- Posted by Michael McKee
- On 14 March 18
- Capital Requirements, CRR, Financial Regulation, IFRS 9, LGD Estimation, PD Estimation, Prudential Consolidation, Treatment of Exposures
The below article is reproduced from the February 2018 edition of Exchange – International magazine. For more about financial services regulatory issues across the world, the full magazine is available for download here.
There have been a number of developments in relation to the Capital Requirements Regulation (575/2013) (CRR) and Capital Requirements Directive (2013/36) (CRD IV) during recent months. We summarise some of these updates below.
On 12 December 2017, the EU adopted Regulation (2017/2395) (IFRS 9 Regulation), which amends the CRR to provide for transitional arrangements to mitigate the impact of IFRS 9, which was adopted in the EU on 22 November 2016, in relation to own funds and large exposures of certain public sector exposures denominated in the domestic currency of any Member State.
The IFRS 9 Regulation inserts a new Article 473a into the CRR, which includes provisions on transitional arrangements for the introduction of IFRS 9 and IFRS 9-like expected credit loss models (Analogous ECLs) in order to mitigate the impact of the impairment requirements resulting from IFRS 9 on capital and leverage ratios, and imposes disclosure requirements on institutions that apply transitional arrangements for IFRS 9 and Analogous ECLs.
The final EBA guidelines on uniform disclosure of IFRS transitional arrangements under the CRR were published on 12 January 2018, and will apply from 20 March 2018 until the end of the transitional period, which finishes on 20 March 2023.
Final EBA guidelines on PD estimation, LGD estimation and the treatment of defaulted exposures under the IRB approach
On 20 November 2017, the European Banking Authority (EBA) published its final guidelines on probability of default (PD) estimation, loss given default (LGD) estimation and the treatment of defaulted exposures (IRB Guidelines), as part of its general review of its Internal Ratings Based (IRB) models approach under the CRR.
The IRB Guidelines are designed to address the discrepancies identified by the EBA in the methodologies underlying risk estimates, which have arisen due to the flexibility of the IRB framework.
The IRB Guidelines seek to align terminology and definitions, particularly in relation to key concepts underlying the estimation of risk parameters, including in relation to default rate and realised LGD. The IRB Guidelines also seek to clarify the application of certain regulatory requirements and specify principles for the estimation of risk parameters.
The EBA has recognised that the IRB Guidelines may lead to material model changes for some institutions, and therefore is proposing a deadline for full compliance to be the end of 2020, although the EBA states that it expects preparations for implementation should begin “immediately”.
EBA consults on methods of prudential consolidation
On 9 November 2017, the EBA published a consultation paper setting out draft regulatory technical standards (Draft Consolidation RTS) on the methods of prudential consolidation under the CRR and entities which may give rise to a step in risk.
The Draft Consolidation RTS elaborate on some of the conditions, criteria and indicators which may allow the application of a different method of consolidation than full consolidation under Article 18(1) CRR, including proportional consolidation or the aggregation method, or the application of the equity method. The Draft Consolidation RTS also includes indicators that should be assessed when institutions are seeking to identify which undertakings may bear a step in risk, based on the Basel Committee on Banking Supervision (BCBS) guidelines from October 2017.
At the time of writing, the consultation is expected to close on 9 February 2018, with the final draft RTS submitted to the Commission for endorsement thereafter.
Final EBA guidelines on treatment of connected persons under CRR
On 14 November 2017, the EBA published its final report setting out guidelines on the definition of connected clients under the CRR (CC Guidelines), and particularly focus on the circumstances under which an institution’s clients would be regarded as constituting a group of connected clients (GCCs) under control and economic dependency relationships.
With respect to control relationships, the CC Guidelines clarify the concept of single risk and clarify that the burden of proof is on the institution to demonstrate that there is not a single risk where a control relationship exists. The CC Guidelines clarify that institutions should make use of their clients’ consolidated financial statements when assessing the existence of control and provide a non-exhaustive list of criteria and indicators of control for those clients not subject to EU accounting rules.
