EN    EN EN 
 
EN    EN  COMMISSION OF THE E UROPEAN COMMUNITIES 
Brussels, 13.7.2009 
SEC(2009) 974 final 
  
COMMISSION STAFF WORKING DOCUMENT 
Accompanying document to the 
 
Proposal for a 
 
DIRECTIVE OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL 
 
amending Capital Requirements Directive on trading book, securitization issues and 
remuneration policies 
 
IMPACT ASSESSMENT 
 
[COM(2009) 362 final] 
[SEC(2009) 975 final] 
 
EN ii   EN 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. Background ................................................................................................................ .. 3 
2.2. Stakeholder Consultation ............................................................................................. 5 3. Problem Definition....................................................................................................... 6 3.1. Overview of the Capital Requirements Directive ........................................................ 6 
3.2. Capital Requirements for Trading Book...................................................................... 8 3.2.1. Shortcomings of VAR Models..................................................................................... 9 3.2.2. Trading Book Charge for Default Risk...................................................................... 12 3.2.3. Capital Requirements for Securiti zation Positions in Trading Book......................... 13 
3.3. Capital Requirements for Re-securitization Positions ............................................... 14 3.4. Disclosure of Securitization Risks ............................................................................. 16 3.5. Remuneration Schemes.............................................................................................. 17 3.5.1. Inappropriate Structure and Internal Control Systems............................................... 17 
3.5.2. Insufficient Supervisory Oversight ............................................................................ 18 3.5.3. Latest Developments and Need for Legislative Action ............................................. 19 3.6. Risks Inherent in Baseline Scenario........................................................................... 20 3.7. Is Action Necessary at EU Level? ............................................................................. 20 4. Objectives.................................................................................................................. . 21 
5. Policy Options, Impact Analysis and Comparison .................................................... 21 5.1. Trading Book ............................................................................................................. 2 3 
5.2. Re-securitization ........................................................................................................ 2 5 
5.3. Disclosure of Securitization Risks ............................................................................. 29 5.4. Supervisory Review of Remuneration Policies.......................................................... 30 5.5. Summary of Policy Options....................................................................................... 35 5.6. Cumulative Impact of Proposed Amendments .......................................................... 36 
5.6.1. Overall Benefits ........................................................................................................ . 36 
5.6.2. Compliance Costs....................................................................................................... 3 7 
6. Monitoring and Evaluation ........................................................................................ 39 Glossary....................................................................................................................... ............. 41 
Annex on Procyclicality........................................................................................................ ... 44 
 
 
EN 3   EN 1. INTRODUCTION  
The extent of the financial crisis has expos ed unacceptable risks pertaining to the current 
regulation of financial institutions and markets which have proved real and systemic in times of serious turbulence. According to the latest IMF
1 estimates, crisis-related writedowns on 
assets originated globally will reach $4.1 trillion by 2010, with global banking industry expected to bear about two thirds of the losses
2, half of which (or $1.4 trillion, equivalent to 
9% of EU's GDP) is now attri butable to European banks.  
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 nationa l governments undertook a 
broad range of unprecedented measures and initia tives with the bill thereof being shouldered 
by the taxpayer. These measures should be matched with a robust and internationally 
coordinated reform of regulator y weaknesses that transpired dur ing the crisis. In recognition 
of these weaknesses, already in 2008 the European Commission (Commission) proposed 
certain amendments3 to the bank regulation revising capital requirements for securitization 
positions and provisions on home-host supervisory issues and crisis arrangements.  
However, to prevent recent and present problems from occurring in the fu ture and ensure that 
risks linked to the broader i ssues of financial instability  and procyclicality are more 
effectively contained, additional changes to the EU capital regulation of banks are needed. Such changes would provide for restoring bus inesses' and citizens' trust in financial 
institutions as reliable intermediaries for transl ating their deposits into investment that is key 
for the long-term health of the EU economy.  
2. P
ROCEDURAL ISSUES AND STAKEHOLDER CONSULTATION  
2.1. Background 
The financial crisis has prompted a broad EU a nd international effort to identify the reasons 
behind the problems and develop effective policie s to tackle them head-on. Such reflection 
focused in on revising key elements of the Base l II bank capital framewor k in order to address 
concerns over capital adequacy, including the issue of procyclicalit y. In the buoyant years 
preceding the turmoil, credit institutions aggressi vely took risks that turned out to be not 
adequately captured by capital requirements, including the risks contained in the trading book. 
In order to achieve higher capital ratios cons idered appropriate by mark et participants, banks 
have had to seek fresh capital  in a difficult economic envir onment that, in turn, led to 
tightening of their lending standards, exacerb ating negative cyclical trends in the real 
economy (for more background on proc yclicality please see annex).  
As part of its efforts to deal with the financial crisis, in November 2008, the Commission 
mandated a High Level Group chaired by Mr. Jacques de Larosière to propose 
                                                 
1 IMF, Responding to the Financial Crisis and Measuring Systemic Risk  (Global Financial Stability Report), 
April 2009 
2 Of which only about one third has occurred so far 
3 Consisting of a proposal for a Directive of the European Parliament and of the Council amending Directives 
2006/48/EC and 2006/49/EC as regards banks affiliated to central institutions, certain own funds items, large 
exposures, supervisory arrangements, and crisis management, COM/2008/0602 final - COD 2008/0191, 
Commission Directive 2009/27/EC amending certain Annexes to Directive 2006/49/EC, and a draft Commission Directive amending Directive 2006/48/EC, submitted for the scrutiny of European Parliament on 
March 16, 2009 
 
EN 4   EN recommendations for reforming the European fi nancial supervision and regulation. The thirty 
one recommendations4 of the HLG represented a comprehe nsive set of concrete possibilities 
for regulatory5, supervisory and global repair action a nd were elaborated in the Commission's 
Communication6 for the spring European Council of March 4, 2009. 
The Communication outlined details of the ambitious reform of the European financial system 
that the Commission intends to propose over the course of 2009. The proposals that this 
impact assessment accompanies are listed in  the detailed action plan included in the 
Communication. With respect to initiatives geared to addre ssing perverse incentives and 
excessive risk-taking in the financial se rvices sector, the Co mmunication included a 
commitment to table a recommendation on re muneration practices in the sector, which7, 
together with a recommendation8 on remuneration of directors of listed companies, was 
adopted by the Commission on April 29, 2009. The communication9 accompanying the two 
recommendations set out additional steps necess ary for their more effective implementation, 
referring to a need to modify the Capital Requirements Directive10 (CRD) in order to bring 
banks' and investment firms' remuneration pol icies and their link with risk management 
clearly within prudential oversig ht laid out under the Directive11.  
At the international level, the G20 Declaration of April 2, 2009 on Strengthening of the 
Financial System12 conveyed the commitment of the global leaders13 to address the crisis with 
internationally consistent efforts that are ai med at strengthening transparency, accountability 
and regulation and include, among others, endors ing and implementing the principles of the 
FSF1415 on compensation and supporting sustaina ble compensation schemes as well as 
                                                 
4 http://ec.europa.eu/internal_market/fin ances/docs/de_larosiere_report_en.pdf   
5 Recommendations called for the Basel Committee to urgen tly amend rules with a view  to gradually increase 
capital requirements and reduce thei r pro-cyclical impacts and advo cated for a better alignment of 
compensation incentives with the long-term firm profitability and stronger supervisory oversight of the 
adequacy of financial institutions' compensation policies. 
6 http://ec.europa.eu/commission_barroso/president/pdf/press_20090304_en.pdf   
7 Commission Recommendation on remuneration policies in the financial services sector (C(2009) 3159/2) 
8 Commission Recommendation complementing Recommendations 2004/913/EC and 2005/162/EC as regards 
the regime for the remuneration of directors of listed companies (C(2009) 3177/2) 
9 Communication from the Commi ssion accompanying Commission Recommendation complementing 
Recommendations 2004/913/EC and 2005/162/EC as regards the regime for the remuneration of directors of listed companies and Commission Recommendation on remuneration policies in the financial services sector 
(COM(2009) 211/2) 
10 Consisting of Directive 2006/48/EC relating to the taki ng up and pursuit of the business of credit institutions 
and Directive 2006/49/EC on the capital adequacy of investment firms and credit institutions 
11 The impact assessment accompanying the Commission Recommendation on remuneration in the financial 
services sector has conducted an analysis of the impacts of introducing the principles on remuneration policy 
on which the CRD supervisory oversight would build. The present report therefore discusses only incremental 
impacts of including key elements of these principles under supervisory oversight for credit institutions and investment firms through relevant legislative changes.  
12 http://www.g20.org/Documents/Fin_Dep s_Fin_Reg_Annex_020409_-_1615_final.pdf   
13 European leaders expressed their support for these meas ures at the European Council of March 19-20, 2009 
14 The Financial Stability Forum 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 st ability in significant international financial centres, 
international financial institutions, sector-specific inte rnational groupings of regulators and supervisors, and 
committees of central bank experts. The FSF seeks to co-o rdinate the efforts of these various bodies in order to 
promote international financial stability, improve the functioning of markets, and reduce systemic risk. 
15 These principles require compensati on practices in the financial industry to align employees' incentives with 
the long-term profitability of the firm. The principles call for effective governance of compensation, and for 
 
EN 5   EN improving the quantity of capital  in the banking system onc e the economic recovery is 
assured. 
The report of the FSF on Addressing Pr ocyclicality in the Financial System16 set out 
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. 
Recommendations for bank capital framework were developed with the Basel Committee on 
Banking Supervision (Basel Committee)
17 with an intention to m itigate the risk that the 
regulatory capital framework amplifies the tran smission of shocks between the financial and 
real sectors and include propos als to reduce the reliance on cyclical VAR-based capital 
estimates and enhance the risk coverage for re-securitization instruments and default and 
migration risk for non-securitiz ed credit products. In support of the recommendations of the 
FSF and the G20, the Basel Committee is activ ely working on developing necessary more 
detailed changes to the current rules in line with a timetable set by the G2018. 
2.2. Stakeholder Consultation 
The Commission discussed possible improvements to  the current legislative text at the CRD 
working group (CRDWG) whose members are nominated by the European Banking 
Committee (EBC). The issues covered by this initiative were examined by the CRDWG members three times in spring of 2009. 
An online public consultation on proposed draft  revisions to trading book and securitization 
provisions ran from March 25 until April 29, 2009 on the website of Directorate-General for 
Internal Market and Services  (DG MARKT). Eighteen responses  were received from both 
industry associations and individual institutio ns from various Member States as well as 
worker trade unions. The comments were gene rally supportive of th e objectives of the 
Commission's draft proposals. The responses were used to enhan ce the analysis of impacts of 
certain policy options; amendments to them we re also considered to ensure that policies 
geared to strengthening of the prudential framework do not create  undue aberrations in 
financial markets.  
With regard to proposed treatm ent of trading book and securiti zation activities, throughout the 
project the Commission services have followed a nd participated in the work of international 
forums, the Basel Committee in particular.  
A separate online public consultation on a pro posed draft of remune ration policy provisions 
ran from April 29 until May 6, 2009 on DG MARK T website. Twenty three responses were 
received from a wide range of stakehol ders including banking, insurance and asset 
                                                                                                                                                        
 
compensation to be adjusted for all types of risk, to be symmetric with risk outcomes, and to be sensitive to the 
time horizon of risks. See http://www.fsforum.org/publications/r_0904b.pdf   
16 http://www.fsforum.org/publications/r_0904a.pdf   
17 The Basel Committee on Banking Supervision consists of central bank and supervisory authority 
representatives from twenty countries. Nine EU Member  States are represented – Belgium, France, Germany, 
Italy, Luxembourg, the Netherlands, Spain, Sweden, and the UK. The othe r countries represented are Canada, 
Japan, Switzerland, the US and, from 2009, Australia, Brazil, China, India, Korea, Mexico and Russia. The 
European Commission, along with the European Central Bank, participates as an observer in the Committee 
and in its working groups. 
18 The Basel Committee has issued following consultative documents that cover the subject areas of this report: 
- Revisions to the Basel II market risk framework; http://www.bis.org/publ/bcbs148.pdf?noframes=1   
- Guidelines for computing capital for incremental risk in the trading book;  http://www.bis.org/publ/bcbs149.pdf?noframes=1
  
- Proposed enhancements to the Basel II framework; http://www.bis.org/publ/bcbs150.pdf?noframes=1   
 
EN 6   EN management sectors, national s upervisory and regulatory authorit ies as well as worker trade 
unions. The responses were used  to elaborate the analysis of impacts of possible policy 
options.  
Given the timeframe in which the proposal wa s developed, it was not possible to extend the 
period of the above consultati ons to the customary eight-week practice and to separately 
consult relevant sectoral social dialogue committees on this impact assessment. The Commission services will inform and consult them on the initiative and the impact 
assessment, to the extent that they have  not responded to the aforementioned public 
consultations. 
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, Employment , Competition, Health and Consumers, Legal 
Service, and Secretariat General. The stee ring group met three times in April and May 2009. 
The draft impact assessment was discu ssed with the Impact Assessment Board
19 (IAB) of the 
Commission on May 28, 2009. This re vised impact assessment re port reflects the comments 
of the IAB as follows: 
– Impacts of the proposed changes in the area  of remuneration policies on banks' employees 
and their interplay with the guidelines i ssued by the Committee of  European Banking 
Supervisors (CEBS) have been  clarified in section 5.4; 
– A table outlining the revisions to the CRD  proposed by the Commission during 2008 – 
2009 has been included; 
– An annex on the main causes of procyclicality  as well as the ongoing EU and international 
work to address them has been added; 
– Glossary of technical te rms has been expanded; 
– Other comments by the IAB have been  reflected throughout the report. 
3. PROBLEM DEFINITION  
3.1. Overview of the Capital Requirements Directive 
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 their depositors are protected. This is aimed at ensuring financial 
stability and maintaining confidence in financial institutions.  
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 regulatory authority in their own Member State. 
In the EU, the current bank capital framework is represented by the Capital Requirements 
Directive (CRD) comprising Directives 2006/48/EC and 2006/49/EC and reflecting the 
                                                 
19 The IAB is an independent internal body of the Commi ssion set up to ensure more consistent and higher 
quality of impact assessments prepared by various Commission departments. The IAB works under the direct authority of the Commission President. Its members are appointed in their personal capacity and on the basis of 
their expert knowledge. 
 
