COMMISSION STAFF WORKING PAPER IMPACT ASSESSMENT
Date: 2011-07-20
Institutions: European Commission
Subjects: banking policy, credit institution, financial intervention, financial legislation, market intervention, provision of services, right of establishment, speculative capital, tax system

EUROPEAN COMMISSION 

Brussels, 20.7.2011 
SEC(2011) 949 final 

COMMISSION STAFF WORKING PAPER 

IMPACT ASSESSMENT 

Accompanying the document 

Regulation of the European Parliament and the Council  

on prudential requirements for the credit institutions and investment firms 

{COM(2011) 452 final} 
{SEC(2011) 950 final} 

 
 
 
 
  
 
 
 
This document commits only the Commission's 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. 

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

Procedural issues and stakeholder consultation ........................................................... 3 

2.1. 

Stakeholder consultation .............................................................................................. 3 

2.1.1.  CEBS............................................................................................................................ 4 

2.1.2.  CRD Working Group ................................................................................................... 4 

2.1.3.  Other public consultations............................................................................................ 4 

2.2. 

Consultation with other services of the Commission................................................... 5 

2.2.1. 

Inter-service Steering Group ........................................................................................ 5 

2.2.2. 

Impact Assessment Board ............................................................................................ 5 

3. 

3.1. 

3.2. 

3.3. 

3.4. 

3.5. 

3.6. 

3.7. 

3.8. 

4. 

5. 

Problem definition........................................................................................................ 6 

Background .................................................................................................................. 6 

Management of liquidity risk ....................................................................................... 7 

Eligibility of capital instruments and application of regulatory adjustments .............. 9 

Counterparty credit risk.............................................................................................. 11 

Pro-cyclicality of lending........................................................................................... 11 

Options, discretions and minimum harmonisation..................................................... 13 

Risks inherent in baseline scenario ............................................................................ 14 

Is action necessary at EU level?................................................................................. 15 

Objectives................................................................................................................... 17 

Policy options: analysis and comparison ................................................................... 20 

5.1. 

Liquidity risk.............................................................................................................. 21 

5.1.1.  Liquidity Coverage Ratio........................................................................................... 21 

5.1.2.  Net Stable Funding Ratio ........................................................................................... 26 

5.2. 

5.3. 

5.4. 

5.5. 

5.6. 

Eligibility of capital instruments and application of regulatory adjustments ............ 28 

Counterparty credit risk.............................................................................................. 33 

Leverage..................................................................................................................... 36 

Capital buffers............................................................................................................ 38 

Single rule book in banking ....................................................................................... 41 

 
 
5.7. 

5.8. 

Choice of policy instrument ....................................................................................... 43 

Cumulative impact of the package............................................................................. 45 

5.8.1.  Package of preferred options and relevant transitional provisions ............................ 45 

5.8.2.  Cumulative impact on the industry ............................................................................ 47 

5.8.3.  Administrative costs................................................................................................... 48 

5.8.4.  Economic impact in transitional period ..................................................................... 49 

5.8.5.  Long-term economic impact ...................................................................................... 51 

5.9. 

Impacts on SMEs ....................................................................................................... 52 

6. 

Monitoring and evaluation ......................................................................................... 54 

Glossary.................................................................................................................................... 56 

Annex I: Extended impact analysis.......................................................................................... 60 

Annex II: Take-up of national options and discretions analysed by CRDWG ...................... 148 

Annex III: Economic and financial importance of the banking sector in Europe.................. 167 

Annex IV: Liquidity Coverage Ratio as specified in February 2010 public consultation ..... 174 

Annex V: Net Stable Funding Ratio as specified in February 2010 public consultation....... 176 

Annex VI: Eligibility criteria for core Tier 1, non-core Tier 1 and Tier 2 regulatory capital as 

specified in February 2010 public consultation ....................................................... 178 

Annex VII: Regulatory adjustments as specified in February 2010 public consultation....... 181 

Annex VIII: Assessment of administrative costs and burdens............................................... 183 

Annex IX: Quantitative impact of the CRD IV: QUEST model............................................ 186 

Annex X: Overview of quantitative models........................................................................... 192 

 
 
 
1. 

INTRODUCTION 

The  extent  of  the  financial  crisis  has  exposed  unacceptable  risks  pertaining  to  the  current 
regulation  of  financial  institutions.  These  risks  proved  substantial  and  systemic  in  times  of 
serious  turbulence.  According  to  the  IMF1  estimates,  crisis-related  losses  incurred  by 
European banks between 2007 and 2010 are close to €1 trillion or 8% of the EU GDP. The 
crisis  did  not  stay  limited  to  the  financial  sector  but  spread  to  the  real  economy  as  well:  it 
plunged the EU economy in a severe recession, with the EU GDP contracting by some 6% in 
2009. 

In  order  to  restore  confidence  and  stability  in  the  banking  sector  and  ensure  that  credit 
continues  to  flow  to  the  real  economy,  both  the  EU  and  its  Member  States  (MS)  adopted  a 
broad range of unprecedented measures with the taxpayer ultimately footing the bill. In this 
context,  between  October  2008  and  October  2010  the  European  Commission  (Commission) 
has  approved  €4.6  trillion  (equivalent  to  39%  of  the  EU  GDP)  of  state  aid  measures2  to 
financial institutions of which more than €2 trillion were effectively used in 2008 and 2009. 
Combined  with  fiscal  measures  aimed  at  pulling  EU  economies  out  of  the  recession, 
supportive measures to the banking industry contributed to higher budget deficits and pushed 
sovereign  indebtedness  levels  up.  This  intensified  markets'  perception  of  rising  sovereign 
risks, imposing second-round costs on the MS. 

The unprecedented level of fiscal support to banks needs to be matched with a robust reform 
addressing the regulatory  shortcomings exposed during the crisis. In recognition of this, the 
Commission already proposed certain amendments to bank regulation in October 2008 (CRD 
II3)  and  July  2009  (CRD  III4).  However,  to  prevent  recent  problems  from  occurring  in  the 
future  and  ensure  that  risks  linked  to  the  broader  issues  of  financial  instability  and  pro-
cyclicality  are  more  effectively  contained,  additional  internationally  coordinated  changes  to 
the EU capital and liquidity regulation of banks are needed.  

2. 

PROCEDURAL ISSUES AND STAKEHOLDER CONSULTATION 

2.1. 

Stakeholder consultation 

Throughout the project the Commission services have closely followed and participated in the 
work of international forums, particularly the Basel Committee5 in charge of developing the 

1 IMF, Meeting New Challenges to Stability and Building a Safer System, April 2010 
2 Measures comprise €3 trillion of guarantees, €138 billion of liquidity and bank funding support, €546 billion of 

approved state recapitalisations and €349 billion of asset relief 

3 Consisting of a Directive 2009/111/EC of the European Parliament and of the Council of 16 September 2009 
amending  Directives  2006/48/EC,  2006/49/EC  and  2007/64/EC  as  regards  banks  affiliated  to  central 
institutions,  certain  own  funds  items,  large  exposures,  supervisory  arrangements,  and  crisis 
management,  Commission  Directive  2009/27/EC  of  7  April  2009  amending  certain  Annexes  to 
Directive  2006/49/EC,  and  Commission  Directive  2009/83/EC  of  27  July  2009  amending  certain 
Annexes to Directive 2006/48/EC  

4  Directive  2010/76/EU  of  the  European  Parliament  and  of  the  Council  of  24  November  2010  amending 
Directives 2006/48/EC and 2006/49/EC as regards capital requirements for the trading book and for re-
securitisations, and the supervisory review of remuneration policies 

5  The  Basel  Committee  on  Banking  Supervision  consists  of  central  bank  and  supervisory  authority 
representatives from twenty seven countries. Nine EU MS are represented: BE, FR, DE, IT, LU, NL, 
ES,  SE,  and  UK.  The  Commission  participates  as  an  observer  in  the  Committee  and  in  its  working 
groups. 

 
 
                                                 
Basel  III  framework.  The  European  Banking  Committee  (EBC)  and  the  Committee  of 
European  Banking  Supervisors  (CEBS,  as  of  2011  replaced  by  the  European  Banking 
Authority) – the committees of the Lamfalussy process - have been extensively involved and 
consulted  throughout  the  project.  Their  views  have  contributed  to  the  preparation  of  this 
impact  assessment  and  the  proposal  that  it  accompanies.  Consultative  work  with  other 
stakeholder groups has been conducted in part through these committees.  

2.1.1.  CEBS 

In November 2009, the Commission invited CEBS to conduct a comprehensive quantitative 
impact  study  (QIS)  on  the  impact  of  the  CRD  IV  legislative  proposal  that  this  impact 
assessment accompanies on the EU banking industry. 246 banks from 21 member countries of 
CEBS  participated  in  the  study,  including  50  Group  16  banks  and  196  Group  2  banks, 
representing some 70% of the consolidated European banking sector in terms of capital. 

A significant share of total assets of EU credit institutions of €42 trillion7 is owned by Group 
1 banks (for more on the economic and financial importance of the banking sector in Europe, 
see  Annex  III).  Given  differences  as  regards  their  size,  nature  of  activities,  risk  profile  and 
risk  management  approaches,  results  from  the  EU  QIS  for  Group  1  and  Group  2  banks 
throughout this report are analysed separately. The results have been anonymised to preserve 
confidentiality of MS-level indicators (on request of the participating MS). 

In  response  to  the  Commission's  calls  for  advice,  CEBS  also  conducted  extensive  public 
consultations and in October 2008 submitted a technical advice in the area of national options 
and discretions.8  

2.1.2.  CRD Working Group 

In the area of national options and discretions, between 2008 and 2011 the Commission 
services held six meetings of the CRD Working Group (CRDWG), whose members are 
nominated by the EBC. The group worked on preparing a 'single rule book' in banking, on the 
basis of CEBS' technical advice. For a detailed list of provisions analysed by the CRDWG, 
please refer to Annex II.  
Other parts of the proposal were discussed by the CRDWG four times in 2010 - 2011. In 
addition, sub-groups of the CRDWG in the areas of liquidity, capital definition, leverage ratio, 
counterparty credit risk and capital buffers have also been established to conduct work at an 
even more technical level and to develop legislative drafts in the respective areas. 

2.1.3.  Other public consultations 

The  preparatory  work  related  to  the  CRD  IV  proposal  started  already  in  2009  when  the 
Commission  services  conducted  a  first  public  consultation9  on  the  latest  wave  of  possible 
amendments to the CRD. This was followed by a consultation that ran in February - April of 
201010  and  included  questions  on  potential  policy  measures  pertaining  to  liquidity  and 
counterparty credit risk management, capital definition, leverage ratio, capital buffers, and the 

6  Group  1  banks  are  those  that  have  Tier  1  capital  in  excess  of  €3  billion,  are  well  diversified,  and  are 

internationally active. All other banks are considered Group 2 banks. 

7 ECB, EU Banking Structures, September 2010 
8 

See 

http://www.c-ebs.org/getdoc/354c6e4c-f22a-46a0-9025-0c55f460a5a6/2008-17-10-Final-Advice-on-

options-and-national-di.aspx  

9 See http://ec.europa.eu/internal_market/consultations/2009/capital_requirements_directive_en.htm  
10 See http://ec.europa.eu/internal_market/consultations/2010/crd4_en.htm  

 
 
                                                 
'single rule book'. A third consultation elaborating on the possible design of a countercyclical 
capital  buffer  ran  in  October  -  November  2010.11  A  fourth  consultation  on  capital 
requirements for certain types of counterparty credit risk was conducted in February - March 
2011.12 

In  April  2010  the  Commission  services  conducted  an  open  public  hearing  on  the  CRD  IV 
proposal.  The  event  was  actively  attended  by  all  the  stakeholder  groups,  including  the 
industry, regulators, supervisors, non-financial companies, and international organisations. 

Responses  to  the  four  public  consultations  and  views  expressed  at  the  public  hearing 
constitute  an  important  source  of  stakeholder  views  on  effectiveness  of  potential  policy 
measures and are reflected throughout the report.  

In  addition,  the  Commission  services  conducted  separate  extensive  consultations  with  the 
industry,  including  the  Group  of  Experts  in  Banking  Issues  (GEBI),  various  EU  banking 
industry associations and individual banks. 

2.2. 

Consultation with other services of the Commission 

2.2.1. 

Inter-service Steering Group 

An Inter-Service Steering Group (ISSG) was set up to follow progress and feed in views from 
other services of the Commission, including Directorates-General for Enterprise and Industry, 
Economic  and  Financial  Affairs,  Taxation  and  Customs  Union,  Health  and  Consumers, 
Competition, Legal Service, and Secretariat General. Experts from the Directorate-General for 
Economic  and  Financial  Affairs  contributed  to  this  impact  assessment  with  analyses  of 
implications of the proposal for the macro-financial stability and of macro-economic impacts 
during a transitional period (see Annex IX). The ISSG met four times in 2009 and five times 
in 2010. 

2.2.2. 

Impact Assessment Board 

The draft impact assessment was discussed with the Impact Assessment Board (IAB) of the 
Commission on 10 November 2010. On the basis of the IAB comments, a new simplified and 
shortened report for non-expert readers has been prepared. The initial draft, with a number of 
amendments, has been maintained to provide for a more detailed assessment of impacts (see 
Annex  I:  Extended  Impact  Analysis).  These  amendments,  made  in  response  to  the  IAB 
recommendations, included: 

- changes to the presentation of policy options related to February 2010 public consultation of 
the Commission services; 
- clarification on which preferred policy options are aligned with Basel III and which ones are 
not (and if so, how they differ from Basel III);  
- inclusion of references to the work of the Basel Committee underpinning the calibration of 
new capital requirements and an explanation for why some 3rd countries indicated their 
intention to opt for higher thresholds; 
- elaboration on the impact of the package on banks with different business models, costs for 
bank clients, and the probability of next banking crisis; 
- more extensive overview of stakeholders' views expressed during public consultations; 

11 See http://ec.europa.eu/internal_market/consultations/2010/capitalbuffer_en.htm  
12 See http://ec.europa.eu/internal_market/consultations/2011/credit_risk_en.htm  

 
 
                                                 
- clarification on the scope of the initiative concerning the single rule book, application of the 
preferred option in practice, and assessment of effectiveness of policy options considered in 
this area with respect to enhancing financial stability; and 
- explicit linking of policy options to identified problems (see Table 1). 

The IAB examined the above revisions and subsequently issued additional recommendations 
that  have  been  reflected  as  appropriate  in  this  impact  assessment.  More  specifically,  further 
clarifications have been introduced as regards differences between the preferred options and 
Basel  III,  presentation  of  policy  options  in  the  area  of  the  single  rule  book,  proposals  for 
higher capital thresholds in certain jurisdictions and impact on small and medium sized banks 
and their clients.  

Note:  Annex  I  (Extended  Impact  Analysis)  follows  the  structure  of  this  report  in  terms  of 
section  numbering.  Therefore,  for  additional  background  and  more  in-depth  analyses 
pertaining to individual sections of this report the reader should refer to respective sections of 
Annex I. 

3. 

PROBLEM DEFINITION 

3.1. 

Background 

The current EU bank capital framework is represented by the Capital Requirements Directive 
(CRD) comprising Directives 2006/48/EC and 2006/49/EC and reflecting the proposals of the 
Basel  Committee  for  the  Basel  II  Framework13  (Basel  II)  and  Trading  Book  Review14.  It 
covers both credit institutions and investment firms and stipulates the minimum amounts of 
own  financial  resources  that  banks  must  have  in  order  to  cover  the  risks  to  which  they  are 
exposed.  

The  financial  crisis  has  unveiled  a  number  of  shortcomings  of  Basel  II  and  necessitated 
unprecedented  levels  of  public  support  in  order  to  restore  confidence  and  stability  in  the 
financial  system.  In  the  EU,  the  effective  level  of  public  support  for  the  banking  sector 
reached,  on  average,  11%  of  GDP  as  of  October  2010  with  the  corresponding  metric  for  a 
number of MS well in excess of the EU average. This prompted a broad EU and international 
effort to identify the reasons behind the problems and to develop effective policies to tackle 
them head-on. In this context, already in November 2008, the Commission mandated a High 
Level  Group  (HLG)  chaired  by  Mr.  Jacques  de  Larosière  to  propose  recommendations  for 
reforming  European financial  supervision and  regulation. The  thirty one  recommendations15 
of  the  HLG  represented  a  comprehensive  set  of  concrete  possibilities  for  regulatory, 
supervisory  and  global 
the  Commission's 
repair  action  and  were  elaborated 
Communication16  for  the  spring  European  Council  of  4  March  2009.  Most  of  the  proposals 
that this impact assessment accompanies are listed in the detailed action plan included in the 
Communication.  

in 

Given  the  level  of  integration  within  the  global  financial  system,  however,  reaching  an 
international  consensus  on  measures  that  would  be  effective  in  containing  the  problems 

13 See http://www.bis.org/publ/bcbs107.htm  
14 See http://www.bis.org/publ/bcbs116.htm  
15 See http://ec.europa.eu/internal_market/finances/docs/de_larosiere_report_en.pdf  
16 See http://ec.europa.eu/commission_barroso/president/pdf/press_20090304_en.pdf  

 
 
                                                 
identified  is  crucial.  In  this  regard,  the  G-20  Declaration  of  2  April  200917  conveyed  the 
commitment of the global leaders18 to address the crisis with internationally consistent efforts 
to, among others, improve the quantity and quality of capital in the banking system, introduce 
a  supplementary  non-risk  based  measure  to  contain  the  build-up  of  leverage,  develop  a 
framework  for  stronger  liquidity  buffers  at  financial  institutions  and  implement  the 
recommendations19 of the Financial Stability Board (FSB)20 to mitigate the pro-cyclicality. 

In response to the mandate given by the G-20, in September 2009 the Group of Central Bank 
Governors  and  Heads  of  Supervision  (GHOS),  the  oversight  body  of  the  Basel  Committee, 
agreed21  on  a  number  of  measures  to  strengthen the regulation of the banking sector. These 
measures  were  endorsed  by  FSB  and  the  G-20  leaders  at  their  Pittsburgh  Summit  of  24-25 
September  200922  and  were  fleshed  out  in  detail  and  made  available  for  stakeholder 
comments  in  two  consultation  documents  of  the  Basel  Committee  in  December  200923.  In 
February  –  April  2010  the  Commission  conducted  a  parallel  public  consultation  within  the 
EU, going beyond the set of measures covered by the documents of the Basel Committee. 

In  December  2010,  the  Basel  Committee  issued  detailed  rules  of  new  global  regulatory 
standards on bank capital adequacy and liquidity that collectively are referred to as Basel III.24 
The  proposal  that  this  impact  assessment  accompanies  directly  relates  to  the  regulatory 
standards included in Basel III.  

The following sub-sections present the analysis of the main problems and drivers underlying 
them for the CRD areas under review. A 'problem tree' is included at the end of the section. 

3.2.  Management of liquidity risk 

Problem Drivers 

- Shortcomings in liquidity risk 
management, including stress 
testing 

- Asset and liability maturity 
mismatches 

- No harmonized and 
sufficiently explicit regulatory 
treatment at EU level 

Problems 

- Existing liquidity risk management approaches and supervisory regimes 
inadequately captured risks inherent to the underlying market practices and 
trends, contributing to bankruptcy of several institutions and strongly 
undermining financial health of many others, threatening the financial stability 
and necessitating unprecedented levels of central bank liquidity and 
government support 

- Differences in national liquidity regimes give rise to level-playing field 
issues for cross-border firms and hamper effectiveness of supervision as well 
as cooperation between supervisory authorities 

Funding  liquidity  risk  arises  because  inflows  and  outflows  of  funds  at  banks  are  not 
synchronised. A bank is deemed to be liquid as long as at each point in time outflows of funds 

report 

17 See http://www.g20.org/Documents/Fin_Deps_Fin_Reg_Annex_020409_-_1615_final.pdf  
18 European leaders expressed their support for these measures at the European Council of 19-20 March 2009 
19  The 

(see 
http://www.financialstabilityboard.org/publications/r_0904a.pdf)  set  out  fifteen  recommendations  to 
mitigate mechanisms that amplify procyclicality by covering three areas: bank capital framework, bank 
loan  loss  provisions,  and  leverage  and  valuation  issues.  The  proposal  that  this  impact  assessment 
accompanies directly relates to a number of recommendations issued by FSB.  

on  Addressing 

Procyclicality 

Financial 

System 

FSB 

the 

of 

in 

20 FSB promotes international financial stability through information exchange and international co-operation in 
financial  supervision  and  surveillance.  It  brings  together  national  authorities  responsible  for  financial 
stability 
institutions,  sector-specific 
international groupings of regulators and supervisors, and committees of central bank experts.  

international  financial  centres, 

international  financial 

in 

21 See http://www.bis.org/press/p090907.htm  
22 See http://www.g20.org/Documents/pittsburgh_summit_leaders_statement_250909.pdf  
23 See http://www.bis.org/publ/bcbs164.htm and http://www.bis.org/publ/bcbs165.htm  
24 See http://www.bis.org/publ/bcbs189.htm and http://www.bis.org/publ/bcbs188.htm  

 
 
                                                 
are smaller or equal to the sum of inflows and its stock of liquid assets. Therefore, it should 
manage  its  liquidity  risk  with  a  view  to  ensure  that  the  above  constraint  is  never  breached. 
The  global  financial  crisis  that  started  in  summer  of  2007  has  brought  to  light  various 
shortcomings in current liquidity risk management approaches that incapacitated a number of 
financial institutions to comply with this constraint.  

Existing  bank  liquidity  risk  management  approaches,  including  liquidity  stress  tests,  and 
supervisory  regimes  were  shown  to  be  inadequate  in  fully  grasping  risks  inherent  to  the 
underlying  market  practices,  such  as  originate-to-distribute  securitization,  use  of  complex 
derivative  instruments  and  reliance  on  wholesale  funding  with  short-term  maturity 
instruments. In the run-up to the crisis, many financial institutions have increasingly turned to 
the  capital  markets  for  funding  their  operations  with  instruments  of  shorter  maturity  and 
became  reliant  on  wholesale  funding  sources  such  as  commercial  paper,  repurchase 
agreements  ('repos'),  and  interbank  markets.25  Events  of  the  crisis  clearly  illustrated  that 
during times of market stress investors exhibit heightened risk aversion by demanding higher 
compensation for risk, requiring banks to roll over liabilities at considerably shorter maturities 
or refusing to extend financing altogether.26 

Also,  banks'  assumptions  pertaining  to  asset  liquidity  in  secondary  markets  as  well  as  its 
interaction with funding liquidity turned out to had been erroneous. If asset markets are liquid, 
assets  can  be  sold  at  their  fair  value  or  hypothecated  at  low  haircuts.  However,  bank  assets 
have  a  potential  to  become  illiquid,  in  particular  in  stressed  conditions  when  market 
participants withdraw from the relevant markets. Then they can only be sold at a discount or 
hypothecated  at  much  higher  haircuts.  Moreover,  many  financial 
institutions  also 
underestimated  the  extent  of  the  interaction  between  market  liquidity  and  funding  liquidity. 
Rising  arrears  on  US  sub-prime  mortgages  that  were  extensively  packaged  in  residential 
mortgage  backed  securities  caused  investors  to  lose  faith  in  ratings  of  these  and  other 
structured products and led to heightened concerns about accuracy of their valuation. The loss 
of  investor  confidence  was  transmitted  through  a  fall  in  their  price,  as  market  liquidity  for 
such  securities  evaporated,  to  an  increase  in  funding  risk  as  margins  and  haircuts  related  to 
them increased. In turn, this forced additional deleveraging and selling, effectively creating a 
vicious  feedback  loop  between  deteriorating  market  liquidity  and  disappearing  funding 
liquidity.  

As of August 2007, money markets also tightened because banks started hoarding liquidity to 
better  position  themselves  against  possible  funding  shortfalls.  Such  behaviour  was  further 
intensified due to a lack of understanding about the level of exposure to difficult-to-value and 
potentially impaired assets and, in relation to this, financial health of other institutions. 

The  above  factors  were  not  properly  captured  by  the  bank  liquidity  risk  management  and 
contributed  to  a  demise  of  several  financial  institutions  and  strongly  undermined  health  of 

25 According to Barclays Capital, over decade leading to the crisis, European bank wholesale funding as % of 

balance sheet has increased from 40% to 70%. 

26 Bear Sterns failed in March 2008 once it found itself unable to secure funding on the repo market and was 
subsequently  taken  over  JPMorgan  Chase.  Lehman  Brothers,  another  US  investment  bank,  filed  for 
bankruptcy  in  September  2008,  in  part  because  of  difficulties  in  addressing  similar  funding  liquidity-
related  problems.  UK  mortgage  lender Northern  Rock  collapsed  in  September  2007,  following  a  first 
wave  of  illiquidity  in  the  interbank  market.  Failures of  Bradford &  Bingley  and HBOS  in  September 
2008 were also partially driven by their reliance on wholesale funding markets. 

 
 
                                                 
many  others,  threatening  the  financial  stability  and  necessitating  unprecedented  levels  of 
public sector and central bank liquidity support.27 

While  currently  a  number  of  MS  impose  some  form  of  quantitative  regulatory  standard  for 
liquidity, no harmonised sufficiently explicit regulatory treatment on the appropriate levels of 
short-term  and  long-term  liquidity  exists  at  the  EU  level.  Differences  in  national  liquidity 
regimes arise from different degrees of resilience to liquidity stress that different MS aim at as 
well  as  certain  nationally  determined  factors  such  as  insolvency  regimes,  deposit  insurance 
arrangements,  central  bank  credit  and  collateral  policies.  As  regards  supervisory  reporting, 
diversity  in  current  national  approaches  hampers  effective  communication  and  cooperation 
between  supervisory  authorities  and  imposes  additional  costs  on  cross-border  institutions, 
causing potential level-playing field issues.  

3.3. 

Eligibility of capital instruments and application of regulatory adjustments 

Problem Drivers 

- Certain capital instruments did not 
fulfil loss absorption, permanence 
and flexibility of payments criteria  

- List of regulatory adjustments 
incomplete or applied not to a 
relevant layer of regulatory capital  

- Lack of harmonization in 
application of regulatory 
adjustments 

Problems 

- Tier 1 capital ratios reported by banks and, thus, their capital were not 
reflective of their capacity to absorb losses on a going-concern basis. As 
the crisis deepened and banks faced growing losses and writedowns, their 
fundamental solvency was called into question, leading to broader 
financial instability and necessitating extensive public sector support 

- Variations in the definition of Tier 1 capital stemming from differences 
in application of adjustments across the MS obstructed its comparability 
and reliability, leading to market participants' and regulators' focus on 
alternative measures 

The  EU  banking  system  entered  the  crisis  with  capital  of  insufficient  amount  and  quality. 
Mounting  losses  forced  banks  to  rebuild  their  capital  bases  at  the  time  when  it  was  most 
difficult to do so, in turn, necessitating governments to provide support to the banking sector 
in many countries and on a massive scale and contributing to the onset of economic downturn.  

The crisis has shown that certain capital instruments did not meet the expectations of markets 
and  regulators  with  regard  to  their  loss  absorption,  permanence  and  flexibility  of  payments 
capacity  on  a  going-concern  basis.  This  in  particular  pertains  to  hybrid  capital  instruments 
(hybrids) and certain types of non-hybrid instruments that make part of banks' Tier 1 capital.  

When  these  instruments  included  a  possibility  to  defer  or  cancel  a  coupon  (i.e.,  criterion  of 
flexibility  of  payments)  to  enable  banks  to  conserve  resources  during  difficult  times28,  such 
possibility  was  not  widely  exercised.  This  was  in  part  driven  by  a  stigma  of  dividend 
cancellation being interpreted by the market as a signal of distress. Effectively, the outflow of 
dividends and coupons contributed to the weakening of the banking sector at the time when 
capital  was  most  needed.  As  regards  the  criterion  of  permanence,  there  were  instances  of 
banks redeeming hybrids despite the higher cost of replacing them at the time of crisis. This 
was in particular true when market expectations were based on instrument's contractual terms 
that provided for an incentive to redeem the instrument by increasing the interest rate to be 
paid if redemption is not executed.29 Instances of hybrid capital instruments absorbing losses 

27  Between  September  and  December  2008,  ECB  loans  to  the  euro  area  credit  institutions  increased  by  some 

70% to over €800 billion. For public sector support, please see footnote #2.  

28 According to CEBS, in 2006 some 80% of hybrids reported by EEA banks as Tier 1 capital had a right for 

issuers to suspend payments in case of solvency difficulties and in other situations 

29 According to CEBS, in 2006 42% of hybrids (mostly innovative instruments) reported by EEA banks as Tier 1 

capital had such feature at the time of their issue 

 
 
                                                 
during the crisis have also been rare. As a result, the crisis effectively delineated those capital 
instruments  that  acted  as  a  'going-concern'  capital  from  those  that  acted  rather  as  a  'gone-
concern'  capital.  In  fact,  skipping  options  to  redeem30  and  cancelling  /  deferring  coupon 
payments31 on hybrid capital became more prevalent only later in the crisis, in the context of 
state aid to financial institutions, and was in part due to the Commission policy that included 
the objective of 'burden sharing'.32  

Another problem lied in the fact that the list of adjustments to regulatory capital proved to be 
incomplete as certain balance sheet items such as minority interests33 and deferred tax assets 
(DTAs)34 whose loss absorption potential is less certain on a going-concern basis in times of 
market  distress  have  been  effectively  removed  by  market  participants  and  regulators  from 
capital  ratios  as  reported  by  individual  institutions.  The  crisis  also  showed  that  regulatory 
adjustments  when  applied  were  not  applied  to  the  appropriate  layer  of  regulatory  capital. 
Under the CRD, the current adjustments are generally applied on a 50%-50% basis to Tier 1 
and Tier 2.35 This allowed banks to report high Tier 1 ratios, despite the fact that they had low 
levels  of  Tier  1  capital  (as  perceived  by  the  markets)  when  entirely  excluding  adjustments 
such as for investments in other financial institutions in excess of 10% of the common stock 
of such institutions.36  

Currently,  regulatory  adjustments  in  the  EU  are  not  harmonised,  as  MS  have  discretion  to 
apply additional adjustments.37 As regards minority interests, MS have discretion to include it 
in  the  regulatory  capital.38  The  resultant  variations  in  the  definition  of  Tier  1  capital  across 
MS obstructed the comparability and further compromised the reliability of this measure. This 
led  to  the  loss  of  confidence  in  Tier  1  as  measure  of  capital  adequacy  prompting  market 
participants and regulators to instead focus on alternative measures, mostly based on common 
equity, net of balance sheet elements whose loss absorption potential proved to be uncertain 
during market distress.   

The  above  shortcomings  contributed  to  the  banking  sector  entering  the  crisis  with  reported 
Tier 1 capital ratios that were not reflective of institutions' effective capacity to absorb losses 
on  a  going-concern  basis.  As  the  crisis  deepened  and  banks  faced  growing  losses  and 

in 

30 This was the case for RBS, Bradford & Bingley, KBC Group 
31 This was the case for BayernLB, Commerzbank, Lloyds, RBS, Allied Irish Banks, Bank of Ireland, Cajasur 
32  Commission  communication  on  the  return  to  viability  and  the  assessment  of  restructuring  measures  in  the 
see  http://eur-
crisis  under 

financial 
lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:C:2009:195:0009:0020:EN:PDF  

the  State 

current 

sector 

rules; 

aid 

the 

33 Minority interest represents shares issued by a group entity and is available primarily to absorb losses which 
occur in that entity. However, minority interest may not necessarily be readily available to absorb losses 
elsewhere  in  a  group,  including  the  consolidating  entity.  Therefore,  in  cases  where  a  group  entity  is 
overcapitalised, inclusion of minority interest at the consolidated entity level may represent an artificial 
enhancement to its capital ratios. According to HSBC, at the end of 2009 minority interests contributed 
€95 billion to European bank capital. 

34  DTAs  can  be  defined  as  the  amounts  of  income  taxes  that  may  be  recovered  by  a  company  in  the  future. 
However, DTAs whose realisation through reduced future tax payments is contingent on a bank's ability 
to generate profits raise prudential concern as they may not provide protection to depositors in case of 
insolvency.  

35 Article 66 
36 A deduction from Tier 1 capital only in this case is warranted to prevent a reduction in capital as a result of 
loss absorption in one financial institution from being immediately reflected as a loss of capital in the 
investing financial institution. 

37 Article 61 
38 Article 65 

 
 
                                                 
writedowns  which  directly  reduced  their  retained  earnings,  their  fundamental  solvency  was 
called into question.  

3.4. 

Counterparty credit risk 

Problem Drivers 

Problems 

- Current provisions do not adequately capture CCR 

- Shortcomings in risk management practices as 
regards back testing, stress testing and collateral 
management 

- Current provisions do not entail sufficient 
incentives to move bilaterally cleared OTC 
instruments to central counterparties and to post 
adequate initial margin 

- Existing provisions did not ensure appropriate risk 
management of financial institutions as well as adequate 
and non-cyclical regulatory requirements against CCR 
that materialised during the crisis 

- Calibration of provisions did not provide sufficient 
incentives to clear bilateral OTC instruments through 
central counterparties, leading to lack of confidence and 
exacerbating instability in times of market stress 

The  crisis  revealed  a  number  of  shortcomings  in  the  current  regulatory  treatment  of 
counterparty  credit  risk  (CCR)  exposures  arising  from  derivatives,  repos  and  securities 
financing  activities.  For  instance,  while  the  CRD  covers  the  risk  of  counterparty  default,  it 
does not address the credit valuation adjustment (CVA) risk, associated with deterioration in 
the  creditworthiness  of  a  counterparty.  Yet,  during  the  crisis  roughly  two-thirds  of 
counterparty credit losses were due to CVA losses with the remainder due to actual defaults. 
Current provisions also do not recognize the unique, systemic risk associated with exposures 
associated  with  over-the-counter  (OTC)  derivatives  given  the  extent  to  which  they  are 
concentrated  at  large  financial  institutions,  whose  counterparties  generally  are  other  large 
financial  institutions.  Given  such  interconnectedness,  financial  institutions'  credit  quality 
deteriorated simultaneously proving them to be relatively more sensitive to systemic risk than 
non-financial firms. Under current rules, the CCR capital requirement was too low during the 
period preceding the crisis, but increased rapidly as the financial turmoil started, making the 
requirement  pro-cyclical.  The  crisis  also  revealed  a  number  of  significant  shortcomings  in 
institutions’  risk  management  of  counterparty  credit  exposures,  including  in  particular  the 
areas of back-testing, stress testing, and collateral management. 

The existing framework did not provide sufficient incentives to move bilaterally cleared OTC 
derivative  contracts  to  multilateral  clearing  through  central  counterparties  (CCPs).  Even 
though CCPs can play an important role in the efforts to reduce the systemic risk arising from 
the intricate web of exposures formed by holdings of derivative products by banks, they were 
not widely used to clear trades. Regulatory capital requirements for bilaterally cleared trades 
were  not  sufficiently  high  to  offer  an  attractive  incentive  to  clear  OTC  derivative  trades 
through  a  CCP.  Instead,  the  need  to  post  initial  margin  when  clearing  trades  with  a  CCP 
apparently more than offset the fact that no regulatory cost was involved for such trades.  

3.5. 

Pro-cyclicality of lending 

Problem Drivers 

Problems 

- Market failures, including limitations 
in risk measurement, information 
asymmetries and inappropriate 
responses to risk and changes in 
economic conditions 

- Inappropriate responses to risk and other market failures contribute 
to leverage build-up and a concomitant overextension of credit in the 
economic upturn and cause banks to maintain generous discretionary 
distributions during periods of stress, when capital should be 
conserved 

- Irresponsiveness of regulatory 
requirements to risk build-up at the 
macro level 

- Lack of explicit limits to leverage of 

- Lack of a limit to leveraging capital and irresponsiveness of capital 
requirements to the build-up of risk at the macro level led to 
accumulation of financial imbalances which precipitated steep credit-
related losses and, once the economic cycle turned, prompted a de-

 
 
Problem Drivers 

Problems 

credit institutions 

leveraging spiral 

Pro-cyclical effects can be defined as those which tend to follow the direction of and amplify 
an  economic  cycle.  In  this  regard,  bank  lending  also  can  contribute  to  amplification  of 
business fluctuations, which in turn may exacerbate financial instability. The cyclical nature 
of  bank  lending  has  many,  often  interconnected  sources  that  include  both  market  and 
regulatory failures.39  

While  financial  institutions  fare  better  at  assessing  relative  risk,  they  have  difficulties  in 
assessing  absolute  level  of  risk  especially  over  a  prolonged  period,  and  so  rarely  identify 
booms with consequences for systemic risk. The misperception of risk may be exacerbated by 
a strong industry-wide drive for profit and moral hazard of implicit safety nets. Hence, when 
macro-economic  conditions  were  favourable,  banks  engaged  in  a  rapid  expansion  of  their 
balance  sheets  without  due  consideration  about  implications  for  system-wide  financial 
stability.  

When  economic  conditions  became  depressed  and  collateral  values  declined,  information 
asymmetries with respect to the quality of clients’ balance sheets impeded access to funding 
even  for  borrowers  with  profitable  projects.  Such  pro-cyclical  effects  proved  to  be  more 
pertinent to borrowers which are more prone to asymmetric information, including small and 
medium-sized  enterprises  not  subject 
to  external  ratings  and  extensive  disclosure 
requirements. 

Inappropriate  responses  of  financial  institutions  to  changes  in  economic  conditions  in  some 
cases could be explained by short-term bias of remuneration structures or herding behaviour. 
While, given the difficulties to raise capital, banks should have made greater efforts to rebuild 
regulatory capital (to limit its depletion due to accumulating losses), many of them maintained 
generous  discretionary  distributions  to  their  shareholders,  providers  of  other  capital 
instruments and employees.40  

One  feature  of  current  risk-based  minimum  capital  requirements  is  that  they  vary  over  the 
economic cycle. Provided credit institutions could meet them, there is no explicit regulatory 
constraint on leverage of institutions. The lack of a limit to their leverage and irresponsiveness 
of regulatory capital requirements to the build-up of risk at the macro level enabled banks to 
recklessly  grow  their  balance  sheets.41  Increases  in  leverage  combined  with  investment  in 
more  risky  products  allowed  many  banks  to  seek  higher  returns,  as  high  levels  of  available 
liquidity resulted in risk premia falling to historically low levels. When financial asset prices 
started  to  fall,  assets  had  to  be  marked-to-market  for  losses  incurred  and  banks  had  to  de-

39 For a thorough description of the main sources of pro-cyclicality please see: 

BIS,  Addressing  financial  system  procyclicality:  a  possible  framework,  Note  for  the  FSF  Working 
Group on Market and Institutional Resilience, September 2008; and  
Masschelein,  N.,  Monitoring  pro-cyclicality  under  the  capital  requirements  directive:  preliminary 
concepts for developing a framework, NBB Working Paper Document No. 120, 2007 

40 Dividends of 21 large banks from the US and Europe increased from 0.4% of their assets in 2000 to 1.1% in 
2007 and were still at 0.7% through the first three quarters of 2008, in spite of a deepening financial 
crisis. Acharya, V., I. Gujral, and H. S. Shin, Bank Dividends in the Crisis: A Failure of Governance, 
March 2009 

41 ECB’s analysis of credit-to-GDP gap from 1995 to 2009 in 19 MS showed that credit in the years preceding 
the  financial  crisis  grew  at  a  fast  pace  in  a  number  of  them  (e.g.,  IE,  LV,  LT,  HU),  signalling 
accumulation  of  risk  at  the  systemic  level  and  imminence  of  significant  credit-related  losses  for  their 
banking sectors. 

 
 
                                                 
 
 
leverage  by  selling  them  in  order  to  minimize  regulatory  capital  requirements  and  meet 
margin calls from their counterparties, prompting further asset price declines (see section 3.2 
for  the  interaction  between  market  liquidity  and  funding  liquidity).  According  to  the  IMF 
estimates,  between  2007  and  2010  crisis-related  writedowns  and  loan  provisions  on  bank 
assets originated globally reach $2.3 trillion, $1.3 trillion of which is attributable to European 
banks, equivalent to 8% of the EU GDP. 

Policy  measures42  adopted  by  the  Commission  so  far  address  only  some  specific  aspects  of 
the above-listed market and regulatory failures and, therefore, may not be entirely effective in 
limiting the extent of leverage build-up in the balance sheets of financial institutions and the 
concomitant  overextension  of  credit.  In  June  2010  the  Commission  adopted  a  report43  on 
effects of the CRD on the economic cycle noting that it would examine additional measures to 
mitigate  the  pro-cyclicality.  These  measures  i)  should  limit  the  build-up  of  leverage  in  the 
banking sector, thus, helping to contain the risk of destabilising deleveraging processes and ii) 
should curb the excessive risk-taking in times of economic growth but could be drawn down 
during economic downturns to increase resilience of the banking sector and support the credit 
flow to the economy.44  

3.6. 

Options, discretions and minimum harmonisation 

Problem Drivers 

- Diverging national rules due to the 
inclusion in the CRD of a number of 
national options and discretions 

- Gold-plating of the current 
provisions 

- Lack of detail within certain CRD 
provisions that allow for supervisory 
judgement and / or choice to be made 

Problems 

- Diverging national rules allow for competitive distortions in the 
internal market and lead to a fragmented and inconsistent financial 
supervision, impeding legal clarity and resulting in excessive 
administrative burden for cross-border banks.  

- Mutual recognition of 'host' MS treatment at consolidated level 
creates opportunities for regulatory arbitrage whereas application of 
'home' MS discretions at 'host' level hinders supervisory cooperation 
and level playing field 

Over the recent years the EU banking market has become highly integrated: currently around 
70% of EU banking assets is in the hands of some 40 banking groups with substantial cross-
border activities. However, efficiency of the internal market in wholesale and retail banking 
services is undermined by divergences in national rules on capital and liquidity requirements. 

The CRD is a recast of the Consolidated Banking Directive (2000/12/EC), resulting in some 
150 national options and discretions. The CRD is also a 'minimum harmonisation' directive.45 
This means that MS may 'add' stricter prudential rules, which gives rise to a practice known as 
'gold-plating'.  Divergences  in  national  rules  stemming  from  the  possibility  of  application  of 
national options, discretions and gold-plating are exacerbated by the process of transposition 
itself.  Finally,  national  rules  transposing  the  CRD  are  interpreted  in  accordance  with  local 
traditions and approaches thereby deepening the divergences in application of the CRD across 
the MS further.  

42 For instance, the CRD III proposal included provisions on an express obligation for financial institutions to 
establish  and  maintain  remuneration  policies  and  practices  that  are  consistent  with  effective  risk 
management. The Commission also proposed to set up a European Systemic Risk Board to oversee the 
stability of the financial system, identify systemic risks at the European level and issue risk warnings.  

43 See http://ec.europa.eu/internal_market/bank/docs/regcapital/monitoring/23062010_report_en.pdf  
44 Analysis of the Basel Committee showed that ‘severely stressed’ banks entered the crisis with a higher degree 
of balance sheet leverage. This analysis was based on leverage ratios for 117 banks from 19 countries in 
2006 and 2007, of which 27 banks were identified as 'severely stressed' during the financial crisis. See 
http://www.bis.org/publ/bcbs180.pdf 

45 Recital 15 of Directive 2006/48/EC 

 
 
                                                 
Where  the  legal  text  does  not  include  criteria  on  which  judgements  or  choices  are  made  by 
supervisors, some options and discretions may result in a lack of legal clarity. While all MS 
have a supervisory treatment that appears to be legally compliant, any given exposure might 
receive  different  treatment  from  one  MS  to  another.  Effects  of  disparate  approaches  have  a 
direct  effect  on  a  firms'  ability  to  properly  and  fairly  compete  in  another  MS,  leading  to  an 
unlevel playing field. 

Diverging application of the CRD undermines the reform of the EU supervisory architecture 
and,  therefore,  may  impair  effectiveness  and  efficiency  of  supervision.  From  2011,  the 
European  Banking  Authority  (EBA)  replaced  CEBS,  taking  over  CEBS’  responsibilities  as 
well  as  receiving  additional  powers.  In  particular,  it  has  been  entrusted  with  developing 
technical standards in areas of bank regulation that concern issues of highly technical nature 
where uniform conditions for implementing EU acts are needed. For such standards to be best 
developed and most effective, national requirements should not diverge, i.e., there should be 
no possibility to apply stricter rules, different options or discretions. 

Different  application  of  legislation  in  different  MS  is  particularly  burdensome  for  firms 
operating  cross-border.  They  have  to  report  on  their  compliance  with  different  sets  of 
requirements  at  consolidated  and  subsidiary  levels  which  gives  rise  to  additional  reporting 
costs. In order to allow cross-border banks to minimize these costs, the CRD II introduced a 
requirement for supervisors to apply a uniform reporting format by the end of 2012, which is 
under development by EBA. However, work on common reporting format represents only a 
partial  solution  from  the  industry's  perspective,  as  aforementioned  divergences  mean  that 
differently defined data would need to be reported from one MS to another. 

Consequences  of  regulatory  divergences  are  particularly  pertinent  when  considering  the 
treatment of banking groups. Under the CRD, as a general rule, the consolidating supervisor 
should  apply  'home'  MS  rules  at  consolidated  level,  unless  otherwise  provided  for  in  the 
directive. Where rules are not harmonised, this may result in banking groups with subsidiaries 
in other MS having to apply diverging rules at solo (‘host’ MS) level and consolidated level. 
Mutual recognition of the host MS national discretion provides some degree of flexibility by 
allowing  the  use  of  local  rules46  at  consolidated  level  but  may  also  create  opportunities  for 
regulatory  arbitrage.  The  CRD  also  provides  the  possibility  to  apply  'home'  discretions  at 
'host' level. This is discussed, on a case by case basis, in colleges of supervisors involving all 
relevant supervisors of banking groups. In this context, supervisors may decide to apply any 
blend of 'home' and 'host' discretions. Due to the number of options and discretions, positions 
of national authorities with regard to suitability of specific prudential measures vis-à-vis parts 
of the group may diverge, hindering efficiency and effectiveness of supervisory cooperation. 
Moreover,  as  practices  may  vary  from  one  college  to  another,  banking  group-specific 
outcomes are delivered, which may have negative implications for the level playing field.  

3.7. 

Risks inherent in baseline scenario 

There  is  a  broad  international  consensus  that  problems  outlined  in  sections  3.2  -  3.6 
individually, and even more so when taken together, played a significant contributing role in 
exacerbating the economic cycle and in precipitating the extreme financial instability that in 
turn  evoked  the  global  economic  recession,  damaging  soundness  and  international 
competitiveness  of  the  EU  banking  sector  and  subjecting  a  wide  range  of  stakeholders, 

46 The CRD provides 18 cases of explicit reference to mutual recognition of national discretions implemented by 

another national authority 

 
 
                                                 
including bank creditors, shareholders, employees, borrowers and taxpayers, to unprecedented 
economic costs. If no action in these areas is taken, the risk that systemic shocks of a similar 
scale occur in the future will not be addressed.  

3.8. 

Is action necessary at EU level? 

Based  on  the  nature  of  problems  outlined  in  the  above  analysis,  several  major  justifications 
that  meet  the  principle  of  subsidiarity  for  action  at  the  EU  level  become  apparent.  They 
include  a  need  to  enhance  the  integration  of  EU  internal  banking  market  (by  removing 
national options, discretions and possibilities to 'gold-plate'), address several market (e.g., in 
the  area  of  countercyclical  policy  measures)  and  regulatory  failures  (e.g.,  capital  definition 
and liquidity risk management rules, capital requirements for CCR) that were brought to light 
by the financial crisis, correct for regulatory arbitrage opportunities which are made possible 
by the current legislation (due to the availability of certain national options and discretions) 
and ensure a consistent EU approach for tackling various issues covered by the scope of this 
report, which would do away with the need for MS to pursue individual approaches that risk 
fragmenting the internal market.  

Most importantly, only a common EU-level approach could be expected to effectively provide 
for  financial  stability  and  tame  excessive  financial  pro-cyclicality,  as  currently  policies  that 
are  directed  toward  these  key  systemic  aspects  are  either  geared  to  national  needs  or  are 
absent altogether. With respect to the latter, the crisis clearly demonstrated the ineffectiveness 
of the national liquidity risk supervision approaches. 

As regards the proportionality of proposed EU actions, it is implicitly assessed in section 5 in 
the  process  of  comparison  of  potential  policy  options  in  terms  of  their  effectiveness  and 
efficiency vis-à-vis the relevant policy objectives. 

 
 
PROBLEM DRIVERS 

Shortcomings in liquidity risk 
management, including stress testing 

Asset and liability maturity mismatches 

No harmonised and sufficiently explicit 
regulatory treatment at EU level  

Certain capital instruments did not fulfil 
loss absorption, permanence and 
flexibility of payments criteria  

List of prudential adjustments incomplete 
or applied not to a relevant layer of 
institutions' regulatory capita l  

Lack of harmonization in application of 
prudential adjustments  

Current provisions do not capture all the 
risk adequately: 

(cid:57)  Generalised / specific wrong way risk 
(cid:57)  Systemic risk related to large financial 

institutions 

(cid:57)  No capital requirement for mark-to-market 
losses due to credit value adjustments 

Current provisions do not entail 
incentives to: 

(cid:57)  Move bilateral OTC to clearing through 

central counterparties 

(cid:57)  Post adequate initial margin 

Shortcomings in risk management 
practices: 

(cid:57)  Back testing 
(cid:57)  Stress testing 
(cid:57) Collateral management 

Cyclical nature of bank lending due to 
market failures such as: 

(cid:57) Limitations in risk measurement 
(cid:57) Information asymmetries 
(cid:57) Inappropriate responses to risk and 
changes in economic conditions 

Irresponsiveness of regulatory 
requirements to risk build-up at the macro 
level

Lack of explic it limit to leverage build-up 

Current provisions leave room for 
diverging rules across MS through: 

(cid:57)  National options 
(cid:57)  National discretions 
(cid:57)  Additions above minimum harmonisation due 

to possibility to gold-plate 

Lack of detail within certain provisions 
that allow for supervisory judgement and / 
or choice to be made 

L
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C
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D
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C
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P
A
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Y

C
R
E
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T 

R
I
S
K 

P
R
O 
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Y
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L
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S
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R
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E

B
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K

PROBLEM TREE  

GENERAL 
PROBLEMS 

 Cyclicality of bank lending  

Opportunities for regulatory 
arbitrage 

Sub-optimal level of risk 
management 

Prudential capital and 
liquidity requirements 
inadequate in relation to 
undertaken risks  

Inadequate prudential 
requirements for 
systemically important 
institutions  

Lack of legal clarity 

Unlevel playing field 

Sub-optimal level of 
supervisory co-operation 
and convergenc e 

Increased compliance 
burden for cross-border 
institutions 

Inc reased risks to financial 
stability  

Increased pro-cyclicality of 
the financial system  

Creditor protection not 
optimised 

Implications for 
international 
competitiveness of EU 
banking industry

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  
 
  
 
 
 
4. 

OBJECTIVES 

The  overarching  goal  of  this  initiative  is  to  ensure  that  the  effectiveness  of  bank  capital 
regulation  in  the  EU,  represented  by  the  CRD,  is  strengthened  and  its  adverse  impacts  on 
depositor  protection  and  pro-cyclicality  of  the  financial  system  are  contained,  while 
maintaining  the  competitive  position  of  the  EU  banking  industry.  This  translates  into  the 
following four general policy objectives to:  

- Enhance financial stability (G-1); 

- Enhance safeguarding of depositor interests (G-2); 

- Ensure international competitiveness of EU banking sector (G-3); 

- Reduce pro-cyclicality in the financial system (G-4). 

In light of the problems presented in sections 3.2 - 3.6, five sets (in the areas of liquidity risk 
management,  definition  of  capital,  counterparty  credit  risk,  pro-cyclicality,  and  single  rule 
book) 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 and liquidity requirements (S-1); 

- Enhance bank risk management (S-2); 

- Prevent regulatory arbitrage opportunities (S-3); 

- Enhance legal clarity (S-4); 

- Reduce compliance burden (S-5); 

- Enhance level playing field (S-6); 

- Enhance supervisory cooperation and convergence (S-7) 

- Align prudential requirements for systemically important financial institutions (SIFIs) with 
the risks that they pose (S-8); 

- Reduce cyclicality of bank lending (S-9); 

and, in turn, should facilitate the attainment of the four general policy objectives. 

Table 1 provides an overview of the linkages between:  

- identified problems and drivers underlying them; 

- operational, specific and general objectives to address the problem drivers; and 

- policy options to achieve the objectives.  

 
 
Table 1: Summary of problems, objectives and policy options 

Problems 

Problem Drivers 

Operational Objectives 

Specific Objectives 

General Objectives 

S-1 

S-2 

S-3 

S-4 

S-5 

S-6 

S-7 

S-8 

S-9 

f
o
y
c
a
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e
c
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y
t
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n
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k
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t
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l
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g
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d
l
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f

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e
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d
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p
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l
a
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d
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n
g
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l

A

s
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F
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S
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f

s
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s
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f
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R

g
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k
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c
n
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p
m
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e
c
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R

n
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d
r
u
b

G-
1 

l
a
i
c
n
a
n
i
f

e
c
n
a
h
n
E

y
t
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l
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b
a
t
s

G-
2 

f
o
g
n
i
d
r
a
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e
f
a
s

e
c
n
a
h
n
E

s
t
s
e
r
e
t
n
i

r
o
t
i
s
o
p
e
d

G-
3 

U
E
f
o

s
s
e
n
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v
i
t
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t
e
p
m
o
c

l
a
n
o
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t
a
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t
n
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e
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u
s
n
E

r
o
t
c
e
s
g
n
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k
n
a
b

G-
4 

y
t
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l
a
c
i
l
c
y
c
-
o
r
p
e
c
u
d
e
R

m
e
t
s
y
s

l
a
i
c
n
a
n
i
f

e
h
t

n
i

Liquidity risk management 
- Existing liquidity risk management approaches and 
supervisory regimes inadequately captured risks inherent to 
the underlying market practices and trends, contributing to 
bankruptcy of several institutions and strongly undermining 
financial health of many others, threatening the financial 
stability and necessitating unprecedented levels of central 
bank liquidity and government support.  

- Differences in national liquidity regimes give rise to level-
playing field issues for cross-border firms and hamper 
effectiveness of supervision as well as cooperation between 
supervisory authorities. 

Definition of capital 

- Banking sector – due to the drivers outlined - entered the 
crisis with reported Tier 1 capital ratios and, thus, capital 
that were not reflective of banks' capacity to absorb losses 
on a going-concern basis. As the crisis deepened and banks 
faced growing losses and writedowns, their fundamental 
solvency was called into question, leading to broader 
financial instability and necessitating extensive public 
sector support 

- Variations in the definition of Tier 1 capital stemming 
from differences in application of regulatory adjustments 
across the MS obstructed its comparability and reliability, 
leading to market participants' and regulators' focus on 
alternative measures 
Counterparty credit risk 
- Existing CRD provisions did not ensure appropriate risk 
management of financial institutions as well as adequate 
and non-cyclical regulatory requirements against the 
counterparty credit risk that materialised during the crisis  

- Calibration of provisions does not provide sufficient 
incentives to clear bilateral OTC instruments through 
central counterparties, leading to lack of confidence and 
exacerbating instability in times of market stress 

Shortcomings in liquidity risk 
management, including stress tests 

Asset and liability maturity 
mismatches  

Ensure that institutions have 
sufficient high quality liquid assets 
to withstand an acute stress scenario 
lasting for 30 days 

Ensure that institutions fund their 
activities with more stable sources 
of funding on an ongoing structural 
basis 

√ 

√ 

√ 

√ 

No harmonized and sufficiently 
explicit regulatory treatment at EU 
level 

Develop appropriately explicit and 
harmonized EU level regime for 
management of liquidity risk 

√ 

Certain capital instruments did not 
fulfil loss absorption, permanence and 
flexibility of payments criteria  

List of regulatory adjustments 
incomplete or applied not to a relevant 
layer of institutions' regulatory capital  

Enhance loss absorption, 
permanence and flexibility of 
payments of going-concern capital 
instruments 

Enhance loss absorption of 
regulatory capital by appropriate 
application of regulatory 
adjustments from the relevant layers 
of capital 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

Lack of harmonization in application 
of regulatory adjustments  

Develop a harmonised set of 
provisions in the area of definition 
of capital  

Current provisions do not adequately 
capture counterparty credit risk 

Enhance adequacy of capital 
requirements for the counterparty 
credit risk 

Current provisions do not entail 
incentives to move bilateral OTC to 
clearing through central counterparties 
and to post adequate initial margin 

Provide incentives to move bilateral 
OTC to clearing through central 
counterparties and to post adequate 
initial margin 

Shortcomings in risk management 
practices as regards back testing, 
stress testing and collateral 

Enhance bank risk management 
practices 

18 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

4.1-
4.3 

s
n
o
i
t
p
O
y
c
i
l
o
P

1.1-
1.3 

2.1-
2.3 

1.1-
2.3 

3.1-
3.5 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Problems 

Problem Drivers 

Operational Objectives 

Specific Objectives 

General Objectives 

S-1 

S-2 

S-3 

S-4 

S-5 

S-6 

S-7 

S-8 

S-9 

f
o
y
c
a
u
q
e
d
a

e
c
n
a
h
n
E

y
t
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d
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q
i
l

d
n
a

l
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p
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s
t
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m
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q
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k
s
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r
k
n
a
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c
n
a
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n
E

t
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a
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a
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s
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a

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t
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P

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A

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d
r
u
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G-
1 

l
a
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c
n
a
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f

e
c
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E

y
t
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l
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a
t
s

G-
2 

f
o
g
n
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d
r
a
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f
a
s

e
c
n
a
h
n
E

s
t
s
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t
n
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r
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t
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p
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d

G-
3 

U
E
f
o

s
s
e
n
e
v
i
t
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t
e
p
m
o
c

l
a
n
o
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a
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t
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e
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u
s
n
E

r
o
t
c
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s
g
n
i
k
n
a
b

G-
4 

y
t
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l
a
c
i
l
c
y
c
-
o
r
p
e
c
u
d
e
R

m
e
t
s
y
s

l
a
i
c
n
a
n
i
f

e
h
t

n
i

Procyclicality of lending 
- Lack of a limit to leveraging capital and irresponsiveness 
of regulatory capital requirements to the build-up of risk at 
the macro level led to accumulation of financial imbalances 
which, once the economic cycle turned, prompted a de-
leveraging spiral and precipitated steep credit-related losses  

- Inappropriate responses to risk and other market failures 
contribute to leverage build-up and a concomitant 
overextension of credit in the economic upturn and cause 
banks to maintain generous discretionary distributions 
during periods of stress, when capital should be conserved  

Options, discretions and minimum harmonisation 

- Diverging national rules allow for competitive distortions 
in the Internal Market and lead to a fragmented and 
inconsistent financial supervision, impeding legal clarity 
and resulting in excessive administrative burden for cross-
border banks 

- Mutual recognition of 'host' MS treatment at consolidated 
level creates opportunities for regulatory arbitrage; 
application of 'home' MS discretions at 'host' level hinders 
supervisory cooperation and level playing field 

management 

Market failures, including limitations 
in risk measurement, information 
asymmetries and inappropriate 
responses to risk and changes in 
economic conditions 

Irresponsiveness of regulatory 
requirements to risk build-up at the 
macro level 

Lack of explicit limits to leverage of 
credit institutions 

Diverging national rules due to the 
inclusion in the CRD of a number of 
national options and discretions 

Gold-plating of the current provisions 

√ 

√ 

√ 

√ 

√ 

√ 

Introduce an explicit limit on banks 
capacity to leverage their capital 

Improve banks' capacity to absorb 
losses over periods of stress and still 
meet the minimum regulatory 
capital requirement 

Protect banking sector from 
excessive credit growth and build-
up of risks at the macro-level while 
ensuring credit flow to the economy 
in the economic downturn  

Remove national options and 
discretions in the CRD 

Remove regulatory additions above 
the agreed minimum standards 

Lack of detail within certain CRD 
provisions that allow for supervisory 
judgement and / or choice to be made 

Make provisions allowing for 
supervisory judgement and / or 
choice more specific  

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

s
n
o
i
t
p
O
y
c
i
l
o
P

5.1-
5.3 

6.1-
6.4 

5.1-
6.4 

7.1-
7.4 

19 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
5. 

POLICY OPTIONS: ANALYSIS AND COMPARISON 

This  section  presents  the  policy  options  and  their  impacts  for  each  policy  area  individually. 
Due  to  the  number  of  the  areas  covered,  the  analysis  of  policy  options  and  the  comparison 
thereof  have  been  combined  for  each  area.  Cumulative  impacts  of  all  preferred  options  are 
discussed at the end of the section.  

Presentation of options in each policy area includes a 'retain current approach' scenario. While 
this usefully serves as a baseline for assessing impacts of alternative policy options, it needs 
to  be  kept  in  mind  that  sections  5.1-5.5  pertain  to  proposals  linked  to  Basel  III  that  were 
developed by the Basel Committee with the active participation of the Commission services, 
on behalf of all 27 EU MS. Hence, 'retain current approach' options should be evaluated also 
bearing  in  mind  the  damage  that  their  adoption  would  inflict  on  the  credibility  of  the 
Commission in the context of setting global bank regulation standards. 

Most policy option sets also include an option  based  on  the  Commission  services'  February 
2010  public  consultation.  As  such,  it  represents  a  policy  option  whose  development  was 
underpinned  by  a  tremendous  amount  of  preparatory  work  and  which  was  subjected  to  an 
extensive  consultation  process  in  the  EU.  Importantly,  the  feedback  received  from  EU 
stakeholders  was  key  for  the  Commission  services'  negotiating  positions  at  the  Basel 
Committee, shaping the final policy solutions of Basel III. Inclusion of this option also serves 
to  enhance  the  transparency  of  the  Basel  III  process,  by  showing  how  the  thinking  on 
individual parts of the new framework evolved over the course of 2010. 

Details of the new framework were fleshed out by the Basel Committee in December 2010. 
Policy options pertaining to the new liquidity measures are analysed in section 5.1. As regards 
the new capital requirements, respective policy options are discussed in sections 5.2-5.5. The 
calibration,  including  phase-in  and  grandfathering  arrangements,  of  Basel  III  is  shown  in 
Tables  2  and  3  below.  However,  EU  MS  will  be  allowed  to  'gold-plate'  the  new  minimum 
requirements during the phase-in period, which means that they can apply already in 2013 the 
level of capital required by Basel III in 2019. 

Table 2: Calibration of Basel III, in % of RWAs 

Common Equity 
(after deductions) 

Tier 1 Capital 

Total Capital 

Minimum requirement 

Conservation buffer 

Minimum requirement plus conservation buffer 
Countercyclical buffer range 1 
Notes: 1 Common equity or other fully loss absorbing capital 
Source: Basel Committee 

4.5 

2.5 

7.0 

0-2.5 

6.0 

8.5 

8.0 

10.5 

Table 3: Transitional arrangements for Basel III framework (all dates are as of January 1) 
2013 
Policy measure 

2017 

2018 

2014 

2015 

2016 

2012 

2011 

2019 

Leverage ratio 

Supervisory monitoring 

Parallel run                                         

Disclosure starts on 1/1/2015 

Migration 
to Pillar 1 

Minimum common equity (CET1) 
capital ratio  
Capital conservation buffer 
Minimum common equity plus 
capital conservation buffer 
Phase-in of deductions from CET1 

Minimum Tier 1 capital 

3.5% 

4.0% 

4.5% 

4.5% 

4.5% 

4.5% 

4.5% 

0.625% 

1.25% 

1.875% 

2.5% 

3.5% 

4.0% 

4.5% 

5.125% 

5.75% 

6.375% 

7.0% 

20% 

5.5% 

40% 

6.0% 

60% 

6.0% 

80% 

6.0% 

100% 

6.0% 

100% 

6.0% 

4.5% 

20 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Policy measure 

2011 

2012 

Minimum total capital 
Minimum total capital plus capital 
conservation buffer 
Capital instruments no longer 
qualifying as non-core Tier 1 
capital or Tier 2 capital 

Liquidity Coverage Ratio 

Net Stable Funding Ratio 

Source: Basel Committee 

Observation 
period 
begins 

Observation 
period 
begins 

2013 

8.0% 

2014 

8.0% 

2015 

8.0% 

2016 

8.0% 

2017 

8.0% 

2018 

8.0% 

2019 

8.0% 

8.0% 

8.0% 

8.0% 

8.625% 

9.25% 

9.875% 

10.5% 

Phased out over a 10 year period beginning 2013 

Introduce 
minimum 
standard 

Introduce 
minimum 
standard 

It  needs  to  be  stressed  that  the  calibration  of  the  new  minimum  capital  requirements  was 
determined by taking into account the impact that the new policy measures would have on the 
numerator  (i.e.,  definition  of  eligible  capital)  and  the  denominator  (i.e.,  measures  affecting 
risk  weighted  assets)  of  the  ratios.  Therefore,  analyses  underpinning  the  phase-in 
arrangements and the calibration of the new rules are presented after preferred policy options 
relevant  for  the  calculation  of  the  ratios  have  been  identified  (in  line  with  the  approach 
followed by the Basel Committee). 

5.1. 

Liquidity risk 

To  address  the  problems  in  the  area  of  liquidity  risk  management,  in  its  February  2010  the 
Commission services consulted on the two key potential policy measures: Liquidity Coverage 
Ratio and Net Stable Funding Ratio. 

5.1.1.  Liquidity Coverage Ratio 

To address shortcomings in liquidity risk management and to improve short-term resilience of 
the  liquidity  risk  profile  of  financial  institutions  by  ensuring  that  they  have  sufficient  high 
quality liquid assets to withstand an acute stress scenario lasting for 30 days, the Commission 
services proposed to introduce a Liquidity Coverage Ratio (LCR). Main policy options in this 
area are as follows: 

-  Policy option 1.1: Retain current approach; 
-  Policy option 1.2: Introduce LCR as specified in the February 2010 public consultation; 
-  Policy option 1.3: Introduce LCR adopted by the Basel Committee subject to observation 

period. 

Policy option 1.1: Retain current approach 

Under this policy option, problems related to short-term liquidity risk management, as 
outlined in section 3.2 may not be entirely addressed. Given the recently agreed Basel 
liquidity standards, it may be expected that under this policy option certain MS would adopt 
these sounder standards. Other MS may pursue different alleys for strengthening liquidity 
regimes and others may not act at all. This would lead to further divergence of standards 
within Europe, creating opportunities for regulatory arbitrage and un-levelling the playing 
field. 

Policy option 1.2: Introduce LCR as specified in the February 2010 public consultation 

LCR would require credit institutions to match net liquidity outflows during a 30 day period 
of  acute  stress  with  a  buffer  of  'high  quality'  liquid  assets,  i.e.,  to  maintain  LCR  of  at  least 
100%.  The  net  liquidity  outflows  (the  denominator)  during  the  period  of  stress  would  be 

21 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
completely  defined  in  the  CRD,  detailing  inter  alia  what  percentage  of  a  given  source  of 
funding a credit institution has to assume would be withdrawn from it. The outflows covered 
would  reflect  both  institution-specific  and  systemic  shocks  built  upon  actual  circumstances 
experienced in the global financial crisis and discussed in section 3.2. The provisions on the 
list  of  high  quality  liquid  assets  (the  numerator)  to  cover  these  outflows  should  ensure  that 
these assets are of high credit and liquidity quality.47 For more detailed specifications of both 
the numerator and the denominator of the ratio please see Annex IV.  

As regards the buffer of high quality liquid assets, the Commission services consulted on the 
impact  of  both  a  narrow  regulatory  definition  of  the  buffer  composed  of  cash,  central  bank 
reserves  and  high  quality  sovereign  debt,  as  well  as  a  somewhat  broader  definition  which 
included non-financial corporate bonds and covered bonds of high quality up to 50% of the 
buffer.48 

The standards would apply at the level of individual legal entities. This is desirable as long as 
constraints on the transferability of assets, mutual support commitments and central liquidity 
risk  management  within  groups  continue  to  apply.  However,  application  to  individual  firms 
could  be  waived  by  supervisors  provided  that  it  is  possible  to  identify  a  set  of  institutions 
belonging  to  the  same  group  with  centrally  managed  liquidity  risk,  legally  binding  mutual 
commitments  for  liquidity  support  between  the  relevant  institutions  and  freely  transferable 
assets  between  legal  entities  even  when  under  stress.  Where  these  conditions  are  met,  the 
requirements  would  be  applied  on  a  consolidated  level  only  to  the  entities  belonging  to  a 
group. Individual legal entity level application would be complemented by application at the 
consolidated level to ensure a sound liquidity position of the overall banking group.  

Because in this area different MS currently apply different standards, banks were not familiar 
with  standardised  data  requests  included  in  the  QIS.  While  this  points  in  the  direction  of 
possibly  significant  one-off  compliance  costs  related  to  information  provision,  i.e., 
administrative  costs,  when  migrating  to  the  new  standards,  it  may  be  expected  that  there 
would be important ongoing cost savings for cross-border groups that currently typically have 
to report on individual legal entity basis (and even separately at the level of branches that do 
not have a legal personality) according to very diverse national regimes and, in addition, on a 
consolidated basis according to their home country regime. Hence, administrative costs due to 
EU  legislation,  as  discussed  in  section  5.8.3,  should  be  offset  by  savings  of  administrative 
costs  due  to  national  reporting  requirements.  On  top  of  that,  harmonised  reporting  would 
facilitate communication between supervisors of the different legal entities of a group.  

EU QIS showed that as of December 2009 under the narrow definition of liquid asset buffer, 
average LCR was 52.4% and 74.1% for Group 1 and Group 2 banks, respectively. Group 1 
banks from only two countries and Group 2 banks from 9 countries had average LCR above 
100%. Under the broader definition of liquid asset buffer, average LCR improved by some ten 
percentage points for both groups.  

Feedback  from  numerous  public  consultations  showed  that  the  'narrow'  liquid  asset  buffer, 
however,  does  not  address  the  situation  of  jurisdictions  such  as  DK  that  may  not  have 
sufficient supply of eligible assets. Most respondents to the consultations also claimed that the 
'narrow' buffer definition entails the concentration risk of specific asset classes while labelling 

47 They should have low credit and market risk, ease and certainty of valuation, low correlation with risky assets, 
active and sizeable market, low market concentration, presence of committed market makers, be listed 
on developed exchange market, and be likely to attract investors in stressed market situations 

48 Those rated AA and above with a 20% haircut and those rated A- up to AA- with a 40% haircut 

22 

 
 
 
                                                 
bank (covered) bonds as illiquid would hamper bank ability to raise funds. Refinements were 
deemed to be necessary also as regards assumptions used to estimate several categories of net 
liquidity  outflows  (the  denominator),  for  instance,  to  recognize  that  central  bank-eligible 
assets that are not part of the liquid asset buffer and retail deposits constitute a better source of 
liquidity than assumed by this option. Public authorities of certain MS, on contrary, were in 
favour of a 'narrow' asset buffer on the grounds of financial stability. 

Policy  option  1.3:  Introduce  LCR  adopted  by  the  Basel  Committee  subject  to  observation 
period 

Policy option 1.3 reflects the specification of LCR announced by the Basel Committee in its 
Basel III rules text in December 2010. It takes into account the above mentioned concerns and 
recalibrates the LCR requirement by building on the 'narrow' definition of liquid asset buffer 
under policy option 1.2. 

'Narrow'  liquid  asset  buffer  under  this  option  is  broadened  to  include:  i)  non-financial 
corporate and covered bonds not issued by the bank itself of high credit and liquidity quality 
with  a  15%  haircut  and  ii)  exposures  to  sovereign  and  public  sector  entities,  central  banks, 
that  are  risk-weighted  at  20%  under  the  CRD,  with  a  15%  haircut.  The  inclusion  of  these 
assets (termed 'Level 2' assets) is capped at 40% of the liquid asset buffer. Level 2 assets are 
also of very high liquidity, but possess the properties of high quality liquid assets included in 
the 'narrow' definition to a somewhat lesser extent. The limit on these assets would ensure that 
assets  of  the  very  highest  quality  make  up  the  majority  of  the  buffer  while  allowing  banks 
some flexibility to improve the profitability of their liquid asset holdings. This option entails 
three alternatives to accommodate the specific situation of jurisdictions which do not have a 
sufficient supply of Level 1 assets in their domestic currency to meet the aggregate demand of 
banks with significant exposures in this currency. However, its Level 2 cap of 40% is lower 
than that of the broader buffer definition under option 1.2. 

This  option  foresees  that  before  2015,  a  range  of  qualitative  and  quantitative  criteria  to 
determine high credit and liquidity quality and to determine to which of the two levels in the 
buffer individual assets should be assigned will be tested by EBA with a view to advising the 
Commission  on  the  appropriate  set  and  calibration  of  such  criteria.  Preliminary  criteria  that 
put particular emphasis on assets' external ratings have been set by the Basel Committee, but 
the testing of alternative criteria should allow by 2015 to identify final criteria that place more 
emphasis on experienced liquidity and less on such ratings. 

This option also elaborates on the expected outflow assumptions of a number of bank liability 
categories.49  For  operational  activities  with  financial  institution  counterparties,  it  creates  a 
25%  outflow  bucket  for  custody,  clearing  and  settlement,  and  selected  cash  management 
activities.  Importantly  to  the  EU,  a  similar  treatment  is  given  to  mutual  deposits  of 
cooperative and other types of bank networks. 

In  line  with  the  general  desire  to  introduce  harmonised  standards  and  be  less  dependent  on 
individual banks' ability to model risks and assumptions that banks would make, this option 
also establishes a harmonised treatment of net inflows rather than leaving their determination 

49 Categories such as retail deposits; secured and unsecured deposits from sovereign, public sector entities and 
central  banks;  undrawn  committed  credit  and  liquidity  lines  to  retail  and  SME  customers;  undrawn 
committed credit lines to sovereign, public sector entities and central banks 

23 

 
 
 
                                                 
to  bank  discretion.50  Importantly,  to  ensure  a  minimum  level  of  liquid  asset  holdings,  the 
amount of inflows that can offset outflows is capped at 75% of total expected cash outflows 
as calculated in the standard. This effectively requires that a bank must maintain a minimum 
amount  of  stock  of  liquid  assets  equal  to  25%  of  the  outflows  in  order  to  cover  potential 
timing  mismatches  between  in-  and  outflows  during  the  30  days  and  possible  delays  of 
inflows under stress. 

The  above  revisions  to  option  1.2  have  been  determined  based  on  the  current  data.  The 
foreseen observation period will confirm whether any further changes are required. 

Similarly to policy option 1.2, the standards would apply at the level of individual legal and 
consolidated  entities.51  The  Commission  will,  based  on  a  report  from  EBA  and  taking  into 
account the contribution of ESRB, review before 2015 whether the ratio has any unintended 
consequences on the business and risk profile of European institutions, trade finance, financial 
markets and the economy. The Commission should be able to modify the ratio accordingly as 
appropriate  via  a  delegated  act.  A  mechanism  would  be  built  into  the  CRD  IV  proposal 
ensuring that the ratio will only apply after the Commission has concluded its review and has 
made the necessary modifications, if any.  

Under this policy option, average EU LCR is 66.5% for Group 1 banks and 87.1% for Group 
2 banks, comparable to the LCR averages of the broader buffer definition under option 1.2. In 
terms  of  distributional  impacts  with  respect  to  bank  size,  under  this  option  the  impact  of 
having LCR of 100% is less pronounced for smaller (i.e., Group 2) banks in most of the MS. 
In  terms  of  implications  of  this  policy  option  on  banks  from  other  major  international 
jurisdictions that are large and active abroad, the EU Group 1 LCR average is lower than that 
of  a  sample  of  84  large  international  banks  from  twenty  members  of  the  Basel  Committee 
(including eight EU MS) that as of December 2009 stood at 82.9%.52 

On the basis of the QIS, shortfall of liquid assets for the entire EU banking sector is estimated 
at about €1.6 trillion.53 As regards the aggregate supply of liquid assets in the economy, when 
the above purchases of liquid assets are financed by new equity of banks, this may effectively 
represent a switch between the direct holdings of such assets by ultimate investors with the 
indirect ones (through holding bank equity). Yet there may not necessarily be a big effect on 
the aggregate assets in the economy, as ultimately all securities would continue to be held - 
directly and indirectly – by the ultimate investors, including bank shareholders. Liquid asset 
shortfalls  shall  also  not  be  confused  with  related  bank  costs  which  stem  from  the  foregone 
return  on  assets,  i.e.,  the  difference  between  average  return  on  loans  and  average  return  on 
assets included in the buffer.  

LCR could lead to a contraction of the interbank market for short-term maturity. There is also 
the risk of a potential reduction in the liquidity – and therefore maybe an increase of costs – of 
instruments excluded from the buffer, such as ABS or foreign currency swaps, as they would 
be  relatively  disregarded  by  banks.  Nevertheless,  incentivising  banks  to  find  alternative 

50 Banks are assumed to realise inflows of 100% from their lending to other financial institutions, but should, due 
to  the  need  to  continue  providing  lending  to  firms  and  households,  only  assume  50%  of  the  inflows 
contractually due from these counterparties.  

