2 Credit institutions and investment firms
| (25852)
11545/04
+ ADDs 1-3
COM(04)486
| Draft Directives recasting Directive 2000/12/EC relating to the taking up and pursuit of the business of credit institutions and recasting Directive 93/6/EEC on the capital adequacy of investment firms and credit institutions
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| Legal base | Article 47(2) EC; co-decision; QMV
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| Document originated | 14 July 2004
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| Deposited in Parliament | 23 July 2004
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| Department | HM Treasury |
| Basis of consideration | EM of 29 September 2004
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| Previous Committee Report | None
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| To be discussed in Council | Not known
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| Committee's assessment | Politically important
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| Committee's decision | For debate in European Standing Committee B
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Background
2.1 Existing Community requirements relating to the taking up
and pursuit of the business of credit institutions and to the
capital adequacy of investment firms and credit institutions are
based on a 1988 agreement (referred to as the Basel Accord or
Basel I) of the G-10 Basel Committee on Banking Supervision[5]
for the prudential supervision of internationally active banks.
This agreement led to harmonisation of requirements for internationally
active banks to hold capital to protect deposit holders against
the potential risk of borrowers defaulting (credit risk requirements),
and with a subsequent amendment, to the introduction of additional
capital requirements for market risk (the risk associated with
changes in market values of traded assets and liabilities). The
Basel Accord has been adopted in over 100 countries. Community
implementation of the Basel Accord extended the scope of application
beyond internationally active banks to cover all credit institutions
and investment firms so as to give a level playing field to firms
operating in the same market.
2.2 The Commission says the present rules have made
a significant contribution to the single market and to the creation
of high standards of prudential supervision. However, work at
international and Community level has identified a number of shortcomings.
In particular, current requirements provide only a limited differentiation
between borrowers' different default risks and an incomplete coverage
of different risk types — for instance operational risk[6]
is not covered. The Basel Committee and the Commission also feel
that requirements have not kept pace with developments in financial
markets. They have failed to prevent firms from arbitraging risks,
which has effectively allowed them artificially to distort their
capital requirements. They have also failed to recognise work
by financial institutions on developing "economic capital"
models which provide a better alignment of capital to actual risk.
2.3 During the last six years the Basel Committee
has worked to produce a new Basel Accord (Basel II, published
in June 2004). There may be some further amendment before it is
implemented, for example to take account of current work on regulatory
capital for trading book exposures. The new agreement is built
on three interlocking pillars — minimum capital requirements,
supervisory review and market discipline/disclosure. The first
pillar is designed to provide financial institutions with a framework
for the calculation of minimum regulatory capital requirements.
These consist of elements to cover credit and market risk (the
latter would be unchanged from the current Accord) and a new specific
capital requirement for operational risk. The second pillar provides
firms and supervisors with the opportunity to review the risk
management process. It introduces a process of supervisory review,
which is intended to ensure not only that banks have adequate
capital, but also that they have appropriate systems in place
to provide good monitoring and management of all their risks.
The third pillar is designed to allow for comparisons to be made
by other market participants and to encourage market discipline
by developing a set of disclosure requirements that would allow
risk exposures, risk assessment processes and hence capital adequacy
to be compared across institutions.
2.4 The new accord has been designed to ensure that
there is no overall change to the minimum capital within the system
compared with the current requirements. Individual institutions
may however experience increases or decreases in their own regulatory
capital requirements depending on their business mix and on the
degree of sophistication they adopt.
The document
2.5 The Commission presents two draft Directives
recasting[7] the existing
legislation applying Basel I, that is Directive 2000/12/EC relating
to the taking up and pursuit of the business of credit institutions
and Directive 93/6/EEC on the capital adequacy of investment firms
and credit institutions.
2.6 In addition to taking account of Basel II, the
Commission's proposal deals with matters specific to the Community,
such as the treatment of investment firms in relation to capital
requirements and adjustments to the Basel requirements it considers
appropriate, such as the treatment of venture capital and the
operational risk requirements for some categories of investment
firms.
