EUR 500 million to be set at values by 
default, even if they apply the formulae 
option. 30 % 70 %     
IRB Annex VII, 
Part 2, Para. 
15 (last 
sentence) Maturity 
for EU-
firms 
investing 
primarily 
in real 
estate (< 
EUR 
1,000 
mio.) The Competent Authorities may allow 
maturity of exposures to European 
corporates that invest primarily in real 
estate with consolidated assets of less than 
EUR 1,000 million to be set at values by 
default, even if they apply the formulae 
option. 17 % 83 %     
IRB Annex VII, 
Part 2, Para. 
20 & Annex 
VIII, Part 1, 
Para. 26 Possibility 
to extend 
the list of 
unfunded 
protection 
providers 
for the 
purposes 
of 
calculation 
of dilution 
risk For the purposes of the calculation of 
dilution risk, the Competent Authorities 
may extend the list of unfunded credit 
protection providers further than those 
included in Annex VIII, Part 1, Para. 26. 40 % 60 %     
IRB Annex VII, 
Part 4, Para. 
44 Number of 
days past 
due "In all cases, the exposure past due shall be 
above the threshold defined by the 
competent authorities and which reflects a 
reasonable level of risk"         
IRB Annex VII, 
Part 4, Para 
48 Number of 
days past 
due DoD days past due for retail and PSEs: " for 
retail and PSE exposures, the competent 
authorities of each Member States shall set 
the exact number of days  past due that all 
credit institutions in its jurisdiction shall 
abide by under the definition of defaults set 
out in §44, for exposures to such 
counterparts situated within this Member 
State. The specific number shall fall within 
90-180 days and may differ across product 
lines. (...)"         
IRB Annex VII, 
Part 4, Para 
56 Flexibility 
in data 
collection The Competent Authorities may apply less 
stringence as regards the data needed for 
estimation and collected before the 
implementation of the directive, provided 
the credit institution makes appropriate adjustments. 83 % 
(10 
%) 7 %     
CREDI
T RISK 
MITIG
ATION Annex VIII, 
Part 1, Para. 
8 Unrated 
listed 
institutions Recognition as collateral of unrated, listed 
institution securities: "debt securities issued 
by credit institutions which securities do not 
have a credit assessment by an eligible 
ECAI may be recognised as eligible 
collateral if they fulfil the following criteria 
..."         
CREDI Annex VIII, Recognitio The Competent Authorities may authorise 40 % 57 %   3 % 
 
 157  Exercise of options and national 
discretions by Member States 
Area Directive 
2006/48 
(unless 
indicated 
2006/49) Denominati
on Description Yes 
(with 
provis
o) No Not 
yet 
decide
d N/A 
T RISK 
MITIG
ATION Part 1, Para. 
15 n of shares 
in Finnish 
housing 
companies 
as eligible 
collateral their credit instituti ons to recognise as 
eligible collateral shares in Finnish housing 
companies that are operating in accordance 
with the Finnish Housing Company Act of 
1991 provided that certain conditions are 
met. 
CREDIT RISK 
MITIG
ATION Annex VIII, 
Part 1, Para. 16 Waiver to 
definition of RRE Waiver eligibility criterion RRE: "the 
competent authorities may waive the 
requirement for their credit institutions to 
comply with condition (b) in § 13 for 
exposures secured by re sidential real estate 
property situated within the territory of that 
Member State if the competent authority 
have evidence that (...).         
CREDI
T RISK 
MITIG
ATION Annex VIII, 
Part 1, Para. 
17 Waiver to 
definition 
of CRE Waiver eligibility criterion CRE: "the 
competent authorities may waive the 
requirement for their credit institutions to 
comply with condition (b) in § 13 for 
exposures secured by co mmercial real  estate 
property situated within the territory of that 
Member State if the competent authority 
have evidence that (...).         
CREDI
T RISK 
MITIG
ATION Annex VIII, 
Part 1, Para. 
19 Mutual 
recognitio
n of the 
waiver Application of the waiver in §17 within EU: 
"the competent authorities of a Member 
State, which do not use the waiver in §17, 
may recognise as eligible commercial real 
estate property recognised as eligible in 
another Member State by virtue of the 
waiver".         
CREDI
T RISK 
MITIG
ATION Annex VIII, 
Part 1, Para. 
20 Amounts 
receivable 
as eligible 
collateral The Competent Authorities may recognise 
as eligible collater al amounts receivable 
linked to a commercial transaction or 
transactions with an original maturity of 
less than or equal to one year. Eligible 
receivables do not include those associated 
with securitisations, s ub-participations or 
credit derivatives or amounts owed by 
affiliated parties. 90 % 
(3 %) 7 %     
CREDI
T RISK 
MITIG
ATION Annex VIII, 
Part 1, Para. 
21 Other 
physical 
collateral The Competent Authorities may recognise 
as eligible collateral physical items of a type 
other than real estate collateral, if satisfied 
as to the following: (a) liquid markets for 
disposal of the collateral do exist in an 
expeditious and economically efficient 
manner; and (b) well-established, publicly 
available market prices for the collateral do 
exist. the institution must be able to 
demonstrate that there is no evidence that 
the net prices it receives when collateral is 
realised deviates significantly from these 
market prices. 77 % 
(7 %) 16 %     
CREDI
T RISK 
MITIG
ATION Annex VIII, 
Part 1, Para. 
25 Instrument
s 
repurchase
d on 
request Instruments issued by third party 
institutions which will be repurchased by 
that institution on request may be 
recognised as eligible  credit protection.         
CREDI
T RISK 
MITIG
ATION Annex VIII, 
Part 1, Para. 
28 Eligible 
protection 
providers Member states may also recognize as 
eligible providers of unfunded credit 
protection, other financial institutions 
authorised and supervised by competent 
authorities and subject to prudential 43 % 53 % 3 %   
 
 158  Exercise of options and national 
discretions by Member States 
Area Directive 
2006/48 
(unless 
indicated 
2006/49) Denominati
on Description Yes 
(with 
provis
o) No Not 
yet 
decide
d N/A 
requirements equivalent to those applied to 
credit institutions. 
CREDI
T RISK 
MITIG
ATION Annex VIII, 
Part 2, Para. 
9a (ii) Minimum 
requireme
nts for the 
recognition of 
receivable
s as 
collateral Credit institutions must take all steps 
necessary to fulfil local requirements in 
respect of the enforceability of security 
interest. There shall be a framework which allows the lender to have a first priority 
claim over the collateral subject to national 
discretion to allow such claims to be subject 
to the claims of preferential creditors 
provided for in legislative or implementing 
provisions. 73 % 
(7 %) 17 %   3 % 
CREDI
T RISK 
MITIG
ATION Annex VIII, 
Part 2, Para. 
16 Treatment 
of 
exposure 
protected 
by a 
guarantee 
which is 
counter-
guaranteed 
by a 
central 
governme
nt or 
central 
bank. Treatment where an e xposure is protected 
by a guarantee which is counter-guaranteed 
by a central government or central bank 
(…): the exposure may be treated as 
protected by a guarantee by the entity in 
question provided the following conditions 
are satisfied : a); b) and c) the competent 
authority is satisfied th at the cover is robust 
and that nothing in the historical 
evidence...in question.         
CREDI
T RISK 
MITIG
ATION Annex VIII, 
Part 3, Para. 
12 Permission 
of internal 
models 
approach 
for 
calculation 
of fully 
adjusted 
exposure 
value (E*) The Competent Authorities may permit 
credit institutions meeting certain 
requirements to use an internal models 
approach taking into account correlations to 
calculate the adjusted exposure value for 
exposures resulting from the application of 
a master netting agreement. 83 % 
(13 
%) 3 %     
CREDI
T RISK 
MITIG
ATION Annex VIII, 
Part 3, Para. 
19 Permission 
to use 
empirical 
correlations within 
and across 
risk 
categories The Competent Authorities may allow 
credit institutions to use empirical 
correlations within risk categories and 
across risk categories if they are satisfied that the credit institution’s system for 
measuring correla tions is sound and 
implemented with integrity. 83 % 
(10 
%) 7 %     
CREDI
T RISK 
MITIG
ATION Annex VIII, 
Part 3, Para. 
43 Own 
estimates 
of 
volatility 
adjustment
s 
(categories 
of 
security) When debt securities have a credit 
assessment from a recognised ECAI 
equivalent to investment grade or better, the 
Competent Authorities may allow credit 
institutions to calculate a volatility estimate 
for each category of security. 90 % 
(3 %) 3 %   3 % 
CREDI
T RISK 
MITIG
ATION Annex VIII, 
Part 3, Para. 
72 Reduced 
LGDs for 
leasing 
transaction
s Until 31 December 2012, the Competent 
Authorities may, subject to the indicated 
levels of collateralisation, allow credit 
institutions to assign lower levels of LGD 
for senior exposures in the form of 
Commercial Real Estate leasing and of 
equipment leasing. 41 % 
(3 %) 55 %     
 
 159  Exercise of options and national 
discretions by Member States 
Area Directive 
2006/48 
(unless 
indicated 
2006/49) Denominati
on Description Yes 
(with 
provis
o) No Not 
yet 
decide
d N/A 
CREDI
T RISK 
MITIG
ATION Annex VIII, 
Part 3, Para. 
73 Cap at 
50% RW 
for CRE Cap for RRE: "subject to the requirements 
of this paragraph and §75 and as an 
alternative to the treatment in § 69 to 73, the 
competent authorities of a Member State 
may authorise credit institutions to apply a 
50% risk weighting to the part of the 
exposure fully collateralised by RRE 
property or CRE property situated within 
the territory of the Member State if they 
have evidence that (...)         
CREDI
T RISK 
MITIG
ATION Annex VIII, 
Part 3, Para. 
89 Sovereign 
guarantees The Competent Authorities may apply 
reduced risk weights to exposures or 
portions of exposures guaranteed by the 
central government or central bank, where 
the guarantee is denominated in the 
domestic currency of the borrower and the 
exposure is funded in that currency. 83 % 
(3 %) 13 %     
SECUR
ITISAT
ION Article 
152(10)(b) Discretion 
to disapply 
the 
securitisati
on 
framework For banks that do not move to standardised 
approach in 2007, the treatment of 
securitisation may be disapplied by 
competent authorities. 73 % 17 % 7 % 3 % 
SECUR
ITISAT
ION Article 97.3 Recognitio
n of ECAI 
: mutual 
recognitio
n Recognition of ECAI within EU for 
securitisation purposes: "if an ECAI has 
been recognised as eligible by the 
competent authorise of one Member State 
for the purpose of paragraph I, the 
competent authorities of the other Member 
States may recognise that ECAI as eligible 
for those purposes without carrying out 
their own evaluation process"         
SECUR
ITISAT
ION Article 98.2 Mutual 
recognitio
n of 
quality 
steps Recognition of mapping within EU for 
securitisation purposes: When the 
competent authorities of a Member State 
have made a determin ation under paragraph 
I, the competent authorities of the other 
Member States may recognise that 
determination without carrying out their 
own determination process.         
SECUR
ITISAT
ION Annex IX, 
Part 4, Para. 
30 Treatment 
of certain 
retail 
exposures 
subject to 
early 
amortisati
on 
provision The Competent Authorities may apply a 
treatment analoguous to the lines of para. 26 
to 28 in the case of securities subject to an 
early amortisation provision of certain retail 
exposures (uncommitted, unconditionally 
cancellable without prior notice, early 
amortisation is triggered by a quantitative 
value in respect of something other than the 
three months average excess spread) for 
determining the conversion figure. 47 % 
(10 
%) 40 % 3 %   
SECUR
ITISATION Annex IX, 
Part 4, Para. 43 The 
Internal Assessmen
t approach Use of ‘internal assessment approach’ for 
unrated ABCP exposur es: "subject to the 
approval of the competent authorities, when 
the following conditions are satisfied, a 
credit institution may attribute to an unrated 
position in an asset backed commercial 
paper  programme a derived rating as laid 
down in §43"         
SECUR
ITISAT
ION Annex IX, 
Part 4, Para. 
43 last Public 
availabilit
y of the The requirement for the assessment 
methodology to be publ icly available may 
be waived by the competent authorities …         
 
 160  Exercise of options and national 
discretions by Member States 
Area Directive 
2006/48 
(unless 
indicated 
2006/49) Denominati
on Description Yes 
(with 
provis
o) No Not 
yet 
decide
d N/A 
sentence ECAI's 
assessment 
SECUR
ITISAT
ION Annex IX, 
Part 4, Para. 
53 (last 
sentence) Applicatio
n of the 
simplified 
Supervisory Formula 
Method The Competent Authorities may permit 
credit institutions to apply for 
securitisations involvi ng retail exposures 
the Supervisory Formula Method using simplifications for certain risk parameters. 80 % 
(10 
%) 7 % 3 %   
SECUR
ITISAT
ION Annex IX, 
Part 4, Para. 
58 Exception
nal 
treatment 
when 
KIRB 
cannot be 
calculated When it is not practical for the credit 
institution to calculate the risk-weighted 
exposure amounts fo r the securitised 
exposures as if they had not been 
securitised, a credit institution may, on an 
exceptional basis and subject to the consent 
of the competent authorities, temporarily be 
allowed to apply the following method for 
the calculation of ri sk-weighted exposure 
amounts for an unrated securitisation 
position in the form of a liquidity facility.         
OPERA
TIONA
L RISK Article 102.4 
& Annex X, 
Part 4, Para. 
1 and 2 Combinati
on of 
approache
s The Competent Authorities may allow 
institutions to use a combination of 
approaches. 87 % 
(10 
%) 3 %     
OPERA
TIONA
L RISK Article 104.3 Alternativ
e 
Standardis
ed 
Approach The Competent Authorities may under 
certain conditions authorise institutions to 
use a alternative indicator to calculate its 
capital requirements. 60 % 
(3 %) 37 %     
OPERA
TIONAL RISK Article 105.4 Qualifying 
criteria for AMA 
within the 
same 
group The Competent Authorities may allow the 
qualifying criteria set out to be met by the parent and its subsid iaries considered 
together. 80 % 
(13 %) 7 %     
OPERA
TIONA
L RISK Annex X, 
Part 2, Para. 
3 and 5 Alternativ
e 
Standardis
ed 
Approach The Competent Authorities may authorise 
institution to calculate its capital 
requirement using an alternative 
standardised approach.  63 % 
(3 %) 30 %   3 % 
OPERA
TIONAL RISK Annex X, 
Part 3, Para. 11 Process 
for quantitativ
e 
standards Correlations in operational risk losses 
across individual operational risk estimates may be recognised only if credit institutions 
can demonstrate to the satisfaction of the 
competent authorities that their systems for 
measuring correlations are sound, 
implemented with integrity, and take into 
account the uncertainty surrounding any 
such correlation estimates (...)"         
OPERA
TIONA
L RISK Article 20.2 
Dir. 
2006/49/EC Minimum 
level of 
own funds The Competent Authorities may allow 
investment firms with limited licence to 
provide own funds which are always more 
than or equal to the higher of the capital 
requirement for credit and market risk or 
25% of the preceding years fixed overheads. 70 % 13 %   17 % 
OPERA
TIONA
L RISK Article 20.3 
Dir. 
2006/49/EC Minimum 
level of 
own funds The Competent Authorities may allow 
investments firms which hold 730 000 EUR 
in initial capital, but which fall within 
certain categories, to provide own funds 
which are always more than or equal to the 
higher of the capital requirement for credit 
and market risk or 25 % of the preceding 50 % 
(3 %) 30 %   17 % 
 