51  This  is  in  alignment  with  Basel  III  rules  since  they  outline  treatment  at  the  consolidated  group  level  while 
leaving the implementation at the sub-group and stand-alone bank levels to discretion of its members, in 
order to ensure greater consistency and level playing field between domestic and cross-border banks 

52 Source: QIS on the impact of Basel III reforms on the BCBS' countries 
53 Sources: EU QIS, Commission services' calculations 

24 

 
 
 
                                                 
sources  of  funding  is  a  key  step  to  enhance  financial  stability,  reduce  the  reliance  of  the 
banking industry on such (wholesale) markets and limit the contagion channels. 

The introduction of LCR is estimated to reduce the EU GDP by 0.11% four and a half years 
since the start of implementation, compared to the baseline trend, if its benefits are not taken 
into  account.54  However,  the  new  framework  should  be  understood  as  an  insurance  scheme 
securing  the  stability  of  individual  institutions  and  eventually  of  the  financial  system  as  a 
whole.  Complying  with  the  LCR  requirement  as  defined  under  this  option  is  expected  to 
reduce the probability of a systemic crisis by some 40%, equivalent to annual GDP benefits in 
the range of 0.1% to 0.5%.55 The new measures should be able to address the pro-cyclicality 
and  volatile  patterns  of  banks'  unregulated  liquidity  management:  on  the  one  hand, 
underestimated risks when liquidity is cheap and easily available and, on the other hand, rapid 
contagion and loss of confidence in crisis situation due to the asymmetry of information and 
insufficient liquidity reserves.  

Comparison of policy options 

Retaining  the  current  scenario  (option  1.1),  implies  that  problems  related  to  short-term 
liquidity  risk  management,  as  outlined  in  section  3.2,  may  not  be  addressed  effectively, 
depending on the actions taken in this area by national supervisors and/or the industry. While 
tightening  of  national  liquidity regimes  may  provide  for  a  degree  of  increased  effectiveness 
with  respect  to  regulation  (objective  S-1)  and  bank  management  (objective  S-2)  of  risks 
discussed  in  this  section,  there  is  no  guarantee  that  necessary  progress  would  be  achieved 
quickly enough and evenly across the EU. 

While  both  policy  options  1.2  (LCR  as  specified  in  the  February  2010  public  consultation) 
and  1.3  (LCR  developed  by  the  Basel  Committee  subject  to  observation  period)  entail 
effective approaches with respect to contributing to the achievement of relevant objectives S-
1  (Enhance  adequacy  of  capital  and  liquidity  requirements),  S-2  (Enhance  bank  risk 
management)  and  G-1  (Enhance  financial  stability),  option  1.3  is  more  effective  due  to  its 
more precise calibration of a number of elements relevant for the calculation of LCR. While 
these  two  options  are  comparable  in  terms  of  compliance  costs  for  the  industry,  option  1.2 
(i.e., its version of the broader buffer definition) is more efficient than option 1.3 in terms of 
achieving the above objectives. Option 1.2 has a higher cap for additional assets eligible for 
the  liquid  asset  buffer  and  generally  could  be  better  tailored  to  the  EU  specificities  both  in 
terms of the numerator and the denominator given that they would be entirely defined in the 
CRD. As such, it would impose lower adjustment costs on both the industry, and via indirect 
impacts,  on  other  economic  agents.  Given  its  superior  effectiveness  as  regards  the  relevant 
policy objectives, however, option 1.3 is identified as a preferred option. 

Table 4: Summary of policy option effectiveness and efficiency 

Policy Option 

1.1 Retain current approach 
1.2 Introduce LCR as specified in the February 2010 
public consultation 
1.3 Introduce LCR adopted by the Basel Committee 
subject to observation period 

Policy Option Comparison Criteria 

Enhance adequacy 
of capital and 
liquidity 
requirements [S-1] 
3 

Effectiveness 
Enhance bank 
risk 
management 
[S-2] 
3 

2 

1 

2 

1 

Enhance 
financial 
stability 
[G-1] 
3 

2 

1 

Efficiency 

3 

1 

2 

54 Sources: EU QIS, Basel Committee (MAG report, see section 5.8.4), Commission services' calculations 
55 Sources: EU QIS, Basel Committee (LEI report, see section 5.8.5), Commission services' calculations 

25 

 
 
 
                                                 
Scale of option ranking: 1=most effective / efficient, 3=least effective / efficient 
Effectiveness measures extent to which options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources 

5.1.2.  Net Stable Funding Ratio 

To address shortcomings in the management of funding structure over a one year horizon, the 
Commission services propose to introduce a Net Stable Funding Ratio (NSFR). Main policy 
options in this area are as follows: 

-  Policy option 2.1: Retain current approach; 
-  Policy option 2.2: Introduce NSFR as specified in the February 2010 public consultation; 
-  Policy option 2.3: Introduce NSFR adopted by the Basel Committee. 

Policy option 2.1: Retain current approach 

Under this policy option, funding problems arising from asset - liability maturity mismatch, as 
outlined in section 3.2, may not be entirely addressed. While tightening of national liquidity 
regimes may provide for a degree of increased effectiveness with respect to management and 
supervision  of  risks  discussed  in  this  section,  there  is  no  guarantee  that  necessary  progress 
would be achieved quickly enough and evenly across the EU.  

Policy option 2.2: Introduce NSFR as specified in the February 2010 public consultation 

NSFR  would  require  credit  institutions  to  maintain  a  sound  funding  structure  over  the  one-
year  horizon  in  an  extended  firm-specific  stress  scenario  such  as  a  significant  decline  in  its 
profitability or solvency. To this end, assets currently funded and any contingent obligations 
to fund would have to be matched, depending on their liquidity profile at a one year horizon 
(reflected in the so-called 'required stable funding factors'), with sources of funding that can 
be considered stable over the same one year horizon. Annex V contains specifications of both 
sources  of  available  stable  funding  (the  numerator)  and  required  stable  funding  for  various 
asset types (the denominator) of the ratio, as outlined in February 2010 public consultation.  

In  terms  of  level  of  application,  NSFR  would  apply  at  the  level  of  individual  legal  and 
consolidated  entities  in  line  with  the  approach  envisaged  for  application  of  LCR.  For  the 
reasons  outlined  in  the  discussion  of  LCR,  costs  related  to  information  provision,  i.e., 
administrative costs, under this policy option are expected to be significant (see section 5.8.3).  

EU QIS showed that as of December 2009 the average NSFR for Group 1 banks was 79.8%. 
No country was, on average, able to meet the requirement under this policy option, with MS 
observing ratios in the range of 60.6% to 97.2%. A wider range of results across countries was 
observed for Group 2 banks (43.4% - 155.7%), while its average NSFR of 83.7% was slightly 
higher than that of Group 1.  

Feedback  from  numerous  public  consultations  showed  that  this  policy  option,  however, 
requires further refinements with respect to calibration of available stable funding factors (the 
numerator)  and  required  stable  funding  factors  as  regards  certain  asset  types  (the 
denominator) and that it may unfairly penalise certain business models.56 With respect to the 

56 Respondents claimed that banks being dependent on capital markets would be given a better ratio than retail 
deposit banks which have been stable. It was also recognised that NSFR might favour broker / dealers 
while penalising the universal banking model. 

26 

 
 
 
                                                 
latter, some respondents called for the phasing in of the ratio to allow banks for adjusting their 
business models. 

Policy option 2.3: Introduce NSFR adopted by the Basel Committee 

Policy option 2.3 reflects the specifications of NSFR announced by the Basel Committee in its 
Basel III rules text in December 2010. It takes into account the abovementioned concerns by 
recalibrating certain available stable funding and required stable funding factors.57  

As a result, average NSFR is higher for most countries when compared to policy option 2.2, 
and the EU average rises to 91.1% for Group 1 banks and to 93.9% for Group 2 banks, while 
MS averages continue to be widely dispersed. In terms of distributional impacts, smaller (i.e., 
Group  2)  banks  tend  to  have  higher  NSFR  ratios.  EU  banking  sector's  shortfall  to  meet  the 
NSFR requirement of 100% as of December 2009 is estimated in the vicinity of €3.2 trillion.58  

As  regards  implications  of  this  policy  option  on  banks  from  other  major  international 
jurisdictions that are large and active abroad, the EU Group 1 NSFR average is comparable to 
that of a sample of 85 large international banks from twenty members of the Basel Committee 
(including eight EU MS) that as of December 2009 stood at 92.7%.59  

Given the above impact and acknowledging the novelty of this requirement, this policy option 
entails an observation period that starts in 2012. The observation period would allow for the 
assessment  of  any  unintended  implications  of  the  ratio  for  institutions  of  different  size  and 
business model, trade financing, financial markets and credit provision to the real economy. 
The  establishment  of  the  actual  regulatory  requirement,  subject  to  appropriate  revisions 
relative to its preliminary form, would be left to another legislative proposal before 2018. 

This  policy  option  would  be  less  costly  for  the  industry  than  option  2.2,  as  in  effect, 
compliance with NSFR would start only in seven years from 2010, giving institutions ample 
time  to  make  necessary  adjustments  to  their  funding  structure,  asset  and  liability  maturity 
mismatch  and  activities  which  are  the  most  vulnerable  to  liquidity  risk  in  periods  of  stress. 
Institutions  would  still  be  subject  to  the  costs  related  to  provision  of  information  to 
supervisors during the observation period (see section 5.8.3). 

Comparison of policy options 

Retaining  the  current  scenario  (option  2.1)  implies  that  problems  related  to  longer-term 
funding  liquidity  risk  management  may  not  be  addressed.  While  both  policy  options  2.2 
(NSFR as specified in the February 2010 public consultation) and 2.3 (NSFR adopted by the 
Basel Committee) entail an effective approach with respect to contributing to the achievement 
of relevant objectives S-1 (Enhance adequacy of capital and liquidity requirements) and S-2 
(Enhance  bank  risk  management)  as  well  as  G-1  (Enhance  financial  stability)  and  other 
relevant  general  objectives,  option  2.3  is  more  effective  due  to  its  more  precise  –  from  a 

57 Available stable funding factors for retail and SME deposits are raised, while required stable funding factors 
for i) residential mortgages and other loans that qualify for the 35% or better risk weight under Basel II 
standardised approach for credit risk, ii) government and public sector entity securities with risk-weight 
of 20% under the CRD, and iii) certain off-balance sheet commitments are lowered 

58  Sources:  EU  QIS,  Commission  services'  calculations.  Expected  shortfall  shall  not  be  confused  with  related 
bank costs which may stem (depending on actions taken by banks to comply with the requirement) from 
substituting  sources  of  funding  with  lower  available  stable  funding  factors  with  those  with  higher 
available stable funding factors. 

59 Source: QIS on the impact of Basel III reforms on the BCBS' countries 

27 

 
 
 
                                                 
prudential  angle  –  calibration.  Policy  option  2.3  is  the  most  efficient  option  in  terms  of 
achieving  the  above  policy  objectives  as  it  would  impose  lowest  adjustment  costs  on  the 
industry  and,  via  the  reduced  likelihood  of  unwelcome  side  effects  for  the  industry  and  the 
financial  markets,  on  other  economic  agents.  Policy  option  2.3  is  identified  as  a  preferred 
option. 

Table 5: Summary of policy option effectiveness and efficiency 

Policy Option Comparison Criteria 

Policy Option 

Enhance adequacy 
of capital and 
liquidity 
requirements [S-1] 
3 

Effectiveness 
Enhance bank 
risk 
management 
[S-2] 
3 

2.1 Retain current approach 
2.2 Introduce NSFR as specified in the February 2010 
public consultation 
2.3 Introduce NSFR adopted by the Basel Committee 
Scale of option ranking: 1=most effective / efficient, 3=least effective / efficient 
Effectiveness measures extent to which options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources 

2 

2 

1 

1 

Enhance 
financial 
stability 
[G-1] 
3 

2 

1 

Efficiency 

3 

2 

1 

5.2. 

Eligibility of capital instruments and application of regulatory adjustments 

In the process of preparing the legislative proposal, a number of policy alternatives on various 
individual aspects of the definition of regulatory capital have been examined. They could be 
sensibly grouped in the following key policy options: 

-  Policy option 3.1: Retain current approach; 
-  Policy  option  3.2:  Modify  only  the  eligibility  criteria  for  own  funds,  as  specified  in  the 

February 2010 public consultation; 

-  Policy option 3.3: Modify both eligibility criteria and regulatory adjustments as specified 

in the February 2010 public consultation; 

-  Policy option 3.4: Modify both eligibility criteria and regulatory adjustments as adopted by 

the Basel Committee; 

-  Policy option 3.5: Modify both eligibility criteria and regulatory adjustments as adopted by 

the Basel Committee, adjusted in certain areas to take account of EU specificities. 

Policy option 3.1: Retain current approach 

Under this policy option, problems related to the definition of capital and outlined in section 
3.3  will  not  be  entirely  addressed.  While  CRD  II  harmonised  the  criteria  and  established 
explicit limits for different types of Tier 1 hybrid capital, further amendments were shown by 
the  crisis  to  be  necessary  in  order  to  enhance  quality  of  regulatory  capital.  As  regards 
regulatory  adjustments,  current  CRD  provisions  allow  for  national  discretion  to  make 
additional adjustments, however, this does not guarantee that a necessary progress would be 
achieved quickly enough and in a uniform manner across the EU.  

Policy  option  3.2:  Modify  only  the  eligibility  criteria  for  own  funds  as  specified  in  the 
February 2010 public consultation 

This  policy  option  would  tighten  eligibility  criteria  for  the  different  layers  of  regulatory 
capital. The Commission services' public consultation of February 2010 outlined such criteria 
with  respect  to  core  Tier  1,  non-core  Tier  1  and  Tier  2  capital  (see  Annex  VI).  As  regards 
core,  or,  Common  Equity  Tier  1  (CET1),  the  resultant  ineligibility  of  certain  capital 

28 

 
 
 
instruments would have a varying effect on institutions from different MS.60 Impacts on non-
core  Tier  1  capital  would  be  mainly  driven  by  elimination  of  innovative  and  dated  hybrid 
instruments.61  As  regards  Tier  2  capital  instruments,  EU  banks  that  are  organised  as 
cooperative networks / societies would no longer be permitted to include in it commitments of 
their  members  (e.g.,  uncalled  capital  and  commitments  to  make  further  non-refundable 
payments), based on the prudential rationale that capital should be paid up in order to ensure 
that it may be relied upon when required. 

However,  the  above  amendments  would  address  only  issues  relating  to  the  eligibility  of 
capital  instruments.  They  would  not  address  the  regulatory  adjustments  necessary  to  ensure 
that the amount of regulatory capital recognised adequately reflects the amounts that would be 
available  to  absorb  losses  on  a  going  concern  or  in  insolvency.    A  lack  of  further 
harmonisation  of  regulatory  adjustments  would  result  in  the  maintenance  of  the  current 
divergent approaches in the EU to adjusting regulatory capital. Therefore, this policy option 
would only be partially effective in achieving the relevant policy objectives. 

Policy option 3.3: Modify both eligibility criteria and regulatory adjustments as specified in 
the February 2010 public consultation 

This  policy  option  builds  on  option  3.2  by  addressing  additional  problems  that  pertain  to 
application  of  regulatory  adjustments.  To  this  end,  it  lengthens  the  list  of  these  adjustments 
and  makes  their  application  more  appropriate  with  respect  to  tiers  of  regulatory  capital, 
proposing to apply most of them entirely to the CET1 capital (see Annex VII).   

As  a  result  of  stricter  capital  eligibility  requirements  and  re-allocation  of  regulatory 
adjustments to CET1 capital, under this policy option the CET1 ratio to risk-weighted assets 
(RWAs) declines in all countries, while its average for the EU falls from 11.1% by some 7 
percentage points for Group 1 banks and from 11.5% by some 5 percentage points for Group 
2 banks.62 Majority of this impact comes from the new regulatory adjustments: QIS showed 
that total adjustments under this option reduce eligible CET1 capital by some 60% for Group 
1  banks,  and  some  40%  for  Group  2  banks.63  In  terms  of  distributional  effects,  impacts  of 
individual regulatory adjustments on CET1 capital vary from one MS to another, while CET1 
ratios  of  smaller  (Group  2)  banks  are  affected  less  than  those  of  large  and  internationally 
active banks.  

In  their  responses  to  the  consultation  on  the  eligibility  of  instruments  for  CET1  capital, 
several  public  authorities  and  many  industry  respondents  stated  that  greater  onus  should  be 
placed  on  the  substance  of  a  capital  instrument,  e.g.  its  ability  to  absorb  losses  effectively, 
than  on  its  legal  form.  As  regards  eligibility  of  Additional  Tier  1  capital  instruments,  there 
was  a  significant  support  among  public  authority  respondents  for  all  such  instruments  to  be 
required to have a principal write-down or conversion feature with an objective trigger, in line 
with  the  approach  taken  in  CRD  II,  in  order  to  ensure  that  such  instruments  absorb  losses 
effectively  and  help  an  institution  to  remain  as  a  going  concern.  Views  of  industry 

60  Impact  is  relatively  more  pronounced  in  several  MS  due  to  the  exclusion  of  some  classes  of  shares,  silent 

partnerships, participation capital, preferred shares and supplementary cooperative shares 

61 According to CEBS, as of end of 2006 almost 50% of Tier 1 hybrid instruments in the EEA were innovative 

hybrids. At the same time, such innovative hybrids constituted a majority of dated hybrid instruments 

62  Current  CET1  ratio  calculated  according to  the predominant form  of Tier  1  capital  (gross  of deductions)  as 

applied by the bank or the relevant national supervisor 

63 In terms of individual deductions, at the EU level the most material impact comes from deductions for material 

holdings of financial institutions, goodwill, DTAs, other intangibles and minority interests 

29 

 
 
 
                                                 
respondents  on  this  topic  were  mixed.  With  respect  to  regulatory  adjustments,  a  significant 
number  of  public  authority  respondents  and  many  industry  respondents  expressed  concern 
about  the  appropriateness  of  the  proposed  non-recognition  of  minority  interest  and  full 
deduction of DTAs and investments in certain other unconsolidated financial entities.   

Policy option 3.4: Modify both eligibility criteria and regulatory adjustments as  adopted by 
the Basel Committee 

This  policy  option  reflects  the  new  definition  of  capital  approach  outlined  in  the  Basel  III 
rules text. Importantly, compared to option 3.3 this option entails a number of changes with 
respect to certain regulatory adjustments, improving upon the underlying prudential rationale 
and taking account of the impact of the proposals on the industry and potential impact on the 
economy.  

More  specifically,  it  provides  some  recognition  in  CET1  to  the  minority  interest  in  a 
subsidiary that is a credit institution, investment firm, or firm subject to the same prudential 
requirements  and  supervision  as  credit  institutions  and  investment  firms,  by  deducting  only 
the part of such minority interest that relates to capital above the regulatory minimum plus the 
capital  conservation  buffer  (please  see  section  5.5)  of  such  subsidiary.64  It  also  allows  the 
netting  of  long  and  short  positions  in  capital  instruments  of  other  unconsolidated  financial 
entities, under specific circumstances, and includes an exemption for underwriting positions 
held  for  five  working  days  or  less.  The  treatment  of  significant  investments  in  the  common 
shares  of  unconsolidated  financial  institutions  (i.e.,  more  than  10%  of  their  issued  share 
capital),  mortgage  servicing  rights,  and  DTAs  from  timing  differences  is  also  modified  by 
giving these items limited recognition in CET1.65 As a result, regulatory adjustments of Group 
1 banks as a percentage of eligible CET1 capital, compared to option 3.3, decline by one third 
to some 40%, while Group 2 banks experience a less pronounced decline.66 

Impacts  of  other  individual  adjustments  at  the  MS  level  continue  to  vary  and,  when  taken 
together,  exert  a  major  albeit  less  pronounced,  than  under  option  3.3,  impact  on  the  CET1 
capital ratios. As a result and without considering the impact of other proposals included in 
the legislative proposal, average EU CET 1 capital ratio for Group 1 banks increases by some 
2 percentage points to 5.8% whereas that of Group 2 banks improves slightly to 7.1%.  

As regards eligibility of Additional Tier 1 capital instruments, this option would entail a less 
stringent  treatment  than  under  options  3.2  and  3.3,  as  it  would  require  only  instruments 
classified  as  liabilities  to  be  required  to  have  a  principal  loss  absorption  mechanism,  which 
would  effectively  have  a  positive  impact  on  the  EU  banking  sector's  Tier  1  capital  of  an 
estimated €89 billion.  

QIS also showed that under this policy option, combined current CET1 capital for 208 Group 
1 and Group 2 banks would decline by some €490 billion67, Tier 1 capital by €370 billion and 
total  capital  by  some  €420  billion.  Actual  capital  shortfall  for  the  EU  banking  sector, 

64 Equivalent treatment of minority interest has been proposed for Tier 1 and total capital 
65 For each of these adjustments, such recognition is capped at 10% of a bank’s common equity after application 
of all other adjustments. Also, banks have to deduct the amount by which the aggregate basket of the 
three items exceeds 15% of their CET1 capital, calculated after all regulatory adjustments 

66  In  terms  of  individual  deductions,  at  the  EU  level  the  most  material  impacts  are  due  to  goodwill,  material 

holdings of financial institutions and DTAs 

67  Change  between  current  predominant  form  of  Tier  1  capital  without  any  deductions  and  CET1  capital  as 

defined under option 3.4 

30 

 
 
 
                                                 
however, would depend on the level of calibration of the new minima, implications of other 
parts of the proposal on the RWAs,  and capital  buffers that  banks hold in excess of current 
regulatory minima. These aspects are assessed cumulatively in section 5.8 of this report.  

Most  importantly,  it  is  expected  that  the  new  capital  definition  rules  should  significantly 
impact  the  stability  of  the  financial  system  by  enhancing  its  capacity  to  effectively  absorb 
economic and financial shocks thereby preserving the viability of financial institutions.  

Policy option 3.5: Modify both eligibility criteria and regulatory adjustments as adopted by 
the Basel Committee, adjusted for certain EU specificities 

Under this policy option, a number of modifications have been considered to the approach of 
the Basel Committee outlined under option 3.4 in order to align it better with EU regulatory 
and  banking  sector  specificities.  The  modifications  reflect  certain  features  of  option  3.3 
(Modify both the eligibility criteria and regulatory adjustments as specified in February 2010 
public  consultation)  as  well  as  stakeholder  feedback  received  in  relation  to  public 
consultations. They include: 

- restricting CET1 to instruments that qualify under national law as equity capital68 and meet 
the CET1 criteria, rather than to ordinary shares that meet the CET1 criteria – this approach 
places greater onus on the substance of a CET1 instrument. It recognizes the fact that some 
EU  institutions  issue  instruments  other  than  ordinary  shares  having  the  loss  absorbency 
equivalent to that of ordinary shares;  

-  derogations  from  specific  CET1  eligibility  criteria  for  institutions  that  are  mutuals, 
cooperative  societies  or  similar  institutions  –  this  will  help  to  ensure  that  the  potential  for 
general derogation from the CET1 criteria afforded by Basel III is applied appropriately and 
consistently in the EU;   

- rather than recognition in CET1 only where associated with an instrument that qualifies as 
CET1, recognition in CET1 also of share premia that qualified as original own funds  under 
Article  57(a)  of  Directive  2006/48/EC  prior  to  31  December  2010  –  the  purpose  of  this 
approach is to provide recognition of the loss absorbing nature and role of such share premia, 
while  also  restricting  the  treatment  to  instruments  issued  prior  to  the  entry  into  force  of  the 
stricter definition of capital introduced by CRD II;  

-  a  requirement  for  all  Additional  Tier  1  capital  instruments,  rather  than  only  liabilities,  to 
have principal write down or conversion feature69 - this approach takes account of the raising 
of capital quality in CRD II and ensures that the principal amount of both equity instruments 
and liabilities are able to absorb losses effectively on a going concern basis;   

- full, rather than limited, deduction from CET1 of mortgage servicing rights, as for all other 
intangible  assets  -  such  an  approach  takes  account  of  the  relative  illiquidity  and  uncertain 
value of mortgage servicing rights, and the potential difficulty of realising significant amounts 
of  them  in  a  stressed  or  emergency  situation.  EU  banks  have  limited  amounts  of  mortgage 
servicing rights - by virtue of their US subsidiaries – and therefore impact of this adjustment 
is expected to be very small;  

68 This represents a 'substance over form' approach, as it allows instruments other than common shares that meet 

all the eligibility criteria of Basel III to be included in CET1 

69  This  addresses  the  issue  that  preference  shares,  while  not  being  effective  at  absorbing  losses  on  a  going 

concern basis, would not be required to have a write-down or conversion 

31 

 
 
 
                                                 
- a restriction on the recognition of hedging for the purposes of determining the amounts to be 
deducted  for  investments  in  other  unconsolidated  financial  entities  to  the  trading  book.  The 
purpose of this approach is to limit the potential for double counting of capital in the financial 
system  through  the  provision  of  hedges  by  entities  that  are  not  subject  to  an  equivalent 
deduction  requirement,  and  to  reflect  the  fact  that  such  holdings  in  the  non-trading  book 
continue to the maturity of the instrument and are difficult to hedge effectively;  

-  an  alternative  approach  for  deduction  of  significant  holdings  in  unconsolidated  insurance 
entities  combined  with  enhancements  to  the  current  approach  to  applying  the  methods  laid 
down  in  the  Financial  Conglomerates  Directive  (FICOD).  The  purpose  of  this  is  to  take 
account of, and to enhance, the cross sector treatment laid down in the FICOD of holdings of 
capital instruments in banking and insurance;  

- recognising minority interest – and certain regulatory capital issued by subsidiaries - to the 
extent that those subsidiaries are credit institutions or investment firms and the capital is used 
to meet minimum capital requirements, capital conservation buffer and countercyclical capital 
buffer (see section 5.5). This recognises the importance of the countercyclical capital buffer, 
the capital used to meet it, and it aims at avoiding any disincentives to its use; 

-  clarification  of  the  treatment  of  DTAs  that  automatically  convert  into  a  claim  on  the  state 
when a firm makes a loss. Where their ability to absorb losses when needed is ensured, such 
DTAs would not have to be deducted.  

The  overall  net  impact  of  these  modifications  on  the  CET1  ratios  of  Group  1  and  Group  2 
banks presented under option 3.4 is assumed not to be of major significance, as some of them 
would make the new capital requirements more stringent while others would have an opposite 
effect. Most importantly, the adjustments have been developed with a view to ensure that the 
relevant  policy  objectives  are  attained  in  the  most  effective  manner  and  that  Basel  III 
framework  is  meaningfully  and  flexibly  applied  to  a  diverse  spectrum  of  the  EU  banking 
firms. 

Comparison of policy options 

Retaining the current scenario (option 3.1) implies that problems related to quality of capital, 
may  not  be  addressed  effectively,  depending  on  the  actions  taken  in  this  area  by  national 
supervisors and/or the industry. Of the remaining policy options, option 3.2 would be the least 
effective with respect to contributing to the achievement of the relevant policy objectives due 
to  its  focus  on  eligibility  criteria  only.  Policy  options  3.3,  3.4  and  3.5  are  perceived  to  be 
rather effective although they vary in terms of treatment of individual regulatory adjustments 
and,  additionally,  options  3.3  and  3.5  are  more  aligned  with  certain  EU  regulatory  and 
banking  sector–specific  aspects.  In  this  regard,  option  3.5  is  more  developed  as  it  reflects 
outcomes  of  extensive  public  consultations.  Hence,  policy  option  3.5  is  the  most  efficient 
option and is identified as a preferred option. 

Table 6: Summary of policy option effectiveness and efficiency 

Policy Option Comparison Criteria 

Effectiveness 

Policy Option 

Enhance 
adequacy of 
capital and 
liquidity 
requirement
s [S-1] 

Enhance 
bank risk 
managem
ent 
[S-2] 

Prevent 
regulatory 
arbitrage 
opportunit
ies [S-3] 

Enhance 
level 
playing 
field [S-6] 

3.1 Retain current approach 

5 

5 

5 

5 

Align 
prudential 
requireme
nts for 
SIFIs with 
the risks 
they pose 
[S-8] 
5 

Reduce 
cyclicality 
of bank 
lending 
[S-9] 

Efficie
ncy 

5 

5 

32 

 
 
 
Policy Option Comparison Criteria 

Effectiveness 

Policy Option 

Enhance 
adequacy of 
capital and 
liquidity 
requirement
s [S-1] 

Enhance 
bank risk 
managem
ent 
[S-2] 

Prevent 
regulatory 
arbitrage 
opportunit
ies [S-3] 

Enhance 
level 
playing 
field [S-6] 

4 

4 

4 

3.2 Modify only the eligibility criteria as specified 
in the February 2010 public consultation 
3.3 Modify both eligibility criteria and regulatory 
adjustments as specified in the February 2010 
public consultation 
3.4 Modify both eligibility criteria and regulatory 
adjustments as adopted by the Basel Committee 
3.5 Modify both eligibility criteria and regulatory 
adjustments as adopted by the Basel Committee, 
adjusted for certain EU specificities 
Scale of option ranking: 1=most effective / efficient, 5=least effective / efficient 
Effectiveness measures extent to which options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources 

1-3 

1-3 

1-3 

1-3 

1-3 

1-3 

1-3 

1-3 

1-3 

4 

2-3 

2-3 

1 

Align 
prudential 
requireme
nts for 
SIFIs with 
the risks 
they pose 
[S-8] 

4 

1 

2-3 

2-3 

Reduce 
cyclicality 
of bank 
lending 
[S-9] 

Efficie
ncy 

4 

1-3 

1-3 

1-3 

4 

3 

2 

1 

5.3. 

Counterparty credit risk 

To  address  problems  related  to  current  rules  on  the  counterparty  credit  risk  (CCR)  the 
Commission  services  considered  a  number  of  revisions  in  this  area  with  the  main  policy 
options as follows: 

-  Policy option 4.1: Retain current approach; 
-  Policy  option  4.2:  Enhance  adequacy  and  minimize  cyclicality  of  CCR  capital 
requirement  and  enhance  incentives  for  clearing  OTC  instruments  through  central 
counterparties (CCPs); 

-  Policy  option  4.3:  Enhance  adequacy  and  minimize  cyclicality  of  CCR  capital 
requirement,  enhance  incentives  for  clearing  OTC  instruments  through  CCPs  and 
differentiate the treatment of exposures to CCPs. 

Policy option 4.1: Retain current approach 

Under  this  policy  option,  problems  outlined  in  section  3.4  would  not  be  addressed.  The 
capitalisation  for  CCR  would  remain  to  be  insufficient  and  the  corresponding  risk 
management standards inadequate.  

Policy option 4.2: Enhance CCR requirement 

This  policy  option  amends  the  CCR  framework  in  several  areas  in  order  to  ensure  a  more 
appropriate  capitalisation  for  CCR.  Credit  institutions  would  be  subject  to  an  additional 
capital  charge  for  mark-to-market  losses,  i.e.,  credit  valuation  adjustment  (CVA)  risk, 
associated with deterioration in the creditworthiness of a counterparty. The new CVA capital 
charge would promote sound practices in managing this risk and recognise its hedging which 
would allow banks to mitigate the impact of this capital charge. As far as financial markets 
are concerned,  the recognition of hedging is likely to cause an increase  of demand for  both 
single-name  and  index  credit  default  swaps  (CDS)  and  contribute  to  further  growth  of  the 
corporate CDS market.  

To address the systemic risk within the financial sector, this option suggests raising the risk 
weights on exposures to financial institutions relative to the non-financial corporate sector, as 

33 

 
 
 
financial exposures are more highly correlated than non-financial ones.70 This amendment is 
expected  to  encourage  diversification  of  counterparty  risk  among  smaller  institutions  and, 
overall, should contribute to less interconnectedness between large or systemically important 
institutions and, possibly, limit the propagation of a shock originating in a default of a large or 
systemically  important  financial  institution  (SIFI).  This  option  would  also  mitigate  the 
cyclicality of CCR capital requirement by requiring to calculate it based on data that includes 
a period of stress and would strengthen standards for CCR management, including collateral 
management, stress testing and model back-testing.  

This  option  would  also  considerably  reinforce  the  existing  incentives  for  institutions  to  use 
CCPs for OTC derivatives as it would increase the assessed capital requirements against such 
exposures  if  completed  on  a  bilateral  basis  rather  than  through  a  CCP.  Assuming  that  most 
institutions dealing with OTC derivatives move to CCP clearing, a number of the derivatives 
currently  traded  on  the  OTC  markets  would  have  to  become  more  standardized. 
Standardisation can be a powerful tool of raising market efficiency and liquidity, however, as 
regards  hedging,  it  might  in  certain  instances  weaken  the  relationship  between  a  derivative 
and  underlying  risk/instrument  and  can  therefore  not  be  extended  to  the  entire  OTC 
derivatives market.  

Due to proposals under this policy option, RWAs of EU Group 1 banks on average increase 
by some 10%71, with the increase concentrated in 3 MS. Most of the increase is driven by the 
proposed  CVA  charge.  The  average  increase  in  RWAs  of  Group  2  banks  is  negligible, 
illustrating that these banks have typically less exposure to OTC derivatives. 

Policy  option  4.3:  Enhance  CCR  requirement  and  differentiate  treatment  of  exposures  to 
CCPs  

This policy option reflects the new CCR framework adopted by the Basel Committee that was 
outlined in the Basel III rules text in December 2010. It builds on the policy option 4.2 and 
entails a recalibration and differentiation of the treatment of exposures to CCPs depending on 
the  type  of  the  exposure  a  credit  institution  has  vis-à-vis  a  CCP  (i.e.,  collateral  &  mark-to-
market  exposures  versus  default  fund  contributions72)  and  whether  the  respective  CCP 
complies  with  a  set  of  stringent  risk  management  standards.73  Compared  to  the  existing 
regime, these changes would lead to an increase of capital requirement for exposures to CCPs. 
However, institutions would still be expected to use CCPs for OTC derivative clearing as the 
increase  in  capital  requirement  for  exposures  arising  from  bilaterally  cleared  transactions 
would be significantly greater. 

The overall increase in regulatory capital under this policy option would be greater than that 
under option 4.2. Importantly, it is expected to limit the scope for contagion (banks should be 
less  affected  by  a  default  of  counterparty)  and  contribute  to  strengthening  of  the  financial 

70 For regulated financial institutions with assets in excess of $100 billion and unregulated financial institutions 

regardless of their size 

71 Not including capital charges for exposures to CCPs 
72 The default fund contributions are designed to cover losses, over and above initial margin, following a clearing 

member default 

73 As CCPs also concentrate risk, a CCP with insufficiently robust risk management processes can actually 

increase the systemic risk. To address this, in 2010 the Commission adopted a proposal for a Regulation 
on OTC derivatives, central counterparties and trade repositories, which envisages subjecting CCPs to 
stringent business conducts and harmonised organisational and prudential requirements such as internal 
governance rules, audit checks, greater requirements on capital etc; see 
http://ec.europa.eu/internal_market/financial-markets/derivatives/index_en.htm#proposals 

34 

 
 
 
                                                 
stability, which may further translate into lower risk premia banks have to pay for obtaining 
funds and better availability of financing for the economy. 

In the context of this option, the Commission services publicly consulted on the capitalisation 
of exposures to CCPs and the treatment of incurred CVA in February-March 201174.  

The  latter  deals  with  the  issue  of  how  to  treat  losses  against  the  CVA  risk  which  a  bank  in 
question writes down upfront. Given that incurred CVA has been recognized in the Profit & 
Loss  account,  and  thus  effectively  represents  an  amount  that  cannot  be  lost  again  were  the 
counterparty  to  default,  the  Basel  Committee  suggested  a  treatment  where  incurred  CVA 
could be deducted from the exposure amount (Exposure at Default) in the calculation of the 
capital requirements for the default component of CCR.  

A  vast  majority  of  respondents  to  the  Commission  services'  consultation  nevertheless 
expressed serious concerns about such an approach, arguing that it is conceptually inadequate 
and that the degree of the recognition of incurred CVA is disproportionately low.  

The  Commission  services  have  extensively  analysed  the  comments  received75  and  as 
subsequently  suggested  an  alternative  treatment,  which  would  allow  for  a  greater,  however 
still prudent, degree of recognition of incurred CVA. In essence, such treatment would allow 
institutions applying the IRB approach to offset the regulatory expected loss for CCR by the 
amount of incurred CVA, but this offset would be capped at the level of expected loss on the 
trade/netting set to which it relates. Institutions applying the Standardised Approach would be 
subject to the same treatment as proposed by the Basel Committee. 

The  Commission  services  consider  the  above  alternative  treatment  for  institutions  applying 
the IRB approach conceptually sounder, consistent with the rest of the regulatory framework 
applied  to  those  institutions  and  more  effective  in  eliminating  the  double  count  referred  to 
above.  The  benefits  of  such  approach  would  nevertheless  be  somewhat  diminished  by  the 
possible  costs  implied  for  internationally  active  banks  by  divergence  from  the  treatment 
proposed  by  the  Basel  Committee,  provided  that  such  treatment  is  confirmed  and 
implemented as announced in the Basel III framework published in December 2010.  

However,  in  the  view  of  the  Commission  services  any  such  divergences  would  not  have 
material  implications  for  the  EU  industry  overall  and  therefore  are  not  elaborated  further  in 
this assessment. 

Comparison of policy options 

Policy  option  4.1  entails  possible  significant  costs  in  terms  of  inadequate  management 
standards  for  CCR.  In  contrast,  policy  option  4.2  is  effective  in  addressing  all  key 
shortcomings  outlined  in  section  3.4.  It  ensures  more  adequate  and  less  cyclical  capital 
requirements for CCR, thus, helping to reduce the systemic risk across the financial system.  

Additional measures proposed under policy option 4.3 contribute to the effectiveness of this 
option  with  regard  to  enhancing  capital  requirements  (objective  S-1)  and  bank  risk 
management  (objective  S-2)  and  reducing  the  systemic  risk  as  they  ensure  an  appropriate 
capitalisation  for  exposures  to  CCPs  and  provide    incentives  to  move  OTC  derivative 

74 http://ec.europa.eu/internal_market/bank/regcapital/index_en.htm#consultation_credit_risk  
75http://circa.europa.eu/Public/irc/markt/markt_consultations/library?l=/financial_services/credit-

risks&vm=detailed&sb=Title  

35 

 
 
 
                                                 
contracts to CCPs with the highest risk management standards. As a result, policy option 4.3 
is identified as a preferred policy option. 

Table 7: Summary of policy option effectiveness and efficiency 

Policy Option Comparison Criteria 

Effectiveness 

Policy Option 

Enhance adequacy 
of capital and 
liquidity 
requirements [S-1] 
3 
2 

Enhance bank 
risk 
management 
[S-2] 
3 
2 

Align prudential 
requirements for 
SIFIs with the risks 
they pose [S-7] 
3 
2 

Reduce 
cyclicality of 
bank lending [S-
9] 
3 
2 

1 

1 

Efficien
cy 

3 
2 

1 

4.1 Retain current approach 
4.2 Enhance CCR requirement  
4.3 Enhance CCR requirement and 
differentiate treatment of exposures to CCPs  
Scale of option ranking: 1=most effective / efficient, 3=least effective / efficient 
Effectiveness measures extent to which options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources 

1 

1 

5.4. 

Leverage 

To address the build-up of excessive leverage on banks' and investment banks' balance sheets 
and  to  contain  the  cyclicality  of  bank  lending,  the  Commission  services  investigated  a 
possibility of introducing a non risk-based leverage ratio.  The main policy options in this area 
are as follows: 

-  Policy option 5.1: Retain current approach; 
-  Policy option 5.2: Introduce supplementary non-risk based leverage ratio as specified in 

the February 2010 public consultation; 

-  Policy  option  5.3:  Conduct  extensive  monitoring  of  different  types  of  supplementary 

non-risk based leverage ratio. 

Policy option 5.1: Retain current approach 

Under  this  policy  option  the  risk  of  excessive  leverage  during  the  next  economic  upturn 
would  not  be  addressed  other  than  by  increased  capital  requirements,  once  adopted.  Also, 
there  would  be  no  overall  backstop  against  model.  In  addition,  supervisors  may  introduce 
various national treatments in this area, which could undermine the level playing field within 
the EU and internationally. 

Policy  option  5.2:  Introduce  leverage  ratio  as  specified  in  the  February  2010  public 
consultation 

This policy option would introduce a leverage ratio as per the definition included in the public 
consultation of February 2010. In the process of the EU QIS, several possible variations of the 
ratio  were  assessed.76  For  the  principal  variant  of  the  ratio77  QIS  showed  that  smaller  EU 
banks are less leveraged: the average Group 2 bank leverage ratio of 3.1% is almost double 
that of 1.6% of Group 1 banks. This is mostly explained by larger Group 1 banks being more 
impacted by the new definition of Tier 1 capital (see section 5.2) and the proposed treatment 
for non-traditional banking assets such as derivatives.  

76  For  example,  both  Tier  1  and  total  capital  for  the  numerator  of  the  ratio  were  considered,  while  for  the 
calculation of the exposure base (the denominator) a possibility of excluding high quality liquid assets 
from the on-balance sheet exposure amount was examined 

77  Numerator  defined  as  the  new  definition  of  Tier  1  capital,  while  denominator  defined  as  both  on-  and  off-
balance sheet exposures. As regards off-balance sheet exposures, credit conversion factor of 100% was 
used,  written  credit  derivatives  were  measured  at  100%  of  their  notional  value,  other  derivatives 
measured at potential future exposure, and no netting of financial derivatives was recognised 

36 

 
 
 
                                                 
Feedback to the public consultations indicated that the exposure base (i.e., denominator of the 
ratio) under this option in some cases may give a too wide capture of leverage.78 Furthermore, 
both national authorities and the industry expressed concerns that institutions with lower risk 
business  models  would  be  affected  disproportionately  as  low  capital  requirements  of  such 
institutions would result in higher leverage ratios. Given that these institutions are critical for 
providing credit to the real economy (including to SMEs) a wrong calibration of the leverage 
ratio might therefore have unintended consequences for the economic recovery. 

Policy option 5.3: Conduct extensive monitoring of leverage ratio 

While  a  non  risk-based  supplementary  leverage  ratio  (although  differently  defined)  already 
exists  in  the  US,  Canada  and  Switzerland,  experience  with  this  measure  in  the  EU  is  very 
limited. Therefore, both its definition and its calibration need to be chosen very carefully to 
avoid any unintended adverse impacts. Importantly, discussions on the design of the ratio at 
the level of the Basel Committee also confirmed many of these concerns. Therefore, Basel III 
rules  text  foresees  a  review  period  of  a  full  credit  cycle  to  assess  the  effectiveness  of  this 
policy measure. Such review would assess impacts on lower risk business models; lending to 
SMEs and trade financing; interaction of the ratio with the risk based capital requirements and 
other aspects. The review of the leverage ratio would also consider the impact that differences 
in  financial  reporting  frameworks  may  have  on  comparability  and  the  international  level 
playing field for the EU credit institutions.  

The Commission services intend to conduct such monitoring for several alternative definitions 
of the numerator and the denominator of the ratio, including the definitions outlined in Basel 
III rules and in February 2010 public consultation, which would feed into the development of 
the most effective variant of this policy measure. Prior to making it a binding measure from 
2018, on the basis of the review the Commission services will prepare a report and a proposal 
on the final design and calibration of the leverage ratio.  

Comparison of policy options 

Effectiveness of the current scenario (option 5.1) depends on the actions taken in this area by 
national supervisors and/or the industry which is no guarantee that necessary progress would 
be  achieved  quickly  enough  and  evenly  across  the  EU.    While  most  of  alternative 
formulations  of  the  ratio  examined  under  option  5.2  would  provide  for  a  certain  degree  of 
effectiveness as regards contributing to the achievement of objectives S-1 (Enhance adequacy 
of capital and liquidity requirements), S-2 (Enhance bank risk management), and S-9 (Reduce 
cyclicality of bank lending), they also entail a risk of unintended consequences. Policy option 
5.3 is expected to be more effective and efficient than option 5.2 due to its more appropriate – 
from  a  prudential  angle  -  design  and  calibration  following  the  monitoring  exercise  and, 
therefore, is chosen as a preferred option.  

Table 8: Summary of policy option effectiveness and efficiency 

Policy Option 

5.1 Retain current approach 

Policy Option Comparison Criteria 

Enhance adequacy 
of capital and 
liquidity 
requirements [S-1] 
3 

Effectiveness 
Enhance bank 
risk 
management 
[S-2] 
3 

Reduce 
cyclicality of 
bank lending 
[S-9] 
3 

Efficiency 

3 

78 These cases include application of proposed conversion factors of 100% for unconditionally cancellable off-
balance  sheet  exposures  such  as  credit  cards  and  of  gross  nominal  values  of  derivatives  without 
allowing for netting under the Basel II framework 

37 

 
 
 
                                                 
Policy Option Comparison Criteria 

Policy Option 

Enhance adequacy 
of capital and 
liquidity 
requirements [S-1] 

Effectiveness 
Enhance bank 
risk 
management 
[S-2] 

5.2 Introduce leverage ratio as specified in the February 
2010 public consultation 
5.3 Conduct extensive monitoring of leverage ratio 
Scale of option ranking: 1=most effective / efficient, 3=least effective / efficient 
Effectiveness measures extent to which options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources 

2 

1 

1 

2 

Reduce 
cyclicality of 
bank lending 
[S-9] 

2 

1 

Efficiency 

2 

1 

5.5. 

Capital buffers 

In line with the conclusions of its report on the effects of the CRD on the economic cycle, the 
Commission  services  examined  a  possibility  of  policy  instruments  that  would  move  in  a 
counter-cyclical fashion to bank capital levels, i.e., would increase in economic upturns and 
decrease in downturns.  The key policy options in this area are as follows: 

-  Policy option 6.1: Retain current approach; 
-  Policy  option  6.2:  Introduce  a  capital  buffer  to  enhance  individual  banks’  ability  to 
absorb losses over prolonged periods of market stress, i.e., capital conservation buffer; 
-  Policy option 6.3: Introduce a capital buffer to protect banks from periods of risk build-

up at the macro level, i.e., countercyclical capital buffer; 

-  Policy  option  6.4:  Introduce  a  dual  capital  buffer,  comprising  both  a  capital 

conservation buffer and a countercyclical capital buffer. 

Policy option 6.1: Retain current approach 

Under this policy option the pro-cyclicality would be addressed only with the policy measures 
that  have  been  already  adopted  by  the  Commission  or  new  measures  adopted  by  MS. 
However, since the pro-cyclicality is driven by a number of drivers, additional measures are 
necessary, in particular, to address market failures of behavioural nature which contribute to 
building  up  of  systemic  risk  and  weaken  financial  resilience  of  individual  firms  in  times  of 
stress.  Moreover,  tackling  of  the  problem  of  a  systemic  nature  requires  certain  macro-level 
and / or cross-border arrangements which are feasible only with the EU level action.  

Policy option 6.2: Capital conservation buffer 

The design of a capital conservation buffer was laid out in the Commission services’ public 
consultation  of  February  2010.  The  buffer  would  have  a  fixed  target  over  the  regulatory 
capital minimum to absorb losses in 'stressed' periods that may span a number of years. Banks 
would  be  expected  to  build  up  such  capital  in  good  economic  times.  Those  banks  that  fell 
below  the  target  would  face  constraints  on  discretionary  distributions  of  earnings  (i.e., 
dividend  payments,  share  buybacks,  discretionary  payments  on  other  Tier  1  capital 
instruments and discretionary bonus payments to staff) until conservation capital buffer target 
is reached.79 These rules would be applied at the consolidated group level, however, in order 
to conserve resources in specific parts of the group national supervisors would have an option 
to apply the regime at the 'solo' level.  

Such  approach  would  be  effective  at  ensuring  that  the  banking  sector  accumulates  capital 
buffers  when  it  has  the  earnings  capacity  to  do  so.  This  should  enhance  resilience  of 

79 The further from the target (within the range between the minimum and the target) the level of capital falls, the 
higher percentage of its earnings in the subsequent year a bank would be required to conserve 

38 

 
 
 
                                                 
individual  institutions  in  periods  of  stress  by  positioning  them  to  absorb  related  losses. 
However,  this  approach  does  not  ensure  that  retention  of  capital  to  cover  risks  at  the 
individual bank level would coincide with the periods of excessive credit growth at the macro 
level  and  a  concomitant  build-up  of  systemic  risks  which  need  to  be  prevented  to  protect 
banks (as well as other economic agents) from consequences of ensuing systemic crises.  

Policy option 6.3: Countercyclical capital buffer 

The design of a countercyclical capital buffer was laid out in the Commission services’ public 
consultations  of  February  2010  and  October  2010.  The  buffer  would  take  account  of  the 
macro-financial  environment  in  which  banks  operate.  National  supervisors  would  set  the 
buffer  for  credit  exposures  in  their  jurisdiction.  The  buffer  would  be  subject  to  an  upper 
bound and would only be imposed when there is evidence that the excess credit growth results 
in  a  build-up  of  the  system-wide  risk.80  Banks  with  exclusively  domestic  credit  exposures 
would  only  be  subject  to  the  buffer  determined  by  their  national  supervisors.  In  relation  to 
exposures  located  in  other  MS,  banks  providing  services  by  means  of  a  branch  or  free 
provision of services would apply the buffer as determined by the host MS supervisors, when 
the buffer is set between 0% and 2.5% of risk weighted assets.81 When the buffer determined 
by host MS exceeds 2.5%, home MS authorities would be allowed, but not obliged to apply a 
buffer rate higher than 2.5%.  

Banking groups having subsidiaries in other MS for the purposes of calculating the buffer on 
the consolidated basis would have to apply the buffer add-ons determined by the competent 
authorities  of  the  subsidiaries.  In  practice,  this  means  that  cross-border  credit  institutions 
would  have  to  look  at  the  geographic  location  of  their  credit  exposures  and  calculate  their 
countercyclical  capital  buffer  according  to  the  buffers  prevailing  in  those  MS  where  their 
exposures are located. For groups, decisions on the level of the counter-cyclical buffer could 
take place in the context of the joint decision process of Article 129(3) of the CRD whereby 
the consolidating supervisor and the other relevant competent authorities would consult each 
other and decide on the application of the buffer at consolidated level and at the level of each 
subsidiaries. The consequences of not meeting the countercyclical capital buffer would be the 
same as those of not meeting the capital conservation buffer (i.e., constraints on discretionary 
distributions of earnings). 

This policy option would be effective at ensuring that bank capital regulation is responsive to 
macro-financial environment and, in turn, would protect the banking sector from systemic risk 
linked to excessive credit growth. At the level of individual institutions, however, it may not 
be  entirely  effective  at  ensuring  that  banks  have  sufficient  capital  buffers  to  absorb  losses 
incurred during protracted turbulent periods. 

80 The size of the buffer would be linked to aggregate private sector credit/GDP gap. When credit/GDP is near or 
below its long-term trend, the buffer would be set to zero and when credit/GDP exceeds its long term 
trend  by  an  amount  which  suggests  there  could  be  excess  credit  growth,  the  buffer  would  be  greater 
than 0. Analysis of the credit/GDP gap showed that it does not always work well in all jurisdictions at 
all  times.  Thus,  rather  than  relying  mechanistically  on  the  credit/GDP  guide,  supervisors  would  be 
expected  to  apply  judgment  in  setting  of  the  buffer  in  their  jurisdiction.  In  this  context,  ESRB  may 
provide guidelines to national supervisors on how to apply the buffer.  

81  The  corresponding  treatment  applies  to  exposures  located  in  3rd  countries.  In  cases  where  banks  have 
exposures to jurisdictions that do not operate and publish buffer decisions, national supervisors would 
have to set buffers for such exposures. Also, ESRB may issue recommendations on level of buffers set 
at home MS and for 3rd countries. 

39 

 
 
 
 
                                                 
Policy option 6.4: Dual capital buffer 

The  design  of  a  dual  capital  buffering  approach  was  laid  out  in  the  Commission  services’ 
public consultations of February 2010 and October 2010. The approach effectively entails a 
combination  of  policy  options  6.2  and  6.3  and  is  broadly  aligned  with  the  approach  of  the 
Basel Committee.82 Combining the two buffers means that application of the countercyclical 
buffer  would  take  effect  by  adjusting  the  size  of  the  buffer  range  established  by  the 
conservation  buffer.  Other  key  modalities  of  operating  such  a  dual  capital  buffer  would 
remain  as  presented  in  discussion  of  its  individual  components.  The  key  advantage  of  this 
policy  option  over  the  other  two  alternatives  is  that  by  combining  them  it  addresses  their 
respective shortcomings discussed above.  

The  calibration  of  this  policy  option  is  presented  in  Table  2  while  its  impact  on  the  EU 
banking  industry  is  assessed  in  section  5.8  (cumulatively  with  new  minimum  capital 
requirements). Capital buffers are expected to protect banks in the downturn period thanks to 
the release of the buffer and limit the risks of negative spill-overs on the real economy. They 
may,  however,  entail  a  risk  of  negative  impact  on  credit  volume  in  'catching  up'  countries. 
While  the  financial  stability  implications  of  this  rapid  credit  growth  should  certainly  be 
addressed,  a  balance  must  be  struck  in  order  not  to  unnecessarily  slow  down  the  growth 
acceleration.83  

Comparison of policy options 

As  discussed  above,  policy  option  6.1  is  largely  ineffective  in  tackling  relevant  problem 
drivers.  Policy  option  6.2  is  more  effective  than  option  6.3  in  terms  of  enhancing  banks' 
capacity to absorb losses over protracted periods of 'stress' (objective S-1) but is less effective 
than option 6.3 in terms of operating in a countercyclical manner, which is a precondition for 
minimizing  the  cyclicality  of  bank  lending  (S-9).  Policy  option  6.4  addresses  the  above 
concerns by combining the two types of capital buffers into one buffering approach. In terms 
of compliance costs for the banking industry, option 6.2 would be the most costly and option 
6.3  would  imply  the  least  compliance  costs,  as  the  countercyclical  buffer  would  be  applied 
only  in  times  when  credit  growth  at  the  aggregate  level  becomes  excessive,  whereas  costs 
related to option 6.4 would fall in between the two extremes. However, when effectiveness of 
policy  options  is  considered  simultaneously,  option  6.4  is  identified  as  the  most  efficient 
alternative, and, in turn, as a preferred policy option. 

Table 9: Summary of policy option effectiveness and efficiency 

Policy Option Comparison Criteria 

Policy Option 

Enhance adequacy of 
capital and liquidity 
requirements [S-1] 
4 
1-2 
3 
1-2 

Effectiveness 
Enhance bank risk 
management 
[S-2] 
4 
1-3 
1-3 
1-3 

6.1 Retain current approach 
6.2 Conservation capital buffer 
6.3 Countercyclical capital buffer 
6.4 Dual capital buffer 
Scale of option ranking: 1=most effective / efficient, 4=least effective / efficient 
Effectiveness measures extent to which options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources 

Reduce cyclicality of 
bank lending 
[S-9] 
4 
3 
1-2 
1-2 

Efficiency 

4 
2-3 
2-3 
1 

82 Proposals foresee the EU-specific involvement of ESRB to foster macro-prudential supervision and integration 
of 'capital conservation plans' whereby banks that operate in the buffer zone would have to present such 
plans to their supervisor for approval of capital conservation measures. 

83 This is addressed by allowing for supervisory judgement on the buffer level and on the timing of its activation 

40 

 
 
 
                                                 
5.6. 

Single rule book in banking 

The options regarding the deletion of option and national discretions will be referred to in the 
rest of the analysis as follows: 

-  Policy option 7.1: Retain current approach; 
-  Policy option 7.2: Minimum harmonization of national supervisory approaches; 
-  Policy option 7.3: Maximum harmonization of national supervisory approaches; 
-  Policy option 7.4: Maximum harmonisation of national supervisory approaches with 

some exceptions.  

Policy option 7.1: Retain current approach 

Under  this  option,  national  options  and  discretions  will  be  kept  in  the  CRD  together  with  a 
'minimum harmonisation' approach allowing MS to lay down stricter prudential rules, leaving 
the problems outlined in section 3.6 unaddressed.  

Policy option 7.2: Minimum harmonization 

Under this approach, options and discretions would be removed, but the CRD would be kept 
as  a  minimum  harmonisation  directive.  The  removal of other options  and  discretions would 
take  place  in  the  framework  of  the  existing  CRD  rules  via  mutual  recognition,  deletion, 
granting choice to institutions and making an option a general rule. Supervisors would still be 
able  to  require  compliance  with  stricter  rules,  because  of  the  possibility  of  gold-plating. 
Because of gold-plating, the option might be partially effective with respect to objectives of 
enhancing supervisory cooperation and level playing field, as certain degree of differences in 
national supervisory approaches would be preserved. 

The option should not represent a significant incremental change to capital requirements and 
in the long run may result in compliance cost savings, particularly for institutions with cross-
border  activities.84  In  the  short  term,  the  removal  of  options  and  discretions  would  imply 
increase in compliance costs with a new set of rules, however.85  

Policy option 7.3: Maximum harmonization 

The  deletion  of  national  options  needs  to  be  coupled  with  a  maximum  harmonisation 
approach  to  fully  deliver  on  the  objectives  of  reducing  compliance  burden,  enhancing  level 
playing field, legal clarity and supervisory convergence. This option would also maximize the 
role  of  EBA  in  ensuring  a  consistent  set  of  harmonised  rules.86  The  scope  of  'maximum 
harmonisation' would be limited to Pillar 1 (minimum capital requirements, large exposures 
rules, liquidity, own funds) and Pillar 3 (disclosure) provisions of the CRD. Other areas of the 
directive  do  not  lend  themselves  to  maximum  harmonisation  because  of  specific  risk 
assessments (e.g., Pillar 2) or the absence of full harmonisation.  

84  Based  on  the exercise  to  measure  the  baseline  administrative  costs  and burden  of  the EU  legislation,  which 
included the CRD and was conducted in 2008, total annual administrative costs related to the CRD are 
roughly  €851  million  with  the  ensuing  administrative  burden  of  €333  million.  See  EU  Project  on 
Baseline Measurement and Reduction of Administrative Costs, Report on the Financial Services Priority 
Area, March 2009 

85 This holds true in particular in relation to banks subject to the IRB approach, where internal systems would 

have to be slightly changed 

86 As a result, EBA will be expected to develop some 50+ technical standards in various policy areas which will 

have an impact on its human resources requirements and related costs. 

41 

 
 
 
                                                 
Downside  to  this  approach  is  that  maximum  harmonisation  may  limit  the  ability  of  MS  to 
require stricter rules on the financial stability grounds. This shortcoming should not be over-
estimated  given  that  supervisors  may  resort  to  Pillar  2  to  tailor  capital  requirements  to  the 
risks  to  which  a  bank  is  exposed.  In  addition,  to  this  end  Basel  III  provides  for  a  macro-
prudential  capital  buffer,  discussed  under  section  5.5,  whereby,  if  necessary,  national 
supervisors  would  be  able  to  set  a  countercyclical  buffer  level  in  excess  of  2.5%.87 
Importantly,  by  ensuring  that  firms  follow  the  same  rules  in  all  EU  markets,  maximum 
harmonisation is intended to boost confidence in the stability of credit institution across the 
EU, especially in time of stress, and thus enhance the financial stability.  

It  should  also  be  noted  that  under  options  7.1  and  7.2  the  application  at  national  level  of 
stricter rules for reasons of the financial stability would only be applicable to domestic banks 
and  subsidiaries  of foreign  banks  in  that  country.  Such  regulatory  changes  would  create 
regulatory  arbitrage  opportunities  for  branches  in  those  MS,  partly  invalidating  macro-
prudential  policy  actions.  Under  this  option,  a  regulation  would  enable  the  Commission  to 
adopt  temporary  increases  in  minimum  standards,  preventing  regulatory  arbitrage  and 
contributing to the effectiveness of macro-prudential policy actions. 

Nevertheless,  there  are  circumstances  where  gold-plating  is  rooted  in  market  /  product 
specificities or the legal framework of a MS.88 Thus, consideration of some flexibility to the 
maximum harmonisation approach seems to be warranted. 

Policy option 7.4: Maximum harmonization with some exceptions 

Under this option, the single rule book would provide for some flexibility to resort to gold-
plating in areas rooted in market/local product specificities or the legal framework of MS.  

Analysis  of  CEBS'  advice  and  discussions  with  stakeholders  suggest  that  areas  for  the 
application  of  stricter  rules  may  include  the  preferential  treatment  of  real  estate  exposures, 
lending in foreign currency and 'high risk items' identified by EBA guidelines. In addition, in 
order to enhance national and EU financial stability, this policy option foresees a possibility 
for MS to 'gold-plate' the new minimum requirements that would otherwise be phased in from 
2013 to 2019 as outlined in Table 3. This means that MS would be allowed to apply in 2013 
the level of capital required by Basel III in 2019. 

This approach would be similar to the one adopted in other legislative texts (e.g., the MiFID), 
which  provide  for  a  full  harmonisation  while  allowing  MS  to  adopt  stricter  rules  in  well 
identified areas of the text.  

Comparison of policy options 

Retaining the current scenario (policy option 7.1) implies that the relevant problems are not 
addressed and effectiveness of EBA is compromised. Maximum harmonization (policy option 
7.3)  is  more  effective  than  minimum  harmonization  (policy  option  7.2)  and  maximum 
harmonisation with some exceptions (policy option 7.4) with respect to attaining objectives of 

87 Such level should apply only to institutions that are incorporated in their jurisdictions. The buffer should be 
capped at 2.5% for the purposes of calculating the institution specific countercyclical capital buffer of 
all other institutions that have credit exposures in the jurisdiction in question. 

88 During the public consultations, some supervisors stressed the need of being able to apply stricter quantitative 
limits (e.g., lower LTV ratios for a preferential treatment of real estate) given the specificities of their 
local market 

42 

 
 
 
                                                 
enhancing supervisory cooperation and convergence (S-7), enhancing legal clarity (S-4) and 
enhancing level playing field (S-6) as it contains both the deletion of national options and the 
removal of the possibility to supplement the CRD provisions with national legislation. Option 
7.3  is  perceived  to  be  less  effective  than  option  7.4  in  terms  of  achieving  the  objective  of 
enhancing  financial  stability  in  national  MS  as  it  does  not  cater  for  specificities  of  local 
markets  (G-1).  In  this  regard,  option  7.4  entails  a  harmonised  and  transparent  regulatory 
framework  that  is  intended  to  enhance  the  financial  stability  together  with  a  possibility  of 
applying stricter rules in certain cases. From the efficiency angle, option 7.3 appears to be the 
most  efficient  for  banking  groups  with  cross-border  operations  (due  to  the  greater  expected 
savings of administrative costs), whereas for banks with domestic operations, options 7.2 and 
7.4 may be more efficient (lower costs due to fewer changes in national rules as a result of to 
their harmonisation at the EU level).  

In summary, policy option 7.4 (Maximum harmonization with some exceptions) is identified 
as a preferred option, as it entails the most balanced trade-off between expected effectiveness 
in  terms  of  contributing  towards  relevant  policy  objectives,  including  the  objective  of 
financial stability, and the net administrative cost implications for the EU banking industry.  

Table 10: Summary of policy option effectiveness and efficiency 

Policy Option Comparison Criteria 

Effectiveness 

Policy 
Option 

Prevent 
regulatory 
arbitrage 
opportunities 
[S-3] 

Enhance legal 
clarity [S-4] 

Reduce 
compliance 
burden 
 [S-5] 

Enhance 
level playing 
field [S-6] 

Enhance 
supervisory 
cooperation 
and 
convergence 
[S-7] 

Enhance 
financial 
stability   
[G-1] 

Efficien
cy 

7.1 Retain current 
approach 

7.2 Minimum 
harmonisation  

7.3 Maximum 
harmonisation  

4 

3 

1-2 

4 

3 

1 

4 

1-3 

1-3 

4 

3 

1 

1-2 

7.4 Maximum 
harmonisation 
with some 
exceptions 
Scale of option ranking: 1=most effective / efficient, 4=least effective / efficient 
Effectiveness measures extent to which options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources 

1-3 

2 

2 

4 

3 

1 

2 

2-4 

2-4 

2-4 

1 

4 

1-3 

1-3 

1-3 

5.7. 

Choice of policy instrument 

This section discusses the options as regards the most appropriate way of implementing the 
preferred  policy  choices  discussed  in  sections  5.1-5.6.  The  key  alternatives  that  were 
considered are as follows: 

-  Policy option 8.1: Amend the CRD to integrate the proposed provisions; 
-  Policy option 8.2: Limit the scope of the CRD to authorization and arrangements for 
ongoing  supervision  and  propose  a  regulation  on  prudential  requirements  for  credit 
institutions. 

Policy option 8.1: Amend the CRD 

The  policy  options  retained  in  the  sections  above  could  be  implemented  by  amending  the 
CRD.  This  would  maintain  coherence  of  rules  in  the  three  areas  of  authorisation,  ongoing 
supervision, and prudential requirements in one single text. This option would leave MS with 
a certain degree of flexibility to maintain divergent rules at the stage of their transposition into 

43 

 
 
 
national law. It would give MS the option of imposing stricter rules on matters which are not 
fully harmonised under the preferred policy option 7.4 (Maximum harmonisation with some 
exceptions). Finally, MS could continue to integrate the rules into national legal texts. 

Policy option 8.2: Limit the scope of the CRD and propose a regulation 

The policy options retained in the sections above could also be implemented by two separate 
instruments:  an  amendment  of  the  CRD  concerning  authorisation  of  credit  institutions  and 
arrangements  for  their  supervision,  and  a  new  regulation  on  prudential  requirements. 
Separating  prudential  requirements  from  the  other  two  areas  would  reflect  differences  in 
subject-matter,  nature  and  addressees.  Prudential  requirements  establish  criteria  for  the 
evaluation  of  the  risk  linked  to  certain  banking  activities  and  of  the  funds  necessary  to 
counter-balance those risks. As such, they do not regulate access to deposit taking activities 
but  govern  the  way  in  which  such  activities  are  carried  out  in  order  to  ensure  protection  of 
depositors and financial stability.  

Shaping  prudential  requirements  in  the  form  of  a  regulation  would  ensure  that  those 
requirements,  which  already  today  are  worded  as  obligations  for  credit  institutions  ("credit 
institutions  shall…"),  will  in  fact  be  directly  applicable  to  them.  This  would  prevent  the 
transposition  from  producing  diverging  national  requirements.  At  the  same  time,  this 
instrument  could  cater  for  the  flexibility  needed  under  option  7.4  (Maximum  harmonisation 
with some exceptions) as rules on authorisation and ongoing supervision would continue to be 
in  the  form  of  a  directive.  As  regards  prudential  requirements,  if  in  some  limited  areas 
flexibility would be needed for MS to lay down stricter rules, this could be accommodated by 
an appropriate wording in the regulation.  

A regulation would clearly demonstrate that credit institutions follow the same rules in all EU 
markets,  which  should  boost  confidence  in  the  stability  of  credit  institutions  across  the  EU, 
especially  in  times  of  stress.  Being  directly  applicable  across  the  EU,  it  would  reduce 
regulatory complexity and firms' compliance costs, especially for credit institutions operating 
on  a  cross-border  basis,  and  would  contribute  to  the  elimination  of  regulatory  arbitrage 
opportunities. 

Comparison of policy options 

Policy  option  8.2  (Limit  the  scope  of  the  CRD  and  propose  a  regulation)  is  more  effective 
than  option  8.1  (Amend  the  CRD  to  integrate  the  proposed  provisions)  with  regard  to 
contributing to the achievement of objectives of preventing regulatory arbitrage opportunities 
(S-3), enhancing legal clarity (S-4), reducing compliance burden (S-5), enhancing supervisory 
convergence  (S-7),  enhancing  financial  stability  (G-1)  and  safeguarding  depositor  interests 
(G-2),  as  outlined  above.  It  also  entails  a  more  efficient  alternative  since  a  regulation  on 
prudential requirements would enable the EU to implement any changes faster, as they would 
not require transposition by national legislators.89 On this basis, option 8.2 is identified as a 
preferred policy option. 

89  This  would  enable  the EU  to  meet  internationally  agreed  deadlines  for implementation  and  to react  quicker 

when market developments require changes to the rules  

44 

 
 
 
 
 
                                                 
Table 11: Summary of policy option effectiveness and efficiency 

Policy Option Comparison Criteria 

Effectiveness 

Policy 
Option 

Prevent 
regulatory 
arbitrage 
opportunities 
[S-3] 

Enhance legal 
clarity [S-4] 

Reduce 
compliance 
burden 
 [S-5] 

1 

2 

2 

2 

8.1 : Amend the 
CRD 
8.2 Limit scope 
of the CRD and 
propose a 
regulation 
Scale of option ranking: 1=most effective / efficient, 2=least effective / efficient 
Effectiveness measures extent to which options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources 

1 

1 

1 

Enhance 
supervisory 
cooperation 
and 
convergence 
[S-7] 
2 

Enhance 
financial 
stability [G-
1] 

2 

1 

Enhance 
safeguardin
g of 
depositor 
interests [G-
2] 
2 

1 

Efficien
cy 

1 

1 

5.8. 

Cumulative impact of the package 

This section discusses the cumulative impact of preferred options within individual areas as 
presented  in  the  preceding  sub-sections.  It  looks  at  the  cumulative  impact  of  proposals  in 
terms of additional capital that EU banking industry needs to raise in order to meet the new 
minimum capital requirements. Next, impact of the proposal on costs related to information 
provision to supervisors and third parties is discussed. Finally, impacts of tighter capital and 
liquidity requirements on the EU economy in the transitional period and in the long-term are 
assessed. 

5.8.1.  Package of preferred options and relevant transitional provisions 

The following table summarizes the twenty seven policy options analysed. Individual options 
within  each  policy  set  are  ranked  in  terms  of  their  relative  effectiveness90  and  efficiency91 
with regard to achieving applicable longer term policy (specific) objectives. Preferred options, 
where identified in the impact assessment, are highlighted.  

Table 12: Summary of policy option effectiveness and efficiency 

Policy 
Option  

Set 

Liquidity 
Coverage ratio 

Policy 
Options 

1.1 Retain current approach 

1.2 Introduce LCR as specified in Feb 2010 PC 

1.3 Introduce LCR adopted by Basel 
Committee subject to observation period 

2.1 Retain current approach 

Net Stable 
Funding ratio 

2.2 Introduce NSFR as specified in Feb 2010 
PC 

Eligibility of 
capital 
instruments and 
application of 
regulatory 
adjustments 

2.3 Introduce NSFR adopted by Basel 
Committee 

3.1 Retain current approach 

3.2 Modify only the eligibility criteria as 
specified in Feb 2010 PC 

3.3 Modify eligibility criteria and regulatory 
adjustments as specified in Feb 2010 PC 

Policy Option Comparison Criteria 

Effectiveness 

f
o

y
c
a
u
q
e
d
a
e
c
n
a
h
n
E

s
t
n
e
m
e
r
i
u
q
e
r

l
a
t
i
p
a
c

k
s
i
r
k
n
a
b
e
c
n
a
h
n
E

t
n
e
m
e
g
a
n
a
m

y
r
o
t
a
l
u
g
e
r

t
n
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3 

2 

1 

3 

2 

1 

5 

4 

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2 

1 

3 

2 

1 

5 

4 

5 

4 

1-3 

1-3 

1-3 

3 

1 

2 

3 

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5 

4 

3 

5 

4 

2-3 

5 

4 

1 

5 

4 

1-3 

90 Measures extent to which options achieve relevant objectives 
91 Measures extent to which objectives can be achieved for a given level of resources   

45 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
                                                 
Policy Option Comparison Criteria 

Effectiveness 

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Effici
ency 

Policy 
Option  

Set 

Policy 
Options 

3.4 Modify eligibility criteria and regulatory 
adjustments based on Basel approach 

3.5 Modify eligibility criteria and regulatory 
adjustments based on Basel approach with 
some adjustments for EU specificities 

4.1 Retain current approach 

4.2 Enhance CCR requirement  

4.3 Enhance CCR requirements and 
differentiate treatment of exposures to CCPs 

5.1 Retain current approach 

Counterparty 
credit risk 

Leverage ratio 

5.2 Introduce leverage ratio as specified in Feb 
2010 PC 

5.3 Conduct extensive monitoring of leverage 
ratio 

Capital buffers 

6.1 Retain current approach 

6.2 Conservation capital buffer 

6.3 Countercyclical capital buffer 

6.4 Dual capital buffer 

7.1 Retain current approach 

7.2 Minimum harmonization 

Single rule book 

7.3 Maximum harmonization 

7.4 Maximum harmonization with some 
exceptions 

8.1 Amend the CRD 

8.2 Limit scope of the CRD and propose a 
regulation 

Choice of policy 
instrument 

f
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1-3 

1-3 

1-3 

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1-3 

1-3 

1-3 

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2-3 

1 

3 

2 

1 

3 

2 

1 

4 

3 

2 

1 

3 

2 

1 

4 

1-2 

3 

1-2 

1-3 

1-3 

1-3 

4 

3 

1 

2 

4 

3 

1-2 

1-2 

2 

1 

4 

3 

1 

2 

2 

1 

4 

1-3 

1-3 

1-3 

2 

1 

4 

3 

1 

2 

2 

1 

2-3 

1-3 

2-3 

1-3 

3 

2 

1 

3 

2 

1 

3 

2 

1 

4 

3 

1-2 

1-2 

2 

1 

3 

2 

1 

3 

2 

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4 

2-3 

2-3 

1 

4 

1-3 

1-3 

1-3 

2 

1 

Scale of option ranking: 1=most effective / efficient, 5=least effective / efficient 

The proposed calibration, including phase-in and grandfathering arrangements, of the package 
is aligned with the Basel III rules text and is shown in Tables 2 and 3 above.92 To set the new 
level of minimum capital requirement and capital buffers, the Basel Committee conducted a 
number  of  supporting  analyses.93  In  terms  of  the  new  minimum  going-concern  capital,  it 
found  that,  for  instance,  the  median  of  the  99th  percentile  distributions  of  historical  annual 
risk-weighted  returns  across  six  jurisdictions  of  the  Committee  is  about  -5%.94  With  some 
adjustments for the impact that Basel III is expected to have on RWAs and eligible capital, 
this served as a basis for the new level of CET1 and T1 capital requirements. 

As regards calibration of capital buffers, cumulative net income of 73 banks from 14 countries 
over the financial crisis period (from Q3 2007 to Q4 2009) as a share of year-end 2006 RWAs 
was analysed. This analysis showed that mean losses95 of banks with negative cumulative net 
income over this period equalled 5% of RWAs. During major crises, when access to capital 

92 It needs to be noted that Switzerland has announced its intention to proceed with more stringent requirements 
than  agreed  by  the  Basel  Committee.  However  this  pertains  to  requirements  for  its  two  systemically 
important  financial  institutions.  Similarly,  the  Independent  Commission  on  Banking  of  the  UK  in  its 
interim  report  of  April  2011  suggested  that  large  UK  retail  banking  operations  hold  equity  capital  of 
10%  of  their  RWAs  and  that  such  capitalization  should  become  the  international  standard  for 
systemically important financial institutions. However, the prudential requirements for such institutions 
at both the international and the EU level have not been finalised.  

93 See http://www.bis.org/publ/bcbs180.pdf  
94 Risk-weighted return measured by RORWA and calculated as the ratio of net income to RWAs 
95 When measured with pre-tax, pre-distribution net income 

46 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
                                                 
markets is limited, cumulative losses of such extent can be absorbed only by those banks that 
have adequate capital buffers, accumulated during more favourable economic conditions.  

The rationale for the proposed transitional provisions as well as impacts on the industry, other 
economic agents and financial stability are discussed in the remainder of section 5.8. 

5.8.2.  Cumulative impact on the industry 

When  estimating  capital  shortfall  due  to  the  CRD  IV  package,  the  impact  of  new  CET1 
minimum  requirement  and  capital  buffers  is  assessed  together.  Table  13  shows  estimated 
impact  on  capital  ratios  separately  for  Group  1  and  Group  2  banks  after  application  of  the 
CRD III and IV proposals, assuming a full implementation of both proposals as of December 
2009.  

Table 13: Capital ratios for Group 1 and Group 2 banks, in %:  

Group

Group 1
Group 2

CET1

Gross 1
10,7
11,1

New 2
4,9
7,1

T1

Total

Old
10,3
10,3

New
5,6
7,6

Old
14,0
13,1

New
8,1
10,3

Notes: 1 'Gross' is the ratio of new gross CET1 (without deductions) relative to old 
RWA. 2 New CET1 shows net CET1 (with deductions) relative to new RWA. 'New' 
ratios do not reflect the effect of transitional and grandfathering provisions which will 
mitigate the effective impact on banks' capital ratios in the period up to 2023 
Source: CEBS 

In  terms  of  impact  on  the  CET1  ratio,  large  EU  banks  (average  CET1  ratio  of  4.9%)  are 
affected more than a sample of 74 large international banks from eighteen Basel Committee 
countries whose average CET1 ratio as of December 2009 stood at 5.7% upon application of 
equivalent rules.  

