Capital Requirements Directive IV (CRD IV)

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1 Capital Requirements Directive IV (CRD IV) A Cicero Consulting Special Report

2 Cicero Introduction Page 3 Timelines and transitional arrangements Page 6 PART ONE GENERAL PROVISIONS Page Subject matter, scope and definitions Page Level of application of requirements Page 7 PART TWO OWN FUNDS Page 8 PART THREE MINIMUM CAPITAL REQUIREMENTS Page General requirements, valuation and reporting Page Minimum capital requirements for credit risk Page Minimum capital requirements for operational risk Page Minimum own funds requirements for market risk Page Own funds requirements for settlement risk Page Own funds requirements for credit valuation Page 38 PART FOUR LARGE EXPOSURES Page 39 PART FIVE EXPOSURES TO TRANSFERRED CREDIT RISK Page 41 PART SIX LIQUIDITY Page Definitions and Liquidity Coverage Requirement Page Liquidity reporting Page Reporting on stable funding Page 43 PART SEVEN LEVERAGE Page 44 PART EIGHT DISCLOSURE BY INSTITUTIONS Page 45 PART NINE DELEGATED AND IMPLEMENTING ACTS Page 47 ANNEX CAPITAL BUFFERS (from the Directive) Page 48 2 P a g e

3 Introduction The European Commission has at last adopted its long-awaited proposal to strengthen the European banking sector through stricter capital requirements, and better liquidity management, obliging the EU s more than banking institutions to hold more and better quality capital to prevent that markets dry up in times of crisis. The product of the Commission s efforts can be seen today in the form of a Regulation and a Directive, which should be considered together as one package. As Mario Nava, the Commission official leading the drafting process, has pointed out, the best way to achieve a Single Rulebook in the EU is through a Regulation. The Directive deals with complementary components of banking reform that need to be transposed into national law but where more flexibility is required. This includes rules on defining competent authorities, on access to deposit-taking activities, effective supervision, corporate governance in financial institutions, and a sanctions regime. The EU is the first jurisdiction implementing the international Basel III agreement, and its intentional lead on being the first to implement higher capital requirements will certainly be a point made at this year s G20 meeting in France. Mirroring Basel III, the Regulation requires banks to hold 4.5% of Minimum Tier 1 Capital in 2013, which will be gradually increased until it reaches 6% in In addition, banks will need to hold onto an additional 2.5% in the Capital Conservation Buffer, as well as to a Countercyclical Capital Buffer between 0% and 2.5%, which is to be determined at national level. European Commissioner Michel Barnier has been accused of being both too soft and too hard in implementing Basel III. European banks say the requirements are too tough and will prevent banks from lending. The European Banking Federation (EBF) said it welcomes the Single Rulebook for banks, but has concerns about the impact of the liquidity provisions on bank lending. Guido Ravoet, Chief Executive of the EBF said: It will be key that the observation periods be used fully to examine how to address this major concern and understand the true impact of the new ratios. However, although the Regulation notes that nothing prevents institutions from holding more capital, national Member States may not impose stricter rules. Avoiding regulatory arbitrage is the concern of Barnier. Some Member States including the UK, Sweden and Spain have on the other hand stated that maximum harmonisation is not the aim of the CRD, and instead they call for more flexibility in the implementation of CRD IV. This is a crucial element for the UK, which has concerns that this would potentially undermine its new Financial Policy Committee, as well as curtails one of 3 P a g e

4 the leading proposals from the Independent Commission on Banking to raise the level of capital requirements to 10% for domestic retail banking operations. This call seems to be heard to a degree. Despite the fact the Commissioner Barnier has repeatedly insisted that the EU will honour the balance and level of ambition included in Basel III, the package seems to set lower standards than Basel III. The calculation of the two capital buffers has been put into the Directive, which allows for more flexibility in transposing these requirements into national law. In previous drafts this was still a component of the Regulation. Barnier has justified this divergence by emphasising that while the Basel agreements would only apply to internationally active banks, the EU has always applied them widely to all banks and investment firms active in the EU s single market which by itself is cross-border in nature. According to the Commissioner these particular circumstances had to be taken into account. This has had two major implications for the CRD IV package. Firstly, the criteria for eligible types and definitions of high quality liquid assets under the short-term 30-day Liquidity Coverage Ratio (LCR) are looser than the criteria under Basel III given the European circumstances. Here the lobby from countries and institutions relying more than others on covered bonds demonstrates its effectiveness. The exact composition and features of the LCR and eligible assets will be determined by the European Banking Authority (EBA) after a review period ending in This would allow for other assets, such as gold, to be included. Secondly, Basel III s long-term Net Stable Funding Ratio (NSFR), which should enable a bank to withstand a one-year period of stress, is absent from the Commission s proposals. In this respect the Regulation only notes that the EBA will evaluate the precise form of a stable funding requirement, leaving it to banks to report the assets they hold to meet this requirement. The Commission will use the observation period until 2018 to prepare a legislative proposal. A political observation can be made about CRD IV: the lack of reliance on external credit assessments. Indeed, the vast majority of the Regulation prescribes how banking institutions should develop their own models to calculate their exposures in their portfolios, and this forms the basis for determining their minimum capital requirements. The role and activities of Credit Rating Agencies (CRAs), as we know, will be further addressed by legislation in autumn of this year, but today s proposals already encourage banks to carry out their own analysis of risk, rather than relying automatically on external ratings. The Regulation also introduces supervisory checks for leverage, with a view to reconsidering the introduction of a binding leverage ratio in Banks will need to report their leverage to the 4 P a g e

