REPORT FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT AND THE COUNCIL Market developments potentially requiring the use of Article 459 CRR
Date: 2017-03-08
Institutions: Directorate-General for Financial Stability, Financial Services and Capital Markets Union, European Commission
Subjects: bank, banking policy, banking system, credit policy, financial control, financial legislation, financial market, market supervision, private-sector liquidity, trade information

EN 

   EN 

   EUROPEAN COMMISSION  Brussels, 8.3.2017  COM(2017) 121 final   REPORT FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT AND THE COUNCIL Market developments potentially requiring the use of Article 459 CRR  
 
 
Market developments potentially requiring the use of Article 459 CRR 

This  report  is  to  inform  the  European  Parliament  and  the  Council  on  market 
developments potentially requiring the use of Article 459 of the Capital Requirements 
Regulation  (CRR)1  in  the  past  year.  It  is  based  on  an  assessment  provided  by  the 
European Systemic Risk Board (ESRB)2. 

1. 

BACKGROUND 

Article 459 CRR provides that the Commission, assisted by the ESRB, has to submit a 
report,  at  least  on  an  annual  basis,  to  the  European  Parliament  and  the  Council  on 
market  developments  potentially  requiring  the  use  of  this  Article.  Pursuant  to  Article 
459 CRR, the Commission may impose, for a period of one year, stricter requirements 
concerning the level of banks' own funds, large exposures, or public disclosure, under 
specific conditions, in particular upon the recommendation or the opinion of the ESRB 
or  EBA.  The  required  conditions  are  that  these  measures  are  necessary  to  address 
changes  in  the  intensity  of  micro-prudential  and  macro-prudential  risks  which  arise 
from  market  developments  in  the  Union  or  outside  the  Union  affecting  all  Member 
States, and that the instruments of the CRR/CRDIV are not sufficient to address these 
risks. 

2.  CONCLUSION AND WAY FORWARD 

The European Commission has not yet seen any circumstances that would warrant the 
use  of  Article  459  CRR,  considering  in  particular  that  this  Article  allows  only  for 
tightening measures, the priority of the other CRR/CRDIV instruments and the fact that 
measures  under  Article  459  CRR  may  only  be  imposed  where  the  respective  market 
developments affect all Member States. In accordance with this assessment, neither the 
ESRB nor the EBA have recommended to the Commission to take action under Article 
459 CRR at this stage. 

The Commission will continue to monitor in close cooperation with the ESRB relevant 
market developments in the Union or outside the Union potentially requiring the use of 
this Article.  

3.  ANALYSIS 

3.1. 

General overview 

The Commission considers the situation of the EU financial system in the past year to 
be  considerably  different  from  circumstances  warranting  measures  under  Article  459 
CRR. More specifically, there is no credit-driven overheating of the economy. Leverage 
in  the  economy,  whilst  high  by  both  historical  and  international  standards,  is  not 

1 Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on 
prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 
648/2012 (OJ L 176, 27.6.2013, p. 1). 
2 The assessment provided by the ESRB on 2 May 2016 is available at 
https://www.esrb.europa.eu/pub/pdf/other/20160502_letter_md.en.pdf?90e22809ce71729e2d5902d9aa7d
bf46. In addition, this report also builds on the European Commission's economic forecast and analysis by 
the European Central Bank, the European Supervisory Authorities, the European Banking Authority and 
the International Monetary Fund. 

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increasing, nor is there evidence of increasing leverage in the banking sector. This trend 
can be expected to continue. 

