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 - Summary of the impact assessment [COM(2009) 362 final] [SEC(2009) 974]
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) 975 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 

SUMMARY OF THE IMPACT ASSESSMENT 

[COM(2009) 362 final] 
[SEC(2009) 974] 

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1. 

BACKGROUND 

The financial crisis has prompted a broad EU and international (G20, the Financial Stability 
Forum, the Basel Committee) effort to identify the reasons behind the problems and develop 
effective policies to tackle them head-on. 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.  

In  tackling  another  aspect  of  the  high  propensity  to  aggressive  risk  taking,  the  Commission 
has  already  issued  a  Recommendation  on  remuneration  policies  in  the  financial  services 
sector explaining the role these arrangements played in precipitating the financial crisis1. The 
Commission  Communication2  accompanying  it  set  out  additional  steps  necessary  for  their 
more  effective  implementation,  referring  to  a  need  to  modify  the  Capital  Requirements 
Directive3  (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. 

2. 

STAKEHOLDER CONSULTATION 

–  The  Commission  discussed  possible  improvements  to  the  current  legislative  text  at  the 
CRD working group, whose members are nominated by the European Banking Committee, 
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. The comments were generally supportive 
of the objectives of the Commission's draft proposals. With regard to proposed treatment of 
trading  book  and  securitization  activities,  throughout  the  project  the  Commission  has 
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.  Twenty  three  responses  were  received  from  a  wide 
range  of  stakeholders  including  banking,  insurance  and  asset  management  sectors,  national 
supervisory and regulatory authorities as well as worker trade unions  

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2 

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Commission  Recommendation  on  remuneration  policies  in  the  financial  services  sector  (C(2009) 
3159/2) 
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) 
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 

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3. 

3.1. 

PROBLEM DEFINITION 

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) models under Annex V 
of Directive 2006/49/EC. 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 that 
would not be exceeded with a 99% confidence level if the institution held on to its portfolio 
over a 10-day horizon. 

However, VAR models are based on short periods of historical data which may not capture 
relevant market stress episodes. In addition, VAR models' assumption of independent returns 
did  not  hold  at  times  of  market  stress  when  correlations  between  risk  factors  increased. 
Therefore, capital requirements as determined by using VAR models were not robust enough 
to  absorb  potential  trading  book  losses  and  contributed  to  the  sub-optimal  level  of  risk 
management. Resultant swings in capital position exacerbated procyclicality of bank lending 
and investment with negative implications for the real economy. 

Additional losses were caused by the fact that trading book charge for default risk currently 
does not capture the credit rating migration risk4 and by the absence of a robust institutions' 
internal modelling methodology for default and migration risk for securitization positions in 
the trading book. 

3.2. 

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.  As  a  result,  capital  required  for  re-securitizations  does  not 
adequately reflect their higher risk compared to 'normal' securitisations.  

In  April  2008,  the  IMF  estimated  that  mark-to-market  losses  on  the  Collateralized  Debt 
Obligations  (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 
billion5,  assuming  on  average  60%  loss  on  these  instruments  since  the  preceding  year. 
Deterioration in bank capital positions, driven by losses from re-securitizations, exacerbated 
procyclicality of bank lending with follow-on negative implications for the real economy. 

3.3. 

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. 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. 

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5 

Risk of losses due to credit rating downgrades 
IMF, Containing Systemic Risks and Restoring Financial Soundness ,Global Financial Stability Report, 
April 2008 

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As  more  and  more  banks  kept  posting  more  and  more  losses  relating  to  securitisation 
positions, market confidence in banks' stability declined further and further.  

3.4. 

Remuneration Schemes 

impact  assessment  accompanying 

the  recent  Commission  Recommendation  on 
The 
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 crisis6. 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.  

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 effectively. 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 jurisdictions where the Recommendation does not apply.  

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; 

–  Enhance safeguarding of creditor interests; 

–  Ensure international competitiveness of EU banking sector; 

–  Reduce pro-cyclicality of the financial system. 

In  light  of  the  problems  outlined,  ten  operational  objectives  have  been  identified  to  address 
the problem drivers. Effective realization of such operational objectives should contribute to 
the  achievement  of  the  longer  term  specific  objectives  aiming  at  enhancing  adequacy  and 
minimizing cyclicality of capital requirements, eliminating regulatory arbitrage opportunities, 
reinforcing bank risk management, improving investor understanding of bank risk profile and 
enhancing  legal  clarity.  In  turn,  this  should  facilitate  the  attainment  of  the  general  policy 
objectives.  

5. 

POLICY OPTIONS, IMPACT ANALYSIS AND COMPARISON 

Altogether,  fourteen  different  policy  options  have  been  designed,  impact-assessed  and 
compared with a view to addressing the various issues identified in the analysis. This section 
describes the expected impacts of policy measures in each area. 

