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]
Date: 2009-07-13
Institutions: European Commission
Subjects: activity report, bank, economic policy, economic recession, employment policy, financial institution, financial services, pay, remuneration of work, wage determination

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COMMISSION OF THE EUROPEAN 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] 

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This document commits only the Commission's services involved in its preparation and does 
not prejudge the final form of any decision to be taken by the Commission 

TABLE OF CONTENTS 

1. 

2. 

2.1. 

2.2. 

3. 

3.1. 

3.2. 

Introduction .................................................................................................................. 3 

Procedural Issues and Stakeholder Consultation ......................................................... 3 

Background .................................................................................................................. 3 

Stakeholder Consultation ............................................................................................. 5 

Problem Definition....................................................................................................... 6 

Overview of the Capital Requirements Directive ........................................................ 6 

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 Securitization Positions in Trading Book ......................... 13 

3.3. 

3.4. 

3.5. 

Capital Requirements for Re-securitization Positions ............................................... 14 

Disclosure of Securitization Risks ............................................................................. 16 

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. 

3.7. 

4. 

5. 

5.1. 

5.2. 

5.3. 

5.4. 

5.5. 

5.6. 

Risks Inherent in Baseline Scenario........................................................................... 20 

Is Action Necessary at EU Level? ............................................................................. 20 

Objectives................................................................................................................... 21 

Policy Options, Impact Analysis and Comparison .................................................... 21 

Trading Book ............................................................................................................. 23 

Re-securitization ........................................................................................................ 25 

Disclosure of Securitization Risks ............................................................................. 29 

Supervisory Review of Remuneration Policies.......................................................... 30 

Summary of Policy Options ....................................................................................... 35 

Cumulative Impact of Proposed Amendments .......................................................... 36 

5.6.1.  Overall Benefits ......................................................................................................... 36 

5.6.2.  Compliance Costs....................................................................................................... 37 

6. 

Monitoring and Evaluation ........................................................................................ 39 

Glossary.................................................................................................................................... 41 

Annex on Procyclicality ........................................................................................................... 44 

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1. 

INTRODUCTION 

The  extent  of  the  financial  crisis  has  exposed  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  IMF1  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 losses2, half of which (or $1.4 trillion, equivalent to 
9% of EU's GDP) is now attributable 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 national governments undertook a 
broad range of unprecedented measures and initiatives with the bill thereof being shouldered 
by  the  taxpayer.  These  measures  should  be  matched  with  a  robust  and  internationally 
coordinated reform of regulatory weaknesses that transpired during 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 future and ensure that 
risks  linked  to  the  broader  issues  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  businesses'  and  citizens'  trust  in  financial 
institutions as reliable intermediaries for translating their deposits into investment that is key 
for the long-term health of the EU economy.  

2. 

PROCEDURAL ISSUES AND STAKEHOLDER CONSULTATION 

2.1. 

Background 

The financial crisis has prompted a broad EU and international effort to identify the reasons 
behind  the  problems  and  develop  effective  policies  to  tackle  them  head-on.  Such  reflection 
focused in on revising key elements of the Basel II bank capital framework in order to address 
concerns  over  capital  adequacy,  including  the  issue  of  procyclicality.  In  the  buoyant  years 
preceding  the  turmoil,  credit  institutions  aggressively  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 considered appropriate by market participants, banks 
have  had  to  seek  fresh  capital  in  a  difficult  economic  environment  that,  in  turn,  led  to 
tightening  of  their  lending  standards,  exacerbating  negative  cyclical  trends  in  the  real 
economy (for more background on procyclicality 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 

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recommendations for reforming the European financial supervision and regulation. The thirty 
one recommendations4 of the HLG represented a comprehensive set of concrete possibilities 
for regulatory5, supervisory and global repair action and 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  addressing  perverse  incentives  and 
excessive  risk-taking  in  the  financial  services  sector,  the  Communication  included  a 
commitment  to  table  a  recommendation  on  remuneration  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 necessary 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  policies  and  their  link  with  risk  management 
clearly within prudential oversight 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 aimed at strengthening transparency, accountability 
and regulation and include, among others, endorsing and implementing the principles of the 
FSF1415  on  compensation  and  supporting  sustainable  compensation  schemes  as  well  as 

4 http://ec.europa.eu/internal_market/finances/docs/de_larosiere_report_en.pdf  
5 Recommendations called for the Basel Committee to urgently amend rules with a view to gradually increase 
capital  requirements  and  reduce  their  pro-cyclical  impacts  and  advocated  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  Commission  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 taking 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_Deps_Fin_Reg_Annex_020409_-_1615_final.pdf  
13 European leaders expressed their support for these measures 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  stability  in  significant  international  financial  centres, 
international  financial  institutions,  sector-specific  international  groupings  of  regulators  and  supervisors,  and 
committees of central bank experts. The FSF seeks to co-ordinate the efforts of these various bodies in order to 
promote international financial stability, improve the functioning of markets, and reduce systemic risk. 
15 These principles require compensation 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 

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improving  the  quantity  of  capital  in  the  banking  system  once  the  economic  recovery  is 
assured. 
The  report  of  the  FSF  on  Addressing  Procyclicality  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  mitigate  the  risk  that  the 
regulatory capital framework amplifies the transmission of shocks between the financial and 
real  sectors  and  include  proposals  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-securitized credit products. In support of the recommendations of the 
FSF  and  the  G20,  the  Basel  Committee  is  actively  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  institutions  from  various  Member  States  as  well  as 
worker  trade  unions.  The  comments  were  generally  supportive  of  the  objectives  of  the 
Commission's draft proposals. The responses were used to enhance the analysis of impacts of 
certain  policy  options;  amendments  to  them  were  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 treatment of trading book and securitization activities, throughout the 
project the Commission services have followed and participated in the work of international 
forums, the Basel Committee in particular.  

A separate online public consultation on a proposed draft of remuneration policy provisions 
ran from April 29 until May 6, 2009 on DG MARKT website. Twenty three responses were 
received  from  a  wide  range  of  stakeholders  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 other 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  

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management sectors, national supervisory and regulatory authorities 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 was developed, it was not possible to extend the 
period  of  the  above  consultations  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 Directorates-General for Enterprise and Industry, 
Economic  and  Financial  Affairs,  Employment,  Competition,  Health  and  Consumers,  Legal 
Service, and Secretariat General. The steering group met three times in April and May 2009. 
The draft impact assessment was discussed with the Impact Assessment Board19 (IAB) of the 
Commission on May 28, 2009. This revised impact assessment report 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  issued  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 terms 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  minimum  amounts  of  own  financial  resources  that 
banks must have in order to cover the risks to which 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  are  a  key  component  in  the  single  market  in 
financial services: mutual recognition of requirements 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  Commission  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. 

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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  became  more  comprehensive.  In 
particular,  they  were  expanded  to  cover  'operational'  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 capital 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  requirements  for  credit  risk  of  their 
corporate portfolios, by using their own ‘risk inputs’ such  as probability of default and loss 
given  default.  The  calculation  of  these  risk  inputs  was  made  subject  to  a  strict  set  of 
operational requirements to ensure that they are robust and reliable.  

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  (see  Box  1)  representing  additional  marked  differences  from  a 
predecessor legislation. 

Box 1: Three pillar structure of the CRD: 
Pillar  1  covers  the  minimum  capital  required  for  credit  risk,  operational  risk  and  market  risk;  the 
minimum capital requirements became much more risk-sensitive and comprehensive than in the past, 
facilitating improved coverage of the real risks run by the institution.  