The EU economy is on a subdued growth path, which means that the risk of overheating 
in  the  economy  is  limited.  According  to  the  latest  Commission  forecast,  real  GDP 
growth will be below 2% in 2016 and 2017 in the EU and euro area. The output gap will 
remain negative and consumer price inflation is forecast to stay below the 2% threshold 
that  the  ECB  considers  consistent  with  price  stability.  Consistent  with  low  rates  of 
inflation and the subdued growth environment, central bank rates have reached very low 
levels.  This,  together  with  asset  purchases  by  central  banks,  has  translated  into  low 
interest  rates  on  bond  and  credit  markets.  Despite  low  interest  rates,  debt  of  non-
financial  corporations  and  households,  relative  to  GDP,  is  not  increasing  in  most  EU 
Member States, and a downward trend is expected to set in once economic growth picks 
up.  In  the  current  subdued  growth  environment  demand  for  credit  should  not  boost 
excess  leverage  in  the  financial  sector.  External  developments  are  unlikely  to  lead  to 
overheating pressure in the EU economy in the near term as both world GDP and world 
trade are forecast to grow substantial below long-term trends. The outcome of the UK 
Referendum  about  the  country's  membership  in  the  EU  significantly  increased 
uncertainty  (as  measured  by  the  Baker-Bloom  index)  has  added  downside  risks  to  the 
growth  prospects  of  the  EU  economy  and  may  curtail  many  actors'  desire  to  become 
more  indebted.  The  banking  sector,  which  forms  the  backbone  of  the  EU  financial 
system,  is  not  increasing  leverage.  Banks'  regulatory  capital  ratios  picked  up  during 
2015 and remained at about the same level during 2016 according to preliminary EBA 
data. This holds for both Core Equity Tier (CET) 1 ratios and total capital ratios. The 
weighted  average  EU  CET1  ratio  stood  at  13.5%  in  mid-2016,  and  less  than  5%  of 
banks had a ratio of below 11%. ECB statistics suggest that the total balance sheet size 
of  monetary  financial  institutions  (MFIs)  excluding  the  European  System  of  Central 
Banks (ESCB) barely increased during 2015 and 2016. For comparison, in the pre-crisis 
period  2001-2008 MFI total asset  growth was about  10%  p.a. Banks' lending  has also 
been subdued in the EU. For example bank lending to the private sector in the euro area 
has  grown  by  less  than  nominal  GDP  in  2015  and  2016.  The  ESRB  measure  of  the 
credit GDP gap is negative and may have just bottomed out in 2016. High levels of non-
performing loans (NPLs) act as a break on credit growth. They imply costs for banks in 
managing loans, thereby reducing incentives to expand credit supply. They are also an 
indication  of  debt  overhang  in  the  corporate  and  household  sectors.  Corporations  or 
households  with  bad  debt  may  think  twice  before  investing,  knowing  that  banks  will 
charge a higher credit cost to compensate for the risk 

According to the results of the 2016 EBA stress test, the aggregate EU banking sector is 
satisfactorily  resilient  to  shocks.  In  the  adverse  scenario,  which  combines  a  severe 
recession  with  large  shocks  to  a  wide  set  of  financial  asset  prices,  the  average  CET1 
ratio would fall to 9.4%. This is higher than the comparable 8.5% outcome of the 2014 
stress test and means that the EU banking sector has continued to build up considerable 
buffers to use in case of adverse economic developments. What is more, the stress test 
revealed  considerable  heterogeneity  of  banks'  exposure  to  adverse  shocks  across 
institutions. Hence, changes of risks in this area could be more appropriately addressed 
by national measures under CRR/CRDIV than by broad-brush measures under Article 
459 CRR.  

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3.2. 

EU financial stability risks identified by the ESRB 

Over  the  past  year,  the  ESRB  has  identified  four  overarching  risks  for  the  European 
economy.  These  risks  are  the  re-pricing  of  risk  premia  in  global  financial  markets, 
amplified  by  low  market  liquidity,  further  weakening  of  banks’  and  insurers’  balance 
sheets,  deterioration  of  debt  sustainability  in  sovereign,  corporate  and  household 
sectors,  and  shocks  and  contagion  from  the  shadow  banking  sectors.  The  potential 
relevance of these risks for measures under Article 459 CRR is assessed in more detail 
below.  

(a)  Re-pricing of risk premia 

The  possible  re-pricing  of  risk  premia  in  global  financial  markets,  amplified  by  low 
liquidity, is being considered as a major  macrofinancial risk in the European financial 
sector. 

This risk is inter alia motivated by high prices in a number of asset classes relative to 
historical averages. High asset prices are to a significant extent driven by a low interest 
rate level, which spurs a search for yield among many investor classes. Although there 
are  signs  of  high  risk-taking  in  some  corporate  bond  markets  and  real  estate  markets, 
they are heterogeneous across market segments and Member States. This is particularly 
valid  for  signs  of  overheating  that  are  present  in  real  estate  markets  in  some  Member 
States, but virtually absent in others. 

Capital positions of financial institutions subject to CRDIV/CRR should be sufficiently 
high to weather a materialisation of this risk. In the EBA stress test, market risk in the 
adverse scenario curtailed the CET 1 ratio by just 1 percentage point, out of a total drop 
by 3.8 percentage points in the adverse scenario. Hence, market risk was not the main 
contributor to the capital erosion identified in the stress test. Of course, the market risk 
can  materialise  in  a  different  form  than  assumed  in  the  stress  test.  It  is,  however, 
reassuring  that  over  recent  years  the  financial  sector  has  shown  sufficient  resilience 
during  episodes  of  sharp  adjustments  of  risk  premia  on  global  markets.  Such  events 
were the flash rally in US Treasuries in October 2014, the sell-off in the German Bund 
in May/June 2015, the exchange and share price adjustment after the UK Referendum in 
June  2016  and  the  sudden  increase  in  Japanese  yields  in  August  2016.  These  left  a 
short-lived trail in other financial asset prices and did not cause havoc in any financial 
institution. A further notable market development relates to occasional sharp reactions 
of  EU  banks'  share  prices3.  While  one  may  regret  that  exposures  to  market  risk  are 
difficult  to  monitor,  policy  proposals  in  this  area  are  under way  with  the  fundamental 
review of the trading book initiated in the Basel framework and are expected to be more 
effective than any measure towards more transparency under Article 459 CRR.  

