EU Banking Supervision 9789460949319, 9789462361065

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EU Banking Supervision

EU Banking Superv ision

Ro e l Theissen

Published, sold and distributed by Eleven International Publishing P.O. Box 85576 2508 CG The Hague The Netherlands Tel.: +31 70 33 070 33 Fax: +31 70 33 070 30 e-mail: [email protected] www.elevenpub.com Sold and distributed in USA and Canada International Specialized Book Services 920 NE 58th Avenue, Suite 300 Portland, OR 97213-3786, USA Tel.: 1-800-944-6190 (toll-free) Fax: +1 503 280-8832 [email protected] www.isbs.com Eleven International Publishing is an imprint of Boom uitgevers Den Haag.

ISBN 978-94-6236-106-5 ISBN 978-94-6094-931-9 (E-book) © 2013 Roel Theissen | Eleven International Publishing This publication is protected by international copyright law. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the publisher. Printed in The Netherlands

Table of Contents Opening Remarks

xi

Part A Overview 1

An Overall Picture of Current Banking Supervision

2

The Legislative Response to the 2007-2013 Subprime Crisis and the Origins of the Current Prudential Regime Introduction The Origins and Future of the Capital Requirements Directive (CRD) The Wider Policy Response to the 2007-2013 Subprime Crisis

2.1 2.2 2.3 3 3.1 3.2 3.3 3.4 3.5

Policy and Legal Basis of Banking Supervision Introduction Economic, Legal or Accountancy? Who Sets Banking Supervision Standards? Legal Basis of EU Supervision Regulation National Implementation – Minimum Harmonisation, Goldplating and National Discretions

1

27 27 31 60 71 71 71 73 98 112

Part B Bank 4 4.1 4.2 4.3 4.4 4.5

What is a Bank? Introduction What Do Banks Do? Why Supervision of Banks? The CRD Definition of a Bank Government Banks and Exempted Banks

139 139 140 146 173 189

5 5.1 5.2 5.3 5.4

Market Access Introduction License Requirements Cross-Border Market Access in the EU Market Access by Mergers and Acquisitions of Qualifying Holdings

197 197 204 228

v

259

Table of Contents

5.5 5.6

Cross-Border Market Access and Third Countries Prohibition to Receive Deposits or Other Repayable Funds from the Public

273 280

Part C Ongoing Requirements 6 6.1 6.2 6.3 6.4

287 287 291 320

6.5

Quantitative Supervision – Outline And Underpinnings Introduction The Solvency Ratio and Other Financial Buffer Requirements Standard and Self-Developed Models for Calculating Risk Accounting Standards (Transparency, Consolidation, Valuation and Original Own Funds) Procyclicality

7 7.1 7.2 7.3

Quantitative Requirements – Capital and own Funds Introduction to CRD Financial Buffers Five CRD-Definitions – One Numerator One Solvency Ratio Numerator – Three Tiers

375 375 384 416

8 8.1 8.2 8.3 8.4

431 431 448 454

8.5 8.6

Quantitative Requirements – Credit Risk Introduction Standardised Approach Foundation and Advanced IRB Derivatives and Related Products in the Standardised and the IRB Approach (Counterparty Credit Risk) Credit Risk Protection Securitisations, Covered Bonds and Syndicated Loans

9 9.1 9.2 9.3 9.4 9.5

Quantitative Requirements – Market Risk Introduction The Trading Book Standard Treatment of Different Market Risks Internal Model Approach (and Scope) Market Risk Protection

509 509 515 520 530 540

10 10.1 10.2 10.3

Quantitative Requirements – Operational Risk Introduction Basic Indicator Approach Standardised Approach and Alternative Standardised Approach

543 543 549 550

vi

340 362

464 471 484

Table of Contents

10.4 10.5

Advanced Measurement Approach (AMA) Operational Risk Protection in the AMA

555 561

11 11.1 11.2 11.3

Quantitative Requirements – Large Exposures Introduction Large Exposures Regime Limitations on Qualified Holdings Outside Financial Sector

565 565 568 577

12 12.1 12.2

Liquidity Requirements Introduction Quantitative Requirements on Liquidity?

581 581 587

13 13.1 13.2 13.3 13.4

599 599 608 617

13.6

Organisational Requirements Introduction Who is Responsible for What? Organisational Requirements on All Banks Additional Requirements for All Banks that Qualify as Investment Firms Additional Requirements for Banks that Apply Internal Models to Calculate Quantitative Requirements Stress Testing in Pillar 1, Pillar 2, and in EBA

14 14.1 14.2 14.3

Own and Supervisory Assessment Process (Pillar 2) Introduction ICAAP – the Banks Own Assessment SREP – the Supervisory Review

663 663 666 669

15 15.1 15.2

Pillar 3 Disclosure By Banks Introduction Pillar 3

677 677 682

16 16.1 16.2 16.3 16.4 16.5 16.6

Conduct of Business Supervision Introduction Restrictions on Behaviour in Investment Markets Market/System Integrity (Market Abuse, AML/CFT) Trading Venue Safeguards Disclosure Obligations to Clients and Markets Customer Protection on Financial Products

691 691 699 715 726 733 747

13.5

vii

641 645 650

Table of Contents

17 17.1 17.2 17.3 17.4

Consolidated and Solo Requirements Introduction Level of Application – Solo/Consolidated Parents of EU Banking Groups Financial Conglomerates – Additional Consolidation and Additional Solo Requirements Third Country Parents or Subsidiaries Groups of Cooperative/Mutual Banks

767 767 771 789

813 813 818 827

18.5 18.6

Terminating a Bank – Crisis Management Introduction Systemically Important Financial Institutions (‘Too Big To Fail’) Supervision When a Bank Is in Crisis Lender of Last Resort and State-Aid (The Role of Central Banks and Governments) Guarantee funds Prudential Banking Supervision in the Liquidation Process

19 19.1 19.2 19.3 19.4 19.5

Non-Bank Prudential Regimes – A Comparison Introduction Non-Bank Investment Firms Electronic Money Institutions and Payment Institutions Insurers Collective Investment (UCITS/AIFM/Pension Funds)

895 895 896 904 909 921

17.5 17.6 18 18.1 18.2 18.3 18.4

794 802 805

850 866 886

Part D Prudential Supervisors 20 20.1 20.2 20.3 20.4 20.5 20.6 20.7

Rights and Obligations of the Prudential Supervisor Introduction Investigative Instruments – Information, Secrecy and Data Protection Corrective Instruments – Prevention, Intervention or Punishment Human Rights Limitations Administrative Limitations on Supervisory Powers Delegation of Supervisory Tasks and/or of Supervisory Responsibilities Supervisory Disclosure

viii

937 937 946 973 990 996 1002 1005

Table of Contents

21 21.1 21.2 21.3 21.4 21.5 21.6 21.7 21.8 21.9 21.10 22 22.1 22.2 22.3 22.4 22.5

Domestic and Cross-Border Institutional Set-Up Introduction Domestic Organisation and Cooperation Constitutional Issues for EBA and for a Eurozone Supervisor Cross-Border Cooperation in the European Banking Authority (EBA) by National and Future Cross-Border Supervisors General Cross-Border Practical Cooperation Home Host Cooperation Regarding the Same Legal Entity Colleges (Home Host) Cooperation on Entities in the Same Group Cooperation with Third Countries Funding Civil Liability

1011 1011 1021 1030

Financial stability Introduction ESCB/ECB – Institutional Aspects Central Banks’ Monetary Policy Oversight and Supervision of Payment, Trading and Delivery Systems Macroprudential Supervision

1133 1133 1140 1145

1051 1062 1065 1071 1094 1101 1112

1152 1166

Part E Legislative Process 23 23.1 23.2 23.3

The EU Legislative Process for Banking Supervision Introduction The Formal Legislative Process For Banking Legislation: the TFEU Adapted Legislative Process in the Financial Sector (Lamfalussy/Larosière)

1183 1183 1187 1197

Acronyms and Definitions

1225

Index

1227

ix

Opening Remarks Banking supervision has returned to the centre of public and political attention. New laws are being introduced to address lessons learnt from the most recent financial crisis; the 2007-2013 subprime crisis. What went wrong and what type of laws should be introduced or reinforced? Whether this is the right question is debatable. A prior question is “what are the current rules”, and whether a crisis could have been avoided if the existing requirements and supervision had been properly applied, or better written. This question is addressed in this book, intending to give an overview and some detail on the topics relevant to EU banking supervision today. For the follow-up question on what to do, the jury is still out. It would depend on what society actually wants to achieve by banking supervision, and whether such purpose can be achieved by the current or future framework. This question is addressed in a separate book that appears simultaneously; ‘Are EU banks safe?’. Over a period of four decades the main features of the national laws and authorities in the EU member states have gradually become similar – harmonised – by EU laws. Financial services are essential to the goal of the single market for services in the EU. This policy has been successful in many respects. The vast majority of banking assets are now owned by a limited number of banks that operate in multiple member states. Wholesale customers can roam freely in the single market; as can their banks. Retail customers could do so if they chose to. For civil law, tax law, language and other reasons they are less likely to cross borders to foreign banks, though they appear relatively happy to do business with subsidiaries and branches of foreign banks in their own jurisdiction. The success of this policy results in more drivers to harmonise the rules. This compensates the fact that national public authorities no longer have full control of such cross-border business, even while the backup facilities for failing banks remain national. The national laws and authorities – and the large number of EU rules they have to comply with – have come under criticism. Politicians and voters had the impression that supervision would prevent banking failures and financial crises, and were rudely disabused of this notion in the 2007-2013 subprime crisis. In search for safety, the body of EU rules continues to grow, both in the number of rules and in the impact of such rules. New proposals are partly copied from national experience, partly invented by Brussels legislators, and partly derived from the global discussion in the context of the G20 or the Basel Committee of Banking Supervisors. Discussions at the global level sketch the general direction on banking supervision, and have great informal authority. As they are not based on treaties, they are, however, not binding on banks or on banking supervisors.

xi

Opening Remarks

This is different for the EU rules. Member states have committed themselves (and their citizens) in the EU treaties to abide by the jointly agreed rules. For banking, the room for manoeuvre that the member states have left themselves has steadily declined. The European Commission aims to further limit national deviations from the EU standard. The bulk of national rules will be the subject of a new – largely directly applicable – set of European rules. Both the existing and future rules contain copy paste sections of existing and past rules. The approaching directives and regulations combine these with some truly new proposals based on amongst others new global standards, additional crisis fighting tools, and some upgrades of existing features. The discussion on the desirability and impact of the new rules is hampered by the fact that a full overview of existing banking rules is difficult to obtain. Most articles and proposals focus on specific features, without necessarily setting out what the actual upgrade is (if any), what was already there, and how it fits into the wider picture of banking supervision related legislation. As the EU rules increasingly dictate the exact conditions under which banks and banking supervisors operate in the member states, a full description is also useful by and of itself. This book intends to fill this gap. It provides an introduction to EU banking supervision regulations, to provide a common basis of knowledge for people working or studying in the field of banking supervision in the EU, or unfamiliar with parts of the broad array of banking supervision requirements and instruments. The focus is on currently applicable regulations, mostly drafted before the most recent financial crisis hit, as well as those rules and regulations drafted in its wake, which are in the process of being rolled out at the date of this publication. It aims to include a crosslink of aspects of banking supervision both with other aspects of banking supervision, as well as with related subjects such as crisis management, financial stability in general, monetary policy, payment systems, company law and bankruptcy law. Providing an overview serves both those who currently need to make decisions on banking supervision, and those with a business, scientific or societal interest in banking supervision. It can provide necessary background to assess how contemplated amendments would fit into the existing supervisory map. The actions of banks, their individual supervisors and the member states, as well as of EU institutions such as the ECB and the European Commission are subject to a complex set of incentives and considerations. Important among those are not only the text of the law and the purposes it sets out to achieve, but also whether those can be paid for, who will bear losses and in which country, and whether a full application of the law would be proportionate. Ultimately, banking supervision is not an idealistic environment but a very pragmatic environment: ‘if I do something now, will it help prevent this bank going

xii

Opening Remarks

bankrupt or will it actually speed it on its route to failure? If I don’t do it, will it go bankrupt, and if so, whose interests are still protected?’ Jargon and abbreviations are difficult to avoid when discussing EU banking supervision. The use of abbreviations is avoided where possible, but jargon is more infectious. When working in this area, at a certain point in time you stop to realise that not everyone knows what an ABS or SPV is, or even what they mean when written in full as asset backed security or special purpose vehicle, respectively. Where it was realised that jargon/abbreviations are used, jargon is explained where first used, and referenced to later on in the book. Abbreviations are only used for the core players in this field and the core legislative texts they helped develop, and limited to about 40 (see the list at the end of this book). Standard or self-explanatory jargon as used in the business sections of newspapers is, however, used freely. One key example of jargon is the distinction that banking legislators make between regulation and supervision. Roughly, practitioners in banking supervision refer to regulation when they mean the legal requirements (including the non-binding advice on how to apply those requirements), while supervision refers to the application of those rules in practice. However, requirements and their application in practice are the same. A requirement without an effective method to ensure application has no impact; supervision without an underlying clear requirement to uphold is meaningless. The subject of this book on supervision is therefore the way the prudential requirements are set, read and applied in practice. A practical problem for this overview is that banking supervision is not a particularly academic piece of work, nor can it be looked at in isolation from a range of other academic and practical issues. Banking and its supervision are strongly influenced by tax law, accountancy, company law, public law, economic models, monetary policy, pragmatism, politics and lots and lots of money. The result makes both the law and the practice complex, and subject to continuous change. The waterfall of new legislation over the last 20 years, that intensified with the introduction of new players such as the new European supervisory authorities, makes obtaining a proper insight difficult if not impossible. The sheer size of the developing policy documents and rule book(s) and its complex interaction ensures that. Though individual drafters and supervisors may understand individual texts, and perhaps the generic structure, hubris is the price of anyone claiming to understand the full detail of everything That claim is not made here. Especially on issues that are not the primary expertise of the author (legal, policy and teaching), a best attempt is made to interpret the binding rules on primarily accountancy and economics driven subjects, helped by 14 years of working in this field. An additional problem is that there is little consensus

xiii

Opening Remarks

on exactly how banking supervision works, or how the law should be applied even among the happy few. The disparate way the CRD and other components were applied and interpreted were a major reason for the introduction of the above-mentioned authorities. The description contained in this book is thus built upon my interpretation of the requirements, and my reading of the facts, where possible based on case law, literature, and EU based supervisory publications. Any mistakes are of course mine, though some of that blame can no doubt be shared with the somewhat vague terminology and cross-references and the sheer amount of paper that has come to determine the content of banking supervision. Remarks to improve the accuracy and completeness of the description contained in this book are always appreciated. The research for this book has been closed as per 1 June 2013. Main legislative news has been added up to 1 July 2013.

xiv

Part A Overview

1

An Overall Picture of Current Banking Supervision

Introduction Banking supervisory requirements, policy documents and reporting forms amount to thousands of pages, examples and interpretations. They cover different areas of expertise, ranging from legal, politics, economics and accounting. It can be difficult to see the wood for the trees when working at a bank, in financial academia, at a supervisor or when interested for another reason in the banking sector. Before going into details, this chapter provides a helicopter view of banking supervision. Each of the issues referenced below is discussed in (much more) detail in chapters 2-23 of this book, which also provide the necessary legislative and literature references. Prudential banking supervision is the part of government involvement in banks that is primarily focused on maintaining the financial health (also known as the solidity) of individual banks (see chapter 3). It partially overlaps with other government involvement in banks, such as – conduct of business supervision on banks; focused on the behaviour of banks towards their clients and in the market place (see chapter 16); – competition supervision on banks; focused on ensuring a properly functioning market for banking services (see chapter 18.4 for the effect of competition supervision on state aid to banks); and – macroprudential or systemic supervision; focused on the collective behaviour of participants in the financial system (see chapter 4.3, 18 and 22). Banking Supervision Legislation Banks are subjected to prudential supervision for several reasons. These derive from the fact that banks play a key role in western society. They provide a variety of services, including safekeeping of deposits and of financial instruments, they fund investments of private persons and companies in homes and machines, and provide back office services in the financial markets. If a bank fails when it no longer has assets left to pay its creditors, many clients will lose their savings or assets. In addition, as banks are interlinked through financial lending, investments and other transactions that may not yet be settled (paid or delivered), the failure of a bank might lead to perceived or real risks to other entities, including other banks. If the market thinks another related or similar entity is at risk when one bank fails, individual market participants will try to limit their exposure to the related

1

EU Banking Supervision

or similar banks. Such flight away from real or perceived risk can cause market fears to transform into a self-fulfilling prophecy, with ever-wider contagion risks. Prudential supervision was introduced to keep banks as healthy as possible, and maintain their possibilities to help fund economic activities, serve as tools for monetary and other governmental purposes, and repay the deposits entrusted to them. In order to remain healthy, banks have to keep their finances and organisation in order. Larger banks tend to want to operate both in their domestic markets and across borders. In the EU (and in other market economies) this is stimulated in order to create a common market with better and cheaper services and opportunities for both banks and their clients. Prudential banking supervision is built around: 1. a regime for licensing banks for domestic and cross-border activities (chapter 4 and 5); 2. quantitative requirements (chapters 6-12); 3. qualitative requirements (chapters 12-16); 4. a regime on termination of a bank (chapter 18); 5. requirements per legal entity and on a group wide basis (chapters 5 and 17). These requirements bind banks, but are also given into the care of a supervisor. For this purpose, supervisors are supported by: 6. rights to information from the banks (chapter 20); 7. powers to intervene in banks (chapter 5 and 20); and 8. cooperation across borders, and cooperation with other public authorities (chapter 21). In addition to banking supervisors, central banks and ministries of finance are involved in banks for financial stability purposes (chapter 18 and 22), as well as for the purpose of drafting new and consistent rules (chapter 3, 21 and 23) Sources of Banking Supervision Rules Banking supervisory standards can theoretically be developed at worldwide, regional (such as the EU) and domestic levels. In practice, the three levels work concurrently, and are heavily interlinked (with national lawmakers involved in the drafting process of regional and worldwide standards). Financial health requirements for the banks have been developed internationally, based on national and international experience. The initial target was to increase the trust foreign governments can have in incoming banks from each participating country. Supervisors and central banks of the largest financial centres jointly developed accords containing a minimum level of requirements and supervision on banks at the

2

1

An Overall Picture of Current Banking Supervision

worldwide level. They worked under the umbrella of the so-called Basel Committee of Banking Supervisors or BCBS. Its accords are not contained in a treaty or other binding text, and are not enforceable between countries. However, they have a strong status and are largely adhered to by both the members of the committee and supervisors and legislators from other countries. Within the EU, these worldwide accords have been filled in and translated into EU wide binding rules. This transfer of architectural responsibility for new EU rules was given in return for a large contingent of EU institution and member state representatives being involved in the worldwide drafting process. The currently applicable BCBS rules include the so-called Basel core principles for effective banking supervision (regularly assessed on a country-by-country basis by the IMF in its ‘financial sector assessment programs’; see chapter 21.1). Even better known is the socalled Basel capital accord as first agreed in 1988. It sets out a framework with minimum standards on the solidity of internationally operating banks. The capital accord has been amended several times. The version that is currently applicable is Basel II½, while a newer amendment referred to as Basel III is expected to become applicable between 2013 and 2019. Basel II ½ was agreed in response to the first stages of the 2007-2013 subprime crisis, to deal with the easiest or most urgent issues where the capital accord was deemed too light or out of touch with reality, such as the way financial instruments that the bank trades in can impact on its financial buffers. The core binding legislation in the EU on prudential banking supervision that implements the Basel work (now up to Basel II½) is contained in the capital requirements directive (CRD). This is the generic term for two directives, the recast banking directive (RBD) and the recast capital adequacy directive (RCAD). A new version of the CRD (CRD IV project) is to a large extent based on the Basel III amendment of the Basel accord. The CRD IV directive and the CRR as published in 2013 will gradually enter into force in in the period from 2014 until 2021. Basel III contains major amendments as agreed in December 2010 in order to deal with some of more cumbersome aspects of the capital accord that are being amended to embrace the lessons the Basel committee learned from the crisis; see chapter 2. This includes the quality and quantity of financial buffers that are needed to deal with sustained recessions, where the previous versions mainly tried to allow a bank to survive a fairly short term recession up to one year. Follow-up work is ongoing, so it is unlikely that Basel III and the CRD IV directive and CRR will be the final word on the content of the requirements on and supervision of banks. Both at the global and European level the research and negotiation work is done in the context of collaborative groupings. Representatives of domestic legislators or supervisors are members of such groups. The policy process is based on initiatives and input from all such members, sometimes on the basis of proposals of or research by centrally employed

3

EU Banking Supervision

staff. Decisions are usually based on full consensus of all representatives of domestic or regional authorities (though at the EU level first qualified and then simple majority voting has gained importance in steps). For external viewers the process may look like first worldwide standards are being set, subsequently translated in EU rules under high pressure to keep the worldwide standards; subsequently laid down in domestic laws that are forced to comply with EU rules. However, the role of domestic authorities is key at all levels, and it remains a bottom-up process. See chapters 2, 3, 5 and 21. Within the EU, the legislative initiative belongs to the EU Commission. On technical issues, from 2004 until end 2010, the Committee of European Banking Supervisors (CEBS) assisted it. Early 2011 this committee gained additional status as a regulatory agency of the EU, and has been recast into the European Banking Authority (EBA). The EBA has taken over all tasks of CEBS on advising the Commission on new EU legislation and on harmonising supervisory practices across the EU on a voluntary basis. As a new feature, EBA will have some new instruments to draft new binding rules, to enforce harmonised practices, and to intervene in day-to-day supervision by individual supervisory authorities if the collective of national supervisors (i.e. the decision making body of EBA) so desires. The EU The focus of this book is EU rules; regional rules. Within the context of the EU treaties, the Council and Parliament can issue binding legislation for all its member states if and only if the Commission issues a proposal for such new legislation. The Council brings together representatives of the member state governments, and the Parliament brings together directly elected parliamentarians from all member states. They can legislate if there is a TEU provision that allows them to, and if the subject matter can better be dealt with at the regional level than at the domestic level. Council and Parliament both need to approve the content of any rules, before the rules become binding within the EU. For banking supervision, the EU work has resulted in ever more harmonised rules at the EU level since the seventies. These harmonised rules have to be implemented and applied by the member states in their domestic legislation and practices. Harmonisation is not – yet – complete. Negotiations at both the worldwide level and the EU level are often hampered by the need for consensus in the rule-making process though that has decreased sharply with new voting arrangements at e.g. EBA, with some countries eager to defend national structures and hobbies and others doubtful on the benefits of harmonisation and the loss of regulatory competitiveness of their own banks. In spite of the fact that many – especially smaller – members will only go against a clear majority if the issue is of key importance to their country, the compromises needed to bring sufficient parliamentarians and member states along mean that there remains a significant amount of deviation at the

4

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An Overall Picture of Current Banking Supervision

national level. If sufficient consensus cannot be achieved, no rules are issued. The current set of rules can be seen as a halfway built house on the road to full harmonisation of banking supervision. The minimum requirements on banking supervision are laid down in it, but the new occupants are still allowed to build an extra floor and choose the kitchen and bathroom of their liking, and plant trees and shrubs to hide the bits of the standard lay-out they did not like but that were already built, or the enormous extension they chose to build themselves. To achieve a single market in the EU, such national add-ons should not hamper cross-border market access for banks and their clients. The EU treaties specify that there should be a single market for both companies and their clients in the EU, except to the extent needed to defend legitimate interests of the member states or their citizens. As banking can impact on such legitimate interests (fraud, incompetence, credit crunches can play havoc with the financial market in a state and the access to essential financial services of its citizens), national interventions could be large if there was no harmonisation of the requirements. The national add-ons and deviations are the small – but inconvenient to banks and their customers – remainders of the initially very high thresholds against cross-border activities of banks. EU banking rules thus contain the compromises on minimum requirements that have to be fulfilled by any bank and any supervisor. In return for signing up to this minimum level, any member state has to accept banks from all other member states doing business in their territory and its banks and citizens gain access to other markets and service providers. On issues where no full agreement could be reached or where harmonisation has not yet achieved consensus, the EU banking rules specify on which limited subjects the host member state of the bank can add its own supervision or requirements on an incoming bank that is licensed and supervised by another member state. Each licensed banking entity has access to the domestic savings and loans markets of all member states, as well as their investment services markets, after following a simple notification procedure, and with very limited ongoing involvement of the host member states in the remaining un-harmonised areas. This simplified cross-border permissions regime is known as the ‘European passport’. The European passport is a common construct in all EU financial sector legislation (insurance, collective investment, individual investment services, deposit taking and lending), where member state undertakings are regulated at a minimum level, and then allowed – with minor hindrances and after a brief administrative procedure – to operate across border. Officially, the CRD European passport is limited to two of the three legal forms in which a bank can operate in another member state. The passport covers the legal entity that has a banking licence when it establishes an office (a branch of the legal entity) in the other member state and if the legal entity provides cross-border services over e.g. the internet. The third form, establishing or taking over a subsidiary (a separate legal entity controlled by the legal entity holding the banking licence) benefits from a similar access rights under the EU treaties,

5

EU Banking Supervision

but has not been granted a European passport in the CRD. Such a subsidiary is obliged to go through the more cumbersome licensing process in the host member state and local supervision, though the EU treaties do bestow the right of access to the subsidiary of an EU bank if the subsidiary fulfils the minimum requirements set out in the CRD. The recipient member state (host member state) has little or no opportunity to expulse such market participants (branch, cross-border services or subsidiaries) that are already supervised by another member state. This is based on the assumption, backed up by EU laws, that supervision in each member state is of an agreed minimum quality level and will be exercised by the licensing supervisor (the supervisor of the home member state) across the EU, including on the activities of the legal entity in the host member states. This assumption ensures that the freedoms of establishment and services as protected in the EU treaties cannot be undermined by local rules, except in the aforementioned specified areas. These include some conduct of business supervision rules, as well as liquidity supervision and – if the activities of a branch in the host member state are important to the local economy – some additional rights to information and involvement in the resolution of the bank to which the branch belongs. What is Banking, and How Does a Company Obtain Permission To Start Banking? The core activities of a bank are taking deposits from the public and lending the funds obtained onward to other members of the public and to professionals (in both the private and public sector). If a company wants to perform this combination of activities, it is required to have a licence as a bank before it actually does so. If it obtains a banking licence it can indeed legitimately perform borrowing and lending activities. In addition, it will also be allowed to perform various other financial services. With the banking licence comes permission (unless the licence has restrictions under local law) to perform investment activities, payment services, e-money issuance, and so on. Only the local supervisor can grant a licence to a bank established in its member state for activities in the EU. A company has to fulfil several conditions before a supervisor is allowed to issue the licence. The EU requires that the supervisor checks e.g. whether there is a (viable) business plan, enough own funds of at least 5 million euro, and experienced people of good standing at the helm of the new bank. These basic requirements continue to be applicable to all licensed banks as long as they operate, with the exception of the requirement for a start-up business plan. This part of the European legislation has been left essentially unchanged since the rules were issued in the seventies and eighties of the last century. Once a bank has a licence of an EU supervisor, it can start its domestic activities. If it so desires, the licensed legal entity can also start providing cross-border services and set up

6

1

An Overall Picture of Current Banking Supervision

branches in other member states after fulfilling a rather simple notification process. Branches are bank-offices located in another country that are part of the same legal entity that holds the licence. For branches, the bank will also have to comply with some material criteria (to safeguard the existing activities in its home state as well as the interests of the financial markets in the other member state). For both branches and cross-border activities, the licensing (home) supervisor has full responsibility for prudential supervision (supervision on the financial solidity of the bank). Conduct of business supervision is still to some extent allocated to the local supervisors on the foreign activities, though this too is shifting; see chapter 16. For branches, the local (host) authorities also retain the power to impose and supervise monetary requirements (e.g. obligations to hold funds at the central bank) and requirements to have cash at hand for foreseeable withdrawals (so-called liquidity requirements, see below). A legal entity with a bank licence thus is subject to monetary requirements from its home state central bank, prudential requirements by its licensing supervisor, a limited set of liquidity requirements for any branches in the EU, and conduct of business supervision in any member state where it is active. If it is active in third countries, those may install any supervision they deem fit (within restrictions set by the WTO). As an alternative to setting up a branch (a foreign establishment within the legal entity with the license), any company can also set up subsidiaries (separate legal entities controlled by the existing person or legal entity) in other member states. If the parent is a licensed bank itself, its subsidiaries benefit from the freedom of establishment of the parent. Under the treaty, setting up a local subsidiary is considered one of the options of all EU nationals, including legal entities. This means that local supervisors of the new subsidiary have a much narrower scope to deny a licence to this type of new bank than with new banks set up by and for nationals or by third country entities, as EU banks have additional rights under the treaty. Such subsidiaries of existing EU banks should in any case quite easily get a local banking licence if well set up and funded, as they can make use of the already supervised organisation of the licensed parent bank. The licensing supervisor of the subsidiary has the primary supervisory obligations and rights towards the subsidiary legal entity. However, the supervisor of the parent has rights and obligations under the EU consolidation and cooperation framework. These rights and obligations follow from its supervisory tasks with regard to the parent legal entity (see below). This division of tasks – leaving the responsibility (and power) to the supervisor of the home state of a banking group while offering local supervisors a clear role in the local banking organisation activities in a branch or subsidiary – is a compromise between the desire for the single market for banking in the EU and the desire to protect local markets against external risks brought by foreign banks. The compromise laid down in the banking directives is acceptable to member states that accept such ‘foreign’ activities in their local

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EU Banking Supervision

markets, amongst others because it provides benefits to local customers by lowering prices and increasing sources of credit for their consumers and companies. More importantly it allows their local banks to have the benefit of reciprocity. They can operate in other member states under the same compromise. The assumption is that the licensing supervisor and its member state take on the full responsibility, though there are (even public) examples where that formal task was not carried out in practice (e.g. the Landsbanki/Icesave collapse in 2008). See chapters 4 and 5. Due to the growth of cross-border banking and the potential that the home supervisor may attach equal value to the interests of the host economy, the (underused) instruments that host supervisors already had in crisis situations have been expanded. If a branch is important in the local market (‘significant’ branch), the host supervisor can apply to gain a role in the cooperation and information exchange networks of supervisors on the bank, with some of the rights that a supervisor of a locally licensed subsidiary would have. If a European bank wants to start banking in a non-EU country, it needs to apply for local permission under the local third country rules. Obtaining local permission of the host third country can be a difficult process with high local requirements, though some limited rights of access have been stipulated via the treaties of the world trade organisation. The reverse is true for banks from third countries that want to operate within the EU. See chapter 5.5. Ongoing Prudential Requirements The bulk of EU banking supervision requirements focus on the period after a bank has obtained its licence, and before it is terminated. Like the human life cycle, ‘births’ and ‘deaths’ of banks are relatively rare; most of the life cycle of a bank is spent just plain living and growing. Even a crisis such as the 2007-2013 subprime crisis does not change this, though in a crisis more banks will be terminated, merged, or become subsidiaries of another bank or of the state (see below). Ongoing supervision is currently centred on three ‘pillars’. The concept of the three pillars was introduced in 2004 in the so-called Basel II version of the capital accord as was introduced in EU legislation in 2006, and effectively applied since 2008. The pillars are not mentioned explicitly in EU legislation, but each pillar has been given a legal basis in it. In practice, the work of supervisors on a licensed bank is built around the Basel concepts. They consist of: – pillar 1: a quantitative calculation of risk – pillar 2: a qualitative assessment of risk – pillar 3: transparency/disclosure requirements on supervisory risk indicators

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An Overall Picture of Current Banking Supervision

The three pillars do not actually cover the whole body of ongoing supervision. Liquidity requirements, risk concentrations and organisational/governance requirements only fit awkwardly into this system. They fall into all or none of these pillars. Mergers and acquisitions, the introduction of new subsidiaries and expansions of the licensed activities, dealing with market concentrations and the ongoing requirements from the licensing process are not explicitly part of the pillars either. The second – qualitative – pillar provides a catchall, however, under which ‘all’ risks can be taken into account. Pillar 1 Within the large number of requirements for banks, an ever larger and ever more detailed part is focused on quantitative requirements to have financial buffers of sufficient size in relation to the risk a bank has. The quantitative requirements consist of standardised or modelled estimations of the credit risk, market risk and operational risk a bank is exposed to. After measuring the credit risk, market risk and operational risk, banks are required to hold minimum levels of ‘capital’ in relation to the calculated risks. These buffers should absorb losses if those risks materialise, in order to increase the chances that all ‘normal’ creditors such as bondholders, savers and other depositors get a full pay-out of their claims if the bank fails. The amount of financial buffers required in relation to the risk is the socalled solvency ratio. Banks have to have a minimum of 8% of this ratio in certain types of ‘capital’. This includes capital/own funds as such terms are used in annual accounts, but also rather quaint low quality types of financial buffers such as short term subordinated loans; though some of the lowest quality capital buffers will likely no longer be acceptable in the near future under the Basel III version of the accord, to the extent it is copied into EU legislation (see chapter 2, 6 and 7). The solvency ratio requirement is in addition to the minimum level of own funds in absolute terms of at least 5 million euro that a bank has to have from the date it starts operating under the licensing requirements. The shareholders (and subordinated bondholders) thus provide a buffer in both absolute and relative terms for the losses of a bank. This buffer is drawn upon to protect the ‘normal’ creditors of a bank, such as depositors. See chapter 6 and 7. The calculation of credit risk (see chapter 8) and market risk (see chapter 9) is made on the basis of the estimated value and the estimated risk embodied in the assets of the bank. The reasoning is that if the assets of the bank are of good quality, and sufficient buffers are held in relation to the potential deteriorating of that quality, the repayment in full of depositors and other creditors is more likely. Looking at the balance sheet, the capital on the right upper hand of the ‘debts’ side is calculated in relation to the credit risk and/or market risk of the assets on the left hand side of the balance sheet. If the capital is large enough to absorb all losses on the asset side of the balance sheet, it would prevent a writedown on the value of debts to ‘normal’ creditors as booked on the bottom right hand side

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EU Banking Supervision

of the balance sheet. The calculation of operational risk is not linked to individual assets. It intends to look at the total business of the bank and the risk inherent to that (see chapter 10). The amount of financial buffers required is linked to that inherent risk. For credit risk and market risk, the link is between the risk inherent in assets and potential assets (off balance sheet items) and the amount of financial buffers that needs to be held for those risks. There are at the moment no quantitative capital requirements directly linking a level of financial buffers to the liabilities of the bank to its creditors. This means that the bank does not have to hold capital for the amount of debt it has. Instead it depends on the assumption that the management of the risk in assets will automatically ensure sufficient solidity for the bank to meet its obligations to its creditors (depositors, including bondholders). EU legislators have – for the quantitative pillar – added an additional calculation to the regime of the worldwide capital accord. The so-called large exposures regime limits in absolute terms the size of exposures to specific counterparties or groups of counterparties. The reasoning is that too much concentration to such (groups of) counterparties can lead to the failure of the bank if its counterparty fails or changes bank. For large exposures in the area of market risk, the regime can be partially replaced/supplemented by the insertion of an additional financial buffer requirement in the solvency ratio. See chapter 11. After the EU capital requirements were revised in 2006 to reflect the Basel II version of the Basel capital accord, the CRD was issued to replace the previous version of the banking rules. This does not mean that the CRD was ‘new’. Some parts were copied unchanged from earlier versions. Especially the current definition of capital is dated and too wide, and riddled with possibilities to add national deviations. For liquidity risk, no consensus could be found at the worldwide or EU level on quantitative requirements, even with such options to deviate at the national level. Apart from some limited recommendations on liquidity risk management, liquidity remains a domestic and non-harmonised requirement on banks, their subsidiaries and their branches. In the follow-up to the 2007-2013 subprime crisis, both the definition of capital and the rules on mandatory liquidity will likely be revised substantially at the EU level if and in as far as the Basel III version of the capital accord will survive the negotiations at the EU level. The calculations of the pillar 1 requirements for market risk and credit risk have already been tweaked following the agreement in the EU on the implementation of the Basel II ½ of the capital accord in 2009. Overall, the solidity of banks should benefit from the proposed changes, making them more likely to survive both individual losses and severe market stresses, see chapter 2, 6.2, and 7-11.

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An Overall Picture of Current Banking Supervision

Pillar 2 and 3 Building upon the minimum quantitative requirements of pillar 1, banks are subjected to qualitative (pillar 2, see chapter 14) and disclosure (pillar 3, see chapter 15) requirements. The pillar 2 requirements come on top of the licensing requirements under which amongst others the business plan of each new bank is assessed; the pillar 3 requirements come on top of company law transparency and – if applicable rules on bond or shares issuing (see chapter 5 and 16 respectively). Qualitative organisational requirements aim to ensure that the organisation has self-controlling and self-cleansing capabilities, and is managed by trustworthy and competent people. The bank-organisation has to deliver trustworthy information to its board and to its supervisors. Some of these qualitative requirements are part of the licensing process. They have to be adhered to when the bank is being authorised to operate, but also apply on an ongoing basis when it operates under the licence. In 2006 – as part of the implementation of the Basel II amendment to the capital accord – the qualitative requirements were expanded to include a self-assessment process of the bank. This self-assessment is the first stage of the pillar 2 process. During the self-assessment, the actual risks that the specific bank is exposed to are compared to the outcome of the minimum requirements of pillar 1 (quantitative requirements) and to the capacity of the bank’s organisation to handle unexpected events. The banking supervisor subsequently checks the self-assessment, as the second stage of the pillar 2 process. If the quantified pillar 1 requirements do not fully capture all the actual risks, additional safeguards may be necessary (such as increasing the amount of financial buffers or strengthening risk management). In principle the bank should do this of its own accord as a result of the self-assessment. If the bank, however, refrains from doing so, the supervisor can order it to do so, sometimes with specific instructions to beef up an aspect of internal governance or of its capital buffers. In a pragmatic manner, the two-step assessment also takes into account various risk categories which have not (yet) been quantified in pillar 1. Based on work and consultation after 2006, a consensus evolved between EU supervisors on a quantitative approach to e.g. interest rate risk in the banking book. Though not covered in pillar 1, they are in practice subjected to a ‘quantitative approach’ under pillar 2, leading to almost automatic additional buffers being held for this specific type of risk. See chapter 14. Banks are subjected to a broad range of disclosure requirements deriving from non-prudential sets of rules. The disclosed information in annual accounts, prospectuses or press releases is used by prudential supervisors to assess where their attention is warranted. Prudential rules from the start included obligations to disclose information privately to the supervisor, using e.g. reporting forms or the application letter for a banking licence. Banks are obliged to inform the supervisor of unusual events or transgressions of the law,

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EU Banking Supervision

in addition to the normal flow of information via reporting forms. Supervisors basically should have access to anything within the bank, either in a standardised format or as a result of ad hoc information requests; see chapter 20.2. This wide access is balanced by an obligation of the supervisor to keep any information that is disclosed by the bank to the supervisor alone secret, e.g. if the bank has not voluntarily or obligatorily – under e.g. listing or company law requirements – shared it with the public already. Pillar 3 refers to a new component of the disclosure regime, introduced in the EU in 2006 in line with the above-mentioned Basel II amendment to the Basel capital accord. The pillar 3 transparency requirement is based on the assumption that additional information made known to the markets will lead to peer group and clients induced adjustments to the risk profile of the bank. The pillar 3 requirements are supplementary (and in part overlap) with the information banks publish in their annual accounts. Pillar 3 forces the bank to publish some of the information it sends to supervisors, and thus partially circumvents the fact that the supervisor itself is not allowed to publish or share such information. Examples include the amount of financial buffers available and how the bank manages its risks; see chapter 15. Ongoing Prudential Supervision The quantitative and qualitative requirements are ongoing obligations on banks, applicable from the moment the bank obtains the licence until the last deposit has been repaid (thus possibly lasting well beyond a withdrawal of the banking licence, though the EU rules are less than clear on the nature of supervision in a run-down or liquidation scenario; see chapter 18). The ongoing supervisory obligations limit the risk taking and freedom of action of banks considerably. They force banks to invest in resources they may not deem necessary for commercial purposes (e.g. IT investments to enable reporting to supervisors). Banks are generally willing to make this ‘sacrifice’ in exchange for being allowed to enter the potentially highly profitable (and thus equally high risk) business of banking, though naturally they try to limit the amount of such costs to increase their profitability. Individual counterparties have little benefit in checking whether a bank complies with these obligations, even if they has the necessary expertise and access, as the costs of looking at the health of a bank in the type of detail set out in the CRD greatly surpass the value of the contracts individual counterparties and the bank engage in. Supervisory authorities have been set up to verify that banks comply. This reduces the risk of a bank systematically not complying for all counterparties of the bank. Whether they can fulfil that task depends on the strength of the requirements and on the resources made available to the supervisor (money, expertise, manpower). The resources and instruments of supervisors are not harmonised yet in the EU. The EU legislation is at the moment still neutral as to the exact methods and institutional set-up of supervisory authorities. How and to what extent supervisory

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An Overall Picture of Current Banking Supervision

authorities verify compliance with the EU prudential requirements is left to the finances and risk-appetite of member states. That said, some gentle pressure results from minimum demands in EU legislation on what the supervisors are supposed to do. The work of CEBS, and now of EBA, has led to some further harmonisation on the supervisory set-up. These efforts are supported by (albeit vague) requirements on home/host cooperation and information exchange, which also require at least some competence and resources (IT, people, travel costs). The work of EBA and the practical contacts between supervisors from different member states – even when they are or were not yet laid down in EU legislation – has led to similarities in supervisory practices. Generally, national supervisors perform both on-site and off-site supervision. On-site supervision involves a trip of employees of the supervisory authority to the premises of the bank, talking to executives and employees of the bank and scrutinising requested documents at the bank. These visits can either be general in scope, the follow-up on deficiencies noticed earlier, or thematic investigations based on subjects that have been prioritised by the supervisor to be performed at all banks, and can include extensive travel if the activities of the bank range across borders. Off-site supervision is generally performed by employees of supervisory authorities at their own desks, based on information sent to the supervisor by the bank. Such information comes in three formats, individually requested information (e.g. in a letter or during an on-site visit), information that has to be given by the bank once certain trigger events happen (e.g. falling below certain safety thresholds), and information that is sent periodically in pre-set reporting formats, mostly consisting of quantitative reports on the business of the bank. All information received from the bank, and all signals received through other channels (e.g. from the central bank as monetary authority or as payment system supervisor) are fed into a risk analysis by the supervisor. The supervisor generally employs an IT-tool to perform the analysis of the input, to ensure standardisation of the data, opinions and assessments. Different banks are visited by different employees of the supervisory authority, but the risk analysis needs to be consistent to allow comparability and correct prioritisation. The outcome of the analysis tool, identifying weaknesses at each bank and their relative risk to the bank or to the banking sector or society as a whole, determine the level of priority and depth of attention to be paid to a specific bank. The risk analysis tools of the supervisors are not harmonised at the EU level. However, a best practice is slowly evolving due to both sharing of policy information and increased cooperation in practice in e.g. so-called ‘colleges’ of supervisors that supervise individual banking entities that are part of the same banking group. In addition to attention being paid to the regular reporting by the bank and regular visits and research at a bank, ad hoc events (such as a change in

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EU Banking Supervision

ownership, large unexpected losses, a change in management) demand and get ad hoc attention from the supervisory authority. The prudential requirements are phrased in a general and often objective sounding manner. It should be noted, however, that their application implies a strong reliance on supervisory judgement. Within the EU legislation, supervisory judgement is exercised e.g.: – within the context of the minimum requirements on specific issues the supervisor is the party to ascertain what a certain requirement means in a practical situation; – whether the minimum requirement has been fulfilled in his opinion; and – even after the minimum requirements have been met, the supervisor has to take an overall look to see whether it actually means that the bank is sound (pillar 2). Supervisory judgement is needed in the assessment of the criteria set and of the data, but also in the assessment of whether the underlying goals of the requirements are being met, i.e. financial stability, depositor protection, and the single market. The minimum quantitative, qualitative and disclosure requirements are a means to an end, not an end in itself. If in the opinion of the supervisory authority transgressions are made either of the individual obligations or there is an overall tendency towards potential danger, the supervisor will need to employ its instruments to adjust the behaviour of a bank, or in extreme circumstances, to withdraw its licence and/or apply for its bankruptcy. In line with local procedural laws, this will likely lead to an assessment in a court of law ex ante or ex post whether the supervisory authority can indeed take such a measure (e.g. bankruptcy may need to be applied for at bankruptcy court, and ‘unjust’ liquidation measures can be challenged in administrative courts or in the context of the establishment of supervisory liability) or whether he has correctly taken a measure (e.g. instructions given or the withdrawal of a licence can be challenged in the local administrative courts); see chapter 20. Market Exit Regardless of prudential requirements, banks can still fail. This can be the result of a long sickbed, where a bank is no longer able to make profits (e.g. due to increased competition or an outdated business model). It can also be the immediate result of an internal or external shock (e.g. a big trading loss, or many creditors asking for their money back at the same time), or part of a wider crisis in the economy and/or banking sector. If only a single bank no longer fulfils its own purposes, makes no profits anymore, or fails due to an internal or external shock, this is not a problem for society as a whole. The entity (or most of its assets and debts) is usually absorbed by other banks or large investors if the business can be salvaged at commercial rates. If a bank is relatively unimportant for the economy, it is unlikely that it will be saved by state-actors if no private sector solution can be found to sculpt a certain path to future profitability. If unimportant, neither depositor

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An Overall Picture of Current Banking Supervision

protection nor financial stability would trigger state intervention. Most voters in a country would get their money back under the deposit guarantee scheme, and unprotected depositors and other creditors would be able to absorb the remaining losses, if any, upon liquidation. The (voluntary or involuntary) market exit of such a bank should be a manageable process for its creditors and supervisors. For a single bank in trouble, the prudential requirements and monitoring help ensure that the plug is pulled in a timely manner, when the creditors can still be paid in full (in a voluntary wind down) or can still look forward to an eventual much higher pay-out than in a bankruptcy of a ‘normal’ commercial undertaking. In some member states anecdotal evidence suggests that a timely bankruptcy eventually results in close to a full pay-out from the estate for unsecured creditors such as depositors1. Losses are in that case related to not having the funds available for other investments during the liquidation procedure and losing interest income. If despite the requirements on banks and despite the monitoring by supervisors (and their hopefully timely interventions when needed) a bank is no longer viable, it may need to be wound up. The board and shareholders can decide to terminate the activities of an unprofitable bank that does not have a viable business plan for the future, or a banking group can e.g. decide to terminate a certain banking subsidiary. If the bank still fulfils all the minimum requirements, it can be voluntarily liquidated, selling the assets and paying off the creditors. The licence can then be cancelled, either at the initiative of the bank or the supervisor, depending on local administrative laws. Supervision continues to apply as long as there are still banking activities that have to be wound down (especially if there are still non-professional depositors). If there are no financial surpluses or if other minimum requirements on banks are no longer fulfilled – and it is not likely that this situation can be amended – a bank can become insolvent. In this respect, it is like any other commercial business. Prudential supervision and the potential systemic relevance of a bank, however, plays a role in the way the scenario unfolds. Banks are more likely to be systemic (important to the financial or general economy) than normal companies. Normal companies are only systemic if they are e.g. large employers, or provide indispensable services. A bank almost by definition provides key indispensable services in modern society, especially if the bank is large or provides a niche service. Banks are therefore more likely to be saved by other banks, by the central bank (in case of liquidity support) or by the state (where state aid is allowed).

1

For example the liquidators of the Icelandic bank Landsbanki (with branches in the UK and the Netherlands under the Icesave brand) announced a likely 99% pay-out for unsecured creditors. Similar percentages have been achieved for small Dutch banks such as Van der Hoop Bankiers (100% pay-out for unsecured creditors), and are expected for some of the European prudentially supervised subsidiaries of Lehman Brothers Holdings Inc (for instance UK broker-dealer Lehman Brothers International (Europe).

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EU Banking Supervision

On the other hand, if such an intervention is not deemed necessary or possible to any of those, a bank goes into insolvency much sooner than a regular company. In most countries, bankruptcy law allows a company to be declared bankrupt when it has ceased paying its due debts. For banks, even when they are still able to pay all the debts that are due at that point in time, it may be failed by the supervisor if it is unlikely to continue to do so for debts that become due in the future. A transgression or development into the danger zone of its minimum capital requirements will lead to the supervisor being forced to either look for a quick amelioration of that situation (e.g. by an injection of capital by the current shareholders or by another commercial party that wants to buy and recapitalise the bank) or to apply for bankruptcy and the application of the deposit guarantee scheme at a point in time that the financial buffers are still so large as to be able to absorb potential losses. For a bank that triggers the thresholds towards insolvency, without anyone being willing and able to save it, two regimes become applicable: – the ‘normal’ insolvency and bankruptcy processes, with some specific add-ons for financial institutions (e.g. regarding their participation in open transactions on financial markets). In the event of insolvency, the bankruptcy laws and protection laws of the home state apply, i.e. of the state that has given the licence to the legal entity; also – the depositor protection and investor compensation schemes provide protection. Consumers and small- and medium sized enterprises benefit from depositor protection, meaning that they get a substantial pay-out within days or months; even before the liquidation of the bank has properly started. Since 2010 the guaranteed amount is harmonised across the EU at 100.000 euro. Depositor protection schemes guarantee the re-payment of 100.000 euro worth of deposits, savings and similar claims on the bank, in the event of its insolvency. The investor compensation scheme guarantees the return of 20.000 euro worth of financial instruments held for the client by the bank, which provides additional safety just in case the bank failed at keeping such separate from its own assets, as obliged under conduct of business-rules. The depositor and investor compensation schemes are not officially linked, nor are they linked to formal liquidation or bankruptcy proceedings, but if one is being applied, the others in practice becomes inescapable for a bank. Putting a bank through a formal liquidation is unpopular. Even a small bank in bankruptcy – where depositors get most of their money back within a short period of time – can be disruptive. Like in any bankruptcy, some will lose their jobs, some will lose expected funding, and some will lose part of their assets. Depositors are only protected up to the amount guaranteed, and this protection may be contested or lacking if they fall into an unprotected category (e.g. pension funds or some public authorities, or hold the deposit in a form that is not protected, such as subordinated loans). This need not be a problem

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An Overall Picture of Current Banking Supervision

for society at large. By spreading their exposures over many banks, individual counterparties that are not protected or not protected in full by deposit insurance (e.g. consumers and small companies that have assets over the protected deposit insurance thresholds) can further manage their risk of a – hopefully temporary – loss of assets (as already mitigated by the prudential requirements). The financial buffers provided by shareholders and subordinated bondholders serve their purpose in such cases to protect unsecured creditors, such as depositors. See chapter 18. The risks for counterparties and the economy are not so easily handled if the failing bank is large, if it is part of a failing big banking group, or if its failure is part of a wider crisis. There is, however, no clear set of criteria to determine importance or non-importance. A failure of a single bank is often manageable for society, but if there are already other risks to stability, important (and sometimes even unimportant) banks failing could reinforce the negative influences on financial stability. Member states then often try to step in with guarantees or an outright takeover to prevent the negative impact on the local economy and especially on its voters (i.e. the employees or depositors at the bank). State aid for banks can only be provided if the conditions under the European treaties are fulfilled, but these include aid for important institutions or where there is a more general crisis. See chapter 18.4. With the increase in cross-border financial activities, the demise of a bank and factors influencing financial stability are also no longer bound by national borders. The 2007-2013 subprime crisis provides a prime example of the intensification of this development. The failure of a cross-border operating bank, or of a big debtor of banks (e.g. a sovereign issuer) will trigger losses in many jurisdictions. Such losses can be so large that they have financial stability consequences in other jurisdictions than where the main supervisor is located. In the event of an imminent failure, it is both important and very difficult, for the various public authorities with an interest in the bank to cooperate across borders. There is a distinct risk that the various authorities have different opinions. If state authorities in one jurisdiction act unilaterally to save the bank as a whole, this is also saves the bank’s activities in other jurisdictions. It simultaneously causes a disproportionate risk for their taxpayers. If they only try to save the local bits, the financial system in other countries may be damaged, especially if the local supervisors are not made aware of the problems at the bank. Supervisors do not always share such information across borders, to avoid actions taken by the host authorities (publicity, warnings to other banks, to depositors) that might precipitate the bankruptcy of the bank. To mitigate the potential damage of unilateral action, within the EU there are some minimum legal duties to compensate retail clients and to share information in normal times

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EU Banking Supervision

and in times of trouble. The EU mandates the provision of a deposit insurance scheme for all depositors at the legal entity with a banking licence. The home member state is responsible for the financial solidity of the licensed bank (on a solo basis, not a group basis; see below), and thus also for the depositors of the legal entities it licensed. The deposit insurance covers both its ‘own’ nationals with claims on the bank and nationals of other member states with claims on the bank. A legal responsibility to share (correct) information between supervisors is also applicable, though the language is fuzzy, and it has not been filled in yet by case law. Supervisors have tried to clarify their mutual obligations to some extent by entering into (non-binding) contractual arrangements. These memorandums of understanding aim to foster cooperation and information exchange. Cross-border cooperation arrangements have not kept pace with the emergence of large systemically important banking groups operating across internal EU borders, nor with the activities of such large groups across the EU borders. For the EU part of banking groups, the establishment of colleges of supervisors, as well as first CEBS and then EBA, and a possible EU level banking supervisor is forever trying to play catch-up. The disconnect between the increase in cross-border operating banking business and the fiscal responsibilities of individual member states will make progress on a joined up supervision and liquidation effort difficult. As the money of the member states is involved, this is an area that is guarded vehemently from a sovereignty point of view, but equally an area where no member state is so solvent that it is able to save its local financial system (and/or the sometimes large foreign business of the banks it licensed). Banks and Banking Groups All of the problems that can assail a legal entity with a banking licence can also assail a banking group as a whole. By way of example, the banking group Lehman Brothers at the time of its demise consisted of more than 7000 legal entities. Though the top holding was not a ‘bank’ in the EU definition, many of its subsidiaries had banking licences issued by supervisors in amongst others the EU, or were owned via such locally licensed banks. If a bank fails, it can cause a problem for any other bank it has links with via investments, loans or other cooperative arrangements. Within a banking group, problems in one bank are even more likely to infect the other legal entities within the group, both by the large contractual and ownership ties as well as by the assault on the reputation of all entities that are part of the same group if one of them fails. There is a likelihood of infection and one entity taking its group entities down with it. On the other hand, when the group is healthy, it can diversify its activities across sectors and borders, and if the problems in one of the entities are of a limited scope, the group as a whole will be likely to be able to absorb losses or the need for additional capital injections in one of its component-banks that has run into problems via the profits made in other markets. A banking group can also afford to

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An Overall Picture of Current Banking Supervision

invest in management tools, as such can be used by multiple banks within the group, sharing costs and burdens. In normal times and with mild problems, being part of a banking group is beneficial for each of the component banks and for their creditors (both due to the benefit of reputation and of sharing costs). The benefits and risks resulting from being part of a banking group have led to a key disagreement between economists (and bankers) on the one hand and legal experts (and supervisors of important subsidiaries) on the other hand. Economists see a banking group as one entity, jointly operated and active and mutually supporting, with legal entities of various types inserted for rather bothersome tax or legal reasons only, i.e. thus supposedly not material for management purposes. Lawyers and supervisors of subsidiary-banks see a banking group as a group of legal entities that cooperate in life but die alone. Once the problems of entities in the group become too large for the group to absorb, those failing entities become a risk for every other bank in the group. Any centralisation of management and funding arrangements during a bankruptcy scenario will exacerbate the problems at each legal entity, who will all go bankrupt with large claims on each other, and uncertainty for the creditors of the specific bank. The cooperative structure of a banking group in normal times ends abruptly when the group is no longer viable. Supervisors, liquidators, and the courts will stop treating it as a going concern, but will look at the viability and standalone solidity of each legal entity. In practice, a banking group does not go bankrupt as a group with all creditors of all entities sharing equally in the proceeds of the liquidation. For example, the parent and some of the subsidiaries will be bankrupt, administered by different liquidators from different countries. These sell the assets, the debts and/or the organisation, or wait for rental income and repayments to arrive at the estate (e.g. from mortgage loans made by the bank when it was solvent). These assets can include the shares in other banks and subsidiaries that are still solvent. Such are sold on as a solvent legal entity and thrive again as part of another financial group. Creditors (e.g. depositors) of surviving or sold entities will get paid in full, creditors of entities that are not bailed out will suffer as a result of liquidation, at a minimum by a delay in the repayment of debts owed. For supervisors of subsidiaries it is very important that not only the whole group but also each banking entity that they have licensed is well managed and well capitalised. In case the banking group does not survive, the depositors at the local subsidiary may in that case still get their money back, and the economic function of such a well-capitalised entity may even continue to be provided if the bank gains a new shareholder. This demand for standalone solidity by host supervisors immediately takes away some of the economic benefits of size and centralisation that a banking group working together

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EU Banking Supervision

would enjoy. The difficulty is that both the economic/managerial and the legal/liquidation point of view are correct. They just look at it from different angles, i.e. from a going concern point of view and from a licensing/liquidation point of view. To cover both angles, both solo and consolidated (group-wide) supervision are applicable under the CRD. The benefits, dangers and the full picture of the banking group is important, as well as the information on individual entities. Most quantitative requirements are applicable at both a solo and a consolidated level. Licensing requirements are applicable on a solo basis only, while e.g. pillar 3 is applicable only on a consolidated level. If applied consistently, the benefits and risks of belonging to a single banking group are acknowledged, while at the same time making sure that the individual banks do not only not pose a risk to the (local) society and banking system, but also not to the other banks in the group. See chapter 17. Supervisory Tools The EU requires that each member state has a ‘competent authority’ for banking supervision; a banking supervision authority. Apart from this requirement, there are only indirect rules on the organisation of such an authority. The member states have great freedom on institutional aspects. National supervisors are different as to the level of independence of the authority (from the central bank, from the ministry of finance or from the banks) or whether an authority can also have other tasks or competencies, such as monetary policy, financial regulation, conduct of business supervision or prudential supervision in other financial sectors. Funding arrangements are also left to the discretion of the member states, both as to the level of funding (which determines the number of supervisors and the strength of its knowledge, analysis and action) and its sources (general tax, central bank profits or specific levies on supervised institutions or on the customers of banks). Banking supervision can also be split over several authorities within a member state. EU legislation just demands that the institution chosen to perform duties set out in the directive is able to do so, and that the directive obligations are not only implemented in domestic laws but also applied in practice in a credible manner. If clear responsibilities laid down in EU legislation are not lived up to, persons who should have been protected under those responsibilities may have a liability claim on the state and/or supervisory authority, directly derived from EU legislation. See chapter 3.5, 20 and 21. Supervisors are charged with monitoring the bank and the banking group, and intervening where necessary. To make EU banking legislation credible, the supervisor has to have the investigative and corrective instruments and resources that allow him to fulfil his tasks. These include the above-mentioned far reaching rights to information, to access the bank and its executives and employees, as well as rights to take measures that are binding upon the bank. The EU has so far not harmonised the legal instruments the supervisory authorities have, except to mention some specific instruments such as the withdrawal of

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An Overall Picture of Current Banking Supervision

the licence as the heaviest punishment (effectively ending the bank) and the right to e.g. require additional capital if the pillar 2 assessment is not satisfactory in relation to the risk the bank or banking group faces. In addition, the EU directives require member states to ensure that supervisors have the legal and practical tools to make the EU rules effective (and apply them). When an EU based public authority has powers over a citizen (natural person or legal entity), some fundamental rights and administrative laws come into play. These enforce the rule of law, and consist of safeguards to ensure fairness, transparency and accountability regarding the measures taken by the public authority. Such safeguards apply to the relation between a bank and its supervisor. They also apply between the natural persons employed by a bank and the supervisor of that bank. Natural persons enjoy even more protection than the bank itself (usually a legal entity). These rights include rights to privacy of e.g. prospective executives, the right to property, the rights of defence against criminal law proceedings, and e.g. principles on good process, such as the right to be heard upon the results of an administrative process before a final decision is made. This means that e.g. the right to information is balanced by the obligation to keep confidential information secret, and that instruments have to be applied in a proportionate and well-explained manner. See chapter 20. Cross-Border Cooperation Both in the investigative phase and during any interventions, cross-border cooperation is important when dealing with cross-border operating banks. More and more banks operate in multiple member states and third countries, and banking groups have large market shares in multiple jurisdictions. Public authorities usually have a remit that is limited to their own territory. For banking, especially in the single market as created within the EU, exceptions have been made to the territorial remit of supervisors. Supervisors of one member state can follow the activities of its banks wherever they go. Without access to information on those activities and possibilities to effectively supervise them, achieving the goals of supervision would not be possible in an open market. Expanding the power of public authorities is the counterpart to the European passport of the banks. Prior to the single market (and even now when visiting third countries where EU banks have activities) this required local permission to do research, as well as voluntary cooperation between the local and the home supervisor. Within the EU, reducing the thresholds between the various local markets (freedom of capital, establishment and services) has led to a formalisation of the minimum levels of cross-border cooperation and information exchange for types of businesses such as banks may impact on public policy or safety. The cooperation focuses on banks and banking groups with activities in multiple jurisdictions, as well as on developments, clients and employees active in multiple jurisdictions.

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EU Banking Supervision

Cooperation is most developed on a bank that has cross-border branches or services, or where supervisors have given licenes to banks that belong to the same group. The underlying system of the CRD is based home state supervision, with add-on tasks for host supervisors only where there is a clear reason for that add-on. For the individual banks in the group, the banking supervisor of the member state where that legal entity has obtained the licence also supervises that specific bank. Some limited tasks (so-called host state supervision, mainly consisting of liquidity supervision) are allocated to the supervisor of the branches of that specific legal entity in other member states of that bank. The rule of home supervision for each legal entity is less obvious under the EU treaty freedoms if the bank is part of a group of licensed banks. A subsidiary of a licensed bank falls under the freedom of establishment of the parent under the treaties. The fact that the headquarters and main centre of business of the subsidiary are based in the country where it has its licence allows the solo responsibility to remain at the subsidiary supervisor (the host supervisor from the point of view of the parent, though it is the home supervisor of the subsidiary). In that case, in addition to this solo supervision by each of the licensing supervisors of the individual banks in the group, the whole group – including banks and non-banks – is also supervised on aspects of financial solidity and organisation as if it were a single entity. The home state supervisor of the bank – or the holding – at the head of the group is given additional tasks in order to supervise the group as a whole in a consolidated manner, to the benefit of the parent and the subsidiaries (and their supervisors). These tasks have, however not been accompanied by equivalent powers. The home supervisor of the group mainly has powers to coordinate and stimulate. To intervene, he still has to either convince other supervisors to act, or act in his capacity of the (licensing) supervisor of the group-entities in his jurisdiction (and e.g. force the parent to implement measures at subsidiaries). He cannot impinge on the rights and obligations of the supervisor on the subsidiary on a solo basis. In some limited areas (model validation since 2006, pillar 2 measures since 2010 and assessing the role of supervisors in countries where the group has activities but no legal entity), the home supervisor has gradually obtained some instruments with which he can overrule the individual supervisors in setting some basic outlines of how the banking group can best be set up for supervision in normal times. If the supervisors that are involved in supervising the group e.g. cannot reach agreement within six months on model validation or pillar 2 measures, the lead supervisor can take a form of the decision on behalf of all supervisors (to which they subsequently are bound, even if they disagreed). Since the establishment of EBA, the supervisors involved can also choose to refer disagreements on these and some (enumerated) other issues to EBA for a binding mediation procedure. The intent remains to avoid a dispute by achieving consensus. The debate on measures to be taken on a specific bank or banking group – plus information sharing and coordinating supervision activities – takes place in the context of so-called colleges of supervisors. A college consists of the consolidated home state supervisor, the

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An Overall Picture of Current Banking Supervision

licensing supervisors of the bank-subsidiaries and the host-supervisors on the systemic branches of the various banks that are part of the group. EBA has also been allocated a seat at the table of the colleges, to monitor the functioning of all colleges (a task given to the permanent support staff of EBA on behalf of the collective of all EU supervisors that is EBA’s decision making body). The head of the college (i.e. the home state supervisor of the highest entity in the group), the college itself and EBA have been given responsibilities to act jointly and decisively in both normal times and during crises. They, however, lack credible instruments to enforce an agreement or to enforce efficient and effective coordinated action when the bank is in trouble. The EBA has been allocated some formal powers to intervene and take emergency measures, but this power has been effectively neutered by the fact that its decisions cannot have an impact on the fiscal responsibilities of the member states involved. For normal times there are no key incentives to take the national interest first, so that the available procedures on cooperation and decision making can indeed result in the desired joined up behaviour of supervisors as if they are one collaborative body. See chapter 18, 20 and 21. Outside the area of a common interest in the same banking group, ad hoc cooperation is desirable and mandatory. If a supervisor has information on a banking group in another member state, or can provide other assistance to the supervisors on that banking group, it has to provide that information or assistance on an ad hoc basis. By way of example, if a new executive is appointed at a bank, the supervisor may request information on his qualities from the supervisor of a bank where the executive previously served. On the policy side, each banking supervisor essentially is allowed to set its own policy in a manner consistent with the local laws and the broad instructions of their government. All European banking supervisors meet and discuss policy, and have done so already for decades. In 2004 the establishment of the Committee of European Banking Supervisors (CEBS) upgraded this collaboration. CEBS advised the European Commission on draft legislation and sets out non-binding policy standards and guidelines to its members; the banking supervisory authorities. The aim was that its members – and their member states – adopt laws and practices consistent with those non-binding standards and guidelines that they helped develop, or at least to explain transparently where they felt compelled to deviate. Initially it operated on a consensus basis except for level 2 advice, but in 2009 all decisions were subjected to the same (qualified majority) voting system if no consensus was possible. As per 2011 a new European Banking Authority (EBA) has replaced CEBS. Basically, it is the same organisation, but with improved formal (EU agency) status and expanded policy and implementation tasks. Decisions are now made by simple majority, except for specified (more important) issues where qualified majority voting remains the rule. EBA gained additional supporting tasks on ongoing supervision, and the power to

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EU Banking Supervision

develop (and have issued by the Commission) binding standards on supervision policy. This is part of the so-called Lamfalussy framework as amended by the follow-up to the De Larosière report. This Lamfalussy/Larosière process focuses on policy development, subsequent agreement on regulation and application of such regulation. It consists of four levels. EBA is the lead at the third level of the process, and provides key-supporting tasks on the three other levels of the framework: Level 1 refers to primary banking legislation, based directly on the treaty and issued after a proposal of the Commission has been (amended and) endorsed by Council and Parliament. Level 2 refers to secondary banking legislation, based on level 1 legislation, on those issues where Council and Parliament agreed that the Commission could use delegated legislative powers on certain technical issues. The Commission has the power to agree on such delegated binding legislation, with a call-back option of the Council and Parliament. EBA has gained a right of initiative for some enumerated areas of delegated binding legislation, with limited scope for the Commission to deviate from the proposals of EBA. Level 3 refers to the harmonisation work done by the collective of supervisors embodied by first CEBS, now EBA. EBA tries to make sure that all supervisors apply the binding EU rules in a similar manner by deliberation, discussion and issuing guidelines. EBA also gained the right to propose draft standards. The standards, however, have to be endorsed at level 2 (under delegated power by the Commission) before they become binding upon supervisors and banks. Level 4 refers to the power of the Commission to address non-compliance with EU laws of member states. EBA has now gained an explicit role in this process vis-à-vis the national supervisors that execute CRD-tasks on behalf of the member states, based upon de facto work of CEBS to check who has implemented which rules in which manner. See chapter 3, 21.3 and 23. Other Banking Supervisors and Other Prudential Supervisors Prudential banking supervisors do not operate in a vacuum, nor are they the sole guardian of public interests when it comes to banking. Other public authorities interested in banks are amongst others: – competition authorities; – monetary authorities (central banks); – payment system supervisors and financial markets supervisors; – financial crime investigators; – conduct of business supervisors and consumer protection authorities; – ministries of finance and parliamentarians, for over- or under-funding society; – and many more who are interested in finance, including the state or local authorities that have to invest funds or attract funds.

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An Overall Picture of Current Banking Supervision

The monetary authorities and payment system supervisors (often both part of the central bank), provide a similar – and mutually supporting – function as banking supervisors to safeguard financial stability. Where banking supervisors look at the risk the bank or banking group provides to their counterparties and the system, the central bank has a task looking at the impact of systems and currencies on financial stability. The central bank is very interested indeed in the many systems (payment systems, clearing and settlement systems) in which banks play a key role, as well as in the possibilities to enforce their (monetary) interest rate policy via the banks. The central bank generally plays a coordinating role on financial stability, backed up by the finance ministries (i.e. the state) if problems get out of hand. This coordination role follows from the fact that they provide the banks with liquidity support if a bank has a (temporary) lack of cash, but still is solvent. System supervision by central banks and prudential supervision on individual banks by banking supervisors overlap in an unclear border area. If problems at a bank or at banks cannot be contained by the instruments available to supervisors, the central bank gradually needs to step in to contain consequences thereof for other banks and for the financial system. If this does not suffice either (or the banking authorities/central banks do not have sufficient tools) the state may need to step in to contain consequences for society and the voters. A concept of so-called macroprudential supervision is currently being developed. It will cover the collective behaviour of the participants in the financial market. The existing prudential and monetary instruments target individual aspects of stability (via prudential supervision and central bank tools) will be gradually added to by instruments targeted to oversight of the financial system as a whole. This oversight already exists, but lacks teeth (and credibility following the 2007-2013 subprime crisis). A new financial stability forum under the name European Systemic Risk Board is being set up with the secretariat provided by the ECB. National central bank governors will dominate it. It will have the power to collect information. On the basis of that information and the analysis by its members it is able to highlight trends and issue warnings to the authorities that can/may deal with the identified problems. The ESRB cannot act itself (even though its individual members can under their national mandate). See chapter 22. A close companion of prudential supervision is conduct of business supervision. Conduct of business supervision is not focused on the health of the bank, but on its obligation to provide services to its clients fairly, and to operate in the financial markets dealing honestly with its counterparties. Conduct of business requirements sometimes overlap with prudential requirements, e.g. on organisational and on transparency requirements. The core of conduct of business requirements for banks is laid down in the markets in financial instruments directive (Mifid). The Mifid rules apply to all investment firms. Investment firms basically are the firms that are professionally active on the financial markets by e.g.

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EU Banking Supervision

investing on their own accounts or on behalf of clients. Many of them are banks. Mifid introduces obligations to e.g. act honestly, fairly and professionally in accordance with the best interest of the client of investment services delivered by the bank. For certain other services, such as consumer credit, similar requirements are made under EU consumer protection legislation. The EU has not (yet) set harmonised protection rules for all areas of financial services (e.g. not yet in the area of mortgage loans). See chapter 16. Banks are not the only financial institutions under prudential supervision. The prudential supervision on non-bank investment firms is largely derived from banking prudential requirements. Insurers, issuers of e-money and providers of payment services have their own prudential regime that sometimes, but not always, shows some similarities with banking prudential rules. See chapter 19.

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The Legislative Response to the 2007-2013 Subprime Crisis and the Origins of the Current Prudential Regime

2.1

Introduction

The 2007-2013 subprime crisis has caused frenetic action by supervisors and banks. The financial consequences of the crisis – adding up rescuing banks, the credit crunch and the sovereign crises for those states not able to deal with these liabilities – lead to worldwide coordinated demands of heads of government to beef up banking regulation. In response, supervisors, central banks and ministries of finance (including the EU Commission) have engaged in high profile work on redrafting the banking supervision regime. After the helicopter view of banking supervision in chapter 1, this chapter offers a similar view of how this tapestry of current rules came into being, and where it is going in reaction to the 2007-2013 subprime crisis. Chapters 3-23 will subsequently delve into the content of the current rules, with a brief description of planned future rules. Basis for the Post-Crisis Adaptations Prudential supervision on banks was introduced in the original member states of the EU at different times, in reaction to local economic and political developments. The first crossborder efforts to provide common principles for banking supervision date from the seventies of the last century. Almost simultaneous, work began both at the worldwide and EU level; see chapter 2 and 3. Banking supervisors at their own initiative started a so-called ‘groupe de contact’ in 1972. A more formal committee of ministries of finance and supervisors as an advisory body to the Commission was established in 1977, working amongst others on the basis of reports of the groupe de contact. At the worldwide level, the Basel Committee on Banking Supervision (‘BCBS’) was established in 1974. The discussions at the worldwide and regional level gradually resulted in both non-binding but influential papers on various banking supervision subjects issued by the BCBS, and in the EU publishing its binding rules in the form of directives. The EU reduced some barriers to cross-border banking operations in 1973, and published the ‘first banking directive’ in

27

EU Banking Supervision 19771. The first banking directive started a drive toward harmonisation by coordinating a few details of the content of banking supervision in a binding manner across national borders. These first efforts were followed by waves of refinements and/or filling in gaps. At the EU level, relatively quiet times were followed with priority agendas such as a consolidation and implementation effort in the context of the ambitious 1999 ‘financial services action plan’2 of the Commission. At the time, the Commission was dissatisfied with the speed at which European financial markets integrated and the speed at which the benefits thereof arrived at the door of European customers and of the financial undertakings themselves. The plan aimed to improve Europe-wide financial markets by introducing new harmonised rules via a new specialised rule making process. Financial markets were found to move more rapidly into new products and risks than could be accommodated by the stately pace of EU negotiations on new legislation. The EU legislators introduced the four level arrangement known as the Lamfalussy process initially only in the securities sector. This process made maximum use of the leeway allowed under the then applicable EU treaties to delegate preparatory legislative work and harmonisation work to the ‘technical’ level of supervisory authorities. The formal EU legislators (Council and Parliament on the basis of Commission proposals) would remain responsible for the framework, ensuring democratic accountability and influence. The Lamfalussy process was expanded to all financial sectors – including banking – in 2004. Expectations were high of the benefits of the financial services action plan. These expectations were not fully met, which resulted in additional (and follow-up) priorities set out in the Commission White paper 2005-2010, as well as in work plans of the various new organisations set up under the Lamfalussy process. The credit crisis added pressure on the implementation and on the revision of the work. First aid measures were adopted both by the BCBS and the EU in 20093. Apart from dealing with the practical issues of a crisis (supervising banks, forcing them to become healthy on their steam or to accept help, taking emergency measures, stimulating financial markets and other parts of the economy), prudential legislation had to be adapted to the lessons learned. The G20 – including a strong EU contingent of member states and the Commission – coordinated a legislative agenda. Based upon input received from

1 2

3

Directives 1973/183/EEC and 1977/780/EEC (First Banking Directive). See chapter 2.2 and 3.4. See chapter 2.2. For a description of this plan and its predecessors, see E. Ferran, Building an EU Securities Market, Cambridge, 2004, chapter 1, and L. Dragomir, European Prudential Banking Regulation and Supervision, The Legal Dimension, Oxon, 2010, chapter 3. See the G20 plans and, for instance, Commission Communication, Driving European Recovery, COM(2009) 114 final, 4 March 2009.

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amongst others national legislators, supervisors and banks, a flight forward was chosen on prudential issues. There was no evaluation of whether the still applicable Basel I capital accord as at that time applicable in the EU, or the new Basel II capital accord that was slowly being implemented in the early years of the crisis provided the right basic foundations for safety. The choice was made to accept the existing structures as they stood, and to focus on improvements. This would allow fast and muscular legislative action aligned with the muscular supervisory action needed to try to calm financial markets. The only way was up; no time for contemplation. The G20 asked the BCBS to start/continue its work on the capital accord. Expanded with representatives of those G20 countries that did not yet have a seat prior to the crisis, the BCBS has churned out several pieces of work to amend the Basel II version of the Basel accord in force at the time. On capital requirements, the new amended versions are known as Basel II ½ (delivered in 2009) and Basel III (delivered in 2010) respectively. Basel II ½ contained some first aid that was quickly needed and quickly possible, mainly to double the amount of financial buffers needed for market risk (for assets held in the trading book). EU legislators have already agreed some of the first aid legislation. Part of this concerns own initiative work (CRD II); part is derived from BCBS work (CRD III amongst others implements Basel II½). The roman numerals II and III are based on the fact that it concerns the first major changes following the adoption of the CRD (original version or nr ‘I’) in 2006. The EU has also agreed the CRD IV project, intending to implement Basel III, as well as some regional work on sanctions regimes. Basel III will thus become part of the EU legislation from 2014. A new regulation and directive have been agreed at the start of 2013 by the Council and Parliament, and will recast the existing version of the CRD. The CRR 575/2013 and the CRD IV directive 2013/36/EU will replace the RBD and RCAD. This is the third recast of the prudential banking directives. The current recast versions date from 2006, the previous from 2000, indicating that the expected shelf life of banking prudential rules is about 6 years. Even the new CRD IV project still contains many identical or similar rules as applicable today. Some long-neglected areas become more strict (the amount and quality of financial buffers for unexpected losses) and in one area a new set of requirements is added to the existing rulebook (liquidity). Existing rules are tightened and upgraded the calculations less prone to being ineffective or evaded/gamed by the banks. The G20 work programme also contains chapters that are not directly focused on prudential supervision of banks. Some of these will nonetheless have a direct impact on the business of banks and on prudential supervision. Work allocated to the Financial Stability Board includes the (over-)reliance on external ratings and the above-mentioned systemically

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important institutions if they operate in a cross-border context. Other institutions are working on issues such as the use of trading platforms, clearing and settlement for derivatives, and other issues determining the structure of the financial markets in which banks operate. The EU has had its own legislative response, largely within the boundaries of the G20 agenda. Some aspects appear truly to be solely aimed at weaknesses identified in the crisis, others realise older wish lists. They intend to strengthen banks internal processes as well as internal and external supervision, and will make it less likely that this (exact) type of crises will happen again. The Lamfalussy structures were amended to strengthen and bind supervisory authorities and the EU level structures that bring them together, again looking for the outer boundaries of what is allowed under the current version of the EU treaties after the amendment by the Lisbon treaty. Before these were bedded down, the crisis overtook such implementation by necessitating discussions towards a banking union in the Eurozone. The beefed-up and new requirements will have a large impact on the business of banks. The crisis gave an excuse to address both long known but politically sensitive issues and problems discovered in the crisis. The focus has been on dealing with some misfired innovations and the growth in the sheer size of the banks and the financial markets they operate in. Long known problems included e.g. the national discretions in the definition of capital (financial buffers to weather future losses, which were too loose especially in countries where the banking sector was politically well connected), the rather low key stress testing requirements, the treatment of derivatives in the credit risk calculations, making risk assessments substantive enough (e.g. the treatment of market risk and its financial buffers that did not provide any buffer at all). The policy action taken reflects that the existing rules underestimated the risk embodied in securitisations, in the fast growing derivatives markets and in macroprudential correlation issues (banks that acted wisely individually by deleveraging and cash hoarding caused instability as that course of action lead to further weaknesses at other banks). They overestimated the control shareholders exercised, or the self-restraint employees/managers would have in the face of short term incentives under share-price or short term profit related payment structures. The policy response to the financial crisis is described in chapter 2.3. How such responses fit into the legislative history of the capital requirements directive is set out in chapter 2.2. For a description of the 2007-2013 subprime crisis and the EU policy response issued via official channels please see the Liikanen report4. It differentiates five waves in the crisis: from the initial subprime phase in bad lending; via the systemic phase after the Lehman

4

High-level Expert Group on Reforming the Structure of the EU Banking Sector, Final Report, 2 October 2012 (Liikanen Report). For the five phases or waves of the crisis, see chapter 2 of the Report.

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collapse in September 2008; an economic crisis phase of recession and state aid; a sovereign crisis in which the bank-sovereign feedback loop developed as a result of state aid versus sovereign bond holdings; and lastly a crisis of confidence in the EU phase, where the euro as a currency is being challenged. For EU banks and from an EU banking supervision point of view, the 2007-2013 period nonetheless amounts to a single period of economic misery.

2.2

The Origins and Future of the Capital Requirements Directive (CRD)

Introduction The core of the current EU legislation on the supervision of banks is formed by the capital requirements directive or CRD. Even though the term CRD indicates a single piece of work, it actually consists of two directives: – directive 2006/48/EC of the European Parliament and the Council of 14 June 2006 relating to the taking up and pursuit of the business of credit institutions (recast); and – directive 2006/49/EC of the European Parliament and of the Council of 14 June 2006 on the capital adequacy of investment firms and credit institutions (recast). These are referred to as the ‘recast banking directive’ (RBD) and the ‘recast capital adequacy directive’ (RCAD) respectively in this book. In the RBD, the main elements of licensing, ongoing prudential supervision and termination of banks are dealt with. The RCAD deals with a specific subject only: the treatment of market risk. This has been kept outside of the RBD, because it is also relevant to specialised non-bank firms that operate in the financial markets. The RCAD contains the prudential requirements for such investment firms (that have a licence under the markets in financial instruments directive (Mifid; see chapter 16.2) as well as the common framework for banks and non-bank investment firms for the treatment of market risk. Both directives are in the remit of EBA, but the RCAD is also within the competence for ESMA, which is also responsible for Mifid5. The RBD and RCAD will soon be replaced by a new regulation and directive, recasting the existing version of the CRD. The capital requirements regulation (CRR) 575/2013, and the capital requirements directive IV (CRD IV directive) 2013/36/EU will replace the RBD and RCAD from the start of 2014. Large parts of the CRR will enter into force only at the end of 2014, while the main innovations in both documents (on capital quality and quantity as well as

5

Art. 1.2 EBA Regulation gives the full RCAD to EBA. Simultaneously art. 1.2 ESMA Regulation gives RCAD to ESMA too, but ‘without prejudice’ to the prudential supervision competence of EBA.

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additional safety indicators in the form of additional ratios) will only enter into force from 2016-20216. The CRD dates from 2006, but has predecessors dating from 19737. Those predecessors were ‘recast’ into the current directives. This recasting involved some modernisations, but many provisions were copied unchanged (with changed numbers). The 2006 version of the EU banking supervision legislation is the most recent major overhaul and renumbering of the relevant EU legislation. Since its introduction it has been partially revised again. The policy response to the 2007-2013 subprime crisis continuously results in new plans for amending segments of the requirements on the banks and/or the supervisory framework. When reading the CRD, it should be borne in mind that it is the result of a decades-long negotiating process, where small or large segments were updated or replaced continuously. It was negotiated at different times, by different experts, bringing together expertise and policy documents from widely differing areas. The various subjects (increasingly) have a highly technical and complicated content, with a tendency to add ever more detail in each subject. Experts on one topic were not necessarily expert – or even involved – in other topics. Combined with powerful industry lobbies, national lobbies, vested interests, final negotiations bound to an externally set tight deadline in e.g. the financial services action plan (see below), and a subject that is on the crossroads of accountancy, legal, political and economic areas of interest, nobody should be surprised that the CRD is not a work of art: i.e. not particularly balanced, not easily accessible and not easily understandable8. The CRD is based on a series of key policy documents developed at the worldwide and regional level. The key documents at the worldwide level were the adoption of the Basel capital accord and the development in 1997 of the Basel core principles for effective banking supervision9. The core principles were revised in 2006 and in 2012, with accompanying detail on how the IMF assesses supervisory systems of countries under these core principles. As set out in chapter 2, the Basel III version of the capital accord is likely to be implemented in the EU in 2014-2019. These worldwide efforts have driven EU legislative work and practical supervision.

6 7

8 9

Art. 163 CRD IV Directive and art. 521.2 CRR. Directive 1973/183/EEC abolished some restrictions on the freedom of establishments and freedom to provide services in respect of self-employed activities of banks and other financial institutions. It remained in force until it was absorbed into the Consolidated Banking Directive of 2000, the direct predecessor of the CRD. Also see R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 4; and J. Black, Rules and Regulators, Oxford, 1997, chapter 6 on the UK Financial Services Rulemaking Process. For a description of the background and negotiations of these key documents see C.A.E. Goodhart, The Basel Committee on Banking Supervision, A History of the Early Years 1974-1977, Cambridge, 2011. Also see A.F. Lowenfeld, International Economic Law, Second Edition, New York, 2008, chapter 23. Also see chapter 21.1.

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Policy drives by the Commission have equally been very important10. These have come in waves since the initial introduction of legislative proposals to harmonise banking requirements in the seventies. The most important broader legislative projects that had an impact on prudential banking legislation were the 1985 Commission white paper, ‘completing the internal market’, and the financial services action plan as published in 1999 by the Commission11. These proved to be turning points in financial services EU legislation. Policy development was shifted from the domestic to the EU level, though the execution remained firmly national and national supervisors became key advisors on policy development. After these plans were executed within the tight timelines set, an evaluation phase was expected subsequently to the finalisation of the EU financial services action plan. That plan had overburdened both legislators and market participants. The intention was to pause the legislative agenda, and focus on implementation and – at most – some polishing of existing legislation. The agenda for this so-called ‘regulatory pause’ was set out in a 2005 Commission white paper12. The emphasis was to shift from fast paced introduction of new legislation to the ‘better regulation’ testing of any new laws, and on correct and harmonised application in practice of the existing legislation. From the start, the pause was more a public relations exercise rather than an actual pause in the work instigated by the Commission. However, the ‘pause’ was cast aside in full only in the wake of the 2007-2013 subprime crisis. Eager to show muscular action in the face of increasing criticism on the gaps in legislation and application of amongst others banking supervision, a new legislative programme started in the follow-up to the 2007-2013 subprime crisis. Aside from this regional response, worldwide and national legislative responses also started their muscular response to the crisis, leading to a plethora of plans, timelines and (legislative) proposals at the worldwide, regional and national level. To understand the gist and true impact of these plans in the EU, both the worldwide work and the EU work can only be understood if set in the context of what was already there, and the development thereof. This chapter aims to perform this timeline for the Basel work that lies at the core of quantitative requirements on banks, and the EU work that has taken the worldwide work and put it into a binding format, accompanied by EU specific addendums and deviations. Basel Policy Papers The Basel Committee of Banking Supervisors has issued several papers. Some are investigative reports, but more important are the papers that codify a common understanding 10 These have been described in detail in e.g. H. Davies & D. Green, Banking on the Future, The Fall and Rise of Central Banking, Princeton, 2010 and N. Moloney, EC Securities Regulation, 2nd ed, Oxford, 2008, chapter I. 11 Commission White Paper, Completing the Internal Market, 14 June 1985, COM(85) 310, Commission Communication, Financial Services: Action Plan, 11 May 1099, COM(1999) 232. 12 Commission White Paper, Financial Services Policy 2005-2010, Commission White Paper, 1 December 2005, COM(2005) 629 final.

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on how banking requirements and supervision should work. The members of the committee – including several EU member states – agreed to copy such common understanding papers at home into their banking supervision practices. The Basel accord is the most famous of such consensus papers. It is a patchwork of original texts and (major) amendments, which have been implemented up to and including the Basel II ½ revision mentioned below. The timeline of the capital accord is as follows: 1988 The Basel accord (first version, also referenced as Basel I). This first version introduced a short and simple approach to banking supervision, well suited to the relatively small number of banks of significant size that existed at the time, and focused on capital requirements for credit risk. It contained provisions on: – definition of capital (providing a financial buffer for risks); – scope (which parts of banking groups are covered); – method to calculate credit risk for all assets and off balance sheet items (exposures), including a special regime for OTC derivatives13 and similar instruments known as counterparty credit risk; – solvency ratio, requiring ‘8%’ of capital for the calculated credit risk; – some high level organisational requirements (internal governance). 1996 The market risk amendment added a separate calculation to account for the increasing significance of the role of banks in the markets in financial instruments, and allowed more sophisticated banks to calculate market risk in line with their own data and models instead of being forced into a simple process (like existed for credit risk) that did not take into account different risks within the defined broad categories. It contained: – requirements on several specific types of market risk – including position risk as a replacement credit risk treatment – for those exposures that are held with the intent to trade them (trading book assets), not keep them to maturity – adding requirements on foreign exchange risk and commodity risk for all exposures – allowing parts of market risk to be calculated by an internal model as developed by the bank and amending the solvency ratio and the capital definition to include a capital requirement for market risk that can partly be covered by very low quality (tier 3; subordinated short term loans) capital. 1998 Sydney press release14: – amendment to the definition of capital, further loosening it to include hybrid capital as part of the accepted highest quality financial buffers.

13 Complex financial instruments traded off trading platforms. 14 BCBS, Sydney Press Release of 27 October 1998.

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2004 Basel II amendment15. The Basel II amendment to the capital accord tried to repair some of the obvious gaps in the first Basel accord on the calculation of capital requirements for credit risk. This structural revision in 2004 introduced a supervisory review process and a disclosure regime for banks. It also added new capital requirements on operational risk and started a differentiation between banks of varied sophistication. In line with the existing experiment in the market risk area, the most advanced banks – within defined parameters – could start calculating capital requirements for credit risk and operational risk on the basis of their own assessment of risks. However, issues where no consensus was likely were left aside. This included the definition of capital (financial buffers), where vested interests in the member countries were too diverse. Also – lacking a supporting crisis at the time – the policymakers were not allowed to become more strict on banks. In order to be allowed to go forward, they agreed with politicians and banks that the overall capital level of banks would not go up, even though the complexity (and thus the risk) of the business of banks and the supervisory requirements had increased. The agreement on this version of the accord spurred the recasting of existing bank prudential rules in the EU into the first version of the CRD. Nonetheless, it contained: – revision of the treatment of credit risk, introducing more models and risk sensitivity; – adding a specific regime on securitisation to the credit risk treatment; – introduction operational risk treatment; – no material amendment regarding the scope of the accord, its market risk component, nor the definition of capital. 2009 Basel II½. This first response amendment overhauled the Basel accord in 2009 on several obvious gaps that were exposed in the wake of the 2007-2013 subprime crisis, with a focus on securitisations and trading risks. The CRD III directive implemented this package (CRD II contained own initiative work of the EU; see below16: – strengthening of securitisation regime within credit risk and market risk; – strengthening of position risk requirements (market risk); – addition of detailed risk management issues to the pillar 2 assessment of internal governance, including on remuneration requirements, liquidity management as well as some detail on stress testing.

15 BCBS, International Convergence of Capital Measurement and Capital Standards, June 2004 (Basel II), and BCBS, The Application of Basel II to Trading Activities and the Treatment Of Double Default Effects, July 2005. 16 Basel II½, BCBS, Revisions to the Basel II Market Risk Framework, July 2009 in combination with BCBS, Enhancements to the Basel II Framework, July 2009; the date of implementation was later adapted to end 2011 via a press release, which also made some minor changes to the market risk paper, BCBS, Adjustments to the Basel II Market Risk Framework announced by the Basel Committee, 18 June 2010. A stress testing annex was added in a later revision incorporating all changes in the market risk paper, published in BCBS, Revisions to the Basel II Market Risk Framework, updated as of 31 December 2010, February 2011.

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2010 Basel III amendment. This second response overhaul of the capital accord contains amendments on substantive issues such as liquidity and the type of financial buffers that can cover capital requirements and the amount of such financial buffers needed. Followup work has been announced on large and systemic institutions and the calibration of e.g. a leverage ratio and of quantitative liquidity requirements. It is not yet implemented in the EU. It: – replaces the existing definition of capital with a more rigid definition, and kicking out low quality items such as tier 3 capital (short term subordinated bonds); – strengthens the solvency ratio, increasing the amount of high grade capital that needs to be held for credit risk/operational risk/market risk capital requirements; – introduces additional solvency ratio requirements to ensure beefing up financial buffers in economic good times, and to prevent dividends and bonuses when the bank does not have surplus capital above the minimum level; – strengthens the counterparty credit risk requirements for all OTC derivatives and similar instruments; – introduces of a leverage ratio in due course (maximizing the assets a bank holds in relation to its capital), initially to be considered in the context of pillar 2; – introduces a short term (liquidity coverage ratio) and a long term (net stable funding ratio) quantitative liquidity risk requirement, though the strength of these requirements is not yet clear due to announced follow-up work; – prescribes very, very gradual implementation, with some requirements slowly building up (more common equity tier 1 capital), and others introduced only as per 2018 as binding commitments (leverage ratio, net stable funding ratio). The BCBS had announced further work on a score of issues pertaining to the capital accord, such as the calibration of the liquidity risk requirements, the concept of the trading book, the calculation of the leverage ratio and the additional requirements on systemically important financial institutions, some of which have since been delivered17.

17 See for instance the adjustments to the Basel III Framework contained in BCBS, treatment of trade finance under the Basel Capital Framework, October 2011; ‘Minimum requirements to ensure loss absorbency at the point of non-viability’ attached to a BCBS Press Release, Basel Committee Issues Final Elements of the Reforms to Raise the Quality of Regulatory Capital, ref 03/2011, 13 January 2011; and Basel III: the Liquidity Coverage Ratio and Liquidity Risk Monitoring Tools, January 2013. These and related FSB/BCBS work on financial buffers global systemically important institutions have already been accommodated in the CRD IV project (see below).