In relation to economic dependencies, the CC Guidelines state that if institutions can demonstrate that financial difficulties of one client would not lead to the funding or repayment difficulties for another client, the clients would not be considered as a single risk. The CC Guidelines also present a non-exhaustive list of situations that should be considered by institutions when assessing economic dependencies.
The CC Guidelines consider the potential for control and economic dependency relationships to interlink to create a GCC, and emphasise that the fundamental concept is that of single risk, regardless of the type of connection which caused it.
The CC Guidelines also set out control and management procedures for identifying GCCs and state the EBA’s expectation that institutions identify all control relationships and take reasonable steps and use readily available information to investigate and identify economic dependencies among their clients.
Competent authorities have two months from publication of the translations of the CC Guidelines to indicate whether they will comply with them. The CC Guidelines will apply from I January 2019.
SECURITISATION REGULATION AND CRR AMENDMENT REGULATION IN FORCE
On 17 January 2018, Regulation (2017/2402) (Securitisation Regulation) and Regulation (2017/2401) (CRR Amendment Regulation) entered into force, and will apply from I January 2019. The Securitisation Regulation lays down common rules for securitisation, creating a European framework for simple, transparent and standardised (STS) securitisation while the CRR Amendment Regulation ensures that the effects of these changes are reflected in a firm’s capital treatment under Regulation (575/2013), the Capital Requirements Regulation (CRR).
The Securitisation Regulation sets out a legal framework for securitisation in the EU. It defines securitisation and imposes various risk-retention, due-diligence and transparency obligations on the parties involved. It also contains the rules for selling securitised products to retail investors, a prohibition on re-securitisation, the requirements for securitisation special purpose entities and securitisation repositories as well as the framework for STS securitisation.
The CRR Amendment Regulation sets out the rules on capital treatment of securitised products, with STS securitisations attracting lower capital charges than non-STS securitisations. It also provides for the hierarchy of methodologies for calculating capital and establishes the risk-weight floors and caps. The CRR Amendment Regulation replaces the existing provisions in the CRR relating to the regulatory capital treatment of securitisation exposures held by institutions in the EU.
The reforms introduced by the Securitisation Regulation and CRR Amendment Regulation are part of the European Union’s Capital Markets Union plan adopted in September 2015.
On 19 December 2017, the European Securities and Markets Authority (ESMA) issued three consultation papers seeking feedback on draft regulatory technical standards relating to:
- the requirements for the third parties seeking authorisation to provide STS verification services (ESMA33- 128-108);
- disclosure requirements, operational standards and access conditions (ESMA33- 128-107); and
- the format and content of STS notifications, and the information for assessing whether securitisation complies with STS criteria (ESMA33-128-33).
The consultations will be open for feedback until 19 March 2018. ESMA intends to finalise the draft technical standards, and expects to publish its final report on the STS notification and third party application requirements in July 2018, and its report on reporting requirements and operational standards/access conditions by the end of 2018.
DEVELOPMENTS IN EU STRESS TESTING
Following the 2016 EU-wide stress test, the European Banking Authority (EBA) has been working to update and develop the relevant methodology, guidelines and templates for the upcoming 2018 stress testing exercise. The ongoing workstream is discussed in more detail below.
EBA consulted on draft guidelines on stress testing
Under Article 100(2) of the Capital Requirements Directive IV Directive 2013/36 (CRD IV), the EBA is required to issue guidelines to enable competent authorities to use common methodologies in annual stress tests. To fulfil this obligation, on 31 October 2017, the EBA published a consultation paper setting out its draft guidelines on institutions’ stress testing.
The guidelines provide detailed guidance for firms when designing and conducting a stress testing programme and cover the following issues:
- the taxonomy of stress testing;
- the description of types of stress test exercises;
- the reverse stress testing process for regular stress testing and recovery planning purposes; and
- additional risk areas, including credit and counterparty risk, liquidity risk and conduct risk.
The draft guidelines also contain the feedback received in a previous consultation by the EBA, as well as set out the policy decisions taken in response.