(b)  Further weakening of banks’ and insurers’ balance sheets 

A further weakening of banks' and insurers' balance sheets is another overarching risk 
for EU financial stability identified by the ESRB. The trend decline in EU banks' share 
prices  during  most  of  2016  underpins  the  relevance  of  this  risk  since  it  indicates  a 
substantial  loss  in  banks'  market  values.  Downward  share  price  developments 

3 Since share price developments are closely linked to the risk of a further weakening of banks’ and 
insurers’ balance sheets they are assessed in the next section. 

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accelerated notably when markets priced in news about economic risks, reiterating the 
close connection between the first two items on the ESRB list of systemic risks. More 
detailed  inspection,  however,  suggests  that  the  pronounced  decline  in  banks'  share 
prices  was  not  primarily  driven  by  scepticism  about  banks  becoming  insolvent,  but 
rather  about  their  profitability  outlook.  If  markets  had  been  concerned  about  banks' 
solvency,  CDS  prices  and  yields  of  banks'  debt  instruments  should  have  also  gone  up 
strongly,  but  this  could  not  be  observed  apart  for  some  institute-specific  financial 
instruments.  

Particularly noteworthy episodes in 2016 that inform about the profit outlook for banks 
were  (i) weak  economic  data  releases  in  February  2016  (ii) the  outcome  of  the  UK 
Referendum in June 2016, and (iii) the EBA stress test results in August 2016. During 
these  three  episodes,  most  banks'  share  prices  severely  underperformed  share  price 
developments  of  non-banks  and  in  all  three  episodes  market  analysts  pointed  to 
determinants  of  profitability.  In  February  2016,  the  weak  data  releases  intensified  the 
notion  that  interest  rates  will  remain  low  for  long,  which  would  entrench  low  profit 
margins  and  small  revenues  from  maturity  transformation.  The  outcome  of  the  UK 
Referendum  questions  whether  London  will  continue  to  fulfil  its  role  as  financial  hub 
for  the  EU  efficiently.  Exit  of  the  UK  from  the  EU  may  entail  higher  costs  in  cross-
border  wholesale  funding.  The  EBA  stress  test  revealed  the  sensitivity  of  banks  to  an 
adverse economic scenario.  

Although  a  higher  capital  ratio  of  the  EU  banking  system  at  large  and  of  the  most 
vulnerable banks specifically may have contained the valuation losses in these episodes, 
a request to banks by public authorities to accomplish higher capital ratios is likely to 
have had detrimental effects. The reason is that the low profitability of many banks has 
already  reduced  the  scope  to  increase  capital  substantially  at  short-term  notice.  First, 
low profitability reduces the amount available to increase capital from retained profits. 
Second, if banks raise capital ratios by accelerating the ongoing reduction in activity or 
risk  taking,  profitability  is  likely  to  dampen  further  and  there  is  a  risk  that  credit 
constraints  to  the  economy  could  emerge.  Third,  the  low  equity  valuations  unveil  the 
high costs of equity banks face in issuing capital via equity issuance. Based on an EBA 
survey, the IMF estimates that the average cost of equity in the EU banking system is 
around  9%.  Returns  on  equity  are  around  6%  on  average  according  to  EBA  data  and 
around 2% for medium-sized banks. As costs of equity outstrip the returns on equity for 
many  banks,  requests  to  increase  capital  ratios  would  weaken  profitability  further. 
Consistent  with  this  theoretical  argument  is  what  some  market  analysts  (from 
investment  banks  and  credit  rating  agencies)  reported  about  the  likely  trigger  for  the 
share price losses in February 2016. They considered rumours that supervisors imposed 
possible  restrictions  on  dividend  payments  to  shareholders  on  some  banks  in  order  to 
strengthen  their  capital  position  a relevant  trigger.  Hence,  the  investor  base  for  equity 
investments  in  banks  has  been  sensitive  to  policy-induced  measures  that  curtail  the 
profitability  of  their  investment.  This  experience  suggests  that  the  policy  instruments 
proposed by Article 459 CRR are unlikely effective in periods of subdued growth and 
downbeat  expectations  about  banks'  profit  outlook.  As  said  above,  measures  under 
Article  459  CRR  are  likely  most  effective  in  times  of  excess  optimism  in  banks 
profitability and in share price valuations. 