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Table 2.1 Basel accord

1988 BI

Scope

Credit Operational Market Solvency Pillar 2 Pillar 3 Liquidity of capital risk risk risk ratio risk

Intro

Intro

1996 Market risk

RC

1998 Sydney

RC

2004 B II

FR

2009 B II½

PR

2010 B III Post B II 2011-

FC

Intro

Intro

Intro

Intro

RC

RC

RC

PR

Intro

Intro

RC

PR

FR

RC

RC

RC

Intro FR

Intro: Introduction of rules on this subject FR: Full revision of this subject PR: Partial revision (of aspects of this subject) RC: Recalibration of this issue (either strengthening or loosening) B I, II, II½, BIII : Basel accord (revised) versions Not yet (fully) implemented in the EU in 2013; to be partially introduced in 2014

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EU Banking Supervision

The BCBS finalised its proposals on the Basel III amendment to the capital accord in 2010. This strand of work was started simultaneously with the quick-fix changes in Basel II ½. Basel II ½ focused on the trading book, on securitisations and on remuneration policy18. Basel III focuses on credit risk, and the introduction of a liquidity regime. The Basel III package amends the capital accord on the definition of capital, on the solvency ratio and on the treatment of the credit risk embodied in derivatives, and introduces three new ratios on short term liquidity, long term liquidity and leverage. The capital accord provisions on operational risk, large swathes of credit risk rules outside the areas of derivatives and securitisations, and on the scope of the accord have not been changed from the Basel II version of the accord. The basic outline of Basel III was presented in press releases in July and September, and the full package was published in December 2010 after it was endorsed by the G2019. It will equally not be the end-station of prudential supervision, as the BCBS has announced a range of follow-up work, including a fundamental review on the treatment of market risk and new add-ons on the treatment of large systemic entities. Issues that need subsequent action, amendment, monitoring or research include the treatment of systemically important financial institutions (sifi’s; see chapter 6.2 and 18.2) as well as the final calibration of the leverage ratio and of the long term liquidity rules. All these issues are contentious both between supervisors and between supervisors and banks, and will have a material impact on the business models of banks and their profitability. The general layout and structure of the capital accord is not changed under Basel III, it remains focused on the consolidated capital of banking groups (instead of individual legal entities) and requires such groups to have sufficient financial buffers to deal with credit risk, market risk and operational risk. Where Basel II ½ focused on upgrading market risk and securitisation-calculations, the Basel III amendment of the existing Basel capital accord revisits two more fundamental former ‘no-go areas’: the definition of capital (financial buffers) and an increase in the amount of capital required to buffer for the risks banks have on the one hand, and the introduction of a separate set of requirement on liquidity buffers on the other hand. The BCBS has indicated that in the past, banking crises occurred on average every 20 to 25 years in any given country. The Basel III accord – the third

18 Basel II½, BCBS, Revisions to the Basel II Market Risk Framework, July 2009 in combination with BCBS, Enhancements to the Basel II Framework, July 2009. Implemented by CRD III 2010/76/EC in the EU, which had to be transposed into national legislation by year end 2010 on remuneration (and some technical issues), and by year end 2011 for securitisations and the trading book. See chapters 9, 8.6 and 13.3. 19 BCBS, Basel III: a Global Regulatory Framework For More Resilient Banks and Banking Systems; BCBS, Basel III: International Framework for Liquidity Risk Measurement, Standards and Monitoring, 16 December 2010, www.bis.org, also see chapter 6 and 12. The outline of Basel III was published in the form of BCBS press releases of 26 July 2010 and 12 September 2010.

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configuration of the Basel capital accord – intends to (further) decrease that frequency and the severity of such crises.20 The BCBS presented its proposals to the G20 in summer 2010. After endorsement, they were published in their final form in December 201021. The EU Commission – an integral though officially non-voting component of the BCBS – had already been consulting on various components of the package during the development of Basel III. The EU plan was to adhere to the timetable set by the BCBS for implementation; see below. Other BCBS papers of a high impact include: – Basel core principles for effective banking supervision (1997, 2006 and 2012), against which supervisors are checked by the IMF in the context of the so-called financial sector assessment programme22; – banking secrecy and international cooperation in banking supervision (1981); – a series of papers starting with the so-called ‘concordat’ on cross-border cooperation in home host situations (starting in 1975, and replaced in 1983, this issue has been revisited many times, for instance supplemented in 2010 with good practice principles on supervisory colleges); which influenced and was influenced by the EU arrangements on home host cooperation (see chapter 21.6, 21.7 and 21.8); – management and supervision of cross-border electronic banking activities (2003); – guidelines on dealing with weak banks and on cross-border bank resolution; – core principles for effective deposit insurance systems (2009). Apart from these papers, major studies, advice, guidelines, press releases, newsletters have been published on various subjects such as crisis management, accountancy, internal organisation and cross-border cooperation. The BCBS appears to have a fondness for the number three. Three pillars for its capital framework, three tiers in capital, three main categories of risk, and the third version of the Basel accord as a result of a major overhaul. There is no sound theoretical basis for the 20 BCBS, An Assessment of the Long-Term Economic Impact of Stronger Capital and Liquidity Requirements, August 2010, www.bis.org. 21 BCBS, Basel III: a Global Regulatory Framework for More Resilient Banks and Banking Systems, 16 December 2010, in combination with BCBS, Basel III: International Framework for Liquidity Risk Measurement, Standards and Monitoring, 16 December 2010. The BCBS also publishes (and updates) documents containing ‘frequently asked questions’ and/or interpretative documents to the Basel III Amendment and earlier texts on its website, which provide further guidance to the accord. 22 For a discussion, see D.Q. Rendón, ‘The Formal Regulatory Approach to Banking Regulation’, Journal of International Banking Regulation, Vol. 2, 2001, pages 27-49. The most recent version of the core principles were published in 2012, updating the previous 2006 version with lessons learned in the 2007-2013 subprime crisis. BCBS, Core Principles for Effective Banking Supervision, September 2012. See chapter 21.1.

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various divisions in its work, and they are used pragmatically. The references to different versions and different pillars do facilitate discussions. Such distinction can, however, cause confusion if people assume that there is a clear distinction between pillars, versions of the capital accord, risks, or that such concepts are independent of each other. The versions of the capital accord largely overlap. The pillars are standing on top of each other rather than next to each other (pillar 2 addresses the question what additional measures are necessary on top of the mathematical approach in pillar 1, and pillar 3 forces banks to disclose issues from pillar 1 and 2; see chapter 14 and 15. Market risk and credit risk are heavily interlinked, and the core distinction is based on the subjective intent of the bank to trade an asset or to keep it; see chapter 9.2. The Basel accord represents the common opinion of the member central banks and supervisors (with a potent role of the EU Commission as an ‘observer’ in the BCBS processes; see chapter 3). In the introduction to the capital accord, the BCBS indicates that it expects its members to move forward with the appropriate adoption procedures in their respective countries, and encourages supervisory authorities worldwide to follow suit. In one perspective, the EU banking legislation is solely a means to achieve this goal. In another perspective, the EU banking legislation is the legal translation of the common opinion of the BCBS members, and replaces that opinion with the legislators’ translation. In either perspective, the EU banking legislation sets out what member states, supervisors and banks have to do. The Basel papers provide a background to those legal obligations, and also can give guidance on issues where EU banking legislation does not speak. On issues where the BCBS cannot agree, or not agree in sufficient detail, the EU is more or less on its own. Due to the tensions between the various USA federal supervisors and with the USA legislature at the end of the finalisation of the Basel II revision (not unlike potential tensions between the various EU and domestic supervisors and legislators23), on who should be involved at which steps of the process of determining the international policy approach, the BCBS was more or less frozen for several years. It barely managed to finalise the Basel II framework. Work on liquidity and the definition of capital was at a full standstill (though on these issues the lack of political support may just have exacerbated large differences of opinion at a technical level). Importantly it was difficult to move forward to agree on practical implementation methods on the implementation of Basel II while it was unknown how it would be implemented in the USA. This changed only as a result of the 2007-2013 subprime crisis. 23 USA supervisors joined not all at the same time, and it was not clear that they agreed on the way Basel II should be implemented, nor whether they had political backing for it. This resulted in delays in issuing the proposed rules. Within the EU, the political side is represented by having the Council also at the table at the BCBS (and the need for political agreement on the implementation of the capital accord via the legislative process described in chapters 3 and 23).

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The BCBS intends the Basel capital accord as minimum standards: ‘It sets out the details (…) for measuring capital adequacy and the minimum standard to be achieved which the national supervisory authorities represented on the Committee will propose for adoption in their respective countries’24. Adding bits and pieces to the worldwide standards is expected. Prominent examples are the EU large exposures regime, and the USA prompt corrective action system based on the leverage ratio25. In the CRD context, goldplating has a more negative connotation when pursued by individual member states, which is logical as the CRD gives more comprehensive details, especially in the newer parts following the introduction of the market risk and Basel II amendments. The CRD and its Predecessor Directives The CRD is composed of (still recognisable) components of the original directives that entered into force between 1973 and 2006. These predecessor directives26 dealt with: – abolishment of some restrictions on the freedom of establishment and freedom to provide services (1973); – coordination of the licensing process, including some cross-border freedoms, and setting up the banking advisory committee to advice the Commission on further harmonisation (1977 and 1985; also known as the first banking directive); – supervision of banks and banking groups on a consolidated basis (1983, replaced and broadened in 1992); – composition of own funds (financial buffers for risk) of banks (1989, 1991 and 1992); – further coordination of licensing requirements, takeover requirements and introduction of the open markets for banks on the basis of their licence and supervision by their home supervisor (1989; also known as the second banking directive); – introduction of a solvency ratio between risk weighted assets of a bank and its own funds (1989, 1995, 1996 and 1998); – introduction of a regime to monitor and control large exposures (1992) – introduction of a market risk regime into the solvency ratio (1993 and 1998; also known as the capital adequacy directive, the direct predecessor of the RCAD);

24 Page 1 BCBS A Revised Framework, June 2006. 25 A leverage ratio will in due course also be introduced into EU legislation, but the prompt corrective action not; see chapter 6.2. 26 Directive 1973/183/EEC, 1977/780/EEC (First Banking Directive), 1985/345/EEC, 1989/299/EEC, 1989/646/EEC (Second Banking Directive), 1989/647/EEC, 1991/633/EEC, 1992/16/EEC, 1992/30/EEC, 1992/121/EEC, 1993/6/EEC, 1995/15/EC, 1995/26/EC (BCCI Directive), 1995/67/EC, 1996/10/EC, 1996/31/EC. 1998/31/EC, 1998/32/EC, 1998/33/EC, 2000/12/EC (Consolidated Banking Directive), 2001/24/EC, 2002/87/EC, and 2005/1/EC. Smaller amendments, relating to e.g. certain types of semi-public institutions that need not be treated as a bank were introduced in 1986/137/EEC and 1986/524/EEC, 1996/13/EC, Commission Directive 2007/18/EC, and in several accession treaties for states that became member states more recently.

41

EU Banking Supervision – in response to the BCCI case27 introducing clarifications on the licensing and on the cooperation requirements for supervisors (1995, also known as the BCCI directive); – a consolidation – with mainly textual changes where there are changes at all – of all the above-mentioned directives, except the capital adequacy directive, into one directive (2000, also known as the consolidated banking directive, see below); – introduction of a bankruptcy directive, that ensured that each legal entity with a banking licence would be wound up in only one bankruptcy proceeding for the EU instead of the traditional bankruptcy proceedings in each member state where the entity had assets (2001, also known as the winding-up directive); – introduction of supplementary supervision on financial conglomerates and other types of mixed groups that do not mainly consist of banks (2002 and 2008, also known as the financial conglomerates directive); – introducing a special legislative structure for the whole financial sector, including banking (2005, also known as the Lamfalussy directive). The CRD was issued in 2006. It recast the above-mentioned consolidated banking directive and the capital adequacy directive into respectively the RBD and RCAD. The financial conglomerates directive, the e-money directive, the winding-up directive and the deposit guarantee directive were left out of this project and still exist as separate documents. The CRD has been revised since its introduction by the following amending directives28: – introducing an amended mergers and acquisition screening procedure for the whole financial sector, including banking (2007, in reaction to the Antonveneta takeover by ABN Amro); – two ‘technical’ directives under the Lamfalussy structure by level 2 (Commission directives) to introduce some risk management improvements and harmonisation; – e-money directive, divorcing the requirements on e-money institutions from banking requirements; – CRD II, containing changes in the structure of cross-border cooperation between supervisors on a banking group in normal times and in crisis times in response to the 2007-2013 subprime crisis, as well as inserting other strands of work into the legislation, 27 The BCCI was a cross-border operating bank. It failed in 1991, amid allegations of fraud and incompetence. Within the EU, two supervisors had assumed some responsibilities, but neither had taken those especially serious with regard to more than the local activities. It was not clear whether the supervisor of the statutory seat (Luxembourg) had the responsibility for looking at BCCI as a whole, or whether the supervisor of the branch with the most significant activities (United Kingdom) would need to do this. With both supervisors pointing at the other as failing to supervise the overarching structure of BCCI; the only good news was that member states decided that such lack of clarity on who is responsible for supervising a bank should not be allowed to occur again. 28 2006/48/EC (RBD), 2006/49/EC (RCAD), amended by Directives 2007/44/EC, 2008/25/EC, 2009/110/EC Commission Directives 2009/27 and 2009/48, 2009/111/EC (CRD II), 2010/76/EC (CRD III), 2010/78/EU (Omnibus I) and 2011/89/EU (FCD II).

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The Legislative Response to the 2007-2013 Subprime Crisis and the Origins of the Current Prudential Regime

e.g. on hybrid capital that can serve as high quality financial buffers in the context of the solvency ratio (2009). Some of the annexes were simultaneously amended on issues regarding risk management by Commission directives (level 2 legislation). All are applicable in the EU as per end 201029; – CRD III, containing changes in the treatment of the trading book (market risk) as well as a strengthening of the securitisation regime (which is an important component of the credit risk regime), and introducing a specific regime on remuneration (salary and bonuses) practices in banks (internal organisation) (2010, in response to the revisions of the Basel II version of the revised capital accord by the BCBS in 2009; the Basel II ½ amendment. Partially applicable in the EU since end 2010, partially since end 201130; – Omnibus I, introducing the updated Lamfalussy structures along the lines of the report by the working group chaired by De Larosière31, by replacing CEBS by the European Banking Authority (2010); – FCD II directive, amending group supervision and conglomerate supervision (2011). The CRD directives are being re-arranged (and mixed with the Basel III proposals) effective as per 2014 into a new regulation and a new directive in the context of the CRD IV project (see below). The structure of the currently applicable recast banking directive (RBD) of 2006 that is the main part of the CRD is derived from its direct predecessor, the consolidated banking directive of 200032. That directive brought together (or ‘consolidated’) the different directives that previously focused on a single aspect of the rules for banks. The high number of directives formed a difficult to oversee patchwork on banking supervision in the EU. The consolidated banking directive tried to copy, without changing, the existing rules on quantitative banking supervision into a new integrated structure. The predecessor of the RCAD, the original capital adequacy directive of 1993, was left outside of the 2000 consolidation effort, as were non-quantitative pieces of legislation such as the deposit guarantee directive. The RCAD, like its predecessor, relates both to banks and to investment firms33 and the integration would have caused additional headaches for the legislators at the time. On the other hand, the two directive structure causes headaches for users now instead; see below.

29 CRD II Directive 2009/111, and level 2 Commission Directives 2009/27/EC and 2009/83/EC. 30 CRD III Directive 2010/76/EC. The changes in remuneration policies and the supervision thereof will be applicable also from year end 2010, while the trading book and securitisation rules have to be implemented by the member states only as per year end 2011. 31 See chapter 21.3-21.4, and 23.3. 32 Consolidated Banking Directive 2000/12/EC. 33 Capital Adequacy Directive 1993/6/EEC, also see chapter 16.2 and 19.2.

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EU Banking Supervision

The 2006 revision resulting in the CRD (RBD and RCAD taken together) was undertaken due to the need to implement of the Basel II amendment to the capital accord. The earlier work of the BCBS in that area – the Basel I Accord and its market risk amendment – had been the basis for large parts of the existing EU banking directives legislation. The introduction of Basel II into the existing consolidated banking directive necessitated a dramatic increase of the number of articles and annexes dealing with credit risk, as well as the introduction of a new chapter and annex on operational risk. A full renumbering was considered desirable, which resulted in the consolidated banking directive being ‘recast’ into the RBD directive that is part of the CRD. The simultaneous recasting of the original capital adequacy directive into the RCAD was less dramatic, but several stylistic changes were introduced (e.g. relocating some definitions into annexes and upgrading the own funds and large exposures requirements into the directive itself, numbering the recitals and re-ordering the subjects on which provisions were included). Both the original and the recast directives are minimum harmonisation directives, meaning that member states have to ensure compliance with the CRD, but can add stricter rules (‘goldplate’). On nonharmonised issues, member states have full freedom to goldplate within the treaty boundaries for all banks active in their territory; on minimum harmonisation issues they can goldplate for their own banks, building on the CRD provisions but going further with higher requirements (e.g. a higher risk weighting percentage). See chapter 3.5. In a first response to the crisis the CRD was amended via the CRD II and III directives (see above). As a crisis-measure, the CRD II directive can largely be described as window dressing34. Even though hybrid capital had already been discovered to be highly contentious (as it did not prove to be loss absorbing at all during the crisis, and thus did not provide a financial buffer for the normal unsecured creditors), the CRD II still introduced it formally into the CRD based on pre-crisis work. Previously, it had been allowed by many member states under the national discretions that riddle the definition of capital35. Though the requirements to limit the types of acceptable capital is laudable, it only eliminated the most egregious types, and allowed even those to remain on banking books until 2040; see chapter 7). Even though codified into EU law in 2009, the hybrids were excluded as financial buffers from the 2011 EBA stress tests and recapitalisation exercises, and will be replaced by a – tighter – hybrid form in the CRD IV project. The existing ongoing work on large exposures was upgraded and folded into the CRD II. Other – relatively small – parts of CRD II amendments will have a higher impact, such as the improvement of the position of host supervisors of bank branches that are ‘significant’ in the host market. Such

34 CRD II Directive 2009/111/EC, plus Level 2 Directive 2009/83/EC to amend annexes of the RBD and Level 2 Directive 2009/27/EC to amend annexes of the RCAD. 35 See chapter 3.5 and 7.

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The Legislative Response to the 2007-2013 Subprime Crisis and the Origins of the Current Prudential Regime

host state supervisors will now participate in colleges, gain information rights and gain crisis intervention powers for supervisors, central banks and ministries of finance (see chapter 18, 21.6 and 21.7). The CRD III directive is more directly related to the crisis. It implements Basel II ½, and contains new rules on the trading book. Assets held in the trading book for which financial buffers had been calculated under light touch market risk requirements had proven to be particularly thinly capitalised. Major upgrades were made on the credit risk treatment of securitisation transactions, including rules requiring the bank to retain an interest in the underlying assets (which is hoped to make that market more trustworthy for investors); see chapter 8.6. The risk management rules that according to Basel had to be taken into account in the pillar 2 assessment have been half-heartedly copied into the licensing rules of the CRD. This allows a supervisor to address them also in the context of pillar 2 that encompasses ‘all risks’ the bank is exposed to. The remuneration rules agreed in the worldwide context, however, were politically welcome in a vengeful society, and are heartily endorsed in the CRD now as part of the same risk management rules. See chapter 13). The changes on internal governance have been effective since 1 January 2011 (e.g. on risk management/internal governance), but the majority of the CRD III amendments started to apply only at the end of 2011. For the CRD IV directive implementing Basel III; see below. Apart from the CRD, several other EU laws are focused partly or in whole on banks36. These include e.g. conduct of business directives, and the various legislative efforts to relax restrictions on the movement of capital that came into effect since the 1960’s. Directives focused wholly or partly on banks include e.g. the deposit-guarantee directive, the markets in financial instruments directive (Mifid), the electronic money directive, the accounts of banks directive and various others. For banks, these do not contain prudential rules. They either provide supportive arrangements (e.g. accounting rules underpin the prudential rules) or conduct of business rules that also apply to banks if they engage in the regulated activities (see chapter 6.4 and 16). The Basel work and the EU banking legislation contain many similarities. The BCBS, however, is limited by the fact that it operates solely by consensus, and by its focus on the large cross-border institutions. Its procedures – in which experts from all its members are involved from the early drafting stages in its wide range of working groups – ensure that 36 The conduct of business directives and their application to banks are described in chapter 16, depositguarantee (1994/19/EC) in chapter 18.5, the accounting rules (amongst others directive 1986/635 and the IFRS regulation 1606/2002/EC) in chapter 6.4 and 15, and the electronic money and payment services directives (2009/110/EC respectively 2007/64/EC) in chapter 19.3.

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EU Banking Supervision

on many issues a technical compromise can be reached. On some other, more political, issues, peer pressure suffices to bring the more extreme outliers back into the herd to the point where they at least do not protest when a package of new rules is approved. To this extent, there is no difference with the EU negotiations process to establish directives. However, the BCBS cannot go forward if one of its members actively opposes the introduction of a subject onto its agenda. The same applies if an issue is worked on, but a BCBS member vetoes it on its own accord or is instructed by the political authorities in its jurisdiction to oppose a new standard on that issue. This is different in the EU due to the (qualified) majority voting process in its institutions, and because the right of initiative for proposing new legislation lies not with the joint member states but with the Commission (see chapter 23). A member state with a strong opinion on one item will need to find a coalition in order to block components of the directive proposals it does not like. The coalition needs to be strong enough to be able to form a blocking minority under the qualified majority voting rules of the treaties37. Some acknowledged weaknesses and gaps in the Basel work may be explained by this difference. The Basel II amendment to the Basel revised framework had been criticised – even though the decision to move away from the dated Basel I version of the accord was generally supported – for its failure to address e.g. capital definition, the level of capital, its pro-cyclical effects on the banking system as a whole, the reliance on external risk rating agencies, its failure to set high standards for assets held for trading purposes and the fact that the agreement on Basel II did not prevent the 2007-2013 subprime crisis from materialising (or being solved sooner after the subsequent implementation of the accord in the EU via the 2006 CRD). It was also criticised for its theoretical character, the discrepancy between Basel II model and internal models (underestimating risk for some assets, overestimating for others), and its perceived overly controlling nature38. Whether this criticism is correct to the extent and level of detail posed is debatable39 but the issues identified can indeed be considered weaknesses. The Basel II revision brought substantial benefits nonetheless in delivering a more central role for internal organisation requirements, by providing incentives for banks to improve their models and risk awareness, by making possible flexibility regime and added market discipline40. The hope is that the further revisions will bring in more safety while maintaining the advantages of the existing accord.

37 In the EU, a form of majority voting is applicable to banking legislation and guidelines. See chapter 23 on the EU legislative process. 38 See e.g. the collection of writers in H. Scott (Ed.), Capital Adequacy Beyond Basel, New York, 2005, and the arguments discussed (rather defensively) in F. Cannata & M. Quagliariello, ‘The Role of Basel II in the Subprime Financial Crisis: Guilty or not Guilty?’, Carefin WP3/09, January 2009. 39 R.J. Theissen, Are EU Banks Safe?, The Hague, 2013. 40 D.T. Llewellyn, ‘A Regulatory Regime and the New Basel Capital Accord, Journal of Financial Regulation and Compliance, Vol. 9, 2001, page 327-337.

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Basel Accord, CRD and Three Pillars The three pillar structure of the BCBS is difficult to retrieve from the CRD. The Basel accord allocates its standards to the three pillars as follows: Pillar 1: all quantitative calculations leading to the minimum capital requirements; see chapter 6-12. This includes – the formula for setting of the minimum capital based on adding the requirements per quantified risk category; – the constituent parts which can be taken into account in the capital which can be used to fulfil the requirements; – calculation of credit risk capital requirements, using either standardised approach or internal ratings based approach, adding to either capital requirements related to securitisation activities; – calculation of operational risk capital requirements; – calculation of market risk capital requirements. Pillar 2: the supervisory review process, based on the institutions own assessments of its capital needs; see chapter 13-14. Pillar 3: market discipline; see chapter 15. Visualized, this structures ongoing banking supervision as follows: Pillar 1

Pillar 2

Pillar 3

Quantitative requirements Capital requirements for – Credit risk – Operational risk – Market risk

Qualitative requirements and overall risk assessment

Disclosure

In terms of relative attention paid to the three pillars in the drafting process and the resulting Basel II accord and CRD, the division is more as follows (though even this overemphasises the attention paid in the Basel accord and EU legal texts to the second and third pillar):

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EU Banking Supervision

2

1 Op risk

Credit risk

3

Market risk

In addition, the Basel capital accord contains guidance on the scope of application of consolidated supervision. This, however, focuses largely on the consequences of its theoretical focus on large internationally active banks on the deduction it deems necessary to capital. The equivalent of the European (and national) provisions on licensing, supervision, cross-border cooperation between supervisors and liquidation is not contained in the capital accord but primarily in the BCBS core principles. The CRD provisions on ongoing supervision are built around the same pillars as the BCBS, but do not use the concepts or terminology as such. In the CRD, all three pillars of the capital accord requirements are laid down in Title V of the RBD (the other parts of the RBD do not relate to the capital accord or capital requirements, but to e.g. licensing). Within this title, pillar 1 is contained in the extensive chapter 2, pillar 2 in chapters 3 and 4, and pillar 3 in chapter 5. Additional detail is contained in the annexes to the RBD and, for market risk, in chapters III, IV and V of RCAD. This leads to several important differences between the Basel accord and the CRD: – The CRD is less easy to read, due to the split of the same subject matter over RBD and RCAD, in an uneasy tangle of cross-references. – In the CRD the pillars are deemed technical instruments of supervision only, dealt with on a par with issues such as licensing, passporting, relations with third countries, and powers of execution. In the CRD, where the Basel concepts are translated into legal instruments and powers, the relative importance of quantitative or qualitative requirements is important in order to calibrate the type of possible response to a transgression. – Issues such as passporting and powers of execution cannot be found in the Basel capital accord, because they deal with political powers. In the BCBS, the members do not have the political nor legal power to transfer responsibilities or assume them, other than on technical aspects. Such subject matter is touched upon in less detailed work such as the Basel core principles. In the CRD, the member states have reached a compromise on who has which power on the activities of banks, in order to enable a single market

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to be established for banking services. That the compromise has been laid down often in highly ambiguous wording, does not make it less important. – One of the main areas where the CRD adds clarity (and complexity) is in its scope. The Basel accord focuses on large cross-border operating well-diversified groups. It does not deal with cross-sector operating conglomerates41, nor does it intend to set standards for smaller firms or for firms that operate in one country only. On the other hand, the CRD applies to any bank, large or small, and to investment firms. It is applicable regardless of whether a bank has diversified its activities, and irrespective of whether it operates on a cross-border basis or only within one of the member states42. Two Directive Structure Difficulties of the CRD The two directive structure and the unchanged amalgamation of multiple old directives into the RBD part of the CRD leads to difficulties in the application of definitions and in deciphering cross-references. Both the RBD and RCAD regularly refer to ‘this directive’. Sometimes, the intent is really to refer to the RBD or RCAD only, but in some of the newer texts added in 2006, ‘this directive’ is intended to be both, in line with the ‘capital requirements directive’ reference used both in external literature and by the drafters during the legislation process. This is the cause of problems in the ‘supervision’ provisions43, delineating the tasks of supervisors in relation to ‘this directive’. By way of an example: the obligation for supervisors to check the compliance of banks with the full CRD is laid down in a less than perfect way in art. 124 RBD. Art. 124 RBD only refers to compliance with ‘this directive’ (i.e. the RBD, not the CRD which also includes RCAD). This is consistent with the use of the term ‘this directive’ elsewhere in the RBD and with the cross-references between RBD and RCAD. However, there is no provision in RCAD extending the scope of art. 124 RBD to the banks subject to RCAD. Art. 37 RCAD only makes art. 124 RBD applicable to investment firms, which under the RCAD definition excludes banks. The intention was, however, to have supervisors include also the market risk provisions of RCAD in their review and evaluation, as can be intimated from the references in annex XI to market risk and trading book issues. As it concerns a minimum harmonisation directive, the actual text of the CRD does not prevent national legislators to implement it as intended. This ambiguity appears to be unintended, and derived from the general usage of the term CRD to cover two separate directives, which were worked 41 The BCBS is, however, a parent committee of the Joint Forum, together with the equivalent worldwide structures in the securities sector and the insurance sector. The Joint Forum issues separate guidance on financial conglomerates, subject to the approval of its three parent committees. 42 Whether banks or banking groups based outside the EU, in so-called third countries, and their supervisors can be treated in similar ways as EU banks and supervisors needs to be assessed on a case-by-case basis, both for banks supervised by BCBS members and by non-BCBS members. 43 Art. 124-144 RBD and art. 37-38 RCAD.

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EU Banking Supervision

on as if they were one when Basel II was introduced. The same reference is also used in the obligations on e.g. supervisory disclosure and on supervisory cross-border cooperation. The cross-referencing in the RCAD, making large swathes of the RBD applicable to investment firms, makes it difficult to determine the applicable regime for the unwary reader. The problem is exacerbated by incoherent use of definitions within and across the RBD and RCAD44. The CRD IV project intended – in addition to implementing Basel III – to make an end to this confusion; see below. A single new directive and a single new regulation replace the RBD and RCAD, integrating banking and investment firm prudential rules. Per subject, a choice is made to put it into the CRD IV directive (to be implemented into national law by member states) or into the CRR (directly applicable across the EU). The intention is to provide a more accessible and readable set of rules45. The background for some of the choices made is not clear (the additional capital buffers and pillar 2 provisions could as easily have been in the regulation as in the directive), and cross-referencing correctly between the proposed directive and regulation will be as important then and now; though that appears to be better understood in the CRD IV project. The definitions article of the directive is basically a full reference exercise to the definitions article of the regulation, avoiding the contradictory definitions on e.g. ‘this directive’ or original own funds or trading platforms of the current two directives46. Overview of Quantitative Changes and Impact Assessment on CRD IV The early changes to the capital accord were implemented at incredible speed, both for BCBS work and its adaptation and implementation in EU law, with work starting in 2007 and the rules made formal in 2009 and 2010 (with an implementation date within 1 or 2 years). This was possible only by bypassing normal procedure, the most important of which was a performing an impact assessment. This was remedied during the negotiations on Basel III. CEBS-EBA published the results of a comprehensive quantitative impact study47 in December 2010, including both the Basel II ½ work (officially referred to as the enhancements to the Basel II framework and revisions to its market risk approach) and the – at the time tentative – thinking on Basel III (including the liquidity requirements, the upgrade in the quality of capital and the various ratios relating to capital, and the refinement of the calculation of credit risk for derivatives). The impact assessments show 44 On the difficulties of the two directive structure and its origins also see L. Dragomir, European Prudential Banking Regulation and Supervision, the Legal Dimension, 2010, page 128 and further. 45 Commission, CRD IV – frequently asked questions, 20 July 2011, Memo/11/527. 46 Art. 3 CRD IV Directive and art. 4 CRR. 47 CEBS, Results of the Comprehensive Quantitative Impact Study, 16 December 2010, www.eba.europa.eu. Also see BCBS, An assessment of the long-term economic impact of stronger capital and liquidity requirements, August 2010, www.bis.org.

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that especially larger banks – which prior to the crisis were on average much higher leveraged than their smaller competitors – will be hard hit by the various requirements. It also shows that the long implementation term should allow them to cope by either changing their business or by increasing their safety measures. The Commission published its own cost benefit analysis with its proposals for CRD IV48. The amount of risk weighted assets will likely increase, as will the need to raise new financial buffers (84 billion euro by 2015 and 40 billion euro by 2019). The benefits are more difficult to quantify, but have been estimated by the Commission. An annual increase of EU GDP is in the range of 0.3% – 2% is expected, by reducing the probability and frequency of systemic crises, and the amplitude of the business cycle. The CEBS/EBA study differentiated the impact between large banks (tier 1 capital in excess of 3 billion euro, well diversified and internationally active) and other banks. The larger banks were more leveraged, with lower quality capital, more securitisation assets hidden in their banking book, more exposed to risky derivatives trading and with worse short term liquidity arrangements. Market discipline had apparently not captured this, even though the date of measurement was end 2009, when banks had already had more than two years to adapt to the crisis. On the contrary, such larger and thus likely systemically important, banks were apparently entrusted with more loans in relation to own funds than their smaller, local cousins as seen from the leverage ratios. Whether the diversification angle is sufficient to compensate for the riskier profile on assets is questionable, it is more likely that the ‘too big to fail’ assumption and the associated implicit state guarantee has given large banks a competitive edge over smaller banks. See chapter 4.3 and 18. The value of impact assessments performed by the authors of the rules is relative. It helps drive choices on the issues to be considered, helps take the less costly road, and helps clarify what needs to be achieved (and what the regulator is willing to give up – largely on behalf of others – in exchange). Both costs and benefits are hard to estimate/model, with problems increasing if the benefits are nebulous (financial stability/safety/world peace) and the costs are only marginally clearer (what will new IT systems cost, what is the base rate for growth and how much growth will we deduct/add based on what scenario?)49. The bottom line remains that there is hope – based on modelled expectations – that the negative impact will be negligible, and that depending on detailing, execution and modelled 48 See the cost benefit analysis in the explanatory memorandum relating to the proposed CRR part of CRD IV COM(2011) 452 final, part I, page 7. The separate impact assessments are concerned instead with choices made on policy options. 49 See e.g. the qualifications on the models used to calculate the cost side of the equation made in P. Angelini, L. Clerc, V. Cúrdia, L. Gambacrta, A. Gerali, A. Locarno, R. Moto, W. Roeger, S. Van den Heuvel & J. Viček, J., Basel III: Long-Term Impact on Economic Performance and Fluctuations, BIS Working Papers No. 338, February 2011.

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expectations there will be benefits that are equally large for those who regulators deem more worthy of protection. Regime from 2014; Basel III / CRD IV As indicated above, in the follow-up to the 2007-2013 subprime crisis, several revisions have been implemented (CRD II, CRD III as based on Basel II½50 and the introduction of EBA), and proposed for adoption (CRD IV, with a large part of its innovations based on Basel III); see above. In July 2011 the Commission published its proposals on implementing Basel III51. These entailed a full recasting of the CRD. The two current directives, RBD and RCAD, have been thrown into a blender together with the Basel III accord and worldwide principles on e.g. corporate governance for banks, and re-divided into a new directive and a new regulation. The intention is to make the banking rules more cohesive and accessible, which has to be applauded (as they are currently neither cohesive nor accessible; see above). The CRD IV directive contains all issues where the Commission thinks the member states should have an active role in deciding how those rules should apply to their markets or to the types of legal entities and legal structures in their country. Directives require member states to amend local laws to incorporate the directive content, but contain leeway on how exactly to do this. The subjects allocated to the directive include setting up domestic supervisors, the licensing process, cross-border market access, the countercyclical capital buffer from Basel III, corporate governance requirements, the supervisory review process (pillar 2), and a new set of sanctions that supervisors should have at their disposal. More likely, some of these subjects were considered either very dated and inconsistent (e.g. the licensing rules) or politically sensitive in the sense that governments do not agree on how hard to treat all banks or some particularly politically powerful banks in their jurisdiction (sanctions, pillar 2). For e.g. corporate governance requirements and some crisis fighting instruments the allocation to a directive would make some sort of sense, as company law and tax laws are largely not harmonised in the EU. The CRR (capital requirements regulation) contain all quantitative capital requirements, including the new definition of capital, the new requirements on a leverage ratio and liquidity risk (the short term liquidity coverage ratio only at this time), as well as the existing credit risk, market risk, operational risk calculation methods with some minor amendments, such as the way external ratings are used. The regulation will – with the added detail in delegated binding regulations to be drafted by EBA and/or the Commission – form a 50 Basel II½; BCBS, Revisions to the Basel II Market Risk Framework, July 2009 in combination with BCBS, Enhancements to the Basel II Framework, July 2009. 51 CRD IV project published on 20 July 2011; Commission, Proposal for a Directive as part of CRD IV, COM(2011) 453 final, 20 July 2011, Proposal for a Regulation as part of CRD IV, COM(2011) 452 final.

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‘single rulebook’ on prudential (quantitative) requirements. This entails deleting national discretions – finally implementing amongst others the CEBS advice on deleting national discretions of 2008 – and prohibiting goldplating (minimum and maximum harmonisation), except in a limited number of cases52. Maximum harmonisation can only be deviated from by the member state or the domestic supervisor when justified by a set of national circumstances that is narrowly defined in the EU treaties, if justified by local financial stability grounds or if justified on the basis of the banks specific risk profile (via pillar 2). This would prohibit EU member states from following national hobbies, but also from anticipating on e.g. FSB or BCBS policies until the moment they are actually copied into the EU ‘single rulebook’; see below. In essence, the Basel III accord has been copied into the CRD IV project, resulting in the CRD IV directive and the CRR. Political agreement was achieved in April 2013 on the CRDIV/CRR proposals, allowing the documents to be implemented in and from 2014. The Commission hopes that it will reduce the chance of severe systemic crises by 70%, and reduce the severity if they do occur nonetheless53. If adopted by Parliament and Council, it will give large portions of the non-binding Basel III version of the capital accord the status of binding law. The regulation containing most of the quantitative requirements that are at the heart of Basel III will be applicable directly in all member states, ensuring that there will be much less room for divergent application and interpretation. There are several big deviations from the Basel accord, however. Some make the prudential requirements stronger than the international level playing field, others lead to a significant weakening of the demands within the EU54. The CRD IV directive and some parts of the CRR will be applicable from the start of 2014; while amongst others those parts of the CRR that are dependent on further detail to be provided in binding rules of the Commission or EBA will only enter into effect as per the end of 201455. Even after that, the implementation of many new and higher requirements contained in the CRR and CRD IV directive will gradually become applicable up to 201956.

52 See chapter 3.5. 53 M. Barnier, CRD IV, 20 July 2011, Speech/11/533. The proposal for the CRR part of the CRD IV project indicated an estimation of a 29% to 89% reduction of the probability of a systemic banking crisis in seven member states as a result of CRD III and CRD IV combined, and an additional reduction in the amplitude of the business cycle. COM(2011) 452 final, part I, page 7. 54 Commission, CRD IV – frequently asked questions, MEMO/11/527 of 20 July 2011. 55 Art. 456 and 521 CRR. 56 See e.g. art. 8, 21, 460-461 and 521 CRR on the new liquidity requirements, and art. 467-468 CRR on fair value implementation. For the gradual increase in solvency ratio requirements see chapter 6.2.

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Deviations strengthening prudential supervision include: – the proposals cover – in addition to the bigger international banks BCBS focuses on – also smaller banks and investment firms in a proportional manner. This approach is also part of the currently applicable CRD, and strengthens supervision of the financial system and the level playing field within the EU. It also enables member states to accept all banks and investment firms based anywhere in the EU to have business in their national territory, thus strengthening the single market. The new CRD IV project intends to cover 8200 banks that own more than 50% of world banking assets57; – it includes provisions on corporate governance, sanctions, and clarity on what supervisors should do. These initiatives are all basically aligned with BCBS or FSB work on e.g. corporate governance. They are, however, not formally part of the Basel III capital accord, and in this sense are deviations; – in line with FSB proposals it makes a start in adding additional caution requirements when banks and capital requirements rely on external ratings (see chapter 8.1). Deviations weakening prudential supervision compared to the Basel accord include: – in a deviation both from the current CRD and from Basel III, unconsolidated significant holdings in other financial entities such as insurance will no longer need to be deducted from capital58. This eases investments by banks in the insurance sector significantly. It gives the EU bancassurance model (including financial conglomerates) a huge boost. A specific risk is double counting of capital (capital invested in the insurance subsidiary serving in that sector as a buffer for insurance risks, is counted also as capital in the banking side of the group for banking risk). A tightening of the financial conglomerates regime – delayed several times – is now promised to start the drafting process in 2012 in return for this benefit given to some of the largest EU banking/insurance groups to further limit this specific risk. The difference in the benefit and the possible unspecified future tightening of financial conglomerates supervision is, however, likely to be significant. Even financial entities that do have to be deducted can be counted as common equity tier 1 capital if they individually are less than 10% of common equity tier 1 and do not – together with the even worse quality deferred tax assets mentioned below – exceed a common threshold. See chapter 7; – deferred tax assets (potential deductions from future tax obligations) can be counted as part of capital if the member state promises to transform them into claims upon the state if the bank makes a loss59. This in addition to the use of the BCBS agreed exemption of a limited amount of such intangibles to be exempted. Specifically, up to 10% of 57 M. Barnier, CRD IV, 20 July 2011, Speech/11/533. 58 Arts. 48 and 49 CRR. 59 Arts. 36.1 sub c, 38, 39, 40 and 48 CRR distinguishes between deferred tax assets that rely and do not rely on future profitability (while the BCBS phases both out).

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common equity tier 1, even such ultra-low quality deferred tax assets that are dependent on future profitability (that will never happen if the bank is bankrupt) can be counted in common equity tier 1 if they – together with investments in financial entities that should be deducted otherwise – are less than a threshold amount of this supposedly highest quality category. This is a weakening of the definition of capital under Basel III, even though the conditions are an improvement of the current leaky definition of capital in the CRD. See chapter 7; – the definition of the highest form of financial buffers, the common equity tier 1 category of own shares and retained profits, is different. Instead of a limitation to ‘ordinary shares’ that fulfil 14 criteria of safety, it focuses only on those criteria. This accommodates the much wider range of legal forms that currently exist in the EU, including mutuals, building societies, cooperative banks and other non-joint stock savings institutions60. Though in theory this does not lead to a weakening, the practice may be less secure. The fulfilment of those criteria is left to national states, and some weak constructions favoured by politically powerful cooperatives or other non-joint stock companies may well be approved. Accompanying deviations relate to the lengthening of the phasing out period for non-recognised shares that are issued prior to 31 December 2011, instead of the Basel cut-off date of 12 September 2010, and in the context of state aid even until 30 June 2012 for private aid given in conjunction with state aid, and 1 January 2014 for state aid, applicable until 2017 for state aid or 2021 other noncompliant shares61. This accommodates several instruments issued in the context of state aid or other ‘strengthening’ of the capital position of EU banks; – the lower capital requirements for lending to small- and medium sized enterprises, and the potential for member states to exclude lending to such smaller companies from the additional buffers for countercyclicality and capital conservation62; – the net stable funding requirement (long term liquidity requirements) is initially not introduced in the EU. The CRR contains a placeholder requirement to adequately meet stable funding requirements, subject to review and subsequent definition of actual quantitative requirements63. The BCBS introduces the long term liquidity requirement in Basel III, but will revisit them during a monitoring term prior to 2018.

60 According to the Commission, the mutual/cooperative banks form 13% of the EU banking sector. M. Barnier, CRD IV, 20 July 2011, Speech/11/533. 61 Art. 483 and 484 CRR, deviating from the improved quality demands for common equity tier 1 financial buffers. 62 Recital 44 and art. 501 CRR, and art. 129 and 130 CRD IV Directive. Also see European Parliament, Press Release on EU Bank Capital Requirements Regulation and Directive, 15 April 2013 and the assessment of EBA on the riskiness for banks of lending to smaller enterprises in EBA, Assessment of SME Proposals for CRD IV/CRR, September 2012. 63 Art. 413, 415, 427, 428, 510 CRR.

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EU Banking Supervision

The BCBS has set different implementation dates for different components of its Basel III amendment to the Basel accord. Advance monitoring on some instruments starts already in 2011, but implementation dates vary between 2013 and 2015. For example, the short term liquidity rules64 should enter into force in 2015 after a monitoring period from 2011.The new solvency ratio rules should partially enter into force in 2013 and are annually increased until they reach their final level in 2017. The long term liquidity ratio (the socalled net stable funding ratio) will – after an already announced recalibration – only enter into force in 2018. The EU legislation was slightly delayed, and only published in June 2013. At a December 2012 meeting of the BCBS, all members of the committee indicated that they would indeed implement it; while its chair indicated that the implementation (e.g. in the EU) would implement it at the level agreed under the BCBS timeline for the date of actual implementation65. The CRD IV directive and CRR enter into force in 2014, and becomes applicable in full force in the course of 2014-2019. For the directive, most of the immediately applicable provisions are unchanged copies from the RBD and RCAD on e.g. licensing and pillar 2. The new administrative sanctions indeed have to be implemented by 2014, but the truly new additional financial buffers (countercyclical, capital conservation and systemic risk buffers plus associated instruments) enter into force only in 2016 and will even then be gradually increased from a low base66. The CRR enters into force from the start of 2014, but all (most) new rules or areas require level 2 Commission rules or EBA standards and thus will become applicable only at the end of 2014. Separately, the harsher new requirements on e.g. financial buffer quality will gradually be introduced over a longer timeframe stretching beyond 202067. Other aspects of the new Basel III regime (e.g. on a leverage ratio and liquidity requirements) will be introduced after long test periods. See chapter 6, 7 and 12. Most of such time-delayed issues are subject to a review foreseen in the CRR before implementation68. The EU is thus on track to be able to make the medium- and long term timelines, but it will require a substantial effort of legislators at the EU and national level, as well as of supervisors at the EU and national level to ensure that the new rules, adapted to the EU context, are in place. The level 1 texts hopefully allow later re-calibrations in the level 2 rules and standards. In addition to the high impact Basel III amendment, the CRD IV project also encompasses politically sensitive issues such as the change to a regulation for 64 The so-called liquidity coverage ratio, as already revised early 2013 in BCBS, Basel III: the Liquidity Coverage Ratio and Liquidity Risk Monitoring Tools, January 2013. See art. 412, 415 and 509 CRR. 65 BCBS, Press Release, Implementation of the Basel III Framework, 14 December 2012. 66 Art. 160 and 162 CRD IV Directive. 67 See various provisions in the CRR, including art. 460-494 on liquidity and capital, art. 499 on leverage, and art. 521 with delays on supervisory instruments and disclosure requirements, as well as on all issues that will need to be given detail by Commission (or EBA developed) delegated acts or standards. 68 Art. 502-519 CRR.

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the quantitative rules, with both minimum and maximum harmonisation. For a project with this amount of complexity and opposing interests, it remarkably has stayed largely on schedule so far, though level 2 rules and standards, and the interaction with the banking union aspects and repercussions from e.g. additional bailouts may cause the project to be further delayed as happened to the Solvency II project; see chapter 19.4. The pressure to have something, even if imperfect, ready is however high in light of the banking aspects of the crisis. Banks and supervisors had of course already started their preparations, on the basis of the international consensus as laid down in Basel III and the simultaneous consultations by the Commission and CEBS/EBA69. The Commission proposals allocated subject to the directive and to the CRR parts of CRD IV, and this has been unchanged in the final texts. The basics of the quantitative calculations are in the regulation, but areas of work are allocated to the directive if they are either not yet harmonised (e.g. licensing), or if national market circumstances are deemed important by a majority of member states or by key member state-negotiators. Member states can retain national hobbies or structures more flexibly if they are contained in directives, if they do not want to or cannot force other member states to copy such. See chapter 23 on the rulemaking process. The main changes following from the negotiations focus not on the substance of capital requirements, but on various add-ons. The political agreement is stricter on bonuses, adds the globally systemically important institutions mandatory additional buffer, and ideas on board diversity, transparency and benchmarking70. Table 2.3 CRD IV Subject

Regulation

Directive

Market access

Licensing European passport Mergers and acquisitions

Quantitative calculations

Definition of financial buffer eleThe new capital conservation buffer ments (own funds/capital definitions) The new countercyclical capital buffer Calculation of credit risk, market risk The new systemic risk buffer and operational risk Solvency ratio The new leverage ratio calculation The new liquidity ratio calculation

Qualitative requirements

Specialised governance requirements Pillar 2 requirements and governance for specific regulation-subjects Pillar 3 disclosure by banks

69 See Basel III as published on www.bis.org, see above, and the various consultations published in 2009 and 2010 on www.ec.europa.eu under the heading of regulatory capital for banks, e.g. on the countercyclical capital buffer. 70 European Parliament, Press release on EU Bank Capital Requirements Regulation and Directive, 15 April 2013.

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EU Banking Supervision

Subject

Regulation

Group or legal entity focus

Level of application of regulationLevel of application of directive-subjects subjects on solo basis and/or consoli- on solo basis and/or consolidated basis, dated basis plus general principles of consolidated supervision

Directive

Supervisory organisation

Reporting requirements to the supervisor

Crisis management

Who is the supervisor Which rights and instrument, and which duties, e.g. on secrecy and on pillar 2 assessments and interventions based Cross-border cooperation Supervisory disclosure Existing (minor) provisions are copied into the CRD IV project. A fuller review is part of the separate proposals on recovery and resolution described in chapter 18. Though dealing with the same subject, these proposals are not merged with the CRD IV project.

Single Rulebook The Commission has the desire to establish a so-called ‘single rulebook’. It is referred to it in several documents, and the reference can be found in recitals to currently applicable rules such as the EBA regulation71. It is not entirely clear what a single rulebook will entail. It appears to mainly target avoidance of deviations by member states and supervisors, instead of actually bringing all relevant legislation into one easily accessible and comprehensive collection of rules and guidance. References to the single rulebook are found both in cross-sectoral documents and in sectoral documents, such as the Omnibus I directive and in the CRD IV project. As the CRR can largely not be deviated from, a single set of level 1 rules in the areas covered by the regulation will be more likely due to the severe limitation the power of member states to deviate). The CRD IV directive will remain minimum harmonisation on key issues of e.g. licensing, or additional systemic risk buffers (allowing member states both to go further than the requirements set, and to adapt/adopt the rules into local laws)72. Part of the single rulebook thinking thus appears to be the reduction in national options and discretions73 and goldplating at the national level (see chapter 3.5), and more mutual recognition where differences nevertheless occur. At the EU level regulations and both minimum and maximum harmonisation would be more frequently used (see chapter 3.5 and 23). According to the Omnibus I directive recital, the focus of the single rulebook is not only on rules, however, but also on uniform application, 71 Recital 22 EBA Regulation 1093/2010. Recital 8 Omnibus I Directive 2010/78/EU. Commission letter to CEBS, CRD IV – Single Rule Book, 9 June 2010. 72 Recital 2 and 14 and art. 1 and 3 CRR and recital 9 and 10 CRD IV Directive. Also see page 10 of Commission, Proposal for a Regulation as Part of CRD IV, COM(2011) 452 final. 73 Commission, Impact Assessment Accompanying a Proposal for a Regulation as Part of CRD IV, COM(2011) 949 final, 20 July 2011, page 4.

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likely via the enhanced role of colleges and EBA, and in the Eurozone via the involvement of the ECB in the anticipated single supervisory mechanism (see chapter 21). As the rulebook will consist in the banking side from a directive and a regulation and a series of technical standards and guidelines on prudential supervision, complemented by windingup directives, a possible recovery and resolution directive, deposit guarantees and a series of conduct of business rules, it cannot in any sensible manner be considered a single rulebook in either a practical or a legal way. The Commission has also chosen to integrate the content of most annexes to the current CRD into the main text of the CRD IV project (possibly even further reducing the speed at which they can be changed if needed; see chapter 23). However, there does not appear to be any inclination to reduce the amount of delegated legislation at level 2 (either directly to the Commission, or to the Commission depending upon draft standards drafted by EBA), nor the number of guidelines and recommendations at level 3 or interpretations at level 4, nor the filling in of vague terms by domestic legislators/supervisors74. The directives on crisis management (winding-up, deposit guarantee and the proposals on recovery and resolution) nor the regulations on the institutional aspects (ESRB, EBA and the proposed banking union) have not been integrated at this stage. The overlapping areas with other sectors (financial conglomerates with important insurance and bank activities, and conduct of business requirements on banks), continue to be separate. How this plethora of binding and non-binding rules can be considered a single rulebook is not yet clear, nor is its accessibility to those who have no prior knowledge of both financial supervision and the intricacies of EU legislative procedures, legislative results and the diverse websites in which elements of such can be found. Literature – Dragomir, Larisa, European Prudential Banking Regulation and Supervision, The Legal Dimension, Oxon, 2010, chapter 3 – Davies, Howard; Green, David, Global Financial Regulation, The Essential Guide, Cambridge, 2008 – Empel, Martijn van (Ed), Financial Services in Europe: An Introductory Overview, Kluwer Law International, Alphen aan den Rijn, 2008, page 25-62 – Mooslechner, Peter; Schuberth, Helene; and Weber, Beat, The Political Economy of Financial Market Regulation, Edward Elgar Publishing, Cheltenham, 2006, chapter 5 – Norton, Joseph J., Devising International Bank Supervisory Standards, Kluwer Law International, Alphen aan den Rijn, 1995

74 See e.g. the ECB, opinion on CRD IV, 25 January 2012, page 2-3.

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– Padoa-Schioppa, Tommaso, Regulating Finance, Balancing Freedom and Risk, Oxford University Press, Oxford, 2004 – Kindleberger, Charles P., A Financial History of Western Europe, 2nd ed., Oxford University Press, Oxford, 1993 – Goodhart, Charles, The Basel Committee on Banking Supervision, A History of the Early Years 1974-1997, Cambridge University Press, Cambridge, 2011 – Dewatripont, Mathias; Tirole, Jean, The Prudential Regulation of Banks, MIT Press, Cambridge, 1994 – Dassesse, Marc; Isaacs, Stuart; Penn, Graham, EC Banking Law, 2nd ed., Lloyds of London Press, London, 1994 – Pecchioli, R.M., The Internationalisation of Banking: The Policy Issues, OECD, 1983 – Pecchioli, R.M., Prudential Supervision in Banking, OECD, 1987

2.3

The Wider Policy Response to the 2007-2013 Subprime Crisis

Introduction This particular crisis is one in a long series, ranging from the Great Depression in the 1930’s to local crises that were devastating in a country or region, but did not register abroad. The series includes sovereign crises (such as the peso or rouble crises), financial innovation crises (such as the LTCM hedge fund failure in September 1998) sector specific crises (such as the USA savings and loans crisis in the 1980s75 or the dot-com bubble up to the year 2000), and institution specific crises (due to e.g. fraud or mismanagement, such as the fall of Barings in 1995, the BCCI failure in 1991 or the Herstatt failure in 1974). The 2007-2013 subprime crisis is quaint in its duration, but mainly in its combination of all of the above mentioned triggers in sequence during its existence76. The crisis – and the series of which it is part – has been described in a range of papers and books77. The first press attention being paid to it related to subprime lending in the USA. Risk management standards as well as customer protection standards were ignored in lending to persons without a credit history or a steady income78. This was not deemed a 75 See chapter 18. Also see M. Dewatripont & J. Tirole, The Prudential Regulation of Banks, Cambridge, 1994, chapter 4. 76 For a description of the USA side of the various actions taken by federal authorities to deal with the first stages of the crisis see L.A. Cunningham & D. Zaring, ‘The Three or Four Approaches to Financial Regulation: a Cautionary Analysis Against Exuberance in Crisis Response’, The George Washington Law Review, Vol. 78, 2009, p. 39. 77 Some are mentioned at the end of this chapter and of chapter 18.1. 78 Bad risk management is a prudential concern, but selling the loans to people who should not have had them is a problem under both conduct of business requirements and contract law. This, as well as selling the loans to investors with sometimes misleading information, exposes the banks to legal and reputational risk.

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problem; in part because the prices of the homes that provided the collateral for the mortgage-loans were assumed to go upward. When the number of defaults of borrowers increased and house prices – against expectations – went down, lenders started to go bankrupt in 2005 and 2006. Many of these lenders were non-banks. They had, however sold the mortgages onwards to amongst others banks, or were owned or bought by banks. This started the process of contagion. The risk management practices of the subprime lenders, the lack of financial control of the retail-borrowers and the credulous nature of investors in such mortgages were the starting points of the crisis, but by a long distance not its only cause. Risk management had suffered from an excess of liquidity – pumped into the economy by central banks to deal with earlier minor crises such as the LTCM debacle or ‘created’ by banks increasingly lending/trading to and from each other rather than in interaction with the real economy – and from an overreliance on ratings and mathematical models. Combined with market fear once it became clear that nobody knew where risks had landed and expectations on state intervention proved to be founded on quicksand, the local and possibly manageable USA-based crisis escalated to the long term worldwide crisis. A range of factors contributed to the start and to the exacerbation of the crisis once it had begun. Some of the factors mentioned (see the papers mentioned at the end of this chapter) by the banking industry, banking supervisors, central banks, academics, other financial enterprises and public authorities, and sometimes even by all of these parties, include: – insufficient oversight by non-executives of executives and other senior management, inadequate risk management and complex and opaque organisation structures, into which risk management and internal control were not sufficiently integrated79; – inconsistent and low-quality financial buffers components demanded by legislators (within the EU and worldwide), leading to low availability of forms of financial buffers that could have been able to absorb financial shocks for the bank. Reliance on e.g. short term subordinated loans or hybrid bonds as a buffer for a long term crisis did not provide a true loss absorbing buffer. These weak and non-harmonised financial buffers were being used as buffers for losses by the new large international and increasingly leveraged banks (see chapter 7.2); – the amount of financial buffers was calculated on the basis of assumptions on risk that were known not to apply in crisis situations or known not to absorb long term losses, and the historic data used to underpin the assumptions and calculations built on numbers collected in an unusually long beneficial market situation; see chapter 6;

79 BCBS, Principles for Enhancing Corporate Governance, October 2010, §6. EBA, Guidelines on Internal Governance (GL44), 27 September 2011, §21-22.

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– an overreliance on the calculation of the amount of required capital when such calculation was dated and did not reflect new market characteristics (e.g. the reliance on wholesale funding from foreign professional lenders instead of local deposit funding) and the effect of liberalisation of the capital markets (e.g. easily drying up international funding and the emergence of ever larger banking groups); – gaming the prudential requirements was made easy by a combination of innovative financial instruments such as hybrid capital, derivatives and securitisation of illiquid assets and a distinct (supervisory, political and industry) lack of enthusiasm for tightening up capital requirements in response to such gaming (e.g. the relatively low market risk requirements for assets in the quaint so-called ‘trading book’, securitisations growing disproportionally important for cash management and reduction of capital requirements; see chapter 8.6, 9.2 and 12); – an overreliance on the assumption that markets are efficient, when markets can also show irrational behaviour and herding behaviour; – an overreliance on low interest rates and easy monetary conditions as the wonder oil for any economic bump encountered, leading to ever greater amounts of money sloshing around the financial system, looking for high(er) returns, leading to downward pressure on risk management standards80. Easy availability of interbank credit without collateral and/or with collateral, leading to the assumption that this also would be the case in a crisis (leading to a lack of preparation on liquidity); – a relatively long spell of calm markets, in which all types of financial instruments were easily sold and bought, leading to the working assumption that this also would be the case in a crisis (when the expected easy access to cash in return for assets was denied when markets dried up in a fear-based environment); – a prudential supervisory regime and accountancy regime that stimulated cyclical behaviour amongst others through reliance on internal and external ratings, and through reliance on fair value accounting with its easy paper ‘profits’ in a rising economy. This lead to cliff effects when ratings and values plummeted when fear increased in the financial markets; – market reactions to supervisory and state interventions were not taken into account in prudential or legal frameworks. For instance requiring new capital or shareholders can trigger a default clause in debt instruments. Closing down Lehman Brothers Inc led to a lack of trust in all banks that were previously expected to be ‘saved’ by the local sovereign, and thus to interbank markets drying up and ratings going down. This made borrowing and thus lending more expensive, as for instance the value of assets (such as bonds issued by another bank) dropped. Many prudential instruments turned out

80 A. Maddaloni & J. Peydró, Bank Risk-Taking, Securitization, Supervision and Low Interest Rates, ECB WP 1248, October 2010.

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–

–

–

–

–

The Legislative Response to the 2007-2013 Subprime Crisis and the Origins of the Current Prudential Regime to be ineffective, as they might trigger market responses that would go in the opposite direction; insufficient knowledge about where risks that had left the banking balance sheets had ended up in the form of investments in securitised assets or as open positions under derivative contracts; banks and non-bank financial institutions (including in the unregulated financial market) being highly leveraged in order to get higher returns on capital. Debt was favoured over shares in order to benefit from different tax treatment of interest and dividend; a lack of attention (and lack of allocation of responsibility) to non-monetary, nonmicroprudential issues, such as systemic risk, interconnectedness and macro risks of the banking sector/financial sector/economy as a whole; large banks being able to game the rules excessively (by active lobbying), and being able to allocate assets to the part of the group where requirements were lowest (e.g. first loss positions sold to into insurance subsidiaries), or setting up their own risk assessment models, where market discipline was absent in good times due to amongst others the assumption that the bank would be too big to fail (and thus benefited from an implicit state guarantee for which it didn’t pay in higher requirements or a fee81); and, a lack of attention to resolution instruments and the absence of political support for cross-border funding of supervision and resolution.

The measures to address these weaknesses and strengthen supervision and supervisory requirements are carefully balanced between providing for additional buffers in the banks and stopping the clearest other gaps on the one hand, while on the other hand not being so tough that the added requirements on top of the crisis provide the tipping point in the direction of a new wave of bankruptcies. The grandfathering arrangements and long transitional arrangements of the Basel and EU legislative responses have to be viewed in the context of this balancing exercise. The fall-out of the crisis has not yet settled in the EU nor in other (Western) markets. Banks are still enfeebled, as are the sovereigns that spent a large part of their lending capacity to bail them out and take other crisis measures. Banks may still be hiding some of the losses on assets they will eventually need to acknowledge onto their balance sheet82. 81 See below, as well as chapter 4 and 18.2. Also see R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 3. 82 In the nationalization of the SNS financial conglomerate a key component was whether the valuation of commercial property portfolio by an accountants firm hired by SNS was used, or the lower valuation of the assets by a valuer requested by the State to value the assets independently, on which basis the Dutch

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This does not help with introducing measures to avoid a future crisis. The refusal to stare the facts in the eye is be partially abetted by the supervisors and legislators that seek to keep ‘their’ banks in safe financial waters and able to access funding (and lend onwards to the economy). The ongoing problems at banks range from issues relating to misrepresentations of assets sold to others (e.g. via securitisation vehicles or in the USA to the government sponsored Fanny Mae and Freddy Mac vehicles), and to acknowledging losses on assets held, but imperfectly valued (such as the real estate on the balance sheets of Spanish cajas). A main prop-up to the banking sector is the liquidity provision (in local currencies or in dollar-funding) by central banks, eager to avoid another Lehman style market panic. In the area of prudential banking supervision, three strands of work can be distinguished: – improving the capital accord; partially implemented already, and with the Basel III amendment and the subsequent translation thereof in the CRD IV project to be implemented in 2014); see chapter 2; – improving the crisis management tools of supervisors (of which at the EU level nothing is yet in place, but new instruments are proposed by the Commission in its recovery and resolution proposals); and – improving the institutional framework; partially implemented already with EBA and the colleges of supervisors, which will be partially overtaken in 2014 by a segment of banking union in the Eurozone. Prudential supervision is by a long stretch not the only area where banks are confronted by fundamental changes. Conduct of business requirements are increasing, both as to the quality of protection within the current scope by e.g. clarifying which financial services are so safe that they do not require the heaviest forms of customer protection, and by expanding the number of counterparties that are protected, as several so-called professional counterparties turned out to be as naïve or inexperienced in some of the financial instruments sold to them as consumers. The same applies to the infrastructure of trading in financial instruments, where plans are being developed for the rules on trading platforms (sometimes operated by banks and/or in which banks are large stakeholders), the rules on clearing and settlement and trading off exchange in financial instruments, including socalled ‘OTC-derivatives’, complex instruments traded ‘over the counter’, i.e. in bilateral or multilateral deals. See chapter 16 and 22.

authorities had taken action. Raad van State, VEB/State, 25 February 2013, Case 201301173/1/A3, §17.317.3.3 (Dutch). Also see chapter 6.4.

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Crisis Management Tools Equally important as the CRD IV project and institutional changes are proposals to improve crisis management capabilities of public authorities. These come in several guises, including plans to revisit the deposit insurance systems, plans to impose living wills on banking groups and similar preparations by the supervisory authorities, and plans to force countries to improve their public law and civil law instruments on dealing both with individual failing banks and with financial stability situations. If the proposals on such recovery and resolution instruments are adopted, the costs of some bankruptcies will become more likely to be borne by specialized taxes on the banking sector, in the form of up front contributions to deposit guarantee funds and newly proposed ‘resolution funds’, as well as by bail-inable subordinated and even senior unsecured debt. Whether that will be sufficient for a large failure or a systemic crisis is unlikely, in which case the banks may need to top up their contributions (taxes or fees) to the funds, up to the level where such contributions would become the systemic trigger of cross-institution infection, after which the general public funds would remain the fall-back option. See chapter 18 for a description of the proposals. EU Institutional Changes Apart from the technical banking issues, the allocation of responsibility and especially funding remains key. The EU and its member states have been called on the weak spots in its organisational structure and on its financial structure. The toothless financial stability pact has been replaced by binding rules, the role of central banks has become more explicit again in crisis times, EBA has been set up, and further changes are expected including the establishment of parts of a so-called banking union; initially limited to a single supervisory mechanism, in turn limited to the Eurozone. The organisation of colleges was the subject of CRD II, of the EBA regulation that established the European Banking Authority as the successor of CEBS), and of the 2011 FCD II directive. Those involved in supervising the same banking group are forced into a ‘college’ of supervisors for that bank, upgrading obligatory cooperation between national supervisors. The main supervisor of the group (the so-called consolidating supervisor) is identified as the one responsible as licensing supervisor for the bank/holding at the head of the group. This supervisory authority is also in charge of consolidated supervision and chairing the college, and gained some additional powers. The large set of responsibilities and expectations became slightly less unbalanced when viewed from the instruments-side, as the consolidating supervisor was given a few new instruments to deal with other supervisors that licensed banks within the group. The EBA has been given a seat at the table of each college, and is to be considered a supervisor for the purposes of information exchange. Some of the instruments given in CRD II to the consolidating supervisor were handed

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over to EBA as part of its tasks in dispute resolution and its tasks to force supervisors (and banks) to apply EU rules83. Lastly, the college-arrangements for banks that are part of a group that also contains insurers and other supervised entities were upgraded and harmonised in 2011 (to be effective mid 2013)84. EBA also gained additional roles on proposing new binding level 2 legislation (to be ‘adopted’ i.e. issued by the Commission in line with the EU treaties; see chapter 23), in addition to its non-binding harmonisation work. All these changes have formally come into force as per end 2010 as part of the so-called ‘omnibus I directive’. The omnibus I directive was adopted simultaneously with the regulations setting up EBA and its sisterauthorities, and amends the various directives – such as the CRD – in their area of competence in order to give them a clear role. Political agreement was reached mid 2012 on the fact that a single supervisory mechanism for the Eurozone would be proposed and introduced, as a component of future banking union85. The Commission subsequently proposed allocating supervisory tasks for Eurozone banks to the ECB, while maintaining the role of EBA for the whole of the EU86. In combination with the European stability mechanism and a deposit insurance review the hope is that it would help break the link between sovereign debt and banking health in the Eurozone. It is unclear how such a banking union will look in practice, and whether a coresupervisor will have teeth and claws in addition to the job-title normally bestowed on EU compromise institutions such as the now defunct CEBS, or to the ESRB. In view of creating a true single market for banking services, and delinking national budgets from national banks the underlying premise is sound. However, the Commission proposals show the hallmarks of a hasty compromise, with references to both the continued reliance on the special knowledge and resources of national supervisors, their partial abolishment, instructions to obey the ECB in anything it wants, for the ECB to build up a functioning supervisor and new structure within a year that will take on all Eurozone banks at a time of crisis, and lacks demarcations with conduct of business supervisors, local state aid and deposit guarantee systems, and relies on speedy adoption of the wide range of simultaneous policy initiatives in a ‘buy it or die’ approach to deal with the financial crisis. The Council

83 See the subsequent changes to art. 129-132 RBD by art. 1.31-1.34 CRD II Directive 2009/111/EC, and by art. 9.32-36 Omnibus I Directive 2010/78/EU; as well as the additional tasks given to EBA in art. 18-21 EBA Regulation 1093/2010. 84 FCD II Directive 2011/89/EU, amending amongst others the Financial Conglomerates Directive 2002/87/EC and the RBD. 85 Euro Area Summit Statement, 29 June 2012. 86 Commission, Proposed Single Supervisory Mechanism ECB Regulation and Proposed Single Supervisory Mechanism Amendment to the EBA Regulation, COM(2012) 511 final and COM(2012) 512 final, 12 September 2012.

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and Parliament reached a compromise agreement in April 2013, but final texts had yet to be published when this book closed. The single supervisory mechanism proposals do not apply to the whole of the EU, but would set up a system composed of the ECB and national supervisors for the Eurozone member states (plus other member states on a voluntary basis), with final responsibility allocated to the ECB; see chapter 21.3. If the Council agrees unanimously – the treaty requires unanimity for this eventuality87 – the ECB will take over the prudential supervision tasks of the participating member states supervisors for the larger banks, but rely on the work of national supervisors for smaller banks (for both in close cooperation with each other). The ECB governing Council (ECB board plus the Eurozone member state national central bank governors) would become responsible for supervising all Eurozone banks, but it could delegate some decision making powers to a newly established supervisory Council. The national banking prudential supervisors would not be abolished, but would lose most of their independent powers. EBA will nominally not lose powers, but for instance the colleges that EBA now is a member of would be abolished if they only cover Eurozone activities, and the new system for the Eurozone will likely become very dominant at EBA. National parliaments will lose power as the ECB will not be accountable to them (though under the political compromise it will become accountable in some manner to the European Parliament), and the amount of double resources and fees generated by the ECB and the remaining stubs of national prudential banking supervisors is likely to be high in the initial years while the kinks are being worked out. How it will relate to the ECB, to EBA and to the national supervisors and national legal systems and public purses makes a detailed agreement difficult to reach. The plan is to transfer the tasks to EBA one year after the final texts are published, subject to operational issues. The expectation is now for end 2014. Preventing that the markets will consider member states that have too large banking groups in relation to their GDP to be the only one standing guarantee for their health will be key. Some member states have learned this lesson the hard way (Iceland, Italy, Spain), some do not have material banking systems, but some member states do and may move on common supervision and – hopefully – common funding to avoid landing in that predicament (Germany, the UK, the Netherlands and France). See chapter 18 and 21.3. The Commission has also published proposals on a joint resolution framework for Eurozone banks, that is planned to be in place almost simultaneously with the single supervisory mechanism. A common deposit guarantee fund is not (yet) proposed.

87 Art. 127.6 TFEU.

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Related Work on Shadow Banking After initially focusing on banks and on first aid crisis management measures in all sectors of the financial economy, work is also progressing on shadow banking. The size and interconnectedness of financial institutions that do not qualify as a bank but nonetheless provide similar services and pose – individually or in combination – similar risks to financial stability directly or via their links to banks88. The work on alternative investment funds can be seen as a preamble to regulating such near-banks, but similar work could be expected on other entities, such as some money market funds, that may not yet be captured by the new or existing supervisory regimes for investment funds or on other entities that engage in some of the same services that banks do; see chapter 19. The regimes on instruments or systems that may provide the linking pin between financial stability and near banks, or between near banks and ‘normal’ banks also receive attention. This ranges from reviewing the consolidation regime (and its exceptions), the securitisation regime, and the clearing and settlement regimes. The shadow banking work is progressing at different speeds, and would complement some of the above-mentioned proposals for the banking sector (on links to other entities, on securitisation and on exposures to e.g. central counterparties) that are being gradually introduced in the banking sector regulations. Outlook The work set up in response to the 2007-2013 subprime crisis is ambitious. Though it started in the USA, the crisis mercilessly exposed the failures in worldwide standards, EU practices and the unhealthy relationship between ever larger cross-border banking groups and the sovereign member states where they are headquartered. Whether the right path has been chosen to get out of this crisis and prevent a similar crisis from happening again is yet to be determined89. For certain banking legislators, supervisors and banks have laid out an ever more detailed and binding framework with which they have to comply. The current framework, the improvements that will enter into force shortly and the longer distance plans are described in this book. The timelines look untenable, but the different parties in the process are working towards them nonetheless. EBA noted 320 deliverables in its work programme for 2012 alone, of which around 200 are related to CRD IV followup, including drafting lengthy sets of proposed standards90. These will need to be ready (proposals published, consulted, impact assessed, politically and practically agreed, pub88 FSB, Report on Shadow Banking: Strengthening Oversight and Regulation, 27 October 2011; and the related Progress Report FSB, Strengthening the Oversight and Regulation of Shadow Banking, 16 April 2012. Also see FSB, Progress in the Implementation of the G20 Recommendations for Strengthening Financial Stability, 10 April 2011, page 4; FSB, Global Shadow Banking Monitoring Report 2012, 18 November 2012 and 3 simultaneously published consultation papers on aspects of shadow banking. Commission, Green Paper, Shadow Banking, COM(2012) 102 final. Also see recital 51 CRD IV Directive. 89 See R.J. Theissen, Are EU Banks Safe?, The Hague, 2013. 90 EBA, Work Programme 2012, EBA BS 2011 137 final, 15 December 2011.

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lished, adopted by the Commission, re-published, prepared for by banks, implemented, applied and pursued) sometime in 2013/2014. The introduction of additional pressure and distraction in relation to the banking union agreed at the political level of national governments in 2012 will not help with timely implementation of the CRD IV project, though – if indeed established in a high quality manner on banking supervision and crisis funding across the EU – it will help address some of the key political/financial causes of the continuing crisis. Literature – Goodhart, Charles A.E., The Regulatory Response to the Financial Crisis, Cheltenham 2009 – Ferran, Eilís; Moloney, Niamh; Hill, Jennifer G.; Coffee, John C. Jr, The Regulatory Aftermath of the Global Financial Crisis, Cambridge, 2012 – Davies, Howard, The Financial Crisis, Who is to Blame?, Cambridge, 2010 – Tett, Gillian, Fool’s Gold, London, 2009 – Dewatripont, Mathias; Rochet, Jean-Charles; Tirole, Jean, Balancing the Banks – Global Lessons from the Financial Crisis, Princeton University Press, Princeton USA, 2010 – Llewellyn, David T., The Global Banking Crisis and the Post-crisis Banking and Regulatory Scenario, University of Amsterdam Research Papers in Corporate Finance, June 2010 – Theissen, Roel J.; Houmann, Alan, Funding is Key, 2009, www.thebanker.com – EIOPA/CEIOPS, Lessons Learned from the Crisis (Solvency II and beyond), CEIOPSSEC-107/08, 19 March 2009 – High-level Expert Group on Reforming the Structure of the EU Banking Sector, Final Report, 2 October 2012 (Liikanen Report) – Final Report of the High-Level Group on Financial Supervision in the EU, chaired by Jacques de Larosière, 25 February 2009 (De Larosière Report) – UK Financial Services Authority, The Turner Review, March 2009; – UK Financial Services Authority, A Regulatory Response to the Global Banking Crisis. Discussion Paper 09/2, March 2009 – Walker, David, A Review of Corporate Governance in UK Banks and Other Financial Industry Entities – Final Recommendations, 26 November 2009 (the Walker Review), www.hmtreasury.gov.uk – CEPS, Concrete Steps Towards More Integrated Financial Oversight, the EU’s Policy Response to the Crisis, 2008 – Kellermann, A. Joanne; Haan, Jakob de; Vries, Femke de (Eds.), Financial Supervision in the 21st Century, Springer, Belin, 2013 – UK Parliamentary Commission on Banking Standards, Changing Banking for Good, 12 June 2013

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– Wymeersch, Eddy; Hopt, Klaus J.; Ferrarini, Guido (Eds.), Financial Regulation and Supervision, Oxford University Press, Oxford, 2012 – A range of reports analyses individual failures. By way of example, see Cour des comptes, Dexia: un sinistre coûteux, des risques persistants, 15 July 2013 (French), page 176 and 180; De Moor-van Vlugt, A.J.C.; Du Perron, C.E., De bevoegdheden van de Nederlandsche Bank inzake Icesave, 11 June 2009 (Dutch) – Rethel, Lena; Sinclair, Timothy, The Problem with Banks, London/New York, 2012

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3.1

Introduction

The previous chapters described the current supervisory system and an overview of the response to the most recent financial crisis. In this chapter the originators of the current and future banking supervision standards are introduced and the (legal and practical) restrictions under which they operate at the EU, worldwide and at the domestic level. The intent is to describe: – the power and limitations of European law in the area of banking supervision; – the international process, its power and limitations under the umbrella of the Basel Committee of Banking Supervisors (BCBS); – the way European legislation affects individual member states of the EU; and – the way European legislation affects individual institutions (supervisors and banks) and their stakeholders in the EU.

3.2

Economic, Legal or Accountancy?

A complicating factor in understanding banking regulation is the perception of the requirements as either economic/accountancy or as legal, depending on the background of the speaker. If only life was so simple. Banking supervision, and the design thereof, historically was the domain of central bankers. Most papers on banking supervision practices have thus been drafted by economists and/or accountants. These focused on the safety that can be found in good financial buffers. Due to the growing complexity of the models used to estimate how big financial buffers should be able to hang a sign with ‘safe bank’ above a savings bank, and not helped by the mathematical approach favoured by economists and the increasingly influential econometrists or ‘quants’, the legal side of quantitative capital adequacy requirements has been underdeveloped. At the same time non-mathematical areas such as deposit insurance, e-commerce, bank licensing and resolution as well as large swathes of conduct of business regulation have been left to relatively understaffed legal departments. These areas suffered from lack of attention by those with an economics background (e.g. on the affordability of the guarantees blithely given to depositors) and lack of priority in the policy setting bodies in the area of

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banking supervision. This split in the playground has had an effect on EU banking legislation. Obvious results are the relative size of quantitative requirements to qualitative requirements, and the relative size of ongoing quantitative supervision requirements to market access and market exit requirements. More important, however, is the clash between the intent of the drafters of the Basel accords that form the basis of the quantitative requirements, and the intent of the drafters of the EU requirements. The perception of the drafters of the Basel accord was that this was not a legal document, and should not be regarded as such1. That is indeed very much the case. The Basel documents contain a narrative on good quality ongoing banking supervision, largely based on a mathematical calculation of capital adequacy. Capital adequacy is subsequently taken as an indicator of the solidity of the bank under supervision. It basically tells the story how supervision should be set up, and what the banks should take into account from an economic point of view when dealing with their supervisor(s). It combines guidance and expectations with explanatory texts in equal measure. The addressees are not legal entities as such, but the economic group that operates under one central command at a consolidated level. The CRD on the other hand has been written with the aim to establish legal obligations of the member states, of the supervisors and of the legal entities they supervise. It needs to fit into the broader framework of relevant regulation for commercial entities as well as add clarity where the Basel accord has (unwanted) flexibility, lack of parameters or national discretions that are not relevant for the member states of the EU. The EU legislative process takes place in a primarily political and legal environment. The drafters of the original policy accord were fine with the translation into EU laws – even if such rules were not issued by them but by Council and Parliament – as long as the ‘binding’ rules did not deviate from the Basel texts. Apart from political expediency (no doubt with some eye-rolling by the banking supervisors on the weird language into which their work was cast), this ascent of the legislative approach was helped by supervisors being confronted by the increasingly vocal opposition to moral suasion-type supervision on the banks. In the last decades of the twentieth century and the first decade of this century (when the Basel Accords and most of the EU banking requirements were drafted), EU banks were growing in size, profits, number of employees (voters) and tax contributions, and thus in political power. This growth was supported by market deregulation, providing easier access to foreign markets and foreign capital. Prudential supervisors could no longer build on moral suasion between two local players (the traditional framework was a roleplay of ‘father knows best’ and ‘good boys listens earnestly’). The instruments central

1

See J. Norton, Devising International Bank Supervision Standards, Dordrecht, 1995, chapter 1, foreword and prelude.

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banks/supervisors traditionally used became less effective under the influence of EU interventions and the efficiency gains made when the capital markets and the markets for other activities of banks were liberalised2. It could no longer be assumed automatic that the local public authorities and local banks would automatically act from a common interest in a stable and safe banking business. Instead, the authorities found increasingly argumentative and diverse banking organisations on the other side of the table. The life of individual employees of the supervisory authorities was simplified tremendously if they could point to a binding rule that had copied the policy papers that they had co-drafted, such as the Basel accords. The problem was that concepts that were fine in a narrative were copied verbatim into a legal text, and that flexible concepts were instead made absolute. For instance, capital adequacy is important in both the CRD and Basel texts. In Basel it is, however, primarily an indicator of good health, while the EU legislation equates good health with that indicator. A bank is deemed safe if it has adequate capital as calculated, unless the supervisor can prove it is not, while the Basel texts are built on the opposing reasoning that a bank is safe if there is capital adequacy in the supervisors subjective opinion, in which context the mathematical calculation is (key) input.

3.3

Who Sets Banking Supervision Standards?

Introduction The worldwide BCBS standards inspire EU laws, which in turn force a member state to amend its local laws. Domestic banking supervision cannot be understood properly without understanding the directives and cooperative arrangements at the European level. In a similar fashion, European banking supervision cannot be understood properly without understanding the worldwide policy initiatives. However, the interaction also works in reverse, as the distinction between the levels is not clear-cut. The three levels interact as follows: 1. Worldwide treaties, accords and guidance: – mostly non-binding; – inspired and drafted by national and regional legislators. 2. European treaties, directives, regulations and guidance:

2

See e.g. T. Padoa-Schioppa, Reflections on Recent Financial Incidents, Speech, Basel, 8 March 2002; E. Ribakova, Liberalization, Prudential Supervision, and Capital Requirements: the Policy Trade-offs, IMF WP/05/136.

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– mostly based on worldwide accords and guidance (and in response to incidents such as mergers and acquisitions problems or other EU specific mishaps); – drafted at the EU level with input from national legislators and supervisors; – the EU treaties, directives and regulations are binding, though some need to be transposed in national legislation; – other EU texts on banking supervision (recommendations and guidelines) are nonbinding, though guidelines are subject to a ‘comply or explain’ law3. 3. Domestic laws, domestic supervisory regulations and guidance: – mostly based on European directives, translating them into local laws (European ‘regulations’ apply directly in the member states); – with deviations and add-ons – e.g. based on BCBS work – in as far as allowed by the European directives; – increasingly checked by EU bodies to bring about harmonisation in the supervisory rules and in their application. There is no clear lead in the policy development interplay between the member states in and with the various worldwide and EU institutions. A new coordinating role has fallen on the G20 if and in as far it is willing to act and in as far as its members and other countries are willing to accept its decisions. However, none of the countries or institutions have an exclusive role. Authority on the content has to be earned instead of being granted by treaty. To obtain the harmonisation and open markets designated as goals in the EU and BCBS context, the experts or negotiators need to cooperate and achieve consensus where possible. Where there is no treaty-based legal structure – such as at the BCBS or G20 – there is even a veto in effect, as all members will need to sign up to the end-result4. If there is a clear majority opinion after negotiations in more technical sub-groups, most smaller countries and even some larger ones will, however, limit a true veto to issues that are of paramount importance to their country5. But, except when binding treaties are agreed as in the case

3

4 5

The charter of CEBS emphasised the voluntary nature of the application of its level 3 work by its membernational supervisors, but contained a ‘comply or explain’ rule in art. 5.7 since a revision that became effective on 10 July 2008, and the Recast Commission Decision of 2009 ordered members to ‘stand ready’ to provide reasons for non-compliance; art. 14 Recast Commission Decision of 23 January 2009, C(2009) 177 final, replacing decision 2004/5/EC. This was backed up by the work of a review panel (peer review). The upgrade to a legal requirement to ‘comply or explain’ with the establishment of EBA makes it more likely that the national supervisors that were members of CEBS and are now of EBA, and especially domestic lawmakers outside the supervisory authority feel more bound to consider – and comply or explain – such guidelines. Art. 16 EBA Regulation 1093/2010. L. Dragomir, European Prudential Banking Regulation and Supervision, the Legal Dimension, 2010, page 223. As confirmed in BCBS, Charter, January 2013, page 3. C. Goodhart, The Basel Committee on Banking Supervision, a History of the Early Years 1974-1997, Cambridge, 2011, chapter 14.

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of the EU that result in binding requirements in directives or regulations, none of the work agreed by these bodies takes away the power of states to act unilaterally. Policy follows the scope of activities of the supervisors of the banks. Banking supervisors have a worldwide scope. The activities of the larger banking groups include cross-border services to clients worldwide, as well as cross-border branches and subsidiaries worldwide. Large banks compete both in the local and worldwide financial markets. Their activities carry risks for the local economies and vice versa. If local activities run into trouble, the parent/group can be infected, leading to potential risks for the home economy of the banking group. If the financial solidity of the bank is important at all, then it has to be looked at taking into account all its activities, regardless where they occur, and where possible subject to similar or at least non-contradictory rules of the local and home supervisors. Increased harmonisation of supervisory methods is important to assure that activities elsewhere are subject to similar conditions where international and local banks compete, and to increase awareness and cooperation between supervisors. As a second effect, harmonised rules open up markets with benefits for clients and banks alike. The intention to open up markets is most explicitly applicable within the EU with its single market goal (see chapter 4.3). Both wholesale and retail client financial markets are open across the EU to banks established and licensed to operate in any of the member states. Financial markets for wholesale clients are liberalised at the EU level, and to a large extent even at the worldwide level6. This liberalisation is, however, conditional upon the trust that both countries and clients have that the bank is subject to a minimum harmonised standard of sufficiently strict and high quality supervision. Where a bank is not subject to such supervision, it will be deemed less solid and perhaps a too risky counterparty to be allowed into the local markets7. For the EU retail market, the policy standards set in binding EU laws allow supervisors to accept branches and subsidiaries of banks from other member states – and to a lesser extent from third countries – without far reaching additional controls on their soil with the intent to provide services to retail clients, because of the supervision already carried out by the supervisor in the other country. Even outside of the EU, there is increased reciprocal access to each other’s financial markets, based amongst others on increasing harmonisation as more and more nations sign up to BCBS standards8. 6

7 8

Exceptions occur e.g. when currencies are not freely exchangeable, or investments are subject to local conditions. For retail clients, local conditions are frequent in the worldwide context, and as noted in chapter 3.4, 5 and 16 within certain boundaries also within the EU. See the deregulation remarks in chapter 4.3, and E. Ribakova, Liberalization, Prudential Supervision, and Capital Requirements: the Policy Trade-offs, IMF WP/05/136. For markets outside the EU the extent to which the local banking market has been opened usually tries to balance the stimulation of a domestic banking system, the benefits of free flows of capital, and the benefits of mutual learning experiences which are possible if the banking markets are open. Examples are the (limited) opening of banking markets in India and China. See chapter 5.5 on the market access by and to third countries,

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Soft Law/Hard Law Standard Setters There are no worldwide treaties on banking supervision, with the exception of a limited set of undertakings related to opening up financial markets in the General Agreement on Trade in Services (GATS) in the context of the World Trade Organisation (WTO). The worldwide consensus regarding the content of banking supervision is based on informal agreements by states and their supervisors, as well as the work of some international committees and institutions which meet on a voluntary basis to discuss common standards and deliverables. The gatherings currently most relevant for policy development on banking supervision at the worldwide level are: – the G20 meetings on the financial crisis (which has taken over the lead role from both the G8 and the G10 groupings); – the Financial Stability Board (FSB, until 2009 known as the financial stability forum); – the Basel Committee of Banking Supervisors (BCBS); – formal international organisations such as the World Bank and the IMF that stimulate harmonised high quality financial standards to support their primary goals. Banking supervision did not attract high level worldwide attention until relatively recently. The BCBS started its activities under the umbrella of the Bank for International Settlements only in 1974, in response to the (unexpectedly large) problems that occurred when banks with international business failed9. Attention at a political level is even more recent. The General Agreement on Trade in Services of the WTO, containing specific provisions on opening markets in financial services including banking, was signed in 1994. The Financial stability board was set up only in 199910, and the G20 heads of governments meeting was convened for the first time in response to the start of the 2007-2013 subprime crisis. The EU treaties do provide a platform for common standards and for binding directives and regulations in the area of financial services at the regional level (see chapter 3). The gatherings currently most relevant for policy development are: – the Commission, and more specifically the teams within the markets directorate focused on financial legislation for the markets and on consumer protection (the Commission is the spider in the web of all four Lamfalussy levels of legislation and harmonisation work; see chapter 3 and 23);

where special attention is given to the General Agreement on Trade in Services as administered by the World Trade Organisation. 9 The failure of the Herstatt Bank in Germany (threatening international payment systems) and of the Franklin National Bank (a USA bank with a branch in London). 10 Initially set up as the Financial Stability Forum by the G7, it was transformed – with a wider membership – into the Financial Stability Board by the G20 in 2009 in response to the 2007-2013 subprime crisis.

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– ECON (the committee within the European Parliament responsible for financial services, playing a key role on level 1 legislation and on monitoring level 2 and 3 of the Lamfalussy framework); – Ecofin (the Council of finance ministers, playing a key role on level 1 legislation); – European banking committee (‘EBC’, the committee of finance ministry functionaries, chaired by the Commission; with a key role on level 2 legislation); – the EFC-FST, composed of higher level finance ministry functionaries with central bank input; – EBA (European Banking Authority); – the ECB and ‘its’ ESRB. The rules set at the worldwide level by the BCBS are not ‘hard’ law, in the sense of binding, precise, with delegation of powers and sanctions if promises are not kept. Instead they are non-binding, but rely on the efforts of the member organisations contribute to and implement agreed standards11. Though the EU rules can be binding, key aspects of EU rules remain ‘soft’, e.g. on issues where national states have exercised national prerogatives (such as fiscal issues), where there was not yet sufficient experience or consensus to agree on ‘hard’ law, or where no need for hard rules was felt and instead a choice was made for setting ‘soft’ rules only, leaving a national prerogative on whether and how to comply. Such soft rules can be reinforced by peer reviews, assessment programmes and ‘comply or explain’ programmes as instituted for EBA guidelines and for the Basel core principles, but they remain non-binding12. The EU set of rules is special in that it also increasingly consists of binding, precise rules that contain delegation of powers, and contain sanctions if promises are not kept. Such precise and binding rules include the EU translation of rules that are ‘soft’ law at the worldwide level (e.g. the subsequent versions of the Basel capital accord, which would have been unlikely to have been agreed by the members of BCBS if they had been part of a binding treaty), that gains a ‘hard’ status in its codification into EU directives. Directives still have elements of looseness in the national translation of these EU rules (see chapter 3.5). The EU rules will harden further under future EU regulations and EBA standards, which are directly applicable in each member states, with relatively little wiggle room. Such transferral of sovereignty at the international level is usually reserved for issues that have low importance, or where the costs of reaching such precise agreement and commitment is less than the likely costs of having to deal with the issues 11 As again confirmed in BCBS, Charter, January 2013, page 1 and 2. K. Alexander, The Role of Soft Law in the Legalization of International Banking Supervision: A Conceptual Approach, ESRC Centre For Business Research, University of Cambridge, WP 168, June 2000. C. Goodhart, The Basel Committee on Banking Supervision, A History of the Early Years 1974-1997, Cambridge, 2011, chapter 14. 12 See e.g. the IMF financial sector assessment programmes on the BCBS core principles. BCBS, Core Principles for Effective Banking Supervision, September 2012. Also see the work of the implementation subgroup of the BCBS, and the peer review and ‘comply or explain’ rule for EBA Guidelines. See chapter 21 and 23.

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at the national level. The benefit of opting for soft law (less binding, so easier to commit to, with options to deviate if new circumstances arise, with less parties having to agree) has in the course of the 2007-2013 subprime crisis slowly eroded for EU member states both at the EU and worldwide level negotiations. Accepting binding and stricter laws that impinge on local sovereignty is more acceptable if banks from other member states will no longer be able to threaten local financial stability either. That said, even ‘hard’ law is not always applied in a hard and unblinking manner. The Basel accords on many issues contain new or experimental sets of rules. Examples are pillar 2 and 3 when introduced around 2008, or the use of internal models to calculate capital requirements when introduced in the area of market risk in 1996 (see chapter 6.2, 14 and 15). On such issues, and in areas where gaps have been identified, the translation into ‘hard’ law by copying such laws into the CRD has not meant that supervisors have applied them in a ‘apply or accept punishment’ modus, even though the letter of the EU directives and national law says they should (albeit that the law contains little detail on what or how to apply them). Instead, the benefit of soft laws as a tool for compromise and learning has been applied by monitoring and joint learning with the industry, where only egregious transgressions have been acted upon, and best practices published and advised13. It may have been – from a legal point of view – better to spell this out in the law. In practice soft law benefits of the BCBS framework have survived in this manner the EU hard law translation of them. This may be caused or explained by the fact that many supervisors are likely to be more conversant with – and give more authority to – the Basel accords than with the CRD or the local laws, if only because they are an easier and more comprehensive read. Europe The EU has been a major testing ground of cross-border cooperation and harmonisation on financial services. This is the result of the EU goal to create a single market on financial services between the member states; see chapter 4.3. A host of legislative and organisational action has been undertaken, with increasing speed and intensity over the last decade. The Commission has played a key role here, drafting and getting buy-in on ambitious long term legislative projects in the financial services area; see chapter 2.

13 K. Alexander, The Role of Soft Law in the Legalization of International Banking Supervision: a Conceptual Approach, ESRC Centre for Business Research, University of Cambridge, WP 168, June 2000, page 8. See e.g. the pillar 3 research papers of EBA discussed in chapter 15, and the guidance on model approval in the area of operational risk discussed in chapter 6.2, 6.3 and 10.