Changes in capital ratios are driven by the changes in capital definition rules and RWAs. The 
preferred policy options outlined in this report are expected to increase the RWAs of Group 1 
banks on average by 24.5%, and the RWAs of Group 2 banks – by a modest 4.1%. The extent 
of capital shortfalls that the EU banking industry would face due to the proposals is estimated 
in the range of €370 billion as of December 2009, at CET1 of 7% (consisting of a minimum 
requirement  of  4.5%  and  capital  conservation  buffer  of  2.5%).96  Under  the  proposal,  the 
existing public sector injections estimated at some €90 billion would be grandfathered until 1 
January  2018.97  In  the  long  run  they  would  add  to  the  CET1  capital  shortfall,  raising  it  to 
some €460 billion or 2.9% of the EU banking sector's RWAs.98 However, the estimate should 
be viewed as the high end of the capital shortfall because: 

- it is based on bank capitalisation levels as of December 2009 which most likely will have 
increased in response to supervisory and market pressure even if the CRD were not amended,  

- estimates do not incorporate the impact of phasing-in and grandfathering provisions that will 
spread  the  impact  for  most  banks  during  implementation  period.  More  specifically,  capital 
shortfall that the EU banking industry would face at CET1 of 3.5%, effective from 2013, is 

96 Of this figure, some €37 billion is attributable to the CRD III proposal (in terms of Tier 1 capital, as definition 

of CET1 did not exist prior to CRD IV proposal) 

97 The figures on state aids were not available for all participating MS  
98 Expected shortfall shall not be confused with related cost of capital. On the implications of the proposal on the 

expected cost of equity please see section5.8.5. 

47 

 
 
 
 
                                                 
immaterial,  whereas  capital  shortfall  at  CET1  of  4.5%,  effective  from  2015,  is  estimated  at 
€84 billion99, 

-  it  does  not  capture  the  interaction  between  liquidity  and  capital  proposals  (i.e.,  larger 
proportion of liquid assets that banks will hold in order to comply with LCR will reduce the 
amount of their RWAs relative to total assets), and  

-  only  the  minimum  capital  requirement  is  a  critical  requirement  whose  breaching  would 
trigger  supervisory  intervention,  whereas  consequences  of  falling  behind  the  capital  buffer 
target are confined to banks' curtailing their discretionary distributions of earnings.100  

The  industry  is  not  expected  to  raise  the  entire  shortfall  amount  in  the  capital  markets.  For 
instance, combined net profit of some 100 biggest EU banks in 2009 was around €33 billion 
and  bank  profits  are  likely  to  rise  as  economic  situation  improves  and  provisions  for  non-
performing loans decline.101  

As regards the impact of new liquidity requirements, the implications of LCR are discussed in 
section 5.1.1., while  those  of  NSFR  - in  section 5.1.2.  It  should be noted  that  the  estimated 
shortfalls  to  comply  with  LCR  and  NSFR  are  not  additive  since  depending  on  the  actions 
taken to minimize them, decreasing the shortfall in one standard may result in a decrease in 
the shortfall of the other.  

5.8.3.  Administrative costs 

Implementation of legislation entails costs for businesses. Costs that are linked to providing 
information  either  to  public  or  private  parties  are  called  administrative  costs.  The  share  of 
these  costs  that  is  specifically  linked  to  information  that  businesses  would  not  collect  and 
provide  in  the  absence  of  a  legal  obligation  is  called  administrative  burdens.  The 
Commission's  Better  Regulation  strategy  is  aimed  at  measuring  administrative  costs  and 
reducing  administrative  burdens.  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 of the impact assessment) and had to be designed accordingly.  

In August-September 2010, the Commission services distributed a questionnaire to the GEBI 
members about the impacts of CRD IV proposal on administrative burdens (see Annex VIII). 
Analysis of replies showed that, overall, the biggest impacts on both the on-going burdens and 
the  related  one-off  implementation  costs  are  expected  due  to  new  measures  in  the  area 
liquidity risk management, comprising roughly 70% of all administrative burdens. Proposals 
for the counterparty credit risk were also identified as a source of significant administrative 
burdens  for  Group  1  banks.  As  regards  proposal  for  the  'single  rule  book',  the  number  and, 
particularly, the diversity of replies received were insufficient to assess its varying impact by 

99 This estimate assumes full deductions, i.e., does not account for phase-in arrangements for deductions (40% in 

2015) 

100 Counter-cyclical capital buffer is not considered in the above calculation as it would only be in effect when 
there is an excess credit growth that is resulting in a system wide build-up of risk, but would stay at zero 
at all other times 

101 Source: Bloomberg, Orbis, Commission services' calculation 

48 

 
 
 
                                                 
MS (which depends on the degree to which options and discretions are exercised) and bank 
type. In this regard, banks with more cross-border activity would benefit from harmonisation 
of the current national provisions the most as the ensuing administrative burden savings are 
expected to reduce their burdens related to Basel III measures.  

5.8.4.  Economic impact in transitional period 

A key factor determining banks' responses to new capital and liquidity standards is the length 
of the period during which the new requirements will be phased in. If the transition period is 
short, banks may choose to curtail credit supply or adjust capital composition in order to lift 
capital  ratios.  A  longer  transition  period  could  substantially  mitigate  the  impact,  allowing 
banks to retain more of their profits (by reducing dividend payments or improving operational 
efficiency), issue new equity, reduce fixed costs or take other necessary steps to adjust.  

To inform the policy question of appropriate transitional provisions, the Basel Committee and 
the  FSB  set  up  a  Macroeconomic  Assessment  Group  (MAG)  whose  members  were 
macroeconomists  and  econometricians  from  central  banks,  regulatory  agencies  and 
international  institutions.  For  the  full  analysis  of  MAG  please  see  its  Interim  and  Final 
Reports  that  were  published  in  August  and  December  2010.102  When  applying  MAG's  key 
findings in the EU context, it is important to note that its work was based on a high number of 
macroeconomic  models  developed  and  used  for  policy  analysis  in  central  banks  and 
international organisations, with a high representation of models pertaining to MS or broader 
regions  of  the  EU.  The  group's  Interim  Report  was  based  on  the  results  of  89  individual 
macroeconomic  models,  of  which  51  models  relate  to  the  EU103,  whereas  its  Final  Report 
used 97 modelling simulations, of which 49 relate to the EU.104  

MAG modelled implementation scenarios of 2, 4, 6, and 8 years. The key findings as regards 
transitional  periods  of  4  and  8  years  -  as  they  were  given  more  consideration  in  Basel  III 
deliberation  process  -  are  compared  in  Table  14.  The  table  also  shows  the  outcomes  of  the 
macroeconomic  modelling  conducted  by  ECB  and the  Commission  (for  more  details  on  the 
Commission  model  please  see  Annex  IX).105  Overall,  it  shows  that  shorter  implementation 
scenarios have a greater impact on annual GDP growth rates since the projected decline in the 
level of GDP relative to baseline would take place over a shorter time. This implies sharper 
adjustment  costs  for  the  industry  and  the  macro-economy.  A  longer  implementation  period 
shall minimize any potential transitory effects on GDP and credit availability. This is in part 
because the maximum GDP loss is estimated to occur around the end of the transition period, 
which could be at a more mature and resilient stage of the current recovery.  

102 See http://www.bis.org/publ/othp10.htm, http://www.bis.org/publ/othp12.pdf  
103 Of them, 6 models relating the euro area, 9 to FR, 7 to DE, 8 to IT, NL and ES each, and 5 to the UK. 
104 Of them, 20 models relating the euro area, 7 to NL and IT each, 5 to the UK, 4 to FR and 3 to DE and ES 

each. 

105 For a comparison of various public and private sector quantitative models, please see Annex X 

49 

 
 
 
 
 
 
 
                                                 
Table 14: Overview of the implementation period scenarios for new capital standards 
Timing of 
estimated decline 
in GDP since start 
of implementation 

Implemen
tation 
period 

Result / Model 

Estimated annual 
decline in the EU 
GDP growth below 
baseline, % 

Source 

Decline in GDP 
below baseline per 
percentage point 
increase in capital 
requirement, % 
B 
0.19 

Estimated decline 
in the EU GDP 
below baseline due 
to capital shortfall, 
% 
C=B*2.9 
0.55 

Four years 

Eight 
years 

Median of 89 
models 
Median of 16 
models with impact 
on lending standards 
Median of 11 
models with impact 
on lending standards 
and endogenous 
monetary policy 
Multi country model 
(with impact on 
lending standards) 
Christiano-Motto-
Rostagno model 

Median of 97 
models 
Median of 12 
models with impact 
on lending standards 
Median of 14 
models with impact 
on lending standards 
and endogenous 
monetary policy 
Multi country model 
(with impact on 
lending standards) 
Christiano-Motto-
Rostagno model 
DSGE bank-
augmented model 

MAG 

MAG 

A 
18 quarters 

18 quarters 

MAG 

18 quarters 

ECB 

ECB 

MAG 

MAG 

18 quarters 

18 quarters 

35 quarters  

35 quarters  

MAG 

35 quarters  

ECB 

ECB 

European 
Commission 

35 quarters 

35 quarters 

36 quarters 

0.32 

0.17 

0.19 

0.29 

0.17 

0.23 

0.16 

0.08 

0.39 

0.14 

0.93 

0.49 

0.55 

0.84 

0.49 

0.67 

0.46 

0.25 

1.12 

0.42 

D=(1+C)^(1/(A/4))-1 
0.10 

0.16 

0.09 

0.10 

0.15 

0.05 

0.06 

0.04 

0.03 

0.09 

0.04 

Sources: Basel Committee, ECB, European Commission 

Lengthening  of  the  implementation  period  would  also  give  banks  more  time  to  adjust  their 
business models and cost structures, reduce the severity of the impact of lending cuts on bank-
dependent sectors, allow more time for stable non-bank channels of credit intermediation to 
develop, and give markets more time to absorb the asset sales, debt issues and equity issues 
that might accompany banks' balance sheet adjustments. Hence, the transitional phase-in and 
grandfathering  provisions  for  the  capital  requirements  agreed  by  the  Basel  Committee  and 
outlined  in  Table  3  are  likely  to  accommodate  the  above  adjustment  processes  the  most  as 
they effectively imply an eight-year transition period from 2011 to 2018.  

As regards the optimum implementation timing for the new liquidity requirements, given their 
novelty  and  the  related  possibility  of  unintended  consequences  on  financial  institutions  of 
different  sizes  and  business  lines,  observation  periods  coupled  with  review  clauses  are 
justified.  LCR,  including  any  revisions  will  be  introduced  on  1  January  2015,  while  NSFR, 
with appropriate revisions, will move to the minimum standard on 1 January 2018.106  

In  summary,  work  of  the  Basel  Committee's  MAG,  ECB  and  the  Commission  on  the 
assessment of macroeconomic costs show that the transition to stronger capital and liquidity 
standards is likely to have a limited impact on the aggregate output.  

106 The increased holding of liquid assets due to LCR is expected to reduce the EU GDP by 0.11% below the 
baseline  after  four  and  a  half  years  from  the  start  of  implementation  (Sources:  the  Basel  Committee 
(MAG), EU QIS, Commission services' calculations) 

50 

 
 
 
 
 
 
 
 
 
 
                                                 
5.8.5.  Long-term economic impact 

It  shall  be  emphasised  that  the  above  analyses  measured  only  transitional  costs  without 
considering  benefits  from  enhanced  financial  stability  and  mitigated  pro-cyclicality  which 
would start to accrue immediately, and which have been assessed by the Basel Committee in a 
separate analysis of the long-term economic impact (LEI).107 By examining the historical data 
and a number of studies on the economic costs of systemic crises, it concluded that there are 
clear  net  long  term  economic  benefits  from  increasing  the  minimum  capital  and  liquidity 
requirements from their current levels. LEI analysis implies annual net benefits of increase in 
the EU GDP in the range of 0.3%-2% which stem from a reduction in the expected frequency 
of systemic banking crises108 and are optimized when CET1 capital is calibrated in the range 
of  6%  to  9%.  It  needs  to  be  noted  that  the  approach  adopted  by  the  Committee  was  rather 
conservative  and  that  actual  net  economic  benefits  can  be  expected  to  be  higher.  The 
quantification  of  benefits  did  not  include  those  stemming  from  a  reduced  severity  of  future 
crises and reduced  pro-cyclicality in the system. On  the cost side assumptions were equally 
conservative,  including  a  full  pass  through  of  costs  to  customers  via  lending  rates,  no 
reduction  in  cost  of  debt  and  equity  (with  an  ROE  assumption  based  on  a  high  historical 
average).  According  to  the  Modigliani-Miller  (MM)  propositions109,  however,  increases  in 
banks' capital levels as a result of Basel III shall reduce their leverage and, by making returns 
to their investors less volatile, the cost of equity. In this respect, macro-economic modelling 
of the Commission services showed that when the MM propositions are assumed to hold at 
least partially (50%), economic costs of the new rules in terms of their impact on the GDP are 
reduced  in  half  by  2020-2030  (see  Annex  IX).110  The  cost  of  debt  may  go  down  as  well 
because of better capitalization levels. 

In addition to the benefits from reducing output losses associated with reduced frequency of 
banking  crises,  higher  capital  and  liquidity  requirements  may  also  reduce  the  amplitude  of 
normal  business  cycles.  When  considering  a  possibility  of  introducing  a  counter-cyclical 
capital buffer, which causes the capital requirement to increase in step with the credit-to-GDP 
ratio111, LEI analysis showed that the volatility of output would be reduced substantially, with 
the  standard  deviation  declining  by  almost  one  fifth  with  respect  to  a  baseline  in  which  no 
countercyclical capital rules are implemented.  

Another model developed jointly by the Commission services and academics112 looked at the 
long  term  macro-economic  impact  of  Basel  III  in  seven  MS.  Regarding  the  effects  on  the 
probability of a systemic banking crisis, the research finds that its reduction depends on how 
much  banks  will  recapitalize  under  Basel  III.  Results  show  that  when  banks  recapitalize  to 
10.5%113 level, the probability of a systemic banking crisis is reduced within the range of 29% 

107 See http://www.bis.org/publ/bcbs173.htm  
108 Based on LEI analysis, the Commission services estimate that complying with the LCR requirement and the 

new capital requirements can be expected to reduce the probability of a systemic crisis by some 70% 

109  Modigliani,  F.,  and  M.  Miller,  The  cost  of  capital,  corporation  finance  and  the  theory  of  investment,  The 

American Economic Review, 48, 1958 
Miller M., Do the M&M propositions apply to banks?, Journal of Banking & Finance, 19, 1995 
110 When MM propositions are assumed to hold entirely (i.e., 100%), the scenario of regulatory change in terms 
of  economic  costs  (measured  as  impact  on the  GDP)  by 2020-2030 does  not differ from  the  baseline 
scenario.  

111 Based on the simulations that increase the capital requirement in the neighbourhood of ±2 percentage points 

around the steady state 

112 Marchesi M., S. Zedda, F. Campolongo, R.  De Lisa, J. Cariboni, M. Petracco Giudici, Basel III: a macro-
economic cost-benefit analysis, 2010, JRC EUR Report 61485, EUR 24603 EN (mimeo, forthcoming) 

113 Consisting of total capital requirement of 8% and conservation buffer of 2.5% 

51 

 
 
 
                                                 
 
to 89%. The analysis found substantial net economic benefits of the new framework for two 
MS and a more neutral net economic effect in the remaining five MS analysed. 

5.9. 

Impacts on SMEs 

A  recent  study114  launched  by  the  Commission  found  that  bank  credit  constitutes  the  most 
significant external source of SME financing. In this respect, the study found that there is a 
significant positive effect of the business cycle on bank loans to medium-sized firms, with the 
effect on small firms also significant but smaller. This effect might be explained by a number 
of regulatory and market failures, including the problem of asymmetric information.115 When 
economic  conditions  become  depressed  and  collateral  values  decline, 
information 
asymmetries  with  respect  to  the  quality  of  clients’  balance  sheets  make  obtaining  the  bank 
credit difficult even for clients with profitable projects. When economic conditions improve 
and  collateral  values  rise,  the  opposite  situation  tends  to  occur.  In  this  regard,  lending  to 
SMEs is affected more than lending to large companies as SMEs are not subject to external 
ratings and extensive disclosure requirements. 

Therefore, SMEs, to the extent that they are credit rationed by banks, are expected to be the 
primary  beneficiaries  of  smoothened  pro-cyclicality  brought  about  by  the  enhanced 
countercyclical  properties  of  the  EU  bank  capital  regulation,  including  capital  buffers, 
improved  adequacy  and  quality  of  regulatory  capital  and  the  leverage  ratio.  These  changes 
will allow SMEs to engage in projects that are profitable and vital for the economic growth 
and prosperity not only during an expansionary leg of the cycle, but, more importantly, when 
the economic climate turns sour.  As importantly, the proposals will benefit SMEs and their 
workforce further by smoothening the cyclicality of demand for the products and services that 
they generate, given that SMEs contribute some 60% of the total value added of the EU's non-
financial business economy.116   

According  to  the  Commission  macroeconomic  model,  compliance  with  the  new  capital 
framework  is  expected  to  reduce  the  stock  of  loans  on  average  by  1.8%  and  increase  loan 
rates on average by some 29 basis points by 2020-2030.117 However, it needs to be stressed 
that costs of a comparable extent most likely would arise even in the absence of a regulatory 
reform, due to the market pressure and expectations with respect to enhanced post-crisis bank 
capital levels and liquidity management.  

114 EIM, Cyclicality of SME Finance, March 2009 
115 The drivers behind such cyclicality are outlined in section 3.5 
116 Eurostat, European business facts and figures, 2009 
117 Specification of the Commission's QUEST model and more detailed presentation of modelling of the Basel 
III impacts on the EU economy are provided in Annex IX. It needs to be noted that modelling outputs in 
Annex  IX  are  expressed  as  a  change  in  a  variable  for  2.5  percentage  point  increase  in  Tier  1  capital 
ratio. For this reason, estimates have to be rescaled to assess the impact of a shortfall of CET1 capital of 
2.9%  of  risk-weighted  assets.  In  this  calculation,  it  was  assumed  that  capital  shortfalls  expressed  as 
percentage points of Tier 1 and CET1 capital are comparable, given that CET1 is part of Tier 1. Hence, 
impact of the proposal on loan rates is derived as follows: 0.25 (average increase in loan rate by 2020-
2030,  0%  MM  offset,  expressed  in  percentage  points)  /  2.5  (increase  in  Tier  1  ratio,  expressed  in 
percentage  points)  x  2.9  (regulatory  capital  shortfall  in  percentage  points  expressed  as  CET1  capital 
over risk weighted assets) = 0.29 percentage points. Using the same rationale, impact of the proposal on 
the  stock of  loans  is derived as  follows: -1.51  (average decrease  in  stock  of  loans by  2020-2030,  0% 
MM  offset,  expressed  in  %)  /  2.5  (increase  in  Tier  1  ratio,  expressed  in  percentage  points)  x  2.9 
(regulatory capital shortfall in percentage points expressed as CET1 capital over risk weighted assets) = 
-1.8%.  

52 

 
 
 
                                                 
While  the  proposals  are  expected  to  lead  to  a  higher  cost  of  bank  credit  –  which  is 
compensated  by  social  benefits  -  across  the  entire  spectrum  of  bank  customers,  SMEs  are 
expected to be impacted less than their large counterparts. Even though the start of Basel III 
transitional period has been set for 2013, most banks have embarked on a de facto transition 
to complying with the new rules following the publication of the framework in late 2010 and 
early  evidence  (Q4  2010  and  Q1  2011)  on  the  impact  of  costs  related  to  bank  capital  and 
liquidity  position  on  credit  standards  for  loans  and  credit  lines  shows  that  more  euro  area 
banks tightened their credit standards for large enterprises than for SMEs.118  

SMEs are expected to be affected less severely also to the extent that they transact more with 
smaller (or Group 2) banks119, whose capital and liquidity shortfalls have been estimated to be 
smaller than those of the largest EU (or Group 1) banks (see Table 15). In a similar vein, it is 
expected  that  the  proposals,  by  accommodating  certain  specificities  of  the  EU  cooperative, 
mutual  and  similar  banks  (e.g.,  see  policy  options  1.3  and  3.5),  will  reduce  the  compliance 
costs  for  these  institutions  and  in  turn  result  in  smaller  indirect  costs  to  their  customers, 
including SMEs.  

Table 15: Overview of impacts of various proposals by bank group 

Policy area / proposed measure(s) 

EU averages 
Group 1 banks  Group 2 banks 

Liquidity risk 1:  
Liquidity Coverage Ratio, % 
Net Stable Funding Ratio, % 

Rules on capital definition, CET1 capital ratio, %  

Rules on counterparty credit risk, % change of total RWAs  

Leverage ratio, % 1 

66.5 
91.1 

5.8 

9.7 

2.5 

87.1 
93.9 

7.1 

0.2 

3.5 

Combined impact of CRD III and CRD IV on:  
Total RWAs, % change 
CET1 capital ratio, % 
Notes: 1 Based on Basel III definitions, in the EU will be subject to monitoring periods and follow-on re-calibration 
Source: CEBS 

24.5 
4.9 

4.1 
7.1 

The extent to which costs of Basel III implementation would be passed onto bank customers 
is  also  unclear  given  that  exposure  to  the  new  measures,  as  shown  by  the  EU  QIS,  is  not 
uniform across banks while their market power on the lending market may be too weak.120 In 
this regard, upon full application of CRD III and the CRD IV proposal some 25% of Group 1 
banks and some 75% of Group 2 banks had CET1 capital ratio in excess of 7% already at the 
end  of  2009  (see  Chart  1).  Furthermore,  the  distribution  of  CET1  ratios  of  Group  2  banks 
indicates that the smaller the bank the higher its CET1 ratio.121 In competitive markets, such 
asymmetric shocks are typically much more difficult to pass onto customers, including SMEs. 

118 ECB, The euro area bank lending survey, April 2011 
119 Some research shows that smaller banks are more prone to lend to SMEs because they are better suited for the 
'relationship  lending',  which  is  primarily  based  on  information  gathered  by  the  loan  officer  through 
continuous,  personalized  and  direct  contacts  with  SMEs,  their  owners  and  managers,  and  the  local 
community in which they operate. E.g., see Berger, A., L. Klapper, G. Udell, The Ability of Banks to 
Lend to Informationally Opaque Small Businesses, Journal of Banking Finance 25, 2001 

120  ECB  euro  area  bank  lending  surveys  show  that  pressure  from  competition  plays  an  important  role  in 
offsetting  the  impact  of  factors  that  drive  banks  to  tighten  their  credit  standards.  See  ECB,  The  euro 
area bank lending survey, April 2011 

121 As roughly three quarters of banks in the Group 2 sample had CET1 capital ratios in excess of the sample 

mean of 7.1%. 

53 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
                                                 
Moreover, monitoring periods foreseen for LCR, NSFR and the leverage ratio in combination 
with extended phase-in and inclusion of grandfathering provisions are expected to give banks 
necessary time to adjust their business models accordingly and provide lending to companies 
to support economic growth.  

Also,  the  proposal  includes  a  review  clause  on  the  preferential  risk  weight  for  exposures  to 
SMEs  under  €1  million  that  is  currently  available  for  banks  applying  the  standardised 
approach  for  credit  risk.  The  preferential  treatment  is  retained  in  the  proposal  and  EBA  is 
tasked with preparing an analysis for the Commission on whether the current level of the risk 
weight and the cap for its application are commensurate with the actual credit loss history of 
such exposures over a full economic cycle. 

Chart 1: Distribution of CET1 capital ratios for Group 1 and Group 2 EU banks following 
the application of CRD III and the CRD IV proposal 122 

Source: CEBS, EU QIS 

Most importantly, higher cost of credit in the long run will be offset by important economic 
and  social  benefits  accruing  not  only  to  SMEs  but  a  wide  range  of  stakeholders,  including 
corporate  and  individual  borrowers  and  creditors,  governments,  and  the  EU  citizens  in 
general,  due  to  the  anticipated  reduction  in  a  frequency  of  banking  crises,  the  extent  of  net 
economic benefits whereof was assessed in the preceding section.  

6. 

MONITORING AND EVALUATION 

It  is  expected  that  the  proposed  amendments  will  start  entering  into  force  in  2013.  The 
amendments  are  tightly  inter-linked  with  other  provisions  of  the  CRD,  that  are  already  in 
effect since 2007-2008 or that will come into effect following the implementation of CRD II 
and  CRD  III.  The  current  and  recent  proposals  underscore  the  importance  of  timely  and 
appropriate changes of the rules in response to the market events. Therefore, it is likely that 
individual provisions of the CRD will continue to be formally evaluated on a piecemeal basis, 

122 In the plot, the mean is shown with the "x", the median is shown with the red line, 25th and 75th percentiles of 
the  distribution  are  delineated  by  the  blue  box,  while  the  black  horizontal  lines  mark  10th  and  90th 
percentiles  of  the  distribution.  In  the  EU  QIS,  sample  means  were  calculated  on  the  basis  of  the 
'composite bank'; in this case, by dividing the sum of CET1 capital by the sum of risk-weighted assets. 
A median represents the value that separates the higher half of the sample from the lower half. An Xth 
percentile distribution represents the value that separates X% of lower values from (100%-X%) higher 
values of the sample. 

54 

 
 
 
 
                                                 
following the outcomes of various monitoring exercises both at the EU and the international 
level or a necessity to act as dictated by the markets. 

Special  arrangements  will  be  put  in  place  by  the  Basel  Committee  and  EBA  to  ensure  that 
necessary data for the monitoring of leverage ratio and the new liquidity measures is collected 
to allow for the calibration of these policy tools. Additionally, the Commission services will 
continue to participate in the working group of the Basel Committee and the joint task force 
established by ECB and EBA, that monitor the dynamics of bank capital positions, globally 
and in the EU, respectively.  

55 

 
 
 
GLOSSARY 

Administrative 
burden 

Costs  specifically  linked  to  information  provision  that  businesses  would  not  collect 
and provide in the absence of a legal obligation 

Business-as-usual 
factor 

Expresses costs of providing the information that would be collected and processed by 
businesses even in the absence of the legislation as a percentage of total information 
provision-related costs 

Call option 

A contract between two parties, whereby the buyer of the option has the right, but not 
the  obligation  to  buy  an  agreed  quantity  of  a  particular  commodity  or  financial 
instrument  from  the  seller  of  the  option  at  a  certain  time  (the  expiration  date)  for  a 
certain price.  

Central 
counterparty (CCP) 

An entity that interposes itself between counterparties to a contract traded within one 
or more financial markets, becoming the buyer to every seller and the seller to every 
buyer 

Consolidating 
supervisor 

The  supervisor  responsible  for  the  supervision  on  a  consolidated  basis  of  a  banking 
group. As a rule, this is the supervisor of the Member State where the parent bank of 
the group is based 

Contestable market  Market served by a small number of firms, but which is characterized by competitive 
pricing because of the existence of potential short-term entrants 

Contingent capital 

Debt that converts into equity when there is a crisis or when certain triggers are met 

Covered bond 

A corporate bond with a recourse to a pool of assets that secures or "covers" the bond 
if the originator (usually a financial institution) becomes insolvent 

Counterparty  credit 
risk (CCR) 

The risk that the counterparty to a transaction could default before the final settlement 
of  the  transaction's  cash  flows.  An  economic  loss  would  occur  if  the  transactions  or 
portfolio  of  transactions  with  the  counterparty  has  a  positive  economic  value  at  the 
time  of  default.  Unlike  a  firm’s  exposure  to  credit  risk  through  a  loan,  where  the 
exposure  to  credit  risk  is  unilateral  and  only  the  lending  institution  faces  the  risk  of 
loss,  CCR  creates  a  bilateral  risk  of  loss:  the  market  value  of  the  transaction  can  be 
positive  or  negative  to  either  counterparty  to  the  transaction.  The  market  value  is 
uncertain and can vary over time with the movement of underlying market factors. 

Credit 
risk 

migration 

Risk that a portfolio's quality will deteriorate over time without allowing a re-pricing 
of  its  constituent  loans  or  instruments  to  compensate  for  the  increase  in their  default 
risk 

Credit risk 

Risk  of  losses  in  on  and  off-balance  sheet  positions  resulting  from  the  failure  of  a 
counterparty to perform according to a contractual arrangement 

Credit 
mitigation 

risk 

Technique  used  by  a  credit  institution  to  reduce  the  credit  risk  associated  with  an 
exposure which the credit institution holds 

Run-off 
(deposit) 

rate 

Rate that reflects the amount of funding maturing over a given period of time and/or 
that are expected to be withdrawn 

Expected 
Exposure (EPE)  

Positive 

The  weighted  average  over  time  of  expected  exposures  where  the  weights  are  the 
proportion that an individual expected exposure represents of the entire time interval. 
When calculating the minimum capital requirement, the average is taken over the first 
year,  or,  if  all  the  contracts  in  the  netting  set  mature  before  one  year,  over  the  time 
period of the longest maturity contract in the netting set. 

56 

 
 
 
 
of 
Flexibility 
payments  (of  capital 
instruments) 

A  criterion  that  requires  that  the  capital  instrument  must  contain  features  permitting 
the  noncumulative  deferral  or  cancellation  of  payment  of  coupons  or  dividends  in 
times of stress 

Funding liquidity 

Ability to meet their liabilities, unwind or settle their positions as they come due 

Going concern 

Concept that refers to a company's ability to continue functioning as a business entity. 
Hence, 'going concern capital' instruments are those that are effective in maintaining a 
bank as a going concern  

Haircut 

A percentage that is subtracted from the par value of the assets that are being used as 
collateral 

Herding behaviour 

A  tendency  of  market  participants  to  conform  in  their  behaviour  with  that  of  their 
peers 

capital 

Hybrid 
instruments 
(hybrids) 

Securities  that  contain  features  of  both  equity  and  debt.  The  ultimate  purpose  of 
issuing such instruments is to cover economic capital needs and to provide support in 
the  event  of  financial  stress  or  potential  losses.  Hybrids  help  to  diversify  both  the 
investor  and  capital  base  of  a  bank,  and  are  often  structured  to  qualify  as  regulatory 
capital on the one hand and achieve tax deductibility on the other. 

Hypothecation 

A practice where a borrower pledges collateral to secure a debt 

Innovative hybrids 

A specific type of hybrid instruments that include an incentive to redeem, like a step-
up  or  other  feature.  Non-innovative  instruments  are  hybrid  instruments  with  no 
incentive to redeem. Innovative instruments were assigned a limit of 15% of 'original 
own funds' by the CRD II.  

Internal 
Based 
approach 

Ratings 
(IRB) 

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 

Leverage 

Degree to which a credit institution's exposures exceed its capital level 

Loss  absorption  (of 
capital instruments) 

A criterion that requires that the capital instrument must be available to absorb losses, 
both on a going concern basis and in liquidation, and to provide support for depositors’ 
funds if necessary 

Loss  given  default 
(LGD) 

The loss, measured as a percentage of the 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 

Margin 

Margin  is  collateral  that  the  holder  of  a  financial  instrument  has  to  deposit  to  cover 
some or all of the credit risk of his counterparty. When the margin posted falls below 
the minimum margin requirement, a margin call issued.  

Market liquidity 

An asset's ability to be sold without causing a significant movement in the price and 
with minimum loss of value 

Market risk 

Market risk is the risk of losses due to price fluctuations of financial instruments in the 
trading book 

Minority interest 

The  share  capital  of  an  entity  that  is  fully  consolidated  in  the  banking  group's 
regulatory accounts but is not owned by the group 

Mortgage 
security (MBS) 

backed 

Securitization where underlying exposures include mortgage loans, most commonly on 
residential property, in which case securitization is referred to as residential mortgage 

57 

 
 
 
backed security (RMBS) 

National discretion 

Discretion  refers  to  a  situation  in  which  competent  authorities  or  Member  State  are 
given a choice as to whether to apply, or not to apply, a given provision 

National option 

An  option  refers  to  a  situation  in  which  competent  authorities  or  Member  States  are 
given  a  choice  on  how  to  comply  with  a  given  provision,  selecting  from  a  range  of 
alternatives  

Operational risk 

Risk of loss resulting from inadequate or failed internal processes, people and systems 
or from external events, and includes legal risk 

Original own funds 

The most reliable and liquid element of a 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 

Permanence 
(of 
capital instruments) 

A criterion that requires that the capital instrument must be permanently available so 
that  there  is  no  doubt  that  it  can  support  depositors  and  other  creditors  in  times  of 
stress 

Pro-cyclicality 

Procyclicality  of  the  financial  system  can  be  defined  as  the  tendency  of  financial 
activity  to  amplify  business  fluctuations  which  may  lead  or  contribute  to  financial 
instability 

Prudential 
and deductions 

filters 

Adjustments to the accounting figures, which reduce or eliminate unwanted effects of 
reporting for the calculation of regulatory capital 

Required 
funding factor 

stable 

A factor that approximates the amount of a particular asset that could not be monetised 
through sale or use as collateral in a secured borrowing during a liquidity event lasting 
one year. In the context of NSFR, such amounts are expected to be supported by stable 
funding 

Re-securitization 

Securitization where one or more of the underlying exposures meet the definition of a 
securitization 

Securitization 

Transaction or scheme, whereby the credit risk associated with an exposure or pool of 
exposures is tranched, with payments in 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 

Repo 
agreement) 

(repurchase 

In a repo contract, the borrower agrees to sell a security to the lender and to buy the 
same security from the same lender at a fixed price at some later date 

Securities  financing 
activities 

While the rationale behind a repo contract is borrowing or lending of cash, in securities 
financing,  the  purpose  is  to  temporarily  obtain  a  security  for  other  purposes  such  as 
covering short positions 

Single rule book 

In  the  context  of  CRD  IV,  the  term  pertains  to  the  removal  of  national  options  and 
discretions together with maximum harmonisation of legal provisions 

Standardized 
approach 

Method  by  which  a  bank  can  use  external  ratings  (if  available)  by  external  credit 
assessment institutions to calculate its regulatory capital requirements for credit risk 

Sub-prime 
mortgages 

Mortgages that are usually granted to borrowers with lower credit ratings 

Synthetically  dated  Hybrids  that become  effectively  dated  as  a result  of  exercising of  the  embedded  call 

58 

 
 
 
hybrids 

option 

Tier 1 capital 

See Original own funds 

Tier 2 capital 

Trading book 

Regulatory capital that is used to absorb losses on a gone concern basis, i.e., when a 
company is in liquidation 

Comprises  those  instruments  held  for  short-term  resale  or  to  hedge  other  financial 
instruments that are held for short-term resale 

Wrong-way 
specific 
generalised 

risk, 
and 

Specific  wrong-way  risk  arises  when  the  exposure  to  a  particular  counterparty  is 
positively correlated with the probability of the default of the counterparty, i.e., when 
the credit exposure and default risk increase together  

Generalised  wrong-way  risk  relates  to  a  situation  where  the  probability  of  default  of 
counterparties is adversely correlated with general market risk factors 

59 

 
 
 
ANNEX I: EXTENDED IMPACT ANALYSIS 

TABLE OF CONTENTS 

1. 

2. 

Introduction ................................................................................................................ 62 

Procedural issues and stakeholder consultation ......................................................... 63 

2.1. 

Stakeholder consultation ............................................................................................ 63 

2.1.1.  CEBS.......................................................................................................................... 63 

2.1.1.1.  EU Quantitative Impact Study ................................................................................... 63 

2.1.1.2.  Work on national options and discretions.................................................................. 64 

2.1.2.  CRD Working Group ................................................................................................. 64 

2.1.3.  Other public consultations ......................................................................................... 65 

2.1.4.  Consultations with the industry.................................................................................. 65 

2.2. 

Consultation with other services of the Commission................................................. 65 

2.2.1. 

Inter-service Steering Group ...................................................................................... 65 

3. 

3.1. 

3.2. 

3.3. 

3.4. 

3.5. 

Problem definition...................................................................................................... 66 

Background ................................................................................................................ 66 

Management of liquidity risk ..................................................................................... 69 

Eligibility of capital instruments and regulatory adjustments ................................... 74 

Counterparty credit risk.............................................................................................. 78 

Pro-cyclicality of lending........................................................................................... 80 

3.5.1.  Underlying market failures and systemic aspects ...................................................... 81 

3.5.2.  Leverage and lending cyclicality ............................................................................... 83 

3.6. 

Options, discretions and minimum harmonisation .................................................... 85 

3.6.1.  Current framework ..................................................................................................... 85 

3.6.2.  Policy context: the new EU financial architecture..................................................... 86 

3.6.3.  Scope of the exercise.................................................................................................. 87 

3.6.4.  Problems stemming from diverging national rules .................................................... 88 

3.6.5.  Further problems stemming from treatment of divergences at consolidated level .... 89 

3.7. 

3.8. 

Risks inherent in baseline scenario ............................................................................ 91 

Is action necessary at EU level?................................................................................. 91 

60 

 
 
 
4. 

5. 

Objectives................................................................................................................... 93 

Policy options: analysis and comparison ................................................................... 96 

5.1. 

Liquidity risk.............................................................................................................. 97 

5.1.1.  Liquidity Coverage Ratio........................................................................................... 97 

5.1.2.  Net Stable Funding Ratio ......................................................................................... 104 

5.2. 

5.3. 

5.4. 

5.5. 

5.6. 

5.7. 

5.8. 

Eligibility of capital instruments and application of regulatory adjustments .......... 108 

Counterparty credit risk............................................................................................ 115 

Leverage................................................................................................................... 119 

Capital buffers.......................................................................................................... 122 

Single rule book in banking ..................................................................................... 126 

Choice of policy instrument ..................................................................................... 131 

Cumulative impact of the package........................................................................... 133 

5.8.1.  Package of preferred options and relevant transitional provisions .......................... 133 

5.8.2.  Cumulative impact on the industry .......................................................................... 134 

5.8.3.  Administrative costs................................................................................................. 136 

5.8.4.  Economic impact in transitional period ................................................................... 137 

5.8.4.1.  Four-year implementation period............................................................................. 137 

5.8.4.2.  Eight-year implementation period ........................................................................... 138 

5.8.4.3.  Optimum implementation period ............................................................................. 140 

5.8.5.  Long-term economic impact .................................................................................... 142 

5.9. 

Impacts on SMEs ..................................................................................................... 144 

6. 

Monitoring and evaluation ....................................................................................... 147 

61 

 
 
 
1. 

INTRODUCTION 

The  extent  of  the  financial  crisis  has  exposed  unacceptable  risks  pertaining  to  the  current 
regulation of financial institutions and markets. These risks proved substantial and systemic in 
times of serious turbulence. According to the IMF123 estimates, between 2007 and 2010 crisis-
related writedowns and loan provisions on bank assets originated globally reach $2.3 trillion, 
roughly half of which (or $1.3 trillion, equivalent to 8% of the EU GDP) is now attributable 
to European banks. The crisis which started in the financial sector plunged the EU economy 
in a severe recession, with the EU GDP contracting by some 5.7% or €0.7 trillion in 2009. 

In  order  to  restore  confidence  and  stability  in  the  banking  sector  and  ensure  that  credit 
continues  to  flow  to  the  real  economy,  both  the  EU  and  its  Member  States  (MS)  adopted  a 
broad range of unprecedented measures with the taxpayer ultimately footing the bill of global 
rescue  and  recapitalization  initiatives.  In  this  context,  between  October  2008  and  October 
2010 the European Commission (Commission) has approved €4.6 trillion (equivalent to 39% 
of  the  EU  GDP)  of  state  aid  measures124  to  financial  institutions  of  which  more  than  €2 
trillion  were  effectively  used  in  2008  and  2009.  Combined  with  fiscal  measures  aimed  at 
pulling  EU  economies  out  of  the  recession,  supportive  measures  to  the  banking  industry 
contributed  to  higher  budget  deficits  and  pushed  sovereign  indebtedness  levels  up.  This 
intensified markets' perception of rising sovereign risks, imposing second-round costs on the 
EU Member States' fiscal stance and ultimately constraining economic policy options in the 
medium term. 

The  unprecedented  level  of  fiscal  support  to  banks  needs  to  be  matched  with  a  robust  and 
internationally coordinated reform addressing the regulatory shortcomings exposed during the 
crisis.  In  recognition  of  these  regulatory  weaknesses,  the  Commission  already  proposed 
certain  amendments  to  bank  regulation,  revising  capital  requirements  for  securitization 
positions and provisions on home-host supervisory issues and crisis arrangements in October 
2008125 (CRD II) as well as amendments to capital requirements for the trading book and for 
re-securitizations,  and  to  the  supervisory  review  of  remuneration  policies  in  July  2009126 
(CRD III).  

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  pro-cyclicality  are  more 
effectively  contained,  additional  internationally  coordinated  changes  to  the  EU  capital  and 
liquidity  regulation  of  banks  are  needed.  Such  changes  would  provide  for  restoring 
businesses'  and  citizens'  trust  in  financial  institutions  as  reliable  and  resilient  intermediaries 

123 IMF, Meeting New Challenges to Stability and Building a Safer System (Global Financial Stability Report), 

April 2010 

124 Measures comprise €3.5 trillion of guarantees, €156 billion of other liquidity and bank funding support, €546 

billion of approved state recapitalisations and €402 billion of asset relief 

125 Consisting of a Directive 2009/111/EC of the European Parliament and of the Council of 16 September 2009 
amending  Directives  2006/48/EC,  2006/49/EC  and  2007/64/EC  as  regards  banks  affiliated  to  central 
institutions,  certain  own  funds  items,  large  exposures,  supervisory  arrangements,  and  crisis 
management,  Commission  Directive  2009/27/EC  of  7  April  2009  amending  certain  Annexes  to 
Directive  2006/49/EC,  and  Commission  Directive  2009/83/EC  of  27  July  2009  amending  certain 
Annexes to Directive 2006/48/EC  

126  Directive  2010/76/EU  of  the  European  Parliament  and  of  the  Council  of  24  November  2010  amending 
Directives 2006/48/EC and 2006/49/EC as regards capital requirements for the trading book and for re-
securitisations, and the supervisory review of remuneration policies 

62 

 
 
 
                                                 
for translating their deposits into productive investment that is key for the long-term health of 
the EU economy.  

2. 

PROCEDURAL ISSUES AND STAKEHOLDER CONSULTATION 

2.1. 

Stakeholder consultation 

Throughout the project the Commission services have closely followed and participated in the 
work  of  international  forums,  particularly  the  Basel  Committee127  and  its  various  working 
groups in charge of developing policy proposals in individual areas of the proposal. 

The  European  Banking  Committee  (EBC)  and  the  Committee  of  European  Banking 
Supervisors  (CEBS)  –  the  committees  of  the  Lamfalussy  process  -  have  been  extensively 
involved and consulted throughout the project as well and their views have contributed to the 
preparation of this impact assessment and the proposal that it accompanies. Consultative work 
with other stakeholder groups has been conducted in part through these committees.  

2.1.1.  CEBS 

2.1.1.1.  EU Quantitative Impact Study 

In November 2009, the Commission invited CEBS to conduct a comprehensive quantitative 
impact  study  (QIS)  on  the  impact  of  the  legislative  proposal  that  this  impact  assessment 
accompanies  on  the  EU  banking  industry.  246  banks  from  21  member  countries  of  CEBS 
participated in the study, including 50 Group 1128 banks and 196 Group 2 banks (see Table 1). 
The  analyses  were  performed  based  on  data  at  consolidated  group  level  as  of  31  December 
2009, i.e., subsidiaries of European banks were excluded to avoid double counting. The total 
capital  of  participating  banks  amounted  to  €1,464  billion  which  represents  approximately 
70%  of  the  consolidated  European  banking  sector.  In  total,  all  50  EU  Group  1  banks 
participated in the QIS. The coverage of Group 2 banks was lower: 4%, or 196 of more than 
4,500  Group  2  banks  participated,  representing  38%  of  the  risk  weighted  assets  (RWAs)  of 
Group  2  banks  of  the  participating  countries.  Importantly  for  the  interpretation  of  the  data, 
almost all participating countries indicated that the submitted Group 2 data is representative 
of their Group 2 bank population. 

Table 1: Participation of Group 1 and Group 2 banks in the EU QIS 
EL 

HU 

DK 

NO 

AT 

DE 

LU 

NL 

BE 

FR 

PL 

IE 

IT 

FI 

PT 

SI 

ES 

SE 

UK 

EU 

4 

5 

14 

18 

Bank 
count 
Note: Due to confidentiality concerns data for CY and CZ have been omitted while the number of their banks reflected in the 
EU total. 
Source: CEBS 

246 

13 

11 

78 

22 

22 

5 

9 

4 

7 

3 

1 

8 

7 

2 

6 

127  The  Basel  Committee  on  Banking  Supervision  consists  of  central  bank  and  supervisory  authority 
representatives  from  twenty  seven  countries.  Nine  EU  Member  States  are  represented  –  Belgium, 
France, Germany, Italy, Luxembourg, the Netherlands, Spain, Sweden, and the UK. The other countries 
represented  are  Canada,  Japan,  Switzerland,  the  US  and,  from  2009,  Argentina,  Australia,  Brazil, 
China,  Hong  Kong,  India,  Indonesia,  Korea,  Mexico,  Russia,  Saudi  Arabia,  Singapore,  South  Africa 
and  Turkey.  The  European  Commission,  along  with  the  European  Central  Bank,  participates  as  an 
observer in the Committee and in its working groups. 

128  Group  1  banks  are  those  that  have  Tier  1  capital  in  excess  of  €3  billion,  are  well  diversified,  and  are 

internationally active. All other banks are considered Group 2 banks 

63 

 
 
 
 
                                                 
According to ECB129, in 2009, total assets of credit institutions in the EU27 reached €42,144 
billion (for more on the economic and financial importance of the banking sector in Europe, 
see Annex II). A significant share thereof is owned by Group 1 banks. Given differences as 
regards  their  size,  nature  of  activities,  risk  profile  and  risk  management  approaches,  results 
from  the  EU  QIS  throughout  this  impact  assessment  report  are  used  separately  for  Group  1 
and Group 2 banks, and cumulative impact on the EU industry, where necessary, is estimated 
by  applying  extrapolation.  Please  note  that  EU-level  averages130  and  totals,  when  quoted  in 
the  impact  assessment,  may  include  NO  banks.  Importantly,  MS-level  averages  and  totals 
have  been  anonymized  randomly  on  request  of  the  MS  participating  in  the  QIS  in  order  to 
preserve  confidentiality  of  results,  yet  still  presented  in  the  report  to  illustrate  distributional 
effects of the new rules. 

2.1.1.2.  Work on national options and discretions 

In  the  area  of  national  options  and  discretions,  CEBS  played  a  key  role  as  a  source  of 
technical  expertise.  The  committee's  work  was  carried  out  in  response  to  the  Commission's 
calls  for  advice  of  March  2007.  CEBS'  technical  advice  was  received  in  October  2008131, 
following extensive public consultation of the draft advice.  

The industry was consulted by CEBS as part of the preparation of its technical advice, which 
included an ad hoc joint  CEBS-industry expert group.132 The position of the industry on all 
national  options  and  discretions  is  available  on  CEBS  web  site.133  Twenty  responses  were 
received  to  the  public  consultation.  In  the  view  of  most  respondents  of  the  industry,  in  line 
with the objective of a single market, all national options and discretions should be removed. 
However, certain respondents stressed that there are also some cases where the existence of 
local market conditions or legislative specificities justify the adoption of different approaches 
so that certain options and national discretions should be maintained.  

2.1.2.  CRD Working Group 

In the area of national options and discretions, the Commission services held six meetings of 
the  CRD  Working  Group  (CRDWG),  whose  members  are  nominated  by  the  EBC,  in 
December  2008,  March  and  April  2009,  October  2010,  and  February  and  March  2011.  The 
group worked on preparing a single rule book in the EU, considering the technical advice of 
CEBS and the potential removal of the remaining options which was not suggested by CEBS. 
For a detailed list of provisions analysed by the CRDWG, please refer to Annex II.  

Other  parts  of  the  proposal  were  discussed  by  the  CRDWG  in  June  and  October  2010,  and 
February and March 2011. It shall be noted that working sub-groups of the CRDWG in the 
areas of liquidity, capital definition, leverage ratio, counterparty credit risk and capital buffers 
have  also  been  established  in  2010  to  conduct  work  at  even  more  technical  level  and  to 
develop legislative drafts in the respective areas. 

129 ECB, EU Banking Structures, September 2010 
130  Unless  noted  otherwise,  averages  were  calculated  by  creating  a  composite  bank  at  a  country  and  a  total 

sample level which means that all country and total sample averages effectively are weighted averages 
131  See  http://www.c-ebs.org/getdoc/354c6e4c-f22a-46a0-9025-0c55f460a5a6/2008-17-10-Final-Advice-on-

options-and-national-di.aspx  

132 See http://www.c-ebs.org/getdoc/1d48fde8-6672-4df5-a526-b406472c6af2/National-Discretions.aspx  
133 See http://www.c-ebs.org/getdoc/5d174851-eb98-4a34-a542-6ab9b6f89eaa/CP18.aspx  

64 

 
 
 
                                                 
2.1.3.  Other public consultations 

The preparatory work related to the CRD IV legislative proposal started already in summer of 
2009  when  the  Commission  services  conducted  a  first  public  consultation134  on  the  latest 
wave of possible amendments to the CRD. This was followed by another public consultation 
that ran from February to April of 2010135 that included a second round of questions on the 
'single  rule  book'  as  well  as  consulting  on  a  list  of  potential  policy  measures  pertaining  to 
liquidity  and  counterparty  credit  risk  management,  definition  of  capital,  leverage  ratio, 
conservation  and  countercyclical  capital  buffers  and  appropriate  treatment  of  systemically 
important financial institutions. A third public consultation elaborating on the possible design 
of the countercyclical capital buffer ran from October to November 2010.136 A fourth public 
consultation  on  capital  requirements  for  certain  types  of  counterparty  credit  risk  was 
conducted in February – March 2011.137 

Responses to these consultations constitute an important source of data and key stakeholder 
views  as  regards  the  impacts  and  effectiveness  of  potential  policy  measures  outlined  in  the 
consultation. Feedback to the public consultations included calls for assessing implications of 
certain  important  aspects  of  the  proposal.  These  aspects  include  implementation  dates  and 
phase-in  of  new  rules,  grandfathering  of  existing  provisions  and  cumulative  impact  of 
individual measures of the package on the industry, the economy and the financial stability. 

Also,  on  26  April  2010  the  Commission  services  conducted  an  open  public  hearing  on  the 
CRD  IV  proposal.  The  event  was  open  to  all  stakeholders  who  have  responded  to  the 
consultation of February 2010 and actively attended by all the stakeholder groups, including 
industry, regulators, supervisors, non-financial companies, international organisations. 

2.1.4.  Consultations with the industry 

In  addition,  the  Commission  services  conducted  separate  extensive  consultations  with  the 
industry,  including  the  Group  of  Experts  in  Banking  Issues  (GEBI),  various  EU  banking 
industry associations and individual banks. 

A  number  of  policy  measures  with  a  potentially  material  impact  on  the  industry,  such  as 
treatment  of  deferred  tax  assets  and  of  minority  interests,  and  design  of  new  liquidity 
requirements, as well as industry's assessment of costs and benefits of the entire package were 
discussed  by  the  GEBI  members  at  the  Group's  meetings  in  April  and  October  2010.  In 
August  –  September  2010,  the  GEBI  was  invited  to  provide  input  into  assessment  of 
administrative burdens related to the CRD IV (see Annex VIII). 

2.2. 

Consultation with other services of the Commission 

2.2.1. 

Inter-service Steering Group 

An Inter-Service Steering Group (ISSG) was set up to follow progress and feed in views from 
other services of the Commission, including Directorates-General for Enterprise and Industry, 
Economic  and  Financial  Affairs,  Taxation  and  Customs  Union,  Health  and  Consumers, 
Competition, Legal Service, and Secretariat General. Experts from the Directorate-General for 

134 See http://ec.europa.eu/internal_market/consultations/2009/capital_requirements_directive_en.htm  
135 See http://ec.europa.eu/internal_market/consultations/2010/crd4_en.htm  
136 See http://ec.europa.eu/internal_market/consultations/2010/capitalbuffer_en.htm  
137 See http://ec.europa.eu/internal_market/consultations/2011/credit_risk_en.htm 

65 

 
 
 
                                                 
Economic and Financial Affairs contributed to this impact assessment by conducting analysis 
of  implications  of  the  proposal  on  the  macro-financial  stability  and  of  macro-economic 
impacts  during  a  transitional  period  (see  Annex  IX).  The  ISSG  met  four  times  in  June  - 
September 2009 and five times in January – October 2010. 

3. 

PROBLEM DEFINITION 

3.1. 

Background 

Capital  requirements  rules  stipulate  the  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.  

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  MS.  The  current  EU  bank 
capital  framework  is  represented  by  the  Capital  Requirements  Directive  (CRD)  comprising 
Directives 2006/48/EC and 2006/49/EC and reflecting the proposals of the Basel Committee 
for  the  Basel  II  Framework138  (Basel  II)  and  Trading  Book  Review139.  It  covers  both  credit 
institutions and investment firms. 

With the adoption of the CRD, capital requirements became more comprehensive140 and risk 
sensitive141. 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. 

138 See http://www.bis.org/publ/bcbs107.htm  
139 See http://www.bis.org/publ/bcbs116.htm  
140 Rules were expanded to cover 'operational' risk, e.g., the risk of systems breaking down 
141  Rules  include  a  possibility  for  institutions  to  adopt  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 approach enabled institutions to determine capital requirements for credit risk of 
their portfolios, by using their own ‘risk inputs’ such as probability of default and loss given default. 
The  calculation  of  these  risk  inputs  was  made  subject  to  a  strict  set  of  operational  requirements  to 
ensure that they are robust and reliable. 

66 

 
 
 
                                                 
The  financial  crisis  has  unveiled  a  number  of  shortcomings  of  Basel  II  and  necessitated 
unprecedented levels of public support in order to restore confidence and stability (see Chart 
1).  This  prompted  a  broad  EU  and  international  effort  to  identify  the  reasons  behind  the 
problems and to develop effective policies to tackle them head-on.  

Chart 1: Public capital injections in the banking sector, in % of 2009 GDP 

Total approved injections

Effective capital injections 

8

7

6

5

4

3

2

1

0

IE LU BE NL UK DK DE AT LV EU EL FR IT SE HU PT FI

PL SK

Source: European Commission 

As  part  of  its  efforts  to  deal  with  the  financial  crisis,  already  in  November  2008,  the 
Commission  mandated  a  High  Level  Group  (HLG)  chaired  by  Mr.  Jacques  de  Larosière  to 
propose  recommendations  for  reforming  the  European  financial  supervision  and  regulation. 
The thirty one recommendations142 of the HLG represented a comprehensive set of concrete 
possibilities for regulatory143, supervisory and global repair action and were elaborated in the 
Commission's Communication144 for the spring European Council of 4 March 2009.  

Most  of  the  proposals  that  this  impact  assessment  accompanies  and  the  amendments  to  the 
CRD  (CRD  III)  already  adopted  by  the  Commission  in  July  2009  are  listed  in  the  detailed 
action  plan  included  in  the  Communication.  Such  'phased'  approach  to  revising  the  current 
rules reflects the balance between, on the one hand, a necessity to swiftly tackle the problems 
that  transpired  during  the  crisis  and  restore  the  financial  stability,  and,  on  the  other  hand, 
given  the  level  of  integration  within  the  global  financial  system,  reaching  an  international 
consensus  on  measures  that  would  be  effective  in  containing  the  problems  identified  (see 
Table  2  for  more  details  on  the  three  waves  of  the  CRD  amendments).  With  respect  to  the 
latter,  the  G-20  Declaration  of  2  April  2009  on  Strengthening  of  the  Financial  System145 
conveyed  the  commitment  of  the  global  leaders146  to  address  the  crisis  with  internationally 
consistent efforts that are aimed at strengthening transparency, accountability and regulation 
by, among others, improving the quantity and quality of capital in the banking system once 
the  economic  recovery  is  assured,  introducing  a  supplementary  non-risk  based  measure  to 
contain the build-up of leverage in the banking system, developing a framework for stronger 

142 See http://ec.europa.eu/internal_market/finances/docs/de_larosiere_report_en.pdf  
143 Recommendations called for the Basel Committee to urgently amend rules with a view to gradually increase 
capital  requirements,  reduce  their  pro-cyclical  impacts  and  tighten  norms  for  liquidity  management. 
They also called for EU to adopt and confirm with the Basel Committee a common definition of own 
funds  clarifying  whether  and  to  what  extent  hybrid  capital  instruments  should  be  counted  as  Tier  1 
capital. 

144 See http://ec.europa.eu/commission_barroso/president/pdf/press_20090304_en.pdf  
145 See http://www.g20.org/Documents/Fin_Deps_Fin_Reg_Annex_020409_-_1615_final.pdf  
146 European leaders expressed their support for these measures at the European Council of 19-20 March 2009 

67 

 
 
 
                                                 
liquidity  buffers  at  financial  institutions  and  charging  FSB147,  the  Basel  Committee  and 
CGFS148,  while  working  with  accounting  rule  setters,  to  implement  the  recommendations149 
of FSB to mitigate the pro-cyclicality. 

In response to the mandate given by the G-20, in September 2009 the Group of Central Bank 
Governors  and  Heads  of  Supervision  (GHOS),  the  oversight  body  of  the  Basel  Committee, 
agreed150 on a number of measures to strengthen the regulation of the banking sector. These 
measures were endorsed by the FSB and the G-20 leaders at their Pittsburgh Summit of 24-25 
September  2009151  and  were  fleshed  out  in  detail  and  made  available  for  stakeholder 
comments in two consultation documents in December 2009152. In February – April 2010 the 
Commission conducted a parallel public consultation within the EU, going beyond the set of 
measures covered by the documents of the Basel Committee.  

In  December  2010,  the  Basel  Committee  issued  detailed  rules  of  new  global  regulatory 
standards  on  bank  capital  adequacy  and  liquidity  that  collectively  are  referred  to  as  Basel 
III.153 The proposal that this impact assessment accompanies directly relates to the standards 
covered by Basel III.  

The following sub-sections present analysis of main problems and drivers underlying them for 
the CRD areas under review in this proposal. Problem drivers are identified  in italics and a 
'problem tree' is included at the end of the section. 

Table 2: Three 'waves' of the CRD amendments by the Commission 2008 - 2011 
Timing of 
proposals 

Major CRD provision areas 
changed 

Justification / key objectives 

October 2008 

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 

Derogations for bank networks from 
certain prudential requirements 

Revision of treatment of life insurance as 
eligible collateral 

Area 'left open' at the time of the CRD adoption in 2006 

Inconsistency identified in the CRD transposition process 

147 The Financial Stability Board was convened in April 1999 to promote international financial stability through 
information exchange and international co-operation in financial supervision and surveillance. It brings 
together  national  authorities  responsible  for  financial  stability  in  significant  international  financial 
centres,  international  financial  institutions,  sector-specific  international  groupings  of  regulators  and 
supervisors,  and  committees  of  central  bank  experts.  FSB  seeks  to  co-ordinate  the  efforts  of  these 
various bodies in order to promote international financial stability, improve the functioning of markets, 
and reduce systemic risk. 

148 The Committee on the Global Financial System (CGFS), monitors developments in global financial markets 

149  The 

for the central bank Governors of the G10 countries  
on  Addressing 

report 

FSB 

of 

the 

System 
(http://www.financialstabilityboard.org/publications/r_0904a.pdf  )  set  out  fifteen  recommendations  to 
mitigate mechanisms that amplify procyclicality by covering three areas: bank capital framework, bank 
loan loss provisions as well as leverage and valuation issues. The proposal that this impact assessment 
accompanies directly relates to a number of recommendations issued by the FSB.  

Procyclicality 

Financial 

the 

in 

150 See http://www.bis.org/press/p090907.htm  
151 See http://www.g20.org/Documents/pittsburgh_summit_leaders_statement_250909.pdf  
152 See http://www.bis.org/publ/bcbs164.htm, http://www.bis.org/publ/bcbs165.htm  
153 See http://www.bis.org/publ/bcbs189.htm, http://www.bis.org/publ/bcbs188.htm  

68 

 
 
 
                                                 
Timing of 
proposals 

Major CRD provision areas 
changed 

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

Justification / key objectives 

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 

June 2011 

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 

Enhancing and harmonizing requirements 
for liquidity risk management  

Revision and harmonization of definition 
of capital rules, regulatory adjustments 

Revision of capital requirements for the 
counterparty credit risk 

Introduction of a supplementary non-risk 
based measure to contain leverage 

Introduction of capital buffers  

Single rule book in banking  

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 

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 

Making supervisory rules more consistent by reducing number of national options and 
discretions to provide for reduction of compliance burden and enhanced level playing field 

3.2.  Management of liquidity risk 

The  global  financial  crisis  that  started  in  summer  of  2007  has  evidenced  the  crucial  role  of 
interacting  market  and  funding  liquidity  for  the  banking  sector.  It  brought  to  light 
shortcomings  of  current  liquidity  risk  management,  including  stress  testing  exercises  of 
institutions  and  asset  and  liability  maturity  mismatches,  and  evidenced  the  need  to  review 
banking  supervisors'  approach  to  liquidity  risk  management.  Structured  products  and 
interbank  market  operators  suffered  liquidity  constraint,  eventually  leading  to  drying  out  of 
liquidity, resulting in choking balance sheets of banks. The inability to mobilize resources led 
to a severe liquidity constraint on some banks, pressing central banks in providing emergency 
liquidity  support.  The  propagation  of  the  crisis  from  certain  structured  products  to  mature 
financial  markets  through  the  interplay  of  balance  sheets  and  exposure  to  credit  risk 
highlighted  the  connection  between  market  liquidity  risk  and  funding  liquidity  risk,  and  the 
vulnerability of banks' balance sheet to liquidity risks.  

Funding  liquidity  risk  arises  because  inflows  and  outflows  of  funds  at  banks  are  not 
synchronised.  A  bank  is  deemed  to  be  liquid  as  long  as  at  each  point  in  time  outflows  of 
liquidity  are  smaller  or  equal  to  the  sum  of  inflows  and  the  bank’s  stock  of  liquidity. 
Therefore, it should manage its liquidity risk with a view to ensure that the above constraint is 
never breached. However, the existing liquidity risk management approaches, including stress 
tests, and supervisory regimes were shown to be inadequate in fully grasping risks inherent to 
the underlying market practices such as (i) originate-to distribute securitization; (ii) reliance 
on  wholesale  funding  with  short  term  maturity  instruments;  (iii)  proliferation  of  complex 
financial  instruments  with  underestimated  underlying  risks.  Also,  assumptions  pertaining  to 
(iv)  asset  market  liquidity,  as  well  as  (v)  interaction  between  market  liquidity  and  funding 
liquidity  turned  out  to  had  been  erroneous  while  (vi)  behavioural  aspects  of  financial 
institutions played an immense role in the course of the crisis. These factors contributed to a 
demise  of  several  financial  institutions  and  strongly  undermined  health  of  many  others, 
threatening the financial stability and necessitating unprecedented levels of public sector (see 

69 

 
 
 
Chart 1) and central bank liquidity support (for the extent of the ECB liquidity support since 
2007 see Chart 2). They are analysed in more detailed below. 

Chart 2: ECB loans to the euro area credit institutions and deposits of euro area credit 
institutions with the ECB, 10-day moving average in € billion, January 2007 – June 2010 

1.000

800

600

400

200

500

375

250

125

0

01/2007

04/2007

07/2007

10/2007

01/2008

04/2008

07/2008

10/2008

01/2009

04/2009

07/2009

10/2009

01/2010

04/2010

Loans to banks (lhs)

Deposits by banks (rhs)

Sources: ECB, European Commission services' calculation 

  i.  Securitization  was  used  widely  by  financial  institutions  to  expand  funding  sources  and 
create additional balance sheet capacity. As the process of pooling assets, selling them to a 
special  purpose  vehicle,  obtaining  credit  ratings  and  issuing  securities  takes  time,  market 
stress  during  this  timeframe  resulted  in  banks  having  to  warehouse  and,  therefore,  fund 
assets  for  longer  than  planned:  according  to  the  ESF,  in  2008,  95%  of  all  European 
securitization issuance was retained by banks (and used for repo with the ECB and the Bank 
of England) with primary issuance market effectively closed due to significantly diminished 
investor appetite for these instruments.154  

  ii.  In  the  run-up  to  the  crisis,  many  financial  institutions  have  increasingly  turned  to  the 
capital  markets  for  funding  their  own  operations  as  well  as  those  of  related  entities  with 
instruments of shorter maturity and became more reliant on wholesale funding sources such 
as commercial paper, repurchase agreements ('repos'), and interbank markets. Events during 
the crisis illustrated clearly that during times of market stress investors exhibit heightened 
risk  aversion  by  demanding  higher  compensation  for  risk,  requiring  banks  to  roll  over 
liabilities at considerably shorter maturities or refusing to extend financing altogether. Some 
forms  of  securitization  such  as  off-balance  sheet  structured  investment  vehicles  and 
conduits raised funds by selling asset backed commercial paper (ABCP) of average maturity 
of 90 days while the assets backing it typically comprised pools of loans, mainly mortgages. 
To  ensure  funding  liquidity  of  such  off-balance  sheet  vehicles,  'sponsoring'  banks 

154 European Securitisation Forum, ESF Securitization Data Report, Q4 2008 

70 

 
 
 
 
 
                                                 
committed  to  provide  a  credit  line,  the  so-called  'liquidity  backstop',  effectively  exposing 
themselves  to  liquidity  risk  pertaining  to  maturity  mismatch  of  these  entities.  When 
investors, following the spike in sub-prime mortgage defaults became concerned about the 
value  of  structured  products  and  lost  confidence  in  the  reliability  of  their  ratings,  their 
appetite  for  ABCP  evaporated  and  banks  sponsoring  these  vehicles  were  called  upon  to 
provide liquidity. As banks had to fulfil such contingent asset funding commitments, some 
of  them  ran  into  funding  difficulties.  In  July  2007,  IKB,  a  German  bank  was  unable  to 
service a liquidity guarantee of €8.1 billion it had provided to its Rhineland Funding conduit 
and the state-owned development bank that owned 38% of the IKB took over the liquidity 
facility  committed  to  Rhineland  Funding.155  Other  European  banks  had  also  to  provide 
liquidity to their ABCP conduits to varying degrees.156 Additional liquidity needs were also 
created when institutions felt compelled to provide support to affiliated investment vehicles 
even when there was no contractual obligation to do so, since they perceived that a failure to 
do so would impact their reputation adversely. For instance, in June 2007 Bear Stearns, a 
large US investment bank, in order to protect its reputation, injected $3.2 billion into two of 
its  hedge  funds  that  had  trouble  meeting  margin  calls  due  to  losses  on  asset  backed 
securities (the two funds filed for bankruptcy protection shortly thereafter).  

  In addition to the commercial paper, financial institutions extensively used other wholesale 
funding  sources  such  as  repo  and  interbank  markets.  Repos  allow  institutions  to  obtain 
typically  short-term  funding,  under  the  condition  of  periodic  margin  calls,  mobilizing 
resources entailing opportunity costs.157 Recent changes in risk management practices made 
such  transactions  more  sensitive  to  liquidity  risk:  margin  calls  were  made  on  a  daily  or 
intraday  basis  compared  to  weekly  or  monthly  ten  years  ago  and  re-use  of  collateral  had 
notably  increased.  While  the  use  of  collateral  was  aimed  at  mitigating  counterparty  credit 
risk,  it  gave  rise  to  funding  liquidity  risk  when  counterparties  had  to  provide  additional 
collateral  on  short  notice  due  to  changes  in  market  price  and  in  response  to  increased 
haircuts,  reflecting  deteriorated  market  liquidity,  asset  quality  and  their  own  counterparty 
risk. Moreover, financial institutions and investment banks in particular increasingly relied 
on overnight repos, effectively requiring them to roll over a significant part of their funding 
on  a  daily  basis.  Bear  Sterns  failed  in  March  2008  once  it  found  itself  unable  to  secure 
funding on the repo market and was subsequently taken over JPMorgan Chase, in a deal that 
effectively  wiped  out  its  shareholders  value.  Lehman  Brothers,  another  investment  bank, 
filed for bankruptcy in September 2008, in part because of difficulties in addressing similar 
funding liquidity-related problems. 

  iii.  The  use  of  derivative  instruments  of  ever  increasing  complexity  created  additional 
challenges  for  management  of  liquidity  risk.  Predicting  their  cash  flows  and  correlations 
with other financial assets in times of stress proved to be difficult. AIG, largest insurer in 
the  world,  suffered  from  a  liquidity  crisis  when  its  credit  ratings  were  downgraded  below 
"AA" levels in September 2008.158 As AIG was active in underwriting derivatives insuring 
mortgage  backed  securities,  the  credit  rating  downgrade  imposed  that  it  posts  additional 

155  IKB  also  received  a  rescue  package  of  some  €3.5  billion  from  German  government  and  private  and  state 

sector banks to cover potential losses from structured investments it had made 

156  E.g.,  HBOS  provided  liquidity  support  to  its  Grampian  programme  that  had  some  $36  billion  commercial 

paper outstanding 

157 Formally, the collateral is sold to the lender, subject to an agreement to repurchase it at an agreed price and 

moment in time 

158  This  risk  materialised  once  on  September  15,  2008  S&P  and  Moody's  downgraded  AIG  long-term  credit 
ratings by three and two notches, respectively, among other justifications citing 'reduced flexibility in 
meeting additional collateral needs'. 

71 

 
 
 
                                                 
collateral. Fearing contagion to the rest of the market through balance sheet interplay, the 
US government bailed AIG out with support reaching some $180 billion by end-2009.  

  iv. Assumptions pertaining to asset market liquidity were another source behind the recent 
funding  shock.  Financial  institutions  can  satisfy  their  liquidity  needs  by  selling  assets  or 
hypothecating  them.  If  asset  markets  are  liquid,  assets  can  be  sold  at  their  fair  value  or 
hypothecated  at  low  haircuts.  However,  because  of  their  nature,  banks’  assets  have  to  a 
large  extent  a  potential  to  become  illiquid,  in  particular  in  stressed  conditions,  when  they 
can only be sold at a discount or hypothecated at much higher haircuts. This is in particular 
true  for  complex  instruments  that  were  not  actively  traded  among  a  large  number  of 
participants which made assessing their price and secondary market liquidity challenging as 
more and more parties withdrew from the relevant markets. Financial institutions had made 
overly  optimistic  assumptions  about  the  asset  market  liquidity  of  certain  structured 
products,  such  as  asset  backed  securities  and  loan  books.  They  had  often  assumed 
continuous high liquidity of these markets, and indeed some had treated loan securitisation, 
asset backed securities held on balance sheet and ABCP programs as very resilient sources 
of  liquidity  in  the  event  of  funding  difficulties,  not  anticipating  that  the  liquidity  of  such 
markets may disappear.  

  v.  Many  financial  institutions  also  underestimated  the  extent  of  a  vicious  feedback  loop 
between market liquidity and funding liquidity. Rising arrears on US sub-prime mortgages 
that  were  extensively  packaged  in  residential  mortgage-backed  securities  caused  investors 
to  lose  faith  in  the  ratings  of  structured  securities  and  led  to  heightened  concerns  about 
accuracy  of  their  valuation.  The  loss  of  investor  confidence  in  a  wide  range  of  structured 
securities was transmitted through a fall in their price as market liquidity for such securities 
evaporated. This led to an increase in funding risk as margins and haircuts related to these 
securities  increased,  which,  in  turn,  forced  additional  deleveraging  and  selling,  effectively 
creating  a  vicious  circle  between  deteriorating  market  liquidity  and  disappearing  funding 
liquidity. Also, as long as the institution's solvency is unquestioned, it will find it relatively 
easy to obtain credit on a secured or even unsecured basis. However, as many banks held 
large  positions  in  difficult-to-value  and  potentially  impaired  securities,159  concerns  about 
their solvency arose that aggravated further banks funding difficulties, as discussed below. 

  vi. The flow of funds between banks was determined not only by contractual relationships, 
which have been formed prior to the crisis, but also by endogenous behavioural reactions of 
banks.  In  stressed  conditions,  institutions  with  a  liquidity  surplus  tend  to  refrain  from 
lending in the interbank market because of precautionary hoarding of liquidity for their own 
potential  liquidity  needs.  In  fact,  as  of  August  2007  money  markets  tightened  as  banks 
started  hoarding  liquidity,  as  explained  above,  to  meet  contingent  claims  with  respect  to 
their  off-balance  sheet  vehicles  and  conduits,  meet  margin  calls  on  repo  and  derivative 
transactions,  or  to  better  position  themselves  against  possible  funding  shortfalls.  Such 
behaviour was further intensified due to a lack of understanding about the level of exposure 
to difficult-to-value and potentially impaired assets and, in relation to this, financial health 
of other institutions. The combination of these factors made banks reluctant to lend funds to 
each other, as evidenced by TED160 spread (see Chart 3). These concerns prompted banks in 

159  Notably,  structured  securities  the  value  of  which  depends  on  underlying  assets  that  may  not  be  fully 

transparent to the public 

160 The difference between the three-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.  It  is  a  widely  used  proxy  to  measure  the  liquidity  in  the  interbank 
market because, at times of uncertainty, it reflects both the fact that banks charge higher interest rate to 

72 

 
 
 
                                                 
the euro area to park their short term liquidity with the ECB rather than engage in inter-bank 
lending  admittedly at higher rates (for dynamics of the euro zone banks' deposits with the 
ECB  see  Chart  2).  Absent  liquidity  on  the  interbank  market,  several  financial  institutions 
relying  on  wholesale  funding  faced  liquidity  tightening.  Mortgage  lender  Northern  Rock 
collapsed  in  September  2007,  following  a  first  wave  of  illiquidity  in  the  interbank  market 
that started a month before. Failures of Bradford & Bingley and HBOS in September 2008 
were also partially driven by their reliance on wholesale funding markets.161  

The  nature,  magnitude  and  duration  of  the  liquidity  shock  were  not  fully  anticipated  by  the 
financial  sector  and,  particularly,  by  banks  that  had  been  aggressive  in  leveraging  their 
balance  sheets  and  reliance  on  inter-bank  funding.  The  shock  underscored  shortcomings  in 
liquidity  risk  management,  including  stress  testing  exercises,  of  institutions  as  risk 
management had focussed predominantly on firm-specific constraints and not enough on the 
implications  of  market-wide  disruptions  or  combinations  of  firm-specific  and  market-wide 
shocks.  While  higher  capital  levels  had  been  thought  to  allow  banks  to  absorb  unexpected 
losses and provide reassurance to markets, events of 2007-2008 demonstrated that even well 
capitalised banks faced serious liquidity problems, that had been precipitated in part by asset 
and liability maturity mismatches. These events illustrated how quickly and severely liquidity 
risks  can  materialise  and  certain  sources  of  funding  can  disappear,  compounding  concerns 
related to the valuation of assets, capital adequacy and financial stability in general.  

Chart 3: TED spread in percentage points, January 2007 – December 2008 

6,00

5,00

4,00

3,00

2,00

1,00

0,00

01/2007

04/2007

07/2007

10/2007

01/2008

04/2008

07/2008

10/2008

Sources: US Federal Reserve, European Commission calculation 

While interventions of central banks and deposit  guarantee schemes  can limit the impact of 
liquidity shocks, they raise the problem of moral hazard wherein banks may be insufficiently 
prudent  in  managing  their  liquidity  risk  ex-ante,  expecting  the  central  bank  to  provide  the 

each other for unsecured loans but also a reduction in T-bill rate as institutions increase their demand 
for collateral of the highest quality. 

161 According to Barclays Capital, over decade leading to the crisis, European bank wholesale funding as % of 
balance  sheet  has  increased  from  40%  to  70%,  while  the  simple  funding  gap  expressed  as  loans  less 
deposits has tripled from approximately $1 trillion to over $3 trillion. 

73 

 
 
 
                                                                                                                                                         
necessary  liquidity  in  times  of  stress.  Moreover,  the  crisis  also  confirmed  the  perceived 
‘stigma’ of borrowing from the central bank which led some institutions to withdraw lines and 
cut  exposures,  thus  exacerbating  rather  than  easing  of  funding  pressure  and  compromising 
effectiveness of central bank intervention. 

In recognition of the need for credit institutions to improve their liquidity risk management, 
the  CRD  was  amended  in  2009  to  include  minimum  qualitative  standards  for  institutions' 
liquidity risk management and the supervisory review of that risk management.162  However, 
these  amendments  fell  short  of  providing  for  harmonised  quantitative  standards,  thereby 
leaving regulatory standards in this important field un-harmonised while in the area of capital 
requirements,  both  a  quantitative  standard  and  qualitative  requirements  on  the  internal 
management  exist  in  European  legislation.  While  a  number  of  MS  impose  some  form  of 
quantitative  regulatory  standard  for  liquidity,  no  harmonised  sufficiently  explicit  regulatory 
treatment  on  the  appropriate  levels  of  short-term  and  long-term  liquidity  exists  at  the  EU 
level. There are differences in national liquidity regimes that arise from different degrees of 
resilience  to  liquidity  stress  that  different  MS  aim  at.  Linkages  to  certain  nationally 
determined factors such as insolvency regimes, deposit insurance arrangements, central bank 
credit and collateral policies or structure of the banking sector also play a role.  