 161  Exercise of options and national 
discretions by Member States 
Area Directive 
2006/48 
(unless 
indicated 
2006/49) Denominati
on Description Yes 
(with 
provis
o) No Not 
yet 
decide
d N/A 
years fixed overheads. 
QUALI
FYING 
HOLDI
NGS 
OUTSIDE 
THE 
FINAN
CIAL 
SECTO
R Article 122.1 Special 
treatment 
for 
insurance 
undertakin
gs Member States may exempt insurance 
sector undertakings from the general limits 
established for qualifying holdings. 70 %   27 % 3 %   
QUALI
FYING 
HOLDI
NGS 
OUTSI
DE 
THE 
FINAN
CIAL 
SECTO
R Article 122.2 Alternativ
e - 
deduction Member States may decide not to apply 
limits on qualifying holdings, provided 
excess is deducted from own funds. 60 % 
(3 %) 33 % 3 %   
TRANS
ITIONA
L 
PROVI
SIONS Article 153, 
Para. 1 (first 
sentence) Transition
al 
treatment 
for certain 
property 
leasing 
transaction
s The Competent Authorities may, until 
December 31, 2012, allow leasing 
exposures on offices or commercial 
premises in their territory and subject to 
certain conditions, to be rated 50%. 23 %  77 %     
TRANS
ITIONA
L 
PROVI
SIONS Article 153, 
Para. 2 
(second 
sentence) Transition
al 
definition 
of the 
secured 
portion of 
a loan The Competent Authorities may, until 
December 31, 2010, allow, for the purpose 
of defining the secured portion of a loan, 
recognise eligible collateral other than the 
one meeting the requirements. 13 %  87 %     
TRANS
ITIONA
L 
PROVI
SIONS Article 154.1 Transition
al use of a 
different 
definition 
of past due Until December 31, 2011, the Competent 
Authorities may set the number of days past 
due up to 180 days if local conditions make 
it appropriate (for the purposes of 
application of the standardised approach). 
The specific number may differ across 
product lines. 10 % 
(3 %) 80 % 7 %   
TRANS
ITIONA
L 
PROVI
SIONS Article 154.2 Transition
ally 
shorter test 
of use Institutions applying for the use of IRB 
before 2010 may benefit from a test of use 
shorter than 3 years but above 1, until 
December 31, 2009. 83 % 
(7 %) 7 % 3 %   
TRANS
ITIONA
L 
PROVI
SIONS Article 154.3 Transition
ally 
shorter 
requireme
nt of use 
for 
LGD/conv
ersion 
factors 
estimates For those institutions applying for the use of 
their own LGD/conversion factors 
estimates, the three-year period of 
experience in use required by Article 84.4 
may be reduced to two until December 31, 
2008. 90 % 
(3 %) 7 %     
TRANS Article 154.4 Transition The Competent Authorities may, until 37 % 57 % 3 %   
 
 162  Exercise of options and national 
discretions by Member States 
Area Directive 
2006/48 
(unless 
indicated 
2006/49) Denominati
on Description Yes 
(with 
provis
o) No Not 
yet 
decide
d N/A 
ITIONA
L 
PROVI
SIONS al 
treatment 
for certain 
types of 
participati
ons December 31, 2012, allow credit 
institutions to continue to apply Basel I 
treatment to certain types of participations. (3 %) 
TRANS
ITIONA
L 
PROVI
SIONS Article 154.6 Transition
al 
exemption 
for certain 
equity 
exposures The Competent Authorities may, until 
December 31, 2017, exempt from IRB 
certain equity exposures held on December 
31, 2007. 53 %  47 %     
TRANS
ITIONA
L 
PROVI
SIONS Article 154.7 Days past 
due for 
corporate "Until 31 December 2011, for corporate 
exposures  the competent authorities of each 
Member State may set the number of days 
past due that all credit institutions in its 
jurisdiction shall abide by under the 
definition of default set out in Annex VII, 
Part 4, §44 for exposures to such 
counterparts situated within this Member 
State."         
TRANS
ITIONA
L 
PROVI
SIONS Article 155 Transition
al 
calculation
s: 
standardis
ed 
approach - 
operationa
l risk 
(credit 
institutions
) Until December 31, 2012, the "trading and 
sales" business line may be applied a 15% 
factor, if it represents at least 50% of the 
total relevant indicators. 40 % 60 %     
TRANS
ITIONA
L 
PROVI
SIONS Annex VII, 
Part 2, Para. 
8 (second 
subparagraph
) Transition
al LGD for 
covered 
bonds Until December 31, 2010, covered bonds 
may be assigned an LGD of 11.5%  73 % 
(3 %) 20 %   3 % 
TRANS
ITIONA
L 
PROVI
SIONS Annex VII, 
Part 4, Para. 
66, 71, 86 
and 95 Transition
al 
reduction 
of 
minimum 
length of 
observatio
n periods Member States may transitionally allow a 
reduction of the minimum length of the 
observation periods required for own 
estimations of PD, L GD and CCF, subject 
to an absolute minimum of 2 years. 84 % 
(10 
%) 3 % 3 %   
TRANS
ITIONA
L 
PROVI
SIONS Article 44 
Dir. 
2006/49/EC Transition
al 
calculation
s: 
standardis
ed approach - 
operationa
l risk 
(investmen
t firms) Until December 31, 2012, the "trading and 
sales" business line may be applied a 15% 
factor, if it represents at least 50% of the 
total relevant indicators. 50 % 33 %   17 % 
TRANS
ITIONA
L 
PROVIArticle 46 
Dir. 
2006/49/EC Alternativ
e 
transitiona
l Until December 31, 2011, the Competent 
Authorities may choose not to apply 
requirements for operational risk as set out 
in Article 75(d) of directive 2006/48/EC to 40 % 43 %   17 % 
 
 163  Exercise of options and national 
discretions by Member States 
Area Directive 
2006/48 
(unless 
indicated 
2006/49) Denominati
on Description Yes 
(with 
provis
o) No Not 
yet 
decide
d N/A 
SIONS operationa
l risk 
requireme
nt low size investment fi rms. An alternative 
treatment applies instead. 
TRANS
ITIONAL 
PROVI
SIONS Article 47 
Dir. 
2006/49/EC Transition
al applicabili
ty of 
recognized 
specific 
risk 
models Until December 31, 2009, or any other date 
specified by the Competent Authorities on a case-by-case basis, it may be provided that 
for institutions that have received specific 
risk model recognition prior to January 1, 
2007, previous requirements (as in the old 
directive) apply. 35 % 
(3 %) 52 % 6 % 3 % 
TRADI
NG 
BOOK Article 18.2 
and 3 
Dir. 
2006/49/EC Applicatio
n of the 
banking 
book rules 
to trading 
book, if 
not 
material The Competent Authorities may allow 
institutions to apply banking book rules to 
their trading book exposures, provided the 
trading book activities does not exceed 
certain limits. 93 % 
(3 %) 3 %     
TRADI
NG 
BOOK Article 19.2 
Dir. 
2006/49/EC Specific 
risk 
requireme
nt for 
covered 
bonds Member States may set a reduced specific 
risk requirement for covered bonds, with 
reductions similar to those applied in the 
banking book under the standardised 
approach. 57 % 40 % 3 %   
TRADI
NG 
BOOK Article 19.3 
Dir. 
2006/49/EC 
and Annex I, 
point 52 Third 
country 
CIU A Competent Authority of one member 
state may make use of  the approval of 
another one without conducting its own 
assessment. 63 % 
(3 %) 30 % 3 %   
TRADI
NG 
BOOK Article 26 
Dir. 
2006/49/EC Offsetting 
trading 
positions For the purposes of calculation of 
consolidated capital requirements, the 
Competent Authorities may authorise the 
offsetting of trading (trading book, 
commodities, etc.) positions even when 
they are booked in different institutions 
within the group, subject to certain 
conditions. 60 % 
(7 %) 30 % 3 %   
TRADI
NG 
BOOK Article 33.3 
Dir. 
2006/49/EC Alternativ
e 
requireme
nts for 
valuation 
in absence 
of readily 
available 
market 
prices The Competent Authorities, in the absence 
of readily available market prices, may 
choose not to apply da ily mark to market 
and, instead, require institutions to apply 
alternative methods subject to their 
approval. 77 % 
(3 %) 20 %     
TRADI
NG 
BOOK Annex I, 
Para. 4, 2nd 
subparagraph 
(first 
sentence) 
Dir. 
2006/49/EC Capital 
requireme
nt for an 
exchange-
traded 
future Subject to certain conditions, the Competent 
Authorities may allow that the capital 
requirement for an exchange-traded future 
contract be equal to the margin required by 
the exchange. 37 % 
(3 %) 57 % 3 %   
TRADI
NG 
BOOK Annex I, 
Para. 4, 2nd 
subparagraph 
(second 
sentence) Capital 
requireme
nt for OTC 
derivative 
cleared by Subject to certain conditions, the Competent 
Authorities may allow that the capital 
requirement for an OT C derivative cleared 
by a clearing house to be equal to the 
margin required by the clearing house. 30 % 
(7 %) 60 % 3 %   
 
 164  Exercise of options and national 
discretions by Member States 
Area Directive 
2006/48 
(unless 
indicated 
2006/49) Denominati
on Description Yes 
(with 
provis
o) No Not 
yet 
decide
d N/A 
Dir. 
2006/49/EC a clearing 
house 
TRADI
NG 
BOOK Annex I, 
Para. 5, 2nd 
subparagraph 
Dir. 2006/49/EC Prescriptio
n of 
specific 
methodologies for 
the 
calculation 
of delta The Competent Authorities may prescribe 
that delta be calculated following 
methodologies specified by them. 37 % 60 % 3 %   
TRADI
NG 
BOOK Annex I, 
Para. 5, 3rd 
subparagraph 
Dir. 
2006/49/EC Capital 
requireme
nt for 
exchange-
traded 
written 
options 
and OTC 
options 
cleared by 
a clearing 
house Subject to certain conditions, the Competent 
Authorities may allow that the capital 
requirement for an exchange-traded written 
option, or an OTC option cleared by a 
clearing house to be equal to the margins 
required by the exchange or the clearing 
house, respectively.  30 % 
(7 %) 60 % 3 %   
TRADI
NG 
BOOK Annex I, 
Para. 5, 3rd 
subparagraph 
Dir. 
2006/49/EC Capital 
requireme
nt for 
exchange-
traded 
bought 
options 
and OTC 
bought 
options 
cleared by 
a clearing 
house Subject to certain conditions, the Competent 
Authorities may allow that the capital 
requirement for an exchange-traded bought 
option, or an OTC bought option cleared by 
a clearing house to be equal to the 
requirement for the underlying instrument. 43 % 
(7 %) 47 % 3 %   
TRADI
NG 
BOOK Annex I, 
Para. 14 
Dir. 
2006/49/EC Specific 
risk charge 
for a non-
qualifying 
issuer The Competent Authorities may require that 
instruments issued by non-qualifying 
issuers are applied a specific risk capital 
charge higher than 8% or 12% and/or 
disallow offsetting for the purposes of 
general market risk between such instruments and any other instrument. 40 % 57 % 3 %   
TRADI
NG 
BOOK Annex I, 
Para. 26 
Dir. 
2006/49/EC Use of 
duration 
instead of 
the 
standard 
system for 
calculation 
of the 
general 
risk of 
traded 
debt 
positions The Competent Authorities may, either in 
general or on an individual basis, allow 
institutions to use a system for calculating 
the general risk for traded debt instruments 
which reflects duration instead of the 
system set out in the directive. 90 % 
(10 
%)       
TRADI
NG 
BOOK Annex I, 
Para. 35, first 
sentence 
Dir. 
2006/49/EC Reduced 
specific 
risk 
requireme
nt for 
certain The Competent Authorities may allow 
certain equity portfolios to be assigned a 
specific risk requirement of 2% instead of 
4%. 80 % 20 %     
 