EN 7   EN proposals of the Basel Committee for the Basel II Framework20 (Basel II) and Trading Book 
Review21. It covers both credit institutions and investment firms. 
With the adoption of the CRD , capital requirements becam e more comprehensive. In 
particular, they were expanded to cover 'opera tional' risk (e.g. the risk of systems breaking 
down). Also, the rules were made more risk-sensitive, with a possibility for institutions to adopt approaches to determining regulatory capita l that are appropriate to their situation and 
to the sophistication of their risk management. For instance, the Internal Ratings Based (IRB) 
approach enabled institutions to determine capital requirement s for credit risk of their 
corporate portfolios, by using th eir 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 th at they are robust and reliable.  
The CRD also enhanced the role of the ‘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. 
According to the ECB22, in 2007, total assets of appr oximately 8,300 credit institutions23 in 
the EU27 were €41,072 billion with  a significant share thereof owned by some 40 large cross-
border groups24.  
Certain amendments to the CRD have been  proposed by the Comm ission in October 200825. 
In its Communication for the spring Europe an Council of March 4, 2009 the Commission 
outlined a number of revisions to the Directive that it intends to propose in 2009. The proposal that is accompanied by this impact assessment covers a sub-set of revisions 
envisioned in the Communication (see Table 1).  
                                                
 
20 http://www.bis.org/publ/bcbs107.htm   
21 http://www.bis.org/publ/bcbs116.htm   
22 ECB, EU Banking Structures , October 2008 
23 At a Member State level, this figure includes branches and subsidiaries of banks from other EU and third 
countries. Where a foreign bank has several branches in a given MS, they are counted as a single branch. 
24 In 2005, 46 cross-border banking groups held about 68% of consolidated EU banking assets 
25 See footnote #3 
 
EN 8   EN Table 1:  Three 'waves' of the CRD amendments 2008 - 2009 
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 
Revision of treatment of life insurance as 
eligible collateral Inconsistency identified in the CRD transposition process 
Revision of capital requirements for 
Collective Investment Undertakings under the IRB approach Inconsistency identified in the CRD transposition process October 2008 
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 (for more details, see Table 2) 
Introduction of supplementary measure to address leverage and/or liquidity risk 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 
Introduction of counter-cyclical treatment 
of bank loan provisions 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 Autumn 2009 
(forthcoming)** 
Making supervisory rules more consistent  
by reducing number of national options and discretions  Harmonize core set of standards ap plied across the Member States 
** Changes included in the Commission Communication for the spring European Council of March 4, 2009  
The following sub-sections present analysis of  main problems and drivers underlying them for 
the CRD areas under review in this proposal. At the end of Section 3, problem drivers and the 
ensuing problems are summarized in a problem tree. 
3.2. Capital Requirements for Trading Book 
Credit institutions and investment firms ('institutions') may calculate their capital 
requirements for market risk using their internal 'value-at-risk' (VAR)26 models under Annex 
V of Directive 2006/49/EC27. Market risk is the risk of loss es due to price fluctuations of 
financial instruments in the trading book, the trading book comprising those instruments held 
for short-term resale or to hedge other financial instruments that are held for short-term resale. 
Under the current provisions, inst itutions' VAR models shall provi de an assessment of the loss 
                                                 
26 VAR models measure the risk of loss on a specific portfolio of financial assets. For a given portfolio, 
probability (confidence level) and time horizon, VAR is defined as a threshold value such that the probability 
that the mark-to-market loss on the portfolio over the given time horizon does not exceed this value (assuming 
normal markets and no trading in the portfolio) is the given probability level. 
27 In order to do so, their internal models have to fulfil a number of conditions and an explicit supervisory 
approval needs to be received. 
 
EN 9   EN that would not be exceeded with a 99% probab ility (the 'confidence level') if the institution 
held on to its portfolio over a 10-day horizon. 
3.2.1.  Shortcomings of VAR Models 
Drivers: VAR models based on short periods of historical data which may not capture 
relevant market stress episodes 
   VAR models' assumption of independent returns does not hold at  times of market 
stress when correlations be tween risk factors increase 
Problems: Capital requirements as determined  by using VAR models are not robust enough to 
absorb potential trading book losses and contribute to sub-optimal level of risk management.  
Swings in capital position, linked to trading losse s and volatility of capital requirements for 
the trading book, risk exacerbating procyclical ity of bank lending and investment with 
negative implications for the real economy. 
Starting with the second half of 2007, severa l banks reported trading losses many times 
exceeding their VAR estimates. While the VAR estimates had soared due to historically high volatility, they still grossly unde restimated market risks. As a result, banks experienced a 
large number of 'backtesting exceptions', i. e., instances when the actual loss exceeded 
estimated VAR for a given day. Statistically, th is number should not be higher than three per 
year for VAR calculated assuming a 99% confidence level. An analysis by Standard and Poor's
28, however, shows that a number of backtes ting exceptions recorded by several large 
European and US banks in 2007 reached multiples of this number29. The large number of 
VAR exceptions casts doubt on th e robustness of VAR models in  stress conditions. To recall, 
banks may calculate capital re quirements on the basis of these VAR models. Even though 
capital requirements, when derived this way, al so incorporate a safety margin, backtesting 
exceptions constitute events when actual lo sses in the trading book may have exceeded the 
actual capital required  for the trading book30. 
Importantly, institutions' own estimates of econ omic capital for market risk indicate that 
current regulatory capital requirements for market risk are insufficient. For example, Deutsche Bank in its annual report
31 estimated economic capital required  for its traded market risk at 
€5.5 billion32 at the end of 2008. Meanwhile, its regul atory market risk charge was around 
€1.9 billion, i.e., 65% less than bank's own economic capital estimate.  
VAR models are based on historic al data on risk factors, regul atory requirements setting a 
look-back period of one year. Th ey therefore provide limited in sight into risks that do not 
show within the model's 'time window'. In pa rticular, if the time wi ndow does not encompass 
periods of illiquidity that leads to increases in asset price volatility, VAR will fail to produce a 
relevant measure of risk on some positions. An example of such positions is positions taken against the TED spread
33. Although the spread di d not vary much before mid 2007, it widened 
                                                 
28 Standard & Poor's, Trading Losses at Financial Institutions Underscore Need for Greater Market Risk 
Capital , April, 2008 
29 Bank of America N.A., UBS and Deutsche Bank all reported a number of backtesting exceptions - based on 
actual or hypothetical profit and loss - in excess of 10.  
30 Unfortunately, this important information is not disclosed separately by banks. 
31 http://annualreport.deutsche-bank.com/200 8/ar/riskreport/ove rallriskposition.html   
32 Before diversification 
33 The difference between the three-month 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 
 
EN 10   EN considerably in the second half of the year be cause of the liquidity crunch (see Chart 1). 
During the first weeks of  August 2007, a bank e xposed to a widening of the spread would 
have incurred losses that VAR m odels could not have predicted. 
Chart 1:  TED spread in percentage points, July 2006 – December 2007 
0,000,501,001,502,002,503,00
07/2006 09/2006 11/2006 01/2007 03/2007 05/2007 07/2007 09/2007 11/2007 
Sources: US Federal Reserve, European Commission calculation 
However not only will the short look-back pe riod render the VAR base d regulatory capital 
less sound in the sense that actual losses may exceed the regulatory cap ital requirement. An 
additional problem caused by the short look-back period is that capital requirements become 
volatile34. For instance, VAR measure of Deutsche Bank35 increased from €76.9 million at the 
end of 2006 to €131.4 million at the end of 2008, i.e ., by more than 70% - an increase that is 
still likely to understate the actual volatility  of the VAR measure assuming a constant 
portfolio composition, as one ca n safely assume that the ba nk have tried to reduce its 
exposures over the stress ed period in question.  
This volatility of capital requirements implies that banks can take a lot of risk during good 
times but are curtailed in their risk taking ab ility during more difficu lt times, as regulatory 
capital requirements rise at the time when the level of available capital is eaten up by losses 
from operations yet raising additional capital in  the markets becomes more expensive, if not 
impossible. While such risk rea ssessment can be viewed as rati onal from the individual firms 
perspective, it considerably reduces liquidity  in already stressed capital markets and in a 
wider sense also introduces volatility into banks' ability and willingness to lend to the real economy thus exacerbating the underlying cyclical trends. 
Most VAR models use correlations among risk factors that are not stressed. Under stress 
conditions like the ones experienced duri ng the 2007-2008 episode, however, correlations 
change and the benefits of risk diversific ation as assessed by VAR in the preceding more 
                                                
 
34 VAR will fluctuate depending what the observed volatilities in the different short look-back periods are. 
35 http://annualreport.deutsche-bank.com/2008/ar/notes/a dditionalnotes/37riskdisclosures/marketrisk.html   
 
EN 11   EN benign environment turn out to have been overestimated. To illustrate, a bank trading in both 
equity and bond risks will in good times benefit fr om risk diversification as shares and bonds 
will often not experience losses at the same time. When market conditions deteriorate, 
extreme movements can however occur in  all risk categories simultaneously.  
Moreover, in times of stress, bad days tend to cluster. The square root of time rule, which 
banks use to scale up one-day VAR estimate in to regulatory 10-day VAR  equivalent, assumes 
that daily returns are inde pendent over time. Disclosure s by UBS AG provide a useful 
illustration that, in times of stress, this assumption does not hold (Chart 2).  
Chart 2:  Average 10-day VAR in million of Sw iss francs for UBS AG investment bank 
300350400450500550600650700
2006-I 2006-II 2006 -III 2006-IV 2007-I 2007-II 2007 -III 2007-IV
Average 10-day VAR Derived from 1-Day VAR (under the CRD)
 
Sources: UBS, European Commission calculation 
The chart contains two VAR m easures for the same confidence level: the first one derived 
from a one-day VAR, using the square root of  time, and the second computed separately 
using 10-day shocks for all the relevant risk factors.  It could be seen that  in the fourth quarter 
of 2007, average 10-day VAR became 40% higher than what one-day VAR and the square 
root of time would suggest36. While in the more benign preceding quarters of 2007 the 
measure based on the one-day VAR did not und erestimate the 10-day VAR figures, under the 
stressed market conditions the observed 10- day VAR became significantly higher as 'bad' 
days had followed one another. Needless to say,  the same problem would arise if the one-day 
VAR was scaled up to even longer holding periods. 
                                                 
36 Based on the same time window of five years of historical data, one-day VAR at the 99% confidence level was 
equal to Swiss francs (CHF) 149 million and 10-day 99% VAR was CHF 665 million. Assuming independent daily returns across time, one-day VAR would be equivalent to a 10-day VAR of CHF 471 million ( √10 x 149 
million).  
 
EN 12   EN Therefore, quantifying VAR under the above assumptions does not provide for a sound basis 
of regulatory capital as it does  not reflect the stre ss conditions under wh ich regulatory capital 
matters most, i.e., the conditions under which actual losses are likely to  exceed a VAR-based 
capital requirement. The described characterist ics might also contribute to the problem of 
cyclical volatility of capital requirements that might have pro-cyclical effects for the real 
economy.  
3.2.2.  Trading Book Charge for Default Risk 
Default risk not covered by a VAR model calibra ted to a 99% confidence level and a 10 day 
holding period is material37. Therefore, the Directive also requires institutions from 201038 (to 
be changed to 2011 by CRD amendments currently being negotiated39) onwards to hold 
capital for incremental default risk that goes bey ond the default risk implicitly included in the 
market risk assessed by the VAR models. Therefore, the risk of  unexpected losses related to 
the incremental default risk that institutions mi ght have incurred during the crisis in their 
trading book has been already addressed by the legislation40.  
From today's perspective a capital charge that measures only the default risk in the trading 
book – as it was introduced in 2005 – does not seem well-placed to capture the highly 
relevant risk of market fluctuat ions short of actual default. Indeed, such credit risk-related 
losses in trading books proved to be a very import ant driver of the current crisis, as evidenced 
by losses on financial in struments held at fair value thr ough profit and lo ss – a category not 
completely identical with the regulatory tr ading book but the closest possible approximation 
in public financial reports. Thes e credit related losses stemmed to an important degree also 
from 'normal' credit exposures th at were not securitisations.  
Deutsche Bank, for instance, for the year 2008 reported41 mark-downs in the 'Sales & Trading 
(debt and other products)' business of €5.8 billion42, of which commercial real estate loans 
accounted for €1.1 billion. In Credit Trading, the bank reported further losses of €1.7 billion 
related to credit proprietary trading, mainly driven by losses on long positions in corporate 
debt and basis risk of hedges between corp orate names and derivatives to hedge them. 
Globally, potential writedowns by banks on their exposures to corporate debt instruments 
originated in the US, Europe and Japan are estimated to reach $252 billion by 20104344. 
                                                 
37 For positions with low default risk such as bonds of  good credit quality, at relatively short time horizons, 
default risk at the 99% confidence level may well be zero,  while default risk at the 99.9% confidence level and 
assuming a longer holding period will be  positive and material because at su ch a high confidence level, also 
defaults of good issuers cannot be excluded and because de faults tend to occur in clusters. In addition, and not 
least relating to regulatory arbitrage, it is important to note that the CRD capital requirements for the banking book, which comprises items held to maturity, are ca librated to a 99.9% confidence level and a one year 
holding period. 
38 Currently, under a grandfathering position expiring by 31 December 20 09, banks and investment firms may 
still apply Annex V as it stood prior to the introduction of the 'incremental default risk' requirement. 
39 Proposal for a Directive of the European Parliament and of the Council amending Directives 2006/48/EC and 
2006/49/EC as regards banks affiliated to central institutions, certain own funds items, large exposures, supervisory arrangements, and crisis management, COM/2008/0602 final - COD 2008/0191 
40 Proposal that this impact assessm ent accompanies, includes cer tain clarifications on how capital requirements 
for this type of risk shall be quantified 
41 http://annualreport.deutsche-bank.com /2008/ar/servicepages/downl oads/files/dbfy2008_financial_report.pdf#page=16   
42 Additional negative fair value adjustments of €2.3 billion would have been required had reclassifications, in 
accordance with the amendments to IAS 39, not been made 
43 IMF, Responding to the Financial Crisis and Measuring Systemic Risk  (Global Financial Stability Report), 
April 2009 
 
EN 13   EN Driver:  Trading book charge for default risk does not  capture credit rating migration risk 
Problems: Current capital requirements for tr ading books do not adequately reflect all 
material credit risks which together with re gulatory arbitrage possibilities contribute to 
undercapitalization and faci litate excessive risk taking in the expansionary phase of the 
lending and economic cycle. When these risk s materialize, capital position is affected 
negatively which risks exacerbating procyclical ity of bank lending and investment with 
negative implications fo r the real economy.  
However, it is important to understand that thes e losses resulted from ma rking debt to market, 
i.e., they were mainly driven by a changed mark et perception of the corporate names' default 
risk which can be loosely referred to as 'migratio n risk' rather than the actual default of these 
names. Therefore, incremental risk charge as  introduced in 2005 does no t capture all relevant 
material credit-related risk in the trading book, leading to undercapitali zation of institutions 
that, in turn, exposes them and their stakeholders  (creditors, shareholders ) to the risk of steep 
losses when economic climate deteriorates and also risks inducing proc yclical behaviour over 
the economic cycle.  
It may also be noted that in the banking book, th e capital charge looks at default risk over 
much longer time horizons and contains an adju stment for migration risk for long maturity 
debt. Therefore, in the current situation the tr ading book treatment of default risk could also 
lead to regulatory arbitrage oppor tunities, i.e., an incentive to move debt items to the trading 
book where not all their material  risks are captured by capital requirements. This further 
enhances the abovementioned causalities. 
3.2.3.  Capital Requirements for Securitiz ation Positions in Trading Book 
Driver: A robust institutions' internal mode lling methodology for default and migration risk 
for securitisation positions in the trading book is missing 
Problems: Current reliance on own models for secu ritization default risk allows for regulatory 
capital arbitrage and undermines the soundness of institutions. The resulting 
undercapitalization facilitates excessive risk taki ng in the expansionary phase of the lending 
and economic cycle. When these risks material ize, capital position is affected negatively 
posing risk to bank creditors and shareholders  and risks exacerbating procyclicality of bank 
lending and investment with negative implications for the real economy.  
The default risk charge introdu ced in 2005 essentially allowed banks to make use of their 
own models, even for securitis ation positions held in the tr ading book. In the banking book, 
however, banks are required to calculate cap ital requirements based on a supervisory 
methodology; the reason being that scepticism about banks ability to  model securitisation 
risks at the same level of soundness as 'normal'  credit risk prevailed. Confronted with the 
need to build own models for securitisation ri sks in the trading book, th e industry admitted in 
a letter to the Basel Committee in October 200845 that while they felt comfortable with 
modelling corporate credit, the behaviour of se curitisation risk 'over the economic cycle is 
less well understood'46. 
                                                                                                                                                         