Pillar 2 covers the review and evaluation of the credit 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,  whereby  they  would  need  to  assess  their  capital  needs 
considering all the risks they face. These rules also require supervisors to evaluate institutions’ overall 
risk profile to ensure that they hold adequate capital. 

Pillar 3 covers the disclosure by institutions and facilitates a better understanding of the soundness and 
stability of financial institutions. 
According to the  ECB22, in 2007, total assets of approximately  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 Commission in October 200825. 
In  its  Communication  for  the  spring  European  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 

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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 open' 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 

October 2008 

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 

Revision of capital requirements for 
Collective Investment Undertakings under 
the IRB approach 

Inconsistency identified in the CRD transposition process 

Inconsistency identified in the CRD transposition process 

Revision of capital and risk management 
requirements for securitization positions 

Change in response to the financial crisis, to provide for attainment of long-term policy 
objectives of bank capital regulation 

July 2009** 

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 

Enhancing supervisory review of 
remuneration policies 

Introduction of supplementary measure to 
address leverage and/or liquidity risk 

Autumn 2009 
(forthcoming)** 

Introduction of counter-cyclical treatment 
of bank loan provisions 

Making supervisory rules more consistent  
by reducing number of national options 
and discretions  

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) 

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 

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 

Harmonize core set of standards applied 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 

institutions  and 

investment  firms  ('institutions')  may  calculate 

Credit 
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  losses  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, institutions' VAR models shall provide 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. 

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that  would  not  be  exceeded  with  a  99%  probability  (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 between 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 losses and volatility of capital requirements for 
the  trading  book,  risk  exacerbating  procyclicality  of  bank  lending  and  investment  with 
negative implications for the real economy. 

Starting  with  the  second  half  of  2007,  several  banks  reported  trading  losses  many  times 
exceeding their VAR estimates. While the VAR estimates had soared due to historically high 
volatility,  they  still  grossly  underestimated  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, this number should not be higher than three per 
year  for  VAR  calculated  assuming  a  99%  confidence  level.  An  analysis  by  Standard  and 
Poor's28,  however,  shows  that  a  number  of  backtesting  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 the robustness of VAR models in stress conditions. To recall, 
banks  may  calculate  capital  requirements  on  the  basis  of  these  VAR  models.  Even  though 
capital  requirements,  when  derived  this  way,  also  incorporate  a  safety  margin,  backtesting 
exceptions  constitute  events  when  actual  losses  in  the  trading  book  may  have  exceeded  the 
actual capital required for the trading book30. 

Importantly,  institutions'  own  estimates  of  economic  capital  for  market  risk  indicate  that 
current regulatory capital requirements for market risk are insufficient. For example, Deutsche 
Bank in its annual report31 estimated economic capital  required for its traded market risk at 
€5.5  billion32  at  the  end  of  2008.  Meanwhile,  its  regulatory  market  risk  charge  was  around 
€1.9 billion, i.e., 65% less than bank's own economic capital estimate. 

VAR  models  are  based  on  historical  data  on  risk  factors,  regulatory  requirements  setting  a 
look-back  period  of  one  year.  They  therefore  provide  limited  insight  into  risks  that  do  not 
show within the model's 'time window'. In particular, if the time window 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 spread33. Although the spread did 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/2008/ar/riskreport/overallriskposition.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  bill;  TED  is  an  acronym  formed  from  T-Bill  and  ED,  the  ticker  symbol  for  the 
Eurodollar futures contract 

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considerably  in  the  second  half  of  the  year  because  of  the  liquidity  crunch  (see  Chart  1). 
During  the  first  weeks  of  August  2007,  a  bank  exposed  to  a  widening  of  the  spread  would 
have incurred losses that VAR models could not have predicted. 

Chart 1: TED spread in percentage points, July 2006 – December 2007 

3,00

2,50

2,00

1,50

1,00

0,50

0,00

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  period  render  the  VAR  based  regulatory  capital 
less sound in the sense that actual losses may exceed the regulatory capital 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  can  safely  assume  that  the  bank  have  tried  to  reduce  its 
exposures over the stressed 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  ability  during  more  difficult  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 reassessment can be viewed as rational 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  during  the  2007-2008  episode,  however,  correlations 
change  and  the  benefits  of  risk  diversification  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/additionalnotes/37riskdisclosures/marketrisk.html  

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benign environment turn out to have been overestimated. To illustrate, a bank trading in both 
equity and bond risks will in good times benefit from 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 into regulatory 10-day VAR equivalent, assumes 
that  daily  returns  are  independent  over  time.  Disclosures  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 Swiss francs for UBS AG investment bank 

700

650

600

550

500

450

400

350

300

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  measures  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 underestimate 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).  

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Therefore, quantifying VAR under the above assumptions does not provide for a sound basis 
of regulatory capital as it does not reflect the stress conditions under which regulatory capital 
matters most, i.e., the conditions under which actual losses are likely to exceed a VAR-based 
capital  requirement.  The  described  characteristics  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 calibrated 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 beyond 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  might  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  fluctuations  short  of  actual  default.  Indeed,  such  credit  risk-related 
losses in trading books proved to be a very important driver of the current crisis, as evidenced 
by losses on financial instruments held at fair value through profit and loss – a category not 
completely identical with the regulatory trading book but the closest possible approximation 
in  public  financial  reports.  These  credit  related  losses  stemmed  to  an  important  degree  also 
from 'normal' credit exposures that 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  corporate  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 such a high confidence level, also 
defaults of good issuers cannot be excluded and because defaults 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  calibrated  to  a  99.9%  confidence  level  and  a  one  year 
holding period. 
38 Currently, under a grandfathering position expiring by 31 December 2009, 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 assessment accompanies, includes certain clarifications on how capital requirements 
for this type of risk shall be quantified 
41 http://annualreport.deutsche-bank.com/2008/ar/servicepages/downloads/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 

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Driver: Trading book charge for default risk does not capture credit rating migration risk 

Problems:  Current  capital  requirements  for  trading  books  do  not  adequately  reflect  all 
material  credit  risks  which  together  with  regulatory  arbitrage  possibilities  contribute  to 
undercapitalization  and  facilitate  excessive  risk  taking  in  the  expansionary  phase  of  the 
lending  and  economic  cycle.  When  these  risks  materialize,  capital  position  is  affected 
negatively  which  risks  exacerbating  procyclicality  of  bank  lending  and  investment  with 
negative implications for the real economy.  

However, it is important to understand that these losses resulted from marking debt to market, 
i.e., they were mainly driven by a changed market perception of the corporate names' default 
risk which can be loosely referred to as 'migration risk' rather than the actual default of these 
names. Therefore, incremental risk charge as introduced in 2005 does not capture all relevant 
material  credit-related  risk  in  the  trading  book,  leading  to  undercapitalization  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 procyclical behaviour over 
the economic cycle.  

It  may  also  be  noted  that  in  the  banking  book,  the  capital  charge  looks  at  default  risk  over 
much  longer  time  horizons  and  contains  an  adjustment  for  migration  risk  for  long  maturity 
debt. Therefore, in the current situation the trading book treatment of default risk could also 
lead to regulatory arbitrage opportunities, 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 Securitization Positions in Trading Book 

Driver:  A  robust  institutions'  internal  modelling  methodology  for  default  and  migration  risk 
for securitisation positions in the trading book is missing 

Problems: Current reliance on own models for securitization default risk allows for regulatory 
capital  arbitrage  and  undermines 
resulting 
undercapitalization facilitates excessive risk taking in the expansionary phase of the lending 
and  economic  cycle.  When  these  risks  materialize,  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.  

institutions.  The 

soundness  of 

the 

The  default  risk  charge  introduced  in  2005  essentially  allowed  banks  to  make  use  of  their 
own models, even for securitisation positions held in the trading book. In the banking book, 
however,  banks  are  required  to  calculate  capital  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 risks in the trading book, the industry admitted in 
a  letter  to  the  Basel  Committee  in  October  200845  that  while  they  felt  comfortable  with 
modelling  corporate  credit,  the  behaviour  of  securitisation  risk  'over  the  economic  cycle  is 
less well understood'46. 