Low  profitability  in  EU  banks  is  driven  by  cyclical,  legacy  and  structural  factors. 
Subdued nominal economic growth and low central bank interest rates have been major 
cyclical  factors.  Nominal  economic  growth  has  constrained  the  financial  sectors' 

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potential  to  expand  service  provision  to  the  economy.  Demand  for  bank  lending  has 
been equally subdued. Low interest rates and a flat yield curve imply low margins for 
financial  intermediaries,  most  evident  in  lower  profits  from  maturity  transformation. 
Moreover,  the  zero-lower  bound  of  interest  rates  impacts  banks'  profitability  since 
banks are not able to charge negative interest rates to retail depositors as these have the 
alternative of holding cash instead of deposits. Legacy factors relate first of all to high 
burden of non-performing loans (NPL) in some parts of the banking system, especially 
in  those  Member  States  where  prolonged  low  economic  growth  led  to  high  levels  of 
NPLs. Banks have different option to address NPLs, but often the incentives doing so 
are not sufficient. For example, realising losses from NPLs or selling them at a discount, 
unless  already  provisioned,  would  trim  profits  and  capital  ratios.  The  alternative  of 
maintaining  them  on  the  balance  sheet  (evergreening)  provides  temporary  relief,  but 
comes at the expense of more uncertain asset quality, which may result in higher costs 
on  funding  markets  and  in  reluctance  to  expand  lending  to  the  economy.  Also,  high 
NPLs imply high cost of managing bad loans. 

Low profitability in the banking sector if entrenched may lead to solvency issues in the 
medium  term.  Although  macro-prudential  policy  may  play  a  role  in  addressing  the 
cyclical  factors  behind  low  profitability  by  loosening  existing  constraints  on  bank 
activity, Article 459 CRR is not a suitable means in this respect. It only allows stricter 
prudential requirements for a period of one year and not a loosening. Article 459 CRR 
has  also  limited  impact  on  NPLs.  The  legacy  problem  of  high  NPLs  would  best  be 
tackled by more efficient insolvency procedures that allow banks to resolve NPLs more 
quickly.  As  proposed  by  the  Commission,  the  Council  addressed  NPLs  in  Country 
Specific  Recommendations  to  six  Member  States  in  July  2016.  The  Commission  is  in 
close  communication  with  national  authorities  as  well  as  European  stakeholders  to 
ensure adequate action. Prudential requirements under Article 459 CRR might be able 
to foster structural change since financial institutions struggling to meet them would be 
prompted to shrink balance sheets, reduce business or even exit the market. Given the 
temporary  nature  of  measures  under  Article  CRR  459,  i.e.  active  for  a  period  of  one 
year,  however  they  are  not  suitable means  to  foster  any  desirable  structural  change in 
the EU banking system. 

(c)  Deterioration of debt sustainability in sovereign, corporate and household 

sectors 

The  deterioration  of  debt  sustainability  in  sovereign,  corporate  and  household  sectors, 
even if applying rather uniformly and significantly to all Member States, would not be 
effectively addressed by measures under Article 459 CRR. 

The impact of measures that reduce leverage in the banking sector on debt sustainability 
of non-financial actors is ambiguous. While it is possible that they lead to deleveraging 
in  the  non-financial  economy  that  spills  over  to  improved  debt  sustainability,  it  may 
also  result  in  impaired  access  to  credit  that  provokes  the  existing  debt  positions  to 
become unsustainable. 

(d)  Shocks and contagion from the shadow banking sectors 

As  regards  risks  posed  by  the  shadow  banking  sector,  the  approach  taken  under  the 
large exposures regime of the CRR seems sufficient at this stage and there is no need 
for  recourse  to  Article  459  CRR.  EBA  Guidelines  on  limits  on  exposures  to  shadow 

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banking entities were adopted in December 2015 and apply from 1 January 20174. They 
provide general principles institutions should comply with in order to address risks that 
exposures to shadow banking  entities  may pose  them, a principle approach for setting 
limits  to  exposures  to  shadow  banking  entities  and  a  fallback  approach  in  case 
institutions are not able to apply the principal approach. The work done by the EBA will 
feed into the Commission report under Article 395(2) CRR on the appropriateness and 
impact  of  imposing  such  limits,  which  will  also  take  into  account  international 
developments on risks arising from shadow banking entities. 

4 https://www.eba.europa.eu/documents/10180/1310259/EBA-GL-2015-
20+GL+on+Limits+to+Exposures+to+Shadow+Banking+Entities.pdf/f7e7ce6b-7075-44b5-9547-
5534c8c39a37.  

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