REPORT FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT AND THE COUNCIL on Effects of Regulation (EU) 575/2013 and Directive 2013/36/EU on the Economic Cycle
Date: 2018-04-09
Institutions: Directorate-General for Financial Stability, Financial Services and Capital Markets Union, European Commission
Subjects: bank, credit institution, credit policy, economic analysis, economic cycle, financial requirements, financial risk, financial stability, financial supervision

EN 

  EN 

   EUROPEAN COMMISSION  Brussels, 9.4.2018 COM(2018) 172 final  REPORT FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT AND THE COUNCIL on Effects of Regulation (EU) 575/2013 and Directive 2013/36/EU on the Economic Cycle {SWD(2018) 89 final}  
 
 
REPORT FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT AND 
THE COUNCIL 

on Effects of Regulation (EU) 575/2013 and Directive 2013/36/EU on the Economic Cycle 

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INTRODUCTION 

Article  502  of  Regulation  (EU)  575/2013  of  the  European  Parliament  and  of  the 
Council1requires  the  Commission  to  examine  periodically  whether  risk-sensitive 
regulatory  requirements,  as  established  in  that  Regulation  and  in  Directive 
2013/36/EU  of  the  European  Parliament  and  of  the  Council2,  create  unintended 
procyclical effects by reinforcing the endogenous relationship between the financial 
system and the real economy and thereby amplifying the real economic cycle.  

The  Commission  is  required  to  submit  a  proposal  for  any  appropriate  corrective 
measures, should such procyclical effects be found. The specific goal of this report is 
thus  to  analyse  whether  there  is  evidence  that  the  provisions  in  Regulation  (EU) 
575/2013  and  Directive 2013/36/EU  contribute  to  any  procyclical  effects  of  capital 
ratio requirements. 

The Commission prepared earlier and similar reports on procyclicality of capital ratio 
requirements  in  2010 and 2012.3 This  third report is  the first  one  under Regulation 
(EU)  575/2013.  This  third  report  draws  upon  a  dedicated  report  by  the  European 
Banking  Authority  (EBA),  which  encompasses  contributions  from  the  European 
Systemic  Risk  Board  (ESRB),  the  European  Central  Bank  (ECB)  and  authorities 
from EU Member States.4 It further builds on a broader examination of the literature. 

There is broad consensus among regulators and academics that the financial system 
is  inherently  unstable  and  subject  to  risks  which  can  have  severe  negative 
consequences for the real economy once they materialise. This is borne out also by 
historical  experience.  The  global  financial  crisis,  which  broke  out  a  decade  ago, 
provided  a stark  reminder.  To  counter  that  financial instability,  financial  regulation 
and macroprudential policy aim at limiting systemic risk. With the lessons from the 
crisis  in  mind,  ensuring  sufficiently  high  capital  levels,  especially  for  banks,  is 
generally seen to reduce the probability of systemic financial crises and their cost if 
they do occur.  

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). 
Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the 
activity of credit institutions and the prudential supervision of credit institutions and investment firms, 
amending  Directive  2002/87/EC  and  repealing  Directives  2006/48/EC  and  2006/49/EC  (OJ  L 176, 
27.6.2013, p. 338). 
SEC(2010)754, COM (2012) 400. 
EBA  Report  under  Article  502  CRR, 
https://www.eba.europa.eu/documents/10180/1701905/Report+on+the+Cyclicality+of+Capital+Requir
ements+%28EBA-Op-2016-24%29.pdf   

issued  on  22  December  2016  (EBA-Op-2016-24): 

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However,  capital  ratio  requirements  to  ensure  sufficient  capital  might  themselves 
become  a  source  of  instability  as  the  risk-based  approach  embedded  in  Regulation 
(EU)  575/2013  and  Directive  2013/36/EU  implies  that  capital  ratio  requirements 
become looser in an upturn and tighter in a downturn. Such procyclicality of capital 
ratio  requirements  is  a  key  potential  externality  of  the  financial  system  which  can 
cause financial stability risks and is therefore of concern to regulators. 