44 50% of all global crisis-related writedowns in the bank ing sector is estimated to be incurred by European 
banks.  Applying the same share to losses on corporate debt instruments, writedowns attributable to European 
banks can be approximated to fall in the region of $125 billion. 
45 http://www.bis.org/publ/bcbs14041/ca/isda.pdf   
46 These difficulties pertain to problems encountered while identifying what constitutes the default of the 
securitisation instruments given that the contractual agreem ents typically make the payments a function of pool 
 
EN 14   EN Essentially, reliance on own mode ls for securitisation default risk as currently envisaged in 
the CRD is fraught with two problems: one is that the current modelling abilities of banks do 
not provide sufficient comfort th at the outcome in terms of cap ital is sound e nough; the other 
one is that compared to th e banking book, allowing models in the trading book only may 
again provide incentives for arbitraging capital standards by moving items into the trading book. 
3.3. Capital Requirements for Re-securitization Positions 
Annex IX Part 4 of Directiv e 2006/48/EC sets out the risk weights determining capital 
requirements for securitisation positions in ba nks' non-trading books. In most cases, banks 
will determine capital requirements for securitis ation positions by reference to the external 
rating of the securitisation positions. However, so  far, no distinction is being made between 
normal securitisation positions and re-securitisation positions that have other securitisation positions as underlying assets. 
Driver: Capital requirements for re-securi tization positions in the banking book do not 
adequately capture risk of unexpected (low frequency high severity) losses. 
Problems: Capital required for re-securitizations  does not adequately reflect their higher risk 
compared to 'normal' securitisations. Swings  in capital position, driven by losses from re-
securitizations and volatility of  capital requirements, exacerbate pro-cyclicality of bank 
lending with possible negative imp lications for the real economy 
Re-securitisations are more sensitive to the u ltimately underlying exposures defaulting jointly. 
High correlation of losses on mortga ge loans affects a mortgage backed security (MBS), i.e., a 
security packaging the mortgage loans directly, less severely than a re-securitisation position 
such as a collateralised debt obligation (CDO) re-packaging mortgage backed securities for 
any given rating of the two securities. For i llustration, a AAA rated MBS is unlikely to suffer 
impairment even if the underlying mortgage poo l experiences heavy, high ly correlated losses, 
because it is constructed to have a strong sa fety margin protecting it from losses in the 
underlying pool of mortgages. This is different for a more junior secu ritisation tranche with 
an initial rating of, say, BBB. Heavy correlated losses in th e underlying mortgage pool are 
likely to lead to a credit quality impairment fo r this security even if its initial rating was 
considered to be of good investment quality. 
For a CDO with an initial rating of AAA the situ ation is different. It will be built on MBS 
with lower, say BBB, credit ra tings - however again subject to a strong safety margin 
protecting it from initia l losses on any of the underlying secu ritisations. This leads to an 
expected probability of default comparable to  that of the AAA mortgage backed security. 
Unexpectedly high, heavily correlated losses on mortgage loans, however, lead to many underlying BBB securities experiencing impairment  at the same time which will eventually 
affect also the AAA-rated re-securitisation (see Chart 3 for the dynamics of rating changes for 
CDOs backed by US originated assets). 
In April 2008, the IMF estimated that mark-to- market losses on the CDOs of US sub-prime 
and alt-A mortgage backed securities incurr ed by the euro area and UK banks totalled $32 
billion, with losses for banks globally reaching $153 billion
47, assuming on average 60% loss 
                                                                                                                                                         
performance; at the same time, it is particularly challe nging in terms of data availability and data processing 
capacity to model risk based on the defaults and migrations of securitized assets in the pool. 
47 IMF, Containing Systemic Risks and Restoring Financial Soundness  (Global Financial Stability Report), April 
2008 
 
EN 15   EN on these instruments since the preceding year. By  the end of 2008, the TABX index, used as a 
benchmark for CDOs backed by sub-prime MBS, showed no distinction in pricing between 
senior and junior tranches, wh ich were all marked at aro und 3 to 4 cents on the dollar, 
reflecting the erosion of  any protection from relative subordi nation of securities in the capital 
structure and deepening of losses48.  
Chart 3:  Credit rating upgrades and downgrad es of US-originated CDOs, 2007-200849 
05001.0001.5002.0002.5003.0003.500
2007-I 2007-II 2007 -III 2007-IV 2008-I 2008-II 2008 -III 2008-IVUpgrade - Fitch Upgrade - Moody's Upgrade - S&P
Downgrade - Fitch Downgrade - Moody's Downgrade - S&P
 
Sources: European Securitisation Forum 
Ratings issued by credit rating agencies aim at assessing only the lik elihood (or, expected 
probability) of default50. Bank capital regulation, on the other hand, puts emphasis on the 
unexpected  losses, incurred once defaults materializ e, which banks should be able to absorb 
with the capital that they are required to hold51. Therefore, for a give n credit rating, a re-
securitisation constitutes a greater prudential c oncern than a straight securitisation position, 
because in cyclical downturns credit losses be come more correlated and, as a result, certain 
re-securitisations, due to their intrinsic stru cture, are affected heavier than 'normal' 
securitisations. It is consequently problema tic that capital requireme nts do not distinguish 
between securitisation and re-secu ritisation that are assigned the same external credit rating, 
assigning the same risk weight to either.  
                                                 
48 IMF, Financial Stress and Deleveraging  (Global Financial Stability Report), October 2008 
49 Because the tree agencies track different securities and apply slightly different ratin g criteria, the numbers are 
not directly comparable. 
50 See http://www.fitchratings.com.br/ytmr0608.pdf   
51 While expected losses should be covered with banks' on-going profits 
 
EN 16   EN An undesirable problematic effect  is that banks are unlikely to  be adequately capitalised for 
losses on re-securitisation if correlated credit losses occur. The capital requirements are 
calibrated to 'normal' securitisations. Losses may exceed these capital requirements in the cyclical downturn as credit losses cluster. If banks then do not hold enough capital before the 
cycle turns down, losses will cyc lically compromise their capital positions with possible 
negative consequences for the economy as a whole. 
3.4. Disclosure of Securitization Risks 
Annex XII of Directive 2006/48/EC sets out disc losure requirements that banks, subject to a 
materiality threshold, have to make about thei r risk positions and how they assess regulatory 
capital against these. There is a dedicated sect ion on securitisation risks,  however this section 
currently only requires information on securiti sation risks in the banki ng, not in the trading 
book. 
Driver: Inadequate level of public disclosu re of risks stemming from investments in 
securitizations 
Problems: Lack of transparency of banks' exposur es to securitizations c ontributed to the loss 
of effectiveness of market discipline wh ich bore a negative impact on banks' risk 
management, and the loss of market confidence,  which had a negative impact on the liquidity 
of inter-bank markets, particularly affecti ng banks whose business model was reliant on 
wholesale funding 
As more and more banks kept posting more  and more losses relating to securitisation 
positions, market confidence in banks' stability declined further and further. Particularly noteworthy are episodes like thos e of German IKB and Hypo R eal Estate banks. One day, 
companies publicly stated that they did not see an impact on their business from the sub-
prime crisis only to realise a few days later th at in fact indirectly they are hugely exposed 
given their role for instance as liquidity prov iders for securities arbitrage conduits or as 
investors in complex re-securitisations
52. These episodes culminated  in profit warnings and 
finally billions of write-offs, leaving market participants unsure about  who else was exposed 
without having told the public so. 
In principle, the CRD took account of this  concern by introducing public disclosure 
requirements to strengthen markets' unders tanding of banks' risks and capital positions, 
thereby contributing to market confidence an d risk management discipline over banks' 
management. Unfortunately, the directive's disclo sure requirements entered into force too late 
(i.e., for financial year ending in 2008) to have a positive impact in this crisis. For the future, 
however, it is also important to understand that the existing disclosure requirements in the 
CRD might not have been sufficiently comple te to address the concerns of market 
participants.  
In this context, it should be noted in particular that while a big chunk of losses53 on 
securitisation positions has resu lted from banks' trading books, these positions are not covered 
by the disclosure requirements in the CRD54. In addition, a lot of uncertainty arose around 
                                                 
52 http://www.ikb.de/content/en/press/press_releases/200714599/070720_vorlErgebnisQ1.jsp , 
    http://www.ikb.de/content/en/press/press_re leases/200714599/070730_KfW_staerkt_IKB.jsp   
53 As evidenced by relatively large share of losses in the fair value through profit and loss category that, in terms 
of scope, may be assumed to be close to the regulatory trading book category 
54 It needs to be pointed out, that Commission Communication of February 25, 2009 on the treatment of 
impaired assets in the Community banking sector set out crite ria that need to be satisfied by eligible institutions 
 
EN 17   EN how securitisation positions are va lued (at cost, at market or m odel-based values, for instance) 
by individual banks, having im portant impact on the losses being taken and those probably 
still 'hiding' in the valuation of cer tain assets of unclear quality.   
The necessity of having such disclosure requirements in place is underpinned by the latest 
estimates of securitization-rela ted losses by the IMF, according to which potential writedowns 
on these instruments for banks globall y are expected to reach $948 billion55 by 201056. 
Finally, the Basel Committee perceived57 further shortcomings in existing disclosure 
standards in relation to banks' activities as s ponsor of asset backed commercial paper (ABCP) 
programmes, their use of own credit assessmen ts for such programmes and, finally, in their 
investments in re-securitisati on and in their warehousing of lo ans to be securitised on their 
balance sheet.  
3.5. Remuneration Schemes 
The impact assessment accompanying th e recent Commission Recommendation on 
remuneration policies in the financial services sector examined in detail the shortcomings of the remuneration arrangements prevalent in the financial services indu stry and explained the 
role these arrangements played in  precipitating the financial crisis
58. These shortcomings were 
shown to pertain to the stru cture of remuneration policies and inappropriate corporate 
governance systems. Furthermore, the ensuing ri sks to the institutions themselves and, more 
generally, to financial stability were not s ubject to adequate over sight by supervisors. 
3.5.1.  Inappropriate Structure and In ternal Control Systems 
Drivers: Inappropriately stru ctured remuneration policies wh ich failed to align employees' 
incentives with the long-term objectives of a company  
    Lack of appropr iate governance systems 
Problems: Excessive short-term risk taking impaired soundness of inst itutions, disrupted 
financial stability and exacerbated proc yclicality in the financial system 
Annual cash bonuses are a key variable element of remuneration in the financial services 
industry. To this end, investment banks set as ide a significant portion of their income to 
provide the bonus pool59. In the run up to the financial crisis, bonuses typically made up a 
substantial portion of employees' pay, sometimes  more than 75% of total compensation. 
While companies viewed year-end bonuses as a means to motivate and retain their employees, 
employees grew to see them as a normal and e xpected part of their compensation, regardless 
of firm profitability. For categor ies of staff whose daily activiti es are inseparable from risk-
taking decisions, together with  the typically short-term fo cus of bonus systems (which 
generally assess and reward performance on an annual basis), the fact that bonuses constituted 
a high relative share of the to tal pay, provided them with perv erse incentives to excessive 
                                                                                                                                                         
in order to benefit from asset relief measures. Criteria include requirements for full ex ante transparency and 
disclosure of impairments on the assets which would be covered by the relief measures. 
55 Includes RMBS, CMBS, CDOs of ABS, consum er ABS originated in the US and Europe. 
56 IMF, Responding to the Financial Crisis and Measuring Systemic Risk  (Global Financial Stability Report), 
April 2009 
57 http://www.bis.org/publ/bcbs150.pdf   
58 For more in-depth description and analysis of th e problems please see the im pact assessment accompanying 
the recommendation (SEC(2009) 580) 
59 For large investments banks, a portion of their net revenue set aside for employee compensation can exceed 
50%, with much of that pool earmarked for bonuses 
 
EN 18   EN risk-taking geared at maximizing short-term profits to the detriment of the long-term health of 
companies and, more generally, to financial st ability. Moreover, while bankers and traders 
shared in any profits they ge nerated, losses were predominantly borne by shareholders and 
taxpayers. To the extent that they entail ( possibly disproportionate) rewards on the upside, 
with no risk adjustment or deferred payment to  take account of future performance of the 
business unit or institution as a whole, remunera tion policies can have a procyclical effect by 
contributing to the excessive cred it growth and risk-taking in the expansionary phase of the 
economic cycle.  
The impact of improperly structured rem uneration policies was further aggravated by 
shortcomings in firms' risk management a nd internal control systems. Whilst the CRD 
includes requirements for an internal capita l assessment by financial institutions, whereby 
they would need to assess their capital needs considering all the risks they face which would, 
in theory, also cover risks st emming from their remuneration policies, this was not found to 
be the case, in practice.  Indeed, senior management of firm s which suffered the biggest losses 
tended to encourage the expansi on of risk without a commensurate focus on controls across 
the organization or at th e level of business-lines60. Moreover, within these firms, the drive by 
senior management to generate earnings was not accompanied by clear guidance on the 
tolerated level of exposure to risk. 
3.5.2.  Insufficient Supervisory Oversight 
Driver: Lack of express requirements to supervise risks arisi ng in connection with 
remuneration policies 
Problems: Absence of clear legal requirement s contributed to insu fficient oversight by 
supervisors of risks posed by inappropriate re muneration policies which facilitated excessive 
short-term risk taking by institutions 
Under the current European supe rvisory framework, there is no express requirement that the 
remuneration policies of financial institutions should be subject to supervisory oversight. 
During the process of authori zation and ongoing prudential supe rvision, the supervisory and 
regulatory authorities oversee the organizational structure of financial institutions as well as their internal control and risk management, a nd assess the risk prof ile of the financial 
institutions taking into account inter alia  operational and business risks
6162. This could in 
                                                 