44  50%  of  all  global  crisis-related  writedowns  in  the  banking  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 agreements typically make the payments a function of pool 

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Essentially,  reliance  on  own  models  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 that the outcome in terms of capital is sound enough; the other 
one  is  that  compared  to  the  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  Directive  2006/48/EC  sets  out  the  risk  weights  determining  capital 
requirements  for  securitisation  positions  in  banks'  non-trading  books.  In  most  cases,  banks 
will  determine  capital  requirements  for  securitisation  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-securitization  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 implications for the real economy 

Re-securitisations are more sensitive to the ultimately underlying exposures defaulting jointly. 
High correlation of losses on mortgage 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 illustration, a AAA rated MBS is unlikely to suffer 
impairment even if the underlying mortgage pool experiences heavy, highly correlated losses, 
because  it  is  constructed  to  have  a  strong  safety  margin  protecting  it  from  losses  in  the 
underlying pool of mortgages. This is different for a more junior securitisation tranche with 
an  initial  rating  of,  say,  BBB.  Heavy  correlated  losses  in  the  underlying  mortgage  pool  are 
likely  to  lead  to  a  credit  quality  impairment  for  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  situation  is  different.  It  will  be  built  on  MBS 
with  lower,  say  BBB,  credit  ratings  -  however  again  subject  to  a  strong  safety  margin 
protecting  it  from  initial  losses  on  any  of  the  underlying  securitisations.  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  incurred  by  the  euro  area  and  UK  banks  totalled  $32 
billion, with losses for banks globally reaching $153 billion47, assuming on average 60% loss 

performance; at the same time, it is particularly challenging 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 

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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,  which  were  all  marked  at  around  3  to  4  cents  on  the  dollar, 
reflecting the erosion of any protection from relative subordination of securities in the capital 
structure and deepening of losses48.  
Chart 3: Credit rating upgrades and downgrades of US-originated CDOs, 2007-200849 

3.500

3.000

2.500

2.000

1.500

1.000

500

0

2007-I

2007-II

2007-III

2007-IV

2008-I

2008-II

2008-III

2008-IV

Upgrade - 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  likelihood  (or,  expected 
probability)  of  default50.  Bank  capital  regulation,  on  the  other  hand,  puts  emphasis  on  the 
unexpected losses, incurred once defaults materialize, which banks should be able to absorb 
with  the  capital  that  they  are  required  to  hold51.  Therefore,  for  a  given  credit  rating,  a  re-
securitisation  constitutes  a  greater  prudential  concern  than  a  straight  securitisation  position, 
because in cyclical downturns credit losses become  more  correlated  and,  as  a  result,  certain 
re-securitisations,  due  to  their  intrinsic  structure,  are  affected  heavier  than  'normal' 
securitisations.  It  is  consequently  problematic  that  capital  requirements  do  not  distinguish 
between securitisation and re-securitisation 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 rating 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 

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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  cyclically  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 disclosure requirements that banks, subject to a 
materiality threshold, have to make about their risk positions and how they assess regulatory 
capital against these. There is a dedicated section on securitisation risks, however this section 
currently  only  requires  information  on  securitisation  risks  in  the  banking,  not  in  the  trading 
book. 

Driver:  Inadequate  level  of  public  disclosure  of  risks  stemming  from  investments  in 
securitizations 

Problems: Lack of transparency of banks' exposures to securitizations contributed to the loss 
of  effectiveness  of  market  discipline  which  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  affecting  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  those  of  German  IKB  and  Hypo  Real  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  that  in  fact  indirectly  they  are  hugely  exposed 
given  their  role  for  instance  as  liquidity  providers  for  securities  arbitrage  conduits  or  as 
investors  in  complex  re-securitisations52.  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'  understanding  of  banks'  risks  and  capital  positions, 
thereby  contributing  to  market  confidence  and  risk  management  discipline  over  banks' 
management. Unfortunately, the directive's disclosure 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  complete  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 resulted 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_releases/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 criteria that need to be satisfied by eligible institutions 

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how securitisation positions are valued (at cost, at market or model-based values, for instance) 
by  individual  banks,  having  important  impact  on  the  losses  being  taken  and  those  probably 
still 'hiding' in the valuation of certain assets of unclear quality.   

The  necessity  of  having  such  disclosure  requirements  in  place  is  underpinned  by  the  latest 
estimates of securitization-related losses by the IMF, according to which potential writedowns 
on these instruments for banks globally 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 sponsor of asset backed commercial paper (ABCP) 
programmes,  their  use  of  own credit assessments  for  such  programmes  and,  finally,  in  their 
investments  in  re-securitisation  and  in  their  warehousing  of  loans  to  be  securitised  on  their 
balance sheet.  

3.5. 

Remuneration Schemes 

impact  assessment  accompanying 

The 
the  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 industry and explained the 
role these arrangements played in precipitating the financial crisis58. These shortcomings were 
shown  to  pertain  to  the  structure  of  remuneration  policies  and  inappropriate  corporate 
governance systems. Furthermore, the ensuing risks to the institutions themselves and, more 
generally, to financial stability were not subject to adequate oversight by supervisors. 

3.5.1. 

Inappropriate Structure and Internal Control Systems 

Drivers:  Inappropriately  structured  remuneration  policies  which  failed  to  align  employees' 
incentives with the long-term objectives of a company  

   Lack of appropriate governance systems 

Problems:  Excessive  short-term  risk  taking  impaired  soundness  of  institutions,  disrupted 
financial stability and exacerbated procyclicality 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  aside  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 expected part of their compensation, regardless 
of firm profitability. For categories of staff whose daily activities are inseparable from risk-
taking  decisions,  together  with  the  typically  short-term  focus  of  bonus  systems  (which 
generally assess and reward performance on an annual basis), the fact that bonuses constituted 
a  high  relative  share  of  the  total  pay,  provided  them  with  perverse  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, consumer 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 the problems please see the impact 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 

17 

   EN 

 
 
                                                                                                                                                         
risk-taking geared at maximizing short-term profits to the detriment of the long-term health of 
companies  and,  more  generally,  to  financial  stability.  Moreover,  while  bankers  and  traders 
shared  in  any  profits  they  generated,  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, remuneration policies can have a procyclical effect by 
contributing to the excessive credit growth and risk-taking in the expansionary phase of the 
economic cycle.  