This  report  examines  whether  capital  ratio  requirements  are  procyclical  and  if  so, 
whether they have an impact on the level of capital that banks actually hold or desire 
to hold. 

METHODOLOGY 

The  question  of  procyclicality  of  capital  ratio  requirements  is  in  first  instance  an 
empirical one. Recent literature surveys find limited and rather inconclusive evidence 
on  the  long-run  impact  of  changes  in  capital  ratio  requirements  on  the  level  or 
growth  rate  of  bank  lending,  even  though  negative  near-term  impacts  are 
documented. To shed  further light  on the issue, the EBA report examines evidence 
for  the  Union  on  the  procyclical  impact  of  recent  regulation  on  capital  ratio 
requirements  for  banks.  The  EBA  report  uses  information  available  from  public 
sources  as  well  as  dedicated  data  collected  from  National  Competent  Authorities. 
The  empirical  evidence  examined  covers  aggregate  and  micro-level  evidence 
whether  bank's  capital  ratio  requirements  mirror  the  development  of  the  overall 
business cycle as well as regression analyses. 

The  data  used  by  EBA  mostly  span  the  period  2008-2015,  covering  the  global 
financial crisis and its aftermath. In  addition to aggregate statistics and survey data 
the  EBA  relies  on  a  sample  of  144  individual  banks  active  in  13  Union  and  EEA 
countries and representing some 95% of the Union banking sector's total assets. The 
sample includes banks with different scales of operation, ranging from international 
systemic  banks  to  ones  that  are  active  only  domestically.  It  covers  banks  with 
different business models, including retail and commercial banks, universal banks, as 
well  as  a  number  of  banks  with  more  specialised  activities,  such  as  covered  bond 
issuance or investment banking. 

MAIN FINDINGS  

Capital  ratio  levels  of  the  Union  banking  sector  have  significantly  increased  since 
risk-sensitive  capital  ratio  requirements  were  first  introduced.  The  increase 
accelerated  since  2014  with  the  application  of  the  capital  ratio  requirements  laid 
down  in  Regulation  (EU)  575/2013  and  Directive  2013/36/EU.  The  significant 
increase in capital has been driven primarily by a rise in banks' Common Equity Tier 
1 requirements, rather than by the cyclicality of underlying internal rating based risk 
parameters,  notably  probability  of  default  and  loss  given  default.  These  risk 
parameters remained  relatively stable over the sample period which covers a major 
economic downturn in most Member States. This stability can be explained by banks' 
active portfolio reshuffling. Overall capital ratio levels have increased faster than the 
required  regulatory  minimum  ratios  which  could  reflect  a  preference  of  banks  for 
additional room for manoeuvre in their capital buffers in a period of uncertainty. 

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In  contrast  to  the  rise  in  mandatory  and  overall  capital  buffers,  total  risk-weighted 
asset ratios of European banks declined from 2008 onwards, with some modest pick-
up  since  2014.  Loan  portfolios  mirrored  this  trend.  In  particular,  loans  from  euro 
area-based  banks  to  non-financial  corporations  decreased  in  the  aftermath  of  the 
global financial crisis as weak aggregate demand weighed on the demand for credit. 
Some  pick-up  was  only  registered  towards  the  end  of  the  sample  period.  The 
decrease  in  risk-weighted  assets  has  been  larger  than  the  fall  in  the  exposures  as 
defined  for  the  leverage  ratio,  suggesting  a  rebalancing  of  bank  portfolios.  The 
development of risk-weighted exposures was largely due to the trends in credit risk, 
the most important subcategory.  

Various  alternative  regression  specifications  confirm  that  changes  in  exposures, 
notably  exposure  at  default,  rather  than  changes  in  risk  parameters,  have  driven 
observed  cyclical  patterns  in  bank  capital.  While  there  is  some  limited  procyclical 
effect  of  the  macro  economy  on  bank  variables,  notably  on  minimum  required 
capital,  there  is  no  marked  difference  between  risk-based  and  standardised 
approaches in this respect. These findings are broadly supported by a portfolio-level 
analysis and by bank lending surveys.  