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Financial services had been recognised during the early stages of European unification as an area where the European ‘common market’ might be possible14. Initial attention was given to harmonising accounting standards and liberating the free movement of capital. On the basis of the progress there, possibilities were seen for increasing cross-border market access within the EU for financial services providers, and for creating benefits from increased competition for EU citizens. In the seventies of the last century the first directives on banking supervision were introduced; see chapter 2. National and different supervisory practices were identified as a potential barrier to the common market. There were already some lines of communication between national supervisors, but these had not yet been institutionalized. Some areas of supervision had similar characteristics in most member states at the time, either by chance or by supervisors and legislators copying concepts from different countries. However, both working methods and legislative texts varied widely. For banks and banking clients that operate in a domestic market only, such differences in member states legislation present little or no problems, as there was a level playing field between all domestic industry participants within a member state. Local customers knew what they could and could not expect from a bank. If a bank, however, wanted to provide services in another member state, it would have to fulfil the local supervisory requirements of two different member states at the same time. Such requirements could include high additional capital investments for each establishment in a different member state, and by definition caused high administrative burdens and complexity in the operation of the bank. The reasoning was that local customers would only know they were doing business with a bank that was equally ‘safe’ as the banks they were accustomed to, if additional local supervision was introduced (as there was no common standard). The variety in supervisory requirements in the member states reflected differences in culture, in the development of the local banking system, the number and types of crises the banks of a particular member state had encountered or caused, and the authority and reputation of the local banking supervisor. The European banking supervisors had started to do some stocktakes of supervisory practices and discussions on how supervision was done best in the context of a so-called ‘groupe de contact’ after its establishment in 197215. 14 See for instance Commission White Paper, Completing the Internal Market, 14 June 1985, COM(85) 310, which mentions financial services as of prime importance to the internal market. This effort was continued in amongst others Commission Communication, Financial Services: Action Plan, 11 May 1099, COM(1999) 232, and Commission White Paper, Financial Services Policy 2005-2010, 1 December 2005, COM(2005) 629 final. 15 The groupe de contact consisted of mid-level representatives EU supervisors and was established in 1972 with six members (when the EU was still the EEC; the European Economic Community). Originally, it worked solely on behalf of the member-organisations to discuss common issues and problems. It was officially referenced as an advisory body to the Mixed Supervisors/Ministries of Finance ‘Banking Advisory Committee’ in the last recital of the so-called First Banking Directive 1977/780/EEC. See art. 6 of that directive on the

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Its members were mostly mid-ranking employees of the banking supervisors. The establishment of the groupe de contact was followed in 1977 by the establishment of the banking advisory committee in the first banking directive, which brought together the Commission with representatives of the ministries of finance as well as banking supervisors. At the time banking supervision authorities were often a department of the national central banks. The central banks had taken on responsibilities for the solidity of banks as an add-on to their monetary and stability tasks. Both groups established in the seventies still exist, though in new formats. The banking advisory committee has been split into (a) the Committee of European Banking Supervisors (‘CEBS’ – since 2011 replaced by the European banking authority, ‘EBA’) – a high level meeting of supervisors from all member states, and (b) the European Banking Committee (also known as the ‘EBC’) consisting of mid-level representatives of the ministries of finance from all member states16. The EBC is focused on the political angle of new regulation. EBA is focused on both the technical angle of regulation, as well as on the application of such EU laws. The groupe de contact is no longer a standalone committee, but currently reports to the board of supervisors of EBA. The national central banks, with a strong role for the ECB, were allocated monetary authority and with it a role in banking regulation design and execution (e.g. by rights of advice and of to be an observer at prudential supervision committees). The introduction of committees and the subsequent changes in the organisational structure on banking supervision cooperation were the result of an ever increasing pressure to open up financial markets. If financial markets were no longer domestic, the response to new developments could no longer be formulated domestically. New structures were designed to be able to respond in a coordinated fashion quickly to changes in the structure of such markets, keeping them both safe and competitive, but hampered by a desire to maintain independence at the national level and national influence at the international level. The goal of the institutions in which national supervisors, central banks and/or ministries of fiancé come together remains to advice on new legislation, help such new legislation to be adopted, to discuss further possibilities to harmonise the application of such legislation and to increase practical cooperation. The efforts of regulators and supervisors have often been smothered by their own success. When cooperation leads to opening up of markets,

‘Banking Advisory Committee’. Upon the split of the BAC, the groupe de contact became the ‘main’ working group of CEBS, and subsequently a subcommittee of EBA. 16 See the Commission Decisions of November 2003 establishing CEBS (2004/5/EC) and EBC (2004/10/EC). The CEBS Commission Decision was recast on 23 January 2009 to reflect a review into the Lamfalussy structures (Commission Decision C(2009) 177 final); in turn replaced a year later by EBA Regulation 1093/2010.

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financial market participants get a taste for more and have little patience with the slower moving policy process. EBA, like its predecessor CEBS, works through a variety of main subgroups on the various issues on the table17. The subgroups are often chaired by a high-ranking supervisor and have mid ranking employees of all national supervisory authorities as members. They cover all areas of banking supervision, and deal with most issues in line with mandates from the Commission and/or the work programme of EBA. The subgroups aim to try and adopt a view acceptable to most members, on proposals of expert groups working on specific subjects. The experts are nominated by the member-organisations. Most issues are negotiated at the expert level. Any unresolved issues are kicked up to the subgroup that tries to discuss and negotiate a compromise on (most of) them and reports to EBA on progress made. Final proposals as agreed at the subgroup-level and any remaining unresolved issues are sent to the main committee of EBA, the board of supervisors, where these are resolved, adopted, or sent back for further work with additional instructions (depending on the issue by simple or qualified majority18). On own initiative work the EBA board of supervisors can also decide to cancel the work. However, if an advice is requested by the Commission, or either draft standards (to be adopted by the Commission) or guidelines are mandated by EU laws, EBA has to deliver a result. Those results may include blank areas, gaps and euphemisms for failure, but more likely they will deliver a majority view laid down in the work (with reference to the minority opinion of the members that do not fully agree with the advice). Consensus is desirable, but may not always be possible. Where work is mandated, the EBA board of supervisors votes on the proposals drafted by its subgroups. If a qualified majority or simple majority agrees as determined by the importance of the work, the work is finalised accordingly19. The voting members the boards of EBA, its chair and its executive director are obliged to act independently, and disregard e.g. national or institutional interests when voting if those are not in line with the interests of the EU as a whole20. Whether this is realistic in practice may be a subject for debate, but the intent is clearly that national interests should be sacrificed if there is a more important

17 Art. 41 EBA Regulation 1093/2010 also allows the Board of Supervisors to set up internal groups and panels, and to delegate clearly defined tasks to such or to the Management Board or Chair. See chapter 21 for the role of such a panel in dispute resolution between supervisors. 18 Initially it operated on a consensus basis except for level 2 advice, but in 2009 all decisions were subjected to the same (qualified majority) voting system if no consensus was possible. See art. 14 Commission Decisions Establishing CEBS of 23 January 2009, C(2009) 177 final, Recasting Commission Decision 2004/5/EC. 19 Determined in line with the voting arrangements set out in the European treaties; see recital 53 and art. 44 EBA Regulation 1093/2010. Also see chapter 23.3. 20 Art. 42, 46, 49 and 52 EBA Regulation 1093/2010. Also see chapter 23.3.

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EU wide interest. It remains the personal opinion of each person whether that is the case. It should be noted that no such obligation exists for the member states representatives when voting on (banking) legislation at the EBC or at the Council The general structure of EBA reflects some of the same elements of its predecessor CEBS. Additions are a new independent chair (replacing the chair selected by the members of the committee/board of supervisors). The board of supervisors that consists of representatives of the national supervisors remains – like the committee in CEBS-times – the decision making body. Figure 3.1 EBA structures 2011

EBA structures 2011 Independent non-voting chair Board of supervisors Decision making body of EBA (London) Joint committee cooperation with ESMA and EIOPA

Management board

Banking stakeholder group

Executive director & EBA employees

Various subgroups Subcommittee on Financial Conglomerates (mainly with EIOPA)

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Figure 3.2 EBA structures 2004-2010 CEBS structures 2004-2010 Committee of European Banking Supervisors CEBS (London) 3L3 cooperation with CESR and CEIOPS and a working committee with CEIOPS on financial conglomerates

CEBS Bureau

Consultative panel

Secretary-general CEBS secretarial

Groupe de Contact

Expert group prudential requirements

Expert group

Various subgroups

Various subgroups

Accounting subgroup

Operational networking

Own funds subgroup

Auditing subgroup

information

Review Panel

Reporting subgroup

All heads of domestic supervisory authorities are voting members of the board of EBA, like they were at CEBS. They jointly take the decisions on e.g. new guidelines, draft technical standards to be submitted to the Commission, mediation decisions and emergency decisions; see chapter 18, 21 and 23. They will also be responsible for the annual work programme (forward looking), the proposal for an annual budget (forward looking), and the annual report (backward looking), all of which are sent to the Parliament, Council and Commission. The budget is sent via the Commission to both other bodies, as Parliament and Council have to approve any subsidies to EBA the Commission proposes from the

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head of a unified supervisor attending meetings of EBA, ESMA, EIOPA and likely the ESRB, while being in the loop of practical supervision at his home authority. The Commission continues to send a representative as a non-voting member to the board (though the requirement that the representative should be high-level is not copied from the CEBS decision). It has also gained a seat at the table of the management board (at CEBS it was not part of its predecessor; the so-called bureau). The role of the new management board at EBA has been expanded to have a greater role in setting policy directions on behalf of the board of supervisors. Its members are the chair, plus six members of the board of supervisors elected by and from the voting members. The voting members are free to send an alternative if they like (without an obligation to attend a minimum number of management board meetings). The Commission and the executive director are non-voting members, though the Commission has a vote on the budget. Likely the presence of the Commission is part of the checks and balances it required in return for the new regulatory tasks EBA has gained that give the Commission only little leeway when deciding to endorse them or not (see chapter 2, 21 and 23.3)24. In the European political and legislative context, the Parliament (especially its ECON subgroup), the Council (especially its Ecofin subgroup) and the Commission (especially its markets directorate) play a key role in setting the outer boundaries and criteria that new banking legislation has to fulfil. It actually has taken in depth positions on prudential quantitative and qualitative rules. This is surprising as – outside of a crisis – a lot of the attention of voters is focused only on issues that directly impact on them, most often in the conduct of business area or on issues such as deposit guarantees. The fact that the Parliament appoints a rapporteur on each legislative proposal may help, as regardless of the level of public interest there will always be at least one parliamentarian who will look in depth at the content, and report on it to ECON. The amount of lobbying focused on the Parliament could also play a role. It may be more intensive in Brussels than in many national parliaments, with the increasing power of the European Parliament and an acknowledgement by the industry that most of its rules are set in Brussels even before but especially during the 2007-2013 subprime crisis. The emphasis on e.g. cheap funding for small- and medium sized enterprises25 or for electricity liberalisation – even if those should prove relatively more risky than reflected by the amount of financial buffers required – comes from priorities set out in the recitals of EU banking directives, and translated into e.g. lower risk weights than could possibly be justified by the facts. The Parliament – like 24 Art. 40-53 EBA Regulation 1093/2010. 25 Recital 44 and art. 501 CRR and art. 129 and 130 CRD IV Directive. Also see European Parliament, Press Release on EU Bank Capital Requirements Regulation and Directive, 15 April 2013 and the assessment of EBA on the riskiness for banks of lending to smaller enterprises in EBA, Assessment of SME Proposals for CRD IV/CRR, September 2012.

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the Council – also has to agree with the framework of banking supervision legislation as proposed by the Commission after input EBA and from subordinates of the Council members that gather in groupings like the above-mentioned EBC, has been taken into account to the extent the Commission finds necessary/acceptable. See chapter 23. The Court of Justice has the final say on whether any EU legislation – and its application – is compliant with the boundaries set in the EU treaties. At the same time as upgrading the level of the membership (even when considering that the member can send a high ranking alternate after he personally has attended at least two meetings annually), the presence of non-supervisory central banks has been de-emphasised. Domestic central banks are welcome as a personal guest of the member (the head of the domestic supervisory authority), but otherwise are represented by the ECB and the ESRB (though such bodies are non-voting members only at EBA). Nonetheless, central banks play an important role in banking supervision and have a strong say in the regulatory setup thereof. Their influence is linked to their mandate on financial stability and monetary considerations (see chapter 18 and 22). EBA (and the EBC) is mostly focused on microprudential issues and the committees and their subgroups are dominated by delegates who work at supervisory departments in central banks or at standalone supervisory authorities. The monetary side of central banks normally has observer status at these gatherings. This secondary role at banking supervisors-groups is compensated by a large number of central bank dominated groups where supervisors have observer status only. These focus on the role of banks for monetary purposes and financial stability purposes. The ‘banking supervisory committee’ was set up in 1990 by the so-called committee of governors, which later became the European monetary institute; which currently is the European central bank (‘ECB’)26. The banking supervisory committee was focused on all issues in which both supervisors and central banks had a common interest, including banking supervision. When CEBS was set up to deal with banking supervision, the banking supervisory committee still existed as well. It was basically composed of representatives of the same institutions as CEBS. Its work programme became skewed more to financial stability concerns, including the implications of crisis management for the wider economy. Its role was not always clear, overlapping both with the ‘own’ work of the ECB and with the work done by the supervisory groupings such as CEBS. Searching for an ‘own’ area of competence was difficult. It did not have a clear role on what are now named ‘macroprudential’ issues, and any analytical work it did on potential threats to financial stability was not high level or visible enough. The old Banking Supervision Committee of the ECB had not delivered sufficient warnings on financial stability concerns in the period before the 2007-2013 subprime crisis, though whether this was part of its work was not exactly clear. After a 26 R. Smit, The European Central Bank, Institutional Aspects, The Hague, 1997, page 333.

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second27 acrimonious debate on the role of the ECB in CEBS/EBA and in banking supervision in general (opposed mainly by non-central bank supervisors and non-Eurozone member states, as well as by those who find central banks too powerful), and its responsibility for macroeconomic issues for the EU as a whole (opposed by some non-Eurozone member states) a compromise was reached on the establishment of a new (high level) systemic risk organisation. The new European Systemic Risk Board (ESRB) has been established as per end 2010; see chapter 22.528. Though lacking in any real powers to address systemic risk problems, the ESRB will have the power to collect information from e.g. supervisors and central banks and to issue warnings and recommendations to member states and European institutions. The board is dominated by the governors of the national central banks (accompanied by one non-voting representative of the national supervisory community), with the chairmanship and secretariat provided by the ECB. In addition the chairmen of EBA and of the insurance and securities sector authorities (EIOPA and ESMA) will be present, as well as representatives of the Commission and the EFC. Two vice chairs provide balance between the various interests at EU level, with the first vice chairmanship going to the UK Bank of England governor (a non-Eurozone non-central bank currently without supervisory tasks), and the second going to the chair of the joint committee of the European supervisory authorities. Apart from these groupings of central banks and banking supervisors, specific structures have been set up to bring together central banks and ministries of finance (e.g. the financial stability table of the economic and financial committee29); see chapter 18, 21.7 and 22. Basel Committee of Banking Supervisors (BCBS) The Basel Committee of Banking Supervisors consists of representatives of central banks and banking supervisors from several countries. In 1974, when the G10 central bank governors established the BCBS, it was a spin-off of the cooperation between central banks of the largest financial markets at that time. This includes many of the original members of the EU, and some of its practices resembled the working of the above-mentioned EU Groupe de Contact30. At times, more than half the membership of the Committee consisted 27 The initial debate on the role of the ECB/ESCB in banking supervision resulted in the current treaty provision that a role could be allocated to the ECB (but was not), and the ECB was to contribute to prudential laws and policies (which power it actively uses, including in the subsequently developed Lamfalussy process). See chapter 23 and R. Smit, The European Central Bank, Institutional Aspects, The Hague, 1997, chapter 5. 28 See ESRB Regulation 1092/2010 and ECB/ESRB Regulation 1096/2010. Also see www.esrb.europa.eu. 29 Art. 134 TFEU. 30 Belgium, France, Germany, Italy, Luxembourg, the Netherlands, Spain (since 2001), Sweden and the United Kingdom. Outside the EU, the membership up to 2009 included Switzerland, Japan as the sole representative of the Asian world, the USA and Canada for North America, and no members from Africa, Australia or Latin America. See C.A.E. Goodhart, The Basel Committee on Banking Supervision, A History of the Early Years 1974-1977, Cambridge, 2011, chapter 2 and page 435-437 of chapter 12.

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of authorities from EU member states. With the rise of the G20 in response to the 20072013 subprime crisis (see chapter 2 and below), the European authorities no longer have a dominant number of seats since 2009. Authorities from EU member states that also have a seat on the BCBS do not represent the EU there, but they take developments at the EU table into account (though national interests are likely to be brought equally loudly to the table). In addition to the seats held by some member states, the EU has several of its institutions represented at the BCBS with observer status. These are the European Commission (the only ‘ministry of finance’ type organisation represented in the BCBS), EBA and the ECB. The secretariat is based at (and funded via) the Bank of International Settlements (BIS) in Basel, Switzerland. The BIS also hosts the G10 governors of central banks, to which the BCBS reports, and other standing committees such as the committee on payments and settlement systems (CPSS)31. The BIS is often referred to as the central banker’s bank, reflecting the origins of the BCBS. Figure 3.3 BCBS Structure BCBS structure Basel Committee on Banking Supervision BCBS Secretariat Based at BIS

Coordination Group Cooperation with IOSCO, IAIS and Joint Forum

Standards Implemetation Group SIG

Policy Development Group PDG

Accounting Task Force ATF

International Liaison Group ILG

Various subgroups

Various subgroups

Various subgroups

Various subgroups

Authorities (often both supervisors and central bankers) of the now 28 countries involved and the various observers need to discuss and find a consensus on some highly technical issues, with a large repercussions for their national legislation and national banking markets. The Basel papers have set the standard for supervision across its membership for decades, 31 See C. Goodhart, The Basel Committee on Banking Supervision, a History of the Early Years 1974-1997, Cambridge, 2011, chapter 13.

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and have become the standard also for non-member countries. As a standard, the Basel Accord and the other papers of the BCBS are binding neither upon its membership nor on others. As a consensus based document, it has, however, had a large impact on domestic regulation on those issues where the members actually were able to achieve such a consensus. Europe and North America were up to 2009 (overly) well represented at the BCBS with 9 EU members, one other European country (Switzerland), two members from North America (USA and Canada), and Japan. The BCBS had been under pressure to broaden its membership for years. Influence in Basel was no longer aligned to the changing landscape in the banking world. Intermediate steps had been taken, in which the BCBS allowed membership of its subgroups on e.g. the implementation of the capital accord, the development of new policy or on accounting issues to be broadened to non-BCBS members, and by increasing a dialogue with regional groups via the liaison subgroup32 in addition to a biannual International Conference of Banking Supervisors. In response to the 20072013 subprime crisis and in a belated acceptance of the increasing importance of the banking markets outside the western world, the membership has been enlarged substantially in 2009 under pressure of the G20. In March 200933, Australia, Brazil, China, India, Korea, Mexico and Russia became members. In June 200934, it was further expanded, no doubt under great pressure, by adding the remaining members of the G20 not yet on the Committee: Argentina, Indonesia, Saudi Arabia, South Africa and Turkey. In addition, Hong Kong SAR and Singapore were added to the membership. The component of EU members is still large at around a third. The downside of the expansion is both a more cumbersome process and – for the original members based in the EU – a loss in relative influence, both no doubt key reasons for the original members to resist change for so long. To establish its output of banking supervision standards, the BCBS follows a voluntary process, based on the maximum consensus achieved35. The negotiating process was originally intent on agreeing a simple but common banking supervision framework. This goal was achieved by investigating, codifying (and building upon) the previous national experience of its membership. The result of the negotiations was the publication of the Basel Accord (also known as Basel I), the market risk amendment to Basel I, the Basel core principles for effective banking supervision, and the overhaul of major parts of the Basel Accord (known as Basel II), in addition of a wide variety of supporting guidelines, press releases and working papers. Under high pressure from the G20 to deliver, the increase in the membership has not meant that the BCBS did not succeed in publishing a new 32 Of those regional groups, the EU had obtained a preferred position and was included in the meetings of the full BCBS too. 33 Press release dated 13 March 2009 on www.bis.org/press/p090313.htm. 34 Press release dated 10 June 2009 on www.bis.org/press/p090610.htm. 35 BCBS, Charter, January 2013.

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amendment following the crisis. The Basel III papers do, however, contain several gaps and issues identified for future re-calibration. See chapter 2. The consistency between EU regulation and the BCBS standards and vice versa is one of the results of the investment of the EU authorities in the BCBS process, and the large proportion of BCBS members that is also heavily involved in the EU process. Generally, the main outline of prudential policy is discussed first in the Basel context. An exception was the 1996 BCBS market risk work that was based in part on previous EU work. The BCBS can be seen as the worldwide think tank. It brings together domestic and regional expertise, and subsequently provides the outlines of (parts of) a common supervisory approach to large, cross-border operating banks that can be agreed upon by its members. Those outlines are simultaneously based on and provide inspiration for the basic thinking on banking supervision in the EU36. To understand EU laws containing prudential rules, it is unavoidable to take into account the intention as explained in the BCBS texts. Many third countries have also taken on board the BCBS texts. This includes countries not involved in the process at all, which follow the lead of this assembly of (larger) banking supervisors. Sadly, this does not mean that there is no difference with the way Basel documents have been implemented in various (member and third) countries. Such discrepancies are the result of e.g.: – the high level character of some parts of the Basel accord and other documents; – the various explicit national discretions contained in the Basel accord; – the non-binding character of BCBS work, which allows member states to treat each aspect of the accord as a national discretion; – the room left by the use of ambiguous or undefined terminology. Identical complaints can, however, also be made when comparing the European CRD visà-vis the national implementation thereof in the member states, even though the CRD is binding (see chapter 3.4-3.5). The BCBS has from the start been accountable to the governors of the G10 central banks. The 2004 Basel II package was endorsed by this group (its official name is the group of central banks governors and heads of supervision). At that time it was composed of representatives from the same jurisdictions as the BCBS itself (the G10). This has been made more explicit and referenced more clearly in the wake of the latest crisis, possibly to make the various reporting lines more clear37. For example, the recitals of the CRD IV project

36 For a history of the BCBS and its impact on EU and UK banking supervision, see C. Hadjiemmanuil, Banking Regulation and the Bank of England, London, 1996, page 53-77. 37 BCBS, Charter, January 2013, page 2 and 4.

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regulation proposal references not only the BCBS, but also the endorsements of the group of central bank governors and heads of supervision (GHOS) as an intermediate step for their finalisation. Like the BCBS, the membership of its oversight body has also been expanded with those G20 countries that were not yet a member before the crisis. The BCBS – as well as the group of central bank governors and heads of supervision – has also gradually been brought more under political control, though the exact political accountability is not yet clear. As an indication of political control on the capital accord, the Basel III amendment to that accord agreed in the wake of the 2007-2013 subprime crisis was not published in full until it was presented to and endorsed by the G20 heads of government38. The BCBS works closely with several other similar committees, working in e.g. the field of securities laws (conduct of business and markets) and insurance supervision. The joint forum, which works on financial conglomerates and some other issues that are of interest to all sectors, brings together the BCBS, the international organisation of securities commissions (IOSCO) and the international association of insurance supervisors (IAIS). The G20/G7 The G-organisations are informal bodies. There is no treaty on which they are based, nor do they have delegated powers from non-represented countries. In spite of this lack of formal statute, they have gathered de facto control over many international bodies and states. The G7 leaders – composed of the heads of state of the 739 largest economies of the world plus the head of the Eurogroup – have long taken a lead role in trying to deal with threats to the global financial system40. Recently, especially in the wake of the 2007-2013 subprime crisis, this role has been taken over by the G2041. Where the original composition of the BCBS was based on the gathering the larger financial economies in the G10, and the composition of the G7 was based on political power, the selection of G20 members was based not only on economic size, but also on factors such as geographic spread and population size. They include a wider geographical and wealth spread than the G7, but remains focused on either large economies or on countries that have large populations if there is not a larger economy from their region. Members are the EU, Argentina, Australia, Brazil,

38 See chapter 2 and recital 1 CRR. 39 The Group of Eight consists of representatives of Canada, France, Germany, Italy, Japan, Russia, the United Kingdom and the USA, with observership status of the EU, and has been meeting since 1975. Its membership has been under discussion, and may be expanded (though this pressure may have eased with the increasing importance of the G20 meetings). 40 The G8 was for instance involved in the follow-up to the Asian financial crisis in the late nineties. See e.g.K. Kaiser, et al. (Ed.), Shaping a New International Financial System, Hants, 2000, that describes amongst other the role of the G7. 41 Initially set up as the Group of Twenty (G20) Finance Ministers and Central Bank Governors, it has been meeting since 1999.

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Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, the United Kingdom, and the USA. The different selection criteria mean that some large financial centres such as the Netherlands and Luxembourg (respectively the 16th economy by GDP and the hub for EU investment funds and private banking) are represented in the BCBS because they were part of the largest financial economies when the G10 was established, but not in the G20, while countries with large populations (but small financial systems) have gained a seat at both the G20 and from this platform have gained representation on the BCBS. The intention is to make the process fairer and increase buy-in on crisis-work across the globe. The BCBS now brings together the membership of the G10 and the G20, but in essence has become a G20 body with added membership. The G20 has had several discussions and set the agenda on revisions to the worldwide financial services provision and its supervision. In the early years of the G20 (established in 1999) it was a meeting of the finance ministers and central bankers of its member states. With the increased focus on the impact of the 2007-2013 subprime crisis on the worldwide economy, the G20 leaders also started meeting in 2008 and 2009. They took final responsibility, and in practice changed the nature of the G20 from a ministerial to a heads of state organisation. As the G-organisations bring together members of the (political) governments (where the BCBS and similar bodies are gatherings of bureaucrats), they gained political responsibility for making decisions on the way forward after the crisis. The G20’s broad base gave it sufficient authority to deal with the essentially worldwide issues at stake. The G20 has started to provide steering to the work of supervisors worldwide, including the development of policy by the Basel Committee of Banking Supervisors and the similar organisations in the area of insurance and investment services. To this end, the G20 issued e.g. an action plan and several communiqués, in which orders were given to national legislators, the BCBS and similar organisations in the insurance and securities sector, to the IMF and World Bank and to supervisors on amongst others banks worldwide. Effectively, these orders have been accepted on issues such as broadening the membership of the BCBS and its work plan, re-invigorating the IMF and World Bank, transforming the financial stability board and on the work of supervisors, and to deal with issues including the remuneration (i.e. salaries and bonuses) of bankers, the strengthening of banking capital. It has also been used to crack down on tax havens/uncooperative jurisdictions, in a sign that the G20 does not consider its remit limited to crisis-remedial actions but has taken on board the wider architecture of (worldwide) financial services and financial stability.

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Financial Stability Board (FSB) The FSB was set up as the so-called ‘financial stability forum’ in 1999. Its initial goal was to bring together several international and national authorities with a direct interest in international financial stability. These would assess vulnerabilities affecting the financial system, identify and oversee action, and could promote coordination and information exchange among central banks, supervisors and others with a responsibility for financial stability. Up to 2009, it was a relatively low-key organisation, with the secretariat hosted at, and funded by, the bank for international settlements. It did not have an authority or audience consistent with its wide-ranging mandate. In the follow-up to the 2007-2013 subprime crisis, however, it became a central point of contact for the various organisations looking to improve international financial stability. The G20 leaders decided42 to upgrade the organisation, broaden its mandate and rename it into the financial stability board (FSB). The mandate of the FSB is now focused on planning, assessing, monitoring, stimulating and ensuring cooperation by standard setting committees, regulators and supervisors as well as international financial institutions. With the buy-in from the G20 leaders and the commitment of its members, it is well on its way to become a focus point for financial stability stimulation, if it can remain effective and help deliver concrete results when the immediate effects of the 2007-2013 subprime crisis have waned. The FSB is built up of a: – plenary meeting (the decision making body of the FSB); – steering committee (responsible for operational execution between meetings of the plenary of the FSB work); – secretariat (hosted at the BIS); – chairperson (responsible for overseeing all bodies of the FSB). The membership of the (plenary meeting of the) FSB is extensive, consisting of – six standard setting bodies on financial supervision and accounting43; – four worldwide international financial institutions (BIS, IMF, OECD, World Bank); – national authorities of G20 member countries (including the European Commission and the ECB on behalf of the EU) and of Hong Kong, the Netherlands, Singapore, Spain and Switzerland; 42 London Summit, ‘Declaration on Strengthening the Financial System’ of the G20 leaders of 2 April 2009. 43 The BCBS, CGFS, CPSS, IAIS, IASB and IOSCO. The BCBS, IAIS and IOSCO are standard setting bodies for respectively banking, insurance and securities supervision, the CGFS and CPSS set standards for the global financial system and for payment and settlement systems, and are – like the BCBS – hosted by the BIS. The IASB sets accounting/financial reporting standards; see below.

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– non-members by special invitation of the chair (to attend on an ad-hoc basis). It brings together and keeps an overview of e.g. the work of the various sectoral organisations, and endorses the results of that work to the G20. It publishes continuous updates (in the form of reports to the G20) on the progress of all the financial stability work on its website. In addition, it develops several strands of work within its own structures if those do not fit well within one of its member-organisations, and are a core part of its financial stability mandate, such as moral hazard, bail-ins and procyclicality (see chapters 4.3, 6.5 and 18). Worldwide Operating Institutions The world trade organisation (WTO), the bank for international settlements (BIS), the international monetary fund (IMF), the OECD, the World Bank and multilateral development banks such as the EBRD have tasks that benefit from financial stability and/or open markets. Their involvement in discussions on financial stability and banking supervision is supplementary to their core tasks. Their interest translates in participation in various international committees that set standards or discuss financial stability, and in extensive research. Such research addresses both future developments, evaluations of past distress in the markets. The IMF and World Bank perform a key role by also assessing compliance by individual countries with the Basel core principles for effective banking supervision (and similar principles written for the insurance and securities sector)44. In addition to its research and support tasks, the BIS provides the secretariat for the financial stability board and for the BCBS, alongside similar committees for e.g. payment services. The WTO was established in 1995, in order to monitor the implementation of the results of the Uruguay round of negotiations under the auspices of the UN: the General Agreement on Tariffs and Trade 1994 of which its establishment was part. For banking services, and financial services in general, annex 1B is the important document, containing the General Agreement on Trade in Services (GATS). On financial services, it contains both general obligations that are taken on board by all WTO members, as well as specific commitments that can differ per member; see chapter 5.5. These obligations focus on opening markets in general, and on e.g. the treatment of applications for a banking licence for a local subsidiary of a bank based in a WTO member state. The EU is a member (in line with the possibility under the European treaties45), alongside the individual EU member states. The EU is seen as one territory for WTO purposes, and its commitments (and exemptions) 44 See www.imf.org, and e.g., J. Viñals & J. Fiechter, The Making of Good Supervision: Learning to Say ‘No’, 2010, IMF SPN/10/08. Also see chapter 19 and 21.1. BCBS, Core Principles for Effective Banking Supervision, September 2012. 45 Art. 300 and 310 TFEU.

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are put forth jointly (e.g. on the cooperation with Switzerland), with some country specific add-ons (e.g. on Nordic cooperation or on preferential cooperation with former colonies). For the impact of the GATS on market access see chapter 5.5, and on its lesser impact on consolidation respectively cross-border cooperation see chapter 17.5 and 21.8. The WTO has become less relevant in practice as a vehicle for liberalising cross-border access into the EU (or of EU banks into other countries) due to the failure (so far) to conclude the Doha round of negotiations. Depending on the reactions to instinctively protectionist feelings after the 2007-2013 subprime crisis, the Doha negotiations may either receive a stimulus from the realisation that free trade helps all the countries involved, or result in its final failure. If the negotiations are successful in full or in part, the conclusion of supplementary bilateral negotiations between the EU and various third countries for improved cooperation and mutual market access for financial services providers will receive a fresh impetus. In addition to sovereign-based organisations, accounting standard setters also play a large role in banking supervision; see chapter 6.4. Both banking supervision and the trust put by the public in banks is amongst others based on quantitative information. In order to achieve a common understanding on what this information actually means, several international bodies have been working to harmonise accounting and auditing standards. The subject of accounting standards – the standards under which public accounts of public companies and banks are drawn up – are the remit of the International Accounting Standards Board (IASB). Auditing standards – the standards that accountants need to live up to when drawing up and verifying the accounts of their clients – are the remit of the International Federation of Accountants (IFAC) and its largely independent International Auditing and Assurance Standards Board (IAASB). These organisations are set up as private organisations. Their work is, however, increasingly scrutinised and endorsed by regulators and supervisors, and approval by regulators has become necessary to allow firms to draw up accounts under the standards for e.g. public disclosure purposes; see chapter 6.4 and 15. To ensure that the standards are in line with the public interest and that regulators and supervisors continue to be willing to endorse their work, both the IASB and the IFAC have established accountability mechanisms to respectively the ‘monitoring board46’ and the ‘monitoring group47’ on which regulators/supervisors are represented. Banking supervision 46 The IASCF Monitoring Board consists of representatives of the European Commission, the USA Securities and Exchange Commission, the Japan Financial Services Authority, the (emerging markets committee and the technical committee of the) International Organisation of Securities Commissions (IOSCO) and, as an observer, the BCBS. 47 The Monitoring Group brings together the International Organisation of Securities Commissions (IOSCO), the European Commission, the BCBS, the International Association of Insurance Supervisors (IAIS), the World Bank, the Financial Stability Forum and as an observer the International Forum of Independent Audit Regulators.

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(and insurance supervision) take accounting standards as a starting point, and adjust them as needed. Proper and trustworthy auditing is at the same time quite similar to the work of prudential supervisors, though with different goals (public investors scrutiny or solidity supervision). Domestic Institutions Even though the subject of this book is European banking supervision, no such thing exists at the time of writing of this book. European banking supervision is still a patchwork of national legislation and supervision, set up under basic minimum requirements agreed at the EU level by representatives of the national legislators and supervisors (and to some extent influenced by Brussels based civil servants and parliamentarians, each with close links to national groups). Though this sounds complicated and less than efficient or effective, this patchwork nature and the high influence of nationals of the member states has in practice allowed the member states to delegate a substantial amount of control (rulemaking, checks and balances) to the EU, at least in areas such as financial supervision. This may change for all EU or Eurozone banks, or for the larger banks operating in that region, under plans to introduce a banking union in response to the 2007-2013 subprime crisis48. At the national level, the relevant parties developing local policies and regulation, and the input at the European level (and for those member states concerned also at the worldwide level) are: – ministries of finance/treasury. At the EU level national ministries of finance send representatives to the Council and several working groups that assist the Council or the Commission49. At the national level they have responsibility for drafting legislation and having it approved under its national legislative process in order to implement the EU consensus texts within the timelines set. The government minister responsible for finance/treasury provides political direction for this work, and for the accountability to (and cooperation with) national parliaments; – central banks (monetary authority; with a role for the ECB if the central bank is part of the euro-zone). At the EU level national central banks send representatives to various working groups and committees. At the national level they have responsibility for commenting on draft legislation and bringing financial stability and monetary issues to the attention of the legislators and the public at large;

48 See chapter 21.3, and R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 4.6. 49 Several ministries (and central banks) also second their employees to the Commission, Council or Parliament to assist those in their tasks, and to liaise between these EU institutions and their seconding authority.

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– prudential banking supervisory authorities (sometimes a standalone entity, sometimes part of a cross-sector authority, sometimes part of the central bank which in that case has dual responsibilities). At the EU level prudential supervisors send representatives to various working groups and committees such as EBA. At the national level they are responsible for commenting on draft legislation, bringing supervisory issues to the attention of the legislators, setting banking supervisory policies and executing (prudential) banking supervision in cooperation with e.g. a separate conduct of business or markets supervisor. Ministries, central banks and prudential supervisors have to work closely together. This is especially true in crisis situations, but also in day-to-day information exchange and legislative/policy work. Each of the three has the power to obstruct, and thus to make the others less effective and/or appear less competent, and the tasks of all three can only be achieved if they work in a trusting and positive environment. Though each has its own role both nationally and at the EU level – and can thus have quite different inputs and opinions – the more effective member states coordinate the input given at the various groupings they are members of. Local parliaments and other ministries generally have a limited role due to the highly technical nature of the legislation, and lack of interest during good economic times in such issues. If national parliaments should choose to exercise it, they have gained additional influence on the EU legislative process under the Lisbon treaty amendments (see chapter 23.2). Such interest is, however, more likely for conduct of business supervision, where the interests of consumers are more visibly at stake, and for prudential issues at times when banks fail. Future Developments Under the ‘banking union’ proposals of the Commission, the ECB would gain rulemaking power for prudential banking rules, that will be applicable to all banks in its future remit, i.e. in the Eurozone and in voluntarily participating member states50. In principle those rules should emanate from the EU-wide rulemaking bodies (Parliament/Council, Commission, EBA). However the treaty provisions give the ECB the power to issue rules in its areas of competence. Once the regulation is adopted unanimously by the Council, prudential supervision becomes part of its competence for all activities of all banks that are active in the participating member states. The proposed regulation hints that the ECB should not circumvent the EBA, and requests it to only issue rules if it thinks that the EBA has not issued relevant rules or if the EBA work is not detailed enough.

50 See art. 127 and 132 TFEU, and Commission, Proposed Single Supervisory Mechanism ECB Regulation, COM(2012) 511 final, 12 September 2012, recitals 26 and 27.

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Literature – Goodhart, Charles, The Basel Committee on Banking Supervision, A History of the Early Years 1974-1997, Cambridge University Press, Cambridge, 2011 – Tarullo, Daniel, Banking on Basel: The Future of International Financial Regulation, The Peterson Institute for International Economics, Danvers, MA, 2008 – Davies, Howard; Green, David, Global Financial Regulation: The Essential Guide, Cambridge University Press, Cambridge, 2008 – Haan de, Jakob; Oosterloo, Sander; Schoenmaker, Dirk, European Financial Markets and Institutions, Cambridge University Press, Cambridge, 2009 – Chalmers Damian; Hadjiemmanuil, Christos; Monti, Giorgio; Tomkins, Adam, European Union Law: Text and Materials, Cambridge University Press, Cambridge, 2006, chapter 3 – Dragomir, Larisa, European Prudential Banking Regulation and Supervision, The Legal Dimension, Routledge, 2010, chapter 8 – Smits, René, The European Central Bank, Institutional Aspects, Kluwer Law International, The Hague, 1997 – Padoa-Schioppa, Tommaso, Regulating Finance, Balancing Freedom and Risk, Oxford University Press, Oxford, 2004 – Black, Julia, Restructuring Global and EU Financial Regulation: Capacities, Coordination and Learning, LSE Law Society and Economy WP 18/2010 – Ferran, Eilís; Moloney, Niamh, Hill; Jennifer G.; Coffee, John C. Jr, The Regulatory Aftermath of the Global Financial Crisis, Cambridge University Press, Cambridge, 2012, especially the contribution of Eilís Ferran – Wymeersch, Eddy; Hopt, Klaus J.; Ferrarini, Guido (eds.), Financial Regulation and Supervision, Oxford University Press, Oxford, 2012

3.4

Legal Basis of EU Supervision Regulation

Introduction One of the stated end-goals of the EU treaties is to create a single market where both clients and service providers can interact as if there are no borders between the member states. In its most unequivocal sense, a single market in financial services would be achieved if all providers and their clients are subject to the same rules, regardless where they provide or receive services in the EU. The treaty contains a legal basis for the member states to create such a market, but this has so far not been used. Providing this option is a farreaching goal, requiring full harmonisation (or in the terminology of the treaties ‘approximation’) of national regulation of financial services, and possibly a common supervisor. Plans for common rules on this basis are now part of the CRD IV project. For banks, even

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a common supervisor may be founded as part of a banking union. The establishment of a credible and effective single supervisory mechanism and the timeline of such establishment will depend on amongst others funding pressures on banks and governments in the later stages of the 2007-2013 subprime crisis51. The currently applicable version of the CRD is based on less ambitious treaty-provisions, that do not impact on purely national markets but ‘only’ on cross-border aspects of such markets. In this chapter the possible legal basis for banking supervision rules are sketched, as well as the consequences this has for the type of laws that can be issued to harmonise (supervision of) banking markets. In chapter 3.5 the impact of such rules in the national arenas of the member states are described. The legislative process (and the associated lobbying and consultation process) is described in further detail in chapter 23. The treaties in general – and the specific legal basis chosen – have a direct impact on the content of banking directives and regulations. The Court has long standing case law that secondary EU legislation such as directives will be interpreted in line with the treaty provisions if at all possible (instead of being annulled for incompatibility), in the same manner that national laws need to be interpreted in line with directive provisions52. Legal Basis for Banking Legislation The EU member states agreed to create several freedoms that are directly applicable in the member states, and give rights to their citizens (including legal entities). Harmonisation on the content of such freedoms and of the legitimate restrictions of such freedoms can be achieved under a legislative process that allows the Council and Parliament to issue directives on the basis of (qualified) majority voting, enabling a clear majority of member states to overrule outliers. Such directives help harmonise the necessary public interest rules and regulations, so that those do not contain unnecessary restrictions for cross-border activities. If such restrictions are eased, this establishes at least a partial single market for the cross-border aspects (though not a full internal market, where each participant is subject to the same rules and circumstances within each member state as well as in crossborder trade). The free movement of financial services is part of the ‘free movement of persons, services and capital’ title of the TFEU53. Relevant for the banks are: 51 See chapter 2 and 21.3, and R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 4.6. 52 See for instance explicit considerations of the Court in the above-mentioned Co-insurance cases, e.g. Commission/France, Court of Justice 4 December 1986, Case 220/83. For the relation national law to EU directive, see chapter 3.5, and Testa and Lazzeri/Consob, Court of Justice 21 November 2002, Case C-356/00, §43. 53 Art. 45-66 TFEU, for the non-discrimination articles see art. 45, 49, 56/61 and 63/65 TFEU. The freedoms of establishment and of services explicitly apply both to natural persons and to companies or firms; art. 54 and 62 TFEU. The legal form is also not relevant, e.g. freedom of establishment applies both to branches and subsidiaries, Caixabank France, Court of Justice 5 October 2004, Case C-442/02.

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– freedom of establishment (for physical establishments such as branches and subsidiaries); – freedom of services (without a local establishment); – freedom of capital and payments; and – freedom of workers (for their employees). These freedoms are the core of the current interim version of the EU internal market, where the different legal systems are harmonised to achieve a partial version of a true internal market54. To achieve that internal market through agreeing common rules under which the freedoms can materialise, the EU has a far-reaching remit to legislate55. The treaty provisions and legislation based on them help limit the applicability of any exceptions that are allowed. The freedom of services is the catch-all provision. It provides protection when the other freedoms do not provide more specific protection of crossborder activities56. Within the boundaries set, the treaty-freedoms guarantee a lack of discrimination on the basis of nationality. They guarantee that any national of a member state can: – set up agencies, branches or subsidiaries in any member state; – provide services from one member state to a recipient in another member state (including temporary pursuit of these activities in the other member state, governed by local rules); – move capital and payments both between member states and between member states and third countries; and – employ workers from any member state. These are not absolute freedoms, but require the institutions and member states to progressively issue directives to abolish restrictions, and retain only those necessary on grounds of public policy, public security or public health57. This allows leeway for member states to restrict the freedoms in the absence of more detailed harmonisation (see chapter 3.43.5). These exceptions given to member states have been interpreted in a restrictive manner

54 See art. 3 TEU and art. 26, 53, 59, 113 and 114 TFEU on the gradual approach to an internal market. 55 Art. 26 TFEU. Please note that in a purely national context, the treaty cross-border freedoms do not provide protection, Hoefner and Elser/Macroton, Court of Justice 23 April 1991, Case C-41/90. 56 A national measure can impact on more than one of these freedoms. In that case there is no ranking between the freedoms (even though art. 57 TFEU could be read otherwise). Depending on the circumstances of the case, more than one freedom can be applicable, though if one is only of entirely secondary importance, the case will be ruled on under the ‘dominant’ freedom. Fidium Finanz, Court of Justice 3 October 2006, Case C-452/04. Also see chapter 5.3. 57 Art. 45, 46, 52 and 55 TFEU, and Van Duyn/Home Office, Court of Justice 4 December 1974, Case 41/74. See, however, chapter 3.5 on direct effect.

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by the Court of Justice, as they diminish the freedoms given to the citizens of the member states. After the treaty-freedoms have been harmonised for cross-border activities, the next step would be to introduce rules in specific types of services that would regulate a true internal market; both fully harmonising activities in member states as well as those that cross-borders within the internal market., The treaties has separate anchors that target such internal market harmonisation, and for specific issue-base laws such as consumer protection. The freedoms of establishment and services are themselves dependent on the freedom of capital. As that EU freedom has been extensively harmonised and liberalised58, this particular dependency no longer provides constraints to the provision of banking services within the single market. With the increasing ease of cross-border capital and payments, (also) the need for general good requirements for local access to e.g. security providers has decreased59. The freedoms of capital and workers are thus not the subject of this book on banking supervision (except for their relevance in chapter 3.4 and 5). The basis for EU regulation of banking supervision can potentially be found in60: – the attainment of the above-mentioned freedom of establishment for particular activities (only) via directives, including the coordination of provisions in member states laws on self-employed activities that could stimulate or hinder the freedom to take up and pursue activities as self-employed persons. This is the article of the treaty currently used for the CRD and the deposit guarantee directive as well as for the CRD IV directive; – to liberalise the market in a specific service (only) via directives that coordinate the conditions for providing that service (under the above-mentioned freedom of services); – the approximation of legislation of the member states with the primary purpose to establish the single market (defined as an area without internal frontiers in which the free movement of goods, persons, services and capital is ensured), via directives or regulations or any other legislative measure available. This is the legal basis used for the CRR;

58 Free Movement of Capital Directive 88/361/EEC, which included the liberalisation of e.g. short term, medium term and long term financial loans and credits. Also see chapter 4.3 on deregulation. 59 Art. 49, 58 and 63 TFEU and Parodi/Banque Albert de Bary et Cie, Court of Justice 9 July 1997, Case C222/95. In France/Ambry, Court of Justice 1 December 1998, Case C-410/96, the Court indicated that a security of a local insurer or bank could not be required, even where immediate payment was necessary for consumer protection purposes, as payment transfers are currently possible at short notice also from security givers established in other member states. 60 Art. 50, 53, 59, 62, 114, 115, 169 and 352 TFEU. The anti-competition and state-aid provisions of art. 101109 TFEU are relevant to banks too, but are generally not counted as part of prudential banking requirements nor even conduct of business requirements.

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– the approximation of legislation of the member states that directly affect the establishment or functioning of the single market (which legislation does not target the internal market directly, but ‘affects’ it – a more general concept) (only) via directives; – consumer protection via any type of legislative measure available (see chapter 16.6); – where action is necessary, but the treaties do not provide the necessary power, the Council could potentially act on a proposal of the Commission if it wants to and the decision has unanimous support of the member states, via any type of legislative measure available. The directives on prudential banking supervision (the CRD) mention the TFEU in general, and in addition specify that they are based on the self-employed persons provision (i.e. the freedom of establishment). The reference to ‘self-employed’ distinguishes it from the separate freedom for workers who are employed by another entity. The freedom of establishment allows persons, including legal entities, to establish themselves anywhere in the EU, subject to certain safeguards or overriding concerns. Those concerns are viable where banking is concerned. Banking is one of the industries that have a high impact on the local economy and financial system. If non-harmonised, under the general good/public policy exceptions member states could thus impose their own requirements on banks from other member states, making this freedom of a theoretical nature only for banking services. The EU can attempt to harmonise the areas where member states could and would otherwise act unilaterally in a way that limits cross-border activities61. This reduces the scope for unilateral action under the general good/public policy rule, as the member states – when agreeing to the harmonised rules – indicate that this is the level of protection needed. The banking directives in effect serve as the instrument to ensure that the freedom does not impinge on national views on the level of protection needed. They set out the qualification or safeguards banks have to be subjected to by local authorities, before the banks can claim their rights to the freedom of establishment in other member states. However, it appears impossible to base the full range of prudential requirements on this provision alone. Some of the other possible basis for legislation would need to be taken into account too, even if they are not explicitly mentioned in the prudential banking directives. The Court of Justice has in the past indicated that the then applicable banking directives officially refer to this self-employed persons freedom, but that ‘it is clear’ that the directives constitute the essential instrument for the achievement of the internal market for banks from the point of view of both the freedom of establishment and freedom to provide financial ser-

61 Deposit Guarantee Case, Germany/Parliament and Council, Court of Justice 13 May 1997, Case C-233/94, §10-21. Also see chapter 3.5.

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vices62. Even though the CRD only references the freedom of establishment, the Court would likely continue to interpret it to rest on a dual basis of both freedoms, possibly in combination with the internal market legal basis. The choice made for the primary foundation of banking legislation matters for several reasons: – some of these foundations for legislation (i) require unanimous consent in the Council, giving each of the member states an effective veto against legislation that hampers domestic interests, (ii) require parliamentary approval or consultation, while others do not, and/or (iii) limit the type of legislative measures that can be taken to directives only; – the legal basis referred to in the CRD to some extent limits the scope of what can be included in the legislation. If a provision does not fit in the explicitly chosen primary freedom of establishment or other ‘implied’ supporting legal basis for legislation, it may not be valid, would not need to be implemented and cannot be enforced against the member states, nor can its protection be invoked in litigation, at least if it could not fully be based on another available legal basis in the treaty (and the conditions for that legal basis such as unanimous voting are fulfilled)63. The Court of Justice does, however, provide some leeway to the EU legislature to include sub-issues into broader harmonising measures or to legislate where there are potential dangers to harmonisation64, e.g. by including a freedom of establishment provision in a regulation that is primarily aimed at consumer protection. It is neither politically nor legally contested that the current CRD and its predecessors are based on the freedom of establishment and the freedom of services. The choice for this particular basis gives ample room to harmonise the licensing and most ongoing supervision requirements. However, the choice also limits the CRD to an interpretation that is consistent with that goal. The CRD-rules apply in order to allow the opening up of the internal market for cross-border operating banks and their clients. The other goals of the CRD can be based on this treaty-basis because the harmonisation of such requirements allows member states to withdraw their barriers to cross-border banking (which they previously had for reasons of the general good, e.g. to protect their residents against less-supervised banks from other states). If financial stability or depositor protection standards were not harmonised, member states could and should have kept in place the internal borders within the internal market. They could e.g. require local licensing, local solvency and local man62 Peter Paul/Bundesrepublik Deutschland, Court of Justice 12 October 2004, Case C-222/02. The judgement refers to the predecessor directives of the CRD as applicable at the time of the contested bank failure. 63 See e.g. Tobacco Advertising Case, Germany/Parliament and Council, Court of Justice,5 October 2000, Case C-376/98. Also see E. Ferran, Building an EU Securities Market, Cambridge, 2004, page 29. See below on the Court of Justice case law on choosing the correct TFEU legislative basis. 64 See e.g. UK/Parliament and Council, Court of Justice 6 December 2005, Case C-66/04. Also see the ‘legal basis’ case law mentioned below.

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agement, in order to protect the safety of their financial system. The conditions in the CRD provide that other member states must have established minimum supervision on their banks (both in the law and in practice) in order to allow them to go abroad, and will recognise the supervision as set up in each other member state in return. The provisions on both the freedom of establishment and of services indicate that directives are the only type of legislative instrument that can be used for harmonisation in the context of these freedoms65. Directives allow member states leeway on the way they implement them into their national legislation. For other subjects, such as consumer protection, the EU treaties allow a choice of legislative instruments between directives and regulations. Regulations work directly in the member state without the need to translate their text in local legislation. The use of regulations takes away the adaptation possible when translating directive texts into member state legislation. By limiting the type of legislation to directives, the contracting parties to the treaties thus intended to limit the direct effect of the EU legislation on services and establishments, and increase their own freedom to allow national specificities to be accommodated in the applicable rules that fill in these freedoms (see chapter 3.5 and 23.2). If there is no sufficient backing for a directive (or where possible for a regulation), there is no specific harmonisation. Member states are then competent to lay down rules that influence the application of a freedom, but such provisions must not constitute an obstacle to the effective exercise of the fundamental freedom involved66. Where a provision of the treaty offers a protection to cross-border freedoms (instead of one of the full harmonisation legal basis), it cannot be applied to activities that are confined in all respects to a single member state. This would offer the member states more latitude to regulate purely local issues67. However, if the provision can influence the cross-border level playing field vis-à-vis financial institutions in other member states, the Court has accepted that a financial institution can invoke the protection of a treaty provision against its own supervisor68.

65 Art. 50, 59 and 294 TFEU. See chapter 23 on the legislative process. 66 Kraus/Baden-Württemberg, Court of Justice 31 March 1993, Case C-19-92. Also see chapter 3.5. 67 Höfner and Elser/Macrotron, Court of Justice 23 April 1991, Case C-41/90 for an example of this, but e.g. also Kraus/Baden-Würtemberg, Court of Justice 31 March 1993, Case C-19/92, where a cross-border aspect in the case made the German applicant able to invoke the treaty freedoms vis-à-vis the German public authorities. 68 Skandia, Court of Justice 20 April 1999, C-241/97; where a Swedish insurer successfully invoked the direct effect (see chapter 3.5) of a directive provision to make void a requirement regarding local investments as set by its local supervisor and member state.

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Treaty-Restrictions on Harmonisation Harmonisation also has costs. Though the benefits for larger banks and open economies are clear, smaller banks may desire more locally adapted rules, and some member states may desire to engage in regulatory competition to attract foreign funds and business to their local (financial and labour) markets. Local differentiation also allows different approaches to be tested, and successful regulations could then be copied across more markets69. Such ideas were more popular before the 2007-2013 subprime crisis, since when the regulatory competition to low levels and less intrusive supervision have – at least temporarily – become less popular. Harmonisation has become the tool to achieve this, with member states still allowed to compete if they so desire on issues that should not impact on safety. The loss of multiple testing grounds for innovative approaches to regulation does mean, however, that future rules will more often be theory-based instead of copied from successful experiments, and that smaller local banks lose a competitive edge. The EU treaties still provide some restrictions on forced harmonisation. The banking directives are circumscribed by the legal basis used, and by restrictions on the power of the EU, and the needed backing of e.g. member states, as set out in the TFEU70. The legislative process to negotiate and issue directives is described in chapter 23.2, and includes the obligatory cooperation of the various EU institutions, such as the European Parliament, the Council and the Commission. Several principles are also applicable to any piece of legislation – the principles of conferral, subsidiarity and proportionality71 – as well as fundamental rights of both undertakings and natural persons: – The principle of conferral indicates that the EU shall act only within the limits of the competences the member states ‘conferred’ upon it in the treaties, and only to reach the goals set out for the transfer of the competence. As many of the powers are couched in broad or vague terms, this is an easy hurdle to pass for proponents of EU legislative intervention. – The subsidiarity principle means that the EU shall take (legislative) action only if the objectives cannot be sufficiently achieved by the member states, and only if those objectives can be better achieved by the EU as a whole. – Even if the subsidiarity principle is complied with, the proportionality principle entails that the (legislative) action should not go beyond what is necessary to achieve those 69 J.A. Wilcox, ‘The Increasing Integration and Competition of Financial Institutions and of Financial Regulation’, Research in Finance, Vol. 22, 2005, page 215-238. 70 Art. 5 TEU and Protocol 2 to the EU and TFEU contain the subsidiarity and the proportionality principles, while art. 294 describes the legislative process and safeguards. The recitals of the directives and regulations refer to their compliance with such principles, and require compliance e.g. also of regulatory standards; see for example recital 23 EBA Regulation 1093/2010. 71 Also see D. Chalmers, C. Hadjiemmanuil, G. Monti & A. Tomkins, European Union Law, Cambridge, 2006, chapter 5.4 and 10 on the principles, and chapter 6 on fundamental rights.

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objectives. Traditionally, the Court of Justice has given the EU legislators considerable leeway to determine that a legislative measure is ‘proportional’ in areas where it has political responsibilities, by making legislation void on this ground only when it is manifestly inappropriate in light of the objectives of the measure72. – All legislation of the EU has to be compatible with the fundamental rights of all persons (both legal entities and natural persons, though legal entities enjoy more limited protection). These include the rights of privacy and of protection against prosecution (e.g. the rights of defence and silence). These are applicable to both the legislation itself and to their application in practice73. The fundamental rights are laid down in amongst others the European Convention of Human Rights, and the charter of fundamental rights of the European union. Legislation can clarify in a democratic process what kind of limitations of fundamental rights are necessary and legitimate, e.g. to protect fundamental rights of others. Prudential supervision and the instruments of banking supervisors as laid down in the CRD contain such limitations, in this case of the fundamental rights of banks and their employees. An example is the right of banking supervisors to require the cooperation of banks to allow and help supervisors investigate their files and their premises and the obligation to report selfincriminating issues when banking supervisory rules are broken. This has to be counterbalanced by a measured application of the supervisors’ rights. In the CRD, the accent regarding fundamental rights is thus laid on banking supervisors needing to take the fundamental rights into account while exercising the instruments they have, in view of the goals for which those have been given. They should e.g. not be used for other purposes than banking supervision, or used in a vindictive way. See chapter 20.4. Regulation of the requirements for prudential banking supervision can be seen as one of the areas where the subsidiarity and proportionality principles allow the EU to act jointly74. These principles have been very flexibly applied in practice. A legislative action complies with the principles if the EU legislators agree it does so, and nobody contests it in a wellreasoned manner in court to show they are manifestly misapplied75. There is only limited scope for third parties to disagree, even though it could be grounds for an appeal to the Court of Justice. The main function of these principles has been to bring to the negotiation table a discussion on the appropriateness of any action at the EU level, and if so of the 72 Schräder/Hauptzollamt Gronau, Court of Justice 11 July 1989, Case C-265/87. 73 Chapter 20.4. See art. 6 TEU, and recitals 70 RBD and 40 RCAD. 74 See e.g. the Commission White Paper, Completing the Internal Market, 14 June 1985, COM(85) 310, Commission Communication, Financial Services: Action Plan, 11 May 1099, COM(1999) 232. 75 It is, however, largely up to the EU legislators to determine that this principle is complied with. See the Deposit Guarantee Case, Germany/Parliament and Council, Court of Justice 13 May 1997, Case C-233/94, §22-29 and 54-56.

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scale of the intervention and its benefits and costs. As such, it provides a basis for good legislative practices, including consultation and impact analysis. Since the amendment by the Lisbon treaty, national parliaments have been given a specific role as to assessing draft EU legislation against the subsidiarity principle76. If enough national parliaments agree, they can force a reassessment of the appropriateness of EU legislative action. Theoretically this could put some binders on the legislative ambition of the EU. Moving the Legal Basis During the Crisis In the 2007-2013 subprime crisis, some of the assumptions on supervision and (applied) requirements underpinning the freedoms were proven wrong. The financial markets and the types of cross-border financial services offered had evolved in size, risk and interconnectedness, while not all member states were equally vigorous in implementing the CRD and supervising above the minimum levels set in the CRD77. Weaker supervision in some member states threatened to impact on the financial stability in other member states. To stave off unilateral action by member states to introduce new barriers, a new legislative push has been undertaken to increase the minimum levels of protection offered on a harmonised basis (e.g. by providing higher depositor protection, and by clarifying the rights of host supervisors if they have concerns over an important bank establishments in their jurisdiction; see chapter 2, 5, 18 and 21). Under both legislative basis (freedom of establishment and freedom of services), the form of a directive chosen for the CRD is correct. If those basis would continue to be used this would ensure that the member states would continue to leeway to adapt the rules to local circumstances, even if that would not be best for the EU as a whole (see chapter 3.4)78. Prior to 2010, no attempt has been made in the prudential area (unlike in the conduct of business area; see chapter 16), to change the legislative basis to a basis that also would allow harmonisation via the legislative format of a regulation79. In the context of EU legislation, directives are addressed to member states, and force those to bring their national legislation in line with the directives. If regulations can be used, and are agreed, those would work 76 Art. 5 TEU, and the Protocols 1 and 2 on respectively ‘the role of national parliaments’ and on ‘subsidiarity and proportionality’. 77 For instance, Icelandic supervision in the run-up to the default of its three big banks, UK pre-crisis light touch approach, the deferential and consensual approach to banking supervision in the Netherlands and the hands-off supervision of the politically powerful public banking sector in Germany and Spain that stocked up on exposures to volatile property sectors (respectively in the USA and in Spain). 78 Art. 50 and 59 TFEU. 79 The specific provisions to harmonise in the form of directives on services and establishment overrule the general internal market provision of art. 114 TFEU where it concerns provisions on cross-border cooperation and conditions. Regulations might be used on the content of banking supervision itself, as this is an internal market area not limited to the cross-border freedoms.

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directly in every member state, necessitating only local clarification as to how they fit into local institutions and procedural laws, and how related legislation (e.g. administrative laws) should be applied in the context of such an EU regulation. As stated above, several of the other anchors in the EU treaties would allow a shift to the ‘regulation’ form. This would however necessitate a shift in the ‘goal’ of the CRD, or of parts of the CRD. This is necessary to fit under that anchor, and be compliant with the above-mentioned Court of Justice case law80. For prudential supervision, the most promising legal basis would be the general approximation of laws with the primary purpose to achieve the internal market81, targeted to make national rules on each member states own nationals identical, which goes beyond the cross-border focus of the freedoms. This would allow regulations to be used. End 2010 the EU legislators agreed new rules impacting on the prudential area for the first time under this legal basis. It consists of two avenues of attack, the second of which may not be TFEU-compliant. The EU uses the ‘primary purpose single market’ legal basis to establish the three new European supervisory authorities, including EBA, in a regulation. Especially for setting up an EU wide advisory body, bringing together supervisors, central bankers and EU officials the use of this legal basis is defensible. It is less defensible that e.g. the EBA regulation contains a mandate to the Commission to issue its own and EBA’s binding rules on the content of prudential supervision in the form of regulations. Most obvious is the contradiction on issues such as cross-border licensing (market access) provisions that are directly related to the freedoms of establishment and services. Looking at the content, the use of regulations could have been defensible if the main rules on that content (i.e. the CRD itself) had been issued in the form of a regulation. As this is not (yet) the case, using directly applicable technical rules that limit the scope of implementation freedom that the member states enjoy under the CRD appears to be indefensible, unless the provisions could also have been issued under a legal basis that does allow regulations to be used to achieve harmonisation. The content of the standards relate to issues such as (minimum) credit risk, market risk and financial buffer requirements, which may or may not be such rules (and in part are going to apply on that basis if they have been allocated to the CRR instead of the CRD IV directive; see below). Still, the standards (regulations) are intended to provide further details on subject matters set out in directives issued under the ‘freedom of establishment’ legal basis. It is up to the Court of Justice to determine whether the regulations to be issued will be deemed valid or void (see chapter 23). In part

80 Also see chapter 23.1. 81 Art. 114 TFEU. The potential downside is that – should the Court of Justice deem the content of the legislation to go too far – it might be stricken down in future. See the Tobacco Advertising Case, Germany/Parliament and Council, Court of Justice 5 October 2000, Case C-376/98. Also see S. Weatherill, ‘Consumer Policy’, in P. Craig & G. De Búrca, (Eds.), The Evolution of EU law, 2nd edition, Oxford, 2011, chapter 27.

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this skirts close to the edge of treaty interpretation82, in part it may have skirted over this edge83. A regulation on the content of banking supervision was proposed and has been published mid-2013, using the same legal basis as the EBA regulation. The CRD IV project as first issued in July 2011 includes both a regulation and a directive. The CRD IV directive remains based on the Treaty freedoms of establishment and services. The CRR regulation – containing most of the prudential quantitative requirements – has been based in a similar manner as the EBA regulation on the legal basis of achieving the single market84. Whether prudential requirements have the primary focus of achieving the internal market is defensible, but it could be contested that it does not target the internal market but only affects it. However, in my opinion it is in line with the text of the article, and with the way it has been applied. The Parliament and the member states in the Council appear to agree to the CRD IV project; including the new legal basis of its regulation-part. If some member states had wanted to contest that prudential regulation does not harmonise the internal market but only ‘affects’ it (a more limited legal basis with more leeway for member states), their defence has been weakened by the fact that the EBA regulation is already up and running. The argument for using a regulation is being strengthened by the usual delay in implementation of these highly technical provisions in the member states, as well as the lack of harmonisation that results from the uneven translation into local laws85. A regulation works directly, reducing the delay caused by the national legislative process and hopefully eliminating language issues causing an unlevel playing field. For the standards that provide detail on CRR requirements, the legality issue of such standards being issued as level 2 regulations no longer applies. As the CRD IV directive remains based on the freedom of establishment – allowing only harmonisation via directives – the validity of any level 2 regulations based on it (including the standards drafted by EBA) remains uncertain until this issue has been clarified by the Court of Justice.

82 For two reasons, of which the ‘legal basis’ issue is dealt with here. See the EBA Regulation 1093/2010 (and the Omnibus I Directive on the Powers of the European Supervisory Authorities 2010/78/EU). In chapter 20.3 and to some extent chapter 3 the scope of the mandate to the new authorities is discussed. Their mandate is much broader than has previously been approved by the Court of Justice for agencies set up by lower EU legislation, such as this regulation. 83 The existing Level 2 Mifid Regulation would be subject to a similar concern as the Level 1 Mifid Directive is based on the same art. 53 TFEU. It has not yet been challenged for this particular reason. 84 Art. 114 TFEU, see introduction to the CRR. According to its introduction, the CRD IV Directive remains based on the freedom of establishment article (art. 53 TFEU). 85 Commission, CRD IV – Frequently Asked Questions, 20 July 2011, Memo/11/527.

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EEA Relevance Iceland, Liechtenstein and Norway are not part of the European Union. However, under the European economic area agreement, they are part of the European Economic Area (or ‘EEA’) along with all the member states of the EU. One of the key subjects covered in the EEA Agreement are financial services. The three EEA countries are in effect obliged to implement all EU legislation on financial services in their domestic legislation. In return, their financial markets become part of the EU single market, allowing EU banks access to their territories and their banks access to the whole of the EU. As a result, the three EEA states can be deemed to be ‘member states’ in the context of the CRD. Absent the EEA agreement, they would instead have been classified as third countries without specific CRD rights86. The three EEA countries do not have voting rights in the Council, nor are their citizens represented in Parliament. Officially they have no say in the content of the directives. Their agreement does not need to be achieved in the negotiating process, so there are no carve outs specifically for their purposes in the text of the EU directives. They are, however, observers in the regulatory process. They send delegates to the various working groups working in Brussels on draft legislative texts, and their supervisors sit at the table at EBA and its working groups. As agreement on most issues is achieved on a consensus basis, they can contribute on content and influence the outcome in practice. If there are specific carve-outs necessary, those are taken care of either directly in the EEA Agreement, or in the formal process for recognising EU legislation in the EEA context. Though they cannot block legislation (without huge repercussions on all trade relations with the EU member states) they can for instance, exclude similar organisations from the scope of banking supervision as have been excluded from the CRD by EU member states directly. The EFTA surveillance authority monitors the three non-EU EEA states, in a similar manner as the Commission does for the EU member states. The EFTA Court of Justice87 has jurisdiction on the application of e.g. the treaty freedoms (as copied in the EEA agreement) where they apply to the banks of the non-EU EEA states. The only banking legislation that does not have the remark on top that it is relevant for the EEA are the EBA and the ESRB regulation. Iceland, part of the EEA, has since the collapse of its banking system as a result of the 20072013 subprime crisis, decided to start negotiations to become a full member of the EU.

86 See, however, chapter 5.5and 17.5 on the limited cooperation with third country supervisors and the rights of market access enjoyed by some third country financial service providers. 87 Court of Justice of the European Free Trade Agreement, competent on issues relating to the EEA Agreement.

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Switzerland is not part of the EEA. It was an active participant in the negotiations for it, but in a referendum the Swiss opted out of joining the European Economic Area. Via its participation in the BCBS, its prudential regulation of banks is similar to the regulation in the EU. As the monetary authority for Liechtenstein, the Swiss National Bank even has a direct impact on parts of the EEA. Swiss citizens and companies are treated as third country entities – not able to benefit from the treaty fundamental freedoms – unless there is a specific agreement to the contrary. Apart from the insurance agreement, the agreement between the EU and Switzerland on the free movement of persons provides the basis for a right to provide services for 90 days per calendar year for Swiss companies to the EU and vice versa, but that agreement explicitly allows member states to impose prior authorisation procedures and ongoing prudential supervision88. In the insurance sector, an agreement has been implemented between the EU and Switzerland, which has also resulted in a close working relationship between European insurance supervisors and the Swiss insurance supervisors. Such close cooperation on policy areas does not exist in the banking (prudential nor conduct of business) areas. The EU did create the basis for such agreements on branches of third country banks and on consolidated supervision, but has not made use of this authority89. As part of the WTO, a member of the G10 and of the BCBS, Switzerland in practice has preferential treatment in the area of banking, This has a larger impact on the whole of the EU due to the geographical location of Switzerland in the middle of the EU. US, Japanese and Canadian banks have limited their activities more often to a few EU countries only. Literature – Usher, J.A., The Law of Money and Financial Services in the European Community, 2nd ed., Oxford University Press, Oxford, 2000 – Craig, Paul; De Búrca, Gráinne (Eds.), The Evolution of EU law, 2nd ed., Oxford University Press, Oxford, 2011 – Chalmers, Damian; Hadjiemmanuil, Christos; Monti, Giorgio; Tomkins, Adam, European Union Law: Text and Materials, Cambridge University Press, Cambridge, 2006

88 Art. 5 – and art. 17, 18 and 22 of the Annex I to the – Agreement of 21 June 1999, in force since 1 June 2002. Also see Fidium Finanz, Court of Justice 3 October 2006, Case C-452/04. 89 Art. 38.3 respectively 39 RBD.

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3.5

National Implementation – Minimum Harmonisation, Goldplating and National Discretions

Introduction National implementation of EU legislation is obligatory. Member states have committed themselves to do so in the EU treaties, and the Commission is charged with ensuring that all member states fulfil their commitments (with as final arbiter the Court of Justice). Member states are also bound not to take steps or allow situations to continue that could destroy the effectiveness of the treaties or other EU legislation90. This chapter focuses on the role of EU legislation and case law that limit the freedom of member states to have the type of domestic laws and enforcement behaviour that it may have chosen itself. For the CRD, and other directives related to banking supervision, the obligation to implement and respect EU laws means that the member states have to transpose the EU requirements into local requirements, and subsequently to apply them. Where regulations are or will be used as the format for EU banking laws, those will apply directly in the member states to supervisors and subjects; see chapter 3.4-3.5. The transposition of EU directives into local laws provides member states with leeway to choose the best instrument available within their national structures, and to make it as consistent as possible with other national legislation, e.g. on company law, contract law or administrative procedures. On the way and process of implementation of directives, the member states have a substantial amount of freedom, as long as the content of the directives is fully implemented within the timeline set91. The member states rules determine how the directives are implemented, e.g. via a full (national) parliamentary process, or via changes in lower echelon legislation, including supervisory rules or practices; or a combination. For the EU, only the effective result is relevant. Apart from choosing legislative measures to implement EU legislation, the member states can also allow e.g. private bodies to issue collectively applicable rules that are consistent with the EU legislation (e.g. a mutually organized bank, a stock exchange, bankers organisation or education/conflict resolution institutions). The member state in that case retains responsibility for such delegated legislation. It is responsible for collective rules of private bodies that go against EU legislation, and will need to check whether the

90 Art. 291 TFEU, and e.g. Hoefner and Elser/Macroton, Court of Justice 23 April 1991, Case C-41/90. This is a consequence of the fact that EU laws, issued within the boundaries of the treaties, are supreme over national laws. D. Chalmers, C. Hadjiemmanuil, G. Monti & A. Tomkins, European Union Law, Cambridge, 2006, chapter 2 and 5. 91 See e.g. Hamilton/Volksbank Filder, Court of Justice of 10 April 2008, Case C-412/06.

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rules issued by semi-private or even fully private associations go against e.g. the freedom of services or establishment, if such associations in practice control the domestic market92. To determine whether EU directives are properly implemented, it is important to assess the amount of leeway the directive leaves to member states on the content. There are four main categories of provisions in directives, allowing different degrees of freedom to the member states: – minimum harmonisation provisions, requiring member states to implement the content specified. They allow member states to add stricter requirements to the minimum set out in the directive in a practice derogatively referred to as ‘goldplating’ (the most common category); – minimum and maximum harmonisation provisions, where the member states have to achieve at a minimum the agreed content, but have no freedom to add stricter requirements. This achieves a high level of harmonisation, similar to regulations, even though terminology and the way it is written down in local laws still may lead to discrepancies between member states; – provisions within minimum (and maximum) harmonisation directives that explicitly allow member states on certain specified details the choice between various options or gives them a so-called ‘discretion’, i.e. a free hand in a specific area. Such options and national discretions are common in areas where no consensus could be reached, or where a specific national practice needed to be accommodated and other member states did not want that practice to become available in their country; – provisions that make explicit that on a certain area no harmonisation has been achieved, and explicitly leaves the content to the member state (basically the same category as areas where no directive is applicable). This allows the member state to issue any type of rule they desire, within the boundaries set by the treaties and by the directive containing this provision. ‘Minimum harmonisation’ directives set out requirements (preferably with a minimum of possibilities to deviate, or – if unavoidable – with equivalent options amongst which the member states can choose) that all member states have to implement for their ‘own’ companies. Minimum harmonisation ensures that if a company that is subject to those minimum rules opts to operate on a cross-border basis, each member state knows that it is subject to the national laws of its home member state that are compliant with the directive. However, the member states are free to impose additional requirements on their own

92 See e.g. Commission/Austria, Court of Justice 25 June 2009, Case C-356/08, §37, and International Transport Workers’ Federation and Finnish Seamen’s Union/Viking Line, Court of Justice 11 December 2007, C438/05, §33, 34, and 57.

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companies, and under some conditions (see under ‘general good’ below) also on incoming companies from other EU member states. Even though the financial services area the EU legislation is still mostly confined to directives, the tendency to ever more detailed directives with both minimum and maximum harmonisation agreements has led to a decreased distinction between regulations and directives. Such directives need to be implemented almost word by word93, leaving only the delay to allow for such translation into national law as the main distinction with the immediately applicable regulations. As a benefit, this allows for a true level playing field within the single market, as a downside, this impinges on national sovereignty and deletes room for experimentation with new types of financial regulation in a smaller arena, unless this is specifically allowed in national options and discretions incorporated into the EU legislative texts. Minimum and maximum harmonisation directives, in addition to the directive consisting of minimum requirements on the member states to at least implement the level prescribed in the directive, also contain a maximum requirement (regarding some or all of the provisions) not to go further than the level prescribed in the directive. In practice, such maximum harmonisation has been introduced in areas where convergence had already taken place under predecessor directives, with limited deviations yet to be negotiated, or where there was a clear and public/political ‘need to act’94. Though the CRD remains largely a minimum harmonisation directive, it contains a few provisions on mergers and acquisition that are also maximum harmonisation. In the negotiation processes, the Commission has been slowly migrating in the direction of every less potential to deviate for the member states. The minimum harmonisation directive format still is the basic assumption in the CRD, with the maximum harmonisation paragraph being added if at the end of the drafting process by the Commission of a legislative proposal, the Commission concludes that there is sufficient convergence and support for limiting the freedom of the member states to unilaterally legislate additional requirements. Such maximum harmonisation clauses have become prevalent in the conduct of business directives95. Outside of the targeted area of the EU rule, however, the member state is free to regulate. For instance, it can choose to widen the scope of directive provisions to other types of assets or agreements, or fill in aspects that are left unclear (or as a national discretion) in the EU regulation or directive96.

93 Enka/Inspecteur der invoerrechten, Court of Justice 23 November Case C-38/77, §12-17. 94 An example of the first category is the Prospectus Directive 2003/71/EC; see chapter 16.5. An example of the second category is the Mergers and Acquisitions Directive, see chapter 5.4. Also see E. Ferran, Building an EU Securities Market, Cambridge, 2004, chapter 5C. 95 See chapter 16. Also see N. Moloney, EC Securities Regulation, 2nd edition, Oxford, 2008, chapter I. 96 Volksbank/CJPC, Court of justice 12 July 2012, Case C-602/10.

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Regulations, that are minimum and maximum harmonisation by definition and do not require the additional time for national implementation, are the ultimate EU ideal and have become only a small step up from minimum/maximum directives. Member states are hesitant to embrace them for fear of losing flexibility. With the CRD IV project as published in June 2013, the legislators has clearly decided to in part skip the intermediate step of introducing maximum harmonisation in a directive for the banking area The CRD IV directive contains partially minimum and partially minimum/maximum provisions; while the majority of the CRR regulations do not allow individual member states to deviate; see below. Freedom for Member States to Deviate from the Current CRD The RCAD makes its minimum-harmonisation character explicit; with one of its articles explicitly allowing the member states to go beyond the requirements set out in the directive97. At the same time, however, binding articles on the minimum and/or maximum harmonisation character are lacking both in the RBD and in Mifid, relegating the identification of allowed goldplating to the recitals98. The RBD enumerates several issues in its binding articles where member states can go further (e.g. liquidity, the components of own funds consolidation on mixed activity holdings, and until recently large exposures)99. The non-binding recitals mention a whole range of very specific issues where member states can go beyond the requirements contained in the RBD100. Together these cover many aspects of the RBD, but not all. The Mifid contains neither recitals nor binding articles on the subject. The contradictory approaches to establishing minimum and maximum harmonisation intentions give no certainty, which allows member states significant freedom from a legal point of view due to the messy legislative discipline in the amalgamated patchwork of CRD provisions (see chapter 3.5). The key issue is, however, that the Commission is likely to sue if the Mifid is substantially deviated from, and not if the RBD (or RCAD) is goldplated. The perceived need for goldplating is partly due to the still substantial differences in supervisory culture and traditions, and local laws, as well as the still substantial areas of requirements that consist of vague or ambivalent terminology and national discretions;

97 Recital 8 and art. 1.2 RCAD. 98 The Cross-Sector Directive with its amendments to both mergers and acquisitions contains an exception, where maximum harmonisation is made explicit on new insert in RBD and Mifid. See chapter 5.4. 99 Art. 113.1 RBD on large exposures was deleted (but not the related recital 47), but see e.g. art. 41, 60, 61, 63, 137 RBD. See Verdonck, Everaert and De Baedts, Court of Justice 3 May 2001, Case C-28/99 on the interpretation of such freedom to goldplate by the Court of Justice in the context of a previous version of the Market Abuse Directive 2003/6/EC. 100 Recital 7, 8, 9, 15, 17, 47, 59, 69 RBD, mention the authorisation process, qualified holdings, secrecy, the solvency ratio, parts of pillar 2 and of supplementary consolidation/solo supervision.

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see chapter 2 and below. References to minimum harmonisation are included in the recitals to the RBD101. As long as the fundamental freedoms of the TFEU are not contravened (see below, under general good and direct effect), the member states are free to: – institute a licensing and supervision regime for area of financial services that have not been harmonised; – institute additional requirements for its nationals for harmonised areas, but not for incoming service providers that benefit from the European passport (see chapter 5). The proportionality principle (see chapter 3.4) can equally be used to defend minimum harmonisation. However, this basic assumption that minimum harmonisation is to be preferred has not prevented legislators to include maximum harmonisation requirements into financial services legislation where they consider it justified, such as in conduct of business regulation102, and where they had a clear reason to limit the (proven) inclination of national authorities to defend national interests against European open markets. There are several exceptions to the minimum harmonisation character of the CRD: – the approval process acquisition of qualifying holdings in a bank described further in chapter 5.4 contains maximum harmonisation103; – several prohibitions on specific types of goldplating (e.g. economic necessity test in licensing, solvency requirements on incoming branches are prohibited) – a wide range of national options and discretions sometimes leave the member state with no minimum level at all on the substance, e.g. on the definition of capital; – the abstention to include rules on liquidity requirements. In non-harmonised areas such as the liquidity regime for incoming branches, host member states can issue to a large extent any liquidity regime they require, as long as they do not result in actions forbidden by other provisions of the treaties or the CRD; – if the ‘general good’ is involved, member states can deviate, though this possibility is increasingly limited (see below). Because of its minimum harmonisation character, the CRD has on the one hand brought huge benefits by allowing member states in the Council to agree to a (minimum) protection

101 Recital 6-8 RBD. 102 For example the Markets in Financial Instruments Directive (MIFID), setting out conduct of business requirements on amongst others banks, is both a minimum and maximum harmonisation directive. In 2008 the expanded and recast Consumer Credit Directive 2008/48/EC also became a maximum directive, thus limiting the potential for additional national consumer protection to issues specified in the directive; see art. 22 of the directive. Under the previous version of the directive, national legislators could freely add to the protection offered, see Scarpelli/NEOS Banca, Court of Justice 23 April 2009, Case C-509/07. Also see chapter 16. 103 See art. 19.8 RBD.

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level which can be trusted across the EU, but has on the other hand not lead to any consistency in the exact level of protection offered to banks and clients above the minimum level nor of the burden of requirements on banks in each of the member states. It also contains a few provisions where maximum harmonisation is explicitly intended (branch supervision by the host, and mergers and acquisitions), or where the wording of a provision is clearly intended to be exhaustive in order to achieve a goal of the directive, such as the level playing field or the reduction of cross-border thresholds104. CEBS-EBA made an overview of causes and solutions for the goldplating issue in the context of the desired ‘single rulebook’, which was taken on board both in the EBA regulation and in the proposals for the CRD IV105. A variation of goldplating minimum requirements is available to member states in areas that have (explicitly or implicitly) not been harmonised at the EU level at all. The member states are free to add any legislation it desires in such areas, as long as it does not contravene the treaties or the areas harmonised in directives106. The member states and supervisors have to exercise their own discretion as to whether they want to go further than the directives demand (and thus be more strict towards their own banks). Examples are the Spanish dynamic provisioning regime and the UK liquidity regime for its own banks. In cross-border issues such as additional requirements on subsidiaries of foreign EU-banks, such freedoms are more limited, as they impinge on the treaty-freedoms of services and establishment. If the goldplating can have a cross-border effect as is for instance the case with a wider definition of ‘bank’ or ‘investment firm’ with the related European passport consequences, the national legislators must identify such goldplating clearly, to avoid confusion as to whether or not such a licensed entity has a European passport under the RBD; which is not the case if it does not fall within the scope of the EU definition107. National Options and Discretions Both the historic segments of the CRD (e.g. on licensing and definition of capital, which survive basically unchanged from the seventies and eighties of the twentieth century) and the chapters introduced to accommodate the Basel II accord in 2006 are riddled with national options and discretions. Politically, these were the price to be paid to enable agreement to be reached on the main architecture of common standards and on several core subjects. With the still low level of cross-border operations and the low profile of

104 Inspire art, Court of Justice 30 September 2003, Case C-167/01, §68-70, and Skandia, Court of Justice 20 April 1999, Case C-241/97. 105 CEBS-EBA, Analysis on the Scope of Full Harmonisation in the CRD, 8 October 2010. 106 See Verdonck, Everaert and De Baedts, Court of Justice 3 May 2001, Case C-28/99 §37-38. 107 See chapter 4.4 and 5.3, and Testa and Lazzeri/Consob, Court of Justice 21 November 2002, Case C-356/00, §43.

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cross-border supervision at the time, these compromises had limited practical impact. However, with the development of the single market in financial services and the increase of the number of large, complex financial institutions operating in various member states through branches, cross-border services and subsidiaries, the national options and discretions increasingly developed from a minor irritant to a barrier in and of themselves to the further development of the single market. Especially in areas impacting on IT services and on controls, such options and discretions provide a layer of additional complexity and costs. This discussion became a hot topic during the implementation of the negotiated new CRD-provisions on Basel II. Though the national discretions and options in the Basel II related new provisions were not especially numerous compared to those in the older text, the larger banks focused part of their comments on the additional costs and problems in management and control introduced not for business reasons but for – sometimes not fully motivated or transparent – national hobbies. This lead to efforts to reduce the more blatantly unnecessary options and discretions during the last rounds of negotiations, amongst others as a result of an advice of CEBS-EBA108. It was also expected that the supervisory disclosure regime, in which the choices made by national legislators on those new options and discretions would be published in a comparable manner (see chapter 20.7), would serve harmonisation due to market and peer pressures. This turned out not to be the case, at least not to the extent anticipated. The supervisory disclosure regime did, however, provide valuable insight into the different choices made. Combined with increasing pressure of cross-border operating banks, confronted in their implementation efforts with the problem, the Commission mandated CEBS-EBA to revisit the issue. CEBS-EBA subsequently issued proposals to delete a substantial number of the new discretions. Combined with some expiring discretions (that were valid only for a transitional period), this would result in an 80% reduction of the 152 national discretions identified109. This was partly achieved by replacing some with a set of objective criteria, partly by deleting options and agreeing on a single EU wide treatment, partly by giving some options to the banks (instead of to the member state), partly by giving some options to the supervisor to assess on a case-by-case basis (instead of a generic rule by the member state). Some national discretions on e.g. preferential treatment of domestic markets were maintained, but its benefits would become applicable to all banks – instead of only to local banks – due to the concept of mutual recognition (whereby a supervisor

108 CEBS National Discretions Exercise, CEBS/04/62, 15 September 2004, www.eba.europa.eu. CEBS advised to delete 23 out of an identified 143 options in the Basel II related provisions of the at that time proposed CRD, and to revisit the remainder after the introduction of the CRD. 109 CEBS, advice on options and national discretions, CEBS 2008 169, Advice 17 October 2008, was drafted to fulfil the Commission Call For Technical Advice 10, 20/27 April 2007. Follow-up advice requested by the Commission is dated 10 June 2009, www.eba.europa.eu.

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accepts the decision of the local supervisor on the risk in the local market; similar to the way the countercyclical buffer will work in the CRD IV project; see chapter 2 and 6.2). Sadly, the Commission for years delayed the necessary amendments because it decided to integrate it with the work to implement Basel III, instead of using the fast-track Lamfalussy procedure to quickly dispose of (the majority of) these discretions110. The 152 discretions did not include the discretions contained in the ‘older’ chapters of the CRD, such as the definition of capital and the treatment of large exposures. In the revision work ongoing in those areas following the adoption of Basel III, the number of national discretions will, however, also decrease substantially. The CRD IV project embraces the reduction of national discretions. As a result, the introduction and continued existence of national options and discretions for member states to use during the implementation process should become focused on its true purposes. These include taking account of true national market differences in a limited number of cases. Some of the national discretions in the CRD derive from national discretions in the Basel revised framework. The BCBS acknowledged that this could lead to an unlevel playing field. It attempted to limit the potential divergence by establishing a subcommittee to monitor implementation111. General Good and Major Needs Even in areas fully harmonised in EU directives or regulations, member states have a (limited) possibility to retain national provisions, or make interventions contrary to directives or regulations. If the national provision serves a so-called ‘major need’ it falls within the scope of one of the exceptions to the treaty-freedoms112. These major needs can include public morality, public policy or public security, or the protection of industrial and commercial property where it concerns single market harmonisation, or public policy, public security or public health for the freedom of establishment. A condition to be able to appeal to major needs is that the national provisions do not constitute means of arbitrary discrimination or a disguised restriction on trade between member states. The Commission is empowered to assess the proper use of this exemption.

110 As Chair of the CEBS Expert Group that drafted the 2008 Advice; I will admit to a bias against this delay. 111 BCBS, International Convergence of Capital Measurement and Capital Standards: A Revised Framework, June 2006, page 2. 112 Art. 36 and 114 TFEU for single market harmonisation issues, and art. 52, 62 and 65 TFEU for the freedoms of establishment, services and capital. Also see chapter 3.4 and 23.

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Regarding the freedom of free movement of (legal and natural) persons, the type of major needs measures possible have been the subject of harmonisation efforts in a directive113. For public health reasons e.g. natural persons that have potentially epidemic diseases can be denied entry. For public policy or security concerns, likely more relevant for the freedom of movement of persons employed by banks as well as for the banks themselves, domestic measures taken have to be proportional and have to be based exclusively on the personal conduct of the individual concerned. Past conduct and even past criminal convictions are not by themselves grounds for denying entry to a person. Domestic restrictions based on public policy or security have to be based on the personal conduct of the individual that presents a ‘genuine, present and sufficiently serious threat affecting one of the fundamental interests of society’, and considerations of general prevention are not accepted. The grounds cannot be invoked to serve economic needs, and have to be applied in a proportional fashion (taking into account e.g. the social and cultural integration into the host member state). These provisions on the freedom of movement of persons illustrate that – even outside of the areas of harmonisation on e.g. trustworthiness of bank managers – the exceptions under the treaty allow only a narrow interpretation of any domestic rules that restrict the basic freedoms. The ‘major needs’ exceptions for the freedoms of establishment and services (on which the RBD is based) can be coordinated by directives such as the RBD. This limits the extent to which member states can call upon such exceptions to put limitations for foreign banks and foreign bank-employees to operate in their territory via cross-border services or via establishments, including agencies, branches or subsidiaries114. Substantial areas where ‘major needs’ might conceivably be important are, however, not yet fully harmonised, including in the area of prudential supervision on banks; neither under the CRD nor by the CRD IV project. Where harmonisation has not been fully achieved in directives or regulations issued to harmonise the conditions under which the single market or freedoms are applied, those directives will indicate that they contain minimum harmonisation (i.e. that member states may go further, see above), options or discretions (i.e. that the member state may make specified choices) or that in deviation or addition to the provisions of the directives or regulations so-called ‘general good’ provisions can be used. General good as applicable to harmonising measures such as directives and regulations appears to be a translation of the major needs issue by the Court, in the grey area of defendable exceptions to generic EU rules that are not contained in the treaties 113 Currently for natural persons by recitals 22-31 and art. 27-33 of Directive 2004/38/EC (replacing Directive 1964/221/EEC). Also see Van Duyn/Home Office, Court of Justice 4 December 1974, Case 41-74. 114 Art. 49, 52 and 62 TFEU. To this extent, the RBD not only is based on art. 50 TFEU, but also on art. 52 TFEU.

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themselves. Such restrictions on the freedoms can be used when and where no detailed harmonisation is available, e.g. on the content of recovery/resolution/bankruptcy regimes, and – until the moment that (further) harmonisation is achieved that addresses a specific concern – in the past on issues such as distance selling (see on the current harmonised distance selling regime chapter 16.6). It is unlikely that such a claim could be made in most core areas of prudential banking supervision at the current state of play of integration of the banking services markets in the EU (e.g. on the calculation of the solvency ratio). However, the CRD and related prudential directives are still in a halfway house with a wide range of minimum harmonisation provisions and national options and discretions. Key-areas are not yet harmonised115 or not yet harmonised in full, such as licensing provisions, crisis resolution, the definition of capital, the funding of supervision, state aid and the pay-out of deposit guarantees. Liquidity, licensing, and deposit guarantee systems, as well as crisis related issues are being negotiated on in 2013 or have been agreed in 2013. Some aspects will be harmonised somewhere between 2014 and to 2019, others are yet to be negotiated upon or issued, or are dependent on a range of further detail to be provided by EBA regulatory standards. On licensing conditions, no harmonisation is being undertaken yet. Some of the issues will only be harmonised for Eurozone banks, not for all EU banks; allowing different treatments by the supervisory regimes and supervisors involved.116. In all areas where no or only part harmonisation is achieved, there is scope for additional requirements over and above the areas covered by harmonised provisions117. In the insurance area, supervisors have obliged themselves under the Siena protocol to publish the ‘general good’ provisions they impose on incoming branches of insurers that are licensed elsewhere in the EU. In addition, the Commission has published a (nonbinding) recommendation containing its views on the general good concept in the insurance sector118. Such lists of provisions are not available in the banking sector but the Commission

115 In which case the public policy exception discussed in chapter 3.5 would apply; see the Deposit Insurance Case, Germany/Parliament and Council, Court of Justice 13 May 1997, Case C-233/94, §10-19. 116 E.g. in the CRD IV Project, the discussion on recovery and resolution, or the discussions on banking union mentioned in chapter 2 and 21.3 of this book. 117 L. Dragomir, European Prudential Banking Regulation and Supervision, the Legal Dimension, 2010, page 170-175. 118 Art. 6 Siena Protocol (general protocol relating to the collaboration of the insurance supervisory authorities of the member states of the European union (revised)) of March 2008, CEIOPS-Doc-07/08 and the publication of the lists on www.eiopa.europa.eu. Interpretative Communication of the Commission Concerning the Freedom to Provide Services and the General Good of the Insurance Sector [Official Journal C 43 of 16.02.2000], last updated in 2005.

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EU Banking Supervision has issued a (non-binding) communication on ‘general good’ also for the banking sector119. The examples in the insurance sector list appear to be centred on some goldplating provisions (where the domestic authorities have built on minimum harmonisation requirements), gaps between directives (non-harmonised areas of insurance), requirements to have local representatives, and provisions of local contract- and/or consumer protection laws. Issues where the general good can be a reason to intervene relate e.g. to client protection, the reputation of the financial sector, or to the fiscal responsibilities of the member states120. In a crisis – or in anticipation to a crisis – additional requirements to e.g. put cross-border establishments in the form of a subsidiary instead of branch could however be based on the fiscal responsibilities that are excepted in e.g. the EBA regulation. If one member state believed that another member state would not be able to fund e.g. the deposit guarantee claims of its citizens on a branch, or the branch might endanger the ‘macroprudential’ financial system, including the stability of other banks or of its deposit guarantee fund due to the type and size of business in the a branch, it might invoke the general good exception and require a full subsidiary (though it appears not to have been used for that purpose during the 2007-2013 subprime crisis). Also see chapter 2.1 and 5.3. Where full harmonisation has been achieved, the threshold to implement additional requirements for the general good increases. An example is the area of the freedom of capital. This freedom has been fully liberalised. The applicable directive121 indicates that member states are allowed to take all requisite measures to prevent infringement of its local laws, including banking prudential supervision laws, but those measures and procedures may not have the effect of impeding capital movements carried out in accordance with EU laws. Loans made across borders fall both under the freedom of capital and under the freedom of services. If both are equally important in a specific case, or where the freedom of capital is ‘dominant’, the CRD provisions and the national regimes based on them need to be interpreted in the most liberalised fashion possible122. The goals and intents are also key when the different language versions of the treaty, directives or regulations differ. The

119 Part 2 of the Commission Interpretative Communication, Freedom to Provide Services and the Interest of the General Good in the Second Banking Directive, SEC(97) 1193 final, 20 June 1997. A communication is not-binding, but if worded in an imperative manner, it could appear to be binding. In that case, however, it is void and the Court of Justice will strike it down. See France/Commission, Court of Justice 20 March 1997, C-57/95. 120 The fiscal responsibilities are also codified explicitly in the EBA Regulation. The reputation of the financial system of the home state was accepted as a reason to institute limitations on cross border services in the public interest in Alpine Investments/ Minister van Financiën, Court of Justice 10 May1995, C-384/93, §3031 and 42-44; in that case referring to a cold calling prohibition. Art. 37 RBD mentions as an example of general good provisions, rules governing the form and content of advertising. 121 Art. 65 TFEU and art. 4 Freedom of Capital Directive 1988/361/EEC. 122 See chapter 5.3 and e.g. State Debt Management Agency/Íslandsbanki-FBA hf., EFTA Court 14 July 2000, Case E-1/00.