The  impact  of  improperly  structured  remuneration  policies  was  further  aggravated  by 
shortcomings  in  firms'  risk  management  and  internal  control  systems.  Whilst  the  CRD 
includes  requirements  for  an  internal  capital  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 stemming from their remuneration policies, this was not found to 
be the case, in practice. Indeed, senior management of firms which suffered the biggest losses 
tended to encourage the expansion of risk without a commensurate focus on controls across 
the organization or at the 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  arising  in  connection  with 
remuneration policies 

Problems:  Absence  of  clear  legal  requirements  contributed  to  insufficient  oversight  by 
supervisors of risks posed by inappropriate remuneration policies which facilitated excessive 
short-term risk taking by institutions 

Under the current European supervisory framework, there is no express requirement that the 
remuneration  policies  of  financial  institutions  should  be  subject  to  supervisory  oversight. 
During the process of authorization and ongoing prudential supervision, the supervisory and 
regulatory authorities oversee the organizational structure of financial institutions as well as 
their  internal  control  and  risk  management,  and  assess  the  risk  profile  of  the  financial 
institutions  taking  into  account  inter  alia  operational  and  business  risks6162.  This  could  in 

60  Senior  Supervisors  Group,  Observations  on  Risk  Management  Practices  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  risk  that  credit  institutions  should  take  into  account  when  designing  those 
governance arrangements. That Annex does not refer expressly 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 requirement 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 are authorised and regulated under Directive 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 Directive, 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 

18 

   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 Need for Legislative Action 

The recently adopted Commission Recommendation on remuneration policies in the financial 
services sector aims at tackling the problems described in the previous sections by setting out 
principles on sound remuneration policies. These include a general principle that firms should 
establish and maintain comprehensive remuneration 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.  Complementing  this  general  principle,  there  are  more  detailed 
recommendations  relating  to  the  balance  between  fixed  and  variable  components  of 
remuneration (that is, between core salary and bonus); the determination 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  (supervisory)  board  for  overseeing  the  policy  and  its 
application  and  the  involvement  of  properly  independent  control  functions  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 elaborate a set of principles which should enable 
firms to ensure that their remuneration structures are consistent with, and do not jeopardise, 
the risk management and internal governance that are the subject of enforceable obligations 
for regulated firms. A recommendation is an appropriate instrument for setting out a general 
framework  and  laying  down  detailed  principles  and  objectives.  However,  since  a 
recommendation  is  not  a  legally  enforceable  instrument,  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  the  remuneration  schemes  of  certain  regulated 
financial institutions in a broader context of sound risk management, so that relevant policy 
objectives  are  achieved  more  effectively63.  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  risks  stemming  from  a  possible  deficit  of  compliance  with  its 
principles  would  come  from  the  banking  and  investment  banking  sectors,  not  least  because 
these institutions are at the centre 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 institutions.  While the Directive does regulate the payment and receipt of inducements, this 
regime is relevant to benefits received from third parties in the course of the provision 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 

19 

   EN 

 
                                                                                                                                                         
An  enhanced  supervisory  role  in  this  context  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  shareholders  do  not  always  have  in  mind  long-term 
objectives and may rather look for short-term share value increases 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 potential 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  taken  together,  played  a  contributing  role  in 
exacerbating  economic  cycle  and  precipitating  extreme  financial  instability  that  in  turn 
evoked the global economic recession, damaging soundness and international competitiveness 
of  the  EU  banking  sector  and  subjecting  a  wide  range  of  stakeholders,  including  bank 
creditors 
to 
unprecedented  economic  costs.  If  no  action  in  the  outlined  areas  is  taken,  the  risk  that 
systemic shocks of a similar scale occur in the future will not be addressed. In fact, in addition 
to  the  proposed  ones,  measures  in  other  areas  will  be  necessary  to  tackle  this  risk  more 
effectively. 

(e.g.  depositors),  shareholders,  employees,  borrowers  and 

taxpayers, 

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 arbitrage 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.  remuneration  polices),  address  certain  regulatory  failures  that  were 
brought  to  light  by  the  continuing  financial  crisis  (e.g.,  capital  requirements  for  re-
securitizations),  ensure  a  consistent  EU  approach  for  tackling  various  issues  covered  by  the 
scope  of  this  report,  which  would  do  away  with  the  need  for  Member  States  to  pursue 
individual approaches that risk fragmenting internal market.  

More  importantly,  only  EU-level  approach  could  be  expected  to  effectively  provide  for 
financial  stability  and  tame  excessive  financial  procyclicality,  where  policies  geared  to 
national needs have been shown to be inappropriate 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 

20 

   EN 

 
                                                 
4. 

OBJECTIVES 

The  overarching  goal  of  this  initiative  is  to  ensure  that  the  effectiveness  of  bank  capital 
regulation in the EU, represented by the Capital Requirements Directive, is strengthened and 
any of its excessive pro-cyclical impacts on the real economy are contained while maintaining 
the  competitive  position  of  the  EU  banking  industry.  This  translates  into  the  following  four 
general policy objectives to:  

–  Enhance financial stability (G-1); 

–  Enhance safeguarding of creditor 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  sections  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 capital requirements (S-1); 

–  Minimize cyclicality of capital requirements (S-2); 

–  Eliminate regulatory arbitrage 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 identified 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 their impacts on stakeholders for each of the four 
areas.  Due  to  the  number  of  the  areas  covered,  the  analysis  of  policy  options  and  the 
comparison  thereof  have  been  combined  for  each  area.  Cumulative  impacts  of  all  preferred 
options are discussed at the end of the section. 

As the impact assessment pertains to the provisions 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 appropriateness and need for a legislative measure 
has been provided in sections 2.1 and 3.5.3. 

EN 

21 

   EN 

 
Table 2: Summary of problems and objectives 

Problems 

Problem Drivers 

Operational 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 

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R

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 
possibilities 
undercapitalization 
Capital Requirements for Re-securitizations 

arbitrage 

possibly 

lead 

to 

- Capital required for re-securitizations does not adequately reflect 
their higher risk compared to "normal" securitisations 
-  Swing 
losses  from  re-
securitizations,  exacerbated  pro-cyclicality  of  bank  lending  with 
possible negative implications for the real economy 
Disclosure of Securitization Risks 

in  capital  position,  driven  by 

-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 
Remuneration Schemes 
-Excessive  short-term 
institutions,  disrupted 
procyclicality in the financial system 

impaired  soundness  of 
stability  and  exacerbated 

risk 
financial 

taking 

robust 

institutions' 

A 
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 

√ 

√ 

√ 

√ 

√ 

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  

Capital requirements for re-securitization positions 
in the banking book do not adequately capture risk 
of unexpected (low frequency high severity) losses  

Make capital requirements more prudent 
to  reflect  risks  pertaining  to  extreme 
future events 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

Set  more  prudent  regulatory  capital 
requirements 
re-securitization 
positions in banking book 

for 

Discourage  investments  in  complex  re-
securitizations 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

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 
long-term 
employees' 
objectives of a company 

incentives  with 

the 

Strengthen  the  link  between  pay  and 
long-term performance 
Prevent  incentives  for  excessive  risk-
taking in remuneration policy 

Lack  of  appropriate  governance  systems  with 
regard to remuneration policies 

Enhance 
remuneration policy 

corporate  governance  on 

Insufficient degree of supervisory oversight 

Enhance  the  role  of  supervisors  with 
regard 
remuneration 
policy management 

to  overseeing 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

EN 

22 

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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  stated  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  aligned  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 requirement66. This 
change  may  be  expected  to  roughly  double  the  requirements  given  the  current 
environment; however, obviously as the 'normal' 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 developed internal modelling capability and, more 
importantly, have received an explicit recognition of their models from supervisors. At the 
end of first half 2008, capital requirements for trading book for large EU banks67 made up 
on  average  6-7%  of  their  total  minimum  capital  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  default  risk  in  the  trading  book  to  capture  losses  short  of 
issuer default, e.g. rating downgrades, to address 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 requirements for banks to perform stress testing under Pillar 2 of 
the CRD on the adequacy of their overall capacity to withstand different scenarios 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  regulatory  formula  aimed  at  ensuring  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 that 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 

23 

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–  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  agreed  payments  given  that  the  contractual 
agreements typically make the payments a function of pool performance while  it is overly 
difficult to model price risk based on the defaults 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 maintain capital levels that are in line with their 
internally  developed  'targets'  which  are  typically  more  linked  to  their  economic  capital 
planning68 or a need to obtain and / or maintain a desired 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 additional 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  stability  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-cyclical  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  requirements),  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 general objective G-3 (Ensure 
international competitiveness of EU banking industry) because these changes would be in line 
with what currently is envisaged at the level of the Basel Committee, an international standard 
setting  body  bringing  together  the  supervisors  of  all  large  internationally  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, including 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  requirements  to  reflect  risks  to  extreme  events  in 
practice  less  well  than  option  2;  data  availability  constraints  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. 