60 Senior Supervisors Group, Observations on Risk Management Pr actices during the Recent Market 
Turbulence , March 2008 
61 More specifically, in the banking sector, Article 22 of the CRD requires competent authorities to require every 
credit institution that they authorise and supervise to have robust governance arrangements, including effective 
processes to identify, manage, monitor and report the risks to which it is or might be exposed. Annex V to that 
Directive elaborates categories of ri sk that credit institutions  should take into account when designing those 
governance arrangements. That Annex does not refer expr essly to risks arising in connection with remuneration 
policies, although it is not intended to be definitive and it is arguable that such risks could fall within the scope 
of the general provision in that Annex that the management body must approve and periodically review the 
strategies or policies for taking up, managing, monitoring and mitigating the risks to which the credit institution is or might be exposed. This requirem ent applies at consolidated level to all firms which are captured under the 
scope of prudential consolidation (Article 125 of the CRD).  This includes (by virtue of Article 31 of Directive 
2006/49/EC) investments firms that ar e authorised and regulated under Di rective 2004/39/EC, and subsidiaries 
of a credit institution that are not themselves authorised  banks but which are 'financial institutions' (as defined 
in the CRD) carrying on credit, securities or investment services.  
62 Similarly, the Markets in Financial Instruments Dir ective, MiFID, (Directive 2004/39/EC and implementing 
Directive 2006/73/EC) which covers the provision of investment services and activities by credit institutions 
and investment firms and the operation of regulated markets and multilateral trading facilities, and imposes 
 
EN 19   EN principle cover risk related to poorly designed remuneration policies of financial institutions 
as defined under the CRD.  
Given the resulting absence of clear legal requirements, until recently, financial supervisory 
and regulatory authorities have not focused on the implications of remuneration policies for 
risk which facilitated excessive short-term driven risk-taking on behalf of supervised institutions.  
3.5.3.  Latest Developments and N eed for Legislative Action 
The recently adopted Commission Recommendation on remuneration policies in the financial 
services sector aims at tackli ng the problems described in the pr evious sections by setting out 
principles on sound remuneration policies. These include a general princi ple that firms should 
establish and maintain comprehensive remunera tion policies, applying to those categories of 
staff whose professional activities have a material  impact on the risk profile of the financial 
undertaking, which are consistent with sound and effective risk management and do not 
induce excessive risk-taking. Comp lementing this general princi ple, there are more detailed 
recommendations relating to the balance be tween fixed and variable components of 
remuneration (that is, between co re salary and bonus); the dete rmination of the bonus element 
on the basis of performance; deferred payment of bonuses with a link to the firm's future 
performance; the responsibility of the (superv isory) board for overseeing the policy and its 
application and the involvement of properly in dependent control functi ons in its design and 
operation. The Recommendation is addressed widely to all firms carrying on activities that are 
subject to regulation within the financial sector (irrespective of whether the firms are themselves regulated).   
The objective of the Recommendation is to elabor ate a set of principles which should enable 
firms to ensure that their remuneration structur es are consistent wit h, and do not jeopardise, 
the risk management and internal governance that  are the subject of enforceable obligations 
for regulated firms. A recommendation is an ap propriate instrument fo r setting out a general 
framework and laying down detailed prin ciples and objectives. However, since a 
recommendation is not a legally enforceable inst rument, there is a case  in the context of 
prudential supervision for a legally binding EU  instrument reinforcing the role of the 
supervisors and empowering them to assess th e remuneration schemes of certain regulated 
financial institutions in a broader context of sound risk management, so that relevant policy 
objectives are achieved more effectively
63. There is also a possibility that in the absence of 
binding EU legislation there might be a potential for regulatory arbitrage, if companies chose 
to relocate to jurisdictions where the Recommendation does not apply.  
While the Recommendation pertains to all sectors of financial services, at  the current juncture 
it appears that the greatest ri sks stemming from a possible de ficit of compliance with its 
principles would come from the banking and in vestment banking sectors, not least because 
these institutions are at the cen tre of the problems described in the previous sections.  
                                                                                                                                                         
requirements relating to the internal organisation and control structures within investment firms and credit 
institutions that carry on MiFID services, does not either  have specific provisions that deal with remuneration 
policy within these ins titutions.  While the Directive does regulate the payment and receipt of inducements, this 
regime is relevant to benefits received from third partie s in the course of the provis ion of investment services 
(for example, commissions paid in connection with the sale of a financial product) and is unlikely to touch 
upon core remuneration policies within a regulated firm. 
63 Such approach has been identified as a preferred option in the long term in the impact assessment 
accompanying the Recommendation 
 
EN 20   EN An enhanced supervisory role in this contex t is further warranted because of the market 
failure which is manifested by the shareholders ' apparent lack of capacity and willingness to 
establish a greater alignment between the risk -taking horizon and the long-term viability of 
companies. As recent events have demonstrated, this has consequences for financial stability. 
Studies showed that institutional shareholde rs do not always have in mind long-term 
objectives and may rather look fo r short-term share value increas es with their average holding 
periods being between one and two years64, while in the US the average share is held for less 
than a year65. Because financial stability is a public good and it was shown to be undervalued 
by private institutions, better internalisation of pote ntial costs of instability to society by these 
institutions themselves is warranted. 
3.6. Risks Inherent in Baseline Scenario 
There is a broad and growing international consensus that the four problem areas under 
review individually, and even more so if ta ken together, played a 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 (e.g. depositors), shareholders, employees, bo rrowers and taxpayers, to 
unprecedented economic costs. If no action in th e outlined areas is taken, the risk that 
systemic shocks of a similar scal e occur in the future will not be  addressed. In fact, in addition 
to the proposed ones, measures in other areas will be necessary to t ackle this risk more 
effectively. 
3.7. 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 correct for regulatory arbi trage opportunities which are made possible by the 
current legislation (e.g., capital requirements for securitisation  positions in the trading book) 
or absence thereof (e.g. remunera tion polices), address certain regulatory failures that were 
brought to light by the conti nuing financial crisis (e.g., capital requirements for re-
securitizations), ensure a cons istent EU approach for tackling various issues covered by the 
scope of this report, which would do away w ith the need for Member States to pursue 
individual approaches that risk  fragmenting internal market.  
More importantly, only EU-level approach coul d be expected to effectively provide for 
financial stability and tame excessive financial procyclicality, where policies geared to national needs have been shown to be inapprop riate and ineffective from a broader systemic 
perspective. 
                                                
 
64 Gaspar, Massa, Matos, Shareholder Investment Horizons and the Market for Corporate Control , Journal of 
Financial Economics, vol 76, 2005, pp. 135-165 
65 On the New York Stock Exchange, the average share is currently held for less than a year, as compared to 
about five years in 1960 and two years in 1990. R. Khurana and A. Zelleke, You Can Cap the Pay, but the Greed 
Will Go On , The Washington Post, 8 February 2009 
 
EN 21   EN 4. OBJECTIVES  
The overarching goal of this initiative is to en sure that the effectiveness of bank capital 
regulation in the EU, represented by the Capita l Requirements Directive, is strengthened and 
any of its excessive pro-cycli cal impacts on the real economy ar e contained while maintaining 
the competitive position of the EU banking indust ry. This translates into the following four 
general  policy objectives to:  
– Enhance financial stability (G-1); 
– Enhance safeguarding of cr editor interests (G-2); 
– Ensure international competitiveness of EU banking sector (G-3); 
– Reduce pro-cyclicality of the financial system (G-4). 
In light of the problems presented in sec tions 3.2 through 3.5, four sets of operational  
objectives have been identified to  address the applicable problem drivers. Effective realization 
of such operational objectives should contribute  to the achievement of the following longer-
term specific  policy objectives to:  
– Enhance adequacy of capita l requirements (S-1); 
– Minimize cyclicality of capital requirements (S-2); 
– Eliminate regulatory arbitr age opportunities (S-3); 
– Reinforce risk management incentives (S-4); 
– Improve investor understanding of bank risk profile, i.e., market confidence (S-5); 
– Enhance legal clarity (S-6); 
and, in turn, should facilitate the attainment of the four  general policy objectives. 
Table 2 provides an overview of the identifi ed problems, drivers underlying them as well as 
operational, specific and general objectives , by indicating linkages between them.  
5. POLICY OPTIONS , IMPACT ANALYSIS AND COMPARISON  
This section presents the policy options and thei r impacts on stakeholders for each of the four 
areas. Due to the number of the areas covere d, the analysis of policy options and the 
comparison thereof have been combined for eac h area. Cumulative impacts of all preferred 
options are discussed at the end of the section. 
As the impact assessment pertains to the provisi ons of existing EU legislation, the analysis of 
the type of policy instrument was assumed to be superfluous. In the area of remuneration 
schemes, the argumentation underlying the appropria teness and need for a legislative measure 
has been provided in sections 2.1 and 3.5.3. 
 
EN 22   EN Table 2:  Summary of problems and objectives 
Specific Objectives General Objectives 
S-1 S-2 S-3 S-4 S-5 S-6 G-1 G-2 G-3 G-4 
Problems Problem Drivers Operational Objectives 
Enhance adequacy 
of capital requirements 
Minimize 
cyclicality of capital requirements 
Eliminate 
regulatory arbitrage opportunities 
Reinforce risk 
management incentives 
Improve investor 
understanding of bank risk profile 
Enhance legal 
clarity 
Enhance financial 
stability 
Enhance 
safeguarding of 
creditor interests 
Ensure int'l 
competitiveness of 
EU banking sector 
Reduce pro-
cyclicality of the 
financial system 
A robust institutions' internal modelling 
methodology for default and migration risk for 
securitisation positions in the trading book is missing Enhance alignment of securitisation 
capital requirements for trading book 
with those of the banking book  √  √    
Charge for default risk does not capture credit 
rating migration risk  Introduce capital charges to capture 
credit rating migration risk √ √ √ √   Capital Requirements for Trading Book  
- Not all material credit risks in trading books are appropriately 
reflected in current capital requirements 
- Capital requirements of institutions as determined by using VAR 
models are not robust enough to absorb potential trading book 
losses 
- Swings in capital position, linked to trading losses and volatility 
of capital requirements for trading activities, risk exacerbating 
pro-cyclicality of bank lending and investment with possible 
negative implications for the real economy 
- Regulatory arbitrage possibilities possibly lead to 
undercapitalization  VAR models based on short periods of historical 
data which may not capture relevant stress episodes  
VAR models' assumption of independent returns 
does not hold at times of market stress when 
correlations between risk factors increase  Make capital requirements more prudent 
to reflect risks pertaining to extreme 
future events √ √  √   √ √ √ √ 
Capital Requirements fo r Re-securitizations 
- Capital required for re-securitizat ions does not adequately reflect 
their higher risk compared to "normal" securitisations 
- Swing in capital position, driven by losses from re-
securitizations, exacerbated pro-cyclicality of bank lending with possible negative implications for the real economy Capital requirements for re-securitization positions 
in the banking book do not adequately capture risk 
of unexpected (low frequency high severity) losses  Set more prudent regulatory capital 
requirements for re-securitization positions in banking book 
Discourage investments in complex re-
securitizations √ √  √ √  √ √ √ √ 
Disclosure of Securitization Risks 
-Lack of transparency of banks' exposure to securitizations 
contributed to the loss of market confidence, which had a negative impact on the liquidity of inter-bank markets, particularly 
affecting banks who relied on wholesale funding  Inadequate level of public disclosure of risks 
stemming from investments in securitizations Enhance public disclosure requirements 
for securitization positions     √ √  √ √   
Failure of remuneration policy structures to align 
employees' incentives with the long-term objectives of a company Strengthen the link between pay and 
long-term performance 
Prevent incentives for excessive risk-
taking in remuneration policy    √   
Lack of appropriate go vernance systems with 
regard to remuneration policies Enhance corporate governance on 
remuneration policy    √   Remuneration Schemes  
-Excessive short-term risk taking impaired soundness of 
institutions, disrupted financ ial stability and exacerbated 
procyclicality in the financial system 
Insufficient degree of supervisory oversight Enhance the role of supervisors with 
regard to overse eing remuneration 
policy management √  √ √  √ √ √ √ √ 
 
EN 23   EN 5.1. Trading Book 
With respect to policy options  on capital requirements for bank trading books, three policy 
options are considered: 
- Policy option 1:  Retain the current CRD treatment; 
- Policy option 2 : Impose a set of targeted measures  to strengthen existing trading book 
capital requirements; 
- Policy option 3 : Change the modelling standard to a 99.9% 1-year level for all positions in 
the trading book. 
Policy option 1:  Retain the current CRD treatment  
This option does not achieve any of the stat ed operational objectives . It also does not 
contribute to the specific  and general objectives. 
Policy option 2:  Impose a set of targeted measures to strengthen existing trading book capital 
requirements  
The following targeted amendments that are al igned with what is envisaged by the Basel 
Committee could be introduced to respond to the individual problems outlined in the problem definition sections 3.2.1 - 3.2.3: 
– Add VAR based on stress scenario to ordinary VAR, adding an additional capital buffer to 
withstand stress conditions and dampening the volatility of the capital requirement
66. This 
change may be expected to roughly double  the requirements given the current 
environment; however, obviously as the 'norma l' VAR component may decrease again in a 
more benign environment later, the stress VAR will remain high. This impact is pertinent 
mostly to large institutions that have a deve loped internal modelling capability and, more 
importantly, have received an explicit recognitio n of their models from supervisors. At the 
end of first half 2008, capital requirement s for trading book for large EU banks67 made up 
on average 6-7% of their total minimum cap ital requirements. Therefore, introducing a 
requirement for a capital buffer would translate into the like 6-7% increase in the minimum 
capital requirements, other things being constant.  
– Extend the existing charge for de fault risk in the trading b ook to capture losses short of 
issuer default, e.g. rating downgrades, to addre ss in particular the fact  that losses on traded 
debt most of the time did not involve issuers actually defaulting. The overall impact of this 
change on the capital requirements will obviously depend on how banks portfolios will adjust in terms of composition to the post-crisis  environment. In particular trading in better 
rated instruments will become more expensive for banks as these instruments are relatively 
more subject to migration than to default risk. 
                                                
 
66 'Stressed VAR' is different from the existing requiremen ts for banks to perform stress testing under Pillar 2 of 
the CRD on the adequacy of their overa ll capacity to withstand different s cenarios of stress and, if necessary, 
hold additional capital. 'Stressed VAR' is, by contrast, part of the minimum capital requirements for the trading 
book only and represents an amendment to the regu latory formula aimed at en suring that such minimum 
capital requirements under Pillar 1 are adequate with the risks in the trading book: as outlined in the problem 
definition section, current minimum requirements for the trading book have been shown to be too volatile and 
too low at times of market stress. 'Stress VAR' is being proposed to address these shortcomings. 
67 Estimate is based on a sample of 27 large EU banks th at have adopted the internal risk-based (IRB) approach 
for managing the credit risk of their corporate portfolios. It implicitly assumes that these banks have their 
internal models for market risk management recognized by supervisors.  
 