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provision has to be applied in the entire EU in the same manner, taking into account the different language versions, the goals that are aimed at and the true intent of the author(s)123. The Commission has been given a special power to rule on national goldplating on banking supervision rules that are introduced in emergency circumstances, in the interest of the EU single market goal. It can decide whether additional measures taken by host member states to – in emergencies – protect the interest of depositors, investors and other to whom services are provided are legitimate. Those measures have to be notified to the Commission and the home member state, and the Commission subsequently has the right to decide that the host member state shall amend or abolish such measures124. Verification of Implementation Both the Commission and EBA are active in the field of checking compliance with the binding rules contained in directives and regulations and providing supporting guidance to the member states and their domestic supervisory agencies. The level 4 power to prosecute member states before the Court of Justice for failing to implement a directive in full or in part has under the TFEU been exclusively allocated to the Commission. Parliament can institute an inquiry on non-compliance, but only if there are no court proceedings pending125. The power to prosecute of the Commission is, however, only relatively rarely used. Common causes for starting these proceedings are late implementation or inaction, and the most flagrant cases of outright refusal to correctly implement a directive by a member state126. Generally, member states exercise considerable self-discipline when following their obligation to implement the content of directives. However, they suffer frequent delays in complying if the changes require the full local parliamentary process under domestic legislative rules. For such formal issues, the Commission does tend to start proceedings, and this prosecution is accepted by the member states. However, a true battle on the content between the Commission and a member state can be highly disruptive to both the issue at stake, and as a result of a changing attitude of the member state on wider cooperation in Council on widely varying EU legislative proposals the Commission also wants to get accepted. The war between Germany and the Commission on the deposit guarantee directive that lead to a request by Germany to annul the directive placed a burden on a range of different negotiations on draft directives. A compromise was found that 123 See e.g. IMC Securities BV/Stichting autoriteit financiële markten, Court of Justice 7 July 2011, Case C445/09 and the consistent case law mentioned there. 124 Art. 33 RBD. 125 Art. 226 TFEU. 126 Late implementation cases are frequent, but a largely formal stick with which to forcefully remind member states of their duty to implement within rather strict timelines. An example for suing for inaction, see Commission/France, Court of Justice 16 December 1999, Case C-239/98; or Commission/Spain, Court of Justice 4 December 2008, Case C-113/08 on late implementation of the RCAD.

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allowed Germany to retain its (anti-competitive) joint full guarantee schemes of the associations operating in Germany, and institute a local separate version that foreign banks could join, but that only offered the minimum deposit guarantee127. It is quite understandable – though a conflict of interest – that where good relations are mutually beneficial, outright public prosecution is avoided if at all possible. This leaves issues relating to bad implementation of details, lack of application in practice, and obstructionism in applying implemented EU directives more susceptible to peer pressure and public scrutiny, instead of the subject of formal processes started by EU institutions. The Commission has formulated priorities for starting infringement procedures, to clarify when it would prosecute or not. It has also published an explanation of the process it will follow when non-compliance is discovered or complained about128. The process includes an informal stage where the Commission discusses the possible infringement with the member state. Following that discussion, the Commission will make a ‘revised’ opinion, and can then start court proceedings if the member state still does not agree. If convicted by the Court of Justice, the member state is expected to comply of its own accord. If it fails to do so, separate proceedings can be instituted to exact substantial fines129. The range of peer pressure and transparency instruments either applied directly by the Commission or by CEBS-EBA and/or the member states upon binding requirements proposed by the Commission has been expanded after the introduction of the Lamfalussy process130. Older disclosure requirements include providing information to the Commission and putting explicit references to the EU directives in local legislation that intends to implement it. Newer instruments build upon requiring such information to be made available in comparable formats, using the increasing possibilities of the internet and IT facilities. The Commission for example publishes transposition tables published on the Commission website on directives developed in the context of the EU financial services

127 Meanwhile, Germany was late in implementing the directive, which lead to a local court making it liable – for the minimum amount – for the deposit guarantee obligation for a small bank that failed in the mean time (see the reference to that judgement in the Peter Paul Judgement as discussed under the heading of direct effect below, and in chapter 18.5 and 21.10. Also see Germany/Parliament and Council, Court of Justice 13 May 1997, Case C-233/94., in which the attempts to overturn the directive by Germany were stopped. 128 Memo/07/343 of 5 September 2007, containing an ‘explanation of European Commission infringement proceedings for non-compliance with community law’ (re-cast communication of the Commission on the application of art. 228 of the TFEU [SEC(2005)1658]). 129 Also see D. Chalmers, C. Hadjiemmanuil, G. Monti & A. Tomkins, European Union Law, Cambridge, 2006, chapter 9. 130 Leading to reports that show discrepancies in the effectiveness of national supervisors such as CEBS-EBA, Mapping of Supervisory Objectives, including Early Intervention Measures and Sanctioning Powers, 2009/47, March 2009.

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action plan. The CRD also introduced a supervisory disclosure regime that forces supervisory authorities to join up and publish the use they make of the choices left to them in EU legislation (see below on national discretions, and chapter 20.7 on supervisory disclosure). The role of CEBS to work on harmonisation and correct implementation by its memberorganisations has been formalized in 2010/2011 when EBA was constituted131. EBA now has a trigger that will necessitate the Commission to act if in its activities it finds a breach of EU laws. The EBA members, the supervisory authorities, are the primary targets of this EBA role that is linked to the incorrect or non-application of EU law. Where the deviation from EU law is a consequence of domestic political choices in domestic non-compliant legislation, it will in effect target the non-compliant member state itself. If EBA finds a potential breach it has the power to investigate. The investigation can result in a recommendation. If the non-binding recommendation is not followed, the Commission is requested to issue a formal opinion. This opinion should be strongly influenced by the EBA recommendation. That may trigger ‘normal’ proceedings by the Commission before the Court for non-compliance under the treaty if the supervisor does not comply. In addition, EBA can intervene in a limited number of circumstances if the supervisor disregards the formal opinion. If the rule breached is directly applicable under a regulation – such as the CRR – it can issue a decision that is directly binding on individual banks. Non-binding EU documents need not be implemented, not even – or especially not – if they are worded in a manner that suggests that it is binding132. Examples are opinions, recommendations and guidance issued by level 1 or level 3 institutions. Until 2011, there was an informal expectation that supervisors and banks would only deviate from these non-binding guidelines if they had good reason to do so, and were willing to make their reasoning transparent. The charter of CEBS emphasised the voluntary nature of the application of its level 3 work by its member-national supervisors, but contained a ‘comply or explain’ rule in, and the recast Commission decision of 2009 ordered members to ‘stand ready’ to provide reasons for non-compliance. This could e.g. refer to local specificities of the market, or often to its domestic legislators refusing to adapt domestic laws that prevent compliance. Peer pressure under the supervisory disclosure framework did not help, as it

131 Recital 27-29 and art. 17 EBA Regulation 1093/2010. Directive provisions with direct effect (see below) are excluded from this new EBA power, and remain the sole remit of the Commission (and of the bank in question if the local rule is negative for it). 132 For instance a Commission communication is not-binding, but if worded in an imperative manner, it could appear to be binding. In that case, however, it is void and the Court of Justice will strike it down. See France/Commission, Court of Justice 20 March 1997, C-57/95. This applies also to guidelines and such. Whether the comply or explain language that gives any EBA guideline semi-binding status is acceptable will depend on future case law; see article 16 EBA Regulation 1093/2010. It could be defended that certain acts prescribe a specific legislative procedure, which is not followed in the creation of guidelines. See chapter 23.

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concerned non-binding documents, and supervisory disclosure relates to binding rules only. However, such non-binding documents in effect did and do set the standard national supervisors and national legislation is measured against. This was backed up by the work of a new review panel (peer review). The upgrade to a full legal requirement to ‘comply or explain’ with the establishment of EBA makes it more likely that the national supervisors that were members of CEBS and are now of EBA, and especially domestic lawmakers outside the supervisory authority feel more bound to consider – and comply or explain – such guidelines133. As a result, as per the start of 2011, the principle of ‘comply or explain’ has been obligatory. Both supervisors and banks are obligated under the EBA regulation to make ‘every effort’ to comply. If guidelines are not complied with in spite of this effort, the EBA regulation follows this up by a reporting obligation on the explanation134. Noncompliance by supervisors is politically the most serious. They have to indicate within two months after publication of a guideline or recommendation whether they comply (or intend to comply). This includes amending their legal framework, their supervisory rules, and supervisory processes, e.g. to ensure that the local (civil, administrative, company) laws do not hinder the application of the guidelines135. EBA is obligated to publish the non-compliance (probably as an addition to its supervisory disclosure framework). The supervisor is also obliged in its report to explain why it deviates. EBA can choose whether it wants to exercise additional pressure (or in the rare cases of a good reason to not comply provide this good reason) by publishing the reasoning too. If it intends to publish the reasoning, it has to inform the supervisor first. An additional pressure mechanism is that in its (public) report to Council, Parliament and Commission, EBA has to publish detailed information on which supervisors did not comply with which guideline (and a roadmap to compliance). If the supervisor (or the member state) involved is susceptible to such pressure, these publications may result in a change in the domestic laws and policies. If a bank does not comply with a non-binding guideline or recommendation that is addressed to banks – despite making the obligatory effort to comply – it may have to report it to EBA (likely via its own supervisor). This is the case if the guideline or recommendation stipulates that all banks need to send a report as to whether they comply or not. Even

133 Art. 5.7 CEBS Charter since a revision that became effective on 10 July 2008. Art. 14 Recast Commission Decision establishing CEBS of 23 January 2009, C(2009) 177 final, replacing Decision 2004/5/EC. Art. 16 EBA Regulation 1093/2010. L. Dragomir, European Prudential Banking Regulation and Supervision, the Legal Dimension, 2010, page 223. 134 Recital 26, art. 16 and 43.5 EBA Regulation 1093/2010. 135 See e.g. the explanation on page 12 of EBA, Guidelines on Internal Governance (GL44), 27 September 2011. The EBA Regulation provision is not limited to supervisory laws, but non-supervisory laws that are not within the influence of the member states can potentially be used as an explanation for (temporary?) deviation.

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though the guideline is not binding, the EBA regulation establishes that in that case each bank is nonetheless bound to send a clear and detailed report136. Direct Claims by EU Citizens on EU Treaties and Regulations (Direct Effect) The good implementation of EU directives, regulations and treaties is not solely dependent on self-discipline of EU bodies and member states, verification by other EU bodies. If an EU provision has not been implemented at all or not implemented correctly, EU citizens may be jeopardized or damaged by behaviour that – if the provision had been implemented – should have been made illegal under their national legislation. This violates EU laws, but whether the courts should give precedence to national laws or to the EU laws depends on the type of EU law and the clarity of its wording. For treaty-provisions and for regulation-provisions such precedence is relatively simple to give as they are supposed to work directly in the member states (for directives see below). The Court of Justice has confirmed that both the treaty and regulation can contain provisions that have so called ‘direct effect’ in the EU137, if the provision is: – unconditional; and – sufficiently precise. In that case, the member state did and do not have the option to disregard its duty to implement. In addition to the implementation work of the Commission and EBA (see above), often the negative consequences are felt only by a bank or customer that is subjected to the illegal national provision. The Court accepts persons that are directly harmed by non-implementation as an additional litigator with a personal interest to ensure that member states live up to their obligation to implement. In upholding such a provision and giving it direct effect towards the member state, the national courts do not overstep their authority. On the contrary, it is up to them to ensure the legal protection that citizens have from such direct effect within the context of normal local procedural rules138. It is not relevant to whom the specific provision is addressed

136 Art. 16 EBA Regulation 1093/2010. 137 See art. 288 TFEU and e.g. Van Gend & Loos/ Netherlands Inland Revenue Administration, Court of Justice 5 February 1963, Case 26-62; Marshall/Southampton and South-West Hampshire Area Health Authority, Court of Justice 26 February 1986, case 152/84; and Kraus/Baden-Württemberg, Court of Justice 31 March 1993, Case C-19-92. Also see chapter 21.10 on liability, and D. Chalmers, C. Hadjiemmanuil, G. Monti & A. Tomkins, European Union Law, Cambridge, 2006, chapter 2 and 9. 138 Rewe-Zentralfinanz eG and Rewe-Zentral AG/Landwirtschaftskammer für das Saarland, Court of Justice 16 December 1976, Case 33/76. The normal local procedural rules do not apply if they make it impossible in practice to exercise the direct effect rights (but reasonable time-limits for appeal do not make this impossible).

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EU Banking Supervision according to its text; the key question is who it is intended to protect139. If the provision is not precise, it would require choices normally made by the legislature to define how and when the intended goal of the provision is to be achieved. Treaty and regulation provisions that are unconditional and sufficiently precise conditions can be invoked vis-à-vis the member state at fault (vertical effect; either in defence against prosecution or in search of compensation for damages from the government), and vis-à-vis anyone else (horizontal effect). Since the early seventies of the last century, it is also clear that the TFEU freedoms contain such rights that citizens can invoke directly140. Even in the absence of lower EU or domestic legislation such as directives, or if such lower legislation contain provisions that are not in line with the freedom in question, the TFEU is applicable and will be applied by the courts (thus in effect annulling the lower EU legislation, domestic legislation or other local collective agreements or rules from non-public bodies141). If a provision is unconditional and sufficiently precise, the Court will give it direct effect, and will apply it to the case at hand, overruling lower ranking EU or national laws. This direct effect can be invoked by anyone who can legitimately bring the case to the Court, such as – depending to the subject matter – EU institutions, member states and private persons that are affected; see chapter 3.3 and 23. The national courts are required to apply any direct effect EU rule – either at the request of a party or at its own motion – and setting aside any domestic law that predates it or that has been enacted after the EU rule came into force as if those had not been written to the extent they are incompatible, without delay and without waiting for e.g. legislative repeal142. The fact that harmonising directives would have made it easier to apply the benefits of e.g. a treaty freedom does not mean that in their absence the freedoms would not apply. Several domestic provisions that hampered the freedoms of establishment or to provide services have been successfully challenged if they fulfilled the conditions and the concrete hindrance to the treaty did not fall within the scope of one of the exceptions contained in the provision or under the ‘general good’ doctrine143. The success of the claim on a treaty freedom, in addition to it being unconditional and clear, also depends on whether the person claiming the protection of a provision is the intended beneficiary of that protection. E.g. the freedom 139 International Transport Workers’ Federation and Finnish Seamen’s Union/Viking Line, Court of Justice 11 December 2007, Case C-438/05, where the treaty provision had horizontal direct effect; also see below. 140 See e.g. Reyners/Belgium, Court of Justice 21 June 1974, Case 2-74. 141 See e.g. Walrave, Court of Justice 12 December 1974, Case 36-74. 142 Amministrazione delle finanze dello stato (Italian State Administration)/Simmenthal SPA, Court of Justice 9 March 1978, Case 106/77. 143 See e.g. Van Binsbergen/Netherlands, Court of Justice 3 December 1974, Case 33-74.

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to provide services is intended for EU citizens, not for third country companies and not (always) for domestic companies, except if cross-border trade is involved144. On the other hand, such harmonisation or the lack of it does not protect entities that use the freedom just to escape onerous but legitimate domestic legislation. However, if a company is set up in one country solely or mainly to work in another member state, using the treaty freedoms solely to evade legitimate rules in the member state that is the main target of the work (e.g. more goldplating, higher fees to be paid for supervision or deposit insurance), the Court of Justice case law recognises his claim to the treaty-freedom, but nevertheless allows the member state to treat the formally foreign company as a domestic company and impose the (additional) conditions on them145. The CRD-recitals encourage the authority where the licence is requested to deny the licence if they notice such an evasion reason in the licence application146. For regulations such as the CRR that will become applicable in the course of 2014, all the rules contained in it that are unconditional and sufficiently precise can be invoked by the bank, if it is the party protected or addressed. To the lesser extent that such a regulationprovision is geared specifically towards depositors or other counterparties of a bank, these can also invoke it. Apart from litigation between private parties, this can lead to liability claims against the member states (including its supervisory authority; see chapter 21.10). Direct Claims by EU Citizens Based on EU Directives (Direct Effect)? For directives, there was no clarity as to their ‘direct effect’ prior to a series of judgements of the Court of Justice starting in the seventies of the twentieth century. The treaties did not explicitly state whether such direct effect was intended or not. Directives normally allow a period of time for their implementation into domestic law. If the directive text should already have been applied in practice because its implementation term had passed, the absence of direct effect would mean that individual natural or legal persons may be deprived of a benefit that should have been available to them in line with certain directiveprovisions.

144 Fidium Finance, Court of Justice 3 October 2006, Case C-452/04. 145 Veronica, Court of Justice 3 February 1993, Case C-148/91; TV10, Court of Justice 5 October 1994, Case C23/93. 146 Recital 10 RBD. Please note that the host member state cannot unilaterally rescind or limit the licence, as they are mandated to trust the assessment by the licensing supervisor. See chapter 5.3 and 21 and Commission/Belgium, Court of Justice 10 September 1996, Case C-11/95. They can challenge that licensing decision at the Court of Justice and the Commission too (in addition to imposing the additional national protections that the entity tried to escape).

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Standing case law of the Court of Justice is that, though directives are addressed to member states, provisions which are clear and direct, and do not need additional details, can be invoked by such parties vis-à-vis the member state (vertical effect) after the date of implementation has passed. The member state cannot invoke its own failure to perform the obligations to implement that the directive put upon the member state as a defence when a protected individual invokes a direct effect provision in a directive147. This means that anyone can invoke the overruling EU directive provision if the member state prosecutes on the basis of, or otherwise tries to apply a domestic provision that is not compatible with such an EU provision. In some cases, even a claim for reparation by the member state (or an EU institution) can be based on non-compliance with a direct effect provision; see below and chapter 21.10. It is not relevant whether a directive provision, in the domestic context chosen by that member state, has to be implemented by the executive central government, the legislature, governmental agencies, or by regional governments, and they can be invoked against any public authority – acting in either a public or private capacity as e.g. a licensor or as a contractor – if one of them has failed to implement it correctly148. Direct effect can theoretically be granted to the whole directive, but this is relatively rare. Often parts of directives grant options to the member states. In that case, in order for a provision (or set of provisions) to confer direct effect protection to individuals against a member state that failed to implement it in time or correctly, the provision also needs to be severable from the other parts of the directive that do not fulfil the conditions for direct effect. That a provision contains various options for the member states by itself does not hamper the ‘sufficiently precise’ criterion, if in each of the options available a certain minimum protection is offered. The Court of Justice has put the threshold for this assessment relatively low, probably to reinforce the single market goal149. Whether the provisions of the CRD qualify for ‘direct effect’ vis-à-vis the supervisor and the state has not yet been determined. However, the Peter Paul judgement150 has made clear that the predecessor directives of the current versions of the CRD, the deposit guarantee directive and Mifid did not intend to provide a general rights of depositors vis-à-vis the member state authorities to protect individual clients of banks as to the power of the bank to repay its deposits, above the minimum pay-out guaranteed by the deposit guarantee directive.

147 Pubblico Ministero (Public Prosecutor)/Ratti, Court of Justice 5 April 1979, Case 148/78; Francovich and Bonifaci/Italy, Court of Justice 19 November 1991, Joined Cases C-6/90 and C-9/90. 148 Marshall/Southampton and South-West Hampshire Area Health Authority, Court of Justice 26 February 1986, Case 152/84. 149 Becker/Finanzamt Munster-innenstadt, Court of Justice 19 January 1982, Case 8/81. 150 Peter Paul/Bundesrepublik Deutschland, Court of Justice 12 October 2004, Case C-222/02.

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Whether individual directive-provisions provide such rights, or the directives as a whole or on certain issues provide direct effect protection to e.g. the banks, would depend on the assessment of various questions: a. is the specific provision unconditional? b. is it sufficiently precise as to the intended beneficiaries, the intended providers of the protection and the intended content of the protection151? c. Is the provision (or set of provisions) severable from other provisions in the same directive that do not fulfil the above-mentioned conditions? For example, the annexes on model validation or on the market risk calculation (see chapter 6.3 and 9) are of a detailed technical nature that might qualify. However, unlike e.g. market access provisions, it is not directly clear whether the model requirements are there to protect the banks (e.g. against unfair competition or against governmental intervention), or to protect their clients, both or neither (e.g. only introduced for public financial stability purposes). For certain types of directive-provisions, there is case law that clarifies the direct effect character. This applies to ‘bound’ decisions (e.g. that a supervisor has to grant an exemption to a rule or permission to operate in its territory if the bank proves it fulfils the conditions or alternatively that a supervisor is forbidden to require certain actions). The bank can invoke such bound decisions directly152. The same applies to those parts of banking directives that have a clear and primary ‘protection’ character. Examples are consumer/retail client protection issues such as a claim to deposit insurance, or on certain bank products as regulated under consumer credit and investment advice153. Other examples are examples of protection provisions for the banks, such as the prohibition for the host supervisor to demand endowment capital or solvency requirements on a branch of a bank operating under the European passport; see chapter 5.3. Citizens can generally not invoke provisions containing national discretions, as they are not ‘unconditional’. This applies to a large number of the CRD provisions, though the number of discretions is slowly being reduced (see above). An exception may be made for ‘either/or’ national discretions, where the member state solely has the choice between two or more alternative approaches. If the

151 See e.g. Francovich and Bonifaci/Italy, Court of Justice 19 November 1991, Joined Cases C-6/90 and C-9/90, §12. 152 In a similar manner as the Finanzamt Munster/Becker Case shows. Also see Skandia, Court of Justice 20 April 1999, Case C-241/97, where an insurer invoked successfully the direct effect of a provision that gave it freedom to invest certain assets (those not used to cover the technical provisions) as it saw fit. 153 See e.g. Rampion/Franfinance, Court of Justice 4 October 2007, Case C-429/05, which allowed national courts to apply national legislation without taking into account illegal national restrictions in a consumer credit violation of Directive 87/102/EEC (since replaced by directive 2008/48/EC, see chapter 16.6). Also see Scarpelli/NEOS Banca, Court of Justice of 23 April 2009, Case C-509/07.

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member state chooses yet another approach, a citizen (a bank or a depositor that is the intended beneficiary of the provision) could claim protection. However, unlike for treaty provisions and regulation provisions, directive provisions generally do not have horizontal direct effect. How a directive provision is implemented is up to the member state. The choices that are left to the member state impact on the inter-citizen relation and thus on the rights under contractual or legal rights vis-à-vis each other. This defence cannot be invoked by the member state itself or by other public authorities, as they are ‘at fault’ for failing to implement in time and correctly. On the contrary, citizens – including banks – can invoke the non-applicability of the directive, because they are not at fault in the late implementation and the treaty only binds the member state to the directive154. If this damages the interests of someone, this party – e.g. a counterparty of the bank – will need to seek financial compensation from the member state in court. A minor exception applies. Also in the relation between citizens, the Court of Justice has consistently upheld that the available domestic legislative and contractual provisions have to be interpreted in light of the directive provisions and intent155. Even if a treaty or directive provision does not have direct effect, it may still have an impact on the way lower EU regulation or domestic regulation is applied. If at all possible, these will be read in line (‘construed’) with the intent of the ‘higher’ provisions156. As a result, defences raised by companies against certain consumer protections provisions have been struck down at the request of their clients157. If a treaty provision is invoked, or one of the until recently rare regulations in the financial services area, such can be the basis of a claim between citizens, as those would have horizontal direct effect158.

154 Marshall/Southampton and South-West Hampshire Area Health Authority, Court of Justice 26 February 1986, Case 152/84. 155 See e.g. Testa and Lazzeri/Consob, Court of Justice 21 November 2002, Case C-356/00, §43; and Cofinoga Merignac/Sachithanathan, Court of Justice 4 March 2004, Case C-264/02. Also see D. Chalmers, C. Hadjiemmanuil, G. Monti & A. Tomkins, European Union Law, Cambridge, 2006, chapter 9. 156 See e.g. Rampion/Franfinance, Court of Justice 4 October 2007, Case C-429/05, and the Co-insurance cases, amongst others Commission/Denmark, Court of Justice 4 December 1986, Case C-252/83. 157 See chapter 16. 158 See above. Defrenne/Sabena, Court of Justice 8 April 1976, Case 43/75, International Transport Workers’ Federation and Finnish Seamen’s Union/Viking Line, Court of Justice 11 December 2007, Case C-438/05.

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Liability The direct effect case law provides some protection for individuals against non-compliance by their member state (and sometimes other citizens) with EU legislation. A non-compliant domestic law cannot be upheld against the citizen. In addition, the Court of Justice has provided a second layer of protection, in the form of liability. Such liability provides a financial incentive against gambling on non-compliance by the member state, even if the domestic legislation does not provide for liability for illegal laws or behaviour of the government. Liability of the member state may derive from direct effect provisions (in addition to the above-mentioned right to invoke the provision against the state in order to force or stop it applying non-compliant domestic legislation) where damages have occurred because the member state did not fulfil its own obligation under a direct effect provision. Sometimes, however, a direct effect provision does not put an obligation on the state, and some provisions that clearly intend to provide protection do not qualify as direct effect provisions under the criteria for direct effect. In that case, liability may also derive from the (failure in the) basic obligation of the member state to implement both direct effect and non-direct effect EU legislation, depending on the nature of the breach of the EU legislation that resulted in losses and damages159. For the liability of non-implementation of directives, the Court has made liability – directly based on EU law – conditional upon: – the directive should have resulted in rights of individuals; – it is possible to identify the content of those rights; – there is a causal link between the breach of the obligation of the member state to implement the directive and the losses and damages suffered by the individuals with the above-mentioned rights. If this is clear, the individual has a right to damages directly based on EU law, which can be sought within the context of national liability law procedures. Those procedures have to safeguard this EU right to damages, meaning that they should not be unduly restrictive and in addition treat the EU derived right to damages at least as favourable as similar liability claims established under domestic law. See chapter 21.10 for a general discussion of liability issues relating to the EU prudential supervision legislation on banks. Future Developments The CRD IV project built on a tradition to ever further harmonise prudential banking requirements. A large part will become a regulation (the CRR), which will be directly

159 Brasserie du Pêcheur and Factortame III, Court of Justice 5 March 1996, Joined Cases C-46/93 and C-48/93, which builds on Francovich and Bonifaci/Italy, Court of Justice 19 November 1991, Joined Cases C-6/90 and C-9/90.

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applicable in the member states without local adaptations. The room for goldplating will in due course be severely limited compared to the current situation, with minimum and maximum harmonisation applying on most issues, with narrowly defined exceptions on e.g. local immovable property markets, or during transitional periods160. Pending full harmonisation on some core issues that may arrive only at the later stages of the implementation from 2014-2019 (and beyond), the CRR and CRD IV directive allow member states to maintain or introduce additional regimes on issues such as the additional capital buffers, the leverage ratio and the liquidity ratios; see chapter 6.2 and 12. According to the recitals, for financial stability reasons national add-ons may continue to be necessary, though the prudential minimum demands are deemed to be maximum harmonisation/uniform rules with some clearly identified exceptions on e.g. national immovable property markets or on leverage and liquidity rules pending harmonisation161. Though banks may apply stricter standards on their own accord, member states and supervisors cannot force them on the issues harmonised in the CRR (unless they can bring it e.g. in the context of a pillar 2 assessment of an individual bank or similar arrangements that are not part of the CRR but remain unharmonised or are part of the CRD IV directive). Some issues – nominally because their ‘local’ specificities are important but more likely because the subjects are either not mature yet or could not likely be compromised upon – will permanently be part of a directive (the CRD IV directive) that via its implementation in national laws allows greater variation. In addition to explicit options and discretions such as on remuneration limits, the directive does not refer to maximum harmonisation or ‘uniform’ rules, and implies minimum harmonisation162. The directive provisions may also have ‘direct effect’, especially where they command action to intervene in a bank. For the add-ons to the solvency ratio relegated to the proposed directive (e.g. pillar 2, the countercyclical capital buffer), this may result in debate if local authorities ignore clear signals of stress, and refuse to intervene. The sanction regime contained in the CRD IV project is an example of providing details on the type of administrative instruments supervisors should have, which is also copied in other recent legislative efforts for Mifid II and the area of market abuse in the conduct of business area in a cross-sector effort of the Commission; see chapter 16. It is also an area where minimum harmonisation applies (and identifies criminal sanctions as an area where no harmonisation has been achieved)163. 160 See e.g. page 10 of Commission, Proposal for a Regulation as Part of CRD IV, COM(2011) 452 final; and CEBS-EBA, Analysis on the scope of full harmonisation in the CRD, 8 October 2010. 161 Recital 3, 9, 12, 13, 16, 18, 118 and art. 1 and 3 CRR. Also see the ‘Single Rulebook’ idea discussed in chapter 2. 162 Recital 15 and art. 1 CRD IV Directive refers respectively to the harmonisation that is necessary and sufficient to secure the mutual recognition of bank licences and supervision and to the ‘rules’ instead of to the ‘uniform rules’ mentioned in art. 1 CRR. 163 Recital 42 and art. 65 CRD IV Directive.

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The development of a potential banking union may impact on the design of the legislation. The CRR would fit with an EU wide supervisor, as would the guidelines and standards issued by EBA (if EBA remains part of the architecture of the banking union). This is not the case for the directive, as that requires a national translation for which there is no EU equivalent. Under the proposals of the Commission to set up a single supervisory mechanism as part of the banking union, the ECB would be tasked with supervising most EU harmonised rules of the CRD in the participating member states (Eurozone and voluntarily participating member states). The member states can still goldplate those rules while the current CRD is not yet replaced by the CRD IV project – and for the issues specified in the CRD IV project even thereafter – or intervene for general good reasons. How such intervention or goldplating would work when the national prudential supervisors are largely wound down, or are – as proposed – obliged to obey every instruction of the ECB in its areas of competence is less than likely, especially if other local administrative, penal, or goldplating rules are in conflict, or if the fiscal responsibility of the member state is in play164. Literature – Weatherill, Stephen; Beaumont, Paul R., EU Law, Penguin Books, 1999 (on e.g. infringement and direct effect) – Walker, George A., European Banking Law – Policy and Programme Construction, British Institute of International Comparative and Commercial Law, London, 2006 – Dragomir, Larisa, European Prudential Banking Regulation and Supervision, The Legal Dimension, Routledge, 2010 (on e.g. the general good, direct effect and on supervisory liability) – CEBS-EBA, Analysis on the Scope of Full Harmonization in the CRD, 8 October 2010

164 Commission, Proposed Single Supervisory Mechanism ECB Regulation, COM(2012) 511 final, 12 September 2012, page 4 and 5, recital 15, 30, art. 5, 6, 8, 13, 16.2.

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Part B Bank

4 4.1

What is a Bank? Introduction

What is a bank? It may sound like a simple question, but it has proven not to be. The consequences of being a bank are far reaching. Some undertakings have been trying to be included in that definition in order to enjoy the advantages of being a bank, such as benefits in terms of reputation, cheaper funding, and the possibility to attract deposits. At the same time, other undertakings have been trying to be excluded in order to escape the downsides of being a bank, such as compliance and supervisory costs, lost independence due to extensive regulation and supervision, and restrictions on the risk appetite allowed. Defining what a bank is serves the following purposes: – define the essence of banking services in a manner that helps clarify why these should be the subjects of supervision, and – if supervised – should be trusted to provide such banking services; – help in drawing clear lines between a bank and other types of financial and nonfinancial companies, and hopefully help justify why banks are subject to such relatively intrusive supervision when others are not or not to the same extent. First a general description is given of banks and near banks, and their activities. Then the reasons for supervision as given in the CRD and related documents are discussed in chapter 4.3. Finally, the legal definition of a bank – or more legalistically correct – a credit institution is analysed in more detail in chapter 4.4. The analysis of the business of an undertaking in light of the elements of the definition determines whether that company is a bank under EU prudential legislation, with all the downsides (for instance the need for a license and costly supervision) and the upsides (for instance access to potentially lucrative business activities and the likelihood of being rescued when the business fails).

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4.2

What Do Banks Do?

Introduction The activities of a bank are used in EU legislation to define it. The EU definition is based on the so-called transformation function of banks; i.e. taking deposits and making loans. In practice, banks perform activities in the following main categories1: 1. providing safekeeping services to professional and private persons and institutions (for money and securities); 2. providing short term loans to professional and private persons and institutions; 3. provide secured or unsecured long term loans even when they do not have equally long term obligations (transforming short term deposits into e.g. long term mortgages and business loans); 4. providing payment services (allowing money to be transferred without involving sacks of coins); 5. asset management (where the client delegates some or all management of his assets to the bank); 6. investment banking on a wholesale scale, including advice on and execution of sales or public listings of financial instruments for their clients, and maintaining secondary markets for their clients; 7. investment banking on a retail scale, including buying financial instruments for their clients; 8. proprietary trading in the financial markets (trading for their own account, not related to services for their clients but possibly as counterparty for their clients). Anyone is allowed to make loans, or trade in the financial markets for their own account; both possibly with some customer protection provisions that target the specific interaction with the client or the market. Specialist asset management firms, investment firms and payment services firms operate under less stringent regimes than banks. Even some of the safekeeping services can be engaged in without a banking license (e.g. attract money from consumers by issuing bonds if a prospectus is available, or only from certain professional parties); see chapter 5.6, 16 and 19. So what makes banks special? What are their core activities and why do these services need the added attention of prudential banking legislators and supervisors?

1

See art. 4 sub 1 RBD and the range of financial activities set out in Annex I RBD. For a segmentation of such activities into the different functions that the banking sector provides to society see R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 2.2.

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Under the system set up in the CRD and other financial services directives, all of these activities are permissible to banks2. Not all of those activities are, however, necessary to fall within the CRD definition of a bank. This definition is much more limited, focusing on the business of borrowing from non-professional clients and lending (limited versions of the above-mentioned first and second activities) in a transformation of borrowed money into lent money (the third activity). This transformation business of banks provides safety to savers and funding to house buyers and businesses, and is deemed essential for the safety and economic wellbeing of society. It focuses also on a key feature of a failing bank. Stripped to the bones, a bank always fails if it can no longer attract money for safekeeping (and onward investment) and has to pay back money on demand to the customers for which it had previously kept such assets safe, if the bank cannot claim money back at the same short notice from those it has lent to. Please note that this does not say anything about the causes of the failure of the bank. This statement is true at the same level as the statement that somebody died because his heart stopped beating; it does not say anything about the internal illness or external attack that caused the heart to stop beating. The collection of funds of clients – with a promise to return it – but using it meanwhile for making (longer term) loans to other clients is according to the legislator the main reason why banks are more dangerous than other financial services providers and non-financial companies. Most of the other activities mentioned either do not require a licence and are non-regulated, or are restricted to the wider category of so-called investment firms. Most banks also qualify as investment firms, and the banking licence can – at the discretion of the licensing member state – be expanded to the investment services mentioned, and usually is. If so, the banks become subject to additional rules to regulate those activities that are also applicable to non-banks that perform such activities. Such competitors are, however, not prudentially supervised, or prudentially supervised under lighter regimes; see chapter 19. However, please note that member states have the option to restrict some of these activities of their own banks (but not of banks performing that activity in their country from other EU member states; see chapter 5). The CRD bank definition looks specifically at focused undertakings that take money from the public with the promise to redeem it in full, and lending such money onwards to anyone who needs it. These two banking services centre on the protection of the public, and around the core service banks provide to society; the transformation of inactive savings into funding for the economy. Even though these two services when looked at separately are not exclusive to a bank, anyone who provides this particular set of activities in combination

2

Provided its licensing supervisor thinks it can handle such activities; see chapter 5. Also compare principle 4-7 and page 25-29 of BCBS, Core Principles For Effective Banking Supervision, September 2012.

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has to have a banking licence, and is subjected to stringent requirements. The combination of these activities leads to one of the strictest forms of prudential supervision exercised in the EU on financial institutions. Unlike insurers or collective investment firms, banks are allowed to invest in a wide range of high-risk assets (such as loans to each other, to companies, households and countries, as well as in more convoluted financial instruments), but this freedom comes with intrusive supervision on how they assess their risks and manage those risks. The bank is subsequently compensated for the high level of requirements and scrutiny by the following: – a bank is the only financial institution that can attract deposits at a large scale from anyone, without issuing a prospectus3. This opens the route to the lucrative transformation into loans to customers (lent at usually higher interest rates) or making other high revenue investments for their own account; – its non-professional customers trust a bank more because of heightened governmental attention being paid to it, including supervision and deposit insurance; – in normal market circumstances, its professional customers trust the bank more for the same reason (excluding deposit insurance that is not available for professionals), with an additional expectation that banks are not allowed to fail easily by governments (especially if ‘too big to fail’), often leading to state intervention that reduces losses for creditors (implicit state guarantee; see chapter 18); – a bank is the only financial institution that is allowed to perform almost any financial service (with the exception of writing certain insurance contracts, that under the insurance directives can only be ‘written’ by specialised insurance legal entities; see chapter 19.4), resulting in banks being important players in almost any part of the financial markets. Impact on Ongoing Supervision The fact that the definition of a bank in the CRD and the requirement of a banking licence are built around the deposit/loan transformation process does not mean that this is also the focus of ongoing banking supervision of a licensed bank. On the contrary, the deposit taking business and the loan making business attract only a proportional amount of the attention of supervisors. The attention paid to it has actually declined simultaneously with the decline of the proportion of the banks’ funding that is derived from deposits taken from the public, instead focusing on the wholesale markets, and the decline share of the business of banks that is devoted to borrowing/lending relative to the trading/investment business. Banks funding is increasingly dependent on the interbank market (and other professional money markets), unsecured bond issues and the secured funding markets,

3

Art. 5 RBD and, if in the form of bonds or other transferable securities, art. 1.2 Prospectus Directive 2003/71/EC. See chapter 5.6.

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e.g. via repurchase agreements and securitisation/covered bond markets4. During the 20072013 subprime crisis, the relative value of consumer deposits for banks rose again due to the drying up of some of those professional markets, but this effect was undermined by the central bank’s expansion of their liquidity facilities for banks, with unrestricted access as long as there was a form of collateral (see chapter 18.4 and 22.3). For the economy, the lending role of banks was deemed more important than the safekeeping (with interest) function. The other services provided by banks – such as investment services – are supervised as equally important independent risk categories, irrespective of whether they have a direct bearing on the lending/deposit taking business. The attention focused is proportional to the risk following from it to the health of the bank as a whole (which in turn is important for its role in the financial system and to its ability to repay funds entrusted to it). Whether the definition helps to identify the goals of ongoing supervision is doubtful. Ongoing supervision does not focus primarily on deposit taking and loan making, but on the usefulness of these banking services to society at large, as well as on the protection of counterparties. The development of the financial markets over the decades since the banking definition has been introduced has led to an increased importance of the other banking services. These are now at least equally important with the deposit taking/loan making business. The definition of a bank as a result does not reflect the changed role of banks in financial markets and the economy5. Various countries – inside and outside of the EU – distinguish between several categories of banks, such as investment banks, building societies, cooperative banks, commercial banks, private banks, etcetera. In this book, these distinctions are not dealt with. They are all either banks under the CRD definition or not. If it is a bank under the CRD regime, both the licensing rules and the ongoing supervision rules apply. If not, and the company doesn’t opt into the banking regime or is not allowed by domestic legislation to opt in, it is not a bank, but is perhaps another type of financial undertaking, such as an investment firm. Near Banks Banks form only one of several categories of financial undertakings regulated in the EU. Several of the other categories ‘benefit’ from targeted prudential European legislation (e.g. investment firms, investment funds, insurers). Others are only subject to supervision on

4 5

P. Disyatat, The Bank Lending Channel Revisited, BIS Working Paper 297, Basel 2010; R. Gropp & F. Heider, The Determinants of Bank Capital Structure, ECB WP 1096, Frankfurt, 2009. R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 4.3.

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certain activities (e.g. consumer credit, issuing bonds or shares by an otherwise nonfinancial company). The definitions used do not always make clear the distinction between the various categories, causing overlap and gaps. As a result, banks can also be investment firms or managers of a UCITS fund, while mortgage lenders and consumer credit lenders are currently not necessarily the subjects of prudential supervision. Banks and others (governments, insurers, investment manager) can also set up specialised vehicles that compete in specific areas, but are not the subject of the same type of costs and restrictions that flow from prudential supervision6. This patchwork of uneven regulation has been an unavoidable consequence of the organic growth of EU legislation. Targeted legislation was introduced only where the member states agreed that a common framework would work better than the existing national approach. Furthermore, the choice was made to introduce positive definitions, instead of defining one category as not being another. As the question whether an institution is a bank or e.g. an investment firm has grave consequences both for the activities they are allowed to develop and for the costs related to the public supervision imposed on them, this can be the subject of intense debate between a firm and a licensing authority. Several unregulated or only partially regulated types of undertakings have similar businesses as banks. Partially regulated are brokers/dealers, insurers, pension funds, and specialised clearing and settlement services providers as well as the stock exchanges (which all have targeted regulation that is less restrictive on financial stability purposes or on client protection purposes; see chapter 16 and 19). Until recently, large categories were unregulated (in the sense that there is no supervision on the entity, only on its behaviour on the financial markets) including hedge funds, private equity, issuers of asset-backed securities, government banks with public goals, and a wide variety of exempted institutions (such as intra-group treasury companies7. Some of these companies belong to sectors that were not really substantial until the last decade, and are currently the subject of new legislation and legislative efforts. These include the regulation of hedge funds via their management companies. Though these companies did not play a significant role in the immediate causes of the 2007-2013 subprime crisis, they were targeted for regulation due to long standing concerns on their opaqueness and effect on domestic and international financial markets. Other examples are the various new laws, proposals and consultations on the financial market infrastructure (central counterparties in the clearing process and custodians in the

6 7

Z. Pozsar, T. Adrian, A. Ashcraft, & H. Boesky, Shadow Banking, Federal Reserve Bank of New York Staff Reports 458, July 2010. See chapter 4.4-4.5, 16 and 19.

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settlement process; see chapter 16.4 and 22.4). However, even if all these directives and proposals are published and subsequently implemented, substantial parts of the types of functions banks provide are not covered by direct supervision if provided by an entity that does not fulfil the definition of a bank. The definition is quite limited and it could be argued that it is not fair to subject banks to stringent supervision when their competitors are not8. The fact that others are not (yet) captured, however, does not mean that banks should not be. It only indicates that their competitors may also need to be regulated, if they are as important to the goals that banking legislation attempts to achieve, as banks are. Nearbanks have been brought to the attention of the financial stability board, which may take action. An important distinction with near-banks is that banks also attract loans (deposits) from consumers and small- and medium sized enterprises, which others are generally not allowed to (see chapter 4.4 and 5.6). The protection of (small) depositors is thus not relevant for most of the near banks. Large depositors are supposed and expected to be able to take care of themselves, or at least to bear their own risks if they do not. A prime example of such failure to manage risks was when banks and other professional invested in assetbacked securities; where their risk assessment turned out to have been limited to checking whether there was a high enough credit rating, leading to huge losses during the 2007-2013 subprime crisis. Banks and other professional investors in such securities were supposed to do their own risk assessment, or to be able to bear the losses if their risk assessment fails. That does not mean that losses made by these professional parties are not in the end borne by small depositors. They often are, e.g. when insurers, pension funds or public authorities make losses and can no longer keep their promises to consumers. Do Size and Complexity Matter? For the determination of whether an institution is a bank, neither its size nor its complexity, nor it’s cross-border character, nor its particular importance to society are factors. At the global level there are no real definitions of what a bank is, at the EU level it focuses strictly on the type of activities an institution has. If it has a certain type of business of borrowing and lending (also see chapter 4.4) it is a bank and requires a licence. If it is big/important/relevant – but does not fulfil all of the components of the definition – it is not a bank under EU legislation9. Whether or not such agnosticism on size was intended or an accident; it leads to a uniform treatment to establish whether a licence is required or not. Once it is determined that a certain business is a bank, a licence is made mandatory. In the subsequent licensing process,

8 9

See chapter 4.4; and R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 4.3. National legislation may choose to use a wider definition for national purposes; see chapter 4.4 and 5.

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however, both business plans and the size and complexity of the bank are relevant factors in the deliberation on the licence; see chapter 5. In ongoing supervision (and crisis management), the size and complexity and the scarcity of the services of a bank become paramount. Both the rules for licensed banks and the supervision of those rules as described in this book differentiate based on the size of banks. Small and simple banks have more leeway (proportionality) in the application of rules and get relatively few resources allocated to them by supervisors, compared to e.g. banks that are systemically important on the worldwide level10. In the wake of the crisis; small scale banking activities have regained political favour also at the EU level11. Literature – Pozsar, Zoltan; Adrian, Tobias; Ashcraft, Adam; Boesky, Hayley, Shadow Banking, Federal Reserve Bank of New York Staff Report 458, July 2010

4.3

Why Supervision of Banks?

Introduction The introduction of supervision of banks has several goals. For the EU rules that apply to banks (CRD, deposit insurance directive, conduct of business rules), such goals are set out in the recitals of each set of legislation. The stated goals of EU legislation have a clear impact on its application. The Court of Justice has consistently looked at the goals of legislation to determine e.g. limitations in the powers of government agencies, to determine the power of the EU to legislate in an area, and in which manner, and the liability of member states or others. The goals determine how the legislation has to be implemented, applied, and how transgressions are assessed12. They also determine the scope for e.g. member states to deviate from EU legislation13. Three separate questions can be posed on the goals for introducing banking supervision rules of the EU: 10 See for systemically important institutions chapter 18.2. 11 Recital 49 CRD IV Directive. 12 See e.g. Peter Paul/Bundesrepublik Deutschland, Court of Justice 12 October 2004, Case C-222/02, and Spector/CBFA, Court of Justice 23 December 2009, Case C-45/08, §61. See chapters 16, 19 and 23 for various examples how the goals defined the judgements of the Court. Also see R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, for a discussion on a potential reformulation of the goals and structure of prudential banking legislation. 13 See for examples on the impact of the goals on the latitude given to a member state to insert additional requirements or to deviate from the rules in a directive that intend to harmonise e.g. disclosure or price setting policies for ‘general good’ reasons, Inspire Art, Court of Justice 30 September 2003, Case C-167/01, and Commission/Italy, Court of Justice 25 February 2003, Case C-59/01.

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– What are the reasons for any government to regulate banking? – How active should the regulation be supervised? – What are the reasons for issuing such legislation at the EU level? The answers to these questions determine the goals of EU banking legislation. The goals of the directives, explicit or implicit in the texts of the directives and the treaty provisions they are based on, determine how banking supervision legislation will be applied by the Court of Justice. The main focus in this chapter is on the reasons to introduce prudential supervision, and describes the stated goals of the capital requirements directive. Those goals are also supported by other EU rules, such as the deposit insurance directive (described in chapter 18.5) and the conduct of business rules (described in chapter 16). This chapter just describes the stated goals of the CRD, and provides some background14. Please note that the goals of legislative bodies to introduce prudential legislation, may not be the goals allocated to supervisors by such European or national legislators. For instance depositor protection may be a goal allocated to some supervisors (or deposit guarantee funds), but others are limited to e.g. financial stability, or to ensure compliance with the rules as formulated15. That those rules may have as a goal to directly or indirectly protect creditors or other clients of a bank can have a role in interpreting the law (and thus the obligation of the supervisor) but may not have lead legislators to give such a reason as an explicit driver of supervisory actions (and thus a cause for liability; see chapter 21.10. Why Banking Supervision? Government supervision finds its root cause in the reparation of market imperfections. Such market imperfections are noted by legislators as and when they occur either frequently or with a high impact on society. Such imperfections can include e.g. the abuse of information advantages, abuse of power (including usury), depositors losing money when banks fail, or recessions triggered by failing banking systems16. Translated to the area of banking supervision, such market imperfections include: 14 For a further analysis of the goals and of the question whether the CRD is fit for purpose to achieve the goals see R.J. Theissen, Are EU Banks Safe?, The Hague, 2013. 15 See the analysis of objectives made in CEBS-EBA, Mapping of Supervisory Objectives, including Early Intervention Measures and Sanctioning Powers, 2009/47, March 2009. 16 Controlling credit and lending via informal or formal rules predates the EU efforts. The USA has a longer experience, as do individual member states. See e.g. D. Elliot, G. Feldberg & A. Lehnert, The History of Cyclical Macroprudential Policy in the United States, WP 2013-29, 15 May 2013. Also see religious attempts to control the negative effects of lending or at least of usury practices within the same community in e.g. the Bible. 1 Timothy 6:10 notes ‘For the love of money is the root of all evil’. Matthew 25:27 states ‘Then you ought to have invested my money with the bankers, and at my coming I should have received what was my own with interest’. Exodus forbids extracting interest from ‘my people’, but appears to allow interest raised

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– dangers caused by banks to financial stability (prudential supervision); – protection of the smaller and/or less sophisticated counterparties of banks against abuse (conduct of business); – protection of creditors when the bank might become unable to return the funds in full (prudential supervision and depositor protection). The CRD mentions both financial stability and depositor protection, and leaves aside conduct of business supervision. It adds two other goals. The first relates to the funding role of banks, and focuses on a range of areas that should get funding such as small- and medium sized enterprises and the energy sector. The second is an EU specific goal: the creation of the single market. These purposes have been drawn on to draft the CRD. Conduct of business supervision (see chapter 16) takes care of a third reason banks are placed under supervision: the protection of counterparties of banks against abuse of the relative position of power (resulting from having the needed money, as well as knowledge regarding the product, regarding the client and regarding the markets) the bank has over its clients. Prudential supervision is primarily concerned with financial stability, and – also via deposit guarantee systems – with the protection of savers. Implicit in these goals is that the clients/counterparties of a bank can (and do) delegate some of the scrutiny they would have to give to a bank before entrusting it with their business to the state. Part of the work on e.g. amendments to the CRD and the new recovery and resolution regime is to ensure that that trust can be given, and the bank can thus operate on the basis of that trust17. For an individual client, it is unrealistic to assume that he has the knowledge, expertise, money and time to fully assess whether his counterparty the bank is safe and disinclined to abuse this relative position of power. At the same time, for banks checking the financial position of his counterparty is part of their core business (risk management). Clients should still look at indicators of reputation (e.g. is it supervised, does deposit insurance apply, what do rating agencies or the markets say about the value and creditworthiness of the bank, and are there many clients litigating against the bank) but cannot be expected to look at e.g. the derivatives position of the bank or its internal risk management process.

from persons belonging to other people; Exodus 22:25. Leviticus abhors taking interest and profit, but only from your brother (or at least those of the same people), while seven verses later almost fondly approving slavery (to give a sense of proportions); Leviticus 35-46. Deuteronomy 23.19 and 23.20 explicitly approves of interest charged to foreigners, but such interest cannot be charged to your brother. The Koran forbids usury in several places, which prohibitions have been the subject of subsequent hadith. Koran 3:130 forbids interest that results on doubling or quadrupling the sum lent, and Koran 4:161 forbids usury as it devours another persons wealth wrongfully. 17 E.g. see page 4 of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012.

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For very small clients, doing simple business with their bank (a loan to or from the bank in the form of a current account or mortgage), this task of monitoring is even more disproportional, especially if balanced against the economic value for the state of such lending and borrowing. Banking supervision addresses one of the imbalances between the relative positions of power between clients and banks, and collectivises some of the scrutiny that clients/counterparties should do but are truly unable to do or which would be disproportionally burdensome to individual clients. It also collectivises a demand for the banks’ safety that the clients/counterparties are not able to demand individually from their banks. The benefits for society of stimulating lending to the bank (savings, surplus money in current account) by ensuring that such lending is ‘safe’ are deemed so big that some customers are absolved from any scrutiny of their bank at all, as their deposits and financial instruments are insured in full – up to 100.000 euro – by the government in combination with the collective of all banks18. Both for financial stability and to ensure banks can play their transformational role (deposits to loans) for society, the reputation of the banks active in the economy of a country is very important. The reputation of banks being safe determines whether money will be entrusted to banks, albeit through deposits, interbank loans, or buying its shares or bonds. Due to the nature of the business, if the banking sector is not trusted, money will not only stop flowing into it, but also not flow from the bank to consumers and businesses, stopping (a part of) the economy in its tracks. The existence of credible banking supervision enhances the trust clients have in banks. However, the maintenance of the reputation of banks has not always received prime attention from prudential regulators, except in the context of decisions on forbearance (stopping supervisors from acting on transgressions for fear of hurting the reputation of and trust in banks; see chapter 18.3 and 20.3). Reputational risk as a result of the actions of the bank itself has received marginal attention at best from prudential supervisors and rule makers, under internal governance requirements and in the calculation of financial buffers for operational risk19. However, there is no coherent approach on issues of abuse, duty of care, trustworthiness of lower ranking managers and other employees, disclosure, etcetera, each of which aim at ensuring that a bank’s shirt is kept clean. At best supervisors exhort banks to comply with the law and set up a compliance function to verify this internally20. To a lesser extent the viability of a bank or the banking sector may be impacted by trustworthiness issues. The tampering with Libor interest rates and the various miss-selling scandals does not appear to impact on the likelihood that clients will continue to entrust savings to them or rely on their advice. A bank that deceives 18 See chapter 18.5. Also see R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 3.2-3.3. 19 See chapter 10 and 13. M. Power, Organized Uncertainty, Designing a World of Risk Management, Oxford, 2007, chapter 5. 20 See e.g. the principles contained in BCBS, Compliance and the Compliance Function in Banks, April 2005.

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its clients or counterparties will, however, be more likely to deceive its owners and supervisors. This would reduce the likelihood of the bank remaining safe. Financial Stability The banking sector is the most relevant of the financial sectors to the wellbeing of society at large. This relates to the importance of its services and the risk it poses. The relevant services include the transformation services mentioned (transforming inactive savings into funding for the economy) as well as payment services, safekeeping and to specific funding roles on financial markets. Well-functioning banks are important for the solidity and growth of the economy, and a reduction of e.g. their funding of the economy can damage it substantially21. Their importance to stability has increased with the increase of the size and the width of the activities banks currently engage in. Apart from banking supervision, several other public authorities are involved in working for financial stability purposes, including monetary authorities, systems supervisors and insurance supervisors; see chapter 21 and 22. Banking services to professional and consumers market are equally relevant to financial stability and to the transformation function of banks. However, the CRD only requires a licence and provides legislation and supervision only on banks that are funded in whole or in part by consumer deposits. As these consumer deposits fall within the definition of a bank, the CRD indirectly also covers the role of banks in the professional market (but not for financial institutions that perform the same services excluding deposit taking from consumers). In the 2007-2013 subprime crisis, such non-bank providers of wholesale services that were essential to the professional market also included large investment firms (such as Bear Sterns), specialised financial vehicles in insurance groups (such as AIG) and other financial and commercial companies. Some banks turned out to be important even if they had only minor deposit taking business, due to the infrastructure they provided for financial markets, or due to their interconnectedness in those financial markets. This experience shows some gaps in legislation (in the inter-professional market). It has, however, also emphasised the usefulness of the goal of financial stability supervision for those institutions covered by banking supervision under the CRD. This importance has only increased with the liberalisation of the capital markets. When the markets were domestic and the capital streams controlled, there was little or no risk following from the fact that some large players were not subject to prudential requirements. Their scope for actions was instead controlled by capital/monetary requirements per jurisdiction. This is no longer

21 See e.g. D.W. Diamond & P.H. Dybvig, ‘Bank Runs, Deposit Insurance, and Liquidity’, Journal of political Economy, Vol. 91, No. 3, June 1983, page 401-419, reprinted (edited) in Federal Reserve Bank of Minneapolis Quarterly Review, Vol. 24, No. 1, 2000, page 14-23.

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true22. It may be that non-banks (sometimes referred to as shadow banks or near banks) will need to be brought under similar prudential supervision as banks, because they are as important to financial stability as banks and can equally infect other players in financial markets if and when they fail. Protection of Savers/Depositors and Other Clients of Banks Another goal of banking supervision is the protection of savers. However, in banking supervision (and the deposit guarantees), not all savers are deemed equally important to protect. Some counterparties benefit from broad protection, while others are deemed so professional – equal to the professional status of the bank – that they need no protection at all. There is an inherent stress between the protection of counterparties of banks, and the own responsibility of the individual counterparty. In principle, it is the own responsibility of the counterparty to assess whether he or she wants to trust the financial undertakings. If you lend somebody money, it is your own responsibility to assess whether you think you will get your money back, whether the borrower – the neighbour, your children, the company that promises to deliver the couch to your house in six weeks but wants prepayment now – is likely to honour its financial obligations. The same principle applies if the borrower is a bank. If the counterparty is a professional financial entity itself, this responsibility is unencumbered, and little or no individual prudential protection is guaranteed (apart from the positive effects of generic integrity supervision and the trustworthiness of financial accounts and other information disclosed by the bank). On the other end of the spectrum is the consumer, where there is debate about whether he or she needs to exercise judgement in selecting a bank. The question is whether any financial undertaking that the consumer is allowed to engage with should by definition be safe for the consumer. Between these two extreme client-types are nonfinancial corporates (some are so small they can be equated to consumers, some are highly financially sophisticated), and e.g. municipalities. Different persons will answer this question in a different manner. The current status quo in EU legislation is that the consumer and other retail clients do need to check whether the financial undertaking is allowed to trade with him, and that the responsibilities of the client increase with: – the amounts involved (e.g. limit of the deposit guarantee system, see chapter 18.5); – the amount of choice he has (e.g. no choice with an occupational pension fund, some choice when selecting a bank account); and – his own financial sophistication.

22 See chapter 3 and compare with E. Ribakova, Liberalization, Prudential Supervision, and Capital Requirements: the Policy Trade-offs, IMF WP/05/136.

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Professional financial parties such as insurers, governments and pension funds are deemed to need no protection both under conduct of business rules as under depositor protection rules. However, the 2007-2013 subprime crisis has shown again that not all professionals exercise their judgement well. Nor are they necessarily professional (in the sense of having actual expertise) in areas outside of their own speciality. Small and mid-sized pension funds and municipalities are professionals by definition under deposit protection legislation, but are unlikely to have sophisticated understanding of complex derivatives, even though they engage in them upon the advice of banks. Some deal in instruments on which they have no expertise, some deal with counterparties they have not checked as to financial health and expertise, and some deal in instruments regarding which they do not know on whom they have a claim or how secure it is. If it concerns only an individual professional, this is no problem for the economy. Such a professional is betting its own existence. If it engages in a transaction that it does not understand, or gambles on a good outcome in spite of understanding the risks, it should and would go bankrupt if it loses its gamble. However, the recent crisis has given fuel to the counterargument that many professionals again have obligations to others, who shall fail if the professional fails, and so on. This is true for pension funds, collective investment funds, banks and insurers, and voters and employees rely on municipalities and other public authorities to provide services (which they cannot do if they lose substantial amounts of money. Examples where professional and/or highly educated persons lost substantial amounts of money are the Lehman bankruptcy and the (lack of effective) due diligence by the various feeder funds to Madoff. The discussion on the type of protection they need versus the amount of regulation they need to force them to exercise judgement has been decided largely by instituting additional regulation (and liabilities) on trading, clearing and settlement systems, and by the introduction of the AIFM directive; see chapter 16 and 22. In practice, many professionals have been bailed out themselves, or were prevented from suffering losses by making sure that a failing professional they were exposed to would not fail (AIG, various German Landesbanken). These professionals and their – often professional – counterparties were protected at a high cost/risk to the taxpayer. The lack of saver protection given to professionals also has had the perverse effect that it has actually speeded up the failure of some banks. If you do not have protection, and you have granted credits (i.e. have deposits at or given loans) to a bank that may become troubled, a wise professional withdraws those funds, or plans not to renew the loan. Such non-renewal exacerbates existing problems, and causes a lack of liquidity at the bank that was already in trouble. Banks have become more vulnerable to this due to the increased importance of lending from professionals by banks (wholesale funding via e.g. bonds and securitisations), relative to the size of the deposits they attracted. A wholesale loan of 1 billion dollar is easier to administer and likely requires a lower interest rate than a large

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number of savings accounts that hold the same amount of money lent to the bank by the savers. Both small and large savers benefit from the fact that prudential supervision makes their bank safer. For smaller savers the primary protection is, however, the fact that they are given depositor protection by the state (and by the collective of banks). They are given a free pass on own responsibility, as long as they limit their deposits to 100.000 euro per client per bank. They thus will have to check whether the deposit taking institution has a licence from an EU banking supervisor and – if they have more funds to put into deposits – spread them over multiple banks; see chapter 18.5. In addition to the protection of savers/depositors mentioned in the CRD, these and several other types of customers of banks benefit from protection under other EU rules. Such protection is given under the above-mentioned conduct of business rules and consumer protection rules. These in essence try to balance the information and financial education advantages of banks by ensuring that clients benefit from certain rights to correct and fair information, that banks only provide services that are (also) in the interest of the client, and/or e.g. rights of withdrawal. Also here professionals get little protection, and nonprofessional clients get some protection. Of this last category, the subset of consumers get additional protection on e.g. sales techniques. See chapter 16.6. In addition to ensuring that banks treat their clients fairly, the Commission has also started a drive to educate consumers about financial services23. Is Prevention of Bankruptcy a Goal? Prevention of bankruptcy is not a goal of banking supervision. Instead, supervision should increase the viability of a bank, but actually let it fail at a moment that minimises costs for the real economy24. The sheer existence of multiple references to bank liquidation in the CRD, the existence of the winding down directive and the deposit guarantee directive should hint this even in good times25. Sadly, even people who are aware of the existence of such hints regularly need a crisis such as the 2007-2013 subprime crisis to drive this message home. Banking remains a business, and businesses are risky, as is entrusting assets to any business. Banks are doubly risky, because they do not have ‘true’ assets you can hold in your hands, but mainly hold assets that are bookkeeping entries that are difficult to

23 See e.g. www.dolceta.eu. 24 Recital 34 CRD IV directive, and BCBS, Supervisory Guidance on Dealing with Weak Banks, March 2002. T. Padoa-Schioppa, Regulating Finance, Oxford, 2004, chapter 1; various authors in A.J. Kellermann, J. de Haan, F. de Vries, (Eds.), Financial Supervision in the 21st century, Amsterdam, 2013, e.g. in chapter 1 and 2; and R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 2. See chapter 18. 25 See e.g. art. 44, 47, 48, 65, 64 RBD, and the EU legislation described in chapter 18.

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value. Banks can be badly run, have bad luck or be the victim of a wider crisis and the relative illiquidity of its assets (e.g. mortgage loans) compared to its debts (e.g. current accounts or wholesale lending)26. This can easily lead to liquidity problems for banks, and possibly to a bankruptcy. If a bank loses the trust of its lenders/depositors, they will try to take their money out before the bank goes bankrupt. The resulting bank ‘run’ either by actual queues or by electronic withdrawals can bankrupt a bank in days, as can market developments if the bank has bet on the wrong side27. Of the people who do not regularly read the RBD and accompanying EU legislation, many will expect that preventing bankruptcy is a goal; perhaps even that such prevention is guaranteed or that any losses in such a failure may be compensated to lenders, or at least to retail depositors. Such losses are indeed likely to be more limited than when a non-supervised company fails due to the existence of the banking and banking supervision rules, and their goals of financial stability and depositor protection. They are, however, not aimed at preventing all possible losses. Most likely because such a goal would come at too high a cost. Ultimate safety results in ultimate economic and civil rights costs (who will pay for such intrusive supervision, how much less would the economy grow if commercially viable but risky business is no longer allowed, how many jobs would be lost, by how much will lending for housing or the state be reduced etcetera) and the loss of human rights freedoms of banks, bankers and of their wholesale and retail clients (intervening in the right to property and privacy of banks and their clients to an ever larger extent). Banks are ‘only’ expected to be organized so as to reduce the likelihood of a failure, and supervised in order to ensure that banks are organized and capitalised at a level that makes them aware of the risks they run in the inherently risky financial services sector. Based on the current set of requirements, resources and restrictions, the safety of clients of banks is strived for, but in no way guaranteed. That does, however, mean that the expectations of the general public on supervisory requirements, supervision and damage-mitigation measures surrounding the bankruptcy of a bank do not appear to be met28. The regulation and supervision of banks is geared towards reducing the potential negative impact of a bank failure on financial stability and on savers. Making banks less likely to fail, and to limit the consequences should it fail can be seen as goals of banking supervision. Eliminating the chance of bankruptcy is not.

26 BCBS, Supervisory Guidance on Dealing with Weak Banks, March 2002. 27 D. Llewellyn, The Economic Rationale for Financial Regulation, FSA Occasional Paper Series 1, London, April 1999; referring to the failure of Barings almost overnight due to trading losses. 28 C. van der Cruijsen, J. de Haan, D. Jansen & R. Mosch, Knowledge and Opinions about Banking Supervision: Evidence from a Survey of Dutch Households, DNB WP 275, December 2010. See R.J. Theissen, Are EU Banks Safe?, The Hague, 2013.

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Why Supervision on Top of Legislation? The requirements on banks are clear. Manage your risk along these lines; have financial buffers of that size; be reasonably nice to your counterparties. The question can arise whether the public authorities should indeed monitor the regulated activity. If the rules are clear, why do we need supervision? In most areas of the law, enforcement is in the hands of the counterparty (you take them to court to enforce the contract) or the prosecution arm of the state (police and public prosecutor to enforce a criminal law). These possibilities exist (and are frequently used) for banks transgressing contract law rules or criminal law rules. So why not make do with those tools, and instead institute a continuous monitoring regime too on financial solidity requirements? Several choices can and have been made on enforcing regulation: – Regulation that is not monitored at all. For example, contract law and company law is not monitored by public authorities, aside from criminal breaches that are not necessarily actively sought out by criminal authorities; – Rules that require active self-regulation and self-monitoring. For example, mortgage issues are currently subject to self-regulation, underpinned by the agreement between the EU and self-regulatory bodies (see chapter 16.6); – Regulation that is monitored in some aspects, such as only the activity, by the public authorities. For example, consumer protection directives monitor only the activity, not necessarily the service provider as a whole, nor do they set thresholds for entry into the market. The various directives and regulations do, however, require active enforcement against (frequent or inherent) infringements29; – Regulation that is monitored by passive public authorities. For example, the approval process for prospectuses for UCITS and for the issue of market instruments is delineated by the prospectus submitted to the public authorities, see chapter 16.5; – Regulation that is monitored by active public authorities on both the activities and the service providers as a whole. Examples are the insurance, investment firm, markets in financial instruments and banking sectors, where the entry into the market, the ongoing activities and the closing down of the activities are all regulated and actively monitored, independent of submissions by the service provider, see chapter 5, 16 and 19. Even when supervision is deemed necessary, this need not necessarily be done by a government agency. Both supervision by self-regulatory bodies and/or by the government serve to safeguard the interests of the group and of society as a whole. Both can lead to trust the supervised person. Initially, self-regulation and supervision served as the safeguarding

29 See chapter 16.6, and Regulation 2006/2004 on cooperation between consumer protection enforcement authorities.

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mechanism in the more liberal markets, but under the influence of EU directives this has shifted towards public sector supervision (made palatable to free market proponents by several small financial crises across the EU and conduct of business problems). For prudential banking supervision, the choice was made for the active form of supervision on banking organisations, in addition to a patchwork of monitoring and supervisory styles for various, but not all, of the individual activities of banks. For institutions that do have the potential to not only harm individual counterparties, but also the financial system as a whole, or the wider society as a whole, the more invasive form of active supervision by public authorities has become acceptable to politicians, society, and even – though grudgingly – to banks themselves. This includes active supervision on the investment activities of banks, and enforcement style supervision on e.g. its consumer credit activities30. The fact that almost all supervisory tasks are now being allocated to public bodies does not mean that differences in sentiment and basic philosophy on public intervention versus self-regulation preferences are gone. The internationalisation of the financial market, and as part of this the creation of the single market in the EU, has led to the demise of self-regulation31. Self-regulation works well in markets where the participants know each other well, and share a common culture and ethos and a healthy interest in keeping that segment of the market trustworthy, even at the expense of profitability. If any of these aspects are missing, self-regulation loses its authority. Added to this, with the increase of a more Anglo-Saxon focus on profitability over common interests for individual companies, industry driven self-restraint no longer was fully aligned with developing consensus in society to improve the protection against ‘unfair’ treatment of those who do not belong to the insiders in the market. Supervision of the rules is a sign of mistrust of the banks, and an instrument to enhance trust in them by their counterparties. Based on past experience on market imperfections and market failures society does not trust that institutions of this importance to society, savers and borrowers will automatically act in the best interest of all, while pursuing their own primarily commercial goals32. This is especially important to realise as banking is based on trust. Banks have liquid liabilities (the claims of savers usually are due when

30 Some activities of banks are relatively under-supervised, at least at the EU level. This includes their conduct in the mortgage market, and their clearing activities. At the domestic level, some member states have legislated in these unharmonised areas. 31 Also see J. Black, Rules and Regulators, Oxford, 1997, chapter 2. 32 See for the possible choices amongst others W.H. van Boom, A. Ogus, M. Faure, in W.H. van Boom, M. Lukas & C. Kissling (Eds.), Tort and Regulatory Law, Rotterdam/Linz/Vienna, 2007; and R.J. Theissen, Are EU Banks Safe?, The Hague, 2013. For mainly non-financial examples of gradated public interventions in market activities motivated by perceptions of market failures see A.I. Ogus, Regulation: Legal Form and Economic Theory, Oxford, 1994/2004.

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claimed at short notice, as is funding attracted in the professional money markets), and largely illiquid assets (e.g. long term mortgage loans). If the trust in a bank evaporates, for whatever reason, the withdrawals of liquid funds can quickly evaporate the power of the bank to replace its illiquid assets by the cash it needs for the requested pay-outs. Lack of trust and the accompanying evaporation of liquid assets has been the cause of several crises, such as in Asia, the crisis in the thirties of the last century in the central eastern European countries, and the currently still ongoing 2007-2013 subprime crisis33. Governmental supervision has expanded and deepened during each crisis and in the period immediately following34. Good supervision and its enhancement during a crisis can be considered to be in the interest of the banks themselves. A reputable home supervisor increases trust in the banks it supervises, helping it to obtain better interest rates on the capital markets and attract or keep depositors. The reputation of and trust in banks – a key aspect of financial stability and a growing economy – is thus bolstered by the reputation and trust in the regulation of the banks and the active enforcement of such rules by a government agency. Good supervision on a single bank (so-called microprudential supervision) also helps other banks. Apart from any inter-bank contractual relations there may be, trust in banks in general suffers if one of their number fails. Why Banking Supervision at the EU Level? Even if it is clear that a form of prudential banking supervision is necessary to safeguard the interest of market participants, including other professional market participants and consumers, the choice is still open to organise this at the national, EU or global level. The rationale for drawing up the current set of reasonably detailed, reasonably harmonised set of prudential banking supervision requirements at the EU level depends on the answer to three questions: – Why does the EU favour a common/internal market for financial services, including banking? – If such a common/internal market is favoured, why is it necessary and/or beneficial to set harmonised standards for prudential banking supervision at the EU level? – If there are common standards, does it require European execution of such supervision (either in a network of national supervisors or with EU add-ons)?

33 See B. Eichengreen, Capital Flow and Crisis, Cambridge, 2004, chapter 10. Also see the papers mentioned in chapter 22.1. 34 See e.g. the failure of Herstatt, leading to Basel work and the initial banking directives and the failure of BCCI, leading to the BCCI Directive. Also see chapter 22.1.

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The TFEU and the recitals to the CRD contain the answers to these questions. In support of the TFEU obligations to create a common/internal market, including financial services35, the CRD recitals state36: – That the CRD ‘constitutes the essential instrument for the achievement of the internal market from the point of view of both the freedom of establishment and the freedom to provide financial services, in the field of credit institutions’; – ‘To make it easier to take up and pursue the business of credit institutions, it is necessary to eliminate the most obstructive differences between the laws of the member states’; – To create ‘equal and fair conditions of competition between comparable groups of credit institutions’; – To introduce supervision of banks on a consolidated basis to protect ‘the interests of the depositors of credit institutions’ and to ensure ‘the stability of the financial system’; – To protect savings and ‘to provide similar safeguards for savers by setting equivalent financial requirements’. If there is a significant risk that their bank or investment firm fails, clients will not entrust their money or securities to them; – ‘The introduction of rules concerning the taking up and pursuit of the business of credit institutions, and their prudential supervision’; – ‘The establishment of the capital adequacy requirements applying to investment firms and credit institutions, the rules for their calculation and the rules for their prudential supervision’; – ‘The smooth operation of the internal market require not only legal rules but also close and regular cooperation and significantly enhanced convergence of regulatory and supervisory practices between the competent authorities of the member states’; – ‘For markets to operate with increasing effectiveness and for citizens to be afforded adequate levels of transparency’ in relation to public disclosure by supervisors; – ‘To strengthen market discipline’ by adding further public disclosure obligations on banks; – plus a range of public policy goals that can be served by a lenient treatment under banking supervision rules; see below on limits to achieving the goals, such as the promotion – by proportional supervision – of microcredit activities.

35 Art. 3 TEU and a range of TFEU provisions on the achievement of a partial or full internal market and the protection thereof, including art. 26, 53, 59, 63, 101, 107, 113 and 114 TFEU. Also see chapter 3.4. The underlying rationale of a single market is not the creation of prosperity (though that is welcome), but the alignment of the interests of member states and creation of joint interests. The mutual dependency and common interest is instead intended to prevent war, ending a sad cycle of ever larger wars between European countries. See for instance M. Kohnstamm, The European Community and its Role in the World, Columbia, 1963. 36 Recital 2, 3, 5, 8, 9, 22, 57, 61 and 62 RBD, and recital 2, 9, 34 and 35 RCAD.

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According to the Court of Justice, the supervisors are under an obligation to protect a plurality of interests, including more specifically the stability of the financial system. The obligations of the supervisor are thus linked to this plurality, giving the supervisor leeway to act more in line with one or the other interest, under the specific obligation to look at financial stability. The Court makes an exemption for rules contained in the directive giving individual rights to banks or their clients. For the predecessor directives of the CRD (and the deposit guarantee directive), the Court of Justice thus determined that such goals do not necessarily lead to a duty to act in the interest of depositors37. On the contrary, the member state involved was allowed to stipulate that these general goals were all in the public interest only, and prevented depositors to claim ‘direct effect’ (see chapter 3.5) protection from the government or the supervisor under the general scope of the directives as long as the specific provisions of the directives were fulfilled. The member state (Germany) was thus liable for failing to implement the deposit guarantee directive in time, but only up to the minimum coverage set out in that directive. According to the recitals38 “due regard should however be had to the objective differences in their statutes and their proper aims also laid down by national laws”. The TFEU goal to create a single market by instituting amongst others the freedoms of services and of establishment are a given from a legal point of view (see chapter 3.4). This goal is binding on all member states. The rationale of the two freedoms mentioned is derived from increasing the efficiency and benefits of commerce to the economy of all member states of the EU, by opening up opportunities for safe and more competitive trading across borders. As regards the version of the banking directives applicable during the time period covered by the above-mentioned Peter Paul judgement, the Court indicated that the approach adopted by the legislature in the field of banks is to achieve only the essential harmonisation necessary and sufficient to secure the mutual recognition of authorisations and of prudential supervision systems, making possible the granting of a single licence recognised throughout the community and the application of the principle of home member state prudential supervision. With the easing of capital transfer restrictions came the expectation and the obligation39 to ensure that financial services are an area where, like on transport or agriculture, the EU brings ‘easy’ benefits into a crucial sector for facilitating commerce by allowing banks to

37 Peter Paul/Bundesrepublik Deutschland, Court of Justice 12 October 2004, Case C-222/02. Also see chapter 18.5 and 21.10 on respectively deposit guarantees and supervisory and state liability for defective supervision. Also see R.M. Pecchioli, Prudential Supervision in Banking, OECD, 1987, page 14 who identifies preserving the integrity of the financial system as the primary goal amid a multiplicity of objectives. 38 Recital 5 RBD. 39 Art. 58 TFEU.

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compete each other’s traditional markets by cross-border services and by creating branches and subsidiaries. Though the TFEU freedoms set out the principles, they do allow member states to impose restrictions if this is required for a number of objective reasons. Under the Cassis de Dijon case law40, member states are obliged to allow a product legally in circulation in another member state also on its own territory under a ‘mutual recognition’ rule, unless they can cite e.g. consumer protection or systemic concerns as a cause for concern important enough to add local rules before the product is admitted. This was taken on board by the Commission in its 1985 document ‘completing the internal market’41; and underpinned for the financial services sector by the judgement of the Court of Justice in the German insurance case42. The Court deemed it possible to require local authorisations and ongoing supervision for cross-border services in the form of insurance in areas where insufficient harmonisation has taken place, in view of the particular sensitivity of insurance for the protection of consumers. Some of the reasons given would also apply to banking. The financial stability factor weighs especially heavy in the banking sector. Without legislation at the EU level, this would mean that the single market can be limited by member states, though the Court also ruled that the general good/public policy conditions would need to be fulfilled. See chapter 3.5. The directives of the EU in the area of financial services limit the possibility of member states to make use of those potential restrictions. The directives harmonise the (minimum) conditions financial services providers need to fulfil in order to take away any concerns member states may have under those (objective) criteria. These include conduct of business supervision (see chapter 16) and prudential supervision. The conduct of business requirements address market imperfections under which more knowledgeable, larger or more mercenary companies could fail to protect their customers and/or other market participants, and prudential requirements focus on addressing market imperfections following the failure of a financial services provider43. The objectives of the RBD are the introduction of rules concerning the taking up and pursuit of the business of credit institutions, and their prudential supervision. According to the recitals, these cannot be sufficiently achieved by the member states, and can by rea40 Rewe-Zentral AG/Bundesmonopolverwaltung für Branntwein, Court of Justice 20 February 1979, Case 120/78 (Cassis de Dijon). 41 Commission White Paper, Completing the Internal Market, 14 June 1985, COM(85) 310. 42 Commission/Germany, Court of Justice 4 December 1986, Case 205/84. The authorisation was condoned (to the extent necessary for the defined public policy reasons), however, the demand of a local establishment was voided, as it deprived the freedom to provide cross-border services of all effectiveness. 43 Also see N. Moloney, EC Securities Regulation, 2nd edition, Oxford, 2008, chapter 1.

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sons of scale and effects be better achieved at the Community level. According to this statement, the requirements of art. 5 of the Treaty on subsidiarity and proportionality are fulfilled (see chapter 3.4), as a result of which the EU is allowed to issue legislation. The statement by itself, unchanged since the seventies, of course does not make it true if not supported by fact. There are, however, good reasons to assume this is indeed the case: – spill-over effects of financial crises; – multi-jurisdiction groups, that would not be fully supervised if every member state followed its own course; – regulatory competition, leading to a race to the bottom in boom-years, and a race to the harshest possible nationalistic rules in bust-years; – contagion-effects of the failure of a bank to other undertakings and depositors (financial stability, see chapter 22). If there were no EU single market, there would be no need for common rules. On the other hand, if there were no common rules, there could be no EU single market. Unhelpful as this circle reasoning is, it has shown itself to be true in the 2007-2013 subprime crisis and in cross-border bankruptcies, such as Lehman and Icesave (Landsbanki), as well as in previous cross-border bankruptcies and crises, e.g. of Bank Herstatt in 1974 (leading to the establishment of the BCBS and its initial work), Banco Ambrosiano in 1982 (leading to the introduction of consolidated supervision44) and BCCI (leading to further strengthening of the supervision of group ties). Such issues cannot be dealt with at the domestic level. Non-harmonised national rules would otherwise result in substantial gaps and overlaps, either in banking supervision or in the single market. The desirability of the single market is a given flowing from the EU treaties in as far as supervision of financial services is concerned. The Commission set out its ambitions in a sequence of projects; including the multi-year legislative effort in the form of the financial services action plan (see chapter 2). This plan was followed by the plans laid out in the White paper 2005-2010, and overtaken by the equally ambitious list of improvements to be achieved in the wake of the 2007-2013 subprime crisis; see chapter 2.3. Over the years, the level of detail in financial legislation has increased tremendously. The increased complexity of banking business necessitated this in part, as did the detail on alternative models to calculate financial buffers. However, the increased detail also results from the concerns that, despite various legislative projects, in certain areas such as retail banking no true internal market was developing. Banking groups increasingly complained about local rules for reporting and capital for subsidiaries and sometimes for branches, that were adding

44 C. Hadjiemmanuil, Banking Regulation and the Bank of England, London, 1996, page 58 and 72.

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EU Banking Supervision costs to doing business across borders45. Such costs were deemed a hindrance in practice to the freedoms necessary to establish the single market. The goals for regulation at the EU level are similar to the BCBS objectives46, amongst which ‘further strengthen the soundness and stability of the international banking system while maintaining sufficient consistency that capital adequacy regulation will not be a significant source of competitive inequality among internationally active banks’ For the purpose of this book, the desirability of the single market is a given, together with the limits and deviations allowed by the treaties (see chapter 3.4 and 3.5). The CRD works towards this purpose, along with other directives and regulations issued in areas of consumer protection, competition control, but has not yet achieved this goal. For instance the retail-banking sector is often noted as an area where there are still concerns47. Within the semi-capitalist environment in the EU, financial markets act as the facilitator for investment, and banks play a significant role in lubricating its workings. This role can be bigger if they can do this in an open and more competitive market. As an added benefit, the joint work on banking supervision has led to technical improvements in many jurisdictions as a result of learning from good practices in other member states. Also, in some countries banks were so strong and politically connected that sharper conditions could not be politically implemented unless the blame could be clearly heaped onto EU legislators. Limits to Achieve the Primary Goals of Banking Supervision The legislators included a wide range of issues that either should be respected by the regulation or by supervisors, or should not be hampered by banking supervision. Such limits have to be respected even if this leads to less safety in the banking sector. If it concerns national hobbies that were part of the compromise on new EU rules, such limits lead to national discretions (see chapter 3.5). If it concerns EU wide priorities, they lead to less stringent, less prudent provisions in the CRD and limits as to the use of resources and instruments by the supervisor in order to respect other public policy goals. Examples referred to in the recitals to the RBD are goals to: – respect the principle of proportionality as well as human rights; – liberalisation of gas and electricity markets (‘both economically and politically important for the Community’) leads to ‘proportionate’ rules that ‘should not unduly interfere’;

45 See e.g. M. Wolgast, ‘M&As in the Financial Industry: a Matter of Concern for Bank Supervisors?’, Journal of Financial Regulation and Compliance, Vol. 9, No. 3, 2001, page 225-236. 46 Page 2 BCBS, International Convergence of Capital Measurement and Capital Standards: A Revised Framework, June 2006. 47 B. Casu & C. Girardone, ‘Competition Issues in European Banking’, Journal of Financial Regulation and Compliance, Vol. 17, No. 2, 2009, page 119-133.

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– stimulate the development of microcredit, by ensuring that prudential regulation and supervision of such activities are proportionate48; – avoid distortions of competition; – ensure that data protection provisions being complied with; and – ensure that cross-border operating credit institutions are not ‘disproportionally’ burdened as a result of the continued responsibilities of individual member states, though this goal could conceivably be linked to the above-mentioned single market goal as well as to an administrative burden-reduction. New legislation introduced or proposed in the wake of the 2007-2013 subprime crisis introduces additional exemptions. Examples include the need to stimulate the economy by facilitating lending, and a relaxation from the strict requirements for certain types of trade finance, or to take into account the macroprudential issues when intervening at banks, leading to either an earlier intervention or to legal forbearance49. Banks were downsizing the (risky) trade finance business – needed to smoothen trade between e.g. rich countries and poor countries – due to the proposed higher risk weighting; in response to which the BCBS adjusted its rules already50. Limitations to the primary goals (safety and stability) to safeguard other primary goals (such as green energy, foreign trade or competition) require a political choice on the balance between the goals51. By way of example, the stimulation of competition between banks is by definition not ‘stable’ for each bank. Increased competition will increase the risk that a non-competitive bank will fail, possibly resulting in financial instability. From a prudential point of view, a little competition is good to ensure that banks are on their toes on safety, risk awareness and taking on board new developments, on the other hand too much competition in a cutthroat environment may actually cut the throat of a bank. This is not a desirable outcome from a prudential supervision point of view, especially in view of the resulting political blame-game52. Which goal has precedence is not always clear, as the articles and recitals of the CRD are silent on precedence.

48 This particular issue was not part of the original CRD recitals, but was part of the recitals of the CRD II Directive; recital 37 CRD II Directive 2009/111/EC. 49 Commission, CRD IV – Frequently Asked Questions, 20 July 2011, memo/11/527. D. Nouy, ‘Unintended Consequences of Supervision’, and A. Houben, ‘Aligning Macro- and Microprudential Supervision’, in A.J. Kellermann, J. de Haan, F. de Vries, (Eds.), Financial Supervision in the 21st century, Amsterdam, 2013, chapter 4 and 13.3. Also see chapter 20-22. 50 BCBS, Treatment of Trade Finance Under the Basel Capital Framework, October 2011. 51 E.J. Kane, Regulation and Supervision: an Ethical Perspective, NBER WP 13895, March 2008; R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 2-3. 52 See e.g. D. Martinez-Miera & R. Repullo, ‘Does Competition Reduce the Risk of Bank Failure?’, The Review of Financial Studies, Vol. 23, No. 10, 2010, page 3638-3664.

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Even the primary goals of banking legislation and supervision can conflict with other goals of banking supervision. The interests of savers and the interests of financial stability may drive banking supervision into different directions (saving a bank that has a supporting role in clearing and settlement, but not one that has a limited number of depositors that are largely covered by deposit insurance). To give a legislative example, the stimulus of small- and medium sized enterprises or of green energy as formulated as goals for bank regulation, can lead to too low risk percentages being allocated to them53, to the detriment of savers who lent the bank the funds that it uses to make the loans and to the detriment of financial stability. The same applies to such considerations as the level playing field or the EU single market in banking services. This has direct implications for the direct effect of banking legislation, and the liability of public authorities involved in banking supervision (see chapters 3.5 and 20.10). The BCBS favours compensation to be paid by governments if they have chosen to influence or override commercial decisions to achieve public policy objectives, if this has lead to non-performing loans54. De facto, the deposit guarantee system and (for some banks) state aid already provide compensation at least to senior creditors of the bank if it fails while responding to incentives under badly designed or conflicting prudential requirements. Disadvantages of Regulation and Supervision The introduction of regulation and supervision has distinct downsides. The market loses self-cleansing capability at the same time that the negative effects of problems (e.g. clients losing their savings in the bankruptcy of a badly managed bank) are being mitigated. Several downsides are associated with the introduction of banking regulation: – moral hazard in banks and in their clients (see below); – regulation steering banks all in the same direction, increasing systemic risks (also known as procyclicality; see chapter 6.5); – regulation can be used as a tool to unevenly distribute favours to certain areas of society – such as government borrowers or small- and medium sized enterprises – to the disadvantage of the safety of the banks or the access to money of other borrowers. This downside is also an upside, if used sparingly to stimulate areas of the economy that truly need it (i.e. not to favour public authorities, as that is actually illegal under the

53 Recital 44 and art. 501 CRR, and art. 129 and 130 CRD IV Directive. Also see European Parliament, Press Release on EU Bank Capital Requirements Regulation and Directive, 15 April 2013 and the assessment of EBA on the riskiness for banks of lending to smaller enterprises in EBA, Assessment of SME Proposals for CRD IV/CRR, September 2012. 54 BCBS, Core Principles for Effective Banking Supervision, September 2012, §53. Another type of taking responsibility by government is proposed in R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 3.4.

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treaties even though it is rampant in e.g. the CRD55, but to favour green energy, nongovernmental organisations, art, start-ups, pension funds, central counterparties or other objectively deserving borrowers; to the extent that this market does not grow beyond safety boundaries for the banks, or for the sector involved); – Regulation, deposit insurance and supervision distorts markets by changing the behaviour of banks and their clients from managing their own risk and being responsible for their own actions towards managing bank regulation, and assuming the fallacious reasoning that if an action is not explicitly forbidden by banking supervisors, it by definition is deemed safe. Some opponents of government intervention (both monetary and prudential supervision) favour free banking, where banks would be forced by counterparties to be much more capitalised in order to entice risk conscious customers to entrust funds to them. The check on safety would be performed by customers, and banks and customers would be free from distorting government intervention in an equilibrium that is perceived to be more natural. The assumptions are that such a system would be safer because depositors would demand high capitalisation, and lender of last resort and deposit insurance should be abolished56. Some favour market discipline and self-regulation as better alternatives to regulation and supervision57. Ensuring safety via the markets indeed has its benefits, if only that governments do not implicitly take on responsibility for the local banks by monitoring them on a continuous basis. However, lack of supervision has not prevented banks from collapsing before supervision was introduced (and made ever more intrusive) in the twentieth century. Regulation, supervision and deposit insurance have helped increase the role of banks as key players in the economy, and proposing the deletion of such – even if voters/politicians would countenance the reduced safety when dealing with banks – would impact on the size of the economy. It appears slightly naïve to yearn for an abolition of government intervention in light of the current role of banks, especially if based on economic or ‘historic’ perceptions that turn out not to be based in fact. See chapter 18 on the long history of

55 Art. 124 and 125.2 TFEU. The bonds of governments are nonetheless given preferential treatment that stimulates banks to hold them, even though it is clear that also governments can default. See chapter 4.5 and 8.1. Also see Recital 44 and art. 501 CRR that provide for at a minimum temporary less capital requirements for bank lending to smaller companies, and art. 129.2 and 130.2 CRD IV Directive that allow a national discretion to exempt lending to smaller enterprises from two additional financial buffers. See the assessment of EBA on the riskiness for banks of lending to smaller enterprises in EBA, Assessment of SME Proposals for CRD IV/CRR, September 2012. 56 As proposed by e.g. K. Dowd, ‘The Case for Financial Laissez-Faire’, The Economic Journal, Vol. 106, No. 436, 1996, page 679-687, and L.J. Sechrest, Theory, History, and a Laissez-Faire Model, Alabama, 2008. See the discussion of free banking arguments in relation to the rise of the Bank of England in C. Goodhart, The Evolution of Central Banks, London, 1988. Also see R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 2.2. 57 See e.g. the essays contained in H. Scott (Ed.), Capital Adequacy Beyond Basel, New York, 2005.

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banking crises pre- and post the introduction of supervision on the goals of government intervention in banking that contradict free banking58. Moral Hazard – Facts and Mythical Solutions Increased safety leads to increased risk acceptance, reduced risk awareness and even to increased risk appetite. “I am doing something legal and in any case my counterparties will be protected due to insurance/supervision no matter what.” Persons who do not care about the well-being of counterparties could even think: “I am doing something legal and in any case there is no use or benefit in dealing with the worst-case scenario as I will have lost my job in any case, though the government will undoubtedly step in to save our counterparties, thus also saving my job”59. This phenomenon is called moral hazard. This term is used to describe the behaviour of systemic banks (who correctly believe they will be bailed out, or at least that their more vulnerable or systemic clients will be bailed out60) and of anyone who has taken out an insurance policy. Insurance – whether under a policy or in standing government practice – distorts normal market practice. Without implicit insurance the bank would go down regardless of consequences to others, unless someone still sees value in it and is willing to invest at commercial terms. These market distortions lead to behaviour changes, regardless of whether this is intended by regulators or the market participants. If your property is insured against theft or loss, you are likely to pay less attention to safeguarding your property. If the well-being of your dependents is insured, there is less reason to stop undertaking hazardous activities. Especially if the competition performs such hazardous activities, or might do, or if the public authorities are actively cheering you on to increase lending and reduce lending standards in order to achieve various public policy goals (e.g. avoid a credit crunch, support small- and medium enterprises, or increase private home ownership)61. While e.g. high capital ratios has clear financial stability and depositor protection benefits, growth based on more lending by banks relative to their capital base and depositor base has its proponents too62. 58 Also see R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 2.2 on the relation to free banking ideology. 59 After an anecdote in A.G. Haldane (Bank of England), Why Banks Failed the Stress Test, 13 February 2009, page 12. G.H. Stern & R.J. Feldman, Too Big to Fail, the Hazards of Bank Bailouts, 2004/2009, page 18, note that moral hazard is something deliberately sought after, but just a reaction to the facts in the market. Due to the expected government intervention – specifically a bailout – those facts do not reflect the true risk in their undertaking. 60 Examples include both explicit state aid, the lender of last resort function, deposit guarantees, and implicit support through low monetary policy rates that allow banks to increase profitability to shore up depleted capital. See chapter 18 and 22. 61 See the discussion on the effects monetary policy, and the study on the effects of the lender of last resort function in M. Mink, Procyclical Bank Risk-taking and the Lender of Last Resort, DNB WP 301, July 2011. 62 For choices between growth, stability and the use of higher capital ratios, deposit insurance and their effect on lending growth, see e.g. Z. Fungáčová, L. Weill & Mingming Zhou, Bank Capital, Liquidity Creation and Deposit Insurance, Bank of Finland Institute for Economies in Transition Discussion Papers 17/2010.