5 competent authorities, but no specific limits are set. Mark Hoban, the UK Financial Secretary to the Treasury considers this indebtedness rule vital. Disclosure is essential to improve transparency and therefore market discipline on potentially reckless firms, he said. Othmar Karas MEP made similar remarks last year in October, when the European Parliament unanimously adopted his report on CRD IV. We must remember that the financial and economic crisis was in its origins not a crisis of equity, but very much a liquidity crisis", underlined Karas. Then there is the question of interplay with other EU legislation, notably the European Markets Infrastructure Regulation (EMIR) dealing with over-the-counter (OTC) derivatives and trade repositories. Under Basel III, banks exposures to non-cleared derivatives are assigned a higher risk weight, and thus higher costs. In line with this and with EMIR, the CRD IV package encourages banks to move onto centralised clearing for their derivatives. Today s package will follow the timelines as agreed by the Basel Committee, with entry into force foreseen on 1 January 2013 and full implementation on 1 January This puts considerable international pressure on the European Parliament and Council of Ministers when negotiating their respective positions on the proposals, and means that the EBA will need to start working on the many draft standards and implementing measures for the European Commission. No doubt that Council and Parliament are preparing the grounds for battle after the summer break. Tim Gieles Senior Associate Cicero Brussels 5 P a g e

6 Timelines and transitional arrangements The CRD IV package follows the timelines as agreed by the Basel Committee, with entry into force foreseen on 1 January 2013 and full implementation on 1 January The specific transitional arrangements as foreseen under Basel III and CRD IV are as follows: Minimum common equity Capital conservation buffer Minimum Tier 1 capital Minimum total capital Minimum total capital plus conservation buffer Leverage ratio 30 day LCR 1 year NSFR Supervisory monitoring Observation period begins Observation period begins 3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5% 0.625% 1.25% 1.875% 2.5% 4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.625% 9.25% 9.875% 10.5% Disclosure starts Introduce minimum standard Introduce minimum standard 6 P a g e

7 PART ONE GENERAL PROVISIONS 1.1 Subject matter, scope and definitions This Regulation lays down rules concerning prudential requirements that institutions supervised under Directive XXX shall meet. Scope and definitions Article 1,2,4 Institutions must register and document all their transactions, systems and processes in a way that the competent authorities may verify compliance with the requirement of this Regulation at all times. Individual Member States may extend the scope of application of this Regulation to financial institutions that are authorised and supervised as credit institutions under national law. Application of stricter requirements by institutions Article 3 Member States may maintain or introduce national provisions in areas where the Regulation does not provide for harmonised rules as long as they do not contradict or undermine EU rules. The liquidity requirements set out in this Regulation shall not have any binding effect before their application where Member States maintain or introduce national provisions on liquidity. National competent authorities must notify the EBA of national measures adopted and will publish these notifications on its website. It will also annually report to the Commission. 1.2 Level of application of requirements Application of requirements on an individual basis General Principles Article 5 Institutions shall comply with the minimum capital requirements, capital buffers, large exposure regime and exposures to transferred credit risk. Credit institutions shall comply with the liquidity coverage and reporting requirements obligations on an individual basis. Derogation to the application of prudential requirements on an individual basis Article 6 Member States may chose not to apply to any subsidiary of an institution, where both the subsidiary and the actual institution are subject to authorisation and supervision by the same Member State. Member States may exercise the option provided for in paragraph 1 where the parent undertaking is a financial holding company or mixed financial holding company set up in the same Member State as the institution. Derogation to the application of liquidity requirement on an individual basis Article 7 The competent authorities may waive the obligations on the liquidity coverage and reporting requirements to a parent institution and its subsidiaries in the EU and supervise them as a single liquidity sub-group as long as they fulfil the set conditions. Individual consolidation method Article 8 The competent authorities may decide on a case-by-case basis to allow parent institutions to calculate their capital requirements, buffers, credit risk, and large exposure regimes on an individual consolidated basis, provided it can demonstrate that it can promptly transfer own funds. 7 P a g e