Such  differences  in  national  liquidity  regimes  may  give  rise  to  potential  level-playing  field 
issues,  particularly,  for  firms  that  have  cross-border  operations.  As  regards  supervisory 
reporting,  diversity  in  current  national  approaches  imposes  additional  costs  on  cross-border 
institutions  and  hampers  effective  communication  and  cooperation  between  supervisory 
authorities.  In  addition  to  the  lack  of  comparability  of  national  reporting  frameworks, 
effectiveness  of  supervision  was  impacted  adversely  by  inadequate  timeliness  and  content, 
e.g.,  missing  off-balance  sheet  items,  of  supervisory  reports.  Finally,  the  absence  of  a 
harmonised liquidity regime leads to liquidity supervision being carved out from the principle 
of home country supervision over branches of credit institutions within the EU, whereas in all 
other  areas  of  prudential  rules,  a  level  of  harmonisation  has  been  reached  that  allows  credit 
institutions to exercise their freedom of establishment without their branches being subject to 
host country rules and supervision. 

3.3. 

Eligibility of capital instruments and regulatory adjustments 

The  EU  banking  system  entered  the  crisis  with  capital  of  insufficient  amount  and  quality. 
Mounting  losses  forced  banks  to  rebuild  their  capital  bases  at  the  time  when  it  was  most 
difficult to do so, in turn, necessitating governments to provide support to the banking sector 
in  many  countries  and  on  a  massive  scale  (see  Chart  1)  and  contributing  to  the  onset  of 
economic downturn. More specifically, the existing CRD provisions on definition of capital 
were shown to suffer from the following shortcomings: 

i.  Certain  capital  instruments  did  not  meet  the  expectations  of  markets  and  regulators  with 
regard to their loss absorption, permanence and flexibility of payments capacity on a going-
concern basis. This in particular pertains to the effectiveness in relation to the above three 
criteria of hybrid capital instruments (hybrids) and certain types of non-hybrid instruments 
that make part of 'original own funds'. The original CRD as adopted back in 2006 did not 
establish  an  EU  framework  for  the  recognition  of  hybrids  within  banks'  Tier  1  capital 
despite the fact that the criteria of loss absorption, flexibility of payments and permanence 
which are critical for determining an instrument's inclusion as a component of Tier 1 capital 

162 Directive 2009/111/EC amending Directive 2006/48/EC 

74 

 
 
 
                                                 
had been agreed at the G10 level and announced in the Sydney Press Release163 in 1998. As 
a  result,  several  MS  (non-members  of  G10)  did  not  have  a  regime  for  including  hybrids 
within Tier 1 capital, while supervisors in jurisdictions with such a regime had discretion to 
assess  whether  instruments  satisfy  the  criteria  agreed  at  the  G10  level.  This  shortcoming 
was largely addressed with the adoption of the CRD II that established a harmonised set of 
stringent  criteria  for  Tier  1  hybrid  capital164  and  introduced  explicit  limits165  on  different 
types  of  Tier  1  hybrid  capital,  such  as  convertible  capital,  innovative  hybrids  and  other 
hybrids. However, these provisions take effect only as of end 2010.  

  As  regards  the  flexibility  of  payments,  the  crisis  has  shown  that  when  these  instruments 
included  a  possibility  to  defer  or  cancel  a  dividend  (coupon)  to  enable  banks  to  conserve 
resources  during  difficult  times166,  such  possibility  was  not  widely  exercised.  This  was  in 
part driven by a stigma of dividend cancellation being interpreted by the market as a signal 
of distress. In fact, since banks routinely paid dividends on their common shares, they had 
to pay them on hybrids as well (so called 'dividend pusher' clause), as in most cases issuers 
of both bonds and equities must pay coupons on bonds before they pay dividends on shares. 
While supervisors have the authority under certain conditions to restrict dividend payments 
by  banks,  they  not  always  exercised  this  option  because  of  the  consideration  that  banks 
would find it difficult to raise additional capital if they cancelled or cut dividends/coupons. 
Also, bank creditors did not exercise an appropriate level of market discipline as they fully 
expected  that  due  payments  would  be  continually  made.  Effectively,  the  outflow  of 
dividends and coupons contributed to the weakening of the banking sector at the time when 
capital was most needed.  

  As  regards  permanence,  there  were  instances  of  banks  calling  hybrids  despite  the  higher 
cost  of  replacing  them  at  the  time  of  crisis.167  This  was  in  particular  true  when  market 
expectations were based on instrument's contractual terms that provide for a step-up in the 
interest  rate  if  call  is  not  exercised  which  effectively  made  such  hybrids  synthetically-
dated.168  Even  though  seemingly  in  the  interest  of  banks'  shareholders,  skipping  the  call 
options  (e.g.,  RBS,  Bradford  &  Bingley,  KBC  Group)  or  cancelling/deferring  coupon 
payments  (e.g.,  BayernLB,  Commerzbank,  Lloyds,  RBS,  Allied  Irish  Banks,  Bank  of 
Ireland, Cajasur) on hybrid capital – where banks had the discretion to suspend payments - 
became  more  prevalent  only  later  in  the  crisis,  in  the  context  of  state  aid  to  financial 

163 See http://www.bis.org/press/p981027.htm  
164 Article 63a 
165 Article 66; CRD II admits hybrids up to 50% of Tier 1 capital. 
166 According to CEBS, in 2006 only 19% of hybrids reported by EEA banks as Tier 1 capital did not have a 
right for the issuer to suspend payments, while as regards the remaining instruments, issuers had a right 
to  do  so  in  case  of  solvency  difficulties,  breach  of  regulatory  solvency  or  other  limits  fixed  by 
supervisors and in other situations 

167 In fact, the markets were caught by surprise when in December 2008 Deutsche Bank broke this convention by 
announcing that it would not buy back €1 billion of subordinated lower Tier 2 bonds. Its decision was 
based on economic grounds: accepting the step-up allowed the bank to pay annual interest of about 4% 
versus 7% if it tried to replace it with a new debt. As a result, credit default swaps on the Markit iTraxx 
Financial  Index  linked  to  subordinated  bonds  of  25  European  banks  and  insurers  jumped  20  basis 
points, reflecting investors' concern that Deutsche Bank's decision would encourage other borrowers to 
skip  a  call  on  all  hybrids  –  whether  Tier  2  or  Tier  1  hybrids  (sources:  Bloomberg,  Financial  Times). 
Other instances of skipping a call on hybrid securities had been rare: in April 2008, Italian bank Credito 
Valtellinese Scrl chose not to call bonds of €150 million. 

168 According to CEBS, in 2006 42% of hybrids (mostly innovative instruments) reported by EEA banks as Tier 

1 capital had a step-up feature at the time of their issue 

75 

 
 
 
                                                 
institutions,  and  was  in  part  due  to  the  Commission  policy  that  included  the  objective  of 
'burden sharing'.169  

  In relation to loss absorption, the CRD II provisions170 require hybrid securities to provide 
'for principal, unpaid interest  or dividend to be  such as to  absorb losses and to not hinder 
recapitalisation  of  the  credit  institutions'.171  According  to  CEBS172,  in  2006  for  39%  of 
hybrids  reported  by  EEA  banks  as  Tier  1  capital,  issuers  had  a  right  to  write  down  a 
principal on a going concern basis either permanently or temporarily, while 1% of hybrids 
had  a  possibility  of  conversion  to  ordinary  shares.  For  instance,  payment  of  principal  and 
interest  on  Bradford  &  Bingley's  hybrid  capital  was  deferred  until  after  its  repayment  of 
liability  to  the  UK  government  that  was  provided  to  the  bank  in  the  process  of  its 
nationalisation.173  However,  such  instances  of  hybrid  capital  instruments  absorbing  losses 
during the crisis have been rare. More importantly, as in case with flexibility of payments 
and  permanence  criteria,  events  of  the  crisis  demonstrated  that  majority  of  Tier  1  hybrids 
met  the  three  criteria  of  Tier  1  capital  only  once  bank  recapitalization  by  governments 
commenced.  

  As a result, the crisis effectively delineated those capital instruments that acted as a 'going-
concern'  capital  from  those  that  acted  rather  as  a  'gone-concern'  capital.  This  made  both 
market participants174 and regulators175 to consider using much stricter definitions of capital, 
which among other elements also excluded hybrids, to measure banks' strength on a going-
concern basis.   

ii.  The  list  of  regulatory  adjustments  proved  to  be  incomplete  as  a  number  of  balance  sheet 
items  whose  valuation  and/or  loss  absorption  potential  is  less  certain  on  a  going-concern 
basis  in  times  of  market  distress  (such  as  minority  interests,  deferred  tax  assets,  pension 
fund  assets)  have  been  effectively  removed  by  market  participants  and  regulators  from 
regulatory  capital  ratios  as  reported  by  individual  institutions.  This  list  is  not  harmonised 

169  Commission  communication  on  the  return  to  viability  and  the  assessment  of  restructuring  measures  in  the 
http://eur-
crisis 

financial 
lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:C:2009:195:0009:0020:EN:PDF  

current 

sector 

under 

rules, 

State 

the 

aid 

the 

in 

170 Article 63a  
171  When  a  credit  institution  incurs  huge  losses  it  may  need  to  be  recapitalised.  Availability  of  the  hybrid 
principal and flexibility to stop the payment of coupons on hybrid may not be sufficient to attract new 
share capital as investors would be concerned that new capital provided to recapitalise the institution is 
used directly to benefit existing hybrid holders. To address this, hybrids must contain a mechanism that 
makes the recapitalisation easier by limiting the potential future outflows to the holders of hybrids. 

172  CEBS,  Report  on  a  quantitative  analysis  of  the  characteristics  of  hybrids  in  the  European  Economic  Area 

(EEA), March 2007 

173 See http://corporate.bbg.co.uk/media-centre/latest-news/2010/2010-02-23.aspx  
174 For instance, Standard & Poor's calculates an individual bank 'total adjusted capital' (TAC) with a definition 
different  from  that  of  regulatory requirements.  The credit  rating  agency  limits  the  inclusion of Tier 1 
hybrid instruments for most banks to 25%. When combined with additional adjustments to TAC (such 
as  for  pension  deficits,  intangibles)  as  well  as  adjustments  to  risk  weighted  assets  under  Basel  II, 
Standard & Poor's risk adjusted capital ratio for a global sample of 45 banks in mid 2009 was equal to 
6.3%,  markedly  below  their  average  regulatory  Tier  1  ratio  of  9.7%.  S&P,  S&P  Ratio  Highlights 
2009, 
Disparate  Capital 
http://www.standardandpoors.com/ratings/articles/en/us/?assetID=1245195414308  

Strength  Among  The  World's  Biggest  Banks,  November 

175 For instance, in early 2009, the US conducted a stress test on 19 largest banking groups by measuring their 
financial health on the basis of 'Tier 1 common capital', effectively excluding hybrids. 'Tier 1 common 
capital' was calculated as Tier 1 capital (that excludes certain intangible assets, including goodwill and 
deferred  tax  assets)  less  non  common  elements,  including  qualifying  perpetual  preferred  stock, 
qualifying  minority  interest  in  subsidiaries,  and  qualifying  trust  preferred  securities;  for  more 
information please see  http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20090507a1.pdf  

76 

 
 
 
                                                 
across  the  EU,  as  Article  61  of  the  CRD  provides  MS  with  a  discretion  as  regards 
deductions of items that are not included in Article 57. 

  Minority  interest  represents  shares  issued  by  a  group  entity  and  is  available  primarily  to 
absorb  losses  which  occur  in  this  entity.  Currently,  national  practices  as  regards  the 
inclusion of minority interest, including extent thereof, in 'original own funds' across the EU 
differ,  as  Article  65  of  the  CRD  provides  for  a  discretion.  According  to  estimates  of 
HSBC176,  at  the  end  of  2009  minority  interests  contributed  €95  billion  to  European  bank 
capital  (or  46%  of  the  global  total  of  €206  billion)  of  which  €75  billion  were  included  in 
Tier 1 and €60 billion in core Tier 1. Over 65 European banks had capital contribution from 
minority  interests,  of  which  15  had  minority  interest  in  excess  of  €1  billion  that  in  some 
cases  constituted  over  20%  of  their  Tier  1  capital.  However,  minority  interest  may  not 
necessarily  be  readily  available  to  absorb  losses  elsewhere  in  a  group,  including  the 
consolidating entity. Therefore, in cases where a group entity is overcapitalised, inclusion of 
minority interest at the consolidated entity level may represent an artificial enhancement to 
its capital ratios. For this reason it may be warranted to subject minority interest to a haircut 
and regulators in some EU MS (e.g., IT) and international jurisdictions have been already 
following this rationale.  

  Deferred  tax  assets  (DTAs)  can  be  defined  as  the  amounts  of  income  taxes  that  may  be 
recovered  by  a  company  in  the  future.  They  may  arise  due  to  (i)  temporary  timing 
differences between statutory and tax accounting profits (e.g., limitations to deductions for 
tax purposes in the current period), (ii) unused tax losses that can be carried forward to use 
against future taxable profits, or (iii) tax credit carry forwards which are unused tax credits 
that can be used against future taxable profits. However, DTAs whose  realisation  through 
reduced  future  tax  payments  is  contingent  on  a  financial  institution's  ability  to  generate 
profits raise prudential concern as they may not provide protection to depositors in case of 
insolvency. Moreover, DTAs can be written down in a period of stress when banks' future 
profitability  becomes  less  certain.  As  a  result,  as  crisis  evolved  market  participants, 
including  investors,  industry  analysts  and  credit  rating  agencies,  grew  increasingly 
concerned  about  the  impact  of  DTAs  on  the  quality  of  regulatory  capital  measures  of 
banks.177 According to the CEBS, regulators in several MS (e.g., SE, DK), already require 
that DTAs be deducted from banks' Tier 1 capital while in AT tax losses carried forward are 
not allowed under national GAAP.  

iii.  The  crisis  also  showed  that  regulatory  adjustments  when  applied  were  not  applied  to  the 
appropriate  layer  of  regulatory  capital.  Under  the  CRD,  the  current  adjustments  are 
generally applied on a 50%-50% basis to Tier 1 and Tier 2 (although in some cases solely to 
Tier 1 capital).178 This allowed banks to report high Tier 1 ratios, despite the fact that they 
had  low  levels  of  Tier  1  capital  when  considered  100%  net  of  the  adjustments  such  as 
adjustment for investments in other financial institutions in excess of 10% of the common 
stock  of  such  financial  institutions.  A  deduction  in  this  case  is  warranted  to  prevent  a 
reduction  in  capital  as  a  result  of  loss  absorption  in  one  financial  institution  from  being 
immediately reflected as a loss of capital in the investing financial institution. Furthermore, 
current  provisions  of  the  CRD  enabled  some  banks  to  circumvent  this  requirement 

176 See http://ec.europa.eu/internal_market/bank/docs/gebi/hsbc_en.pdf  
177 According to Fitch Ratings, DTAs of US banks rated by the agency increased by 300% over the 12 month 
period  ending  June  2009,  which,  given  the  uncertainty  surrounding  certain  banks'  operating 
performance,  increases  the  risk  that  they  would  need  to  write  down  their  DTAs;  Fitch  Ratings,  US 
Banks' Deferred Tax Assets, September 2009 

178 Article 66 

77 

 
 
 
                                                 
altogether by virtue of a national discretion allowing to treat the above investments in other 
financial institutions as equity and debt instruments as part of banks' trading book in cases 
where they acted as market makers in these securities.179 

The  above  shortcomings  contributed  to  the  banking  sector  entering  the  crisis  with  reported 
Tier 1 capital ratios that were not reflective of institutions' effective capacity to absorb losses 
on  a  going-concern  basis.  As  the  crisis  deepened  and  banks  faced  growing  losses  and 
writedowns  which  directly  reduced  their  retained  earnings,  their  fundamental  solvency  was 
called  into  question.  Moreover,  variations  in  the  definition  of  Tier  1  capital  stemming  from 
differences  in  application  of  regulatory  adjustments  across  the  MS  obstructed  the 
comparability and reliability of this measure. This led to the loss of confidence in Tier 1 as 
measure  of  capital  adequacy  by  market  participants  and  regulators  who  instead  focused  on 
alternative  measures  mostly  based  on  common  equity  and  adjusted  for  the  balance  sheet 
elements  whose  value  and  loss  absorption  potential  proved  to  be  uncertain  during  market 
distress, such as tangible common equity or core Tier 1 capital.   

As  importantly,  the  crisis  has  confirmed  the  importance  of  banks  having  sufficient  capital 
buffers  in  good  times  to  enable  them  to  weather  difficult  times,  as  accessing  private  equity 
and  hybrid  capital  markets  for  most  European  banks  during  the  crisis  proved  to  be  rather 
difficult,  which  made  the  taxpayers  provide  the funding  for  the  resultant  shortfall  of  capital 
and impeded the flow of bank credit the real sector of the EU economy (please see section 3.5 
for more detailed discussion of the escalation of pro-cyclical effects).  

3.4. 

Counterparty credit risk 

According  to  the  data  of  the  International  Swaps  and  Derivatives  Association  (ISDA),  the 
total  outstanding  notional  amount  of  the  over-the-counter  (OTC)  derivatives  from  2001  to 
2007  on  average  grew  at  the  annual  rate  of  37%,  reaching  $454  trillion  globally  in  2007180 
whereas  according  to  the  International  Capital  Markets  Association  (ICMA),  the  value  of 
outstanding repo contracts on the books of 68 European institutions reached some €6.4 trillion 
in 2007. The crisis revealed a number of shortcomings in the current regulatory treatment of 
counterparty  credit  risk  (CCR)  exposures  arising  from  derivatives,  repos  and  securities 
financing  activities.  It  showed  that  the  existing  CRD  provisions  did  not  ensure  appropriate 
management  and  adequate  capitalisation  of  financial  institutions  against  the  CCR  that 
materialised  during  the  crisis  which  was  driven  by  a  number  of  factors,  of  which  the  most 
material are the following:  

i.  The current framework did not adequately capture specific and generalised wrong-way risk. 
Specific wrong-way risk arises when the exposure to a particular counterparty is positively 
correlated  with  the  probability  of  the  default  of  the  counterparty181,  i.e.,  when  the  credit 
exposure  and  default  risk  increase  together.  Generalised  wrong-way  risk  relates  to  a 
situation  where  the  probability  of  default  of  counterparties  is  adversely  correlated  with 
general  market  risk  factors.182  During  the  crisis,  a  key  observation  was  that  defaults  and 
deteriorations in the creditworthiness of trading counterparties occurred precisely at the time 
when  market  volatilities,  and  therefore  counterparty  exposures,  were  higher  than  usual. 

179 Directive 2006/49/EC, Annex VII, part D 
180 According to ISDA, of 500 biggest global companies in 2008 (based on 2008 Fortune Global 500) 471 used 

some type of the OTC derivatives. 

181 Annex III, Part 1, point 28 
182 Annex III, Part 1, point 27 and Part 6, point 34 

78 

 
 
 
                                                 
Although  the  current  rules183  require  monitoring  of  specific  wrong-way  risk,  no  standard 
practice has been developed by institutions and many of them entered into transactions with 
substantial exposure to this type of risk. A particular example of such transactions related to 
the purchase of credit protection from the so-called 'monoline'184 insurers. Monolines such 
as AMBAC, MBIA and ACA provided insurance on mortgage-backed securities and other 
structured products. When defaults on sub-prime mortgages soared and monolines' ability to 
make  payments  on  all  the  insurance  contracts  signed  became  less  certain,  their 
creditworthiness  was  downgraded  by  the  credit  rating  agencies,  leading  to  a  tsunami  of 
margin calls and subsequent demise of several monolines on one side and mark-to-market 
losses combined with increased capital charges in relation to the insured securities for banks 
that held them, on the other.185  

  The framework also did not directly require capital for mark-to-market losses due to credit 
valuation adjustments (CVA). Roughly two-thirds of counterparty credit losses were due to 
CVA  losses  and  only  one  third  were  due  to  actual  defaults.186  The  current  framework 
addresses CCR as a default and credit migration risk, but does not fully account for market 
value losses short of default. 

ii.  The  calculation  of  CCR  associated  with  a  derivative  contract  or  credit  guarantee  between 
financial  institutions  accounts  for  a  degree  to  which  the  market  values  of  their  assets  are 
correlated. An increase in probability of default at one institution is likely to coincide with 
deterioration in asset quality at the counterparty, implying an increased probability that the 
counterparty  will  default  on  the  derivative  or  guarantee  contract.  Under  the  current  CRD 
provisions, counterparty exposures associated with OTC derivatives are assigned the same 
asset  value  correlation  (AVC)  as  that  which  is  used  for  a  direct  loan  to  a  counterparty.187 
However  this  approach  does  not  recognize  the  unique,  systemic  risk  associated  with  such 
exposures  given  the  extent  to  which  they  are  concentrated  at  large  financial  institutions, 
whose counterparties generally are other large financial institutions. The crisis confirmed 
that  large  financial  institutions  were  more  interconnected  than  reflected  in  the  capital 
framework.  As  a  result,  when  markets  entered  the  downturn,  institutions'  counterparty 
exposures  to  other  financial  firms  also  increased.  During  the  crisis,  financial  institutions 
proved  to  be  relatively  more  sensitive  to  systemic  risk  than  non-financial  firms  and  their 
credit quality deteriorated simultaneously. Evidence suggests that asset values of financial 
firms are more correlated with each other in comparison to those of non-financial firms. The 
work conducted by the Basel Committee of AVCs between some 12,400 firms from 1995 to 
2008 showed that average AVC for financial firms with assets of at least $25 billion relative 
to the financial sector index was at least 25% higher than the average AVC for non-financial 
firms relative to the overall market index. 

183 Annex III, Part 6, points 35 and 39 
184 Monoline insurers guaranteed the timely repayment of the bond principal and interest in case an issuer of the 
debt defaulted. Essentially, monolines provided a back-up guarantee to the debt issued by lower rated 
borrowers in exchange for insurance premiums and, therefore, had to be highly rated by the credit rating 
agencies  in  order  to  fulfil  such  a  role.  For  instance,  a  borrower  rated  A,  by  paying  a  premium  to  a 
monoline could use for its debt the monoline's AAA rating which made the debt attractive to additional 
investors and reduced the interest rate to be paid on the debt. 

185  In  January  2008  Barclays  Capital  estimated  that  potential  losses  for  banks  globally  due  to  downgrades  of 

monoline insurers could be in the range of $48-$143 billion 

186 According to estimates of the Basel Committee 
187  After  quantifying  exposure  at  default  as  a  multiple  (α)  of  the  expected  positive  exposure  (EPE)  to  the 

counterparty, the Basel II formula for corporate loans is applied 

79 

 
 
 
                                                 
iii.  The  existing  framework  did  not  provide  sufficient  incentives  to  move  bilaterally  cleared 
OTC  derivative  contracts  to  multilateral  clearing  through  central  counterparties  (CCPs). 
CCPs can play an important role in the efforts to reduce the systemic risk arising from the 
intricate web of exposures formed by holdings of derivatives products by banks and other 
financial institutions. However, regulatory capital requirements for bilaterally cleared trades 
were  not  sufficiently  high  to  offer  an  attractive  incentive  to  clear  OTC  derivative  trades 
through  a  CCP.  Instead,  the  need  to  post  initial  margin  when  clearing  trades  with  a  CCP 
apparently more than offset the fact that no regulatory cost was involved for such trades. 

iv.  Calculation of capital based on Effective Expected Positive Exposure (EPE) did not provide 
sufficient  incentives  for  posting  adequate  initial  margins  throughout  the  cycle.  Initial 
margining was typically very low at the start of the crisis and increased rapidly during the 
turmoil. The raising of initial margin during the crisis served to protect the institutions, but 
also  triggered  weakened  position  if  not  the  failure  of  certain  counterparties,  thus 
exacerbating  the  crisis  (see  section  3.2  on  funding  liquidity  problems  related  increase  in 
margin calls on complex transactions). 

v.  The  crisis  also  revealed  a  number  of  significant  shortcomings  in  institutions’  risk 
management  of  counterparty  credit  exposures,  including  in  particular  the  areas  of  back-
testing, stress testing, and collateral management. The difficulties in statistical interpretation 
of  back-testing  results  for  CCR  suggest  that  many  firms  did  not  appropriately  consider 
problems  that  were  identified  by  back-testing.  The  use  of  models  with  poor  back-testing 
results contributed to an underestimation of potential losses. Stress testing of CCR was not 
comprehensive,  was  run  infrequently,  sometimes  on  an  ad  hoc  basis;  and,  in  many 
institutions,  provided  inadequate  coverage  of  counterparties  or  the  associated  risks.  The 
crisis  also  highlighted  a  number  of  areas  of  concern  that  were  related  to  the  management 
and operation of the collateral management process. 

3.5. 

Pro-cyclicality of lending 

Pro-cyclical effects can be defined as those which tend to follow the direction of and amplify 
an  economic  cycle.  Within  the  financial  system,  such  effects  have  a  significant  bearing.  In 
particular, bank lending could contribute to amplify business fluctuations, which in turn may 
exacerbate  financial  instability.  Recent  empirical  evidence  confirms  that  shocks  to  credit 
supply  have  the  potential  to  affect  economic  activity  in  the  predominantly  bank-based  euro 
area. Other theories, such as the monetary theory of the business cycle188 emphasize the role 
played by an artificial credit expansion in fostering a boom-bust cycle. The theory underlines 
the  potential  for  generating  economic  cycles  by  the  fractional  reserve  banking  sector  when 
bank credit is misaligned from the intermediation of real savings. The cyclical nature of bank 
lending  has  many,  often  interconnected  sources  that  include  both  market  and  regulatory 
failures.189  

188 The theory was pioneered by Ludwig von Mises and F.A. von Hayek obtained the Economics Nobel Prize in 

1974 for his contribution to it. 

189 For a thorough description of the main sources of pro-cyclicality please see: 

BIS,  Addressing  financial  system  procyclicality:  a  possible  framework,  Note  for  the  FSF  Working 
Group on Market and Institutional Resilience, September 2008; and  
Masschelein,  N.,  Monitoring  pro-cyclicality  under  the  capital  requirements  directive:  preliminary 
concepts for developing a framework, NBB Working Paper Document No. 120, 2007 

80 

 
 
 
                                                 
 
 
3.5.1.  Underlying market failures and systemic aspects 

The  cyclical  nature  of  bank  lending  is  in  part  driven  by  several  market  failures  such  as 
limitations  in  the  measurement  of  risk,  information  asymmetries  between  borrowers  and 
lenders  and  inappropriate  responses  of  financial  institutions  to  changes  in  the  economic 
conditions: 

i.  Financial  institutions  have  difficulties  in  assessing  absolute  level  of  risk  (while  they  fare 
better at assessing relative risk), especially over a prolonged period, and so rarely identify 
booms with consequences for systemic risk. Hence, when macro-economic conditions were 
favourable,  banks  engaged  in  a  rapid  expansion  of  their  balance  sheets  without  due 
consideration about implications for system-wide financial stability.  

  Measures  of  risk  may  be  quite  low  as  vulnerabilities  and  risk  accumulate  during  the 
expansion  phase  but  spike  once  tensions  arise,  for  example,  the  market  risk  embedded  in 
banks'  trading  book  can  be  easily  underestimated  if  measured  over  short  holding  periods. 
Such limitations to perception of risk are in part attributable to the paucity of information 
regarding the dynamics of systemic risk and are explained by certain theories of behavioural 
finance such as disaster myopia190 and cognitive dissonance191.  

  The misperception of risk may be exacerbated by a strong industry-wide drive for profit and 
moral hazard of implicit safety nets. 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.192  

ii.  When  economic  conditions  are  depressed  and  collateral  values  decline,  information 
asymmetries  with  respect  to  the  quality  of  clients’  balance  sheets  can  imply  that  even 
borrowers  with  profitable  projects  find  it  difficult  to  obtain  funding.  When  economic 
conditions  improve  and  collateral  values  rise,  the  opposite  situation  may  occur.  This 
reasoning suggests that pro-cyclical effects may be more pertinent to borrowers which are 
more  prone  to  asymmetric  information,  including  small  and  medium-sized  enterprises  not 
subject to external ratings and extensive disclosure requirements. 

iii.  Inappropriate  financial  institutions'  responses  to  changes  in  economic  conditions  in  some 
cases  are  explained by  short-term bias of remuneration structures  or herding behaviour193. 
Remuneration  policies  in  financial  institutions  had  an  enhancing  pro-cyclical  effect  where 
they  entailed  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.  

  The  crisis  also  showed  that  while  in  the  absence  of  raising  capital  by  the  private  sector 
greater efforts should have been made to rebuilding of regulatory capital (in order to limit 
the  rate  and  level  of  its  depletion  due  to  accumulating  losses),  many  banks  maintained 

190 Tendency to underestimate the likelihood of high-loss low-probability events 
191 Tendency to interpret information in a biased way, so that it reinforces the prevailing belief entertained by the 

economic agent 

192 For a comprehensive review see Borio, C., C. Furfine, and P. Lowe, Procyclicality of the financial system and 

financial stability: issues and policy options, BIS Paper No 1, 2001 

193 A tendency of market participants to conform in their behaviour with that of their peers 

81 

 
 
 
                                                 
generous  discretionary  distributions  to  their  shareholders,  providers  of  other  capital 
instruments and employees. In some cases banks that had depleted their capital buffers used 
the distribution of capital as a way of signalling their financial strength to the markets. Such 
practices put shareholders' interests above those of depositors and created peer pressure on 
other  banks  to  follow  suit.  As  a  consequence,  financial  institutions  in  aggregate  ended  up 
increasing distributions at the exact point in time when they should have been conserving 
their earnings and capital. According to Acharya et al. 194 dividends of 21 large banks from 
the US and Europe increased from 0.4% of their assets in 2000 to 1.1% in 2007 and were 
still at 0.7% through the first three quarters of 2008, in spite of a deepening financial crisis.  

In light of the financial crisis, the effect of pro-cyclical feedback mechanisms on the financial 
system has been examined by a number of international groups, including the FSB, the Basel 
Committee,  the  G-20  and,  within  the  EU,  a  working  group  of  the  Economic  and  Financial 
Committee (EFC). Several of these groups, including FSB, the Basel Committee and the G20, 
published their findings and / or recommendations in spring 2009. In line with the above, the 
Commission in its Communication of 4 March 2009, announced that it would pursue certain 
measures aimed at enhancing level of capital and introducing counter-cyclical buffers and a 
supplementary metric to better control leverage and liquidity risks.  

In order to address the harmful effect of poorly designed remuneration structures, in 2009 the 
Commission  adopted  the  CRD  III  proposal  which  included  provisions  to  supplement  the 
requirements  of  the  CRD  with  an  express  obligation  for  credit  institutions  and  investment 
firms to establish and maintain, for those categories of staff whose professional activities have 
a material impact on their risk profile, remuneration policies and practices that are consistent 
with effective risk management.  

To  improve  the  adequacy  of  bank  capital  requirements,  the  CRD  III  proposal  also  included 
provisions for increase in regulatory capital requirements for the trading book activities and 
re-securitizations  held  in  the  banking  book.  During  the  financial  crisis,  weakness  of  the 
minimum  capital  requirements  in  these  areas  led  to  additional  stress  on  banks'  capital 
positions which, in turn, contributed to the tightening of bank lending standards. Importantly, 
measures to address the risk capture in the area of CCR (see section 3.4) that are part of the 
current  CRD  IV  proposal  shall  have  a  positive  effect  on  limiting  the  cyclicality  of  the 
minimum capital requirements. 

In 2010, the European Parliament and the Council adopted the Commission's proposal to set 
up a European Systemic Risk Board (ESRB)195 to oversee the stability of the financial system 
as  a  whole.  ESRB  would  identify  systemic  risks  at  the  European  level  and  issue  risk 
warnings. Adding a robust macro-prudential overlay to the current micro-prudential approach 
should help to address sources of pro-cyclicality linked to limitations in the risk measurement 
and  inappropriate  responses  of  market  participants  to  risk.  This  should  support  the  timely 
identification of cycles and the build-up of risks in the system which, when accompanied by 
robust links to supervisors and policymakers, could enable action to be taken earlier to avoid 
excessive volatility and pro-cyclicality in a downturn.  

194  Acharya,  V.,  I.  Gujral,  and  H.  S.  Shin,  Bank  Dividends  in  the  Crisis:  A  Failure  of  Governance,  31  March 

2009 (http://www.voxeu.org)  

195  Regulation  (EU)  No  1092/2010  of  the  European  Parliament  and  of  the  Council  of  24 November  2010  on 
European  Union  macro-prudential  oversight  of  the  financial  system  and  establishing  a  European 
Systemic Risk Board  

82 

 
 
 
                                                 
3.5.2.  Leverage and lending cyclicality 

However,  the  measures  proposed  by  the  Commission  so  far  were  designed  to  address  only 
some specific aspects of the above-listed market failures and, therefore, may not be entirely 
effective  in  limiting  the  extent  of  leverage  build-up  in  the  balance  sheets  of  financial 
institutions  and  the  concomitant  overextension  of  credit.  On  23  June  2010  the  Commission 
adopted a report to the European Parliament and to the Council on the effects of the CRD on 
the  economic  cycle196  noting  that  it  would  examine  additional  measures  which  i)  limit  the 
build-up  of  leverage  in  the  banking  sector  and  ii)  curb  the  excessive  risk-taking  in  times  of 
economic  growth  but  could  be  drawn  down  during  economic  downturns  to  increase  the 
resilience of the banking sector and to support the credit flow into the economy.   

The  financial  crisis  has  shown  that  credit  institutions'  leverage  –  the  degree  to  which  their 
exposures  exceed  their  capital  levels  –  can  increase  to  unsustainable  levels  and  have  a  pro-
cyclical effect on the financial system. In the run up to the crisis, many investors, including 
banks,  actively  sought  higher  yields  as  high  levels  of  available  liquidity  resulted  in  risk 
premia  falling  to  historically  low  levels.  Exceptionally  low  interest  rates,  combined  with 
issues of moral hazard and market contestability, pushed banks to search for higher returns, 
whether through an increase in leverage or investment in more risky financial products.  

One  feature  of  current  risk-based  minimum  capital  requirements  is  that  they  vary  over  the 
economic cycle, e.g., they decrease as borrowers' creditworthiness improves during economic 
expansions. Provided credit institutions could meet their risk-based capital requirements, there 
is no explicit regulatory constraint on their leverage. The lack of a limit to their leverage and 
irresponsiveness of regulatory capital requirements to the build-up of risk at the macro level 
enabled banks to grow their balance sheets by taking on more risks.  

In this regard, the analysis of credit growth, using credit-to-GDP gap as indicator, from 1995 
to  2009  carried  out  by  the  ECB  for  19  MS  showed  that  credit  in  the  years  preceding  the 
financial  crisis  grew  at  a  fast  pace  in  a  number  of  them  (such  as  IE,  LV,  LT  and  HU), 
signalling the building up of financial imbalances, accumulation of risk at the systemic level 
and imminence of significant credit-related losses for their banking sectors (see Table 3).197 A 
corresponding  calculation  that  has  been  conducted  by  the  Basel  Committee  to  measure  the 
level of this metric for five years prior to the outbreak of a crisis for a sample of very severe 
banking crises, including those that e.g. took place in Nordic countries in 1991 and Mexico in 
1994, showed average credit-to-GDP gaps consistently in excess of 10%.198   

When financial asset prices started to fall, the opposite feedback loop was in high gear: assets 
had to be marked-to-market for losses incurred and banks had to de-leverage by selling them 
in  order  to  minimize  regulatory  capital  requirements  and  meet  margin  calls  from  their 
counterparties,  prompting  further  asset  price  declines  (see  section  3.2  for  the  interaction 
between market liquidity and funding liquidity).  

Analysis by IMF199 based on the sample of 36 large international commercial and investment 
banks showed that leverage might be a useful indicator of vulnerability of a bank. According 

196 See http://ec.europa.eu/internal_market/bank/docs/regcapital/monitoring/23062010_report_en.pdf  
197  In  some  EU-12  MS,  fast  pace  of  credit  growth  can  in  part  be  attributed  to  their  lower  pre-crisis  levels  of 

credit/GDP  

198 See http://www.bis.org/publ/bcbs172.pdf?noframes=1  
199 IMF, Responding to the Financial Crisis and Measuring Systemic Risk (Global Financial Stability Report), 

April 2009 

83 

 
 
 
                                                 
to this analysis, in the period from January 2005 till June 2007 (before the start of the current 
cycle and the beginning of the sub-prime crisis), leverage200 of non-intervened201 banks was 
equal  to  7.6,  while  leverage  of  intervened  commercial  banks  and  intervened  US  investment 
banks was equal to 9 and 13.7, respectively. 
Table 3: Credit-to-GDP gap for selected EU countries in %, annual averages202 

1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009

1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009

IE
0.7
1.3
5.1
4.5
10.2
9.2
4.6
-0.3
-2.1
6.2
19.0
28.4
31.6
40.2
39.4

AT

-0.1
-0.6
-0.3
0.6
-0.4
-2.2
-3.8
-3.2
-3.2
-2.7
-3.4
-1.8
-0.2

LT

0.1
0.5
1.2
1.9
0.7
0.8
2.0
4.3
7.5
9.6
14.0
15.8
13.0
10.3

BE
-2.1
2.2
4.9
5.0
5.8
4.3
3.5
0.3
-1.0
0.6
-1.0
-2.0
6.1
8.7
9.1

BG

-7.0
7.6
13.3
13.0
12.3
12.5
14.1
15.9
17.5
12.5
19.2
22.7
15.7

LU

LV

0.3
0.7
-1.7
-1.8
-2.7
-1.1
-1.7
3.8
8.7
9.3

-0.5
0.3
1.8
2.7
3.5
5.1
9.5
14.4
10.7
-0.3
-1.0

CZ

-0.2
1.5
-3.0
-3.2
-3.1
-3.8
-4.4
0.7
5.1
9.0
12.4
15.0
16.8
15.9

M T

-0.2
-0.7
-1.7
0.6
-0.8
-2.3
-6.3
-5.5
-2.5
-1.1
1.1
2.6
3.1
5.4

DK
0.4
3.2
3.9
7.0
7.5
7.3
8.8
9.4
9.4
9.4
11.7
15.7
20.3
21.4
22.0

PL

0.1
-0.1
-0.3
0.4
-0.1
-1.1
-1.7
-1.7
-1.6
-2.4
-0.2
3.7
7.6
9.2

EE

0.3
0.5
0.5
2.0
2.2
4.1
9.2
15.4
14.5
7.3
5.1

PT
-0.6
1.9
6.0
12.6
26.0
32.8
30.6
19.0
8.2
-3.4
-8.1
-2.1
-1.5
4.4

FI
-24.9
-27.9
-27.8
-25.3
-18.0
-13.8
-11.1
-5.3
1.1
5.9
9.6
12.5
13.0
16.1
21.5

RO

0.1
-1.4
-0.8
0.8
2.2
3.3
3.5
3.9
6.5
8.9
15.5
9.3

GR

-0.1
-0.4
-0.5
0.2
1.9
3.2
3.6
4.4
-0.2

SI

-0.3
-0.1
1.3
2.1
1.7
1.1
-1.1
-1.5
1.0
4.5
7.4
10.9
12.4
11.5

HU

0.5
0.4
-0.3
0.1
2.1
1.4
-3.4
1.2
5.1
6.9
6.6
5.5
8.2
14.0

SK

0.0
0.4
0.7
0.1
-6.0
-1.8
2.4
4.0
7.1
10.1
11.4
12.5
13.2

Note: Green: 2%<gap<5%; Orange: 5%<gap<10%; Red: gap>10%; No colour: gap<2%. Results for 2009 are most likely 
distorted due to the impact of the financial crisis on macroeconomic variables. 
Sources: Individual countries' data, ECB calculation 

Another  analysis203,  conducted  by  the  Basel  Committee  looked  at  leverage  ratios  for  117 
banks  from  19  countries  in  2006  and  2007,  of  which  27  banks  were  identified  as  'severely 
stressed' during the financial crisis. The results of the analysis showed that severely stressed 
banks  entered  the  crisis  with  indicators  showing  a  higher  degree  of  balance  sheet  leverage. 
For instance, average leverage, when measured by tangible common equity as a percentage of 
tangible  assets,  for  the  group  of  severely  stressed  banks  was  equal  to  2.65%  in  2006  in 
comparison to 3.81% for the group of non-stressed banks.204 

Even  though  certain  targeted  measures  to  the  CRD  that  are  expected  to  contribute  to 
containing  the  build-up  of  excessive  bank  leverage  have  been  proposed  and  might  be 
supplemented  by  additional  amendments  in  the  future,  given  that  leverage  is  also  driven  by 
factors outside the bank capital framework and works in a pro-cyclical fashion which - as the 
recent events have shown - has damaging consequences for a wide range of economic agents, 

200 Measured as a ratio of debt to common equity 
201 Intervened institutions are those that have gone bankrupt or that have received government capital injections 
or have had assets purchased by government or received loans to facilitate a merger or acquisition 
202 Credit-to-GDP gaps calculated as a difference between the ratio and its long term trend, whereas the trend is 
derived  based  on  quarterly  data  using  a  one  –sided  Hodrick-Prescott  filter  with  a  choice  for  the 
smoothing parameter λ a value of 400,000 

203 See http://www.bis.org/publ/bcbs180.pdf  
204 Difference statistically significant at 5% level 

84 

 
 
 
 
                                                 
it  is  appropriate  to  consider  developing  a  measure  that  controls  the  overall  extent  to  which 
financial institutions can leverage their capital.  

The  need  to  introduce  a  leverage  ratio  as  a  back-stop  measure  to  the  risk-based  capital 
requirements  results  from  the  difficulty  of  quantifying  systemic  risk,  in  particular  at  the 
micro-level  of  financial  institutions.  As  the  current  crisis  has  demonstrated,  the  entire 
financial  sector  can  move  into  a  high-gear  of  balance-sheet  expansion  in  the  boom  phase, 
blurring the analysis of risk by financial institutions. As the ex-ante identification of systemic 
risks and formation of asset-bubbles is largely a probabilistic exercise, the introduction of a 
'hard' leverage ratio would help alleviate an excessive expansion of credit. 

3.6. 

Options, discretions and minimum harmonisation 

3.6.1.  Current framework 

The  CRD  is  a  recast  of  the  Consolidated  Banking  Directive  (2000/12/EC).  In  2000,  seven 
banking  directives  and  their  amending  directives  were  replaced  by  one  single  Directive.  In 
2006,  the  CRD  introduced  the  Basel  II  framework  in  European  legislation.  As  a  result,  the 
CRD  provisions  include  a  significant  number  of  options205  and  discretions206.  In  particular, 
the recast of 2000/12/EC to introduce the Basel II framework has resulted in 101 options and 
discretions  which  have  been  identified  by  CEBS.207  To  a  large  extent,  insertion  of  national 
options  and  discretions  in  the  CRD  has  been  used  to  facilitate  compromises  between 
diverging  positions  of  MS  and  the  European  Parliament  and  to  better  accommodate 
specificities of local markets.  

In  addition  to  the  aforementioned  availability  of  options  and  discretions,  the  CRD  is  a 
'minimum harmonisation' Directive. This is explicitly acknowledged in recital 15 of Directive 
2006/48/EC208  and  means  that  MS  may  'add'  stricter  prudential  rules,  which  gives  rise  to  a 
practice known as 'gold-plating'.  

Divergences in national rules stemming from the possibility of application of national options 
and discretions and gold-plating are exacerbated by the process of transposition itself. Finally, 
national  rules  transposing  the  CRD  are  interpreted  in  accordance  with  local  traditions  and 
approaches  thereby  deepening  the  divergences  in  application  of  the  CRD  across  the  MS 
further. 

205 An option refers to a situation in which competent authorities or MS are given a choice on how to comply 

with a given provision, selecting from a range of alternatives. For example, for purposes of risk-
weighting institutions or local authorities, MS may apply either the central government risk-weight 
based method or the credit assessment based method.  Options granted to credit institutions to flexibly 
make use of prudential treatments reflecting different risk management processes are not included in 
this list.  

206  Discretion  refers  to  a  situation  in  which  competent  authorities  or  MS  are  given  a  choice  as  to  whether  to 
apply,  or  not  to  apply,  a  given  provision.  For  example,  a  competent  authority  under  particular 
circumstances can apply a 50% risk-weight to commercial real estate, or waive capital requirements at 
solo level for domestic subsidiaries. 

207 Competent authorities are required under Article 144 (b) of the CRD to disclose 'the manner of exercise of the 
options  and  discretions  available  in  Community  legislation'.  CEBS  has  developed  a  'supervisory 
disclosure framework' for that purpose (http://www.c-ebs.org/Supervisory-Disclosure.aspx) 
208 "The Member States may also establish stricter rules than those laid down in Article 9(1), first subparagraph, 
Article 9(2) and Articles 12, 19 to 21, 44 to 52, 75 and 120 to 122 for credit institutions authorised by 
their competent authorities. The Member States may also require that Article 123 be complied with on 
an individual or other basis, and that the sub-consolidation described in Article 73(2) be applied to other 
levels within a group" 

85 

 
 
 
                                                 
3.6.2.  Policy context: the new EU financial architecture 

This accumulation of national options and discretions and the possibility to make 'additions' at 
national level when transposing the directive have resulted in administrative burden for firms 
operating  in  different  MS.  This  has  been  explicitly recognised  by  the  Ecofin  Council  in  the 
context of the review of the Lamfalussy process. In its conclusions of 4 December 2008, the 
Ecofin  invited  MS  "to  keep  under  review  the  options  and  discretions  implemented  in  their 
national legislation, limit their use (wherever possible) and report to the Commission on these 
findings". The Ecofin also invited the Institutions "to introduce a 'review clause' in future EU 
legislation  on  all  options  and  discretions  included  in  the  respective  acts".  When  this  review 
clause  comes  into  effect  after  a  specified  time,  the  necessity  and  use  of  the  options  and 
discretions  should  be  reviewed  and,  where  necessary,  abolished  where  there  is  no 
demonstrated need. 

Likewise,  the  High  Level  Group  on  Financial  Supervision  in  the  EU  chaired  by  Jacques  de 
Larosière209  invited  the  EU  to  develop  a  more  harmonised  set  of  financial  regulation.  As  a 
follow-up to this report, Commission Communication of 4 March 2009 emphasised that "key 
differences in national legislation stemming from exceptions, derogations, additions made at 
national level or ambiguities contained in current directives should be identified and removed, 
so  that  a  harmonised  core  set  of  standards  is  defined  and  applied  throughout  the  Member 
States", and called for a 'rolling' plan to deliver a single rule book. In the context of the future 
European supervision architecture, the European Council also stressed the need to establish a 
European single rule book applicable to all financial institutions in the Single Market.210 

As a follow-up to the de Larosière report, in 2009 the Commission has proposed the creation 
of a European System of Financial Supervisors that already became operational as of January 
2011. At the EU-level, the four existing Lamfalussy Level 3 Committees of Supervisors have 
been replaced by three new European Supervisory Authorities (ESAs), i.e., EBA, a European 
Insurance  and  Occupational  Pensions  Authority  (EIOPA),  and  a  European  Securities  and 
Markets  Authority  (ESMA),  each  of  them  having  a  legal  personality  and  their  Joint 
Committee  for  common  issues  such  as  anti-money  laundering,  financial  conglomerates, 
accounting and others. These new ESAs took on all the missions of the previous Committees 
and received additional increased responsibilities, defined legal powers and greater authority.  

In particular, the ESAs have been entrusted with the task of developing technical standards in 
areas  specified  in  their  respective  sectoral  legislation.  The  areas,  where  the  Authorities  are 
empowered  to  develop  technical  standards  for  endorsement  by  the  Commission,  concern 
issues  of  a  highly  technical  nature  where  uniform  conditions  for  implementing  Community 
acts are needed.  

For  standards  to  be  best  developed,  requirements  of  the  CRD  should  not  diverge,  i.e.,  there 
should be no possibility to apply stricter rules, or different options and national discretions at 
a  national  level.  The  technical  standards  developed  by  the  new  ESAs  (Article  7  of  the 
proposed  Regulations)  will  be  adopted  by  the  Commission  in  the  form  of  regulations  (or 
decisions).  

Against this background, maximum harmonisation and the removal of options and discretions 
would be instrumental in allowing the new authorities to develop technical standards that will 

209 See http://ec.europa.eu/internal_market/finances/docs/de_larosiere_report_en.pdf (recommendation No 19) 
210 Brussels European Council 18 and 19 June 2009 

86 

 
 
 
                                                 
become  legally  binding  once  endorsed  by  the  Commission,  and,  thus,  in  fully  underpinning 
the reform of the EU supervisory architecture.211 In addition, further clarity and consistency 
of the Community legislation would limit scope for disagreement between supervisors, and, 
where disagreement will occur, powers granted to the Authorities will enable them to resolve 
the  matter  with  reference  to  Community  legislation  and,  in  particular,  already  accepted 
standards.  

3.6.3. 

Scope of the exercise 

CEBS  has  identified  101  national  options  and  discretions  to  be  disclosed  in  its  supervisory 
disclosure  framework  in  accordance  with  Article  144  of  the  CRD.  The  way  MS  have 
implemented  these  options  and  discretions  is  disclosed  on  CEBS'  web-site.212  Additional 
potential  national  discretions  have  been  identified  by  the  industry  representatives  in  their 
responses  to  CEBS'  questionnaire  of  July  2007.  In  total,  CEBS  analysed  152  options  and 
discretions.213 Annex II provides an insight into extent to which they have been exercised by 
individual  MS.  Majority  of  the  national  discretions  and  options  can  be  grouped  into  the 
following categories:  

i.  national options and discretions reflecting the diversity of domestic market because of local 

economic or institutional conditions;214 

ii.  national options and discretions reflecting different supervisory approaches;215 

iii.  provisions in the CRD under which supervisors shall make a supervisory judgment (based 
on criteria or some conditions) that are not strictly speaking 'national options', but some MS 
have implemented these provisions as an option.216 

211 For a presentation of technical standards, please see the Commission staff working document accompanying 
the  draft  Council  and  Parliament  Regulation  on  a  European  Banking  Authority,  draft  Council  and 
Parliament  Regulation  on  a  European  Insurance  and  Occupational  Pensions  Authority,  draft  Council 
and Parliament Regulation on a European Securities and Markets Authority 
212 See http://www.c-ebs.org/Supervisory-Disclosure/Options-and-national-discretions.aspx  
213 CEBS proposed to keep as a national discretion only 28% of them with accompanying proposals, i.e., deletion 
of  the  option,  making  an  option  a  general  rule,  letting  the  choice  of  the  use  of  an  option  to  credit 
institutions for the 65% of the provisions analyzed. Of the 28% that were proposed to be kept, about 
one third would expire by the end of 2011, meaning that any change in the text of the CRD would have 
no  or  limited  validity  by  the  time  the  provision  would  have  been  amended  through  the  legislative 
process. 

214 An example of an ‘institutional condition’ would be the structure of institutions in a MS, such as local and 
regional authorities. Accounting treatment, company law, supervisory philosophy, and so on, do not fall 
into  this  category.  For  example,  in  Annex  VI,  Part  1,  point  15,  the  Competent  Authorities  may,  in 
exceptional  cases,  treat  exposures  to  public  sector  entities  as  exposures  to  the  central  government  in 
whose jurisdiction they are established where, in their opinion, there is no difference in the risk between 
such  exposures  because  of  the  existence  of  an  appropriate  guarantee  from  the  central  government.  In 
Annex  VIII,  Part  1,  point  28,  MS  may  also  recognize  as  eligible  providers  of  unfunded  credit 
protection, other financial institutions authorised and supervised by competent authorities and subject to 
prudential requirements equivalent to those applied to credit institutions. 

215 For example, in terms of scope of application, some supervisors make use of solo-consolidation: under 

Article 70, MS may allow, on a case-by-case basis, for the purpose of the calculation of the individual 
requirements of the parent institution, and subject to certain conditions, the incorporation of subsidiaries 
whose material exposures or liabilities are all to that parent institution. Another example is Article 80(3) 
that allows MS to choose between two alternative methods for risk-weighting exposures to credit 
institutions: (a) on the basis of the risk-weight of the corresponding central government and (b) on the 
basis of the credit assessment of the institution itself. 

87 

 
 
 
                                                 
This impact assessment and the legislative proposal that it accompanies do not tackle certain 
national  options and discretions that will be addressed in separate exercises in line with the 
review clauses specified in the legislation.217 

Part of the divergence in national rules stems from the fact that the CRD, as explained earlier, 
is a 'minimum' harmonisation directive, allowing MS to establish stricter rules than those laid 
down under some of its provisions. 'Regulatory additions' made at national level are threefold: 

i.  additions in areas which are not explicitly covered by sectoral legislation (e.g., supervisory 

provisioning policy that is implemented in some MS); 

ii.  additions  explicitly  allowed  in  the  Directive  in  areas  which  lack  full  harmonisation  (e.g., 
Article  61  on  the  composition  of  own  funds),  or  not  sufficiently  harmonised  (e.g., 
supervision of liquidity in accordance with Article 41); and 

iii.  additions  in  areas  which  are  fully  harmonised:  the  Commission  has  been  informed  of  the 
degree to which Member States resorted to 'gold-plating' in a report on the transposition of 
the CRD in the 27 Member States.218  

Only  the  third  category  of  regulatory  additions  is  discussed  in  this  section.  The  second 
category is discussed in the context of the problem definition of bank liquidity (section 3.2) 
and  capital  definition  framework  (section  3.3).  Other  harmonization-related  aspects  will  be 
tackled at the time of revision or introduction of respective provisions.  

3.6.4.  Problems stemming from diverging national rules 

The  EU  banking  market  is  becoming  increasingly  integrated:  currently  around  70%  of  EU 
banking  assets  is  in  the  hands  of  some  40  banking  groups  with  substantial  cross-border 
activities.  Especially  in  the  EU-12,  banking  markets  are  dominated  by  foreign  (mostly 
Western European) financial groups. In these countries, on average 65% of banking assets are 
held by foreign-owned banks; while in EE, the CZ and SK this statistic is in excess of 92%. 
However,  efficiency  of  the  internal  market  in  wholesale  and  retail  banking  services  is 
undermined by divergences in national rules on capital and liquidity requirements. 

216 For example, in Article 84(2) when IRB approach is used by an EU parent or financial holding company and 
its  subsidiaries,  the  competent  authorities  may  allow  the  minimum  requirements  to  qualify  for  IRB 
approach to be met by parent and subsidiaries considered together. This is a supervisory decision to be 
applied  on  a  case  basis  after  considering  the  features  of  banks'  IRB  system,  i.e.  centralised 
system/decentralised system.  

217 These include: 

i) options pertaining to provisions on the regulatory treatment of 'large exposures'. CRD II significantly 
reduced  the  number  of  options  and  discretions,  but  some  options  have  been  left  as  a  result  of 
compromises. The Parliament and the Council agreed to review them by the end of 2011; 
ii)  options  pertaining  to  the  scope  of  application  (i.e.,  application  of  requirements  at  solo,  sub-
consolidated and consolidated level), subject to a specific review clause by the end of 2011. 
218 DLA Piper UK LLP, Study on the Implementation of Directive 2006/48/EC and Directive 2006/49/EC by the 

27 Member States, final report, February 2009.  
Examples include the regime of past due items, risk weight of 100% instead 75% for retail exposures, 
risk-weight of 50 % instead of 35% for residential real estate, concept of loss for operational risk, 
eligibility criteria for collateral, more sophisticated definition of dilution risk for receivables, restrictive 
transposition of the use test for IRB banks, restrictive definition of the retail exposure class under the 
IRB framework, higher capital requirements for foreign currency risk. 

88 

 
 
 
                                                                                                                                                         
 
 
 
As  a  result  of  'gold-plating',  national  options  and  discretions  available  in  the  legislation, 
there is a high level of divergence in how the rules are implemented by MS and subsequently 
applied  by  the  national  supervisory  authorities  who  also  have  a  possibility  under  certain 
provisions  to  exercise  judgment  or  make  a  choice,  thus  expanding  the  scope  of  national 
divergences further. These divergences have several consequences: 

i.  Where the legal text does not include criteria on which judgements or choices are made by 
supervisors, some options and national discretions may result in a lack of legal clarity.  

ii.  While all MS have a supervisory treatment that appears to be legally compliant, any given 
exposure  might  receive  very  different  treatment  from  one  MS  to  another.  The  lack  of  a 
consistent approach across the EU is a major concern for industry as the effects of disparate 
approaches have a direct effect on firms' ability  to properly  and  fairly compete in another 
MS, leading to an uneven playing field. 

iii.  The different rules in different MS also make it more difficult for depositors, investors and 
other  stakeholders  to  make  effective  comparisons  between  the  financial  situation  and 
stability  of  credit  institutions  from  different  MS,  leading  to  increased  market  uncertainty 
especially in situations of financial stress. 

iv.  The  different  application  of  the  legislation  in  different  MS  is  particularly  burdensome  for 
firms  operating  cross-border.  They  have  to  calculate  and  report  different  sets  of 
requirements  according  to  the  rules  of  the  consolidating  supervisor,  the  supervisor  of  the 
subsidiary  (or  the  host  supervisor)  for  national  discretions  pertaining  to  the  features  of  a 
local market which gives rise to additional supervisory reporting costs.  

v.  The presence of divergences hampers the development of a single reporting framework in 
the EU in order to allow cross-border banks to minimize their supervisory reporting costs. 
In this regard, CRD II requires competent authorities to apply a uniform reporting format by 
the end of 2012 and EBA is already developing a common reporting framework ('COREP'). 
However,  a  uniform  reporting  format  does  not  mean  that  the  contents  of  the  data  to  be 
reported are identical throughout the EU. This is because there is no harmonisation of data 
definitions which is driven by, among other factors, differences in the CRD implementation 
and  in  supervisory  approaches  because  of  the  proliferation  of  national  options  and 
discretions. 

3.6.5.  Further problems stemming from treatment of divergences at consolidated level  

Consequences  of  regulatory  divergences  are  particularly  pertinent  when  considering  their 
treatment at consolidated level. Under the CRD, as a general rule the consolidating supervisor 
(home competent authority) should apply 'home' country rules at a consolidated level, unless 
otherwise  provided  for  in  the  directive.  Where  rules  are  not  harmonised,  this  may  result  in 
banking groups with a subsidiary in another jurisdiction having to apply diverging rules at a 
solo level (host country) and at a consolidated level (home country).  

There are legal and practical exceptions to this general principle: 

i.  Mutual  recognition  (possible  recognition  of  the  host  treatment  at  home  level).  The  CRD 
provides  18  cases  of  explicit  reference  to  mutual  recognition  of  national  discretions 

89 

 
 
 
implemented  by  another  national  authority219  and  the  supervisory  disclosure  framework 
discloses the way those 18 cases of national discretions are applied, and whether MS allow 
for  mutual  recognition.  Mutual  recognition  of  the  host  supervisor’s  national  discretion 
provides some degree of flexibility by allowing at consolidated level the use of local rules 
and at the same time reduces administrative burdens incurred by the parent credit institution 
in relation to the subsidiaries. It also allows credit institutions to apply the 'host' treatment 
for  exposures  directly  held  by  the  credit  institution,  and  thus  ensure  a  level  playing  field 
between firms providing services in the same MS. The CRD contains only a limited number 
of  mutual  recognition-based  provisions.  However,  mutual  recognition  of  national 
discretions  should  not  be  seen  as  an  optimum  or  definitive  solution,  as  it  might  result  in 
embedding  national  discretions  in  Community  legislation.  Mutual  recognition  only  lends 
itself to national discretions justified because of local or institutional conditions (see above). 

ii.  Reporting  practices  vary  from  one  country/bank  to  another.  Under  a  'building'  block 
approach,  the  consolidating  bank  aggregates  the  capital  requirements  calculated  by  each 
legal  entity  of  the  group,  and  therefore  essentially  bases  the  calculation  of  capital 
requirements  on  host  country  rules.  This  reporting  practice  comes  down  to  broadly 
recognising  the  treatment  of  host  countries  (i.e.,  mutual  recognition).  In  certain 
circumstances, i.e., when the prudential treatment depends on the booking of an exposure, 
this reporting practice might lead to regulatory arbitrage.220  

iii.  The  CRD  provides  the  possibility  to  apply  'home'  discretions  at  'host'  level.  This  is 
discussed,  on  a  case  by  case  basis,  in  colleges  of  supervisors  involving  all  relevant 
supervisors  of  banking  groups.  In  the  context  of  the  joint  decision  for  using  advanced 
approaches to credit risk and operational risk, supervisors may decide to apply any blend of 
'home'  and  'host'  discretions.  However,  due  to  the  number  of  options  and  discretions 
available in the CRD, positions of national authorities with regard to suitability of specific 
prudential  approaches  or  measures  vis-à-vis  parts  of  the  group  may  diverge,  hindering 
efficiency  and  effectiveness  of  supervisory  cooperation.  In  case  of  disagreement,  the 
consolidating  supervisor  may  have  the  last  say.221  Effectively,  mutual  recognition  under 
Article  129  delivers  banking  group-specific  outcomes  as  practices  may  vary  from  one 
college of supervisors to another. This approach may lead to potential problems of different 
treatment of different cross-border groups, and may have implications for the level playing 
field in the host jurisdiction. 

219 For example, regarding the preferential treatment of commercial real estate (i.e. 50% risk weight under Annex 
VI, Part 1, section 9.2) that MS may allow under specific conditions, when this discretion is exercised 
by the competent authority of one MS, the competent authority of another MS may allow their credit 
institutions  to  risk  weight  at  50%  such  exposures  fully  and  completely  secured  by  mortgages  on 
commercial property.  

220 For example, if subject to mutual recognition, the option to risk-weight banks using the assessment of a 

credit rating agency or the rating of the sovereign may lead to regulatory arbitrage. The risk-weighting 
of exposures to credit institutions differs depending on whether it is determined (a) on the basis of the 
risk-weight of the corresponding central government or (b) on the basis of the credit assessment of the 
institution itself. If a banking group may apply option (a) at solo level in Member State X while its 
home country (Member State Y) applies option (b), and if option (a) results in lower capital 
requirements, the group will be incentivised to book its exposure to credit institutions in Member State 
X. 

221 Article 129(2) 

90 

 
 
 
                                                 
3.7. 

Risks inherent in baseline scenario 

There  is  a  broad  international  consensus  that  problems  outlined  in  sections  3.2  -  3.6 
individually, and even more so when taken together, played a significant 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,  shareholders,  employees,  borrowers  and  taxpayers,  to  unprecedented  economic 
costs. If no action in these areas is taken, the risk that systemic shocks of a similar scale occur 
in the future will not be addressed.  

3.8. 

Is action necessary at EU level? 

Based  on  the  nature  of  problems  outlined  in  the  above  analysis,  several  major  justifications 
that  meet  the  principle  of  subsidiarity  for  action  at  the  EU  level  become  apparent.  They 
include  a  need  to  enhance  the  integration  of  EU  internal  banking  market  (by  removing 
national  options,  discretions  and  possibilities  to  gold-plate),  address  several  market  (e.g.,  in 
the  area  of  countercyclical  policy  measures)  and  regulatory  failures  (e.g.,  capital  definition 
and liquidity risk management rules, capital requirements for CCR) that were brought to light 
by the financial crisis, correct for regulatory arbitrage opportunities which are made possible 
by the current legislation (due to the availability of certain national options and discretions) 
and ensure a consistent EU approach for tackling various issues covered by the scope of this 
report, which would do away with the need for MS to pursue individual approaches that risk 
fragmenting internal market.  

Most  importantly,  only  a  common  EU-level  approach  could  be  expected  to  effectively 
provide  for  financial  stability  and  tame  excessive  financial  pro-cyclicality,  as  currently 
policies that are directed toward these key systemic aspects are either geared to national needs 
or  are  absent  altogether.  With  respect  to  the  latter,  the  crisis  clearly  demonstrated  the 
ineffectiveness of the national liquidity risk supervision approaches. 

As regards the proportionality of proposed EU actions, it is implicitly assessed in section 5 in 
the  process  of  comparison  of  potential  policy  options  in  terms  of  their  effectiveness  and 
efficiency vis-à-vis the relevant policy objectives. 

91 

 
 
 
PROBLEM DRIVERS 

Shortcomings in liquidity risk 
management, including stress testing 

Asset and liability maturity mismatches 

No harmonised and sufficiently explicit 
regulatory treatment at EU level  

Certain capital instruments did not fulfil 
loss absorption, permanence and 
flexibility of payments criteria  

List of prudential adjustments incomplete 
or applied not to a relevant layer of 
institutions' regulatory capita l  

Lack of harmonization in application of 
prudential adjustments  

Current provisions do not capture all the 
risk adequately: 

(cid:57)  Generalised / specific wrong way risk 
(cid:57)  Systemic risk related to large financial 

institutions 

(cid:57)  No capital requirement for mark-to-market 
losses due to credit value adjustments 

Current provisions do not entail 
incentives to: 

(cid:57)  Move bilateral OTC to clearing through 

central counterparties 

(cid:57)  Post adequate initial margin 

Shortcomings in risk management 
practices: 

(cid:57)  Back testing 
(cid:57)  Stress testing 
(cid:57) Collateral management 

Cyclical nature of bank lending due to 
market failures such as: 

(cid:57) Limitations in risk measurement 
(cid:57) Information asymmetries 
(cid:57) Inappropriate responses to risk and 
changes in economic conditions 

Irresponsiveness of regulatory 
requirements to risk build-up at the macro 
level

Lack of explic it limit to leverage build-up 

Current provisions leave room for 
diverging rules across MS through: 

(cid:57)  National options 
(cid:57)  National discretions 
(cid:57)  Additions above minimum harmonisation due 

to possibility to gold-plate 

Lack of detail within certain provisions 
that allow for supervisory judgement and / 
or choice to be made 

L
I
Q
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C
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B
O
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PROBLEM TREE  

GENERAL 
PROBLEMS 

Inc reased risks to financial 
stability  

Increased pro-cyclicality of 
the financial system  

Creditor protection not 
optimised 

Implications for 
international 
competitiveness of EU 
banking industry

 Cyclicality of bank lending  

Opportunities for regulatory 
arbitrage 

Sub-optimal level of risk 
management 

Prudential capital and 
liquidity requirements 
inadequate in relation to 
undertaken risks  

Inadequate prudential 
requirements for 
systemically important 
institutions  

Lack of legal clarity 

Unlevel playing field 

Sub-optimal level of 
supervisory co-operation 
and convergenc e 

Increased compliance 
burden for cross-border 
institutions 

92 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  
 
  
 
 
 
4. 

OBJECTIVES 

The  overarching  goal  of  this  initiative  is  to  ensure  that  the  effectiveness  of  bank  capital 
regulation  in  the  EU,  represented  by  the  CRD,  is  strengthened  and  its  adverse  impacts  on 
depositor  protection  and  pro-cyclicality  of  the  financial  system  are  contained,  while 
maintaining  the  competitive  position  of  the  EU  banking  industry.  This  translates  into  the 
following four general policy objectives to:  

- Enhance financial stability (G-1); 

- Enhance safeguarding of depositor interests (G-2); 

- Ensure international competitiveness of EU banking sector (G-3); 

- Reduce pro-cyclicality in the financial system (G-4). 

In light of the problems presented in sections 3.2 - 3.6 five sets (in the areas of liquidity risk 
management,  definition  of  capital,  counterparty  credit  risk,  procyclicality,  and  single  rule 
book)  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 and liquidity requirements (S-1); 

- Enhance bank risk management (S-2); 

- Prevent regulatory arbitrage opportunities (S-3); 

- Enhance legal clarity (S-4); 

- Reduce compliance burden (S-5); 

- Enhance level playing field (S-6); 

- Enhance supervisory cooperation and convergence (S-7) 

- Align prudential requirements for systemically important financial institutions (SIFIs) with 
the risks that they pose (S-8); 

- Reduce cyclicality of bank lending (S-9); 

and, in turn, should facilitate the attainment of the four general policy objectives. 

Table 4 provides an overview of the linkage between: 

-  identified  problems  and  drivers  underlying  them  (indicated  in  italics  in  the  problem 
definition); 

- operational, specific and general objectives to address the problem drivers; and 

- policy options to achieve the objectives. 

93 

 
 
 
Table 4: Summary of problems, objectives and policy options 

Problems 

Problem Drivers 

Operational Objectives 

Specific Objectives 

General Objectives 

S-1 

S-2 

S-3 

S-4 

S-5 

S-6 

S-7 

S-8 

S-9 

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Liquidity risk management 
- Existing liquidity risk management approaches and 
supervisory regimes inadequately captured risks inherent to 
the underlying market practices and trends, contributing to 
demise of several institutions and strongly undermining 
health of many others, threatening the financial stability and 
necessitating unprecedented levels of central bank liquidity 
and government support.  

- Differences in national liquidity regimes give rise to level-
playing field issues for cross-border firms and hamper 
effectiveness of supervision as well as cooperation between 
supervisory authorities. 

Definition of capital 

- Banking sector – due to the drivers outlined - entered the 
crisis with reported Tier 1 capital ratios and, thus, capital 
that were not reflective of banks' capacity to absorb losses 
on a going-concern basis. As the crisis deepened and banks 
faced growing losses and writedowns, their fundamental 
solvency was called into question, leading to broader 
financial instability and necessitating extensive public 
sector support 

- Variations in the definition of Tier 1 capital stemming 
from differences in application of regulatory adjustments 
across the MS obstructed its comparability and reliability, 
leading to market participants' and regulators' focus on 
alternative measures 
Counterparty credit risk 
- Existing CRD provisions did not ensure appropriate risk 
management of financial institutions as well as adequate 
and non-cyclical regulatory requirements against the 
counterparty credit risk that materialised during the crisis  

- Calibration of provisions does not provide sufficient 
incentives to clear bilateral OTC instruments through 
central counterparties, leading to lack of confidence and 
exacerbating instability in times of market stress 

Shortcomings in liquidity risk 
management, including stress tests 

Asset and liability maturity 
mismatches  

Ensure that institutions have 
sufficient high quality liquid assets 
to withstand an acute stress scenario 
lasting for 30 days 

Ensure that institutions fund their 
activities with more stable sources 
of funding on an ongoing structural 
basis 

√ 

√ 

√ 

√ 

No harmonized and sufficiently 
explicit regulatory treatment at EU 
level 

Develop appropriately explicit and 
harmonized EU level regime for 
management of liquidity risk 

√ 

Certain capital instruments did not 
fulfil loss absorption, permanence and 
flexibility of payments criteria  

List of regulatory adjustments 
incomplete or applied not to a relevant 
layer of institutions' regulatory capital  

Enhance loss absorption, 
permanence and flexibility of 
payments of going-concern capital 
instruments 

Enhance loss absorption of 
regulatory capital by appropriate 
application of regulatory 
adjustments from the relevant layers 
of capital 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

Lack of harmonization in application 
of regulatory adjustments  

Develop a harmonised set of 
provisions in the area of definition 
of capital  

Current provisions do not adequately 
capture counterparty credit risk 

Enhance adequacy of capital 
requirements for the counterparty 
credit risk 

Current provisions do not entail 
incentives to move bilateral OTC to 
clearing through central counterparties 
and to post adequate initial margin 

Provide incentives to move bilateral 
OTC to clearing through central 
counterparties and to post adequate 
initial margin 

Shortcomings in risk management 
practices as regards back testing, 
stress testing and collateral 

Enhance bank risk management 
practices 

94 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

4.1-
4.3 

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1.1-
1.3 

2.1-
2.3 

1.1-
2.3 

3.1-
3.5 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Problems 

Problem Drivers 

Operational Objectives 

Specific Objectives 

General Objectives 

S-1 

S-2 

S-3 

S-4 

S-5 

S-6 

S-7 

S-8 

S-9 

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Procyclicality of lending 
- Lack of a limit to leveraging capital and irresponsiveness 
of regulatory capital requirements to the build-up of risk at 
the macro level led to accumulation of financial imbalances 
which, once the economic cycle turned, prompted a de-
leveraging spiral and precipitated steep credit-related losses  

- Inappropriate responses to risk and other market failures 
contribute to leverage build-up and a concomitant 
overextension of credit in the economic upturn and cause 
banks to maintain generous discretionary distributions 
during periods of stress, when capital should be conserved  

Options, discretions and minimum harmonisation 

- Diverging national rules allow for competitive distortions 
in the Internal Market and lead to a fragmented and 
inconsistent financial supervision, impeding legal clarity 
and resulting in excessive administrative burden for cross-
border banks 

- Mutual recognition of 'host' MS treatment at consolidated 
level creates opportunities for regulatory arbitrage; 
application of 'home' MS discretions at 'host' level hinders 
supervisory cooperation and risks delivering group-specific 
prudential treatment that may hamper level playing field 

management 

Market failures, including limitations 
in risk measurement, information 
asymmetries and inappropriate 
responses to risk and changes in 
economic conditions 

Irresponsiveness of regulatory 
requirements to risk build-up at the 
macro level 

Lack of explicit limits to leverage of 
credit institutions 

Diverging national rules due to the 
inclusion in the CRD of a number of 
national options and discretions 

Gold-plating of the current provisions 

√ 

√ 

√ 

√ 

√ 

√ 

Introduce an explicit limit on banks 
capacity to leverage their capital 

Improve banks' capacity to absorb 
losses over periods of stress and still 
meet the minimum regulatory 
capital requirement 

Protect banking sector from 
excessive credit growth and build-
up of risks at the macro-level while 
ensuring credit flow to the economy 
in the economic downturn  

Remove national options and 
discretions in the CRD 

Remove regulatory additions above 
the agreed minimum standards 

Lack of detail within certain CRD 
provisions that allow for supervisory 
judgement and / or choice to be made 

Make provisions allowing for 
supervisory judgement and / or 
choice more specific  

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

√ 

s
n
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5.1-
5.3 

6.1-
6.4 

5.1-
6.4 

7.1-
7.4 

95 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
5. 

POLICY OPTIONS: ANALYSIS AND COMPARISON 

This  section  presents  the  policy  options  and  their  impacts  for  each  policy  area  individually. 
Due to the number of areas covered, the analysis of policy options and the comparison thereof 
have been combined for each area. Cumulative impacts of all preferred options are discussed 
at the end of the section.  

While presentation of options in each policy area includes a 'retain current approach' scenario 
which  usefully  serves  as  a  baseline  for  assessing  impacts  of  alternative  policy  options  (and 
reflects  the  standard  methodology  of  conducting  impact  assessments  at  the  Commission),  it 
needs to be kept in mind that sections 5.1-5.5 pertain to proposals linked to Basel III that were 
developed by the Basel Committee with the active participation of the Commission services, 
on behalf of all 27 EU MS.  

Details of the new framework were fleshed out by the Basel Committee in December 2010. 
Policy options pertaining to the new liquidity measures are analysed in section 5.1. As regards 
the new capital requirements, respective policy options are discussed in sections 5.2-5.5. The 
calibration,  including  phase-in  and  grandfathering  arrangements,  of  Basel  III  is  shown  in 
Tables  5  and  6  below.  However,  EU  MS  will  be  allowed  to  'gold-plate'  the  new  minimum 
requirements during the phase-in period, which means that they can apply already in 2013 the 
level of capital required by Basel III in 2019. 

Table 5: Calibration of Basel III, in % of RWAs 

Common Equity 
(after deductions) 

Tier 1 Capital 

Total Capital 

Minimum requirement 

Conservation buffer 

Minimum requirement plus conservation buffer 
Countercyclical buffer range 1 
Notes: 1 Common equity or other fully loss absorbing capital 
Source: Basel Committee 

4.5 

2.5 

7.0 

0-2.5 

6.0 

8.5 

8.0 

10.5 

Table 6: Transitional arrangements for Basel III framework (all dates are as of January 1) 
2013 
Policy measure 

2017 

2018 

2015 

2016 

2014 

2012 

2011 

2019 

Leverage ratio 

Supervisory monitoring 

Parallel run                                         

Disclosure starts on 1/1/2015 

Migration 
to Pillar 1 

Minimum common equity (CET1) 
capital ratio  
Capital conservation buffer 
Minimum common equity plus 
capital conservation buffer 
Phase-in of deductions from CET1 

Minimum Tier 1 capital 

Minimum total capital 
Minimum total capital plus capital 
conservation buffer 
Capital instruments no longer 
qualifying as non-core Tier 1 
capital or Tier 2 capital 

Liquidity Coverage Ratio 

Net Stable Funding Ratio 

Source: Basel Committee 

Observation 
period 
begins 

Observation 
period 
begins 

3.5% 

4.0% 

4.5% 

4.5% 

4.5% 

4.5% 

4.5% 

0.625% 

1.25% 

1.875% 

2.5% 

3.5% 

4.0% 

4.5% 

5.125% 

5.75% 

6.375% 

7.0% 

20% 

5.5% 

8.0% 

40% 

6.0% 

8.0% 

60% 

6.0% 

8.0% 

80% 

6.0% 

8.0% 

100% 

6.0% 

8.0% 

100% 

6.0% 

8.0% 

4.5% 

8.0% 

8.0% 

8.0% 

8.0% 

8.625% 

9.25% 

9.875% 

10.5% 

Phased out over a 10 year period beginning 2013 

Introduce 
minimum 
standard 

Introduce 
minimum 
standard 

96 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
It  needs  to  be  stressed  that  the  calibration  of  the  new  minimum  capital  requirements  was 
determined by taking into account the impact that the new policy measures would have on the 
numerator  (i.e.,  definition  of  eligible  capital)  and  the  denominator  (i.e.,  measures  affecting 
risk  weighted  assets)  of  the  ratios.  Therefore,  analyses  underpinning  the  phase-in 
arrangements and the calibration of the new rules are presented after preferred policy options 
relevant  for  the  calculation  of  the  ratios  have  been  identified  (in  line  with  the  approach 
followed by the Basel Committee). 