It  seems  that  since  2008  crisis-related  effects  rather  than  changes  in  capital 
requirements have been a major force in shaping bank credit supply in recent years. 
There  is  some  evidence  of  a  structural  break  in  the  regulatory  regime  due  to  the 
transition to the Basel III framework imposed through Regulation (EU) 575/2013 and 
Directive 2013/36/EU affecting the interaction between bank  capital, credit and the 
real  economy.  Even  so,  it  is  difficult  to  distinguish  level  shift  effects  from  a  more 
lasting  potential  procyclical  impact  of  the  regulatory  requirements  introduced  by 
Regulation (EU) 575/2013 and Directive 2013/36/EU.  

The results from the empirical analyses have to be treated with due caution. This is 
partially due to the limited sample size and lack of detailed breakdowns of the data. 
Also,  the  period  since  introduction  of  Regulation  (EU)  575/2013/Directive 
2013/36/EU has been short compared to the typical duration of a financial cycle. The 
period  examined  was  characterised  by  strong  swings  in  real  activity,  substantial 
crisis-induced financial losses, public capital injections and a strong regulatory drive 
to increase capital buffers culminating in the transition towards Basel III-compliant 
minimum capital requirements, which is due to be completed by 2019.  

More  detailed  empirical  findings  are  given  in  the  Commission  Staff  Working 
Document accompanying this report. In all, the available evidence does not show a 
sizeable  procyclical  impact  of  the  regulatory  framework  laid  down  in  Regulation 
(EU) 575/2013 and Directive 2013/36/EU.  

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MEASURES TO ADDRESS PROCYCLICALITY 

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The  rules  laid  down  in  Regulation  (EU)  575/2013  and  Directive  2013/36/EU 
incorporate a number of measures aimed at mitigating procyclicality in bank lending, 
including higher capital ratio requirements, countercyclical and capital conservation 
buffers, the introduction of a leverage ratio, and reduced dependency on credit rating 
agencies  for  prudential  requirements  and  stress  tests.  On  23  November  2016,  the 
Commission  adopted  a  proposal  to  amend  capital  requirement  regulations  by 

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incorporating the remaining elements of the regulatory framework agreed within the 
Basel  Committee  on  Banking  Supervision  (BCBS).5  On  20 September  2017  the 
Commission  published  a  proposal  on  the  review  of  the  Union  system  of  financial 
supervision,  with  a  number  of  further  proposed  targeted  improvements.  The 
Commission advocated targeted adjustments to the composition and organisation of 
the  European  Systemic  Risk  Board  and  its  coordination  with  Union  bodies  and 
institutions.6  Some  of  the  main  measures  aimed  at  mitigating  procyclicality  are 
summarised below. 

4.1  Application  of  the  capital  ratio  requirements  laid  down  in  Regulation 
(EU) 575/2013 and Directive 2013/36/EU 

As  de-leveraging  of  credit  in  international  banks  in  response  to  regulatory 
requirements  set  by  national  supervisors  may  occur  outside  home  jurisdictions,  the 
full  implementation  of  the  single  rule  book  should  reduce  regulatory  arbitrage.  In 
particular,  it  might  mitigate  procyclical  effects  of  ring-fencing  of  capital  and 
asymmetric  de-leveraging  in  "host  countries",  that  is  excessive  credit  retrenchment 
by  internationally  active  banks  in  countries  outside  their  home  jurisdiction.  That  is 
supported  by  the  different  pillars  of  the  Banking  Union,  comprising  common 
resolution and deposit insurance provisions. 

4.2  Capital Conservation Buffer and Countercyclical Capital Buffer 

One  key  regulatory  response  to  the  perceived  procyclicality  of  bank  lending  is  the 
introduction of a Capital Conservation Buffer and a Countercyclical Capital Buffer. 
These  extra  buffers,  built  up  over  good  economic  times,  can  be  released  in  an 
economic downturn to enable banks to absorb their losses in an orderly way that does 
not  lead  to  costly  increases  in  the  price  of  credit,  which  can  aggravate  recession. 
They  should  mitigate  both  the  existing  lack  of  responsiveness  of  regulatory 
requirements to risk build-up at the macro level and their cyclicality. Since dynamics 
can  be  very  different  across  different  markets,  the  buffers  are  determined  on  a 
national base. The European Systemic Risk Board developed common guidance for 
setting countercyclical capital buffer rates.7 