 165  Exercise of options and national 
discretions by Member States 
Area Directive 
2006/48 
(unless 
indicated 
2006/49) Denominati
on Description Yes 
(with 
provis
o) No Not 
yet 
decide
d N/A 
equity 
portfolios 
TRADI
NG 
BOOK Annex I, 
Para. 35 (last 
sentence) 
Dir. 
2006/49/EC Alternativ
e 
maximum 
weight of an 
individual 
position in 
an 
institution'
s equity 
portfolio The Competent Authorities may authorise 
that individual positions represent a 
maximum of 10% of the total equity 
portfolio (instead of 5% as in the Directive), 
provided that the sum of such positions do 
not exceed 50%. 70 % 27 %   3 % 
TRADI
NG 
BOOK Annex III, 
Para. 2.1, last 
sentence 
Dir. 
2006/49/EC Discretion
al use of 
net present 
value for 
determinin
g the open 
position in 
currencies 
or gold The Competent Authorities have the 
discretion to allow institutions to use net 
present value when determining their open 
positions in currencies or gold. 80 % 20 %     
TRADI
NG 
BOOK Annex III, 
Para. 3.1 
Dir. 
2006/49/EC Lower 
capital 
requireme
nts for 
closely 
correlated 
currencies The Competent Authorities may allow 
institutions to provide lower capital 
requirements for positions in closely 
correlated currencies, as defined in the 
Directive. 57 % 43 %     
TRADI
NG 
BOOK Annex IV, 
Para. 7 
Dir. 
2006/49/EC Definition 
of 
'positions 
in the 
same 
commodit
y' The Competent Authorities may regard, in 
some cases, different but closely linked 
commodities as the same, for the purposes 
of calculating the pos ition in a commodity. 77 % 
(3 %) 20 %     
TRADI
NG 
BOOK Annex IV, 
Para. 8 
Dir. 
2006/49/EC Capital 
requireme
nt for 
exchange-
traded 
commoditi
es OTC 
commodit
y 
derivatives 
cleared by 
a clearing 
house Subject to certain conditions, the Competent 
Authorities may allow that the capital 
requirement for an exchange-traded 
commodity, or an OTC commodity 
derivative cleared by a clearing house to be 
equal to the margins required by the 
exchange or the clearing house, 
respectively. 33 % 
(3 %) 64 %     
TRADI
NG 
BOOK Annex IV, 
Para. 10 
Dir. 2006/49/EC Prescriptio
n of 
specific methodolo
gies for 
the 
calculation 
of delta for 
derivatives 
on 
commoditi
es The Competent Authorities may prescribe 
that delta for commodity derivatives be 
calculated following methodologies specified by them. 30 % 
(7 %) 63 %     
 
 166  Exercise of options and national 
discretions by Member States 
Area Directive 
2006/48 
(unless 
indicated 
2006/49) Denominati
on Description Yes 
(with 
provis
o) No Not 
yet 
decide
d N/A 
RADIN
G 
BOOK Annex IV, 
Para. 10, 
three last 
subparagraph
s 
Dir. 
2006/49/EC Capital 
requireme
nt for 
exchange-
traded 
options 
and OTC 
options 
cleared by 
a clearing 
house Subject to certain conditions, the Competent 
Authorities may allow that the capital 
requirement for an exchange-traded written 
option, or an OTC option cleared by a 
clearing house to be equal to the margins 
required by the exchange or the clearing 
house, respectively. Also OTC bought 
options may be assigned the same 
requirement as the underlying commodity. 37 % 
(7 %) 57 %     
TRADI
NG 
BOOK Annex IV, 
Para. 14 
Dir. 
2006/49/EC Offsetting 
positions 
in the 
same 
commodit
y The Competent Authorities may allow 
positions in the same commodity - or in 
commodities regarded as the same - to be 
offset prior to assignment to the appropriate 
maturity band. 90 % 10 %     
 
 167  ANNEX III:  ECONOMIC AND FINANCIAL IMPORTANCE OF THE BANKING SECTOR IN EUROPE  
The size of the EU banking sector 
The EU banking sector is a key sector in the EU economy. In relative terms, the EU banking sector is larger than 
its US counter part, respectively 340% of GDP and 92% of  GDP in 2009. Until the outbreak of the crisis, the EU 
banking sector grew steadily, in terms of total assets, to  reach a maximum of over €45,000 bn in late 2008. After 
this peak, it slightly declined and stagnated at around €43,000 bn. 
Chart 1: Total assets of Euro Area MFIs 
MFIs excluding the Eurosystem. € bn 
1 5,00020,00025,00030,00035,00040,00045,000
2002 2003 2004 2005 2006 2007 2008 2009 2010EU 27
Euro Area
 
   Source : ECB: Aggregated balance sheet of EA MFIs and own calculations 
Chart 1 illustrates the increasing size of the banking sector  by plotting the evolution of the total assets of Euro 
Area Monetary and Financial Institutions (MFIs). Although MFIs include both money markets funds and credit 
institutions, the share of the former is relatively neg ligible (just over €1,000 bn, around 4% of MFIs).  
In 2008, the banking sector in EU27 was 3.4 times its GDP309. However, these aggregate figures hide very 
different realities across countries. The banking sector is, in general, much more developed in the old Member 
States than in the recently acceded ones. LU, MT, IE, CY, UK and DK have a very  important banking sector 
with a size over 4 times their GDP. On the other hand, RO, LT, PL, BG, SK, CZ are characterized by a banking 
sector smaller than th eir GDP (See Chart 2). 
Over the recent years (2005-2008), the banking sector grew steadily in most countries, although the growth has 
been particularly important in MT, IE, CY and DK.  
  
  
Chart 2: Total assets of credit institutions  with respect to GDP  
                                                 
309 It should however be kept in mind that GDP is an annual flow  while the size of the banking sector in terms of 
total assets is a stock. 
 
 168  
012345678
Luxembourg
Malta
Ireland
Cyprus
UK
Denmark
Netherlands
France
Austria
EU27
MU15
Belgium
Germany
Sweden
Spain
Portugal
Italy
Finland
Greece
Estonia
Slovenia
Latvia
Hungary
Czech Rep
Slovakia
Bulgaria
Poland
Lithuania
Romania
2005
 2006
 2007
 2008
 
Note : Values for Luxembourg  ranked from 26.2 in 2005 to 25.4 in 2008. 
           Source: European Central Bank and own calculations. 
The EU banking sector is the main financing source for the real economy (see next section). It is also a major 
contributor to the added value of our economies and an important employer. The EA financial sector generates an added value of over €400 bn (equivalent to 5% of the GDP).  
The crucial role of bank intermediation fo r the real economy: intermediation vs. direct 
financing 
In general, financial system impacts allocative efficiency in the real ec onomy through its intermediary role, 
producing information about possible investments, mobilizing savings, monitoring investments, managing and 
diversifying risk as well as easing the exchange of goods and services. Empirical evidence would indicate that 
restricting bank activities has generally negative reperc ussions for economic growth although there may be a 
trade-off in terms of stability. Similarly, facilitating bank entry generally yields benefits in terms of competition 
and access to finance and so enhances  economic growth. Althou gh effects of competition on financial stability 
have been subject of controversy, most recent eviden ce suggests that increased competition via contestable 
markets is positive for stability.  
In the EU, the banking sector is the main financing source for the real economy. In th e Euro Area, almost 50% of 
the financing of the real economy is performed via banking loans310.   
In 2009, the outstanding amount of loans granted by Euro Area MFIs was €17,700 bn, while outstanding amount 
of securities issued in official markets were €15,300 bn for bonds and €4,400 bn for shares and equity. When the 
interbank loans and the securities issued by banks are not considered the figures were €11,750 bn for loans, €10,000 bn for bonds and €3,800 bn for shares and equity. 
It should be underlined that the role of the banks as providers of financing to the economy goes beyond their 
"direct" intermediation activity. Beyond the lending activities, MFIs are very active in both the equity and bond 
markets. Indeed, in 2009, EA MFIs held over €5,000 bn bonds and €1,200 bn shares, corresponding to 
approximately one third of the respective markets. Ther efore, taking into consideration the lending activity 
through loans and the financing through securities, the bank ing sector is responsible for about two thirds of the 
financing available in the Euro Area. 
 
 
Chart 3: Sources of financing in the Euro Area 
        Total, € bn     Excluding MFIs, € bn 
                                                 
310 Equity, bonds and loans not issued in official market or through the banking system are neglected. 
 
 169  02, 0004, 0006, 0008, 00010,00012,00014,00016,00018,000
1999 2001 2003 2005 2007 2009Total  loans
Total  bonds
Total shares
02,0004,0006,0008,00010,00012,00014,00016,00018,000
1999 2001 2003 2005 2007 2009Loans to non- MFIs
Bonds (non-MFIs)
Shares (non-MFIs)
 
        Total, %     Excluding MFIs, % 
0%20%40%60%80%100%
1999 2001 2003 2005 2007 2009Total shar es
Total bonds
Total loans
0%20%40%60%80%100%
1999 2001 2003 2005 2007 2009Shar es (non-MFIs)
Bonds ( non-MFIs)
Loans to non-M FIs
 
          Note: Data for bonds and shares issued outside  official markets are not available. 
          Source: European Central Bank and own calculations. 
Chart 4: Aggregate balance sheet of Euro Area MFIs 
MFIs excluding the Eurosystem 
2006           2009 
Loans to EA 
residentsDebt securitiesSharesExternal assetsRemaining assets
DepositsDebt securities  
iss uedExter nal  li abi l iti esCapital and reservesMMF sharesRemaining liabilities
0%10%20%30%40%50%60%70%80%90%100%
Assets LiabilitiesLoans to EA 
residentsDebt securitiesSharesExternal a ssetsRemaining  assets
DepositsDebt securities 
issuedExternal liabilitiesCap ital and 
reservesMM F sharesRem aining liabi lities
0%10%20%30%40%50%60%70%80%90%100%
Assets Liabilities 
         Source : European Central Bank and own calculations. 
The importance of financial regulation for fi nancial stability and sustainable growth  
While the banking sector generally contributes to economic  and financial development, the financial crisis has 
painfully revealed its weaknesses and the risks it bears for the entire economy. This section briefly reviews the 
 
 170  theory and empirical evidences regard ing the role of regulation (for example minimum capital requirement), the 
capacity to lend and the economic activity. 
A growing body of empirical research on the links between financial development and economic growth 
produces a remarkably consistent narrative: The services provided by the financial system exert a first-order impact on long-run economic growth.
311  
First, countries with better-developed financial systems te nd to grow faster. Specifically, countries with (i) large, 
privately-owned banks that funnel credit to private enterprises and (ii) liquid stock exchanges tend to grow faster than countries with corresponding lower levels of financial development. The level of banking development and 
stock market liquidity each exerts an  independent, positive influence on economic growth. Second, simultaneity 
bias (whether economic growth leads to financial development or vice versa) does not seem to be present, suggesting that it is indeed financial development that co ntributes to economic growth. Third, better-functioning 
financial systems ease the external financing constraints that impede firm and industrial expansion. Thus, one 
channel through which financial development matters for growth is by easing the ability of financially 
constrained firms to access ex ternal capital and expand. 
Building on this last point, some studies suggest this is due to a "broad credit channel" (Oliner and Rudebusch, 
1996), where the supply of funds comes from all financial intermediaries and markets, not just banks. This view is supported by Discroll (2004) who finds that for U.S. states, bank loans themselves have small, often negative and statistically insignificant effects on output. This coul d be due to the fact that firms are not in fact bank-
dependent, and are able to substitute other forms of fina nce, such as bond or equity financing for firms with 
ready access to such markets, trade cred it or other kinds of borr owing from other firms in  the case of firms which 
do not have such access.  
The existence of a credit channel operating through the banking system cannot be denied however. Kroszner, 
Laeven and Klingebiel (2007) analyse the effects of financia l crisis on externally dependent sectors in both, well- 
and poorly-developed financial systems. They show that in times of crisis, externally dependent sectors 
(comprised of young firms or firms with a large fraction of hard-to-measure intangible assets) tend to experience 
a greater contraction of value added in well-developed, financial systems than in countries with shallower 
financial systems. Their reasoning is that a deeper financ ial system allows sectors dependent on external finance 
to obtain relatively more external funding in normal peri ods, so a crisis that significantly impairs the functioning 
of banks has a disproportionately negative effect on externally dependent firms in such systems. In contrast, 
since externally dependent firms tend to obtain relatively less external financing in shallower financial systems, a 
crisis in such countries has less of an effect on the growth of these s ectors. Similarly, the authors find a 
disproportionately negative impact of banking crises on re al growth in sales, real gr owth in earnings, and real 
stock returns for firms in externally dependent industri es. While these results might suggest a dark side of 
financial development, the authors do not find evidence that on net the externally dependent firms fare worse in 
deep financial systems. 
Overall, while the finding that financial development has a positive impact on economic growth is generally 
accepted , an important limitation of almost all studies on  financial development and growth should be noted: 
There is a significant difficulty in designing empirical  proxies for “financial development” (Levine and 
Demirgüç-Kunt, 2008).  
There are two reasons for this difficulty: First, researchers do not have very good cross-country measures of the 
ability of financial systems to provide their services (to facilitate the screening of firms before they are financed, 
the monitoring of firms after they are financed, the managing of idiosyncratic project risk and liquidity risk, as 
well as the exchange of good s, services, and financial claims) to the economy. Second, international financial 
market integration makes the size of a domestic financial sy stem an inadequate indicator  of efficiency gains in 
terms of accessibility to credit and fina ncial services, intermediation costs, or productivity of capital employed 
(Guiso et al. 2004).  
Traditional approaches to bank regulation emphasize the positive features of capi tal adequacy requirements 
(Dewatripont and Tirole, 1994). Capital serves as a buff er against losses and hence failure. Furthermore, with 
limited liability, the proclivity of banks towards higher risk  activities is curtailed with greater amounts of capital 
                                                 
311 The following paragraph builds on work by Bagehot (1873), Gurley and Shaw (1955), Goldsmith (1969), and 
McKinnon (1973), recent research has employed different econometric methodologies and data sets in 
producing three core results (Levine and Demirgüç-Kunt, 2008) 
 
