COMMISSION STAFF WORKING PAPER EXECUTIVE SUMMARY OF THE 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) 950 final 

COMMISSION STAFF WORKING PAPER 

EXECUTIVE SUMMARY OF THE IMPACT ASSESSMENT 

Accompanying the document 

Proposal for a  

REGULATION OF THE EUROPEAN PARLIAMENT AND THE COUNCIL 

on prudential requirements for credit institutions and investment firms 

{COM(2011) 452 final} 
{SEC(2011) 949 final} 

 
 
 
 
  
 
 
1. 

BACKGROUND 

The  extent  of  the  financial  crisis  has  exposed  unacceptable  risks  pertaining  to  the  current 
regulation  of  financial  institutions.  According  to  the  IMF  estimates,  crisis-related  losses 
incurred by European banks between 2007 and 2010 are close to €1 trillion or 8% of the EU 
GDP. 

In order to restore stability in the banking sector and ensure that credit continues to flow to the 
real  economy,  both  the  EU  and  its  Member  States  adopted  a  broad  range  of  unprecedented 
measures  with  the  taxpayer  ultimately  footing  the  related  bill.  In  this  context,  by  October 
2010  the  European  Commission  (Commission)  has  approved  €4.6  trillion  of  state  aid 
measures to financial institutions of which more than €2 trillion were e ffectively used in 2008 
and 2009.  

The  level  of  fiscal  support  provided  to  banks  needs  to  be  matched  with  a  robust  reform 
addressing  the  regulatory  shortcomings  exposed  during  the  crisis.  In  this  regard,  the 
Commission already proposed a number of amendments to bank regulation in October 2008 
(CRD1  II)  and  July  2009  (CRD  III).  The  legislative  package  that  this  report  accompanies 
contains  globally  developed  and  agreed  elements  of  bank  capital  and  liquidity  standards 
known  as  Basel  III.  The  Commission  services  actively  participated  in  the  process  of  their 
development  on  behalf  of  all  EU  Member  States.  The  package  is  extended  to  include  a 
proposal for harmonisation of other provisions of CRD with a view to deepening the Single 
Market  and  strengthening  the  effectiveness  of  supervision.  This  report  pertains  only  to  the 
assessment of impacts of the measures described below. 

2. 

STAKEHOLDER CONSULTATION 

Throughout the project the Commission services have participated in the work of international 
forums, particularly the Basel Committee on Banking Supervision (BCBS) that was in charge 
of development of new policy measures in the areas of liquidity and counterparty credit risk 
management,  definition  of  regulatory  capital  and  pro-cyclicality.  The  European  Banking 
Committee  and  the  Committee  of  European  Banking  Supervisors  (CEBS)  have  been 
extensively involved and consulted throughout the project.  

To  support  the  analysis  of  impacts  of  this  legislative  package  on  the  EU  banking  industry, 
CEBS conducted a quantitative impact study. 246 banks from 21 member countries of CEBS 
participated  in  the  study,  including  50  Group  12  banks  and  196  Group  2  banks,  together 
representing some 70% of the consolidated EU banking sector in terms of capital. CEBS also 
provided  a  technical  advice  to  the  Commission  in  the  area  of  harmonisation  of  national 
options and discretions. 

The Commission services organised a public hearing in April 2010 and conducted four public 
consultations  in  2009-2011  on  the  policy  measures  comprised  by  the  legislative  package3. 

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3 

Capital Requirements Directive. 
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. 
See http://ec.europa.eu/internal_market/bank/regcapital/index_en.htm. 

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Responses to the consultations constitute an important source of data and stakeholder views 
as regards the impacts and effectiveness of potential measures. In addition, the Commission 
services conducted separate extensive consultations with the industry, including the Group of 
Experts in Banking Issues, various EU banking industry associations and individual banks. 

3. 