2.7 The re-casting is also designed to introduce
more flexibility into the legislative framework, to ensure that
it can continue to keep pace with developments both in Basel and
within Community markets, through amendments under comitology
procedures.[8]
The Government's view
2.8 The Financial Secretary to the Treasury (Mr Stephen
Timms) says:
"The UK Government is broadly supportive of
the Commission's proposals, as they will allow the new Basel framework
to be implemented within the EU. The proposals will deliver improvements
in risk management by European credit institutions. Evidence suggests
that this will reduce the likelihood and impact of a major banking
collapse, which would be harmful to the European economy. The
Directives will also lead to a more efficient allocation of regulatory
capital within the EU, with capital requirements becoming more
proportionate to the underlying risks associated with the borrower,
rather than the more arbitrary allocations required by the current
rules.
"While for some business lines and therefore
institutions this will inevitably lead to a rise in the amount
of capital that they are required to hold, capital requirements
for lending to retail customers and Small and Medium-sized Enterprises
should fall. Some of this reduction is expected to feed through
into lower costs for raising credit.
"It is however important to ensure that the
requirements within the EU take into consideration the specificities
of European markets and the wider scope of application, as the
requirements will apply to all credit institutions and investment
firms, as well as some commodities and energy dealers.
"The Directives will also increase [the] flexibility
of the existing legal framework, allowing for market developments
and improvements in risk management techniques to be more quickly
reflected in European law."
2.9 The Minister also gives us a detailed commentary
on the financial implications of the proposals:
"The work by PWC [PriceWaterhouseCoopers —
commissioned by the Commission] concluded that the proposals would
have, at worst a neutral, if not a slight positive impact on the
European economy. However within this there will be different
winners and losers.
"For credit institutions, as a whole, regulatory
capital requirements will fall by an average of 5 per cent —
for firms with a higher concentration of retail or SME lending
this fall is likely to be more significant — while for firms
with higher concentration of equity exposures, regulatory capital
requirements are likely to rise. The precise impact will depend
largely on the institution's business mix, and on the approaches
that it takes to the calculation of regulatory capital (credit,
market and operational risk), but additionally on the supervisory
review process carried out under Pillar 2.
"While regulatory capital requirements are likely
to fall for most UK credit institutions due to their high proportion
of retail lending, the precise impact on prices and availability
of credit will depend on the ability/desire for credit institutions
to adjust the actual level of capital (which in the UK is significantly
above regulatory minima) that they hold. The ability/desire to
adjust actual capital will depend on a number of factors —
including the reaction of ratings agencies to adjustments in capital,
future business plans of the credit institutions and the specific
competitive conditions in different product markets.
"It has been suggested that a move to more risk
sensitive capital requirements could increase the pro-cyclical
nature of the banking sector. If credit institutions use 'point
in time' ratings then capital requirements would rise as ratings
decline and fall as ratings rise. The Basel committee and Commission
have recognised these concerns and taken a number of steps to
reduce the potential impact — by requiring firms to carry
out stress test as part of their Pillar 2 requirements and hold
capital as a buffer against such a downturn, flattening the risk
weights under the more advanced approaches (to prevent large shifts
in regulatory capital requirements) and requiring firms to use
more forward looking or 'through the cycle' ratings.
"The report carried out by PWC concludes that:
'sufficient steps have been taken to mitigate the procyclicality
of the current proposals'. The Commission has however included
an article within their proposal, which requires a report to be
submitted on a biennial basis to assess the pro-cyclical impacts
of the proposals and to propose changes to the framework should
these be deemed necessary.
"For small investment firms (those requiring
either €50,000 or €125,000 initial capital) the regulatory
capital requirements should remain unchanged from those currently
required.