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Moral hazard is evident both in the banks themselves (taking more risk in their investments and activities), in depositors and other counterparties of banks (who entrust their funds to the bank in part because they assume that someone else is checking the power of the bank to return their money), and in supervisors (who will assume that the board should have done more, that markets will be able to absorb losses and that public funds can be used if a gamble on regulatory forbearance fails63. For managers and traders at listed banks, this is aggravated by principal-agent issues, as managers/traders will likely not be the major shareholders or depositors, so they are taking risks with funds of others of which a significant proportion of any profit will accrue to them, while their losses will mainly be borne by the state, shareholders and depositors64. Theoretically, it is strange that even investors in banks and executives of banks have such assumptions, regardless of their financial sophistication. Every text on banking supervision and crisis management starts by stating unequivocally that: – the survival of a bank is the own responsibility of the bank; and – that if a bank fails, every measure should be taken to put those costs on the risk-bearing investors (i.e. wipe out their risk-bearing investment such as shares or subordinated loans) even if the government should decide to intervene. The conclusion may be that either banking supervisory texts are not read, not believed, or not deemed to be fair. For each of these conclusions incidental evidence can be found in the – sometimes unpredictable – choices to bail or fail certain banks or corporations in the 2007-2013 subprime crisis. Most likely is that such claims are not believed. Under the concept of ‘constructive ambiguity’, public authorities have maintained that they will not bail out or guarantee banks if they are not solvent, not even when they are important for relevant numbers of depositors or important for wider financial stability purposes (or at least that the bank should not count on such actions). The myth of constructive ambiguity – never believed by the supervisors themselves65 – was effectively punctured in the crisis when government after government bailed out or guaranteed individual banks or the whole banking system (e.g. the UK, Ireland, the Netherlands, Belgium, Germany), failed to bail the banks out just because the country was too small to bear the costs (Iceland), or when the one courageous attempt to cling to the theory that markets would be able to sort out a bankruptcy and would not rely on state aid blew up in the face of the relevant gov63 See chapter 18.3, 20.3 and 20.9. Also see R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 3. 64 See e.g. K. Alexander, ‘Corporate Governance and Banks: the Role of Regulation in Reducing the PrincipalAgent Problem’, Journal of Banking Regulation, Vol. l 7, Nos. 1-2, 2006, page 17-40. See for a similar potential moral hazard effect for central counterparties in the clearing and settlement process: J.C. Kress, ‘Credit Default Swap Clearinghouses and Systemic Risk: Why Centralised Counterparties Must Have Access to Central Bank Liquidity’, Harvard Journal on Legislation, Vol. 48 No. 1, 2011. Chapter 18 and 20.3. 65 R.M. Pecchioli, Prudential Supervision in Banking, OECD, 1987, page 19 and 133.

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ernment and the worldwide economy (the USA in the case of the Lehman brothers bankruptcy)66. The ESM guidelines on recapitalisation even correctly mention systemic relevance as a condition for a banking sector recapitalisation67. Even though constructive ambiguity should be declared officially dead, at least for any bank of somewhat relevant size, the emphasis of some of the renovations and updates of prudential supervision and bankruptcy management schemes appears to be to restore faith in private sector solutions, in a misplaced belief that governments will again be able to let the markets believe that they will let major banks fail68. It appears to be maintained at the moment mainly to indicate to shareholders and some creditors that they will be made to suffer too; that their rights will not be respected even if the functions banks provide to e.g. depositors are ‘saved’69. A supplementary explanation may be that capital buffers supplied by the shareholders are relatively small compared with the potential profit70, or that shareholders are in practice not in control at banks that take large risks. Such control of the actual risks banks engage in is instead exercised by executives or traders. These groups take a large part of the potential profit, and have even less money at stake in case the bank fails than a shareholder does, though they may lose their jobs and/or reputation. The fear of such reputational damage or job loss may outweigh moral hazard risks in most sane people; though any high risk fast money environment may not be conducive to sanity. Associated with the moral hazard issue is the – often negative – influence regulation has on the nature of day-to-day banking practices. Decisions on granting a loan to a certain counterparty will no longer be only determined by the actual risk, but also by the risk allocated to that loan by financial regulators. This means that high-risk lenders that fall into a low risk category by sheer accident (e.g. the Greek government prior to the 20072013 subprime crisis) can be the beneficiaries of loans they should never have obtained. Examples also include loans to governments or companies that are on the verge of defaulting, but have not yet done so, the lower risk allocated by legislators to e.g. small-

66 IMF, A Fair and Substantial Contribution by the Financial Sector: Final Report for The G20, June 2010, page 54. BCBS, Report and Recommendations of the Cross-Border Bank Resolution Group, March 2010, page 3. R.M. Lastra (Ed.), Cross-border Bank Insolvency, Oxford University Press, Oxford, 2011, chapter 13, as written by M. Waibel. 67 Art. 3 of ESM, Guideline on Financial Assistance for the Recapitalisation of Financial Institutions, www.esm.europa.eu. The undated guidelines were retrieved on 27 June 2013. 68 For instance in the preamble of FSB, Key Attributes of Effective Resolution Regimes for Financial Institutions, October 2011. See chapter 18. Also see R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 3. 69 The European Court of Human Rights (ECHR) has reasoned in the Northern Rock Case that having a policy of moral hazard reduction is an additional argument for a lower valuation of property rights (shares) in a bank that are expropriated in a crisis; Grainger/UK, ECHR, 10 July 2012, Case 34940/10, §42. 70 H. Benink, J. Daníelsson & A. Jónsson, ‘On the Role of Regulatory Banking Capital’, FinancialMarkets, Institutions & Instruments, Vol. 17 No. 1, February 2008.

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and medium sized borrowers or to state-borrowers in order to stimulate loans to that sector. Those might not be consonant with the actual risk those loans pose to the bank if made without consideration of the variation in practice of the risk profiles within that sector. The risk modelling allowed to more sophisticated banks for credit risk (see chapter 6.3 and 8.3) was intended in part to stimulate banks to distinguish between the risk profiles of specific borrowers, instead of on the generic risk profiles of specific borrowers-categories. The financial stability board (FSB) has been attempting to reduce moral hazard. It has focused on those institutions it deems most liable to moral hazard (in the sense of expecting to be saved by public authorities). Together with amongst others the BCBS it has developed the concept of systemically important financial institutions (sifi's). During the first stage this work focused mainly on banking groups, but it intends to pull in other institutions (such as infrastructure, insurers and near banks) in the future. The FSB and BCBS distinguish between globally systemically important financial institutions (g-sifi's) and those banks that are ‘only’ domestically important; see chapter 18.2. For the global institutions, they recommend a string of future measures, while emphasizing that national authorities should feel it to be their obligation to deal with domestic systemically important financial institutions along similar lines under newly developed principles. The stated goal is to reduce moral hazard. Thankfully – as it seems an illogical expectation that anyone will ever again believe that large banks will fail without government intervention – this is not what the measures it proposes actually aim at. Instead, the FSB has developed six strands of work, which will make these systemically important financial institutions pay for the implicit government insurance they receive, and provide measures to deal with the institution in a measured manner when the insurance is invoked (i.e. breaking it up without causing global fall-out and saving the important bits, without having to save the bad and unimportant bits too). The strands of work are71 to: – increase loss absorbency, mainly by increasing capital (largely delegated to the BCBS for the banks, see chapter 6.2 and 7); – develop resolution strategies (e.g. bail-ins, living wills/recovery and resolution plans, nationalisation tools); see chapter 18.3; – reinforce supervisory strength vis-à-vis these institutions (now often David vs. Goliath); see chapter 20 and 21; – strengthen financial infrastructure, so those can deal with the default of a financial institution without a hiccup (a task made difficult as parts of the systemically important

71 FSB, Reducing the Moral Hazard posed by Systemically Important Financial Institutions, FSB Recommendations and Time Lines, 20 October 2010, based on its Interim Report of 18 June 2010. FSB, Intensity and Effectiveness of SIFI Supervision, Recommendations for Enhanced Supervision, 2 November 2010. www.financialstabilityboard.org.

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institutions actually are the infrastructure by providing e.g. cash management or securities settlement); see chapter 22.4; and – ensure effective and consistent cross-border implementation of the above. The 2010 FSB reports were so high level that they appeared stratospheric in their recommendations. Slightly more detailed criteria were published in 2011 and 2012, that may gradually be translated into EU laws, guidelines and working practices; see chapter 18.2. New instruments, requirements and bankruptcy regimes have been anticipated in the EBA regulation72. The key role assigned to tougher capital buffers to reduce the moral hazard is strange, to say the least. Research has shown that in the previous capital accords, capital requirements may not have been the cause of moral hazard for publicly traded banks73. The capital levels of healthy and big banks were not determined by capital requirements, but by market forces (also see chapter 6.2). The only clear exception is when the capital requirements are close to being breached, in which case they gain in importance (as the supervisor becomes more likely to intervene). Moral hazard does not appear to be created or solved by changes in the official minimum levels set by governments, but by e.g. the introduction of supervision itself (with the public assumption that the bank will thus be safe) or by the expectation of a bailout if the bank is not safe, regardless of capital levels. This is in line with the fact that smaller banks are generally better capitalised than large banks74, in line with the focus of the FSB on the large banks, and in line with the supervisory emphasis that small banks should be liquidated if they fail (while bigger banks/groups will get special treatment because they are systemic)75. The only purpose of the added buffers appears to be the reduction of the need of taxpayer funds to be lend or invested in a bailout76. Whether that will be effective is debatable, in light of the likelihood of innovation making capital requirements less tight over time, especially at the large banks that can make optimal use of the leeway and gaps in capital requirements77.

72 Art. 21-27 and 32 EBA Regulation 1093/2010. See chapter 13.6, 18 and 20.3, as well as 21.4. 73 See chapter 6.2, and e.g. R. Gropp & F. Heider, The Determinants of Bank Capital Structure, ECB WP 1096, Frankfurt, 2009. 74 See chapter 2 and 18.2 and e.g. BCBS, The Basel Committee’s Response to the Financial Crisis: Report to the G20, October 2010, page 12; C.M. Buch, S. Eickmeier & E. Prieto, In Search of Yield? Survey-based Evidence on Bank Risk Taking, Deutsche Bundesbank Economic Studies no 10/2011, page 17. 75 BCBS, Report and Recommendations of the Cross-Border Bank Resolution Group, March 2010, page 24. 76 Also see the proposals on recovery and resolution of the Commission, and the state aid character thereof, in chapter 18.3 respectively 18.4. 77 See chapter 2 and 6. Also see R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 2 and 3.

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Deregulation/Reregulation The development of the current extensive framework of EU directives is related to the deregulation/reregulation debate78. With the liberalisation of capital markets in the EU and the USA (and elsewhere) and a gradual reduction of cross sector hindrances, new risks arose, including increased convergence of market structures, interconnectedness, increased risk appetite to compensate for loss of franchise and the entry into markets that were not well understood by the market entrant. Such increasing risks that accompanied the economic benefits of deregulation were not always managed well by governments and market participants. The liberalisation of e.g. market access across borders and capital markets was not counterbalanced in advance by sufficiently strict requirements and good quality supervision79. On the contrary, the liberalisation was accompanied by a dominant economic theory adhered to by banks, legislators, supervisors and central banks that market based self-control under an efficient market theory would provide the safety needed in the face of the change engendered by liberalisation and innovation80. The resulting mini-crises, incidents, bankruptcies and the 2007-2013 subprime crisis each gave an incentive to regulate a particular type of risk that, limited by the hope to maintain the economic growth generated by the deregulation process. Examples of negative externalities include abuse of unjust advantages, abuse of trust, monopolies, and information/expertise asymmetries. These market failures (where the market did not achieve efficiency without negative consequences) combined with the EU agenda to create a single and competitive market with benefits to end-users has provided a massive impetus to create common rules that deal with all (potential) negative externalities in the area of financial services, including in the area of banking and its supervision. Future Developments The CRD IV project adds some additional public policy goals81. It wants to stimulate a diverse banking culture, amongst others by favouring cooperatives and credit unions in

78 Predicted quite well by E.L. Rubin, ‘Deregulation, Reregulation, and the Myth of the Market’, Washington and Lee Law Review, Vol. 45, 1988, page 1249. A. Mullineux, ‘Financial Sector Convergence and Corporate Governance’, Journal of FinancialRegulation and Compliance, Vol. 15, No. 1, 2007, page 8-19. Also see D.W. Diamond & P.H. Dybvig, ‘Bank Runs, Deposit Insurance, and Liquidity’, Journal of political Economy, Vol. 91, No. 3, June 1983, page 401-419, reprinted (edited) in Federal Reserve Bank of Minneapolis Quarterly Review, Vol. 24, No. 1, 2000, page 14-23. S.B. Kamin, Financial Globalisation and Monetary Policy, Fed. Board International Finance Discussion Papers 1002, June 2010. 79 Compare E. Ribakova, Liberalization, Prudential Supervision, and Capital Requirements: the Policy Tradeoffs, IMF WP/05/136. Also see P.E. Masouros, Corporate Law and Economic Stagnation, The Hague, 2013, chapter 1.4 and 1.5. 80 D.T. Llewellyn, The Global Banking Crisis and the Post-Crisis Banking and Regulatory Scenario, University of Amsterdam Research Papers in Corporate Finance, June 2010. 81 Recital 32, 44, 51, 62, 63, 73, 107-109, 115, 122, art. 395, 505, 509 and 510 CRR and recital 34 and 49 CRD IV Directive.

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support of better funding for citizens, infrastructure projects. It adds that it particularly wants to strengthens the need for funding of small- and medium sized enterprises. In light of the credit crunch suffered by such enterprises, it tries to stimulate banks’ lending to such enterprises by (further) reducing the amount of financial buffers that banks need to hold for such loans. This very partly mitigates the pressures to increase buffers and reduce leverage that are simultaneously pushed to reduce the potential for a bank failing; and adds another potential criticism of the veracity of risk weighted assets being unrepresentative of the actual risk the bank has on its balance sheets. A similar approach is chosen for trade finance, which is a new public policy goal added to the recitals, and receiving lighter treatment due to assumptions on its quality that may or may not be supported by fact. The recovery of member states that suffered a particularly harsh crisis and set up bad banks that issued bonds is stimulated by giving such bonds preferential status. Lastly, the objective to encourage economically useful banking activities and to discourage unsustainable financial speculation without real added value is added to the plethora of public policy goals, though there is as yet no substance to this recital, pending the deliberations on the recommendations of the Liikanen report82. Literature – Rendón, David Q., The Formal Regulatory Approach to Banking Regulation, Journal of International Banking Regulation, 2001, volume 2, page 27-49 – Goodhart, Charles, Some Regulatory Concerns, London School of Economics Special Paper 79, December 1995 – Llewellyn, David, The Economic Rationale for Financial Regulation, Occasional Paper Series 1, Financial Services Authority, London, April 1999 – Eichengreen, Barry, Capital Flows and Crises, MIT Press, Cambridge, 2004 – Cecchetti, Stephen G., Money, Banking and Financial Markets, 3rd ed, McGraw-Hill Higher Education, New York, 2011, chapter 14 – Padoa-Schioppa, Tommaso, Regulating Finance: Balancing Freedom and Risk, Oxford University Press, Oxford, 2004 – Lastra, Rosa María, Central Banking and Banking Regulation, London School of Economics, London, 1996, chapter 2 – Dewatripont, Mathias; Tirole, Jean, The Prudential Regulation of Banks, MIT Press, Cambridge, 1994, chapter 2 – Dragomir, Larisa, European Prudential Banking Regulation and Supervision: The Legal Dimension, Routledge, 2010, chapter 1 and 2

82 Recital 32 CRR. See chapter 2, 4.2 and 4.4, as well as R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 2.2 and 4.4.

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– Walker, George A., European Banking Law – Policy and Programme Construction, British Institute of International and Comparative, London, 2006, chapter 6

4.4 The CRD Definition of a Bank Introduction As set out in chapter 4.3, EU legislators have multiple reasons to supervise banks, that have evolved with the implementation of the single market and the changes in the role banks have in the EU economy. If banks are regulated, it becomes important to determine what makes an entity or person into a bank. The definition should capture all entities that are essential to the (evolving) role of banking83. The basic definition of a bank has, however, not been changed by the EU in forty years84. It dates from a simpler time in banking, and reflects the original business of a consumer-oriented bank: borrowing money from its customers (depositors) mostly short term, and lending money to its customers (e.g. for mortgages or commercial loans) mostly long term. A bank (‘credit institution’ in the atrocious EU terminology) has been defined as ‘an undertaking whose business is to receive deposits or other repayable funds from the public and to grant credits for its own account’. There is a gap between the popular perception of a bank (which in the EU has evolved to include their dominant positions in investment banking and in the financial markets in general) and the narrow core activities on which the CRD has based its raison d’être. Nondefinition activities are allowed to banks, but they do not establish that an institution is a bank; see chapter 4.2. The definition is used to set the scope for both the licensing requirement, the ongoing supervision requirement, and the applicability of provisions that ease cross-border market access within the EU. The recitals of the CRD make clear that it is the intention to make the scope of the definition broad, capturing all institutions whose business it is to receive repayable funds from the public and to grant credits for their own account85. The definition and its components have to be broadly interpreted. If a institution fulfils each of the components of the definition, it is a bank. The only exceptions are those entities specifically exempted in the CRD from the licence and supervision requirements, such as some regional development banks (see chapter 4.5). The definition can be split up into the following aspects:

83 As further discussed in R.J. Theissen, Are EU Banks Safe?, The Hague, 2013. 84 The definition was introduced in art. 1 First Banking Directive, 1977/780/EEC, and has not been changed since. 85 Art. 4.1.a RBD and recital 6 RBD. Also see Italy/Romanelli, Court of Justice 11 February 1999, Case C-366/97.

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– – – – –

undertaking; whose business is to (…) and (…) for its own account; to receive deposits or other repayable funds; from the public; to grant credits.

Each of these components has to be applicable to the existing or proposed business, before a bank is a bank under the CRD. None of these essential components of the definition has been further defined in the CRD, though the recitals provide some insight on what ‘deposits or other repayable funds’ are. There has only been a limited amount of case law at the EU level on this topic, and CEBS-EBA has not (yet) worked in this area. Undertaking The term undertaking is a neutral concept. The Court of Justice has defined it in competition cases as ‘every entity engaged in an economic activity, regardless of the legal status of the entity and the way in which it is financed’86. An economic activity can be any activity consisting in offering goods or services on a market. This can include public entities, except if they are engaged in true public functions (see chapter 4.5). Public law banks that offer commercial-type functions fall within its scope, and are subject to supervision. As the CRD does not contain a definition of an undertaking, it is likely that the same definition as applied in the TFEU competition provisions can also be used to interpret the bank definition. A purely incidental commercial act (e.g. a private person who makes a loan against interest to a colleague) will not fall within its scope, but any organized attempt at an economic activity can be an undertaking. Both natural persons and legal entities can have an undertaking, and an undertaking can also exist of an association of natural persons and/or legal entities, e.g. by contractual arrangements. The CRD is, however, neutral as to the designation of an activity of private or public, or the designation of workers at an entity as private or public law employees87. The designation as public of private is up to the member state, unless, of course, it limits the freedoms set out in the treaty e.g. for incoming establishments; see chapter 5.3 and 5.4.

86 Höfner and Elser/Macrotron, Court of Justice 23 April 1991, Case C-41/90. Also see D.G. Goyder, J. Goyder & A. Albors-Llorens, Goyder’s EC Competition Law, 5th ed., Oxford, 2009, chapter 6.2. 87 Bullo and Bonivento, Court of Justice 7 April 1987, Case 166/85; Mattiazzo, Court of Justice 17 December 1987, Case 422/85.

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Unlike other EU financial services legislation88, the CRD is neutral as to whether a bank should be a legal entity or not. In practice, however, banks are organised as legal entities, as both continuity requirements and the liability limitation for the owners – that is the result of incorporating the bank – are important incentives to organize the bank within a legal entity. Several banking supervision requirements (specifically on licensing) indirectly stimulate incorporation, including e.g. the requirement that at least two persons should direct the business of the bank and the requirements on financial buffers. Banks are normally (the national equivalent of) either a limited liability company, public limited company or a cooperative. As the CRD is neutral on what constitutes an undertaking, it can also be a joint undertaking of several persons (several legal entities) acting informally or formally together in a coordinated fashion. Apart from banks owned by contractual partnerships, there were even ‘one person’-banks before the introduction of the first banking directive in 1977. In such an undertaking, the bank was the business of a natural person, and his assets and the bank’s assets were the same. This was deemed undesirable, due to the absence of checks and balances. To limit the impact of the introduction of the first banking directive on these banks, member states were granted the national discretion to allow such banks to continue operating. This means that a single natural persons can still be a bank with their personal and banking assets intermingled, provided they were already in existence on 15 December 1979. If a member states chooses to allow this, it may also allow an exemption to the requirement of having two persons effectively direct the business of the bank. The CRD does not indicate whether or not a bank that benefits from such an exemption can be sold by one natural person to another natural person. It appears to allow this, as it refers to the credit institution instead of to the natural person that holds the licence. The national legislator will have leeway to allow this or not. Apparently, prior to the introduction of Mifid, for non-bank investment firms it was more likely that a natural person was the holder of the authorisation. The RCAD89 contains a full description of old investment firms (to which by way of this grandfathering arrangement a partial dispensation of initial capital thresholds apply) being inherited and whether or not the grandfathering still applies in that case. Though this is not updated in the RCAD – nor are similar provisions incorporated in the maintained provisions in the RBD – one 88 For example art. 4.1 Mifid, Directive 2004/39/EC, regulating investment firms, requires non-bank investment firms to be organized as a legal entity. As a national discretion, Mifid allows member states to also allow organisation forms that are not legal entities to function, but sets strict boundaries for this. Solvency II requires insurers to assume a specific legal form (mostly public limited companies or mutual associations); art. 17 and Annex III Solvency II Directive 2009/138/EC. The same applies to electronic money institutions. See art. 2 sub 1 Electronic Money Directive 2009/110/EC. See chapter 16.2 and 19. 89 Art. 10 and 13 RCAD, that were not updated when Mifid was introduced.

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may assume that most member states adopt a similar approach to banks, as the reasons for incorporating are even more profound than for investment firms in general. Business To (…) and (…) For Its Own Account The business of the undertaking has to contain both key banking activities, and engage in those for its own account. On the one hand the receipt of deposits or other repayable funds from the public, and on the other hand the granting of credits (for the interpretation of these concepts, see below). If only one of these two is engaged in, the undertaking is not a bank in line with the CRD. It would thus respectively fall under the prohibition for nonbanks to attract deposits or other repayable funds from the public, or under the consumer credit directive and/or the mortgage agreement (see chapters 5.6, 16 and 19). The phrasing in the CRD leads to a focus on the actual business done instead of on formal goals or intentions. Even if its articles of association or similar documents say it is a bank or allow it to perform such activities, it is not a bank under the CRD unless it is actually (planning to start) performing them. On the other hand, even if the articles of association indicate that it is not a bank or even explicitly says it will not perform a key component of the banking definition, it is still a bank and subject to banking regulation if it nevertheless in practice performs those activities90. The impact of the requirement that the business has to be maintained for its own account is less than clear. It appears to apply to the whole of the business (of taking deposits and granting credits), though it could be defended that it only applies to the second key activity (the granting of credits) due to the phrasing of the definition (depending on how the reader wants to read it). In that case the taking of deposits might also be done for the account of another entity, and still the institution would be a bank. The reason for including the limitation that a bank is only a bank if it performs the business for its own account is not clear from the recitals. It appears to indicate that the business must be the ‘own’ business of the undertaking, instead of being done for the account of another person or legal entity. This would differentiate it from e.g. collective investment undertakings, where the investments (including e.g. credits granted) are made for the account of another. A difficulty with this reading is that at the time such investment 90 There is no case law on this, and some authors in literature have a different opinion. They indicate that if the articles of association allow the banking activities to take place, it is subject to banking regulation. Though easier to check, this is for me too formal an approach, easily leading to both overregulation and to gaps by failing to capture entities which actually perform as banks in practice. The CRD definition does not target formal components in the definitions, but the material activities on the ground. In another direction, see ECB CON/2008/84 on the then proposals for the current Electronic Money Directive 2009/110/EC and the literature referenced there.

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undertakings were not yet regulated at the EU level. Another reason could be that intermediaries should not be burdened with banking supervision. This interpretation would make it possible to ‘game’ the definition by allocating part of the profits or losses to another party. As the definition has to be interpreted broadly in order to provide protection to the clients of banks and the financial system, arguably only if all the profits or losses associated with the core banking activities accrue to another party, the undertaking is not acting for its own account (but by definition the other entity is, who in this case uses an agent to perform its own undertaking of being a bank). This interpretation is in line also with the approach taken in the consumer credit directive. That directive differentiates between the full set of obligations as applicable to the creditor (the actual granter of the loan), and a reduced set of requirements on credit intermediaries (partly on behalf of or instead of the creditor)91. A creditor is the person who grants or promises to grant credit in the course of his trade, business or profession. The credit intermediary escapes the full set of requirements only if he is not acting as a creditor himself, but for a fee mediates or assists either the creditor or the consumer when closing a credit agreement. On the other hand, the undertaking for whose account the activities are performed by another, can be a bank even if the clients do not have direct contact with it. In this reading, ‘for its own account’ is used to ensure that a formalistic tactic does not bring the possibility to avoid the application of the licence obligation for banks. The directive does not specify whether the business to attract and lend money should be the main activity, one of the main activities, or that an undertaking may even qualify as a bank if this business is one of its minor business lines, maybe even only accessory to its main business (e.g. manufacturing). The protection thinking behind the introduction of banking supervision should lead to the conclusion that if an undertaking has this collection of deposits and credit granting as a separately identifiable business, it should be treated as a bank. Otherwise, the protection granted to depositors could be escaped by mixing it with other types of activities of the natural person or legal entity (which might actually increase the risk to depositors). On the other hand, lending and borrowing activities that are clearly only undertaken to support the main activity should perhaps not lead to obligatory banking supervision, as they are not a separate ‘business’; a separate profit centre. In those cases, the protection might be limited to the obligations on consumer credit provisions, in combination with the prohibition to attract funds from the public without a prospectus (see chapters 5.6 and 16). It should be noted, however, that there is little or no literature 91 Art. 3.f, 5 and 6 Consumer Credit Directive 2008/48/EC.

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on this issue, and the dividing line may well be drawn elsewhere in domestic legislation interpreting/implementing this definition and/or in case law. To Receive Deposits or Other Repayable Funds This part of the bank definition links the definition of a bank to the goal of protecting savings and creating equal conditions of competition. This is of limited use by itself, except as the basis for the recital92 that the scope of the CRD ‘should therefore be as broad as possible, covering all institutions whose business is to receive repayable funds from the public’. Otherwise the CRD itself again provides only limited further insight into the meaning of these terms, but the Court of Justice has provided an indication of the way it should be interpreted. Amongst others the term ‘deposits or other repayable funds’ has to be interpreted broadly instead of narrowly. The Court indicates that any obligation that contains an intrinsic characteristic or contractual obligation to repay the funds paid has to fall within the scope of the term, in order to make sure that the goal of the protection of savings of the public (specifically of consumers; see below) is achieved93. It is not relevant in which form these repayable funds, including deposits, are received. The CRD mentions that ’deposits’ and ‘other forms such as the continuing issue of bonds and other comparable securities’ can consist of money given in the form of long term savings accounts, current accounts, immediately repayable savings accounts, funds in investment accounts or in other forms94. This allows the definition to remain flexible in the face of new forms of financial products, and deem them to be equivalent to deposits if they include an obligation to repay the funds entrusted in full (plus interest or other rewards for the free use of those funds in the meantime). The obligation to repay in full differentiates ‘deposits and other repayable funds’ from: – funds given for investment purposes, where the claim is not for the nominal amount anymore but for a proportional part of the money in the undertaking (e.g. shares, rights in UCITS); and – funds to pay for services and goods. The difficulty is that the apparent clear borders between these categories are in fact quite blurred. Are funds paid in advance for not yet specified services to a regular commercial counterparty repayable funds or just a pre-payment? Are subordinated or convertible loans an investment or a loan? Is a month’s rent paid as security – that is used by the landlord 92 Recital 5 and 6 RBD. 93 Italy/Romanelli, Court of Justice 11 February 1999, Case C-366/97. 94 Italy/Romanelli, Court of Justice 11 February 1999, Case C-366/97, §13-15. Recital 5 and 6 RBD. Also see the complementary art. 1.2 sub f and j Prospectus Directive 2003/71/EC.

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for its day-to-day business – repayable funds if it has to be paid back at the end of the lease? This can be quite difficult to ascertain, but the wide interpretation given by the Court indicates an affirmative answer95. The term may need to be interpreted broadly, with other aspects of the bank definition providing the needed limitation (e.g. the ‘business’ terminology provides protection against an purely incidental activity leading to a licence obligation). If at all, the arguments for a broad interpretation have increased since the introduction of the term in the first banking directive. The term deposit in the 1994 deposit guarantee directive is used in a very wide definition. The deposit guarantee directive includes protection for: – any credit balance (i) that results from funds left in an account, (ii) from temporary situations deriving from normal banking transactions, (iii) either of which needs to repaid by the bank under the legal and contractual conditions applicable; – any debt evidenced by a certificate issued by a bank (bonds); though the Commission is proposing to eliminate this category (see below); – shares in UK and Irish building societies; – but excludes explicitly (i) instruments that are recognised as ‘own funds’ of banks (see chapter 7), (ii) certain types of covered bonds (as they benefit from separate protection; see chapter 8.6). A ‘deposit’ in that directive can be assumed to be identical to the CRD terminology of ‘deposits and other repayable funds’96. This will change if proposals of the Commission to change the definition of deposit in the depositor protection directive would be adopted by Council and Parliament97. This would limit guaranteed claims to more traditional concepts of deposits, such as current accounts and savings accounts, and exclude bonds issued by a bank (even if held by ‘the public’ see below). This excludes many forms of repayable funds, and even some term-deposits if embodied in a certificate. Other clarifications would be helpful (though possibly unnecessary), e.g. to clarify that repayment means repayment at par. 95 A landlord would, however, not be in the ‘business’ of taking deposits and making credits, or even come within the remit of art. 5 RBD, unless the management of such security-funds is a separate profit-center, and not supportive of its main business any longer. See above, and chapter 5.6. 96 If not identical, the only other option is to assume that deposit in both directives means the same. Both directives use the same definition of bank, and the deposit guarantee directive thus defines ‘deposit’ very widely, and bank more widely because it is defined as being in the business of receiving ‘deposits and other repayable funds’. See art. 1.1 and 1.4 Deposit Guarantee Directive 1994/19/EC. Strangely, the Commission study did not refer to the usage of the term ‘deposit’ in the CRD, except to note that the CRD does not need a definition. This is strange, to say the least. Commission, Cross-sectoral Study On Terminology as Defined in the EU Financial Services Legislation, 27 November 2009, page 11. 97 Commission Proposal, Directive on Deposit Guarantee Schemes (recast), COM(2010)368 final, 12 July 2010, page 2 and proposed art. 2.1 sub a.

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If an undertaking is subject to the CRD and deposit guarantee directive requirements, this provides depositors with the certainty that any institution that accepts deposits is safe(r)98. At the same time, the undertaking has to make substantial investments in order to achieve that safety and to comply with these directives. As a side effect, a partially unintended consequence of the increased safety for creditors is that it makes it more acceptable for banks to be regulated. The licence obligation ensures banks that they are protected in their core transformation business from unfair competition by less regulated firms that did not need to make the same investments in ensuring their own solidity. Apart from ensuring a level playing field between banks operating in the EU that fulfils minimum safety standards, this is achieved by including an additional prohibition for others than licensed banks to attract deposits and other repayable funds from the public (see chapter 5.6). The supervision and deposit guarantee also allow them to compete with other funds that would like to temporarily separate customers from their cash. Legitimate examples at the EU level are specific regulations on types of institutions that accept deposits including e.g. electronic money and payment services, and regulations on issuance of bonds with a prospectus that equally allow such institutions to attract repayable funds from the public. See chapter 5.6, 16 and 19. The receipt of funds in exchange for electronic money is stated by EU law to not constitute deposits or other repayable funds99, if the funds received are immediately exchanged for electronic money. This does not change the definition of ‘deposits or other repayable funds’, but makes an exception to it (like the exempted institutions discussed in chapter 4.5 are still banks, even though they do not fall within the remit of the CRD anymore). In combination with the redeemability requirement for such e-money (see chapter 19.3), it is however strange that they are not considered deposits formally, as it requires the nominally paid funds to be repaid in full. As electronic money institutions would have fallen under the exception for non-banks to attract repayable funds from the public (as there is an alternative and more specific EU protection mechanism), there is no obvious reason why this statement is contained in the electronic money directive. The electronic money directive establishes an (equivalent) regime for electronic money institutions, which are allowed to compete with banks (and governments) issuing electronic money if they comply with that directive (even though those can be waived, exempted etcetera by national legislators and supervisors; see chapter 19.3).

98 Art. 5 RBD and art. 3 Deposit Guarantee Directive. 99 Art. 6 Electronic Money Directive 2009/110/EC. This article also prohibits electronic money institutions (non-banks) to attract other types of deposits, in a double prohibition on top of art. 5 RBD.

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The broad interpretation the CRD favours for its definition components also impacts the prohibition for non-banks to attract deposits or other repayable funds. The intention is that – if you are a bank under the terminology used – you are also allowed to engage in deposit-taking without facing competition from non-banks who do not have the same costs as you, and on whose activities the protection of supervision and deposit insurance do not apply. See chapter 5.6 and 19.3. From the Public The term public has not been defined in the CRD. At a minimum, the term public encompasses consumers, but it is not clear from the CRD who else is protected by the use of this term in both the bank definition and in the prohibition for non-authorised institutions to attract repayable funds from the public (see chapter 5.6). The term is used elsewhere in the context of making information available ‘to the public’, both in the RBD and in other directives100. The question is when the business of an undertaking is addressed to amongst others the general public. As indicated, the CRD does not provide any clues here, leaving the member states with considerable freedom to set the exact delineation. Inferences may be drawn from the prospectus directive and the UCITS directive – and their predecessors – for offerings not listed on a regulated market101. Distinguishing between professional clients and retail clients (consumers, small- and medium sized enterprises and other nonprofessionals), and between people who know you and those who do not would be more helpful. This approach mirrors the Mifid-approach to protect non-professional investors; see chapter 16.2. The borderlines used in for instance the prospectus directive may also – or may not – to drawn upon by the courts when looking at the interpretation of the bank definition: – persons who belong to a restricted circle (language from the old public offers directive) or to a smaller number than 150 persons per member state (language from the replacing prospectus directive) are non-public; – qualified investors are non-public; – relating to funds with a minimum denomination of 100.000 euro102. 100 Art. 19 RBD. Similar provisions were introduced in Mifid and in the insurance directives via the M&A Directive 2007/44/EC; see chapter 2. Also see art. 1 Market Abuse Directive 2003/6/EC where inside information is defined amongst others by the fact that it has not been made public. 101 Art. 2 and 3 Prospectus Directive 2003/71/EC, as amended by Directive 2010/73/EU, and the previous Public Offers Directive 1989/298/EEC. Also see chapter 16, and E. Ferran, Building an EU Securities Market, Cambridge, 2004, page 169-175. 102 Up to the start of 2012, this limit was set at 50.000 euro. The Prospectus Directive was amended by Directive 2010/73/EU. The previous limit was no longer in line with the protection offered to savers under the Deposit Guarantee Directive of 100.000 euro, and recital 9 of the amending directive notes that retail clients have started to make such 50.000 plus investments. The elevation in the protection for depositors as per end 2010 indicated that persons with deposits larger than 50.000 euro need protection too, which was expanded to other types of investments that are covered by the Prospectus Directive. Also see chapter 16.

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Two concrete collections of persons appear accepted as being outside of the term public: – relatively small numbers of people who have a personal relation with the company; – persons with the expertise and/or funds that allow them to do their own research (or can afford to properly outsource this). There is no formal obligation to use the term in the same way in different directives (see e.g. the use of the term own funds in the various directives, chapters 7). The term public nonetheless appears to have been used in line with general usage, i.e. the people in general or the populace. This is in line with the Court case law on the ‘repayable funds’ definition, as both concepts would need a wide interpretation in order to protect savings. Confusingly, the Court in that judgement103 used public and consumers as if these were similar terms, but this appears to be a mistake. The content of the word public was not at stake there, and limiting the term public to consumers is not consistent with the reasoning of the judgement otherwise, nor with the opinion of the advocate general to which it refers in this respect (where the reference is specifically to depositors, savers or the public, instead of to the more limited consumers terminology; see chapter 16.6). There is no cross-reference to the definition of protected persons in the deposit guarantee directive. That definition allows member states to exclude a wide range of entities of coverage. Natural persons and small- and medium sized enterprises can, however, not be excluded. The review of the depositor protection directive includes a proposal to harmonise the protected persons. If such an agreement could be reached, it could be used – instead of the ‘non-professional’ terminology – to help elucidate or even set the definition of ‘public’104. The simultaneous review of the investor compensation directive aligns the concept of protected persons to the Mifid concept of retail clients. If this would be copied into the deposit guarantee directive (and a cross reference in the CRD on ‘public’), it would align four of the key prudential and conduct of business directives relevant to banks on the issue of who is protected105. It is not clear why the prudential directives do not copy the existing Mifid and the draft investor compensation directive. Even though this wide usage of the term public is consistent with the protection goal, and with the usage in public disclosure legislation, it is rather inconsistent with the gradated approach to targeted protected persons in other financial supervision directives (see chapter 16 and 19). Those differentiate between degrees of protection, with more protection 103 Italy/Romanelli, Court of Justice 11 February 1999, Case C-366/97. 104 Art. 4 and Annex I Deposit Guarantee Directive 1994/19/EC, as amended by 2009/14/EC. Commission Proposal, Directive on Deposit Guarantee Schemes (recast), COM(2010)368 final, 12 July 2010, proposed art. 4. 105 See chapter 16; R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 2, 3 and 4.2. Commission Proposal, Directive Amending the Directive on Investor-Compensation Schemes, COM(2010 371 final, page 6.

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for consumers and retail clients, and less protection for larger companies, financial institutions and public authorities. The choice to protect can vary with the goal of the provision. In some cases protection has to be granted to everyone, e.g. to keep markets transparent for both the most professional and the most unprofessional parties in that market. In other cases, protection is only granted to consumers. If so, all non-consumers are expected to be able to take care of their own interests, and are thus free both to trade as they wish (no bar to engage in riskier activities with more knowledgeable counterparts) and to lose their shirt or make a bundle to the best of their abilities and those of the persons they choose to trust. The choice for the term public indicates that the protection here is given to an intermediate group, not to everyone, but also to more market participants than consumers only. Both the banking definition and the deposit guarantee directive do not reflect a gradated approach, like the conduct of business directives. They only provide an on or off switch. If you are ‘public’ in the CRD, your bank is supervised, if you are a protected depositor in the deposit guarantee directive, you get an amount guaranteed. Member states have to protect consumers and retail clients (including small- and medium sized enterprises). As the terms used in the CRD date from the seventies, the innovative developments of opt-in clauses in some areas of conduct of business supervision have not been taken into account. The conduct of business provisions have a clearer protection goal than the CRD. When looking at the conduct of business rules in Mifid106, a rather clear and limited list of who are professional and thus (relatively unprotected) investors is given. If a client belongs to this category, he is not provided with most of the detailed protection granted in the duty of care provisions. As a result, the client can enter into transactions that the bank might not have considered in his best interest. These can be high risk/high potential profit ventures. Especially the eligible investors (a sub-set of the group of professional clients) are deemed to be able to make their own judgement on this. Both in the access to riskier markets, to riskier UCITS and to riskier issues of securities without the full disclosure protection in the form of a prospectus, a similar but now unlimited list exists of people who are deemed not to need the protection granted, and thus have access to high risk/high potential profit ventures; see chapter 16. The list here is unlimited because some categories of people have the right to ask to be treated as if they are a professional market party, even if they do not fall within one of the categories mentioned in the list. They have to fulfil some criteria, but if so, their request is honoured and they can invest where and if their own judgement – or lack of it – leads them to think they should. It should be noted, however, that this contradiction between protections offered to different groups of the public in different directives looks more fundamental than it is. Even where in the duty of care 106 Art. 4.11-4.12 and Annex II Mifid 2004/39/EC; see chapter 16.

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provisions the protection cannot be rescinded officially, the sophistication of the client plays an important role in the assessment by the institution when providing such care. The level 2 directive even focuses almost exclusively on providing detail on the duty of care for retail clients on e.g. targeted information provision107. To Grant Credits In some ways, granting credits is the mirror image of receiving deposits or other repayable funds. Where deposits are entrusted to the bank, credit is entrusted by the bank to its customers. If a credit has been granted, it becomes an asset of the bank (i.e. a claim of the bank for repayment by its customer). ‘To grant credits’ has not been defined in the CRD. It can be assumed, however, that it includes at a minimum the second activity in the list of activities subject to mutual recognition (see chapter 5 on market access). The list gives examples of lending, including e.g.: – consumer credit; – mortgage credit; – factoring, with or without recourse; and – financing of commercial transactions. The directive does not clarify whether the granting of credits is a wider concept than lending, nor does it clarify what types of lending are included. The usage of the term credit in the same context as deposits is unexpected at first sight. The standard terminology couples of either debit/credit or deposits/loans was not chosen in the definition of a bank. If only loans or lending had been meant, it is not clear why this term was not used in the definition instead of ‘credits’. Especially as the term ‘lending’ is used elsewhere in the RBD; in the list of activities subject to mutual recognition108. There are several arguments for choosing a narrow (e.g. only loans), broad (loans, overdraft facilities, deferred payments and similar accommodations), or very broad definition (any funds entrusted to another for deposit/lending or investment) of ‘credit’. These include: – Debit may not have been chosen as an alternative to the deposit and other repayable funds terminology as it would be too wide, including investments (capital is also on the debit side of the balance sheet), and thus would have led to the definition of a bank also encompassing funds entrusted to an undertaking for investment, instead of for repayment (going in the direction of UCITS, investment firms or pension funds). But in a mirror to this reasoning, the term ‘loans’ was not chosen because it might have been too narrow, excluding funds granted by the bank not to have them repaid to their nominal value, but as an investment by the bank. In that case, all items on the credit

107 Art. 31 Mifid Level 2 Commission Directive 2006/73/EC. See chapter 16. 108 Annex I RBD.

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side of the balance of a bank might be ‘credits’, including investments. This would lead to a very wide scope of the directive. – As a counterargument, elsewhere in the CRD credit also has been used mostly as equivalent to lending109. – In the doorstep selling directive a credit agreement includes ‘a grant of funds which is linked to a corresponding obligation of repayment together with interest’, and in the consumer credit directive, a credit agreement is defined as an agreement in which a creditor grants (or promises to grant) credit in the form of ‘a deferred payment, loan or other similar financial accommodation’110. If credit was interpreted in the widest sense, also companies that attract deposits from the public and invest it for their own account (other than providing loans but by investing in e.g. shares or Islamic finance practices) would fall within the remit of the CRD. Though this might be desirable for systemic and for retail client protection concerns, this does not appear to be intended, and the resulting full overlap with some other directives described in chapter 19 would have required further attention. Though not conclusive, the equivalent use of the terminology with the consumer credit and doorstep selling directives, as well as it being closest to normal usage of the term ‘credit’, makes it more defensible to assume that the term ‘credit’ is linked to claims to a nominal sum (with interest), which are similar to loans or deferred payments. Though limited to such similar accommodations, the term includes e.g. overdraft facilities and other promises to extend credit111. A simple explanation – that however assumes a startling lack of discipline in the use of terminology by the drafters of legislation – for the different terminology might be that the annex containing the list was introduced in 1989 with the Second banking directive, while the definition of a bank has not changed since it was introduced in 1977.

109 See e.g. Annex II RBD, introduced like the Annex In 1989 (in the Solvency Ratio Directive), the list of off balance sheet items, ‘guarantees having the character of credit substitutes’ and ‘undrawn credit facilities (agreements to lend, purchase securities, provide guarantees or acceptance facilities)’, though facilities to purchase securities (note, not bonds but all securities) sound as investments too. 110 See chapter 16.6. Art. 2 Consumer Credit Directive 2008/48/EC, and Heininger/Bayerische Hypo- und Vereinsbank, Court of Justice 13 December 2001, Case C-481/99. 111 The Court of Justice ruled that the concept of credits as deferred payments, loans and other accommodations needs to be broadly interpreted, and any exceptions narrowly, in order for consumers to benefit from the Consumer Credit Directive protection. Rampion/Franfinance, Court of Justice 4 October 2007, Case C429/05.

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Credit Institution / E-Money Institutions The CRD does not use the term ‘bank’ but the term ‘credit institution’. Until 2000, and again since April 2011, these terms are interchangeable. As a result of the electronic money directive112, between 2000 and 2011 in addition to banks also e-money institutions were captured by the credit institutions definition. This allowed the ECB to capture e-money institutions in its monetary regulations. The reason for this was not to apply banking supervisory arrangements to e-money institutions, but to include e-money creation within the remit of the ECB. At the time, the remit of the ECB had already been defined (and limited) in the EU treaties to ‘credit institutions’. As the new category of electronic money institutions might in the future also have a perceptible influence on the money available in the market through the creation of electronic money, the ECB wanted to be involved in drafting any regulations and be authorised to issue requirements to them like it could for banks. The only way possible113, without changing the treaties, was to broaden the definition of credit institutions in one of the signatory patchwork solutions of the EU. The actual supervisory requirements for e-money institutions are, however, only vaguely linked to banking supervision requirements. Some, such as licensing requirements, were borrowed from the banking directive, others, such as the quantitative requirements have been based more on the light touch UCITS prudential requirements than on bank prudential requirements, with limitations on the types of investments made, and a simple own funds requirement. See chapter 19.3 and 19.5. This has made the inclusion of e-money institutions in the CRD’s credit institution definition highly confusing114. For this reason the term ‘bank’ rather than ‘credit institution’ is used in this book. It has the advantage too of being closer to actual usage in society and within the political environment, which the legalistic term of credit institution is not. The definition of credit institution has been amended by the new electronic money directive as per 30 April 2011, and is limited to banks only again. The initial e-money directive was never popular. The negotiations brought to the table proponents of the free use of electronic money (who were happy with broad waivers of the regime) the ECB that wanted to claim

112 Electronic Money Directive 2000/46/EC, replaced effectively from April 2011 by the Electronic Money Directive 2009/110/EC; see chapter 19.3. 113 Though such changes in the remit of the ECB/ESCB by changing the definition in lower level legislation such as the CRD was opposed in e.g. R. Smit, The European Central Bank, Institutional Aspects, The Hague, 1997, page 233-241. Smit opines that such links are unnecessary, as ‘credit institution’ in a monetary context should have an independent meaning from the prudential usage; a position likely to be challenged by institutions that are not banks but would find themselves faced with monetary requirements. The Commission has since gone for this side in the payment institutions directive and the redrafted e-money directive. 114 This is emphasised by the use of ‘credit institution’ terminology in the Deposit Guarantee Directive 1994/19/EC in the sense of ‘bank’, not e-money institutions.

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control, and others who wanted to keep this type of services with the banks (who were happy with very strict conditions on the business of the new electronic money institutions and limitations on their investments). The end result pleased nobody, least of all the electronic money providers who were caught in the middle. The applicable regime was not clear at the start (with vast tracts of heavy handed banking regulation applicable to these still relatively small institutions, but without the core quantitative requirements), which situation did not improve when the CRD was introduced without clarifying the applicability of new areas of regulation (e.g. pillar 2 and 3) to electronic money institutions. The Commission started a review in 2005, and in October 2008 proposed a new directive, which was adopted in 2009. Under the new directive, the electronic money institutions are regulated separately. The prudential regime is modelled closely on the regime for payment institutions and applicable since 30 April 2011 in spite of ECB protests115; see chapter 19.3. For the overlap between the terminology ‘bank’ and investment firm, please see chapter 16.2 and 19.3. National Goldplating of the Definition Member states may wish to ‘goldplate’ the banking definition elements to expand some form of protection to large companies, financial institutions and public authorities or expand banking to the risk-investments made by deposit taking institutions. The definition of a bank is nonetheless a core element of the single market provisions of the CRD. Though ongoing supervision does not focus primarily on the deposits/lending business, the European passport regime does. The Court has ruled116 that such core definitions in the freedom of establishments and freedom of services context need to be implemented as they stand. The member state can subsequently expand the regime to other institutions, not covered by the EU definition (e.g. to institutions that perform the same activities, but that invest instead of making loans, or do not attract repayable funds from the public). It has to identify those expansions though as a national rule, not done to implement the directive, so that there can be no confusion in other member states as to the absence of a European passport under the CRD117. The purpose of these restrictions introduced by the Court is that the European passport is granted only to undertakings that fulfil the EU definition; see chapter 3.5 and 5.3. On the other hand, such domestic definition banks – that do not fall under the EU definition – are normally supervised at least as heavily as ‘banks’ in the EU definition. As a result,

115 Art. 20 and 21 Electronic Money Directive 2009/110/EC. 116 Testa and Lazzeri/Consob, Court of Justice 21 November 2002, Case C-356/00. 117 Testa and Lazzeri/Consob, Court of Justice 21 November 2002, Case C-356/00, §35-36 and 45-46.

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the prohibition to non-banks to attracting deposits or other repayable funds from the public is not applicable to these institutions domestically. Host member states, however, do not have to accept a notification under the European passport for them, and can if they so desire restrict their cross-border activities for ‘general good’ reasons (see chapter 5.3 and 5.6 on market access). Future Developments – Shadow Banking The definition of a ‘bank’ is quite dated, but has been kept unchanged in the CRD IV project118. Work is being undertaken by the FSB on shadow banking; also see chapter 2.3. ‘Shadow banks’ can be hedge funds, money market funds, non-bank investment funds, securitisation ‘special purpose vehicles’, and other key service providers that directly compete on key financial services with banks, but do not fall within the definition of a bank e.g. because they do not attract deposits or other repayable funds from the public (but e.g. only from professional market parties) or invest the funds it attracts in e.g. shares, instead of extending loans. Shadow banks can be as large, involved in intermediation in short term money into long term loans/investments as banks119. They are linked to each other and to ‘regular’ banks via loans, investments, shareholdings and through their participation in wholesale lending, clearing and settlement systems. Institutions that actually have similar characteristics as a bank, but do not fall within the banking definition, may have an unfair competitive advantage, and more importantly equally form a potential source of risk to financial stability. This without clearly defined ex ante access to support facilities offered by e.g. central banks nor the accompanying level of prudential supervision and knowledge of supervisors/central banks as sketched in this book. In the 2007-2013 subprime crisis and in the LTCM even earlier, such entities de facto turned out to be susceptible to (shadow-)bank runs. Their failure would have rocked the financial system and they were bailed out, even though they were not submitted to equally harsh supervision in advance. Ironically, the push to deleverage banks, and to segregate risky and non-risky (as if any financial activity is not risky) contemplated in the USA and UK under the Volcker rule and the Vickers report recommendations is pushing even more activities into the shadow banking area, without actually making such activities less systemic120. Such segregation is now also proposed in the Liikanen report, on the recommendations of which the Commission started a consultation121. Such segregation is not likely to increase the stability 118 Art. 4.1 CRR, to which art. 3 CRD IV Directive refers. 119 Z. Pozsar, T. Adrian, A. Ashcraft & H. Boesky, Shadow Banking, Federal Reserve Bank of New York Staff Report 458, July 2010. 120 See R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 2.2 and 4.4; and Z. Pozsar, T. Adrian, A. Ashcraft & H. Boesky, Shadow Banking, Federal Reserve Bank of New York Staff Report 458, July 2010. 121 High-level Expert Group on Reforming the Structure of the EU Banking Sector, Final Report, 2 October 2012 (Liikanen Report). The Commission consultation of the same date invites views on the report and recommendations of the Liikanen group until 13 November 2012.

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neither of banks nor of banking systems, as small banks fail too with systemic consequences, and the segregation into separate legal entities does not appear to be able to reduce contagion risk in an interconnected financial market122. The FSB has published a report and is fostering further work by the BCBS, IOSCO and by special task forces to look at different aspects of shadow banking, procyclical elements of their business and the links with ‘normal’ banks123. The FSB focuses mainly on credit mediation (and the link with ‘normal’ banks), which is in line with the current definition of the core activity of a bank. The Commission has announced that as part of its work on shadow banking – closely linked to the FSB work – it will also consider whether the definition of a bank should be revisited124. The future will have to show whether the approach of the FSB and the Commission is the correct approach125. Reference is made to the review of the deposit guarantee directive, that might impact on the definitions of ‘deposit’ and of ‘public’ discussed above, even though the CRD nor the CRD IV do not cross-refer to the deposit guarantee directive for such purposes; see chapter 18.5.

4.5

Government Banks and Exempted Banks

Introduction If a person or legal entity fulfils all the components of the definition of a bank, it is a bank under the CRD. The licence requirement, regulatory requirements and ongoing supervision are inescapable, unless the bank is specifically exempted in the CRD itself. The only institutions that fall within the definition of a bank but are exempted from the consequences thereof, are listed in the RBD126 (and in the related list in the EEA agreement). Any insti-

122 See R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 2.2 and 4.4; The UK FSA, The Turner Review, March 2009, page 93-96. 123 FSB, Report on Shadow Banking: Strengthening Oversight and Regulation, 27 October 2011; FSB, Strengthening the Oversight and Regulation of Shadow Banking, 16 April 2012; FSB, Progress in the Implementation of the G20 Recommendations for Strengthening Financial Stability, 10 April 2011; page 4; FSB, Global Shadow Banking Monitoring Report 2012, 18 November 2012 and three simultaneously published consultation papers. 124 Commission, Green Paper, Shadow Banking, COM(2012) 102 final, 19 March 2012. 125 R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 2 and 4.3. 126 Art. 2 RBD, with new institutions added when new member states become part of the EU. See e.g. Level 2 Commission Directive 2010/16/EC.

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tution specifically mentioned in that list is exempted from the entire directive, including the prohibition for non-banks to attract deposits or other repayable funds from the public. The list of exempted institutions contains amongst others the central banks of member states (which can be assumed to include the ECB, though it might have been good to be specifically mentioned) and the post office giro institutions, which were still widely kept out of supervision when this list was set up in 1977. The rest of the list is set up is per country, and includes some specifically mentioned government owned banks, as well as e.g. credit unions in the UK and Ireland. If a bank has exposures to such exempted institutions, they do fall, however, in the category of financial institutions (for purposes of consolidation supervision, own funds calculation and exposures to these institutions), except for specifically mentioned government banks such as central banks and the exhaustive list of multilateral investment banks that benefit from an even lower risk weighting. Banks owned or controlled by governments that are not mentioned in the list occupy an odd niche. They are supervised by a government agency, but are themselves either a government agency or are controlled by a government agency at the same time. Government Banks There are two types of government banks: – banks that are owned by government(s) and either perform public policy or provide loans at sometimes non-commercial terms with the express purpose to stimulate certain sectors or regions which would have trouble attracting funds from commercial lenders; and – banks that are owned by government(s) that are operated as and compete with commercial lenders. Even the first category would generally be ‘undertakings’ in the sense of the treaty, regardless of whether they were set up under public law or not, as they perform an economic activity. Their legal status and the way in which they are financed are not relevant for determining it is an undertaking127. The exception is if they do not perform economic activities but have a purely social function, with activities based on the principles of soli127 See e.g. Wouters, Court of Justice 19 February 2002, Case C-309/99 and Fenin/Commission, Court of Justice 4 March 2003, Case T-319/99. This would be different when the activity would have a social purpose only, where the amount paid for the service and the service itself for instance bear no close relationship. This generally is not the case when loans are given by such state owned banks, but needs to be assessed on a case by case basis.

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darity, non-profit-making and with benefits not related to contributions. These include central banks and the ECB, as well as investment institutions such as the European Investment Bank, the EBRD, the World Bank and domestic institutions such as the German Kreditanstalt fur Wiederaufbau and the Dutch provincial development banks. Such purely public purpose banks are generally referred to as development banks (multilateral development banks if owned by several governments). Even though they are undertakings, these banks mostly do not fall under the scope of the CRD supervision because: – they do not fall under the definition of a bank as they do not attract repayable funds ‘from the public’ (but from its shareholding governments or from professional markets); – they fall under the ‘purely social function’ category because they exclusively pursue public policy (governmental goals) and thus are not undertakings, even when they also attract repayable funds from the public; or – they are explicitly exempted from the scope of the CRD by being listed in art. 2 RBD (e.g. the central banks of the member states, including the ECB) or in other EU legislation or treaty as being exempted from banking supervision. However, their status as a credit institution is not always clear. Though in effect institutions such as the European investment bank in Luxembourg and the European Bank for Research and Development in the United Kingdom are not subjected to banking supervision under the CRD, it is not prima facie clear why not. To focus on these two, neither has been explicitly exempted from the CRD, nor are there clear provisions in the TFEU respectively in the statutory documents setting up the EBRD indicating that local banking supervision in respectively Luxembourg and the United Kingdom is not applicable. Both attract repayable funds from retail investors through bond emissions, and use this to grant loans at reasonably commercial terms (but sometimes to those who would not have been able to obtain commercial funding in the free market at all without the intervention of the EIB or EBRD). It can both be defended that their business is performed for public purposes, excluding them perhaps from the term undertaking, but the distinction of their core business to commercial banking is not easy to make. A clearer exception for these and other multilateral investment banks of which the EU and/or member states are members would have been – to say the least – beneficial. As they are international organisations of which member states are members, they already benefit from an exception of the prohibition to attract repayable funds from the public (see chapter 5.6), but as international banks, they should have been exempted from the licence and supervision obligation for banks too. In two procedures between the Commission and the EIB128, the Court has made clear 128 Commission/European Investment bank, Court of Justice 3 March 198, Case 85/86, and Court of Justice 10 July 2003, Case C-15/00. See art. 343 TFEU and the related protocol on the scope of the immunity. However, also see the ambivalent wording of art. 20 and 21 of protocol 5 to the treaties, containing the statute of the European Investment Bank.

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that the EIB can be subject to community law (despite being granted immunity from e.g. tax issues), and that it can indeed claim independence from the Commission on its financial transactions as it ‘must be able to act in complete independence on the financial markets, like any other bank’. Any other bank can indeed act in complete independence. Any other bank does, however, have to comply with banking supervision under the CRD when doing so. Commercial Public Banks More controversial is the category of government banks that operate as commercial banks but are owned or sponsored by the state or other public bodies, such as municipalities. They fall under the bank definition, and are not exempted in general terms from supervision (except when referenced explicitly to in the list of exempted institutions). As to their desirability, opinions are divided between free market enthusiasts and state intervention enthusiasts129. This is outside of the scope of this book. The supervisory controversy is on whether supervisors are really allowed and able to exercise the same supervision on commercially operated government banks as they do to other commercially operated banks. Also, governmental banks benefit from an implicit safety net (and thus a competitive advantage) through its owner. This implied or explicit guarantee reduces their borrowing costs, and defeats the level playing field with ‘normal’ commercial banks. They tend to have a higher risk profile than normal banks in their business130. The controversy has increased during the 2007-2013 subprime crisis, when the number of commercially operated banks owned or guaranteed by governments increased due to state aid (guarantees, loans and investments) and full or partial nationalisations. Simultaneously many state sponsored banks or near-banks that operated prior to the crisis became prominent casualties of the crisis, showing bad risk management, bad management, politically motivated lending practices and/or lack of supervision rigidity or powerlessness to implement supervisory judgement (e.g. the Spanish cajas, the German Landesbanken and the USA government sponsored housing enterprises such as Fannie Mae and Freddy Mac). Such issues were not unknown before the crisis, but were spelled out slightly more clearly by supervisors after the crisis131. Regular commercial banks can complain of unfair competition, as both existing and newly nationalised state banks can get cheaper funding on the professional market, can receive state guarantees that may be on uneconomic terms, and are deemed less likely to fail and 129 E.g. the EU Committee on the Regions is in favour of public banks to stimulate development of less advanced regions. Committee of the Regions 14 February 2001, opinion 2001/C 148/04. 130 R. Gropp, C. Gruendl & A. Guettler, The Impact of Public Guarantees on Bank Risk Taking, Evidence From a Natural Experiment, ECB WP 1272, December 2010. 131 BCBS, Principles for Enhancing Corporate Governance, October 2010, page 19, 38 and 59.

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thus attractive to consumers/depositors. These factors may impact on the profitability, viability and financial stability of (other segments of) domestic markets132. Governments of other member states where a nationalised bank had branches or subsidiaries can complain of a relocation of funds to the home country, under state requirements to stimulate lending there. The clients and employees of nationalised banks can complain of state interference in the types of business the bank engaged in, pressures to increase or reduce risk perception, payment structures. Clients can complain of banks aligning pressures with the state to accept unattractive deals during economic restructuring (e.g. in the Chrysler rescue where senior creditors were asked to accept worse conditions than the workers’ union, a junior creditor). The CRD does not play a large role in this debate, except to indicate that government banks should be supervised in the same manner as other banks (except when exempted; see above). The commercial banks owned by governments are under the same supervisory regulations as regular commercial banks. It may, however, be difficult to operate independently and evenly when supervision is in the hands of a supervisor that is owned, funded and/or given instruments at the discretion of the central government. This danger of undue influence, even where intentions are good, increases when the politically responsible ministry for supervision also manages the ownership of such commercially operating government banks. The OECD has issued guidance on corporate governance for publicly owned companies that may be useful for banks133. An exception has been negotiated into the above-mentioned list of exempted banks for some of these banks (such as post office giro institutions and some named domestic categories of banks). As a result, these are not subject to CRD supervision, and do not fall under the scope of other directives providing e.g. obligatory deposit guarantees (though they can be covered locally). For the rest, the CRD has limited itself to a relatively minor rule that goes towards levelling the playing field between public banks and regular banks134. Government guarantees do not count towards own funds. There are, however, no restrictions from a prudential point of view on government capital injections, guarantees on portfolios that reduce credit risk 132 See e.g. the state guarantees contested in the German Savings Banks Case, WestLB and Nordrhein-Westfalen/Commission, Court of Justice 6 March 2003, Joined Cases T-228/99 and T-233/99, §21; and the discussion that lead to the understanding between the Commission and several German public bodies and the German Savings Bank Association on 17 July 2001; Commission Decision 27 March 2002, C (2002) 1286. 133 OECD Guidelines on Corporate Governance of State-Owned Enterprises, 2005, www.oecd.org; BCBS, Principles for Enhancing Corporate Governance, October 2010, §19. 134 Art. 64.2 RBD, which includes guarantees by member states and by their local authorities (e.g. the German Länder, which are large shareholders in the German Landesbanken).

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or rather low quality hybrids that were frequently used in the context of state aid during the 2007-2013 subprime crisis; on state aid see chapter 18.4. Also, though the national central banks and ECB are forbidden to grant credit to EU and national governmental bodies, they are allowed to provide reserve facilities to publicly owned banks under the same treatment as reserve facilities to private banks135. Please note that the TFEU contains a prohibition of any measure (in the sense of an EU or domestic law or other regulation) that would force financial institutions to grant privileged access to any EU or domestic government agency. This applies both to publicly and privately owned banks136. The sole exemption is if the better conditions are based on prudential considerations. This does give an advantage to governmental bodies, as they generally have a lower risk of default for debts in their own currency, as recognised in the CRD solvency requirements. This risk is, however, not zero. Central Banks As Banks Central banks have a special position in the legislation. They are not subject to any of the requirements on banks due to their inclusion in the list of exemptions mentioned above. They instead have their own (Eurozone or domestic) regime on prudent management. As a counterparty of banks, they are generally treated as central government, allowing banks to treat them as risk free and thus avoid the need to hold capital against loans made to the central bank (either in the form of obligatory reserves or voluntary ‘parking’ of excess funds at the central bank. Under the TFEU, the ECB and the domestic central banks are not allowed to grant overdraft facilities nor any other type of credit facility to any governmental body in the EU137. The only exceptions are publicly owned banks. Even though they are governmental bodies, in the context of the supply of reserves by central banks it is explicitly allowed to treat them as if they are privately owned banks. Under this rule, banks that were nationalised in a crisis such as the 2007-2013 subprime crisis could retain the credit facilities of the ECB and domestic central banks. Future Developments The treatment of government banks and exempted banks does not change in the CRD IV project; except that the treatment of aid given by governments as the highest category of

135 Art. 123 TFEU, and chapter 22. 136 Art. 124 and 125.2 TFEU, which is applicable both to Eurozone and non-Eurozone member states. 137 Art. 123 and 125.2 TFEU, which is applicable both to Eurozone and non-Eurozone member states.

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financial buffers is accepted for a relatively long transitional period, even if it does not objectively qualify as common equity tier 1 capital138. Under the ‘banking union’ proposals of the Commission, the government owned commercial banks in the participating member states would become supervised by the ECB instead of by a local supervisor. This would reduce a potential conflict of interest of the member state and or its supervisory authority. Specifically, the ECB is stimulated to take responsibility for all banks that have benefited from public assistance sooner than the date when supervision of all banks should have passed to the single supervisory mechanism139. As the proposed regulation requires unanimity, it is likely that some exemptions will be made both on government owned banks and for banks that are particularly politically powerful in the current or future participating member states.

138 On financial buffers, see chapter 6.2 and 7. On exempted banks, see art. 2 CRD IV Directive. 139 Commission, Proposed Single Supervisory Mechanism ECB Regulation, COM(2012) 511 final, 12 September 2012, page 8, recital 44 and art. 27.

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5 5.1

Market Access Introduction

Entry into the banking market can be highly profitable. A new entrant gains a chance to engage in the lucrative deposit/lending business, and is allowed to play various even more lucrative roles in the financial markets1. Such services are important to society as they provide core services to all citizens. With the potential for profits comes, however, the potential for loss or fraud if the aspiring bank, or an established bank, does not fulfil basic requirements on safety; see chapter 4. In the context of banking supervision, screening for safety takes place at the entry point for aspiring banks on the basis of minimum-safety indicators, which subsequently have to be maintained above the minimum level by banks with a licence. The Basel core principles – like the Basel capital accord issued by the BCBS – contain several high level provisions on licensing and market access. A bank should only be allowed to enter a market if it has a licence, and a licence should only be given if certain conditions are fulfilled. In case of a banking group taking over another bank or establishing a new bank in another jurisdiction, the impact on the target bank and the whole organisation needs to be taken into account by the supervisors involved. These core principles have been laid down in the CRD, with some specificities of dealing with the fact that the EU is in a halfway between national markets and a single market for banking. If an entity or group of entities new to the banking market wishes to start providing banking services, it has to request a licence for those entities that will actively undertake the banking business. The same applies if a group of legal entities, some of which have a banking licence, wish to start providing banking services through newly established additional group-entities (subsidiaries). Those new establishments are treated as ‘new’ banks under the CRD, and need to apply for a licence in their own name. The facilities and resources that the banking group can provide to the new banking entity will be an asset, but the legal entity will have to fulfil the minimum-conditions too. The licensing requirements have to be fulfilled in the county where the entity has its registered seat (regardless of whether that is the country where the whole group is based or not).

1

Borrowing at no or low interest rates on current accounts and saving accounts or from bond-investors, and lending at medium to high interest rates for e.g. secured or unsecured loans. Investment and advice services range from low risk/steady income to high risk/high potential profit activities.

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If it fulfils all conditions for obtaining a licence and the local supervisor is willing to grant it, the bank can start operating. Strictly speaking, it is not necessary to specify the types of activities the bank may subsequently engage in2. Only when the bank wants to make use of the European passport, the notification has to specify for which activities the passport rights are being used, and that the authorisation covers these activities. To make this clear, most licences explicitly refer to the listed activities, regardless of plans to stay domestic or not. If a bank is given licence to perform all listed activities, which is standard practice in some member states and a gradual process in others, this is colloquially referred to as a universal banking licence3. This book takes as its starting point the universal banks that operate in the single market under their home state licence, even in countries that my not allow all activities to all their bank, or only start to allow by amending the licence if the specific bank shows that it has the requisite expertise and resources. A licensed bank or a group containing several licensed banks, can also wish to access markets in various other ways other than establishing a new legal entity that applies for a new local banking licence. According to the CRD, licensed banks can access the market of other EU member states by4: – cross-border services provision to the market of another country; – cross-border establishment of a branch in another country (part of the same legal entity that already has a licence); – takeover of or merger with a bank in another country. The segmentation into four different types of cross-border expansions is not in line with the TFEU freedoms of establishment and services. Under the treaty, any company has the ‘freedom’ to develop commercial activities in another member state in the form of5: – cross-border services; – agency, branch or subsidiary; – or a combination such services and establishments. Any restriction set up domestically that hinders a bank to develop its business in the other member state, is prohibited under the TFEU. The prohibition applies regardless whether that business is legally set up as a separate entity with a local licence (subsidiary, acquisition)

2 3

4 5

A list of possible activities covered by the licence is contained in Annex I RBD. See for an overview of the practices to limit their banks to some or allow them all types of activities in some EU member states prior to 1987, R.M. Pecchioli, Prudential Supervision in Banking, OECD, 1987, Annex VI. Art. 6-28 RBD. The third country banks regime is referred to in art. 38 RBD; see chapter 5.5. Art. 53 TFEU. Fidium Finanz, Court of Justice 3 October 2006, Case C-452/04. Also see chapter 3.4.

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or as an intrinsic part of the business of the same legal entity (cross-border services, branch, merger). Prohibited restrictions include any measure that prohibits, impedes or renders less attractive the exercise of one of the freedoms. The only exemption allowed is if the measure of the host member state serves an overriding requirement relating to the public interest, is suitable for securing the attainment of the objective it pursues and does not go beyond what is necessary in order to attain that objective; see chapter 3.4-3.5. The Court of Justice confirmed that this general rule applies to banks, including locally licensed subsidiaries of banks that themselves are licensed in another member state. It also ruled that the exemption is only available in limited circumstances, where there really are no alternatives6. The contested case concerned a prohibition to compete on interest rates on sight accounts (current accounts). Competing on interest rates is a key competition weapon for branches and subsidiaries of foreign banks to conquer market share in another member state. The Court voided that requirement because it should not have applied to subsidiaries of banks from other member states, as it restricts their freedom of establishment. Like domestic legislation, directives are valid only where compliant with the treaties. Whether or not the CRD provisions are compatible with the treaties will depend largely on the way they are applied. If both the domestic market where the bank has obtained a licence and the market to which access is sought are part of the EU, specific provisions apply for different forms of market access. For branches and cross-border services, these are referred to as the ‘European passport’. This passport is not unique to banking directives, but is a common feature in financial services directives since their inaugural appearance in the 1985 UCITS directive. For non-banks and groups without licensed banks, they can only access their own or other markets to provide banking services if they obtain a licence or take over or merge with a licensed bank. The European passport for branches and services can be considered a measure that eases the effective exercise by the bank of the TFEU freedoms7. The Court has long standing

6

7

CaixaBank France, Court of Justice 5 October 2004, Case C-442/02 ruled on limitations to obtain market share for the French subsidiary bank of a Spanish parent bank. The freedom of establishment was invoked to battle local restrictions. The freedom of services in the financial sector was the subject of the coinsurance cases of the Commission versus respectively France, Denmark, Germany and Ireland, Court of Justice 4 December 1986, respectively Case 220/83, 252/83, 205/84 and 206/84, where domestic legislation demanding a local establishment and authorisation was deemed legitimate at that stage of harmonisation in the public interest in non-harmonised areas, but not in harmonised areas of co-insurance. However, hinder to the freedoms does have to be proven: see Volksbank/CJPC, Court of Justice 12 July 2012, Case C602/10. See e.g. Reyners/Belgium, Court of Justice 21 June 1974, Case 2/74.

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case law that secondary EU legislation such as directives will be interpreted in line with the treaty provisions if at all possible (instead of being annulled for incompatibility), in the same manner as national laws need to be interpreted in line with directive provisions8. Even though a subsidiary – unlike a ‘branch’ type establishment – does not benefit from the EU passport of the parent, this does not necessarily mean that the requirement of a separate licence is not in line with the treaty freedoms. The legality or illegality of the different treatment depends on the assessment of whether the separate licensing requirement and the ongoing solo supervisory requirements (in the CRD and/or as applied domestically) contain elements that go beyond valid prudential concerns. As it is a separate legal entity with different consequences for local clients in case of bankruptcy and in civil law proceedings, a separate licence appears defensible. The application of the licence requirement still needs to be interpreted in line with the goal of freedom of establishment. This means that the freedom to not grant a licence is restricted for member states if the parent already has such a licence in another member state. In effect, the treaties demand a less onerous licensing process for subsidiaries of EU banks than for subsidiaries of third country banks and new start-ups. This differentiated treatment can be accommodated within the single licensing process set out in domestic laws. Solo requirements, both in the CRD and in the way they (and domestic add-ons) are applied will need to be based on the exemptions available in the treaty; see chapter 3.4-3.5. This chapter describes the RBD conditions for market access for each of the mentioned manners in the EU. Each method has a separate procedure with different characteristics. In all cases the conditions focus on the viability and integrity of the bank both at the time of initial market access anywhere in the EU and following cross-border market access within the EU. Different Procedures for Different Manners to Cross Borders The current market access provisions were established in 1989. The directive they were part of9 was consolidated and recast since, but it has since received only partial revisions, and few additional details. Some additional criteria for the licensing process were inserted in the rules following the BCCI scandal10, and the mergers and acquisitions market access 8

See for instance explicit considerations of the Court in the above-mentioned Co-insurance cases, e.g. Commission/France, Court of Justice 4 December 1986, Case 220/83. For the relation national law to EU Directive, see chapter 3.5 and Testa and Lazzeri/Consob, Court of Justice 21 November 2002, Case C-356/00, §43. 9 Second Banking Directive 1989/646/EEC. In the same time period of the establishment of the European passport, in the USA the limitations on interstate branches were slowly lifted, resulting in similar consolidation and competition developments in the EU and the US markets. See F.S. Mishkin, The Economics of Money, Banking, and Financial Markets, 8th ed, Pearson Adisson Wesley, Boston, 2006, chapter 10. 10 The opaque structure of the international BCCI Group lead to gaps in the supervision of the activities of the group by the various supervisors involved. The use made by the Group of these holes lead to its bankruptcy,

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methodology has been standardised. The power of the supervisors in the country of the target financial institution was clarified and limited in the wake of the takeover in 2005 by ABN Amro of the Italian bank Antonveneta. Except for these niches, the market access requirements reflect the consensus of three decades ago. The RBD provisions have not been amended to reflect the case law of the European Court of Justice on the freedom of establishment and the freedom of services. The process to grant or withdraw a licence is subject to the fair trial rights of the European convention on human rights, as well as administrative law protections. This includes e.g. fair and public hearing within a reasonable time by an independent and impartial tribunal if the bank or other parties involved disagree with the decisions made under market access laws (see chapter 20.4 and 20.5). Table 5.1 Overview of market access and the role of the prudential supervisor11 Method of achieving market access

Role of supervisor of the relevant market (‘host’)

Role of supervisor of the bank seeking market access, if different (‘home’)

New domestic start-up, not by Check criteria for granting bank licensed elsewhere. authorisation and subsequently give licence or not. If licence given: perform full ongoing supervision.

Not applicable, unless there actually is a parent entity and that entity is regulated for instance as an insurer, in which case its supervisor has similar rights and obligations as the supervisor of a bank-parent entity has (see below).

Bank based in one member state Receive notification via home wants to access market in supervisor of the bank. No another member state via cross- ongoing supervision. border services.

Forward notification to (host) supervisor of the relevant market. Include the services in its ongoing supervision.

Bank based in one member state wants to access market in another member state via branch.

Receive notification via home supervisor of the bank. Ongoing supervision on liquidity if it so desires, as well as monetary responsibility. No other ongoing prudential supervision, (but additional role in the area of conduct of business supervision).

Check whether the bank can handle its additional plans, and – if so – forward the notification with additional supervisory information to the (host) supervisor of the relevant market. Include the branch in its ongoing supervision, and cooperate with host supervisor on liquidity supervision.

Bank based in a member state wants to access market in a member state via new legal

Check criteria for granting authorisation and subsequently give licence or not. Take into consideration that parent bank

Provide consultation-advice and information to (host) supervisor of the relevant market. Include the new subsidiary in its super-

and a subsequent wrangle over who should have done what to prevent it. The BCCI Directive, 1995/26/EC, intended to prevent those specific gaps to be allowed again in the financial sector. 11 Art. 6-28 RBD and art. 53 TFEU.

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Method of achieving market access

Role of supervisor of the relevant market (‘host’)

Role of supervisor of the bank seeking market access, if different (‘home’)

entity (subsidiary), which fulfils will provide part of organisation the definition of a bank itself. and secure funding. If licence given: perform full ongoing supervision on solo basis, but within the umbrella of consolidated supervision tasks of home supervisor of parent bank. Note the application of the freedom of establishment.

vision (solo basis as investment and counterparty, more important on consolidated basis), and establish arrangements for cooperation with (host) supervisor of subsidiary within the tasks and responsibilities of consolidating supervisor in CRD.

Bank based in one member state wants to access market in another member state via (full or partial) takeover of existing bank.

Check criteria for granting approval of acquisition of qualified holding and give approval or not. Take into consideration views of supervisor of acquirer, especially on solidity and reputation of acquirer. If approval given: perform full ongoing supervision on solo basis, but – if the holding in the target bank is large enough to make it a subsidiary – within the umbrella of consolidated supervision tasks of home supervisor of parent bank. Note the application of the freedom of establishment.

Provide information and consultation-advice to (host) supervisor of the relevant market. If the holding is large enough to make the target bank a subsidiary: include the new subsidiary in its supervision (solo basis as investment and counterparty, more important on consolidated basis), and establish arrangements for cooperation with (host) supervisor of subsidiary within the tasks and responsibilities of consolidating supervisor in CRD. If it does not become a subsidiary, include it in supervision as an equity investment and as counterparty.

Non-bank based wants to access market in its own or other member state via (full or partial) takeover of existing bank

Check criteria for granting approval of acquisition of qualified holding and give approval or not. If approval given: perform full ongoing supervision on solo basis. Perform consolidated supervision to include the new parent if the target bank has become its subsidiary. Please note the application of the freedom of establishment.

Not applicable, unless the parent is a regulated entity such as an insurer, the in which case the supervisor of that entity has similar rights and obligations as a supervisor of a parent-bank has.

Third country

Up to the member state and supervisor.

Up to the supervisor of the host.

Exception: bank elsewhere provides services to professional market only: no prudential market access requirements, except if those apply under conduct of business or exchanges regulations.

Freedom of services applicable. Freedom of services applicable Regardless of whether there are additional market access requirements, all activities of a bank are included in its prudential supervision.

This chapter deals with the approval process and consequences for the individual legal entities concerned and their supervisors (solo basis, though it includes the possibility to

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access a market by setting up a local subsidiary). For the repercussions on consolidated supervision for the entities in a banking group and for the various supervisors concerned, see chapters 17 and 21. A separate directive has tried to harmonise cross-border activities of all types of serviceproviders. The CRD-provisions and financial sector conduct of business provisions are nonetheless exclusively applicable to banking services. All banking services and other financial services provided by banks are excluded from the scope of the services directive12. It defines the carved-out financial services by way of a non-limitative list, and mentions banking, credit, insurance and re-insurance, occupational or personal pensions, securities, investment funds, payment and investment advice, including the services listed in the RBD13. Future Developments The market access provisions have not been updated in the wake of the 2007-2013 subprime crisis. The provisions have been copied to all intents and purposes unchanged into the CRD IV project14. EBA currently has a possibility to issue draft standards, but under the CRD IV project it will be given the obligation to do so. It has to develop draft binding standards on components of the authorisation process by 2015. Within the archaic texts and limited number of provisions copied into the CRD IV project, it is questionable whether this will be sufficient to upgrade the licensing requirements. The ECB may gain a key role in market access provisions in the Eurozone if the single supervisory mechanism proposed by the Commission as part of the banking union will go through as planned, both on licensing, cross-border access and mergers and takeovers. Literature – Padoa-Schioppa, Tommaso, Regulating Finance: Balancing Freedom and Risk, Oxford University Press, Oxford, 2004, chapter 2 – Cartwright, Peter, Risks and Returns of Prior Approval by Licensing: The Case of Banking, Journal of Banking Regulation, Vol. 7, 3-4, 2006, pages 298-309 – Haas, Ralph de, Multinational Banks and Credit Growth in Transition Economies, Amsterdam, 2005

12 Art. 2.2 Services Directive 2006/123/EC. Also see chapter 16.1. 13 Annex I RBD. 14 Art. 8-27 and 33-47 of the proposed CRD IV Directive of the CRD IV project. Art. 8 of the proposals sets out the timeline for EBA work, for which the option is currently contained in art. 6.2 and 6.3 RBD (as implemented by the Omnibus I Directive 2010/78/EU).

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5.2

License Requirements

Introduction The license requirements have been partially harmonised. If a bank fulfils the definition of a bank under the CRD15, a member state is only permitted to allow it to operate if the bank has a licence. The member state cannot give a licence or authorisation if not at least the conditions mentioned in the CRD are fulfilled16. Each member state can additionally set other requirements, but these have to be notified to the Commission. The collection of such information has not lead to further harmonisation. Each condition set out in the CRD needs to be fulfilled before the member state is allowed to give a licence. This minimum level of scrutiny provides depositor protection, but the level is primarily set to make it acceptable for member states to accept each other’s banks in their markets in the context of the single market goal. The licence allows access to the domestic market but also to the markets of other member states. The requirements and their mandatory assessment protects member states against badly set up foreign banks operating in their territory under the European freedoms of establishment and services; see chapter 5.3. Except for some grandfathering provisions, the only exception to this rule applies to banks that are affiliated to a central body; cooperatives or mutuals. These are exempted from some of the (initial and ongoing) licensing conditions, as long as the central body together with the affiliates comply17. The directive does not prescribe that – if the conditions are fulfilled – the supervisor is obliged to give the licence. The member state can also introduce additional conditions for undertakings established in their territory. The minimum conditions agreed at the EU level as the basis for subsequently obtaining the European passport include18: – a programme of activities (including a business plan); – a link between the activities and the member states where the licence is requested; – at least two persons of sufficiently good repute and with sufficient experience to effectively direct the business of the bank; – the suitability of shareholders and members with qualifying holdings; – the absence of close links with other natural or legal persons that prevent the effective exercise of supervisory functions; 15 See chapter 4.4. A bank is any undertaking (legal entity or not) whose business is to receive deposits or other repayable funds from the public and to grant credits for its own account. 16 Art. 6-22 RBD. Art. 4-10 RCAD is applicable only to non-bank investment firms; see chapter 19.2. 17 Art. 3 RBD. See chapter 17.6. 18 Art. 6-18 RBD, art. 3 Deposit Guarantee Directive 1994/19/EC, and art. 1.2, 11, 13, 14 and 16 Mifid 2004/39/EC. Also see e.g. recital 4 BCCI Directive 1995/26/EC on the minimum criteria regarding close links.

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– own funds commensurate to the expected business plus an initial capital in absolute terms of 5 million euro; – an internal organisation that will be able to handle the proposed business of the bank; – membership of the deposit insurance fund, and – if the bank has any investment activities – of the investor compensation fund. One of the circumstances in which a national supervisor has to be able to revoke a licence is that the conditions for giving the licence are no longer fulfilled19. As a result, every condition to obtain a licence needs to be fulfilled on an ongoing basis by the licensed bank (except for the demand for a business plan). Not every transgression will, however, lead to the licence being cancelled. Licence revocation would end the bank, and would heavily intervene in the (human) rights of the bank and of its owners, as well as potentially have a huge impact on (the local) economy, clients and employees. According to the CRD the licence can only be withdrawn in a limited number of prudential circumstances (possibly expanded by national discretion to include e.g. conduct of business circumstances). Additional safeguards follow from strong procedural and human rights safeguards on the right to property (see chapter 20.4 and 20.5). Most minor infractions of both licensing requirements and ongoing supervision requirements will need to be dealt with in a proportional manner by minor administrative sanctions (in order to ensure that the infraction does not continue). Only major infractions (a clear and continuing lack of own funds or long term lack of approved management) can lead to the licence being withdrawn. One of the conditions for granting a licence – the demand of a business plan – is exempted from the obligation to continuously fulfil it. The business plan only needs to be drafted as a separate document during the licensing process. In practice, the plans of the bank for the future will be part of an ongoing discussion between it and its supervisor. The CRD is silent on how thorough the information gathering (from the bank and other sources) and the assessment of all available information needs to be regarding the application for authorisation. It only prohibits the supervisor to grant the licence if the conditions are not fulfilled. This is a material, not a formal formulation. Assessing the licence application alone cannot lead to an assessment whether the conditions are fulfilled. The prohibition puts a direct obligation on the supervisor to perform a thorough investigation; see chapter 3.4, 3.5, 20, and 21.10. The recitals to the CRD reflect this, indicating that e.g. the programme of activities that a licence applicant has to submit is (only) the starting point for an investigation; see below. Like the area of qualifying holdings (e.g. key shareholders), this is one of the areas where the assessment is not only focused on information obtained from the bank and its prospective managers, but also from other domestic and foreign 19 Art. 17 RBD. See chapter 18 and 20.3.

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supervisors and public authorities who have data or impressions on e.g. the proposed persons who will effectively direct the business of the bank; see below and chapter 20.2 and 21.4. The focus of the TFEU and CRD is on the cross-border impact authorisation process if the new market entrant is part of the group of e.g. another bank (see chapter 5.3). The CRD leaves the access to the local market of purely local banks largely to the local supervisor. The main interest in the CRD is in the above-mentioned obligation to not grant authorisation if the CRD conditions are not fulfilled vis-à-vis other member states to whose markets the bank subsequently has access. The EU approach resembles a curious lack of attention for the licensing process at the worldwide level in the BCBS. Apart from the basic outline that a licence is necessary and that some checks needs to be done prior to issuing a license, there is no level playing field on licensing requirements and on the licensing process at the BCBS20. Perhaps this reflects the overreliance on consolidated supervision in the banking sector, to the detriment of solo legal entity supervision; see chapter 17. In the insurance sector, where the supervisory focus is and remains on the legal entity that performs the insurance contract21, both the EU legislation and the equivalent of the BCBS, the international association of insurance supervisors, contain more details on a level playing field in the (domestic) licensing process22. The IAIS has issued guidance on licensing contains advice. This is easily adaptable to the banking sector licensing requirements, such as on the content of the business plan or the suitability of executive board members and dominant shareholders. Some of the CRD-conditions are sufficiently precise and do not require further national details, qualifying them for ‘direct effect’ as described in chapter 3.5. As the licence has a protection goal, both for depositors and for EU member states that are expected to allow access to such banks in their territories, this would mean that a lax assessment could lead to liability. In practice, the competent authorities assess the application in good detail in as far as locally allocated resources and experience allow, and require each other to do so. Access to sources of information (e.g. intelligence files) and the number of people involved in checking the licence can, however, differ. As the licence is linked to a full passport across the EU, this is also an aspect of mutual trust. A lax assessment and subsequent passporting 20 Principles 4-7 and page 25-29 BCBS, Core Principles for Effective Banking Supervision, September 2012 require a license, that delineates what a bank can do, and is based on ‘an assessment’ of the ownership structure and governance (including suitability of the board and senior management), its plans, controls and management and its projected financial health. If the new bank is the subsidiary of another bank, its supervisor will need to agree too according to the BCBS. 21 See chapter 19.4 and e.g. IAIS, Principles on Group-wide Supervision, October 2008, page 3; IAIS, Insurance Concordat, December 1999, page 5-6. 22 See chapter 19.4, and IAIS, Supervisory Standard on Licensing, 1998/2007, www.iaisweb.org.

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may lead to liability vis-à-vis the (supervisor of the) host member state, but more likely to increased peer scrutiny and judgement that any public authority is eager to avoid. The minimum levels of supervision agreed are aimed to protect other member states that are forced to accept foreign banks under these rules. Even though the bank in question can be allowed not to fulfil the local non-harmonised goldplating requirements, it should at least really fulfil the commonly agreed minimum level once it is allowed to operate abroad. In addition to setting minimum requirements that have to be fulfilled, the CRD also obliges the supervisor to ignore several other aspects. Member states have to take into account that the EU requirements aim to ensure an open market for new entrants and for entrants from other member states. Member states are not allowed not require that there is an economic need for a new bank in the market (which competition provision may have direct effect, to the benefit of the applicant). Any bank that thinks it can make a living and can provide reasonable estimates to back that up shall be allowed to get a licence. Even if the member states or its existing banks deem the market sufficiently full and serviced, it has to grant the licence to a new application, and allow it to try to grab market share. Member states are prohibited to try to protect the status quo in the domestic banking sector, and limit competition to ensure the viability of existing banks23. A bank under the CRD definition needs a licence; and national definitions and requirements need to reflect this. A domestic licence can, however also be granted to an entity that is not a bank under the strict definition contained in the RBD. If licensed, such a non-CRDbank does become a bank to all intents and purposes domestically, though it cannot benefit from the European passport (see chapter 4.4 and 5.3). Programme of Operations The application for a banking licence has to be accompanied by a programme of operations. The RBD indicates that this should set out amongst others the types of business envisaged and the structural organisation of the bank24. The programme should include a full description of the activities of a bank, its internal organisation, its expected financial housekeeping and financial buffers (taking account of the expected profits and losses). Also, it should set out the persons responsible for key positions within the bank. Neither CEBS-EBA nor the BCBS have worked on this particular issue in the context of the licensing process. In the CEBS guidelines for passport notifications (cross-border market access), CEBS-EBA has set some minimum demands on the programme of opera-

23 Art. 8 RBD. Also see chapter 5.4 on mergers and acquisitions. 24 Art. 7 and recital 7 RBD.

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25 §32 CEBS-EBA Guidelines for Passport Notifications. Also see chapter 5.3. 26 IAIS, Supervisory Standard on Licensing, 1998/2007, www.iaisweb.org.

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organisation requirements, pillar 2 assessments, and regular conversations of the supervisors with the bank. A negative-scenario business plan may be required as a recovery plan, or ‘living will’; see chapter 18.3. Such an obligation will in due course require each bank to draw up plans on how it could best be wound down, if its business runs into fatal problems. The Commission has also proposed that the public authorities will be charged to start drawing up resolution plans in parallel with the preparations of the bank27. The requirement for the banks (and banking groups) to draft recovery plans would complement the current requirement to draft a business plan at the time of licensing. It may be wise to combine the two, making business plans mandatory with a focus on both what the bank wants to achieve and how its functions could be maintained if it fails. Such business plan should in that case be continuously demanded throughout the lifetime of the bank both for the positive strategic planning and for the negative recovery/resolution planning. Own Funds and Initial Capital Initial capital and own funds are separate concepts. Own funds is a concept used to define the (level of) financial buffers that have to be maintained in relation to the risk contained in the assets of the bank, under solvency ratio requirements that are part of ongoing supervision (see chapter 6.2 and 7). Initial capital is an absolute number (of 5 million euro) that has to be available within the bank at the beginning and at every moment during the lifetime of the bank. For a large banks, the initial capital regime is not a restrictive feature. To dip below the required initial capital level of 5 million euro would mean that a large bank is already non-compliant with the solvency ratio. For small banks, both financial buffer requirements can be a restrictive measurement. Initial capital needs to be at least 5 million euro at all times during the existence of the bank. The plans on how to maintain sufficient own funds and initial capital will be an important component of the programme of activities for true start-ups (i.e. banks that cannot benefit from the deeper pockets of an established parent financial institution). The own funds and initial capital of a bank need to be separate of the own funds and assets of its owner(s). As the own funds are the primary buffer for the risky business of a bank (see chapter 7), their availability and purpose needs to be clear. This condition is not fulfilled if the financial buffers of the bank cannot be distinguished from the own funds of others. This is generally not a problem if the bank is a legal entity28. Apart from the condition that

27 Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012, art. 5 and 9. Also see the previous Commission Working Document (for consultation and discussion), Technical Details of a Possible EU Framework for Bank Recovery and Resolution, 6 January 2011, page 19 on the recovery plans/living wills to be drafted by the bank, and page 31 on the resolution plans to be drafted by public authorities. 28 But see chapter 4 for banks which are not legal entities.

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there are separate own funds, the application itself does not directly demand a minimum level of such own funds. It is an aspect of ongoing supervision (not of the licensing process) that the own funds should never fall below the required initial capital nor the solvency ratio reflecting the actual business of the bank. The articles of the CRD setting out the required initial capital are dated. They have been copied largely unchanged from the second banking directive. At the time, capital in credit institutions was excessively low in various member states, and setting a high initial capital demand up front would have effectively closed the market to new entrants and at the same time have caused existing banks to operate below the threshold for such new entrants. As a result, the limits have been set bearing in mind rather simple, local institutions; and further reduced in strength by combining them with a number of exceptions. This enabled the EU to agree on a – still low but acceptable – standard for the whole of the industry. To this date, in several member states there are banks that make use of the exceptions to initial capital. This is deemed acceptable, as long as their activities are similarly limited. There are some incentives to upgrade, including the publication of the fact that the institution does not have EU-level initial capital. As this list is not a priority of the Commission (and rightly so in view of the CRD work and the 2007-2013 subprime crisis) it has become an obligation of EBA instead. The previous lack of publication may lead to some liability, if depositors pose that their bank was underfunded, and that they could not check this due to the failure to publish. The list never was a hot publicity item, however. As a peer pressure tool, it is doubtful that this has proven to be effective. It would have been more effective if this grandfathering clause were to be transferred into a sunset clause (ending its validity by a certain date). The initial capital requirements for banks are much higher than for other types of commercial enterprises (where many member states do not even require a minimum level of initial capital for legal entities). Partly this can be explained as a safety measure for creditors of the bank, partly it is inherent in the financial business that the risk of fluctuations in valuing its own financial assets is high, resulting in cyclical changes in available capital and the need for higher financial buffers. However, the latter reason cannot be deemed key, as the separate thresholds for the initial capital of non-bank investment firms are substantially lower than for banks29. General investment firms need to have an initial capital of 730.000 euro. There are substantial reductions in this threshold if the investment firms limits its activities to trading on behalf of others, without holding funds or securities for those others. For those who do none of these higher risk activities, the threshold can 29 Art. 4 to 10 RCAD and chapter 19.2.