As  many  Member  States  still  are  recovering  from  the  recessionary  shock  of  the 
global  financial  crisis,  only  in  few  of  them  do  Countercyclical  Capital  Buffer  rates 
currently  exceed  zero  percent.  Similarly,  Capital  Conservation  Buffers  have  been 
built up, but to date there is no experience with releasing such buffers. In addition, as 
regards  sectoral  financial  stability  risks  related,  for  instance,  to  real  estate,  the 
Countercyclical  Capital  Buffer  affects  all  corporate  and  retail  exposures  and  can 
currently not be targeted to sectoral exposures. Reflections are ongoing in Basel and 
in  the  Union  on  the  merits  of  introducing  sector-specific  buffers  to  address  the 
cyclical nature of some specific risks and to avoid some of the inaction bias inherent 
to the broad scope of the Countercyclical Capital Buffer. 

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http://europa.eu/rapid/press-release_MEMO-16-3840_en.htm.  
http://europa.eu/rapid/press-release_MEMO-17-3322_en.htm. 
Recommendation (ESRB/2014/1). 

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 4.3  Risk weights for specific exposures and other supervisory measures 

The  current  rules  foresee  specific  macro-prudential  measures  to  counter  risks  from 
specific  exposures,  such  as  real  estate.  This  may  take  the  form  of  requirements  on 
risk weights. In particular, under Article 124 of Regulation (EU) 575/2013 competent 
authorities may set a higher risk weight or stricter criteria on exposures secured by 
immovable  property  on  the  basis  of  financial  stability  considerations.  Similarly, 
Article 164 of Regulation (EU) 575/2013 allows competent authorities to set higher 
minimum values for exposure weighted loss given default for exposures secured by 
immovable  property 
the  basis  of  financial  stability 
considerations. Article 458 of Regulation (EU) 575/2013 allows authorities to adjust 
risk  weights  for  targeting  asset  bubbles  in  the  residential  or  commercial  property 
sector or to take measures such as adjusting the level of the own funds or the level of 
the Capital Conservation Buffer, with a bearing on the capital base of banks.  

territory  on 

their 

in 

The EU regulatory framework further comprises measures to mitigate the impact of 
cyclical  risks  on  banks.  These  include  provisions  in  Articles  181  and  182  of 
Regulation (EU) 575/2013 on risk parameters associated with rating grades or pools, 
which require banks to use estimates that are appropriate for an economic downturn 
if those are more conservative than the long-run average. Banks are recommended to 
use  internal  ratings  models  to  adopt  a  through-the-cycle  approach  in  calculating 
capital ratio requirements for credit risk. Moreover, supervisory authorities can take 
into  account  cyclical  risks  for  institution-specific  second  pillar  capital  ratio 
requirements. 

In  addition, the implementation of other  regulatory  requirements have  a bearing  on 
mandatory  capital  levels,  for  example,  the  banking  book  standards  (IRRBB)  and 
IFRS  9  accounting  standards.  The  EU  Supervisory  Review  and  Evaluation  Process 
may  impact  capital  requirements  as  do  resolution  provisions  and  loss  absorbency 
requirements  such  as  the  Minimum  Requirement  for  own  funds  and  Eligible 
Liabilities  (MREL)  and  the  total  loss-absorbing  capacity  thresholds  for  global 
systemically important banks. 

4.4  Leverage Ratio 

The Leverage Ratio is an additional non risk-based capital requirement conceived to 
supplement  the  risk-based  capital  ratio  requirements.  In  the  Union,  the  Leverage 
Ratio  is  being  implemented  in  line  with  Basel  III  requirements,  meaning  that  the 
Leverage  Ratio  is  calculated  by  dividing  Tier  1  capital  by  the  bank's  average  total 
consolidated  assets  (the  sum  of  the  exposures  of  all  assets  and  non-balance  sheet 
items),  the  banks  being  expected  to  maintain  a  leverage  ratio  in  excess  of  3%.  It 
would help to limit excessive bank lending during the upswing of an economic cycle 
when  banks  have  momentum  to  expand  balance  sheets  without  an  appropriate 
increase in capital.  