PROBLEM DEFINITION 

3.1.  Management of liquidity risk 

The  global  financial  crisis  has  brought  to  light  shortcomings  in  the  current  liquidity  risk 
management of institutions, including stress testing exercises and asset and liability maturity 
mismatches. More specifically, existing liquidity risk management practices were shown to be 
inadequate  in  fully  grasping  risks  linked  to  originate-to-distribute  securitisation,  use  of 
complex  financial  instruments  and  reliance  on  wholesale  funding  with  short  term  maturity 
instruments. Assumptions pertaining to asset market liquidity and interaction between market 
liquidity and funding liquidity turned out to have been erroneous while behavioural aspects of 
financial  institutions  also  played  an  immense  role  in  the  course  of  the  crisis.  These  factors 
contributed to a demise of several financial institutions4 and strongly undermined the health of 
many  others,  threatening  the  financial  stability  and  necessitating  unprecedented  levels  of 
public  sector  and  central  bank  liquidity  support.  Between  September  and  December  2008, 
ECB loans to the euro area credit institutions increased by some 70% to over €800 billion. 

While  a  number  of  Member  States  currently  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.  Diversity  in 
current  national  standards  hampers  communication  between  supervisory  authorities  and 
imposes additional reporting costs on cross-border institutions. 

3.2. 

Definition of capital 

The  EU  banking  system  entered  the  crisis  with  capital  of  insufficient  quantity  and  quality. 
More  specifically,  certain  capital  instruments  and,  particularly,  hybrid  capital  instruments5 
(hybrids),  did  not  meet  expectations  of  markets  and  regulators  with  regard  to  their  loss 
absorption6,  permanence7 and flexibility of payments8 capacity on a going-concern basis. In 
fact,  compliance  of  hybrids  with  the  above  three  criteria  in  the  EU  was  enforced  by  the 
Commission  policy  of  'burden  sharing',  when  assessing  national  bank  recapitalization 
measures.  

Also,  the  list  of  adjustments  to  regulatory  capital  proved  to  be  incomplete  as  a  number  of 
balance sheet items such as minority interests and deferred tax assets, whose loss absorption 
potential  is  less  certain  on  a  going-concern  basis  in  times  of  stress,  have  been  effectively 

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Bear Sterns, Lehman Brothers, Northern Rock, HBOS, Bradford and Bingley. 
Hybrids are securities that contain features of both equity and debt. 
The 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. 
The instrument  must be permanently available so that there is no doubt that it can support depositors 
and other creditors in times of stress. 
The instrument must contain features permitting the noncumulative deferral or cancellation of payment 
of coupons or dividends in times of stress. 

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removed  by  market  participants  from  capital  ratios  reported  by  institutions.  Differences  in 
application of regulatory adjustments across Member States further obstructed comparability 
and  reliability  of  Tier  1  capital  measure.  As a result, reported Tier 1 capital ratios were not 
reflective of institutions’ capacity to absorb mounting losses. This necessitated governments 
to provide support to the banking sector in many countries and on a massive scale. 

3.3. 

Counterparty credit risk 

The  crisis  revealed  a  number  of  shortcomings  in  the  current  regulatory  treatment  of 
counterparty credit risk9 arising from derivatives, repo10 and securities financing11 activities. It 
showed  that  the  existing  provisions  did  not  ensure  appropriate  management  and  adequate 
capitalisation for this type of risk. The current rules also did not provide sufficient incentives 
to  move  bilaterally  cleared  over-the-counter  derivative  contracts  to  multilateral  clearing 
through central counterparties12. 

3.4. 

Pro-cyclicality of lending 

Pro-cyclical effects are defined as those which tend to follow the direction of and amplify the 
economic cycle. The cyclical nature of bank lending has a number of interconnected sources 
that include both market and regulatory failures.  

One  feature  of  current  risk-based  minimum  capital  requirements  is  that  they  vary  over  the 
economic cycle. Provided that credit institutions and investment firms could meet them, there 
is no explicit regulatory constraint on the amount of risk they can take on and hence on their 
leverage.  The  lack  of  such  constraint  and  irresponsiveness  of  capital  requirements  to  the 
build-up  of  risk  at  the  macro  level  led  to  an  accumulation  of  financial  imbalances  which 
precipitated  steep  credit-related  losses  and,  once  the  economic  cycle  turned,  prompted  a 
damaging de-leveraging spiral. 

3.5. 