8 Waiver for credit institutions permanently affiliated to a central body Article 9 One or more credit institutions in a Member State may be exempted by competent authorities from the capital requirements, buffers, credit risk, and large exposure regimes, if they belong to a central body that is subject to the same requirements. Prudential consolidation Application of requirements on a consolidated basis Article Parent institutions in a Member State shall comply, to the extent and in the manner prescribed in Article 16, with the obligations laid down in Parts Two to Five on the basis of their consolidated financial situation. EU parent institutions shall comply with the obligations on disclosure by institutions on the basis of their consolidated financial situation. Parent undertakings and subsidiaries subject to this Regulation shall meet the obligations Subsidiaries not subject to this Regulation must implement arrangement, processes and mechanisms to ensure compliance with those provisions. Derogation to the application of own funds requirements on a consolidated basis for groups of investment firms Article 14 Competent authorities exercising supervision of groups may waive, on a case-by-case basis, the application of own funds requirements on a consolidated basis, if certain requirements are met. Where these criteria are met, each EU investment firm shall have in place systems to monitor and control the sources of capital and funding of all financial holding companies, investment firms, financial institutions, asset management companies and ancillary services undertakings within the group. Supervision in case of a derogation Article 15 Investment firms in a group which has been granted the waiver provided for in Article 14 need to notify the competent authorities of the risks which could undermine their financial positions, including those associated with the composition and sources of their capital funding. Supervision will be conducted on a consolidated basis, with the parent undertaking carrying out full consolidation of all its subsidiary institutions and financial institutions. Methods for Prudential Consolidation Article 16 Competent authorities may on a case-by-case basis require only proportional consolidation. Where liquidity requirements apply on a consolidated basis, full consolidation of assets, liabilities and off-balance sheet items of those institutions and their subsidiary institutions and financial institutions applies. The EBA shall develop draft implementing technical standards on consolidation for submission to the Commission by 31 December Scope of Prudential Consolidation Article 17, 18 Competent authorities may exclude certain institutions from consolidation, for example, if the undertaking concerned is situated in a third country where there are legal impediments to the transfer of the necessary information. Joint decisions on the level of application of liquidity requirements Undertakings in third-countries Article 19, 20 The consolidating supervisor responsible for the supervision of subsidiaries of an EU parent institution or an EU financial holding company in a Member State shall do everything within their power to reach a joint decision identifying a single liquidity sub-group. The decision shall be reached within six months after submission by the consolidating supervisor of a report identifying single liquidity sub-groups. The terms investment firm, credit institution, financial institution, and institution shall also apply to undertakings established in third countries, which if established in the EU would fulfil the same definitions. 8 P a g e

9 PART TWO OWN FUNDS 2.1 Definitions specific to own funds Additional Tier 1 capital Other capital instruments Includes Additional Tier 1 items after: - deduction of the items referred to in OF Article 8; and - application of any temporary waiver from deduction from Additional Tier 1 under OF Article 15 Capital instruments issued by relevant entities that do not qualify as Common Equity Tier 1, Additional Tier 1 or Tier 2 instruments Own funds The sum of Tier 1 capital and Tier 2 capital Significant investment Article 22 Any of the following: - Ownership of the Common Equity Tier 1 instruments of a relevant entity which exceeds 10% of the Common Equity Tier 1 instruments issued by that entity; - A participation within the meaning of the first sentence of Article 17 of Directive 78/660/EEC in an insurance undertaking, reinsurance undertaking or a financial undertaking; - Ownership of the Common Equity Tier 1 instruments issued by an entity that is not included in consolidation pursuant to Chapter 2 of Title II of Part One but is included in the same accounting consolidation as the institution for the purposes of financial reporting under the applicable accounting standards Tier 2 capital Means Tier 2 items after: - Deduction of the items referred to in OF Article 11(1); and - Application of any temporary waiver from deduction from tier 2 capital under OF Article General requirements Common Equity Tier 1 items Article 24 Common Equity Tier 1 items of institutions shall consists of the following: - instruments, provided the conditions set out in OF Article 2 are met; - under certain conditions, certain share premium accounts; - retained earnings; - accumulated other comprehensive income; - other reserves; and - funds for general banking risk The EBA will specify draft regulatory technical standards to the Commission by 1 January 2013 dealing with mutuals or cooperatives. The EBA will establish, maintain and publish a list of the forms of capital instruments in each Member State that qualify as Common Equity Tier 1 instruments. This list will also be published by 1 January Common Equity Tier 1 instruments Article Instruments shall qualify as Common Equity Tier 1 items only if they meet the conditions set by the Regulation. Capital instruments issued by mutuals, cooperative instruments, cooperative societies and similar institutions shall qualify as Common Equity 9 P a g e