EN 24   EN – Base the charge for securitisation positions in the trading book on the (simple) risk weights 
in the banking book, addressing  the methodological difficulties  of modelling the default 
and migration risk of securitisations, i.e., difficulty to identify what constitutes the default of the instruments on the contractually agr eed payments given that the contractual 
agreements typically make the payments a func tion of pool performance while  it is overly 
difficult to model price risk based on the defaul ts and migrations of the assets in the pool. 
Again, the overall impact of this change on the capital requirements will obviously depend on how banks portfolios will adjust in terms of composition to the post-crisis environment. 
It is difficult to estimate, however, how much  additional capital banks  would have to raise 
under this scenario, as generally banks tend to main tain capital levels that  are in line with their 
internally developed 'targets' which are t ypically more linked to their economic capital 
planning
68 or a need to obtain and / or maintain a de sired external credit rating which leads to 
higher capital levels than those required by minimum capital requirements. The overall 
solvency ratio for large euro area financial institutions was on average 11.4% at the end of 
first half of 2008, implying an average capital buffer (over the minimum capital requirements) 
of 3.4% of risk-weighted assets6970. As a result of enormous market volatility during the 
second half of 2008, many institutions underwent a dditional stress to their capital positions, 
but, on the other hand, they also benefited from the unprecedented extent of state aid 
measures to recapitalize them. Strengthening the adequacy level of bank capital requirements 
is of a paramount importance in order to enhance financial stabil ity and minimize any 
excessive procyclicality of the financial system . Nevertheless, given a rather bleak economic 
outlook for the EU in the next couple years, introduction of this or any other policy option 
that might have implications for individual banks' capital positions, has to be carefully timed in order to cushion any unwelcome pro-cyclic al impacts of capital regulation on the real 
economy in the near term.  
This option achieves all operational objectives. It contributes towards meeting the specific 
objectives S-1 (Enhance adequacy of capital re quirements), S-2 (Minimize cyclicality of 
capital requirements), S-3 (Eliminate regulatory arbitrage opportunities)  and S-4 (Reinforce 
risk management incentives) and thereby to meeting the general objectives G-1 (Enhance 
financial stability), G-2 (Enhance safeguarding of creditor interests) and G-4 (Reduce pro-
cyclicality of the financial system). It also helps achieving the genera l objective G-3 (Ensure 
international competitiveness of EU banking industry) because these changes would be in line with what currently is envisage d at the level of the Basel Comm ittee, an international standard 
setting body bringing together th e supervisors of all large in ternationally active banks and 
those of the most important emerging markets. 
Policy option 3: Change the modelling standard to a 99.9% 1-year level for all positions in 
the trading book  
This option aims at capturing all price risks, in cluding those from credit related losses, at the 
same soundness standard as that imposed on the banking book, thereby implicitly also capturing the stress that occurs in the worst of  a thousand years.  This option achieves the 
operational objective of more prudent requirement s to reflect risks to extreme events in 
practice less well than option 2;  data availability constraint s will imply that the actual 
implementation of option 3 in individual banks may fall short of achieving this objective – in 
                                                
 
68 See section 3.1 for an example on difference between economic and regulatory capital for market risk. 
69 ECB, Financial Stability Review , December 2008 
70 Doubling of requirements linked to stress VAR scenarios, for instance, would reduce such additional capital 
buffer by some 0.5% points. 
 
EN 25   EN theory, calibration would have to take place on th e basis of hundreds of years of data history 
which are simply unavailable, so banks will have to use scaling up rules th at may not be valid. 
Validation in terms of backtesting will be impossible given the long time series needed. The stress scenario VAR solution discussed above is more straightforward to implement and 
supervise.  
Similarly, it is arguable whether the actual im plementation of this option would achieve the 
operational objective of capturing credit migrati on risk as well as does option 2 which builds 
on well established credit risk modelling techniqu es. Finally, this option will not achieve the 
objective of aligning securitisation treatment in  the trading and banking books more closely.  
By consequence, option 3 appears less effectiv e overall regarding th e specific and general 
objectives attained by option 2. The overall imp act of this option on th e capital requirements 
will not only be a function of the future trad ing strategies of banks, but also one of the 
soundness with which such a requirement would be implemented. This option was also examined and consulted by the Basel Commi ttee however neither the industry nor the 
supervisory community found it to be a workable and effective way forward. 
5.2. Re-securitization 
The question is if and to what extent a revi ew of capital and risk management requirements 
for EU banks is warranted. The following four options have been identified: 
- Policy option 1:  Retain the current CRD treatment; 
- Policy option 2 : Imposing a separate set of higher risk weights for re-securitisation 
positions; 
- Policy option 3 : Imposing higher capital charges high enough to discourage investments in 
complex re-securitizations with a grandfatheri ng for instruments already on banks' balance 
sheet, combined with targeted exemptions; 
- Policy option 4 : Enhanced supervisory oversight of ne w investments in re-securitizations 
combined with deductions from capital fo r highly complex re-securitizations where 
compliance with due diligence is inadequate. 
Policy option 1: Retain the current CRD treatment
 
Under this option, risk weights for securiti sation would continue to be the same for 
securitisation and re-securitisation positions with  the same credit rating. While banks have in 
the past often solely relied on external credit ratings when making thei r investment decisions 
regarding re-securitizations rath er than making their own analys is of risks, the CRD changes 
adopted by the Commission in 2008, require banks  to conduct their own due diligence and 
stress tests for re-securitisations, looking thro ugh to the assets ultimately underlying the 
underlying securitisations. However, the practical  application of these requirements may in 
some cases prove difficult, given limits to info rmation availability and information processing 
ability, which would hamper the effectiveness of  this option in terms of achieving relevant 
policy objectives. 
Policy option 2: Imposing a separate set of higher risk weights for re-securitisation positions  
Under this option, for every rating grade re-s ecuritisation positions would be assigned a 
higher risk weight than other securitisation positions, the higher risk weights for these purposes being set in accordance with the high er risk of unexpected impairment losses as 
discussed above. The Basel Committee has conducted analyses on the unexpected losses of 
 
EN 26   EN residential mortgage backed securities on the one hand and CDOs backed by RMBS on the 
other hand. On the basis of that analys is, the Committee's consultative document71 envisages a 
new set of risk weights for re-s ecuritisation positions that could be used as a basis for risk-
sensitive weightings to be introduced in the CRD . All applicable operational and the specific 
objectives would be attained and this would c ontribute towards achievi ng all of the general 
objectives. 
Policy option 3: Imposing capita l charges high enough to discour age investments in complex 
re-securitisations with a grandfathering for in struments already on banks' balance sheet, 
combined with targeted exemptions  
Under this option, risk weights for re-securitisa tions would be set that  exceed those proposed 
by the Basel Committee (i.e., option 2). In orde r to discourage new investment in highly 
complex securitisations, capital  requirements could be set at  a level equivalent to full 
deduction from capital, meaning that the instituti on has to hold 1 euro capital for 1 euro of 
such a position. Only new investments in certain types of complex re-sec uritisations would be 
subject to such capital charge whereas legacy instruments would benefit from a 
grandfathering subject to the unde rlying asset pools not being adde d to or replenished within 
the re-securitization entities in question. Nota bly, certain government sponsored restructuring 
transactions to 'clean up' banks ' balance sheets ('bad banks') car ried out at the moment would 
also be covered by this grandfathering clause72.  
Clearly, also under this option, the operationa l objective of setting more prudent capital 
requirements would be attained. Objective S-1 (E nhance adequacy of cap ital requirements) is 
met less well than under option 2, because und er this option, capital requirements for new 
investments in complex re-securitizations would by design exceed the level 'adequate' to credit risk. Objective S-2 (Minimize cyclicality  of capital requirements) however is better 
achieved than under option 2 beca use naturally, higher capital requirements always behave 
less cyclically as future losses in economic do wnturn are to a larger  degree pre-empted in 
current capital positions.  
Also objectives S-4 (Reinforce risk manage ment incentives) and S-5 (Improve investor 
understanding of bank risk profil e) are gradually better achie ved than under option 2. Option 
3 avoids giving a signal to the market that it is  safe to invest in wh at essentially are very 
opaque and difficult to analyse instruments subj ect to a gradually higher capital charge. This 
policy option would rather provide a clear sign al, encouraging investments in transparent 
structures rather than in opaque ones, the latter being subject to much higher cost of capital. 
Thereby, better incentives for banks ' risk management would be set. At the same time, less 
investment in overly complex structures will also positively contribute to market confidence 
as banks' risk profiles will be more easily understandable for market participants.  
At the level of general objectives, this opti on would make a stronger contribution towards G-1 
(Enhance financial stability), G-2 (Enhance sa feguarding of creditor interests) and G-4 
(Reduce procyclicality of the financial system) than option 2, however it may be problematic 
in relation to objective G-3 (Ensure internatio nal competitiveness of EU banking sector) as 
higher capital requirements compared to those agreed in the Basel Committee may negatively affect the competitiveness of the EU banking s ector on the investment side. On the other 
                                                
 
71 http://www.bis.org/publ/bcbs150.pdf?noframes=1 ; the approach outlined in the document is likely to be 
followed by jurisdictions outside the EU.   
72 Often, these transactions involve a securitisation SPV holding the bad asse ts, of which the 'good bank' retains 
different tranches. These tranches represent re-securitis ation positions because, the underlying bad assets are 
typically securitisations (however not necessarily re-securitisations). 
 
EN 27   EN hand, on the refinancing side, a stronger capital ization and less exposure to highly complex 
products will be positively perceived by market  participants, actually strengthening the 
competitive position of EU banks.  
The impact on bank capital require ments of option 3 would be mo re material than that under 
option 2. Yet due to its emphasis on bank invest ment decisions going forward and inclusion 
of a grandfathering provision, th is policy option would avoid im mediate capital hit for banks 
that otherwise would be materi al. Respondents to the public cons ultation estimated  that in the 
absence of a grandfathering clause, the impact in terms of the amount of additional capital 
that would have to be raised by European ba nks would be in the region of €100-150 billion. 
The related cost of capital th at the industry might incur could exceed €10 billion per year, 
depending on the market conditions73. Depending on the state of fina ncial markets at the time 
of such approach coming into effect, it would be indeed problematic for banks to raise the 
indicated amount of new capital, which could lead to a furthe r round of selling of these 
instruments or unwelcome pro-cyclical conseq uences for the broader economy in the short-
run.  
Feedback has also shown the importance of havi ng a more targeted scop e for application of 
the proposed treatment: the broad definition of re-securitization may capture instruments such 
as asset backed commercial paper (ABCP) condu its whose risk characteristics are typically 
very different from those of CDOs of RM BS. However, in many cases and for purely 
technical reasons, these conduits may in many in stances still meet the definition of a re-
securitisation74. The current volume of such ABCP c onduits sponsored by EU banks is in 
excess of $252 billion75. If, however, the sponsoring activity became subject to a full 
deduction from capital requirement, EU sponsoring banks would in the most extreme scenario 
have to hold some €190 billion of additiona l capital, which would probably make this 
business model unviable. Careful legal drafting of this option would however be needed to avoid that going forward ABCP structures could be modified to resemble the risk profile of 
CDOs of ABS. 
Policy option 4: Enhanced supervisory oversight  of new investments in re-securitizations 
combined with deductions from capital fo r highly complex re-securitizations where 
compliance with due diligence is inadequate   
Banks investing in re-securitisations will be required, following the CRD changes adopted by 
the Commission in 2008, to exer cise due diligence also with  regard to the underlying 
securitisations and the non-securitisation exposures ultimately underlying the former. 
Depending on the complexity of the layers of securitisation structures  and depending on the 
complexity of the non-securitisation exposures th at ultimately underlie the re-securitisations, 
the required due diligence may be uneconomical or even impossible. This is in particular the 
                                                 
73 The Commission Communication of Dece mber 5, 2008 on the recapitalization of financial institutions in the 
current financial crisis estimated average required rate of return for fundamentally sound euro area banks to be 
in the range of 7% of preferred shares with features similar to those of subordinated debt and 9.3% for ordinary 
shares. 
74 The problem lies in the way these programs are structur ed. Usually, to bundle volumes, a program consists of 
a 'conduit' that issues the commercial paper and receive s cash flows out of separate  Special Purpose Vehicles 
(SPVs) that purchase receivables, each fr om different firms. Thes e firms or the sponsor will often bear the first 
loss on the receivables at the level of these separate purchasing SPVs. This mean s that the exposure of the 
conduit to the purchasing SPV is 'tranched', i.e. a securitization exposure, and the exposure to the conduit - whether in the form of a liquidity guarantee or in the form of commercial paper - becomes a re-securitization. 
75 According to a comment letter submitted by ISDA and other industry federations. 23.9% of this amount was 
euro denominated. 
 
EN 28   EN case where the ultimately underlying exposures are themselves complex exposures such as 
leveraged buy-out or pr oject finance debt.  
Option 4 implies the Basel approach as discus sed under option 2. However, for particularly 
complex re-securitisation positions, it would introduce a specific safegua rd that reinforces 
both the due diligence requirements and the supervisory process to enforce them. 
In a first step, the Committee of European Bank ing Supervisors (CEBS) would be required to 
draw up common guidelines on what types of re-s ecuritizations have to be considered highly 
complex so that banks are at a particularly high risk of fail ing to meet the due diligence 
standards. The reinforced supervision would th en only apply in a targeted fashion to these 
exposures, thereby allowing re-sec uritizations to remain una ffected where it can reasonably 
be expected that banks will be able to economi cally and effectively handle the complexity of 
those re-securitizations and exerci se the required due diligence. 
In the unlikely event of banks proceeding with  investment in types of re-securitizations 
identified by CEBS as difficult for banks to economically and effectively handle the 
complexity thereof and exercise the required due diligence, na tional supervisory authorities 
would in a second step be required to examine, on a periodic but sample basis, each individual new investment of a bank in one of the highl y complex re-securitization exposures according 
to the typology identified by the CEBS to establish whether the necessary due diligence has 
been exercised. However upon establishing that it had not, the cred it institution would 
thereafter be debarred from investing in such class of re-securitization in the future. This 
approach would limit the incremental compliance co sts implicit in the increased surveillance.  
For the highly complex re-securitization expos ures according to the typology identified by the 
CEBS, a general deduction from capital requirem ent would apply unless banks demonstrate in 
the periodic reviews that due dilige nce standards have been met.  
Option 4 would be more-or-less as effective as option 3 in terms of co ntributing to all the 
relevant operational and specific objectives. Howe ver, it would be superior to option 3 in 
relation to objective G-3 (Ensure international competitiveness of EU banking sector) as it would be better aligned with capital requirements agreed in the Basel Committee and would 
result in 'de minimis' impact on the investment  side to the instrument s identified as highly 
complex by the CEBS. It would be also more  efficient than options 2 and 3 as it would 
provide for a more complete atta inment of relevant objectives at  the given level of resources. 
With respect to implications of options 3 and 4 and to a lesser extent options 2 for the future 
credit supply whose funding is facilitated in part by issuan ce of CDOs, available evidence 
shows that in Europe CDO issuance already contracted from €88.7 billion in 2007 to €47.9 billion in 2008
76. Importantly, this contraction would have been even more pronounced had 
the European Central Bank and the Bank of England not been accepting securitization as 
collateral to provide banks with much needed  liquidity: in 2008, 95% of all securitization 
issuance was retained by banks for repo purposes with primary issuance market remaining effectively closed due to signi ficantly diminished investor a ppetite for these instruments
7778. 
Against such ongoing trends of the baseline sc enario, any incremental impact of each of the 
options for the CDO issuance and, in relation, to  the credit supply appear s to be of a limited 
nature. 
                                                 
76 In the US, CDO issuance contracted from €352 billion in 2007 to €40 billion in 2008; source: ESF 
77 European Securitisation Forum, ESF Securitization Data Report , Q4 2008 
78 Here it is important to point out, that if securitizations are structured to avail banks of central bank funding, in 
capital requirements terms such securitizations are not treat ed as such, rather, banks will continue to calculate a 
capital requirement for the securitized assets  as if they had not been securitized. 
 