Options, discretions and minimum harmonisation 

In 2000, seven banking directives were replaced by the Consolidated Banking Directive. This 
directive was recast in 2006 with CRD, while introducing the Basel II framework in the EU. 
As a result, CRD provisions include a significant number of options13 and discretions14. CRD 
is also a 'minimum harmonisation' directive which means that Member States may add stricter 
prudential rules, which gives rise to a practice known as 'gold-plating'.  

As a result, there is a high level of divergence in how the rules are implemented by MS and 
subsequently applied by the national supervisory authorities which is particularly burdensome 

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14 

The risk that the counterparty to a transaction could default before the final settlement of the transaction 
cash flows.  
In a repo (repurchase agreement) contract, the borrower agrees to sell a security to a lender and to buy 
the same security from the same lender at a fixed price at some later date. 
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. 
An entity that interposes itself between counterparties to contracts traded within one or more financial 
markets, becoming the buyer to every seller and the seller to every buyer.  
A choice given to competent authorities or MS on how to comply with a given provision, selecting from 
a range of alternatives. 
A choice given to competent authorities or MS as to whether apply a given provision. 

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for firms operating cross-border. It also gives rise to the lack of legal clarity and an uneven 
playing field.  

4. 

OBJECTIVES 

The overarching goal of this initiative is to ensure that the effectiveness of bank capital and 
liquidity regulation in the EU is strengthened and its adverse impacts on confidence in banks 
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 the financial stability; 

- Enhance safeguarding of depositors' interests; 

- Ensure international competitiveness of the EU banking sector; 

- Reduce pro-cyclicality of the financial system. 

5. 

POLICY OPTIONS: ANALYSIS AND COMPARISON 

Altogether, 27 policy options have been assessed and compared with a view to addressing the 
various issues identified. This section presents expected impacts of policy measures in each 
area as well as cumulative impacts of the entire proposal.  

5.1. 

Liquidity risk 

To  improve  short-term  resilience  of  the  liquidity  risk  profile  of  financial  institutions,  a 
Liquidity  Coverage  Ratio  (LCR)  will  be  introduced  from  2015,  after  an  observation  period 
and a review to apply any necessary refinements to both its composition and calibration and to 
check for any undesired impacts on the industry, financial markets and the economy. Based 
on LCR definition included in Basel III,  compliance  with this requirement in the EU  in  the 
long  run  would  produce  net  annual  GDP  benefits  in  the  range  of  0.1%  to  0.5%,  due  to  a 
reduction in the expected frequency of systemic crises.  

To address funding problems arising from asset-liability maturity mismatch, the Commission 
considers  introducing  a  Net  Stable  Funding  Ratio  (NSFR).  Before  deciding  on  its  final 
calibration and moving it to a minimum standard as of 2018, extensive monitoring of NSFR 
and its implications will be conducted.  

5.2. 

Definition of capital 

The proposals tighten criteria for eligibility of capital instruments for the different layers of 
regulatory capital and make extensive revisions to the application of regulatory adjustments. 
For  Group  1  banks,  revised  regulatory  adjustments  reduce  eligible  common  equity  Tier  1 
(CET1)  capital  by  42%  and  that  of  Group  2  banks  by  33%.  These  reductions  are  driven  by 
adjustments for goodwill, material investments in other financial institutions and deferred tax 
assets.  

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The new CET1 and Tier 1 minimum requirements will be implemented gradually from 2013 
and by 2015 would reach 4.5% and 6%, respectively. Revisions to regulatory adjustments will 
be  introduced  in  2014  –  2019.  Grandfathering  provisions  for  capital  instruments  that  no 
longer meet the new eligibility requirements are also foreseen. 

5.3. 

Counterparty credit risk 

Requirements  for  management  and  capitalization  of  the  counterparty  credit  risk  will  be 
strengthened.  The  proposals  will  also  enhance  incentives  for  clearing  over-the-counter 
instruments through central counterparties. These proposals are expected to affect mostly the 
largest EU banks. 

The  review  of  the  treatment  of  counterparty  credit  risk,  and  in  particular  putting  in  place 
higher own funds requirements for bilateral derivative contracts in order to reflect the higher 
risk  that  such  contracts  pose  to  the  financial  system,  forms  an  integral  part  of  the 
Commission’s efforts to ensure efficient, safe and sound derivatives markets. It complements 
other  Commission’s  regulatory  initiatives  in  this  area,  in  particular  the  proposed  Regulation 
on OTC derivatives, central counterparties and trade repositories, adopted by the Commission 
on 15 September 2010. 