The consultation closed on 31 January 2018, and the EBA intends to finalise the guidelines in the first quarter of 2018 and begin applying them in the second quarter of 2018. These new guidelines will repeal and replace the guidelines on institutions’ stress testing, issued by the Committee of European Banking Supervisors in 2010.
EBA consulted on revised guidelines on common supervisory procedures and methodologies for SREP and supervisory stress testing
On 31 October 2017, the EBA published a consultation paper setting out its draft guidelines on the revised common supervisory procedures and methodologies for the supervisory review and evaluation process (SREP) and supervisory stress testing under Article 107(3) of the CRD IV.
The consultation sets out the proposed changes to the EBA’s current guidelines on common supervisory procedures and methodologies for SREP. The revisions made by the EBA are designed to reflect developments affecting the SREP framework since the original guidelines were finalised, including the introduction of Pillar 2 Capital Guidance and the integration of supervisory stress testing requirements.
The revisions to the guidelines refine and introduce the following:
- Pillar 2 capital guidance;
- supervisory stress testing and the supervisory assessment of institution’s stress testing;
- the alignment of supervisory assessment of interest rate risk in the banking book (IRRBB) with the revision of the EBA’s guidelines on IRRBB;
- scoring framework;
- interaction between SREP elements;
- the articulation of total SREP capital requirements and overall capital requirements and communication of supervisory capital expectations to institutions; and
- consistency with recently published legislation on internal governance.
The deadline for responses was 31 January 2018. The EBA intends for the revisions to apply from 1 January 2019, in time to be used in the 2019 cycle of SREP and joint decisions on institutions’ specific prudential requirements.
EBA confirms methodology and templates for 2018 EU-wide stress test
On 17 November 2017, the EBA published the final methodology to be used in the 2018 EU-wide stress test. The EBA is required to run EU-wide stress tests to assess the resilience of financial institutions to adverse market developments. The consultation on draft methodology took place in June 2017.
The methodology is designed to provide banks with adequate guidance and support for conducting the stress test exercise that was formally launched in January 2018. The methodology covers all relevant risk areas and, for the first time, incorporates International Financial Reporting Standard 9 (IFRS 9) accounting standards, which are covered in more detail above.
The EBA explained that the 2018 EU-wide stress test is primarily focused on assessing the impact of risk drivers on the solvency of banks. The results of the stress test are expected to be published by 2 November 2018.
ECB OPINION ON THE IMPLEMENTATION OF TLAC RULES
The European Central Bank (ECB) published an opinion dated 8 November 2017 on the European Commission’s legislative proposals to implement the Financial Stability Board’s (FSB) total loss absorbing capacity (TLAC) standard.
While welcoming the broader proposals to implement TLAC, the ECB set out some areas of concern around the implementation of the TLAC standards, amendments to the minimum requirement for own funds and eligible liabilities (MREL), transitional arrangements for MREL, early intervention measures, the pre-resolution moratorium tool and the “failing or likely to fail” assessment for less significant credit institutions under the direct responsibility of the Single Resolution Board (SRB).
In light of its concerns, the ECB set out suggested amendments to the Bank Recovery and Resolution Directive, Single Resolution Mechanism, the Capital Requirements Directive and Capital Requirements Regulation in a technical working document attached to the opinion.
BASEL III: EU RESPONSE TO THE FINAL POST-CRISIS REFORMS
On 7 December 2017, the Basel Committee of Banking Supervision (BCBS) finalised the remaining Basel III regulatory reforms and published their content in a document entitled “Basel III: Finalising post-crisis reforms“. The EU authorities published statements on these reforms shortly after the BCBS issued its press release.
The majority of provisions within the Basel III reforms will be introduced on I January 2022, with requirements on output floors to be phased in from this date.
The announcements by the European Commission and the European Banking Authority (EBA) are summarised below.
European Commission to consult on final Basel III standards
The European Commission (Commission) published a press release on 7 December 2017 welcoming the announcement by the BCBS and announcing its plans to consult on the Basel Ill regulatory standards.