 171  at risk. Capital adequacy requirements, especially with deposit insurance, play a crucial role in aligning the 
incentives of bank owners with depositors and other creditors (Berger et al., 1995).  
As reviewed in Santos (2001) and Gorton and Winton (2003), however, theory provides conflicting predictions 
as to whether the imposition of capital requirements will have positive effects on stability and growth. For instance, Kim and Santomero (1988), Besanko and Kanatas (1996), and Blum (1999) argue that capital requirements may increase risk-taking behaviour . Furthermore, Thakor (1996)  models the impact of an 
increase in risk-based capital requirements and concludes these reduce banks’ willingness to screen and lend. In 
a general equilibrium context, Gorton and Winton (2000)  show that raising capital requirements forces banks to 
supply fewer deposits, reducing the liquidity-providing role of banks
312.  
Barrell et al. (2009) argue that changing capital and liquidity ratios  changes the probability of financial 
crises . They show that it would have been beneficial in terms of output to have had a one or even two percentage 
point higher level of capital and liquidity requirements in the UK prior to the current crisis. These results do not 
hold for the Euro Area or the US as they argue that a cr isis in the UK was more likely, suggesting that with 
higher probabilities for a crisis, higher capital requi rements are beneficial for long-term economic output313.   
As banking sector plays a central role  in economy any changes in regulatory  environment that have impact on 
banking sector should indirectly affect also economic  activity. The existing literature suggests the following 
relationships between the regulation and economic growth: 
- Effects of capital requirements and leverage ratios on sustainable financial development are ambiguous; yet 
it is suggested that combining these policies may yield positive results.  
- Effects of deposit insurance in terms of financial stability are ambiguous as they can reduce the systemic 
risk associated with bank runs but may reduce incentives for risk management in covered institutions and incentives for private sector oversight.  
- Strong supervisory power on banks is beneficial for building robust legal systems. 
- Evidence on the effectiveness of private sector monitoring of banks is ambiguous.  
- Bank governance is found to be relevant to financial stability in two important respects: 
- Bank risk is generally higher in banks that have concentrated ownership with substantial cash flow rights. 
- The relation between risk and regulation depends criti cally on each bank’s ownership structure, because it 
can determine whether the impact of regulation is either positive or negative with regard to stability. 
- While private ownership of banks entails risks and needs careful design, government ownership of banks 
usually yields lower levels of financial development and growth, yet more concentrated lending and higher systemic fragility. 
Available evidence from the cost of financial (banking) crisis 
As illustrated in the previous section, financial and banking regulation is crucial to the stability of the sector and eventually the long-term econo mic growth. These findings are further unde rlined by the eviden ce on the cost of 
past (and current) financial and banking crisis and provide a good rationale for designing and implementing appropriate regulation. 
Financial crises, defined as systemic banking crises
314, which can be aggravated by foreign exchange or 
sovereign debt crises, are particularly socially costly, not  only for the rescue of ailing institutions but also in 
terms of opportunity costs and foregone growth. The traditi onal computations of the cost of such a crisis for a 
country are based on a calculation of its direct and indirect fiscal costs, as described in the graph below. 
                                                 
312  It should be noted that this literature does not take into account the Basel II framework where the more direct 
link between capital requirements and the specific risk of banks’ activities may help to ease any 
incentive problems in risk management. 
313 They also refer to the case of Sp ain where the robustness of the banks shows the value of higher capital. 
314 Following the definition of Leaven and Valencia (2008) cited by the "Public Finances in EMU 2009" of the 
European Commission 
 
 172   
However, these fiscal costs do not in clude costs borne by depositors and borrowers, stemming from exposure to 
failed banks, or when facing higher costs for serv ices provided by banks that compensate for losses. 
The debate also focuses on the best way to compute the ec onomic costs of a banking crisis and the extent of what 
is referred to as the output gap caused by this crisis . The literature offers differe nt means to conduct such 
calculations. On the one hand, it would be possible to approximate output losses as the difference between output 
growth before and a few years after the crisis – usually the time that it returns to its trend; on the other hand, to 
be more accurate, the difference could be computed in levels rather than in growth rates of GDP. Finally, 
econometric estimations of output gaps allow controlling for the bias that could come from "normal" cyclical 
output variations. 
The European Commission analysed em pirically in its publication, Public Finances Report in the EMU 2009,  
the costs of 49 crises that  occurred in emerging and market economies since the 1970s. Consistent with the 
figures found by Leaven and Valencia (2008), the Commissi on reported an average direct  net cost of 13%, i.e. 
expenses due only to the rehabilitati on of the banking sector and already accounting for the recovery that the 
government can get from the sale or repayment of impair ed assets that it had to buy – even though the average 
recovery rate did not exceed 18% of the initial gross outla ys. Focusing only on the EU27, these figures show an 
average net fiscal cost of 6.6% of GDP, with a 23.9% recovery ratio, both under the OECD averages 
(respectively 11.4% of GDP and 29.7%). 
All in all, the net fiscal costs of the la st financial crisis should be rather gr eater than those of past crises, mainly 
because of its global nature, and given the recent expansio n of the banking sector and low foreseen recovery of 
impaired assets. In the EU, according to the Commission re port, these net fiscal costs could reach 16.5% of GDP 
on average, with higher figures for so me Member-States taken individually.  
Indeed, as it appears in the graphs below, the extent of cap ital injections and of guarantees on bank liabilities, in 
terms of percentage of GDP, varied greatly from one European country to another, respectively from 1% to 7% and from 1% to almost 240%. 
Chart 6: Public interventions in the banking sector (% of GDP)  - situation at 31/12/2009  Chart 05: The costs of a financial crisis  
 
Source: European Commission, DG Economic and Financial Affairs (2 009): "Public Finances in EMU 2009", European Economy 5, 
10th edition  
 
 173  
012345678
I E LU BE NL U K DK DE AT LV EU EA GR FR I T SE HU PT FI PL SK
Total approved injections
 Effective capital injections 
 
   Source : Commission Services 
Beyond the direct burden of the banking rescue measures, the indirect costs of past financial crises have also 
weighted significantly on social wealth. The gross public debt-to-GDP ratio has on average grown by 18% in the 
course of the years when past crises  occurred, under the multiple pressures of automatic stabilizers and fiscal 
stimuli. In addition to this expenditure effect (+1.1% of GDP in EU27 on average), financial crises also trigger a 
loss through the revenue effect (on aver age -0.9% in the EU27), notably in terms of foregone tax payments, as 
well as a potential strong market effect leading to higher premia on interest payments. 
This consequence is particularly worr ying because of its long-term implica tions. Indeed, in the sample analysed 
by the Commission, it took governments at least eight year s to come back to pre-crisis levels of debt-to-GDP 
ratios, driven up both by the changes in the primary defi cit and by the "snow-ball effect" of interest payments. 
Chart 7: Guarantees on bank liabilities (% of GDP)  
02040608010 0
DK IE BE SE NL SI FI LV AT EU UK EA DE ES CY FR PT LU GR HU SK PL
Total approved guarantees
 Effective guarantees granted
 
       Notes:   Denmark: 237.5% approved guarantees and 205.3% effective guarantees granted. 
Ireland: 167.5% approved and ef fective guarantees granted. 
       Source :  Commission services 
 
 174  ANNEX IV: LIQUIDITY COVERAGE RATIO AS SPECIFIED IN FEBRUARY 2010  PUBLIC 
CONSULTATION  
The public consultation of February 2010 by the Commission services included the following possible 
specification of the LCR.  As regard s the buffer of high quality liquid a ssets, the Commission services consulted 
on the impact of both a narrow  regulatory definition of liquid assets com posed of cash, central bank reserves and 
high quality sovereign debt, as well as a somewhat broader  definition which could also include a proportion of 
high quality corporate bonds and/or covered bonds. 
Item Factor                     
(to be multiplied against 
total amount) 
Stock ("buffer") of "hig h quality liquid assets"  
Cash and qualifying central bank receivabl es (including reserves to the extent 
that they can be drawn do wn in times of stress) 100% 
Qualifying marketable securities from sovereigns, central credit institutions, 
public sector entities, and multi-lateral development banks that could receive a 
0% risk weight for credit risk under the standardised approach 100% 
Domestic sovereign or central bank debt in domestic currency 100% 
For not more than 50% of the buffer, the following additional assets could be 
considered: 
 
Corporate bonds not issued by institutions 
rated AA or higher  
A- to AA- 
 
Covered bonds not issued by the institution itself 
rated AA or higher 
rated A- to AA- 
 
to the extent that those corporate and co vered bonds are traded in large, deep 
and active markets characterised by a lo w level of concentration and a bid-ask-
yield spread that has not exceeded 40 bsp (assigned a 20% haircut) or 50 bsp 
(assigned a 40% haircut) neither during all of the last 10 years nor during a 
relevant period of significant liquidity stress. Furthermore, the maximum 
historic decline of price or increase in haircut over a 30-day period neither 
during the last 10 years nor during a relevant period of significant liquidity 
stress may not exceed 10%. 
  
 
 
 
80% 
60% 
 
 
80% 
60% 
 Cash Outflows over 30 days under the regulatory stress  scenario, taking into account the earliest possible 
call or termination date for the funding  
Retail deposits placed by a natural person (rather than a legal entity), but 
excluding deposits placed by sole prop rietorships and partnerships. However 
deposits by a legal entity, sole proprietorship or partnership where the 
reported sales for the consolidated group of which the firm is a part are less 
than €50 million and the total aggregated funding raised from one such 
customer is less than €1 million may be treated as retail.    
- stable deposits that are both covered by an EEA deposit insurance scheme (or 
a non-EEA scheme recognise d as effective by competent authorities) and are 
made in transactional accounts (e.g. acc ounts where salaries are automatically 
credited) or the depositors have other established relationships with the same 
bank which make deposit withdrawal highly unlikely; 7.5% 
- less stable retail deposits [additional sub-categories to be determined] 15% or higher for possible 
sub-categories 
Unsecured wholesale funding:   
- non-financial corporates, no operational (cash management, salary 
disbursement etc. to be defined further) relationship with credit institution 75% 
- non-financial corporates, sovereigns, central banks and public sector entities 25% of deposits needed for 
 
 175  Item Factor                     
(to be multiplied against 
total amount) 
with operational relationships  operational purposes 
- other legal entity customers and sovereigns, central banks, and PSEs without 
operational relationships  100% 
Secured funding:   
Funding from repo of assets not e ligible for the buffer and securities 
lending/borrowing transactions where assets  not eligible for the buffer are lent 
out 100%  
Liabilities related to derivative collateral calls related to a downgrade of up to 
3-notches 100% of collateral that 
would be required to cover 
the contracts in case of up to 
a 3-notch downgrade 
Market valuation changes on derivatives transactions requiring additional 
collateral/margin treatment still to be 
determined 
Valuation changes on posted non-cash or non-high quality sovereign debt collateral securing derivative transactions  20% 
ABCP, SIVs, Conduits, etc: 100% of maturing amounts 
and 100% of returnable 
assets 
Term ABS (incl. structured covered bonds) 100% of maturing amounts 
Currently undrawn portion of committed credit and liquidity facilities  to:   
- retail clients 10% of outstanding lines 
- non-financial corporates; credit facilities 10% of outstanding lines 
- non-financial corporates; liquidity facilities 100% of outstanding lines 
 -- other legal entity customers 100% of outstanding lines 
Other contingent funding liabilities (s uch as guarantees, letters of credit, 
revocable credit and liquidity facilities etc) treatment still to be 
determined 
Planned outflows related to renewal or extension of new loans (retail or 
wholesale) and any other cash outflows (including planned derivative payables) 100% 
Cash Inflows   
Amounts receivable from retail counte rparties 100% of planned inflows 
from performing assets 
Amounts receivable from wh olesale counterparties 100% of planned inflows 
from performing wholesale 
customers 
Receivables in respect of repo and revers e repo transactions backed by assets 
not eligible for the buffer and securities lending/borrowing transactions where 
assets not eligible for the buffer are borrowed. 100%  
Receivables in respect of repo and revers e repo transactions backed by assets 
eligible for the buffer and securities lending/borrowing transactions where 
assets eligible for the buffer are borrowed. 0% 
Undrawn portion of liquidity lines or other facilities committed to the 
institution 0% 
 
 176  ANNEX V: NET STABLE FUNDING RATIO AS SPECIFIED IN FEBRUARY 2010  PUBLIC 
CONSULTATION  
The public consultation of February 2010 by the Commission services included the following possible 
specification of the NSFR.   
 
Assets requiring stable funding Required 
Stable 
Funding 
Factor 
All cash immediately available to meet obligations not held for operational purposes, not currently encumbered as collateral and not held for planned use as contingent collateral.   
All short-term unsecured instruments and transactio ns with outstanding maturities of less than 
one year.
315 
All securities with stated remaining maturities of  less than one year with no embedded options 
that would increase the expected ma turity to more than one year.  
All securities held where the institution has an offsetting reverse repurchase transaction when 
the security on each transaction has the same unique identifier (e.g. ISIN)  
All loans to financial entities with effective ma turities of less than one year that are not 
renewable and for which the lender has an irrevocable right to call. When the loan is secured, the underlying collateral must have a maturity of less than one year.  0% 
Unencumbered marketable securities with residual maturities over one year representing claims 
on or claims guaranteed by sovereigns, central banks, BIS, IMF, EC, non-central government public sector entities (PSEs) or multilateral deve lopment banks which are rated AA or higher 
and are assigned a 0% risk-weight under the cred it risk standardised approach, provided that 
active repo-markets exist for these securities.  5% 
Unencumbered corporate bonds316 or covered bonds317 satisfying all of the following 
conditions:  
- Central bank eligibility for intraday liquidity needs or overnight liquidity shortages in 
relevant jurisdictions.318 20% 
                                                 
315 Such instruments include but ar e not limited to: short-term governme nt and corporate bills notes and 
obligations; commercial paper; negotiable certificates of deposits; reserves with central banks and sale 
transactions of such funds (e.g. fed funds sold); bankers acceptances; money market mutual funds. 
316 Corporate bonds  are plain vanilla assets whose valuation is easy and standard and does not depend on private 
knowledge, i.e. no complex structured products, no subordinated debt. 
317 Covered bonds eligible under point 68 of Annex VI of Directive 2006/48/EC 
318 Central bank eligibility: This is an optional criterion for jurisdictions whose list of central bank eligible assets 
is only very narrowly defined. In those jurisdictions, the relevant supervisors may exercise discretion to Sources of stable funding availabl e for purposes of the requirement Availability 
Stable funding 
Factor 
Own funds eligible instruments and other liabilities > 1year residual term 100% 
Stable deposits of retail and small business customers  
(non-maturity or residual maturity < 1year) 85% 
Less stable deposits of retail and small business customers  
(non-maturity or residual maturity < 1year) 70% 
Wholesale funding provided by non -financial corporate customers  
(non-maturity or residual maturity < 1year) 50% 
All other liabilities and equity not included above  0% 
 