5.1. 

Liquidity risk 

To address the problems in the area of liquidity risk management, the Commission services in 
its  February  2010  consulted  publicly  on  the  two  key  potential  policy  measures:  Liquidity 
Coverage Ratio and Net Stable Funding Ratio. 

5.1.1.  Liquidity Coverage Ratio 

To address shortcomings in liquidity risk management and to improve short-term resilience of 
the  liquidity  risk  profile  of  financial  institutions  by  ensuring  that  they  have  sufficient  high 
quality liquid assets to withstand an acute stress scenario lasting for 30 days, the Commission 
services proposed to introduce a Liquidity Coverage Ratio (LCR). Main policy options in this 
area are as follows: 

-  Policy option 1.1: Retain current approach; 
-  Policy option 1.2: Introduce LCR as specified in the February 2010 public consultation; 
-  Policy option 1.3: Introduce LCR adopted by the Basel Committee subject to observation 

period. 

Policy option 1.1: Retain current approach 

Under  this  policy  option,  problems  related  to  short-term  liquidity  risk  management,  as 
outlined in section 3.2 may not be entirely addressed. While tightening of national liquidity 
regimes may provide for a degree of increased effectiveness with respect to management and 
supervision  of  risks  discussed  in  this  section,  there  is  no  guarantee  that  necessary  progress 
would  be  achieved  quickly  enough  and  evenly  across  the  EU.    Given  the  recently  agreed 
Basel  liquidity  standards,  it  may  be  expected  that  under  this  policy  option  individual  MS 
would adopt these sounder standards for a few of their largest banks. Other MS may pursue 
different alleys for strengthening liquidity regimes  and others again may  not  act  at  all. This 
scenario  is  likely  to  lead  to  further  divergence  of  standards  within  Europe,  creating 
opportunities for regulatory arbitrage and un-levelling the playing field. 

Policy option 1.2: Introduce LCR as specified in the February 2010 public consultation 

LCR would require credit institutions to match net liquidity outflows during a 30 day period 
of acute stress with a buffer of 'high quality' liquid assets. The net liquidity outflows during 
the  period  of  stress  would  be  completely  defined  in  the  CRD,  detailing  inter  alia  what 
percentage of a given source of funding a credit institution has to assume would be withdrawn 
from  it  (see  Annex  IV).  The  outflows  covered  would  also  include  those  resulting  from 
liabilities  and  contingent  liabilities,  both  contractual  and  non-contractual,  coming  due  and 
would  reflect  both  institution-specific  and  systemic  shocks  built  upon  actual  circumstances 
experienced in the global financial crisis which, as outlined in section 3.2, may include events 
such as: 

97 

 
 
 
- downgrade in the institution’s public credit rating; 
- run-off of a proportion of retail deposits; 
- loss of unsecured wholesale funding capacity; 
- loss of secured, short-term financing transactions for all but high quality liquid assets; 
- increases in market volatilities that have an impact on the quality of collateral or potential 
future  exposure  of  derivatives  positions  and  thus  require  larger  collateral  haircuts  or 
additional collateral; and 
-  a  need  for  the  institution  to  provide  funding  to  honour  non-contractual  obligations  in  the 
interest of mitigating reputational risk. 

The regulatory list of high quality liquid assets (for specific definitions of the 'buffer of high 
quality liquid assets' see Annex IV) to cover these outflows should ensure that these assets: 

- have low credit and market risk: assets which are less risky tend to have higher liquidity. As 
regards  the  credit  risk,  high  credit  standing  of  the  issuer  and  a  low  degree  of  subordination 
increases  an  asset’s  liquidity.  As  regards  market  risk,  low  duration222,  low  volatility,  low 
inflation risk and denomination in a convertible currency with low foreign exchange rate risk 
all enhance an asset’s liquidity; 
- have ease and certainty of valuation: an asset’s liquidity increases if market participants are 
more  likely  to  agree  on  its  valuation.  A  liquid  asset’s  pricing  formula  must  be  easy  to 
calculate  and  not  depend  on  strong  assumptions.  Market  participants  should  have  similar 
views about inputs into those pricing formula, for instance due to public availability thereof; 
- have low correlation with risky assets: the stock of high quality liquid assets should not be 
subject to a wrong-way risk. For instance, assets issued by financial firms are more likely to 
be illiquid in times of liquidity stress in the banking sector; 
- be listed on a developed and recognised exchange market: being listed increases an asset’s 
transparency; 
- have active and sizable market: the asset should have active outright sale and repo markets 
at  all  times  (which  means  having  a  large  number  of  market  participants  and  a  high  trading 
volume). Market breadth223 and market depth224 should be good; 
- have presence of committed market makers: quotes will always be available for buying and 
selling the asset; 
-  have  low  market  concentration:  diverse  group  of  buyers  and  sellers  in  an  asset’s  market 
increases the reliability of its liquidity; 
-  are  likely  to  attract  flight  to  quality  in  stressed  market  conditions:  historically,  the  market 
has shown tendencies to move into some types of assets in a systemic crisis. 

As regards the buffer of high quality liquid assets, the Commission services consulted on the 
impact of both a narrow regulatory definition of liquid asset buffer composed of cash, central 
bank  reserves  and  high  quality  sovereign  debt,  as  well  as  a  somewhat  broader  definition 
which  could  also  include  non-financial  corporate  bonds  and  covered  bonds  of  high  quality, 
i.e., those rated AA and above with a 20% haircut and those rated A- up to AA- with a 40% 
haircut, up to 50% of the buffer. 

In order to strengthen the resilience of European credit institutions against liquidity risk and to 
introduce  a  harmonised  regulatory  measure  at  European  level,  the  standards  would  apply  at 
the  level  of  individual  legal  entities.  Application  at  individual  entity  level  within  European 

222 Price sensitivity of a fixed income security to changes in interest rate 
223 Price impact per unit of liquidity 
224 Units of the asset that can be traded for a given price impact 

98 

 
 
 
                                                 
groups  is  desirable  so  long  as  constraints  on  the  transferability  of  assets,  mutual  support 
commitments  and  central  liquidity  risk  management  within  groups  continue  to  apply.  The 
envisaged scope of application takes account of the fact that liabilities have to be repaid by 
legal  entities  in  principle  and  that  the  liquidity  to  meet  the  resulting  outflows  should  be 
available at the legal entity level. However, application to individual firms could be waived 
by competent authorities provided that it is possible to identify a set of institutions belonging 
to the same group to which the requirements can be meaningfully applied on a consolidated 
basis  because  liquidity  risks  are  managed  centrally  in  the  group,  there  are  legally  binding 
mutual  commitments  for  liquidity  support  between  the  relevant  institutions  and  assets  are 
freely transferable between legal entities even when under stress. Where these conditions are 
met, the requirements would be applied on a consolidated level only to the entities belonging 
to a group. 

Individual  legal  entity  level  application  would  be  complemented  by  application  at  the  full 
consolidated  level  in  order  to  ensure  a  sound  liquidity  position  of  the  overall  group  and  to 
facilitate alignment with international standards that will expect internationally active banks 
to report their consolidated liquidity position.  

In contrast to areas that are related to capital, liquidity data in a quantitative impact study were 
collected  for  the  first  time.  Because  in  this  area  different  MS  currently  apply  different 
standards, banks were not familiar with standardised data requests. Hence, the classification 
of liquidity risk positions as required in the QIS did not necessarily match their classification 
at  banks  internally  or  for  MS  prudential  reporting  purposes  which  made  gathering  and 
splitting the data into required regulatory sub-categories for participating banks difficult. QIS 
results  on  liquidity,  thus,  should  be  interpreted  as  a  directional  tool  to  assess  calibration-
driven changes rather than a precise estimate of actual quantitative impact.  

These difficulties also point in the direction of possibly significant one-off compliance costs 
related to information provision, i.e., administrative costs (see section 5.8.3) when migrating 
to the new standards. However, given that the same type of information would be needed for 
individual legal entity level application and also considering that the standards would be for 
the  first  time  fully  harmonised  across  the  EU,  it  may  be  expected  that  there  would  be 
important ongoing cost savings for cross-border groups that currently typically have to report 
on individual legal entity basis (and even separately at the level of branches that do not have a 
legal  personality)  according  to  very  diverse  national  regimes  and,  in  addition,  on  a 
consolidated basis according to their home country regime. Hence, administrative costs due to 
EU  legislation,  as  discussed  in  section  5.8.3  should  be  offset  by  savings  of  administrative 
costs  due  to  national  reporting  requirements.  On  top  of  that,  harmonised  reporting  would 
facilitate communication between supervisors of the different legal entities of a group.  

EU QIS showed that as of December 2009 under the narrow definition of liquid asset buffer, 
average LCR was 52.4% and 74.1% for Group 1 and Group 2 banks, respectively. Under the 
broader  definition  of  liquid  asset  buffer,  average  LCR  improved  by  some  ten  percentage 
points for both groups.  

Feedback  from  numerous  public  consultations  showed  that  the  narrow  liquid  asset  buffer, 
however,  does  not  address  the  situation  of  jurisdictions  such  as  DK  that  may  not  have 
sufficient supply of eligible assets. Most respondents to the consultations also claimed that the 
'narrow' buffer definition entails the concentration risk of specific asset classes while labelling 
bank (covered) bonds as illiquid would hamper bank ability to raise funds. Refinements were 
deemed to be necessary also as regards assumptions used to estimate several categories of net 

99 

 
 
 
liquidity  outflows  (the  denominator),  for  instance,  to  recognize  that  central  bank-eligible 
assets that are not part of the liquid asset buffer and retail deposits constitute a better source of 
liquidity than assumed by this option. Public authorities of certain MS, on contrary, were in 
favour of a 'narrow' asset buffer on the grounds of financial stability.  

Policy  option  1.3:  Introduce  LCR  adopted  by  the  Basel  Committee  subject  to  observation 
period 

Policy option 1.3 reflects the specification of LCR announced by the Basel Committee in its 
Basel III rules text in December 2010. It takes into account the above mentioned concerns and 
recalibrates the LCR requirement by building as follows on  the 'narrow' definition of liquid 
asset buffer under policy option 1.2: 

- Narrow liquid asset buffer is broadened to include: i) non-financial corporate  and covered 
bonds not issued by the bank itself of high credit and liquidity quality with a 15% haircut and 
ii)  exposures  to  sovereign  and  public  sector  entities,  central  banks  that  are  risk-weighted  at 
20%  under  the  CRD  with  a  15%  haircut.  The  inclusion  of  these  assets  (termed  'Level  2' 
assets)  is  capped  at  40%  of  the  liquid  asset  buffer.225  Level  2  assets  are  also  of  very  high 
liquidity, but possess the properties of high quality liquid assets listed above to a somewhat 
lesser  extent.  However,  they  generally  generate  higher  yield  and  holding  them  is  therefore 
more  attractive  for  banks.  The  limit  on  these  assets  would  ensure  that  assets  of  the  very 
highest  quality  make  up  the  majority  of  the  buffer  while  allowing  banks  some  flexibility  to 
improve the profitability of their liquid asset holdings.  
-  Determination  Level  2  assets:  this  option  foresees  that  before  2015,  a  range  of  qualitative 
and  quantitative  criteria  to  determine  high  credit  and  liquidity  quality  and  to  determine  to 
which  of  the  two  levels  in  the  buffer  individual  assets  should  be  assigned  will  be  tested  by 
EBA with a view to advising the Commission on the appropriate set and calibration of such 
criteria.  Preliminary  criteria  have  been  set  by  the  Basel  Committee  that  put  particular 
emphasis on assets' external ratings, but the testing of alternative criteria should, before 2015, 
allow for identification of final criteria that place more emphasis on experienced liquidity and 
less on such ratings. 
- This option entails three alternatives to accommodate the specific situation of jurisdictions 
that do not have a sufficient supply of Level 1 assets in their domestic currency to meet the 
aggregate demand of banks with significant exposures in this currency. However, its Level 2 
cap of 40% is lower than that of the broader buffer definition under option 1.2. 
- 'Stable'226 retail and SME deposit run-off rate is reduced to 5%, while that of 'less stable'227 
deposits  to  10%,  from  7.5%  and  15%  under  option  1.2,  respectively.  It  is  difficult  to  find 
evidence of empirical run-off rates that is not very dependent on individual circumstances, not 
least relating to the deposit guarantees afforded by the public sector to retail depositors. Given 
the further harmonisation and improvement of legal depositor protection in the EU, lower run 
off  rates  appear  justified  in  tendency,  not  pretending  that  there  was  a  unique  'right'  level  of 
these run-off rates. 
- Roll-off for unsecured deposits from sovereigns, public sector entities and central banks is 
reduced  to  75%  as  opposed  to  100%  under  option  1.2.  For  secured  funding  received  from 
these  entities,  this  option  recognises  that  they  are  likely  to  continue  to  roll-over  secured 

225 Whereas assets that qualify for the 'narrow' definition of liquid asset buffer are termed 'Level 1' assets 
226 See Annex IV for definition 
227 Less stable deposits could include deposits which are not covered by effective deposit insurance, high value-
deposits, deposits of sophisticated or high net worth individuals and deposits which can be withdrawn 
quickly and foreign currency deposits, as determined by each jurisdiction 

100 

 
 
 
                                                 
funding during a time of stress, and for secured funding backed by assets that would not be 
included  in  the  buffer  of  liquid  assets,  assumes  a  25%  roll-off  of  funding.  This  addresses 
concerns of stakeholders that central bank-eligible assets should be included in the proposal 
by allowing a bank to count the majority of any central bank funding it has obtained as stable 
funding, and therefore to increase its stock of liquid assets by monetising less liquid collateral 
at the central bank, to the extent that the central bank has already provided that funding.  
- Secured funding: outflow and inflow haircuts are aligned with Level 1 and Level 2 buffer 
asset haircuts. 
- Undrawn committed facilities: this option assumes 5% run-off on credit and liquidity lines 
to retail and SME customers, down from 10% under option 1.2. It also applies a 10% run-off 
for credit lines and 100% run-off for liquidity lines to sovereigns, central banks, and public 
sector entities (in addition to non-financial corporates).  
- This option also establishes a harmonised treatment of net inflows rather than leaving their 
determination  to  bank  discretion,  making  the  standards  less  dependent  on  individual  banks' 
ability to model risks and assumptions. Banks are assumed to realise inflows of 100% from 
their lending to other financial institutions, but should, due to the need to continue providing 
lending  to  firms  and  households,  only  assume  50%  of  the  inflows  contractually  due  from 
these  counterparties.  Importantly,  to  ensure  a  minimum  level  of  liquid  asset  holdings,  the 
amount of inflows that can offset outflows is capped at 75% of total expected cash outflows 
as calculated in the standard. This effectively requires that a bank must maintain a minimum 
amount  of  stock  of  liquid  assets  equal  to  25%  of  the  outflows  in  order  to  cover  potential 
timing mismatches between inflows and outflows during the 30 days and possible delays of 
inflows under stress. 
- For operational activities with financial institution counterparties, this option creates a 25% 
outflow  bucket  for  custody  and  clearing  and  settlement  activities,  as  well  as  selected  cash 
management  activities.  These  activities  would  require  specific  supervisory  approval  before 
the funds specifically related to those activities could be considered 'operational', i.e., not all 
funds from a counterparty would qualify. The bank that has deposited the operational deposits 
would receive no inflow recognition for those deposits, as they would be expected to remain 
at the other bank during a time of stress because for those operational deposits, the depositing 
bank  would  find  it  impossible  to  withdraw  significant  funds  without  compromising  its  own 
ability  to  operate.  Importantly  to  the  EU,  similar  treatment  is  given  to  mutual  deposits  of 
cooperative and other types of bank networks. 

Similarly to policy option 1.2, the standards would apply at the level of individual legal and 
consolidated entities. This is in alignment with Basel III rules since they outline treatment at 
the  consolidated  group  level  while  leaving  the  implementation  at  the  sub-group  and  stand-
alone bank levels to discretion of its members, in order to ensure greater consistency and level 
playing field between domestic and cross-border banks.  

The Commission will, based on a report from EBA and taking into account the contribution of 
ESRB,  review  before  2015  whether  the  ratio  has  any  unintended  consequences  on  the 
business  and  risk  profile  of  European  institutions,  trade  finance,  financial  markets  and  the 
economy. The Commission should be able to modify the ratio accordingly as appropriate via 
a delegated act. A mechanism would be built into the CRD IV proposal ensuring that the ratio 
will  only  apply  after  the  Commission  has  concluded  its  review  and  has  made  the  necessary 
modifications, if any. 

Under  this  policy  option,  average  EU  LCR  is  66.5%  for  Group  1  banks  and  to  87.1%  for 
Group 2 banks, comparable to the LCR averages of the broader buffer definition under option 
1.2.  In  terms  of  distributional  impacts  with  respect  to  bank  size,  Charts  4  and  5  show  that 

101 

 
 
 
under this option the impact is less pronounced for smaller (i.e., Group 2) banks in most of the 
MS.  In  terms  of  implications  of  this  policy  option  on  banks  from  other  major  international 
jurisdictions that are large and active abroad, the EU Group 1 LCR average is lower than that 
of  a  sample  of  84  large  international  banks  from  twenty  members  of  the  Basel  Committee 
(including eight EU MS) that as of December 2009 stood at 82.9%.228 

Chart 4: Distribution of LCR for Group 1 
banks, in %: country averages 

Chart 5: Distribution of LCR for Group 2 banks, in %: 
country averages 

               LCR of 100% 

300

250

200

150

100

50

0

300

250

200

150

100

50

0

               LCR of 100% 

I

C

H

B

K

J

F

EU

G

D

L

E

A

P

G

U

J

L

H

F

N

K

E

D EU S M R

B

C

A

Notes: LCRs are capped at 400%. EU averages for both Group 1 and Group 2 banks include data for three additional 
countries that are not shown individually. 
Source: CEBS 

The combined shortfall of liquid assets to meet the LCR threshold of 100%, calculated as a 
sum  across  individual  banks  where  a  shortfall  is  observed,  for  Group  1  and  Group  2  banks 
that  participated  in  the  QIS,  is  about  €1  trillion  under  this  policy  option  (see  Chart  6), 
equivalent to €1.6 trillion when extrapolated to the entire EU banking sector. As regards the 
aggregate supply of liquid assets in the economy, when the above purchases of liquid assets 
are  financed  by  new  equity  of  banks,  this  may  effectively  represent  a  switch  between  the 
direct  holdings  of  such  assets  by  ultimate  investors  with  the  indirect  ones  (through  holding 
bank  equity).  Yet  there  may  not  necessarily  be  a  big  effect  on  the  aggregate  assets  in  the 
economy, as ultimately all securities would continue to be held - directly and indirectly – by 
the  ultimate  investors,  including  bank  shareholders.  Liquid  asset  shortfalls  shall  also  not  be 
confused  with  related  bank  costs  which  stem  from  the  foregone  return  on  assets,  i.e.,  the 
difference  between  average  return  on  loans  and  average  return  on  assets  included  in  the 
buffer.  

The LCR could lead to a contraction of the interbank market for short-term maturity. There is 
also  the  risk  of  a  potential  reduction  in  the  liquidity  –  and  therefore  maybe  an  increase  of 
costs – of instruments excluded from the buffer, such as ABS or foreign currency swaps, as 
they  would  be  relatively  disregarded  by  banks.  Nevertheless,  incentivising  banks  to  find 
alternative sources of funding is a key step to enhance financial stability, reduce the reliance 
of the banking industry on such (wholesale) markets and limit the contagion channels. 

If the averages of Group 1 and Group 2 banks are weighted based on their share of RWAs, 
EU banking industry's LCR can be approximated at 74% under this policy option, from which 
an implicit increase of 34% in the buffer of eligible liquid assets to achieve compliance with 
the LCR of 100% can be derived.229 The resultant impact on bank lending and the economic 
output can be assessed based on the work of the Macroeconomic Assessment Group (MAG) 
of  the  Basel  Committee.230  In  its  analysis  of  transitional  costs  of  the  new  rules,  MAG 
estimated  that  tightening  of  the  liquidity  requirement,  consisting  of  a  25%  increase  in 

228 Source: QIS on the impact of Basel III reforms on the BCBS' countries 
229 100%/74%-1=34% 
230 See http://www.bis.org/publ/othp10.pdf?noframes=1  

102 

 
 
 
                                                 
holdings of liquid assets to total assets ratio, produced a median increase in lending spreads of 
14 basis points and a fall in lending volumes of 3.2% after four and a half years, associated 
with  a  median  decline  in  the  GDP  of  0.08%  below  the  baseline.  Hence,  impact  on  the  EU 
GDP due to the introduction of the LCR can be approximated to a decline in GDP of 0.11% 
over the period of four and a half years, compared to the baseline trend.231 

Chart 6: Liquidity shortfall for Group 1 and Group 2 banks combined as of December 2009, in € million  

Policy option 1.3

Policy option 1.2, 'narrow' buffer

500

400

300

200

100

0

E

G

H

L

J

B

C

A

D

K

M

R

S

P

Q

O

U

I

T

Notes: Country H, L and N totals include shortfalls only for Group 2 banks (Group 1 banks removed based on request of 
national supervisors). No LCR shortfalls estimated for countries U, I, T under both policy options.  
Source: CEBS 

Despite the costs that the implementation of new liquidity requirements may entail for some 
institutions  in  a  transition  period,  the  new  framework  should  be  understood  as  an  insurance 
scheme securing the stability of individual institutions and eventually of the financial system 
as  a  whole.  The  new  measures  should  be  able  to  address  the  pro-cyclicality  and  volatile 
patterns  of  banks'  unregulated  liquidity  management:  on  the  one  hand,  underestimated  risks 
when liquidity is cheap and easily available and, on the other hand, rapid contagion and loss 
of confidence in crisis situation due to the asymmetry of information and insufficient liquidity 
reserves.  

Analysis of the Basel Committee of the long-term economic benefits of the new rules showed 
that  increases  in  liquid  asset  holdings  of  50%  for  the  average  bank  reduces  the  estimated 
probability a systemic banking crisis by 1.1 percentage points (from 2% to 0.9%) when bank 
capitalisation is kept constant at 9%.232 Therefore, estimated increase in liquid asset holdings 
of 34% by the EU banking industry can be assumed to reduce the probability of a systemic 
crisis by some 0.8 percentage points (or 40%), equivalent to annual GDP benefits of 0.14% to 
0.48% under the 'no permanent effect' and 'moderate permanent effect' scenarios, respectively 
(please see section 5.8.5 for more on the analysis of long-term economic benefits by the Basel 
Committee). 

231 Assuming liquid asset share is increased while total assets do not change. However, if meeting the LCR did 
not affect the amount of assets not eligible for the LCR buffer, then the above effect would be smaller, 
as the liquid to total asset ratio would increase by less than 34%. 

232  When  measured  as  tangible  common  equity  (TCE)  to  RWAs  under  Basel  I  and  II  definitions.  This  is 
equivalent to the average of some 6% CET1 ratio that the EU banks would have after the application of 
Basel III provisions 

103 

 
 
 
 
                                                 
Comparison of policy options 

Retaining  the  current  scenario  (option  1.1),  implies  that  problems  related  to  short-term 
liquidity  risk  management,  as  outlined  in  section  3.2,  may  not  be  addressed  effectively, 
depending on the actions taken in this area by national supervisors and/or the industry. While 
tightening  of  national  liquidity  regimes  may  provide  for  a  degree  of  increased  effectiveness 
with  respect  to  regulation  (objective  S-1)  and  bank  management  (objective  S-2)  of  risks 
discussed  in  this  section,  there  is  no  guarantee  that  necessary  progress  would  be  achieved 
quickly enough and evenly across the EU. 

While  both  policy  options  1.2  (LCR  as  specified  in  the  February  2010  public  consultation) 
and  1.3  (LCR  developed  by  the  Basel  Committee  subject  to  observation  period)  entail 
effective approaches with respect to contributing to the achievement of relevant objectives S-
1  (Enhance  adequacy  of  capital  and  liquidity  requirements)  and  S-2  (Enhance  bank  risk 
management)  as  well  as  G-1  (Enhance  financial  stability)  and  other  relevant  general 
objectives,  option  1.3  is  more  effective  due  to  its  more  precise  calibration  of  a  number  of 
elements  relevant  for  the  calculation  of  LCR.  While  these  two  options  are  comparable  in 
terms of compliance costs for the industry, policy option 1.2 (i.e., its version of the broader 
buffer definition) is more efficient than option 1.3 in terms of achieving the above objectives. 
Option  1.2  has  a  higher  cap  for  additional  assets  eligible  for  the  liquid  asset  buffer  and 
generally could be better tailored to the EU specificities both in terms of the numerator and 
the  denominator  given  that  they  would  entirely  be  defined  in  the  CRD.  As  such,  it  would 
impose  lower  adjustment  costs  on  both  the  industry,  and  via  indirect  impacts,  on  other 
economic  agents.  Given  its  superior  effectiveness  as  regards  the  relevant  policy  objectives, 
however, policy option 1.3 is identified as a preferred option. 

Table 7: Summary of policy option effectiveness and efficiency 

Policy Option Comparison Criteria 

Policy Option 

Enhance adequacy 
of capital and 
liquidity 
requirements [S-1] 
3 

Effectiveness 
Enhance bank 
risk 
management 
[S-2] 
3 

1.1 Retain current approach 
1.2 Introduce LCR as specified in the February 2010 
public consultation 
1.3 Introduce LCR adopted by the Basel Committee 
subject to observation period 
Scale of option ranking: 1=most effective / efficient, 3=least effective / efficient 
Effectiveness measures extent to which options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources 

2 

1 

1 

2 

Enhance 
financial 
stability 
[G-1] 
3 

2 

1 

Efficiency 

3 

1 

2 

5.1.2.  Net Stable Funding Ratio 

To  address  shortcomings  in  funding  liquidity  risk  management  by  requiring  institutions  to 
achieve  and  maintain  a  sound  funding  structure  over  a  one  year  horizon,  the  Commission 
services propose to introduce a Net Stable Funding Ratio (NSFR). Main policy options in this 
area are as follows: 

-  Policy option 2.1: Retain current approach; 
-  Policy option 2.2: Introduce NSFR as specified in the February 2010 public consultation; 
-  Policy option 2.3: Introduce NSFR adopted by the Basel Committee. 

Policy option 2.1: Retain current approach 

104 

 
 
 
Under this policy option, funding problems arising from asset - liability maturity mismatch, as 
outlined in section 3.2, may not be entirely addressed. While tightening of national liquidity 
regimes may provide for a degree of increased effectiveness with respect to management and 
supervision  of  risks  discussed  in  this  section,  there  is  no  guarantee  that  necessary  progress 
would be achieved quickly enough and evenly across the EU.  Given the recent agreements by 
the Basel Committee in this area, it may be expected that under this policy option individual 
MS  would  pursue  these  sounder  standards  for  a  few  of  their  largest  banks.  Other  MS  may 
follow different alleys for strengthening liquidity regimes and others again may not act at all. 
Thus,  this  scenario  would  likely  lead  to  further  divergence  of  standards  within  Europe, 
creating opportunities for regulatory arbitrage and un-levelling the playing field. 

Policy option 2.2: Introduce NSFR as specified in the February 2010 public consultation 

The  NSFR  would  require  credit  institutions  to  maintain  a  sound  funding  structure  over  the 
one-year horizon in an extended firm-specific stress scenario where an institution encounters 
and  investors  and  customers  become  aware,  for  instance,  of  a  significant  decline  in  its 
profitability  or  solvency,  a  potential  downgrade  in  its  debt,  counterparty  credit  or  deposit 
rating or a material effect that calls into question its reputation or credit quality.  

To  the  above  end,  the  assets  currently  funded  and  any  contingent  contractual  and  non-
contractual  obligations  to  fund  would  have  to  be  matched  to  a  predetermined  extent, 
depending on their liquidity profile at a one year horizon (reflected in the so-called 'required 
stable funding factors'), with sources of funding that can be considered stable over the same 
one year horizon.233 The required stable funding factors and the degree to which sources of 
funding  can  be  considered  stable  would  be  set  out  in  the  CRD.  Annex  V  contains 
specifications  of  both  sources  of  stable  funding  (the  numerator)  and  the  required  stable 
funding for various asset types (the denominator) of the ratio, as outlined by the Commission 
services in its public consultation of the February 2010.  

In terms of level of application, the approach envisaged for the LCR above would pertain to 
the NSFR as well, i.e., the NSFR would apply at the level of individual legal and consolidated 
entities. 

As  already  mentioned  in  the  analysis  of  the  LCR,  liquidity  data  were  collected  for  the  first 
time in a QIS which meant that banks were not familiar with standardised data requests in this 
area. Hence,  QIS  results  as regards the NSFR  should  be seen  as a  directional  tool to  assess 
calibration-driven changes rather than a precise estimate of actual quantitative impacts of the 
new  standard.  This  may  also  contribute  to  possibly  significant  compliance  costs  related  to 
information provision, i.e., administrative costs (see section 5.8.3) under this policy option.  

EU  QIS  showed  that  as  of  December  2009  the  average  NSFR  for  Group  1  was  79.8%.  No 
country was, on average, able to meet the requirement under this policy option, with the MS 
observing  ratios  in  the  range  of  60.6%  to  97.2%.  A  wider  range  of  results  across  countries 
was observed for Group 2 banks (43.4% - 155.7%), while the average NSFR of 83.7% was 
slightly  higher  than  that  of  the  sample  of  Group  1  banks.  The  combined  shortfall  of  stable 
funding  to  meet  the  NSFR  threshold  of  100%,  calculated  as  a  sum  across  individual  banks 

233 The required stable funding factors assigned to various types of assets are parameters intended to approximate 
the amount of a particular asset that could not be monetised through sale or use as collateral in a secured 
borrowing on an extended basis during a liquidity event lasting one year. Such amounts are expected to 
be supported by stable funding. 

105 

 
 
 
                                                 
where a shortfall was observed, for Group 1 and Group 2 banks participating in the QIS was 
about €3.4 trillion under this scenario (see Chart 9).234  

Feedback  from  numerous  public  consultations  showed  that  this  policy  option,  however, 
requires further refinements with respect to definition of available stable funding factors (the 
numerator of the ratio) and required stable funding factors as regards certain asset types (the 
denominator  of  the  ratio)  and  that  it  may  also  distort  incentives  across  business  models,  in 
particular,  as  regards  retail  versus  wholesale  banking.235  With  respect  to  the  latter,  some 
respondents called for the phasing in of the ratio to allow banks for adjusting their business 
models. As a result, while this policy option may be effective in achieving relevant specific 
objectives,  such  as  S-1  (Enhance  adequacy  of  capital  and  liquidity  requirements)  and  S-2 
(Enhance  bank  risk  management),  it  would  do  so  with  certain  unwelcome  distributional 
effects  across  banking  business  models  and  with  overall  higher  than  warranted  compliance 
costs for the industry and, through indirect effects, other economic agents. 

Policy option 2.3: Introduce NSFR adopted by the Basel Committee 

Policy option 2.3 reflects the specifications of NSFR announced by the Basel Committee in 
its Basel III rules text in December 2010. It takes into account the above mentioned concerns 
and  recalibrates  the  NSFR  requirement  by  raising  the  available  stable  funding  factor  for 
'stable'  and  'less  stable'  retail  and  SME  deposits  and  lowering  the  required  stable  funding 
factors  for  i)  residential  mortgages  and  other  loans  that  qualify  for  the  35%  or  better  risk 
weight under Basel II standardised approach for credit risk, ii) government and public sector 
entity  securities  with  risk-weight  of  20%  under  the  CRD,  and  iii)  certain  off-balance  sheet 
commitments.236  

Under this policy option, average NSFR is higher for most countries when compared to policy 
option  2.2,  and  the  EU  average  NSFR  rises  to  91.1%  for  Group  1  banks  (with  four  MS  on 
average meeting the requirement) and to 93.9% for Group 2 banks. In terms of distributional 
impacts  with  respect  to  bank  size,  Charts  7-8  show  that  under  this  option  the  impact  is 
generally less pronounced for smaller (i.e., Group 2) banks.  

In  terms  of  implications  of  this  policy  option  on  banks  from  other  major  international 
jurisdictions that are large and active abroad, the EU Group 1 NSFR average is comparable to 
that of a sample of 85 large international banks from twenty members of the Basel Committee 
(including eight EU MS) that as of December 2009 stood at 92.7%.237 

234 Expected shortfall shall not be confused with related bank costs which may stem (depending on actions taken 
by  banks  to  comply  with  the  requirement)  from  substituting  sources  of  funding  with  lower  available 
stable funding factors with those with higher available stable funding factors. 

235 Respondents claimed that banks being dependent on capital markets would be given a better ratio than retail 
deposit banks which have been stable. It was also recognised that NSFR might favour broker / dealers 
while penalising the universal banking model. 

236 The available stable funding factors for 'stable' and 'less stable' retail and SME deposits are raised from 85% 
and 70% to 90% and 80%, respectively, in comparison to policy option 2.2. The required stable funding 
factor  for  residential  mortgages  and  other  loans  that  qualify  for  the  35%  or  better  risk  weight  under 
Basel  II  standardised  approach  for  credit  risk  is  lowered  to  65%  from  100%.  The  extent  to  which 
conditionally  revocable  and  irrevocable  credit  and  liquidity  facilities  would  need  to  be  pre-funded  is 
lowered  to 5%  from  the  requirement  of  10%.  The  required  stable funding  for government  and  public 
sector entity securities with risk-weight of 20% under the CRD is reduced to 20%, down from 100%.  

237 Source: QIS on the impact of Basel III reforms on the BCBS' countries 

106 

 
 
 
 
                                                 
Chart 7: Distribution of NSFR for Group 1 
banks, in %: country averages 

Chart 8: Distribution of NSFR for Group 2 banks, in %: 
country averages 

            NSFR of 100% 

200

175

150

125

100

75

50

25

0

200

175

150

125

100

75

50

25

0

               NSFR of 100% 

H

B

I

K

D

G

EU

C

J

F

E

L

A

E

F Q D H U P

J EU N C

B M K R

S O L G A

Notes: EU averages, in addition to countries shown in the charts, include three additional countries for Group 1, and one for 
Group 2.  
Source: CEBS 
The combined shortfall of stable funding to meet the NSFR threshold of 100%, calculated as a 
sum across individual banks where a shortfall is observed, for Group 1 and Group 2 banks 
that participated in the QIS as of December 2009 was about €1.8 trillion under this policy 
option (see Chart 9), equivalent to €3.2 trillion when extrapolated to the entire EU banking 
sector.  
Chart 9: Liquidity shortfall for Group 1 and Group 2 banks combined as of December 2009, in € million  

Policy option 2.3

Policy option 2.2

1000

800

600

400

200

0

E

L

G

J

C

A

B

K

D

H M

P

R

S

O

U

I

Q

T

Notes: Country F, L and M totals include shortfalls only for Group 2 banks (Group 1 banks removed based on request of 
national supervisors). No NSFR shortfalls estimated for countries U, I, Q, and T under option 2.3.  
Source: CEBS 
Given the novelty of this requirement, this policy option acknowledges a possibility of 
unintended consequences across business models and / or funding structures. In this regard, 
this option entails an observation period that starts in 2012 before making further appropriate 
revisions to the NSFR calibration and moving it to a regulatory requirement as from 2018. 
The observation period would allow for the assessment of any unintended implications of the 
ratio not only for the industry, but also trade financing, financial markets and credit provision 
to the real economy. In practice, this would be implemented by introducing appropriate 
reporting requirements for credit institutions as part of the present legislative proposal in 
order to provide for a sound basis for the observation period and a monitoring of such a 
requirement across business models. The establishment of the actual regulatory requirement, 
subject to appropriate revisions relative to its preliminary form, would be left to another 
legislative proposal before 2018. 
This policy option would be less costly for the industry than option 2.2, as in effect, 
compliance with the eventual NSFR would start only in seven years from 2010, giving the 

107 

 
 
 
institutions ample time to make necessary adjustments to their funding structure, maturity 
mismatch and activities which are the most vulnerable to liquidity risk in periods of stress. 
Institutions would still be subject to the costs related to provision of information to 
supervisors during the observation period (see section 5.8.3). 
Comparison of policy options 
Retaining the current scenario (option 2.1) implies that problems related to longer-term 
funding liquidity risk management, as outlined in section 3.2, may not be addressed 
effectively, depending on the actions taken in this area by national supervisors and/or the 
industry. While tightening of national liquidity regimes may provide for a degree of increased 
effectiveness with respect to regulation (objective S-1) and bank management (objective S-2) 
of risks discussed in this section, there is no guarantee that necessary progress would achieved 
quickly enough and evenly across the EU. 
While both policy options 2.2 (NSFR as specified in the February 2010 public consultation) 
and 2.3 (NSFR adopted by the Basel Committee) entail effective approaches with respect to 
contributing to the achievement of relevant objectives S-1 (Enhance adequacy of capital and 
liquidity requirements) and S-2 (Enhance bank risk management) as well as G-1 (Enhance 
financial stability) and other relevant general objectives, option 2.3 is more effective due to its 
more precise calibration – from a prudential angle - of a number of elements relevant for the 
calculation of the NSFR and a possibility of a further fine-tuning of the ratio and 
minimization of undesired destabilising effects for the industry and in the financial markets.  
Policy option 2.3 is the most efficient option in terms of achieving the above policy objectives 
as it would impose lowest adjustment costs on both the industry and, via the reduced 
likelihood of unwelcome side effects, on other economic agents. Policy option 2.3 is 
identified as a preferred option. 

Table 8: Summary of policy option effectiveness and efficiency 

Policy Option Comparison Criteria 

Policy Option 

Enhance adequacy 
of capital and 
liquidity 
requirements [S-1] 
3 

Effectiveness 
Enhance bank 
risk 
management 
[S-2] 
3 

2.1 Retain current approach 
2.2 Introduce NSFR as specified in the February 2010 
public consultation 
2.3 Introduce NSFR adopted by the Basel Committee 
Scale of option ranking: 1=most effective / efficient, 3=least effective / efficient 
Effectiveness measures extent to which options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources 

1 

1 

2 

2 

Enhance 
financial 
stability 
[G-1] 
3 

2 

1 

Efficiency 

3 

2 

1 

5.2. 

Eligibility of capital instruments and application of regulatory adjustments 

To address shortcomings in the area of definition of capital, including issues pertaining to the 
loss absorption, permanence and flexibility of payments of capital instruments that shall be 
counted towards the regulatory going-concern capital as well as issues regarding the 
completeness, appropriateness and lack of harmonized application of regulatory adjustments, 
the Commission services considered wide-ranging adjustments in this area. In the process of 
preparing the legislative proposal, a number of policy alternatives on various individual 
aspects have been examined; they could be sensibly grouped in the following key policy 
options: 

-  Policy option 3.1: Retain current approach; 
-  Policy  option  3.2:  Modify  only  the  eligibility  criteria  for  own  funds,  as  specified  in  the 

February 2010 public consultation; 

108 

 
 
 
 
 
 
-  Policy option 3.3: Modify both eligibility criteria and regulatory adjustments as specified 

in the February 2010 public consultation; 

-  Policy option 3.4: Modify both eligibility criteria and regulatory adjustments as adopted by 

the Basel Committee; 

-  Policy option 3.5: Modify both eligibility criteria and regulatory adjustments as adopted by 

the Basel Committee, adjusted for certain EU specificities. 

Policy option 3.1: Retain current approach 
Under this policy option, problems related to eligibility of capital instruments and application 
of regulatory adjustments that are outlined in section 3.3 will not be entirely addressed. The 
CRD II already harmonised the criteria and established explicit limits for different types of 
Tier 1 hybrid capital and these provisions took effect as of end 2010. However, further 
amendments were shown by the crisis to be necessary in order to enhance the loss absorption, 
flexibility of payments and permanence of common equity and hybrid Tier 1 capital. As 
regards regulatory adjustments, current CRD provisions allow for national discretion to make 
additional adjustments. While revision of these adjustments by individual MS may lead to 
improved quality of capital, there is no guarantee that a necessary progress would be achieved 
quickly enough and in a uniform manner across the EU, thus, hampering the functioning of 
the single banking market and undermining the financial stability.  

Policy option 3.2: Modify only the eligibility criteria for own funds as specified in the 
February 2010 public consultation 
This policy option would entail tightening of criteria for eligibility of capital instruments for 
inclusion in the different layers of regulatory capital, as specified in the Commission services' 
public consultation of February 2010. The consultation document outlined such criteria with 
respect to core Tier 1, non-core Tier 1 and Tier 2 capital, which are listed in Annex VI.  
As regards core, or, common equity Tier 1 (CET1), the ineligibility of some types of 
instruments would have a relatively more pronounced impact in several MS due to the 
exclusion of instruments such as some classes of shares, silent partnerships, participation 
capital, preferred shares and supplementary cooperative shares.   
Impacts on non-core Tier 1 capital would be driven by elimination of innovative and dated 
hybrid instruments. According to CEBS analysis, as of end of 2006, almost 50% of Tier 1 
hybrid instruments in the EEA were innovative hybrids (mostly prevalent in UK, FR, DE, NL 
and IT); at the same time, such innovative hybrids constituted a majority of dated hybrid 
instruments.238  
As regards Tier 2 capital instruments, the CRD provisions239 permit the commitments (e.g., 
uncalled capital and commitments to make further non-refundable payments) of the members 
of credit institutions set up as cooperative societies to be included within lower Tier 2 capital 
provided they may be included in capital under national law.240  The approach proposed in 
criterion 1 as regards the eligibility for Tier 2 capital (see Annex VI) would exclude such 
commitments from Tier 2 based on the prudential rationale that capital should be paid up in 
order to ensure that it may be relied upon when required. This would have an impact on those 
EU banks that are organised as cooperative networks / societies. 
However, the above amendments would address only issues pertaining to the eligibility of 
capital instruments. They would not address the regulatory adjustments necessary to ensure 

238  CEBS,  Report  on  a  quantitative  analysis  of  the  characteristics  of  hybrids  in  the  European  Economic  Area 

(EEA), March 2007 
239 Articles 57(g) and 64(1) 
240 An identical treatment is afforded to the joint and  several commitments of borrowers for credit institutions 

organised as funds 

109 

 
 
 
 
 
                                                 
that the amount of regulatory capital recognized adequately reflects the amounts that would be 
available to absorb losses on a going concern basis or in insolvency. A lack of further 
harmonization of regulatory adjustments would result in maintenance of the current divergent 
approaches in the EU to adjusting regulatory capital. Therefore, this policy option would only 
be partially effective in terms of achieving the relevant policy objectives. 
Policy option 3.3: Modify both eligibility criteria and regulatory adjustments as specified in 
the February 2010 public consultation 
This policy option builds on option 3.2 by addressing problems identified in section 3.3 that 
pertain not only to capital eligibility but also to regulatory adjustments.  To this end, this 
policy option entails lengthening the list of these adjustments as well as making their 
application more appropriate with respect to layers of regulatory capital. As specified in the 
consultation of February 2010 (see Annex VII), most of modified adjustments would be 
applied to the core, or, common equity Tier 1 (CET1) capital.  
EU QIS showed that under this policy option, total deductions amount to some 60% of CET1 
capital prior to deductions for Group 1 banks, and some 40% for Group 2 banks. In terms of 
individual deductions, at the EU level the most material impact on banks' eligible CET1 
capital would come from deductions for material holdings of financial institutions and 
goodwill. Other significant reductions in eligible CET1 capital would be driven by deductions 
for DTAs, other intangibles and minority interests in countries where minority interests are 
included in the current predominant form of Tier 1 capital.  
February 2010 public consultation of the Commission services included a proposal for 
deduction of only those DTAs that are subject to future profitability (i.e., tax losses carried 
forward). However, CEBS analysed the impact of deducting various types of DTAs. The 
analysis showed that DTAs related to future profitability comprise roughly one third of total 
DTAs in the EU, although in six MS they represent more than the half of existing DTAs.  
Overall, the impacts of individual regulatory adjustments on CET1 capital vary from one MS 
to another, and taken together have a major impact on CET1 capital ratio. 
As a result of stricter capital eligibility requirements and re-allocation of regulatory 
adjustments to CET1 capital, under this policy option the CET1 ratio would decrease for all 
countries as shown in Charts 10 and 11. Average EU CET1 ratio falls from 11.1% by some 7 
percentage points for Group 1 banks and from 11.5% by some 5 percentage points for Group 
2 banks, with considerable variation in the magnitude of the decline between and within 
countries. In terms of distributional effects, smaller (i.e., Group 2) banks are less severely 
affected by the definition of capital proposals than large and internationally active banks. 
Chart 10: Change in CET1 capital ratios 
for Group 1 banks due to capital definition 
proposal, in %: country averages 

Chart 11: Change in CET1 capital ratios for Group 2 banks due 
to capital definition proposal, in %: country averages 

20

16

12

8

4

0

New EU average

New CET1

Current CET1

20

16

12

8

4

0

New EU average

New CET1

Current CET1

L

H

J

EU

F

B

C

G

D

A

E

S

K

F

R

O

L

J

H

E

M

EU

G

D

A

C

T

B

Notes: Current CET1 ratio calculated on a smaller sample of banks and according to the predominant form of Tier 1 capital 
as applied by the bank or the relevant national supervisor; and is gross of deductions. New CET1 ratios capture the effects of 
proposals for eligibility to CET1 capital and deductions from it as well changes to RWAs related to definition of capital 
proposal. New CET1 ratios are understated to the extent that they reflect a full DTA deduction (as opposed to deduction of 
DTAs related to future profitability only). EU Group 1 'Current CET1' and Group 2 'New CET1' averages each include one 
additional MS that is not shown individually, while Group 1 'New CET1' and Group 2 'Current CET1' averages each include 
two additional MS. 
Source: CEBS 

110 

 
 
 
In their responses to the consultation as regards the eligibility of instruments for CET1 
capital, several public authorities and many industry respondents stated that greater onus 
should be placed on the substance of a capital instrument, e.g., its ability to absorb losses 
effectively, than on its legal form. As regards eligibility of Additional Tier 1 capital 
instruments, there was a significant support among public authorities for all such instruments 
to be required to have a principal write-down or conversion feature with an objective trigger, 
in line with the approach taken in CRD II, in order to ensure that such instruments absorb 
losses effectively and help an institution to remain as a going concern. Views of the industry 
on this topic were mixed. With respect to regulatory adjustments, a significant number of 
public authority respondents and many industry respondents expressed concern about the 
appropriateness of the proposed non-recognition of minority interest and full deductions of 
DTAs and investments in certain other unconsolidated financial institutions. 
Policy option 3.4: Modify both eligibility criteria and regulatory adjustments as adopted by 
the Basel Committee 
This policy option reflects the new definition of capital approach adopted by the Basel 
Committee that was outlined in the Committee’s Basel III rules text in December 2010. This 
option, compared to option 3.3, entails a number of changes with respect to certain regulatory 
adjustments, improving upon the underlying prudential rationale and taking into account of 
the impact of the proposals on the industry and potential impact on the economy. The key 
changes are as follows: 
- Minority interests: this option provides some recognition in CET1 to the minority interest 
supporting the risks of a subsidiary that is a credit institution, investment firm, or firm subject 
to the same prudential requirements and supervision as credit institutions and investment 
firms in the CET1.241 For this, minority interest should meet the criteria of common stock of 
the consolidating bank. However, capital above the regulatory minimum and a capital 
conservation buffer (please see section 5.5) of a subsidiary would be deducted in proportion 
to the minority interest share. 
- Investments in capital instruments of other financial institutions: this option includes an 
exemption for underwriting positions held for five working days or less and, under specific 
circumstances, allows the netting of long and short positions in other unconsolidated financial 
entities. 
- The treatment of significant investments in the common shares of unconsolidated financial 
institutions (i.e., more than 10% of their issued share capital), mortgage servicing rights, and 
deferred tax assets from timing differences is modified by giving these deductions a limited 
recognition when calculating the CET1, with such recognition capped at 10% of a bank’s 
common equity component for each of the above deductions. At the same time, banks would 
have to deduct the amount by which the aggregate basket of the three items above exceeds 
15% of their CET1 capital, calculated after all regulatory adjustments, while the items 
included in the 15% aggregate limit would be subject to full disclosure. Amounts that are not 
deducted from the CET1 as per the above approach, however, are risk weighted at 250%. 
EU QIS showed that CET1 deductions as % of new CET1 capital gross of deductions for 
Group 1 banks compared to option 3.3 decline markedly, while Group 2 banks experience a 
less pronounced decline (see Table 9). In terms of individual deductions, at the EU level the 
most material impacts are due to goodwill, material holdings of financial institutions and 
DTAs.  For both bank groups, deduction of surplus of items included in the basket has a low 
impact while deduction of mortgage servicing rights has no impact at all. Impacts of other 
individual adjustments continue to vary from one MS to another and, when taken together, 
exert a major albeit less pronounced, than under option 3.3, impact on the CET1 capital ratios. 

241 Equivalent treatment of minority interest has been proposed for Tier 1 and total capital. 

111 

 
 
 
                                                 
Table 9: CET1 deductions and minority interest as a percentage of new CET1 capital gross of deductions: 
comparison of policy option 3.3 and 3.4 for Group 1 and Group 2 banks 

y
r
t
n
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3
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0

0

-3

-4

-5

-4

-5

-2

-9

-3

-6

-12

-62

-45

-20

-33

-42

0
0
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0
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-2
-4
-1
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0

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-5
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-6
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-3

-4
-1
-3
-8
0
-3
-6
-1
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0

-2
0
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-5
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-8
-9
-4
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-4
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-2

-1
-10
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-20
-7
-11
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-9
-8
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-2

-3
-35
-15
-1
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-34
-69
-37
-24
-28
-8
-22
-9

-3
-3
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-5
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-1
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0
-8
0
-22
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0

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0
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-14
-47
-6
-41
-10
-16
-16
-29
-8
-12

-13
-19
-9
-35
-31
-16
-14
-13
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-1

-34
-67
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-32
-26
-6
-111
-12

-3
-3
-3
-8
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-1
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-6
-7
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-23
0

-28
-2
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-17
-4
-2
-6
-6
-6
-8
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-11
-39
-34
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-23
-23
-12
-16
-13
-7
-12
-10

-70
-68
-55
-47
-47
-43
-43
-37
-25
-24
-20
-16

-14
-4
-2
-14
-7
-3
-8
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0
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0
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-8
-10
-12
-4
-7
-9
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-69
-74
-71
-80
-93
-54
-80
-42
-28
-33
-24
-18

A
B
C
D
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F
G
H
I
J
K
L
M
N
O
P
Q
R
S
EU 4
-5
Notes: 1 Deductions for DTAs are based on full DTA deduction whereas the Commission services consulted only on 
exclusion of DTAs relating to future profitability of an institution; 2 'Other' includes deductions related to investments in 
own shares, shortfall of provision to expected losses, cash flow hedge reserve, cumulative changes in own credit risk, 
pension fund assets and securitisation gains on sale; 3 It is assumed that minority interest was already excluded from the 
current predominant form of Tier 1 capital. Therefore, minority interest is not included in the sum of deductions from CET1, 
and is shown for information purposes; 4 Group 1 EU average includes 3 more countries that are not shown individually 
while Group 2 EU average includes 2 additional countries.  
Source: CEBS 
As a result and without considering the impact of other proposals included in the CRD IV, 
average EU CET 1 capital ratio for Group 1 banks, compared to option 3.3, increases by some 
2 percentage points to 5.8% whereas that of Group 2 banks improves slightly to 7.1%, 
representing lower reductions from the current levels of predominant form of Tier 1 capital 
(see Charts 12 and 13 for distribution of CET1 capital ratios by country for Group 1 and 
Group 2 banks).  
As regards eligibility of Additional Tier 1 capital instruments, this option would entail a less 
stringent treatment than the policy options 3.2 and 3.3 discussed above since those options 
would require all such instruments, irrespective of them being regarded as equity or liabilities 
for accounting purposes, to contain a meaningful statutory or contractual loss absorption 
mechanism, whereas only instruments classified as liabilities must have principal loss 
absorption under the Basel approach, which effectively would increase Tier 1 capital under 
this option by an estimated €89 billion. Notably, treatment under policy option 3.4 would not 
be in line the provisions of CRD II in conjunction with CEBS' guidelines on hybrid capital 
instruments which is reflected under options 3.2 and 3.3. As a result certain MS would be 
affected less severely under option 3.4 in terms of its impact on Tier 1 capital. 

-3

-1

Chart 12: CET1 capital ratios (country 
averages) for Group 1 banks due to capital 
definition proposal, in % 

Chart 13: CET1 capital ratios (country averages) for Group 2 
banks due to capital definition proposal, in % 

112 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
New EU average

20

16

12

8

4

0

20

16

12

8

4

0

New EU average

L

K

I

J

H

E

EU

C

G

B

D

F

A

S

F

Q

O

L

J

R

M

E

H

P

N

A

G

EU

D

K

C

B

Notes: CET1 ratios capture the effects of proposals on eligibility for CET1 capital and deductions from it as well changes to 
RWAs related to definition of capital proposal. Group 1 EU average ratio includes 3 more countries that are not shown 
individually while Group 2 EU average includes 2 additional countries. 
Source: CEBS 
It can be estimated that under this policy option, combined current CET1 capital for 208 
Group 1 and Group 2 banks would decline by some €490 billion242, Tier 1 capital by €370 
billion and total capital by some €420 billion. Actual capital shortfall for the EU banking 
sector, however, would depend on the level of calibration of the new minima, implications of 
other parts of the proposal on the RWAs, and capital buffers that banks hold in excess of 
current regulatory minima (as can be seen from Charts 12 and 13). These aspects are assessed 
cumulatively in section 5.8.2 of this report.  
It is expected that the new capital definition and regulatory adjustments should significantly 
impact the stability of the financial system, by not only increasing the level of capital, but 
more importantly by increasing its quality, i.e., its capacity to effectively absorb economic 
and financial shocks thereby preserving the viability of financial institutions. In addition, 
some specific deductions, such as for unconsolidated investments in financial institutions, 
should have the effect of reducing systemic risk. 
Policy option 3.5: Modify both eligibility criteria and regulatory adjustments as adopted by 
the Basel Committee, adjusted for certain EU specificities 
Under this policy option, a number of adjustments have been considered to the approach of 
the Basel Committee outlined under option 3.4 in order to align it better with EU regulatory 
and banking sector specificities. These adjustments reflect certain features of option 3.3 
(Modify both the eligibility criteria and regulatory adjustments as specified in February 2010 
public consultation) as well as stakeholder feedback received in relation to public 
consultations. They include: 
- restricting CET1 to instruments that qualify under national law as equity capital243 and meet 
the CET1 criteria, rather than to ordinary shares that meet the CET1 criteria – this approach 
places greater onus on the substance of a CET1 instrument. It recognizes the fact that some 
EU institutions issue instruments other than ordinary shares having the loss absorbency 
equivalent to that of ordinary shares;  
- derogations from specific CET1 eligibility criteria for institutions that are mutuals, 
cooperative societies or similar institutions – this will help to ensure that the potential for 
general derogation from the CET1 criteria afforded by Basel III is applied appropriately and 
consistently in the EU;   
- rather than recognition in CET1 only where associated with an instrument that qualifies as 
CET1, recognition in CET1 also of share premia that qualified as original own funds under 
Article 57(a) of Directive 2006/48/EC prior to 31 December 2010 – the purpose of this 
approach is to provide recognition of the loss absorbing nature and role of such share premia, 
while also restricting the treatment to instruments issued prior to the entry into force of the 
stricter definition of capital introduced by CRD II;  

242  Change  between  current  predominant  form  of  Tier  1  capital  without  any  deductions  and  CET1  capital  as 

defined under option 3.4 

243 This represents a 'substance over form' approach, as it allows instruments other than common shares that meet 

all the eligibility criteria of Basel III to be included in CET1 

113 

 
 
 
 
                                                 
- a requirement for all Additional Tier 1 capital instruments, rather than only liabilities, to 
have principal write down or conversion feature244 - this approach takes account of the raising 
of capital quality in CRD II and ensures that the principal amount of both equity instruments 
and liabilities are able to absorb losses effectively on a going concern basis;   
- full, rather than limited, deduction from CET1 of mortgage servicing rights, as for all other 
intangible assets - such an approach takes account of the relative illiquidity and uncertain 
value of mortgage servicing rights, and the potential difficulty of realising significant amounts 
of them in a stressed or emergency situation. EU banks have limited amounts of mortgage 
servicing rights - by virtue of their US subsidiaries – and therefore impact of this adjustment 
is expected to be very small;  
- a restriction on the recognition of hedging for the purposes of determining the amounts to be 
deducted for investments in other unconsolidated financial entities to the trading book. The 
purpose of this approach is to limit the potential for double counting of capital in the financial 
system through the provision of hedges by entities that are not subject to an equivalent 
deduction requirement, and to reflect the fact that such holdings in the non-trading book 
continue to the maturity of the instrument and are difficult to hedge effectively;  
- an alternative approach for deduction of significant holdings in unconsolidated insurance 
entities combined with enhancements to the current approach to applying the methods laid 
down in the Financial Conglomerates Directive (FICOD). The purpose of this is to take 
account of, and to enhance, the cross sector treatment laid down in the FICOD of holdings of 
capital instruments in banking and insurance;  
- recognising minority interest – and certain regulatory capital issued by subsidiaries - to the 
extent that those subsidiaries are credit institutions or investment firms and the capital is used 
to meet minimum capital requirements, capital conservation buffer and countercyclical capital 
buffer (see section 5.5). This recognises the importance of the countercyclical capital buffer, 
the capital used to meet it, and it aims at avoiding any disincentives to its use; 
- clarification of the treatment of DTAs that automatically convert into a claim on the state 
when a firm makes a loss. Where their ability to absorb losses when needed is ensured, such 
DTAs would not have to be deducted.  
The overall net impact of the above adjustments on the CET1 ratios of Group 1 and Group 2 
banks presented under option 3.4 is assumed not to be of major significance, as some of them 
would make the new capital requirements more stringent while others would have an opposite 
impact. Most importantly, the adjustments have been developed with a view to ensure that the 
relevant policy objectives are attained in the most effective manner and that Basel III 
framework is meaningfully and flexibly applied to a diverse spectrum of the EU banking 
firms. 
Comparison of policy options 
Retaining the current scenario (option 3.1) implies that problems related to quality of capital, 
as outlined in section 3.3 may not be addressed effectively, depending on the actions taken in 
this area by national supervisors and/or the industry. While tightening of national approaches 
may provide for a degree of increased effectiveness with respect to capital adequacy 
(objective S-1) and bank management of risks (objective S-2) discussed in this section, there 
is no guarantee that necessary progress would be achieved quickly enough and evenly across 
the EU. 
Of the remaining policy options, option 3.2 would be the least effective with respect to 
contributing to the achievement of the relevant policy objectives due to its focus on eligibility 
criteria only. Policy options 3.3, 3.4 and 3.5 are perceived to be rather effective although they 
vary in terms of treatment of individual regulatory adjustments and, additionally, options 3.3 

244  This  addresses  the  issue  that  preference  shares,  while  not  being  effective  at  absorbing  losses  on  a  going 

concern basis, would not be required to have a write-down or conversion 

114 

 
 
 
                                                 
and 3.5 are more aligned with certain EU regulatory and banking sector–specific aspects. In 
this regard, option 3.5 is more developed as it reflects outcomes of extensive public 
consultations. Hence, policy option 3.5 is the most efficient option and is identified as a 
preferred option. 
Table 10: Summary of policy option effectiveness and efficiency 

Policy Option Comparison Criteria 

Effectiveness 

Policy Option 

Enhance 
adequacy of 
capital and 
liquidity 
requirement
s [S-1] 

Enhance 
bank risk 
managem
ent 
[S-2] 

Prevent 
regulatory 
arbitrage 
opportunit
ies [S-3] 

Enhance 
level 
playing 
field [S-6] 

4 

4 

5 

4 

5 

5 

3.1 Retain current approach 
3.2 Modify only the eligibility criteria as specified 
in the February 2010 public consultation 
3.3 Modify both eligibility criteria and regulatory 
adjustments as specified in the February 2010 
public consultation 
3.4 Modify both eligibility criteria and regulatory 
adjustments as adopted by the Basel Committee 
3.5 Modify both eligibility criteria and regulatory 
adjustments as adopted by the Basel Committee, 
adjusted for certain EU specificities 
Scale of option ranking: 1=most effective / efficient, 5=least effective / efficient 
Effectiveness measures extent to which options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources 

1-3 

1-3 

1-3 

1-3 

1-3 

1-3 

1-3 

1-3 

1-3 

5 

4 

2-3 

2-3 

1 

Align 
prudential 
requireme
nts for 
SIFIs with 
the risks 
they pose 
[S-8] 
5 

4 

1 

2-3 

2-3 

Reduce 
cyclicality 
of bank 
lending 
[S-9] 

Efficie
ncy 

5 

4 

1-3 

1-3 

1-3 

5 

4 

3 

2 

1 

5.3. 

Counterparty credit risk 

To address problems related to current rules on the counterparty credit risk (CCR), discussed 
in section 3.4, the Commission services propose a number of revisions in this area with the 
main policy options as follows: 

-  Policy option 4.1: Retain current approach; 
-  Policy  option  4.2:  Enhance  adequacy  and  minimize  cyclicality  of  CCR  capital 
requirements  and  enhance  incentives  for  clearing  OTC  instruments  through  central 
counterparties (CCPs); 

-  Policy  option  4.3:  Enhance  adequacy  and  minimize  cyclicality  of  CCR  capital 
requirements, enhance incentives for clearing OTC instruments through CCPs and adjust 
the treatment of exposures to CCPs. 

Policy option 4.1: Retain current approach 
Under this policy option, problems outlined in section 3.4 would not be addressed. The 
capitalisation for CCR would remain to be insufficient and the corresponding risk 
management standards inadequate. Credit institutions would continue to lack incentives to 
move their bilaterally cleared OTC derivative contracts to multilateral clearing through central 
counterparties (CCPs). No consideration would be given to the degree of cyclicality of the 
capital requirements.  
Policy option 4.2: Enhance CCR requirements 
This policy option would entail amending the CCR framework in several areas in order to 
ensure a more appropriate capitalisation for CCR. This would include the following 
amendments: 
- Capital requirements for credit valuation adjustment (CVA) risk: credit institutions would be 
subject to an additional capital charge for mark-to-market losses (i.e., CVA risk) associated 
with deterioration in the creditworthiness of a counterparty. As mentioned in section 3.4, 
while the current regulatory standards cover the risk of a counterparty default, they do not 
address such CVA risk, which has been a greater source of losses than outright defaults. The 
new CVA capital charge has been designed in a risk sensitive manner. It would also allow 

115 

 
 
 
recognising both single name and index hedges of the CVA risk and thus promote sound 
practices in managing this risk. Such approach would allow banks to considerably mitigate 
the impact of the new CVA capital charge and, in turn, largely address concerns of the end 
users of derivatives - expressed in the public consultations - about the possible 
disproportionate impact of this measure on non-financial institutions using derivatives for risk 
mitigating purposes, in case banks' hedging of the CVA risk were not adequately 
recognised.245 As far as financial markets are concerned, the recognition of hedging is likely 
to cause an increase of demand for both single-name and index Credit Default Swaps (CDS) 
and contribute to further growth of the corporate CDS market.  
- Adjustment of the asset value correlations: to address the systemic risk within the financial 
sector, this option suggests raising the risk weights on exposures to financial institutions 
relative to the non-financial corporate sector, as financial exposures are more highly 
correlated than non-financial ones. Specifically, it suggests applying a multiplier of 1.25 to 
the asset value correlation of exposures to regulated financial firms (with assets above $100 
billion) and to all exposures to unregulated financial firms (regardless of size). The measure is 
expected to encourage diversification of CCR among smaller institutions and, overall, should 
contribute to less interconnectedness between large or systemically important institutions and, 
possibly, limit the propagation of a shock originating in a default of a large or systemically 
important financial institution (SIFI). To the extent that wholesale financial markets are 
characterised by a hub and spoke structure, relationships between hubs will be weakened and 
banks in spokes will have an incentive to increase the number of their relationships. This 
could reduce the scope to benefit from scale economics and therewith reduce overall 
efficiency. On the other hand, it also implies stronger competition among hubs and possibly 
lower margins in wholesale financing, which could have beneficial effects for the economy at 
large as well as in terms of a reduction of systemic risk as a whole. 
- Calibration of the exposure at default for CCR exposures: credit institutions would be 
required to calculate the Effective Expected Positive Exposure metric based on data that 
includes a period of stress to address general wrong-way risk. The amendments would also 
explicitly determine the treatment of exposures with counterparties where specific wrong-way 
risk has been identified. These amendments would dampen the cyclicality of the respective 
capital requirements. The resultant increase in regulatory capital would limit the scope for 
contagion (banks should be less affected by a default of counterparty) and should contribute 
to strengthening of the financial stability, which may further translate into lower risk premia 
banks have to pay for obtaining funds and better availability of financing for the economy.    
- Strengthening standards for collateral management and initial margining, stress testing and 
back-testing (model validation). 
- Clearing of OTC instruments through CCPs: this option would also considerably reinforce 
the existing incentives for institutions to use CCPs for OTC derivatives as the proposed 
amendments would increase the assessed capital requirements against such exposures if 
completed on a bilateral basis rather than through a CCP. Assuming that most institutions 
dealing with OTC derivatives move to CCP clearing, a number of the derivatives currently 
traded on the OTC markets would have to become more standardized, which is one of 
requirements to be cleared and also a necessary condition to achieving the counterparty risk 
reduction benefits of central clearing. Standardisation can be a powerful tool of raising market 
efficiency and liquidity. As regards hedging, standardisation might in certain instances 

245 Specifically, end users of derivatives (including non-financial institutions) feared that banks would pass the 

additional costs resulting from the new CVA charge on to their counterparties by increasing the price of 
the respective derivative products, which are being used by end users for risk mitigation purposes. End 
users claimed that this would disincentivise them to enter into such derivative transactions and thus 
mitigate the risk accordingly. 

116 

 
 
 
                                                 
weaken the relationship between a derivative and underlying risk/instrument and can therefore 
not be extended to the entire OTC derivatives market. As market participants (including non-
financial institutions / end users of derivatives) have an interest in tailor-made contracts, the 
strengthening of CCPs may lead to higher costs for them as liquidity will suffer in the non-
standardised segments. 
The number of banks included in the CCR analysis in the EU QIS was considerably smaller 
than the overall number of participating banks. This can be primarily attributed to the fact that 
this type of risk is relevant only to banks with significant OTC derivative and/or SFT 
activities as well as insufficient data quality which led to the exclusion of 17 of the 50 Group 
1 banks from the analysis.  
Due to proposals under this policy option, the remaining 33 Group 1 banks had an average 
increase in their RWAs of some 10%246; most of it due to the proposed CVA charge. Capital 
increases related to other measures, including the rise in the asset value correlation, were by 
comparison modest. Across EU MS, above-average increases in the RWAs were observed in 
banks from MS H, E and J. Notably, the average increase in RWAs of Group 2 banks was 
significantly smaller at 0.2%, illustrating that these banks have typically less exposure to OTC 
derivatives, and that proposals with regard to CCR have major implications only for the 
largest EU banks. 
Policy option 4.3: Enhance CCR requirements and adjust treatment of exposures to central 
counterparties  
This policy option reflects the new CCR framework adopted by the Basel Committee that was 
outlined in the Committee’s Basel III rules text in December 2010. It builds on the policy 
option 4.2 and entails, in addition, a recalibration and differentiation of the treatment of 
exposures to CCPs247 depending on the type of the exposure the credit institution has vis-à-vis 
a CCP and whether the respective CCP complies with a set of stringent risk management 
standards.248  
More specifically, this proposal would differentiate between (i) collateral and mark-to-market 
exposures to CCPs and (ii) the default fund contributions249:  
- The collateral and mark-to-market exposures would attract a very low (e.g., 1%) risk weight, 
reflecting the low (however, non-zero) risk that such exposures entail.250 Such treatment 
would, however, be allowed, only if a given CCP meets a set of robust risk management 
standards. The collateral and mark-to-market exposures to CCPs that are not compliant with 
these standards would be treated like any other bilateral counterparty. Such approach would 

246 Not including capital charges for exposures to CCPs 
247 Currently, banks’ exposures to CCPs generally attract a zero EAD; few requirements are placed on CCPs in 

order for banks to use a zero EAD in calculating their exposures to such entities. 

248 A CCP is an entity that interposes itself between counterparties to a contract traded within one or more 

financial markets, becoming the buyer to every seller and the seller to every buyer. A CCP can play an 
important role in the efforts to reduce the systemic risk arising from the web of exposures formed by 
holdings of derivatives products by banks and other financial institutions However, a CCP also 
concentrates risk, which means that a CCP with insufficiently robust risk management processes can 
actually increase the systemic risk. In order to avoid such a situation, supervisors need to ensure that a 
CCP has in place strong risk management procedures and is, more generally, subject to and complies 
with strict rules/standards governing all aspects of its operations. In this context, on 15 September 2010, 
the Commission adopted a proposal for a Regulation on OTC derivatives, central counterparties and 
trade repositories, which envisages subjecting CCPs to stringent business conducts and harmonised 
organisational and prudential requirements such as internal governance rules, audit checks, greater 
requirements on capital etc; see http://ec.europa.eu/internal_market/financial-
markets/derivatives/index_en.htm#proposals 

249  The  default  fund  contributions  are  designed  to  cover  losses,  over  and  above  initial  margin,  following  a 

clearing member default 

250  Collateral  held  by  an  entity  acting  as  a  custodian  will,  provided  such  collateral  will  not  form  part  of  the 

custodian's estate in a bankruptcy, receive a zero risk weight.  

117 

 
 
 
                                                 
considerably promote the use of the CCPs with high risk management standards with all the 
related positive impact on financial stability.  
- The default fund contributions would attract higher capital charge (compared to collateral 
and mark-to-market exposures) that would be derived on the basis of a risk sensitive 
approach, reflecting the financial resources waterfall of a CCP in question. The capital charge 
applied to the default fund contributions would therefore vary according to the financial 
resources (such as initial margins or CCP own capital) available to support any possible losses 
before the default fund contributions are used. Such approach would considerably increase 
incentives for firms to post higher initial margins, which would in turn increase the robustness 
of CCPs and enhance the financial stability. The treatment of default fund contributions 
posted with a CCP that does not comply with the enhanced standards would be significantly 
more conservative.  
The above described approach would, compared to the existing regime, lead to an increase of 
capital requirement for exposures to CCPs. This increase however would only be marginal 
and not significantly affect the effectiveness of the goal to reinforce the incentives for 
institutions to use CCPs for OTC derivatives outlined in the discussion of policy option 4.2 as 
the increase in capital requirements for exposures arising from bilaterally cleared transactions 
would be significantly greater. 
In the context of this option, the Commission services publicly consulted on the capitalisation 
of exposures to CCPs and the treatment of incurred CVA in February-March 2011251.  
The latter deals with the issue of how to treat losses against the CVA risk which a bank in 
question writes down upfront. Given that incurred CVA has been recognized in the Profit & 
Loss account, and thus effectively represents an amount that cannot be lost again were the 
counterparty to default, the Basel Committee suggested a treatment where incurred CVA 
could be deducted from the exposure amount (Exposure at Default) in the calculation of the 
capital requirements for the default component of CCR.  
A vast majority of respondents to the Commission services' consultation nevertheless 
expressed serious concerns about such an approach, arguing that it is conceptually inadequate 
and that the degree of the recognition of incurred CVA is disproportionately low.  
The Commission services have extensively analysed the comments received252 and as 
subsequently suggested an alternative treatment, which would allow for a greater, however 
still prudent, degree of recognition of incurred CVA. In essence, such treatment would allow 
institutions applying the IRB approach to offset the regulatory expected loss for CCR by the 
amount of incurred CVA, but this offset would be capped at the level of expected loss on the 
trade/netting set to which it relates. Institutions applying the Standardised Approach would be 
subject to the same treatment as proposed by the Basel Committee. 
The Commission services consider the above alternative treatment for institutions applying 
the IRB approach conceptually sounder, consistent with the rest of the regulatory framework 
applied to those institutions and more effective in eliminating the double count referred to 
above. The benefits of such approach would nevertheless be somewhat diminished by the 
possible costs implied for internationally active banks by divergence from the treatment 
proposed by the Basel Committee, provided that such treatment is confirmed and 
implemented as announced in the Basel III framework published in December 2010.  
However, in the view of the Commission services any such divergences would not have 
material implications for the EU industry overall and therefore are not elaborated further in 
this assessment. 
Comparison of policy options 

251 http://ec.europa.eu/internal_market/bank/regcapital/index_en.htm#consultation_credit_risk  
252http://circa.europa.eu/Public/irc/markt/markt_consultations/library?l=/financial_services/credit-

risks&vm=detailed&sb=Title  

118 

 
 
 
                                                 
Policy option 4.1 entails possible significant costs in terms of inadequate capital and risk 
management standards for CCR, with its resulting negative consequences for financial 
stability. This option can be therefore discarded from any further considerations.  
In contrast, policy option 4.2 is effective in addressing all key shortcomings outlined in 
section 3.4 – it ensures more adequate and less cyclical capital requirements for CCR, 
strengthens risk management standards and provides additional incentives to move OTC 
derivative contracts to CCPs, thus, helping to reduce the systemic risk across the financial 
system.  
Measures proposed under policy option 4.3 (on top of those proposed under policy option 4.2) 
enhance capital requirements (objective S-1) and bank risk management (objective S-2) and 
reduce the systemic risk even further by ensuring an appropriate capitalisation for exposures 
to CCPs and providing additional important incentives to move OTC derivative contracts to 
CCPs with the highest risk management standards. As a result, policy option 4.3 is identified 
as a preferred policy option. 
Table 11: Summary of policy option effectiveness and efficiency 

Policy Option Comparison Criteria 

Effectiveness 

Policy Option 

Enhance bank 
risk 
management 
[S-2] 

Enhance 
adequacy of 
capital and 
liquidity 
requirements [S-
1] 
3 
2 

Align 
prudential 
requirements 
for SIFIs with 
the risks they 
pose [S-7] 
3 
2 

1 

Reduce 
cyclicality of 
bank lending 
[S-9] 

Efficiency 

3 
2 

1 

3 
2 

1 

4.1 Retain current approach 
4.2 Enhance CCR requirements  
4.3 Enhance CCR requirements and adjust 
treatment of exposures to CCPs  
Scale of option ranking: 1=most effective / efficient, 3=least effective / efficient 
Effectiveness measures extent to which options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources 

3 
2 

1 

1 

5.4. 

Leverage 

To address excessive build-up of leverage on banks' and investment banks' balance sheets and 
help contain the cyclicality of bank lending, the Commission services investigated a 
possibility of introducing a non risk-based leverage ratio.  The main policy options in this area 
are as follows: 
-  Policy option 5.1: Retain current approach; 
-  Policy option 5.2: Introduce supplementary non risk based leverage ratio as specified in 

the February 2010 public consultation; 

-  Policy option 5.3: Conduct extensive monitoring of different types of supplementary non 

risk based leverage ratio. 

Policy option 5.1: Retain current approach 
Under this policy option the building up of excessive leverage during the next economic 
upturn would not be addressed other than by increased minimum capital requirements, once 
adopted. Also, there would be no overall backstop against model risk. In addition, there would 
be a risk that supervisors may introduce various national treatments in this area, which could 
undermine the level playing field within the EU and internationally. 
Policy option 5.2: Introduce leverage ratio as specified in the February 2010 public 
consultation 
This policy option would introduce a leverage ratio as per the definition included in the public 
consultation of February 2010, which was closely aligned with the consultative document of 
the Basel Committee of December 2009.  
In the process of the EU QIS, several variations of a possible ratio were assessed. For 
example, both Tier 1 and total capital for the numerator of the ratio were considered, while for 

119 

 
 
 
the calculation of the exposure base (the denominator) a possibility of excluding high quality 
liquid assets from the on-balance sheet exposure amount was examined.  
The distributions of average leverage ratios for Group 1 and Group 2 banks of different 
countries for the principal variant of the ratio are shown in Charts 14 and 15. Notably, at the 
EU level, the average Group 2 bank leverage ratio of 3.1% (representing a multiple leverage 
of 32 times Tier 1 capital) is almost double that of 1.6% (representing a multiple leverage of 
63 times Tier 1 capital) of Group 1 banks, indicating that smaller EU banks are less leveraged. 
This outcome is mostly explained by the fact that larger Group 1 banks are more impacted by 
i) the new Basel definition of Tier 1 capital (see section 5.2) and ii) the proposed treatment for 
non-traditional banking assets. In particular, the proposed deductions from CET1 capital were 
considered to be fully and directly applicable without recognising the mitigating effects of the 
agreed phasing-in regime, which has a significant impact on the Tier 1 capital base. Non-
traditional banking assets constitute a relatively larger portion of Group 1 bank business 
(compared to Group 2 banks) and their treatment had an important impact on the exposure 
base by not allowing netting of derivatives, valuing written credit derivatives at 100% of their 
notional value and capturing off-balance sheet exposure at 100%. 
Feedback to the public consultations showed that the exposure base (i.e., denominator of the 
ratio) under this option is broadly defined and in some cases may give a too wide capture of 
leverage. These cases include application of proposed conversion factors of 100% for 
unconditionally cancellable off-balance sheet exposures such as credit cards and of gross 
nominal values of derivatives without allowing for netting under the Basel II framework. 
Furthermore, both national authorities and the industry expressed concerns that institutions 
with lower risk business models would be affected disproportionately as low capital 
requirements of such institutions would result in higher leverage ratios. Given that these 
institutions are critical for providing credit to the real economy (including to SMEs) a wrong 
calibration of the leverage ratio might therefore have unintended consequences for the 
economic recovery. 