The Basel Ill framework sets global minimum standards for the amount of capital which banks must hold to cover the risks that they are exposed to. In the press release, the Commission explained that, in order to implement these standards in the EU, current banking regulations like the Capital Requirements Regulation (575/2013) (CRR) will need to be amended. The Commission stated that before proposing any amendments, it planned to launch a consultation and carry out an impact assessment to examine the effect of implementing Basel III on the EU economy.
The Commission stressed that any such future legislative proposals will be independent from the CRR amendments it had adopted in November 2016 and which were being negotiated by the European Parliament and the Council of the EU.
EBA Basel III impact assessment
On 7 December, the EBA published a monitoring report setting out the impact of Basel III reforms on the EU banking system. This report was soon followed by a more detailed ad hoc cumulative impact assessment (Impact Assessment) on 20 December 2017.
The Impact Assessment was based on December 2015 data and analysed the overall impact of the final Basel III reform package on 88 EU institutions from 17 member states. The EBA published the following findings:
- EU banks’ minimum tier I capital requirement would increase by 12.9% at the full implementation date (14.1% for the large and internationally active banks and 3.8% for all other banks);
- EU banks would need EUR17.5 billion of additional common equity tier I capital and the total capital shortfall would be EUR39.7 billion;
- 20.5% of the banks in the sample would be constrained by the output floor, set by the BCBS at 72.5% of the standardised approach requirements; and
- the aggregate output floor was the strongest driver of the increase in minimum regulatory capital, whereas the revisions to the credit risk and operational risk frameworks had had a more moderate impact.
The EBA recognised that using the data from 2015 meant that the analysis did not “reflect bank-level changes in capital, portfolio composition and adjustments to business models” that had occurred since then. It also noted that the full implementation of the Fundamental Review of the Trading Book was assumed for the purposes of Impact Assessment.
ESMA PUBLISHES TECHNICAL ADVICE, ITS AND GUIDELINES ON MMF REGULATION
On 17 November 2017, ESMA published a final report (dated 13 November 2017) providing technical advice, draft implementing technical standards (ITS) and guidelines under the Regulation on Money Market Funds (2017/1131) (MMF Regulation). The final versions of these implementing tools are set out in Annex III to ESMA’s report.
The report provides a summary of the feedback provided to the ESMA consultation paper published on 24 May 2017 and sets out ESMA’s response. It contains draft technical advice under Articles 15 and 22 of the MMF Regulation relating to (i) quantitative and qualitative liquidity requirements and quantitative and qualitative credit quality requirements; (ii) criteria for validation of the credit quality assessment methodology; (iii) criteria for qualification of the credit risk, and of the relative risk of default of an issuer and of an instrument; (iv) criteria for estimating qualitative indicators on the issuer of the instrument; and (v) meaning of material change.
The draft ITS contain a set of templates to be used by managers of money market funds when reporting to competent authorities. ESMA confirmed that managers will not need to send quarterly reports, as required under Article 37 of the MMF Regulation, to National Competent Authorities (NCAs) immediately upon the MMF Regulation entering into force, i.e. July 2018, but the requirement will only kick in in October/November 2019.
Managers will not be required to retroactively provide data for any period prior to this starting date. As a next step, ESMA promised to begin work on the guidelines and IT guidance in order for MMFs to have all the necessary information before submitting the reports to the NCAs.
The guidelines published in the final report provide the competent authorities and market players with details about stress test scenarios under Article 28 of the MMF Regulation. In particular, they include guidance on the establishment of common parameters of the stress test scenarios in relation to hypothetical events like a change in interest rates or occurrence of macro systemic shocks. ESMA stated that, in addition to the stress tests required under sections 5.1 to 5.7 of the guidelines, managers of MMFs should also conduct common reference stress test scenarios. The results of these will have to be reported to NCAs as described under Article 37 of the MMF Regulation. As in the case of the ITS mentioned above, ESMA will update the guidelines in good time before the submission of the necessary reports to the NCAs. The calibrations of the common reference stress test scenarios will be specified with the guidelines update.
ESMA submitted the technical advice and ITS to the European Commission, who then, on 16 January, launched a consultation which closed for comments on 12 February 2018. The MMF Regulation will enter into force on 21 July 2018.