10 Tier 1 instruments only if the conditions laid down in Article 26 and this Article are met. If the conditions laid down in Article 26, and Article 27 cease to be met the Common Equity Tier 1 instrument will cease to qualify as such and the share premium accounts relating to that instrument shall cease to qualify as Common Equity Tier 1 items. Prudential Filters Securitised assets Article 29 Institutions must exclude from any element of own funds any increase in its equity under the applicable accounting standard that results from securitised assets, including increases associated with future margin income that results in a gain or sale for the institution. Cash flow hedges and changes in value of own liabilities Article 30 Fair value reserves related to gains or losses on cash flow hedges of financial instruments that are not valued at fair value, including projected cash flows and gains or losses on liabilities of the institution that are valued at fair value shall not be included in any element of own funds by institutions. Additional value adjustments Article 31,32 Institutions are required to apply the provisions of Article 100 to all their assets measured at fair value when calculating the amount of their own funds and shall deduct from Common Equity Tier 1 capital the amount of any additional value adjustments necessary. Institutions must generally not make adjustments to remove from their own funds unrealized gains or losses on their assets or liabilities measured at fair value. Deductions from the Common Equity Tier 1 items Article Institutions shall make certain deductions from Common Equity Tier 1 items, including losses for the current financial year, intangible assets and deferred tax assets that rely on future profitability. Certain deductions shall be exempted or added additional risk weights. Tier 2 items Article 59 Tier 2 instruments Article 60 Tier 2 items shall consist of the following: - Instruments, including subordinated loans, where the conditions set out in OF Article 10 are met; - The share premium accounts related to the instruments referred to in point (a) that were issued from 31 December 2010; - For institutions calculating risk-weighted exposure amounts in accordance with Chapter 2 of Title II general credit risk adjustments, gross of tax effects, up to 1.25% of risk-weighted exposure amounts calculated in accordance with Chapter 2 of Title II of Part Three; and - For institutions calculating risk-weighted exposure amounts under Chapter 3 of Title II, positive amounts, gross of tax effects, resulting from the calculation. To calculate the amount of Tier 2 capital, institutions shall deduct any tax charge foreseeable at the moment of the calculation or shall suitably adjust that amount insofar as such tax charges reduce the amount up to which theses items may be applied to cover risks or losses. Instruments qualify as Tier 2 instruments if certain conditions are met, including that they are issued and fully paid up; that they are not purchased by the institution or its subsidiaries or that the purchase of the instruments is not funded directly or indirectly by the institution at issuance or thereafter. Deductions for Tier 2 holdings Article Certain items will be deducted from Tier 2 items. These include direct and indirect holdings by an institution of own Tier 2 instruments, and holdings of the Tier 2 instruments of relevant entities with which the institution has reciprocal cross holdings that the competent authority considers to have been designed to inflate artificially the own funds of the institution. 10 P a g e

11 Indirect holdings arising from index holdings Article 71 As an alternative to the look through approach, an institution may use a conservative estimate of the underlying exposure of the institution to the CET Tier 1, Additional Tier 1 and Tier 2 instruments that are included in the indices. Conditions for reducing own funds Article 72,73 This article applies where an institution takes any of the following actions: - the reduction or repurchase of CET 1 instruments issued by the institution in a manner that is permitted under applicable national law; - the call, redemption or repurchase of Additional Tier 1 instruments or Tier 2 instruments prior to the date of their contractual maturity. Temporary waiver from deduction from own funds Article 74 The competent authority may temporarily waive the provision on deduction referred to in this Title, if an institution temporarily holds ordinary shares or shares that qualify as Additional Tier 1 or Tier 2 instruments in a relevant entity for financial assistance purposes operation to save that entity. Continuing review of quality of own funds Article 75 The EBA will continuously monitor the quality of CET 1, Additional Tier 1 and Tier 2 instruments issued by institutions. The EBA will make recommendations to the Commission by 31 December 2013 on possible enhancements to facilitate greater convergence in the prudential treatment of own funds. These recommendations will take into account relevant development in international accounting standards and the work of the FSB and BCBS. 2.3 Minority interest and Additional Tier 1 and Tier 2 instruments issued by subsidiaries Minority interests that qualify for inclusion in consolidated Common Equity Tier 1 capital Articles Minority interests can comprise Common Equity Tier 1 instruments of a subsidiary where prescribed conditions are met. Additional Tier 1 and Tier 2 instruments issued by special purpose entity, and the related retained earnings and share premium accounts are included in qualifying Additional Tier 1, Tier 1 or Tier 2 capital or qualifying own funds as applicable. Qualifying Tier 1 /Tier 2 items included in consolidated capital Articles Institutions are required to determine the amount of qualifying Tier 1 capital of a subsidiary that is included in consolidated Tier 1 capital by subtracting from the qualifying Tier 1 capital of that undertaking the result of multiplying the amount referred to in the Article. Institutions are required to determine the amount of qualifying own funds of a subsidiary that is included in consolidated Tier 2 capital by subtracting from the qualifying own funds of that undertaking that are included in consolidated own funds the qualifying Tier 1 capital of that undertaking that is included in consolidated Tier 1 capital. 2.4 Qualifying holdings outside the financial sector General Treatment Article 84, 85 An institution must apply a risk weight of 1250% to a qualifying holding, the amount of which exceeds 15% of its eligible capital, in an undertaking which is not a relevant entity. An institution shall apply a risk weight of 1250% to the total amount of its 11 P a g e