Chart 14: Leverage ratios (country averages) 
for Group 1 banks, in % 

Chart 15: Leverage ratios (country averages) for Group 2 
banks, in % 

8

7

6

5

4

3

2

1

0

           EU average 

8

7

6

5

4

3

2

1

0

               EU average 

I

L

D

J

C

H

B

EU

E

F

A

G

Q

S

A

M

R

P

K

C

D

H

EU

J

F

E

B

G

Notes: Leverage ratio using the new definition of Tier 1 capital in the numerator, and both on- and off-balance sheet 
exposures in the denominator. More specifically, in the denominator credit conversion factor of 100% for all off-balance 
sheet exposures was used, including for unconditionally cancellable commitments, written credit derivatives were measured 
at 100% of their notional value, other derivatives measured at potential future exposure, and no netting of financial 
derivatives was recognised. Group 1 EU average includes 4 additional countries that are not shown individually while Group 
2 EU average includes 2 additional countries. 
Source: CEBS 
Policy option 5.3: Conduct extensive monitoring of leverage 
While a non risk-based supplementary leverage ratio (although differently defined) already 
exists in the US, Canada and Switzerland, experience with this measure in the EU is very 

120 

 
 
 
 
 
 
 
limited. Hence, both its definition and calibration need to be chosen very carefully to avoid 
any unintended adverse impacts. Discussions in this regard at the level of the Basel 
Committee also confirmed these concerns. Therefore, Basel III rules text foresees a review 
period of a full credit cycle to assess the effectiveness of this policy measure. Such review 
would assess, among others:  
- impacts on lower risk business models versus higher risk business models, and effects of 
possible migration from the former to the latter (the EU QIS did not provide sufficient 
information on the distribution of leverage ratios across different banking business models);  
- changes in overall balance sheet structure due to securitisation;   
- interaction of the ratio with the risk-based capital requirements;  
- impacts on markets for specific financial products such as repos and covered bonds;  
- its effectiveness of mitigating pro-cyclicality throughout an economic cycle;  
- impacts on lending to SMEs and trade financing; and  
- impacts that differences in financial reporting frameworks may have on comparability and 
the international level playing field for the EU institutions.  
Until a more extensive monitoring of the leverage ratio has been carried out it is not possible 
to define the most effective design and absolute minimum level of the leverage ratio for all 
types of EU credit institutions and investment firms. The Commission services intend to 
conduct such monitoring for several alternative definitions of the numerator and the 
denominator of the ratio (including the definitions outlined in Basel III rules and in February 
2010 public consultation), which would feed into the development of the most effective 
variant of this policy measure. On the basis of this review and prior to making it a binding 
measure from 2018, the Commission services will prepare another proposal on the final 
design and calibration of the leverage ratio.  

Comparison of policy options 
Retaining the current scenario (option 5.1), implies that problems related to excessive build-
up of leverage, as outlined in section 3.5.2, may not be addressed effectively, depending on 
the actions taken in this area by national supervisors and/or the industry. While tightening of 
national regimes may provide for a degree of improved effectiveness with respect to 
regulation (objective S-1) and bank management (objective S-2) of risks discussed in this 
section, there is no guarantee that necessary progress would be achieved quickly enough and 
evenly across the EU. 
Under policy option 5.2 steps were taken to examine a number of alternative formulations of 
the leverage ratio. While most of alternative formulations examined would provide for a 
certain degree of effectiveness as regards contributing to the achievement of relevant 
objectives S-1 (Enhance adequacy of capital and liquidity requirements), S-2 (Enhance bank 
risk management), and S-9 (Reduce cyclicality of bank lending), they may also entail a risk of 
unintended consequences (which can be only ascertained following a more extensive 
monitoring exercise) which makes this option less attractive from the efficiency standpoint. 
Policy option 5.3 is marginally more effective and efficient than option 5.2 due to its more 
appropriate – from a prudential angle - eventual design of both the numerator and the 
denominator of the ratio as well as its eventual calibration following the monitoring exercise. 
Policy option 5.3 therefore is identified as a preferred option.  
Table 12: Summary of policy option effectiveness and efficiency 

Policy Option 

Policy Option Comparison Criteria 

Enhance adequacy 
of capital and 
liquidity 
requirements [S-1] 

Effectiveness 
Enhance bank 
risk 
management 
[S-2] 

Reduce 
cyclicality of 
bank lending 
[S-9] 

Efficiency 

121 

 
 
 
 
 
Policy Option 

5.1 Retain current approach 
5.2 Introduce leverage ratio as specified in the February 
2010 public consultation 
5.3 Conduct extensive monitoring of leverage ratio  
Scale of option ranking: 1=most effective / efficient, 3=least effective / efficient 
Effectiveness measures extent to which options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources 

2 

1 

1 

2 

Policy Option Comparison Criteria 

Enhance adequacy 
of capital and 
liquidity 
requirements [S-1] 
3 

Effectiveness 
Enhance bank 
risk 
management 
[S-2] 
3 

Reduce 
cyclicality of 
bank lending 
[S-9] 
3 

2 

1 

Efficiency 

3 

2 

1 

5.5. 

Capital buffers 

The Commission has already adopted certain policy proposals aimed at tackling some of the 
market  failures  outlined  in  section  3.5  and  mitigating  the  pro-cyclicality  in  the  financial 
system.  However,  additional  policy  measures  are  needed  to  address  the  outstanding  yet 
significant  problem  drivers.  To  this  end,  the  Commission  services,  in  line  with  the 
conclusions  of  the  report  on  the  effects  of  the  CRD  on  the  economic  cycle  of  June  2010, 
examined  a  possibility  of  implementing  instruments  that  would  move  in  a  countercyclical 
fashion  to  bank  capital  levels,  i.e.,  would  increase  in  economic  upturns  and  decrease  in 
downturns.  Such  measures  would  smooth  the  cyclicality  of  bank  lending  by  providing  for 
supplementary capital buffers that would ensure financial soundness of banks throughout the 
economic cycle and protect the sector from periods of systemic risk build-up. The key policy 
options in this area are as follows: 

-  Policy option 6.1: Retain current approach; 
-  Policy  option  6.2:  Introduce  a  capital  buffer  to  enhance  individual  banks’  ability  to 
absorb losses over prolonged periods of market stress, i.e., capital conservation buffer; 
-  Policy option 6.3: Introduce a capital buffer to protect banks from periods of risk build-

up at the macro level, i.e., countercyclical capital buffer; 

-  Policy  option  6.4:  Introduce  a  dual  capital  buffer,  comprising  both  a  capital 

conservation buffer and a countercyclical capital buffer. 

Policy option 6.1: Retain current approach 
Under this policy option, drivers of pro-cyclicality discussed in section 3.5 would be 
addressed only with the policy measures that have been already adopted by the Commission 
or new measures adopted by MS. However, since the pro-cyclicality is driven by a number of 
such drivers, additional measures are necessary, in particular, when it comes to dealing with 
market failures of behavioural nature, e.g., limitations in risk measurement at the absolute 
level (which, among other factors, contribute to building up of systemic risk and incapacity to 
sustain losses evoked by crises that follow) or inappropriate responses to risk and changes in 
economic conditions (which have been shown to weaken financial resilience of individual 
firms in times of stress). Hence, this policy option is largely sub-optimal in terms of its 
effectiveness vis-à-vis attainment of relevant policy objectives. Furthermore, supplementary 
policy measures to address the problem of a systemic nature may require certain macro-level 
and / or cross-border arrangements which are feasible only with the EU level legislation.  
Policy option 6.2: Capital conservation buffer 

The design of a capital conservation buffer was laid out in the Commission services’ public 
consultation  of  February  2010.  The  buffer  would  be based on a fixed buffer target over the 
regulatory capital minimum to absorb losses in 'stressed' periods that may span a number of 
quarters / years. Banks would be expected to build up such capital in 'good' economic times. 
Those banks that fell below the target would face constraints on discretionary distributions of 
earnings  (i.e.,  dividend  payments,  share  buybacks,  discretionary  payments  on  other  Tier  1 

122 

 
 
 
capital  instruments  and  discretionary  bonus  payments  to  staff)  until  conservation  capital 
buffer target is reached.  

More  specifically,  a  buffer  range  would  be  established  above  the  new  regulatory  minimum 
capital  requirement  and  capital  distribution  constraints  would  be  imposed  on  those  banks 
whose  capital  levels  fall  in  this  range.  It  is  important  to  emphasize,  that  in  such  instances, 
banks would be able to conduct business as normal; the constraints imposed would relate only 
to  discretionary  distributions,  and  not  operations  of  banks.  The  restriction  on  distributions 
would depend on a distance to the target level – the further from the target (within the range 
between  the  minimum  and  the  target)  the  level  of  capital  falls,  the  higher  percentage  of  its 
earnings in the subsequent year a bank would be required to conserve. These rules would be 
applied at the consolidated group level, i.e., restrictions would be imposed on distributions out 
of  the  consolidated  group,  however,  in  order  to  conserve  resources  in  specific  parts  of  the 
group national supervisors would have an option to apply the regime at the 'solo' level.  

Such  approach  would  be  effective  at  ensuring  that  the  banking  sector  accumulates  capital 
buffers  when  it  has  the  earnings  capacity  to  do  so.  This  should  enhance  resilience  of 
individual  institutions  in  periods  of  stress  in  the  financial  markets,  as  they  would  be  better 
positioned to absorb related losses. However, this approach does not ensure that cumulating 
the  additional  capital  to  cover  risks  at  the  individual  bank  level  would  coincide  with  the 
periods of excessive credit growth at the macro level and a concomitant build-up of systemic 
risks  which  need  to  be  prevented  to  protect  banks  (as  well  as  other  economic  agents)  from 
consequences  of  ensuing  systemic  crises.  Industry  representatives,  in  their  responses  to  the 
public consultation, argued that effectiveness of this policy option in terms of containing the 
cyclicality  of  bank  lending  would  be  limited  due  to  their  unwillingness  to  skip  dividends, 
which would effectively lead to their perception of a target of the conservation capital buffer 
as a new regulatory minimum capital requirement (which it will not be).  

Policy option 6.3: Countercyclical capital buffer 

The design of a countercyclical capital buffer was laid out in the Commission services’ public 
consultations of February 2010 and October 2010. The buffer would ensure that bank capital 
requirements take account of the macro-financial environment in which banks operate and, in 
turn,  to  achieve  the  broader  macro-prudential  goal  of  protecting  the  banking  sector  and  the 
real  economy  from  the  system-wide  risks  stemming  from  the  boom-bust  evolution  in 
aggregate  credit  growth.  Importantly,  the  countercyclical  capital  buffer  would  also  help  to 
lean  against  the  build-up  phase  of  the  cycle  which  would  occur  through  the  capital  buffer 
acting  to  raise  the  cost  of  credit,  and  therefore  dampen  its  demand,  when  there  would  be 
evidence that the stock of credit has grown to excessive levels relative to its long term trend.  

Competent  authorities  in  each  MS  would  be  responsible  for  setting  the  buffer  add-on253 
applicable to credit exposures to counterparties located in their jurisdiction. The add-on would 

253  The  methodology  for  calculating  buffer  add-on  has  been  developed  by  the  Basel  Committee  and  has  been 
subject to public consultation conducted by the Commission services. The methodology transforms the 
aggregate private sector credit/GDP gap into a suggested buffer add-on. It indicates a zero guide add-on 
when  credit/GDP  is  near  or  below  its  long-term  trend  and  a  positive  guide  add-on  when  credit/GDP 
exceeds its long term trend by an amount which, on the basis of available historical data, suggests there 
could be excess credit growth that may be associated with a build up of system-wide risk. Analysis of 
the credit/GDP gap showed that while it would often have been a useful guide in taking buffer decisions 
in  the  past,  it  does  not  always  work  well  in  all  jurisdictions  at  all  times.  Thus,  rather  than  relying 
mechanistically on the credit/GDP guide, authorities would be expected to apply judgment in setting of 
the  buffer  in  their  jurisdiction  after  using  the  best  information  available  to  gauge  a  build-up  of  the 
system-wide risk. 

123 

 
 
 
                                                 
be  subject  to  an  upper  bound  and  would  only  be  imposed  when  there  is  evidence  that  the 
excess  credit  growth  results  in  a  build-up  of  the  system-wide  risk.  Credit  institutions  with 
exclusively domestic credit exposures would only be subject to the add-on determined by the 
competent authorities of the home MS, whereas institutions providing services in other MS by 
means of a branch or free provision of services in relation to exposures located in those MS 
would apply the buffer add-on as determined by the host MS competent authorities, when the 
buffer is set between 0% and 2.5% of risk weighted assets.254 When the buffer determined by 
host  MS  exceeds  2.5%,  home  MS  authorities  would  be  allowed,  but  not  obliged  to  apply  a 
buffer rate higher than 2.5%. 

Banking  groups  having  subsidiaries  in  other  MS  for  the  purposes  of  calculating  the  buffer 
add-on on the consolidated basis would have to apply the buffer add-ons determined by the 
competent  authorities  of  the  subsidiaries.  In  practice,  this  means  that  cross-border  credit 
institutions  would  have  to  look  at  the  geographic  location  of  their  credit  exposures  and 
calculate their countercyclical capital buffer according to the add-ons prevailing in those MS 
where their exposures are located. For banking groups, decisions on the level of the counter-
cyclical buffer could take place in the context of the joint decision process of Article 129(3) 
of the CRD whereby the consolidating supervisor and the other relevant competent authorities 
would  consult  each  other  and  reach  a  joint  decision  on  the  application  of  the  buffer  at 
consolidated  level  and  at  the  level  of  each  subsidiaries.  In  case  of  a  disagreement,  the 
respective  competent  authorities  would  make  their  own  decision  in  accordance  with  their 
responsibilities,  i.e.,  consolidated  requirement  would  be  determined  by  the  consolidating 
supervisor  whereas  'solo'  requirements  -  by  competent  authorities  responsible  for  the 
supervision of subsidiaries.  

Countercyclical buffer add-on decisions would be pre-announced by 12 months to give banks 
time to meet the additional  capital  requirements  before they take  effect,  while reductions in 
the buffer would take effect immediately to help reduce the risk of the supply of credit being 
constrained  by  regulatory  capital  requirements.  The  consequences  of  not  meeting  the 
countercyclical  capital  buffer  would  be  the  same  as  those  of  not  meeting  the  capital 
conservation buffer (i.e., constraints on discretionary distributions of earnings). 

In cases where  banks  have  exposures to jurisdictions that do not operate and publish buffer 
add-ons,  the  competent  authorities  would  have  to  set  their  own  buffer  add-ons  for  such 
exposures.  This  could  be  done  by  using  credit  and  GDP  data  and  other  information  on 
economic and financial conditions for those jurisdictions available from BIS, IMF and other 
sources.  In  the  European  context,  this  option  allows  for  the  involvement  of  the  European 
Systemic Risk Board (ESRB) to foster macro-prudential supervision, e.g., by recommending 
buffer add-ons for third country jurisdictions.  

This policy option would be effective at ensuring that bank capital regulation is responsive to 
macro-financial environment and, in turn, would protect the banking sector from the systemic 
risk  linked  to  excessive  credit  growth.  At  the  level  of  individual  institutions,  however,  this 
policy  may  not  be  entirely  effective  at  ensuring  that  they  have  sufficient  capital  buffers  to 
absorb losses incurred during protracted turbulent periods, especially considering the fact that 
credit growth in aggregate is used to gauge the need for buffer adjustments. 

Policy option 6.4: Dual capital buffer 

254 The same applies to exposures located in third countries, i.e., the competent authorities would have to use the 
buffer  add  on  calculated  by  the  third  country  in  which  the  credit  institution  operates  through  a 
subsidiary or a branch. 

124 

 
 
 
                                                 
The  design  of  a  dual  capital  buffering  approach  was  laid  out  in  the  Commission  services’ 
public consultations of February 2010 and October 2010. The approach effectively entails a 
combination of policy options 6.2 and 6.3. In terms of its key structural features, it is aligned 
with the approach of the Basel Committee. Combining the two buffers means that application 
of  the  countercyclical  buffer  would  take  effect  by  adjusting  the  size  of  the  buffer  range 
established  by  the  conservation  buffer.  As  discussed  under  option  6.3,  the  countercyclical 
element would be 'turned on' when there are significant risks that stock of credit has grown to 
historically high levels. Similarly, other key modalities of operating such a dual capital buffer 
would remain as presented in discussion of its individual components.  

The key advantage of this policy option over the other two alternatives is that by combining 
them  it  addresses  their  respective  shortcomings  in  relation  to  relevant  policy  goals,  i.e., 
inclusion  of  the  capital  conservation  buffer  would  cover  risks  on  the  individual  bank  level 
while inclusion of the countercyclical capital buffer would cover risks at the macro level and 
would  make  the  capital  buffers  of  banks  move  in  a  more  countercyclical  fashion  to  the 
economic cycle.  

The calibration of this policy option is presented in Table 5 while its impact on the EU 
banking industry is assessed in section 5.8 (cumulatively with new minimum capital 
requirements). Capital buffers are expected to have a positive impact on financial stability by 
design of the measures. By creating an additional buffer when excess credit growth is 
observed, they should protect banks in downturn periods thanks to a release of the buffer, 
thereby limiting the risks of negative spill-overs to the real economy. The pro-cyclical effects, 
therefore, would be mitigated. There may be, however, a risk of negative impact on credit 
volume in 'catching up' countries. The process of economic catching up is very often 
accompanied by a deepening of the financial sector and a rapid increase in credit growth. 
While the financial stability implications of this rapid credit growth should certainly be 
addressed, a balance must be struck in order not to unnecessarily slow down the 
recovery/growth acceleration. This concern is addressed by allowing for a supervisory 
judgement when deciding on the buffer level and timing of activation. 
Comparison of policy options 
As discussed above, policy option 6.1 is largely ineffective in tackling relevant problem 
drivers and achieving relevant policy objectives. Policy option 6.2 is more effective than 
option 6.3 in terms of enhancing banks' capacity to absorb losses over protracted periods of 
'stress' in the markets (objective S-1) but is less effective than option 6.3 in terms of operating 
in a countercyclical manner, which is a precondition for minimizing the cyclicality of bank 
lending (S-9). Policy option 6.4 addresses the above concerns by combining the two types of 
capital buffers into one buffering approach.  
In terms of compliance costs for the banking industry, option 6.2 would be the most costly 
and option 6.3 would imply the least compliance costs, as the countercyclical buffer would be 
applied only in times when credit growth at the aggregate level becomes excessive, whereas 
costs related to option 6.4 would fall in between the two extremes, depending on its 
calibration. However, when effectiveness of policy options is considered simultaneously, 
option 6.4 is identified as the most efficient alternative, and, in turn, as a preferred policy 
option. 
Table 13: Summary of policy option effectiveness and efficiency 

Policy Option 

6.1 Retain current approach 

Policy Option Comparison Criteria 

Enhance adequacy 
of capital and 
liquidity 
requirements [S-1] 
4 

Effectiveness 
Enhance bank 
risk 
management 
[S-2] 
4 

Reduce 
cyclicality of 
bank lending 
[S-9] 
4 

Efficiency 

4 

125 

 
 
 
Policy Option 

6.2 Conservation capital buffer 
6.3 Countercyclical capital buffer 
6.4 Dual capital buffer 
Scale of option ranking: 1=most effective / efficient, 4=least effective / efficient 
Effectiveness measures extent to which options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources 

Policy Option Comparison Criteria 

Enhance adequacy 
of capital and 
liquidity 
requirements [S-1] 
1-2 
3 
1-2 

Effectiveness 
Enhance bank 
risk 
management 
[S-2] 
1-3 
1-3 
1-3 

Reduce 
cyclicality of 
bank lending 
[S-9] 
3 
1-2 
1-2 

Efficiency 

2-3 
2-3 
1 

5.6. 

Single rule book in banking 

The options regarding the deletion of option and national discretions will be referred to in the 
rest of the analysis as follows: 

-  Policy option 7.1: Retain current approach; 
-  Policy  option  7.2:  Minimum  harmonization  of  national  supervisory  approaches 
through removal of options and discretions and specification of criteria for supervisory 
judgments and / or choices; 

-  Policy  option  7.3:  Maximum  harmonization  of  national  supervisory  approaches 
through removal of options and discretions and specification of criteria for supervisory 
judgments  and  /  or  choices  combined  with  removal  of  a  possibility  to  supplement  the 
CRD provisions with national rules in harmonised areas of the CRD; 

-  Policy  option  7.4:  Maximum  harmonisation  of  national  supervisory  approaches 
through removal of options and discretions and specification of criteria for supervisory 
judgments  and  /  or  choices  combined  with  removal  of  a  possibility  to  supplement  the 
CRD provisions with some exceptions in specific areas where gold plating is justified.  

Policy option 7.1: Retain current approach 
Under this option, national options and discretions will be kept in the CRD together with a 
'minimum harmonisation' approach allowing MS to lay down stricter prudential rules.  
In prudential terms, stricter prudential rules are usually driven by financial stability concerns. 
Some MS have decided not to implement certain provisions of the CRD255, or to provide for 
stricter rules256. 'Gold-plating' applies to all banks irrespective of the risk to which a given 
credit institution is or might be exposed. As part of this impact assessment, the Commission 
services asked CEBS to provide an analysis on areas where MS already 'gold-plates' the 
directive. Views of European supervisors were mixed as to whether existing 'gold-plating' 
provisions should be kept. On the one hand, some stressed that 'gold-plating' may prove 
useful for financial stability in the future. On the other hand, others emphasised that a full 
harmonisation was crucial in specific areas of the Directive, e.g., own funds, liquidity.  
Some MS have set the minimum solvency ratio at, e.g., 10% instead of the 8% required by the 
Directive, on macro-prudential grounds. Under Basel II, however, harmonised Pillar 1 capital 
requirements are complemented by a Pillar 2 capital requirement. Supervisors shall determine 
whether banks' own funds ensure a sound management and coverage of their risks, and shall, 
where appropriate, require higher capital requirements. In contrast, gold-plating – as a means 
to ensuring financial stability by providing higher minimum capital requirements – does not 
lend itself to a proportionate and thorough analysis of the risks that banks run. Under Basel 
III, banks would still be expected to operate above the minimum level of capital requirements 
as determined by supervisors under Pillar 2. In addition, it must be noted that Basel III would 

255 For the treatment of equity under the CRD, certain MS have not transposed the "PD/LGD" approach, arguing 

that this leads to less conservative capital requirements as opposed to other methods.  

256 For example, strict LTV requirements for exposures secured by real estate, or high risk weight for speculative 

real estate programs  

126 

 
 
 
                                                 
considerably increase the level of minimum capital requirements and provide for a macro-
prudential tools (e.g., capital buffers) to increase levels of capital when needed for macro-
economic reasons. This means that gold-plating the level of minimum capital requirements 
for reasons of financial stability does not seem to be necessary under Basel III. 
Downside to the current gold-plating approach and the existence of national options and 
discretions is the conflicting requirements at solo and consolidated level that increase 
compliance burden for groups. This is less of a problem for local banks without entities in 
other MS. In terms of supervisory convergence, gold-plating and options and national 
discretions may be detrimental to effective supervisory cooperation in colleges of supervisors 
as diverging supervisory approaches will not only be driven by different interpretations of a 
common rule book, but also by different rules laid down by MS to implement the same rule 
book. EBA would not be fully able to ensure a consistent implementation of Community 
legislation by providing interpretative guidelines (Article 16 of the EBA Regulation), by 
contributing to compliance with Union law (Article 17 of the EBA Regulation), and by 
developing technical standards (Article 18 of the EBA Regulation).  
Assuming that the consolidating supervisor 'imposes' the use of a national discretion at group 
and at local level – as authorised under Article 129(2) – retaining the current approach may 
also have implications for the level playing field in the host jurisdiction as explained under 
section 3.6.5.  
Policy option 7.2: Minimum harmonization 
Under this approach, options and discretions would be removed, but the CRD would be kept 
as a minimum harmonisation directive.  
Removing options and discretion in isolation is only partially effective in achieving the 
objectives of reducing compliance burden and enhancing supervisory convergence. In 
particular, when an option currently allows for a stricter prudential requirement257, removing 
this option by defining a clear set of criteria could be circumvented by the ability of 
supervisors to require stricter rules. Minimum harmonisation is not fully effective in meeting 
the objective of ensuring a level playing field. Capital requirements fall within the 
responsibility of the home supervisors. Banks providing services in a host country – either by 
free provision of services or through a branch – are not subject to the requirements of the host 
country which may differ from the requirement in the home country.  
Where the exercise of an option currently leads to a less stringent treatment, e.g., 50% risk 
weight for commercial real estate, its generalisation may be at odds with the objective of 
financial stability. In keeping with this objective, harmonisation should be done – under this 
policy option – upwards towards the most prudent standard. In the above example of 
commercial real estate, this could mean proposing a lower level of loan-to-value (LTV) 
requirement. Downside to this approach is that harmonisation towards the most prudent 
standard does not always accommodate differences in local markets. 
Under this option, the mutual recognition of national options would be made 'binding' - and 
not only 'optional' - where options are strictly rooted in local specificities and where mutual 
recognition would not give rise to regulatory arbitrage. This is in particular the case for 
country specific exposures258 where assets are country-specific and cannot be moved around 
across different entities of a bank.  
Because of gold-plating, the option might be partially effective with respect to objective of 
enhancing supervisory cooperation, because certain degree of differences in national 
supervisory approaches would be preserved. 

257 For example, competent authorities may require a risk-weight of 150% for 'high risk items'. The CRD does 

not provide for clear criteria. 

258 For example, Finnish residential housing companies attracting a preferential treatment under Annex VI, Part 

1, point 45 of the CRD 

127 

 
 
 
                                                 
This option would entail compliance costs as banks would have to comply with revised rules. 
This holds true in particular in relation to banks subject to the IRB approach, where internal 
systems would have to be slightly changed. For small banks subject to the Standardised 
approach, the suggested changes would not entail material costs. Their reporting obligations 
would be affected slightly by the revised rules.  
At the same time, this option also is expected to result in compliance cost savings, particularly 
for institutions with cross-border activities. Such savings are recognised by the industry, but, 
based on its feedback, are highly difficult to assess, because: 

–  Reduction of compliance costs would only be of relevance over time. In the short term, the 
removal of options and discretions would imply compliance with a new single set of rules; 

–  A  uniform  reporting  would  entail  a  reduction  of  compliance  costs,  but  it  would  only  be 

effective by the end of 2012; 

–  For banks subject to the IRB approach, significance of the reduction of compliance costs 
depends  on  whether  currently  supervisors  have  come  to  an  agreement  regarding  the 
application of a single set of rules across a banking group.  

The impact on banks' capital requirements might be significant only in relation to 
requirements for exposures secured by real estate where harmonization of the currently 
diverse national rules is suggested, if such harmonization takes place towards the most 
prudent standard. This impact would vary by MS, depending on whether their current 
treatment is less or more stringent vis-à-vis the new harmonised treatment, however, overall it 
is not expected to be material. The removal of other options and discretions (via mutual 
recognition, deletion, granting choice to institutions and making an option a general rule) 
would take place in the framework of the existing CRD rules, and therefore would not 
represent a significant incremental change to capital requirements.  
Both home and host supervisors would be affected simultaneously by the removal of options 
and national discretions. The impact would vary depending on how options have been 
exercised in various MS. Annex II provides an insight into how national options are used.  
Policy option 7.3: Maximum harmonization  
Under this option, option 7.2 (Removal of options and national discretion) is complemented 
by a maximum harmonisation approach. As discussed above, the deletion of national options 
needs to be coupled with a maximum harmonisation approach to fully deliver on the 
objectives of reducing compliance burden, enhancing level playing field, legal clarity and 
supervisory convergence. The role of EBA in ensuring a consistent set of harmonised rules 
would be maximised under this approach.259 
Under this option, the scope of 'maximum harmonisation' would be clearly circumscribed to 
Pillar 1 (minimum capital requirements, large exposures rules, liquidity, own funds) and Pillar 
3 (disclosure).260 Other areas of the Directive do not lend themselves to maximum 
harmonisation, either i) because of the absence of a full harmonisation (e.g., internal 
governance), or ii) because the decisions are based on specific risk assessments (e.g., Pillar 2).  
Downside to this approach is that maximum harmonisation may limit the ability of MS to 
require stricter rules on the financial stability grounds. However, as explained under option 

259 As a result, EBA will be expected to develop some 50+ technical standards in various policy areas which will 

have an impact on its human resources requirements and related costs. 

260 I.e., Title V, Chapter 2, section 2 – subsection 3 (minimum level of own funds), Title V, Chapter 2 – sections 
3 to 6 (i.e. Articles 76 to 122 covering minimum own funds requirements for credit and operational risk, 
large exposures and qualifying holdings outside the financial sector) of 2006/48/EC, Title V, Chapter 5 
(disclosure  by  credit  institutions)  of  2006/48/EC,  and  Chapter  V,  section  1  (provisions  against  risks) 
and section 4 (large exposures) of Directive 2006/49/EC. 

128 

 
 
 
                                                 
7.1, this shortcoming should not be over-estimated given that supervisors may resort to Pillar 
2 to tailor capital requirements to the risks to which a bank is or may be exposed and that 
Basel III provides for a macro-prudential capital buffer, discussed under section 5.5.261 
Importantly, this option would ensure that firms follow the same rules in all EU markets. This 
should boost confidence in the stability of credit institutions across the EU, especially in time 
of stress, and thus enhance the financial stability. The crisis has demonstrated that a clear and 
transparent regulatory framework was critical to maintain confidence in the market in 
liquidity stress situations.  
It should also be noted that under options 7.1 and 7.2 the application at national level of 
stricter rules for reasons of the financial stability would only be applicable to domestic banks 
and subsidiaries of foreign banks in that country. Such regulatory changes would create 
regulatory arbitrage opportunities for branches in those MS, partly invalidating macro-
prudential policy actions. Under this option, a regulation (see section 5.7) would enable the 
Commission to adopt temporary increases in minimum standards. By doing so, the new rules 
would be applicable to all EU banking institutions, preventing regulatory arbitrage 
possibilities and contributing to the effectiveness of macro-prudential policy actions. 
Nevertheless, in stressed situations, stricter rules may be instrumental in ensuring financial 
stability. For example, additional requirements in terms of disclosure for securitised 
exposures have been recommended by CEBS and the Commission to re-establish confidence 
in the inter-bank market. However, recent experience has proved that Community legislation 
could be modified on short notice. In addition, implementation of prudential rules by means 
of a regulation (see section 5.7) would shorten implementation timelines as there would be no 
need for MS to transpose EU legislation into national law. 
In addition, there are circumstances where gold-plating is rooted in market/product 
specificities or the legal framework of a MS. During public consultations, some supervisors 
stressed the necessity of being able to introduce stricter quantitative limits (e.g., lower LTV 
requirements for real estate) in order to make requirements effective given specificities of 
their local market.  
Against this background, there is a merit in considering whether some flexibility in 
implementing the maximum harmonisation approach under option 7.3 would not benefit the 
objective of financial stability while effectively contributing to achievement of the remaining 
specific objectives. 
Policy option 7.4: Maximum harmonization with some exceptions 
Under this option, option 7.3 (Maximum harmonisation) is modified to allow for some 
flexibility. In its analysis of the scope of full harmonisation in the CRD, CEBS emphasised 
that a certain degree of flexibility would be needed. It was stressed that a 'single rule book' 
does not necessarily mean a 'uniform' rule book, and should provide for differences in 
national treatment where market specificities or specific local products call for a different 
treatment.  
Analysis of CEBS' advice and further discussion with stakeholders suggest that the following 
areas lend themselves to the application of stricter rules: 
- qualifying criteria for applying a preferential treatment of real estate exposures, in addition 
to or that are stricter than those provided in EU legislation and / or higher risk weights 
depending on local specificities; 
- treatment of lending in foreign currency; 
- higher risk weights for 'high risk items' identified by EBA guidelines. 

261 Whereby, if necessary, national supervisors would be able to set a countercyclical buffer in excess of 2.5%. 
Such  level  should  apply  only  to  institutions  that  are  incorporated  in  their  jurisdictions.  The  buffer 
should be capped at 2.5% for the purposes of calculating the institution specific countercyclical capital 
buffer of all other institutions that have credit exposures in the jurisdiction in question. 

129 

 
 
 
                                                 
In addition, in order to enhance national and EU financial stability, this policy option foresees 
a possibility for MS to 'gold-plate' the new minimum requirements that would otherwise be 
phased in from 2013 to 2019 as outlined in Table 6. This means that MS would be allowed to 
apply in 2013 the level of capital required by Basel III in 2019. 
This approach would be similar to the one adopted in other legislative texts (e.g., the MiFID), 
which provide for full harmonisation while allowing MS to adopt stricter rules in well 
identified areas of the text.  
Comparison of policy options 
Retaining the current scenario (policy option 7.1), implies that the problems described in 
sections 3.6.4 and 3.6.5 are not addressed and effectiveness of the newly created EBA is 
compromised. Maximum harmonization (policy option 7.3) is more effective than minimum 
harmonization (policy option 7.2) or maximum harmonisation with some exceptions (policy 
option 7.4) with respect to attaining objectives of enhancing supervisory cooperation and 
convergence (S-7), enhancing legal clarity (S-4) and enhancing level playing field (S-6) as it 
contains both the deletion of national options and the removal of the possibility to supplement 
the CRD provisions with national legislation. However, option 7.3 is perceived to be less 
effective than option 7.4 in terms of achieving the objective of enhancing the financial 
stability in national MS as it does not cater for specificities of local markets (G-1). In this 
regard, option 7.4 entails a harmonised and transparent regulatory framework that is intended 
to enhance the financial stability together with a possibility of applying stricter rules in certain 
cases.  
From the efficiency angle, option 7.3 appears to be the most efficient for banking groups with 
cross-border operations (due to the greater expected savings of administrative costs), whereas 
for banks with domestic operations, options 7.2 and 7.4 may be more efficient (lower costs 
due to fewer changes in national rules due to their harmonisation at the EU level).  
In summary, policy option 7.4 (Maximum harmonization with some exceptions) is identified 
as a preferred option, as it entails the most balanced trade-off between expected effectiveness 
in terms of contributing towards relevant policy objectives, including the objective of 
financial stability, and the net administrative cost implications for the EU banking industry.  

Table 14: Summary of policy option effectiveness and efficiency 

Policy Option Comparison Criteria 

Effectiveness 

Policy 
Option 

Prevent 
regulatory 
arbitrage 
opportunities 
[S-3] 

Enhance legal 
clarity [S-4] 

Reduce 
compliance 
burden 
 [S-5] 

Enhance 
level playing 
field [S-6] 

Enhance 
supervisory 
cooperation 
and 
convergence 
[S-7] 

Enhance 
financial 
stability   
[G-1] 

Efficien
cy 

7.1 Retain current 
approach 

7.2 Minimum 
harmonisation  

7.3 Maximum 
harmonisation  

4 

3 

1-2 

4 

3 

1 

4 

1-3 

1-3 

4 

3 

1 

1-2 

7.4 Maximum 
harmonisation 
with some 
exceptions 
Scale of option ranking: 1=most effective / efficient, 4=least effective / efficient 
Effectiveness measures extent to which options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources 

1-3 

2 

2 

4 

3 

1 

2 

2-4 

2-4 

2-4 

1 

4 

1-3 

1-3 

1-3 

130 

 
 
 
 
5.7. 

Choice of policy instrument 

This section discusses the options as regards the most appropriate way of implementing the 
preferred policy choices discussed in sections 5.1-5.6. The key alternatives that were 
considered are as follows: 

-  Policy option 8.1: Amend the CRD to integrate the proposed provisions 
-  Policy option 8.2: Limit the scope of the CRD to authorization and arrangements for 
ongoing  supervision  and  propose  a  regulation  on  prudential  requirements  for  credit 
institutions 

Policy option 8.1: Amend the CRD 
The policy options retained in the sections above could be implemented by amending the 
existing directives of the CRD: 2006/48/EC and 2006/49/EC. This would maintain coherence 
of rules in the three areas of: 
-authorisation,  
-ongoing supervision, and  
-prudential requirements  
in one single text which MS would have to transpose. Maintaining such coherence would 
reflect the fact that, in spite of differences as regards subject matter (i.e., authorisation 
procedures, procedures for ongoing supervision, prudential requirements applicable to the 
provision of credit) and addressees (i.e., MS, competent authorities, credit institutions), all 
three areas of rules are interrelated.  
Maintaining the form of a directive would enable the EU in all these areas to impose binding 
requirements on MS but to give them the choice of form and method to achieve them. It 
would leave MS with a certain degree of flexibility to maintain divergent rules at the stage of 
transposition of the rules into national law. It would give MS the option of imposing stricter 
rules than is foreseen in the EU legal act on matters which are not fully harmonised under the 
preferred policy option 7.4 (Maximum harmonisation with some exceptions). Finally, MS 
could continue to integrate the rules into national legal texts. 
To the extent a directive gives MS the choice of form and method to achieve a result, it 
enables MS to continue exercising legislative actions on matters where EU action does not 
provide added value, and thereby reflects the principle of subsidiarity. However, this only 
applies to matters which are not fully harmonised under the preferred policy option 7.4. 
Policy option 8.2: Limit the scope of the CRD and propose a regulation 
The policy options retained in the sections above could also be implemented by two separate 
instruments: an amendment of the CRD concerning authorisation of credit institutions and 
arrangements for their supervision by competent authorities, and a new instrument on 
prudential requirements for credit institutions in the form of a regulation. 
Separating prudential requirements from the other areas would reflect differences in subject-
matter, nature and addressees. Prudential requirements are rules applicable to credit 
institutions on an ongoing basis which establish criteria for the evaluation of the risk linked to 
certain banking services and of the funds necessary to counter-balance those risks. As such, 
they do not regulate access to deposit taking activities but govern the way in which such 
activities are carried out in order to ensure protection of depositors and financial stability.  
Shaping prudential requirements in the form of a regulation would ensure that those 
requirements, which already today are worded in the form of obligations applicable to credit 
institutions ("credit institutions shall…"), will in fact be directly applicable to them. This 
would prevent the transposition from producing diverging national requirements, interpreted 
according to diverging cultures, and provide for a harmonised set of core rules applicable in 
the EU.  
At the same time, this instrument could cater for the flexibility needed under the preferred 
policy option 7.4. First, rules on authorisation and ongoing supervision would continue to be 

131 

 
 
 
in the form of a directive. Second, as to the prudential requirements, if in some limited areas 
flexibility is needed for MS to lay down stricter requirements or implementing provisions, this 
can be accommodated by an appropriate wording of the regulation. For example, the 
regulation can explicitly allow MS to impose additional requirements, or it can require and 
empower MS to lay down implementing provisions in certain limited areas. 
A regulation would make the requirements applicable to credit institutions more accessible to 
entities operating on a cross-border basis, EU citizens, and third country investors and 
regulators. Moreover, it would clearly demonstrate that credit institutions follow the same 
rules in all EU markets, which should boost confidence in the stability of credit institutions 
across the EU, especially in times of stress. 
A single regulation directly applicable across the EU would reduce regulatory complexity and 
firms' compliance costs, especially for credit institutions operating on a cross-border basis as 
they could rely on identical rules applying throughout the Union.  
A harmonised set of rules in a regulation would also contribute to the elimination of 
regulatory arbitrage opportunities and would reassure depositors that protection standards are 
equal, encouraging them to benefit from the internal market in banking services. 

Comparison of policy options 
Policy option 8.2 (Limit the scope of the CRD and propose a regulation) is more effective 
than option 8.1 (Amend the CRD to integrate the proposed provisions) with regard to 
contributing to the achievement of objectives of preventing regulatory arbitrage opportunities 
(S-3), enhancing legal clarity (S-4), reducing compliance burden (S-5), enhancing supervisory 
convergence (S-7), enhancing financial stability (G-1) and safeguarding depositor interests 
(G-2), as outlined above. 
It also entails a more efficient alternative since a regulation on prudential requirements would 
enable the EU to implement any changes required by market developments more quickly, as it 
is usually immediately applicable after adoption by the legislator. Any future modifications of 
the regulation could be implemented more quickly too, as they would not require 
transposition by national legislators.262 That would enable the EU to meet internationally 
agreed deadlines for implementation, respond swiftly to delays in the implementation of 
internationally agreed reforms in key third country jurisdictions, and also to react quicker 
when market developments require changes to the rules. On this basis, option 8.2 is identified 
as a preferred policy option. 
Table 15: Summary of policy option effectiveness and efficiency 

Policy Option Comparison Criteria 

Effectiveness 

Policy 
Option 

Prevent 
regulatory 
arbitrage 
opportunities 
[S-3] 

Enhance legal 
clarity [S-4] 

Reduce 
compliance 
burden 
 [S-5] 

Enhance 
supervisory 
cooperation 
and 
convergence 
[S-7] 

Enhance 
financial 
stability [G-
1] 

Enhance 
safeguardin
g of 
depositor 
interests [G-
2] 

Efficien
cy 

2 

2 

1 

2 

8.1 : Amend the 
CRD 
8.2 Limit scope 
of the CRD and 
propose a 
regulation 
Scale of option ranking: 1=most effective / efficient, 2=least effective / efficient 
Effectiveness measures extent to which options achieve relevant objectives  
Efficiency measures extent to which objectives can be achieved for a given level of resources 

1 

1 

1 

2 

2 

1 

2 

1 

1 

1 

262  However,  at  the  stage  of  a  switch  from  a  Directive  to  a  Regulation  MS  would  need  to  be  given  a  certain 

minimum period to adapt their national rules. 

132 

 
 
 
 
 
                                                 
5.8. 

Cumulative impact of the package 

This section discusses the cumulative impact of preferred options within individual areas as 
presented in the preceding sub-sections. It looks at the cumulative impact of proposals in 
terms of additional capital that EU banking industry needs to raise in order to meet the new 
minimum capital requirements. Next, impact of the proposal on costs related to information 
provision to supervisors and third parties is discussed. Finally, impacts of tighter capital and 
liquidity requirements on the EU economy in the transitional period and in the long-term are 
assessed. 

5.8.1.  Package of preferred options and relevant transitional provisions 

The following table summarizes the twenty seven policy options analysed. Individual options 
within each policy set are ranked in terms of their relative effectiveness263 and efficiency264 
with regard to achieving applicable longer term policy (specific) objectives. Preferred options, 
where identified in the impact assessment, are highlighted.  
Table 16: Summary of policy option effectiveness and efficiency 

Policy Option Comparison Criteria 

Effectiveness 

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Effici
ency 

Policy 
Option  

Set 

Liquidity 
Coverage ratio 

Policy 
Options 

1.1 Retain current approach 

1.2 Introduce LCR as specified in Feb 2010 PC 

1.3 Introduce LCR adopted by Basel 
Committee subject to observation period 

2.1 Retain current approach 

Net Stable 
Funding ratio 

2.2 Introduce NSFR as specified in Feb 2010 
PC 

2.3 Introduce NSFR adopted by Basel 
Committee 

3.1 Retain current approach 

3.2 Modify only the eligibility criteria as 
specified in Feb 2010 PC 

3.3 Modify eligibility criteria and regulatory 
adjustments as specified in Feb 2010 PC 

3.4 Modify eligibility criteria and regulatory 
adjustments based on Basel approach 

3.5 Modify eligibility criteria and regulatory 
adjustments based on Basel approach with 
some adjustments for EU specificities 

4.1 Retain current approach 

4.2 Enhance CCR requirement  

4.3 Enhance CCR requirements and 
differentiate treatment of exposures to CCPs 

5.1 Retain current approach 

Eligibility of 
capital 
instruments and 
application of 
regulatory 
adjustments 

Counterparty 
credit risk 

Leverage ratio 

5.2 Introduce leverage ratio as specified in Feb 
2010 PC 

5.3 Conduct extensive monitoring of leverage 
ratio  

Capital buffers 

6.1 Retain current approach 

6.2 Conservation capital buffer 

6.3 Countercyclical capital buffer 

6.4 Dual capital buffer 

5 

4 

2-3 

2-3 

1 

3 

2 

1 

3 

2 

1 

5 

4 

3 

2 

1 

3 

32 

1 

5 

4 

5 

4 

1-3 

1-3 

1-3 

1-3 

1-3 

1-3 

1-3 

1-3 

1-3 

3 

2 

1 

3 

2 

1 

4 

3 

2 

1 

3 

2 

1 

4 

1-2 

3 

1-2 

1-3 

1-3 

1-3 

Single rule book 

7.1 Retain current approach 

4 

4 

4 

4 

4 

263 Measures extent to which options achieve relevant objectives 
264 Measures extent to which objectives can be achieved for a given level of resources   

133 

3 

1 

2 

3 

2 

1 

5 

4 

3 

2 

1 

3 

2 

1 

3 

2 

1 

4 

2-3 

2-3 

1 

4 

5 

4 

1 

5 

4 

1-3 

2-3 

1-3 

2-3 

1-3 

3 

2 

1 

3 

2 

1 

3 

2 

1 

4 

3 

1-2 

1-2 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
                                                 
Policy 
Option  

Set 

Policy 
Options 

7.2 Minimum harmonization 

7.3 Maximum harmonization 

7.4 Maximum harmonization with some 
exceptions 

8.1 Amend the CRD 

8.2 Limit scope of the CRD and propose a 
regulation 

Choice of policy 
instrument 

Policy Option Comparison Criteria 

Effectiveness 

f
o

y
c
a
u
q
e
d
a
e
c
n
a
h
n
E

s
t
n
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Scale of option ranking: 1=most effective / efficient, 5=least effective / efficient 
The proposed calibration, including phase-in and grandfathering arrangements, of the package 
is aligned with the Basel III rules text and is shown in Tables 5 and 6 above.265  
To set the new level of minimum capital requirement and capital buffers, the Basel 
Committee conducted a number of supporting analyses.266 In terms of the new minimum 
going-concern capital, it found that, for instance, the median of the 99th percentile 
distributions of historical annual risk-weighted returns across six jurisdictions of the 
Committee is about 5%.267 With some adjustments for the impact that Basel III is expected to 
have on RWAs and eligible capital, this served as a basis for the new level of CET1 and T1 
capital requirements.  
As regards calibration of capital buffers, cumulative net income of 73 banks from 14 
countries over the financial crisis period (from Q3 2007 to Q4 2009) as a share of year-end 
2006 RWAs was analysed. This analysis showed that mean losses268 of banks with negative 
cumulative net income over this period equalled 5% of RWAs. The same analysis found that 
'peak' losses, defined as losses over whatever sub-period of the financial crisis that produced 
the largest negative net income figure, were larger than those incurred for the 'fixed' period of 
Q3 2007 to Q4 2009. During major crises, when access to capital markets is limited, 
cumulative losses of such extent can be absorbed only by those banks that have adequate 
capital buffers, accumulated during more favourable economic conditions.  
The rationale for the proposed calibration as well as its impacts on the industry, other 
economic agents and financial stability are discussed in the remainder of section 5.8. 

5.8.2.  Cumulative impact on the industry 

When estimating capital shortfall due to the CRD IV package, the impact of new minimum 
CET1 requirement and capital buffers is assessed together. This approach reflects the fact that 
the most demanding capital requirement and thus largest capital shortfall for most EU 
countries relates to CET1 capital: if banks raise eligible capital to meet the new regulatory 
CET1 requirement, they will largely meet the new T1 and total capital ratios. This can be seen 
from Table 17 which under columns labelled 'new' shows capital ratios after application of the 
CRD III and IV proposals, assuming a full implementation of both proposals as of December 
2009. Columns that contain ratios labelled 'old' show capital ratios as of December 2009, i.e., 
before implementation of both the CRD III and the CRD IV legislative proposals. The 'new' 

265 It needs to be noted that Switzerland has announced its intention to proceed with more stringent requirements 
than  agreed  by  the  Basel  Committee.  However  this  pertains  to  requirements  for  its  two  systemically 
important  financial  institutions,  whereas  treatment  of  such  institutions  at  both  the  Basel  and  the  EU 
level has not been finalised. 
266 See http://www.bis.org/publ/bcbs180.pdf  
267 Risk-weighted return measured by RORWA and calculated as the ratio of net income to RWAs 
268 When measured with pre-tax, pre-distribution net income 

134 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
                                                 
ratios do not reflect the effect of transitional and grandfathering provisions outlined in Table 
6, which will mitigate the effective impact on banks' capital ratios in the period up to 2023.   
Changes in capital ratios are driven by the changes in capital definition rules and RWAs. The 
preferred policy options outlined in this report are expected to increase the RWAs of EU 
Group 1 banks on average by 24.5% and RWAs of Group 2 banks – by a modest 4.1%. The 
extent of capital shortfalls269 that the EU banking industry would face due to the proposals is 
estimated to fall in the range of €370 billion or approximately 2.3% of EU banking sector's 
RWAs as of December 2009, at CET1 of 7% (consisting of a minimum requirement of 4.5% 
and capital conservation buffer of 2.5%). Of this figure, some €37 billion is attributable to the 
CRD III proposal270 and the remainder is driven by the CRD IV amendments. However, the 
estimate should be viewed as the high end of the capital shortfall because: 
- it is based on bank capitalisation levels as of December 2009 which most likely will have 
increased in response to supervisory and market pressure even if the CRD were not amended,  
- estimates do not incorporate the impact of phasing-in and grandfathering provisions that will 
greatly reduce the extent of capital shortfall in the short run and will spread the impact for 
most banks during implementation period. More specifically, capital shortfall that the EU 
banking industry would face at CET1 of 3.5%, effective from 2013, is immaterial, whereas 
capital shortfall at CET1 of 4.5%, effective from 2015, is estimated at €84 billion271, 
- it does not capture the interaction between liquidity and capital proposals (i.e., larger 
proportion of liquid assets that banks will hold in order to comply with LCR will reduce the 
amount of their RWAs relative to total assets), and  
- it is estimated on the combined impact of the proposed calibration for the minimum 
requirement of 4.5% and the conservation capital buffer of 2.5%; yet only the minimum 
capital requirement is a critical requirement whose breaching would trigger supervisory 
intervention, whereas consequences of falling behind the capital buffer target are confined to 
banks' curtailing their discretionary distributions of earnings. Countercyclical capital buffer is 
not considered in the above calculation as its add-on would only be in effect when there is an 
excess credit growth that is resulting in a system wide build-up of risk, but would stay at zero 
at all other times. 
Table 17: Capital ratios for Group 1 and Group 2 banks, in %:  

Country

CET1

Group 1 banks
T1

Total

CET1

Group 2 banks
T1

Total

Gross 1
12,7
9,4
11,2
11,8
7,4
10,5
6,3
13,1
7,1
4,6

New 2
9,4
5,8
5,1
4,7
4,4
4,4
3,6
3,6
3,4
1,3

Old
12,7
12,0
10,7
10,7
8,1
9,2
8,6
8,5
11,3
8,3

New
9,8
8,7
5,9
4,9
4,8
5,4
4,4
3,8
3,8
1,4

Old
15,9
14,2
14,7
14,3
11,9
12,6
12,4
12,4
14,0
11,9

New
10,5
10,8
8,0
8,0
6,8
9,6
9,2
4,7
6,7
4,6

10,7

4,9

10,3

5,6

14,0

8,1

L
J
H
E
D
C
G
B
F
A
S
Q
O
R
M
P
N
K
Total 3

Gross 1
14,5
14,5
10,8
13,2
7,7
9,0
9,7
12,0
18,2
11,9
22,7
16,1
16,2
14,2
15,5
10,6
11,9
7,4
11,1

New 2
13,2
12,2
9,2
9,4
5,7
5,4
8,2
3,4
16,9
7,6
20,0
13,4
13,3
11,3
9,7
8,8
7,9
5,8
7,1

Old
12,2
14,7
12,2
11,4
9,1
9,5
9,8
8,4
18,9
9,4
14,4
13,8
13,3
15,5
12,6
10,7
9,0
9,3
10,3

New
13,2
12,2
9,2
9,7
6,1
5,7
8,2
4,7
18,0
7,6
20,0
13,4
13,5
11,6
10,9
8,8
10,1
6,8
7,6

Old
13,8
17,2
16,4
12,9
11,7
11,2
14,7
12,0
25,2
12,4
23,0
15,0
14,3
16,9
13,4
12,7
12,1
13,0
13,1

New
15,2
12,8
10,5
10,7
7,5
9,9
12,4
6,8
24,3
11,5
22,7
14,3
13,8
12,4
13,7
8,8
11,9
10,1
10,3

Notes: Countries sorted based on average net CET1 ratio  

269  Estimated  as  the  sum  of  capital  shortfalls  in  order  to  meet  the  new  required  CET1  ratio  across  individual 
banks participating in the EU QIS, and where capital shortfall was observed, and then extrapolating the 
figure to cover 100% of the EU banking sector. 

270 In terms of Tier 1 capital, as definition of CET1 did not exist prior to CRD IV proposal 
271 This estimate assumes full deductions, i.e., does not account for phase-in arrangements for deductions (40% 

in 2015)  

135 

 
 
 
                                                 
1 'Gross' is the ratio of new gross CET1 (without deductions) relative to old RWA. 2 New CET1 shows net CET1 (with 
deductions) relative to new RWA. 3 EU averages for both Group 1 and Group 2 banks include data for two additional 
countries that are not shown individually. 
Source: CEBS 
Impacts on individual MS banking sectors will vary, as could be seen be seen from Table 17 
that shows country average CET1 ratios separately for Group 1 and Group 2 banks. 
Additionally, as of December 2009 there were some €87 billion of state aids in common 
equity capital in five MS.272 Under the proposal, existing public sector injections would be 
grandfathered until 1 January 2018. In the long run, however, they would add to the CET1 
capital shortfall, raising it to some €460 billion or 2.9% of the EU banking sector's RWAs. 
Given the length of suggested phasing-in period, the above capital shortfalls shall be assessed 
against the possibility of banks running profitable operations and subsequently retaining their 
profits. The banking sector is not expected to raise the entire shortfall amount in the capital 
markets. For instance, combined net profit of some 100 biggest EU banks in 2009 was around 
€33 billion and bank profits are likely to rise as economic situation improves and provisions 
for non-performing loans decline.273  
In terms of impact on the CET1 ratio, large EU banks  (average CET1 ratio of 4.9%) are 
affected more by the CRD III and the CRD IV proposals than a sample of 74 large 
international banks from eighteen274 Basel Committee countries whose average CET1 ratio as 
of December 2009 stood at 5.7% upon application of equivalent rules.  
As regards the impact of new liquidity requirements, the implications of LCR are discussed in 
section 5.1.1, while those of NSFR – in section 5.1.2. It should be noted that the estimated 
shortfalls to comply with LCR and NSFR are not additive since depending on the actions 
taken to minimize them, decreasing the shortfall in one standard may result in a decrease in 
the shortfall of the other.  

5.8.3.  Administrative costs 

Implementation of legislation entails costs for businesses. Costs that are linked to providing 
information either to public or private parties are called administrative costs. The share of 
these costs that is specifically linked to information that businesses would not collect and 
provide in the absence of a legal obligation is called administrative burdens. The 
Commission's Better Regulation strategy is aimed at measuring administrative costs and 
reducing administrative burdens.275 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 of the impact assessment) and had to be designed accordingly.  
In August-September 2010, the Commission services distributed a questionnaire to the GEBI 
members about the impacts of CRD IV proposal on administrative burdens. Analysis of 
replies showed that, overall, the biggest impacts on both the on-going administrative burdens 
and the related one-off implementation costs are expected due to new measures in the area 

272 The total sum of state aids is not representative for  the entire QIS sample as data was not available for all 

participating MS  

273 Source: Bloomberg, Orbis, Commission services' calculation. It needs to be pointed out that this figure is not 
distributed  evenly  across  banks  but  reflects  significant  crisis-related  losses  for  a  number  of  large 
European banking groups 

274  Australia,  Belgium,  Canada,  China,  France,  Germany,  Italy,  Japan,  Korea,  the  Netherlands,  Saudi  Arabia, 

Singapore, South Africa, Spain, Sweden, Switzerland, the UK, the US. 

275 For more on the Commission's approach towards dealing with administrative costs and burdens please see: 

http://ec.europa.eu/governance/better_regulation/admin_costs_en.htm  

136 

 
 
 
                                                 
liquidity risk management, comprising roughly 70% of all administrative burdens. Proposals 
for the counterparty credit risk were also identified as a source of significant administrative 
burdens for Group 1 banks. The Commission services conducted a rough estimation of 
administrative burdens for each area of proposals linked to Basel III (see Annex VIII). As 
regards proposal for the 'single rule book', the number and, particularly, the diversity of 
replies received were insufficient to assess its varying impact by MS (which depends on the 
degree to which options and discretions are exercised) and bank type. In this regard, banks 
with more cross-border activity would benefit from harmonisation of the current national 
provisions the most as the ensuing administrative burden savings are expected to reduce 
administrative burdens of the Basel III-related policy measures.  

5.8.4.  Economic impact in transitional period 

A key factor determining banks' responses to new capital and liquidity standards is the length 
of the period during which the new requirements will be phased in. If the transition period is 
short, banks may choose to curtail credit supply or adjust capital composition in order to lift 
capital ratios. A longer transition period could substantially mitigate the impact, allowing 
banks to retain more of their profits (by reducing dividend payments or improving operational 
efficiency), issue new equity, reduce fixed costs or take other necessary steps to adjust.  
To inform the policy question of appropriate transitional provisions, the Basel Committee and 
the FSB set up a Macroeconomic Assessment Group (MAG) whose members were 
macroeconomists and econometricians from central banks, regulatory agencies and 
international institutions. This section overviews its main conclusions as well as those of 
certain macro-models pertaining to the EU countries or the euro zone.  For the full analysis of 
MAG please see its Interim and Final Reports that were published in August and December 
2010.276 
When applying the MAG's key findings in the EU context, it is important to note that  its 
work was based on a high number of macroeconomic models developed and used for policy 
analysis in central banks and international organisations, with a high representation of models 
pertaining to MS or broader regions of the EU. The group's Interim Report was based on the 
results of 89 individual macroeconomic models277, of which 51 models relate to the EU278, 
whereas its Final Report used 97 modelling simulations, of which 49 relate to the EU.279  
MAG modelled implementation scenarios of 2, 4, 6, and 8 years. The transitional periods of 4 
and 8 years are presented below in more detailed, as they were given more consideration in 
Basel III deliberation process. 

5.8.4.1.  Four-year implementation period 

Macro-economic impacts of the new standards over an implementation period of four years 
were estimated using 89 individual models. The median estimate showed that for each 
percentage point increase in capital requirements that is implemented gradually over 4 years, 

276 See http://www.bis.org/publ/othp10.htm, http://www.bis.org/publ/othp12.pdf  
277 The key results are reported based on 89 'standard' models, i.e., standard semi-structural and DSGE models 
used  for policy  analysis  and  forecasting.   In  addition,  MAG's  members  used 15  'satellite'  models  that 
estimate changes in lending spreads and volumes resulting from specified changes in target capital and 
liquidity ratios, 13 bank-augmented DSGE models, i.e., dynamic stochastic general equilibrium models 
incorporating  banking  sectors  and  financial  frictions,  and  8  reduced  form  models  (vector  auto-
regression and other reduced-form models). 

278 Of them, 6 models relating the euro area, 9 to FR, 7 to DE, 8 to IT, NL and ES each, and 5 to the UK. 
279 Of them, 20 models relating the euro area, 7 to NL and IT each, 5 to the UK, 4 to FR and 3 to DE and ES 

each. 

137 

 
 
 
                                                 
after 4.5 years (18 quarters)280 from the start of implementation the GDP would decline by 
0.19% relative to a baseline scenario, consisting of a 0.16% decline as estimated by national 
authorities and an additional drop of 0.03% due to international spill-over effect that was 
estimated separately by the IMF.281 As regards the estimation results of national authorities, 
the vast majority of them are clustered around the median and within the range of 0.07% - 
0.31% when the top and bottom fifth of distribution are excluded (see the bottom panel of 
Chart 17). Therefore, for a 2.9 percentage point increase in required capital (see section 5.8.2) 
such median estimate results in a GDP decline of 0.6% after 4.5 years from the start of 
implementation.282 The 51 models relating to the EU MS or MS groups produced a median 
which is similar to that of the overall sample of models. The projected impacts arise mainly 
from banks passing on higher costs to borrowers with a median estimated increase in lending 
spreads of 15 basis points after 4.5 years (for each percentage point increase in capital 
requirements), which results in a slowdown in investment.  
A sub-set of models that account for the credit supply effects, i.e., tightening lending 
standards (in addition to effects of increasing lending spreads) for each percentage point 
increase in capital requirements produced a median decline in the GDP of 0.32% after 4.5 
years from the start of implementation. For a 2.9 percentage point increase in required capital 
this is equivalent to a GDP decline of 0.9%. Easing of the monetary policy may reduce such 
estimated output losses. In this respect the MAG estimated that such offsets are especially 
pronounced in models that incorporate credit supply constraints, reducing the GDP loss from 
0.32% to 0.17%, for each percentage point increase in capital. 
MAG also assessed impact of tightening liquidity requirement consisting of 25% increase in 
holding of liquid assets, i.e., impact of LCR. This produced a median fall in the GDP of 
0.08% below the baseline over 4.5 years. This estimate is equivalent to a decrease in the GDP 
of 0.11% below the baseline for the EU, given the estimated increase in holdings of eligible 
liquid assets of 34% for the EU's banking industry (see section 5.1.1). Notably, impacts of 
tighter capital and liquidity requirements by MAG were assessed separately whereas some 
positive offsetting effects between holding of liquid assets and capital requirements are 
expected, i.e., a higher share of more liquid and less risky assets to total assets will result in a 
decline in banks' RWAs relative to their total assets.  
Among the models considered by MAG were those used routinely by the Commission and 
ECB. ECB's multi-country model of five largest EU MS (DE, FR, IT, ES, NL) for each 
percentage point increase in capital ratio, considering effects on both credit spreads and 
lending standards, estimated a GDP reduction of 0.19% 4.5 years after the start of 
implementation. For a 2.9 percentage point increase in required capital this produces a GDP 
decline of 0.6%. ECB's Christiano-Motto-Rostagno DSGE model, used for policy analysis, 
for each percentage point increase in capital requirements produced a decline of 0.29% over 
4.5 years, or, a 0.8% decline for 2.9 percentage point increase in capital requirement. 

5.8.4.2.  Eight-year implementation period 

Macro-economic impacts of the new standards over an implementation period of eight years 
were estimated using 97 individual models. The median estimate showed that for each 
percentage point increase in capital requirements that is implemented gradually over 8 years, 
after roughly 9 years (35 quarters)283 from the start of implementation the GDP would decline 

280 The largest GDP impact for the four-year implementation scenario is realised after 4.5 years from the start of 

the implementation. 

281 Reflecting exchange rates, commodity prices, shifts in global demand. 
282 The GDP-impact estimates produced by MAG were in most cases linear to changes in bank capital 
283  The  largest  GDP  impact  for  the  eight-year  implementation  scenario  is  realised  after  35  quarters  (almost  9 

years) from the start of the implementation. 

138 

 
 
 
                                                 
by 0.17% relative to a baseline scenario, consisting of a 0.15% decline as estimated by 
national authorities and an additional drop of 0.02% due to international spill-over effect (see 
the bottom panel of Chart 17). Therefore, for a 2.9 percentage point increase in required 
capital such median estimate results in a GDP decline of 0.5% after 9 years from the start of 
implementation. The projected impacts result from a combination of wider lending spreads 
(median increase of 15.5 basis points after 9 years, for each percentage point increase in 
capital requirements) and reduced lending volumes (median decline of 1.4% after 9 years, for 
each percentage point increase in capital requirements). 
Models that seek to take account of effects of tightening lending standards (in addition to 
effects of increasing lending spreads) generate a stronger macroeconomic impact that those 
without such effects. For each percentage point increase in capital requirements, these models 
produced a median decline in the GDP of 0.23% after 9 years from the start of 
implementation.284 For a 2.9 percentage point increase in required capital this is equivalent to 
a GDP decline of 0.7%. Easing of the monetary policy may reduce output losses from 0.23% 
to 0.16%, for each percentage point increase in capital. 
According to the Commission's bank-augmented DSGE model (QUEST III) calibrated to 
cover all 27 MS, the GDP declines by 0.14% 9 years after start of implementation of the new 
proposals for each percentage point increase in Tier 1 capital ratio.285 This translates in a 
cumulative decline of the GDP of 0.42% for an increase in regulatory capital of 2.9 
percentage points (for more details on the Commission's model as well as a comparison of 
industry and public sector modelling outcomes, please see Annexes IX and X).  

Chart 17: Aggregate impact of one percentage point increase in the target capital ratio: distribution of GDP 
deviation across all models, in % 

284 Including international spill-over effect of 0.02% 
285  Under  the  conservative  assumption  that  Modigliani-Miller  (MM)  theorem  does  not  hold  which  was  also 
assumed by MAG. For more on MM see section 5.8.5 and Annex IX. Note that QUEST III is modelled 
on  the  basis  of  Tier  1  capital  ratio.  Given  that  CET1  capital  is  part  of  Tier  1,  QUEST  III  modelling 
results presented in Annex IX are applied in the context of CET1 ratio shortfalls. The calculation is as 
follows: -0.36% deviation in GDP from baseline by 2019 divided by 2.5 percentage point increase in 
capital ratio = -0.144% deviation in GDP from baseline by 2019 for one percentage point increase in 
capital ratio. 

139 

 
 
 
 
 
 
                                                 
Notes: 1 Distributions are computed across the 89 cases used in the MAG Interim Report, excluding those designed to 
measure the impact of international spill-overs. 2 Distributions are computed across the 97 cases contributed for the MAG 
Final Report, excluding those designed to measure the impact of international spill-overs. 3 The shaded areas indicate the 
range between the 20th and 80th percentile. The vertical line indicates the unweighted median at the quarter indicated 
(measured from the start of implementation). 4 The vertical lines indicate the 18th and (for the eight-year case) 35th quarters.  
Source: Basel Committee  

5.8.4.3.  Optimum implementation period 

In addition to the above transition scenarios, MAG also examined implementation alternatives 
of two and six years. For instance, a two year implementation period led to the largest 
reduction from the baseline path with the trough occurring after two and a half years: the GDP 
would fall a maximum 0.22% relative to the baseline, including international spill-over effects 
for a one percentage point increase in capital. Overall, shorter implementation scenarios have 
a greater impact on annual GDP growth rates since the projected decline in the level of GDP 
relative to baseline would take place over a shorter time (see Table 18). 
Table 18: Overview of the implementation period scenarios for new capital standards 
Timing of 
estimated decline 
in GDP since start 
of implementation 

Estimated annual 
decline in the EU 
GDP growth below 
baseline, % 

Implemen
tation 
period 

Result / Model 

Source 

Decline in GDP 
below baseline per 
percentage point 
increase in capital 
requirement, % 
B 
0.22 

Estimated decline 
in the EU GDP 
below baseline due 
to capital shortfall, 
% 
C=B*2.9 
0.64 

D=(1+C)^(1/(A/4))-1 
0.22 

Two years 

Median of 89 

MAG  

A 
10 quarters 

140 

 
 
 
Timing of 
estimated decline 
in GDP since start 
of implementation 

Decline in GDP 
below baseline per 
percentage point 
increase in capital 
requirement, % 

Estimated decline 
in the EU GDP 
below baseline due 
to capital shortfall, 
% 

Estimated annual 
decline in the EU 
GDP growth below 
baseline, % 

Four years 

Eight 
years 

models 
Median of 89 
models 
Median of 16 
models with impact 
on lending standards 
Median of 11 
models with impact 
on lending standards 
and endogenous 
monetary policy 
Multi country model 
(with lending 
standards) 
Christiano-Motto-
Rostagno model 

Median of 97 
models 
Median of 12 
models with impact 
on lending standards 
Median of 14 
models with impact 
on lending standards 
and endogenous 
monetary policy 
Multi country model 
(with impact on 
lending standards) 
Christiano-Motto-
Rostagno model 
DSGE bank-
augmented model 

MAG 

MAG 

18 quarters 

18 quarters 

MAG 

18 quarters 

ECB 

ECB 

MAG 

MAG 

18 quarters 

18 quarters 

35 quarters  

35 quarters  

MAG 

35 quarters  

ECB 

ECB 

European 
Commission 

35 quarters 

35 quarters 

36 quarters 

0.19 

0.32 

0.17 

0.19 

0.29 

0.17 

0.23 

0.16 

0.08 

0.39 

0.14 

0.55 

0.93 

0.49 

0.55 

0.84 

0.49 

0.67 

0.46 

0.25 

1.12 

0.42 

0.10 

0.16 

0.09 

0.10 

0.15 

0.05 

0.06 

0.04 

0.03 

0.09 

0.04 

Sources: Basel Committee, ECB, European Commission 
A longer implementation period shall minimize any potential transitory effects on GDP and 
credit availability. This is in part because the maximum GDP loss is estimated to occur 
around the end of the transition period, which could be at a more mature and resilient stage of 
the current recovery. Lengthening of the implementation period would also: 
- give banks more time to adjust their business models and cost structures;  
- allow more time for stable non-bank channels of credit intermediation to develop; 
- reduce the severity of the impact of lending cuts on bank-dependent sectors, and  
- give markets more time to absorb the asset sales, debt issues and equity issues that might 
accompany banks' balance sheet adjustments.  
Hence, the transitional phase-in and grandfathering provisions for the capital requirements 
agreed by the Basel Committee and outlined in Table 6 are likely to accommodate the above 
adjustment processes the most as they effectively imply an eight-year transition period from 
2011 to 2018. As regards the optimum implementation timing for the new liquidity 
requirements, given their novelty and the related possibility of unintended consequences on 
financial institutions of different sizes and business lines, observation periods coupled with 
review clauses are justified. LCR, including any revisions will be introduced on 1 January 
2015, while NSFR, with appropriate revisions, will move to the minimum standard on 1 
January 2018.  
In summary, work of the Basel Committee's MAG, ECB and the Commission on the 
assessment of macroeconomic costs show that the transition to stronger capital and liquidity 
standards is likely to have a limited impact on the aggregate output. It shall be emphasised 
that the above analyses measured only transitional costs without considering benefits from 
enhanced financial stability and mitigated pro-cyclicality which would start to accrue 
immediately, and extent of which can be inferred from a discussion of long-term economic 
effects presented in section 5.8.5 below. 

141 

 
 
 
 
 
 
 
 
 
5.8.5.  Long-term economic impact 

Assessment of the long-term implications of the CRD IV proposal is based on the work 
conducted by the Basel Committee and the Commission together with the academics. 
The Basel Committee's assessment of the long-term economic impact (LEI) is summarised in 
the report published in August 2010.286 By examining the historical data and a number of 
studies on the economic costs of systemic crises, the report finds that there are clear net long 
term economic benefits from increasing the minimum capital and liquidity requirements from 
their current levels in order to raise the safety and soundness of the global banking system.  
Charts 18 and 19 illustrate expected net economic benefits for a range of CET1 capital ratios, 
separately for meeting new capital requirements, and capital and liquidity requirements 
together. 
Chart 18: Long-run expected annual net economic 
benefits of increases in capital requirements for a range 
of CET1 ratios, in % of GDP 

Chart 19: Long-run expected annual net economic 
benefits of increases in capital requirements and 
meeting liquidity requirements for a range of CET1 
ratios, in % of GDP 

2,0

1,5

1,0

0,5

0,0

Moderate permanent effect

No permanent effect

2,0

1,5

1,0

0,5

0,0

Moderate permanent effect

No permanent effect

5%

6%

7%

8%

9%

10%

11%

5%

6%

7%

8%

9%

10%

11%

Notes: LEI working group's assessment of net benefits was done on the basis of the ratio of tangible common equity 
(common equity net of goodwill and intangibles) to RWAs under Basel I and II definitions. These ratios were adjusted by 
70% to arrive at CET1 ratio equivalents for the EU banking sector which reflect a 17% increase in RWAs and additional 
deductions on top of goodwill and intangibles of 18% under the capital definition proposals (adjustments based on the 
results of the EU QIS data). Vertical lines indicate capitalization levels at which marginal net economic benefits cease being 
positive. 
Source: Basel Committee, European Commission calculation  
Considering the impact of meeting only new capital requirements (Chart 18), net economic 
benefits are positive for the range of CET1 ratios up to 11%, however, they stop increasing 
marginally at 9.1% CET1 under the 'moderate permanent effect' scenario (annual benefit of 
increase in GDP of 1.96%) and at 7% CET1 under the 'no permanent effect' scenario (annual 
benefit of increase in GDP of 0.33%).287 Similar dynamics is observed when meeting of new 
liquidity requirement is considered, with the marginal net economic benefits rising up to 
CET1 levels of 6.3% and 9.1% under the 'no permanent effect' and 'moderate permanent 
effect' scenarios, respectively. This implies that optimum calibration of the new requirements 
might be in the range of CET1 ratios of 6%-9%, or higher, given the conservative approach 
undertaken, as explained below. 
The above benefits of higher capital and liquidity requirements accrue from reducing the 
probability of financial crisis and the output losses associated with such crises.288 It needs to 
be noted that the approach adopted by the working group was rather conservative: above 
quantification of economic benefits did not include those stemming from reduced severity of 

286 BCBS, An Assessment of the Long-Term Economic Impact of Stronger Capital and Liquidity Requirements, 

August 2010; http://www.bis.org/publ/bcbs173.htm  

287  Under  "large  permanent  effect"  scenario  net  benefits  keep  rising  beyond  the  11%  CET1  ratio,  reaches  the 

level of annual increase in GDP of 5.9% (this scenario is not shown in the chart).  

288 Based on LEI analysis, the Commission services estimate that complying with the LCR requirement and the 

new capital requirements can be expected to reduce the probability of a systemic crisis by some 70% 

142 

 
 
 
                                                 
future crises and reduced pro-cyclicality in the system, given anticipated effects of 
countercyclical policy measures that are included in the proposal. On the cost side, 
assumptions were equally conservative, including a full pass through of costs to customers via 
lending rates, no reduction in cost of debt and equity with an ROE assumption based on a 
high historical average (15%). According to the Modigliani-Miller (MM) propositions, 
increases in banks' capital levels shall reduce their leverage and, by making returns to their 
investors less volatile, the cost of equity.289 In this respect, macro-economic modelling of the 
Commission services showed that when the MM propositions are assumed to hold at least 
partially (50%), economic costs of the new rules in terms of their impact on the GDP are 
reduced in half by 2020-2030 (see Annex IX).290 The cost of debt may decline as well 
because of enhanced bank capitalization levels. This would further reduce the impact on 
lending rates and, via them, on the GDP. Therefore, actual net economic benefits could be 
higher across the CET1 ratios shown in Charts 18 and 19.  
In addition to the benefits from reducing output losses associated with reduced frequency of 
banking crises, higher capital and liquidity requirements may also reduce the amplitude of 
normal business cycles. Higher capital and liquidity ratios permit banks to absorb losses in 
downturns and restrain lending in an expansion, thereby smoothing the supply of credit over 
the cycle, and, as a consequence, also investment and consumption. BCBS' working group on 
LEI assessed this impact by using dynamic stochastic general equilibrium (DSGE) models 
that explicitly integrate bank capital and measures of liquidity. The group found that a 2 
percentage point increase in capital ratio reduces the standard deviation of output by 2 
percentage points, based on the median estimate across the models used. When considering a 
possibility of introducing a counter-cyclical capital buffer, which causes the capital 
requirement to increase in step with the credit-to-GDP ratio291, the analysis showed that the 
volatility of output would be reduced substantially, with the standard deviation declining by 
almost one fifth with respect to a baseline in which no counter-cyclical capital rules are 
implemented.  
Another macro-economic cost-benefit analysis of Basel III has been conducted by the 
Commission services and academics292 by coupling the SYMBOL model293 with a framework 
proposed by the Bank of England to estimate the impact of tightening capital requirements on 
the GDP294. This analysis looked at the long-term economic impact of the new framework in 
seven EU MS.  
Regarding the impact on the probability of a systemic banking crisis295, the analysis found 
that it depends on how much banks will recapitalize under Basel III. Results showed that 

289  Modigliani,  F.,  and  M.  Miller,  The  cost  of  capital,  corporation  finance  and  the  theory  of  investment,  The 

American Economic Review, 48, 1958 
Miller M., Do the M&M propositions apply to banks?, Journal of Banking & Finance, 19, 1995 
Miles,  D.,  Yang,  J.,  and  G.  Marcheggiano,  Optimal  bank  capital,  Bank  of  England  Discussion  Paper 
No. 31, January 2011 

290 When MM propositions are assumed to hold entirely (i.e., 100%), the scenario of regulatory change in terms 
of  economic  costs  (measured  as  impact  on the  GDP)  by 2020-2030 does  not differ from  the  baseline 
scenario.  