 177  Assets requiring stable funding Required 
Stable 
Funding 
Factor 
- Not issued by a credit institution, investment or insurance or financial services firm and 
in particular not issued by the respective firm itself 
- Low credit risk: assets have a credit assessme nt by a recognised ECAI equivalent to at 
least AA, or do not have a credit assessment by a recognised ECAI and are internally rated 
as having a PD equivalent to that associ ated with a AA credit assessments of ECAIs 
- Proven record as a reliable source of liquidity in the markets (repo and sale) even during 
stressed market conditions: ie maximum price change or increase in haircut over a 30-day 
period during the last 10 years or during a relevant period of significant liquidity stress not 
exceeding 10%. 
- Traded in large, deep and active markets ch aracterised by a low level of concentration. 
The bid-ask-yield spread has not exceeded 40 bsp during the last 10 years or during a relevant period of significant liquidity stress.   
Unencumbered gold, corporate bonds, covered bond s, and equity securities that satisfy all of 
the following conditions:  
- Central bank eligibility for intraday liquidity needs or overnight liquidity shortages in 
relevant jurisdictions.319 
- Not issued by a credit institution, investment, insurance, or financial services firm (except in the case of covered bonds). 
- Not issued by the respective firm itself 
- Low credit risk: assets have a credit assessme nt by a recognised ECAI of at least single 
A, or do not have a credit assessment by a re cognised ECAI and are internally rated as 
having a PD equivalent to that associated with a single A credit assessments of ECAIs 
conform the Basel II Accord. 
- Traded in large, deep and active markets ch aracterised by a low level of concentration. 
The bid-ask-yield spread has not exceeded 50 bsp during the last 10 years or during a 
relevant period of significant liquidity stress. 
- Listed on a recognised exchange and included in a large cap market index. 
All assets held in the trading book that are no t securities or loans that satisfy all of the 
following conditions.  
- The instrument’s fair value can be determin ed based on inputs that are quoted prices 
(unadjusted) in active markets for identi cal assets at the measurement date.  
- Traded in large, deep and active markets ch aracterised by a low level of concentration. 
The bid-ask-spread has not exceeded 50 bsp duri ng the last 10 years or during a relevant 
period of significant liquidity stress. 
- Listed on a recognised exchange in multiple time zones and included in a main index. 
Loans to non-financial corporate clients having a maturity of less than one year. 50% 
Loans to retail clients (ie natural persons) having a maturity of less than one year. 85% 
All other assets not included in the above categories.  100% 
                                                                                                                                                         
allow non-central bank eligible corporate bonds prov ided that they meet the other respective criteria 
above.  
319 Central bank eligibility: This is an optional criterion for jurisdictions whose list of central bank eligible assets 
is only confined to tier 1 assets. In those jurisdictions, the relevant supervisors may exercise discretion 
to allow non-central bank eligible corporate bonds provided that they meet the other respective criteria 
 
 178  ANNEX VI: ELIGIBILITY CRITERIA FOR CORE TIER 1, NON -CORE TIER 1 AND TIER 2 
REGULATORY CAPITAL AS SPECIFIED IN FEBRUARY 2010  PUBLIC CONSULTATION  
The public consultation of February 2010 by the Commission services included the following possible eligibility 
criteria for regulatory capital. 
Eligibility criteria for core Tier 1 capital 
1. Represents the most subordinated claim in liquidation of the institution. 
2. Entitled to a claim of the residual assets that is pr oportional with its share of issued capital, after all 
senior claims have been repaid in liquidation, i.e. has an unlimited and variable claim, not a fixed or capped 
claim.  3. Principal is perpetual and never repaid outside of liquidation, setting aside discretionary repurchases or 
other means of effectively reducing capital in a disc retionary manner that is allowable under national law. 
4. The institution does nothing to create an expectation at issuance that the instrument will be bought back, 
redeemed or cancelled nor do the statutory or contractual terms provide any feature which might give rise to 
such an expectation. 5. Distributions are paid out of distributable items (re tained earnings included). The level of distributions 
are not in any way tied or linked to the amount paid in at issuance and are not subject to a cap, except to the 
extent that an institution is unabl e to pay distributions that exceed the level of distributable items. 
6. There are no circumstances under which distributio ns are obligatory. Non-payment is therefore not an 
event of default. 
7. Distributions are paid only after all legal and contractual obligation have been met and payments on more senior capital instruments have been made. There ar e no preferential distributions, including in respect of 
other elements classified as the highest quality issued capital.  
8. It is the issued capital that takes the first and prop ortionately greatest share of any losses as they occur. 
Within the highest quality capital, each instrument absorbs losses on a goin g concern basis proportionately and 
pari passu with all the others. 
9. The paid in amount is recognised as equity cap ital (i.e. not recognised as a liability) for determining 
balance sheet insolvency. 
10. The paid in amount is classified as eq uity under the relevant accounting standards. 
11. It is directly issued and paid-up.  12. The paid in amount is neither secured nor covered by a guarantee of the issuer or related entity or 
subject to any other arrangement that legally or ec onomically enhances the seniority of the claim. 
13. It is only issued with the approval of the owners of the issuing institution, either given directly by the 
owners or, if permitted by applicable law, given by the Board of Directors or by other persons duly authorised by 
the owners. 14. It is clearly and separately disclosed on the institution's balance sheet. 
Eligibility criteria for non-core Tier 1 capital 
1. Issued and paid-up. 2. Subordinated to depositors, general creditors and subordinated debt of the institution. 3. Is neither secured nor covered by a guarantee of th e issuer or related entity or other arrangement that 
legally or economically enhances the seniority  of the claim vis-à-vis institution creditors. 
4. Is perpetual: there is no maturity date and no incentive to redeem. 5. May be called at the initiative of the issu er only after a minimum of five years. 
 a. To exercise a call optio n an institution must receive prior supervisory approval.  
 b. An institution shall do nothing that creates an expectation that the call will be exercised.  c. An institution shall not exercise a call unless: 
  i) it replaces the called instrument with ca pital of the same or better quality and the 
replacement of this capital is done at conditions which ar e sustainable for the income capacity of the institution; 
or 
  ii) the institution demonstrates fully to the competent authorities that its capital position would 
be well above the minimum capital requirements after the call option is exercised. 6. Any repayment of principal (e.g. through repurchase or redemption) shall be subject to prior approval 
by the competent authorities. An institution shall not assu me or create market expectations that such approval 
will be granted. 
7. Dividend/coupon discretion. 
 a. An institution shall have full discretion at all times to cancel distributions / payments.  
 
 179   b. Cancellation of discretionary payments shall not be an event of default. 
 c. An institution shall have full access to cancelle d payments to meet obligations as they fall due. 
 d. Cancellation of distributions / payments shall not impose restrictions on the institution except in relation to distributions to common shareholders. 
8. Dividends / coupons shall be paid out of distributable items. 
9. The instrument shall not have a credit sensitive dividend feature, that is a dividend that is reset periodically based in whole or in part on the current cred it standing of the institution's or that of its group.  
10. The instrument shall not contribute to liabilities exceedi ng assets if such a balance sheet test forms part 
of national insolvency law. 11. An instrument classified as a liability for the purposes of national insolvency law shall have principal 
loss absorption through either: conversion to common shar es at an objective pre-speci fied trigger point or a 
write-down mechanism that allocates losses to the instru ment at a pre-specified tr igger point. A write-down 
shall: 
 a. Reduce the claim of the instrument in liquidation;  b. Reduce the amount re-paid when a call is exercised; and 
 c. Partially or fully reduce coupon / dividend payments on the instrument. 
12. The issuing institution or a related party shall not knowingly purchase, or directly or indirectly fund the purchase of, the instrument. 
13. The instrument shall not have an y feature that could hinder recapita lisation, such as provisions that 
require the issuer to compensate investors if a new instru ment is issued at a lower pr ice during a specified period. 
14. If an instrument is not issued out of an operating entity in the consolidated group (e.g. a Special Purpose 
Vehicle or holding company), proceeds must be immediately available withou t limitation to an operating entity 
in the consolidated group in a form which meets or exceeds all of the other eligibility criteria for non-Core Tier 1 Capital. 
Additional requirements 
The criteria above shall also apply to an instrument that appears in the conso lidated accounts as a minority 
interest.  
This element of capital shall be net of the appropriate corresponding deductions related to holding of non-
common equity capital instruments in other financial institutions. 
Eligibility criteria for Tier 2 capital 
1. Issued and paid-in. 
2. Subordinated to depositors and general creditors of the institution 
3. Is neither secured nor covered by a guarantee of th e issuer or related entity or other arrangement that 
legally or economically enhances the seniority of the cl aim vis-à-vis depositors and general institution creditors 
4. Maturity  a. Has a minimum original ma turity of at least 5 years. 
 b. Recognition in regulatory capital in the rema ining 5 years before the repayment date will be 
amortised on a straight line basis.  c. There are no incentives to redeem. 
5. May be callable at the initiative of the issuer only after a minimum of five years. 
 a. To exercise a call option an institution must receive prior approval by the competent authorities. 
 b. An institution shall not do anything that creates an expectation that the call will be exercised. 
 c. Institutions shall not exercise a call unless: 
  i. they replace the called instrument with capital of the same or better quality, and the 
replacement of this capital is done at conditions which ar e sustainable for the income capacity of the institution; 
or 
  ii. the institution demonstrates fully to the competent authorities that its capital position would be well above the minimum capital requirements after the call option is exercised. 
6. An investor in the instrument shall have no rights to accelerate the repayment of future scheduled 
payments (coupon or principal), except in bankruptcy and liquidation. 7. The instrument shall not have a credit sensitive dividend feature, that is a dividend that is reset 
periodically based in whole or in part on the institution's current credit standing or that of its group. 
8. The institution or a related party shall not have kn owingly purchased, or directly or indirectly have 
funded the purchase of, the instrument 
9. If the instrument is not issued out of an operating entity in the consolidated group (e.g. a Special Purpose Vehicle or holding company), the proceeds sha ll be immediately available without limitation to an 
operating entity in the consolidated group in a form which meets or exceeds all of the other criteria for inclusion 
in Tier 2 Capital. 
Additional requirements 
 
 180  These criteria shall also apply to instruments which appe ar in the consolidated accounts as minority interest.  
This element of capital will be net of the appropriate corresponding deductions related to holding of non-
common equity capital instruments in other financial institutions. 
 
 181  ANNEX VII:  REGULATORY ADJUSTMENTS AS SPECIFIED IN FEBRUARY 2010  PUBLIC 
CONSULTATION  
Prudential filters and deduc tions from the Core Tier 1 
Stock surplus 
Stock surplus (i.e., share premium) may be included in Core Tier 1 only if the shares giving rise to the stock 
surplus qualify as Core Tier 1 capital. Stock surpluses relating to shares excluded from Core Ti er 1, e.g., preference shares, shall be included in the 
same elements of capital as the shares to which they relate.  
Minority interests 
Minority interests may not be included in Core Tier 1. 
Goodwill and other intangibles 
Goodwill and other intangibles shall be deducted from Co re Tier 1 capital. The amount deducted shall be net of 
any associated deferred tax liability that would be extin guished if the goodwill became impaired or derecognised 
under the relevant accounting standards.  
Deferred tax assets 
Deferred tax assets th at rely on future profitability of the institution to be realised shall be deducted from Core 
Tier 1. The amount deducted shall be net of deferred tax liabilities. Deferred tax assets that do no t rely on the future profitability of the institution to be realised - e.g. prepayments 
to tax authorities – shall be assigned the relevant sovereign risk weighting under the institution's approach to 
credit risk for the sovereign asset class, i.e. St andardised or Internal Ratings Based Approach.  
Investments in own shares (treasury stock) 
An institution’s investments in its own common shares sh all be deducted from Core  Tier 1 capital (unless 
already derecognised under the relevant accounting sta ndards). Any own stock which the institution could be 
contractually obliged to purchase shall be deducted from Core Tier 1 capital. The treatment described would 
apply irrespective of the location of the exposure in th e non-trading book or the trading book. In addition: 
 - gross long positions shall be deducted net of short positions only if the short positions involve no counterparty risk; and 
 - institutions shall look through holdings of i ndex securities to deduct exposures to own shares. 
Investments in the common shares of certain banking,  financial and insurance entities which are outside 
the regulatory scope of consolidation 
Institutions shall apply a ‘corresponding deduction appr oach’ to investments in the capital of other credit 
institutions, other financial institutions and insurance entitie s where they fall outside of the regulatory scope of 
consolidation. The deduction shall be applied to the same component of capital for which the capital would 
qualify if it were issued by the institution itself. All holdings of capital which form part of a reciprocal cross holding agreement or are investments in affiliated 
institutions (e.g. sister companies) shall be deducted in full on a corresponding basis. For all other holdings, the 
corresponding deduction approach would apply when the holdings exceeded certain thresholds. For holdings of common stock the thresholds shall be as follows: 
 - if an institution has holdings of common stock in  other credit and financial institutions which exceed 
10% of the common stock of the other cr edit and financial institutions then the full amount of this holding shall 
be deducted from the institution’s Core Tier 1 capital; and 
 - if a institution has holdings of common stock in other credit and financial institutions which in 
aggregate exceed 10% of the institution’s Core Tier 1 (a fter applying all other regulatory deductions) then the 
amount above 10% shall be deducted from th e institution's Core Tier 1 capital.   
This treatment described shall apply irrespective of whethe r the exposure is assigned to the non-trading book or 
the trading book. In addition:  - gross long positions may be deducted net of short positions only if the short positions involve no 
counterparty risk; and 
 - institutions shall look though holdings of index securities to deduct relevant exposures to financial institutions which exceed the threshold limits. 
Shortfall of the stock of prov isions to expected losses 
Any shortfall in the stock of provisions compared with the expected loss amount under the Internal Ratings 
Based (IRB) approach shall be ma de from Core Tier 1 capital. 
Cash flow hedge reserves 
The positive and negative cash flow hedge reserve should be removed from Core Tier 1 capital where it relates 
to the hedging of projected cash flows th at are not recognised on the balance sheet. 
Gains and losses due to changes in own cred it risk on fair valued financial liabilities 
 
 182  All gains and losses resulting from changes in the fair value of liabilities that are due to a changes in the 
institution’s own credit risk shall be removed from Core Tier 1 capital. 
Defined benefit pension fu nd assets and liabilities 
No filter shall be applied to net defined benefit pension fund liabilities. 
The value of any defined benefit pension fund net asset should be deducted from Core Tier 1 capital. Subject to 
supervisory approval, assets in the fu nd to which an institution has unfettered access could be permitted to offset 
the deduction. Such offsetting assets should be assigned the risk weight th ey would receive if they were owned 
directly by the institution. 
Remaining 50:50 deductions 
All remaining deductions currently made 50% from Tier 1 and 50% from Tier 2, and which are not addressed elsewhere in the proposal, should receive a 1,250% risk weight. These include: 
 - certain securitisation exposures;  - certain equity exposures under the Probabil ity of Default / Loss Given Default approach; 
 - free deliveries; and  
 - significant investments in commercial entities. 
 