12 qualifying holdings in undertakings that are not relevant entities. Member States may apply standards that are stricter than those set out in the previous two points. The EBA will develop draft regulatory technical standards to ensure a consistent application by 1 January As an alternative to applying a 1250% risk weight to the amounts in excess of the limits set out in paragraphs 1 and 2, institutions may deduct those amounts. Exceptions to the general treatment Article 86 Shares will not be included in calculating the eligible capital limits specified under general treatment if at least one of the following conditions is met: - Those shares are held temporarily during a financial reconstruction or rescue operation; - The holding of the shares is an underwriting position held for 5 working days or fewer; - Those shares are held in an institution s own name on behalf of others. Shares which are not financial fixed assets shall not be included in the calculation specified. 12 P a g e

13 PART THREE MINIMUM CAPITAL REQUIREMENTS 3.1 General requirements, valuation and reporting Minimum level of own funds Minimum capital requirements Calculation of capital ratios Calculation of total risk exposure amounts Article Institutions should at all times hold at least: - a Common Equity Tier 1 capital ratio of 4.5% - a Tier 1 capital ratio of 6%, and - a total capital ratio of 8% These capital ratios shall be calculated as a percentage of the total risk exposure amount. The total risk exposure amount is calculated as the sum of - the risk weighted exposure amount for credit risk, - the risk weighted exposure for counterparty risk, and the sum of the own funds requirements for: - the trading book business for position risk and large exposures exceeding the set limits; - foreign-exchange risk, settlement risk, and commodities risk - credit valuation adjustment risk of OTC derivatives; and - operational risk; These own funds requirements should be calculated in accordance with the methodologies provided in this Regulation. The Regulation provides an alternative calculation of the total risk exposure amount for certain non-authorized investment firms. Calculation and reporting requirements Valuation and reporting Article Assets and off-balance sheet items shall be valued in accordance with the accounting framework applicable to the institution conform the Regulation on the application of international accounting standards (Regulation EC/1606/2002) and the Directive on annual and consolidated accounts of banks and financial institutions (Directive 86/635/EEC). EBA shall develop technical standards before 1 January 2013 to ensure uniform reporting to authorities. These uniform reporting standards shall apply from 30 June Trading book Positions in the trading book must be either free of any restrictive covenants on their tradability or able to be hedged. Requirements for the Trading Book Article Institutions may include internal hedges in the calculation of capital requirement for position risk provided that they are held with trading intent. Institutions shall mark their positions to market whenever possible, including when applying trading book capital treatment. 13 P a g e

14 3.2 Minimum capital requirements for credit risk General principles Approaches to credit risk Article 102, 103 To calculate credit risk, institutions can either use the Standardised Approach, or the Internal Risk Based Approach, but without using its own estimates of loss given default (LGD) and conversion factors for the calculation of risk weighted exposures. Treatment of securitized exposures Article 104 An institution shall use the standardized approach to calculate the riskweighted exposure of securitized exposures. If an institution is given permission to do so by the competent authorities, it may use the internal assessment approach. General credit risk Institutions shall treat general credit risk adjustments either using the Standardised Approach or using the Internal Risk Based Approach. Modification of exposures due to unrealized gains/losses Article 105 The EBA shall develop technical standards by 1 January 2013 specifying the calculation of general and specific credit risk adjustments, focusing in particular on exposure values. The exposure value of an asset may be reduced or increased in accordance with unrealised gains or losses. Standardised approach Exposure value The exposure value of an asset item shall be its accounting value remaining after specific credit risk adjustments have been applied. Calculation of riskweighted exposure amounts Exemption for intragroup exposures Article The exposure value of derivatives shall be determined in accordance with Chapter 6 (Counterparty Credit Risk). Except for exposures giving rise to liabilities in the form of Common Equity Tier 1, Additional Tier 1 or Tier 2 items, institutions may subject to conditions and with permission of the competent authorities exclude certain intra-group exposures and counterparties from applying risk weights. Risk weights of exposures Securitised positions Short-term credit assessments Article , 125, 126, 128, 129 Depending on their source, form, and eventual corresponding external credit assessments, various risk weights are assigned to an institution s exposures. Risk weighted exposure amounts for securitization positions shall be determined in accordance with Chapter 5 (securitisation). Exposures to institutions and corporates with a short-term credit assessment are assigned a risk weight between 20 and 150 per cent, depending on their external credit assessment. Depending on their asset of collateralization, covered bonds are eligible for a preferential treatment Exposures in the form of covered bonds Article 124 The preferential treatment implies that these covered bonds are assigned a risk weight ranging between 10% and 100%, which is determined on the basis of the risk weight assigned to senior unsecured exposures of the issuing institution. Covered bonds issued before 31 December 2007 do not need to be collateralized and are eligible for the preferential treatment until their maturity. 14 P a g e