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For  more  in-depth  description  and  analysis  of  the  problems  please  see  the  impact  assessment 
accompanying the recommendation (SEC(2009) 580) 

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5.1. 

Trading Book 

With  respect  to  capital  requirements  for  bank  trading  books,  the  following  targeted 
amendments will be introduced to respond to the individual problems: 

–  Adding  an  additional  capital  buffer  based  on  stress  scenario  VAR  to  the  ordinary  VAR. 
This  change  may  be  expected  to  roughly  double  the  trading  book  capital  requirements 
given the current environment.  

–  Extending 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  depend  on  how  banks  portfolios  will  adjust  in 
terms of composition to the post-crisis environment. 

–  Basing  the  charge  for  securitisation  positions  in  the  trading  book  on  the  (simple)  risk 
weights that already exist for the banking book, addressing the methodological difficulties 
of modelling.  

Such enhancement of the adequacy of bank capital requirements is of a paramount importance 
in  order  to  enhance  financial  stability  and  minimize  any  excessive  procyclicality  of  the 
financial system.  

5.2. 

Re-securitizations 

Capital requirements for re-securitization positions of banks will be increased. In line with the 
approach  developed  by  the  Basel  Committee,  for  every  credit  rating  grade,  re-securitization 
positions would be assigned a higher risk weight than other securitisation positions, with such 
higher  risk  weights  being  set  in  accordance  with  a  higher  risk  of  unexpected  impairment 
losses.  

For  particularly  complex  re-securitizations,  the  proposals  would  reinforce  both  the  due 
diligence requirements and the supervisory process to enforce them. The supervisors will have 
to  establish  on  a  periodic  basis  whether  due  diligence  standards  for  investments  in  certain 
types - as identified in advance by the Committee of European Banking Supervisors (CEBS) - 
of  highly  complex  re-securitizations  have  been  adequately  met.  For  these  instruments,  a 
general  deduction  from  capital  requirement  would  apply  unless  banks  demonstrate  that 
necessary  due  diligence  standards  have  been  met.  In  instances,  where  compliance  with 
required  due  diligence  is  found  to  be  inadequate,  institutions  would  be  debarred  from 
investing in such instruments in the future.  

5.3. 

Disclosure of Securitization Risks 

Disclosure requirements would be enhanced in several areas such as securitization exposures 
in the trading book and sponsorship of off-balance sheet vehicles. 

These  changes  will  improve  investor  understanding  of  bank  risk  profile  and,  by  allowing 
market participants to exert discipline, would also reinforce bank risk management incentives. 
The  incremental  administrative  burden  for  the  EU  banking  industry  is  estimated  at  €1.3 
million  per  year  and  is  expected  to  fall  mostly  on  larger  institutions  with  more  advanced 
approaches to risk management. 

5.4. 

Supervisory Review of Remuneration Policies 

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. The relevant principles will be set out in the CRD, but will be closely aligned 
with those set out in the Recommendation on remuneration policies in the financial services 

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sector.  For  the  practical  application  of  this  binding  obligation,  the  guidelines  on  sound 
remuneration  polices  developed  by  CEBS  will  be  also  highly  relevant.  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.  

Making the relevant principles of the Recommendation binding will enhance compliance with 
them at a company level; therefore, there might be an impact on attracting or retaining talent 
at  the  overall  sector  level  which  might  have  negative  short-term  implications  for  the 
international competitiveness position of EU firms. It is essential to underline, however, 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. 

5.5. 

Cumulative Impact of Proposed Amendments 

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  improvements  that  are  being  proposed  aim  to  render  the  CRD  framework  more  robust, 
leading to more effective risk management incentives and practices, more adequate and less 
volatile  bank  capital  requirements  and  enhanced  disclosure  of  bank  risk  positions  to  the 
market participants. 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  SMEs,  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. 

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–  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, 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).  

The overall cumulative impact on compliance costs for the industry is expected to be chiefly 
driven by the cost of capital which would have to be raised in order to comply with revised 
rules. 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.  

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.  

6. 

MONITORING AND EVALUATION 

It is expected that the proposed amendments will enter into force in 2011. The amendments 
are tightly inter-linked with other provisions of the CRD, that are in effect already since 2007-
2008, and that will come into effect following CRD revisions that have already been adopted 
by  the  Council  and  the  European  Parliament  in  2009  or  are  foreseen  for  adoption  by  the 
Commission later in 2009.  

Measuring  the  progress  of  reaching  specific  policy  objectives  will  be  aided  by  the 
Commission's  participation  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 framework globally and 
in the EU, respectively.  

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