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theory, calibration would have to take place on the basis of hundreds of years of data history 
which are simply unavailable, so banks will have to use scaling up rules that 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 implementation of this option would achieve the 
operational objective of capturing credit migration risk as well as does option 2 which builds 
on well established credit risk modelling techniques. 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  effective  overall  regarding  the  specific  and  general 
objectives attained by option 2. The overall impact of this option on the capital requirements 
will  not  only  be  a  function  of  the  future  trading  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  Committee  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 review 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  grandfathering  for  instruments  already  on  banks'  balance 
sheet, combined with targeted exemptions; 

-  Policy  option  4:  Enhanced  supervisory  oversight  of  new  investments  in  re-securitizations 
combined  with  deductions  from  capital  for  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  securitisation  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 their investment decisions 
regarding re-securitizations rather than making their own analysis 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  through  to  the  assets  ultimately  underlying  the 
underlying  securitisations.  However,  the  practical  application  of  these  requirements  may  in 
some cases prove difficult, given limits to information 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-securitisation  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  higher  risk  of  unexpected  impairment  losses  as 
discussed  above.  The  Basel  Committee  has  conducted  analyses  on  the  unexpected  losses  of 

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residential mortgage backed securities on the one hand and CDOs backed by RMBS on the 
other hand. On the basis of that analysis, the Committee's consultative document71 envisages a 
new set of risk weights for re-securitisation  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  contribute  towards  achieving  all  of  the  general 
objectives. 

Policy option 3: Imposing capital charges high enough to discourage investments in complex 
re-securitisations  with  a  grandfathering  for  instruments  already  on  banks'  balance  sheet, 
combined with targeted exemptions 

Under this option, risk weights for re-securitisations would be set that exceed those proposed 
by  the  Basel  Committee  (i.e.,  option  2).  In  order  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  institution  has  to  hold  1  euro  capital  for  1  euro  of 
such a position. Only new investments in certain types of complex re-securitisations would be 
subject  to  such  capital  charge  whereas  legacy  instruments  would  benefit  from  a 
grandfathering subject to the underlying asset pools not being added to or replenished within 
the re-securitization entities in question. Notably, certain government sponsored restructuring 
transactions to 'clean up' banks' balance sheets ('bad banks') carried out at the moment would 
also be covered by this grandfathering clause72.  

Clearly,  also  under  this  option,  the  operational  objective  of  setting  more  prudent  capital 
requirements would be attained. Objective S-1 (Enhance adequacy of capital requirements) is 
met  less  well  than  under  option  2,  because  under  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  because  naturally,  higher  capital  requirements  always  behave 
less  cyclically  as  future  losses  in  economic  downturn  are  to  a  larger  degree  pre-empted  in 
current capital positions.  

Also  objectives  S-4  (Reinforce  risk  management  incentives)  and  S-5  (Improve  investor 
understanding of bank risk profile) are gradually better achieved than under option 2. Option 
3  avoids  giving  a  signal  to  the  market  that  it  is  safe  to  invest  in  what  essentially  are  very 
opaque and difficult to analyse instruments subject to a gradually higher capital charge. This 
policy  option  would  rather  provide  a  clear  signal,  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 option would make a stronger contribution towards G-1 
(Enhance  financial  stability),  G-2  (Enhance  safeguarding  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  international  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  sector  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 assets, of which the 'good bank' retains 
different  tranches.  These  tranches  represent  re-securitisation  positions  because,  the  underlying  bad  assets  are 
typically securitisations (however not necessarily re-securitisations). 

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hand, on the refinancing side, a stronger  capitalization 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 requirements of option 3 would be more material than that under 
option 2. Yet due to its emphasis on bank investment decisions going forward and inclusion 
of a grandfathering provision, this policy option would avoid immediate capital hit for banks 
that otherwise would be material. Respondents to the public consultation 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 banks would be in the region of €100-150 billion. 
The  related  cost  of  capital  that  the  industry  might  incur  could  exceed  €10  billion  per  year, 
depending on the market conditions73. Depending on the state of financial 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  further  round  of  selling  of  these 
instruments  or  unwelcome  pro-cyclical  consequences  for  the  broader  economy  in  the  short-
run.  

Feedback has also shown the importance of having a more targeted scope for application of 
the proposed treatment: the broad definition of re-securitization may capture instruments such 
as  asset  backed  commercial  paper  (ABCP)  conduits  whose  risk  characteristics  are  typically 
very  different  from  those  of  CDOs  of  RMBS.  However,  in  many  cases  and  for  purely 
technical  reasons,  these  conduits  may  in  many  instances  still  meet  the  definition  of  a  re-
securitisation74.  The  current  volume  of  such  ABCP  conduits  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  additional  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  for  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  exercise  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 that 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 December 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 structured. Usually, to bundle volumes, a program consists of 
a 'conduit' that issues the commercial paper and receives cash flows out of separate Special Purpose Vehicles 
(SPVs) that purchase receivables, each from different firms. These firms or the sponsor will often bear the first 
loss  on  the  receivables  at  the  level  of  these  separate  purchasing  SPVs.  This  means  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. 

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case  where  the  ultimately  underlying  exposures  are  themselves  complex  exposures  such  as 
leveraged buy-out or project finance debt.  

Option 4 implies the Basel approach as discussed under option 2. However, for particularly 
complex  re-securitisation  positions,  it  would  introduce  a  specific  safeguard  that  reinforces 
both the due diligence requirements and the supervisory process to enforce them. 

In a first step, the Committee of European Banking Supervisors (CEBS) would be required to 
draw up common guidelines on what types of re-securitizations have to be considered highly 
complex  so  that  banks  are  at  a  particularly  high  risk  of  failing  to  meet  the  due  diligence 
standards.  The  reinforced  supervision  would  then  only  apply  in  a  targeted  fashion  to  these 
exposures,  thereby  allowing  re-securitizations  to  remain  unaffected  where  it  can  reasonably 
be expected that banks will be able to economically and effectively handle the complexity of 
those re-securitizations and exercise 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,  national  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 highly 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  credit  institution  would 
thereafter  be  debarred  from  investing  in  such  class  of  re-securitization  in  the  future.  This 
approach would limit the incremental compliance costs implicit in the increased surveillance.  

For the highly complex re-securitization exposures according to the typology identified by the 
CEBS, a general deduction from capital requirement would apply unless banks demonstrate in 
the periodic reviews that due diligence standards have been met.  

Option  4  would  be  more-or-less  as  effective  as  option  3  in  terms  of  contributing  to  all  the 
relevant  operational  and  specific  objectives.  However,  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  instruments  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 attainment 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  issuance  of  CDOs,  available  evidence 
shows  that  in  Europe  CDO  issuance  already  contracted  from  €88.7  billion  in  2007  to  €47.9 
billion in 200876. 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 significantly diminished investor appetite for these instruments7778. 
Against such ongoing trends of the baseline scenario, any incremental impact of each of the 
options for the CDO issuance and, in relation, to the credit supply appears 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 treated as such, rather, banks will continue to calculate a 
capital requirement for the securitized assets as if they had not been securitized. 