EN 29   EN Policy options 3 and 4 and, to a lesser extent, policy option 2 could have a limiting effect on a 
possibility of the secondary mark et recovery for these instrument s, were the demand for them 
to strengthen as a result of change in risk ap petite of certain other investor groups, as the 
options aim at setting capital requirements that  ensure a prudent attitude of banks towards 
these products – due to their inhe rent structural shortcomings outlined above - irrespective of 
the sentiment prevailing in the market.  
5.3. Disclosure of Securitization Risks 
- Policy option 1:  Retain the current CRD treatment; 
- Policy option 2 : Enhance disclosure requirements in line with the Basel Committee's 
approach, in particular extending the requirements to the trading book. 
Policy option 1: Retain the current CRD treatment  
Under this option, the current set of disclosu res would be left unchanged. Problems outlined 
in section 3.4 would not be addressed. Likewi se, this option would not  achieve any of the 
operational objectives and would not promote a ny of the specific or  general objectives. 
Policy option 2: E nhance disclosures  
Under this option, disclosure requirements wo uld be enhanced focussing on the following 
areas: 
– securitization exposures in the trading book;  
– sponsorship of off-balance sheet vehicles;  
– the Internal Assessment Approach (IAA) for securitizations and ot her ABCP liquidity 
facilities;  
– re-securitization exposures;  
– valuation with regard to s ecuritization exposures; and  
– pipeline and warehousing risks with re gard to securitization exposures.  
The costs that industry incurs as  a result of information provisi on requirements that stem from 
legislation and that are incremental to those linked to the business-a s-usual (BAU) practices 
are known as administrative burden. The incremental administrative burden for the EU banking industry is estimated at €1.3 million per y ear; it is expected to fall mostly on larger 
institutions with more advanced approach to risk management (for assumptions please see 
Box 2).  
 
Box 2:  Administrative burden of new disclosure  requirements for securitization activities 
The administrative burden due to existing public disclosure provisions under Directive 2006/48/EC is 
estimated at €17 million per year79.  The key assumptions behind this estimate include:  
– 20 man days per year to conduct all the necessary tasks, 
– Business-as-usual factor of 75%, which implies th at 25% of costs incurred businesses perceive as 
administrative burden, and 
– Public disclosure requirements apply to all institutions. 
                                                 
79 European Commission, EU Project on Baseline Measurement and Reduction of Administrative Costs , March 
2009 
 
EN 30   EN Any administrative burden of policy option 2 is es timated, by building on the above assumptions as 
follows: 
– Additional disclosure requirements are likely to be fully applicable to larger institutions that are 
active in the specific securitization-related activ ities outlined in this section while impact on 
smaller firms is expected to be of lesser materiality80. For larger banks that have adopted a more 
advanced approach to risk management81, proposed changes are expected to result in an increase of 
approximately 15%82 of annual man days required to meet  existing disclosure requirements. For 
small banks only one half of the above increase, i.e., 7.5% was assumed to be realistic as their 
involvement in the activities for which new disclos ure requirements are introduced has been of a 
lesser extent with a further retrenchment in the aftermath of the crisis very plausible. 
– The two sub-samples are assumed to be approximate ly equal to 2% (larger institutions with more 
advanced risk management) and 98% (remaining smaller institutions) of all credit institutions83. 
Based on the above outlined assumptions, the incr emental administrative burden for EU banking 
industry is estimated at €1.3 million84 per year and could be deemed to be rather immaterial compared 
to the total expected benefits of the proposal.  
This option would contribute to  achieving the relevant oper ational objective and it would 
directly contribute to the speci fic objective S-5 (Improve invest or understanding of bank risk 
profile). Indirectly, it would also contribute to S-4 (Reinforce risk management incentives), 
allowing market participants to exert disciplin e on banks' risk management. By consequence, 
this option may also be expected to have a positive impact towards objectives G-1 (Enhance 
financial stability), G-2 (Enhance safeguarding of creditor interests) and G-4 (Reduce pro-
cyclicality of the financial syst em). The fact that it is in line with internationally agreed 
standards and that it fosters market confiden ce makes also for a positive contribution towards 
objective G-3 (Enhance international competitiveness of EU banking sector). 
5.4. Supervisory Review of Remuneration Policies 
The following three general policy options have been identified for addressing the problems 
identified in relation to th e effect of badly designed re muneration policies on sound risk 
management in financial instituti ons within the scope of the CRD: 
- Policy option 1:  Take no legislative action, and use 'soft' pressure means to promote and 
monitor the widespread implementation of the newly adopted Co mmission Recommendation 
on remuneration policies in the financial services sector;  
- Policy option 2 : Legislation to provide for supervisor y review of remuneration practices and 
policies to ensure that institutio ns comply with the relevant high level principles for sound 
remuneration policies in a way that is appropriat e to their size, internal organization and the 
nature and scope of their activities; 
                                                 
80 Moreover, article 146 of CRD prov ides for a possibility of  proportionate application of disclosure 
requirements by allowing institutions to omit specific disclosures if the information is regarded as not material 
for its users in their making of economic decisions, proprietary or confidential. 
81 Approximated by a bank's choice of the approach for calculation of minimum capital requirement for the 
credit risk of its corporate portfolios. Based on the results of the Quantitative Impact Study 5 (QIS5), 144 EU 
banks have signalled their preference to adopt a more ri sk-sensitive Internal Ratings Based (IRB) approach for 
calculating minimum capital requirements for the credit risk of their corporate portfolios.   
82 Estimated based on the proposed number of net additional information items to be disclosed in Annex XII of 
Directive 2006/48/EC, Part 2, Point 14; assumes average cost per information item is approximately the same. 
83 In 2007, there were some 6,600+ credit institutions in the EU, not counting branches and subsidiaries of banks 
from other Member States and 3rd countries. See ECB, EU Banking Structures , October 2008 
84 17*(0.02*0.15+0.98*.075)=1.3 
 
EN 31   EN - Policy option 3 : Legislation to provide for supervisor y review of remuneration practices and 
policies and requiring a strict and uniform app lication of the relevant  principles for sound 
remuneration policies. 
Also, two additional options that could be viewed  as sub-options of either option 2 and 3 and 
pertaining to the size of institutions to be covered are considered: 
- Policy option 4:  Apply proposed measures to all inst itutions irrespectiv e of their size; 
- Policy option 5:  Apply proposed measures only to systemically important undertakings. 
Policy option 1: No legislative action  
This option would maintain the current legi slative framework described in section 3.5.2, 
without imposing new binding oblig ations on firms, or reinforc ing the supervisory overview 
by competent authorities. 
Within this option, EU action w ould consist of active monitori ng of the applic ation of the 
principles contained in the Commission R ecommendation on remuneration policies in the 
financial services sector, and measures to promote better implementation of the existing 
framework by Member States. Such measures might include dialogue with Member States 
and with interested parties, such as institutiona l shareholders, to encourage their promotion of 
the principles in the Recommendation; regula r evaluation of industry compliance with the 
principles on sound remuneration; and publicati on of a European 'scoreboard' indicating the 
extent to which national law is consistent with the principles in the Recommendation. 
Widespread application of the existing framewor k by regulated firms might also be promoted 
by national regulators in their en forcement of the requirements of  the sectoral directives. As 
indicated, it is arguable that the obligations th at currently apply to credit institutions and 
investment firms under the CRD and MiFID in relation to the identification and management 
of risks already require those firms to ensure  that remuneration polic ies and practices do not 
expose the firm to unmanageable risks that exce ed the level tolerated by the firm. Regulators 
have not focussed on such risks until recently. However, in the light of the current attention to the risks arising from poorly designed remunerati on policies at internati onal level, it is likely 
that regulators will make enhanced use of th eir existing tools of prudential supervision to 
ensure that the remuneration policies of regulat ed institutions are consistent with sound and 
effective risk management.
85 The development by the Comm ittee of European Banking 
Supervisors (CEBS) of high le vel principles on sound remunera tion policies could encourage 
and converge national regulators'  supervisory oversight of re muneration policie s within the 
limits of the existing framework. 
However, the obligation under Ar ticle 22 of the CRD, and the obligation under Article 13 of 
the MiFID have been insufficiently explicit as  regards remuneration policies to prevent the 
proliferation of remuneration structures observe d in recent years that have provided incentives 
for aggressive risk-taking.   
Moreover, by its nature the Recommendation is not binding, and is therefore likely to give 
rise to diverse national application and in terpretation by national regulators in their 
supervision and enforcement of re muneration policies.  While that  diversity can be controlled 
to some extent by active monitoring and 'soft' pressure on the part of the Commission, and by 
                                                 
85 Initiatives of this kind are already being taken by a nu mber of regulators such as the UK's Financial Services 
Authority 
 
EN 32   EN the convergence work carried out by supra-national committees such as the CEBS, 
inconsistent application is likely to persist.   
Similarly, national measures in the field of remu neration that have been adopted in advance of 
and separately from the Recommendation vary in their content and risk creating competitive 
imbalances. While the Recommendation represents a significant step in removing the risk of 
'first mover disadvantage' associated with the national adoption of more  stringent regulation, 
further convergence in supervisory review and enfo rcement is still desirable to ensure that the 
principles on sound remuneration set out in th e Recommendation are ap plied in practice and 
in a way that achieves the objective of sound risk management. 
This option implies a possible impact on the supp ly of talent to the industry, as employment 
in the relevant financial services sectors might  become relatively less attractive (due to the 
level and modalities of remunera tion affected) compared to th e other sectors of the economy 
in the EU and compared to employment, includi ng in the financial services sectors, outside 
the EU. The potential negative effect is attributable mainly to the following principles: i) requiring a deferred element, ii), adjusting performance measurement for risks, cost of capital 
and liquidity and iii) linking early terminati on payments to performa nce. Its extent is 
uncertain and there are arguments  indicating that it might not be  significant: the discounted 
value of the affected part of the remune ration would be known to the employees when 
negotiating their contracts, which will likely l ead to negotiation of a higher fixed component 
of their compensation.  
At the same time, factors such as tax, language, culture and soci al considerations should limit 
the drain of talent abroad. Give n that similar principles on th e structure of remuneration are 
already recommended by the FSF and endorsed by th e G20, risks for EU companies vis-á-vis 
companies situated in other financial centres sh ould be limited further. Also, having principles 
at the EU level should make it easier to promote and export them interna tionally at a bilateral 
or multilateral level thereby further reducing this risk. 
Policy option 2: Legislation to provide for supervisory review of remuneration practices and 
policies to ensure that institutions comply w ith the relevant high level principles for sound 
remuneration policies in a way that is appropria te to their size, internal organization and the 
nature and scope of their activities  
Under option 2, the proposed amendments w ill impose a binding obligation on credit 
institutions and investment fi rms to have remuneration policie s that are consistent with 
effective risk management. This option would pr ovide firms with discretion in relation to the 
procedures they would put in place to ensure  effective compliance with the principles on 
sound remuneration. In particular, it would allow them to achieve compliance in a way that is 
appropriate to their size, intern al organization and scope of thei r activities. The relevant high 
level principles will be set out in the CRD and wi ll be closely aligned with those set out in the 
Recommendation. For the practical application of this binding obligation, the guidelines on 
sound remuneration policies developed by CEBS will be also highly relevant. They will 
provide guidance to banks as to how the bindi ng obligation can be met, and a framework for 
supervisors when assessing banks' remuneration st ructures in the course of the 'Pillar 2' 
supervisory review, which should provide for a more harmonized approach to enforcement of 
these principles.  
This option implies a certain degree of flexibility for companies when revising their 
remuneration schemes, which may minimize  their one-off implementation and on-going 
compliance costs. Only a minority of respondent s to the public consu ltation on remuneration 
policies expressly indicated the extent of potential incremental direct costs for them of complying with remuneration principles under th is option. According to them, such costs 
 
EN 33   EN would be relatively immaterial. Indirectly, th e principles concerning the balance between the 
fixed and variable elements and on deferred paym ent of the variable element could result in 
an increase in the fixed element of remunera tion and a higher share of  fixed costs for the 
companies, which might reduce their financial flex ibility. Supervisors' ro le would be critical 
to ensure that intended effectivenes s of the rules is not compromised.  
Under this option, all national supervisors will be able to  apply both financial and non-
financial sanctions against firms that fail to satisfy supervisors that they comply with the 
relevant principles in a way that  is appropriate to their internal structure and business model. 
The nature of those sanctions will be prescr ibed in national law. However, non-financial 
sanctions could include the power of a public cen sure ('name and shame'). The main forms of 
financial sanctions would be fines. Fines might be imposed against institutions that fail to put 
in place and exercise claw-back cl auses in appropriate cases, as well as in other instances of 
significant failure to comply with the principles. 
The incremental impact of option 2 on a firm's ab ility to attract and retain talented staff is 
linked to its greater incremental effectiveness: making the relevant principles of the Recommendation binding will enhance compliance w ith them at a company level; therefore, 
any impact on attracting or retaining talent at the overall banking sector level should be more 
extensive than under the baseline scenario.  
From the perspective of the institutions' em ployees, the impact of this policy option on 
balance should be positive. On the one hand, so me categories of staff might see their overall 
compensation level fall although th e degree of such effect is di fficult to ascertain, assuming 
that the discounted value of the affected part  of the remuneration would be known to such 
employees which in turn might lead to a negotiation of a hi gher fixed component of their 
compensation. On the other hand, any improvement  in the financial s oundness level of their 
employers in the longer run should minimize th e likelihood of employees' losing their jobs if 
their company would undertake cost cutting or even be unwound if otherwise not tackled 
aggressive risk-taking practices pus hed it into a financial difficulty.  
With respect to the international competitiven ess position of EU firms, any incremental
 
negative short-term impact over and above the ba seline scenario also stems from the binding 
nature of this option. This impact will be m itigated, on the other hand, by the fact that such 
high level principles are intended to serve onl y as guidance to firms on how compliance can 
be achieved. Its extent will also be subject, as mentioned under policy option 1, to the nature 
of actions taken in this area by other internati onal jurisdictions: the G20 Declaration of April 
2, 2009 included the commitment of the global leader s to implement the principles of the FSF 
for sound compensation practices86. In relation to intra-EU competition, certain incremental 
pressure might arise under this option, given that  its scope covers only credit institutions and 
investment firms. 
It is essential to under line that a more effective implementa tion of the relevant principles of 
the Recommendation certainly implies a trade-of f that includes long-term benefits for the 
industry stemming from improved risk manageme nt outcomes and, more importantly, broader 
benefits in terms of a more stable and less procyclical financial system. 
                                                 
86 See footnote # 15 
 
EN 34   EN Policy option 3: Legislation to provide for supervisory review of remuneration practices and 
policies and requiring a strict and uniform application of the re levant principles for sound 
remuneration policies  
Under this policy option, a binding obligation on credit institutions and investment firms to 
have remuneration policies that are consistent  with effective risk management will be 
imposed by requiring a strict and uniform applic ation of the principles for sound remuneration 
policies that would be closel y aligned with those set out in the Recommendation, and, in 
comparison with the preceding policy option, woul d be defined at a more granular level.  
This option would also l eave little or no leeway fo r institutions to comply with the necessary 
changes in a way that is appropriate to their size, internal organization, and the nature and 
scope of their activities. For instance, princi ples might require that the major part of a 
significant bonus be deferred for a period which is  appropriate for the nature of the business 
with the payment of any deferre d part being linked to the futu re performance of the firm, 
including performance of the bus iness unit of the individual conc erned. Lack of flexibility 
under this option would imply that no account can be taken of the business cycle or the needs and expectations of employees and manageme nt in cases where firms are building new 
businesses that might take several years to reach  profitability, no profit ability equates to no 
bonuses, even though firms may wish to motivate their employees by rewarding them if they 
exceed their objectives in building relationships or mitigating risks (i.e., making risk management more effective).  
Under option 3, all national supervisors will be able to apply both financial and non-financial 
sanctions as described un der the previous option.  
All the impacts that are captured by the trade-off between short-term costs and long-term 
benefits described under option 2 would be mo re strongly pronounced under this option due 
to a greater eventual level of compliance by companies under the scop e. This option implies 
lesser flexibility for companies when revi sing their remuneration schemes, with the 
concomitant one-off implementation and on-going  compliance costs higher than under option 
2. In particular, it implies higher than warranted costs for institutions that are smaller and / or 
engaged in more atypical business activities (that merit a more customized approach when complying with the principles) than for their peers.  
While both options 2 and 3 would be more-or-less equally effective with respect to attaining 
relevant operational and specific objectives, option 3, being more pr escriptive, would be 
marginally more effective with respect to at taining objective S-6 (Enha nce legal clarity). On 
the other hand, option 3 might imply some unintended 'side' effects, as it might not be able to 
effectively accommodate all possible real-life bus iness situations. It would also be less 
efficient than Option 2 as the latter would provide for flexib ility when making any necessary 
adjustments to remuneration policies already in place, resulting in lower compliance costs.   
Policy options 4 : Apply proposed measures to all ins titutions irrespective of their size vs.
 