15 Exposures in the form of shares in collective investment undertakings Article 127 Exposures in the form of shares in collective investment undertakings (CIUs) are in principle assigned a risk weight of 100%, unless the institution applies the credit risk assessment method, the look-through approach, or the average risk weight approach. An external credit assessment may only be used to determine the risk weight of an exposure if it has been issued by an ECAI or endorsed by an ECAI. Recognition of external credit assessment institutions (ECAIs) Article 130, 131 ECAIs are all credit rating agencies that are registered or certified in accordance with Regulation (EC) No 1060/2009, and central banks whose credit ratings have been recognized by the EBA. The EBA shall ensure that the methodology of credit assessments by ECAIs is free from political and economic influences, and that access to these assessments is available to all. When certifying an ECAI, the EBA shall also determine with which of the six possible credit quality steps should be associated. The EBA shall submit draft implementing technical standards by 1 January 2014 to ensure uniform application of the certification criteria. Use of credit assessments by Export Credit Agencies Article 132 Upon request of an Export Credit Agency (ECA), the EBA shall decide to recognize its credit assessments if either of the following conditions is met: - it is a consensus risk score from ECAs participating in the OECD Arrangement on Guidelines for Officially Supported Export Credits ; or - the ECA publishes its credit assessments, subscribes to the OECD agreed methodology, and the credit assessment is associated with one of the eight minimum export insurance premiums (MEIP) established by the OECD methodology. Using ECAIs for determining risk weights. Article Subject to requirements, institutions may opt to use eligible ECAIs to determine risk weights assigned to asset and off-balance sheet items. Institutions may only use solicited credit assessments, unless the EBA has permitted unsolicited assessments as part of its recognition process. Short-term credit assessments may only be used for short-term asset and off-balance sheet items constituting exposures to institutions and corporates. Internal rating based (IRB) approach Institutions shall be permitted to calculate their risk weighted exposures using the Internal Ratings Based (IRB) Approach, but requires permission from the competent authorities for each rating system, and internal models approach to equity exposures. Conditions for permission to use the IRB Approach Article Permission will only be given if the competent authorities are confident in the integrity of the process and if: - the system provides accurate and consistent quantitative estimates of risk; - internal ratings play an essential role in the risk management strategy; - all data is collected and stored; - the internal ratings system is subject to internal checks; and - the ratings system is able to submit reporting under the IRB approach, and must have been using the IRB Approach for at least six years prior to application. An institution applying for permission to use of the IRB Approach or for the use of own estimates of Loss Given Defaults (LGDs) must demonstrate that for the previous three years it has been using rating systems that are 15 P a g e

16 broadly equivalent to the minimum requirements for the IRB Approach, or has been using broadly equivalent estimates of LGDs. Exposure typology Article Treatment by type of exposure Article The implementing technical standards to assess the suitability of an institution s rating systems will be developed by the EBA by 31 December The assigning of exposures to different exposure classes will be consistent over time, and must fall within one of the following categories: - claims or contingent claims on central, regional or local governments, or on central or multilateral banks and international organisations; - claims or contingent claims on institutions; - claims or contingent claims on corporates; - retail claims or contingent retail claims; - equity claims, securitization positions, or other non credit-obligation assets. Implementation must be carried out within a reasonable amount of time, to be determined by the competent authorities. When an underlying collective investment undertaking (CIU) is itself another exposure in the form of share in another CIU then the risk weighting will look through the underlying exposure of the latter CIU. When institutions do not meet the conditions set out, then exposure amounts will be calculated using the risk-weight approach for equity, and the standardized approach set out in Chapter 2 for other forms with the exception that the risk weight shall be multiplied by a factor of 2 (to a maximum of 1250%) for exposures subject to specific risk weight for unrated exposures. For all other exposures the risk weight is multiplied by a factor of 1.1, with a 5% minimum. In calculating the risk weighted exposure amounts for credit risk the EBA will determine by 1 January 2014 which third countries also meet the EU requirements. The Commission is granted powers to adopt implementing technical standards to detail how institutions take into account the following factors in risk weighting: - financial strength; - political and legal environment; - transactions and/or asset characteristics; - strength of the sponsor and developer; and - security package. Calculation of various risk weighted exposure amounts Article The Regulation applies various formulae for the calculation of risk weighted exposure amounts for: - retail exposures; - equity exposures; - other non credit obligation assets; - dilution risk of purchased corporate and retail receivables Expected Loss Amounts Article 154, 155 The calculation of expected loss amounts shall be based on the same input figures for PD, LGD and the exposure value per exposure as those that are used to calculate the exposure amounts for various risk weighted exposures. The expected loss amount shall be subtracted from the general and specific credit risk adjustment related to these exposures. Exposures to corporates, institutions and central Article The probability of default (PD) of an exposure to corporate institutions shall be at least 0.03%. The PD of obligors in default will be 100%. Institutions can take into account unfunded credit protection in the PD (see Chapter 4). Qualifying short-term exposures are defined as: 16 P a g e