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Policy options 3 and 4 and, to a lesser extent, policy option 2 could have a limiting effect on a 
possibility of the secondary market recovery for these instruments, were the demand for them 
to  strengthen  as  a  result  of  change  in  risk  appetite  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 inherent 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 disclosures would be left unchanged. Problems outlined 
in  section  3.4  would  not  be  addressed.  Likewise,  this  option  would  not  achieve  any  of  the 
operational objectives and would not promote any of the specific or general objectives. 

Policy option 2: Enhance disclosures 

Under  this  option,  disclosure  requirements  would  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  other  ABCP  liquidity 

facilities;  

–  re-securitization exposures;  

–  valuation with regard to securitization exposures; and  

–  pipeline and warehousing risks with regard to securitization exposures.  

The costs that industry incurs as a result of information provision requirements that stem from 
legislation and that are incremental to those linked to the business-as-usual (BAU) practices 
are  known  as  administrative  burden.  The  incremental  administrative  burden  for  the  EU 
banking industry is estimated at €1.3 million per year; 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 that 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 

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Any administrative burden of policy option 2 is estimated, 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  activities  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 disclosure 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 approximately 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  incremental  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  operational  objective  and  it  would 
directly contribute to the specific objective S-5 (Improve investor understanding of bank risk 
profile).  Indirectly,  it  would  also  contribute  to  S-4  (Reinforce  risk  management  incentives), 
allowing market participants to exert discipline 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  system).  The  fact  that  it  is  in  line  with  internationally  agreed 
standards and that it fosters market confidence 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  the  effect  of  badly  designed  remuneration  policies  on  sound  risk 
management in financial institutions 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 Commission Recommendation 
on remuneration policies in the financial services sector; 

- Policy option 2: Legislation to provide for supervisory review of remuneration practices and 
policies  to  ensure  that  institutions  comply  with  the  relevant  high  level  principles  for  sound 
remuneration policies in a way that is appropriate to their size, internal organization and the 
nature and scope of their activities; 

80  Moreover,  article  146  of  CRD  provides  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 risk-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 

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- Policy option 3: Legislation to provide for supervisory review of remuneration practices and 
policies  and  requiring  a  strict  and  uniform  application  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 institutions irrespective 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  legislative  framework  described  in  section  3.5.2, 
without imposing new binding obligations on firms, or reinforcing the supervisory overview 
by competent authorities. 

Within  this  option,  EU  action  would  consist  of  active  monitoring  of  the  application  of  the 
principles  contained  in  the  Commission  Recommendation  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 institutional shareholders, to encourage their promotion of 
the  principles  in  the  Recommendation;  regular  evaluation  of  industry  compliance  with  the 
principles  on sound remuneration; and publication of a European 'scoreboard' indicating the 
extent to which national law is consistent with the principles in the Recommendation. 

Widespread application of the existing framework by regulated firms might also be promoted 
by national regulators in their enforcement of the requirements of the sectoral directives. As 
indicated,  it  is  arguable  that  the  obligations  that  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 policies and practices do not 
expose the firm to unmanageable risks that exceed 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 remuneration policies at international level, it is likely 
that  regulators  will  make  enhanced  use  of  their  existing  tools  of  prudential  supervision  to 
ensure that the remuneration policies of regulated institutions are consistent with sound and 
effective  risk  management.85  The  development  by  the  Committee  of  European  Banking 
Supervisors (CEBS) of high level principles on sound remuneration policies could encourage 
and  converge  national  regulators'  supervisory  oversight  of  remuneration  policies  within  the 
limits of the existing framework. 

However, the obligation under Article 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 observed 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  interpretation  by  national  regulators  in  their 
supervision and enforcement of remuneration 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 number of regulators such as the UK's Financial Services 
Authority 

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31 

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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 remuneration 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 enforcement is still desirable to ensure that the 
principles on sound remuneration set out in the Recommendation are applied in practice and 
in a way that achieves the objective of sound risk management. 

This option implies a possible impact on the supply 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 remuneration affected) compared to the other sectors of the economy 
in  the  EU  and  compared  to  employment,  including  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  termination  payments  to  performance.  Its  extent  is 
uncertain  and  there  are  arguments  indicating  that  it  might  not  be  significant:  the  discounted 
value  of  the  affected  part  of  the  remuneration  would  be  known  to  the  employees  when 
negotiating their contracts, which will likely lead to negotiation of a higher fixed component 
of their compensation.  

At the same time, factors such as tax, language, culture and social considerations should limit 
the drain of talent abroad. Given that similar principles on the structure of remuneration are 
already recommended by the FSF and endorsed by the G20, risks for EU companies vis-á-vis 
companies situated in other financial centres should be limited further. Also, having principles 
at the EU level should make it easier to promote and export them internationally 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  with  the  relevant  high  level  principles  for  sound 
remuneration policies in a way that is appropriate to their size, internal organization and the 
nature and scope of their activities 

Under  option  2,  the  proposed  amendments  will  impose  a  binding  obligation  on  credit 
institutions  and  investment  firms  to  have  remuneration  policies  that  are  consistent  with 
effective risk management. This option would provide 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, internal organization and scope of their activities. The relevant high 
level principles will be set out in the CRD and will 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 binding obligation can be met, and a framework for 
supervisors  when  assessing  banks'  remuneration  structures  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 respondents to the public consultation on remuneration 
policies  expressly  indicated  the  extent  of  potential  incremental  direct  costs  for  them  of 
complying  with  remuneration  principles  under  this  option.  According  to  them,  such  costs 

EN 

32 

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would be relatively immaterial. Indirectly, the principles concerning the balance between the 
fixed and variable elements and on deferred payment of the variable element could result in 
an  increase  in  the  fixed  element  of  remuneration  and  a  higher  share  of  fixed  costs  for  the 
companies, which might reduce their financial flexibility. Supervisors' role would be critical 
to ensure that intended effectiveness 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  prescribed  in  national  law.  However,  non-financial 
sanctions could include the power of a public censure ('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 clauses 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  ability  to  attract  and  retain  talented  staff  is 
linked  to  its  greater  incremental  effectiveness:  making  the  relevant  principles  of  the 
Recommendation binding will enhance compliance with 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'  employees,  the  impact  of  this  policy  option  on 
balance should be positive. On the one hand, some categories of staff might see their overall 
compensation level fall although the degree of such effect is difficult 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  higher  fixed  component  of  their 
compensation. On the other hand, any improvement in the financial soundness level of their 
employers in the longer run should minimize the 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 pushed it into a financial difficulty.  

With  respect  to  the  international  competitiveness  position  of  EU  firms,  any  incremental 
negative short-term impact over and above the baseline scenario also stems from the binding 
nature of this option. This impact will be mitigated, on the other hand, by the fact that such 
high level principles are intended to serve only 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 international jurisdictions: the G20 Declaration of April 
2, 2009 included the commitment of the global leaders 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 underline that a more effective implementation of the relevant principles of 
the  Recommendation  certainly  implies  a  trade-off  that  includes  long-term  benefits  for  the 
industry stemming from improved risk management outcomes and, more importantly, broader 
benefits in terms of a more stable and less procyclical financial system. 