Policy option 5: Apply proposed measures onl y to systemically important undertakings  
As regards the size of institution that might be covered, the principal options are to apply the 
proposed measures (option 4) to all financial in stitutions independent of their size; or (option 
5) only to significant, systemica lly important undertakings the fa ilure of which has a potential 
impact on the functioning of the relevant fi nancial sector. Option 5, while superficially 
attractive, is inconsistent with the provision s of the CRD for supervision on a consolidated 
basis: it would be illogical  and possibly counter-productiv e for requirements to apply 
differently to different entities in a conso lidated group depending on their size. Therefore, 
option 5 seems to be inferior to option 4 with regard to objective S-6 (Enhance legal clarity). 
 
EN 35   EN Similarly, where remuneration policies are orga nised and managed at group level, it makes 
little sense for the requirements and supervision to apply selectively. 
While option 5 underscores the fact that from the point of view of enhancing financial 
stability (objective G-1), risk-taking behaviour of large firms is more pertinent, option 4 
would be more effective with respect to contri buting to objectives of protection of creditor 
interests (objective G-2) and re ducing pro-cyclicality of the fi nancial system (objective G-4) 
as it would reinforce risk management incentiv es (objective S-4) for a broader scope of 
institutions. Implications of option 4 for the compliance costs of small institutions would be 
mitigated by combining this option with option 2 that allows for a proportionate application of 
the relevant principles.  
In any event, the flexibility w ithin the supervisory review pro cess would enable supervisors to 
focus most intensively on those cases where the remuneration policies and practices gave rise to unmanaged risks. Accordingly, option 4 is more appropriate in the context of a measure targeted at institutions within the scope of the CRD.  
5.5. Summary of Policy Options 
The following table summarizes the fourteen policy options analysed. Individual options 
within each policy set are ranked in terms of their relative effectiveness
87 and efficiency88 
with regard to achieving applic able longer term policy (specifi c) objectives. Options that are 
included in the legislative proposal are highlighted.  
                                                 
87 Measures extent to which options achieve relevant objectives 
88 Measures extent to which objectives can be achieved for a given level of resources   
 
EN 36   EN Table 3:  Summary of policy options' effectiveness and efficiency 
 Policy Option Comparison Criteria 
 Effectiveness 
Policy 
Option  
Set Policy 
Options Enhance 
adequacy 
of capital 
requirem
ents 
[S-1] Minimize 
cyclicalit
y of 
capital 
requirem
ents 
[S-2] Eliminate 
regulator
y 
arbitrage opportun
ities 
[S-3] Reinforce 
risk 
managem
ent 
incentive
s 
[S-4] Improve 
investor 
understa
nding of 
bank risk 
profile 
[S-5] Enhance 
legal 
clarity 
[S-6] Efficienc
y 
1 Retain current approach 3 3 3 3   3 
2 Impose a set of targeted measures 1 1 1 1   1 Capital 
requirement for 
trading books 
3 Change modelling standard 2 2 2 2   2 
1 Retain current approach  4 4  4 4  4 
2 A separate set of higher risk weights  1 3  3 3  2-3 
3 Capital charges to discourage 
investments in complex re-securitizations with grandfathering & targeted exemptions  3 1  2 1-2  2-3 Capital 
requirement for 
re-securitizations 
4 Enhanced supervisory oversight 
combined with deductions from capital 
where due diligence is inadequate 2 2  1 1-2  1 
1 Retain current approach    2 2  2 Disclosure of 
risks from 
securitization 
positions 2 Enhance disclosure requirements    1 1  1 
1 No legislative action 3  3 3  3 3 
2 Legislation  requiring to comply with 
relevant high level principles, while taking 
into account specificities of a firm 1-2  1-2 1-2  2 1 
3 Legislation requiring strict and uniform application of relevant principles 1-2  1-2 1-2  1 2 
4 Application of measures to all 
institutions    1  1 1 Remuneration 
schemes** 
5 Application of measures only to 
systemically important undertaking    2  2 2 
Scale of option ranking: 1=most effective / efficient, 4=least effective / efficient 
**Options 1-3 are compared separately from  options 4-5 as they are complementary 
5.6. Cumulative Impact of Proposed Amendments 
5.6.1.  Overall Benefits 
An estimated $1.4 trillion could be lost in asse t writedowns by European banks as a result of 
the current crisis. These losses together with  ensuing negative consequences for the real 
economy will be shouldered – to a varying degree – by different stakeholder groups, ranging from shareholders of financial institutions to taxpayers. In light of th e lessons learned, it is 
crucial to review certain aspect s of bank regulation so  that the risk of losses of this scale 
occurring in the future is contained. Such containment constitutes the overarching and the most material expected benefit (or cost sa ving) of the proposed amendments and by far 
outweighs the costs that accompany them.  
The policy improvements that are being proposed  are not intended and, therefore, cannot be 
expected to alleviate the situation of the banking sector or the stability of the financial system 
at the current juncture. Rather, their aim is to address issues in certai n areas of bank capital 
regulation that contributed to the evolution of the crisis and the level of aforementioned asset 
writedowns. The changes are expected to rende r the CRD framework more robust in the long 
run, leading to more effective risk management  incentives and practices, more adequate and 
 
EN 37   EN less volatile bank capital requirements and enhanced  disclosure of bank ri sk positions to the 
market participants. The policy option analysis has shown that proposals should contribute to 
limiting excessive pro-cyclical effects stemming  from the current functioning of financial 
system, which is impacted by re gulation, and containing risks to the financia l stability and the 
concomitant costs to society in the future. At  the level of individual stakeholder groups and 
systemic concerns, the expected bene fits of the proposals are as follows: 
– Enhancements to the regulatory capital framewor k - in terms of more  adequate and less 
cyclical capital requirements t ogether with strengthened pub lic disclosure requirements - 
should provide the EU banking industry  with appropriate incen tives for improving their 
risk management as well as their internal governance and control systems and procedures. 
As a result, not only the long-term viability of  EU banks but also their competitive position 
vis-à-vis their interna tional peers in the long run would be enhanced. 
– The proposed revisions will enhance the effectiveness of supervisors ' monitoring of the 
risks that financial instituti ons are exposed to by providing  more legal clarity on banks' 
obligations with respect to  managing risks stemming from  inappropriate remuneration 
policies; by eliminating regulatory arbitrage opp ortunities allowing banks to apply lower of 
the banking or the trading book cap ital charges and streamlini ng the regulatory treatment 
of securitization positions in banks' trading book. 
– Protection of banks' creditors , including depositors, will be enhanced as improved 
effectiveness of the framework and its supervision wi ll lead to a reduc tion of bank default 
risk. 
– Borrowers , including SMEs89, will benefit from a less cyclical nature of bank financing 
allowing them to engage in projects that ar e profitable and vital for the economic growth 
and prosperity. 
– Importantly, by improving the adequacy and curt ailing the cyclicality of regulatory capital 
requirements as well as enhancing risk management incentives for the EU banking institutions, the proposed amendments  will strengthen financial stability
 and mitigate any 
excessive pro-cyclical effects  of bank regulation in the long run, indirectly yielding 
substantial benefits to the wide  range of social stakeholders , including bank employees (via 
improved financial soundness of their employe rs), households (e.g., via less cyclical 
availability of credit and restored trust in their banks ) and taxpayers (via reduced 
likelihood of bank bailouts in the future).  
5.6.2.  Compliance Costs 
The overall cumulative impact on compliance costs fo r the industry is expected to be material, 
chiefly driven by the cost of capital which would have to be raised in order to comply with revised rules. The most material implications in terms of compliance costs emanate from the 
proposed changes for minimum capital requiremen ts for banks' trading book activities and re-
securitization positions that ar e held in their banking books a nd are discussed under respective 
policy options. To the extent that, as a result of  their internal capital planning or credit rating 
agencies' requirements, banks hold capital levels exceeding regulatory requirements, the impact might be partially mitigated by the resultant capital buffers.  
                                                
 
89 A study commissioned by the European Commission showed that there is a significant positive effect of the 
business cycle on bank loans to medium-sized firms, with the effect on small firms al so significant but smaller; 
see EIM, Cyclicality of SME Finance , March 2009 
 
EN 38   EN Introduction of proposals that have a direct be aring on the amount of capital that banks are 
required to hold will have to be carefully timed so that any unintended pro-cyclical impacts on the credit supply and, hence, the real economy ar e avoided or cushioned in the short-term. 
Nevertheless, to the extent that  currently pract ically non-existent market appetite for such 
products resurfaces in the futu re, the credit supply might be impacted unfavourably by 
specific policy options aimed at dissuading banks from investing in re-securitization 
instruments. 
The Commission's Better Regulation strategy is aimed at measuring administrative costs and 
reducing administrative burden. The distinction be tween the two is that the latter denotes 
costs linked to providing the information that businesses would not incur in the absence of 
legislation. The CRD is part of the Co mmission’s Action Programme for reducing 
administrative burdens in the EU which has the goal of administra tive burden reduction of 
25% by 2012. In the area of prudential banking regulation, certain information requirements 
are necessary to provide for the desired level of  financial stability and creditor protection and, 
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 w ith this initiative, it has to be noted 
that they were undertaken with a view to ach ieving multiple operational, specific and general 
objectives (see section 4) and had to be designe d accordingly. Significant implications of the 
proposed changes on reporting obligations for the industry are expected to stem only from 
enhanced disclosure requirements for securi tizations in banks' trading books with the 
estimated resultant administrative burden falling in the range of €1 million per year. 
Proposed amendments are not e xpected to disproportionate ly affect small financial 
institutions vis-à-vis the larg e ones, as the nature of activ ities being reviewed is more 
common to the latter group of institutions.  
The following table lays out the expected net effect of the pr oposals on various stakeholders. 
 
EN 39   EN Table 4:  Summary of impacts on stakeholder groups  
                                Key  
                 Stakeholders  
Issue Areas Banking 
Industry Supervisors Investors / 
Creditors Borrowers Bank 
Employees 3rd Country 
Banks 
Capital requirement 
for trading books  +/- 
(↑ financial 
soundness in 
the long run, 
indirect 
benefits from 
financial 
stability offset 
by  
↑ compliance 
costs) + 
(↑ effectiveness 
of monitoring) + 
(↓ potential 
economic crisis 
related costs)  + 
(↑ improved 
availability of 
credit over 
the cycle) + 
(↓ potential 
crisis related 
costs due to 
enhanced 
soundness of 
their employers)  ≈ 
Capital requirement 
for re-securitizations +/- 
(↑ financial 
soundness in 
the long run, 
indirect 
benefits from 
financial 
stability offset 
by  
↑ compliance 
costs)  + 
(↑ effectiveness 
of monitoring) + 
(↓ potential 
economic crisis 
related costs)  + 
(↑ improved 
availability of 
credit over 
the cycle) + 
(↓ potential 
crisis related 
costs due to 
enhanced 
soundness of 
their 
employers)  +/- 
(↑ competitive 
position in the 
short run offset 
by ↓ in the long 
run as more 
prudent EU 
approach yields 
results) 
Disclosure of risks 
from securitization 
positions +/- 
(↑ financial 
soundness in 
the long run, 
indirect 
benefits from 
financial 
stability and 
market 
discipline 
offset by  
↑ admin 
burden)  + 
(↑ effectiveness 
of monitoring) + 
(→ disclosure 
requirements 
allowing to 
better 
understand 
bank risk 
profile)  ≈ + 
(↓ potential 
crisis related 
costs due to 
enhanced 
soundness of 
their 
employers)  ≈ 
Remuneration 
schemes +/- 
(↑ financial 
soundness in 
the long run, 
indirect 
benefits from 
financial 
stability offset 
by  
↑ compliance 
costs)  + 
(↑ effectiveness 
of monitoring) + 
(↓ potential 
economic crisis 
related costs) + 
(↑ improved 
availability of 
credit over 
the cycle) +/- 
(↓ potential 
crisis related 
costs due to 
enhanced 
soundness of 
their employers; 
→changes to 
remuneration 
policies)  +/- 
(↑ competitive 
position in the 
short run offset 
by↓ in the long 
run as more 
prudent EU 
approach yields 
results) 
Legend: + overall positive effect, - overall negative effect, +/- overall mixed effect, ≈ effect not significant, ↓ decrease, ↑increase, → 
introduction 
6. MONITORING AND EVALUATION  
It is expected that the proposed amendments wi ll enter into force in 2011. For changes in the 
areas of capital requirements for the trading book and re-securitization positions this date is driven by the timetable followed by the Basel Committee. At the same time - as highlighted throughout the report – care will have to be exer cised that, in line with the agreement of the 
G20 of April 2, 2009, any measures  geared to improving the quant ity of capital in the banking 
system are introduced 'only once recovery is assured'. 
The amendments are tightly inter- linked with other prov isions of the CRD, that are already in 
effect since 2007-2008, will come into effect  following the implementation of Proposal 
COM/2008/0602 and following possible CRD revisions  that are foreseen for adoption by the 
Commission later in 2009.  
 