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be as low as 50.000 euro for pure intermediaries, which increases to 125.000 if funds and or securities are sometimes held for clients. If the pure intermediary is also an insurance mediator, the initial capital can become as low as 25.000, provided some conditions are met, including the presence of insurance or guarantees for liability for professional negligence. See chapter 19 for prudential supervision on these other types of financial institutions. Operating and Having Its Head Office and Seat in the Member States Where the Application Is Made. Location Chosen to Avoid Stricter Standards According to the RBD, the undertaking should apply for a licence where it has its registered office (seat)30. Member states should require that the head office is always situated in the member states where it has its registered office, and that it actually operates there. For legal entities, the bank should have its registered office and licence in the member states where it has its head office, with the recitals – but not the binding article itself – also requiring activities in the home member state. The RBD requirement is in practice the same if the bank is not a legal entity, and thus does not have a ‘seat’. Such a bank should have its head office where it has activities, and can only get its authorisation from the member state where it has both. The location of actual management or of activities in another member state (or even a third country) is thus an indicator not to grant a licence. The recitals provide background for the requirement. They state that it is unacceptable if a bank has chosen to apply for a banking licence in one member state with the intention to evade the stricter standards in another member state. Even after the rounds of improvements in the harmonised provisions of the CRD since the BCCI debacle, such differences in domestic law and application are still likely on non-harmonised or ambiguous areas in the CRD (such as liquidity requirements or supervisory practices), as well as in the area of goldplating on top of the minimum harmonisation provisions. The recitals indicate that the supervisor should not issue the licence and – if already given – should withdraw it. This is more an ideological than a practical part of the recitals, though it serves as background for the provision that head office and seat should be in the same member state. It was introduced in response to the failure of the licensing and supervisory structures in the BCCI case, where the licence was granted in Luxembourg, but the main activities were carried out in the UK. Neither of the supervisors wanted to take full responsibility, and the bankruptcy of BCCI surprised both.

30 Recital 10 and art. 11.2 RBD, introduced via the BCCI Directive 1995/26. The ‘seat’ of the company is also relevant for the determination of the competent supervisor in e.g. the transparency directive and the prospectus directive, as well as for the regulated market under Mifid.

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The assessment whether the applicant has as a goal to evade stricter standards could amongst others be based31 on: – the content of the activities programmes; – the geographical distribution of activities; – the activities actually carried on. The assessment will likely be scrutinised in the context of the protection offered by the freedom of establishment. Both the licensing supervisor and the supervisor in the country that would have provided the ‘harsher’ supervision will need to provide objective reasons to object to such a licence application. The margin to prove such escape intention has been reduced by the ever further and ongoing harmonisation of the content of supervision in the EU; see chapter 3.5. Though the text of the recital is clear, the incentives are not. The RBD does not contain a binding obligation on the authority that is examining the authorisation request. It only encourages supervisors to act along these lines. It is unusual for a member state or its authority to accept publicly as a starting point that its standards are lower than those of another member state within the leeway granted by minimum harmonisation character of the CRD, which conclusion is the basis for denying the application. Second, if the bank is important, being the home supervisor adds to the status of the responsible supervisor. Third, there is a clear financial benefit for its local economy to be attractive to financial undertakings. Fourth, the authorities of other member states, especially less influential member states, are rarely willing to create a political incident by accusing another of supervising a bank which should be supervised by them unless there are overwhelming reasons to protest. Fifth, the Court has since the introduction of this RBD provision ruled consistently in the area of company law that the choice to incorporate in any member state is open to any EU citizen, and can be based on lower legal requirements in another member state if that state is willing to accept such an incorporation (even if there is no other link to that member state). The practical use of the recital is therefore limited. The introduction of the requirement to have head office and seat in the same member state was, however, not only based on this recital, but also on practical supervisory issues. It has several beneficial effects: – it provides an argument to deny a licence to less than kosher individuals or activities, where there is no hard evidence that the bank might be used for illegal purposes; – it hampers the transfer of the seat to another member state with the resulting transfer of supervision, loss of knowledge and transfer of fiscal responsibility for state-aid and 31 See recital 10 and art. 24 RBD, as introduced via the BCCI Directive 1995/26/EC.

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deposit insurance, if the bulk of the activities are in the member state in which it used to have its seat (however this appears to be in direct conflict with the intent of the freedom of establishment, see the case law on the freedom of establishment for subsidiaries and on the transfer of seats mentioned below); – it clarifies that – if a licence was granted (and not withdrawn) – the licensing supervisor is responsible for the supervision, regardless of the location of the activities, and the local deposit guarantee scheme is responsible for the (basic) deposit protection, even if the bulk of the deposits are attracted elsewhere. If it did not want to accept this responsibility, the member state should not have granted the licence (and should not have cooperated in the use of the European passport). Whether this directive requirement would stand up in view of the case law on the free market is debatable if it were to be brought to the Court of Justice. The Court has differentiated its approach between cases where formal company law requirements hinder crossborder operations of companies, and rules concerning the carrying on of certain trades, professions or businesses32. For formal company law requirements the Court has ruled that a company or natural person does not ‘abuse’ the freedom of establishment by the simple fact that it chooses to set up the company in the member state where the company law rules are the least restrictive on e.g. initial capital, without having any business there, but solely for the purpose of subsequently pursuing business under the right of establishment in his own or another member state via a branch. The decision to accept that a company is set up under its flag is, however, left to the member state of incorporation. It is free to decide whether all or only one of the three connecting threads mentioned in the RBD are sufficient to allow a company to incorporate under its company laws. The terminology in the CRD has not been updated since to reflect the changes in Court case law or in the company law regulations on the European companies, but they appear to cover identical concepts (except for one). The Court mentions the registered office where the RBD uses statutory seat, it uses central administration where the RBD uses head office (but these may be synonyms), and such concepts can potentially be interpreted in the same manner. However, head office is as yet a undefined concept in the RBD. Member states can also attach importance to e.g. the location where shareholders meetings are held, where board meetings are held, where the executives live in addition to the equally undefined central administration concept. A clearer difference in approach exists for the third connecting factor, where the Court refers 32 Centros, Court of Justice 9 March 1999, Case C-212/97; Überseering/NCC, Court of Justice 5 November 2002, Case C-208/00; and Inspire Art, Court of Justice 30 September 2003, Case C-167/01. Also see M.J. Kroeze & H.M. Vletter-van Dort, ‘History and Future of Uniform Company Law in Europe’, European Company Law, Vol. 5, No. 3, 2008.

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to the principal place of business, which is not a requirement for legal entities applying for a banking licence. The RBD only requires for those persons or other ventures that are not legal entities that the bank actually carries on its business in the member state of application, and does not require those activities to be its principal activities. Unlike for non-banks, in some way banks have to align head office and either its seat if it is a legal entity and at least some activities if it is not, where non-banks – depending on national company law – only have to comply with some of these to be able to establish themselves under the flag of that member state33. Assuming (see chapter 4.4) that most banks are legal entities, they will operate under a similar requirement as the European companies (undertakings that do not operate under domestic company law but under the European flag). These are also required to keep their registered office and real seat in the same member state. If they change one of these, they have to change the other too, similar to banks34. On a case-by-case basis member states can prevent nationals from attempting improperly to circumvent their national legislation, and to prevent anyone from improperly or fraudulently taking advantage of provisions of community law. If so, they still will need to take account on the basis of objective evidence of abuse or fraudulent conduct in line with the objectives pursued, before they can actually deny them the benefit of the TEU provisions. As to rules governing businesses, member states have more leeway to limit the fundamental freedoms in a standardised manner if consistent with the ‘general good’ concept (see chapter 3.5). This limitation appears to apply also to directives, as directives can only be issued on issues where allowed by the treaty (also see chapter 3.4). However, a host member state cannot go so far as to e.g. deny legal stature to such an incoming branch if the home member state has allowed it to use its legal stature abroad, even if it has no activities in its home member state. Any other result would negate the freedom of establishment according to the Court. The Court did allow for the possibility of some restrictions, but those would have to fulfil the general good criteria. The command to have the head office and actual activities in the same member state that gives the licence and thus performs home supervision is appropriate for truly new banks. This is not the case, however, for subsidiaries of existing banks that are already based in a member state. There, the choice between a branch and a subsidiary for the parent bank are equal under the TFEU freedom of establishment. If the home member state is willing

33 Art. 11.2 RBD and Cartesio, Court of Justice 16 December 2008, Case C-210/06. 34 See Cartesio, Court of Justice 16 December 2008, Case C-210/06, and art. 7-9 European Company (SE) Regulation 2157/2001.

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and able to take upon itself the supervisory responsibility and deposit insurance liability, it does not appear in line with the limitations allowed under the treaty to differentiate between a branch and setting up a subsidiary in the same member state as the parent, which does not develop business in the home member state but only in the host member state. In both cases, the risk to depositors and of faulty supervision is equal, and restrictions imposed by the directive and/or the host member state of the branch or subsidiary appear not to comply with the criteria set out in case law. If this reasoning is taken further, in light of the failure of Landsbanki and its Icesave branches in the United Kingdom and the Netherlands during the 2007-2013 subprime crisis, the link between licensing/supervision/deposit insurance arguably also brings with it that a branch can be denied access or asked to transform into a subsidiary – with the accompanying added local supervision – if the home member state is not willing or capable to both spend enough resources on the branch, commensurate with its importance, or its deposit guarantee scheme is not willing or capable to provide the protection that has to be available for branch depositors under the deposit guarantee directive. A separate issue arises for third country banks operating in the EU, and for EU institutions that fall under the definition of a bank (see chapter 4.4) but do not have activities in the EU (e.g. an undertaking based in a member state, which only has the business of lending and borrowing in a country outside the EU). This raises territory issues. The subsidiaries of a third country bank in the EU will need to fulfil the residence requirement. If they have an incoming branch, there is a separate arrangement in the CRD. It allows such third country branches to operate in a specific member state if the local EU supervisor agrees (in spite of not having a head office in the EU). An EU undertaking operated by a third country bank that has as its business banking in any country in the EU or elsewhere does fall within the CRD definition. In principle, it would thus require a licence, but would not be able to get it as its main operations would be in the third country. Member states can skirt away from this responsibility if they adhere importance to a distinction between CRD protections. If they read ‘EU public’ where the CRD has put ‘public’ in the definition of banks, they can exclude third country public from the protection of the CRD and their local supervision laws. The CRD does not offer a basis for this limited interpretation, but also not a clear proof that it does protect third country ‘public’. For example, the UCITS directive uses the same ‘public’ terminology, and offers protection to all clients regardless where they are based, but the directive contains an exemption if only third country public is targeted35. No such provision exists in the CRD, and there is no case law of the Court of

35 E.g. the UCITS Directive explicitly states that if only third country public is targeted, the directive need not be applied. Investor protection against EU based entities is thus only given if the third country has such laws. See chapter 19.5.

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Justice that provides clarity. If they choose not to extend protection from undertakings operating under their flag to third country citizens, they may consider that the CRD does not apply. In my opinion, third country citizens can reasonably interpret the CRD as also providing protection to them, amongst others in light of the UCITS regime. Such an undertaking should not be allowed to operate from the EU, and should instead incorporate in the third country and be supervised as a bank there. The BCCI experience also applies here, with damages to the reputation of EU banking supervision if such a bank would fail. At Least Two Persons of Sufficiently Good Repute and With Sufficient Experience To Effectively Direct the Business of the Bank The directive requires adhesion to the four-eyes principle. This means that one person cannot unilaterally and without checks and balances determine the course taken by the bank, and that if one of the directors leaves the bank, there is still continuity (even though there is at that time a – immediately to be rectified – lack of checks and balances). It also requires these two or more persons who effectively direct the business of the bank to be of some quality. The CRD does not set high standards for such quality. These executives need to have ‘sufficiently’ good repute and ‘sufficient’ expertise. These criteria are also known as ‘fit and proper’ or ‘fitness and propriety’ or ‘fitness and probity’ or ‘suitability’36. The persons who effectively direct the business need to be able to be in control of the (likely complex) business of the bank and to make it both profitable and safe. At the same time, they should be trustworthy for the counterparties of the bank, and to its the supervisor. The supervisor needs to be able to rely on and trust their statements. The CRD does not provide a clear benchmark on when an executive is ‘sufficiently’ experienced and trustworthy37. CEBS and its predecessors had not worked in this area, but CEBS/EBA has been obliged by the CRD III directive to ensure that there are guidelines on the assessment of the suitability of such persons. EBA has since published guidelines on the suitability

36 See e.g. BCBS, Principles for Enhancing Corporate Governance, October 2010 and the 2012 Basel Core Principles. The same criterion is often used to check that key shareholders will be a good influence. The BCBS wants to expand the check on key influencers to both board members and senior managers, but there is no common definition on who such persons are. See below and chapter 13.2. 37 Until recently, the only guidance available stemmed from conduct of business directives, as discussed by A. Buijze, ‘Subjecting Executives in the Financial Sector to Reliability Scrutiny’, Utrecht Law Review, Vol. 4, No. 3, 2008. She notes art. 4.2 Insurance Mediation Directive 2002/92/EC, and a publication by FESCO, the predecessor of CESR/ESMA after consulting amongst others the groupe de contact. European standards on fitness and propriety to provide investment services, 99-Fesco-A, February 1999. Other publications supervisors and/or domestic regulators may have adhered importance to are e.g. chapter 2-4 and annex 4 and 5 of D. Walker, A Review of Corporate Governance in UK Banks and Other Financial Industry Entities – Final Recommendations, 26 November 2009 (the Walker Review) www.hmtreasury.gov.uk. Also see chapter 13.2.

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(good repute and experience) of managers at banks38. These provide a generic set of criteria on the suitability of individual persons as well as of the suitability of persons in the context of the qualifications and expertise available within the board. The Basel core principles refer to an evaluation of expertise and integrity, with expertise commensurate to the intended activities of the bank, and an absence of a record of criminal activities or adverse regulatory judgments of a type that would make the person unfit to have an important position in a bank39. The requirement of fit and proper is common also in the EU rules on other types of financial ventures, which could help courts and supervisors to interpret this requirement and the new guidelines. Most directives do not contain a definition either. The insurance mediation directive provides some minimum criteria for the term it uses. Both the management structure and any staff directly involved in insurance mediation need a good repute (without the prefix ‘sufficiently’). At a minimum, their good repute includes a clean police record on serious issues of property or financial crimes, and they should not have been bankrupt (unless fully rehabilitated). Whether being on the board of a failed bank is a pro or con is not determined by the directive. Absent national guidance or laws on such issues, it remains an evaluation by individual supervisors on the contribution of the person tested for suitability in his or her previous work and other relevant settings (but with the general scope set by the EBA guidelines, from which they can deviate under a comply or explain regime). It may be that a person is suitable in a nine-member board of a big bank because he or she adds specific expertise and good general traits on e.g. ethics, while that person would be unsuitable for a two-person board for a small bank because he or she lacks generalist skills needed for managing an organisation or for the business areas that organisation is active in (see below). Good repute, trustworthiness, is likely to be a yes/no issue. Someone is deemed trustworthy as a financial manager and counterparty or he is not. Issues that signify good repute can be broad, but for the purpose of this requirement they should be geared towards financial trustworthiness. By way of an example, driving through a red light is of course not good, but not likely to be determinative. Failure to subsequently stop when halted by the police is determinative as obedience to appropriate public authorities is part of being financial trustworthy. A murder out of passion may not be relevant for financial trustworthiness, but robbery and white-collar crimes such as fraud prove that a person cannot be trusted with the money and assets of others. Though the alternative phrasing of ‘fit and proper’ is linked to the person himself, the good repute terminology leaves open the possibility to 38 Art. 11.1 RBD, as amended by art. 1.2 CRD III Directive 2010/76/EC. EBA, Guidelines on the Assessment of the Suitability of Members of the Management Body and Key Function Holders, EBA/GL/2012/06, 22 November 2012. 39 Principles Methodology BCBS, Core Principles for Effective Banking Supervision, September 2012, principle 5 and page 26.

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include a ‘guilty by association’ test. For example, persons working with mobsters, even though they themselves have not been accused of specific crimes, could have their reputation suffer. Good repute relates both to crimes, but also to non-criminal behaviour that indicate mismanagement or poor ethics. The mismanagement issue rolls over into experience issue, but e.g. a poor role played in a bankruptcy, or in helping others sell badly designed products can play a role in ‘good repute’ too. The experience required under the RBD is relative to the business. The schooling, previous experience and thinking level will need to be good enough for the size and complexity of the specific organisation that has to be managed and the specific products it sells or buys. The RBD provides little input on the content of the required experience and how it should be assessed in relation to the business, leaving scope for national divergences. The BCBS has indicated that the type of experience or expertise of the board as a whole (executives and non-executives, but focusing on the oversight function) should have – or should aim to obtain – include finance, accounting, lending, bank operations and payment systems, strategic planning, communications, governance, risk management, internal controls, bank regulation, auditing and compliance, local/regional/global economic/market forces, and the legal and regulatory environment40. Both components of fit and proper apply on an ongoing basis. The requirement of sufficient experience includes ongoing attention to the required expertise by the supervisor if the business of the bank changes, deviating from e.g. the business plan, or significantly changing in size and complexity since the person was deemed to comply with this requirement when appointed. A large takeover or substantial growth in (additional) financial activities, number of employees or countries can lead to the need for a formal reassessment, as a sitting person may not or no longer have the necessary expertise in relation to the (expanded or changed) business of the bank. Trustworthiness is more of an absolute, but it will nevertheless need to be reassessed if new facts or allegations arise that give rise to doubt (e.g. inconsistent reports to supervisors, incomplete or inaccurate tax returns or cost invoicing, or new convictions, even when they are still in the appeals process). The text of the RBD leaves unclear whether the requirement applies to each director individually, or whether it applies to the collective. As the ‘fit and proper’ is geared towards protection of counterparties and of financial stability, the requirement in principle has to be interpreted broadly. Not only a minimum number of two persons need to be trustworthy

40 BCBS, Principles for Enhancing Corporate Governance, October 2010, §35-37. The BCBS points out that an induction and ongoing education will be crucial, but also that some of these aspects of required expertise may also be accessed by the board in another manner.

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and provide relevant experience, but all the persons who effectively direct the business have to fulfil those standards. That still leaves unclear whether some standards can be met on a collective basis. On the integrity issue, the requirement is likely to indicate that each individual person has to have high standards of integrity on an individual basis. Lack of integrity in one makes the bank automatically untrustworthy. It would negate the purpose if in a four member team two fulfil the ‘good repute’ standards and the other two are not trustworthy. The need for an individual approach is less clear for the knowledge/experience criterion. Should each person be able to handle the bank in full if the other person(s) is no longer available for any reason, or should the collective be able to deal with the bank and provide for checks and balances within the board, e.g. to avoid undue political influence or mono-cultures41? In the latter case each person ‘only’ needs to be able to act as temporary caretaker and discussant for areas normally not under his competence, in the first case each needs to be able to have the type of combined skillsets to manage all areas of business of large and complex banks (a skillset-combination that is unlikely to exist). With the increase of the size and complexity of banks and especially banking groups this question has gained importance. The BCBS indicates that there should be both appropriate skillsets at the individual level, and that collectively the board should be able to cover all the material financial activities that the bank intends to pursue42. This seems a balanced approach, especially for large banks that will have an equally larger group of persons ‘who effectively direct’ the business of the bank. For an individual banking entity lower down in the group-structure, or a smaller bank that is not part of any banking group, where only the minimum number of persons is available, it will be both more easy for both persons to have the required expertise to manage that bank, and more likely needed if one of the two is no longer available (without a wider buffer of available caretakers within the group). A question can be whether the RBD test applies to the executive directors only, or also to non-executive directors, perhaps also to senior management, and perhaps also to e.g. very dominant shareholders that do not have a seat at the board, but effectively set the tone and direction. As the phrasing ‘effectively direct the business’ is material, not formal, it will depend on the actual role of these persons. This means that the number of people that need to be assessed will – for larger banks – normally be much higher than two, and is likely to include e.g. an active non-executive chair, and dominant members of senior management, who effectively direct the business even if not formally appointed to a high corporate rank43. On the other hand the terminology does not appear to include ‘normal’ 41 For the latter issue see chapter 4.5, and BCBS, Principles for Enhancing Corporate Governance, October 2010, §71. 42 BCBS, Principles for Enhancing Corporate Governance, October 2010, page 10. 43 BCBS, Core Principles Methodology, October 2006, page 11, 12, and 33 refers to mandatory screening of directors as well as senior management, and that the board collectively must have sound knowledge of each

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non-executives who help discuss the direction of the bank, but in a sounding board, assessment/approval and remuneration modus. Especially if non-executives have been allocated little formal power under local company laws, this is not ‘effectively directing’, but providing a balance to the executives who set out the policy and execute it. This balancing role is not explicitly required in the CRD licensing requirements, leaving room for member states to require non-executives at banks, and to determine how strong or weak the role of non-executives should be within its company laws or specifically at bank-companies. The new remuneration requirements introduced in 2011 have, however, made this less clear. They imply that a ‘significant’ bank – and probably also an insignificant bank – has to have non-executives, in addition to executive board members. This could until January 2011 not be deduced from the CRD, at least not as a licensing requirements on all banks. Since that date, the remuneration rules also state that non-executives are part of the ‘management body’ and link this concept subsequently of the ‘persons who effectively direct the business of the bank’44. For corporate/internal governance reasons (1) it can be applauded that non-executives are needed at any bank, especially if it is a large bank, (2) it can be questioned why in that case it is not explicitly referenced in the licensing requirements, and (3) it can be questioned question whether 2 persons are enough if it includes both executive and non-executive board members (as good checks and balances should include a minimum of 2 executives and at least 2 or 3 non-executives to balance each other and to be able to provide continuity of each function). The change via an annex of the RBD that may imply that there only needs to be one executive and one non-executive seems more accidental than well considered, and may be redressed (hopefully by making it explicit) in future corporate governance45 and improved licensing obligations. The BCBS has proposed to expand the test for fitness and propriety to board members (executive and non-executive), senior managers, and owners of the whole or a significant portion of the bank (see below under ‘qualifying holdings’). This requirement has not (yet) been copied explicitly into the RBD. It would be a good idea if it was. The mergers and acquisitions rules of the RBD now prohibit such a check beyond a ‘reputation’ check of prospective buyers of the bank in a takeover situation, unless the individual falls under the ‘effectively direct’ terminology at the bank itself46.

type of activity that the bank wants to engage in, including an understanding of the risks associated of each such type of activity. The quality of board and management has to be considered by the supervisor on an ongoing basis. These principles were continued in the updated version: BCBS, Core Principles for Effective Banking Supervision, September 2012, for instance principle 5 and 15, and page 25 and 42. 44 See chapter 13.2 on the various terms used for management in supervisory requirements, and 13.3 on the remuneration requirements. Art. 11 and annex V §23.f and 24 RBD. 45 See chapter 13 and e.g. BCBS, Principles for Enhancing Corporate Governance, October 2010. 46 See chapter 5.4.

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EBA guidelines provide a common interpretation on some of the above questions; effective from 22 May 2013. They are non-binding, and leave scope for deviations, but address key issues of potential deviations per member state47. The guidelines indicate48: – that the assessment will be after the appointment (but that some members require prior approval); – a primary responsibility for the bank to have a good policy and process on suitability testing, as well as to have its management comply with the suitability demands, which will be taken into account in the subsequent testing by the supervisors; – the requirement applies on an ongoing basis (and events can lead to re-assessments); – EBA recommends to check all members of the management body (in line with the CRD IV project, see below), but also that the bank screens key function holders (defined as persons responsible for the day-to-day management of the bank under the overall responsibility of the management body) with discretionary checks by the supervisor; – all the tested persons need good repute, regardless of the business of the bank, but a person can only be disapproved if there is evidence or reasonable doubt about the good repute. Particular weight is attached to dishonesty offences, and offences under financial or bankruptcy laws; – experience requirements can be differentiated on the position of the bank, and includes educational and practical aspects, skills and knowledge, taking into account the overall composition of the management; – the guidelines specify the information needed for an assessment, but defer to local laws on the other screening methods, including interviews. It is forbidden to demand that one or more of the persons that effectively direct the business of the bank are resident in the country where the bank has applied for (or has obtained) a licence. The head office has to be in the country (see above), but that does not require residence of the individual executives. The EFTA Court (the Court judging the treaty fundamental freedoms in the EEA context) has ruled49 that this is deemed a restriction of the freedom of establishment. It is likely that the Court of Justice will follow the reasoning of its sister-court. It has also explicitly ruled that the good reputation of the local banking sector, and the facilitation of such a residence requirement of banking supervision and enforcement are not sufficiently good reasons to justify a general good exemption for such a local requirement.

47 EBA Guidelines are reinforced by the comply or explain regime of art. 16 EBA Regulation 1093/2010. 48 EBA, Guidelines on the Assessment of the Suitability of Members of the Management Body and Key Function Holders, EBA/GL/2012/06, 22 November 2012. 49 EFTA Surveillance Authority/Liechtenstein, EFTA Court 1 July 2005, Case E-8/04.

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Qualifying Holdings If a person can exert relevant influence on a bank, this makes him of interest to the supervisor even if they do not ‘effectively direct’ its business. In the context of the licensing conditions, such people have to be identified. The conditions differentiate two situations, where the influence is the result of e.g. a capital interest such as a shareholder or member (so-called ‘qualifying holdings’), and where ‘other persons have close links’. For holders of qualifying holdings to become relevant, they need to have influence. The threshold chosen is if the holding is larger than 10%, or allows for equivalent influence50. The assessment of these holdings has been substantially revisited as a result of the mergers and acquisitions directive; see chapter 2. The scrutiny of qualifying holdings is relevant both as a licensing condition, and for market access through a takeover. In the latter context, after an incident involving the role of the Italian supervisor in the takeover of Antonveneta by ABN Amro, the Commission concluded that one of the reasons for the low number of takeovers in the financial sector were the existing procedures and criteria for supervisory approval. These were adapted by the EU, and further filled in by CEBS-EBA. See for the process and the content of the assessment chapter 5.4. Apart from the assessment in the context of a licence (and on an ongoing basis), the CRD also puts obligations on the holder of a qualifying holding to identify himself. It allows the supervisor to intervene if the influence is deemed undesirable. The obligation to step forth as a holder of a qualifying holding also overlaps to some extent for banks of which the shares are traded on a stock exchange with the requirements of the Transparency directive to notify the institution that certain thresholds in the percentage of the total shares placed have been crossed. Some non-bank parents of a bank can be captured in the consolidated supervision of a bank. If so, several requirements apply not only to the financial information on the bank and its subsidiaries, but also on the financial information of the parent and its subsidiaries, as set out in chapter 17. Though the parent in such a group is not supervised on a solobasis, the CRD does require it to have sufficient good standing to be allowed to influence its subsidiary. Apart from the scrutiny under the market access processes (the licensing procedure and under the M&A process described in chapter 5.4), if the parent is captured in the consolidation the executive board members of the parent need to be of sufficiently good repute and have sufficient experience to perform those duties. This is a similar requirement as on the executive directors of the bank itself. If the parent is a regulated entity (e.g. an insurer or another bank) this condition is already dealt with in its own 50 Art. 4.11 and art. 19-21 RBD.

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licensing requirements, though the required skill for dealing with subsidiary-banks has to have been taken into account. If the parent is not a regulated entity, the requirement is separately introduced in the RBD and in the financial conglomerates directive, depending on the type of parent that is consolidated51. The licensing condition concerns itself with holdings in a bank. There are also requirements for qualifying holdings held by a bank in other entities. If a bank has subsidiaries or qualifying holdings in the capital of another financial entity, these are assets of the bank, and relevant for the assessment of e.g. required capital both on a solo basis and a consolidated basis. See chapter 7 on the treatment of certain types of qualifying holdings such as participations in other regulated entities in the definition of capital. Plans to expand can also be relevant for the pillar 2 assessment of the group, and for the role of the home supervisor in the use of the European passport or in the mergers and acquisitions approval process. A separate situation is the ‘close link’ with other persons. Even if someone does not effectively direct the business of the bank, or has the type of influence that leads to the assessment of a suitability of the holder of a qualifying interest, he may still be associated with the bank. This can e.g. be the result of joint ventures, shareholders’ agreements, cooperation or agent agreements, or as someone who can financially or in another way influence persons with qualifying holdings or executive positions. For certain of these, the supervisor has to assess whether the aspiring bank has any such closely linked persons. It concerns situations where natural or legal persons are linked to the bank via a participation of 20% of ownership or equivalent control, full control, or are all controlled by the same third party. It is a very vague term, allowing the supervisor leeway to deny or withdraw a licence if it sees links of the workforce or the business to organized crime or to third country dictatorships, or even only if key subsidiaries will be jointly controlled by the bank and a person based in a noncooperating third country. The supervisor can deny the licence if the link prevents effective supervision of the bank52. For persons based in the EU, the assessment of the licensing authority is limited to the person himself. If it concerns a person based in a third country, or with relevant third country laws governing such a person, the licensing authority can in addition take into account whether the practical and legal circumstances in that third country prevent effective supervision. 51 See art. 13 Financial Conglomerates Directive and art. 135 RBD, as amended as per mid 2013 by art. 3.21 FCD II Directive 2011/89/EU. The requirement does not apply to mixed-activity holding companies, as they are not included in consolidated supervision. As they are not supervised, even indirectly, there is no need to guarantee that information coming from them is trustworthy. However, to ensure that the influence they exercise is benign, it could have been considered to include a separate requirement on their reputation. This aspect can, however, be dealt with via the market access requirements on the bank under the suitability check on shareholders or members. 52 Art. 4.46 and 12.3 RBD, as introduced via BCCI Directive 1995/26/EC.

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Internal Governance For a description of the internal governance requirements see chapter 13.353. These requirements have to be met on the basis of the intended governance structure when the application is submitted, and has to be met in full when the bank starts to make use of the licence once obtained. If the bank has any investment activities or provides any investment services, the Mifid internal organisation requirements are applicable; see chapter 13.454. Membership of Guarantee Funds The deposit guarantee funds and investor compensation funds provide a fall-back for depositors and investors that have given money or financial instruments for safekeeping to banks. Up to certain limits, these funds insure the value of such money or financial instruments in case they are not given back if the bank goes bankrupt. Under Mifid, any bank that performs investment activities or investment services cannot be given a licence unless it is a member of an investor compensation scheme. The link between the authorisation process and membership of a deposit guarantee scheme is less clear cut, but the deposit guarantee directive demands that every licensed bank shall be part of a deposit guarantee scheme. Effectively this leads to the same conclusion that a licence and membership of the deposit guarantee fund are linked, and one cannot be given if the other is not given simultaneously. See chapter 1855. Once a Licence, Always a Licence The CRD does not appear to grant an applicant that fulfils European and national criteria a right to such a licence. The EU-criteria are not set for the protection of applicants, but for the protection of depositors and financial stability. Certain grounds for refusal are not allowed (e.g. economic necessity), a good procedure must be followed, but there is no general right to a licence given to an applicant. Any reason for refusal, however, has to be consistently used on applicants, both from the member state itself and (non-bank) applicants from other member states. For (subsidiaries of) banks in another member state, the TFEU freedom of establishment applies, so a refusal can only be based on general good criteria that exceed (and are not covered by) the CRD already; see chapter 3.4, 3.5 and 5.3. Though the licensing process does not intend to protect the applicant, the licence itself does once it is granted. The CRD and the EU treaties severely restrict the circumstances under which a licence can be withdrawn due to procedural and human rights (right to 53 Art. 7, 22 and Annex I RBD. Other references to internal governance in the RBD (e.g. in art. 123 and 124 RBD) are not directly applicable in the licensing process, but will need to be fulfilled on a continuous basis from the start of operations of the newly licensed bank. 54 Art. 1.2 13, 14, 16 Mifid. 55 Art. 1.2, 11, 16 Mifid and art. 3 Deposit Guarantee Directive 1994/19/EC.

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property) concerns; see chapter 20. Once the licensing authority (often the supervisory authority, sometimes the ministry of finance or a separate domestic authority) has granted the licence, it has value for the bank and both it and its customers and other counterparties count on the continued existence of that licence. One of the reasons a licence can be withdrawn is non-compliance with the licensing conditions, others include non-compliance with own funds requirements or cannot be relied upon to fulfil its obligations to creditors. This will need to be applied in a proportional manner. Most of the categories under which a licence can be withdrawn actually lead to lower key corrective measures by the supervisor during its ongoing supervision, e.g. by requiring a non-trustworthy executive board member to be replaced. The CRD is silent on the transferability of a licence to another entity (by inheritance, via a merger or via a sale by the old banking entity or its liquidator). It is equally silent on such transfer to a foreign entity, or what happens to the licence if the bank chooses to exercise the company law rights to transfer its seat to another member state56. Whether this is possible will be up to local administrative and civil law. If such transference to another entity – or transfer of the seat – is allowed under domestic law(s), the supervisor will need to verify in the context of its ongoing supervision tasks that all the conditions that continuously apply as well as ongoing supervision requirements are and will be fulfilled by the new holder of the licence, with likely key aspects being any new holders of qualifying holdings or new persons who effectively direct the business of the bank. Specific attention will also need to paid to the question whether the previous holder of the licence still fulfils the definition of a bank, and will thus require a licence and/or supervision; also see chapter 18.3 and 18.6. As is shown in chapter 5.4, the assumption in the CRD is that a merger or acquisition does not negate the licence of the entities involved or of the new subsidiary bank, but does necessitate an assessment of the new holder of a qualifying holding. Whether ‘once a licence, always a licence’ is a good idea is something else. The requirements continuously apply to the bank, but are unlikely to be assessed regularly. A true re-assessment of whether a bank fulfils the licensing requirements is rare, mostly when there is a change in ownership (see chapter5.4), or when the bank is in deep trouble already. It might be considered to have a re-assessment biannually, to obtain a specific point in time when it’s strategy and the fit between that strategy and the funds/people/outlook/control is for-

56 See the case law mentioned under the requirement to have the seat and head office in the same member state above. If that requirement is indeed valid in light of the freedom of establishment, the bank will simultaneously also have to transfer its Head Office (and will need to have activities in the other country). It will also need to show that it is not transferring its seat to escape harsher supervision; see also above.

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– in a major improvement the suitability test is transferred from the (two) persons who effectively direct the business to the full management body62. All such should be suitable, or in the antique language that continues to be used: have sufficient good repute and sufficient knowledge, skills and experience on an ongoing basis; also see chapter 13.2; – if there are no qualifying holdings, the obligation to give information on shareholders on members with such holdings is replaced by a new obligation to provide the names and amounts of the holdings of the 20 largest shareholders or members, who will be checked instead of the (lacking) qualifying holdings63; – the reasons for which the licence must be able to be withdrawn is expanded by a list of non-compliance with ongoing supervision requirements, though also those would need to be responded to in a proportional manner; – the issues that apply on an ongoing basis have been more clearly earmarked also in the parts of the CRD IV project that relate to such ongoing supervision, instead of being deducted from the market access/licence withdrawal context64. The authorisation process would remain based on the freedom of establishment legal basis and thus issued in a directive. Member states will continue to translate the provisions into national laws, with options to goldplate the definition and the criteria. EBA will also gain a role in the information exchange on suitability from the start of 2014, by keeping a central database on administrative sanctions65. Under the ‘banking union’ proposals of the Commission, the authorisation process would be allocated to the ECB for all new banks that apply for a licence in one of the participating member states (Eurozone plus voluntary members of the banking union) wants to start activities in another member state66. As the licensing laws would remain national (even under the CRD IV project), the remaining stub of a national supervisor would check and

62

63 64 65 66

licensing regime, but contains only the rudimentary requirement to describe the structure previously contained in art. 7 RBD. Art. 13 and art. 91 CRD IV Directive; compared with art. 11 RBD that referred to the effectively directing persons to be tested. The content of the requirement will now become part of the ongoing requirements with a cross-reference in the licensing requirements; in substance that does not change the ongoing and initial requirement. On the benefit of having suitably knowledgeable and experienced non-executives also see D. Ladipo & S. Nestor, Bank Boards and the Financial Crisis, A Corporate Governance Study of the 25 Largest European Banks, London, May 2009. Art. 14.1 and 14.2 CRD IV Directive. See e.g. the above-mentioned art. 13 and 91 on suitability, and art. 12 CRD IV Directive and art. 93 CRR on initial capital. Recital 39 and art. 69 CRD IV Directive. Commission, Proposed Single Supervisory Mechanism ECB Regulation, COM(2012) 511 final, 12 September 2012, page 6 and art. 13.

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validate the application, and propose its issuance to the ECB. If the ECB agrees on the conformity to EU laws, it will issue the licence.

5.3

Cross-Border Market Access in the EU

General The TFEU sets out the basics for the right of establishment and of cross-border service provision within the EU (see chapter 3.4). However, the TFEU allows limitations to these freedoms for specific public health, public security and public order reasons, and provides the opportunity to harmonise both the effect of the freedoms and their limitations via directives; see chapter 3.5. The financial services area benefits from harmonisation. Before such harmonisation was achieved, domestic governments defined – each in different ways – what a bank was and under what conditions it would be allowed to enter their local market (both for home-grown banks and for EU or third country banks). In the absence of harmonisation directives, domestic governments would be forced to set high borders around their territory. Such services are important to its citizens and its financial system, but only if they are safe. They would invoke the right to limit the freedom of establishment and of services. The protection of the public, of the financial system and of the high standards in a member state would allow member states to act along this inclination67. The CRD provides a commonly agreed framework on various types of cross-border market access methods within the EU. The framework intends to limit and/or eliminate such ‘good reasons’ to limit access, in order to stimulate the single market; see chapter 3.4 and 3.5. Combined with minimum standards on supervision, it allows banks that are authorised and supervised under those minimum standards to operate across the EU, with limited and clearly defined intervention possibilities for host member states. Member states have to allow cross-border services to be provided and branches to be established by banks authorised and supervised by a supervisor of another member state, if the licence of that bank as granted by its own supervisor include the provision of those same services68 in its own member state. This obligation to permit access is linked exclusively to the listed activities in the annexes I to RBD and Mifid. Under the general freedom of establishment, subsidiaries benefit from that general protection too, and any limitations need to fulfil one of the exemptions to such freedom (see below). All the TFEU legal basis mentioned here relate to opening up the single market; one of the three CRD goals. The way this is done, however, may also impact on another CRD goal; 67 Parodi/Banque Albert de Bary et Cie, Court of Justice 9 July 1997, Case C-222/95. 68 See chapter 5.2 as well as art. 23 and Annex I RBD.

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financial stability. There is likely a link between the degree of integration of a foreign bank in the local system, and whether it has an establishment there, and the ease with which it will stop providing services in case of a crisis at the bank or in the wider financial system69. The right of establishment is thus possibly more in line with financial stability than the right to provide cross-border services. In this chapter first some general aspects of the cross-border regimes are sketched. This includes how to determine which form of cross-border activities is planned, and thus which regime for being allowed to start such activities is applicable, and whether the host member state or the home member state can block such international plans of a bank. Subsequently, the procedures for obtaining permission are looked at in more detail. The TFEU and CRD distinguish between the following methods of market access abroad for licensed banks, and establish different procedures depending on the freedom used and the legal structure chosen for the new activities. Which Freedom is Applicable? As set out in chapter 5.1, a bank or banking group can choose to enter the financial services market in another member state in various ways, including: – providing cross-border services; – by establishing a branch in the other member state itself; – by having a domestic subsidiary non-bank financial institution establish a branch in the other member state; – by taking over or establishing a local bank or a local non-bank financial institution in the other member state. The first falls within the scope of the TFEU freedom to provide services, the latter three fall within the scope of the freedom of establishment. As the type of administrative process and ongoing requirements are different for services or establishments, it is relevant to have a touchstone to differentiate between them. The CRD provides only limited clues on how to distinguish them. The Court of Justice has provided a criterion in 1995 in the Gebhard70. A national of a member state comes under the chapter relating to the right of establishment and not the chapter relating to services if: – he pursues a professional activity; – on a stable and continuous basis in another member state;

69 R. de Haas & N. Van Horen, Running for the Exit: International Banks and Crisis Transmission, DNB WP 279, February 2011. R. de Haas, Multinational Banks and Credit Growth in Transition Economies, Amsterdam, 2005, chapter 5 and 6. 70 Gebhard, Court of Justice 30 November 1995, Case C-55/94.

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– where he holds himself out from an established professional base to, amongst others, nationals of that state. Branches can be seen on the streets and have a physical presence and impact on the host member state financial markets. They are places of business in one member state of a legal entity with its head office in another member state, and as such are one of the forms under which the freedom of establishment can be exercised71. Determining whether services in another member state are cross-border in nature or in the form of an establishment is not always clear. In line with the above criterion, the main difference between the two is whether or not there is a bricks and mortar commercial presence of the legal entity on the ground in the receiving member state, in which case it is likely to be a branch. In a communication of 199772, the Commission draws on older Court cases in the context of legislation regarding the establishment of legal jurisdiction for local courts to make further subdivisions between branches and cross-border services, even though the case law mainly dealt with the question how to determine whether a local agent is a branch of a company in another member state or not, or whether a non-permanent presence can be a branch73. To be an establishment – where the foreign entity could be sued in domestic courts – it has to be subject to the direction and control of the parent body, that has the appearance of permanency, has a management and is materially equipped to negotiate business with third parties. If an agent is (1) free to trade on behalf of many, (2) to determine what and how many hours to put in, and (3) can only transmit orders to the company he represents instead of completing and executing those transactions, he is not a permanent extension of the parent body, and thus not an establishment of the company, but an independent intermediary. The Commission communication distinguishes between full service establishments with local management, full service establishments without local management, and e.g. ATM machines for pure cash withdrawal services without personnel. It tries to put it in the CRD context as an argument to eviscerate the need for some notifications also when there is an ‘own’ presence of the bank instead of ‘only’ an independent agent. These distinctions are 71 Art. 4.3 indicates that a branch is a legally dependent part of a bank. A bank can also have branches in its own member state, but those are covered under the main authorisation in its own member state. A subsidiary, an establishment in a separate legal entity, is the other form that can be used under the treaty freedom of establishment. For subsidiaries, there is no European passport. See below, and chapter 2 and 5.1. 72 Commission Interpretative Communication, Freedom to Provide Services and the Interest of the General Good in the Second Banking Directive, SEC(97) 1193 final, 20 June 1997. 73 De Bloos/Bouyer, Court of Justice 6 October 1976, Case 14/76; Somafer, Court of Justice 22 November 1978, Case 33/78; and Blanckaert & Willems/Luise Trost, Court of Justice 18 March 1981, Case 139/80. Under art. 5.5 of the Brussels Convention, since replaced by the identical art. 5.5 Council Regulation 44/2001, a client can also start proceedings at the Court where the ‘branch, agency or other establishment’ is based, instead of only at the Court where the legal entity is based in the EU.

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not very clear, and the Commission is hung up to a too large extent on the local management criterion. This is neither in line with the older case law nor with the 1995 Gebhard case. The proposed distinctions also do not appear in line with the division of labour and responsibilities that is envisaged in the CRD to protect the power of host countries to look closely at the more intrusive – and closer to local depositors – branches. The CRD demands that – if there is a branch – that it has management, not the other way around74. More convincing is the Commissions reasoning that an independent commercial agent that fulfils the above conditions is not a branch, which is fully in line with both the older case law and the 1995 judgement. The services offered via the independent agent would nonetheless qualify as cross-border services of the bank, and it may be that the agent itself is a bank under this approach. For true low profile services where none of the key services that define a bank are rendered via the local office, it may be that member states follow this non-binding interpretation also on some ‘own’ bricks and stones of the bank with e.g. a mailbox or an ATM without any local representative, and bring such low profile establishments into the lightest-touch cross-border services notification regime. The Court in Gebhard ruled that, under the treaty, once the freedom of establishment applies, it supersedes the freedom to provide services (i.e. all the provisions on establishment apply to all activities, regardless of whether they are organisationally performed within the established branch or subsidiary, or cross-border)75. In the context of banking, this would mean that a bank cannot ‘game’ the cross-border rules by simultaneously performing cross-border services, services via a branch, and services via subsidiaries, depending on the most favourable regime offered for that service under the CRD, but has to follow the more burdensome ‘establishment’ regime for all activities in a member state as soon as it has an establishment there. The – less onerous – provisions on freedom of services were deemed to no longer apply. However, in a subsequent case in 2006 (Fidium Finanz), the Court took a more balanced approach regarding the relation between the various freedoms and the protection given to companies under them. The Court had to judge the protection given by the freedom of services and the freedom of capital76. The Court indicated that there is no precedence between the various freedoms. A case can raise the protection of two freedoms at the same time, in which case both will be applied. An important exemption is, however, if one of the freedoms is ‘entirely secondary’ in relation to the other, and may be considered together with it. As there is generally no order of priority between the freedoms, they can be invoked 74 Art. 25 RBD, which does not even demand that such management is based in the host country. If there is a need for management to even be considered a branch, the article would be superfluous. 75 Gebhard, Court of Justice 30 November 1995, Case C-55/94. 76 Fidium Finanz, Court of Justice 3 October 2006, Case C-452/04.

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simultaneously vis-à-vis a national measure. Which one applies dominantly is a matter of the concrete goals of the national measure, and an ad-hoc assessment by the Court. In the 2006 case – where a third country entity was required to have a local establishment to be allowed to do business – this has led to the Court stating that only the freedom of services turned out to be applicable. In an earlier case where a local subsidy to the client was dependent on local approval it turned out that both freedoms were applicable77. The EFTA Court had also ruled that the freedom of capital was applicable78 in a case concerning a favourable subsidy when banks made loans locally instead of to foreign borrowers. The reasoning of the Court in these cases on the ‘equal treatment’ of the freedoms does appear to result in desired outcomes (non-discrimination between EU operators, and leaving a less than forthright third country provider without the protection offered to third country operators under the freedom of capital). If the main rule formulated in 2006 in Fidium Finanz on the relation between services and capital were applied to the 1995 Gebhard judgement on services and establishment, the same outcome may yet have resulted. In the 1995 judgement the regime on establishment can be deemed the dominant regime as soon as there is a branch or subsidiary, with ‘merely an unavoidable consequence’ being the absence of the need for a services notification. As funnelling the supervision of a crossborder operating entity – if at all allowed as set out in the CRD – towards the already existing establishment does not negate the freedom to provide services, the 1995 criterion appears compatible with the later judgement. It would also avoid ‘gaming’ by the protected entity beyond what is necessary for the single market. This would be different if no establishment was yet there, and the member state required it. In that case, only the freedom of services would be invoked, which would be negated by such a requirement79. The Court has kept open the possibility of demanding such an establishment if – so far theoretical – extreme circumstances pertained. Imaginable would be that systemic relevance of certain cross-border services in the host state could be such a reason. See for combinations of different types of activities below. To each of the four methods to enter the financial market of another member state a different CRD-regime on gaining permission of the host member state is applicable. None of these procedures is particularly onerous80. In a proportional manner the increase of the (potential) impact on the host financial system leads to an increase in the role of the host 77 78 79 80

Svensson and Gustavsson, Court of Justice 14 November 1995, Case C-484/93. State Debt Management Agency/Íslandsbanki-FBA, EFTA Court 14 July 2000, Case E-1/00. For this aspect, also see Commission/Italy, Court of Justice 6 June 1996, Case C-101/94. And referred to in a positive manner by the Court in Parodi/Banque Albert de Bary et Cie, Court of Justice 9 July 1997, Case C-222/95.

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supervisor. Prudential requirements of the host supervisor are absent for cross-border services, but are available on a solo basis and sub-consolidated basis (i.e. for subsidiaries of the local subsidiary) for the host supervisor for local subsidiaries and (especially systemically important) incoming branches. Establishing or taking over a subsidiary bank means that any activities developed by the subsidiary do not fall within the scope of the banking licence given to the parent bank. They are not performed by the legal entity that was granted the licence. A member state where a locally established subsidiary wants to become a bank in its own right can and must require it to have a licence. The freedom of establishment is thus more restricted under the RBD when using a separate legal entity. The supervisor of the subsidiary is responsible for the authorisation process of the subsidiary as well as for parts of its supervision. Based on case law of the Court of Justice on the freedom of establishment, the role of the host state of a new subsidiary of an EU bank is, however, limited both during the licensing process and the harmonised ongoing supervision. European Passport for Cross-Border Branches and Services – Content The RBD creates a so-called ‘European passport’ to enable a legal entity with a banking licence to set up branches and/or start selling services across borders in other member states. It replaced the previous need to obtain a separate banking licence for each country where a bank wanted to do business; significantly reducing thresholds for banks to provide services in the single market. The passport process for prudential banking supervision is very low key indeed, in line with the freedoms of establishment and services of the treaties. The European passport was one of the first key achievements of harmonised banking supervision in the EU. Under the European passport regime, a bank with a licence in its own member state can opt to start providing services (cross-border or via a branch) in the territory of another member state (the host state). The bank in that case has to initiate a process under which its home supervisor sends a notification to the supervisor of the country where the bank wants to become active. As long as the licence of that bank as granted by its own supervisor includes the provision of those same services81 in its own member state, the public authorities of the host member state have to grant market access if the notification procedure is followed. In return, the home member state of the bank will be obliged to exercise good supervision at the minimum-level set in the CRD, and has to accept banks from all member states too. Both the home and the host supervisor have only limited possibilities to limit or delay such activities. The vast bulk of prudential supervision subsequently remains with the home supervisor of the legal entity, with some limited rights (more for branches, less for cross-border services) for the host supervisor 81 See chapter 5.2 as well as art. 23 and Annex I RBD.

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of the legal entity; see chapter 17 and 21. The process for cross-border services has been reduced to a formal process, for branches it contains minor but relatively more cumbersome material aspects. A branch is a permanent physical extension of the licensed legal entity into another member state, while cross-border services should not have such a presence in the host market (and are thus less ‘material’ to host member state markets). The borderline between branches and services (and activities that do not require a notification at all, e.g. a visit of a bank official to another bank in the other member state), is not always clear, even though it has consequences both for the type of notification to be sent and – after the bank starts its activities – for the role of host supervisors regarding the cross-border presence of the foreign bank. Banks from the EEA are treated as if they are banks from an EU member state for the purposes of market access. This follows from the EEA Treaty, which reciprocally allows access to and from all the EEA states, including all EU states. This is conditional upon the non-EU EEA states taking over all prudential supervision directives. Banks from other third countries do not benefit from a European passport, unless they have a fully licensed subsidiary in one of the EU member states. Such a subsidiary is an EU entity and – once it has passed all the hurdles from the licensing process – has the same rights and obligations as any other bank with an EU authorisation to passport within the EU. See chapter 5.2 and 5.5. The notification process is triggered when a bank wants to operate ‘within the territory’ of another member state. This terminology is ambiguous82. When the term was introduced, cross-border services provision generally actually required travelling representatives. Wholesale markets had begun to integrate already under the freedom of capital. The size of cross-border markets, especially on the retail side, was marginal at best due to limited electronic contact facilities (mostly telephone and newfangled innovations such as the fax). Only with the development of the internet have cross-border services become easier and more flexible83. With the current technological possibilities to communicate and do business, services can now be provided quite easily across borders. Physical visits are rarely necessary, though for retail markets a physical presence still has marketing value in the deposit taking context. The Commission made an attempt to eviscerate the notification procedure via a communication in 1997. The communication amongst others defended the position that ‘new’ communication methods do not fall under cross-border services, as they do not take place ‘within the territory’ of another member state. This has not resulted in subsequent legislative action, nor has this aspect of the communication gained a broad following

82 Art. 25 and 28 RBD. 83 A.F. Lowenfeld, International Economic Law, Second Edition, New York, 2008, chapter 6.2.

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among member states. That e.g. an internet bank account is not a cross-border service if it is offered to, opened and used by customer in the ‘territory’ of the country where he is based would not be a cross-border service is contestable to say the least. Subsequent legislative efforts such as the distance selling directive appear to support that internet services are cross-border services; see chapter 16.6. As the notification process is not cumbersome, many banks have followed it for pre-emptive reasons. On the other hand, the provision of cross-border services without a physical presence does not appear to be a high priority for investigations or prosecution by host member state authorities. The European passport was a crucial invention that managed to create a cross-border market for the banks (and to a lesser extent for the customers of banks). Significant hurdles still exist in areas such as conduct of business, consumer protection, contract law, taxes and litigation, but from the prudential licensing point of view there are few hurdles left. In ongoing supervision, banks still suffer however from differences in interpretations and goldplating of prudential supervision (to be addressed by the CRR; see chapter 2). Customers suffer from the lack of retail services offered in an accessible and hassle-free manner across borders. From a supervisory point of view, the main criticisms are the lack of a cross-border market exit regime84 to balance the market entry regime, especially on e.g.: – the bankruptcy and unwinding of cross-border groups of banks; – a disconnect between supervisors on the importance of activities in different countries for their individual tasks and responsibilities; and – conflicts of interests between member states between e.g. protection of savers in another member state and efforts to save the activities of the group in the home member state. Apart from inter-supervisor and political wrangling, this has resulted in public anger and/or disputes e.g. in 2008 in the case of the Landsbanki/Icesave group between the Icelandic home authorities and the UK and Dutch authorities after its collapse in 2008, and the Fortis unwinding in the state aid efforts of the Dutch and Belgian (and Luxembourg) authorities in 2008. An immediate result – to avoid barriers being erected by member states in a death stab to the European passport – the cross-border regime has been adapted as per 31 December 2010 for ‘significant’ branches. Host authorities have gained more explicit rights if there is an agreement that the branch in their country is significant (see below under ‘significant branches’). Cross-border services without a bricks and stone presence have, so far, not been identified as potentially significant in the host market. On

84 See chapter 18. Also see R.J. Theissen & A. Houmann, Funding is Key, 2009, www.thebanker.com on the funding issues related to the market exit of an internationally operating bank.

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the market exit issue, the Commission is consulting on the harmonisation of bank failure regimes (see chapter 18). The benefits of the mutual recognition under the European passport are limited to banks as defined in the CRD for specified services, but under its limited procedural demands it eases the cross-border market access. The EU passport is embodied in the notification procedure described below. After the procedure has been fulfilled correctly, the rights (and obligations) of the host member state when the bank starts banking activities in its territory are limited; see chapter 21.6. The passport covers a specific set of banking activities, including investment services defined in Mifid85. The host member state does not have to accept that an institution tries to use the notification procedure if it or its activities are outside of the scope of the passport86. If the institution is a bank in its home state, but either is not the subject of the rather narrow definition of a bank in the CRD, or wants to notify an activity not covered by the CRD European passport, the host can deny it the use of the procedure. Even if that institution is a bank under a wider definition in its home member state, or the activity is a banking activity in its home member state, it only needs to accept without further ado the institutions and passports covered by the directive. The home country can limit the activities of the bank in the licence, but the host country cannot restrict such activities unless they are not in the list of bank-activities87. The company will need to invoke the treaty freedoms in that case. These allow more latitude for the member states involved if the activity is not yet harmonised; see chapter 3.5. The following activities can be included in the European passport88: – the two core activities used to define whether a bank is a bank (see chapter 4.4): (i) acceptance of deposits and other repayable funds and (ii) lending; – the services that benefit from a similar European passport for investment firms under Mifid, including asset management, investment for own account or order execution for clients; – guarantees and commitments; – payment services and other issuance and administration of means of payment; – financial leasing; – trading for own account in a wide range of financial instruments and participation in securities issues; 85 Art. 23-37 and Annex I RBD, and art. 1.2, 31.1, 32 Mifid. 86 Testa and Lazzeri/Consob, Court of Justice 21 November 2002, Case C-356/00. Also see chapter 4.4. 87 Also see J.A. Wilcox, ‘The Increasing Integration and Competition of Financial Institutions and of Financial Regulation’, Research in Finance, Vol. 22, 2005, page 215-238. 88 The activities that have to be (mutually) recognised by a host member state if a home member state sends a notification that a bank licensed for such specific activities wants to perform those too in the host member state are captured in art. 23 and last sentence of Annex I RBD, as well as section A and B of Annex I Mifid.

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trading for the account of customers in a wide range of financial instruments; portfolio management and advice; advice on capital structure, industrial strategy and related questions and advice; providing services on securities issues, mergers and the purchase of undertakings; money broking; safe custody services and safekeeping and administration of securities; credit reference services.

The defined set of activities has not changed since its inception (except to incorporate the updates in Mifid on investment services). It thus neither truly resembles the activities of current day banks nor their terminology. Apart from the defining activities of deposit taking and lending, the other activities listed in the RBD include guarantees and commitments, issuing and administering means of payment, such as credit cards, trading for their own account on financial markets, participating in and service provision on securities issues, portfolio management and advice, and safekeeping and administration of securities. Both the CRD annex and Mifid state explicitly that the services that can be passported by Mifid-licensed investment firms also fall under the scope of the mutual recognition passporting under the CRD for banks89. A presence in another member state is only a ‘branch’ for European passport purposes if it performs one of the activities for which the passport can be used. Apart from such branches – that require notification and host member state cooperation – banks also can have other types of establishments in other member states. Such establishments are often referred to as representative offices (or rep offices). They often are limited to market research and monitoring, but could also have non-financial activities. To establish the difference between a branch that should be notified and a representative office that can operate without notification is often difficult, especially if the bank provides services to clients of the nationality of (or that reside in) the host member state. Does the fact that existing clients have a business meeting at the premises of the rep office with employees of the head office make it a branch? The CRD indicates that this is not the case, as an establishment is only a branch if it carries out directly all or some of the transactions inherent in the business of a bank90. Providing a meeting facility would not count, but if e.g. local employees were involved in the meeting or if clients used its local accounts this could tip the balance towards branch status. 89 Art. 1.2, 31.1, 32 and 68 Mifid and art. 33 and Annex I RBD. The Mifid-activities were explicitly added to a previous version of the RBD in 2004 by Mifid. The two lists overlap, but the added clarity is welcome. An example where otherwise ambiguity might have resulted, is the ‘new’ service of the operation of multilateral trading facilities under Mifid, see chapter 16.4. 90 Art. 4.3 RBD.

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If a bank develops a new activity that does not fall within the scope of the European passport or the process for subsidiaries, it can still avail itself from the freedoms of establishment and services91. This could include e.g. an office for intellectual property, back-office, or even manufacturing. If the other member state does not have any rules to regulate that activity for its own nationals, the incoming national (services, branch or subsidiary) of another member state is in principle entitled to perform those activities through the treaty freedoms. In the absence of any specific harmonisation, member states are, however, free to legislate domestically the conditions under which this freedom is used for a specific activity. Examples include if a bank is a clearing member or manages non-UCITS collective investment funds. The power of the member state is limited by the fact that its laws must not constitute an obstacle to the effective exercise of the fundamental freedoms, unless justified by the ‘general good’ (see chapter 3.5). The Court92 indicated that the host member state may make its permission to enter its markets subject to conditions. These conditions can include complying with e.g. general good provision relating to organisation, qualifications, professional ethics, supervision and liability, as long as any provisions that hinder or make less attractive the exercise of the fundamental freedoms fulfil the following conditions: – they are applied in a non-discriminatory manner; – they are justified by imperative requirements in the general interest; – they must be suitable for securing the attainment of the objective that they pursue; – they must not go beyond what is necessary in order to attain it; – the member state may not ignore the knowledge and qualifications already acquired by the person concerned in another member state. The Court of Justice also accepts a local authorisation process for activities not covered by a harmonised European passport93, provided that: – the objective, non-discriminatory criteria are known in advance to the undertakings concerned, circumscribing the exercise of the national authorities’ discretion, avoiding arbitrary decision; – the conditions and verification thereof are closely related to the objective and overriding purpose of introducing the authorisation requirement; – the procedure is easily accessible and protects the rights of the applicant;

91 Gebhard, Court of Justice 30 November 1995, Case C-55/94. See art. 33 and Annex I RBD on the activities that are part of the European passport. 92 See chapter 3.4-3.5 and e.g. Parodi/Banque Albert de Bary et Cie, Court of Justice 9 July 1997, Case C-222/95. 93 Kraus/Baden-Württemberg, Court of Justice 31 March 1993, Case C-19-92, and Analir/administración general del estado, Court of Justice 20 February 2001, Case C-205/99. Also see chapter 2.

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– any penalties for non-compliance with the local process are not disproportionate to the gravity of the offence. A host member state cannot force a cross-border services provider to have a local establishment, as that would negate the freedom of services. ‘General Good’ Goldplating The host member state and the host supervisor can set regulations for the ‘general good’ issues; see chapter 3.5. Traditionally, such obligations included consumer protection and conduct of business requirements linked to banks core traditional and investment activities94; issues that are key to the domestic economy and residents. Most conduct of business requirements have now been harmonised where it concerns activities on financial instruments. Consumer protection is partially harmonised, but there are still gaps in EU legislation; see chapter 16. The – as yet totally non-harmonised – area of the amount of liquidity a bank must have available to immediately satisfy and demand for cash by its customers in the host member state has also been allocated to host supervisors; see chapter 12. On issues where ‘general good’ requirements are allowed, the host can also institute supervision to check compliance with such requirements (e.g. information gathering and intervention). The ‘general good’ concept is an open term, the size of which is shrinking inversely to the increase of harmonisation (also see chapter 3.5). The harmonisation achieved limits the scope of acceptable ‘general good’ requirements. Requirements might still include e.g. mortgage regulation, advertising rules, consumer financial education, as well as information to be provided to clients when engaging in areas not yet fully harmonised, such as advertising for financial services. The only examples explicitly given by the directive95 are rules governing the form and the content of advertising by the bank in a host member state. Even there, the directive starts from the main rule that advertising services through all available means of communication will be allowed. Some issues that could have fallen within the scope of general good otherwise, have been fully harmonised. In the area of branches this relates to the requirement of endowment capital for the branch. Member states are prohibited to request endowment capital; i.e. own funds actually held at the branch. Such demands are prohibited under any guise. The prohibition is in line with the treatment of branches in company law, where the Court has 94 The Court e.g. accepted a prohibition of cold calling in Alpine Investments/ Minister van Financiën, Court of Justice 10 May1995, C-384/93. The prohibition was set by the home state (not the host state) and prohibited cold calling in the public interest of protecting the reputation of and trust in the Dutch financial sector; see §30-31 and 42-44. 95 Art. 37 RBD.

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EU Banking Supervision forbidden such endowment capital as not being in line with the freedom of establishment96. On non-harmonised issues, there is some flexibility. For example, registration in some register in addition to the cross-border services notification might be required if all general good conditions are fulfilled97. Monetary policy is specifically mentioned as retained by host member states. At first sight this is surprising, as monetary policy is not part of prudential supervision on banks (nor vice versa). There is, however, a strong link between monetary policy and prudential supervision, both for the (common) financial stability goal, and as solvent banks are crucial tools for the execution of monetary policy; see chapter 22. The RBD mentioning the fact that the host member state retains monetary policy prerogatives on branches serves as a (partly superfluous, but politically necessary) clarification that monetary policy was not given up by host member states when they transferred prudential supervision on incoming branches to home member state when the European passport was introduced. In countries where central banks and prudential supervisors were or are the same entity, these tasks were not always fully separated. See the prudential reporting/statistical reporting differences referred to in chapter 20.2. Monetary policy has since been partially harmonised (for the euro-area; see chapter 22), but is still explicitly mentioned in the CRD as left to host member state discretion. The allocation article makes clear that the member state (or ESCB for euro area member states) can still set their own monetary policy, and may involve their own supervisor in its monitoring or execution vis-à-vis the branch. By way of example, part of monetary policy relates to the stability of the currency and the distribution of coins and banknotes across the member state. Particularly large branches can have a role to play here. The emphasis on the role of host state monetary policy is gradually becoming less relevant in the EU. If both the home and the host member state are part of the Eurozone, monetary policy for both countries is not allocated to the domestic central bank any more, but is instead allocated by the TFEU to the ESCB98. Notification Process for Services Respectively Branches The European passport notification procedure for services is very simple, the procedure for branches more complicated due to the additional tests the home and host supervisors may perform before allowing market access. The host member state and its authorities do not have any rights of interference based on prudential concerns for a notification for cross-border services, and only limited room for blocking incoming notifications for branches. It is likely that any goldplating in this area would be deemed incompatible with

96 Inspire Art, Court of Justice 30 September 2003, Case C-167/01. 97 Parodi/Banque Albert de Bary et Cie, Court of Justice 9 July 1997, Case C-222/95. 98 See chapter 22.

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the EU freedoms under the treaty unless there are clear and valid general good reasons. The home member state is equally limited in its possibility to block services and establishment that one of its ‘own’ banks wants to provide abroad, but it has more leeway. They have to respect the freedoms of the banks licensed by them to provide services and set up establishments in the form of branches or subsidiaries in other member states, except where limitations are needed and proportionate99. For financial services providers, the Court of Justice has determined that the home supervisor’s check on whether a bank will be allowed (e.g. by an expansion of its licence) to start specific activities in other member states is in line with EU requirements100. A good reason would be because the expansion cannot be ‘managed’ by the existing bank management and internal governance procedures, leading to a prudential risk to the bank as a whole. The (non-binding) CEBS-EBA guidelines refer to only two issues that can be assessed. The home supervisor does not have to forward the notification if he has reason to doubt whether the internal organisation or the financial situation of the bank can bear the additional activities envisaged101. The notification procedures set out both minimum and maximum harmonisation, as the home and host member states have committed themselves to follow it, and to only make the checks allowed in it. The light administrative process has recently been further harmonised by common interpretations/guidelines and standard forms (which specify the requested information) developed by CEBS-EBA102. The process can be followed in English (under the CEBS-EBA guidelines) for services notifications, as supervisors have collectively waived the need for a translation. For branch notifications a (costly) translation of the envisaged programme of activities is still needed, unless the supervisors involved agree to waive this requirement in a particular case103. A bank that wants to provide services cross-border for the first time in the territory of a particular other member state has to follow a simple administrative procedure for prudential purposes. The freedom of services as established in the TFEU envisages a temporary activity, though that may be supported by infrastructure (e.g. an office) in the host member state in as far as that infrastructure is necessary for the purposes of performing the services in question. The temporary nature can be determined in the light of the duration of the

99 Daily Mail and General Trust, Court of Justice 27 September 1988, Case 81/87, and International Transport Workers’ Federation and Finnish Seamen’s Union/Viking Line, Court of Justice 11 December 2007, Case C-438/05. 100 See the Co-insurance cases, e.g. Commission/Denmark, Court of Justice 4 December 1986, Case 252/83. 101 §34 CEBS-EBA Guidelines for Passport Notifications. 102 CEBS-EBA Guidelines for Passport Notifications of 27 August 2009. The CEBS-EBA Guidelines built on previous work of CESR on Mifid passport notifications. 103 §23 and 33 CEBS-EBA Guidelines for Passport Notifications.

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EU Banking Supervision provision of services, as well as its regularity, periodicity or continuity104. In this sense the CRD cross-border provisions go beyond the minimum required by the freedom, as once the administrative procedure has been followed once for a specific type of activity, any subsequent provision of such services in the territory of that member state does not require a further notification (which under the treaty may have been an establishment if there is a permanent character). The original notification can be broad, and mention all activities, but it can also be limited to a few specific activities mentioned in annex I RBD. If it does, the bank will need to follow the same administrative procedure in order to be allowed to broaden its range of services in the other member state. A bank needs to follow this administrative process for each member state it wants to provide services in. Table 5.2 The process for a services notification in two steps. 1

The licensed bank sends a notification to his home supervisor with: – the name of the member state where it wants to provide cross-border services; – the activities105 it would like to carry on in the other member state.

2

The home supervisor has to send the notification to the host supervisor within one month of receipt.

The bank needs to contact its own supervisor, and ‘notify’ it that it intends to provide services. No assessment is necessary by the home supervisor, though this is an area where some supervisors may have provided for an additional assessment that the bank is ready and able to handle the provision of the specific services outside of its home market (e.g. on aspects of IT, sufficient capital, sufficient resources and knowledge of market circumstances; see the above-mentioned work of EBA/CEBS on notification procedures). If the types of services fall within the scope of its licence, the home supervisor is obliged to send the notification it received from the bank to the supervisor of the targeted host member state. In line with the fact that the host supervisor does not have any right under the RBD to stop incoming provision of services, the RBD does not specify a waiting period. It is a question of interpretation whether a bank has fulfilled its obligations under the CRD as soon as its notification is sent to its own supervisor, and can start providing services crossborder from that point in time, or has to wait until the host supervisor has received the notification. In the context of the notification process for branches (see below) the RBD specifies a waiting period, but there is no mention of a waiting period here. There it is linked to receiving confirmation by the host supervisor or two months after the home

104 Gebhard, Court of Justice 30 November 1995, Case C-55/94. 105 The activities have to among the listed activities for which the European passport is valid; see chapter 5.2.

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supervisor forwarded the notification to the host. Looking at the reasoning for the notification (the host is aware which banks are active in its local market) it is likely that the RBD allows the bank as soon as its home supervisor has informed the host, or a maximum of one month after it sent the notification to the home (the culpability for the lack of information sent then being allocated to its home supervisor, not to the bank). Subsequent to the notification being sent to the host supervisor, the bank remains fully and solely under prudential supervision by its home supervisor for all its activities, including the cross-border services provided. The host prudential rules and regulations are not relevant for the bank, nor does the host prudential supervisor have a task. In the actual subsequent provision of services, the bank will need to take into account local laws if they govern the contracts it enters into. Those cannot impose prudential supervision, however, nor impose barriers that cannot be justified under the ‘general good’ concept; see above, and chapter 3.5. From a consumer protection and conduct of business supervisory point of view, there are obligations set in local laws the bank has to adhere to, but for crossborder services covered and harmonised by Mifid (e.g. investment services and activities), the host member state cannot introduce additional conduct of business rules or supervision106. For a bank, the type of investment services provided have to be notified under the European passport, but the role of the host (Mifid) supervisor ends there. If the bank only wants to access the markets in another member state to execute a trade or become a member of such a trading venue, no notification requirement or other administrative or regulatory requirement can be imposed by member states. The same applies to post trade services, but this right to free passage is limited by financial stability and oversight tasks, on which cooperation is necessary by all supervisors and central banks involved107. In the reverse situation, when a bank that operates a market venue wants to provide arrangements for access in another member state, no legal or administrative requirements are possible either, but in this case an explicit notification is nonetheless required108. The Commission has long deemed the notification for cross-border services an irritant, and has sought to limit its interpretation to traditional ways of communication (letters, visits, etcetera), and exclude e.g. internet based marketing and services109. This would eviscerate the notification obligation, however, which appears defensible, but which

106 Art. 1.2 and 31.1, 31.5 and 31.6 Mifid. This is different for branches, see below. 107 Art. 1.2, 34-35, and 42.6 Mifid. 108 Art. 1.2 and 31.5-31.6 Mifid. This applies also to non-bank investment firms and specialised market operators; see chapter 16.4. 109 Commission Interpretative Communication, Freedom to Provide Services and the Interest of the General Good in the Second Banking Directive, SEC(97) 1193 final, 20 June 1997.

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would necessitate its deletion from the CRD. As long as the obligation is part of the law, it covers cross-border services regardless of the Commission statement. Compared to the services notification procedure, member states have been less willing to give up prudential rights (and obligations) for branches. Branches are likely to have a higher impact on the retail financial markets of the host than cross-border services as they have a permanent physical presence in the host country, and customers may expect them to be ‘local’ banks. The European passport provided a compromise. Having to accept foreign branches was balanced by the promise of a minimum level of harmonised supervision and the advantage of the reciprocity for their banks to branch out with equal minimal fuss. A core role for ascertaining the compliance of the bank with the minimum set of rules is allocated to the supervisor of the head office. The majority of the former additional licensing and ongoing supervision requirements from the host member state fell away. The compromise does, however, contain some powers that were deemed essential for host member states and their supervisors, but prohibits both (previously normal) practices of endowment capital and authorisation (licensing) of branches. A division of labour, where sometimes only the home, sometimes only the host, and sometimes both had a role was necessary. The basic division of labour between the home and host member states is set out in the RBD and for investment services/activities in Mifid110. The process to activate the European passport for a bank starts in the same way as for cross-border services, by a notification sent by the bank to its own supervisor. However, both the content and the assessment by the home supervisor are more elaborate (relative to the cross-border services notifications), as are the powers of the host supervisor. Table 5.3 The process for a branch notification in seven steps. 1 The licensed bank sends a notification to his home supervisor with: – the name of the member states where it wants to establish a branch; – a programme of business, including but not limited to (a) types of business planned and (b) the structural organisation of the branch; – the address in the host member state; – the names of the managers of the branch. 2 The home supervisor has three months to assess the request, taking into account the envisaged business: – adequacy of the administrative structure; – adequacy of the financial situation. 3 The home supervisor has two possibilities: a. If he is satisfied, the home supervisor sends the notification to the host supervisor, with a copy to the bank, if he has no reason to doubt the adequacy of the above-mentioned criteria.

110 Art. 16 and Annex I RBD and art. 1.2, 32.1 and 32.7 Mifid. See chapter 16.2 and 21.

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He also sends information on the banks’ amount of own funds and the sum of the capital requirements under the CRD. b. If he is not satisfied, the bank is informed that the home supervisor has doubts and thus refuses to forward the notification to the host supervisor, including the reasons for this refusal111. The bank can apply to the domestic courts, but pending such challenge cannot affect the establishment of the branch. 4 The host supervisor receives the notification and has two months: – to prepare for supervising the branch; and – to set in writing additional ‘general good’ requirements the branch will have to fulfil. It does not have the power to block setting up the branch, which lies only with the home supervisor (though the host is free to try to convince the home supervisor of its concerns on the bank). 5 The branch can be established and start operating as soon as a communication (with or without the additional general good requirements) is received, or after the two months have passed. 6 The branch starts its operations and the home and host supervisors start their supervision of its activities. The home supervisor has the same powers regarding the branch as it has on parts of the legal entity based in its own territory. The host supervisor has some additional powers. Apart from imposing the ‘general good’ requirements (see step 4 and 5, and chapter 3.5), if any, and applicable non-prudential requirements under e.g. Mifid, these include the regulation of112: – rights to information; – monetary policy requirements; – the supervision of the liquidity of the branch in coordination with the home supervisor. The host supervisor is given a specific set of instruments to be able to supervise any requirements codified in its member state, see chapter 20.3 and 21. 7 If the relevant information in the notification changes (e.g. a change in the programme of operations), the branch has to inform both the home and the host supervisor. Both have a month to exercise their rights under step 3 respectively 4 to block or impose conditions.

Once a bank has a notified branch in another member state, it does not need permission to establish other offices in that member state. All offices in the host market taken together are counted as one branch for the purposes of the notification process and for host member state powers113. If, however, a type of activities is developed that was not yet part of the types of activities in the original notification, it will need to notify both the home and the host supervisor on the additional activities. The home supervisor then has a month to assess whether he has doubts on the additional activities, and the host supervisor simultaneously has a month to set additional conditions as set out above for the original notifica-

111 If the home supervisor does not forward the notification and also does not inform the bank that it failed the assessment within the three months set, this is deemed equivalent to a refusal to send a notification, that the bank can challenge in court. 112 See art. 29 and 41 RBD. These rights are given to the member state, with its own responsibility to make limited or extensive use of them. It can choose not to make use of them, though that does not limit either its joint responsibility for liquidity of the branch or the impact of the branch on its own monetary policy. The measures taken cannot be discriminatory or restrictive just because the Head Office is in another member state or under the supervision of the home supervisor instead of fully under the host supervisor. Art. 41 RBD. 113 Art. 27 RBD.

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EU Banking Supervision tion114. The time for supervisors to assess the additional activities can be shorter, as they are both already aware and involved in the supervision of the branch. The notification under the RBD covers the investment services and activities that are harmonised under Mifid as indicted above. Unlike for cross-border services without bricks and stones, the host supervisor is fully responsible for conduct of business requirements on the branch in its territory115. For access via branches to markets in financial instruments and post trade services to execute orders similar rules apply as in the case of cross-border services to limit the anti-competition administrative or regulatory requirements that member states can impose116. The host prudential supervisor also has responsibility for prudential liquidity supervision and the host member state can impose requirements for monetary policy. The host gains additional information rights and intervention instruments if the branch is deemed ‘significant in the host country; see below. The limitations in the authority of the host supervisor on the branch severely limit its powers to intervene in the branch if it performs activities that are not to its liking. Except for the retained areas of liquidity supervision and conduct of business supervision on investment services/activities, the host supervisor can only intervene – provided that the member state implemented these instruments in its domestic laws – on prudential concerns if either the home supervisor or the branch is in breach of its obligations vis-à-vis the host member state and such poses rather immediate dangers117, or if general good requirements set by the host are breached. Significant Branches In 2010 host supervisors gained additional rights to information on so-called ‘significant’ branches, and gained clearer rights to intervene in emergency situations118. Though all host supervisors can take such emergency measures, the additional information rights and college participation gained by significant branch host supervisors, means that they are more likely to make use of the existing and improved instruments. The upgrade in host supervision resulted from the Landsbanki/Icesave case, and a realisation by the UK and some other member states with large foreign branches in their country such as the Netherlands that they lacked instruments for the relevant proportion of member states

114 115 116 117

Art. 26 RBD. Art. 1.2, 32.1 and 32.7 Mifid; see chapter 13.4 and 16.2. See above and art. 1.2 and 33-35 and 42.6 Mifid. Art. 29-34 RBD. See for a more detailed discussion of the instruments of a host supervisor of a branch and of a significant branch chapter 20.3. Also see C. Hadjiemmanuil, Banking Regulation and the Bank of England, London, 1996, page 95-102. 118 Art. 40-42b RBD. Also see chapter 5.1, 12, 20.3, 20.5 and 21.

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banks that operate on their financial markets via branches119. This shifted the political balance from the previously dominant point of view of home member states that saw benefits in unlimited access of their banks to other member state markets, to even large member states considering themselves as nervous hosts that saw potential sources of financial instability and limited instruments to intervene (that might not even have implemented expansively in the local legislation). The classification as significant – and the additional instruments the host gains from that classification – limits the freedom of establishment of banks. The host suddenly needs to be informed on issues normally only reported to the home supervisor, and can intervene in the activities of the branch – including by closing it to new business – either if the home supervisor does not adequately respond to requests to address transgressions or potential transgressions of local rules, or even without waiting for the home supervisor if there is a true emergency; see chapter 21.6. The introduction of this limitation of the treaty-freedoms has, however, saved the European passport system (that was under attack from supervisors of host markets) and allows it to continue to work in normal times, and may be deemed proportional for the larger branches captured by the definition of significant. The harmonisation of the additional rights of host supervisors also prevents local initiatives that would limit the freedom further in the ‘interest of the general good’ e.g. by introducing punishing liquidity requirements; see chapter 2 and 3.5. The CRD II regime does not envisage mandatory transformation of existing branches that are deemed significant/systemic in the host country into subsidiaries, which could also have been envisaged and would be a much farther reaching limitation of the right of the parent to choose the way it uses its freedom of establishment. For subsidiaries the host would gain additional supervisory tools (including standalone requirements on own funds and solvency) and responsibilities (as the licensing supervisor of the subsidiary it would be responsible for interventions, potential state aid and for the deposit guarantee). The main rule of the EU treaties and the CRD is and remains that the bank can choose the format in which it wants to access other markets (either through services, branches or subsidiaries). Informal pressure may lead to subsidiarisation in practice. Whether such informal pressure can be backed up by a formal demand of the host country to transform a significant/systemic branch into a subsidiary, or to refuse access to a new branch if it were significant/systemic remains to be seen120. As the CRD now explicitly harmonises the way systemic concerns on branches can be channelled into a larger role in information-sharing, colleges and crisis-intervention, it is less likely that the Court of Justice would honour a claim on the general good as a justification for such an intervention in the single market; see chapter 3.5.

119 UK FSA, A Regulatory Response to the Global Banking Crisis; Discussion Paper 09/2, March 2009. 120 As proposed in the UK and USA by M. Brunnermeier, A. Crockett, C. Goodhart, A.D. Persaud, H.S. Shin, The Fundamental Principles of Financial Regulation, Geneva Reports on The World Economy 11, 2009.

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The determination which branches are significant (based on e.g. market share and number of clients, and the potential impact of its demise in the host market) is left to the supervisors involved; also see the discussion on the criteria for systemic relevance in chapter 18.2. The host supervisor makes a request to the home supervisor to mark the branch as significant. If the bank is part of a group under consolidated supervision, the host supervisor makes the request to the consolidating supervisor, bypassing the home supervisor of the subsidiary. Until end 2011 the host supervisor could force its designation on the home supervisor if there was no consensus within two months, but as per 31 December 2011 the issue can be escalated to EBA if the home and host supervisor do not agree121. The request can be made at any time, during or after the notification procedure. The decision on significance is separate from the notification procedure, and does not impede the possibility of the bank to start operating in the host market after the notification procedure has been completed. Subsidiaries A subsidiary of a bank – a separate legal entity – that provides banking services is required to have its own banking licence as set out in chapter 5.2. It does not matter whether the subsidiary is based in the same member state as the parent bank, or in a different member state. Nor does it matter whether it is a newly incorporated entity or an existing entity that has broadened its activities and now (also) falls within the scope of the definition of a bank. If both the parent and subsidiary are located in the same member state, the granting of the licence and the approval of the parent bank as a qualifying shareholder will be part of the ongoing discussion with the own domestic supervisor on how best to structure the banking group. If the subsidiary is established and has its head office/seat in another member state than the member state of the parent, the home supervisor is not empowered to grant the licence under the CRD; see chapter 5.2. Another supervisor will need to get involved, as licences should only be given by the supervisor for a bank if it has its seat and headquarters in its state. That licensing process is, however, limited to the harmonised assessment procedure. The European passport provisions of the CRD may not extend to the establishment of subsidiaries, but the treaty right of establishment does. The power of the host member state to institute requirements going beyond the harmonised requirements for supervision of a bank is – in the case of a subsidiary – limited by the freedom of establishment. The right of establishment is applicable regardless of the legal

121 Art. 42a RBD, introduced by CRD II 2009/111 and the Omnibus I Directive 2010/78/EU; see chapter 21.3 and 21.6. See chapter 18.2 on the definition on systemic and significant banking activities. Some host supervisors may overreact to the 2007-2013 subprime crisis: e.g. the Dutch supervisor in indicated that it would deem any branch that attracts savings from private persons as ‘significant’ in a letter in response to a parliamentary investigation on the crisis; DNB President to the Minister of Finance, letter dated 17 December 2010, 2010/598248, page 13 (Dutch).

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form in which activities are set up in the other member state. Setting up a subsidiary is one way in which a bank may exercise its freedom of establishment under the treaties, even though the specific instrument of the European passport as introduced for branches and cross-border services is not applicable122. Directives need to be compatible with the treaty, and are used to harmonise issues that might otherwise be legitimate barriers to the single market. Parliament and Council have the right to (explicitly) rule that certain activities are excluded from the treaty protection, but the CRD does not contain such a provision. On the contrary, it indicates that it is intended to give detail to the freedom of establishment. For subsidiaries, this is done via the applicability of the ‘normal’ licensing process as harmonised in the RBD. These additional requirements for a subsidiary in the CRD (licence and additional ongoing requirements) have to be read in a restrictive way, as they limit the right of establishment as granted in the TFEU. Host member states can go beyond the minimum harmonisation requirements, but will need to apply the general good/public policy criteria to defend such additional testing or requirements, which is a difficult task (see chapter 3.4 and 3.5). It cannot be denied that this ‘normal’ licensing process (with the required documentation, length of process, and number of conditions that need to be fulfilled), is a bigger restriction on the freedom of establishment than the notification procedure for branches. As both have to be compatible with the freedom of establishment, this difference following from the CRD set-up requires a valid reason (otherwise the licensing requirement would be void as a disproportional restriction of the freedom of establishment). If a bank will be allowed to perform the same cross-border activities in a branch as in a subsidiary, why would the hurdle be higher for subsidiaries than for branches? Reasons that can be derived from the structure of the CRD are that for financial stability and client protection purposes, subsidiaries tend to be more important than branches. Also, for subsidiaries, the local supervisor, deposit insurer and central bank have explicit responsibilities, that should be balanced by explicit powers. In addition domestic bankruptcy laws and tax laws (neither of which are harmonised) have relatively less impact on the viability of a branch than on the viability of a local subsidiary. Whether this reasoning – that the subsidiary-type establishments may be hampered by the applicability of the licence requirement and local supervision – still applies, and will apply after the ongoing harmonisation of the content of supervision via EBA and the gradual integration of supervision/crisis management standards and structures is a reasonable question. So far it has not been challenged. The reverse, that branches are increasingly relevant for financial stability and client protection

122 See chapter 5.1 and above. See art. 49, 50 and 57 TFEU, the German Insurance Case, Commission/Germany, Court of Justice 4 December 1986, Case 205/84, and Caixabank France, Court of Justice 5 October 2004, Case C-442/02.

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purposes, has been acknowledged by the introduction of the ‘significant branch’ regime described above. A case could be made that significant branches and significant subsidiaries should be treated the same, as should insignificant branches and insignificant subsidiaries. In that case the significant establishments could require e.g. licensing and a role of the host, and the insignificant ones not. As a small advantage of the licensing requirement, if the bank decides to go abroad by setting up local subsidiaries the range of activities permitted under its own licence are not relevant for the procedure. The application for a local licence for the new subsidiary will need to set out which activities it wants to undertake under the licence. These can be different from what the parent does or is allowed to do. For the procedure and limitations, see below. The leeway of a member state to block the authorisation of a subsidiary of a licensed service provider of another member state is limited. The Court of Justice has emphasised that the authorisation request of an EU undertaking must be granted if it fulfils the conditions laid down in the local laws, that those conditions may not duplicate equivalent statutory conditions that have already been fulfilled in the home state of the undertaking. The local supervisor must take into account supervision and verifications that have already been carried out in the home member state123. Though the case quoted was related to insurance undertakings, it is likely that the same applies to bank authorisations requested by a bank. The licensing process for a subsidiary can be interpreted in a manner that is consistent with these demands, but it will depend on the type of assessment the licensing supervisor makes whether it stays within the boundaries enforced by the Court (see below). For branches and cross-border services, the process of notification under the European passport appears to comply with these Court of Justice judgements. For procedural issues such as costs, appeal and motivation of the decision by the host member state, the host member state is bound under the single market freedoms to ensure that process should only be used to verify compliance with the public policy objective it is intended for, that the fees charged are not excessive and that refusal can be appealed against. If the process has not been followed, the penalties for non-compliance should not be disproportionate to the gravity of the offence124. On issues fully harmonised via directives the host member state cannot set up additional barriers to a subsidiary. It cannot impose requirements that are either discriminatory visà-vis the treatment of domestic banks or form restrictions to cross-border market access. To some extent this also applies to non-harmonised areas and/or to goldplating, as the 123 The German Insurance Case, Commission/Germany, Court of Justice 4 December 1986, Case 205/84 dealt with host authorisation requirements for cross-border insurance under the freedom of services. Its reasoning can also be applied to the freedom of establishment for conditions that have not yet been harmonised. 124 Kraus/Baden-Wuerttemberg, Court of Justice 31 March 1993, Case C-19/92. Also see chapter 20.3-20.5.

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right of establishment has direct effect. However, on such issues the member state has more leeway to indicate that those restrictions are necessary for general good/public policy reasons (see chapter 3.5 and above). If a subsidiary of a licenced bank tries to obtain a licence in its own name, additional obligations apply to the banks and the supervisors involved. If for instance a Dutch banks enters the UK market via a new local subsidiary, the UK and Dutch supervisors will need to cooperate both in the licensing process for the new UK bank, and as long as both banks are active and part of same group. The licensing supervisor of the subsidiary has to consult the CRD-supervisor of each bank of which the new bank is a subsidiary (subholding-banks and holding-banks), or the supervisor of a bank that is a subsidiary of the same entity controlled by the same persons as own or control the new bank. It will also have to consult the Mifid-supervisor and/or the insurance directives-supervisor of similar entities in the group to which the new bank belongs. Like the European passport, this is a reciprocal process, with similar rights given to the CRD-supervisor of an existing bank if a new regulated entity is set up in another member state. The consultation can be as broad as either of the supervisors involved desires, but at a minimum it has to consist of a consultation on the assessment of the suitability of shareholders and the reputation and experience of directors that are already involved in the management of another entity in the group. Whether this consultation process continues to be necessary separately alongside the new and ever more powerful colleges of supervisors per banking group (and the potential interlinkages across sectors) will need to be assessed in the future125. If – instead of a new venture being set up – the parent takes over an already established and licensed bank, the merger and acquisition rules are applicable. As these are identical for EU and non-EU banks acquiring the holding, the mergers and acquisitions rules are described separately in chapter 5.4. Even apart from freedom of establishment advantages for EU banks, licensed banks from the EU or third countries with similar supervisory standards have an easier time proving that the subsidiary will comply with the licensing requirements, or with the conditions under which approval for a takeover can be obtained. They will be able to show that they themselves qualify on banking expertise and that they are able to provide the new subsidiary both with the requisite own funds and the organisational structure, qualified staff and board members necessary to fulfil the requirements for such approvals. If a bank owns – as its subsidiary – another licensed bank, both become subject to the rules on consolidation. This applies both after an acquisition or after establishing a new bank125 Art. 15 RBD, art. 60 Mifid. See chapter 17 and 21.

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entity. If the banks that are part of the same group are not licensed in the same member state, in addition the cross-border consolidation limitations and obligations become applicable, including the compromises reached on supervising a cross-border active banking group. For consolidation, see chapter 17, for the solo supervisory powers and the cross-border compromise on the various supervisory powers at the solo and the consolidated levels reached, see chapter 21.7 on colleges. CRD-Financial Institutions (European Passport for Specialised Subsidiaries of Banks) Apart from setting up a licensed subsidiary in the host country or using the European passport to set up a branch or provide cross-border services by and within the same licensed legal entity in the host country, banks can also use non-licensed subsidiaries to perform certain ‘banking’ activities mentioned in the RBD annex. As long as those activities taken together do not lead to the subsidiary itself falling within the scope of the definition of a bank under the CRD, they normally would not be of concern for the CRD except for purposes of consolidated supervision. The upside of not falling under the definition is that the subsidiary is not subject to solo supervision (i.e. it does not need to be set up as diligently as required under licensing requirements, and does not need to calculate all quantitative requirements on a solo basis). It only falls under consolidated supervision on its parent bank, and thus under indirect supervision only (in as far as relevant to the health of its parent or the group to which it belongs). The downside of not falling within the scope of the bank definition is that such a subsidiary also in principle cannot benefit from the European passport that comes with the banking licence of the RBD. A subsidiary that has as its business to make loans to certain businesses or to offer financial leasing or money transmission services, does not fall within the scope of the definition of a bank, and when offering services cross-border or establishing a branch might be subject to local licensing laws for its specific activities. The CRD makes one exception to this, for subsidiaries established in the same member state as its parent (that has a CRD licence) that have as their principal activity acquiring holdings or one of the activities 2 to 12 of Annex I RBD. These are defined in the CRD as ‘financial institutions’126. The thinking is that if both entities are established in the same member state, there is no real difference between the parent performing services in another member state itself or the parent using a specialised subsidiary to perform such services

126 Art. 4.5 RBD defines this as an undertaking that is not a bank or e-money institution, that has as its principal activity either to acquire holdings or to carry out one or more of the activities listed in points 2 to 12 of Annex I RBD. This excludes attracting deposits or other repayable funds, credit reference services and safe custody services, as well as those Mifid-services not already embodied in points 2 to 12. Following from art. 24.3 RBD, the European passport regime applies to financial institutions regardless of whether they are directly owned by a bank or via another financial institution.

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in another member state. Under strict conditions, the CRD obliges member states to accept notifications regarding such subsidiaries under the European passport regime127. These conditions are as follows128: – The parent entity (or all parent entities in case of a joint venture) has to be a licensed bank in the same member state as the financial institution; – The financial institution that is going to provide services (cross-border or via a branch) in another member state actually carries out the same business in the member state where its parent is active; – 90% of the voting rights attached to shares in the capital of the financial institution have to be in the hands of the parent bank (by implication this prevents foundations or other legal entities without shares to be used as a financial institution); – The parent bank has to jointly and severally guarantee the commitments entered into by the financial institution (this means that contracts are guaranteed, but that other liabilities following from e.g. taxes, fines and tort need not be guaranteed); – The financial institution shall be prudently managed (to the satisfaction of the home supervisor of the bank); – The financial institution shall be included in the consolidated supervision of the parent, including specifically the solvency ratio, the large exposures regime and the regime on holdings outside the financial sector. Instead of a licence, those financial institutions that fulfil all conditions get a ‘certificate of compliance’. This certificate has to be included in the documents sent to the host supervisor during the notification process. Apart from this, there are three other differences129 with the European passport regime for banks themselves: – Instead of its own capital requirements under the solvency ratio regime, the notification for a branch will be accompanied by the supervisors’ statement on the own funds of the financial institution and the consolidated capital requirements under the solvency regime of the parent; – The grandfathering provisions for pre-established banks prior to the introduction of the European passport regime in 1993 are not applicable; – The single entity approach to branches is not applicable. This is logical as there is no standalone supervision in any case, but it also means that for each place of business set

127 Please note that the principal activity of the entity has to be acquiring holdings or activity 2-12 to qualify as a financial institution, but that art. 24 indicates that they can notify all activities in the Annex, so including activity 1, 13 and 14 and the Mifid activities. There is therefore a grey area that allows financial institutions to perform those services on the basis of the European passport as long as they are not the institutions’ principal activity. 128 Art. 24 and 25.3 RBD. 129 Art. 24.1, 25.3, 26.4, 27 and 28.3 RBD.