291  Based  on  the  simulations  using  a  prudential  rule  that  increases  the  capital  requirement  when  the  credit-to-
GDP  ratio  increases  so  as  to  generate  movements  of  the  capital  ratio  in  the  neighbourhood  of  ±2 
percentage points around its steady state 

292 M. Marchesi, S. Zedda, F. Campolongo, R.  De Lisa, J. Cariboni, M. Petracco Giudici, Basel III: a macro-
economic cost-benefit analysis, 2010, JRC EUR Report 61485, EUR 24603 EN (mimeo, forthcoming) 

293 The SYMBOL model (SYstemic Model of Banking Originated Losses) 
294 

Bank 
http://www.bankofengland.co.uk/publications/fsr/2010/fsr27.htm  

Financial 

England, 

Stability 

of 

Report, 

Box7, 

2010; 

see 

295  The  probability  of  occurrence  of  a  systemic  banking  crisis  is  derived  from  the  distribution  of  liquidity 
shortfalls  of  the  banking  system  on  the  basis  of  the  definition  that  a  systemic  banking  crisis  occurs 

143 

 
 
 
                                                 
 
 
when banks recapitalize to 10.5%296 level, the probability is reduced within the range of 29% 
to 89%. Given the estimated reduction in the probability of a systemic banking crisis, the 
analysis found substantial net economic benefits of the new framework for two MS and a 
more neutral net economic effect in the remaining five MS analysed.  

Impacts on SMEs 

5.9. 
A recent study297 commissioned by the Commission finds that internal financing is the most 
common source of SME financing, and includes owner investment, funding through retained 
profits and sale of assets. As regards the financing from external sources, bank credit is the 
most significant.298 In this respect, the study found that there is a significant positive effect of 
the business cycle on bank loans to medium-sized firms, with the effect on small firms also 
significant but smaller.299 This effect might be explained by a number of regulatory and 
market failures, including the problem of asymmetric information.300 When economic 
conditions become depressed and collateral values decline, information asymmetries with 
respect to the quality of clients’ balance sheets make obtaining the bank credit difficult even 
for clients with profitable projects. When economic conditions improve and collateral values 
rise, the opposite situation tends to occur. In this regard, lending to SMEs is affected more 
than lending to large companies as SMEs are not subject to external ratings and extensive 
disclosure requirements.  
Therefore, SMEs, to the extent that they are credit rationed, are expected to be the primary 
beneficiaries of smoothened pro-cyclicality (see section 5.8.5) brought about by the enhanced 
counter-cyclical properties of the EU bank capital regulation, including capital buffers, 
improved adequacy and quality of regulatory capital and the leverage ratio. These changes 
will allow SMEs to engage in projects that are profitable and vital for the economic growth 
and prosperity not only during an expansionary leg of the cycle, but, more importantly, when 
the economic climate turns sour.  As importantly, the proposals will benefit SMEs and their 
workforce further by smoothening the cyclicality of demand for the products and services that 
they generate, given that SMEs contribute some 60% of the total value added of the EU's non-
financial business economy.301  
According to the Commission macroeconomic model, compliance with the new capital 
framework is expected to reduce the stock of loans on average by 1.8% and increase loan 
rates on average by some 29 basis points by 2020-2030.302 However, it needs to be stressed 

where losses or liquidity shortfalls are higher than a certain threshold, beyond which public authorities 
find  it  difficult  to  avert  the  spreading  of  a  crisis.  In  particular,  it  is  assumed  that  the  threshold  for  a 
systemic banking crisis in any country corresponds to 3% of its GDP. 

296 Consisting of total capital requirement of 8% and conservation buffer of 2.5% 
297 EIM, Cyclicality of SME Finance, March 2009 
298 According to this study, for a sample of 10 EU countries the share of short- and long-term bank loans in total 

SME capital were in the range of 3-17% and 7-31%, respectively 

299 The first report of the Commission on the effects of the CRD on the economic cycle also notes that SMEs 
were  less  successful  than  large  enterprises  in  obtaining  a  bank  credit  for  which  they  had  applied  in 
October 2008 – September 2009 (i.e., economic recession in most EU Member States) and that among 
those  companies  that  have  been  adversely  affected  by  bank  credit  availability,  obtaining  the  needed 
funds 
see 
also 
http://ec.europa.eu/internal_market/bank/docs/regcapital/monitoring/23062010_report_en.pdf . 

difficult 

sources 

SMEs; 

other 

more 

from 

was 

for 

300 The drivers behind cyclicality of bank lending are discussed in section 3.5.1 
301 Eurostat, European business facts and figures, 2009 
302 Specification of the Commission's QUEST model and more detailed presentation of modelling of the Basel 
III impacts on the EU economy are provided in Annex IX. It needs to be noted that modelling outputs in 
Annex  IX  are  expressed  as  a  change  in  a  variable  for  2.5  percentage  point  increase  in  Tier  1  capital 
ratio. For this reason, estimates have to be rescaled to assess the impact of a shortfall of CET1 capital of 
2.9%  of  risk-weighted  assets.  In  this  calculation,  it  was  assumed  that  capital  shortfalls  expressed  as 
percentage points of Tier 1 and CET1 capital are comparable, given that CET1 is part of Tier 1. Hence, 

144 

 
 
 
                                                                                                                                                         
that costs of a comparable extent most likely would arise even in the absence of a regulatory 
reform, due to the market pressure and expectations with respect to enhanced post-crisis bank 
capital levels and liquidity management.  
While the proposals are expected to lead to a higher cost of bank credit – which is 
compensated by social benefits - across the entire spectrum of bank customers, SMEs are 
expected to be impacted less than their large counterparts. Even though the start of Basel III 
transitional period has been set for 2013, most banks have embarked on a de facto transition 
to complying with the new rules following the publication of the framework in late 2010 and 
early evidence (Q4 2010 and Q1 2011) on the impact of costs related to bank capital and 
liquidity position on credit standards for loans and credit lines shows that more euro area 
banks tightened their credit standards for large enterprises than for SMEs.303  
SMEs are expected to be impacted less severely also to the extent that they transact more with 
smaller Group 2 banks304, whose capital and liquidity shortfalls are estimated to be smaller 
than those of Group 1 banks (see Table 19). In a similar vein, it is expected that the proposals, 
by accommodating certain specificities of the EU cooperative, mutual and similar banks (e.g., 
see policy options 1.3 and 3.5), will reduce the compliance costs for these institutions and in 
turn result in smaller indirect costs to their customers, including SMEs.  
Table 19: Overview of impacts of various proposals by bank group 

Policy area / proposed measure(s) 

EU averages 
Group 1 banks  Group 2 banks 

Liquidity risk 1:  
Liquidity Coverage Ratio, % 
Net Stable Funding Ratio, % 

Rules on capital definition, CET1 capital ratio, %  

Rules on counterparty credit risk, % change of total RWAs  

Leverage ratio, % 1 

66.5 
91.1 

5.8 

9.7 

2.5 

87.1 
93.9 

7.1 

0.2 

3.5 

Combined impact of CRD III and CRD IV on:  
Total RWAs, % change 
CET1 capital ratio, % 
Notes: 1 Based on Basel III definitions, in the EU will be subject to monitoring periods and follow-on re-calibration 
Source: CEBS 
The extent to which costs of Basel III implementation would be passed onto bank customers 
is also unclear given that exposure to the new measures, as shown by the EU QIS, is not 
uniform across banks while their market power on the lending market may be too weak. In 
this regard, upon full application of CRD III and the CRD IV proposal some 25% of Group 1 

24.5 
4.9 

4.1 
7.1 

impact of the proposal on loan rates is derived as follows: 0.25 (average increase in loan rate by 2020-
2030,  0%  MM  offset,  expressed  in  percentage  points)  /  2.5  (increase  in  Tier  1  ratio,  expressed  in 
percentage  points)  x  2.9  (regulatory  capital  shortfall  in  percentage  points  expressed  as  CET1  capital 
over risk weighted assets) = 0.29 percentage points. Using the same rationale, impact of the proposal on 
the  stock of  loans  is derived as  follows:  -1.51  (average decrease  in  stock  of  loans by 2020-2030, 0% 
MM  offset,  expressed  in  %)  /  2.5  (increase  in  Tier  1  ratio,  expressed  in  percentage  points)  x  2.9 
(regulatory capital shortfall in percentage points expressed as CET1 capital over risk weighted assets) = 
-1.8%.  

303 ECB, The euro area bank lending survey, April 2011 
304 Some research shows that smaller banks are more prone to lend to SMEs because they are better suited for the 
'relationship  lending',  which  is  primarily  based  on  information  gathered  by  the  loan  officer  through 
continuous,  personalized  and  direct  contacts  with  SMEs,  their  owners  and  managers,  and  the  local 
community in which they operate. E.g., see Berger, A., L. Klapper, G. Udell, The Ability of Banks to 
Lend to Informationally Opaque Small Businesses, Journal of Banking Finance 25, 2001 

145 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
                                                                                                                                                         
banks and some 75% of Group 2 banks had CET1 capital ratio in excess of 7% already at the 
end of 2009 (see Chart 20).  
Chart 20: Distribution of CET1 capital ratios for Group 1 and Group 2 EU banks following 
the application of CRD III and the CRD IV proposal 305 

Source: CEBS, EU QIS 
Furthermore, the distribution of CET1 ratios of Group 2 banks indicates that the smaller the 
bank the higher its CET1 ratio.306 In competitive markets, such asymmetric shocks are 
typically much more difficult to pass onto customers.307  
Moreover, monitoring periods foreseen for LCR, NSFR and the leverage ratio in combination 
with extended phase-in and inclusion of grandfathering provisions are expected to give banks 
necessary time to adjust their business models accordingly and provide lending to companies 
to support economic growth. Also, the proposal includes a review clause on the preferential 
risk weight for exposures to SMEs under €1 million that is currently available for banks 
applying the standardised approach for credit risk. The preferential treatment is retained in the 
proposal and EBA is tasked with preparing an analysis for the Commission on whether the 
current level of the risk weight and the cap for its application are commensurate with the 
actual credit loss history of such exposures over a full economic cycle. 
Most importantly, higher cost of credit in the long run will be offset by important economic 
and social benefits accruing not only to SMEs but a wide range of stakeholders, including 
corporate and individual borrowers and creditors, governments, and the EU citizens in 
general, due to the anticipated reduction in a frequency of banking crises, the extent of net 
economic benefits whereof was assessed in the preceding section.  

305 In the plot, the mean is shown with the "x", the median is shown with the red line, 25th and 75th percentiles of 
the  distribution  are  delineated  by  the  blue  box,  while  the  black  horizontal  lines  mark  10th  and  90th 
percentiles  of  the  distribution.  In  the  EU  QIS,  sample  means  were  calculated  on  the  basis  of  the 
'composite bank'; in this case, by dividing the sum of CET1 capital by the sum of risk-weighted assets. 
A median represents the value that separates the higher half of the sample from the lower half. An Xth 
percentile distribution represents the value that separates X% of lower values from (100%-X%) higher 
values of the sample. 

306 As roughly three quarters of banks in the Group 2 sample had CET1 capital ratios in excess of the sample 

mean of 7.1%. 

307  ECB  euro  area  bank  lending  surveys  show  that  pressure  from  competition  plays  an  important  role  in 
offsetting  the  impact  of  factors  that  drive  banks  to  tighten  their  credit  standards.  See  ECB,  The  euro 
area bank lending survey, April 2011 

146 

 
 
 
 
                                                 
6. 

MONITORING AND EVALUATION 

It is expected that the proposed amendments will start entering into force in 2013. The 
amendments are tightly inter-linked with other provisions of the CRD, that are already in 
effect since 2007-2008 or that will come into effect following the implementation of CRD II 
and CRD III (see Table 2).  
Normally, the practice at the Commission is to conduct an evaluation of a legislation some 
four years after its implementation, however, given the three waves of revisions that the CRD 
will have undergone in 2008-2011 (which may be followed by additional amendments in the 
near future) it might be sensible to conduct a comprehensive evaluation of the CRD that 
would be based on the entirely overhauled capital framework, which complicates setting of 
such target date.  
At the same time, the current and recent proposals underscore the importance of timely and 
appropriate changes of the rules in response to the market events. Therefore, it is likely that 
individual provisions of the CRD will continue to be formally evaluated on a piecemeal basis, 
following the outcomes of various monitoring exercises both at the EU and the international 
level or a necessity to act as dictated by the markets. 
Special arrangements will be put in place by the Basel Committee and EBA to ensure that 
necessary data for the monitoring of leverage ratio and the new liquidity measures is collected 
to allow for the calibration of these policy tools. The Commission services will continue to 
participate in the working group of the Basel Committee and the joint task force established 
by ECB and EBA, that monitor the dynamics of bank capital positions308, globally and in the 
EU, respectively.  

308  Indicators  that  are  monitored  include  capital  adequacy  ratios,  capital  buffers,  parameters  used  as  inputs  in 

minimum capital requirement calculation for the credit risk, etc. 

147 

 
 
 
                                                 
ANNEX II: TAKE-UP OF NATIONAL OPTIONS AND DISCRETIONS ANALYSED BY CRDWG 

Area 

Directive 
2006/48 
(unless 
indicated 
2006/49) 

Denominati
on 

Description 

OWN 
FUNDS 

Article 57 
(second last 
paragraph) 

Inclusion 
of interim 
profits 

OWN 
FUNDS 

Article 58 

Waiver on 
certain 
deductions 

OWN 
FUNDS 

Article 59 

OWN 
FUNDS 

Article 60 

Alternativ
es to 
deductions 

Deduction
s for 
stand-
alone 
requireme
nts 
purposes 

OWN 
FUNDS 

Articles 61, 
63.1, 64.3 
and 65 

List of 
own funds 

OWN 
FUNDS 

Article 13.2 
Dir. 
2006/49/EC 

OWN 
FUNDS 

Article 13.5 
Dir. 
2006/49/EC 

Alternativ
e form of 
calculation 
for 
investment 
firms not 
providing 
certain 
services 
and 
applying 
Article 21 
Flexibility 
in the 
compositio
n of own 
funds for 
investment 
firms 
making 

Member States may permit the inclusion of 
interim profits before a formal decision has 
been taken on the accounts, subject to 
conditions. 
Shares in another credit institution, financial 
institution, insurance or reinsurance 
undertaking may not be deducted if held 
temporarily for the purposes of a financial 
assistance operation designed to reorganise 
and save the entity. 
As an alternative to deductions of 
participations and capital instruments held 
in other financial institutions, credit 
institutions may be allowed to apply, with 
the necessary changes, any of the 
methodologies set out in Annex 1 to the 
Conglomerates Directive. 

For the purposes of the calculation of their 
stand alone requirements, institutions may 
not be required to deduct holdings and 
participations in institutions included in the 
scope of their consolidation. 

The list of own funds elements in the 
Directive is a maximum, both in items and 
amounts. Member States may choose not to 
admit certain elements or to apply lower 
ceilings. They can add further deductions. 
Member states may choose to accept other 
elements of own funds different from those 
in article 57, subject to conditions. Finally 
they can decide on the possible inclusion of 
cumulative preferential shares and 
subordinated loan capital and on the 
inclusion of certain elements normally 
accounted for as assets, when they bear a 
credit ('negative') sign. 

Investment firms that, in view of the 
services they provide, are allowed to 
calculate their own funds as a percentage of 
the turnover of the previous year (Article 
21), may be also authorised to apply a 
definition of own funds other than that 
prescribed by the directive 2006/48/EC. 

If an institution is calculating its own funds 
in accordance with the alternative offered in 
Article 13.2 of directive 2006/49/EC, it can 
be allowed to substitute subordinated loans 
by other elements described in Article 57 of 
directive 2006/48/EC, mainly as Tier 2. 

148 

Exercise of options and national 
discretions by Member States 

Not 
yet 
decide
d 

N/A 

Yes 
(with 
provis
o) 

80 %  
(7 %) 

No 

13 % 

73 % 
(3 %) 

23 % 

57  % 
(0 %) 

43 % 

57 % 
(7 %)  

37 % 

72 % 
(21 
%) 

3 % 

3 % 

47 % 
(3 %) 

3 % 

7 % 

13 % 

27 % 

6 % 

13 % 

 
 
 
  
  
  
  
  
  
  
  
  
  
Area 

Directive 
2006/48 
(unless 
indicated 
2006/49) 

OWN 
FUNDS 

Article 14 
Dir. 
2006/49/EC 

SCOPE 
OF 
APPLIC
ATION 

SCOPE 
OF 
APPLIC
ATION 

SCOPE 
OF 
APPLIC
ATION 

SCOPE 
OF 
APPLIC
ATION 

SCOPE 
OF 
APPLIC
ATION 

SCOPE 
OF 
APPLIC
ATION 

COUNT
ERPAR
TY 
RISK 
IN 
DERIV
ATIVE
S  

COUNT
ERPAR
TY 
RISK 
IN 
DERIV
ATIVE
S  

Article 69.1 

Article 69.3 

Article 70 

Article 72.3 

Article 73.1 

Articles 22, 
24 & 25 Dir. 
2006/49/EC 

Annex III, 
Part 3 

Annex III, 
Part 6, Para. 
7 

Denominati
on 

use of the 
option in 
Article 
13.2 

Excess of 
subordinat
ed capital 

Individual 
waiver for 
subsidiarie
s 

Individual 
waiver for 
parent 
credit 
institutions 

Solo 
consolidati
on 

Exemption 
from Pillar 
III 

Exemption 
from 
consolidati
on 
Consolidat
ed waiver 
for 
investment 
firms 
Alternativ
e template 
for the 
calculation 
of 
potential 
future 
value in 
certain 
cases 
Higher 
value of 
coefficient 
Alpha 
(multiplier 
to 
calculate 
the 
exposure 

Description 

Exercise of options and national 
discretions by Member States 

Yes 
(with 
provis
o) 

No 

Not 
yet 
decide
d 

N/A 

The Competent Authorities may allow 
investment firms to hold subordinated 
capital in excess of ordinary thresholds, up 
to certain limits. 
Member States may grant individual 
institutions which are subsidiaries within a 
group, subject to the fulfilment of certain 
conditions, an exemption from individual 
requirements. The same applies where the 
parent company is a financial holding 
company. 
Member States may grant individual 
institutions which are the parent company 
within a group, subject to the fulfilment of 
certain conditions, an exemption from 
individual requirements.  
Member States may allow, on a case-by-
case basis, for the purpose of the calculation 
of the individual requirements of the parent 
institution, and subject to certain conditions, 
the incorporation of subsidiaries whose 
material exposures or liabilities are all to 
that parent institution. 
The Competent Authorities may decide to 
exempt, fully or partially, a credit institution 
from Pillar III requirements provided such 
institution is included within a group 
complying with comparable disclosures on 
a consolidated basis in a third country. 

27 % 
(7 %) 

5 % 

17 % 

40 % 

57 % 

3 % 

30 % 

77 % 

3 % 

33 % 
(3 %) 

60 % 

3 % 

50 % 
(7 %) 

43 % 

Member States may decide that, if certain 
conditions are met, some subsidiaries need 
not be included in consolidation. 

73 % 
(17 
%) 

7 % 

3 % 

A group of investment firms may be 
exempted from consolidated capital 
requirements, on a case-by-case basis, 
provided conditions are met. 

25 % 
(4 %) 

54 % 

4 % 

14 % 

For institutions complying with certain 
requirements in their trading activities in 
commodities, gold and other products, 
Member States may allow percentages for 
the calculation of potential future value 
other than the general ones. 

30 % 

63 % 

7 % 

Member States may set a value for 
coefficient Alpha higher than 1.4. 

60 % 

37 % 

3 % 

149 

 
 
 
  
  
  
  
  
  
  
  
  
Area 

Directive 
2006/48 
(unless 
indicated 
2006/49) 

COUNT
ERPAR
TY 
RISK 
IN 
DERIV
ATIVE
S  

COUNT
ERPAR
TY 
RISK 
IN 
DERIV
ATIVE
S  

STAND
ARDIS
ED 
APPRO
ACH 

STAND
ARDIS
ED 
APPRO
ACH 

STAND
ARDIS
ED 
APPRO
ACH 

STAND
ARDIS
ED 
APPRO
ACH  

STAND
ARDIS

Annex III, 
Part 6, Para. 
12 

Annex III, 
Part 7c (ii) 

Article 80.3 
& Annex VI, 
Part 1, Para. 
24 

Article 80.7 

Article 80.8 

Article 81.3 

Article 82.2 

Denominati
on 

value of 
certain 
contracts) 
Internal 
determinat
ion of the 
value of 
coefficient 
Alpha 
(multiplier 
to 
calculate 
the 
exposure 
value of 
certain 
contracts) 

Calculatio
n 
(separate/a
ggregate) 
of 'net-to-
gross ratio' 

Risk-
weighting 
exposures 
to credit 
institutions 

Exemption 
of intra-
group 
exposures 
from risk-
weighted 
exposures 

Treatment 
of 
exposures 
to a 
counter-
party 
which is 
member of 
the same 
institution
al 
protection 
scheme. 

Mutual 
recognitio
n of an 
ECAI 

Mutual 
recognitio

Description 

Exercise of options and national 
discretions by Member States 

Yes 
(with 
provis
o) 

No 

Not 
yet 
decide
d 

N/A 

Member States may allow institutions to 
calculate Alpha internally, subject to a floor 
of 1.2. 

67 % 
(7 %) 

23 % 

3 % 

At the discretion of Competent Authorities, 
credit institutions may use either separate 
calculation or aggregate calculation when 
calculating the 'net-to-gross ratio'. If 
Member States permit credit institutions a 
choice of methods, the method chosen is to 
be used consistently. 

Member States may choose between two 
alternative methods for risk-weighting 
exposures to credit institutions: (a) on the 
basis of the risk-weight of the 
corresponding central government and (b) 
on the basis of the credit assessment of the 
institution itself. 
If certain conditions are met, the Competent 
Authorities may assign a 0% risk-weight on 
exposures not forming part of "own funds" 
of a credit institution to its parent 
undertaking, its subsidiary, a subsidiary of 
its parent undertaking or an undertaking 
linked by a relationship within the meaning 
of Article 12(1) of Directive 83/349/EEC. 

63 % 

30 % 

7 % 

(a) 
((b)) 

37 % 

53 % 

60 % 
(10 
%) 

30 % 

If certain conditions are met, the Competent 
Authorities may assign a 0% risk weight on 
exposures not forming part of "own funds" 
to counterparties which are members of the 
same institutional protection scheme as the 
lending institution. 

23 % 

77 % 

If an ECAI has been recognised as eligible 
by the competent authorities of a Member 
State, the competent authorities of other 
Member States may recognise that ECAI as 
eligible without carrying out their own 
evaluation process 
When a competent authorities of a Member 
State have made a determination under § 1 

150 

 
 
 
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
Exercise of options and national 
discretions by Member States 

Yes 
(with 
provis
o) 

No 

Not 
yet 
decide
d 

N/A 

67 % 
(17 
%) 

17 % 

80 % 
(7%) 

13 % 

90 % 
(3 %) 

7 % 

70 % 
(7 %) 

23 % 

67 % 
(13 
%) 

20 % 

77 % 
(10 
%) 

13 % 

Directive 
2006/48 
(unless 
indicated 
2006/49) 

Article 83.2 

Annex VI, 
Part 1, Para. 
5 

Annex VI, 
Part 1, Para. 
11 

Annex VI, 
Part 1, Para. 
14 

Annex VI, 
Part 1, Para. 
15 

Annex VI, 
Part 1, Para. 
17 

Annex VI, 
Part 1, Para. 
29 

Area 

ED 
APPRO
ACH  

STAND
ARDIS
ED 
APPRO
ACH 

STAND
ARDIS
ED 
APPRO
ACH 

STAND
ARDIS
ED 
APPRO
ACH 

STAND
ARDIS
ED 
APPRO
ACH 

STAND
ARDIS
ED 
APPRO
ACH 

STAND
ARDIS
ED 
APPRO
ACH 

STAND
ARDIS
ED 
APPRO
ACH 

Denominati
on 

n of an 
ECAI 

Permission 
to use 
unsolicited 
ratings 

Recognitio
n of a third 
country's 
treatment 
of central 
governme
nt and 
central 
bank 
exposures 
Recognitio
n of a third 
country's 
treatment 
of regional 
governme
nts and 
local 
authorities 
Treatment 
of public 
sector 
entities as 
institutions 
Treatment 
of 
exposures 
to public 
sector 
entities 
guaranteed 
by central 
governme
nts 

Recognitio
n of a third 
country's 
treatment 
of public 
sector 
entities 

Exposures 
to rated 
institutions 
with an 
original 
effective 
maturity 
of more 

Description 

(ECAI  assessment associated with credit 
quality step), the competent authorities of 
other Member State may recognise that 
determination without carrying out their 
own determination process 
In order to use unsolicited ratings, credit 
institutions must get permission from the 
Competent Authorities. To make this 
possible, that alternative should be 
incorporated to legislation (implicit 
discretion). 
When a third country with 
supervisory/regulatory arrangements at least 
equivalent to those in the Community, 
assigns for the exposures to its own central 
government and central bank denominated 
and funded in the domestic currency a lower 
risk weight than the one applicable in 
principle, a member state may allow the 
risk-weight of such exposures in the same 
manner. 

When a third country with 
supervisory/regulatory arrangements at least 
equivalent to those in the Community treats 
exposures to regional government and local 
authorities as exposures to its central 
government, a Member State may allow the 
risk-weight of such exposures in the same 
manner. 

Exposures to public sector entities may be 
treated as exposures to credit institutions, 
without applying the preferential weights 
applicable to short term exposures to 
institutions.  

The Competent Authorities may, in 
exceptional cases, treat exposures to public 
sector entities as exposures to the central 
government in whose jurisdiction they are 
established where, in their opinion, there is 
no difference in the risk between such 
exposures because of the existence of an 
appropriate guarantee from the central 
government. 

When a third country with 
supervisory/regulatory arrangements at least 
equivalent to those applied in the 
Community treats exposures to its public 
sector entities as exposures to institutions, a 
Member State may allow the risk-weight of 
exposures to such public sector entities in 
the same manner.  

"Exposures to institutions with an original 
effective maturity of more than three 
months for with a credit assessment by a 
nominated ECAI is available shall be 
assigned a risk weight according to Table 4 
in accordance with the assignment by the 
competent authorities (...) 

151 

 
 
 
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
Area 

Directive 
2006/48 
(unless 
indicated 
2006/49) 

STAND
ARDIS
ED 
APPRO
ACH  

Annex VI, 
Part 1, Para. 
31 

STAND
ARDIS
ED 
APPRO
ACH 

Annex VI, 
Part 1, Para. 
37 

STAND
ARDIS
ED 
APPRO
ACH 

STAND
ARDIS
ED 
APPRO
ACH  

Annex VI, 
Part 1, Para. 
40 

Annex VI, 
Part 1, Para. 
41 

STAND
ARDIS
ED 
APPRO
ACH  

Annex VI, 
Part 1, Para. 
49 

Denominati
on 

than three 
months 
(quality 
steps) 
Preferentia
l RW 
treatment 
for claims 
on 
institutions 
with an 
original 
maturity 
of 3 
months or 
less under 
Option 2 
(qulaity 
steps) 
Treatment 
of short 
term 
exposures 
to EU 
institutions 
in their 
national 
currency 
Treatment 
of 
exposures 
in the form 
of 
minimum 
reserves 
held by an 
intermedia
ry credit 
institution. 

Treatment 
of 
exposures 
to  
corporates 
(quality 
steps) 

Definition 
of 
Residentia
l Real 
Estate: 
wave to 
independe
nce 
condition 
on any 
cash flow 
generated 
by the 
underlying 

Description 

Exercise of options and national 
discretions by Member States 

Yes 
(with 
provis
o) 

No 

Not 
yet 
decide
d 

N/A 

63 % 
(3 %) 

33 % 

70 % 

30 % 

"Exposures to an institution with an original 
effective maturity of three months or less 
for with a credit assessment by a nominated 
ECAI is available shall be assigned a risk 
weight according to Table 5 in accordance 
with the assignment of the competent 
authorities. 

A Competent Authority may allow short 
term exposures to Member States' 
institutions denominated and funded in the 
national currency a risk weight that is one 
category less favourable than the 
preferential risk weight applicable on 
exposures to EU central governments. 

Provided that certain conditions are met, a 
Member State may permit exposures in the 
form of minimum reserves required by the 
ECB or by the central bank of a Member 
State to be held by a credit institution, in 
accordance with the relevant ECB 
regulation on the application of minimum 
reserves, to be risk weighted as exposures to 
the central bank of the member state 
concerned. 

Exposures for which a credit assessment by 
a nominated ECAI is available shall be 
assigned a risk weight according to the 
following table in accordance with the 
assignment by the competent authorities of 
the credit assessments of eligible ECAIs to 
six steps in a credit quality assessment 
scale. 

Waiver eligibility criterion residential real 
estate (RRE): "competent authorities may 
dispense with the condition contained in § 
45(b) for exposures fully and completely 
secured by mortgages on residential 
property which is situated within their 
territory, if they have evidence that a well-
developed and long-established residential 
real estate market in present in their 
territory with loss rates which are 
sufficiently low to justify such treatment". 

152 

 
 
 
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
Area 

Directive 
2006/48 
(unless 
indicated 
2006/49) 

Denominati
on 

property 
serving as 
collateral. 

STAND
ARDIS
ED 
APPRO
ACH  

STAND
ARDIS
ED 
APPRO
ACH  

STAND
ARDIS
ED 
APPRO
ACH  

Annex VI, 
Part 1, Para. 
50 

Mutual 
recognitio
n of the 
waiver 

Annex VI, 
Part 1, Para. 
51 

RW 50% 
for CRE 

Annex VI, 
Part 1, Para. 
52 

50% RW 
for Finnish 
Housing 
CRE 

STAND
ARDIS
ED 
APPRO
ACH  

Annex VI, 
Part 1, Para. 
53 + Art 153 

Exposures 
related to 
property 
leasing 
transaction
s 

STAND
ARDIS
ED 
APPRO
ACH  

STAND
ARDIS
ED 
APPRO
ACH 

Annex VI, 
Part 1, Para. 
58 

Waive on 
definition 
of the 
CRE 

Annex VI, 
Part 1, Para. 
63 

STAND
ARDIS

Annex VI, 
Part 1, Para. 

Risk-
weighting 
past due 
exposures 
secured by 
non 
eligible 
collateral 
Risk-
weighting 

Description 

Exercise of options and national 
discretions by Member States 

Yes 
(with 
provis
o) 

No 

Not 
yet 
decide
d 

N/A 

Recognition of the treatment in §46 within 
EU: "when the discretion contained in §46 
is exercised by the competent authorities of 
a Member State, the competent authorities 
of another Member State may allow their 
credit institutions to apply a risk weight of 
35% to such exposures fully and completely 
secured by mortgages on residential 
property". 
50% RW for commercial real estate (CRE): 
"Subject to the discretion of the competent 
authorities, exposures fully and completely 
secured, to the satisfaction of the competent 
authorities by mortgages on offices or other 
commercial premises situated within their 
territory may be assigned a risk weight of 
50%" 
Subject to the discretion of the competent 
authorities, exposures fully and completely 
secured, to the satisfaction of the competent 
authorities, by shares in Finnish housing 
companies operating in accordance with the 
Finnish Housing Company Act of 1991 or 
subsequent equivalent legislation, in respect 
of offices or other commercial premises 
may be assigned a risk weight of 50% 
Property leasing transactions: "Subject to 
the discretion of competent authorities, 
exposures related to property leasing 
transactions concerning offices or other 
commercial premises situated in their 
territory and governed by statutory 
provisions whereby the lessor retains full 
ownership of the rented assets until the 
tenant exercises his option to purchase, may 
be assigned a risk weight of 50%. " Art 153: 
(...) the competent authorities may until 31 
December 2012  allow a 50% risk 
weighting to be applied without the 
application of Annex VI, Part 1, § 55 & 56.  
Waiver eligibility criterion CRE: 
"competent authorities may dispense with 
the condition contained in § 51 (b) for 
exposures fully and completely secured by 
mortgages on commercial property which is 
situated within their territory if they have 
evidence  that (...) with loss rates do not 
exceed the following limits (...) 

A risk weight of 100% may be assigned on 
past due exposures which are fully secured 
by non eligible collateral when value 
adjustments reach 15% of the exposure 
gross of the value adjustments, if strict 
operational criteria exist to ensure the good 
quality of the collateral. 

17 % 

83 % 

The applicable risk weight on past due 
exposures secured by mortgages on 

67 % 

33 % 

153 

 
 
 
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
Area 

Directive 
2006/48 
(unless 
indicated 
2006/49) 

64 

ED 
APPRO
ACH 

STAND
ARDIS
ED 
APPRO
ACH 

STAND
ARDIS
ED 
APPRO
ACH 

STAND
ARDIS
ED 
APPRO
ACH 

STAND
ARDIS
ED 
APPRO
ACH 

STAND
ARDIS
ED 
APPRO
ACH 

Annex VI, 
Part 1, Para. 
66 

Annex VI, 
Part 1, Para. 
67 

Annex VI, 
Part 1, Para. 
68(e) 

Annex VI, 
Part 1, Para. 
85 

Annex VI, 
Part 3, Para. 
17 

IRB 

Article 84.2 

IRB 

Article 85, 

Denominati
on 

of past due 
exposures 
secured by 
mortgages 
on 
residential 
property 
Risk-
weighting 
items 
belonging 
to 
regulatory 
high risk 
categories 
Regulatory 
high risk 
categories 
- lower 
risk 
weight due 
to value 
adjustment
s 
Loans 
secured by 
commercia
l real 
estate as 
collateral 
for 
covered 
bonds 
Risk-
weighting 
institutions 
specialisin
g in the 
inter-bank 
and public 
debt 
market 
Exceptions 
to the non-
use of 
domestic 
currency 
ratings for 
foreign-
currency 
exposures 
Requireme
nts for 
IRB 
standards 
for parent 
and EU 
subsidiarie
s 
altogether 
Roll-out 

Exercise of options and national 
discretions by Member States 

Yes 
(with 
provis
o) 

No 

Not 
yet 
decide
d 

N/A 

Description 

residential property net of value 
adjustments may be reduced to 50%, if 
value adjustments are no less than 20% of 
the exposure amount gross of the value 
adjustments.  

The Competent Authorities have the 
discretion to assign a risk weight of 150% 
on exposures associated with particularly 
high risks. 

70 % 
(3 %) 

27 % 

The risk weight on non past due exposures 
receiving a 150% risk weight may be 
reduced to (a) 100% if value adjustments 
exist which are no less than 20% of the 
gross exposure and (b) 50% if value 
adjustments are no less than 50% of the 
gross exposure. 

53 % 
(7 %) 

40 % 

The Competent Authorities may recognise 
loans secured by commercial real estate as 
eligible collateral for covered bonds where 
the required loan to value ratio of 60% is 
exceeded up to a maximum level of 70%, if 
certain defined criteria and conditions are 
met. 

Member States may allow a risk weight of 
10% for exposures to institutions 
specialising in the interbank and public debt 
markets in their home member states, if 
such institutions are subject to close 
supervision and the exposures are 
adequately secured. 

43 % 

57 % 

27 % 

70 % 

3 % 

The Competent Authorities may allow the 
domestic currency rating of an obligor to be 
used for its foreign currency exposures 
provided such exposures arise from 
institutions' participation in a loan extended 
by a Multilateral Development Bank. 

77 % 

23 % 

When IRB approach is used by an EU 
parent or financial hoding company and its 
subsidiaries, Member States may allow the 
minimum requirements to qualify for IRB 
to be met by parent and subsidiaries 
considered together. 

70 % 
(13 
%) 

17 % 

"(1): Subject to the approval of the 

154 

 
 
 
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
Area 

Directive 
2006/48 
(unless 
indicated 
2006/49) 

Denominati
on 

Description 

Exercise of options and national 
discretions by Member States 

Yes 
(with 
provis
o) 

No 

Not 
yet 
decide
d 

N/A 

1+2 

possibility 

IRB 

Article 89.1. 

IRB 

Article 89 
last sentence 

IRB 

Annex VII, 
Part 1, Para. 
6 

IRB 

Annex VII, 
Part 1, Para. 
13 (last 
sentence) 

IRB 

Annex VII, 
Part 1, Para. 
18 

IRB 

Annex VII, 
Part 2, Para. 
5, 7 & Annex 
VIII, Part 1, 
Para. 26 

IRB 

Annex VII, 
Part 2, Para. 

Partial use 
of the 
standardis
ed 
approach 

Mutual 
recognitio
n within 
EU of the 
use of 
standardis
ed 
approach 
for the 
exposures 
listed : 

Lower rate 
for 
specialized 
lending 

Special 
treatment 
for 
revolving 
retail 
exposures 
secured by 
a link to a 
wage 
account 
Treatment 
of 
ancillary 
banking 
services 
Possibility 
to extend 
the list of 
unfunded 
protection 
providers 
for the 
purposes 
of 
recognitio
n of 
unfunded 
credit 
protection 
in PD 
Alternativ
es for the 

competent authorities, implementation may 
be carried out sequentially across the 
different exposure classes (…) (2) 
Implementation as referred to §1 shall be 
carried out within a reasonable period of 
time to be agreed by the competent 
authorities." 
 Subject to the approval of the competent 
authorities, credit institutions permitted to 
use the IRB approach (…) for one or more 
exposure classes may apply Subsection 1 
(standardised approach) for the following 
exposures (…) 

Mutual recognition within EU of the use of 
standardised approach for the exposures 
listed : 'this paragraph shall not prevent the 
competent authorities of other Member 
States to allow the application of the rules 
of Subsection 1 (standardised approach) for 
equity exposures which have been allowed 
for this treatment in other Member States' 

The Competent Authorities may authorise a 
credit institution to generally assign a 50% 
risk weight to SL-Category 1 and 70% to 
SL-Category 2 (regardless of maturity) if 
certain conditions are met. 

60 % 
(13 
%) 

27 % 

The requirement that retail revolving 
exposures be unsecured (Annex VII, Part 1, 
Para. 13 b)) may be waived by the 
Competent Authorities in respect of 
collateralised credit facilities linked to a 
wage account. 

73 % 

27 % 

Exposures to ancillary banking services 
undertakings (equity) can be treated as non-
credit obligation assets. 

90 %  

10 % 

For the purposes of the recognition of 
unfunded credit protection in PD by 
institutions, the Competent Authorities may 
extend the list of unfunded credit protection 
providers further than those included in 
Annex VIII, Part 1, Para. 26. 

40 % 
(3 %) 

57 % 

The Competent Authorities may require all 
institutions in their jurisdiction to use 

33 % 
(3 %) 

64 % 

155 

 
 
 
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
Area 

Directive 
2006/48 
(unless 
indicated 
2006/49) 

12 & 13 

IRB 

Annex VII, 
Part 2, Para. 
15 

IRB 

Annex VII, 
Part 2, Para. 
15 (last 
sentence) 

IRB 

Annex VII, 
Part 2, Para. 
20 & Annex 
VIII, Part 1, 
Para. 26 

IRB 

Annex VII, 
Part 4, Para. 
44 

Denominati
on 

calculation 
of 
maturity 

Maturity 
for EU-
firms (< 
EUR 500 
mio.) 

Maturity 
for EU-
firms 
investing 
primarily 
in real 
estate (< 
EUR 
1,000 
mio.) 
Possibility 
to extend 
the list of 
unfunded 
protection 
providers 
for the 
purposes 
of 
calculation 
of dilution 
risk 

Number of 
days past 
due 

IRB 

Annex VII, 
Part 4, Para 
48 

Number of 
days past 
due 

IRB 

Annex VII, 
Part 4, Para 
56 

Flexibility 
in data 
collection 

CREDI
T RISK 
MITIG
ATION 

Annex VIII, 
Part 1, Para. 
8 

Unrated 
listed 
institutions 

CREDI

Annex VIII, 

Recognitio

Description 

maturity (M) for each exposure in 
accordance with formulae instead of using 
values by default (0.5 years for repos and 
2.5 for other exposures). 
The Competent Authorities may allow 
maturity of exposures to European 
corporates with consolidated assets of less 
than EUR 500 million to be set at values by 
default, even if they apply the formulae 
option. 

The Competent Authorities may allow 
maturity of exposures to European 
corporates that invest primarily in real 
estate with consolidated assets of less than 
EUR 1,000 million to be set at values by 
default, even if they apply the formulae 
option. 

Exercise of options and national 
discretions by Member States 

Yes 
(with 
provis
o) 

No 

Not 
yet 
decide
d 

N/A 

30 % 

70 % 

17 % 

83 % 

For the purposes of the calculation of 
dilution risk, the Competent Authorities 
may extend the list of unfunded credit 
protection providers further than those 
included in Annex VIII, Part 1, Para. 26. 

40 % 

60 % 

"In all cases, the exposure past due shall be 
above the threshold defined by the 
competent authorities and which reflects a 
reasonable level of risk" 
DoD days past due for retail and PSEs: " for 
retail and PSE exposures, the competent 
authorities of each Member States shall set 
the exact number of days past due that all 
credit institutions in its jurisdiction shall 
abide by under the definition of defaults set 
out in §44, for exposures to such 
counterparts situated within this Member 
State. The specific number shall fall within 
90-180 days and may differ across product 
lines. (...)" 
The Competent Authorities may apply less 
stringence as regards the data needed for 
estimation and collected before the 
implementation of the directive, provided 
the credit institution makes appropriate 
adjustments. 
Recognition as collateral of unrated, listed 
institution securities: "debt securities issued 
by credit institutions which securities do not 
have a credit assessment by an eligible 
ECAI may be recognised as eligible 
collateral if they fulfil the following criteria 
..." 
The Competent Authorities may authorise 

156 

83 % 
(10 
%) 

7 % 

40 % 

57 % 

3 % 

 
 
 
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
Area 

Directive 
2006/48 
(unless 
indicated 
2006/49) 

T RISK 
MITIG
ATION 

Part 1, Para. 
15 

Denominati
on 

n of shares 
in Finnish 
housing 
companies 
as eligible 
collateral 

CREDI
T RISK 
MITIG
ATION 

CREDI
T RISK 
MITIG
ATION 

Annex VIII, 
Part 1, Para. 
16 

Waiver to 
definition 
of RRE 

Annex VIII, 
Part 1, Para. 
17 

Waiver to 
definition 
of CRE 

CREDI
T RISK 
MITIG
ATION 

Annex VIII, 
Part 1, Para. 
19 

Mutual 
recognitio
n of the 
waiver 

CREDI
T RISK 
MITIG
ATION 

Annex VIII, 
Part 1, Para. 
20 

Amounts 
receivable 
as eligible 
collateral 

CREDI
T RISK 
MITIG
ATION 

Annex VIII, 
Part 1, Para. 
21 

Other 
physical 
collateral 

CREDI
T RISK 
MITIG
ATION 

CREDI
T RISK 
MITIG
ATION 

Annex VIII, 
Part 1, Para. 
25 

Instrument
s 
repurchase
d on 
request 

Annex VIII, 
Part 1, Para. 
28 

Eligible 
protection 
providers 

Description 

their credit institutions to recognise as 
eligible collateral shares in Finnish housing 
companies that are operating in accordance 
with the Finnish Housing Company Act of 
1991 provided that certain conditions are 
met. 
Waiver eligibility criterion RRE: "the 
competent authorities may waive the 
requirement for their credit institutions to 
comply with condition (b) in § 13 for 
exposures secured by residential real estate 
property situated within the territory of that 
Member State if the competent authority 
have evidence that (...). 
Waiver eligibility criterion CRE: "the 
competent authorities may waive the 
requirement for their credit institutions to 
comply with condition (b) in § 13 for 
exposures secured by commercial real estate 
property situated within the territory of that 
Member State if the competent authority 
have evidence that (...). 
Application of the waiver in §17 within EU: 
"the competent authorities of a Member 
State, which do not use the waiver in §17, 
may recognise as eligible commercial real 
estate property recognised as eligible in 
another Member State by virtue of the 
waiver". 
The Competent Authorities may recognise 
as eligible collateral amounts receivable 
linked to a commercial transaction or 
transactions with an original maturity of 
less than or equal to one year. Eligible 
receivables do not include those associated 
with securitisations, sub-participations or 
credit derivatives or amounts owed by 
affiliated parties. 
The Competent Authorities may recognise 
as eligible collateral physical items of a type 
other than real estate collateral, if satisfied 
as to the following: (a) liquid markets for 
disposal of the collateral do exist in an 
expeditious and economically efficient 
manner; and (b) well-established, publicly 
available market prices for the collateral do 
exist. the institution must be able to 
demonstrate that there is no evidence that 
the net prices it receives when collateral is 
realised deviates significantly from these 
market prices. 

Instruments issued by third party 
institutions which will be repurchased by 
that institution on request may be 
recognised as eligible credit protection. 

Member states may also recognize as 
eligible providers of unfunded credit 
protection, other financial institutions 
authorised and supervised by competent 
authorities and subject to prudential 

157 

Exercise of options and national 
discretions by Member States 

Yes 
(with 
provis
o) 

No 

Not 
yet 
decide
d 

N/A 

90 % 
(3 %) 

7 % 

77 % 
(7 %) 

16 % 

43 % 

53 % 

3 % 

 
 
 
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
Area 

Directive 
2006/48 
(unless 
indicated 
2006/49) 

Denominati
on 

Description 

Exercise of options and national 
discretions by Member States 

Yes 
(with 
provis
o) 

No 

Not 
yet 
decide
d 

N/A 

CREDI
T RISK 
MITIG
ATION 

Annex VIII, 
Part 2, Para. 
9a (ii) 

CREDI
T RISK 
MITIG
ATION 

Annex VIII, 
Part 2, Para. 
16 

CREDI
T RISK 
MITIG
ATION 

Annex VIII, 
Part 3, Para. 
12 

CREDI
T RISK 
MITIG
ATION 

Annex VIII, 
Part 3, Para. 
19 

CREDI
T RISK 
MITIG
ATION 

Annex VIII, 
Part 3, Para. 
43 

CREDI
T RISK 
MITIG
ATION 

Annex VIII, 
Part 3, Para. 
72 

Minimum 
requireme
nts for the 
recognitio
n of 
receivable
s as 
collateral 

Treatment 
of 
exposure 
protected 
by a 
guarantee 
which is 
counter-
guaranteed 
by a 
central 
governme
nt or 
central 
bank. 
Permission 
of internal 
models 
approach 
for 
calculation 
of fully 
adjusted 
exposure 
value (E*) 
Permission 
to use 
empirical 
correlation
s within 
and across 
risk 
categories 
Own 
estimates 
of 
volatility 
adjustment
s 
(categories 
of 
security) 

Reduced 
LGDs for 
leasing 
transaction
s 

73 % 
(7 %) 

17 % 

3 % 

requirements equivalent to those applied to 
credit institutions. 
Credit institutions must take all steps 
necessary to fulfil local requirements in 
respect of the enforceability of security 
interest. There shall be a framework which 
allows the lender to have a first priority 
claim over the collateral subject to national 
discretion to allow such claims to be subject 
to the claims of preferential creditors 
provided for in legislative or implementing 
provisions. 

Treatment where an exposure is protected 
by a guarantee which is counter-guaranteed 
by a central government or central bank 
(…): the exposure may be treated as 
protected by a guarantee by the entity in 
question provided the following conditions 
are satisfied : a); b) and c) the competent 
authority is satisfied that the cover is robust 
and that nothing in the historical 
evidence...in question. 

The Competent Authorities may permit 
credit institutions meeting certain 
requirements to use an internal models 
approach taking into account correlations to 
calculate the adjusted exposure value for 
exposures resulting from the application of 
a master netting agreement. 

83 % 
(13 
%) 

3 % 

The Competent Authorities may allow 
credit institutions to use empirical 
correlations within risk categories and 
across risk categories if they are satisfied 
that the credit institution’s system for 
measuring correlations is sound and 
implemented with integrity. 

83 % 
(10 
%) 

7 % 

When debt securities have a credit 
assessment from a recognised ECAI 
equivalent to investment grade or better, the 
Competent Authorities may allow credit 
institutions to calculate a volatility estimate 
for each category of security. 

Until 31 December 2012, the Competent 
Authorities may, subject to the indicated 
levels of collateralisation, allow credit 
institutions to assign lower levels of LGD 
for senior exposures in the form of 
Commercial Real Estate leasing and of 
equipment leasing. 

158 

90 % 
(3 %) 

3 % 

3 % 

41 % 
(3 %) 

55 % 

 
 
 
  
  
  
  
  
  
  
  
  
  
  
  
Area 

Directive 
2006/48 
(unless 
indicated 
2006/49) 

Denominati
on 

Description 

Exercise of options and national 
discretions by Member States 

Yes 
(with 
provis
o) 

No 

Not 
yet 
decide
d 

N/A 

CREDI
T RISK 
MITIG
ATION 

Annex VIII, 
Part 3, Para. 
73 

Cap at 
50% RW 
for CRE 

CREDI
T RISK 
MITIG
ATION 

Annex VIII, 
Part 3, Para. 
89 

Sovereign 
guarantees 

SECUR
ITISAT
ION 

Article 
152(10)(b) 

SECUR
ITISAT
ION 

Article 97.3 

SECUR
ITISAT
ION 

Article 98.2 

SECUR
ITISAT
ION 

Annex IX, 
Part 4, Para. 
30 

SECUR
ITISAT
ION 

Annex IX, 
Part 4, Para. 
43 

Discretion 
to disapply 
the 
securitisati
on 
framework 

Recognitio
n of ECAI 
: mutual 
recognitio
n 

Mutual 
recognitio
n of 
quality 
steps 

Treatment 
of certain 
retail 
exposures 
subject to 
early 
amortisati
on 
provision 

The 
Internal 
Assessmen
t approach 

SECUR
ITISAT
ION 

Annex IX, 
Part 4, Para. 
43 last 

Public 
availabilit
y of the 

Cap for RRE: "subject to the requirements 
of this paragraph and §75 and as an 
alternative to the treatment in § 69 to 73, the 
competent authorities of a Member State 
may authorise credit institutions to apply a 
50% risk weighting to the part of the 
exposure fully collateralised by RRE 
property or CRE property situated within 
the territory of the Member State if they 
have evidence that (...) 
The Competent Authorities may apply 
reduced risk weights to exposures or 
portions of exposures guaranteed by the 
central government or central bank, where 
the guarantee is denominated in the 
domestic currency of the borrower and the 
exposure is funded in that currency. 

For banks that do not move to standardised 
approach in 2007, the treatment of 
securitisation may be disapplied by 
competent authorities. 

Recognition of ECAI within EU for 
securitisation purposes: "if an ECAI has 
been recognised as eligible by the 
competent authorise of one Member State 
for the purpose of paragraph I, the 
competent authorities of the other Member 
States may recognise that ECAI as eligible 
for those purposes without carrying out 
their own evaluation process" 
Recognition of mapping within EU for 
securitisation purposes: When the 
competent authorities of a Member State 
have made a determination under paragraph 
I, the competent authorities of the other 
Member States may recognise that 
determination without carrying out their 
own determination process. 
The Competent Authorities may apply a 
treatment analoguous to the lines of para. 26 
to 28 in the case of securities subject to an 
early amortisation provision of certain retail 
exposures (uncommitted, unconditionally 
cancellable without prior notice, early 
amortisation is triggered by a quantitative 
value in respect of something other than the 
three months average excess spread) for 
determining the conversion figure. 
Use of ‘internal assessment approach’ for 
unrated ABCP exposures: "subject to the 
approval of the competent authorities, when 
the following conditions are satisfied, a 
credit institution may attribute to an unrated 
position in an asset backed commercial 
paper  programme a derived rating as laid 
down in §43" 
The requirement for the assessment 
methodology to be publicly available may 
be waived by the competent authorities … 

159 

83 % 
(3 %) 

13 % 

73 % 

17 % 

7 % 

3 % 

47 % 
(10 
%) 

40 % 

3 % 

 
 
 
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
Area 

Directive 
2006/48 
(unless 
indicated 
2006/49) 

sentence 

SECUR
ITISAT
ION 

Annex IX, 
Part 4, Para. 
53 (last 
sentence) 

SECUR
ITISAT
ION 

Annex IX, 
Part 4, Para. 
58 

Article 102.4 
& Annex X, 
Part 4, Para. 
1 and 2 

Article 104.3 

Article 105.4 

OPERA
TIONA
L RISK 

OPERA
TIONA
L RISK 

OPERA
TIONA
L RISK 

OPERA
TIONA
L RISK 

Annex X, 
Part 2, Para. 
3 and 5 

OPERA
TIONA
L RISK 

Annex X, 
Part 3, Para. 
11 

Denominati
on 

ECAI's 
assessment 
Applicatio
n of the 
simplified 
Supervisor
y Formula 
Method 

Exception
nal 
treatment 
when 
KIRB 
cannot be 
calculated 

Combinati
on of 
approache
s 
Alternativ
e 
Standardis
ed 
Approach 
Qualifying 
criteria for 
AMA 
within the 
same 
group 
Alternativ
e 
Standardis
ed 
Approach 

Process 
for 
quantitativ
e 
standards 

OPERA
TIONA
L RISK 

Article 20.2 
Dir. 
2006/49/EC 

Minimum 
level of 
own funds 

OPERA
TIONA
L RISK 

Article 20.3 
Dir. 
2006/49/EC 

Minimum 
level of 
own funds 

Description 

Exercise of options and national 
discretions by Member States 

Yes 
(with 
provis
o) 

No 

Not 
yet 
decide
d 

N/A 

The Competent Authorities may permit 
credit institutions to apply for 
securitisations involving retail exposures 
the Supervisory Formula Method using 
simplifications for certain risk parameters. 

80 % 
(10 
%) 

7 % 

3 % 

When it is not practical for the credit 
institution to calculate the risk-weighted 
exposure amounts for the securitised 
exposures as if they had not been 
securitised, a credit institution may, on an 
exceptional basis and subject to the consent 
of the competent authorities, temporarily be 
allowed to apply the following method for 
the calculation of risk-weighted exposure 
amounts for an unrated securitisation 
position in the form of a liquidity facility. 

The Competent Authorities may allow 
institutions to use a combination of 
approaches. 

87 % 
(10 
%) 

3 % 

The Competent Authorities may under 
certain conditions authorise institutions to 
use a alternative indicator to calculate its 
capital requirements. 

60 % 
(3 %) 

37 % 

The Competent Authorities may allow the 
qualifying criteria set out to be met by the 
parent and its subsidiaries considered 
together. 

80 % 
(13 
%) 

7 % 

63 % 
(3 %) 

30 % 

3 % 

70 % 

13 % 

17 % 

50 % 
(3 %) 

30 % 

17 % 

The Competent Authorities may authorise 
institution to calculate its capital 
requirement using an alternative 
standardised approach.  

Correlations in operational risk losses 
across individual operational risk estimates 
may be recognised only if credit institutions 
can demonstrate to the satisfaction of the 
competent authorities that their systems for 
measuring correlations are sound, 
implemented with integrity, and take into 
account the uncertainty surrounding any 
such correlation estimates (...)" 
The Competent Authorities may allow 
investment firms with limited licence to 
provide own funds which are always more 
than or equal to the higher of the capital 
requirement for credit and market risk or 
25% of the preceding years fixed overheads. 
The Competent Authorities may allow 
investments firms which hold 730 000 EUR 
in initial capital, but which fall within 
certain categories, to provide own funds 
which are always more than or equal to the 
higher of the capital requirement for credit 
and market risk or 25 % of the preceding 

160 

 
 
 
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
Directive 
2006/48 
(unless 
indicated 
2006/49) 

Denominati
on 

Description 

years fixed overheads. 

Exercise of options and national 
discretions by Member States 

Yes 
(with 
provis
o) 

No 

Not 
yet 
decide
d 

N/A 

Article 122.1 

Special 
treatment 
for 
insurance 
undertakin
gs 

Member States may exempt insurance 
sector undertakings from the general limits 
established for qualifying holdings. 

70 %    27 % 

3 % 

Article 122.2 

Alternativ
e - 
deduction 

Member States may decide not to apply 
limits on qualifying holdings, provided 
excess is deducted from own funds. 

60 % 
(3 %) 

33 % 

3 % 

Article 153, 
Para. 1 (first 
sentence) 

Article 153, 
Para. 2 
(second 
sentence) 

Article 154.1 

Transition
al 
treatment 
for certain 
property 
leasing 
transaction
s 
Transition
al 
definition 
of the 
secured 
portion of 
a loan 

Transition
al use of a 
different 
definition 
of past due 

The Competent Authorities may, until 
December 31, 2012, allow leasing 
exposures on offices or commercial 
premises in their territory and subject to 
certain conditions, to be rated 50%. 

23 %  

77 % 

The Competent Authorities may, until 
December 31, 2010, allow, for the purpose 
of defining the secured portion of a loan, 
recognise eligible collateral other than the 
one meeting the requirements. 

Until December 31, 2011, the Competent 
Authorities may set the number of days past 
due up to 180 days if local conditions make 
it appropriate (for the purposes of 
application of the standardised approach). 
The specific number may differ across 
product lines. 

13 %  

87 % 

10 % 
(3 %) 

80 % 

7 % 

Article 154.2 

Transition
ally 
shorter test 
of use 

Institutions applying for the use of IRB 
before 2010 may benefit from a test of use 
shorter than 3 years but above 1, until 
December 31, 2009. 

83 % 
(7 %) 

7 % 

3 % 

Area 

QUALI
FYING 
HOLDI
NGS 
OUTSI
DE 
THE 
FINAN
CIAL 
SECTO
R 
QUALI
FYING 
HOLDI
NGS 
OUTSI
DE 
THE 
FINAN
CIAL 
SECTO
R 

TRANS
ITIONA
L 
PROVI
SIONS 

TRANS
ITIONA
L 
PROVI
SIONS 

TRANS
ITIONA
L 
PROVI
SIONS 

TRANS
ITIONA
L 
PROVI
SIONS 

TRANS
ITIONA
L 
PROVI
SIONS 

Transition
ally 
shorter 
requireme
nt of use 
for 
LGD/conv
ersion 
factors 
estimates 
TRANS Article 154.4  Transition

Article 154.3 

For those institutions applying for the use of 
their own LGD/conversion factors 
estimates, the three-year period of 
experience in use required by Article 84.4 
may be reduced to two until December 31, 
2008. 

90 % 
(3 %) 

7 % 

The Competent Authorities may, until 

37 % 

57 % 

3 % 

161 

 
 
 
  
  
  
  
  
  
  
  
  
  
  
Area 

ITIONA
L 
PROVI
SIONS 

TRANS
ITIONA
L 
PROVI
SIONS 

TRANS
ITIONA
L 
PROVI
SIONS 

TRANS
ITIONA
L 
PROVI
SIONS 

TRANS
ITIONA
L 
PROVI
SIONS 

TRANS
ITIONA
L 
PROVI
SIONS 

TRANS
ITIONA
L 
PROVI
SIONS 

Directive 
2006/48 
(unless 
indicated 
2006/49) 

Article 154.6 

Denominati
on 

al 
treatment 
for certain 
types of 
participati
ons 
Transition
al 
exemption 
for certain 
equity 
exposures 

Article 154.7 

Days past 
due for 
corporate 

Article 155 

Annex VII, 
Part 2, Para. 
8 (second 
subparagraph
) 

Annex VII, 
Part 4, Para. 
66, 71, 86 
and 95 

Article 44 
Dir. 
2006/49/EC 

Transition
al 
calculation
s: 
standardis
ed 
approach - 
operationa
l risk 
(credit 
institutions
) 

Transition
al LGD for 
covered 
bonds 

Transition
al 
reduction 
of 
minimum 
length of 
observatio
n periods 
Transition
al 
calculation
s: 
standardis
ed 
approach - 
operationa
l risk 
(investmen
t firms) 
Alternativ
e 
transitiona
l 

TRANS
ITIONA
L 
PROVI

Article 46 
Dir. 
2006/49/EC 

Description 

December 31, 2012, allow credit 
institutions to continue to apply Basel I 
treatment to certain types of participations. 

Exercise of options and national 
discretions by Member States 

Yes 
(with 
provis
o) 
(3 %) 

No 

Not 
yet 
decide
d 

N/A 

53 %  

47 % 

The Competent Authorities may, until 
December 31, 2017, exempt from IRB 
certain equity exposures held on December 
31, 2007. 

"Until 31 December 2011, for corporate 
exposures  the competent authorities of each 
Member State may set the number of days 
past due that all credit institutions in its 
jurisdiction shall abide by under the 
definition of default set out in Annex VII, 
Part 4, §44 for exposures to such 
counterparts situated within this Member 
State." 

Until December 31, 2012, the "trading and 
sales" business line may be applied a 15% 
factor, if it represents at least 50% of the 
total relevant indicators. 

40 % 

60 % 

Until December 31, 2010, covered bonds 
may be assigned an LGD of 11.5%  

73 % 
(3 %) 

20 % 

3 % 

Member States may transitionally allow a 
reduction of the minimum length of the 
observation periods required for own 
estimations of PD, LGD and CCF, subject 
to an absolute minimum of 2 years. 

84 % 
(10 
%) 

3 % 

3 % 

Until December 31, 2012, the "trading and 
sales" business line may be applied a 15% 
factor, if it represents at least 50% of the 
total relevant indicators. 

50 % 

33 % 

17 % 

Until December 31, 2011, the Competent 
Authorities may choose not to apply 
requirements for operational risk as set out 
in Article 75(d) of directive 2006/48/EC to 

40 % 

43 % 

17 % 

162 

 
 
 
  
  
  
  
  
  
  
  
  
  
  
  
Description 

low size investment firms. An alternative 
treatment applies instead. 

Until December 31, 2009, or any other date 
specified by the Competent Authorities on a 
case-by-case basis, it may be provided that 
for institutions that have received specific 
risk model recognition prior to January 1, 
2007, previous requirements (as in the old 
directive) apply. 

Exercise of options and national 
discretions by Member States 

Yes 
(with 
provis
o) 

No 

Not 
yet 
decide
d 

N/A 

35 % 
(3 %) 

52 % 

6 % 

3 % 

The Competent Authorities may allow 
institutions to apply banking book rules to 
their trading book exposures, provided the 
trading book activities does not exceed 
certain limits. 

93 % 
(3 %) 

3 % 

Member States may set a reduced specific 
risk requirement for covered bonds, with 
reductions similar to those applied in the 
banking book under the standardised 
approach. 

A Competent Authority of one member 
state may make use of  the approval of 
another one without conducting its own 
assessment. 

For the purposes of calculation of 
consolidated capital requirements, the 
Competent Authorities may authorise the 
offsetting of trading (trading book, 
commodities, etc.) positions even when 
they are booked in different institutions 
within the group, subject to certain 
conditions. 

57 % 

40 % 

3 % 

63 % 
(3 %) 

30 % 

3 % 

60 % 
(7 %) 

30 % 

3 % 

The Competent Authorities, in the absence 
of readily available market prices, may 
choose not to apply daily mark to market 
and, instead, require institutions to apply 
alternative methods subject to their 
approval. 

77 % 
(3 %) 

20 % 

Subject to certain conditions, the Competent 
Authorities may allow that the capital 
requirement for an exchange-traded future 
contract be equal to the margin required by 
the exchange. 

37 % 
(3 %) 

57 % 

3 % 

Directive 
2006/48 
(unless 
indicated 
2006/49) 

Area 

SIONS 

TRANS
ITIONA
L 
PROVI
SIONS 

Article 47 
Dir. 
2006/49/EC 

TRADI
NG 
BOOK 

Article 18.2 
and 3 
Dir. 
2006/49/EC 

TRADI
NG 
BOOK 

Article 19.2 
Dir. 
2006/49/EC 

TRADI
NG 
BOOK 

Article 19.3 
Dir. 
2006/49/EC 
and Annex I, 
point 52 

Denominati
on 

operationa
l risk 
requireme
nt 
Transition
al 
applicabili
ty of 
recognized 
specific 
risk 
models 
Applicatio
n of the 
banking 
book rules 
to trading 
book, if 
not 
material 
Specific 
risk 
requireme
nt for 
covered 
bonds 

Third 
country 
CIU 

TRADI
NG 
BOOK 

Article 26 
Dir. 
2006/49/EC 

Offsetting 
trading 
positions 

Alternativ
e 
requireme
nts for 
valuation 
in absence 
of readily 
available 
market 
prices 

Capital 
requireme
nt for an 
exchange-
traded 
future 

TRADI
NG 
BOOK 

Article 33.3 
Dir. 
2006/49/EC 

TRADI
NG 
BOOK 

TRADI
NG 
BOOK 

Annex I, 
Para. 4, 2nd 
subparagraph 
(first 
sentence) 
Dir. 
2006/49/EC 
Annex I, 
Para. 4, 2nd 
subparagraph 
(second 
sentence) 

Capital 
requireme
nt for OTC 
derivative 
cleared by 

Subject to certain conditions, the Competent 
Authorities may allow that the capital 
requirement for an OTC derivative cleared 
by a clearing house to be equal to the 
margin required by the clearing house. 

30 % 
(7 %) 

60 % 

3 % 

163 

 
 
 
  
  
  
  
  
  
  
  
  
Area 

TRADI
NG 
BOOK 

Directive 
2006/48 
(unless 
indicated 
2006/49) 

Dir. 
2006/49/EC 

Annex I, 
Para. 5, 2nd 
subparagraph 
Dir. 
2006/49/EC 

TRADI
NG 
BOOK 

Annex I, 
Para. 5, 3rd 
subparagraph 
Dir. 
2006/49/EC 

TRADI
NG 
BOOK 

Annex I, 
Para. 5, 3rd 
subparagraph 
Dir. 
2006/49/EC 

TRADI
NG 
BOOK 

Annex I, 
Para. 14 
Dir. 
2006/49/EC 

TRADI
NG 
BOOK 

Annex I, 
Para. 26 
Dir. 
2006/49/EC 

TRADI
NG 
BOOK 

Annex I, 
Para. 35, first 
sentence 
Dir. 
2006/49/EC 

Denominati
on 

a clearing 
house 
Prescriptio
n of 
specific 
methodolo
gies for 
the 
calculation 
of delta 
Capital 
requireme
nt for 
exchange-
traded 
written 
options 
and OTC 
options 
cleared by 
a clearing 
house 
Capital 
requireme
nt for 
exchange-
traded 
bought 
options 
and OTC 
bought 
options 
cleared by 
a clearing 
house 

Specific 
risk charge 
for a non-
qualifying 
issuer 

Use of 
duration 
instead of 
the 
standard 
system for 
calculation 
of the 
general 
risk of 
traded 
debt 
positions 
Reduced 
specific 
risk 
requireme
nt for 
certain 

Description 

Exercise of options and national 
discretions by Member States 

Yes 
(with 
provis
o) 

No 

Not 
yet 
decide
d 

N/A 

The Competent Authorities may prescribe 
that delta be calculated following 
methodologies specified by them. 

37 % 

60 % 

3 % 

Subject to certain conditions, the Competent 
Authorities may allow that the capital 
requirement for an exchange-traded written 
option, or an OTC option cleared by a 
clearing house to be equal to the margins 
required by the exchange or the clearing 
house, respectively.  

30 % 
(7 %) 

60 % 

3 % 

Subject to certain conditions, the Competent 
Authorities may allow that the capital 
requirement for an exchange-traded bought 
option, or an OTC bought option cleared by 
a clearing house to be equal to the 
requirement for the underlying instrument. 

43 % 
(7 %) 

47 % 

3 % 

The Competent Authorities may require that 
instruments issued by non-qualifying 
issuers are applied a specific risk capital 
charge higher than 8% or 12% and/or 
disallow offsetting for the purposes of 
general market risk between such 
instruments and any other instrument. 

40 % 

57 % 

3 % 

The Competent Authorities may, either in 
general or on an individual basis, allow 
institutions to use a system for calculating 
the general risk for traded debt instruments 
which reflects duration instead of the 
system set out in the directive. 

90 % 
(10 
%) 

The Competent Authorities may allow 
certain equity portfolios to be assigned a 
specific risk requirement of 2% instead of 
4%. 

80 % 

20 % 

164 

 
 
 
  
  
  
  
  
  
  
  
  
Area 

Directive 
2006/48 
(unless 
indicated 
2006/49) 

TRADI
NG 
BOOK 

Annex I, 
Para. 35 (last 
sentence) 
Dir. 
2006/49/EC 

TRADI
NG 
BOOK 

Annex III, 
Para. 2.1, last 
sentence 
Dir. 
2006/49/EC 

TRADI
NG 
BOOK 

Annex III, 
Para. 3.1 
Dir. 
2006/49/EC 

TRADI
NG 
BOOK 

Annex IV, 
Para. 7 
Dir. 
2006/49/EC 

TRADI
NG 
BOOK 

Annex IV, 
Para. 8 
Dir. 
2006/49/EC 

TRADI
NG 
BOOK 

Annex IV, 
Para. 10 
Dir. 
2006/49/EC 

Denominati
on 

equity 
portfolios 
Alternativ
e 
maximum 
weight of 
an 
individual 
position in 
an 
institution'
s equity 
portfolio 
Discretion
al use of 
net present 
value for 
determinin
g the open 
position in 
currencies 
or gold 
Lower 
capital 
requireme
nts for 
closely 
correlated 
currencies 
Definition 
of 
'positions 
in the 
same 
commodit
y' 
Capital 
requireme
nt for 
exchange-
traded 
commoditi
es OTC 
commodit
y 
derivatives 
cleared by 
a clearing 
house 
Prescriptio
n of 
specific 
methodolo
gies for 
the 
calculation 
of delta for 
derivatives 
on 
commoditi
es 

Description 

Exercise of options and national 
discretions by Member States 

Yes 
(with 
provis
o) 

No 

Not 
yet 
decide
d 

N/A 

The Competent Authorities may authorise 
that individual positions represent a 
maximum of 10% of the total equity 
portfolio (instead of 5% as in the Directive), 
provided that the sum of such positions do 
not exceed 50%. 

70 % 

27 % 

3 % 

The Competent Authorities have the 
discretion to allow institutions to use net 
present value when determining their open 
positions in currencies or gold. 

80 % 

20 % 

The Competent Authorities may allow 
institutions to provide lower capital 
requirements for positions in closely 
correlated currencies, as defined in the 
Directive. 

57 % 

43 % 

The Competent Authorities may regard, in 
some cases, different but closely linked 
commodities as the same, for the purposes 
of calculating the position in a commodity. 

77 % 
(3 %) 

20 % 

Subject to certain conditions, the Competent 
Authorities may allow that the capital 
requirement for an exchange-traded 
commodity, or an OTC commodity 
derivative cleared by a clearing house to be 
equal to the margins required by the 
exchange or the clearing house, 
respectively. 

33 % 
(3 %) 

64 % 

The Competent Authorities may prescribe 
that delta for commodity derivatives be 
calculated following methodologies 
specified by them. 

30 % 
(7 %) 

63 % 

165 

 
 
 
  
  
  
  
  
  
  
  
  
  
  
Area 

Directive 
2006/48 
(unless 
indicated 
2006/49) 

RADIN
G 
BOOK 

Annex IV, 
Para. 10, 
three last 
subparagraph
s 
Dir. 
2006/49/EC 

TRADI
NG 
BOOK 

Annex IV, 
Para. 14 
Dir. 
2006/49/EC 

Denominati
on 

Capital 
requireme
nt for 
exchange-
traded 
options 
and OTC 
options 
cleared by 
a clearing 
house 
Offsetting 
positions 
in the 
same 
commodit
y 

Description 

Exercise of options and national 
discretions by Member States 

Yes 
(with 
provis
o) 

No 

Not 
yet 
decide
d 

N/A 

Subject to certain conditions, the Competent 
Authorities may allow that the capital 
requirement for an exchange-traded written 
option, or an OTC option cleared by a 
clearing house to be equal to the margins 
required by the exchange or the clearing 
house, respectively. Also OTC bought 
options may be assigned the same 
requirement as the underlying commodity. 

37 % 
(7 %) 

57 % 

The Competent Authorities may allow 
positions in the same commodity - or in 
commodities regarded as the same - to be 
offset prior to assignment to the appropriate 
maturity band. 

90 % 

10 % 

166 

 
 
 
  
  
  
  
ANNEX III: ECONOMIC AND FINANCIAL IMPORTANCE OF THE BANKING SECTOR IN EUROPE 

The size of the EU banking sector 

The EU banking sector is a key sector in the EU economy. In relative terms, the EU banking sector is larger than 
its US counter part, respectively 340% of GDP and 92% of GDP in 2009. Until the outbreak of the crisis, the EU 
banking sector grew steadily, in terms of total assets, to reach a maximum of over €45,000 bn in late 2008. After 
this peak, it slightly declined and stagnated at around €43,000 bn. 

Chart 1: Total assets of Euro Area MFIs 

MFIs excluding the Eurosystem. € bn 

EU 27

Euro  A rea

45,000

40,000

35,000

30,000

25,000

20,000

15,000

2002

2003

2004

2005

2006

2007

2008

2009

2010

   Source: ECB: Aggregated balance sheet of EA MFIs and own calculations 

Chart 1 illustrates the increasing size of the banking sector by plotting the evolution of the total assets of Euro 
Area Monetary and Financial Institutions (MFIs). Although MFIs include both money markets funds and credit 
institutions, the share of the former is relatively negligible (just over €1,000 bn, around 4% of MFIs).  

In 2008, the banking sector in EU27 was 3.4 times its GDP309. However, these aggregate figures hide very 
different realities across countries. The banking sector is, in general, much more developed in the old Member 
States than in the recently acceded ones. LU, MT, IE, CY, UK and DK have a very important banking sector 
with a size over 4 times their GDP. On the other hand, RO, LT, PL, BG, SK, CZ are characterized by a banking 
sector smaller than their GDP (See Chart 2). 

Over the recent years (2005-2008), the banking sector grew steadily in most countries, although the growth has 
been particularly important in MT, IE, CY and DK.  

Chart 2: Total assets of credit institutions with respect to GDP  

309 It should however be kept in mind that GDP is an annual flow while the size of the banking sector in terms of 

total assets is a stock. 

167 

 
 
 
 
 
 
 
 
                                                 
8

7

6

5

4

3

2

1

0

g
r
u
o
b
m
e
x
u
L

K
U

a
t
l
a
M

d
n
a
e
r
I

l

s
u
r
p
y
C

k
r
a
m
n
e
D

s
d
n
a
l
r
e
h
t
e
N

e
c
n
a
r
F

a
i
r
t
s
u
A

7
2
U
E

5
1
U
M

i

m
u
g
e
B

l

y
n
a
m
r
e
G

n
e
d
e
w
S

l

y
a
t
I

i

n
a
p
S

l

a
g
u
t
r
o
P

d
n
a
n
F

i

l

e
c
e
e
r

G

i

a
n
o
t
s
E

2005

2006

2007

2008

i

a
n
e
v
o
S

l

i

a
v
t
a
L

y
r
a
g
n
u
H

p
e
R
h
c
e
z
C

i

a
k
a
v
o
S

l

d
n
a
o
P

l

a
i
r
a
g
u
B

l

i

a
n
a
u
h
t
i
L

i

a
n
a
m
o
R

Note: Values for Luxembourg ranked from 26.2 in 2005 to 25.4 in 2008. 

Source: European Central Bank and own calculations. 

The EU banking sector is the main financing source for the real economy (see next section). It is also a major 
contributor to the added value of our economies and an important employer. The EA financial sector generates 
an added value of over €400 bn (equivalent to 5% of the GDP).  

The crucial role of bank intermediation for the real economy: intermediation vs. direct 
financing 

In general, financial system impacts allocative efficiency in the real economy through its intermediary role, 
producing information about possible investments, mobilizing savings, monitoring investments, managing and 
diversifying risk as well as easing the exchange of goods and services. Empirical evidence would indicate that 
restricting bank activities has generally negative repercussions for economic growth although there may be a 
trade-off in terms of stability. Similarly, facilitating bank entry generally yields benefits in terms of competition 
and access to finance and so enhances economic growth. Although effects of competition on financial stability 
have been subject of controversy, most recent evidence suggests that increased competition via contestable 
markets is positive for stability.  

In the EU, the banking sector is the main financing source for the real economy. In the Euro Area, almost 50% of 
the financing of the real economy is performed via banking loans310.   

In 2009, the outstanding amount of loans granted by Euro Area MFIs was €17,700 bn, while outstanding amount 
of securities issued in official markets were €15,300 bn for bonds and €4,400 bn for shares and equity. When the 
interbank loans and the securities issued by banks are not considered the figures were €11,750 bn for loans, 
€10,000 bn for bonds and €3,800 bn for shares and equity. 

It should be underlined that the role of the banks as providers of financing to the economy goes beyond their 
"direct" intermediation activity. Beyond the lending activities, MFIs are very active in both the equity and bond 
markets. Indeed, in 2009, EA MFIs held over €5,000 bn bonds and €1,200 bn shares, corresponding to 
approximately one third of the respective markets. Therefore, taking into consideration the lending activity 
through loans and the financing through securities, the banking sector is responsible for about two thirds of the 
financing available in the Euro Area. 