The  theoretical  and  empirical  literature  underlines  the  link  between  procyclical 
leverage  and  financial  instability.  Empirically,  banking  sector  leverage  has  been 
procyclical at an aggregate level in almost all Member States, tending to fall in credit 
booms and rising in downturns. A static leverage ratio limit would therefore address 
the  procyclicality  of  banking  leverage  during  an  upturn.  Furthermore,  it  would 
the  procyclicality  of  risk-weighted  capital  ratio 
operate  as  a  backstop 

to 

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requirements. Indeed, it ensures that capital moves in proportion with total exposure, 
while  aggregate  risk  weights  and  risk-weighted  capital  requirement  can  vary  over 
time, according to the different phases of the cycle.  

4.5  Credit ratings  

Credit  ratings,  obtained  through  specific  credit  rating  agencies  or  internal  rating 
models,  also  play  an  important  role  in  the  determination  of  the  actual  capital  ratio 
level  of  banks.  External  ratings  are  closely  correlated  with  the  economic  cycle, 
implying that capital ratio requirements linked to external ratings will also follow a 
cyclical  pattern,  at  least  at  the  level  of  individual  exposures.  In  view  of  this, 
Regulation  (EU)  575/2013  encourages  the  use  of  internal  ratings  and  strengthens 
provisions on how external ratings can be used. For banks using an internal ratings 
based  approach,  it  requires  independent  risk  assessment  capability  and  creates 
incentives  to  better  manage  credit  risk.  A  through-the-cycle  approach  could  help 
smooth the impact on capital ratio requirements. 

4.6 

Stress tests  

Stress  test  can  be  seen  as  another,  albeit  indirect,  instrument  to  help  avoid  undue 
procyclical responses of credit institutions to meet capital ratio requirements during 
periods of financial stress. In the aftermath of the crisis, micro-prudential stress tests 
were used promptly to assess the capital needs of individual banks. Such stress tests 
are helpful in informing how buffers can be set, also above minimum requirements. 
The EU Supervisory Review and Evaluation Process allows the results of stress tests 
to be used to devise supervisory measures, including capital ratio requirements.  

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CONCLUSION 

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While a procyclical impetus from capital ratio requirements is acknowledged in the 
literature  as  a  potential  source  of  risk,  the  empirical  evidence  is  not  conclusive  as 
regards its actual strength for banks in the Union. There is no evidence of a strong 
procyclical bias of the current framework which would affect the non-financial sector 
in  the  economy.  This  result  may  be  driven  by  the  available  data  not  covering  an 
entire cycle, the lack  of  more granular  data that would allow for distinguishing the 
behaviour  of  different  types  of  banks,  the  challenge  to  control  for  portfolio 
rebalancing effects, the difficulty to disentangle loan supply and demand effects, and 
the difficulty to disentangle the impact of other post-crisis reforms and extraordinary 
policy measures.  

Against the background of the weak evidence on the existence of procyclical effects 
due to the rules laid down in Directive 2013/36/EU and Regulation (EU) 575/2013, 
there is no reason at this juncture to propose significant alterations to the prevailing 
regulatory  framework  for  bank  capital.  The  higher  capital  ratios  achieved  in  recent 
years  imply  that  the  procyclical  impact  of  a  given  loss  will  be  weaker.  The  Union 
financial  regulatory  framework  already  includes  various  tools  to  deal  with  any 
procyclical effects. These include the capital conservation buffer, the countercyclical 
capital buffer, the leverage ratio, adjustments to risk weights for specific exposures 
and other supervisory measures. 

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Looking ahead, the impact of the Union regulatory capital ratio requirements on the 
economic cycle should be monitored regularly and the potential impact, effectiveness 
and efficiency of counter-cyclical instruments should be further analysed. It will be 
important to gather evidence on a continuous basis of any procyclical bias stemming 
from capital ratio requirements becoming stronger. Concrete proposals to change the 
current set-up should be based on such evidence becoming available. 

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