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up in one and the same other member state, a separate notification needs to be sent by the financial institution. If banks own this special type of financial institutions that use the European passport regime, their supervisor has added responsibilities and tasks. The CRD obliges130 the supervisors of the parent bank to ensure that the financial institution on a solo basis: – fulfils initial capital requirements; – the home supervisor is responsible for prudential supervision in general; – fulfils organisational requirements; – is subject to the qualifying holdings regime; – is subject to the home host cooperation regime as well as the supervisory secrecy provisions; – the supervisor has powers to intervene if it does not fulfil its obligations under this partial supervision regime. These are the minimum requirements for supervision. In addition to the consolidated supervision necessary for ensuring the solidity of the banking group as a whole, and the guarantees of contractual obligations, for the purposes of the European passport regime cross-border cooperation has to be ensured, as well as minimum structuring requirements and basic funding requirements. Especially the allocation of responsibility for prudential supervision can lead, at the option of the member state, to the introduction of full banking supervision, including capital requirements on a solo basis. The term ‘financial institutions’ chosen for these specialised subsidiaries is very confusing for the innocent reader. This term in normal usage refers to all or large segments of institutions with their main business in the financial markets. Most types of entities mentioned in chapter 19 normally would be considered financial institutions131. In the CRD passport regime, it is however used for semi-banks (institutions that perform most activities normally associated with banks, but which do not fall within the bank-definition because they do not attract repayable funds from the public) and is subsequently used mainly132 for a subset of subsidiaries.

130 Art. 24.1 and art. 10(1), 19to 22, 40, 42 to 52 and 54 RBD. 131 See for example also the use of this term in art. 47, recital 39 RBD. 132 The term as defined in art. 4.5 RBD and 3.2 RCAD is also used in the area of own funds (holdings in financial institutions are deducted in the same manner as holdings in credit institutions; art. 57 l to n, 58 and 60 RBD), and in the areas of consolidated supervision and information exchange. Very specific provisions on financial institutions supervised like banks is made in the credit risk standardised approach (annex VI part 1 §24 RBD) and credit risk mitigation (Annex VIII, part 1 §28 RBD).

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The definition of ‘financial institution’ could have led to difficulties, were it not that most member states accept any incoming notifications and do not check whether the incoming entity fulfils the definition of financial institution (or of a bank for that matter). The directive leaves leeway to define e.g. principal activity and acquiring holdings differently, but the main issue in the definition could be on the funding side. The definition of bank limits it to those institutions acquiring deposits or repayable funds from the public. Activity 1 of annex I refers to attracting deposits or repayable funds without the limitation ‘from the public’. If a subsidiary is funded partially with own funds but is partially funded by loans from or bonds issued to non-public parties (e.g. from its parent), some member states may deem this still to be a financial institution (as it does not attract from the public) and other member states may deem this to be a bank instead of a financial institution (as its activity is also focused on activity 1, which is prohibited to financial institutions). The first interpretation appears to be correct due to the fact that activity 1 is excluded. These subsidiary-financial institutions are not covered by deposit insurance schemes and thus should not be allowed to attract deposits or other repayable funds from the public. The text of the directive is not clear, however, and allows other interpretations. Combinations of Establishments and Cross-Border Services in one Other Member State As described above, the rules for market access and for ongoing supervision are different depending on the legal format chosen. The freedom to provide services combined with the low key process on notifications under the CRD provide for a low barrier. This impacts both the initial market access and severely limits role for the host in ongoing supervision of cross-border services. Within the freedom of establishment, the CRD, unlike the text of the treaty, differentiates between the regimes for branches and for subsidiaries, with different sets of prudential requirements. This leads to possibilities to game the rules for both banks and member states/supervisors. The CRD does not contain provisions to prevent such gaming, but the treaties do. The Court of Justice has ruled that the freedom to provide services is applicable only when the provisions on the freedom of establishment are not applicable133. An establishment can be any permanent presence according to the Court, including a branch, agency, or even an office managed by employees of the bank or by independent persons who are authorises to act on a permanent basis for the bank. Under the doctrine set out in the Caixabank France case, such permanent presence can also be a subsidiary. This leads to the conclusion that under the treaty, cross-border services to another member state are brought under the regime contained in the provisions on the right of establishment if a

133 Art. 57 TFEU, German Insurance Case, Commission/Germany, Court of Justice 4 December 1986, Case 205/84, and Gebhard, Court of Justice 30 November 1995, Case C-55/94.

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permanent presence is maintained in the same member state. The CRD regimes for services, and the CRD regime for branch-type establishments or subsidiary-type establishments are different. The CRD does not itself contain conclusive provisions on the combination of notifications for branches and for cross-border services134. Banks do combine both types of notifications. If treated separately, this keeps the cross-border services-activities out of the scope of local – CRD compliant – rules applicable to establishments (e.g. liquidity requirements for branches). Supervisors do not appear to challenge this practice, though there may be informal pressure to channel the cross-border services via the branch. As the CRD leaves room for interpretation (in the absence of a clear rule in favour or against such combinations) it has to be interpreted in the way that is most consistent with the treaty and the intention of the directive135. The CRD requirements for cross-border services reduce the power of host supervisors primarily because there is no local link, no pretension vis-à-vis local clients as to the applicability of local rules. Pure cross-border services are generally less effective in retail markets as retail customers tend to prefer brick and mortar addresses in their member state. If a bank can benefit from having bricks and mortar addresses (of subsidiaries or branches) in the host member state, while circumventing the additional rules applicable to such establishments that are justified due to the increased presence in the host member state and thus the greater attracting power to local clients by officially channelling some activities under the services passport instead of via the books of the establishment, this may be the best of two worlds for the bank. The justifications for reduced involvement and lower barriers however no longer apply. The bank gets the benefits of local establishment and should in that case not be able to ‘game’ the CRD by opting to make two different notifications (with the applicability of the corresponding local rules only to the part of their local activities they have chosen to book into the books of the branch). Supervisors should challenge this subdivision between services and establishments by the same bank. It is less clear whether branches and subsidiaries can indeed, as the CRD stipulates, be treated differently under the treaty. Branches require a notification and only allow very limited input of the host supervisor, subsidiaries require a licence and own funds, albeit with limitations on the supervisory power to refuse the licence if an EU parent bank establishes the subsidiary. For ongoing supervision, the differences are more substantial, including a more distinct impact on the supervision of the group for the host supervisor. As the treaty freedom do not distinguish between subsidiaries and offices that are part of the same legal entity, it could be argued that all cross-border activities should be channelled

134 Though art. 23 RBD refers to a European passport either for an establishment, or for services, which would be in line with the case law mentioned. 135 See e.g. the Co-Insurance Cases, e.g. Commission/France, Court of Justice 4 December 1986, Case 220/83.

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via the regime for the most intrusive form of cross-border establishments, i.e. the subsidiary regime. If an EU bank has both a branch and a subsidiary in another member state, the supervision regimes are, however, quite distinct in the CRD. The two establishments are not considered together for ongoing supervision purposes of the host supervisor nor of the home supervisor. The treaty and CRD do not have clear provisions on the combination of activities in another member state via branches and subsidiaries, and there is no Court of Justice case law on such a combination. Both fall within the right of establishment as guaranteed by the treaties. If there is only either a branch or a subsidiary, there is justification for the different treatment of both. A subsidiary has an increased presence in the host member state both in the eye of their clients and under e.g. monetary policy and deposit insurance. If a group has both subsidiaries and branches in a host member state, it becomes difficult to distinguish the branch in that case from the subsidiary; to the extent that most clients will not distinguish between the two. The branch benefits from the increased presence in the host member state that the subsidiary gives to the parent bank, and does not ‘suffer’ from the balanced increased host powers on its business. At a minimum the treaty does not appear to contain provisions that prohibit a member state from treating branch activities as if they are activities of the subsidiary, but an express arrangement treating establishments of a foreign bank the same (or explicitly different for reasons acceptable under the TFEU) would be helpful. Onward Cross-Border Services and Branching by a Branch of a Bank? On the basis of a rather peculiar communication by the Commission, there is a debate on the applicability of the European passport to onward cross-border activities of a branch. For example a branch of a German bank in the UK that provides services from the UK premises to French clients. Should the German bank make a notification to France (and is it allowed to according to the text of the RBD), should the UK branch of the German bank make a notification (and is that allowed), and does it make a difference if it concerns activities via a branch in France or activities via telephone or internet without a branch? The UK apparently lobbied the Commission to obtain a communication with guidance on the width of the passport136. The communication favoured the possibility of such onward passporting. It caused more problems than solved them, as this possibility goes against the text of the European passport provisions in the CRD that refers to a notification of the licensing supervisor The communication was not considered authoritative in this respect, and was not upgraded into the law when the second banking directive provisions were copied in subsequent versions, now into the CRD. The discussion is theoretical in light of 136 Commission Interpretative Communication, Freedom to Provide Services and the Interest of the General Good in the Second Banking Directive, SEC(97) 1193 final, 20 June 1997. C. Abrams, The Financial Services and Markets Act Cross-Border Issues, Journal of Financial Regulation and Compliance, Vol. 8, No. 3, 2000, page 237-255, specifically page 245 and 246.

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the approach of the Court of Justice to cross-border freedoms. These give any person the right to perform activities in the EU. Putting obstacles in the way of such freedom just because it is managed via another establishment of the same entity (or group) does not appear in line with the intent of the treaty freedoms, nor proportional to any legitimate interest. If a branch or cross-border services are part of or provided by the legal entity, the licensing supervisor (i.e. in the example Germany) can easily make the notification in this case both to the UK and to France, which will cover the entire legal entity. Future Developments The CRD IV foresees a gradual movement from host responsibility for liquidity to home supervision of liquidity for branches, simultaneous with further harmonisation of the content of the requirements137. Otherwise, the European passport and the treatment of subsidiaries is materially unchanged in the CRD IV project138. EBA is obliged to develop regulatory standards on the information to be notified by the bank to the home supervisor and onward to the host supervisor, and implementing standards on the procedures, forms and templates for these notifications, both for the European passport for branches and for services139. The draft standards have to be submitted to the Commission by 1 January 2014. Under the ‘banking union’ proposals of the Commission, the notifications under the EU passport for branches and cross-border services would no longer apply if a bank from one participating country (Eurozone plus voluntary members of the banking union) wants to start activities in another member state140. If it chooses to establish a subsidiary in the other member state, it would still need a separate authorisation. Licences would no longer be granted by the Eurozone member state supervisor, but upon a proposal of the remaining parts of the national supervisor issued by the ECB; see above and chapter 5.2. The thinking is that this two-step process would allow the ECB to assess whether it finds a bank safe, while the national authority would be able to assess whether any national discretion-deviations under local laws would be fulfilled (even after the CRD IV project enters into force, the licensing procedure is not fully harmonised).

137 138 139 140

Recital 76 CRD IV Directive. Art. 33-46, 49-52, and Annex I CRD IV Directive. Art. 25.5, 26.5 and 28.4 RBD, as added by the Omnibus I Directive 2010/78/EU. Commission, Proposed Single Supervisory Mechanism ECB Regulation, COM(2012 511 final, 12 September 2012, page 6 and the ambiguous art. 14.

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It is not yet clear how the potential abolishment intra-Eurozone of the notifications for branches and cross-border-services would impact on the attached services under e.g. Mifid, and on the home/host division of labour under such directives between conduct of business supervisors if they are no longer alerted to the new activities of an existing entity in their country, but it may be that the ambiguous phrasing in the regulation would necessitate a notification for conduct of business purposes under the CRD until such tasks are re-regulated in Mifid; also see chapter 21.3.

5.4

Market Access by Mergers and Acquisitions of Qualifying Holdings

Introduction Market access can be gained also by taking a participation in an existing licensed bank that already is active in the relevant market. Such a holding can be gained via a share transaction or by buying the assets and liabilities of a firm, but legal mergers are possible too. The Basel core principles identify the mergers and acquisitions process as a transforming event for both the target and acquirer (for the last if it concerns a major acquisition). The supervisors of both entities (both in a cross-border context and in a domestic context) must have the power to stop the acquisition/merger going ahead if the resulting entity/group is deemed not viable, too risky or cannot be supervised well141. Taking over (a part of) an existing bank by another EU based bank is covered by the treaty fundamental freedoms. If it concerns the acquisition of a limited influence only (i.e. the shareholding will not confer definite influence over the company’s decisions and does not allow them to determine its activities) it is covered by the free movement of capital. If it concerns a full takeover of a company having its registered office in another member state and the shareholding confers a definite influence over the company’s decisions and allows shareholders to determine its activities, the freedom of establishment applies142. Similar to ‘new’ establishments, gaining an establishment via a merger or acquisition is subject to scrutiny of banking supervisors in the target market. The responsibilities and type of assessment of prudential supervisors when approving acquisitions (not of full legal mergers of two legal entities or of assets/liabilities transfers; see below) has shifted dramatically in recent years. The main issue under the previously applicable CRD-regime used to be the interests and continued solidity of the target bank, and whether the proposed acquirer was suitable for the target bank. This was compared 141 Principle 6 and 7 and page 27-29 of BCBS, Core Principles for Effective Banking Supervision, September 2012. 142 Überseering/NCC, Court of Justice 5 November 2002, Case C-208/00.

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to the previously existing situation without the proposed acquirer (regardless whether the existing situation also had a dominant shareholder or whether it was publicly listed without a dominant shareholder). The identity of the proposed acquirer was less important, though it was in practice easier for another bank to qualify as a good acquirer on issues such as solidity and expertise. The interests of the target bank (whether it wanted to be taken over or not) could play in practice an important role in the assessment by its local supervisor, as could the own preferences of the host member state government or supervisor. The lack of criteria for the assessment lead to diverse practices across the EU. In most member states, for smaller institutions the practices were permissive. For national champions this was not the case. Permission to take control of a big bank based in another member state was rarely sought or granted, except where the national champion was failing. This practice changed with the enlargement of the EU towards Central Eastern Europe. In these newer member states, dominant banks increasingly were in the hands of ‘foreign’ banking groups (i.e. groups based in another member state). In the new procedure described below, the influence of the target bank and of the host member state authorities is severely limited, and objections can be based only on non-nationalistic considerations. The intent of the process is to assess whether there are prudential concerns, based on prudentially relevant information, to oppose the intentions of an acquirer to acquire or increase a qualifying holding in a target bank (the same ‘qualifying holding’ that is assessed in the context of the licensing process of a new bank; see chapter 5.2. Though the process is colloquially referred to as mergers and acquisitions or M&A, the CRD provisions actually deal with any acquisition, increase or decrease of a qualifying holding in a bank. The process is identical to approve shareholders of any bank, new or existing, but the process will be more cumbersome if the target bank (or its activities) already existed as the repercussions for the target, the acquirer and their existing customers will need to be considered in addition to the suitability of the shareholders of a new start-up. Cross-Border-Freedom or Financial Stability Host Market Focus? From a national identity and international importance point of view, a takeover of a bank is nice if a bank in your country is taking over another bank, not always so nice if your banks are being taken over from abroad. Especially in closed financial economies (e.g. with large public sector ownership or at least strong public sector control of the banking sector as is common in e.g. Germany, Spain and Italy), this could be politically unwelcome. This is not a prudential concern in and of itself, and within the EU has always been officially frowned upon due to single market concerns. Legitimate prudential concerns focus on financial stability issues, including the solidity of the resulting banks, whether key parts of local economies would continue to be funded even in case of financial problems in either the host or home country, whether the management could handle the enlarged group and

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whether the resulting group was viable. The desirability of growth in the size of banking groups is subject to fashions, and in the wake of the 2007-2013 subprime crisis is currently less popular in the context of the too big to fail/too big to save discussion; see chapter 18.2 on systemic banks. Having big banks was – prior to the crisis – a source of national pride, and will no doubt be again in the future. The long term trend towards opening markets, access via mergers and acquisitions are likely to continue, for larger firms when the short term memory of this crisis fades and for smaller firms – and for parts of failed banks as part of rescue events – even now. Both from a single market point of view (i.e. the point of view of the Commission) and from a growth and status point of view (i.e. the point of view of banks on the prowl) prudential concerns indicate barriers to their ambitions. The legitimacy of these concerns is questioned143, especially where they can potentially be (ab)used by supervisors that are susceptible to non-acceptable nationalist concerns. The main focus for prudential concerns within the context of the EU single market and financial stability goals is whether the resulting banking group and the individual banks that are part of it remain solid. If all assessments of cross-border merits of mergers and acquisitions would have continued to be focused on the legitimate interest of the banks involved, this subject could have been fully covered in chapter 22, 21 and 17 on financial stability, supervisory cooperation and consolidated supervision, or with the licensing requirements in chapter 5.2. However, since the political discussion surrounding the takeover by Dutch ABN Amro of Italian Antonveneta, the accent when verifying mergers and acquisitions has changed from the solidity of the acquired institution to the market access such a merger or acquisition would give to the acquiring institution (especially if the acquiring institution is a bank too). Since 2009, a fully worked out assessment process is in place144 which puts the accent squarely on the single market-interests of the acquirer, unless the merger or acquisition directly and clearly impacts on the legitimate interest of the supervisor of the target bank to assess the continuing solidity of the target bank (the assessment by the supervisor of the acquiring bank was not part of the scope of the legislative initiative, see below). The amendment of the RBD inserted by the mergers and acquisitions directive is more recent than the takeover directive that is applicable to all companies. It nonetheless lacks 143 M. Wolgast, ‘M&As in the Financial Industry: a Matter of Concern for Bank Supervisors?’, Journal of Financial Regulation and Compliance, Vol. 9, No. 3, 2001, page 225-236. 144 Directive 2007/44/EC introduced similar provisions into the RBD, the Mifid, and into the Insurance Directives 1992/49/EEC, 2002/83/EC and 2006/48/EC (direct non-life, life, and reinsurance respectively). CEBS/CEIOPS/CESR provided further guidance on the details in CESR/CEBS/CEIOPS (now ESMA/EBA/EIOPA), Guidelines for the Prudential Assessment of Acquisitions and Increases in Holdings in the Financial Sector Required by Directive 2007/44/EC, 11 July 2008.

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provisions on the relation to the takeover directive or to the EC merger regulation, nor does it contain provisions on the relation to the approval by competition authorities under the EU treaties145. These procedures exist and apply simultaneously, and in theory the prudential assessment can cover aspects that are also covered by the other two sets of procedures and approvals. By implication, however, the previous provisions on mergers and acquisitions had already been limited more and more to prudential concerns, leaving aside the issues dealt with on listed banks by the takeover directive and on competition concerns by the EU treaties. The terminology of the CRD was, however, broad enough to provide ample latitude to member states and banking supervisors to work either with or against takeovers of domestic banks by non-domestic parties. Perhaps such attitudes could have been challenged – even under the old CRD provisions – successfully in court under the anti-discrimination provisions of the TFEU146, but the time and resources necessary for such a challenge, in combination with the needed cooperation with the local supervisor after a successful takeover, meant that the new procedure in the financial directives was necessary if it was indeed intended to provide easier market access to acquiring institutions. Legal Mergers or Asset/Liability Purchases The definition of qualifying holding is a direct or indirect holding which represents 10% or more of the capital or of the voting rights (in this case of the target bank) or which makes it possible to exercise a significant influence over the management of the target. Strangely, the update regarding the process was not used to modernise the scope of the process. Full legal mergers across borders are e.g. possible under the European company regulation or the cross-border merger directive147. A legal merger could include one legal entity being absorbed by the other legal entity or both by a newly constituted legal entity, and its shareholders obtaining shares in the remaining entity. This only falls within the scope of the newly introduced mergers and acquisitions arrangement if yet another groupentity as a result obtains a ‘significant influence’ that falls within the scope of the definition of qualifying holding. For an asset/liability takeover, the RBD is not clear as to the role of supervisors. In effect, a foreign bank based in another member state could use its European passport. It is not clear whether asset transfers (even of all but especially of part of the target bank’s business) 145 However, the M&A Directive does in a limited way harmonise some concepts, including the calculation of the numerical thresholds, with the Transparency Directive 2004/109/EEC. For competition concerns in the context of state aid see chapter 18.4. 146 Art. 18 TFEU. 147 Council Regulation on the Statute for a European Company (SE) 2157/2001 and Cross-Border Merger Directive 2005/56/EC. On the troubled negotiations for the latter directive see L. Frach, Evaluating the Efficiency of the Lamfalussy Process: The Prospectuses Directive, Takeover Directive and MIFID as Case Studies, Research Group on Equity Market Regulation REGEM Analysis 16, Trier University, February 2008.

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would fall within the scope of qualifying holdings under the text, though if all assets and liabilities (the entire undertaking) are transferred such can be assumed. If the assets include bricks and stones and the foreign bank did not yet have a branch in the member state where the assets/liabilities are located, it would need to make a notification of a branch via its own supervisor; see chapter 5.3. If the assets includes subsidiaries with separate banking licences, the mergers and acquisitions procedure would apply to such subsidiaries (but not to other assets bought from the selling bank). As indicated in chapter 3.5 these provisions contain some of the – until 2014 – sporadic maximum harmonisation articles in banking supervision, but this maximum harmonisation is limited to acquisitions of voting rights or capital. More stringent provisions can be instituted by member states on e.g. the acquisition or increase of qualifying holdings consisting solely of significant influence148. For a cross-border legal merger, the treatment of the bank licence(s) of the merging entities will need attention. In some member states, a licence may need to be re-applied for in any merger situation; see chapter 5.2 under ‘once a licence, always a licence’. If a licensed bank is absorbed by a new entity with its headquarters elsewhere, or by a non-bank with its headquarters elsewhere, the licensing provision that the headquarters of the new bank and it licence are in the same member state is by definition no longer fulfilled, even if the local laws allow the licence to be transferred to a the surviving entity in a legal merger. Whether that RBD-condition is still legal in light of transfer of seat case law of the Court of Justice is questioned in chapter 5.2. In practice, the bank would become a branch of a foreign entity, which may or may not continue to have the benefit of a banking licence of its home member state and/or of the licence of the disappearing entity. If the condition would turn out not to be applicable anymore, the RBD provisions are not clear on which country would bear responsibility for supervising the resulting entity, unless the new entity has a licence of its home member state and the licence of the disappearing bank is terminated. If the bank is the absorbing entity in a legal merger, its character may change, and thus the requirements on e.g. the expertise required of the persons who effectively direct its business. Other changes could include changes in the holders of qualifying holdings that need to be approved.

148 Though art. 19.6 RBD only mentions acquisition and art. 19.1 mentions initial acquisitions and subsequent increases of qualified holdings separately, I assume that the term acquisition as used in art. 19.6 RBD would be deemed in court to include acquisition of additional shares or capital to increase the qualified holding.

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Process for Acquisitions of Qualifying Holdings For the intention to directly or indirectly obtain a qualifying holding, approval needs to be obtained by the acquirer149 when thresholds are passed, either when the holding is increased or when it is decreased150. If the holding consists of voting rights or capital, those thresholds are numerical. The thresholds are the achievement of any qualifying holding at all, i.e. at 10% or more of the capital or of the voting rights of the bank, and subsequently at 20%, 30%151 or 50%. In addition, if this happens due to other factors such as cancellation of shares, the approval (or non-opposition) has to be obtained as soon as the target becomes a subsidiary (i.e. when the acquirer obtains dominant influence). If the qualifying holding does not consist (only) of shares or capital, but of significant influence, there are two thresholds only: the significant influence itself152, and when the target becomes a subsidiary. If one of the thresholds is intended to be reached or reached in practice, approval must be sought by the acquirer from the supervisor of the target institution. The supervisor has to: – assess the suitability of the proposed acquirer; – assess the financial soundness of the proposed acquisition; – with the goal to ensure the sound and prudent management of the target bank, while having regard to the likely influence of the proposed acquirer on the target bank (i.e. proportionate to the degree of its actual influence after having obtained its qualifying holding). The assessment can only look at prudential concerns, which are enumerated exhaustively: – the reputation of the proposed acquirer153; – the reputation and experience of the proposed management of the target bank; 149 An acquirer can be a single natural person or legal entity, or a group of natural persons and/or legal entities acting in concert, see below. See art. 19.1 RBD. Each direct or indirect holder will need to obtain approval. 150 See art. 4.11 to 4.13, 19.1 and 20 RBD, as well as art. 1 and 2 of the Seventh Council Directive on Consolidated Accounts 1983/349/EEC. Art. 12.1 RBD indicates that certain voting rights and investments are taken respectively not taken into consideration for the calculation of the numerical thresholds, in order to harmonise some concepts with the Transparency Directive 2004/109/EC. 151 Or alternatively a threshold of 1/3 can be made applicable in a member state if that member state has also applied that threshold under the Transparency Directive 2004/109/EC. 152 According to recital 6, the ‘significant influence’ criterion can also be implemented into domestic legislation as an additional numerical threshold, even below 10%. This appears to contravene the text of the actual provisions, and it is doubtful whether this would hold up if challenged in court. Except for the most diversified publicly listed target banks, a below 10% shareholding will not be deemed significant, especially as the next level of influence, dominant influence, would lead to it being a full subsidiary. 153 According to recital 8 to Directive 2007/44/EC, the reputation implies the determination of whether any doubts exist about the integrity and professional competence of the proposed acquirer and whether these doubts are founded, based for instance on past business conduct. The BCBS goes further by indicating that people who own a significant portion of the bank should be assessed for fitness and propriety in the same manner as board members are assessed. BCBS, Principles for Enhancing Corporate Governance, October 2010, §16.

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– the financial soundness of the proposed acquirer, in relation to the profile of the target bank; – will the target bank continue to comply with the prudential requirements under the CRD (both RBD and RCAD), the Financial Conglomerates Directive and/or the emoney directive; – will the bank become a part of a clear group structure for supervisory purposes (also see the licensing requirement, chapter 5.2); – are there (increased) risks of money laundering or terrorist financing (see chapter 16.3). These criteria (and the provision of sufficient information to assess whether they are complied with) are the only reasons why an acquisition can be denied. Though more detailed and clearer in direction than the articles replaced, these criteria are still open to interpretation by the supervisor. They do not provide the promised legal certainty, clarity and predictability with regard to the result of the assessment process. Likely the goal of increased competition in the single market was partially sacrificed for reasons of financial stability (and possibly to cover remnants of national interest)154. For instance, the directive is not clear on how good the reputation of the acquirer must be, or whether the acquisition is considered sound if the target bank or the whole banking group as a result goes from comfortably solvent to just barely fulfilling the minimum requirements. Member states are obliged to publish lists of the information necessary for the prudential assessment, with the instruction to make those lists sufficiently flexible to be proportionate to the nature of the proposed acquirer and the proposed acquisition. Those lists should – if possible – be similar, but that is not demanded in the directive. CEBS-EBA and the other sectoral authorities have, however, issued guidelines on various issues, including on reputation and on the needed information155. The process is different depending on whether the acquirer is a bank (or another entity subject to or relevant for prudential supervision under EU legislation156) or not. If there are supervisors of another sector or of another member state involved, they are obliged to cooperate and provide each other with the relevant information157. This is relevant if the directly acquiring entity and the target are both under supervision, and the importance of

154 Recital 2 to Directive 2007/44/EC. B. Casu & C. Girardone, ‘Competition Issues in European Banking’, Journal of Financial Regulation and Compliance, Vol. 17, No. 2, 2009, page 119-133. 155 CESR/CEBS/CEIOPS (now ESMA/EBA/EIOPA), Guidelines for the Prudential Assessment of Acquisitions and Increases in Holdings in the Financial Sector required by Directive 2007/44/EC, 11 July 2008. 156 Specifically art. 19b RBD refers to banks, e-money institutions, life assurers, direct-non-life insurers, reinsurance companies, investment firms or UCITS management companies authorised in another member state or in another sector, as well as to their parent undertakings, or natural person or legal entity controlling them. 157 Art. 19b RBD and recitals 6, 8 and 10 to Directive 2007/44/EC which introduced this article into the RBD.

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this requirement further increases when the target is itself the top holding of a financial group and if the acquiring supervised entity is a subsidiary in a financial group. In that case, the notification requirement is applicable to all banks in the target banking group, and all parent banks of the acquirer are also acquirers themselves (as they obtain direct or indirect influence). If the supervisors involved would not cooperate closely, it could be that contradictory decisions were taken, hampering each other’s interests and the interests of the supervised entities. If there are no prudential supervisors for the acquirer as yet, the relevant information on its health and reputation would not be expected to be available at a member state authority. There is no provision if either of the financial groups (target or acquirer) has supervised entities in third countries, but it can be assumed that the obligation within the EU would be good practice when cooperating with prudential supervisors elsewhere. Though not reflected in the binding provisions of the directive, the recitals to the directive mentioned above urge supervisors to go beyond cooperation. They ‘should take into full account the opinion of the competent authority responsible for the supervision of the proposed acquirer, particularly as regards the assessment criteria directly related to the proposed acquirer’. In combination with the statement that the reputation of the proposed acquirer should be ‘facilitated’ if it is authorised and supervised in the EU, there is a strong recommendation that an acquirer should be deemed to have a good reputation if licensed and supervised in the EU. The supervisor has the possibility to oppose the acquisition within a period of 60 working days after it has confirmed (within 2 working days) the receipt of the notification and all required documents from the acquirer. This period can be extended with up to 20 working days if the acquirer is an EU prudentially supervised entity and up to 30 working days if additional information is requested from the acquirer. If the supervisor does not oppose the acquisition in writing within the applicable period, it is deemed to be approved. The supervisor can approve it sooner of course. Any opposition in writing needs to be sent to the acquirer within 2 working days, and needs to set out the reasons for the decision as well as any views or reservations expressed by the competent authority responsible for the acquirer158. With the approval, the supervisor is allowed to set a maximum period for approving or declining to approve the proposed acquisition to shorten the uncertainty and thus viability of the target bank in the markets. The decision or lack of decision can subsequently be challenged in court; see chapter 20.

158 The latter also applies to an approving decision. See art. 19 and art. 19b.2 RBD.

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If there are several potential ‘acquirers’ for the same qualified holding in a target bank, they all have to notify their intention to the supervisor of the target bank159. This applies to joint ventures, as well as if the acquirer is itself a subsidiary. The notification needs to be made by the entity obtaining the qualifying holding directly or jointly, as well as by its parent companies up to the highest in the group or a controlling natural person, if any. The supervisor is bound to treat each in a non-discriminatory manner, which can be assumed to reflect both on nationality160 and on the regular business of the acquirer and the relative size of each acquirer. Each notification has to be dealt with on its own merits. Those acquirers that pass muster can subsequently compete between each other to actually obtain the qualified holding. Though the targeted percentage of the holding in the target bank is solely up to the acquirer, once he obtains the approval, he is more or less stuck with his choice (unless he fails to obtain the holding in the market). If he wants to increase his holding to the next threshold up, or changes his plans to make the initial holding in the target larger (beyond the next threshold up), he will need a new or amended approval. For an increase, this is because with the increased holding the influence and control exercised will increase, while decreasing the influence and control (and thus also the willingness to step in when necessary) of other owners of holdings in the target bank. For a decrease (or smaller acquisition than initially intended), similar considerations prevail, but the CRD provisions are different. With a decreased holding, the influence, support and control exercised via the qualifying holding will likewise decrease, perhaps necessitating improved management and self-sufficiency at the target bank (including a standalone sufficiency of capital and organisation), as well as increasing the influence and control exercised by other owners of holdings, who may not be suitable for that more dominant role. The CRD only indicates a prior notification duty161 for the bank wishing to dispose of (part of) its qualified holding. Unlike for increases, an assessment process does not follow the notification obligation, even though ongoing supervision of both banks may be influenced by a decrease of the holding/commitment. However, it should be noted that the maximum harmonisation provision is limited to acquisitions, and does not extend to dispositions. Member states may ‘goldplate’ in order to add an approval process for dispositions, to assess whether prudential concerns dictate that such a disposition can only take place if and in as far as the target bank remains on a sound footing after the intended disposition.

159 Art. 19.1 RBD and the definition of qualifying holding. 160 As already contained in art. 18 TFEU. 161 Art. 20 RBD.

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There are three main differences between the qualifying holding regime and other market access provisions: – Unlike for an licence, the CRD does not provide for revoking or changing the approval once given. Though an acquired holding is indeed difficult to turn back to the sellers and violate the right of property, this is also true for withdrawing a licence (see chapter 5.2), as a result of which the CRD has an inconsistent gap here in case the conditions for the acquisition are no longer fulfilled; – Unlike for branches and cross-border services notifications, the notification for an (increase or decrease) of a qualified holding are not channelled through the supervisor of the acquirer, if any; – Unlike for licensing and for the home supervisor forwarding a branch notification, if the time allocated for the supervisory assessment is exceeded without explicit opposition in writing being received, the approval is deemed to be given. The emphasis on various non-discrimination provisions, the equal emphasis on the mergers and acquisitions approval being a prudential assessment only, as well as the increased dependence on certain assessments of the acquirer by its own supervisor if available (instead of by the supervisor of the target) indicate that the main reason for setting out the process and criteria was the breaking of national tendencies to block takeovers of banks deemed important in the local markets162. This is in line also with copying the prohibition to assess the economic need of the market, in line with the same prohibition in the licensing provisions where it also prevents artificial borders and protection of established local banks163. This goal has, however, meant that the actual content of the prudential assessment is relatively vague. Still, it is progress that the criteria to be safeguarded are now established, as well as the focus of the assessment. The more detailed information requirements and criteria are left to the member states and banking supervisors, and may be introduced into the RBD following an evaluation164). The approval process for an acquisition of a qualified holding is one of the few areas where the consequences for civil law are also set out in the CRD. If – despite the timely receipt of the decision of the supervisor opposing the acquisition – the acquirer still presses ahead, the member states have to give the supervisor the right to impose at least one of the following three sanctions: – The exercise of the corresponding voting rights to be suspended; – The nullity of votes cast; – The possibility for the annulment of votes cast.

162 See art. 19a.2, 4 and 5, 19.b RBD. 163 Art. 8 and 19a.3 RBD. See chapter 5.2. 164 Art. 6 Directive 2007/44/EC, which directive introduced the new process into the RBD.

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These measures of course only have effect on qualifying holdings consisting of voting rights, not necessarily for capital or for (e.g. contractual) significant influence. Acquirers, especially acquirers not otherwise active in the financial sector, may well not be aware of the additional required approval for a qualified holding, or may not be aware that its holding has reached one of the thresholds in a publicly listed bank. For this reason, each (target) bank has the responsibility to report on an annual basis all qualifying holdings in its capital that it is aware of. It also has to report immediately each known initial qualified holding and increases or decreases of qualified holdings past one of the thresholds to its supervisor. For a publicly listed bank, this can be derived from information from custodians, from the registration for the annual shareholders meeting or in other ways. The fact that the notification/approval process was not followed does not make the acquisition invalid, though it will not befriend the acquirer to the supervisor. As a negative input for the assessment process it will be made worse if the acquirer should have known better or knowingly did not follow the process. Member states are required to give their supervisor the power to put an end to the situation if the supervisor deems the influence given by a qualified holding is likely to operate to the detriment of the prudent and sound management of the target bank165. After a bank has acquired another bank, a whole range of requirements rules the relationship between the two (see chapter 5.3 on subsidiaries). The most important are the consolidation requirements described in chapter 17. If a bank is acquired by a holding company, the provisions on consolidated supervision may lead to inclusion of the new parent into the consolidation by the supervisor of the target bank. Also, please note the treatment of equity exposures to banks where the equity held (even if it is a qualifying holding) does not lead to consolidation, and the special treatment of large exposures to the parent or subsidiaries (see chapter 7.2 and 11.2). In addition, there are limitations on holdings in non-financial companies. These are not in the form of notification or approvals, but consist of maximum total capital invested in such non-financial holdings in relation to the own funds of the bank (see chapter 11.3). The CRD does not provide for – but also does not prohibit – an explicit check on acquisitions of other banks made by a licensed bank by the supervisor of the acquiring bank166. 165 See art. 21.2 RBD for examples of such instruments, which include e.g. the suspension of the exercise of voting rights held by the acquirer. 166 The same applies to mergers and acquisitions of other financially oriented undertakings (though please note that for solo supervision these holdings are deducted from own funds, see chapter 7 and 17, and art. 57 RBD. There are limitations for qualifying holdings by a bank outside the financial sector, however, see chapter 11 and art. 120-122 RBD. The BCBS notes that major acquisitions should be able to be blocked by the supervisor of the acquiring bank; principle 7 and page 28-29 of BCBS, Core Principles For Effective Banking Supervision,

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Under the CRD, the bank will need to take into consideration in any case that it will need to fulfil all its CRD-obligations both at the solo level and at the consolidated level also after it makes the acquisition. This applies to all obligations, including on financial buffers, liquidity and organisation. As larger mergers and acquisitions may impact directly on e.g. available management capabilities or on available liquidity (both RBS and Fortis ran into trouble after financing the takeover of ABN Amro in 2008 mainly with debt instead of with shares or newly raised capital to compensate for the depletion of their capital by paying in cash to the former shareholders167), own funds and imposes additional demands on management and funds for the integration process, the supervisor of the acquirer will generally check whether that bank will be able to carry (in the sense of afford and control) its investment in the other bank. If the taken over entity is guaranteed by or even merged with the acquiring bank, the effects of too big to save in relation to the GDP of the home country and on the funding of the deposit guarantee scheme of the home country may need to be taken into account in any case for financial stability/general good reasons in both the home and the host country; see chapter 3.5 and 18168. EU Competition Rules The assessment on mergers and acquisitions is separate from the analysis made by the Commission or the national competition authorities under EU competition rules. Those look not at prudential concerns but at: – measures that may affect trade and prevent, restrict, or distort competition within the common market through cooperation of undertakings; – abuse of a dominant position by one (or more) undertakings; – state aid (see chapter 18.4). Whether the Commission or one of the national authorities is competent is determined in EU regulations169. If a case has effect in more than 3 member states, the Commission will normally take charge. It can also always take over a case from a national authority if it so desires. The national competition authority with the most direct link to the case will September 2012. Note, however, that any intervention to stop an acquisition of another bank by the home member state may equally run afoul of the protected freedom of establishment as an intervention by the host member state would, unless there are clear public interest goals for the intervention. See Alpine Investments/ Minister van Financiën, Court of Justice 10 May1995, C-384/93. 167 Fortis paid its part fully in cash, RBS paid its part largely in cash (on a net basis 16 billion euro, of which 5 billion in equity). RBS Press Release 16 July 2007. 168 For general good/public interest reasons, cross-border activities in other member states may be curtailed. Alpine Investments/ Minister van Financiën, Court of Justice 10 May1995, C-384/93. 169 See Competition Regulation 1/2003, Commission Notice on Cooperation Within the Network of Competition Authorities, 2004/C 101/3. EC Merger Regulation on the Control of Concentrations between Undertakings, 139/2004. Also see D.G. Goyder, J. Goyder & A. Albors-Llorens, Goyder’s EC Competition Law, 5th ed, Oxford, 2009.

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take the lead unless the Commission takes the wheel. Who has this direct link will be determined by the authorities debating the issue. A network of the Commission and the national authorities exchanges information continuously. The assessment by one authority is allowed to build on work done by other competition authorities. It is possible that mergers affect the financial markets within a member state170. If it transgresses EU competition rules the competition authorities can block it or impose conditions for competition reasons, similar to banking supervisors if they block it or impose conditions for prudential reasons. The competition aspects are solely in the remit of the competition authorities, and are only indirectly relevant for banking supervisors via legal risk/operational risk considerations; see chapter 10 and 13). Banking supervisors are forbidden to take ‘economic need’ into consideration for their own approval process171. Though there is little overlap in competences, the decisions of competition authorities may impact on the viability of both the target bank and the acquiring bank, especially if one of the two is in trouble; also see chapter 18.4 on its role on state aid approval (where the acquirer or sponsor is the member state). This can lead to opposed decisions on the desirability of the planned merger or acquisition even though both sets of authorities have the single market as a goal (for banking authorities combined with sometimes contradictory financial stability and depositor protection goals; see chapter 4.3. Competition policy is out of scope of this book, but is an additional set of rules banks (and their supervisors) will need to take into account when expanding their business or cooperating with each other. Future Developments At the moment, there are no clear proposals on the table to either limit or further enhance the prudential checks on mergers and acquisitions. The CRD IV project has copied the existing rules 99% unchanged, except on EBA standards (see below), an added reference to the relevance of the suitability of the senior management of the acquirer, and a limit of the administrative burdens of banks that are not listed on a regulated market on the notification obligations on potential qualifying holdings172. This might change in light of the introduction in the USA of a concentration rule173. Under the so-called Volcker rule in the Dodd-Frank act makes an attempt to keep deposit-taking banks from the risks associated with proprietary trading. Though the benefit of the wider Volcker-rule is debatable174, the

170 See e.g. P.P. Barros, D. Bonfirm, M. Kim & N.C. Martins, Counterfactual Analysis of Bank Mergers, Banco de Portugal WP 5, 2010. 171 Art. 19a.3 RBD. Compare with art. 8 RBD for the licensing process; see chapter 5.2. 172 Art. 22-32 CRD IV Directive, with minor amendments in art. 22.9, 23.1 sub b and 26.1. 173 Section 622 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Also see Financial Stability Oversight Council, Study & Recommendations Regarding Concentration Limits on Large Financial Companies, January 2011, www.treasury.gov. Xin Huang, Hao Zhou & Haibin Zhu, Systemic Risk Contributions, Fed Board Staff WP 2011-08, January, 2011. 174 See R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 4.4.

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associated concentration rule has a clear benefit in reducing the systemic impact of any individual banking group. It prohibits acquisitions/mergers if the resulting entity will have more than 10% of all liabilities of all financial entities in the USA that are linked to deposit taking entities. Liabilities are – simply put – risk weighted assets minus financial buffers. While introducing a similar limit would have clear benefits on this side of the ocean too, it cannot be done until the issue of joint and fully harmonised recovery and resolution has been resolved175. As long as the funding of bailouts is a state-matter instead of an EU level decision, the individual markets would be too small. EU member states would have to accept that their banks would need to be reduced to minnows compared to their USA counterparts, unless resolution of systemic groups would truly be dealt with on a Eurozone or – even better – EU level. There are efforts moving incrementally in the direction of a banking union, but whether this would transfer state aid responsibility to the EU or Eurozone instead of to individual countries is yet to be determined. As an intermediate stance, it could be considered to introduce explicitly a refusal ground for mergers and acquisitions if the home country supervisor deems the resulting group systemic, and the home member state, either alone or under pre-arrangements with other member states, so big that it would not be able to bear the likely costs of lender of last resort and/or bailout regimes. There is no reason why a country should accept systemic risk that it cannot bear (alone). EBA is allowed but not obliged to develop regulatory standards on the information to be included in applications by an acquirer, and implementing standards on the procedures, forms and templates for the consultation between the supervisors involved176. The CRD IV directive changes this into an obligation to develop standards by end 2015. Under the ‘banking union’ proposals of the Commission, the ECB would gain also the role of approving mergers and acquisitions of Eurozone banks177. Guidelines – CEBS/EBA, CESR/ESMA, CEIOPS/EIOPA, Guidelines for the prudential assessment of acquisitions and increase of holdings in the financial sector required by directive 2007/44/EC, 11 July 2008 – BCBS, Core principles for effective banking supervision, September 2012

175 Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. See chapter 18. 176 Art. 19.9 RBD, as added by the Omnibus I Directive 2010/78/EU. 177 Commission, Proposed Single Supervisory Mechanism ECB Regulation, COM(2012 511 final, 12 September 2012, art. 4.

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5.5

Market Access

Cross-Border Market Access and Third Countries

Introduction Banks from a wide variety of third country operate in the EU178. Equally, the operations of EU banks are not limited to the EU. The CRD focuses on intra-EU rights and obligations. The CRD also applies to the operations of third country banks and banking groups in the EU, and to the operations of branches and subsidiaries of EU banks and their cross-border services in third countries; see e.g. the consolidation requirements described in chapter 17.5). Most CRD-provisions on cross-border market access apply equally to third country and to EU banking groups that want to start operations in an EU member state. Some additional safeguards apply. The most important exception is the lack of a harmonised treatment of third country branches, unlike for EU branches. Under the GATT 1994 (see chapter 3.3) and its General Agreement on Trade in Services (GATS; as applicable from January 1995), the national markets of WTO members in principle are open to financial services providers from other WTO members. GATS sets out general commitments. The signatories sign up to those (and make exceptions to their commitments) in so-called schedules for specific types of services, including financial services. The GATT 1994 and the GATS follow the ‘most favoured nation’ approach, meaning that any right given to one signatory nation is also given to all other signatories. An exception is made for custom unions and free trade areas such as the EU, under which the EU members states can give each other additional rights that are not automatically extended to other GATS members179. Under the GATS, the EU has jointly undertaken some commitments to allow third country banks access to EU markets, in exchange for similar rights for EU banks in the markets of the other countries that are part of GATS180. The GATS provides that WTO members181:

178 Either in the form of cross-border services, subsidiaries or branches. Please note that when referring to third countries, the EEA countries (though in principle ‘third countries’ under EU legislation) are deemed to be member states and thus not third countries for financial supervision rules and regulations (see chapter 2). Under the EEA treaty (an ‘agreement’ as meant in the superfluous art. 38.3 RBD) EEA banks are treated as EU banks for the purposes of amongst others branching within the EU. 179 Art. II and V GATS. A.F. Lowenfeld, International Economic Law, Second Edition, New York, 2008, chapter 3.5 and 6.4. 180 The EU can enter into third country treaties, together with or supplementary to its member states treaties, under art. 133 and 181a TFEU. 181 Art. II, XVI-XVIII General Agreement on Trade in Services, as well as the Annex and Second Annex on Financial Services. Also see the Fifth Protocol on Financial Services of December 1997 in which improved schedules and exemptions were agreed between many WTO countries, including the EU. A.F. Lowenfeld, International Economic Law, Second Edition, New York, 2008, chapter 6.

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– will treat services from any WTO member no less favourable than it would treat services from any other country (any preferential treatment to any country has to be given to all WTO members too, with a limited number of exceptions); – will grant market access to services and service suppliers of any other WTO member under the commitments – and to the extent – set out in the country specific ‘schedule’ of commitments (containing a positive list of categories of services for which they ‘commit’ themselves, and a negative list of limitations on such commitments), and will subsequently treat those no less favourable than its own services and service suppliers; – may introduce prudential supervision if this is not intended to deny market access, but it may ‘recognise’ prudential measures taken by another WTO member (e.g. after harmonisation), with an opt-in for other WTO members if they have similar arrangements. Under the schedule of commitments for the EU, banks based in WTO member countries have some additional rights in the EU under the GATS182. The EU committed its member states at the time to: 1. allow cross-border supply of some auxiliary banking services into the EU; 2. allow consumption abroad by persons from these EU member states of amongst others all banking and other financial services in other (third country) WTO members by its (third country) entities; 3. allow commercial presences of third country entities to be active in the member states of the EU to supply amongst others banking and other financial services via an establishment or by a takeover, and expand such establishments and to provide new financial services. It included, however, a wide authority of EU member states to decline access to cross-border branches from third countries (and denying an onward EU passport to such third country branches; see chapter 5.3 and below). More importantly, it committed to a positive stance towards locally incorporated subsidiaries of third country entities (and granting an EU passport to such subsidiaries if they gained a licence of an EU member state under that positive stance), though specific legal forms and compliance with the regulatory framework may be required; 4. For other – more recent – member states of the EU, whether these commitments apply depends on their own WTO schedule.

182 Art. XVI-XVIII GATS, and GATS/SC/31/Suppl.4/Rev.1 dated 18 November 1999, containing the schedule of specific commitments of the European Communities and their member states at the time. In essence, it makes the ‘understanding on financial services’ as published separately on the WTO website www.wto.org binding on the EU and other signatories that referenced it in their schedules under the conditions and with limitations set out in their schedule.

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These are limited commitments, and they depend on further detail that is still lacking for many third countries. The Commission remains formally committed to further reduce trade barriers183. For this purpose both the CRD and the EBA regulation contain provisions on possible future agreements on cooperation between supervisors, in addition to the policy harmonisation via e.g. the BCBS184. Third country banks thus in principle have the same basic options to enter the market of an EU member state as banks from another member state do: – open a branch or provide cross-border services (though the member states may deny third country branches); – incorporate a local subsidiary bank; – merge with or acquire a local bank. There is, however, no simplified notification process like the European passport for the cross-border services and branches of third country entities. Subsidiaries and Acquisitions When incorporating a local subsidiary bank, or acquiring a local bank, the same rules apply as apply to potential parent banks from another member state. However, here it is not assumed that the parent from a third country is supervised on the same standards and with the same goals and instruments as in the host member state. The parent also does not benefit from the TFEU-freedom of establishment and the local licensing process can in principle be as vigorous under local goldplating licensing requirements as a member state applies to new start-ups. For WTO-members, this is limited by the positive attitude that the member states have committed themselves to look favourably at new subsidiaries of service providers from other countries, and on the supervisory arrangements they have there that impact on the parent and on (a consolidated basis on) the subsidiary. This – similar but as yet further unharmonised – freedom of establishment provides some protection to third country banks that they will not be summarily dismissed. None of the WTO commitments are absolute in the sense that a subsidiary from a bank based in a WTO country e.g. has to be given a licence, but they cannot be denied a licence just because they are from a third country. They will still need to fulfil the same prudential criteria to be able to receive a licence as any bank has (as the GATS allows all prudential regulations, as long as it does not attempt to hinder market access). If there is a bilateral 183 See e.g. Commission, Communication on the External Dimension of the Lisbon Strategy for Growth and Jobs: reporting on market access and setting the framework for more effective international cooperation, COM(2008) 874 final, 16 December 2008. 184 Art. 39 RBD and art. 33 and 75 EBA Regulation 1093/2010. Also see chapter 3.3.

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trade agreement, it is most likely to include provisions on reciprocal access to and from the third country. However, with the exception of the EER and the high level commitment of GATS, I am not aware of such reciprocity agreements on banking on an EU wide basis. Allowing access to third countries thus remains a largely practical issue of assessment by the local supervisor (under local laws, and taking into account the positive sentiment contained in the EU WTO schedule). Even if supervision takes place under different standards and in non-WTO countries, this is not a problem in itself for granting a licence or giving permission for an acquisition of a domestic bank, except in as far as this might impact on the supervision of the EU licensed (either new or acquired) subsidiary185. When licensing a bank with a third country parent, the EU licensing supervisor has a specific additional refusal argument if the laws, regulations or administrative provisions of a third country governing the acquirer (or other person with which the bank has close links) or difficulties in their enforcement, prevent the effective exercise of the supervisory functions of the licensing supervisor, but again please note the favourable treatment to be accorded to banks from WTO countries. Branches and Services Unlike banks from other member states, banks from third countries do not have an EU passport under which they can branch into a member state. Branches from third countries do exist in the EU, and are accepted by national supervisors on the basis of (non-harmonised) domestic legislation. Especially for branches that provide services to the public, there appears to be a tendency to not accept branches anymore. Instead, many member states request the third country bank to set up an EU subsidiary for those services. This request/pressure is allowed under the exemptions contained in the EU schedule to the GATS (see above). The CRD explicitly gives member states discretion as to whether it allows third country branches to operate on their territory. Even if allowed to operate in one member state, such permission only relates to operations in that specific member state. Such a locally licensed branch has no EU passport. An important reason for being uncomfortable with third country branches is that not all EU member states have so called ‘ringfencing’ legislation. Ringfencing is a phenomenon under which local legislators and supervisors require branches to maintain funds in the state in which they operate, to safeguard the interests of local creditors in the event of a bankruptcy. Such funds in that local legal company law/bankruptcy law regime cannot be 185 Art. 12.3 and 38 RBD, and recitals 19 and 20 RBD.

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transferred out of the country without explicit approval, which is often dependent on all local creditors being paid back in full in a bankruptcy. If a member state lacks such ringfencing regimes for branches, it may prefer the third country bank to have a subsidiary instead. As a separate legal entity, a subsidiary provides an automatic ringfence as it is the owner of its own assets, and can be required to have its own financial buffers. That subsidiary would be locally supervised and have more easily defined financial resources. As a bonus for the third country bank, a subsidiary that is licensed in an EU member state has the benefit of an EU passport. If the member state allows third country branches to operate in its market, the CRD does require that both the market access requirements and the ongoing supervision requirements for third country branches are the same or more strict than such requirements for EU branches. As those requirements on EU branches are quite lenient, this does not provide a high barrier. Third country branches could potentially be supervised mainly by their own supervisor, with the same (or more strict) additional requirements on liquidity or monetary policy that are applicable to EU branches. There is no restriction on stricter requirements. Member states can e.g. require the type of endowment capital that the CRD forbids member states to require of branches of EU banks186. Member states can introduce full own funds and solvency requirements on the branch in addition to the liquidity and monetary requirements applicable to EU bank branches. Please note that domestic legislation will in that case also include applicability of reporting requirements (in addition to the applicable public accounting obligations187) to the supervisors for the branch, and give instruments to the supervisors to intervene in the branch. However, where ringfencing is not part of national legislation, those will generally be of limited use to protect the interests of EU clients of the bank. A special problem may be systemic branches and subsidiaries. Lacking the protection of the single market, the third country parent may face additional requirements from EU supervisors. The FSB advises host countries to consider whether to permit a branch presence, taking into account systemic significance in the host country, applicable resolution regimes and cooperation agreements188. Forcing the proposed (or even current) activities of a branch of a third country bank into a subsidiary allows for supervision of own funds 186 Art. 16 RBD is limited to EU bank branches. If a member state requires endowment capital, it may also require its publication as part of the branches public accounting information; art. 3.4 Bank Branch Public Accounts Directive 1989/117/EEC. 187 The Annual Accounts Directive for Bank Branches (1989/117/EEC) is applicable both to branches of EU banks in another member state and to branches of third country banking companies or firms; see chapter 6.4. 188 FSB, Reducing the Moral Hazard posed by Systemically Important Financial Institutions, FSB Recommendations and Time Lines, 20 October 2010, page 5.

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and other supervisory requirements under local (host) laws on the new legal entity (with clearer mutual responsibilities in the context of home host and consolidated supervision). In future agreements with third countries – if any – a similar regime for significant branches could be agreed as has been introduced in the EU via CRD II189. The CRD does not contain provisions on cross-border services and third countries. However, if a third country bank fulfils the banking definition with activities performed in the EU, it will be a bank and require a licence, similar to the situation for a branch. If in the EU it only attracts funds from the public (and does not make loans), it will still be faced with the general prohibition for non-licensed entities (see chapter 5.6). If issuing bonds in the EU, they will thus have to have a prospectus. If it only focuses its services on professional depositors, however, it will not require a banking licence under EU rules190. Some of its services may require a licence under e.g. Mifid (see chapter 19.2), but the capital market is extensively liberalised, also for third country entities operating in the EU. Incoming auxiliary services from entities based in WTO countries will often fall under the GATS schedule of the EU (see above), and thus be allowed. Cross-border Market Access by EU Banks into Third Countries EU banks have substantial operations in third countries either through branches or through shareholdings in third country entities. The rules and restrictions applicable are different per country, and go beyond the scope of this book. Such will often be based on the WTO GATS commitments that such third countries made in their schedules (see above). Reciprocity is an important aspect in providing access to local third country markets to EU entities. Access provided to third country banks will generally raise expectations that EU banks should be allowed similar or at least some form of market access in the third country involved (though under GATS such strict reciprocity is not the rule; where it instead focuses on access on a most favoured trading partner basis; see above). For other developed capitalist countries, this is relatively straightforward. Not only will those generally have similar basic banking rules and supervision (based on the Basel capital accord and the Basel core principles) but also they will generally have banks and an economy that would benefit from mutual market access. For less developed countries, the access to the EU markets will often be less aligned. This can be the result of less effective market protec189 CRD II 2009/111/EU inserted art. 41a RBD with additional rights and limitations as to what a host supervisor can do to gain additional instruments on a branch that is systemic in the host market; see chapter 5.3. 190 Because this is an non-harmonised area, member states can put additional protection of their retail and/or wholesale clients in place, both for cross-border services of third country banks that have a licence in their home third country, and for cross-border services of third country entities that do not have such a licence. See e.g. A. Steck & K. Landegren, ‘Cross-border Services into Germany’, Journal of Financial Regulation and Compliance, Vol. 11, No. 1, 2003, page 21-25.

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tion in the third country (e.g. due to the need for external financing or expertise), or due to more effective market protection in the third country (e.g. to protect fledgling local banks, or to protect locals from insidious western/capitalist/communist/liberal/alien influences). In general, EU legislation leaves it up to its banks to decide where to do business or not. The CRD provides no restrictions on starting businesses, neither in the EU nor in third countries. Only in three cases might local authorities limit the scope of banks to start or continue to have operations in certain third countries: – anti-money laundering and anti-terrorist rules, as well as anti-bribery laws; – EU boycotts of certain third countries that include providing banking services; – where circumstances impacting on the local business or the grip of the parent on the local business are thus that the local business would result in unknown and potentially fatal risks to the bank; – where the bank is not sufficiently organised, staffed, and capitalised to be able to handle the third country business. When an EU bank is active in a third country, that business is fully subject to the supervision of the licensing supervisor (either in full when it concerns a branch, or in a consolidated manner when it concerns a subsidiary). The same is true for branches and subsidiaries of a third country bank in the EU, those will be part of the supervision by its local supervisor. Cooperation The CRD encourages supervisors to cooperate also with third country supervisors wherever possible if they have a subsidiary or branch from that third country in their territory. The financial stability board also stimulates cooperation in colleges across the world between supervisors191. Except for this, the CRD contains few safeguards or requirements on the supervision of licensed branches from third countries. Some additional safeguards follow from other directives than the CRD, notably the deposit guarantee directive and the public accounts of branches directive (see chapter 6.4, 17.5 and 18.5).

191 See chapter 21.8. Such cooperation on policy and on groups may not be feasible unless it were to become obligatory, especially where this clashes with national (fiscal and competitive) interest. See R.J. Theissen & A. Houmann, Funding is Key, 2009, www.thebanker.com. See L.A. Cunningham & D. Zaring, ‘The Three or Four Approaches to Financial Regulation: a Cautionary Analysis Against Exuberance in Crisis Response’, The George Washington Law Review, Vol. 78, 2009, page 89, 105-108.

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Future Developments The CRD IV project does not contain changes in the approach to third country banks192. In the conduct of business area, however, recent legislative proposals contain a joint approach to third country undertakings providing cross-border services to or establishing branches in the EU. The AIFM directive sets up a European passport once access has been granted by one member state under a series of harmonised conditions. The proposals for a new Mifid II/Mifir to replace the Mifid also contain a regime with a EU passport for cross border provision of services to eligible counterparties by third country investment firms (leaving branches and retail services to national discretions)193. This reduces the national discretions in the area of third country market access and subsequent supervision. Similarly, in the USA the access and subsequent supervision of EU and other non-USA banks to the USA market is being upgraded and harmonised in the wake of the 2007-2013 subprime crisis194. Literature – Usher, J.A., The Law of Money and Financial Services in the European Community, 2nd ed., Oxford University Press, Oxford, 2000, chapter 11 – Lowenfeld, Andreas F., International Economic Law, 2nd ed., Oxford University Press, Oxford, 2008, chapter 1, 3 and 6 – Panourgias, Lazaros E., Banking Regulation and World Trade Law, Hart Publishing, Oxford, 2006

5.6

Prohibition to Receive Deposits or Other Repayable Funds from the Public

Introduction The CRD contains two prohibitions. The first prohibition is that you cannot be a bank and operate without a license. This is the core of the CRD. A second prohibition accompanies and reinforces it. You cannot lack a license, and still attract deposits or other repayable funds from the public. This activity is forbidden to any entity other than a (licensed) bank. This second prohibition provides safety for depositors, as well as a protected environment for banks. However, a legion of exceptions apply, both in the form of exceptions made to 192 Art. 47 and 48 CRD IV Directive. 193 Art. 39 and 40 AIFM Directive 2011/61/EU, and page 12-13, recital 34-36 and art. 36-39 of the Commission proposals for Mifir, COM(2011) 652 final, 20 October 2011. The recitals imply that retail services require at a minimum a branch from the third country entity. 194 Federal Reserve System, Enhanced Prudential Standards and Early Remediation Requirements for Foreign Banking Organizations and Foreign Nonbank Financial Companies, 12 CFR part 252, Federal Register, Vol. 77, No. 249, 28 December 2012. Also see chapter 17 on consolidated supervision.

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the definition of deposits and repayable funds (see chapter 5.2, and in the form of other supervised manners to attract such funds. Safety Licensed banks are allowed to attract repayable funds from the public either in the form of bonds or deposits or in any other repayable format195. A depositor is assured that his savings or other repayable funds will be entrusted to a financial institution that has to comply with the licensing and ongoing requirements of the CRD, and is subject to prudential supervision on those requirements. It is also assured that – if despite such supervision a bank should fail – the bank should still have recoverable assets to help repay him after liquidation, hopefully in full. See chapter 18. Additional protection is offered to some depositors under the deposit guarantee directive. The savings and other repayable funds a consumer or small- and medium sized companies entrusted to the bank will be repaid by the deposit guarantee scheme to which the bank belongs up to 100.000 euro; see chapter 18.5. Banks benefit from this semi-monopoly of being allowed to hold funds of their clients for longer than is usual, as it effectively limits the number of competitors for such funds. Apart from the costs for banks following from prudential supervision and the obligation to maintain their funds and organisational set-up, they have the obligation to belong to a deposit guarantee schemes. That scheme offers also a selling incentive to the savers at the bank, as they will be covered up to this amount of 100.000 euro if and when the bank goes bankrupt. Under the deposit guarantee directive banks are forbidden to attract deposits if they do not belong to a deposit guarantee scheme that complies with the minimum characteristics as set out in that directive (see chapter 18.5). Also, the deposit guarantee scheme can – if the local supervisor agrees and after a lengthy process, terminate the membership of a bank to the scheme if it fails to fulfil its obligations to the scheme (implying that banks will generally be obliged to provide information and funding to the scheme, though this is not part of the harmonisation in the current directive). Such eviction will effectively lead to the withdrawal of the license, and thus to the end of the banks’ possibility to legally attract repayable funds from the public196. Banks have to invest heavily both in the form of financial buffers and in the form of organisational set-up in order to ‘earn’ this right to attract repayable funds. The CRD has focused specifically on this right as belonging to the business of a bank. This prohibition thus sets out the only item in the definition of a bank that is exclusive to banks. It prohibits entities that are not licensed banks from attracting such repayable funds from the public (for the meaning of these key terms, see chapter 4.4. The Court of Justice has upheld this

195 Art. 5 RBD, and the complementary art. 1.2 sub f and j Prospectus Directive 2003/71/EC. See chapter 4.4. 196 Art. 3 and 5 deposit guarantee directive.

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prohibition, and indicated that it should be interpreted widely in order to achieve the protection of savings (one of the goals of the CRD)197. Granting credits and other components can be done by anyone, but receiving deposits or other repayable funds from the public is apparently a core business that is exclusively allocated to banks. It covers any type of contractually or intrinsically repayable instrument or contract, as otherwise the protection given to depositors could be circumvented198. This exclusivity, however, comes with many exceptions. In spite of not being licensed banks, some entities are still ‘trusted’ with the money of the public. Trusted entities include: – member states and their regional or local authorities; – public international bodies of which one or more members states are members, such as the EU, the EBRD and the IMF. The European investment bank qualifies too, but by its statute it is required to comply with the investor market rules too, including the obligation to publish a prospectus199; – cases expressly covered by national or community legislation, provided that those activities are subject to regulations and controls that both intend and indeed effectively provide protection to depositors and investors. Examples of community legislation that provides such protection are: – e-money directive for funds attracted in return for electronic money (though the formal structure of this exception is phrased in a different manner, in practice it is a non-bank that attracts repayable funds). See chapter 19.3; – payment services directive for funds attracted that have to be ‘repaid’ to the designated recipient (or failing that, to the client). See chapter 19.3; – prospectus directive for bonds or similar instruments issued with a prospectus by a non-bank, such as other financial institutions or commercial undertakings. Please note that issuers that benefit from one of the exemptions of the prospectus directive, fail to actually protect depositors. Until 2014 that means that they are not excluded from this prohibition unless there are other measures that protect depositors and investors. See below under future developments and chapter 16.5. These exemptions are intended to provide a similar protection as prudential banking supervision to depositors and investors, even though based on very different assumptions as to what constitutes protection. Under prospectuses, bonds gather long term savings of the public, similar to what banks do in the form of savings accounts. Under the prospectus

197 Italy/Romanelli, Court of Justice 11 February 1999, Case C-366/97, 13-14. 198 Italy/Romanelli, Court of Justice 11 February 1999, Case C-366/97, §14-15 and 17. 199 Art. 20 of Protocol 5 to the Treaties.

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directive, the protection is largely in the form of full disclosure (only one of the requirements on banks). This in spite of it being debatable whether normal depositors and investors will read and understand such information prior to entrusting their repayable funds to the issuer in return for the ownership of a bond, i.e. a claim on the company that can be retrieved at a certain time in the future, with interest payments being due in the meantime. However, as banking supervision does not provide a full state guarantee on the funds entrusted either, this may be well balanced, especially as the risk perception/expectation of investors of bonds is perhaps higher than that of depositors in banks. Future Developments The prohibition and the exemptions are copied largely unchanged in the CRD IV directive200. One major discrepancy is, however, that the protection of depositors and investors has been reduced in scope201. If an activity is subject to regulations and controls that have the intention to protect investors and depositors, this will from the start of 2014 be sufficient to no longer be bound by the prohibition. With the deletion of the requirement that such protection is actually applicable to those cases, it will no longer be needed that the depositors and investors are indeed effectively protected by such regulations and controls. If e.g. the prospectus directive exempts small scale offerings, and someone of the ‘public’ lends money in this context, he was never protected by the prospectus directive, and now no longer will be protected by this banking directive prohibition. He does fall within the scope of the prospectus directive even though he does not benefit from it; see chapter 16.5.

200 Art. 9 CRD IV Directive. 201 Art. 9 CRD IV Directive is shortened by the words ‘and applicable to those cases’ when formulating the exemptions to the prohibition (as compared to art. 5 RBD). Art. 2 and 3 Prospectus Directive 2003/71/EC, as amended by Directive 2010/73/EU.

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Quantitative Supervision – Outline And Underpinnings

6.1

Introduction

As soon as an applicant has gained its license it can start operating as a bank. Simultaneously, it becomes subject to quantitative and qualitative requirements under the CRD. The quantitative requirements are described in this chapter 6, and 7-11. Fulfilling those CRDobligations is primarily the own responsibility of the bank. The quantitative and qualitative CRD-obligations of banks go further than required by the individual bank, its individual clients or by the markets for its bonds and shares, except during a financial crisis. The quantitative and qualitative requirements of the CRD can even run counter to such interests (see for instance the possible restrictions on bonuses, dividends, the requirements on IT investments, and on setting aside capital for assets that the bank may consider safe). The third consequence of a license is that a supervisor becomes responsible for ongoing prudential supervision on the bank. The CRD requires a public authority to check whether the bank fulfils its prudential quantitative and qualitative requirements, like the Mifid requires a public authority to check the investment conduct of business obligations of the new bank (see chapter 4, 16 and 19). The quantitative requirements are a core plank of prudential supervision. They go much further for banks than for ordinary commercial companies. Fulfilling the quantitative and qualitative requirements is directly linked to retaining the license to do business, though more importantly fulfilling such requirements is directly linked to avoiding a request for their bankruptcy. Where a withdrawal of the license may be delayed by administrative law and human rights concerns (see chapter 5 and 20), such issues are balanced by financial stability and depositor protection goals in a bankruptcy court. In most bankruptcy regimes someone only goes bankruptcy when it has actually stopped paying its debts. Banks will go bankrupt, or into a moratorium type freeze, when they fail to fulfil quantitative requirements; see chapter 18. A bank that is fully up to its payments on its debts and with a pile of cash to allow it to pay the likely requests in the near future can thus fail basically because it no longer has sufficient financial buffers to cover the risk of future losses on its assets. For banks, the balance between shareholders’ interests and creditors interests has been shifted to benefit creditors. Though creditors may suffer discontinuity of services if their bank fails, they are much more likely to be reimbursed in full in due course than with ordinary commercial counterparties that fail (e.g. a bathroom vendor or seller of beds).

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Unlike banks, ordinary commercial counterparties can – hoping for brighter times ahead – continue operating on a minus capital basis, so that by the time they truly have no cash left they are likely to have drawn down all available resources, leaving little or nothing for remaining creditors. If both the bank and the supervisor have done their job properly to estimate potential risks and needed financial buffers, depositors and other normal creditors of the bank will in due course receive (a large proportion) of their claims. This to the detriment of shareholders and other providers of risk bearing financial buffers, who have lost a space of time in which to – either by gambling or by wise decisions – try to turn around the business with money that is now used to pay out to creditors instead. How to estimate such future risks and needed financial buffers are laid down in the quantitative requirements. The gains made by quantitative supervision are thus are at best partial successes when the goal is defined as ‘safety’. Fulfilling the quantitative requirements, even with a wide risk margin, does not provide certainty that bankruptcy will be avoided. At several stages of the 2007-2013 subprime crisis some banks were amply overcapitalised by CRD quantitative standards. These were as likely to fail as some only marginally capitalised banks, depending on e.g. the types of investments they made, and whether markets expected future large adjustments in e.g. underlying valuations. The CRD-calculation is done on the basis of modelled expectations and information on past performance, which can turn out to be spectacularly wrong in practice. The goal is, however, not safety but stability and depositor protection, and especially the latter goal is met if all depositors and creditors in due course are repaid the full amount of the funds they entrusted to the bank. The trust in this repayment even if the bank fails can be considered to support financial stability. See chapter 4.3. Both the obligations of the bank and the ongoing supervision role of the supervisor are focused on the current and continued ability of a bank to operate. Before looking at the specific components of quantitative requirements in chapter 7 to 11, this chapter 6 deals with three basic themes in quantitative supervision. These are the solvency ratio, the reliance on models, and the impact of accountancy rules. The solvency ratio sets out the minimum amount of qualifying financial buffers (chapter 7) that has to be held by the bank for the calculated credit risk, market risk and operational risk embodied in the assets of the bank (chapters 8, 9 and 10 respectively), models are used in all quantitative calculations, and accountancy concepts are used to determine the input and scope of all quantitative calculations. The solvency ratio is described in chapter 6.2. The reliance on models in the calculation of the quantitative requirements for credit risk, operational risk and market risk that in turn are input into the solvency ratio is discussed in chapter 6.3. The accountancy basis for the quantitative requirements for e.g. the valuation of risk factors and risk

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buffers that are key inputs into both the risk calculation and the buffer estimation that are the components of the solvency ratio is introduced in chapter 6.4. When describing the quantitative requirements, cross-references will be made to qualitative requirements. Chapter 11 and 12 on large exposures and on liquidity requirements present a cross-over between quantitative and qualitative requirements. Large exposures is largely a question of quantitative limits, but with some solvency ratio input. Liquidity supervision is not yet the subject of quantitative requirements at the EU level. Those are being developed and tried out, however, and will be introduced between 2015 and 2019. The quantitative and qualitative requirements interact on a continuous basis, and both need to be fulfilled on a continuous basis. An example of the interaction between the two categories is the requirement that banks that use their own models to calculate quantitative requirements are obliged to have more stringent organisational controls in place than other banks (chapter 13.3). Another example is the so-called pillar 2 (chapter 14). This qualitative assessment checks whether the bank – even when being fully compliant with the quantitative requirements – really has enough (quantitative or qualitative) cover for all the risks it is exposed to; and this analysis may in turn lead to demands for a higher required solvency ratio. Objective, Harmonised and Comparable? The quantitative requirements bring an element of objectivity and comparability into banking supervision. They provide thresholds beyond which supervisors can prove they have to act, and thresholds beyond which banks can claim to be safe. If they can claim to be safe, it helps them to defend themselves against supervisory action (and to some extent against market action). The calculation of quantitative requirements somewhat evens the level playing field between banks. The market can see which banks have more financial buffers compared to the calculated risk it runs. It also allows supervisors to focus scarce resources on relatively weaker institutions (though the size and importance of a bank and other factors are also relevant issues for such resource allocation). The objective value of the solvency ratio, the underlying models and accountancy standards must not be overemphasised for several reasons1: – Quantitative requirements can be gamed by the banks by allocating assets to the lowest requirement category possible (e.g. by shifting assets between the banking book and the trading book, see chapter 9.2), by adapting their business model or by introducing

1

J. Dickson, ‘Supervision: Looking Ahead to the Next Decade’, in A.J. Kellermann, J. de Haan, F. de Vries, (Eds.), Financial Supervision in the 21st century, Amsterdam, 2013, chapter 14.2.

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–

–

– –

slightly amended products that are subject to lower requirements (but do not in essence change their risk profile); Quantitative requirements are based on assumptions in models and in valuations, which include highly subjective assessments by the banks, supervisors and/or external accountants involved; which assessments may be different per bank (see this chapter and chapters 7-11); Quantitative requirements are set by lawmakers not only to increase safety of the banks, but also to stimulate lending to certain categories of borrowers (e.g. small- and medium sized enterprises or homebuyers, deliberately underestimating the risk in those loans,2; Large adjustments in the (market) value of assets can change the financial position of the bank dramatically; Having capital does not mean that a bank has enough cash (liquidity) to outwait a slump in values.

Similarly, the comparability between banks – especially across borders should not to be overemphasised. Yes, the quantitative requirements improve comparability across banks and countries. Yes, the introduction of common accountancy standards for the larger banks (and other companies) in the form of IFRS has further improved comparability. But the underlying assumptions remain subjective, and the introduction of the banks’ own models (even as restricted as they are by the regulatory requirements on such models) introduce additional differences between banks on various types of internal or legal models. Most importantly, the composition of the financial buffers – based on the definition of capital – is incomparable even within the EU and will remain so in the foreseeable future. Apart from the nametags given to elements of the financial buffers there is still only haphazard consensus on the content of many such elements. Harmonisation is only halfway achieved, and thus comparability too3. The Basel III accord and the CRD IV project will take some significant steps in the achievement of harmonisation, further allowing supervisors and the market to act on the basis of comparable information, but even those steps will only lead to the projected harmonisation after the expiry of transitional periods that extend past 2020. Literature – Mishkin, Frederic S., The Economics of Money, Banking, and Financial Markets, 8th ed., Pearson Adisson Wesley, Boston, 2006, chapter 9

2 3

See chapter 3 and 8. Also see R.J. Theissen, Are EU Banks Safe?, The Hague, 2013. See e.g. CEIOPS/EIOPA, Lessons Learned From the Crisis, Report CEIOPS-SEC-107/08, 19 March 2009, www.ceiops.eu.

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– Matthews, Kent; Thompson, John, The Economics of Banking, 2nd ed., Wiley, Chichester, England, 2008

6.2 The Solvency Ratio and Other Financial Buffer Requirements Introduction The business of a bank is money. Most banks own few or no tangibles with a steady value. Banks instead engage in a volatile business, dealing with assets of uncertain value (will the personal loan be paid back, will the Greek government bond retain its value, will the company go under and if so, will its collateral have value?). In order to for the bank convince its counterparties that it is safe to entrust money to it, or to arrange for long running facilities to borrow from it, a bank has to have financial buffers. It needs to have cash money whenever a client wants to get its money back (liquidity; see chapter 12), and it needs to have money in the sense of having overall assets that are comfortably more valuable than its overall debts, so that it will be able to repay even long term debt. If a bank cannot be trusted that the value of its assets safely covers the value of its debts, or that it will have access to cash whenever its clients need the money promised to them, it will fail to attract business. It will also suffer a fast outflow of money to those clients eager to make sure that at least their claims are paid (back) in full if they expect a bankruptcy. The interests of the bank and the supervisor run parallel in this respect, though they may have different opinions as to how much capital or liquidity is necessary to provide this certainty to the market. The risk that a bank has insufficient capital or liquidity comes from a wide range of sources. Some of the more important are: – its assets losing some of their value due to market fluctuations; – people and companies it lent money to going bankrupt; – more cash being withdrawn by depositors from the bank than expected; – not being able to obtain or get an extension of loans from professional market parties; – not being able to sell or cash in on assets; – increases in the financial buffers being demanded by the markets or by legislators. There are no quantitative requirements mandatory for liquidity under the current version of the CRD; see below and chapter 12. At the moment the CRD contains two main quantitative overall requirements, and a supporting specialised requirement4: – A non-risk sensitive minimum own funds requirement of 5 million euro, based on ‘normal’ accountancy rules. This is part of the licensing requirements, but has to be

4

Art. 9 and 75 RBD, and art. 18 RCAD.

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fulfilled on a continuous basis; see chapter 5.2. If not fulfilled, it is a key reason for withdrawing the banking license. For larger banks, the 5 million euro is such a low requirement that it is not breached except in the most exceptional (crisis) circumstances; – A risk sensitive solvency ratio, setting a minimum amount of financial buffers (also known as capital or own funds) for its credit risk, operational risk and market risk risks in a formula set in the CRD, based on the worldwide consensus laid down in Basel II5. The solvency ratio does not assess whether a bank still has sufficient capital to deal with existing expected losses. Instead it aims to manage/model the future capital needs after deducting all expected losses along lines of potential but unexpected losses and gains. The solvency ratio requirement is subject to the so-called Basel I floor, a supposedly transitional measure to avoid gaming and a too high risk-sensitivity of the calculations by the bank; – A restriction on the size of loans/investment made to a client or group of connected clients. It aims to reduce the chance that one or more clients failing would automatically lead to the health of the bank being threatened (large exposures regime; further described in chapter 11. Supervisors may use other objectified indicators that they themselves develop, or base decisions on peer group developments. Such homegrown indicators that supervisors use to focus their investigations or their investigations are, however, not obligatory under EU laws, nor are member states obliged to couple the use of instruments to them (but under minimum harmonisation directives such forms of goldplating are not prohibited either). As an efficiency tool, they will retain their value in the future, but as an indicator of quantitative requirements they will need to be phased out under the minimum maximum CRR of the CRD IV project, unless they are structured as an add-on on the basis of pillar 2 or one of the additional buffers that have been allocated to the minimum harmonisation CRD IV directive instead of the CRR (for instance via the domestic systemic risk buffer allowed under the CRD IV directive; see below)6. The vast majority of CRD provisions deal with the relation between quantifiable risks and quantifiable risk-bearing financial buffers. The financial buffers are not looked at in the sense of representing the value of the bank to its shareholders and other risk bearing investors, but in the sense that it represents the maximum cushion available to compensate

5

6

If the bank uses internal models to calculate its risk exposures, it will also need to calculate the ‘floor’. This is a transitional measure while experience is gathered with the models developed by banks themselves, to cap how low the bank can go in estimating its risk. See chapter 6.3. See for instance J. Sijbrand & D. Rijsbergen, ‘Managing the Quality of Financial Supervision’, in A.J. Kellermann, J. de Haan, F. de Vries, (Eds.), Financial Supervision in the 21st century, Amsterdam, 2013, chapter 2.

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for losses to ‘normal’ debtors (under e.g. bonds, interbank loans or deposits). If the amount of potential losses rises over the amount of available cushions, ‘normal’ lenders to the bank would be at risk of not receiving the full amount of their claims. To limit this risk, the solvency ratio is central to the capital requirements regime laid down in the current version of the CRD. Both other types of quantitative calculations are simple, and are less relevant for systemic banks and the protection of their clients as they do not provide effective boundaries due to the size their business. Minimum Own Funds A traditional measure would be to relate the nominal amount of capital (in the conservative sense of equity plus published reserves) to the nominal amount of assets minus claims of creditors. This type of requirement is embodied in the above-mentioned minimum own funds requirement of 5 million euro. For a very small bank, this would provide a comfortable cushion. For any slightly larger bank the important aspect of minimum own funds is that under accountancy rules, its assets would only need to be worth more (5 million more) than its debts. This will tell the bank and its clients how much the assets can reduce in value (losses) before the capital given by risk bearing investors would be fully consumed, and normal lenders are at risk. There is no substantiation of the number chosen as the threshold. If expressed as a ratio, a percentage between debts and assets, the 5 million can be a substantive percentage for a new (very small) banking start-up. The number – especially compared with the low numbers required for investment firms – is very high for innovative financial firms, that could usefully shake up competition with banks or other financial services providers. Why the number is 5 million for any bank, irrespective of it operating in a niche, as a universal bank, domestically, cross-border or other types of settings is unclear. In effect this protects a monopoly of sorts to the banks and the well-off, which may not be intended. The solvency ratio in that respect is better, as it grows with the (risk of the) business of a bank during its possible path of growth. The first hurdle of 5 million plus start-up losses and investments will nevertheless need to be made and maintained. Rather than differentiating in this approach, the EU has created specific exempted niches for repayable funds attracting institutions such as e-money institutions or wholesale funded lenders such as consumer credit bodies that do not attract deposits; see chapter 5.2, 5.6, 16 and 19. However, for the larger banking groups bestriding the planet at the moment 5 million euro is a fraction of a fraction of a fraction of their balance sheet. For those, the 5 million is irrelevant unless it is breached and the bank is bankrupt. Theoretically this should happen a long time after the solvency ratio is breached, but due to very low risk weights attached to some credit risks (e.g. to governments) or the low level of buffers allocated to operational

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risk events, a bank may be healthy under the solvency risk but de facto below minimum capital requirements. It thus serves as a useful additional indicator of a slightly larger and large banks in (severe) problems. The 5 million requirement does not take into account investment gambles gone wrong, exchange rate risks, lenders’ ability to repay being shocked by e.g. earthquakes, fires or a collapse in the housing market, liquidity facilities given to bad debtors being drawn down, and the likelihood or unlikelihood of the full value of an asset to be realised, either through repayment or through sale of the asset. Neither does it include funds that are available to the bank that, though not being equity, in some respects might be deemed to be risk bearing too. Such non-equity can in theory act as a financial buffer too, if it is loss absorbing preferably while the bank is a going concern. Solvency Ratio In addition to the simple minimum capital requirement with its limited usefulness, quantitative supervision is built around an ever more complicated formulae or model under the general name of the ‘solvency ratio’. This ratio is designed to take all these components into account to calculate the likelihood that due to the relation between risk weighted assets and (risk bearing) financial buffers, the bank will be able to repay its debts to ‘normal’ lenders in full as its likely losses will ‘only’ consume its capital, not the assets covering those debts. The solvency ratio is presented as a fraction (percentage). To obtain a fraction or percentage, a numerator is divided by a denominator. In the original solvency ratio introduced in the first Basel accord of 1988, the ratio was indeed determined in this manner. It divided an expanded concept of own funds (numerator), by the credit risk capital requirements calculation of risk weighted assets (denominator), and demanded that the outcome of this fraction would always be 0,08 (or 8%) or higher7. This fraction gives the relationship between the two, by indicating how much of the numerator number covers the denominator; i.e. how much of the assets (after risk weighting) can go down in value unexpectedly, and still be covered by CRD-own funds (the financial buffers that absorb losses to ensure that normal creditors can be repaid in full). The current solvency ratio is not so simple. It condenses several types of capital requirements calculations into the denominator. The market risk calculation was squeezed in first

7

CEBS-EBA, Explanatory Notes to the Templates, July 2008, on Corep template 2 containing the solvency ratio overview.

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in 1996”8, and in 2006 the operational risk calculation was also added to the denominator. For credit risk and market risk the ratio between the two shows to what extent the capital requirements for the risk weighted assets are covered by the expanded concept of own funds. Within the current formula, however, operational risk has basically no relation to assets but more to ‘normal’ business risks such as fraud. The bulk of the amendments to the original Basel accord – introduced in the EU in the mid-nineties of the last century and in 2007/2008 under the name of the market risk amendment and the Basel II accord respectively – focus on the denominator of the ratio. The numerator (what counts as financial buffers in the CRD/Basel accord) had not been tightened since its initial conception. The 2007-2013 subprime crisis ended the deadlock, and allowed new work to be done on the numerator that will be phased in from 2014 during a lengthy transitional process, as described in chapter 7. Changes in the numerator affect the ratio disproportionally in a 100 to 8 requirement. A change by 1 in the denominator leads to a small increase or decrease in the ratio, a change by 1 in the numerator leads to a large surplus or deficit9. The acceptable elements of financial buffers were well established in each member of the BCBS and each member state of the EU prior to the Basel I accord, but in very different (and sometimes very lenient) ways. Adapting it to provide better security to creditors of the bank would upset the banks in more lenient jurisdictions. After the Basel I compromise text that left large loopholes to national existing practice this had been a political no-go area, with national banking associations lobbying vehemently in favour of the domestic status quo they were used to. In contrast to tightening, easing the definition turned out to be very acceptable to the banking lobby. In order to get support for the market risk amendment, some very low quality financial buffers were allowed into the numerator for the purpose of covering for the additional market risk requirement (see chapter 7.3 on tiering of capital). A further easing was de facto applied (within a CRD definition riddled by national discretions) on the basis of the BCBS press release on hybrid capital; allowing some forms of debt to 8

9

The BCBS indicated “In order to ensure consistency in the calculation of the capital requirements for credit and market risks, an explicit numerical link will be created by multiplying the measure of market risk by 12.5 (i.e. the reciprocal of the minimum capital ratio of 8%) and adding the resulting figure to the sum of risk weighted assets compiled for credit risk purposes. The ratio will then be calculated in relation to the sum of the two, using as the numerator only eligible capital.” BCBS, amendment to the capital accord to incorporate market risk, II §3, updated version of November 2005. Please note that this is not a reference to the new CRR definition of ‘eligible capital’ used in the large exposures and qualifying holdings regimes described in chapter 11, but to the wider own funds definition used in the versions of the Basel capital accord prior to Basel III; see chapter 7. If the denominator was 160 and numerator 16 (ratio is 0.1 or 10%), a change to 161 in the denominator would lead to a new ratio of 0,0994 or 9,94 %, while a change to 17 in the numerator would lead to a new ratio of 0.106 or 10.6%.

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qualify as capital if structured to show some characteristics of loss-bearing capacity. Some member states allowed their banks to use these hybrids as part of the numerator as original own funds but at wildly different maximum percentages; others did not10. The analysis of allowing them to be loss absorbent even in going concern situations focused heavily on whether e.g. a suspension of payments was legally possible, not whether it was likely that banks would use such a possibility when it was not actively breaching minimum capital requirements11. A consensus was introduced in 2010 into the CRD, via the CRD II directive (codifying this relaxation of the numerator within the already too loose CRD definition)12. The current solvency ratio requirement is as follows13: CRD-own funds (the financial buffers of the bank required by the CRD) shall be larger than or equal to: – a capital requirement of 8% of risk weighted exposure amounts of all business (except the trading book and illiquid assets) for credit risk – plus a capital requirement of 8% of risk weighted exposure amounts of illiquid assets of all business, unless these are deducted from the numerator – plus a capital requirement for position risk, settlement and counterparty risk – plus a capital requirement (if certain limits are exceeded) for large exposures risk of the trading book business – plus a capital requirement for foreign exchange risk and commodities risk of all business – plus a capital requirement for operational risk Table 6.1 Solvency Ratio Numerator CRD-OF≥

14

Denominator + (8% credit risk weighted assets minus trading book and illiquid assets) + (8% credit risk weighted illiquid assets minus assets deducted from OF) + (market risk weighted trading book assets plus a large exposures add-on if its limits are exceeded) + (forex risk and commodities risk of all assets) + (operational risk requirement)

10 CEBS/EBA Report on a Quantitative Analysis of the Characteristics of Hybrids in the European Economic Area (EEA), 13 March 2007. Related surveys were published in June 2006, and June 2007); and the subsequent advice CEBS/EBA, Proposal for a Common EU Definition of Tier 1 Hybrids, March 2008. www.eba.europa.eu. 11 A strong incentive not to invoke such clauses was their reputation, and the likelihood that invoking such a clause would shut the market for such funding for them. 12 CRD II Directive 2009/111/EC, see chapter 7. 13 Art. 75 RBD and art. 18 RCAD. 14 The moderated definition of own funds contained in the CRD, see chapter 7.

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In the context of this book, the ratio looks as follows: chapter 7 chapters 8 + 9 (+11.2) + 10, or own funds credit risk plus market risk (and large exposures excess in the trading book) plus operational risk calculations. Each of the denominator components is calculated separately, either in a standardised manner or by an institution specific model, in the manner set out in chapter 6.3, and in more detail in chapters 8 to 11. Each individual outcome is just plain added up. The total of added up denominator components is compared to the calculated CRD-own funds (financial buffers) actually available; as calculated in the manner set out in chapter 7. The added up denominator number is thus no longer directly related to the historical 8% requirement for credit risk capital requirements, though the individual calculations used for each component have been calibrated by the BCBS to be proportional to that original credit risk requirement. In its opinion, credit risk is the largest risk for banks, even though disastrous events for banks have also emanated from market risk and operational risk areas (fraud and/or lax controls leading to theft or trading losses, terrorist attacks leading to inaccessible or lost headquarters of banks, or loss of key personnel). The basic formula for minimum solvency ratio will not change under the Basel III/CRD IV project calculations as it would cause too big shifts in thinking and economic impact. However, as a result of the Basel II ½ and Basel III changes the CRD solvency ratio will be changed for the component-calculations (with an emphasis on the trading book and on better quality numerator/financial buffers). The distinction made in the calculation of the capital requirements between the risk types does not mean that they are not linked. For a company bond, both credit risk and e.g. foreign exchange risk (a component of market risk) will be calculated. The market risk on company bonds held for trading purposes will also in some manner be related to news on the credit risk that the company poses. By subdividing it, separate drivers of value changes become measurable. The overall risk position of the asset should remain important both in the decision to buy it and in decisions on whether the risk it poses is well managed, and well capitalised against15. The numerator component is also subject to a calculation. In addition to ‘real’ own funds in the company law definition (equity plus published reserves), many different items are accepted as ‘own funds’ in the CRD definition (referred to as financial buffers or CRDown funds in this book). These are almost always of a lesser quality than company law own funds, either because they are not available when needed, or as they turn out not to

15 See chapters 13 and 14. D.R. Van Deventer, Fair Value Accounting, CDOs and the Credit Crisis of 20072008, Bank Accounting & Finance, October-November 2008, page 3-8.

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have the same loss absorbing characteristics. Importantly they often do not absorb losses at all during the lifetime of a bank. A (very gradual) elimination of the worst performing financial buffer items is in progress in the follow-up to the 2007-2013 subprime crisis. This enhancement of the quality of capital is planned to reach its culmination between 20142040 (see chapter 2 and 7). At the same time, various items have to be deducted from own funds that are assumed not to provide cover for the bank in a crisis, e.g. certain holdings in insurance companies or substantial investments in financial entities that are not subsidiaries; see chapter 7. To distinguish between high quality financial buffers (such as company law own funds) and low quality items such as short term subordinated loans, a concept called tiering was introduced in the Basel capital accords and taken on board in the EU directives. The various components of the financial buffers are divided into three main categories (tier 1 high quality, tier 2 medium quality and tier 3 low quality) with further distinctions within tier 1 and within tier 2 between core and lesser quality items. Within the current CRD requirements, company law own funds (or core tier 1) ‘only’ needs to cover around 2% of the 8% (so a quarter of the) capital requirements. In many member states this requirement has already been strengthened under goldplating rules, but this is not obligatory under the CRD until the CRD IV project starts to become applicable. See chapter 7.2. The various components of the formula of the solvency ratio will be tightened and added to; see below. The 8% often mentioned, currently reflecting the formula above to arrive at a minimum level for the solvency ratio, is not based on science. It is not entirely clear why this number was chosen, but most likely it is a compromise number chosen by the initial members of the BCBS to reflect a common minimum level of risk appetite. This allowed countries that allowed their banks to operate at lower capital levels to reach the common level, and allowed others to accept that the common understanding reflected safety, while still going for higher capital levels at their banks. At what level the risk weighted assets are sufficiently buffered by CRD own funds is still a matter of judgement, not science. In the EU, it basically reflects the risk appetite of legislators, upon the advice of banks and supervisors, while the way it is applied in practice reflects the risk appetite of the bank and its supervisor (or supervisory college), taking into account the chances of crises and the desire for safety versus other public policy goals for the public authorities and profits for the bank. The formula and the amount chosen turned out to be insufficient in the 2007-2013 subprime crisis, at least the risk appetite in relatively good times or when impacting a single bank turned out not to reflect the actual risk appetite in bad times. This resulted in additional buffers being requested, mainly by add-ons of higher demands on top of the solvency ratio; see below. The numbers chosen are and remain, however, a question of judgement, not science, and thus reflect the adjusted risk appetite of the legislators.