EN 40   EN Normally, the practice at the Commission is to conduct an evaluation of a legislation some 
four years after its implementation, however, gi ven the number of revisions that the CRD has 
and will be undergoing in the near future it might be worthwhile conducting a comprehensive 
evaluation of the CRD that would be based on the entirely overh auled framework, which 
complicates setting of such target date. On the other hand, the current and recent proposals 
underscore the importance of timely and appropr iate changes of the rules in response to 
market events. Therefore, it is also possible that individual provisions of the CRD will continue to be formally evaluated on a piecem eal basis, following the outcomes of various 
monitoring exercises both at the EU and the in ternational level or the necessity to act as 
dictated by the market. 
The Commission, in co-operation with Member St ates will monitor the effectiveness of the 
proposals once implemented. The Commission will al so have regard to other stakeholders 
such as industry and consumers while assessing if the objectives outlined in this impact 
assessment are fulfilled. It will also take accoun t of the macro-prudential indicators already 
developed and utilized by the ECB to monitor th e stability of the banking sector. Outcomes of 
the macro-prudential monitoring work of the to-be-created European body to oversee the stability of the financial system as whole
90 might also be used to gauge the effectiveness 
degree to which genera l policy objectives pert aining to ensuring fi nancial stability and 
limiting procyclicality are attained. 
The Commission also participates in the work ing group of the Basel Committee and the joint 
task force on the impact of the new capital framework, established by the ECB and CEBS, that are monitoring the dynamics of bank capit al positions under the Basel II framework
91 
globally and in the EU, respectively (relevant for measuring progress of reaching specific 
objectives of capital requirement adequacy and cyclicality).  
                                                 
90 As per the Commission Communication for the Spring European Council of March 4, 2009 
91 Indicators that are monitored include capital adequacy ratios, capital buff ers, parameters used as inputs in 
minimum capital requir ement calculation for the credit risk, etc. 
 
EN 41   EN  G LOSSARY  
Administrative 
burden Costs specifically linked to information provision that businesses would not collect and provide 
in the absence of a legal obligation 
Alt-A mortgages Mortgages that are usually granted to borrowers with good credit records who seek atypical 
underwriting or loan terms such as reduced proof of their income  
Assumption of 
independent returns Assumption central to the 'random walk' hypothesis is a financial theory which holds that stock 
price changes have the same distribution and are independent of each other, so the past movement or trend of a stock price or market cannot be used to predict its future movement 
Back-testing (of 
VAR models) Requirement for the institution to monitor the accuracy and performance of its model. The 
back-testing has to provide for each business da y a comparison of th e one-day VAR measure 
generated by the institution's model for the portfolio's end-of-day positions to the one-day 
change of the portfolio's value by the end of the subsequent business day 
Basis risk Risk that a hedge instrument for a given position will not experience a price change in an 
entirely opposite direction, thus, diminishing effectiveness of a hedge 
Business-as-usual 
factor Expresses costs of providing the information that would be collected and processed by 
businesses even in the absence of the legislation as a percentage of total information provision-related costs 
Collateralized 
debt obligation (CDO) Securitization where underlying exposures commonly include mortgage-backed securities 
(MBS), commercial real estate bonds and corporate loans 
Confidence level Statistical measure that could be interpreted as providing an estimate for the number of times 
out of 100 that test results can be expected to fall within a specified range. For example, a 
confidence level of 99% means that the result of an action is expect to meet expectations 99% 
of the time  
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 Stat e where the parent bank of the group is based 
Credit risk Risk of losses in on and off-bal ance sheet positions resulting from the failure of a counterparty 
to perform according 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 
Economic capital Capital held and allocated by the bank internally as a result of its own assessment of risk. It can 
differ from regulatory capita l, which is determined according to supervisory rules 
Incremental 
default risk The default risk of trading book positions that is incremental to the default risk captured by the 
VAR measure as specified by specific requirem ents, e.g., VAR that assumes 10-day holding 
period and 99 % confidence level 
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 risk. De pending on the risk factors the bank is allowed 
to estimate, a distinction is made between a foundation IRB and an advanced IRB approach 
Long position Financial term which means that the holder of the position owns the security, such as a stock or 
a bond, and will profit if the price of the security goes up 
 
EN 42   EN Loss given default 
(LGD) The loss, measured as a percentage of the exposur e at default, which is likely to occur in case a 
borrower defaults; one of the required input para meters to derive the risk weight under the 
internal ratings-based approach 
Market risk Market risk is the risk of losses due to price fluctuations of financial instruments in the trading 
book 
Migration risk Risk of loss resulting from marking-to-market debt instruments, driven by a change in market 
perception (incl. credit ratings) of the corporate names' default risk 
Mortgage backed 
security (MBS) Securitization where underlyi ng exposures include mortgage loans, most commonly on 
residential property, in which case securitization is referred to as residential mortgage backed security (RMBS) 
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 bank's capital that comprises sh are capital, retained 
earnings and hybrid capital instruments which meet the criteria agreed at G10 level. Subject to 
technical differences, original own funds correspond to the Basel Accord terminology of Tier 1 capital 
Procyclicality 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. It operates 
mainly through feedback mechanisms which may give rise to cumulative processes in the form 
of spirals and self-sustaining booms and busts 
Re-securitization Securitization where one or more of the underlying exposures meet the definition of a 
securitization 
Residential 
mortgage backed 
security (RMBS) See Mortgage backed security  
Securitization Transaction or scheme, whereby the credit risk  associated with an exposure or pool of 
exposures is tranched, with payments in such 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 th e ongoing life of such transaction or scheme 
Solvency ratio Measure used to assess a bank’s ability to meet its long-term obligations and thereby remain 
solvent and is often represented by the ratio of a bank’s capital (or Tier 1 capital) over its risk-
weighted assets 
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 
Tier 1 capital See Original own funds  
Trading book Comprises those instruments held for short-term resale or to hedge other financial instruments 
that are held for short-term resale 
Unforeseen event 
risk Risk of losses emanating from events which are outside the parameters of portfolio capital 
allocation and, therefore, might trigger unexpected default of an institution or cause it to 
experience difficulties, regardless of the performa nce of the rest of the portfolio. Such events 
include a sudden drying up of market liquidity, internal fraud, government action, loss of a major customer or market and are usually not reflected in ex ante credit quality assessments 
 
EN 43   EN Unfunded credit 
protection A technique of credit risk mitiga tion where the reduction of the credit risk on the exposure of a 
credit institution derives from the undertaking of a third party to pay an amount in the event of 
the default of the borrower or on the oc currence of other specified credit events 
Value-at-risk 
(VAR) models VAR models measure the risk of loss on a speci fic portfolio of financial assets. For a given 
portfolio, probability (confidence level) and time horizon, VAR is defined as a threshold value 
such that the probability that the mark-to-market loss on the portfolio over the given time horizon does not exceed this value (assuming norm al markets and no tradi ng in the portfolio) is 
the given probability level 
 
EN 44   EN ANNEX ON PROCYCLICALITY  
Procyclical effects can be define d as those which tend to follow  the direction of and enhance 
an economic cycle. Within the financial system , such effects transpir e as the tendency of 
financial activity to amplify business fluctuations, which in turn may contribute to financial instability. These effects operate  through feedback mechanisms, which may give rise to self-
sustaining booms and busts. 
In light of the financial crisis , the effect of procyc lical feedback mechanisms on the financial 
system has been examined by a number of international groups, in cluding the Financial 
Stability Forum (FSF), the Basel Committee of  Banking Supervisors (BCBS), the Group of 
20 (G20) and, within the EU, a working grou p of the Economic and Financial Committee 
(EFC). Several of these groups, including th e FSF, the BCBS and the G20, published their 
findings and / or recommendations in spring 2009. 
The objective of mitigating pro-cyclicality feat ured in the recommendations of the Larosière 
Group. It was reinforced by the Commissi on Communication for the Spring European 
Council of March 4, 2009, which outlined a number of policy measures to stem procyclicality 
in the financial system to be pursued during the course of 2009.  
Systemic Aspects 
Banking business and financial ma rkets are inherently cyclical . The risk appetite of banks 
when lending to their customers tends to in crease in economic upswings, when risks are 
perceived to be lower. However, lending cr iteria tighten during ec onomic downturns, when 
the risk of default is perceived to increase. Th is may then create feedback effects for the real 
economy. 
Some procyclical effects result from imperfecti ons in the financial system. These include the 
inaccurate identification and pricing of risks ac ross an economic cycle, where the incentives 
of market participants enc ourage them to under-estimate risks during the upswing, thus 
fuelling booms in credit and investment. There is evidence to suggest that market agents have 
difficulty in assessing absolute risk, especi ally over a prolonged period (though they fare 
better at assessing relative risk),  and so rarely identify booms w ith consequences for systemic 
risk. 
This misperception of risk may be exacerbated by strong competitive pressures. The decisions 
made by each market participant may be rational in their own terms to promote the success of 
an individual institution during a period of growth (or to preserve capital or liquidity during a 
downturn), but may be sub-optimal when considering the system as a whole. 
These market imperfections are often com pounded by macroeconomic (e.g. monetary) policy 
mistakes, inappropriate incentive structures a nd unintended effects of some regulations (e.g. 
capital rules). 
Adding a robust macro-prudentia l overlay to the current mi cro-prudential approach may 
reduce these systemic weaknesses. Such an ove rlay may support the earl ier identification of 
cycles and the build up of risks in the system, which, when accompanied by robust links to supervisors and policy-makers, could enable ac tion to be taken earlie r to avoid excessive 
volatility and procyclicality in a downturn. 
 
EN 45   EN Following recommendations in the Larosi ère report, on May 27, 2009 the Commission 
adopted a Communication on Fina ncial Supervision in Europe92, proposing the setting up of a 
European Systemic Risk Council (ESRC) to oversee  the stability of the financial system as a 
whole. The ESRC would identify systemic risks at European level and issue risk warnings. 
Mandatory follow-up and monitoring tools, and the possibility to refer issues to global early 
warning mechanisms, would be essential. 
Bank Regulation 
With regard to bank capital regulation, the Basel I framework required banks to hold a 
minimum amount of capital for each type of expos ure, and banks were required to maintain a 
ratio of capital to loans largely independent of the risk of these loans. One of the main objectives of Basel II framework, in the EU tr ansposed by the CRD, was to enhance financial 
stability by making capital requirements more risk  sensitive. As a consequence, the capital 
requirements became more variable (or cyclical ) over time than they were previously under 
Basel I. For instance, with respec t to capital requirements for the cr edit risk as a probability of 
default (PD) of an exposure decreases in  the economic upswing and increases during the 
downturn, capital requirements will fluctuate accordingly over the cycle. This may cause credit institutions, as has been seen during the re cent financial market turmoil, to raise capital 
at the point of the economic cycle when it is mo st expensive to do so. This can have further 
feedback effects, such as banks cu rtailing lending to retain resources. 
It is important to note, however, that regulat ory capital requirements ar e not the only relevant 
factor for banks in deciding how much capital to hold. The expectations of other market 
participants, in particular credit rating agenci es, may force banks to increase their capital 
levels even when an institution comp lies with its regulatory requirements. 
The possibility that more risk-sensitive ca pital requirements under the CRD may create 
additional procyclicality had been recognized  during the design phase. Therefore, the CRD 
already includes certain elements that aim to mitigate these effects, such as the use of downturn Loss Given Default (LGD) estimates, PD estimates being based on long data series, technical adjustments made to the risk weight function, stress testing requirements and Pillar 
2 supervisory review process. 
However, more measures might be necessary to dampen the procyclicality of the capital 
requirements framework. The spectrum of opti ons ranges from reducing its cyclical risk 
sensitivity to enhancing its risk capture and deliberately introducing counter-cyclical buffers 
(comprised of capital and/or provisions). The spectrum is broadly reflected by the 
recommendations that were r ecently put forward by the FSF.  
In its report on Addressing Procyc licality in the Financial System
93, the FSF set out 
recommendations to mitigate mechanisms that amplify procyclicality by covering three areas: 
i) bank capital framework, ii) bank loan loss prov isions as well as iii) leverage and valuation 
issues. Recommendations for bank capital framework were developed with the Basel 
Committee and included the following proposals:  
– Strengthen the regulatory capital framework so th at the quality and level of capital in the 
banking system increase during strong economic  conditions and can be  drawn down during 
periods of economic and financial stress; 
                                                 
92 http://ec.europa.eu/internal_mar ket/finances/docs/committees/supervis ion/communication_may2009/C-2009_715_en.pdf   
93 http://www.fsforum.org/publications/r_0904a.pdf   
 
EN 46   EN – Revise the market risk framework of Basel II to reduce the reliance on cyclical VAR-based 
capital estimates; 
– Supplement the risk-based capital requirement with a simple, non-risk based measure to 
help contain the build-up of le verage in the banking system and put a floor under the Basel 
II framework; 
– Supervisors should use the Basel Committee's enhan ced stress testing practices as a critical 
part of the Pillar 2 supervisory review proces s to validate the adequacy of banks’ capital 
buffers above the minimum re gulatory capital requirement; 
– Monitor the impact of the Basel II framew ork and make appropriate adjustments to 
dampen excessive cyclicality of the minimum capital requirements; 
– Carry out regular assessments of  the risk coverage of the ca pital framework in relation to 
financial developments and banks’ evolving ri sk profiles and make timely enhancements. 
These recommendations provide a br oad orientation, and their effectiveness will be driven by 
the eventual design of the measure(s). In line with the above, the Commission in its 
Communication of March 4, 2009, a nnounced that it would pursue certain measures aimed at 
enhancing level (incl. for the trading book a nd complex securitizations) of capital and 
introducing counter-cyclical buffers  and a supplementary metric to  better contro l leverage and 
liquidity risks. 
Remuneration Policies 
There is now a widespread recognition that remuneration practices in financial institutions 
have contributed to the financial crisis th rough encouraging excessive risk taking, and 
procyclical behaviour. More specifically:  
– There was an excessive concentration on short term profits without adequate regard to 
longer term risks; 
– Perverse incentives were created that exacerba ted excessive risk-taking: if the reward for 
risk-taking is too high, th ere are incentives to relax contro ls within the organisation and to 
take on imprudent levels of risk; 
– Remuneration policies likely fostered conflicts of interest by motivating certain categories 
of staff to behave in a way that prioritises their personal remunerati on over the interests of 
the institution: managers may focus on impr oving quarterly profits over long-term growth 
of the business; trader s may take excessive risks to incr ease their bonus even if the trading 
strategy is not consistent with the risk appetite of the bank. 
Remuneration policies have a proc yclical effect where they entail (possibly disproportionate) 
rewards on the upside and insufficient penalties on the downside, e.g., bonuses based on short-term profits that are paid  immediately, with no risk adju stment or deferred payment to 
take account of future performance of th e business unit or institution as a whole.  
With respect to addressing these issues, the Commission Communicat ion of March 4, 2009, 
included a commitment to table a recommendati on on remuneration practices in the sector, 
which, together with a recommendation on remunera tion of directors of listed companies, was 
adopted on April 29, 2009. The communication accompanying the two recommendations set 
out additional steps necessary for their more effective implementation, referring to a need to 
modify the CRD in order to bring banks' and investment firms' remuneration policies and 
their link with risk manageme nt clearly within prudential  oversight laid out under the 
Directive.