17 governments and central banks - exposures to institutions arising from settlements of foreign exchange; - self-liquidating short-term trade financing transactions, import and export letters of credit; - settlement of securities purchases; - cash settlements by wire transfer and electronic payments; The Commission can adopt implementing technical standards to specify or complete the above list. For equity exposures, the following minimum PDs shall apply: % for exchange traded equity exposures where the investment is part of a long-term customer relationship, where the returns on the investment are based on regular and periodic cash flows; - 0.4% for exchange traded equity exposures including other short positions; and % for all other equity exposures. Exposure value shall be the accounting value measures without taking into account any credit risk adjustments made. Exposure value Equity exposures Other non creditobligation assets Article For purchased assets, the difference between the amount owed and the accounting value remaining after applying credit risk adjustments is denoted discount if the amount owed is larger, and premium if is smaller. For all off balance sheet items not listed in the text the exposure value shall be: - 100% if it is a full risk item; - 50% if it is a medium risk item; - 20% if it is a medium/low risk item; - 0% if it is a low-risk item. The exposure value of equity exposures and other non-credit obligation assets will be calculated as the accounting value remaining after specific credit risk adjustments have been applied. Institutions using multiple ratings system will have to provide a rationale for this. Assignment criteria and processes will be reviewed periodically. Minimum requirements for the IRB Approach Ratings systems Article 165 The structure of ratings systems shall: - Take into account obligor and transaction risk; - Have an obligor rating scale which reflects exclusively quantifications of the risk of obligor default; - Market concentration will necessitate a range of obligor grades to avoid undue concentration; - A distinct facility rating scale is needed for own funds requirement calculations; and - Significant concentrations within one facility grade will need to be supported with substantial evidence. Structure of rating systems Assignment to grades or pools Assignment of exposures Article The structure of rating systems will need to meet certain requirements to be eligible, both for corporate, government and central bank exposures, and for retail exposures. Specific, detailed and consistent processes need to be in place to assign exposures to particular grades or pools, and review and reporting procedures need to be in place to ensure the integrity of the assignments. Each exposure (corporate, government, central bank and retail) shall be assigned to a grade or pool in accordance with the relevant criteria per exposure. Use of models Documentation Article If an institution uses statistical or similar methods to assign exposures to obligors or facilities grades or pools, it shall meet requirements to ensure that the methodology used is not distorting capital requirements, and that data is adequately tested. 17 P a g e

18 The design, use and methodologies shall be documented. Institutions shall collect and store data on the use of their internal rating systems. Stress testing of capital adequacy Article 173 An institution shall have in place and regularly perform sound stress testing processes for use in the assessment of its capital adequacy. Stress testing shall involve identifying possible events that could have unfavourable effects on credit exposures and the institution's ability to withstand such changes. Default of an obligor Article 174 A default shall be considered to have occurred with regard to a particular obligor when either or both of the following has taken place: - the institution considers that the obligor is unlikely to pay its credit obligations to the institution, the parent undertaking or any of its subsidiaries in full, without recourse by the institution to actions such as realising security (if held); - the obligor is past due more than 90 days on any material credit obligation to the institution, the parent undertaking or any of its subsidiaries. The exposure past due shall be above a threshold set by the competent authorities. The EBA shall develop guidelines on the definition of default. Institutions shall meet the set requirements for quantifying the risk parameters associated with rating grades or pools. Requirements for PD and LGD estimates Article This includes that own estimates of the risk parameters for PD, LGS, conversion factor and EL are complete and include all data, information and methods. Institutions shall use PD estimation techniques only with supporting analysis. Own-LGD estimates shall meet the set criteria. The EBA shall develop draft technical standards for submission to the European Commission by 31 December 2013 for estimating PDs and by 31 December 2014 on the assessment of the methodology for estimating LGDs. Requirements for own-conversion factor estimates Article 178 Institutions shall use conversion factor estimates that are appropriate for an economic downturn if those are more conservative than the long-run average. The EBA shall develop draft technical standards for submission to the European Commission by 31 December 2014 on the assessment of the methodology for estimating conversion factors. Institutions shall have clearly specified criteria for the types of guarantors they recognise for the calculation of risk weighted exposure amounts. Minimum requirements for assessing the effect of guarantees and credit derivatives Article 179 The criteria shall be plausible and intuitive, addressing the guarantor's ability and willingness to perform under the guarantee, its likely timing, the degree of correlation with the obligor's ability to repay, and the extent to which risk to the obligor remains. These minimum requirements shall also apply to single-name credit derivatives. The EBA shall develop draft technical standards for submission to the European Commission by 31 December 2014 on the conditions according to which competent authorities may grant guarantees. 18 P a g e

