CRD IV EU reform of banking regulation and capital sufficiency

The CRD IV Directive (Capital Requirements Directive IV) and the CRR Regulation (Capital Requirements Regulation) took effect on 1 January 2014 in the Europe an Union. The set of rules to reform banking supervision fulfills the G 20’s assignment to permanently strengthen the framework for supervising banks as a reaction to the financial crisis. Even though the content of CRD IV is based on the proposals of the Basel Committee (Basel III), it contains additional details and expanded requirements enacted by the EU.

Direct implementation of Basel III

The harmonization of banking regulation in the EU is a core concern of CRD IV. For this reason, large portions of the Basel III provisions are being implemented through a regulation that is directly applicable. No reconciliation with national law is necessary. However, national laws had to be purged of all provisions that competed or conflicted with the Regulation. In Germany, this primarily applied to the Banking Act [Kreditwesengesetz KWG], the Solvency Regulation [Solvabilitätsverordnung SolvV], and Large Exposure and Million Euro Loan Regulation [Groß- und Millionenkreditverordnung GroMiKV].

CRD IV, which is directly binding on all EU institutions, contains detailed requirements for lending institutions and securities companies and mainly regulates equity capital, liquidity, the maximum leverage ratio, and counterparty risk. The CRR, which leaves some leeway for implementation into national law, contains basic provisions on the prerequisites for engaging in the banking business, freedom of establishment and freedom to provide services, and banking supervision principles. The Directive also contains requirements for corporate governance, sanctions, buffer capital, and improved supervision procedures.

Equity capital and minimum capital

The CRR contains a fully revised definition of regulatory equity capital. This entails three clearly defined categories: hard core capital (CET 1 capital), supplementary core capital (AT 1 capital) and supplementary capital (Tier 2 capital). Tier 3 capital has ceased to exist. The proportion of hard core capital should be 4.5 %, the proportion of supplementary core capital should be 1.5 %, and the proportion of supplementary capital should be 2 %. Then there is buffer capital of up to an additional 10 % for systemic risks, systemically relevant institutions, anti-cyclical hedging, and capital maintenance. In contrast to Basel II, a capital instrument is classified solely on the basis of the criteria in the CRR without regard to the legal form of the particular institution.

Particular significance is placed on hard core capital in the equity capitalization of institutions – in both a quantitative and a qualitative sense. Thus the vast majority of minimum capital is to be represented by hard core capital. In addition, an institution that intends to issue a hard core capital instrument must obtain the consent of the relevant regulatory body.

Jumbo loan provisions

The definition of “jumbo loan” has changed. A jumbo loan is classified as such if a customer or group of customers reaches a credit volume of 10 % of the imputable equity capital (sum of core and supplementary capital) of the lending institution. The reporting threshold, which was EUR 1.5 million is now EUR 1 million.

CCP and CVA Risk

Provisions on Central Counterparty (CCP) Risk mainly relate to large banks with significant over-the-counter (OTC) trading in derivatives and financing through securities. The risk of deterioration in the credit standing of the counterparty must now also be secured by equity capital. Losses from Credit Value Adjustments (CVA) will be recognized to a greater extent than even proposed by Basel III.

LCR and NSFR

The Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) have created an EU-wide liquidity regime to ensure short-term liquidity for 30 days and medium- to longterm liquidity for one year. The LCR describes the ratio of highquality liquid assets to potential net capital outflows within the next 30 days in a stressed market environment. The NSFR is a measure of adequate, long-term refinancing. It expresses available and necessary stable refinancing as an annual percentage. Both figures were first introduced as observables: The LCR will apply as a binding minimum requirement as of 1 January 2015 and the NSFR as of 1 January 2018.

Leverage ratio

The leverage ratio introduces a risk-independent debt limit for institutions. Through it, the core capital of the institution is expressed as a percentage of the sum of its non-risk-weighted risk position values. So far, the leverage-ratio has only been introduced as an observable and will receive its final review in 2017.

Governance

The enhanced governance requirements for institutions under CRD IV have resulted in a basic change to some of the provisions of the German Banking Act [Kreditwesengesetz KWG]. Section 25a of the KWG now only contains provisions on management compliance. An upper limit for variable components of compensation and a provision stating that institutions must establish a compliance function were added. For the first time, the KWG now expressly formulates requirements for managing directors and members of the supervisory and administrative bodies (Sections 25c and 25d of the KWG). The new requirements – which range from qualitative requirements for officers to specific obligations in performing the duties of officers, to limitations of powers, and provisions on incompatibility – are intended to counteract the weaknesses in the performance of official duties by managing directors and members of supervisory bodies, which became apparent in the financial crisis. The aforementioned persons must not only be sufficiently qualified, but should also have sufficient time available to conscientiously perform their tasks.

Sanctions

Legislators have taken the opportunity to fundamentally change and supplement the provisions of Section 56 of the KWG on fines. As a result, violations of the code of conduct under the CRR have been included as administrative offenses. At the same time, the level of fines has been significantly increased. The proffered rationale is that fines should exceed the economic benefit that the perpetrator has obtained from the offense. Under Section 60 b of the KWG, the Federal Financial Services Supervisory Authority [BaFin] is even required to publicize any fine that has become final and incontestable. However, the publication may be anonymized in individual cases.

Transitional provisions

The CRR provides that the new equity capital requirements will be introduced gradually. The national regulatory authorities are granted the right to decide how rapidly the transition is to proceed. In setting deadlines, BaFin has basically adhered to the Basel III guidelines. Thus, in the period from 1 January 2014 to 31 December 2014, institutions must maintain a hard core capital ratio of at least 4 % and a supplementary core capital ratio of at least 1.5 %. More detailed transitional provisions are set forth in Sections 23 et seq. of the (new) SolvV.

Conclusion

The CRD IV package harmonizes European banking regulation law and provides a uniform legal framework for the European single market. At least the regularization dumping, engaged in by some states, is now in the past.