"For larger investment firms (those requiring
€730,000 initial capital) the impact will depend on what
form of activities the investment firm is engaged in —some
firms will be able to take advantage of a proposed limited licence
treatment that will limit the amount by which regulatory capital
requirements are expected to rise. The main driver for this expected
increase in regulatory capital requirements is the introduction
of the new operational risk requirement. Another key determinant
of the impact on investment firms will be the outcome of the Basel/International
Organisation of Securities Commissions (IOSCO) work on the treatment
of trading book positions. This work is still ongoing, but should
be completed before the proposals are implemented.
"For commodities and energy dealers caught by
the scope of the Markets in Financial Instruments Directive, the
regime could result in a significant increase in capital requirements.
These firms are currently outside the European prudential capital
regime, although they are subject to domestic requirements in
the UK. In order to comply with the new requirements, these firms
will have to invest a considerable amount of resources in systems
and raise significant additional capital resources as many of
the assets on their balance sheets are not deemed eligible under
the new requirements.
"More generally, for many firms the implementation
of the new requirements will result in significant transitional
costs as firms develop systems and recruit staff to manage the
risk management processes. They will also of course have additional
on-going costs associated with the maintenance and running of
these systems. It is however difficult to judge how much of the
costs associated with these new systems, both initial and on-going,
can be directly attributed to the new requirements and how much
would have been generated anyway.
"For borrowers and other end users the impact
of the proposals will depend on the response of credit institutions
to changes in regulatory capital requirements. According to the
results of the PWC study, the proposals are likely to be beneficial
to retail consumers and SMEs — the precise impact will however
depend on the extent to which credit institutions already price
on the basis of economic capital models."
2.10 The Minister tells us that both the Commission
and the Government have consulted widely on the proposals. The
document includes an extended impact assessment of its proposals
and the Minister gives us the Government's own Regulatory Impact
Assessment (RIA). This latter concludes:
"From the cost benefit analysis … it is
clear that the UK financial services sector stands to be a net
beneficiary as a result of the new requirements, although there
will be winners and losers. The average consumer and small firms
should be no worse off under the proposals than under the current
regime, and indeed it is likely that some of the reduced regulatory
capital requirements are likely to be passed on in the form of
lower pricing."
2.11 But the RIA also says there are concerns about
the impact of the proposal on those firms caught by the increased
scope of legislation within the Community, about the need to ensure
that smaller credit institutions, such as many of the UK's building
societies, are not placed at a competitive disadvantage and about
the phased implementation timetable, which is likely to lead to
inconsistencies in implementation during the transitional period.
So it notes that
"The UK therefore supports the re-cast Directives,
but understands the need to fine tune the proposals to reflect
the greater scope of EU application of the new Basel Accord and
also to reflect the specificities of the EU market."
Conclusion
2.12 Existing Community legislation on these matters
is important for the single market and for the assurance given
to both businesses and customers by ensuring proper prudential
supervision. The draft Directives in this document would update
and improve that legislation in line with revised international
standards.
2.13 But we note that, although the overall benefits
are likely to outweigh the costs, some businesses would be disadvantaged
and that there are issues relating to the fine-tuning of the proposals
which the Government will need to pursue vigorously.
2.14 Given the importance of the subject we recommend
the document for debate in European Standing Committee B. The
debate could usefully explore both the perceived overall utility
of the proposals and progress on ensuring that the concerns about
the present draft are eliminated.
5 The Basel Committee is composed of representatives
of the supervisory authorities (and central banks where these
are not the same institution) of Belgium, Canada, France, Germany,
Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland,
the United Kingdom and the United States. The Financial Services
Authority and the Bank of England represent the UK at the Basel
Committee. Back
6
The risk associated with the failure of internal processes, people
and systems or failure associated with external events (such as
terrorism). Back
7
Recasting, designed to make Community legislation more accessible
and transparent, incorporates in a single text any proposed substantive
amendments and the unchanged provisions of the existing legislation
(and repeals that legislation). Back
8
Comitology is the system of committees which oversees the exercise
by the Commission of legislative powers delegated to it by the
Council and the European Parliament. "Comitology" committees
are made up of representatives of the Member States and chaired
by the Commission. Back
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