86 See footnote # 15 

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33 

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Policy option 3: Legislation to provide for supervisory review of remuneration practices and 
policies  and  requiring  a  strict  and  uniform  application  of  the  relevant  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 application of the principles for sound remuneration 
policies  that  would  be  closely  aligned  with  those  set  out  in  the  Recommendation,  and,  in 
comparison with the preceding policy option, would be defined at a more granular level.  

This option would also leave little or no leeway for 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,  principles  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  deferred  part  being  linked  to  the  future  performance  of  the  firm, 
including  performance  of  the  business  unit  of  the  individual  concerned.  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  management  in  cases  where  firms  are  building  new 
businesses  that  might  take  several  years  to  reach  profitability,  no  profitability  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 under 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 more strongly pronounced under this option due 
to a greater eventual level of compliance by companies under the scope. This option implies 
lesser  flexibility  for  companies  when  revising  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  prescriptive,  would  be 
marginally more effective with respect to attaining objective S-6 (Enhance 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  business  situations.  It  would  also  be  less 
efficient than Option 2 as the latter would provide for flexibility when making any necessary 
adjustments to remuneration policies already in place, resulting in lower compliance costs.   

Policy  options  4:  Apply  proposed  measures  to  all  institutions  irrespective  of  their  size  vs. 
Policy option 5: Apply proposed measures only 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 institutions independent of their size; or (option 
5) only to significant, systemically important undertakings the failure of which has a potential 
impact  on  the  functioning  of  the  relevant  financial  sector.  Option  5,  while  superficially 
attractive,  is  inconsistent  with  the  provisions  of  the  CRD  for  supervision  on  a  consolidated 
basis:  it  would  be  illogical  and  possibly  counter-productive  for  requirements  to  apply 
differently  to  different  entities  in  a  consolidated  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 

34 

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Similarly,  where  remuneration  policies  are  organised  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  contributing  to  objectives  of  protection  of  creditor 
interests (objective G-2) and reducing pro-cyclicality of the financial system (objective G-4) 
as  it  would  reinforce  risk  management  incentives  (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 within the supervisory review process 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  effectiveness87  and  efficiency88 
with regard to achieving applicable longer term policy (specific) 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 

35 

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Table 3: Summary of policy options' effectiveness and efficiency 

Policy 
Option  
Set 

Policy 
Options 

1 Retain current approach 

Capital 
requirement for 
trading books 

2 Impose a set of targeted measures 

Capital 
requirement for 
re-securitizations 

Disclosure of 
risks from 
securitization 
positions 

3 Change modelling standard 

1 Retain current approach 

2 A separate set of higher risk weights 

3 Capital charges to discourage 
investments in complex re-securitizations 
with grandfathering & targeted exemptions 

4 Enhanced supervisory oversight 
combined with deductions from capital 
where due diligence is inadequate 

1 Retain current approach 

2 Enhance disclosure requirements 

1 No legislative action 

2 Legislation  requiring to comply with 
relevant high level principles, while taking 
into account specificities of a firm 

Remuneration 
schemes** 

3 Legislation requiring strict and uniform 
application of relevant principles 

4 Application of measures to all 
institutions 

5 Application of measures only to 
systemically important undertaking 

Policy Option Comparison Criteria 

Enhance 
adequacy 
of capital 
requirem
ents 
[S-1] 

Minimize 
cyclicalit
y of 
capital 
requirem
ents 
[S-2] 

Effectiveness 

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 

3 

1 

2 

4 

3 

1 

2 

3 

1 

2 

4 

1 

3 

2 

3 

1-2 

1-2 

3 

1 

2 

3 

1-2 

1-2 

3 

1 

2 

4 

3 

2 

1 

2 

1 

3 

1-2 

1-2 

1 

2 

4 

3 

1-2 

1-2 

2 

1 

3 

2 

1 

1 

2 

3 

1 

2 

4 

2-3 

2-3 

1 

2 

1 

3 

1 

2 

1 

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 asset 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  the  lessons  learned,  it  is 
crucial  to  review  certain  aspects  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  saving)  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 certain 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 render the CRD framework more robust in the long 
run, leading to more effective risk management incentives and practices, more adequate and 

EN 

36 

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less volatile bank capital requirements and enhanced disclosure of bank risk 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 regulation, and containing risks to the financial stability and the 
concomitant costs to society in the future. At the level of individual stakeholder groups and 
systemic concerns, the expected benefits of the proposals are as follows: 

–  Enhancements  to  the  regulatory  capital  framework  -  in  terms  of  more  adequate  and  less 
cyclical  capital  requirements  together  with  strengthened  public  disclosure  requirements  - 
should  provide  the  EU  banking  industry  with  appropriate  incentives  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 international peers in the long run would be enhanced. 

–  The  proposed  revisions  will  enhance  the  effectiveness  of  supervisors'  monitoring  of  the 
risks  that  financial  institutions  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 opportunities allowing banks to apply lower of 
the banking or the trading book capital charges and streamlining 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 will lead to a reduction of bank default 
risk. 

–  Borrowers,  including  SMEs89,  will  benefit  from  a  less  cyclical  nature  of  bank  financing 
allowing them to engage in projects that are profitable and vital for the economic growth 
and prosperity. 

–  Importantly, by improving the adequacy and curtailing 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  employers),  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 for 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 requirements for banks' trading book activities and re-
securitization positions that are held in their banking books and 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 also significant but smaller; 
see EIM, Cyclicality of SME Finance, March 2009 

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37 

   EN 

 
                                                 
Introduction  of  proposals  that  have  a  direct  bearing  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  are  avoided  or  cushioned  in  the  short-term. 
Nevertheless,  to  the  extent  that  currently  practically  non-existent  market  appetite  for  such 
products  resurfaces  in  the  future,  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  between  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  Commission’s  Action  Programme  for  reducing 
administrative  burdens  in  the  EU  which  has  the  goal  of  administrative  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 with this initiative, it has to be noted 
that they were undertaken with a view to achieving multiple operational, specific and general 
objectives (see section 4) and had to be designed accordingly. Significant implications of the 
proposed  changes  on  reporting  obligations  for  the  industry  are  expected  to  stem  only  from 
enhanced  disclosure  requirements  for  securitizations  in  banks'  trading  books  with  the 
estimated resultant administrative burden falling in the range of €1 million per year. 

Proposed  amendments  are  not  expected  to  disproportionately  affect  small  financial 
institutions  vis-à-vis  the  large  ones,  as  the  nature  of  activities  being  reviewed  is  more 
common to the latter group of institutions.  

The following table lays out the expected net effect of the proposals on various stakeholders. 

EN 

38 

   EN 

 
Table 4: Summary of impacts on stakeholder groups 

                                Key  
                 Stakeholders 

Issue Areas 

Capital requirement 
for trading books  

Capital requirement 
for re-securitizations 

Disclosure of risks 
from securitization 
positions 

Remuneration 
schemes 

Banking 
Industry 

Supervisors 

Investors / 
Creditors 

Borrowers 

Bank 
Employees 

3rd Country 
Banks 

+/- 
(↑ financial 
soundness in 
the long run, 
indirect 
benefits from 
financial 
stability offset 
by  
↑ compliance 
costs) 
+/- 
(↑ financial 
soundness in 
the long run, 
indirect 
benefits from 
financial 
stability offset 
by  
↑ compliance 
costs) 
+/- 
(↑ financial 
soundness in 
the long run, 
indirect 
benefits from 
financial 
stability and 
market 
discipline 
offset by  
↑ admin 
burden) 
+/- 
(↑ 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) 

≈ 

+ 
(↑ 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) 

+ 
(↑ effectiveness 
of monitoring) 

+ 
(→ disclosure 
requirements 
allowing to 
better 
understand 
bank risk 
profile) 

≈ 

+ 
(↓ potential 
crisis related 
costs due to 
enhanced 
soundness of 
their 
employers) 

≈ 

+ 
(↑ 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 will 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 exercised that, in line with the agreement of the 
G20 of April 2, 2009, any measures geared to improving the quantity of capital in the banking 
system are introduced 'only once recovery is assured'. 