 183   A NNEX VIII:  ASSESSMENT OF ADMINISTRATIVE COSTS AND BURDENS  
Implementation of legislation entails costs for businesses. Costs that are linked to providing information either to 
public or private parties are called administrative costs. The share of these costs that is specifically linked to 
information that businesses would not collect and provide in the absence of a legal obligation is called administrative burdens. The Commission's Better Regulation strategy is aimed at measuring administrative costs 
and reducing administrative burdens.
320  
In the area of prudential banking regulation, certain info rmation requirements are n ecessary to provide for the 
desired level of financial stability and creditor protection an d, hence, should be set at a level that ensures an 
equilibrium between ensuing administrative burdens and the benefits that they yield. With regard to the 
legislative changes brought forward with this initiative, it ha s to be noted that they were undertaken with a view 
to achieving multiple opera tional, specific and general objectives and had to be designed accordingly.  
In August-September 2010, the Commi ssion services distributed a questionnaire about the impacts of CRD IV 
proposal on administrative cost to the members of the Group of Experts in Banking issues (GEBI). The 
questionnaire was distributed directly to 25 bank me mbers of the Group and to members of the following 
industry associations: European Banking Federation, European Savings Banks Group, European Association of Co-operative Banks, European Association of Public Banks and European Federation of Building Societies. 
In total, 24 replies from institutions  in 10 Member States were received an d of them, 16 (6 Gr oup 1 banks and 10 
Group 2 banks) were considered in the analysis of administrative burdens of the individual parts of the CRD IV proposal. A number of replies were omitted from this analysis as they contained estimated impacts only at the 
overall package level. It shall be noted that replies from Group 1 banks generally showed a wider dispersion of 
estimates than replies from Group 2 banks. For this reas on, in the calculation of administrative burdens of Group 
1 banks median answers were used as inputs, whereas for Group 2 banks, means were largely used.   
Since the questionnaire referred to  the consultative documents of the Basel Committee of December 2009 and 
announcement of the GHOS of July 2010  as the basis for the estimation of administrative burden s, the eventual 
administrative burdens may be different to the extent th at final CRD IV provisions will differ from the above 
texts. A number of respondents have indicated that the figures - where provided - represent their best-effort 
estimates, as they are still in the process of assessing th e implications of Basel III on their operations, including 
on costs related to reporting and information prov ision. Also, the below estimates overestimate the 
administrative costs and burdens to the extent that they were extrapolated based on the sample of banks almost 
entirely composed of larger institutions (particularly w ith regard to Group 2) from EU-15, whereas i) FTE-
related annual costs are not distributed evenly across the EU-27 and ii) individual proposals (e.g., counterparty 
credit risk) may impact less, if at all, the sma llest EU banks with a simple balance structure. 
Comparing the impacts of different policy tools on administrative burdens (see table below), it can be observed 
that they vary depending on the bank type. In terms of administrative burdens on the on-going basis, Group 1 
banks are the most affected by the proposals for count erparty credit risk, while Gr oup 2 banks are the most 
affected by the new proposals in the area of liquidity risk management. The same observations hold for the one-
off investment costs.  
Overall, annual administrative burden, for Group 1 and Group 2 banks combined, due to the CRD IV provisions that are linked to Basel III is estimated to fall in the area of €3.2 billion (of them, 31% driven by LCR and 38% 
by NSFR), or approximately 0.008% of the EU bank assets . In terms of activities that would drive such costs, the 
respondents most frequently referred to data collecti on, IT/systems maintenance related costs, data quality 
assurance, analysis & review, management reporting and publication of information. 
One-off costs are estimated in the range of €6.9 billi on or approximately 0.016% of the EU bank assets. 
Similarly to the on-going annual costs, these implementation-related expenditures are expected to be the highest in relation to the LCR (31% of all one-off costs) and the NSFR (38% of all one off-costs). With respect to the 
one-off costs, it needs to be kept in mind that they would be spread over a number of years, particularly, given 
the transitional provisions of the CRD IV.  The questionnaire also included a set of questions pertaining to the impact of proposals on the single rule book. 
The Commission services anticipate that the eventual impact in this area will vary by Member State (depending 
on the current exercise of national options and discretions and the extent of 'gold-plating') and bank type whereby banks with more cross-border activity would benefit from harmonization of the rules the most. 
However, the sample size was insufficiently big and diverse to allow for the estimation of the impacts while 
simultaneously giving due consideration to the above factors. 
                                                 
320 For more on the Commission's approach towards dealing with administrative costs and burdens please see: 
http://ec.europa.eu/governance/better_regulation/admin_costs_en.htm   
 
 184  Table:  Administrative burden of CRD IV by the area 
No. Ass. Art.Orig. 
Art.Type of 
obligationDescription of 
required 
action (s)Target group i e i e Int EU Nat Reg
1N / ANon-labelling 
information for third partiesOther Group 1 banks
59 2.672 156.750 1 50 50 7.837.500 100%
2N / ANon-labelling 
information for 
third partiesOther Group 1 banks 132.750 1 50 50 6.637.500 100%
3N / ANon-labelling 
information for 
third partiesOther Group 2 banks 53 816 42.848 1 4.500 4.500 192.813.750 100%
4N / ANon-labelling 
information for 
third partiesOther Group 2 banks 165.300 1 4.500 4.500 743.850.000 100%
Total administrative costs (€) 951.138.750
Administrative costs by origin (€) 951.138.750
No. Ass. Art.Orig. 
Art.Type of 
obligationDescription of 
required 
action (s)Target group i e i e Int EU Nat Reg
1N / ANon-labelling 
information for third partiesOther Group 1 banks
64 3.244 207.600 1 50 50 10.380.000 100%
2N / ANon-labelling 
information for third partiesOther Group 1 banks
900.000 1 50 50 45.000.000 100%
3N / ANon-labelling 
information for 
third partiesOther Group 2 banks 55 3.935 216.403 1 4.500 4.500 973.814.202 100%
4N / ANon-labelling 
information for 
third partiesOther Group 2 banks 455.758 1 4.500 4.500 2.050.908.797 100%
Total administrative costs (€) 3.080.102.999
Administrative costs by origin (€) 3.080.102.999
No. Ass. Art.Orig. 
Art.Type of 
obligationDescription of 
required 
action (s)Target group i e i e Int EU Nat Reg
1N / ANon-labelling 
information for third partiesOther Group 1 banks
64 3.375 216.000 1 50 50 10.800.000 100%
2N / ANon-labelling 
information for 
third partiesOther Group 1 banks 875.900 1 50 50 43.795.000 100%
3N / ANon-labelling 
information for 
third partiesOther Group 2 banks 53 5.083 267.580 1 4.500 4.500 1.204.110.462 100%
4N / ANon-labelling 
information for 
third partiesOther Group 2 banks 574.419 1 4.500 4.500 2.584.883.485 100%
Total administrative costs (€) 3.843.588.948
Administrative costs by origin (€) 3.843.588.948Comments & Assumptions
Median 2 FTE at 120000 euros per year 
and BAU factor of 10%. One off cost after BAU factor of 5%
Mean 3,3 FTE at 99000 euros per year an
d
BAU factor of 17%. One off cost after 
BAU factor of 17%Mean 2,5 FTE at 103000 euros per year 
and BAU factor of 15%. One off cost after 
BAU factor of 15%
NSFRTariff
(€ per hour)Time 
(hour)Price
(per action 
or equip)Freq 
(per year)Nbr 
of 
entitiesTotal nbr
of 
actionsTotal costRegulator y
origin
(%)Total costRegulator y
origin
(%)Comments & Assumptions
Median 2 FTE at 120000 euros per year 
and BAU factor of 14%. One off cost after BAU factor of 10%Total nbr
of 
actionsTotal costRegulator y
origin
(%)
LCRTariff
(€ per hour)Time 
(hour)Price
(per action 
or equip)Freq 
(per year)Nbr 
of 
entitiesTotal nbr
of 
actionsComments & Assumptions
Median 1,5 FTE at 110000 euros per year 
and BAU factor of 5%. One off cost after BAU factor of 10%
Mean 1,5 FTE at 110000 euros per year 
and BAU factor of 13%. One off cost after 
BAU factor of 13%ADMINISTRATIVE BURDENS OF CRD IV
Capital definitionTariff
(€ per hour)Time 
(hour)Price
(per action 
or equip)Freq 
(per year)Nbr 
of 
entities
 
Table:  Administrative burden of CRD IV by the area (continued) 
 
 185  No. Ass. Art.Orig. 
Art.Type of 
obligationDescription of 
required 
action (s)Target group i e i e Int EU Nat Reg
1N / ANon-labelling 
information for third partiesOther Group 1 banks
59 2.813 165.000 1 50 50 8.250.000 100%
2N / ANon-labelling 
information for third partiesOther Group 1 banks
350.000 1 50 50 17.500.000 100%
3N / ANon-labelling 
information for third partiesOther Group 2 banks
37 700 25.913 1 4.500 4.500 116.606.663 100%
4N / ANon-labelling 
information for third partiesOther Group 2 banks
67.475 1 4.500 4.500 303.638.925 100%
Total administrative costs (€) 445.995.588
Administrative costs by origin (€) 445.995.588
No. Ass. Art.Orig. 
Art.Type of 
obligationDescription of 
required 
action (s)Target group i e i e Int EU Nat Reg
1N / ANon-labelling 
information for third partiesOther Group 1 banks
64 10.055 643.500 1 50 50 32.175.000 100%
2N / ANon-labelling 
information for third partiesOther Group 1 banks
2.550.000 1 50 50 127.500.000 100%
3N / ANon-labelling 
information for third partiesOther Group 2 banks
16 971 15.430 1 4.500 4.500 69.437.160 100%
4N / ANon-labelling 
information for third partiesOther Group 2 banks
115.698 1 4.500 4.500 520.639.845 100%
Total administrative costs (€) 749.752.005
Administrative costs by origin (€) 749.752.005
No. Ass. Art.Orig. 
Art.Type of 
obligationDescription of 
required 
action (s)Target group i e i e Int EU Nat Reg
1N / ANon-labelling 
information for third partiesOther Group 1 banks
53 1.688 90.000 1 50 50 4.500.000 100%
2N / ANon-labelling 
information for third partiesOther Group 1 banks
0 1 50 50 0 100%
3N / ANon-labelling 
information for third partiesOther Group 2 banks
65 1.796 117.422 1 4.500 4.500 528.400.717 100%
4N / ANon-labelling 
information for third partiesOther Group 2 banks
91.851 1 4.500 4.500 413.331.066 100%
Total administrative costs (€) 946.231.783
Administrative costs by origin (€) 946.231.783Regulator y
origin
(%)Comments & Assumptions
Median 1 FTE at 100000 euros per year 
and BAU factor of 10%. One off cost after BAU factor of 0%
Mean 1 FTE at 122000 euros per year and 
BAU factor of 6%. One off cost after BAU factor of 6%Freq 
(per year)Nbr 
of 
entitiesTotal nbr
of 
actionsTotal cost Capital buffersTariff
(€ per hour)Time 
(hour)Price
(per action 
or equip)Median 6,5 FTE at 120000 euros per year 
and BAU factor of 18%. One off cost after BAU factor of 15%
Mean 0,6 FTE at 30000 euros per year an
d
BAU factor of 16%. One off cost after 
BAU factor of 16%Counterparty credit riskTariff
(€ per hour)Time 
(hour)Price
(per action 
or equip)Freq 
(per year)Nbr 
of 
entitiesTotal nbr
of 
actionsTotal costADMINISTRATIVE BURDENS OF CRD IV
Total costRegulator y
origin
(%)Regulator y
origin
(%)Comments & Assumptions
Median 1,5 FTE at 110000 euros per year 
and BAU factor of 0%. One off cost after BAU factor of 0%
Mean 0,4 FTE at 70000 euros per year an
d
BAU factor of 9%. One off cost after 
BAU factor of 9%
Comments & AssumptionsLevarege ratioTariff
(€ per hour)Time 
(hour)Price
(per action 
or equip)Freq 
(per year)Nbr 
of 
entitiesTotal nbr
of 
actions
 
 
 186  ANNEX IX: QUANTITATIVE IMPACT OF THE CRD  IV: QUEST  MODEL  
Set up 
QUEST III321 is a standard closed economy dynamic stochastic general equilibrium (DSGE) model with a 
banking sector subject to regulatory policy. The model distinguishes three types of private actors in addition to a 
central bank and a government322. The private sector consists of consumers (saver households), entrepreneurs 
(firms) and a banking sector which intermediates savings and investment .   
 