5.4. 

Countercyclical policy measures 

Proposals  for  capital  buffers  comprise  a  capital  conservation  buffer  and  a  countercyclical 
capital buffer. The (CET1) capital conservation buffer of 2.5% of risk-weighted assets (RWA) 
is  aimed  at  ensuring  banks'  capacity  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  fall  below  the  buffer  target  will  face  constraints  on  discretionary 
distributions of earnings (i.e., dividend payments) until the target is reached.  

The countercyclical capital buffer is intended 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. It will be applied by adjusting the 
size of the buffer range established by the conservation buffer by additional 2.5%. 

In order to limit an excessive build-up of leverage on credit institutions' and investment firms' 
balance  sheets  and  thus  help  containing  the  cyclicality  of  lending,  the  Commission  also 
proposes  to  introduce,  as  an  element  of  the  supervisory  review,  a  non-risk  based  leverage 
ratio.  Implications  of  the  ratio  will  be  monitored  prior  to  it  possibly  becoming  a  generally 
binding requirement on 1 January 2018. 

5.5. 

Single rule book 

The proposals harmonise divergent national supervisory approaches by removing options and 
discretions.  Some  specific  areas,  where  gold-plating  is  driven  by  risk  assessment 
considerations,  market  or  product  specificities  and  Member  States  legal  framework,  remain 
exempted.  

5.6. 

Cumulative impact of the package 

To supplement their own assessment of the impact of Basel III, the Commission reviewed a 
number of studies prepared by both public and private sectors.  

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This  package  and  CRD  III  together  are  estimated  to  increase  RWA  of  Group  1  banks  by 
24.5% and RWA of Group 2 banks by a modest 4.1%. The extent of CET1 shortfall to meet 
the  new  minimum  requirement  and  the  conservation  buffer,  based  on  the  EU  bank  capital 
levels in 2009 is estimated to be immaterial by 2013, at €84 billion by 2015 and €460 15 billion 
by 2019, equivalent to 2.9% of the banking sector's RWA. 

To give banks time to retain more of their profits, improve operational efficiency, issue new 
equity and take other necessary steps to adjust, the new capital requirements entail an eight 
year transition period. Based on analyses of the Basel Committee, ECB, and the Commission 
services, transition to stronger capital and liquidity standards will have only a limited impact 
on the aggregate output. 

In  terms  of  long-term  economic  impact,  analysis  conducted  by  the  Basel  Committee  found 
clear  net  long  term  economic  benefits  of  Basel  III.  This  analysis  implies  net  economic 
benefits  of  annual  increase  in  the  EU  GDP  in  the  range  of  0.3%-2%.  They  stem  from  a 
reduction in the expected frequency of future systemic crises and are optimised when CET1 is 
calibrated in the range of 6% to 9%. 

Another model developed by the Commission and academics found that the proposals would 
reduce the probability of a systemic banking crisis in seven Member States within the range of 
29% to 89% when banks recapitalise to a total capital ratio of at least 10.5%.  

In  addition,  analysis  of  the  Basel  Committee  showed  that  higher  capital,  including  the 
countercyclical capital buffer, and liquidity requirements should also reduce the amplitude of 
normal  business  cycles.  This  is  particularly  relevant  to  SMEs  who  are  dependent  on  bank 
financing throughout the economic cycle.  

6. 

MONITORING AND EVALUATION 

It  is  expected  that  the  proposed  amendments  will  enter  into  force  in  2013.  Measuring  the 
progress  of  reaching  specific  policy  objectives  will  be  aided  by  the  working  groups  of  the 
Basel Committee and the European Banking Authority (EBA), that monitor the dynamics of 
bank capital positions, globally and in the EU, respectively. Special arrangements will be put 
in place by EBA to ensure that necessary data for monitoring of leverage ratio and the new 
liquidity requirements are collected to allow for the finalization of these policy measures in 
due time. 

15 

Of this figure, €37 billion (measured in Tier 1  capital) is attributable to CRD III proposal. 

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