The amendments are tightly inter-linked with other provisions 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 

39 

   EN 

 
 
Normally,  the  practice  at  the  Commission  is  to  conduct  an  evaluation  of  a  legislation  some 
four years after its implementation, however, given 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  overhauled  framework,  which 
complicates  setting  of  such  target  date.  On  the  other  hand,  the  current  and  recent  proposals 
underscore  the  importance  of  timely  and  appropriate  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  piecemeal  basis,  following  the  outcomes  of  various 
monitoring  exercises  both  at  the  EU  and  the  international  level  or  the  necessity  to  act  as 
dictated by the market. 

The  Commission,  in  co-operation  with  Member  States  will  monitor  the  effectiveness  of  the 
proposals  once  implemented.  The  Commission  will  also  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  account  of  the  macro-prudential  indicators  already 
developed and utilized by the ECB to monitor the 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  whole90  might  also  be  used  to  gauge  the  effectiveness 
degree  to  which  general  policy  objectives  pertaining  to  ensuring  financial  stability  and 
limiting procyclicality are attained. 

The Commission also participates in the working 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  capital  positions  under  the  Basel  II  framework91 
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  buffers,  parameters  used  as  inputs  in 
minimum capital requirement calculation for the credit risk, etc. 

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GLOSSARY 

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 day a comparison of the 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) 

Confidence level 

Securitization  where  underlying  exposures  commonly  include  mortgage-backed  securities 
(MBS), commercial real estate bonds and corporate loans 

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 State where the parent bank of the group is based 

Credit risk 

Risk of losses in on and off-balance 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 capital, 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  requirements,  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. Depending 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 

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Loss given default 
(LGD) 

The loss, measured as a percentage of the exposure at default, which is likely to occur in case a 
borrower  defaults;  one  of  the  required  input  parameters  to  derive  the  risk  weight  under  the 
internal ratings-based approach 

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  underlying  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 

Procyclicality 

The most reliable and liquid element of a bank's capital that comprises share 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  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) 

Securitization 

See Mortgage backed security 

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 the 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 performance  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 

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Unfunded credit 
protection 

A technique of credit risk mitigation 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 occurrence of other specified credit events 

Value-at-risk 
(VAR) models 

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 

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ANNEX ON PROCYCLICALITY 

Procyclical effects can be defined as those which tend to follow the direction of and enhance 
an  economic  cycle.  Within  the  financial  system,  such  effects  transpire  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 procyclical feedback mechanisms on the financial 
system  has  been  examined  by  a  number  of  international  groups,  including  the  Financial 
Stability  Forum  (FSF),  the  Basel  Committee  of  Banking  Supervisors  (BCBS),  the  Group  of 
20  (G20)  and,  within  the  EU,  a  working  group  of  the  Economic  and  Financial  Committee 
(EFC).  Several  of  these  groups,  including  the  FSF,  the  BCBS  and  the  G20,  published  their 
findings and / or recommendations in spring 2009. 

The objective of mitigating pro-cyclicality featured in the recommendations of the Larosière 
Group.  It  was  reinforced  by  the  Commission  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  markets  are  inherently  cyclical.  The  risk  appetite  of  banks 
when  lending  to  their  customers  tends  to  increase  in  economic  upswings,  when  risks  are 
perceived  to  be  lower.  However,  lending  criteria  tighten  during  economic  downturns,  when 
the risk of default is perceived to increase. This may then create feedback effects for the real 
economy. 

Some procyclical effects result from imperfections in the financial system. These include the 
inaccurate identification and pricing of risks across an economic cycle, where the incentives 
of  market  participants  encourage  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,  especially  over  a  prolonged  period  (though  they  fare 
better at assessing relative risk), and so rarely identify booms with 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 compounded by macroeconomic (e.g. monetary) policy 
mistakes, inappropriate incentive structures and unintended effects of some regulations (e.g. 
capital rules). 

Adding  a  robust  macro-prudential  overlay  to  the  current  micro-prudential  approach  may 
reduce these systemic weaknesses. Such an overlay may support the earlier 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  action  to  be  taken  earlier  to  avoid  excessive 
volatility and procyclicality in a downturn. 

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Following  recommendations  in  the  Larosière  report,  on  May  27,  2009  the  Commission 
adopted a Communication on Financial 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 exposure, 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 transposed 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 respect to capital requirements for the credit 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 recent financial market turmoil, to raise capital 
at the point of the economic cycle when it is most expensive to do so. This can have further 
feedback effects, such as banks curtailing lending to retain resources. 

It is important to note, however, that regulatory capital requirements are not the only relevant 
factor  for  banks  in  deciding  how  much  capital  to  hold.  The  expectations  of  other  market 
participants,  in  particular  credit  rating  agencies,  may  force  banks  to  increase  their  capital 
levels even when an institution complies with its regulatory requirements. 

The  possibility  that  more  risk-sensitive  capital  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  options  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 recently put forward by the FSF.  
In  its  report  on  Addressing  Procyclicality  in  the  Financial  System93,  the  FSF  set  out 
recommendations to mitigate mechanisms that amplify procyclicality by covering three areas: 
i) bank capital framework, ii) bank loan loss provisions 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 that 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_market/finances/docs/committees/supervision/communication_may2009/C-2009_715_en.pdf  
93 http://www.fsforum.org/publications/r_0904a.pdf  

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–  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 leverage in the banking system and put a floor under the Basel 
II framework; 

–  Supervisors should use the Basel Committee's enhanced stress testing practices as a critical 
part of the Pillar 2 supervisory review process to validate the adequacy of banks’ capital 
buffers above the minimum regulatory capital requirement; 

–  Monitor  the  impact  of  the  Basel  II  framework  and  make  appropriate  adjustments  to 

dampen excessive cyclicality of the minimum capital requirements; 

–  Carry out regular assessments of the risk coverage of the capital framework in relation to 
financial developments and banks’ evolving risk profiles and make timely enhancements. 

These recommendations provide a broad 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, announced that it would pursue certain measures aimed at 
enhancing  level  (incl.  for  the  trading  book  and  complex  securitizations)  of  capital  and 
introducing counter-cyclical buffers and a supplementary metric to better control leverage and 
liquidity risks. 

Remuneration Policies 

There  is  now  a  widespread  recognition  that  remuneration  practices  in  financial  institutions 
have  contributed  to  the  financial  crisis  through  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 exacerbated excessive risk-taking: if the reward for 
risk-taking is too high, there are incentives to relax controls 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 remuneration over the interests of 
the institution: managers may focus on improving quarterly profits over long-term growth 
of the business; traders may take excessive risks to increase their bonus even if the trading 
strategy is not consistent with the risk appetite of the bank. 

Remuneration policies have a procyclical 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 adjustment or deferred payment to 
take account of future performance of the business unit or institution as a whole.  

With respect to addressing these issues, the Commission Communication of March 4, 2009, 
included  a  commitment  to  table  a  recommendation  on  remuneration  practices  in  the  sector, 
which, together with a recommendation on remuneration 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  management  clearly  within  prudential  oversight  laid  out  under  the 
Directive. 

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