In order to ensure a positive share of loans in the balan ce sheet of entrepreneurs it is assumed that they have a 
higher rate of time preference than  savers. It means that entrepreneurs prefer to use profits for their own 
consumption today than to save them for investment tomorrow. In this case the solvency of entrepreneurs requires that banks restrict lending by imposing a collateral constraint. This specification closely follows 
Kiyotaki and Moore (1997)
323; the constraint is a reaction to inform ation asymmetries between borrowers and 
lenders – only the borrowers have information about thei r willingness and ability to repay; thus lenders require 
collateral. 
The behaviour of the different agents in QUEST III is described below. 
Savers:  Savers maximise an intertemporal utility function with co nsumption, liquidity services from deposits and leisure 
as arguments. Savers can hold wealth either in the form of government bonds, bank deposits or bank equity and 
receive interest income from bonds and deposits and dividends as well as  capital gains from bank equity. There 
is an exogenous equity premium on bank stocks. Savers also offer labour services to entrepreneurs and banks 
and receive wage income.  
Entrepreneurs:  Entrepreneurs maximise an intertemporal utility func tion over entrepreneurial consumption (coming from 
profits), subject to an intertempo ral budget constraint, a technologi cal constraint, a capital accumulation 
constraint and a collateral constraint  along the lines suggested by Kiyota ki and Moore (1997). They combine 
capital and labour to produce output using a constant-returns-to-scale (CRS) technology. The output market is 
monopolistically competitive. Entrepreneurs demand labour and make investment decisions. They partly finance investment by taking out loans.  
Banks
324:  
                                                 
321 QUEST III is a New-Keynesian Dynamic Stocha stic General Equilibrium model (DSGE) with 
microeconomic foundations derived from utility and profit optimisation. It includes imperfections in 
goods, labour and financial markets. More information about QUEST III, as well as developments in 
incorporating a financial sector in the model can be found here: http://ec.europa.eu/econo my_finance/research/macroeconomic_models_en.htm
   
322 A Deposit Guarantee Scheme is part of the government setup.  
323 Kiyotaki, N. and J. Moore (1997), Credit Cycles , Journal of Political Economy 105, pp. 211-248 
324 Interbank market can be included with a separation of banks to savings and investment banks. Savings banks 
can be modelled to collect deposits from households, and to only lend to investment banks in the Consumers  
(Households) 
DepositsBanks 
Entrepreneurs 
(Firms) DGSCentral  
Bank 
Consumption 
Goods Labour Bank EquityDGS Contribution
LoansGovernment Taxes Cash 
Bonds Labour 
 
 187  Banks provide loans to entrepreneurs and receive deposits and bank capital from savers. They pay taxes, 
purchase government bonds and contribute to a deposit guarantee scheme (DGS), and receive liquidity from the 
central bank (cash in the form of credits to their reserve account at the central bank).  
Banks maximise their stock market value (present discounted value of future dividend stream) subject to a cash 
flow constraint and a capital and liquidity requirement constraints. Banks can increase capital either by issuing 
new shares or via retained earnings. Both strategies yield identical results. Banks use labour in order to provide intermediation services. Labour in banks is divided in overhead (fixed) labour and variable labour that is 
proportional to loans. The banks pay wages to employ ed labour, and a levy on non-deposit liabilities. Banks 
provide contributions to a DGS.   Government policy (monetary po licy, fiscal policy and DGS): 
The central bank sets the policy rate  according to a standard Taylor rule. The governme nt taxes labour, capital 
and consumption and uses the revenues to finance government purchases of goods and services as well as 
transfers. There is a debt rule which fixes the level of government debt to a target in the long run. Revenues from 
bank levy are collected by the government. DGS contribu tions are collected by the DGS and used to purchase 
government bonds; income generated is added to the banks' DGS contributions. 
Equilibrium is defined as a set of optimality conditions for th e agents and a set of prices that clear all markets.   
Calibration 
All parameters describing behaviour of the non-financial sector are taken from Ratto et al. (2009)325. Our 
preferred balance sheet concept for the banking sector is a consolidated balance sheet, which provides 
information about the stock of loans to the non financial sector. This gives us the leverage position of the non 
financial sector, and yields an accurate estimate of the (loan) capital cost of  the private sector. This is important 
for calculating the macroeconomic im pact of the regulatory measure.326 
The interest data are from the ECB and other EU27 central banks. The pre-crisis figures (2004-2008) suggest a 
loan interest rate of 5.2%, a deposit rate of 2.5% and a rate on government bonds of 4.2%. For the rate of return on bank equity we use a value of 14.3%.
327  
V. Escudero (2009)328 reports that the employment share of financial intermediaries in total employment is about 
3% in EU27 citing Eurostat. Another important characteristic  of loan interest rate determination is a mark up 
over marginal costs charged by ba nks. Recent empirical estimates see Christopoulou et al. (2008)329, show a 
mark up of 58% in the euro area, which is at the uppe r end across sectors. Though it is economically plausible 
that mark up in financial intermediati on is significant because of large overhe ad costs and fixed capital, mark up 
estimates as conducted in this study are likely to be overestimated, s ee Konings et al. (2011)330 if there are fixed 
costs. Therefore we assume a mark up that is close to 30% . The share of labour in banking that is subject to cost 
optimization under new regulation is 75%. 
Pass-through of effects  
In the model banks must observe a minimum capital requi rement, which is a ratio of Tier I capital to risk-
weighted assets331. Whenever the minimum capital re quirements increase the banks face higher costs of capital 
                                                                                                                                                         
interbank market. Investment bank in turn can be modelled to issue bank equity and to borrow from 
households in the form of deposits or from savings banks on the interbank market.  
325 Ratto, M., Roeger W. and Veld, J. in 't, QUEST III: An estimated open-ec onomy DSGE model of the euro 
area with fiscal and monetary policy , Economic Modelling, 2009, vol. 26, No. 1, pp 222-233  
326 Because the model is based on the un consolidated balance sheet of the ba nking sector for EU 27 it uses the 
assumption that the ratio of loans to the non financial sector and interbank loans is slightly higher in EU 
27 compared to the EA. Based on the consolidated EA balance sheet published by the ECB, loans to the non financial sector are about 140% of GDP, hence, QUEST III uses a value of 150% of GDP for EU 
27.  
327 This value is taken from BCBS MAG report and refers to the RoE for the year 2006 of a hypothetical 
European bank for eight European countries (AT, BE , FI, FR, DE, IT, NL), excluding the UK banks, 
which typically have shown higher RoE.  
328 Escudero V., Effects of the Crisis on the Financial Sector: Trends and Policy Issues , International Institute 
for Labour Studies, Discussion Paper 197, 2009 
329 Christopoulou R, P. Vermeulen, Markups in the Euro Area and the US over the Period 1981-2004, a 
Comparison of 50 Sectors , ECB Working Paper, 856, 2008 
330 Konings Josef, W. Roeger, L. Zhao, Price-cost Margins and S hares of Fixed Factors , CEPR Discussion 
Paper, 8290, 2011 
331 The model distinguishes between two types of assets: liq uid, which are given a risk  weight of 5% and illiquid 
which are given a risk weight of 55%. The risk weig hts are the average risk weights for credit risk as 
 
 188  since the return on bank equity is higher than the deposit rate.332 In the model they can respond by obtaining 
more capital through retained earnings, thus decreasing profits, or through issuing new capital, these two options 
produce equivalent results. QUEST III models a complete pass-through of higher capita l costs to the banks' clients via an increase in the 
intermediation spread. The loan interest rate in the model is determined as a mark up over banks' marginal costs. 
Thus the acquisition of new bank capital translates into  an increase in borrowing cost s for firms and a decrease in 
aggregate lending, in the value of firm collateral, in aggreg ate investment and in GDP.  
At the same time banks are required to observe a liquidity requirement. They face an opportunity cost of holding 
more liquid assets than if they did not have to observe a liquidity requirement. The opportunity costs equal the difference between the higher rate of return on loans (illiq uid assets) and the lower rate of return on government 
bonds (liquid assets) that the banks earns  on the share of its assets that are required to be of the liquid type.  
The banks respond to the liquidity requirement in the following way. They increase the demand for deposits to 
meet it and have to pay a higher deposit interest rate (w hich is however still lower than the rate earned on liquid 
assets). This increases marginal bank funding costs, which are shifted onto loan interest rate. This reduces the 
demand for loans in the economy.
333 
Compliance with the minimum capital and liquidity requirements is instantaneous in each period of the model. 
Thus the actual and the required bank capital and liquidity ratios are the same in every period.  
The model pass-through is characterized by some mitigating factors .  
Industry representatives have often cl aimed that the increase in the capita l requirement increas es funding costs 
for banks because they have to use more equity to fund loans. This statement has been contested in the finance 
literature; see Admati et al. (2011)334 and Miles (2011)335. Against this statement, reference is usually made to 
the Modigliani Miller theorem  (1958)336 which stipulates that the structur e of corporate financing does not 
matter (if one disregards tax and subsidy considerations which may affect debt and eq uity differently) because a 
change in the composition of corporate liabilities only distri butes the risk which must be borne by equity owners.  
In the baseline parameter setting of the QUEST model (no MM applicability), the equity premium is 
exogenous337, because the stochastic environment faced by households, firms and banks is not fully specified. 
However in a simpler two-period version of QUEST which is  analytically more tractable it can be shown that the 
MM theorem holds.  
Therefore two additional specifications of the applicability of the MM theorem for bank equity have been included. The rate of return on bank equity is equal to the risk free rate plus an equity premium which depends 
on the covariance of the loan losses (per unit of equity) with the marginal utility of investors in bank capital. 
Under the assumption that the change in capital requiremen ts does not change the riskiness of bank operations, 
an increase in capital requirem ents leads to a proportional decline in the equity premium, because the same risk 
is distributed over a larger equity base. In our first additional specification, the MM theorem holds in full (100%). If the only risk for the shareholder comes from loan default risk, an increase in capital requirements 
would be completely offset by a fall in the equity premium and funding costs should not change.  
Whether a fall in the risk premium could offset increas ed capital requirement by 100% is however questionable. 
Apart from tax considerations (see Modigliani-Miller (1963)
338), there may be other factors which require a 
premium for households to invest in bank equity. In acc ordance with theory, the empi rical evidence in Miles et 
                                                                                                                                                         
reported in 2008 by the Banking Supervision Committee (BSC) of the European System of Central 
Banks  
332 The deposit rate is the rate of return on bank debt. Toge ther with return on bank equity they represent cost of 
funding for the banks.   
333 Notice also, the demand for liquid assets and deposits incorporates all the restrictions imposed on bank 
behaviour implied by the capital and liquidity requirement constraints. An important implication of the 
capital requirement is that the bank is forced to in crease the demand for deposits in such a way as to 
comply with it. 
334 Admati, A., P. DeMarzo, M. Hellwig, P. Pfleiderer (2010), Fallacies, Irrelevant Facts, and Myths in the 
Discussion of Capital Regulation: Why Bank Equity is Not Expensive , Stanford GSB Research Paper, 
No. 2065 
335 Miles, D., Yang, J., and G. Marcheggiano (2011), Optimal bank capital , Bank of England Discussion Paper 
No. 31 
336 Modigliani, F.; M. Miller (1958), The Cost of Capital, Corporation Finance and the Theory of Investment,  
American Economic Review 48 (3): 261–297 
337 This assumption was also retained because it was the working hypothesis of the BCBS MAG report 
338 Modigliani, F.; M. Miller (1963), Corporate Income Taxes and the Cost of Capital: A Correction , American 
Economic Review 53 (3): 433–443 
 
 189  al. (2011) and Kashyap et al. (2010)339 does not show a full offset. Therefore in our second additional 
specification the MM offset holds at 50%,  in line with these empirical results. 
Under the new bank regulatory regime the minimum capital requirements rise. In the absence of any MM offset of higher capital requirements the return on bank equity decreases initially since lower investment demand puts a 
downward pressure on the risk free rate. Over the trans ition period equilibrium investment is restored and the 
risk free rate returns to its steady state thus the return on  bank equity reverts under but very close to its baseline. 
Thus when a new steady state is reached in the long run, in the case when the MM theorem is assumed not to 
hold, the return on bank equity is practically unchanged as the capital requirements increase. In this result 
QUEST differs from industry studies which find substantial post regulation decrease in the return on bank equity under no MM offset. The return on bank equity in QUEST falls below its baseline only when the MM theorem is 
assumed to hold (either in full or partially).      
The information asymmetry in financial intermediation in QUEST III is evident in borrower's collateral 
constraint. When bank regulation brings about higher capital requirements and banks increase the spread 
between loan and deposit rates, the present discounted value of firms' future profits are reduced since firms now have to pay more in order to borrow. Higher firm capital costs result in a decrease in the market value of the 
stock of firm capital and therefore the market value of  firm collateral. Banks are prompted by changes in 
minimum capital requirements to ration the supply of loans based on the firms' abilities to pledge collateral. Higher capital and liquidity requirements raise firm borrow ing costs. In response entrepreneurs start reducing 
leverage and gradually shift to using more own resources in financing their investment decisions. Lower firm 
leverage reduces credit rationing by the bank and thus mitigates financial market imperfections. Finally as the regulatory requirements increase, banks respond by optimizing labour employed in providing 
intermediation services. The model treats three quarters of th e labour employed in banking services as a variable 
factor of production. Whenever banks face higher regulatory requirements th ey increase their interest rate on 
loans and decrease their volume of le nding as loan demand by borrowers falls. Banks are allowed to optimize the 
quantity of labour they use for up to three quarters of the labour employed.
340  
The evolution of the model variables as a result of changes in bank regulation   
In QUEST III, agents are modelled to be forward looking. Firms face investment adjustment costs and a 
collateral constraint. In anticipation of the increase in the cost of loans, they adjust today's behaviour responding 
to tomorrow's increase in regulatory requirements an d banks' intermediation margin. In addition, current 
investment decisions are discounted with a higher future discount rate. Thus the model reports a macroeconomic impact even prior to the implemen tation of the regulatory changes. 
When banks are required to hold more capital their ma rginal costs increase since equity funding is more 
expensive than funding by deposits (the increase in the risk premium of bank equity can be partly or fully offset 
by the applicability of the MM theorem). Banks respond by optimizing assets and liabilities on their balance 
sheets so that all the increase in the margin al costs is transferred to customers. They increase  own capital
341, 
supply fewer loans  and attract more deposits , so that the intermediation margin betw een the loan rate and 
the deposit rate increases342.  
The applicability of the MM theorem determines the magnitude of the response of bank funding costs. If the MM theorem holds, the return on bank equity  decreases. Still bank funding is more expensive than in the 
baseline as new regulation requires a higher share of bank equity funding. If the MM theorem does not hold the 
return on bank equity stays below but very close to its baseline value and funding costs increase even more.  As the intermediation spread increases  borrowing becomes relatively more expensive and firms hold less capital 
thus lowering the value of the collateral that they can pledge against borrowing. As a result firms invest less and 
start relying more on internal sources of funding for their investment decisions. Aggregate investment  in the 
economy decreases, reachin g its lowest point below the baseline al ong the new regulatory implementation 
schedule before stabilizing to a less negative value below the no-change-in-regulation tr end later on. Since firms 
become more self-reliant firm cost of capital increases only during an initial shock in the very short run then 
                                                 
339 Kashyap A., S. G. Hanson, J. C. Stein (2010), An Analysis of the Impact of “Substantially Heightened” 
Capital Requirements on Large Financial Institutions , mimeo 
340 QUEST III assumes that three quarters of the bank employees are not entrusted with managerial and cross-
product servicing tasks but are directly engaged in marketing, originating and servicing loans thus are 
subject to layoffs if bank lending decreases.   
341 Since banks hold more capital today the NPV of their infinite dividend stream increases substantially.   
342 The increase in the bank intermediation margin is not only  a result of a higher loan rate but also a higher rate 
on deposits. Had the deposit rate remained constant the rise in the loan rate for the same increase in the 
intermediation margin would have been lower and the negative impact of new regulation would have been lower. Banks offer higher ra tes on deposits because they try to  expand their balance sheets in 
meeting the liquidity requirement. 
 