Chart 3: Sources of financing in the Euro Area 

        Total, € bn 

Excluding MFIs, € bn 

310 Equity, bonds and loans not issued in official market or through the banking system are neglected. 

168 

 
 
 
 
 
           
 
 
 
 
 
 
                                                 
Total loans
Total bonds
Total shares

18,000

16,000

14,000

12,000

10,000

8,000

6,000

4,000

2,000

0

Loans to non-MFIs
Bonds (non-MFIs)
Shares (non-MFIs)

18,000

16,000

14,000

12,000

10,000

8,000

6,000

4,000

2,000

0

1999

2001

2003

2005

2007

2009

1999

2001

2003

2005

2007

2009

        Total, % 

Excluding MFIs, % 

100%

80%

60%

40%

20%

0%

Total shares
Total bonds
Total loans

100%

80%

60%

40%

20%

0%

Shares (non-MFIs)
Bonds (non-MFIs)
Loans to non-MF Is

1999

2001

2003

2005

2007

2009

1999

2001

2003

2005

2007

2009

          Note: Data for bonds and shares issued outside official markets are not available. 

          Source: European Central Bank and own calculations. 

Chart 4: Aggregate balance sheet of Euro Area MFIs 

MFIs excluding the Eurosystem 

2006 

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%

Remaining assets

External assets

Shares

Debt securities

     2009 

Remaining liabilities

MMF  shares

Capital and reserves

External liabilities

Debt securities 
issued

Loans to EA 
residents

Deposits

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%

Remaining  assets

Re maining liabilities

External a ssets

Share s

D ebt securities

MMF shares
Cap ital and 
reserves

External lia bilities

Debt securit ies 
issued

Loans to EA 
residents

Deposits

Assets

Liabilities

Assets

Liabilities

         Source: European Central Bank and own calculations. 

The importance of financial regulation for financial stability and sustainable growth  

While the banking sector generally contributes to economic and financial development, the financial crisis has 
painfully revealed its weaknesses and the risks it bears for the entire economy. This section briefly reviews the 

169 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
theory and empirical evidences regarding the role of regulation (for example minimum capital requirement), the 
capacity to lend and the economic activity. 

A growing body of empirical research on the links between financial development and economic growth 
produces a remarkably consistent narrative: The services provided by the financial system exert a first-order 
impact on long-run economic growth.311  

First, countries with better-developed financial systems tend to grow faster. Specifically, countries with (i) large, 
privately-owned banks that funnel credit to private enterprises and (ii) liquid stock exchanges tend to grow faster 
than countries with corresponding lower levels of financial development. The level of banking development and 
stock market liquidity each exerts an independent, positive influence on economic growth. Second, simultaneity 
bias (whether economic growth leads to financial development or vice versa) does not seem to be present, 
suggesting that it is indeed financial development that contributes to economic growth. Third, better-functioning 
financial systems ease the external financing constraints that impede firm and industrial expansion. Thus, one 
channel through which financial development matters for growth is by easing the ability of financially 
constrained firms to access external capital and expand. 

Building on this last point, some studies suggest this is due to a "broad credit channel" (Oliner and Rudebusch, 
1996), where the supply of funds comes from all financial intermediaries and markets, not just banks. This view 
is supported by Discroll (2004) who finds that for U.S. states, bank loans themselves have small, often negative 
and statistically insignificant effects on output. This could be due to the fact that firms are not in fact bank-
dependent, and are able to substitute other forms of finance, such as bond or equity financing for firms with 
ready access to such markets, trade credit or other kinds of borrowing from other firms in the case of firms which 
do not have such access.  

The existence of a credit channel operating through the banking system cannot be denied however. Kroszner, 
Laeven and Klingebiel (2007) analyse the effects of financial crisis on externally dependent sectors in both, well- 
and poorly-developed financial systems. They show that in times of crisis, externally dependent sectors 
(comprised of young firms or firms with a large fraction of hard-to-measure intangible assets) tend to experience 
a greater contraction of value added in well-developed, financial systems than in countries with shallower 
financial systems. Their reasoning is that a deeper financial system allows sectors dependent on external finance 
to obtain relatively more external funding in normal periods, so a crisis that significantly impairs the functioning 
of banks has a disproportionately negative effect on externally dependent firms in such systems. In contrast, 
since externally dependent firms tend to obtain relatively less external financing in shallower financial systems, a 
crisis in such countries has less of an effect on the growth of these sectors. Similarly, the authors find a 
disproportionately negative impact of banking crises on real growth in sales, real growth in earnings, and real 
stock returns for firms in externally dependent industries. While these results might suggest a dark side of 
financial development, the authors do not find evidence that on net the externally dependent firms fare worse in 
deep financial systems. 

Overall, while the finding that financial development has a positive impact on economic growth is generally 
accepted, an important limitation of almost all studies on financial development and growth should be noted: 
There is a significant difficulty in designing empirical proxies for “financial development” (Levine and 
Demirgüç-Kunt, 2008).  

There are two reasons for this difficulty: First, researchers do not have very good cross-country measures of the 
ability of financial systems to provide their services (to facilitate the screening of firms before they are financed, 
the monitoring of firms after they are financed, the managing of idiosyncratic project risk and liquidity risk, as 
well as the exchange of goods, services, and financial claims) to the economy. Second, international financial 
market integration makes the size of a domestic financial system an inadequate indicator of efficiency gains in 
terms of accessibility to credit and financial services, intermediation costs, or productivity of capital employed 
(Guiso et al. 2004).  

Traditional approaches to bank regulation emphasize the positive features of capital adequacy requirements 
(Dewatripont and Tirole, 1994). Capital serves as a buffer against losses and hence failure. Furthermore, with 
limited liability, the proclivity of banks towards higher risk activities is curtailed with greater amounts of capital 

311 The following paragraph builds on work by Bagehot (1873), Gurley and Shaw (1955), Goldsmith (1969), and 
McKinnon (1973), recent research has employed different econometric methodologies and data sets in 
producing three core results (Levine and Demirgüç-Kunt, 2008) 

170 

 
 
 
                                                 
at risk. Capital adequacy requirements, especially with deposit insurance, play a crucial role in aligning the 
incentives of bank owners with depositors and other creditors (Berger et al., 1995).  

As reviewed in Santos (2001) and Gorton and Winton (2003), however, theory provides conflicting predictions 
as to whether the imposition of capital requirements will have positive effects on stability and growth. For 
instance, Kim and Santomero (1988), Besanko and Kanatas (1996), and Blum (1999) argue that capital 
requirements may increase risk-taking behaviour. Furthermore, Thakor (1996) models the impact of an 
increase in risk-based capital requirements and concludes these reduce banks’ willingness to screen and lend. In 
a general equilibrium context, Gorton and Winton (2000) show that raising capital requirements forces banks to 
supply fewer deposits, reducing the liquidity-providing role of banks312.  

Barrell et al. (2009) argue that changing capital and liquidity ratios changes the probability of financial 
crises. They show that it would have been beneficial in terms of output to have had a one or even two percentage 
point higher level of capital and liquidity requirements in the UK prior to the current crisis. These results do not 
hold for the Euro Area or the US as they argue that a crisis in the UK was more likely, suggesting that with 
higher probabilities for a crisis, higher capital requirements are beneficial for long-term economic output313.   

As banking sector plays a central role in economy any changes in regulatory environment that have impact on 
banking sector should indirectly affect also economic activity. The existing literature suggests the following 
relationships between the regulation and economic growth: 

-  Effects of capital requirements and leverage ratios on sustainable financial development are ambiguous; yet 

it is suggested that combining these policies may yield positive results.  

-  Effects of deposit  insurance  in  terms  of  financial  stability  are  ambiguous  as  they  can  reduce  the  systemic 
risk associated with bank runs but may reduce incentives for risk management in covered institutions and 
incentives for private sector oversight.  

-  Strong supervisory power on banks is beneficial for building robust legal systems. 

-  Evidence on the effectiveness of private sector monitoring of banks is ambiguous.  

-  Bank governance is found to be relevant to financial stability in two important respects: 

-  Bank risk is generally higher in banks that have concentrated ownership with substantial cash flow rights. 

-  The relation between risk and regulation depends critically on each bank’s ownership structure, because it 

can determine whether the impact of regulation is either positive or negative with regard to stability. 

-  While  private  ownership  of  banks  entails  risks  and  needs  careful  design,  government  ownership  of  banks 
usually yields lower levels of financial development and growth, yet more concentrated lending and higher 
systemic fragility. 

Available evidence from the cost of financial (banking) crisis 

As illustrated in the previous section, financial and banking regulation is crucial to the stability of the sector and 
eventually the long-term economic growth. These findings are further underlined by the evidence on the cost of 
past (and current) financial and banking crisis and provide a good rationale for designing and implementing 
appropriate regulation. 

Financial crises, defined as systemic banking crises314, which can be aggravated by foreign exchange or 
sovereign debt crises, are particularly socially costly, not only for the rescue of ailing institutions but also in 
terms of opportunity costs and foregone growth. The traditional computations of the cost of such a crisis for a 
country are based on a calculation of its direct and indirect fiscal costs, as described in the graph below. 

312  It should be noted that this literature does not take into account the Basel II framework where the more direct 
link  between  capital  requirements  and  the  specific  risk  of  banks’  activities  may  help  to  ease  any 
incentive problems in risk management. 

313 They also refer to the case of Spain where the robustness of the banks shows the value of higher capital. 
314 Following the definition of Leaven and Valencia (2008) cited by the "Public Finances in EMU 2009" of the 

European Commission 

171 

 
 
 
                                                 
Chart 05: The costs of a financial crisis 

Source: European Commission, DG Economic and Financial Affairs (2009): "Public Finances in EMU 2009", European Economy 5, 
10th edition 

However, these fiscal costs do not include costs borne by depositors and borrowers, stemming from exposure to 
failed banks, or when facing higher costs for services provided by banks that compensate for losses. 

The debate also focuses on the best way to compute the economic costs of a banking crisis and the extent of what 
is referred to as the output gap caused by this crisis. The literature offers different means to conduct such 
calculations. On the one hand, it would be possible to approximate output losses as the difference between output 
growth before and a few years after the crisis – usually the time that it returns to its trend; on the other hand, to 
be more accurate, the difference could be computed in levels rather than in growth rates of GDP. Finally, 
econometric estimations of output gaps allow controlling for the bias that could come from "normal" cyclical 
output variations. 

The European Commission analysed empirically in its publication, Public Finances Report in the EMU 2009, 
the costs of 49 crises that occurred in emerging and market economies since the 1970s. Consistent with the 
figures found by Leaven and Valencia (2008), the Commission reported an average direct net cost of 13%, i.e. 
expenses due only to the rehabilitation of the banking sector and already accounting for the recovery that the 
government can get from the sale or repayment of impaired assets that it had to buy – even though the average 
recovery rate did not exceed 18% of the initial gross outlays. Focusing only on the EU27, these figures show an 
average net fiscal cost of 6.6% of GDP, with a 23.9% recovery ratio, both under the OECD averages 
(respectively 11.4% of GDP and 29.7%). 

All in all, the net fiscal costs of the last financial crisis should be rather greater than those of past crises, mainly 
because of its global nature, and given the recent expansion of the banking sector and low foreseen recovery of 
impaired assets. In the EU, according to the Commission report, these net fiscal costs could reach 16.5% of GDP 
on average, with higher figures for some Member-States taken individually.  

Indeed, as it appears in the graphs below, the extent of capital injections and of guarantees on bank liabilities, in 
terms of percentage of GDP, varied greatly from one European country to another, respectively from 1% to 7% 
and from 1% to almost 240%. 

Chart 6: Public interventions in the banking sector (% of GDP) - situation at 31/12/2009 

172 

 
 
 
 
 
To tal appro ved injectio ns

Effective capital injectio ns 

8

7

6

5

4

3

2

1

0

IE

LU

B E

NL

UK

DK

DE

A T

LV

EU

EA

GR

FR

IT

SE

HU

P T

FI

P L

SK

   Source: Commission Services 

Beyond the direct burden of the banking rescue measures, the indirect costs of past financial crises have also 
weighted significantly on social wealth. The gross public debt-to-GDP ratio has on average grown by 18% in the 
course of the years when past crises occurred, under the multiple pressures of automatic stabilizers and fiscal 
stimuli. In addition to this expenditure effect (+1.1% of GDP in EU27 on average), financial crises also trigger a 
loss through the revenue effect (on average -0.9% in the EU27), notably in terms of foregone tax payments, as 
well as a potential strong market effect leading to higher premia on interest payments. 

This consequence is particularly worrying because of its long-term implications. Indeed, in the sample analysed 
by the Commission, it took governments at least eight years to come back to pre-crisis levels of debt-to-GDP 
ratios, driven up both by the changes in the primary deficit and by the "snow-ball effect" of interest payments. 

Chart 7: Guarantees on bank liabilities (% of GDP) 

To tal appro ved guarantees

Effective guarantees granted

100

80

60

40

20

0

DK

IE

B E

SE NL

SI

FI

LV

A T

EU

UK

EA

DE ES

CY

FR P T

LU GR

HU SK

P L

       Notes:   

       Source:  

Denmark: 237.5% approved guarantees and 205.3% effective guarantees granted. 
Ireland: 167.5% approved and effective guarantees granted. 
Commission services 

173 

 
 
 
 
 
ANNEX IV: LIQUIDITY COVERAGE RATIO AS SPECIFIED IN FEBRUARY 2010 PUBLIC 
CONSULTATION 

The public consultation of February 2010 by the Commission services included the following possible 
specification of the LCR.  As regards the buffer of high quality liquid assets, the Commission services consulted 
on the impact of both a narrow regulatory definition of liquid assets composed of cash, central bank reserves and 
high quality sovereign debt, as well as a somewhat broader definition which could also include a proportion of 
high quality corporate bonds and/or covered bonds. 

Item 

Factor                     

(to be multiplied against 
total amount) 

Stock ("buffer") of "high quality liquid assets" 
Cash and qualifying central bank receivables (including reserves to the extent 
that they can be drawn down in times of stress) 
Qualifying marketable securities from sovereigns, central credit institutions, 
public sector entities, and multi-lateral development banks that could receive a 
0% risk weight for credit risk under the standardised approach 
Domestic sovereign or central bank debt in domestic currency 
For not more than 50% of the buffer, the following additional assets could be 
considered: 

Corporate bonds not issued by institutions 
rated AA or higher  
A- to AA- 

Covered bonds not issued by the institution itself 
rated AA or higher 
rated A- to AA- 

to the extent that those corporate and covered bonds are traded in large, deep 
and active markets characterised by a low level of concentration and a bid-ask-
yield spread that has not exceeded 40 bsp (assigned a 20% haircut) or 50 bsp 
(assigned a 40% haircut) neither during all of the last 10 years nor during a 
relevant period of significant liquidity stress. Furthermore, the maximum 
historic decline of price or increase in haircut over a 30-day period neither 
during the last 10 years nor during a relevant period of significant liquidity 
stress may not exceed 10%. 

100% 

100% 

100% 

80% 
60% 

80% 
60% 

 Cash Outflows over 30 days under the regulatory stress scenario, taking into account the earliest possible 
call or termination date for the funding 
Retail deposits placed by a natural person (rather than a legal entity), but 
excluding deposits placed by sole proprietorships and partnerships. However 
deposits by a legal entity, sole proprietorship or partnership where the 
reported sales for the consolidated group of which the firm is a part are less 
than €50 million and the total aggregated funding raised from one such 
customer is less than €1 million may be treated as retail.  
- stable deposits that are both covered by an EEA deposit insurance scheme (or 
a non-EEA scheme recognised as effective by competent authorities) and are 
made in transactional accounts (e.g. accounts where salaries are automatically 
credited) or the depositors have other established relationships with the same 
bank which make deposit withdrawal highly unlikely; 
- less stable retail deposits [additional sub-categories to be determined] 

7.5% 

15% or higher for possible 
sub-categories 

Unsecured wholesale funding: 
- non-financial corporates, no operational (cash management, salary 
disbursement etc. to be defined further) relationship with credit institution 
- non-financial corporates, sovereigns, central banks and public sector entities 

75% 

25% of deposits needed for 

174 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
  
 
with operational relationships  

Item 

- other legal entity customers and sovereigns, central banks, and PSEs without 
operational relationships  
Secured funding: 
Funding from repo of assets not eligible for the buffer and securities 
lending/borrowing transactions where assets not eligible for the buffer are lent 
out 
Liabilities related to derivative collateral calls related to a downgrade of up to 
3-notches 

Market valuation changes on derivatives transactions requiring additional 
collateral/margin 
Valuation changes on posted non-cash or non-high quality sovereign debt 
collateral securing derivative transactions  
ABCP, SIVs, Conduits, etc: 

Term ABS (incl. structured covered bonds) 
Currently undrawn portion of committed credit and liquidity facilities to: 
- retail clients 
- non-financial corporates; credit facilities 
- non-financial corporates; liquidity facilities 
 -- other legal entity customers 
Other contingent funding liabilities (such as guarantees, letters of credit, 
revocable credit and liquidity facilities etc) 
Planned outflows related to renewal or extension of new loans (retail or 
wholesale) and any other cash outflows (including planned derivative payables) 
Cash Inflows 
Amounts receivable from retail counterparties 

Amounts receivable from wholesale counterparties 

Receivables in respect of repo and reverse repo transactions backed by assets 
not eligible for the buffer and securities lending/borrowing transactions where 
assets not eligible for the buffer are borrowed. 
Receivables in respect of repo and reverse repo transactions backed by assets 
eligible for the buffer and securities lending/borrowing transactions where 
assets eligible for the buffer are borrowed. 
Undrawn portion of liquidity lines or other facilities committed to the 
institution 

Factor                     

(to be multiplied against 
total amount) 
operational purposes 

100% 

100%  

100% of collateral that 
would be required to cover 
the contracts in case of up to 
a 3-notch downgrade 
treatment still to be 
determined 
20% 

100% of maturing amounts 
and 100% of returnable 
assets 
100% of maturing amounts 

10% of outstanding lines 
10% of outstanding lines 
100% of outstanding lines 
100% of outstanding lines 
treatment still to be 
determined 
100% 

100% of planned inflows 
from performing assets 
100% of planned inflows 
from performing wholesale 
customers 
100%  

0% 

0% 

175 

 
 
 
 
  
  
ANNEX V: NET STABLE FUNDING RATIO AS SPECIFIED IN FEBRUARY 2010 PUBLIC 
CONSULTATION 

The public consultation of February 2010 by the Commission services included the following possible 
specification of the NSFR.   

Availability 
Stable funding 
Factor 

100% 

85% 

70% 

50% 

0% 

Required 
Stable 
Funding 
Factor 
0% 

Sources of stable funding available for purposes of the requirement 

Own funds eligible instruments and other liabilities > 1year residual term 

Stable deposits of retail and small business customers  
(non-maturity or residual maturity < 1year) 
Less stable deposits of retail and small business customers  
(non-maturity or residual maturity < 1year) 
Wholesale funding provided by non-financial corporate customers  
(non-maturity or residual maturity < 1year) 

All other liabilities and equity not included above  

Assets requiring stable funding 

All  cash  immediately  available  to  meet  obligations  not  held  for  operational  purposes,  not 
currently encumbered as collateral and not held for planned use as contingent collateral.   

All short-term unsecured instruments and transactions with outstanding maturities of less than 
one year.315 

All securities with stated remaining maturities of less than one year with no embedded options 
that would increase the expected maturity to more than one year.  

All securities held where the institution has an offsetting reverse repurchase transaction when 
the security on each transaction has the same unique identifier (e.g. ISIN)  

All  loans  to  financial  entities  with  effective  maturities  of  less  than  one  year  that  are  not 
renewable and for which the lender has an irrevocable right to call. When the loan is secured, 
the underlying collateral must have a maturity of less than one year.  

Unencumbered marketable securities with residual maturities over one year representing claims 
on or claims guaranteed by sovereigns, central banks, BIS, IMF, EC, non-central government 
public sector entities (PSEs) or multilateral development banks which are rated AA or higher 
and  are  assigned  a  0%  risk-weight  under  the  credit  risk standardised  approach,  provided  that 
active repo-markets exist for these securities.  

5% 

Unencumbered  corporate  bonds316  or  covered  bonds317  satisfying  all  of  the  following 
conditions:  

20% 

-  Central  bank  eligibility  for  intraday  liquidity  needs  or  overnight  liquidity  shortages  in 
relevant jurisdictions.318 

315  Such  instruments  include  but  are  not  limited  to:  short-term  government  and  corporate  bills  notes  and 
obligations; commercial paper; negotiable certificates of deposits; reserves with central banks and sale 
transactions of such funds (e.g. fed funds sold); bankers acceptances; money market mutual funds. 

316 Corporate bonds are plain vanilla assets whose valuation is easy and standard and does not depend on private 

knowledge, i.e. no complex structured products, no subordinated debt. 
317 Covered bonds eligible under point 68 of Annex VI of Directive 2006/48/EC 
318 Central bank eligibility: This is an optional criterion for jurisdictions whose list of central bank eligible assets 
is only very narrowly defined. In those jurisdictions, the relevant supervisors may exercise discretion to 

176 

 
 
 
 
                                                 
Required 
Stable 
Funding 
Factor 

Assets requiring stable funding 

- Not issued by a credit institution, investment or insurance or financial services firm and 
in particular not issued by the respective firm itself 

- Low credit risk: assets have a credit assessment by a recognised ECAI equivalent to at 
least AA, or do not have a credit assessment by a recognised ECAI and are internally rated 
as having a PD equivalent to that associated with a AA credit assessments of ECAIs 

- Proven record as a reliable source of liquidity in the markets (repo and sale) even during 
stressed market conditions: ie maximum price change or increase in haircut over a 30-day 
period during the last 10 years or during a relevant period of significant liquidity stress not 
exceeding 10%. 

- Traded in large, deep and active markets characterised by a low level of concentration. 
The  bid-ask-yield  spread  has  not  exceeded  40  bsp  during  the  last  10  years  or  during  a 
relevant period of significant liquidity stress.   

Unencumbered  gold,  corporate  bonds,  covered  bonds,  and  equity  securities  that  satisfy  all  of 
the following conditions:  

50% 

-  Central  bank  eligibility  for  intraday  liquidity  needs  or  overnight  liquidity  shortages  in 
relevant jurisdictions.319 

- Not issued by a credit institution, investment, insurance, or financial services firm (except 
in the case of covered bonds). 

- Not issued by the respective firm itself 

- Low credit risk: assets have a credit assessment by a recognised ECAI of at least single 
A,  or  do  not  have  a  credit  assessment  by  a  recognised  ECAI  and  are  internally  rated  as 
having  a  PD  equivalent  to  that  associated  with  a  single  A  credit  assessments  of  ECAIs 
conform the Basel II Accord. 

- Traded in large, deep and active markets characterised by a low level of concentration. 
The  bid-ask-yield  spread  has  not  exceeded  50  bsp  during  the  last  10  years  or  during  a 
relevant period of significant liquidity stress. 

- Listed on a recognised exchange and included in a large cap market index. 

All  assets  held  in  the  trading  book  that  are  not  securities  or  loans  that  satisfy  all  of  the 
following conditions.  

-  The  instrument’s  fair  value  can  be  determined  based  on  inputs  that  are  quoted  prices 
(unadjusted) in active markets for identical assets at the measurement date.  

- Traded in large, deep and active markets characterised by a low level of concentration. 
The bid-ask-spread has not exceeded 50 bsp during the last 10 years or during a relevant 
period of significant liquidity stress. 

- Listed on a recognised exchange in multiple time zones and included in a main index. 

Loans to non-financial corporate clients having a maturity of less than one year. 

Loans to retail clients (ie natural persons) having a maturity of less than one year. 

All other assets not included in the above categories.  

85% 

100% 

allow  non-central  bank  eligible  corporate  bonds  provided  that  they  meet  the  other  respective  criteria 
above.  

319 Central bank eligibility: This is an optional criterion for jurisdictions whose list of central bank eligible assets 
is only confined to tier 1 assets. In those jurisdictions, the relevant supervisors may exercise discretion 
to allow non-central bank eligible corporate bonds provided that they meet the other respective criteria 

177 

 
 
 
                                                                                                                                                         
ANNEX VI: ELIGIBILITY CRITERIA FOR CORE TIER 1, NON-CORE TIER 1 AND TIER 2 
REGULATORY CAPITAL AS SPECIFIED IN FEBRUARY 2010 PUBLIC CONSULTATION 

The public consultation of February 2010 by the Commission services included the following possible eligibility 
criteria for regulatory capital. 

Eligibility criteria for core Tier 1 capital 

The institution does nothing to create an expectation at issuance that the instrument will be bought back, 

There are no circumstances under which distributions are obligatory. Non-payment is therefore not an 

Distributions are paid out of distributable items (retained earnings included). The level of distributions 

Principal is perpetual and never repaid outside of liquidation, setting aside discretionary repurchases or 

Represents the most subordinated claim in liquidation of the institution. 
1. 
2. 
Entitled to a claim of the residual assets that is proportional with its share of issued capital, after all 
senior claims have been repaid in liquidation, i.e. has an unlimited and variable claim, not a fixed or capped 
claim.  
3. 
other means of effectively reducing capital in a discretionary manner that is allowable under national law. 
4. 
redeemed or cancelled nor do the statutory or contractual terms provide any feature which might give rise to 
such an expectation. 
5. 
are not in any way tied or linked to the amount paid in at issuance and are not subject to a cap, except to the 
extent that an institution is unable to pay distributions that exceed the level of distributable items. 
6. 
event of default. 
7. 
more senior capital instruments have been made. There are no preferential distributions, including in respect of 
other elements classified as the highest quality issued capital.  
8. 
It is the issued capital that takes the first and proportionately greatest share of any losses as they occur. 
Within the highest quality capital, each instrument absorbs losses on a going concern basis proportionately and 
pari passu with all the others. 
9. 
balance sheet insolvency. 
10. 
11. 
12. 
subject to any other arrangement that legally or economically enhances the seniority of the claim. 
13. 
owners or, if permitted by applicable law, given by the Board of Directors or by other persons duly authorised by 
the owners. 
14. 

The paid in amount is classified as equity under the relevant accounting standards. 
It is directly issued and paid-up.  
The paid in amount is neither secured nor covered by a guarantee of the issuer or related entity or 

It is only issued with the approval of the owners of the issuing institution, either given directly by the 

Distributions are paid only after all legal and contractual obligation have been met and payments on 

The paid in amount is recognised as equity capital (i.e. not recognised as a liability) for determining 

It is clearly and separately disclosed on the institution's balance sheet. 

Eligibility criteria for non-core Tier 1 capital 

Issued and paid-up. 
Subordinated to depositors, general creditors and subordinated debt of the institution. 
Is neither secured nor covered by a guarantee of the issuer or related entity or other arrangement that 

1. 
2. 
3. 
legally or economically enhances the seniority of the claim vis-à-vis institution creditors. 
4. 
5. 

Is perpetual: there is no maturity date and no incentive to redeem. 
May be called at the initiative of the issuer only after a minimum of five years. 
a. To exercise a call option an institution must receive prior supervisory approval.  
b. An institution shall do nothing that creates an expectation that the call will be exercised. 
c. An institution shall not exercise a call unless: 

i) it replaces the called instrument with capital of the same or better quality and the 

replacement of this capital is done at conditions which are sustainable for the income capacity of the institution; 
or 

ii) the institution demonstrates fully to the competent authorities that its capital position would 

be well above the minimum capital requirements after the call option is exercised. 
6. 
Any repayment of principal (e.g. through repurchase or redemption) shall be subject to prior approval 
by the competent authorities. An institution shall not assume or create market expectations that such approval 
will be granted. 
7. 

Dividend/coupon discretion. 
a. An institution shall have full discretion at all times to cancel distributions / payments.  

178 

 
 
 
 
 
 
 
 
 
 
 
b. Cancellation of discretionary payments shall not be an event of default. 
c. An institution shall have full access to cancelled payments to meet obligations as they fall due. 
d. Cancellation of distributions / payments shall not impose restrictions on the institution except in 

Dividends / coupons shall be paid out of distributable items. 
The instrument shall not have a credit sensitive dividend feature, that is a dividend that is reset 

relation to distributions to common shareholders. 
8. 
9. 
periodically based in whole or in part on the current credit standing of the institution's or that of its group.  
10. 
of national insolvency law. 
11. 
loss absorption through either: conversion to common shares at an objective pre-specified trigger point or a 
write-down mechanism that allocates losses to the instrument at a pre-specified trigger point. A write-down 
shall: 

An instrument classified as a liability for the purposes of national insolvency law shall have principal 

The instrument shall not contribute to liabilities exceeding assets if such a balance sheet test forms part 

a. Reduce the claim of the instrument in liquidation; 
b. Reduce the amount re-paid when a call is exercised; and 
c. Partially or fully reduce coupon / dividend payments on the instrument. 
The issuing institution or a related party shall not knowingly purchase, or directly or indirectly fund the 

The instrument shall not have any feature that could hinder recapitalisation, such as provisions that 

12. 
purchase of, the instrument. 
13. 
require the issuer to compensate investors if a new instrument is issued at a lower price during a specified period. 
14. 
If an instrument is not issued out of an operating entity in the consolidated group (e.g. a Special Purpose 
Vehicle or holding company), proceeds must be immediately available without limitation to an operating entity 
in the consolidated group in a form which meets or exceeds all of the other eligibility criteria for non-Core Tier 1 
Capital. 
Additional requirements 
The criteria above shall also apply to an instrument that appears in the consolidated accounts as a minority 
interest.  
This element of capital shall be net of the appropriate corresponding deductions related to holding of non-
common equity capital instruments in other financial institutions. 

Eligibility criteria for Tier 2 capital 

Issued and paid-in. 
Subordinated to depositors and general creditors of the institution 
Is neither secured nor covered by a guarantee of the issuer or related entity or other arrangement that 

1. 
2. 
3. 
legally or economically enhances the seniority of the claim vis-à-vis depositors and general institution creditors 
4. 

Maturity 
a. Has a minimum original maturity of at least 5 years. 
b. Recognition in regulatory capital in the remaining 5 years before the repayment date will be 

amortised on a straight line basis. 

5. 

c. There are no incentives to redeem. 
May be callable at the initiative of the issuer only after a minimum of five years. 
a. To exercise a call option an institution must receive prior approval by the competent authorities. 
b. An institution shall not do anything that creates an expectation that the call will be exercised. 
c. Institutions shall not exercise a call unless: 

i. they replace the called instrument with capital of the same or better quality, and the 

replacement of this capital is done at conditions which are sustainable for the income capacity of the institution; 
or 

ii. the institution demonstrates fully to the competent authorities that its capital position would 

The instrument shall not have a credit sensitive dividend feature, that is a dividend that is reset 

An investor in the instrument shall have no rights to accelerate the repayment of future scheduled 

be well above the minimum capital requirements after the call option is exercised. 
6. 
payments (coupon or principal), except in bankruptcy and liquidation. 
7. 
periodically based in whole or in part on the institution's current credit standing or that of its group. 
8. 
funded the purchase of, the instrument 
9. 
Purpose Vehicle or holding company), the proceeds shall be immediately available without limitation to an 
operating entity in the consolidated group in a form which meets or exceeds all of the other criteria for inclusion 
in Tier 2 Capital. 
Additional requirements 

The institution or a related party shall not have knowingly purchased, or directly or indirectly have 

If the instrument is not issued out of an operating entity in the consolidated group (e.g. a Special 

179 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
These criteria shall also apply to instruments which appear in the consolidated accounts as minority interest.  
This element of capital will be net of the appropriate corresponding deductions related to holding of non-
common equity capital instruments in other financial institutions. 

180 

 
 
 
ANNEX VII: REGULATORY ADJUSTMENTS AS SPECIFIED IN FEBRUARY 2010 PUBLIC 
CONSULTATION 

Prudential filters and deductions from the Core Tier 1 

Stock surplus 
Stock surplus (i.e., share premium) may be included in Core Tier 1 only if the shares giving rise to the stock 
surplus qualify as Core Tier 1 capital. 
Stock surpluses relating to shares excluded from Core Tier 1, e.g., preference shares, shall be included in the 
same elements of capital as the shares to which they relate.  
Minority interests 
Minority interests may not be included in Core Tier 1. 
Goodwill and other intangibles 
Goodwill and other intangibles shall be deducted from Core Tier 1 capital. The amount deducted shall be net of 
any associated deferred tax liability that would be extinguished if the goodwill became impaired or derecognised 
under the relevant accounting standards.  
Deferred tax assets 
Deferred tax assets that rely on future profitability of the institution to be realised shall be deducted from Core 
Tier 1. The amount deducted shall be net of deferred tax liabilities. 
Deferred tax assets that do not rely on the future profitability of the institution to be realised - e.g. prepayments 
to tax authorities – shall be assigned the relevant sovereign risk weighting under the institution's approach to 
credit risk for the sovereign asset class, i.e. Standardised or Internal Ratings Based Approach.  
Investments in own shares (treasury stock) 
An institution’s investments in its own common shares shall be deducted from Core Tier 1 capital (unless 
already derecognised under the relevant accounting standards). Any own stock which the institution could be 
contractually obliged to purchase shall be deducted from Core Tier 1 capital. The treatment described would 
apply irrespective of the location of the exposure in the non-trading book or the trading book. In addition: 

- gross long positions shall be deducted net of short positions only if the short positions involve no 

counterparty risk; and 

- institutions shall look through holdings of index securities to deduct exposures to own shares. 
Investments in the common shares of certain banking, financial and insurance entities which are outside 
the regulatory scope of consolidation 
Institutions shall apply a ‘corresponding deduction approach’ to investments in the capital of other credit 
institutions, other financial institutions and insurance entities where they fall outside of the regulatory scope of 
consolidation. The deduction shall be applied to the same component of capital for which the capital would 
qualify if it were issued by the institution itself. 
All holdings of capital which form part of a reciprocal cross holding agreement or are investments in affiliated 
institutions (e.g. sister companies) shall be deducted in full on a corresponding basis. For all other holdings, the 
corresponding deduction approach would apply when the holdings exceeded certain thresholds. For holdings of 
common stock the thresholds shall be as follows: 

- if an institution has holdings of common stock in other credit and financial institutions which exceed 
10% of the common stock of the other credit and financial institutions then the full amount of this holding shall 
be deducted from the institution’s Core Tier 1 capital; and 

- if a institution has holdings of common stock in other credit and financial institutions which in 

aggregate exceed 10% of the institution’s Core Tier 1 (after applying all other regulatory deductions) then the 
amount above 10% shall be deducted from the institution's Core Tier 1 capital.   
This treatment described shall apply irrespective of whether the exposure is assigned to the non-trading book or 
the trading book. In addition: 

- gross long positions may be deducted net of short positions only if the short positions involve no 

counterparty risk; and 

- institutions shall look though holdings of index securities to deduct relevant exposures to financial 

institutions which exceed the threshold limits. 
Shortfall of the stock of provisions to expected losses 
Any shortfall in the stock of provisions compared with the expected loss amount under the Internal Ratings 
Based (IRB) approach shall be made from Core Tier 1 capital. 
Cash flow hedge reserves 
The positive and negative cash flow hedge reserve should be removed from Core Tier 1 capital where it relates 
to the hedging of projected cash flows that are not recognised on the balance sheet. 
Gains and losses due to changes in own credit risk on fair valued financial liabilities 

181 

 
 
 
 
 
 
 
 
 
All gains and losses resulting from changes in the fair value of liabilities that are due to a changes in the 
institution’s own credit risk shall be removed from Core Tier 1 capital. 
Defined benefit pension fund assets and liabilities 
No filter shall be applied to net defined benefit pension fund liabilities. 
The value of any defined benefit pension fund net asset should be deducted from Core Tier 1 capital. Subject to 
supervisory approval, assets in the fund to which an institution has unfettered access could be permitted to offset 
the deduction. Such offsetting assets should be assigned the risk weight they would receive if they were owned 
directly by the institution. 

Remaining 50:50 deductions 

All remaining deductions currently made 50% from Tier 1 and 50% from Tier 2, and which are not addressed 
elsewhere in the proposal, should receive a 1,250% risk weight. These include: 

- certain securitisation exposures; 
- certain equity exposures under the Probability of Default / Loss Given Default approach; 
- free deliveries; and  
- significant investments in commercial entities. 

182 

 
 
 
 
 
 
 
ANNEX VIII: ASSESSMENT OF ADMINISTRATIVE COSTS AND BURDENS 

Implementation of legislation entails costs for businesses. Costs that are linked to providing information either to 
public or private parties are called administrative costs. The share of these costs that is specifically linked to 
information that businesses would not collect and provide in the absence of a legal obligation is called 
administrative burdens. The Commission's Better Regulation strategy is aimed at measuring administrative costs 
and reducing administrative burdens.320  
In the area of prudential banking regulation, certain 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 and had to be designed accordingly.  
In August-September 2010, the Commission services distributed a questionnaire about the impacts of CRD IV 
proposal on administrative cost to the members of the Group of Experts in Banking issues (GEBI). The 
questionnaire was distributed directly to 25 bank members of the Group and to members of the following 
industry associations: European Banking Federation, European Savings Banks Group, European Association of 
Co-operative Banks, European Association of Public Banks and European Federation of Building Societies. 
In total, 24 replies from institutions in 10 Member States were received and of them, 16 (6 Group 1 banks and 10 
Group 2 banks) were considered in the analysis of administrative burdens of the individual parts of the CRD IV 
proposal. A number of replies were omitted from this analysis as they contained estimated impacts only at the 
overall package level. It shall be noted that replies from Group 1 banks generally showed a wider dispersion of 
estimates than replies from Group 2 banks. For this reason, in the calculation of administrative burdens of Group 
1 banks median answers were used as inputs, whereas for Group 2 banks, means were largely used.   
Since the questionnaire referred to the consultative documents of the Basel Committee of December 2009 and 
announcement of the GHOS of July 2010 as the basis for the estimation of administrative burdens, the eventual 
administrative burdens may be different to the extent that final CRD IV provisions will differ from the above 
texts. A number of respondents have indicated that the figures - where provided - represent their best-effort 
estimates, as they are still in the process of assessing the implications of Basel III on their operations, including 
on costs related to reporting and information provision. Also, the below estimates overestimate the 
administrative costs and burdens to the extent that they were extrapolated based on the sample of banks almost 
entirely composed of larger institutions (particularly with regard to Group 2) from EU-15, whereas i) FTE-
related annual costs are not distributed evenly across the EU-27 and ii) individual proposals (e.g., counterparty 
credit risk) may impact less, if at all, the smallest EU banks with a simple balance structure. 
Comparing the impacts of different policy tools on administrative burdens (see table below), it can be observed 
that they vary depending on the bank type. In terms of administrative burdens on the on-going basis, Group 1 
banks are the most affected by the proposals for counterparty credit risk, while Group 2 banks are the most 
affected by the new proposals in the area of liquidity risk management. The same observations hold for the one-
off investment costs.  
Overall, annual administrative burden, for Group 1 and Group 2 banks combined, due to the CRD IV provisions 
that are linked to Basel III is estimated to fall in the area of €3.2 billion (of them, 31% driven by LCR and 38% 
by NSFR), or approximately 0.008% of the EU bank assets. In terms of activities that would drive such costs, the 
respondents most frequently referred to data collection, IT/systems maintenance related costs, data quality 
assurance, analysis & review, management reporting and publication of information. 
One-off costs are estimated in the range of €6.9 billion or approximately 0.016% of the EU bank assets. 
Similarly to the on-going annual costs, these implementation-related expenditures are expected to be the highest 
in relation to the LCR (31% of all one-off costs) and the NSFR (38% of all one off-costs). With respect to the 
one-off costs, it needs to be kept in mind that they would be spread over a number of years, particularly, given 
the transitional provisions of the CRD IV.  
The questionnaire also included a set of questions pertaining to the impact of proposals on the single rule book. 
The Commission services anticipate that the eventual impact in this area will vary by Member State (depending 
on the current exercise of national options and discretions and the extent of 'gold-plating') and bank type 
whereby banks with more cross-border activity would benefit from harmonization of the rules the most. 
However, the sample size was insufficiently big and diverse to allow for the estimation of the impacts while 
simultaneously giving due consideration to the above factors. 

320 For more on the Commission's approach towards dealing with administrative costs and burdens please see: 

http://ec.europa.eu/governance/better_regulation/admin_costs_en.htm  

183 

 
 
 
 
                                                 
1

2

3

4

N/A

N/A

N/A

N/A

Non-labelling 
information for 
third parties
Non-labelling 
information for 
third parties
Non-labelling 
information for 
third parties
Non-labelling 
information for 
third parties

LCR

1

2

3

4

N/A

N/A

N/A

N/A

Non-labelling 
information for 
third parties
Non-labelling 
information for 
third parties
Non-labelling 
information for 
third parties
Non-labelling 
information for 
third parties

NSFR

No.

Ass. Art.

Orig. 
Art.

Type of 
obligation

Description of 
required 
action(s)

Table: Administrative burden of CRD IV by the area 

ADMINISTRATIVE BURDENS OF CRD IV

Capital definition

No.

Ass. Art.

Orig. 
Art.

Type of 
obligation

Description of 
required 
action(s)

Tariff
(€ per hour)

Time 
(hour)

Price
(per action 
or equip)

Freq 
(per year)

Nbr 
of 
entities

Total nbr
of 
actions

Total cost

Regulatory
origin
(%)

Comments & Assumptions

Target group

i

e

i

e

Int

EU

Nat

Reg

Other

Group 1 banks

Other

Group 1 banks

Other

Group 2 banks

59

53

2.672

156.750

132.750

816

42.848

Other

Group 2 banks

165.300

1

1

1

1

50

50

50

50

7.837.500

100%

6.637.500

100%

4.500

4.500

192.813.750

100%

4.500

4.500

743.850.000

100%

Median 1,5 FTE at 110000 euros per year 
and BAU factor of 5%. One off cost after 
BAU factor of 10%

Mean 1,5 FTE at 110000 euros per year 
and BAU factor of 13%. One off cost after 
BAU factor of 13%

Total administrative costs (€)

951.138.750

Administrative costs by origin (€)

951.138.750

Tariff
(€ per hour)

Time 
(hour)

Price
(per action 
or equip)

Freq 
(per year)

Nbr 
of 
entities

Total nbr
of 
actions

Total cost

Regulatory
origin
(%)

Comments & Assumptions

Target group

i

e

i

e

Int

EU

Nat

Reg

Other

Group 1 banks

Other

Group 1 banks

Other

Group 2 banks

64

55

3.244

207.600

900.000

3.935

216.403

Other

Group 2 banks

455.758

1

1

1

1

50

50

50

50

10.380.000

100%

45.000.000

100%

4.500

4.500

973.814.202

100%

4.500

4.500

2.050.908.797

100%

Median 2 FTE at 120000 euros per year 
and BAU factor of 14%. One off cost after 
BAU factor of 10%

Mean 2,5 FTE at 103000 euros per year 
and BAU factor of 15%. One off cost after 
BAU factor of 15%

No.

Ass. Art.

Orig. 
Art.

Type of 
obligation

Description of 
required 
action(s)

Tariff
(€ per hour)

Time 
(hour)

Price
(per action 
or equip)

Freq 
(per year)

Nbr 
of 
entities

Total nbr
of 
actions

Total cost

Regulatory
origin
(%)

Comments & Assumptions

Target group

i

e

i

e

Int

EU

Nat

Reg

Total administrative costs (€)

3.080.102.999

Administrative costs by origin (€)

3.080.102.999

1

2

3

4

N/A

N/A

N/A

N/A

Non-labelling 
information for 
third parties
Non-labelling 
information for 
third parties
Non-labelling 
information for 
third parties
Non-labelling 
information for 
third parties

Other

Group 1 banks

Other

Group 1 banks

Other

Group 2 banks

64

53

3.375

216.000

875.900

5.083

267.580

Other

Group 2 banks

574.419

1

1

1

1

50

50

50

50

10.800.000

100%

43.795.000

100%

4.500

4.500

1.204.110.462

100%

4.500

4.500

2.584.883.485

100%

Median 2 FTE at 120000 euros per year 
and BAU factor of 10%. One off cost after 
BAU factor of 5%

Mean 3,3 FTE at 99000 euros per year and
BAU factor of 17%. One off cost after 
BAU factor of 17%

Table: Administrative burden of CRD IV by the area (continued) 

Total administrative costs (€)

3.843.588.948

Administrative costs by origin (€)

3.843.588.948

184 

 
 
 
 
ADMINISTRATIVE BURDENS OF CRD IV

Levarege ratio

No.

Ass. Art.

Orig. 
Art.

Type of 
obligation

Description of 
required 
action(s)

Tariff
(€ per hour)

Time 
(hour)

Price
(per action 
or equip)

Freq 
(per year)

Nbr 
of 
entities

Total nbr
of 
actions

Total cost

Regulatory
origin
(%)

Comments & Assumptions

Target group

i

e

i

e

Int

EU

Nat

Reg

1

2

3

4

N/A

N/A

N/A

N/A

Non-labelling 
information for 
third parties
Non-labelling 
information for 
third parties
Non-labelling 
information for 
third parties
Non-labelling 
information for 
third parties

Other

Group 1 banks

Other

Group 1 banks

Other

Group 2 banks

Other

Group 2 banks

59

37

2.813

165.000

700

350.000

25.913

67.475

1

1

1

1

50

50

50

50

8.250.000

100%

17.500.000

100%

4.500

4.500

116.606.663

100%

4.500

4.500

303.638.925

100%

Total administrative costs (€)

445.995.588

Administrative costs by origin (€)

445.995.588

Median 1,5 FTE at 110000 euros per year 
and BAU factor of 0%. One off cost after 
BAU factor of 0%

Mean 0,4 FTE at 70000 euros per year and
BAU factor of 9%. One off cost after 
BAU factor of 9%

Counterparty credit risk

No.

Ass. Art.

Orig. 
Art.

Type of 
obligation

Description of 
required 
action(s)

Tariff
(€ per hour)

Time 
(hour)

Price
(per action 
or equip)

Freq 
(per year)

Nbr 
of 
entities

Total nbr
of 
actions

Total cost

Regulatory
origin
(%)

Comments & Assumptions

Target group

i

e

i

e

Int

EU

Nat

Reg

1

2

3

4

N/A

N/A

N/A

N/A

Non-labelling 
information for 
third parties
Non-labelling 
information for 
third parties
Non-labelling 
information for 
third parties
Non-labelling 
information for 
third parties

Other

Group 1 banks

Other

Group 1 banks

Other

Group 2 banks

64

16

10.055

643.500

2.550.000

971

15.430

Other

Group 2 banks

115.698

1

1

1

1

50

50

50

50

32.175.000

100%

127.500.000

100%

4.500

4.500

69.437.160

100%

4.500

4.500

520.639.845

100%

Median 6,5 FTE at 120000 euros per year 
and BAU factor of 18%. One off cost after 
BAU factor of 15%

Mean 0,6 FTE at 30000 euros per year and
BAU factor of 16%. One off cost after 
BAU factor of 16%

Total administrative costs (€)

749.752.005

Administrative costs by origin (€)

749.752.005

Capital buffers

No.

Ass. Art.

Orig. 
Art.

Type of 
obligation

Description of 
required 
action(s)

Tariff
(€ per hour)

Time 
(hour)

Price
(per action 
or equip)

Freq 
(per year)

Nbr 
of 
entities

Total nbr
of 
actions

Total cost

Regulatory
origin
(%)

Comments & Assumptions

Target group

i

e

i

e

Int

EU

Nat

Reg

1

2

3

4

N/A

N/A

N/A

N/A

Non-labelling 
information for 
third parties
Non-labelling 
information for 
third parties
Non-labelling 
information for 
third parties
Non-labelling 
information for 
third parties

Other

Group 1 banks

Other

Group 1 banks

Other

Group 2 banks

53

65

1.688

90.000

0

1.796

117.422

Other

Group 2 banks

91.851

1

1

1

1

50

50

50

50

4.500.000

100%

0

100%

4.500

4.500

528.400.717

100%

4.500

4.500

413.331.066

100%

Median 1 FTE at 100000 euros per year 
and BAU factor of 10%. One off cost after 
BAU factor of 0%

Mean 1 FTE at 122000 euros per year and 
BAU factor of 6%. One off cost after 
BAU factor of 6%

Total administrative costs (€)

946.231.783

Administrative costs by origin (€)

946.231.783

185 

 
 
 
 
ANNEX IX: QUANTITATIVE IMPACT OF THE CRD IV: QUEST MODEL 

Set up 
QUEST III321 is a standard closed economy dynamic stochastic general equilibrium (DSGE) model with a 
banking sector subject to regulatory policy. The model distinguishes three types of private actors in addition to a 
central bank and a government322. The private sector consists of consumers (saver households), entrepreneurs 
(firms) and a banking sector which intermediates savings and investment.   

Consumers 
(Households) 

Labour 

Deposits

Banks 

Cash 

Consumption 
Goods 

Labour 

Bank Equity

DGS Contribution

Central  
Bank 

Bonds 

Taxes 

Entrepreneurs 
(Firms) 

Loans

DGS

Government 

In order to ensure a positive share of loans in the balance sheet of entrepreneurs it is assumed that they have a 
higher rate of time preference than savers. It means that entrepreneurs prefer to use profits for their own 
consumption today than to save them for investment tomorrow. In this case the solvency of entrepreneurs 
requires that banks restrict lending by imposing a collateral constraint. This specification closely follows 
Kiyotaki and Moore (1997)323; the constraint is a reaction to information asymmetries between borrowers and 
lenders – only the borrowers have information about their willingness and ability to repay; thus lenders require 
collateral. 
The behaviour of the different agents in QUEST III is described below. 
Savers:  
Savers maximise an intertemporal utility function with consumption, liquidity services from deposits and leisure 
as arguments. Savers can hold wealth either in the form of government bonds, bank deposits or bank equity and 
receive interest income from bonds and deposits and dividends as well as capital gains from bank equity. There 
is an exogenous equity premium on bank stocks. Savers also offer labour services to entrepreneurs and banks 
and receive wage income.  
Entrepreneurs:  
Entrepreneurs maximise an intertemporal utility function over entrepreneurial consumption (coming from 
profits), subject to an intertemporal budget constraint, a technological constraint, a capital accumulation 
constraint and a collateral constraint along the lines suggested by Kiyotaki and Moore (1997). They combine 
capital and labour to produce output using a constant-returns-to-scale (CRS) technology. The output market is 
monopolistically competitive. Entrepreneurs demand labour and make investment decisions. They partly finance 
investment by taking out loans.  
Banks324:  

321  QUEST  III  is  a  New-Keynesian  Dynamic  Stochastic  General  Equilibrium  model  (DSGE)  with 
microeconomic  foundations  derived  from  utility  and  profit  optimisation.  It  includes  imperfections  in 
goods,  labour and financial  markets.  More  information  about  QUEST  III,  as  well  as developments  in 
incorporating 
here: 
sector 
http://ec.europa.eu/economy_finance/research/macroeconomic_models_en.htm   

financial 

model 

found 

can 

the 

322 A Deposit Guarantee Scheme is part of the government setup.  
323 Kiyotaki, N. and J. Moore (1997), Credit Cycles, Journal of Political Economy 105, pp. 211-248 
324 Interbank market can be included with a separation of banks to savings and investment banks. Savings banks 
can  be  modelled  to  collect  deposits  from  households,  and  to  only  lend  to  investment  banks  in  the 

be 

in 

a 

186 

 
 
 
 
                                                 
Banks provide loans to entrepreneurs and receive deposits and bank capital from savers. They pay taxes, 
purchase government bonds and contribute to a deposit guarantee scheme (DGS), and receive liquidity from the 
central bank (cash in the form of credits to their reserve account at the central bank).  
Banks maximise their stock market value (present discounted value of future dividend stream) subject to a cash 
flow constraint and a capital and liquidity requirement constraints. Banks can increase capital either by issuing 
new shares or via retained earnings. Both strategies yield identical results. Banks use labour in order to provide 
intermediation services. Labour in banks is divided in overhead (fixed) labour and variable labour that is 
proportional to loans. The banks pay wages to employed labour, and a levy on non-deposit liabilities. Banks 
provide contributions to a DGS.   
Government policy (monetary policy, fiscal policy and DGS): 
The central bank sets the policy rate according to a standard Taylor rule. The government taxes labour, capital 
and consumption and uses the revenues to finance government purchases of goods and services as well as 
transfers. There is a debt rule which fixes the level of government debt to a target in the long run. Revenues from 
bank levy are collected by the government. DGS contributions are collected by the DGS and used to purchase 
government bonds; income generated is added to the banks' DGS contributions. 
Equilibrium is defined as a set of optimality conditions for the agents and a set of prices that clear all markets.   

Calibration 
All parameters describing behaviour of the non-financial sector are taken from Ratto et al. (2009)325. Our 
preferred balance sheet concept for the banking sector is a consolidated balance sheet, which provides 
information about the stock of loans to the non financial sector. This gives us the leverage position of the non 
financial sector, and yields an accurate estimate of the (loan) capital cost of the private sector. This is important 
for calculating the macroeconomic impact of the regulatory measure.326 
The interest data are from the ECB and other EU27 central banks. The pre-crisis figures (2004-2008) suggest a 
loan interest rate of 5.2%, a deposit rate of 2.5% and a rate on government bonds of 4.2%. For the rate of return 
on bank equity we use a value of 14.3%.327  
V. Escudero (2009)328 reports that the employment share of financial intermediaries in total employment is about 
3% in EU27 citing Eurostat. Another important characteristic of loan interest rate determination is a mark up 
over marginal costs charged by banks. Recent empirical estimates see Christopoulou et al. (2008)329, show a 
mark up of 58% in the euro area, which is at the upper end across sectors. Though it is economically plausible 
that mark up in financial intermediation is significant because of large overhead costs and fixed capital, mark up 
estimates as conducted in this study are likely to be overestimated, see Konings et al. (2011)330 if there are fixed 
costs. Therefore we assume a mark up that is close to 30%. The share of labour in banking that is subject to cost 
optimization under new regulation is 75%. 

Pass-through of effects  

In the model banks must observe a minimum capital requirement, which is a ratio of Tier I capital to risk-
weighted assets331. Whenever the minimum capital requirements increase the banks face higher costs of capital 

interbank  market.  Investment  bank  in  turn  can  be  modelled  to  issue  bank  equity  and  to  borrow  from 
households in the form of deposits or from savings banks on the interbank market.  

325  Ratto,  M.,  Roeger W.  and Veld,  J.  in  't, QUEST III:  An estimated  open-economy  DSGE model of  the  euro 
area with fiscal and monetary policy, Economic Modelling, 2009, vol. 26, No. 1, pp 222-233  
326 Because the model is based on the unconsolidated balance sheet of the banking sector for EU 27 it uses the 
assumption that the ratio of loans to the non financial sector and interbank loans is slightly higher in EU 
27 compared to the EA. Based on the consolidated EA balance sheet published by the ECB, loans to the 
non financial sector are about 140% of GDP, hence, QUEST III uses a value of 150% of GDP for EU 
27.  

327  This  value  is  taken  from  BCBS  MAG  report  and  refers  to  the  RoE  for  the  year  2006  of  a  hypothetical 
European bank for eight European countries (AT, BE, FI, FR, DE, IT, NL), excluding the UK banks, 
which typically have shown higher RoE.  

328 Escudero V., Effects of the Crisis on the Financial Sector: Trends and Policy Issues, International Institute 

for Labour Studies, Discussion Paper 197, 2009 

329  Christopoulou  R,  P.  Vermeulen,  Markups  in  the  Euro  Area  and  the  US  over  the  Period  1981-2004,  a 

Comparison of 50 Sectors, ECB Working Paper, 856, 2008 

330  Konings  Josef,  W.  Roeger,  L.  Zhao,  Price-cost  Margins  and  Shares  of  Fixed  Factors,  CEPR  Discussion 

Paper, 8290, 2011 

331 The model distinguishes between two types of assets: liquid, which are given a risk weight of 5% and illiquid 
which are given a risk weight of 55%. The risk weights are the average risk weights for credit risk as 

187 

 
 
 
                                                                                                                                                         
since the return on bank equity is higher than the deposit rate.332 In the model they can respond by obtaining 
more capital through retained earnings, thus decreasing profits, or through issuing new capital, these two options 
produce equivalent results. 
QUEST III models a complete pass-through of higher capital costs to the banks' clients via an increase in the 
intermediation spread. The loan interest rate in the model is determined as a mark up over banks' marginal costs. 
Thus the acquisition of new bank capital translates into an increase in borrowing costs for firms and a decrease in 
aggregate lending, in the value of firm collateral, in aggregate investment and in GDP.  
At the same time banks are required to observe a liquidity requirement. They face an opportunity cost of holding 
more liquid assets than if they did not have to observe a liquidity requirement. The opportunity costs equal the 
difference between the higher rate of return on loans (illiquid assets) and the lower rate of return on government 
bonds (liquid assets) that the banks earns on the share of its assets that are required to be of the liquid type.  
The banks respond to the liquidity requirement in the following way. They increase the demand for deposits to 
meet it and have to pay a higher deposit interest rate (which is however still lower than the rate earned on liquid 
assets). This increases marginal bank funding costs, which are shifted onto loan interest rate. This reduces the 
demand for loans in the economy.333 
Compliance with the minimum capital and liquidity requirements is instantaneous in each period of the model. 
Thus the actual and the required bank capital and liquidity ratios are the same in every period.  
The model pass-through is characterized by some mitigating factors.  
Industry representatives have often claimed that the increase in the capital requirement increases funding costs 
for banks because they have to use more equity to fund loans. This statement has been contested in the finance 
literature; see Admati et al. (2011)334 and Miles (2011)335. Against this statement, reference is usually made to 
the Modigliani Miller theorem (1958)336 which stipulates that the structure of corporate financing does not 
matter (if one disregards tax and subsidy considerations which may affect debt and equity differently) because a 
change in the composition of corporate liabilities only distributes the risk which must be borne by equity owners.  
In the baseline parameter setting of the QUEST model (no MM applicability), the equity premium is 
exogenous337, because the stochastic environment faced by households, firms and banks is not fully specified. 
However in a simpler two-period version of QUEST which is analytically more tractable it can be shown that the 
MM theorem holds.  
Therefore two additional specifications of the applicability of the MM theorem for bank equity have been 
included. The rate of return on bank equity is equal to the risk free rate plus an equity premium which depends 
on the covariance of the loan losses (per unit of equity) with the marginal utility of investors in bank capital. 
Under the assumption that the change in capital requirements does not change the riskiness of bank operations, 
an increase in capital requirements leads to a proportional decline in the equity premium, because the same risk 
is distributed over a larger equity base. In our first additional specification, the MM theorem holds in full 
(100%). If the only risk for the shareholder comes from loan default risk, an increase in capital requirements 
would be completely offset by a fall in the equity premium and funding costs should not change.  
Whether a fall in the risk premium could offset increased capital requirement by 100% is however questionable. 
Apart from tax considerations (see Modigliani-Miller (1963)338), there may be other factors which require a 
premium for households to invest in bank equity. In accordance with theory, the empirical evidence in Miles et 

reported  in  2008  by  the  Banking  Supervision  Committee  (BSC)  of  the  European  System  of  Central 
Banks  

332 The deposit rate is the rate of return on bank debt. Together with return on bank equity they represent cost of 

funding for the banks.   

333  Notice  also,  the  demand  for  liquid  assets  and  deposits  incorporates  all  the  restrictions  imposed  on  bank 
behaviour implied by the capital and liquidity requirement constraints. An important implication of the 
capital requirement is that the bank is forced to increase the demand for deposits in such a way as to 
comply with it. 

334  Admati,  A.,  P.  DeMarzo,  M.  Hellwig,  P.  Pfleiderer  (2010),  Fallacies,  Irrelevant  Facts,  and  Myths  in  the 
Discussion of Capital Regulation: Why Bank Equity is Not Expensive, Stanford GSB Research Paper, 
No. 2065 

335 Miles, D., Yang, J., and G. Marcheggiano (2011), Optimal bank capital, Bank of England Discussion Paper 

No. 31 

336 Modigliani, F.; M. Miller (1958), The Cost of Capital, Corporation Finance and the Theory of Investment, 

American Economic Review 48 (3): 261–297 

337 This assumption was also retained because it was the working hypothesis of the BCBS MAG report 
338 Modigliani, F.; M. Miller (1963), Corporate Income Taxes and the Cost of Capital: A Correction, American 

Economic Review 53 (3): 433–443 

188 

 
 
 
                                                                                                                                                         
al. (2011) and Kashyap et al. (2010)339 does not show a full offset. Therefore in our second additional 
specification the MM offset holds at 50%, in line with these empirical results. 
Under the new bank regulatory regime the minimum capital requirements rise. In the absence of any MM offset 
of higher capital requirements the return on bank equity decreases initially since lower investment demand puts a 
downward pressure on the risk free rate. Over the transition period equilibrium investment is restored and the 
risk free rate returns to its steady state thus the return on bank equity reverts under but very close to its baseline. 
Thus when a new steady state is reached in the long run, in the case when the MM theorem is assumed not to 
hold, the return on bank equity is practically unchanged as the capital requirements increase. In this result 
QUEST differs from industry studies which find substantial post regulation decrease in the return on bank equity 
under no MM offset. The return on bank equity in QUEST falls below its baseline only when the MM theorem is 
assumed to hold (either in full or partially).      
The information asymmetry in financial intermediation in QUEST III is evident in borrower's collateral 
constraint. When bank regulation brings about higher capital requirements and banks increase the spread 
between loan and deposit rates, the present discounted value of firms' future profits are reduced since firms now 
have to pay more in order to borrow. Higher firm capital costs result in a decrease in the market value of the 
stock of firm capital and therefore the market value of firm collateral. Banks are prompted by changes in 
minimum capital requirements to ration the supply of loans based on the firms' abilities to pledge collateral. 
Higher capital and liquidity requirements raise firm borrowing costs. In response entrepreneurs start reducing 
leverage and gradually shift to using more own resources in financing their investment decisions. Lower firm 
leverage reduces credit rationing by the bank and thus mitigates financial market imperfections. 
Finally as the regulatory requirements increase, banks respond by optimizing labour employed in providing 
intermediation services. The model treats three quarters of the labour employed in banking services as a variable 
factor of production. Whenever banks face higher regulatory requirements they increase their interest rate on 
loans and decrease their volume of lending as loan demand by borrowers falls. Banks are allowed to optimize the 
quantity of labour they use for up to three quarters of the labour employed.340  

The evolution of the model variables as a result of changes in bank regulation   

In QUEST III, agents are modelled to be forward looking. Firms face investment adjustment costs and a 
collateral constraint. In anticipation of the increase in the cost of loans, they adjust today's behaviour responding 
to tomorrow's increase in regulatory requirements and banks' intermediation margin. In addition, current 
investment decisions are discounted with a higher future discount rate. Thus the model reports a macroeconomic 
impact even prior to the implementation of the regulatory changes. 
When banks are required to hold more capital their marginal costs increase since equity funding is more 
expensive than funding by deposits (the increase in the risk premium of bank equity can be partly or fully offset 
by the applicability of the MM theorem). Banks respond by optimizing assets and liabilities on their balance 
sheets so that all the increase in the marginal costs is transferred to customers. They increase own capital341, 
supply fewer loans and attract more deposits, so that the intermediation margin between the loan rate and 
the deposit rate increases342.  
The applicability of the MM theorem determines the magnitude of the response of bank funding costs. If the 
MM theorem holds, the return on bank equity decreases. Still bank funding is more expensive than in the 
baseline as new regulation requires a higher share of bank equity funding. If the MM theorem does not hold the 
return on bank equity stays below but very close to its baseline value and funding costs increase even more.  
As the intermediation spread increases borrowing becomes relatively more expensive and firms hold less capital 
thus lowering the value of the collateral that they can pledge against borrowing. As a result firms invest less and 
start relying more on internal sources of funding for their investment decisions. Aggregate investment in the 
economy decreases, reaching its lowest point below the baseline along the new regulatory implementation 
schedule before stabilizing to a less negative value below the no-change-in-regulation trend later on. Since firms 
become more self-reliant firm cost of capital increases only during an initial shock in the very short run then 

339  Kashyap  A.,  S.  G.  Hanson,  J.  C.  Stein  (2010),  An  Analysis  of  the  Impact  of  “Substantially  Heightened” 

Capital Requirements on Large Financial Institutions, mimeo 

340 QUEST III assumes that three quarters of the bank employees are not entrusted with managerial and cross-
product servicing tasks but are directly engaged in marketing, originating and servicing loans thus are 
subject to layoffs if bank lending decreases.   

341 Since banks hold more capital today the NPV of their infinite dividend stream increases substantially.   
342 The increase in the bank intermediation margin is not only a result of a higher loan rate but also a higher rate 
on deposits. Had the deposit rate remained constant the rise in the loan rate for the same increase in the 
intermediation  margin would have been lower and the negative impact of new regulation would have 
been  lower.  Banks  offer  higher  rates  on  deposits  because  they  try  to  expand  their  balance  sheets  in 
meeting the liquidity requirement. 

189 

 
 
 
                                                 
decreases or increases only moderately along the implementation schedule. Firm cost of capital changes not only 
in response to changes in bank lending spreads but also in response to changes in the shadow price of bank 
collateral.    
Lower investment is translated into lower GDP, since lower capital accumulation means less output. In the long 
run it also translates into lower consumption and less time spent at work (lower employment). Employment 
falls because less capital translates into lower labour productivity and lower wages. Even though consumption 
represents the largest part of GDP in national accounting the impact on investment through increased costs of 
borrowing is higher and drives down the GDP.  
Consumption rises above the baseline before and during the model periods, in which implementation takes place, 
due to the increase in the opportunity costs of saving. As banks prepare for the implementation of the new 
regulatory regime by increasing the intermediation margin consumers are better off using their current wealth in 
today's consumption rather than saving it in the form of bank deposits or bank equity, which are then to be 
transformed into future consumption343. 
For the purpose of calibrating the change in the minimum capital requirements the QUEST III model uses 
Tier 1 capital.344 The following three table show the impact on various variables when Tier 1 ratio is assumed to 
increase by 2.5 percentage points, depending on the assumption on MM offset (0%, 50% and 100%). 
Cumulative impact of regulatory reforms: new quantitative and qualitative capital requirement, capital 
conservation buffer (0% MM offset) 

2012

2013

2014

2015

2016

2017

2018

2019

average   
2020-2030

2050

Impact on macro variables (deviation from baseline in %)
GDP
consumption
investment
labour hours

-0.11
0.44
-2.34
-0.11

-0.15
0.45
-2.56
-0.11

-0.10
0.24
-1.52
-0.14

-0.20
0.40
-2.70
-0.13

-0.24
0.36
-2.81
-0.14

-0.28
0.31
-2.87
-0.14

-0.32
0.26
-2.89
-0.14

-0.36
0.20
-2.89
-0.14

-0.52
-0.10
-2.71
-0.13

Impact on bank variables (deviation from baseline in %)
volume of loans
volume of deposits
loan rate
deposit rate
return on bank equity
firm cost of capital
Note: impact on rates (loan, deposit, return on bank equity, firm cost of capital) expressed as deviation in percentage points 
Cumulative impact of regulatory reforms: new quantitative and qualitative capital requirement, capital 
conservation buffer (50% MM offset) 

-0.68
2.71
-0.14
-0.11
-0.20
0.12

-0.27
2.97
-0.19
-0.15
-0.25
0.47

-1.13
1.97
0.22
0.03
-0.04
0.04

-1.04
2.22
0.20
0.06
-0.02
0.03

-1.21
1.72
0.23
0.00
-0.06
0.06

-0.84
2.63
0.31
0.23
0.13
0.00

-0.94
2.46
0.18
0.08
0.00
0.02

-0.84
2.69
0.19
0.13
0.04
0.01

-1.51
1.48
0.25
0.01
-0.04
0.07

-0.85
-0.71
-2.35
-0.10

-2.12
1.00
0.27
0.03
-0.01
0.10

2012

2013

2014

2015

2016

2017

2018

2019

average   
2020-2030

2050

Impact on macro variables (deviation from baseline in %)
GDP
consumption
investment
labour hours

-0.06
0.23
-1.27
-0.06

-0.08
0.24
-1.39
-0.06

-0.05
0.13
-0.82
-0.08

-0.11
0.21
-1.48
-0.08

-0.14
0.19
-1.54
-0.08

-0.16
0.16
-1.56
-0.08

-0.18
0.13
-1.56
-0.08

-0.20
0.09
-1.52
-0.08

-0.26
-0.08
-1.24
-0.06

Impact on bank variables (deviation from baseline in %)
volume of loans
volume of deposits
loan rate
deposit rate
return on bank equity
firm cost of capital
Note: impact on rates (loan, deposit, return on bank equity, firm cost of capital) expressed as deviation in percentage points 

-0.57
1.09
0.12
0.02
-0.56
0.02

-0.62
0.86
0.13
0.00
-0.67
0.03

-0.66
0.62
0.14
-0.03
-0.79
0.04

-0.37
1.54
-0.07
-0.05
-0.26
0.06

-0.15
1.68
-0.10
-0.08
-0.20
0.25

-0.51
1.32
0.10
0.05
-0.44
0.01

-0.46
1.50
0.18
0.14
-0.17
0.00

-0.46
1.54
0.11
0.09
-0.32
0.00

-0.74
0.48
0.13
-0.01
-1.34
0.04

-0.37
-0.32
-0.99
-0.04

-0.92
0.30
0.11
0.01
-1.93
0.04

343  The  return  on  bank  equity  and  the  deposit  rate  decrease  prior  to  the  implementation  of  the  new  capital 
requirement  because  of  higher  costs  of  bank  capital  and  the  increase  in  the  intermediation  spread 
respectively. As a consequence consumers start to save less and consume more of their wealth. Due to 
habit formation consumption still remains above the no-change-in-regulation trend even after the rates 
on deposits and equity start rising again.   

344 Data used refer to EU 27 and end of 2009  

190 

 
 
 
 
 
                                                 
Cumulative impact of regulatory reforms: new quantitative and qualitative capital requirement, capital 
conservation buffer (100% MM offset) 

2012

2013

2014

2015

2016

2017

2018

2019

average   
2020-2030

2050

0.13
0.09
0.44
0.02

0.34
-0.44
-0.05
-0.01
-3.85
-0.02

Impact on macro variables (deviation from baseline in %)
GDP
consumption
investment
labour hours

-0.01
0.02
-0.15
-0.02

-0.01
0.02
-0.12
-0.01

-0.01
0.01
-0.08
-0.01

-0.02
0.02
-0.17
-0.02

-0.02
0.01
-0.19
-0.02

-0.03
0.01
-0.18
-0.02

-0.03
-0.01
-0.14
-0.02

-0.03
-0.02
-0.08
-0.02

0.01
-0.06
0.31
0.01

Impact on bank variables (deviation from baseline in %)
volume of loans
volume of deposits
loan rate
deposit rate
return on bank equity
firm cost of capital
Note: impact on rates (loan, deposit, return on bank equity, firm cost of capital) expressed as deviation in percentage points 

-0.02
0.31
0.00
0.00
-0.13
0.02

-0.05
0.30
0.03
0.04
-0.48
0.00

-0.04
0.30
0.00
0.01
-0.31
0.00

-0.08
-0.32
0.04
-0.04
-1.30
0.01

-0.05
0.31
0.02
0.04
-0.67
-0.01

-0.06
0.11
0.03
0.01
-0.88
0.00

-0.08
-0.10
0.03
-0.01
-1.09
0.01

-0.07
-0.55
0.04
-0.07
-1.51
0.02

0.07
-0.58
0.00
-0.04
-2.64
0.01

191 

 
 
 
 
 
ANNEX X: OVERVIEW OF QUANTITATIVE MODELS 

Several impact studies based on various modelling techniques have been carried out by industry associations and 
the public authorities. Most of these studies (especially ones commissioned or carried out by industry 
associations) concentrated on finding the impact on bank capital and loan volume and pricing. A few studies 
have translated the impact on banking further to the general macro-economy.  
Most of the studies focus on the negative impact of new banking regulation, in terms of the increase in the costs 
of new bank capital, rise in loan pricing and credit rationing, fall in investment and GDP. Only a few studies 
have attempted to find precise estimates of the benefits of stronger bank capital in terms of a decrease in the 
probability of a financial crisis. The BCBS LEI report deserves to be mentioned. A summary of some of these 
studies can be found in below table. 
In general, the results of the studies performed by the banking industry are more pessimistic than the ones of 
public institutions as regards the decline in the volume of lending and the temporary and permanent decline in 
GDP. This is mainly due to the data quality, different economic assumptions, regulatory scenarios and modelling 
techniques used. For instance, impact of the regulatory changes on the industry in the BCBS MAG study is 
based on results of the quantitative impact study (reflecting actual impact on the balance sheets of participating 
institutions), whereas industry studies for information that is not publicly available have to rely on estimates. 
Also, the modelling techniques used by the industry such as simulations, accounting projections or simple 
macro-models are rather crude in deriving accurate macroeconomic results. Initially, the industry assumed a full 
implementation of all proposed changes under Basel III, but the final agreement was less binding. Moreover, 
their economic assumptions appear to swell the negative economic impact because: 
- banks are supposed to maintain a certain level of return on equity (RoE) (sometimes very high at pre-crisis 
level), without due recognition to the fact that sounder balance-sheets entail lower risk and therefore a reduction 
in RoE and the cost of capital; 
- the increase in the spreads between lending and deposit rates is fully translated only into higher lending rates 
not into a combination of higher lending rates and lower deposit rates; 
- the increased capital costs are not internalised by banks via cost efficiency measures or a reallocation of the 
assets; 
- non-bank credit channels in the economy are largely overlooked;  
- the transformation of the credit shock into an output impact is based on past elasticities which may differ in a 
radically changed economic environment 
In general, the direct translation of credit shocks into a long-term impact on output and other macro-economic 
variables is not optimal. The growth in nominal terms of bank credit is not the main factor driving output in an 
economy, but rather the efficient intermediation of real savings towards productive activities. Changes in the 
volume of credit are partly accommodated in time via changes in relative prices. It optimises the use of real 
savings and factors of production in the economy and reduces the impact on output 

192 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Overview of selected public and industry studies on the impact of regulatory reforms 

Methodology 
A macroeconomic impact 
via lending margin 
increases and reduced loan 
volumes. Macro impact 
through a set of structural 
and reduced-form models 
A macroeconomic impact 
via lending margin 
increases and reduced loan 
volumes. Macro impact 
through a set of structural 
and reduced-form models 
Average frequency of a 
financial crisis per year: 
4.5%; median cumulative 
loss of crisis: 63% of pre-
crisis GDP; reduced-form 
and structural models 
estimate the impact on 
higher capital and liquidity 
on the probability of a 
crisis 
NiGEM model, higher 
capital and liquidity 
increase the price for bank 
credit  
A sample of 62 banks, 
balance sheet analysis 

Increased costs of capital 
via higher lending rates 
and lower loan volumes 
impacts credit growth 
which in turn impacts GDP 
growth   
Capital calculated 
according to the proposed 
CRD changes 

A sample of 16 large 
banks, balance sheet 
analysis 

Results 
Capital requirement 
impact - GDP falls by 
0.22% relative to 
baseline (average for 
all countries and all 
models) 
GDP falls by 0.61% 
relative to baseline 
(average for all 
countries and all 
models) 

Probability of a 
systemic banking 
crisis falls from 3.3% 
to 1.6%; benefits rise 
from 0.76% to 1.82% 
of GDP per year 

Net present benefit is 
7% of real GDP in 
2009 

If applied 
immediately the new 
capital rules will 
lower the core Tier I 
ratio of an average 
bank to 5.8% 
GDP falls by 4.7% 
relative to baseline 
(euro area) 

Normalized industry 
return on equity less 
than 15%; bank 
implementation costs 
45-70 million euro 
Average ROE falls 
from 13.3% to 5.4% 

Author  Published 

MAG 

BCBS 
MAG 
Group 

LEI costs  BCBS 

LEI 
Group 

Final: 
December 
2010; 
Interim: 
August 
2010  
August 
2010 

Policy changes 
TCE minimum ratio 
from 5.7% (estimated 
by BIS QIS) to 7%; a 
25% increase in 
holdings of liquid 
assets 
Increase in TCE 
minimum ratio by 4%, 
introduction of NSFR  

LEI 
benefits 

BCBS 
LEI 
Group 

August 
2010 

Increase in TCE 
minimum ratio from 
7% to 9%, introduction 
of NSFR 

FSA OP38  FSA 

NIESR 
(UK) 

IMF 

IMF Staff 
Position 
Note 10/16 

IIF 

Cumulative 
impact  
report IIF 

November 
2010 

Interim: 
June 
2010; 
Update: 
October 
2010  

Basel III 
and 
European 
Banking  

JPMorgan 
Equity 
Research 

McKinsey  November 

2010 

JP 
Morgan 

February 
2010 

July 2009  Increase of capital and 
liquidity requirements 
by 3 percentage points

From current Tier I 
ratio to Basel III ratio 
using new rules on 
capital deductions, 
market risk, risk 
weights 
Tier I ratio increases to 
6%, overall ratio to 
8%, redefinition of 
capital, LCR, NSFR, a 
bank levy  

Core Tier I 
requirement is 7%, 
LCR and NSFR 
introduction 

Separation of 
activities, increased 
capital requirement, 
LCR, NSFR, leverage 
ratio, dynamic 
provisioning, bank-
specific taxes, 
resolution and 
recovery  

193