19 Minimum requirements for purchases Article 180 In quantifying the risk parameters to be associated with rating grades or pools for purchased receivables, institutions shall comply with the requirements of legal certainty, effectiveness of monitoring systems, effectiveness of work-out systems and controlling collateral, and the requirements relation to credit availability and cash. Institutions shall also have adequate internal policies and procedures. Validation of internal estimates Article 181 Institutions shall have robust systems in place to validate the accuracy and consistency of rating systems, processes, and the estimation of all relevant risk parameters. Institutions shall also use other quantitative validation tools and comparisons with relevant external data sources. The analysis shall be based on data appropriate to the portfolio, regularly updated, and cover a relevant observation period. Institutions' internal assessments of the performance of their rating systems shall be based on as long a period as possible. The methods and data used for quantitative validation shall be consistent. Calculation of risk weighted exposure amounts for equity exposures under the internal models approach Article 182 For calculating capital requirement institutions shall meet the prescribed requirements. The requirements state that estimates of potential losses shall be robust to adverse market movements. Additionally models used shall be able to capture all material risks embodied in equity returns including both the general market risk and specific risk exposure of the institution s equity portfolio, and be appropriate for the risk profile and complexity of the portfolio. The requirements also impose rigorous and comprehensive stress-testing programmes. Risk management process and controls Article 183, 184 Institutions shall establish policies, procedures and controls to ensure the integrity of the modeling process, which are fully integrated in the overall management information systems and are subject to periodic and independent review. There shall also be systems and procedures for monitoring investment limits and risk exposures of equity exposures. Units responsible for modelling shall be independent and adequately qualified. All material elements of the internal models and the modelling process and validation shall be documented. Corporate governance Article 185 All material aspects of the rating and estimation processes shall be approved by the institution s management body or designated committee. Senior management shall provide notice to the body or committee of changes that will impact the operations of ratings systems. IRB analysis of credit risk shall be an essential part of the management reporting to those parties. Credit risk control Internal audit Article 186, 187 Credit risk control units shall be independent from the personnel and management functions responsible for originating or renewing exposures. They shall also be responsible for the design or selection, implementation, oversight and performance of ratings systems. Internal audit or comparable independent auditing unit shall review at least once a year an institution s rating systems and its operations. 19 P a g e

20 Credit risk mitigation No exposure shall produce a higher risk-weighted amount or expected loss amount than an identical exposure where there is no credit risk mitigation. Cash, securities or commodities purchased, borrowed or received subject to a repurchase agreement or securities or commodities lending or borrowing transaction are treated as collateral. Principles for recognising the effect and eligibility of credit risk mitigation techniques Article Where there are multiple forms of credit risk mitigation there will be a requirement to subdivide the exposure into parts covered by each tool and the risk-weighted exposure shall be calculated separately. For funded credit protection, assets shall be sufficiently liquid and their value sufficient stable to provide certainty as to protection achieved in regard to the approach used to calculate risk-weighted exposure amounts. An institution shall have the right to liquidate or retain the assets from which the protection derives in the event of default, insolvency or bankruptcy of the obligor. For unfunded credit protection, the undertaking party shall be sufficiently reliable, and the agreement legally effective and enforceable, to provide certainty as to the credit protection achieved. Institutions shall be able to show that it has adequate risk management processes to control the risks exposed to as a result of credit mitigation techniques. Funded credit protection Eligible forms of credit risk mitigation Netting Article 191, 192, 196 Institutions may use on-balance sheet netting of mutual claims between the institution and its counterparty as eligible form of credit risk mitigation. For institutions adopting the Financial Collateral Comprehensive Method under Article 218, the effects of bilateral netting contracts covering capital market-driven transactions may be taken into account. Institutions may use the following other funded credit protection: - cash or equivalent held by a third party and pledged to the lending institution; - life insurance policies pledged to the institution; - instruments issued by third party institutions which will be repurchased by that institution on request. Eligibility of collateral under all approaches and methods Article 193 The following items may be used as eligible collateral under all approaches and methods: - cash; - debt securities issued by governments or central banks; - debt securities issued by institutions with a credit assessment by an eligible ECAI; - debt securities issued by other entities with a credit assessment by an eligible ECAI; - debt securities with a short-term credit assessment from an eligible ECAI; - equities or convertible bonds; - gold; and - securitisation positions that are not re-securitisation positions, which have an external credit assessment by an eligible ECAI. Debt securities issued that do not have a credit assessment from an eligible ECAI may be used as collateral if they fulfil the set criteria. Shares in collective investment undertakings may be used as eligible criteria if they fulfil the set conditions. 20 P a g e

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