 190  decreases or increases only moderately along the implem entation schedule. Firm cost of capital changes not only 
in response to changes in bank lending spreads but also in response to changes in the shadow price of bank 
collateral.    Lower investment is translated into lower GDP, since lower capital accumulation m eans less output. In the long 
run it also translates into  lower consumption  and less time spent at work ( lower employment ). Employment 
falls because less capital translates into lower labour productivity and lower wages. Even though consumption represents the largest part of GDP in national accounting the impact on investment through increased costs of 
borrowing is higher and drives down the GDP.  
Consumption rises above the baseline be fore and during the model periods, in which implementation takes place, 
due to the increase in the opportunity costs of saving. As banks prepare for the implementation of the new 
regulatory regime by increasing the intermediation margin  consumers are better off using their current wealth in 
today's consumption rather than saving it in the form of bank deposits or bank equity, which are then to be 
transformed into future consumption
343. 
For the purpose of calibrating  the change in the mi nimum capital requirements  the QUEST III model uses 
Tier 1 capital.344 The following three table show the impact on various variables when Tier 1 ratio is assumed to 
increase by 2.5 percentage points, depending on the assumption on MM offset (0%, 50% and 100%). 
2012 2013 2014 2015 2016 2017 2018 2019average   
2020-2030 2050
GDP -0.10 -0.11 -0.15 -0.20 -0.24 -0.28 -0.32 -0.36 -0.52 -0.85
consumption 0.24 0.44 0.45 0.40 0.36 0.31 0.26 0.20 -0.10 -0.71
investment -1.52 -2.34 -2.56 -2.70 -2.81 -2.87 -2.89 -2.89 -2.71 -2.35
labour hours -0.14 -0.11 -0.11 -0.13 -0.14 -0.14 -0.14 -0.14 -0.13 -0.10
volume of loans -0.27 -0.68 -0.84 -0.84 -0.94 -1.04 -1.13 -1.21 -1.51 -2.12
volume of deposits 2.97 2.71 2.63 2.69 2.46 2.22 1.97 1.72 1.48 1.00loan rate -0.19 -0.14 0.31 0.19 0.18 0.20 0.22 0.23 0.25 0.27deposit rate -0.15 -0.11 0.23 0.13 0.08 0.06 0.03 0.00 0.01 0.03
return on bank equity -0.25 -0.20 0.13 0.04 0.00 -0.02 -0.04 -0.06 -0.04 -0.01
firm cost of capital 0.47 0.12 0.00 0.01 0.02 0.03 0.04 0.06 0.07 0.10Cumulative impact of regulatory reforms: new quantitative and qualitative capital requirement, capital 
conservation buffer 
(0% MM offset ) 
Impact on macro variables (deviation from baseline in %)
Impact on bank variables (deviation from baseline in %)
 
Note: impact on rates (loan, deposit, return  on bank equity, firm cost of capital) expr essed as deviation in percentage points 
2012 2013 2014 2015 2016 2017 2018 2019average   
2020-2030 2050
GDP -0.05 -0.06 -0.08 -0.11 -0.14 -0.16 -0.18 -0.20 -0.26 -0.37
consumption 0.13 0.23 0.24 0.21 0.19 0.16 0.13 0.09 -0.08 -0.32
investment -0.82 -1.27 -1.39 -1.48 -1.54 -1.56 -1.56 -1.52 -1.24 -0.99
labour hours -0.08 -0.06 -0.06 -0.08 -0.08 -0.08 -0.08 -0.08 -0.06 -0.04
volume of loans -0.15 -0.37 -0.46 -0.46 -0.51 -0.57 -0.62 -0.66 -0.74 -0.92
volume of deposits 1.68 1.54 1.50 1.54 1.32 1.09 0.86 0.62 0.48 0.30loan rate -0.10 -0.07 0.18 0.11 0.10 0.12 0.13 0.14 0.13 0.11deposit rate -0.08 -0.05 0.14 0.09 0.05 0.02 0.00 -0.03 -0.01 0.01
return on bank equity -0.20 -0.26 -0.17 -0.32 -0.44 -0.56 -0.67 -0.79 -1.34 -1.93
firm cost of capital 0.25 0.06 0.00 0.00 0.01 0.02 0.03 0.04 0.04 0.04Cumulative impact of regulatory reforms: new quantitative and qualitative capital requirement, capital 
conservation buffer 
(50% MM offset ) 
Impact on macro variables (deviation from baseline in %)
Impact on bank variables (deviation from baseline in %)
 
Note: impact on rates (loan, deposit, return  on bank equity, firm cost of capital) expr essed as deviation in percentage points 
                                                 
343 The return on bank equity and the deposit rate decrease prior to the implementation of the new capital 
requirement because of higher co sts of bank capital and the incr ease in the intermediation spread 
respectively. As a consequence consumers start to sa ve less and consume more of their wealth. Due to 
habit formation consumption still remains above the no-change-in-regulation trend even after the rates 
on deposits and equity start rising again.    
344 Data used refer to EU 27 and end of 2009  
 
 191  2012 2013 2014 2015 2016 2017 2018 2019average   
2020-2030 2050
GDP -0.01 -0.01 -0.01 -0.02 -0.02 -0.03 -0.03 -0.03 0.01 0.13
consumption 0.01 0.02 0.02 0.02 0.01 0.01 -0.01 -0.02 -0.06 0.09
investment -0.08 -0.12 -0.15 -0.17 -0.19 -0.18 -0.14 -0.08 0.31 0.44
labour hours -0.01 -0.01 -0.02 -0.02 -0.02 -0.02 -0.02 -0.02 0.01 0.02
volume of loans -0.02 -0.04 -0.05 -0.05 -0.06 -0.08 -0.08 -0.07 0.07 0.34
volume of deposits 0.31 0.30 0.30 0.31 0.11 -0.10 -0.32 -0.55 -0.58 -0.44loan rate 0.00 0.00 0.03 0.02 0.03 0.03 0.04 0.04 0.00 -0.05deposit rate 0.00 0.01 0.04 0.04 0.01 -0.01 -0.04 -0.07 -0.04 -0.01
return on bank equity -0.13 -0.31 -0.48 -0.67 -0.88 -1.09 -1.30 -1.51 -2.64 -3.85
firm cost of capital 0.02 0.00 0.00 -0.01 0.00 0.01 0.01 0.02 0.01 -0.02Cumulative impact of regulatory reforms: new quantitative and qualitative capital requirement, capital 
conservation buffer 
(100% MM offset ) 
Impact on macro variables (deviation from baseline in %)
Impact on bank variables (deviation from baseline in %)
 
Note: impact on rates (loan, deposit, return  on bank equity, firm cost of capital) expr essed as deviation in percentage points  
 
 
 192  ANNEX X: OVERVIEW OF QUANT ITATIVE MODELS  
Several impact studies based on various modelling techniques have been carried out by industry associations and 
the public authorities. Most of these studies (especi ally ones commissioned or carried out by industry 
associations) concentrated on finding the impact on bank capital and loan volume and pricing. A few studies have translated the impact on banking further to the general macro-economy.  
Most of the studies focus on the negative impact of new banking regulation, in terms of the increase in the costs 
of new bank capital, rise in loan pricing and credit rationing, fall in investment and GDP. Only a few studies have attempted to find precise estimates of the benefits of stronger bank capital in terms of a decrease in the 
probability of a financial crisis. The BCBS LEI report dese rves to be mentioned. A summary of some of these 
studies can be found in below table. In general, the results of the studies performed by the banking industry are more pessimistic than the ones of 
public institutions as regards the decline in the volume of lending and the temporary and permanent decline in 
GDP. This is mainly due to the data quality, differen t economic assumptions, regulatory scenarios and modelling 
techniques used. For instance, impact of the regulato ry changes on the industry in the BCBS MAG study is 
based on results of the quantitative impact study (reflecting actual impact on the balance sheets of participating 
institutions), whereas industry studies for information that  is not publicly available have to rely on estimates. 
Also, the modelling techniques used by the industry such as simulati ons, accounting projec tions or simple 
macro-models are rather crude in deriving accurate macroeconomic results. Initially, the industry assumed a full 
implementation of all proposed changes under Basel III, but the final agreement was less binding. Moreover, their economic assumptions appear to swell the negative economic impact because: 
- banks are supposed to maintain a certain level of return on equity (RoE) (sometimes very high at pre-crisis 
level), without due recognition to the fact that sounder balance-sheets entail lower risk and therefore a reduction 
in RoE and the cost of capital; 
- the increase in the spreads between lending and deposit ra tes is fully translated only into higher lending rates 
not into a combination of higher lending rates and lower deposit rates; 
- the increased capital costs are not internalised by banks via cost efficiency measures or a reallocation of the 
assets; - non-bank credit channels in the economy are largely overlooked;  
- the transformation of the credit shock into an output imp act is based on past elastic ities which may differ in a 
radically changed economic environment In general, the direct translation of credit shocks into a long-term impact on output and other macro-economic 
variables is not optimal. The growth in nominal terms of bank credit is not the main factor driving output in an 
economy, but rather the efficient intermediation of real  savings towards productive activities. Changes in the 
volume of credit are partly accommodated in time via change s in relative prices. It op timises the use of real 
savings and factors of production in the economy and reduces the impact on output 
  
 
  
 
 
 
  
 
  
 
  
 
  
 
  
 
 
 193  Overview of selected public and industry st udies on the impact of regulatory reforms  
 Author Published Policy changes Methodology Results 
MAG BCBS 
MAG 
Group Final: 
December 
2010; 
Interim: August 
2010  TCE minimum ratio 
from 5.7% (estimated 
by BIS QIS) to 7%; a 
25% increase in holdings of liquid 
assets A macroeconomic impact 
via lending margin 
increases and reduced loan 
volumes. Macro impact through a set of structural 
and reduced-form models Capital requirement 
impact - GDP falls by 
0.22% relative to 
baseline (average for all countries and all 
models) 
LEI costs BCBS 
LEI 
Group August 
2010 Increase in TCE 
minimum ratio by 4%, 
introduction of NSFR  A macroeconomic impact 
via lending margin 
increases and reduced loan volumes. Macro impact 
through a set of structural 
and reduced-form models GDP falls by 0.61% 
relative to baseline 
(average for all countries and all 
models) 
LEI benefits BCBS 
LEI 
Group August 
2010 Increase in TCE 
minimum ratio from 
7% to 9%, introduction 
of NSFR Average frequency of a 
financial crisis per year: 
4.5%; median cumulative 
loss of crisis: 63% of pre-
crisis GDP; reduced-form and structural models 
estimate the impact on 
higher capital and liquidity 
on the probability of a 
crisis Probability of a 
systemic banking 
crisis falls from 3.3% 
to 1.6%; benefits rise 
from 0.76% to 1.82% of GDP per year 
FSA OP38 FSA 
NIESR 
(UK) July 2009 Increase of capital and 
liquidity requirements 
by 3 percentage pointsNiGEM model, higher 
capital and liquidity 
increase the price for bank 
credit  Net present benefit is 
7% of real GDP in 
2009 
IMF Staff 
Position 
Note 10/16 IMF November 
2010 From current Tier I 
ratio to Basel III ratio 
using new rules on capital deductions, 
market risk, risk 
weights A sample of 62 banks, 
balance sheet analysis If applied 
immediately the new 
capital rules will lower the core Tier I 
ratio of an average 
bank to 5.8% 
Cumulative 
impact  
report IIF IIF Interim: 
June 
2010; 
Update: 
October 2010  Tier I ratio increases to 
6%, overall ratio to 
8%, redefinition of 
capital, LCR, NSFR, a 
bank levy  Increased costs of capital 
via higher lending rates 
and lower loan volumes 
impacts credit growth 
which in turn impacts GDP growth   GDP falls by 4.7% 
relative to baseline 
(euro area) 
Basel III 
and 
European Banking  McKinsey 
November 
2010 Core Tier I 
requirement is 7%, 
LCR and NSFR introduction Capital calculated 
according to the proposed 
CRD changes Normalized industry 
return on equity less 
than 15%; bank implementation costs 
45-70 million euro 
JPMorgan Equity 
Research JP 
Morgan February 
2010 Separation of 
activities, increased 
capital requirement, LCR, NSFR, leverage 
ratio, dynamic 
provisioning, bank-specific taxes, 
resolution and 
recovery  A sample of 16 large 
banks, balance sheet 
analysis Average ROE falls 
from 13.3% to 5.4%