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One-off (non-legal) Solvency Ratios; the 2011 EBA Stress Test and Recommendation Before the 2007-2013 subprime crisis hit, the capital levels at publicly traded banks usually were well above the level required by legislation16. Management, rating agencies and investors required additional financial buffers when deciding that shares and bonds issued by a bank were worth investing in, often not trusting the flexible risk based BCBS solvency ratio in favour of simple mathematics such as the leverage ratio, if available. For banks in trouble, and when the financial system in general is in trouble, the capital requirements become more binding, in the sense of constrictive on the activities of a bank and starts to determine their actions. This inflection point where banks stop setting their own capital levels but start being led by supervisory requirements, is where supervisory work starts transcending pure monitoring17. During the crisis, banks started to increase capital levels, again well beyond currently applicable minimum requirements. There are multiple reasons for increasing capital buffers. Bond investors want more protection. The minimum requirements will rise in the future due to the introduction of Basel III via the CRD IV project (see below). Importantly, market turmoil forced a strengthening of EBA stress tests as to the required improvement in capital already in 2011, long before such introduction of Basel III as binding legislation18. Lower financial buffers as published by the supervisors have become an indicator of potential failure, and a predictable course to bankruptcy/bailout. Such expectations can cause bank-runs and even higher funding costs, in an ever-increasing self-fulfilling prophecy. The higher requirements formulated by EBA were not part of the EU minimum requirements valid at the time as supposedly guarded by EBA; which it is indeed supposed to stress test19. For the relatively larger banks headquartered in 21 member states that are subjected to the EBA stress tests, the fact that it is not based on any legal requirement does not appear to be relevant for the EU. In an unusual collaboration of the ever-anonymous 16 R. Gropp & F. Heider, The Determinants of Bank Capital Structure, ECB WP 1096, Frankfurt, 2009; and A. Demirguc-Kunt, E. Detragiache & O. Merrouche, Bank Capital, Lessons from the Financial Crisis, World Bank Policy Research Working Paper 5473, 2010. Also see I. Alfon, I, Argimon & P. Bascuñana-Ambros, ‘Management Views About Desired Capital: the Case of UK Banks and Building Societies’, Journal of Financial Regulation and Compliance, Vol. 12, No. 3, 2004, page 263-274; and H. Mueller & J. Siberón, ‘Economic Capital in the Limelight’, Journal of Financial Regulation and Compliance, Vol. 12, No. 4, 2004, page 351-358. See R.J. Theissen, Are EU Banks Safe?, The Hague, 2013. A.R. Fonseca, F. González & L. Pereira da Silva, Cyclical Effects of Bank Capital Buffers with Imperfect Credit Markets, International Evidence, 2010, Banco Central do Brasil, WP 216. 17 Also see the discussion on procyclicality in chapter 6.5. 18 EBA, Overview of the EBA 2011 Banking EU-wide Stress Test, 18 March 2011; EBA 2011 EU-wide Stress Test, methodological note version 1.1, 18 March 2011; EBA, Supporting document 2: capital definition criteria (and the accompanying press statement); EBA, Supporting document 1: banks participating in the 2011 EU-wide stress test, 21 April 2011; EBA 2011 EU-wide stress test, methodological note – additional guidance, 9 June 2011; EBA, European banking authority 2011 EU-wide stress test aggregate report, 15 April 2011. 19 Art. 21-23 and 32 EBA Regulation 1093/2010. See chapter 13.6.

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‘markets’ and supervisors in an attempt to restore confidence in banking services, the legality of any requirement is moot. Both the higher quality of capital required by EBA in its stress tests (though not as strict as Basel III/CRD IV, still higher than the current capital rules of Basel I and II as laid down in the current version of the CRD) and a higher solvency ratio demanded as calculated under a semi-standardised stress test calculation with more limited national discretions is de facto the new minimum (5% solvency ratio should remain even in the most stressed scenario calculated). The same applies to the follow-up recommendation ‘to restore market confidence’. This recommendation of December 2011 asked the major banks that participated in the 2011 stress test to maintain 9% of capital, with sovereign bonds valued at market prices instead of nominal value. The 9% was not under the stressed scenario but ‘normal’ CRD rules, yet adding the stress of the low actual market prices of sovereign bonds and combining it with the demand for higher quality capital (copied from the 2011 stress test)20. National supervisors were invited to comply or explain, and the results would be published (preferably by the participating banks themselves. Market participants are unlikely to do business with the banks that do not explicitly pass the test within the terms set, and supervisors will deem the bank to be in an unsafe scenario, and are likely to intervene if their local administrative law allows them to do so. EBA has thus expanded its job of doing an EU wide stress test and used the market to enforce its desired outcome. The market has more or less blackmailed the less enthusiastic supervisors and banks to participate in this public exercise in order to re-establish credibility. In spite of being stricter than the CRD in place at the time, the stress test of the banks did not achieve market confidence as the sovereigns were at that point in time the weaker link of the banking and member state downward spiral in the crisis. Deviations from existing EU law in the EBA stress tests: – setting the level at 9%, anticipating by multiple years the implementation of the Basel III version of the capital accord in the EU, even if everything goes according to the planned timeline (see below); – denying banks the possibility that the buffer would be achieved via revaluations of the sovereign bonds (the prices were assumed to be fixed at September 2011 levels); – adjusting the capital definition by not admitting hybrid instruments, but admitting equally weak state aid measures and a newly created – to anticipate Basel III implementation in the EU – convertible bond that even for this specific purpose could be equated to core tier 1; – denying banks the possibility that the buffer would be achieved via deleveraging (unscheduled deleveraging would not count against achieving the buffer, unless – under

20 EBA, Recommendation on the creation and supervisory oversight of temporary capital buffers to restore market confidence, EBA/REC/2011/1, 8 December 2011 (with accompanying ‘questions & answers’).

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special permission – a third party had taken over the activities and continued those, to avoid a credit crunch in the economy; – the deviation of its own prudential filters on sovereign bonds (though this is up to EBA itself, the deviation went against legitimate expectations of banks); and – like the 5 % under the stressed scenario, the 9 % under the non-stressed – but already bad – practical situation as at September 2011 is a one-off to be achieved by 30 June 2012, but it is unlikely that such instruments can be immediately repaid (or would be accepted for the 9% calculation if they were) making it long term for all intents and purposes. Solvency Ratios in Basel III / CRD IV, gradual changes from 2014-2019 The solvency ratio will be changed after the 2007-2013 subprime crisis, and complemented by other quantitative ratios on capital and on liquidity. A leverage ratio has been agreed as part of the Basel III package after the 2007-2013 subprime crisis, and partially implemented in the CRD IV project in the EU between 2015 and 2018; see below. The leverage ratio would add a third quantitative capital measure to the solvency ratio and to the 5 million euro initial capital requirement. In line with the Basel III framework, the solvency ratio will be beefed up in its component calculations for e.g. credit risk and financial buffers. It will also be cut into a series of component solvency ratios, all based on the same calculation of the denominator, but with different types and amounts of financial buffers requirements being used for different types of ratios. Increasing the solvency ratio was the preferred option in response to too low levels of capital in the banking industry to absorb losses of any relevant scale during a type of crisis that went beyond a mild recession. However, what the right amount of capital is remains as much of a ‘lucky guess’ as the initial Basel I 8% requirement, and it is not clear – not even on a theoretical level – that an increase in capital will actually make a bank or the banking system safer if the effects on behaviour and evasion are taken into account21. The currently applicable solvency ratio is very one-dimensional. It has to be 8%. By differentiating between three quality tiers of financial buffers that can be used to fulfil this obligation, it in effect consisted of an under-advertised 2% minimum capital requirement when only the highest quality financial buffers (issued and paid up shares and published reserves) were considered (see the tiers of capital described in chapter 7.3). The CRD IV directive and CRR as based on Basel III intends to change this. There is still an 8% minimum solvency ratio requirement, but it will be part of a series of basic but high quality minimum ratios, supplementary requirements, total requirements and, likely, an add-on for systemic

21 See the review in D. Gale, ‘Capital Regulation and Risk Sharing’, International Journal of Central Banking, Vol. 6, No. 4, December 2010, page 187-204.

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banks. This in addition to the leverage ratio set out below, and the liquidity ratios set out in chapter 12. An overview of the solvency ratio in the current CRD and in the CRD IV project is set out in the table below. These add-ons will gradually enter into force between 2014-2019, with the heavier impact only felt in the later years when quantitative limits may be introduced for leverage ratio and liquidity ratios, and the (additional) buffers of higher quality capital have slowly become effective (though transitional provisions on existing capital instruments already issued by banks will continue to apply even after 2019). The minimum required solvency ratio will remain at 8%. However, it will have to be supported by higher quality capital (see chapter 7.3). 4,5% of the minimum 8% has to be covered by the highest quality financial buffers (up from 2%), 2,5% by other financial buffers that are useful in going concern, and 2% by buffers that are only useful in a liquidation context (gone concern). The calculation of the amount of required capital will not change. The credit risk calculation, operational risk calculations and the market risk calculation will retain the same basic structure before and after the implementation of Basel III, with some corrections in the credit risk calculation on e.g. the treatment of derivatives/central counterparties and the use of credit ratings (see chapter 8.1 and 8.4). As set out in chapter 2, 8.6 and 9, the treatment of securitisations and market risk has been changed by the CRD III directive as per year-end 2011, in line with Basel II½22. Additional Buffers Become Part of the Solvency Ratio 2016-2019 New supplementary financial buffers, calculated along the same line as the minimum capital requirements, come on top of the minimum 8% solvency ratio as of 201623. They consist of: – a capital conservation buffer; – a countercyclical capital buffer (with a possible national discretion add-on); – systemic risk buffer; – any pillar 2 capital requirements24. All the supplementary buffers contained in the CRD IV project have been allocated to the directive instead of in the regulation, leaving more scope for deviation (goldplating) for the member states25. The later developed systemic bank surcharge has also become part of the directive26. 22 CRD III Directive 2010/76/EC, amending both the RBD (on securitisations and on remuneration policy) and RCAD (on the treatment of the trading book). 23 Art. 128-142 and 162.2-162.6 CRD IV Directive. 24 Pillar 2 can already now lead to a supervisor asking for a higher solvency ratio, but this becomes more explicit and standard in the CRD IV Directive. 25 See chapter 3.5 and the CRD IV Directive. 26 The BCBS and FSB work on systemic risk buffer was a later add on to the Basel III work; see chapter 18.2.

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The various additional buffers, including the capital conservation, countercyclical and systemic risk buffers are not minimum requirements, in the sense that breaching them leads to intervention by the supervisor as would the breaching of the solvency ratio itself27. The main consequence for the bank if these additional buffers capital are not met is that the bank becomes gradually more limited in the amount of bonuses and dividends (or similar costs such as voluntary pension contributions) it can pay out under so-called capital conservation measures. Proportional to the amount of additional buffers lacking, there are limits on the distribution of profits that could also be used to replenish capital28. Since the end of 2011 such prohibitions can already be anticipated upon by supervisors, as they should have obtained the instruments to prohibit bonuses or dividends if the bank does not have a sound capital base. Until these flexible buffers are applied from 2016 under the CRD IV directive, there is no common clarity as to when a ‘sound’ capital base is available29. In addition to this distribution restriction, the CRD IV copies a requirement from the insurance sector and requires the bank to formulate a capital conservation plan30. This should set out how it will replenish capital as quickly as possible. These harmonica-style buffers are thus aimed at generating action before the minimum buffers are breached. The capital conservation buffer will be 2,5% of risk weighted assets. It has to be met by the highest quality of capital (common equity tier 1, similar to the 4,5% of the minimum capital requirements). It will enter into force in 2016 at a reduced level, and annually increase until the full requirements enter into force in 2019. Member states can anticipate upon this requirement, and shorten the transitional period even already in 2014, but other member states are not required to follow such national discretion add-ons when looking for instance at consolidated requirements or at branches in the other member state of their banks31. The countercyclical buffer is set by the member state on a quarterly basis for all banking activities in its territory, and can range from 0% to 2,5% (also to be filled by common equity tier 1). If the member state sets a buffer between these percentages32, these apply to

27 The solvency ratio and the amount of initial capital of art. 92 and 93 CRR have – like the current solvency ratio – to be met at all times. 28 Art. 141 CRD IV Directive. 29 Art. 136.1 RBD as amended by art. 1.10 CRD III Directive 2010/76/EU. See chapter 20.3. 30 Art. 142 CRD IV Directive. 31 Art. 128-129,160 and 162.2 CRD IV Directive, applicable from the start of 2016 under a gradual implementation schedule. 32 Art. 128, 130, 135-140, 160 and 162.2 CRD IV Directive. Whether the domestic percentage setter will have the political will to stop the party is questionable; also see chapter 22.5. The ESRB is envisaged to draw up guidance/recommendations, and monitor its usage; art. 135-140 CRD IV Directive. Commission, CRD IV – frequently asked questions, 20 July 2011, memo/11/527.

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EU Banking Supervision all activities of any EU bank33 in its territory (also if it performs those under a branch or cross-border services notification), and on a consolidated basis it continues to apply to the activities of any consolidated group-bank in that territory. Like for the capital conservation buffer, the requirement enters into force gradually between 2016 and 2019, but member states have an option to introduce it as soon as 2014 (but other member states are not required to follow this in e.g. the consolidated calculations or for exposures of their banks to the member state that set the countercyclical standard. The buffer percentage set by one member state between 0% and 2,5% will thus be taken into account by the supervisor of another member state. The same applies to third country buffer percentages, though here EU member state authorities may set a higher percentage than the one set by the third country authority (which they cannot do for buffer percentages set by in EU member states). Under the CRD IV project, a member state can also set a higher countercyclical buffer percentage to its local banks in a national discretion. If a member state uses this, it applies to local banks, but other member states do not need to take such higher percentages into account, but in that case could apply the 2,5% agreed upper limit that has to be respected in a cross-border context34. Member states can opt to go for a bigger countercyclical buffer if their domestic economy is particularly overheated, in a national discretion. Those cover local activities, but other member states do not have to take the excess buffer over 2,5% into account in their solvency ratio calculations for their ‘own’ banks that have activities (in cross-border services, branches or subsidiaries) in the country that use the national discretion. Other member states can choose to do so if they so desire for 2,5% plus settings in other member states and third countries, in which case ‘their’ banks will need to take it into consideration in the calculation of the buffer requirement for their particular mix of exposures (depending on where those exposures are ‘located’). Though this sounds simple and straightforward, it will require a complicated additional assessment of where exposures are ‘located’, e.g. if it concerns a derivative or even a regular loan between on the one hand a UK branch of a German bank and on the other hand a Cypriot bank guaranteed by its Greek parent bank, and whether that location changes to another country (and thus another countercyclical buffer) if the rights or debts under such a contract are subsequently sold or taken over by another entity. The task to come up with a suitable method of determining a geographical location of financial contracts would be delegated to EBA35. Increases in countercyclical buffer percentages would in

33 The same is likely to be true for countercyclical buffers set by non-EU BCBS members, in a reciprocal manner. Also see BCBS, Guidance for National Authorities Operating the Countercyclical Capital Buffer, December 2010. 34 Art. 136-140 CRD IV Directive. Also see page 13 of Commission, Proposal for a Directive as part of CRD IV, COM(2011) 453 final, 20 July 2011. 35 Art. 140.5 and 140.7 CRD IV Directive.

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principal apply with a year delay, while decreases apply immediately36. This means that a recession can be immediately ameliorated, but that an upward cycle is subjected to a delayed brake (allowing or even stimulating the banks to continue stoking an upward economy longer). How to set and calibrate the countercyclical buffers is not yet clear. The BCBS has issued some very tentative guidance, but this is neither clear nor binding37. The CRD IV project refers to a role of the ESRB in setting guidelines and monitoring their application by nationally designated authorities, giving – non-binding – recommendations if it considers those buffers to be inadequate, and mediating upon request if there is a lack of coordination between the rates set in different member states38. There is a lack of clear triggers, though credit expansion relative to GDP (but how much, and how dominant is this as an input?) should play in role in setting the buffer at a higher level, and loss accumulation in setting it lower (but how many losses, and how much lower?)39. A subjective analysis by the national authorities in guessing the state of the cycle will be the basis for the level of the buffer for the foreseeable future. Setting it correctly in the absence of clear triggers and with clear incentives to always stimulate the economy (both in the downswing and in the upswing) will be the main task, goal and test of the reliability, expertise and independence of such a national authority. It is far from certain if it can resist such temptations and err on the side of caution. Supervisors have also indicated that a high countercyclical buffer should also be an indicator to reduce the overheating of the economy of the country that set it. Other public authorities and the legislators should treat it as a signal to reduce fiscal or other stimulating measures40. This, however, presupposes agreement between the government and the parties involved in setting the countercyclical buffer in the relevant country. This is not and should not be a given with a view to the different goals of the parties involved (including central banks, supervisors, tax authorities, legislators) on top of the likelihood of different assessments of the economic data41.

36 Art. 136.5, 136.6, 137.2 and 140.6 CRD IV Directive; and BCBS, Guidance for National Authorities Operating the Countercyclical Capital Buffer, December 2010. 37 BCBS, Guidance for national authorities operating the countercyclical capital buffer, December 2010; R. Repullo & J. Saurina, The Countercyclical Capital Buffer of Basel III: a Critical Assessment, CEPR Discussion Paper 8304, March 2011. Also see chapter 6.5. 38 Recital 86-88 and art. 135, 136, 138 and 139 CRD IV Directive. 39 Art. 136 CRD IV Directive. M. Drehman, C. Borio, L. Gambacorta, G. Jimėnez, & C. Trucharte, Countercyclical Capital Buffers: Exploring Options, BIS Working Papers No. 317, July 2010. 40 J. Caruana, Speech ‘Macroprudential Policy: Could it Have Been Different This Time?’, 18 October 2010, www.bis.org. 41 P. Angelini, A. Enria, S. Neri, F. Panetta, & M. Quagliariello, Pro-cyclicality of Capital Regulations: Is It a Problem? How to Fix It?, Banca d’Italia Occasional Papers 74, October 2010, page 35.

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For systemic banks the aim was to making them even more bankruptcy-remote to avoid the inevitable bailout further; see chapter 18.2. In follow-up work to Basel III, systemic banks will face a systemic bank surcharge/buffer. The FSB developed proposals to give incentives to systemically important financial institutions (sifi's) to reduce their systemic importance or to increase their resolvability42. The 2010 report of the FSB is ambivalent as to whether e.g. internal governance measures could be an alternative to higher capital measures, or could be needed in addition to such higher capital requirements43. It was also still quite open as to the type of financial buffers that could be used to fulfil the additional capital requirements, mentioning capital and bail-inable claims. The work of the BCBS on higher solvency ratios for these institutions has been allocated to it within the context of this wider FSB work. Agreement was reached only in November 201144. It specifies that systemic banks (later also other types of systemic financial institutions) should be identified and allocated to risk categories. For each category, a surcharge in the form of a proportionally higher solvency ratio should be introduced, ranging up to 3,5%, to be introduced from the start of 2016. As it considered bail-in debt to have significant downsides for the financial markets if the bank appears to be stressed, it recommended using only core equity tier 1 to cover the additional systemic charge. In October 2012, the work on global systemically important financial institutions was supplemented by a set of BCBS principles for the assessment and additional loss absorbency for domestically important systemic banks45. The BCBS did not opt to provide similar buckets for named systemically important banks, but leaves it to national discretion how much additional loss absorbency should be instituted, and in which manner; also gradually as from January 2016. The compromise was introduced into the negotiations for the CRD IV project, adjusted for the EU context46. EU national supervisors could and can already impose higher minimum solvency ratio for banks they deem systemic. This is either based on goldplating the CRD, if applied in a standard manner under domestic laws, or on the pillar 2 assessment. Supervisors can ask for higher capital under pillar 2 if they think all risks have not yet been taken into account. The systemic importance (‘too big to fail’ see chapter 18.2) under the new systemic risk buffer contained in the CRD IV directive is designated – in line with the possibility

42 FSB, Reducing the Moral Hazard posed by Systemically Important Financial Institutions, FSB Recommendations and Time Lines, 20 October 2010, based on its Interim Report of 18 June 2010 (see page 2 on the goal of the effort). 43 FSB, Reducing the Moral Hazard posed by Systemically Important Financial Institutions, FSB Recommendations and Time Lines, 20 October 2010, page 3. 44 BCBS, Globally systemically important banks: assessment methodology and the additional loss absorbency requirement, November 2011. 45 BCBS, A Framework for Dealing With Domestic Systemically Important Banks, October 2012. 46 Recital 85 and art. 131-134 and 162.2-162.6 CRD IV Directive; gradually applicable as of 2016, but with the option to reduce the transposition term and introduce it even from 2014 in a national discretion.

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to add pillar 2 requirements – as a risk factor not yet captured in pillar 1; see chapter 14. Pillar 2 requirements can include the systemic risk buffer until it becomes applicable in 2016, and after that it supplements is. Both require a continuous adjustment depending on the assessment of the supervisor of whether this specific bank as it stands at that point in time requires a risk buffer for the systemic risk it poses and is subject to, and if so which. In addition to the required individual systemic buffer for globally systemic banks, the CRD IV directive explicitly continues to allow a form of goldplating by member states in the form of individual or national systemic risk buffers, funded by common equity tier 1. There are as a result three different systemic risk buffers, that nonetheless only lead to one requirement per bank47: – A requirement for a specific group identified as a global systemically important institution of between 1% and 3,5% at the consolidated level under harmonised criteria; see chapter 18.2; – A requirement for a specific group, a specific subgroup or an individual bank identified as an ‘other’ systemically important institution by a national supervisor of between 0% and 2% at the consolidated, sub-consolidated or solo level as applicable; see chapter 18.2; – A requirement for the whole banking sector or a subset thereof set as identified by a member state to prevent ‘long term non-cyclical systemic or macroprudenital risks’ in a specific member state that is not covered by the CRR and set by a national authority at a level between 1 and 3%, 3 and 5% or 5% and up, each with a specific procedure to clarify why this is needed. The higher of these buffers applies. The only time such buffers can be cumulative is if a bank(ing group) that is itself specifically identified as relevant is also subject to a general systemic risk buffer, if that buffer only applies to exposures in the member state that introduced it48. All these systemic risk varieties need to be met by common equity tier 1 capital that is not already used for other parts of the solvency ratio. The general systemic risk buffer imposed for (subsets of) the financial sector for risks not covered by pillar 1 may already be applied from the start of 201449. Other member states may or may not choose to recognise such a national surcharge, and apply it to exposures of their banks in the member state that set the surcharge.

47 The individual buffers for specific groups or banks are set out in art. 131 CRD IV Directive, the general one in art. 133 CRD IV Directive. The latter starts to apply in 2014, the individual ones from 2016; see art. 162.5 CRD IV Directive. 48 Art. 133.14-133.16 and 133.4 CRD IV Directive. 49 Recital 85 and art. 133-134 and 162.6 CRD IV Directive, as applicable already from the start of 2014.

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CRD IV project on solvency ratio1

CRD (current) Solvency ratio2

Supplementary capital (CRD IV directive)

Supplementary capital (RBD)

Pillar 2

Pillar 2

Both going and Decided on a gone concern case-by-case basis

Decided on a case-by-case basis

Decided on a case-by-case basis

depending on own and supervisory assessment of needs Systemic bank or (sub)sector

Highest quality In principle up to 3,5% for the biggest individual groups and banks, and a national discretion (with safeguards) for national banking sectors.

Extra Quality countercyclical decided locally national discretion)

Only works on locall

Countercyclical Highest quality banks active in that member

Between 0% in depressions, and 2,5% in boom times

Capital conservation

2,5% (if less, restrictions on dividends and bonuses)

but can be drawn down)

Highest quality

Possible local national discretion surcharges

1. Art. 25-88, 92, 465-491, 494, 501, 504 CRR and art. 97-98, 104, 129-134, 160, 162 CRD IV Directive. 2. Art. 57, 66, 75, 124 and 136 RBD and art. 18 RCAD.

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Minimum capital (CRR)

Minimum capital (RBD/RCAD)

Core tier 1 minimum capital requirement

Highest quality

4,5%

Tier 1 minimum apital requirement

Reasonable quality

2,5%

Tier 2 minimum capital requirement

8% solvency ratio

2%

2%

(tier 1 or better)

concern (or better) concern (or better)

Reasonable quality

4%

2%

Tier 2 (or better) Tier 3 (low quality, market risk)

For the tiers (and the upgrade of the requirements on the components of financial buffers that qualify as high quality going concern capital and as gone concern financial buffers) please see chapter 7. If presented in the order of the quality of the financial buffer that has to cover a segment of the solvency ratio, it breaks down for the CRD IV project as: 7% up to 9,5% Common equity tier 1 for non-systemic banks 7% up to 13% for systemic banks

– – – –

4,5% minimum capital requirement 2,5% capital conservation buffer 0 to 2,5% countercyclical buffer 0 to 3,5% systemic risk buffer plus potential sector wide systemic add-ons

2,5 plus addons

Tier 1 (core or the other – 2,5% minimum capital requirement going concern loss absorb- – potential national discretion extra countercyclical ing capital components) buffer – pillar 2 surcharge

2% plus addons

Tier 2 (or tier 1 if the bank – 2% minimum capital requirement has it) – pillar 2 surcharge

A non-systemic bank that wants to be in the safe zone – without existing or potential restrictions on pay-outs or emergency measures and able to handle additional cyclical demands – will thus have to have at least 14% of financial buffers of varying quality for risk weighted capital. A systemically relevant bank will need to add the systemic surcharge,

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meaning that it may need somewhere between 14 and 17,5% financial buffers (see chapter 18.1-18.2). How the market will react to this new set of ratios is anyone’s guess, especially if the buffers are drawn down as intended in the low parts of a cycle50. If markets react to the supplementary buffers as if they are also part of the minimum (by e.g. requiring high premiums for credit default swaps, refusing to lend to a bank that has drawn down the buffer, withdrawing funds and deposits), the Basel III proposals will miss their desired effect of cyclical flexibility in capital requirements. It will, however, in that case achieve its – perhaps partially unintended – goal of achieving minimum capital requirements that are actually relevant as a buffer in the next financial crises. The capital conservation buffer and the countercyclical capital buffer will be gradually introduced (in four steps with slowly increasing percentages) in 2016-2018, and will fully apply in 201951. The systemic risk buffer will also be gradually built up from 2016-2019, but under a different phrasing of the timeline52. All additional buffers transitional provisions provide that they can already be introduced as a national discretion immediately. Leverage Ratio in Basel III/CRD IV – Reporting from 2015, Limits from 2018 In the CRD there is no minimum ratio (apart from the absolute number of 5 million euro) required between total assets in relation to shareholders equity. Possibly, market pressures will ensure that the company law balance sheet will show the minimum relation investors want. However, in a boom period those demands can be quite negligible, as shown prior to the 2007-2013 subprime crisis. The freedom of banks to increase leverage53 was abused. Such leverage combined with a shift from deposit-funding to wholesale funding was linked to procyclicality54. The sole reliance on one type of solvency ratio was criticised at the EU and worldwide level as a result of the credit crisis. The USA Federal Deposit Insurance Corporation (FDIC) had never been comfortable with a risk weighted solvency ratio as the sole guardian for ensuring adequate capital55. It pushed the introduction of an interna50 See e.g. E. Patrikis, Higher Minimum Capital Standards: BCBS Crowns Common Equity King, 2010, BNA’s Banking Report 30 November 2010, page 5. 51 Art. 160 CRD IV Directive. 52 Recital 85 and art. 131-134 and 162.2-162.6 CRD IV Directive; gradually applicable as of 2016, but with the option to reduce the transposition term and introduce it even from 2014 in a national discretion. 53 C. Roxburgh, Debt and Deleveraging: the Global Credit Bubble and its Economic Consequences, McKinsey Global Institute, London, January 2010, finds that by 2009 the leverage of the banking system had returned to average levels, but at the detriment of public sector debt. 54 Chapter 6.5. H. E. Damar, C.A. Meh, & Yaz Terajima, Leverage, Balance Sheet Size and Wholesale Funding, Bank of Canada WP 2010-39, December 2010. 55 See e.g. the remarks by Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation at the Conference on International Financial Instability in Chicago

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tional version of the leverage ratio it relies on to determine when any bank that is covered by its deposit guarantee should be closed. A leverage ratio provides a maximum to the number of times capital can be used to buffer for assets held. It limits the total size of the balance sheet to x times available capital. The USA leverage ratio56 or tier 1 leverage measure requires banking groups to hold a percentage of tier 1 capital divided by assets on a consolidated basis. The percentage differs between 3 and 4%, and appropriately higher if the bank has serious weaknesses. Though heavily pushed by the FDIC even long before the crisis, the leverage ratio failed to gain supporters in the banking sector or in the community of regulators abroad. It looked doomed to remain a USA goldplating regime to the BCBS work, like the large exposures regime is an EU goldplating regime to the BCBS work. The 2007-2013 subprime crisis started in the USA, and the leverage ratio failed to prevent the bankruptcy of many USA banks. However, the leverage ratio has still gained an international following. It did restrain some of the more extreme risk taking by banks. For instance it forced USA banks to sell the more extreme portions of securitisations to entities that were not constrained by this ratio as well as to a host of – perhaps naïve and profit hungry – German, Dutch and other EU banks. The ratio may indeed have led to at least some more capital being held by the USA banks, though the comparison is difficult to make due to the substantial differences in public reporting under local accountancy standards (e.g. the treatment of securitisation leads to a reduction of the balance sheet size for banks reporting under US GAAP, in line with the non-public securitisation treatment in the Basel accord and CRD, but securitised assets stay on the balance sheet for banks reporting under IFRS57). The need to deleverage and the associated credit crunch after the initial failures did turn out to be less extreme in the USA than in the EU (but that may equally have other causes). In the USA, the bite of the ratio is in the prompt corrective action framework linked to both the risk based capital ratio and to this leverage ratio. To protect deposits, the federal supervisors are obliged to activate a defined set of interventions if either of the ratios are

on 5 October 2006. The Federal Deposit Insurance Corporation is one of federal supervisors, responsible for the winding up phase of all banks and the supervision of some. http://www.fdic.gov/news/news/speeches /archives/2006/chairman/spoct0606.html. 56 See 6000 – Bank Holding Company Act, Appendix D to Part 225—Capital Adequacy Guidelines for Bank Holding Companies: Tier 1 Leverage Measure. http://www.fdic.gov/regulations/laws/rules/6000-2200.html. 57 A. Adhikari & L. Betancourt, ‘Accounting for Securitizations’, Journal of International Financial Management and Accounting, Vol. 19, No. 1, 2008 page 73-105. Also see chapter 6.4 and 8.6.

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EU Banking Supervision (in danger of) no longer being met58. ‘Prompt corrective action’ as applied by the FDIC basically meant a predetermined, automatic, and harsh follow-up regime for each bank breaking through this ratio (not particularly welcomed by the banks nor by the ‘colleague’ federal or state supervisor primarily in charge of supervising the bank, who were more willing to look at the broader picture and the political or economic sensitivities). Prompt corrective action has the benefit of dealing to some extent with forbearance, and it gives a clear – police like – role to the supervisor that is bound to apply it59. You perform this transgression, I respond in that pre-determined manner; tit for tat. It takes away some of the subjectivity in the sanctions phase, and deals with the natural tendency to hope for better times and delay surgical actions. Nonetheless, prompt corrective action will likely move the subjectivity to the determination side (is there a transgression, depending on subjective data on valuation, date of transactions, when do you acknowledge losses) as an incentive to massage the numbers for both the bank and the closely involved line side employees at the supervisor. It takes away flexibility with both its upsides and downsides, and the incentives to look for solutions instead of for avoidance and punishment. In addition to the solvency ratio, the BCBS has indeed added a leverage ratio to its Basel III package; though without the ‘prompt corrective action’ accompanying instrument that made it effective in the USA. The Commission copied the BCBS approach as part of its CRD IV project of July 2011. Key issue differentiating the Basel III/CRD IV approach from the USA leverage ratio is that the CRD IV has no ‘bite’ in the sense of prompt corrective action. The Basel III accord sets the leverage ratio tentatively at 3%, but this number has not (yet) been copied in the EU rules60. In the EU, the leverage ratio will be gradually introduced after a monitoring and disclosure period61. In principle, the leverage ratio is the tier 1 capital (i.e. the highest quality plus other going concern loss absorbing financial buffers) of the bank divided by the total exposure value of on and off-balance sheet items, expressed as a percentage. Data gathering

58 1000 – Federal Deposit Insurance Act, Sec. 38, Prompt Corrective Action. http://www.fdic.gov/regulations/laws/rules/1000-4000.html. 59 The Federal Deposit Insurance Corporation has been a proponent of this option. But also in the EU some defend it for its clear advantages, even in light of its equally clear downsides. See e.g. Centraal Planbureau, Binden voorkomt uitstelgedrag; naar strenger bankentoezicht, CPB Policy Brief 2011/4 (Dutch). See chapter 20.3, on regulatory forbearance. 60 CEBS, Results of the Comprehensive Quantitative Impact Study, 16 December 2010, www.eba.europa.eu. The study showed that 75% smaller banks at the time fulfil such a requirement (on average at 3.5%) while only 40% of the large banks fulfilled it (on average at 2.5%). The lack of a prompt corrective action is in line with existing practice in the member states; see CEBS-EBA, Mapping of Supervisory Objectives, including Early Intervention Measures and Sanctioning Powers, 2009/47, March 2009, page 42-43; and chapter 20.3. 61 See recital 18, 92-96 and art. 4.93, 4.94, 429, 430, 451, 499, 511 CRR, and the accompanying references to governance and pillar 2 in art. 87 and 92.6 CRD IV Directive.

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will start from 2013, and these data have to be published under pillar 3 from end 2014, and can be taken into account by supervisors in their pillar 2 assessments; see chapter 14. Until 2021, banks can use tier 1 capital as defined in the (more relaxed) transitional definitions, and choose which to publish under pillar 362. Public disclosure of the leverage becomes mandatory in 2015, as does reporting to the supervisor. After a review in 2016, the leverage ratio would become binding from 2018, possibly different for different business models. All financial buffers that help buffer risks in a going concern (tier 1 capital, i.e. own funds plus e.g. hybrids) are divided by non-risk weighted assets, and should be – from 2018 – no worse than likely 3%. This does not sound particularly harsh, but prior to the crisis some EU banks were more heavily leveraged. Member states can introduce leverage ratios earlier if they so desire according to the recitals of the CRR. The introduction of a leverage ratio may well help dampen some of the procyclical behaviour of the banks. The leverage ratio has the added benefit of being easy to understand, unlike the solvency ratio, and thus less easily compromised by the institution63. However, the US leverage ratio on which the new leverage ratio was inspired, can be deemed a failure in as far as preventing bankruptcies is concerned. The leverage ratio does not capture all risks an institution is subject to. Also, as shown in the 2007-2013 subprime crisis the USA version did not actually prevent USA institutions going bankrupt, as did their EU counterparts. Other Ratios The solvency ratio, as well as all types of quantitative banking requirements, is focused on asset quality in relation to financial buffers. The assumption is that assets in general cover liabilities in general if there are enough financial buffers to absorb losses in the value of the assets. Theoretically, this sounds good, but in practice it has shown faults where financial buffers were sometimes shockingly inadequate to absorb devaluations of assets and other losses in credit risk and market risk, causing banks to go from healthy solvency ratio’s to bankruptcy in days. Operational risks, however, can be rare but lethal. They cannot be fully covered in the operational risk component of the solvency ratio, as that would take away any commercial rationale behind operating a bank. Another problem has been the treatment of off balance sheet ‘assets’ such as commitments to future liquidity loans. A third problem has been the treatment of risk entailed in the services business. Some banks gain a substantial portion of their profits from e.g. setting up complex transactions for other banks, asset management, custodial services, operating a multilateral 62 Art. 499 CRR. For pillar 3 and for reporting to the supervisor EBA has to develop standards, leading to a later implementation date as per end 2014. 63 See e.g. A. Demirguc-Kunt, E. Detragiache & O. Merrouche, Bank Capital, Lessons From the Financial Crisis, World Bank Policy Research Working Paper 5473, 2010.

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trading facility, or providing payment services. These activities may entail liability and/or reputational risks (incompletely captured by operational risk calculations and thus mostly reliant on possible compliance risk awareness), while the bank itself has little or no assets involved in the deal. Some new aspects of these risks could be assessed under the BCBS capital accords and the EU framework (see chapter 1, 2 and chapters 7 to 11) by providing tweaks and further detail on existing rules. The lack of quantitative measures that focus on depositor protection (i.e. on what should cover liabilities to clients instead on what should cover claims on clients) is one of the main reasons stated for the introduction of banking supervision is depositor protection. If that is so, it is strange that there is no ‘ratio’ or requirement to pledge or hold apart assets to that liability of the bank to its depositors? Such requirements do exist in insurance supervision (the technical provisions; see chapter 19.4); as do limits the types UCITS can invest in, directly related to funds provided by the investors in the UCITS. But even in these areas, however, a shift is taking place towards an asset fetish (the solvency ratio is introduced in insurance supervision) or less binding requirements for UCITS or alternative investments institutions (see chapter 19.5). A shift away from an ‘assets’ focus has not really surfaced; even the proposed leverage ratio is geared towards assets held in relation to financial buffers (instead of protected liabilities related to assets, collateral or financial buffers. A quantitative liability focused requirement that would require assets to cover all liabilities could complement the current solvency ratio requirement. Developments in the conduct of business and the investment services areas64 such as incentivizing the shift of derivatives trading onto trading platforms or at least into similar clearing and settlement systems do reduce the risks. They do not, however, provide for a buffer for the remaining risks (which increase in spite of the reduction per individual transaction due to the simple growth of the sheer size of the financial market). A step in the opposite direction is the differentiation in the priority in ranking in crisis management legislative proposals. These are likely to have the unintended consequence of speeding up a run by wholesale creditors (see chapter 18.3) as they would introduce a requirement to have sufficient bail-inable equity, subordinated bonds and senior unsecured bonds to allow 8% of liabilities to be bailed in as valued at the time of the bank failing; as is proposed in amongst others the Council position for the negotiations on the recovery and resolution directive, though this would need further development65. The Commission proposals on a single resolution mechanism would allow the board of governors of the

64 See chapter 16 and 22. 65 Council, Council Agrees Position on Bank Resolution, 27 June 2013, 11228/13, presse 270.

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resolution agency (in consultation with the ECB as the new single supervisor) to set the level of a new requirement as a percentage of own funds and ‘eligible liabilities’ (that would allow a bail-in under those legislative proposals) in relation to the total of all liabilities and own funds66. This would make the senior unsecured creditors de facto into tier 3 capital providers; to be set at a level that is unpredictable for the bank. The focus on the relation of assets to financial buffers is also one of the reasons for an underdevelopment of liquidity measures. There is currently no EU legislation on long term quantitative liquidity management; though there are some qualitative demands on liquidity risk management; see chapter 12. It was assumed that solvent banks would be able to get short term funding in all market circumstances. The fault in this assumption turned out to be a key cause of bankruptcy for banks when several funding sources dried up in the 2007-2013 subprime crisis (and in previous banking crises). If a bank cannot get loans, it is just as dead as when its assets are low quality or when it suffers from lack of internal controls and gets defrauded. See chapter 12 for a description of the proposed new quantitative ratios that would in part apply from 2015, in part after 2018. Diversification Discount or Surcharge? The Basel accord was, at the time the solvency ratio was developed, geared towards large diversified banking groups. A large diversified banking group has business in different sectors (e.g. lending to different types of industry, different types of retail customers, in different countries or regions) and is of a size to make internal lending and investment possible to solve problems in one area with surplus in another. Equally the standard calculation applied might in some business areas at a certain type in its economic cycle be too lenient for a part of the bank, but no doubt at that moment for another business area be too tight. This would be true for different banks in different areas. Overall, the framework assumed that for all banks, though not perfectly risk aligned in individual business areas of a large diversified banking group, would be risk aligned overall. The various versions of the Basel accord were not drafted with a non-diversified or smaller institution in mind. The BCBS initially was focused solely on the problem of how to supervise large crossborder operating banks, which were almost all diversified in their exposure to different sectors or different countries. This focus of the BCBS has slowly shifted since the initial 1988 Basel accord. On the one hand large cross-border banks have grown much bigger than ever imagined at the time. Mergers and takeovers and the growth of the (liberalized) capital markets have resulted

66 Art. 10, 15, 18 and 24 of the Commission Proposal for a Regulation on a Single Resolution Mechanism, COM(2013) 520 final, 10 July 2013.

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in ever-larger banking groups. On the other hand the Basel accords have also been applied in countries that did not have any large cross-border banks, and to banks that had a local business only. The subsequent versions of the accord have since been adapted to smaller banks by focusing on issues such as proportionality. The EU has applied the Basel accords from the beginning also to its smaller banks and the non-bank investment firms. It wanted to create a level playing field across the EU for all entities competing in the single market (not only for the large ones). The EU banking directives that put the Basel accords into legally binding texts for the EU were applicable to all banks and even to the more limited activity investment firms. This has led to a dual discussion. How should the sometimes detailed provisions of the Basel accord be applied to rather simple banks and firms on the one hand; and on the other whether the ever-larger banks should benefit from a discount because they have diversified the risks they face. Both discussions are dealt with primarily in the context of pillar 2, where diversification is one of the factors that determine whether the supervisor will require the bank to take additional measures to be safer67. In addition, all banks are required to be diversified in the context of credit risk under the general internal governance requirements68. In pillar 1, the references to diversification requirements or benefits are low-key, and were drafted in a neutral manner as to the attention and importance that should be attached to it by each supervisor. The theory is that if a bank is well diversified and correlation between businesses is low, the overall risk is reduced. The solvency ratio and the models used to calculate its denominator components also already assume – correctly in normal times for banks with diversified portfolios – that having investments in different areas reduces the risk in the overall portfolio as various assets will either not be correlated (if one goes up, the value of the other will not necessarily move too) or negatively correlated (if one goes up, another will go down)69. Diversification can mean that it is active in the markets for different types of customers, providing different types of services, in different geographic regions and funded by a diversified set of investors (be they shareholders, bondholders or depositors). The diversification theory, however, does not work in a worldwide recession, such as prevailed immediately after the Lehman collapse in September 2008. At the EU level, the common legislation on how to take diversification into account in the model approvals in pillar 1 and in the supervisory review of all risks the bank is exposed to in pillar 2 is so neutral that discrepancies can arise easily between lawmakers and supervisors in different countries. Especially with the beefed-up cooperation requirements in the context of both 67 Art. 124 and Annex XI §1 sub f RBD; see chapter 14. 68 Art. 22 and annex V §5 RBD. See chapter 13.3. 69 R. Sollis, ‘Value at Risk: a Critical Overview’, Journal of Financial Regulation and Compliance, Vol. 17, No. 4, 2009, page 398-414.

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model approval and pillar 2 (including capital allocation on a per legal entity basis derived from overall consolidated capital adequacy), the potential for strife within colleges is strong. Some bank/banking groups also enjoy competitive advantages because they have a permissive supervisor, which can disturb the single market. Neither is there common legislation on how to charge monoline banks (strong in one sector, in one business activity, like a one trick pony that will fail if their ‘trick’ is no longer legal or popular) for their lack of diversification. The solvency ratio is built on the above-mentioned assumptions of diversification in the standardised approaches, combined with some requirements to monitor diversification in securitisation positions the bank invested in70. If there is no diversification, especially for credit risk an add-on would be likely for credit risk (as the above-mentioned internal governance demand is not met). For banks operating under their internal models, some references to diversification are contained in the requirements on those models: – The IRB models for credit risk are interpreted to be calculated on the assumption of a well-diversified banks71. In addition, for private equity positions reduced requirements are in place if these are diversified72. – The market risk models implicitly allow diversification, by limiting its use on certain components. As per the introduction of Basel II ½/CRD III, banks are forbidden to take benefits into account between default risk and migration risk on one hand, and other market risks on the other in the calculation of the incremental risk charge, while diversification between long and short positions is only possible if conditions are met. In all other issues, the banks are implicitly free to propose diversification issues as part of the model they propose to use for capital calculations73. In addition, for commodities reduced requirements are possible if these are well diversified74. – In the model approval process for the advanced measurement approach to operational risk, banks have to make explicit any reliance on diversification effects built into the model75 (e.g. by assuming that natural catastrophes are unlikely to occur in different parts of the world at the same time, or simultaneously with fraud).

70 Art. 122a.5 RBD. For IRB banks sufficient diversification is e.g. mentioned in Annex VII part 1 §14 RBD. 71 CEBS-EBA, Position Paper on the Recognition of Diversification Benefits Under Pillar 2, 2 September 2010, page 4. 72 Annex VII part 1 §14 and 19 RBD. 73 Annex V §5b and 5e RCAD. 74 Annex IV §21b RCAD. 75 Annex X part 3 §31 RBD. Chapter 10.4 and 10.5. See, critically, A.A. Jobst, ‘The Treatment of Operational Risk under the New Basel Framework: Critical Issues’, Journal of Banking Regulation, Vol. 8, No. 4, 2007, page 336.

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The proposals of banks for their market risk and operational risk models do not have to be accepted by supervisors. The fact that the CRD implicitly or explicitly allows a proposal does deprive supervisor from the position that reducing capital for this reason is unacceptable76. Neither the very partial and focused market risk prohibition in CRD III nor the CRD IV project provide ammunition for a more strict capital calculation. Some supervisors may well approve the model only if it becomes much more conservative in its reliance on diversification benefits, while other will adopt a more liberal interpretation in light of a desire to stimulate the economy or lending to specific sectors of the economy. This is a recipe for the above-mentioned unlevel playing field. The treatment of diversification benefits can be relevant both in the context of model approval and of pillar 2 (contemplating internal governance as well as a general assessment whether all risks have been taken into account. Both are currently allocated to a joint process of supervisors in the colleges of supervisors; see chapter 21.7. CEBS-EBA initially developed a consultation paper for potential guidelines that would also cover pillar 1 solvency ratio calculations, but this effort was in part overtaken by the crisis. A new position paper has been issued. Diversification is now taken on board in the separate group wide pillar 2 guidelines, where the joint supervisory college can even accept it for capital allocation on a group wide and solo basis if a series of conditions are fulfilled, e.g. on capital transferability between group-entities77. CEBS-EBA indicates that supervisors may accept diversification within each risk category if conditions are fulfilled that include a full understanding by all supervisors that are fulfilled. Host supervisors may even then be hesitant to accept capital levels at their legal entity that are too low, if the diversification is not actually also fully embodied in that entity (instead of only being apparent at the consolidated level). Pillar 2 has always been the only area – aside from the relatively less important operational risk – where diversification can be taken into account under the CRD. The initial CEBS/EBA paper was more sympathetic for diversification benefits in models for pillar 1 solvency ratio calculation, alongside pillar 2 practices and positions. The assessment of diversification benefits under pillar 2 cannot lead to an actual reduction of the pillar 1 (solvency ratio) capital requirement, but diversification could be taken into account as a factor mitigating the need for an additional capital buffer under pillar 278. 76 CEBS-EBA, Position Paper on the Recognition of Diversification Benefits Under Pillar 2, 2 September 2010, page 1 and 17. 77 CEBS-EBA, Position Paper on the Recognition of Diversification Benefits Under Pillar 2, 2 September 2010. The original CP20 proposals of June 2008 were replaced by this effort, see page 3, and later supplemented by pillar 2 group-wide guidelines. See CEBS/EBA, Guidelines for the Joint Assessment of the Elements Covered by the Supervisory Review and Evaluation Process (SREP) and the Joint Decision Regarding the Capital Adequacy of Cross-Border Groups (GL39), 22 December 2010, page 24, 37-38. 78 The language of the solvency ratio article and the pillar 2 article do not give room for the conclusion that a reduction is possible. This interpretation was initially not the preferred one by all supervisors, but the mood

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Future Developments The calculation of the solvency ratio as a fraction does not change in the CRR. The main inputs remain equally the same, though a valuation adjustment for derivatives has been added as an input79. It has been combined into one article instead of being spread over the RBD and RCAD, which makes it more accessible. The above-mentioned additional buffers build on the same calculation, except for the leverage ratio and liquidity ratios. The link with initial capital as an ongoing capital requirement has been made more obvious in a separate requirement outside of the licensing and license-withdrawal context80. Please note that – in order to stimulate access to lending for small- and medium sized companies – the EU legislators have reduced capital requirements for lending to them, and allow member states to exclude lending to such smaller companies from the additional buffers for counter-cyclicality and for capital conservation81. Even after the CRD IV directive and CRR have formally become applicable, for some time the solvency ratio old style, will be the only requirement at the EU level, in addition to pillar 2 capital add-ons. The main difference will be that the financial buffers in the numerator will gradually be upgraded as to quality demands. The conservation buffer, countercyclical buffer and systemic risk buffer will enter into force from 2016, even though the other parts of the directive they are part of enters into force in 2014. The capital conservation plan and the capital conservation measures (if the then applicable lower financial buffer requirements are breached) will equally enter into force in 201682. Member states can shorten the transitional period or even delete it, but this is a national discretion without mandatory effect for the single market (see above). The leverage ratio will be introduced, but mainly as a reporting requirement without a minimum level set, and even then alternative lighter touch calculations are available in a transitional period for its introduction until 2021, while a binding quantitative requirement will be introduced only upon a review and possible legislative proposals by end 201683

79 80 81

82 83

appears to have shifted since the 2007-2013 subprime crisis. CEBS-EBA, Position Paper on the Recognition of Diversification Benefits Under Pillar 2, 2 September 2010, page 11. Art. 92 CRR. The credit valuation adjustment risk regime relating to OTC derivatives, is contained in art. 381-386 CRR; see chapter 8.4. Art. 93 CRR. Recital 44 and art. 501 CRR, and art. 129 and 130 CRD IV Directive. Also see European Parliament, Press Release on EU Bank Capital Requirements Regulation and Directive, 15 April 2013 and the assessment of EBA on the riskiness for banks of lending to smaller enterprises in EBA, Assessment of SME Proposals for CRD IV/CRR, September 2012. Art. 141 and 142 CRD IV Directive. Art. 429-430, 499 and 511 CRR, and the accompanying non-quantitative internal governance and pillar 2 reference contained in art. 87 and 98.6 CRD IV Directive.

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Literature – Goodhart, Charles A.E., The Basel Committee on Banking Supervision, A History of the Early Years 1974-1997, Cambridge University Press, Cambridge, 2011 – Pecchioli, R.M., Prudential Supervision in Banking, OECD, 1987, chapter VI

6.3

Standard and Self-Developed Models for Calculating Risk

Introduction The solvency ratio described in chapter 6.2 sets out the relation between quantifiable risk categories and the financial buffers. The calculation of these risk categories results in the denominator of the solvency ratio formula. They are each calculated separately, as described in more detail in chapters 8 to 11. As part of the denominator of the solvency ratio, they are both similar and different. They are different as to the type of risk covered, and the type of data that are needed for the calculation of the capital needed for that risk. The basic thinking underlying their calculation is, however, identical, and rely on either models set in the CRD, or alternatively on models that can be developed by banks for each risk-category or sub-risk-category. This chapter describes why and how models are relied on to calculate each part of the denominator, i.e. to estimate the amount of risk each quantifiable risk category presents to the bank. This chapter discusses the: – advantages and disadvantages of using models to provide input for the denominator of the solvency ratio; – types of risks and the types of risks for which quantifiable estimates are available; – sources and supervisory requirements of the models used for those quantifiable estimates; – limits to the usefulness of the models used to quantify risk. For the procyclicality that is a negative side effect when using predictions to set required financial buffers, reference is made to chapter 6.5. For all three main types of quantifiable risk, the central question is how to assess the future risk of the bank, based on what we know of the current situation of the bank and based on past experience, to predict how much capital will likely be needed to provide a financial buffer for likely losses following from that future risk. The answer to this question is: by using a model and all data available, to make a reasonable estimate that will neither choke beneficial behaviour by banks for the economy nor stimulate risk taking beyond what is proper. The models to calculate risk try to approach reality. A model gives a simplified

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representation of a current financial risk for the bank, by providing a calculation based on hypotheses/assumptions and past data that give an indication of risks that are not yet known but are likely to exist. Models of financial risk are ‘stochastic’ in nature, meaning that for key components such as interest rates, stock prices etcetera they use probabilities that are based both on predictable elements and on random elements. Nobody can predict what value to give to key components of the model at a future date, but stochastic reasoning allows a probability analysis to be made based on past experience and making a bet on likely deviations. The formula that have been developed to take into account all these opposite drivers and available input and available knowledge has subsequently been calibrated so that for a ‘normal’ bank, the credit risk capital requirement is substantially larger than the capital requirements for market risk and operational risk, as at the time of initial development credit risk was the main reason for bank bankruptcy. Both the banks own models (economic capital models) as well as the models contained in supervisory rules (standardised models or supervisory approved ‘internal’ models) have the advantage of allowing such a prediction based on available data. The predictions are also relevant input for the bank itself to know, as it can plan accordingly for strategic reasons and for fallback scenarios. The predictions based on supervisor-approved models are given muscle by hanging a capital requirement on them. The CRD-requirements put pressure on making that prediction as good and conservative as possible84. An additional benefit of establishing supervisor-sponsored models is that they make a wide range of banks more comparable. The quantitative requirements give the banks and supervisors something concrete and relatively objective to base their work on, in addition to setting financial buffer minimum requirements to limit risk. Modelled capital requirements provide some objectivity into the singularly subjective guessing game of when a bank is safe (enough) to be allowed to operate and provide core services in modern society. Disadvantages of Models However, the advantage of getting an moderately objectified calculated risk assessment based on probabilities also is the main disadvantage of using such models. Models try to predict future risks, but sometimes – like any soothsayer – are blatantly wrong. This can be caused by many things, including: – the lack of a fully developed and trustworthy model; – models being developed or implemented in a manner that aims to minimise capital requirements;

84 Without leading to economically undesirable side-effects of cutting down too much on lending and investments, nor on the profits needed to allow banks to operate as part of the private sector. See chapter 4.2, 4.3 and 23.

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– a lack of enough data on the past, or the use of faulty or inconsistent data; – assumptions underpinning the model being ignored, wrong or inconsistently applied; – inaccurate assumptions by unsophisticated users of the information that modelled risks also cover unusual events and crisis; – new or amended products or markets development, that are not reflected in past data or past assumptions that underpin the model; – rare events (tail-events) occurring sooner rather than later within the statistical likelihoods, or ignored as they are not captured by the model; – with a predictive value only over the short time horizons and confidence levels set, and based on the assumption that markets remain operating as in the past; – if everyone uses the same model, everyone will react in the same manner in boom times and in crisis times, exacerbating the cycle (see chapter 6.5); – the model being too complex or compounding errors in data or assumptions; and – with as the icing on the cake the fact that the results are often misunderstood by managers, investors and supervisors that are not themselves modelling-experts, and focused on to the detriment of other relevant factors85. These risks were and are well understood by the BCBS, and were e.g. pointed out in defence of maintaining a slightly higher multiplication factor in the market risk internal model calculation against criticism in 1996. A harsher requirement does not appear to have been politically acceptable at the time in light of the lack of unanimity on more conservatism e.g. in the capital definition86. The expansion to credit risk and operational risk of the more complex internal models in the context of the Basel II amendment of the capital accord was criticised along similar lines87, encountering an equal lack of alternatives (or consensus on such alternatives). The ‘rare events’ assumption – as well as the results being misunderstood – proved to be the downfall of the Basel I and II capital accord models. The models used had set their confidence levels at an apparently wrong level, driven by a range of other public policy goals88. These included a desire of regulators that banking systems should remain competitive, and for banks to continue lending in general, or to address hiccups in growth. The concept of fat tails (predictions of loss distribution in models have fat tails, indicating that catastrophic losses may occur in unlikely – but not negligible – events) was well known. 85 See e.g. H. Mueller & J. Siberón, ‘Economic Capital in the Limelight’, Journal of Financial Regulation and Compliance, Vol. 12, No. 4, 2004, page 357. 86 BCBS, Overview of the Amendment to the Capital Accord to Incorporate Market Risks, January 1996, §9 on the model, and §2 on tier 3 capital national discretions. Its reserves are also highlighted in BCBS Consultative Document, Fundamental Review of the Trading Book, May 2012, annex 1. 87 See e.g. J. Daníelsson, and others, An Academic Response to Basel II, LSE Special Paper 130, May 2001. 88 See chapter 4.3.

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However, a political/technical analysis was made – under pressure from both lobbying banks, politicians and academics – to keep it at an ‘acceptable’ level for economic growth and profits89. If the outcome of a model is subsequently used not as an indicator/warning, but as an insurmountable truth, the bank and its internal and external supervisors may be totally on the wrong foot. They will have failed to provide for a more uncertain future than predicted. A key understanding of models includes accepting the inherent fact that models do not actually predict real events, especially not in times of crisis. They have much the same predictive value for real subsequent events as personalized horoscopes or medical predictions based on family history: they have a guaranteed validity unless they turn out to be invalid. This comes on top of the added complexity that the reliance on models in banking supervision brings. The standard model contained in the Basel accord and the CRD is already complex in the interaction between its components. The size of these standard requirements is nothing compared to the number of rules and interlinking requirements surrounding the conditions under which the banks can use their own models to calculate credit risk, several components thereof, market risk and operational risk. Such rules are contained in the annexes to the CRD, plus in additional work done by CEBS-EBA. For bankers and supervisors that are not on an individual basis quantitative modelling experts it is next to impossible to understand both the models and the commercial and supervisory use made of them. Metrics are increasingly trusted, but only the happy few really understand their working, the assumptions they are based on, and their limitations. For others, including most bankers, almost all politicians and most supervisors, the models provide a black box at which they can point and avoid discussion90. It has the benefit that it also provides clear indicators on what to do, and a veneer of objectivity. In the array of formulae and model descriptions, the less happy majority has to take the outcomes at face value. If the models fail spectacularly in the face of idiosyncratic events or when they are applied to issues for which there is no reliable input91, the trust in the models implode. The 2007-2013 subprime crisis has resulted in criticism of the modelling approach, as the models did not result in adequate buffers against the type of downturn experienced. The risk appetite reflected in the models was, however, never to provide safety in such a crisis.

89 E.g. J.L. Simpson & J. Evans, ‘Benchmarking and Crosschecking International Banking Economic and Regulatory Capital’, Journal of Financial Regulation and Compliance, Vol. 13, No. 1, 2005, page 65-79. 90 The model approval process is hampered by the fact that model builders at the banks will likely be better resourced and paid than the specialists hired on the public purse by banking supervisory authorities. J. Daníelsson, and others, An Academic Response To Basel II, LSE Special Paper 130, May 2001, page 15. 91 L. Matz, ‘Market Turmoil: Are Our Models Letting Us Down?’, Bank Accounting & Finance, October/November 2008, page 41-43.

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EU Banking Supervision The models used predict the likely loss in normal times, within a short time period92. This is, however, only the take-off point or likely minimum if extreme events occur, such as the freezing of interbank markets and several other events in the 2007-2013 subprime crisis or the unloading of risky assets in that crisis and in the 1998 Russia crisis93. The resulting lack of trust is a shame, as models can be useful, but only if their results and especially their limitations are presented in ‘plain English’ for the users, including executive and non-executive board members, most bank-employees, counterparties, and importantly to supervisors and legislators94. The new regulatory models for credit risk and operational risk had not yet been fully introduced in the banks at the time the crisis hit. Overreliance on modelled risks left no real feeling that that outcome was not reality but only a potential average, with huge swings to either side (tail end risk) and an underestimation of the potential for such swings95. The negative feedback on models is both deserved and undeserved. Undeserved because the models never pretended to be more than they were, a tool approximating reality, based on assumptions and taking into account the more likely future events within a one year timeline and assuming more or less normal times96. Deserved because this was not the way they were perceived, used and prescribed by the banks, regulators and markets. These did not take into account the fact that the median outcome is not necessarily the actual outcome plus or minus a percentage, but really only a prophesy which only becomes truth if it actually does, based on assumptions of normal markets. Tail-end events, events with a low probability percentage due to the unlikely occurrence of the causes for such an event, do actually occur (as shown in the run-up to the 2007-2013 subprime crisis). Models also do not take into account the feedback of their use into the market (if banks act on their models, their trading will influence market prices), and the fact that the collective use of similar models may stimulate identical behaviour in the markets (i.e. procyclicality; see chapter 6.5)97. In addition, the approval of the models by supervisors gave an impression of the models and the underlying assumptions and valuations are correct, which – in light 92 U. Nielsen, ‘Measuring and Regulating Extreme Risks’, Journal of Financial Regulation and Compliance, Vol. 17, No. 2, 2009, page 156-171. 93 J. Daníelsson, ‘The Emperor Has No Clothes: Limits to Risk Modelling’, Journal of Banking & Finance, Vol. 26, 2002, page 1273-1296. 94 H. Thomas & Z. Wang, ‘Interpreting the Internal Ratings-Based Capital Requirements in Basel II’, Journal of Banking Regulation, Vol. 6, No.3, 2005, page 274-289. 95 U. Nielsen, ‘Measuring and Regulating Extreme Risks’, Journal of Financial Regulation and Compliance, Vol. 17, No. 2, 2009, page 156-171. 96 H. Thomas & Z. Wang, ‘Interpreting the Internal Ratings-Based Capital Requirements in Basel II’, Journal of Banking Regulation, Vol. 6, No.3, 2005, page 274-289. 97 J. Daníelsson, ‘The Emperor Has No Clothes: Limits to Risk Modelling’, Journal of Banking & Finance, Vol. 26, 2002, page 1273-1296.

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of the relatively low number of hours and the limited expertise on such issues available at supervisors can in no way guarantee that banks are not able to ‘game’ or slant their models/valuations/assumptions in a too optimistic manner. The models used are still in their infancy and range from rather trustworthy to rather bad. This applies both to the models the banks use to calculate the ‘economic capital’ they want to have to on their own accord be able to do business, as well as for ‘regulatory capital’ calculation as prescribed as standardised or internal models under the Basel capital accord and the CRD. Of the more flexible internal models; the credit risk and market risk models are relatively(!) best developed, as data is available and models have been tested in practice in stressed circumstances in the most recent crisis. The experience that can be used for backtesting against predictions helps improve the models even though it does not make them more dependable in an actual crisis; see e.g. chapter 8). The models for operational risk are least advanced, due to the short period in which they have been developed from scratch98, their application of rare occurrences to specific firms and due to a lack of data99. Other subsets of risks may have been ‘calibrated’ to such an extent that they capture only a fragment of the actual risk, though when this is noticed subsequently in a live event, this will feed back into the design or calibration of the model (e.g. the market risk of securities in the banking book up to the 2007-2013 subprime crisis, see chapter 9). The more trustworthy internal models and the standardised model are nonetheless (over)used in the regulatory context. The underlying thinking appears to be that this assessment is better than other available criteria for safety, and that the models will be upgraded in a ‘learning by doing’ process. In the context of the review of the trading book (presented as ‘fundamental), the BCBS has consulted on replacing value at risk models with an expected shortfall model. This does not exist yet, but the underlying assumptions are being developed. It should better reflect tail events and increase risk sensitivity, though due to the lack of experience with such models, it is unclear that they will actually do so100.

98 See e.g. the discussion in F. Flores, E., Bónson- Pont & T. Escobar-Rodríguez, ‘Operational Risk Information System: A Challenge For the Banking Sector’, Journal of Financial Regulation and Compliance, Vol. 14, No. 4, 2006, p 383-401. 99 J. Daníelsson, and others, An Academic Response To Basel II, LSE Special Paper 130, May 2001; S. Manning & A. Gurney, ‘Operational Risk Within an Insurance Market’, Journal of Financial Regulation and Compliance, Vol. 13, No. 4, 2005, p 293-300. P. Jorion, Value at Risk, 2007, 3rd ed, New York, chapter 19. Jorion notes that research (stimulated by Basel), has shown that annual loss for a typical US bank is 0.06% even in good times. For banks with large numbers of assets, this adds up to substantial impact on the profit and loss account. 100 BCBS Consultative Document, Fundamental Review of the Trading Book, May 2012.

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Risks The CRD provides a general definition of risk. A dictionary definition could be the potential of loss or injury. Specific to quantitative risk requirements, risk could be defined as the chance, based on past data and experience in good years and bad years, that in a portfolio of assets of a similar nature, a certain amount of these assets will not retain their value in the near future. That chance can be given a percentage value either by allocating it on the basis of so-called ‘common sense’ (i.e. guesswork based on insufficient evidence but bolstered by a gut feeling and experience) or on the basis of a model based both on hard data and assumptions about what might happen. This chance may not materialise every year, as there are more good or neutral years than truly bad years. But combining this chance with the value of the assets in that category, gives an inkling of the value that is at risk should a bad scenario unfold in the upcoming period. The risk appetite of the bank, the supervisors and of politicians subsequently determines what level of financial buffers should be available to cover against that chance materialising for these assets within a defined time period (see chapter 6.2). In theory, it is thus possible to quantify risks, if you are willing to limit it to (preferably well-founded) calculation of probabilities combined with the sources of hard data available. But risk can come from many sources. There is not sufficient information available on all these sources (in the form of theory or data) to arrive at a consensus view on what such quantification should look like for each risk category. Also, if a bank has only one type of assets or is very small, making a loss in that narrow range risks wiping out the bank, while in a diversified or large bank it might have been taken in stride101. Calculating the risk, and the above-mentioned risk appetite, thus has to take into account the diversification of the assets in the bank, and the chances of losses occurring in all areas at once (correlation). Some risks can be avoided by instituting absolute barriers (limits or prohibitions) on certain activities, others cannot be avoided as they are inherent to the business of banks, and have to be managed. Part of this management is the establishment of qualitative requirements on systems and controls, part of it is the quantification of the risk if possible, to ensure awareness and (for quantitative supervision) the availability of sufficient financial buffers to be able to bear the risk102.

101 See the discussion on diversification benefits in chapter 6.2. 102 C.A.E. Goodhart, ‘Financial Regulation, Credit Risk and Financial Stability’, National Institute Economic Review, No. 192, April 2005, page 118-127, while critical of Basel II notes improved consciousness of risk assessment and risk management as a success of its introduction.

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Risks That Can Be Modelled The CRD mentions a wide range of risks. For many of these the CRD introduces only qualitative requirements. These include e.g. funding risk, strategic risk and reputational risk. For those types of risk the CRD indicates that the bank should e.g. have systems and controls (internal processes) in place that ensure that the bank takes them continuously into account, with a backup via pillar 2; see chapter 13 and 14. For some specific risk categories, the CRD in addition provides for quantitative supervision. For these, either industry practices to model the risk to which the bank was subject and statistical models existed, or supervisors found those specific risks important enough to develop or stimulate the development of such models from scratch. The models provide an outcome, which is set by supervisors/regulators at the level that apparently fits the risk appetite of legislators. This is a negotiated risk appetite based upon advice by bankers and supervisors in the context of the BCBS and EU negotiations. The risk appetite is reflected in the minimum solvency ratio set out in chapter 6.2. The CRD solvency ratio denominator refers to the four main risk types that are be subject to quantitative risk models/formulas. For issues such as liquidity risk, which could be modelled to some extent, the current CRD contains none, but the CRD IV directive and CRR contains some basic steps in that direction. The lack of previous urgency on developing a common quantitative liquidity regime is partly due to different perspectives on the risk that a bank would not of itself ensure that it has sufficient liquid assets to meet its short term obligations, but partly because it is heavily linked to local monetary and economic policy. Pending implementation of Basel III of quantitative binding rules – at the moment still lacking the level 2 rules for the short term requirement and only containing the bare beginning of a one year horizon requirement – there is no EU wide quantitative requirement to have a minimum amount of cash and cash equivalents available to cover cash withdrawals by depositors or by those who have yet undrawn loan facilities (see chapter 2 and 12). The four main risk types for which models exist are: – credit risk, with separate models for subsets of assets; – operational risk; – large exposures (largely limited by ’hard’ maxima for lending to a counterparty; but for the surplus an additional capital requirement was set in the EU); – market risk, subdivided into: (i) position risk (ii) counterparty and settlement risk (iii) commodities risk, and (iv) foreign exchange risk. For the least important of these, the ‘large exposures’ add-on, only one ‘standard’ model is available; hardwired in the CRD as a standardised approach; see chapter 11. For market risk there is a standard model and the possibility of an ‘internal’ model; see chapter 9. An internal model is a bank specific model designed by the bank to fit its particular business,

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subject to minimum conditions set in the CRD. For operational risk and credit risk, in the context of Basel II three versions of models were calibrated. For credit risk a standard model fully hardwired in the CRD, an internal model with few specificities and an internal model with more freedom for the bank are allowed; see chapter 8. For operational risk a simplistic basic indicator approach was introduced for the smallest of banks, alongside a standard model and an advanced model; see chapter 10. For some subsets of these risks separate models are set, where the bank separately can opt for a standard or ‘own’ model, such as for the treatment of derivatives within credit risk or market risk (the so-called ‘counterparty credit risk’ calculation for derivatives and similar instruments; see chapter 8.4).

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Figure 6.1 Quantitative risk – a simplified overview of model-based calculations Calculation via models Operational risk

Credit risk

Basic indicator approach Standardised approach Advanced measurement approach partly based on self developed models

Standardised approach Based on standard model laid down in supervisory requirements IRB approach

Market risk

Foundation IRB partly based on models and/or methods Advanced IRB To larger extent based on self developed models

Standard methods Internal model (linked to counterparty credit risk modelling) partly based on self developed model

Counterparty credit risk data for SA and IRB based on standard or self developed models - mark to market method - original exposure method - standardised method - internal model method Credit risk mitigation data for SA and IRB based on models - volatility adjusment approach (supervisory and own estimates) - internal model for netting Securitisation additional requirements for banks on either SA or IRB

The more developed quantitative approach to risks – via models similar to the models the banks use themselves for economic capital – has been a huge step forward. It is an important cornerstone to be able to both get a grip on the real risks to be guarded against, and to bring to the surface the potential downside for the expected benefits of activities. However,

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this works only if the modelled quantitative approach is well balanced, and the risk appetite reflected in it is actually set correctly (and well understood) by rule makers. For several other risk categories or aspects of the four main risk types, no theory for quantification was yet available and/or no consensus could be reached. Some of these were allocated to the treatment of the so-called pillar 2. Though in principle pillar 2 is not part of quantitative supervision – as it is a judgement call of first the bank and then the supervisor – in practice some of the guidance on it includes semi-quantitative calculations on subjects issues which could not (yet) be agreed upon or worked upon in time for the negotiations for Basel II and the CRD103. Risks, Calculations and Models If models or calculations are used to quantify risks, it reduces the impact of subjective risk perceptions. If the model or calculation is accurate and the calculated risk is closely related to actual subsequent losses, the treatment of risk can be based (at least also) on objective instead of only on subjective criteria. Both the board of a bank and its supervisor’s benefit if they can act on the basis of a good understanding of the risks the bank is subject to. It allows them to take control of the situation at a moment when the losses might still be prevented, or when other measures can be taken to compensate for such losses (e.g. increase profits or attract funds). Establishing this objective good understanding, preferably shared by supervisor, bank and investor, is difficult. There is no calculation available that uncontroversially provides such an understanding. In the present state of art of accountancy and economics, subjective and objective are extremes in a wide range of grey tones ranging from very subjective to moderately objective. The judgements of experts, executives and supervisors play a role both in the design of the model or calculation, and in the application thereof, including the way the raw data are screened. If only data from unusually good times are used, this impacts on the usefulness of the outcome104. Even in the best model or calculation available – if anyone could agree which model that is – the link between predicted risk and actual subsequent loss is shaky105, and unusual events can throw the end-result out of the window. So why should banks bother to make the tremendous effort of collecting data and putting the data into standard or ever more complex calculations/estimations? Especially if

103 See chapter 14. 104 A.G. Haldane, (Bank of England), Why Banks Failed the Stress Test, 13 February 2009. 105 See e.g. R.S. Clarkson, ‘Actuarial Insights Into the Global Banking Catastrophe’, Journal of Financial Regulation and Compliance, Vol. 17, No. 4, 2009, p 381-397, on the lack of reliable estimates of probabilities and flaws on extrapolation to the future of the recent past, and it’s procyclical effects.

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accounting standards already provide ex post information, which also are based on subjective and objective criteria. There are several good reasons: – Any information is better than no information (advantage in measurement); – Having to calculate risk means that a bank is forced to scrutinise and manage its business more in depth and in a more continuous manner than it otherwise would have done (advantage in management); – Banks have been growing more complex and bigger, and its management and its supervisors needs a tool to understand the developments before they materialise, so they can manage the business and its funding needs (advantage in measurement and management); – Supervisors need objectified information and/or a clear criterion to be able to justify using their more far reaching instruments if the bank is running into problems (advantage in democratic/administrative controls against arbitrary behaviour of public authorities). For an understanding of past risk, public accounts have proven to be useful. To obtain a forward-looking understanding of future risk, prior to the Basel accord no such instrument was available. Bankers, supervisors and investors were dependent on intuition and past performance. The benefit of Basel I was in part that it encompassed in its calculation a rough approximation of the likely future risk of the current assets of a bank. Improving on the understanding of future risks is the underlying objective of both risk management and quantitative capital requirements. By understanding future risks those risks can be reduced. Models are a way to improve such understanding of future risks, which development was embraced by supervisors. Standard Model Versus Internal Models The standard models set out in the Basel capital accord and copied into the CRD spell out exactly how a bank should calculate the risk they are exposed to. The first time the BCBS and the EU started to rely on internal models in a main risk area as an alternative way to calculate capital requirements was in the area of market risk. This initial try-out of internal models was based on the value at risk (‘VAR’) calculations that had been developed to help executives of banks grasp how much they could lose. It was based on an investment measure that was rough and ready but had proved to provide useful insight into the financial risks an investment bank was undertaking. The value at risk type of model was developed by banks to allow its board to grasp in a single number the amount it is likely to lose on a certain portfolio of assets if a negative event occurs. In its initial form, value at risk mod-

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elling provided insight into the worst possible loss over a specific time horizon, as a given probability106 in non-crisis times. The supervisory approved internal model approach to market risk capital requirements calculations was introduced in 1998 in the EU, shortly after the introduction of the standardised calculation of market risk (in 1993 in the EU and in 1996 in Basel). The internal model approach to market risk was made available for the calculation of supervisory capital requirements for two reasons107: – At the price of lower capital requirements it would encourage banks to invest in more sophisticated risk-management methods based on the internal model; – EU banks (and investment firms) compete with third country banks and investment firms operating under those models with higher risk-management requirements and lower capital requirements. Enhanced risk management and risk awareness trumps capital any day of the week (though required capital is the most forceful instrument regulators have to hammer home the message that risk is costly). Subsequent to the introduction of the use of own models by the bank for market risk, this approach was introduced also for other main risk areas. The bulk of the amendments to the original Accord which entered into force in the EU in 2007/2008 under the name Basel II focused on the use of internal models to calculate the risk exposure for credit risk and operational risk. This in spite of severe criticisms of the usefulness of the models used for market risk, and questions about who exactly understands such models and whether such bankers’ models would be equally suitable for credit risk and operational risk108. For market risk calculations, an expected shortfall based model is now contemplated as the basis for both standardised and internal models. Both should also be calibrated to similar levels of safety both in good and stressed periods.109 Conditions for Using More Advanced Internal Models The Basel capital accord after Basel II contains minimum conditions for the more advanced internal models as well as a process under which supervisors should pre-approve such 106 For this definition see S.G. Cecchetti, Money, Banking and Financial Markets, 2nd ed, New York, 2008, chapter 5. 107 Recital 5 of 1998/31/EC, amending the original CAD and introducing both commodities risk treatment and the internal model approach in market risk. See chapter 9. 108 J. Daníelsson, ‘The Emperor Has No Clothes: Limits to Risk Modelling’, Journal of Banking & Finance, Vol. 26, 2002, page 1273-1296. C. Goodhart, The Basel Committee on Banking Supervision, a History of the Early Years 1974-1997, Cambridge, 2011, chapter 15 and 16A. 109 BCBS Consultative Document, Fundamental Review of the Trading Book, May 2012, page 20.

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models. Sometimes these are very detailed (e.g. the minimum-assumptions on the likely risk in certain exposures), but in other areas the requirements are flexible. A basic area of flexibility is the actual type of model within the broader range of models that can be used. ‘Value at risk’ as used for credit risk calculation can describe a range of models, ranging from very conservative to aggressive. Such models are continuously being tinkered with and new models are invented. This is due to a (still) limited understanding of the models available by the banks and their supervisory authorities (apart from a small core of modelling experts), how to take into account innovative products, the effect of models on the behaviour of banks and inherent limitations due to the stage of development and underlying assumptions on e.g. what constitutes conservatism, or which counterparties are low-risk or high-risk, and the bias of government-approved models to politically privileged clients. All these factors can make the estimation of risk too low (and thus also the required capital) reflecting a de facto high risk appetite. Examples include the treatment of securitisations and the adaptation of banks to this phenomenon prior to the 2007-2013 subprime crisis. Still current examples are the zero risk allocated to sovereign risk (though this will to some extent be ameliorated in the CRD IV project), the low risk weights for loans to small- and medium sized enterprises (which too low buffer requirement will be further reduced in the CRD IV project), green energy, etcetera. Also see chapter 8.1. These are all examples of tinkering that were built into the government approved models to reflect other public policy goals than financial stability or depositor protection; see chapter 4.3. For internal models, it can be expected that banks would equally succumb to hobbies and pressures, and add their own layer of tinkering that might play havoc with the goal of safety. The banks were intensively involved in the consultation on Basel II, as well as on the CRD and the accompanying CEBS-EBA model validation guidelines (which focused on the ‘new’ models for the IRB and AMA, not on the existing internal models)110. They lobbied in favour of being allowed to use their own internal models without conditions and minimum-levels attached. This would save costs and the model was supposed to be fit for purpose for the capital calculation of each bank. Banking supervisors reacted negatively to this most extreme version, though they liked the modelling approach. This has resulted in what some might call a mongrel approach, others a step in the right direction. The Basel accord after the Basel II amendment ‘stops short of allowing the results of such credit risk models to be used for regulatory capital purposes’111. Nonetheless the BCBS and the EU allowed it to the extent that banks investing in such models would benefit from substantially reduced capital requirements; perhaps to an extent that reflects capture by the lobbying

110 CEBS-EBA, Model Validation Guidelines (CP03), April 2006. 111 §18 BCBS, International Convergence of Capital Measurement and Capital Standards: A Revised Framework, June 2006.

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EU Banking Supervision industry112. The development of improvements of the models and allowing different models to be tested so that the best models would survive necessitated a broad embrace of possible types of models. As a safeguard to arbitrariness or excessive gaming, the choice of model was not given to either the bank or its supervisor, but to both in a balanced process. For supervisors, it is important to obtain comparable results from the banks, as well as to demand inclusion of all aspects they deem appropriate into the models (ranging from asset types to the minimum level of risk accompanying such assets). Banks are allowed to opt to use a self-developed model if they do not want to apply the standardised model of the CRD. They can apply for approval for any model they choose to use in the context of credit risk, operational risk and of market risk. For credit risk and market risk, the main models are variants of the value at risk model113. The choice given to banks allows them, upon considerable investment in the development and maintenance of the model, to fit the capital requirements closer to the internal working of the institution. The supervisor checks whether the model complies with the quality standards set out in the CRD. These relate to e.g. stress testing, quality control procedures, internal processes and board involvement, as well as making sure the model captures all the risks within the category it deals with (e.g. credit risk), and whether the model chosen is up to date on the latest developments in the area of modelling future risks. Many of these conditions were only developed to a limited extent in the CRD, leaving room for potential divergence in the validation, and the level of requirements. CEBS developed guidelines – based amongst others on existing BCBS work – to foster a level playing field for the validation on the criteria to assess the models and the supporting internal governance structures, as well as on the cooperation between supervisors for the IRB and AMA models (which provide insights that may also be useful for instance for the market risk internal model)114. The guidelines were developed prior to experience being gathered, and were supplemented with ad hoc guidelines especially on operational risk models; see chapter 10. This work helped, but did not prevent differences in the capital requirements surfacing in recent research by the BCBS; see below. Only after approval, the modelled risk determines the regulatory capital requirements instead of the standard calculations115.

112 R. Lall, Why Basel II Failed and Why Any Basel III Is Doomed, University College Oxford, GEG Working Paper 2009/52, October 2009. 113 R. Sollis, ‘Value at Risk: a Critical Overview’, Journal of Financial Regulation and Compliance, Vol. 17, No. 4, 2009, page 398-414. U. Nielsen, ‘Measuring and Regulating Extreme Risks’, Journal of Financial Regulation and Compliance, Vol. 17, No. 2, 2009, page 156-171. 114 CEBS-EBA, Model Validation Guidelines (CP03), April 2006. 115 For mixed use of standard and own models see the segment on partial use in chapters 8, 9 and 10. Basel II assumes that the movement to ever more advanced approaches is a gradual process. Data need to be gathered and made accessible for each portfolio of assets.

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A downside to the embrace by supervisors of the value at risk models is the incentive this gives to banks to game the model, or at least not to develop it into a more risk sensitive and ‘true’ reflection of the risk run by the bank. Instead of using it for their commercial purposes to manage their own risks (which only the more risk conscious banks did), suddenly having a model becomes useful to mitigate capital requirements both for risk conscious banks and for less risk conscious banks. Reducing obligatory capital is useful, even when there is – as usual under the previous capital accords – a surplus of capital (see chapter 6.2). The additional buffer looks good to investors/depositors and gives leeway for new business opportunities. It is even more useful if a bank wants to overleverage its use of capital and sail close to the wind. Instead of providing managers with a true picture of risk, the use for supervisory purposes has provided an incentive to reduce the probabilities of risk materialising and tamper with the calculation and input to produce a reduced capital requirement, building on assumptions and inefficiencies in markets. Even in the best of circumstances a model is only as good as its assumptions, data and good intentions. If there is an actual incentive to reduce its effectiveness for the people drafting or paying for it, it is more likely to become a desert mirage; a reflection of the blue sky on hot sand instead of the water that is needed. Backtesting is required to eliminate wilful and accidental underestimation, but the lack of data is a problem to achieve the degree of certainty desired116. Stress testing the results is required to avoid overreliance on limited data, or on experience gained (only) in good economic times117. It should be noted, however, that the standards for stress testing were abysmally low prior to the 2007-2013 subprime crisis; see chapter 13.6. These processes also help to further develop the models themselves. Both standard and internal models will continue to be used after the experience gained in the crisis, hopefully with a more realistic view of their value, but meanwhile retaining an appreciation for their benefits in determining pricing and risk appetite. A key condition for using the internal models to determine regulatory requirements, is that the model is actually also used for internal purposes. The internal model is accepted for supervisory purposes if it is actually a key input used by the bank for its own decision making purposes in the so-called use-test. A model specifically built for regulators would be assumed to hold unrealistic assumptions and be geared towards more positive data, leading to a too low capital requirement. Regulators thus require the bank to prove that the model is also used in its internal decision making on risk appetite, price, strategy, and so on. Though a model built around minimum specifications set by lawmakers is not a commercial model and may not be directly applicable to each segment of decision-making,

116 J. Daníelsson, Blame the Models, June 2008, www.riskresearch.org. 117 See chapter 13.6 and 14. Also see L. Matz, ‘Market Turmoil: Are Our Models Letting Us Down?’, Bank Accounting & Finance, October/November 2008, page 41-43.

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it still has several positive side effects. The calculation of risk is more likely to be noted when making a decision, and it will reinforce the internal standing of risk assessors (risk control functions) if their input is needed in order to make a decision. A negative side effect has, however, been that the outcome of the model has somehow gained an unlikely halo in the form of a conscious or unconscious reasoning along the lines of: ‘supervisors/lawmakers have said that the bank should calculate the risk in this form, and thus the risk is the number shown at the end, and there is no risk but the calculated risk’. This applies also to the standard model, but is reinforced in the internal models that get a specific seal of approval by supervisors after a (hopefully thorough and knowledgeable) assessment. Switching off independent thinking and own risk assessment – and ignoring (fat) tail risk events and assumptions in the poorly understood models – may have led to the under-pricing of risk in e.g. subprime mortgages and the securitisation bonds based on them118. A separate negative side effect has been the fact that – if a model turns out to be wrong – it is difficult to withdraw approval of the model if the standardised calculation would impose much higher requirements (causing the bank to go bankrupt, or shocks and mistrust in the financial markets), or too low requirements (causing the bank to benefit from its own bad model, and competitor banks to suffer unfair competition)119. Reference is made to chapter 17.2 and 21.7 for the situation that the application for approval of a model is made for the whole group120. Basel I Floor – Additional Solvency Ratio For Internal Model Banks The potential for models to be set up in a manner that gradually eviscerates regulatory financial buffers was predicted. As there was no experience with the credit risk and operational risk models (and only limited experience with market risk models), the Basel II accord contained a ‘floor’ of capital requirements set on the basis of a crude calculation referencing the Basel I calculation for credit risk and operational risk. The CRD copied this transitional measure121, which initially expired at the end of 2009. It determined that internal based approach and advanced measurement approach-banks should also continue to calculate the required capital under the consolidated banking directive (the predecessor of the RBD) and the CAD (the predecessor of RCAD). The floor was gradually reduced

118 R.S. Clarkson, ‘Actuarial Insights Into the Global Banking Catastrophe’, Journal of Financial Regulation and Compliance, Vol. 17, No. 4, 2009, p 381-397. A. Ashcraft, P. Goldsmith-Pinkham, J. Vickery, MBS Ratings and the Mortgage Credit Boom, FEDNY Staff Report 449, New York, 2010. 119 BCBS Consultative Document, Fundamental Review of the Trading Book, May 2012, annex 1. 120 Art. 129 RBD and 37.2 RCAD. 121 Art. 152 RBD.

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to 80% of the Basel I calculation over the three years until end 2009. During the 2007-2013 subprime crisis this – again temporarily – measure was re-introduced to apply until the end of 2011122. For banks that only transferred to an internal model calculation on or after 1 January 2010, the floor was not set at Basel I levels, but instead tied to the Basel II standardised approach as copied into the first versions of the CRD, as such banks no longer had the Basel I calculation and assessment-tools in place. Though the CRD did not extend the application beyond 2011, it is likely that the floor still applies in most member states, as the CRD IV project – as per 1 January 2014 – extends the floor again, now set at 6.4% as a temporary capital ratio under a calculation derived from Basel I. The Commission proposed it to last until end 2015, but the final version extends it until end 2017123. The floor calculation can be waived by the supervisor if IRB and AMA conditions are fully met, after consulting EBA. There is no clarity on whether the Basel I floor will ever truly expire, leading in effect to an additional ratio calculation124. The floors have been introduced in a disparate manner in the member states, but EBA made an effort to harmonise the calculation of the floor in its recommendation on temporary capital buffers of December 2011125. The recommendation sketches the two main calculation methods of the floor, and asks the national supervisors of the major banks to which the recommendation pertains to apply one of the two, regardless of other local dispensations that are normally applied. Future Developments The reliance on especially internal models is scrutinised by the BCBS and in the EU126. The disparity in the treatment of similar risks by different bank-developed internal models is noted, as well as the possibly too low estimates of required financial buffers that result from them127. Increasing and harmonising the requirements on internal models does, however, potentially increase the identical behaviour of banks beyond country-borders to possibly the entire Eurozone (under the proposed single supervisory mechanism) and the entire EU or worldwide (under e.g. the new trading book regime under discussion). 122 Art. 152.5a-152.5e RBD, as introduced by CRD III Directive 2010/76/EU. 123 Recital 79 and art. 500 CRR, and page 14 and proposed art. 476 and Annex IV of Commission, Proposal for a regulation as part of CRD IV, COM(2011) 452 final. On ratios see chapter 6.2. 124 Recital 42 and art. 500 CRR ask for a review and possible legislative proposals on the Basel I floor (or a similar backstop). 125 EBA, Recommendation on the creation and supervisory oversight of temporary capital buffers to restore market confidence, EBA/REC/2011/1, 8 December 2011 (with accompanying ‘questions & answers’). 126 High-level Expert Group on Reforming the Structure of the EU Banking Sector, Final Report, 2 October 2012 (Liikanen Report). BCBS Consultative Document, Fundamental Review of the Trading Book, May 2012, see e.g. the level of complexity sketched for both internal and standardised models based on the new expected shortfall in stressed circumstances calculations. 127 BCBS, Regulatory Consistency Assessment Programme (RCAP) Analysis of Risk-Weighted Assets for Market Risk, January 2013 (rev February 2013); BCBS, Regulatory Consistency Assessment Programme (RCAP) Analysis of Risk-Weighted Assets for Credit Risk in the Banking Book, July 2013. UK FSA, A Regulatory Response to the Global Banking Crisis; Discussion Paper 09/2, March 2009, page 71-73.

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Pending the various reviews, the treatment in the CRD IV project on models overall does not change, though there are improvements on benchmarking128. Several improvements are made in specific areas, discussed in chapters 8-10, 13.5 and 13.6. EBA is allowed, but not obliged to draft regulatory standards to specify assessment methodologies for the IRB, AMA and market risk internal models, with the potential to upgrade and further harmonise the model validation guidelines129. The supervisors and EBA will benchmark the models developed by banks to improve their quality, facilitated by regulatory and implementing standards of EBA, to be sent to the Commission before 2014. In a difficult straddle, such benchmarking should not lead to preferred or standard methods nor to herd behaviour130. EBA will become obliged (but without a set deadline) to issue guidelines on benchmarks on issues such as the definition of default and how to ensure consistent treatment of risks by different banks, on the basis of ongoing analysis of the approaches to such issues at different bank using the internal approaches. The same article also introduces an obligation for supervisors to continuously review – or every three years re-assess – the internal models that banks use, regardless of whether they have approved them for capital calculations131. If they have approved them for capital calculations, additional obligations apply to check whether the bank uses the latest techniques and practices, and whether they are accurate (with a specific focus on market risk models that are inaccurate as shown by numerous overshootings). Literature – Cecchetti, Stephen G., Money, Banking and Financial Markets, 2nd ed., McGraw-Hill, New York, 2008, chapter 5 and 12 – UK Financial Services Authority, The Turner Review, March 2009 – Crouhy, Michel; Galai, Dan; Mark, Robert, The Use of Internal Models: Comparison of the New Basel Credit Proposals with Available Internal Models for Credit Risk – Kuritzkes, Andrew P.; Scott, Hal S., Sizing Operational Risk and the Effect of Insurance: Implications for the Basel II Capital Accord – Capital Adequacy Beyond Basel: Banking, Securities and Insurance, New York, Scott, Hal (ed), 2005, chapter 6 and 7 – Lelyveld, Iman van (ed.), Economic capital modelling, London, 2006

128 See part three of the CRR, amongst others art. 143, 221, 225, 259, 283, 312, 363 CRR, and art. 3.53, 77 and 78 CRD IV Directive. 129 Art. 84.2, 105.2, 129.2 RBD, and art. 18.5 RCAD, as added by art. 9.23, 9.25, 9.32, and 10.1 Omnibus I Directive 2010/78/EU. See chapter 8.3, 9.4 and 10.4. 130 Art. 78 CRD IV Directive. 131 Art. 101 CRD IV Directive. Also see art. 110 and 178 CRR on default.

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– Haldane, Andrew G., (Bank of England), Why banks failed the stress test, February 2009 – Matthews, Kent; Thompson, John, The Economics of Banking, 2nd ed., Wiley, Chichester, England, 2008, chapter 13 – Sollis, Robert, Value at risk: a critical overview, Journal of Financial Regulation and Compliance, 2009, page 398-414 – Thomas, H.; Wang, Z., Interpreting the Internal Ratings-Based Capital Requirements in Basel II, Journal of Banking Regulation, vol. 6 no.3, 2005, page 274-289 – Daníelsson, Jón; Embrechts, Paul; Goodhart, Charles; Keating, Con; Muennich, Felix; Renault, Olivier; Shin, Hyun Song, An academic response to Basel II, LSE special paper series, SP 130, Financial Markets Group, London, May 2001 – Daníelsson, Jón, The emperor has no clothes: limits to risk modelling, Journal of banking and finance, 26, 2002, page 1273-1296 – Daníelsson, Jón, Blame the models, Journal of financial stability, June 2008, www.riskresearch.org – Daníelsson, Jón; Perraudin, William, examination of witnesses (questions 105-119) on banking supervision and regulation before the UK house of lords economic affairs committee, 27 January 2009 www.publications.parliament.uk – Basel Committee on Banking Supervision, Operational Risk – Supervisory Guidelines for the Advanced Measurement Approaches, June 2011 – Padoa-Schioppa, Tommaso, Regulating Finance: Balancing Freedom and Risk, Oxford University Press, Oxford, 2004, chapter 4 – Power, Michael, Organized Uncertainty: Designing a World of Risk Management, Oxford University Press, Oxford, 2008, chapter 3 and 7 – Ladipo, David; Nestor, Stilpon, Bank boards and the financial crisis, a corporate governance study of the 25 largest European banks, London, May 2009 – Basel Committee on Banking Supervision, consultative document, Fundamental review of the trading book, May 2012, annex 1 There are several more technical publications on modelling techniques, which I cannot assess as to their quality. For your information, I note: – Jorion, Philippe, Value at Risk: The New Benchmark for Managing Financial Risk, 2006, 3rd ed., McGraw-Hill, New York (especially chapter 3) – Bielecki, Tomasz R.; Rutkowski, Marek, Credit Risk: Modeling, Valuation and Hedging, 2004, 2nd ed., Springer, Berlin – Bluhm, Christian; Overbeck, Ludger; Wagner, Christoph, Introduction to Credit Risk Modeling, Chapman & Hall, 2010 – Joël Bessis, Risk Management in Banking, 2002, 2nd ed., Wiley, Chichester

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– Jobst, Andreas A., Operational Risk – The Sting is Still in the Tail But the Poison Depends on the Dose, IMF WP/07/239, Journal of Operational Risk, vol. 2, no. 2, November 2007 – Shevchenko, Pavel V., Modelling Operational Risk using Bayesian Inference, Springer, Berlin, 2011

6.4 Accounting Standards (Transparency, Consolidation, Valuation and Original Own Funds) Introduction Accounting standards are developed for the public accounts of companies, including banks. These provide the bank, its investors and the supervisor with useful (backward looking) information. The standards have also been used by regulators for other prudential supervision purposes, especially to ‘borrow’ its work as input into quantitative supervision on issues such as the valuation of assets and liabilities, and consolidation. Some concepts are borrowed largely unchanged (e.g. valuation); others are subjected to filters that change the accounting standards concepts in dramatic ways (e.g. own funds). The public accounts of banks are drawn up under one or the other of two parallel regimes: – the IFRS regulation and the IAS Commission regulation132 OR – the Accounts of banks directive (ABD). By reference – unless the ABD deviates from these – this includes (i) the (4th) company law directive on annual accounts (ii) the (7th) company law directive on consolidated accounts, and (iii) the (8th)company law directive on the statutory auditing133.

132 International Financial Reporting Standards Regulation (IFRS regulation) 1606/2002, and International Accounting Standards Commission Regulation (IAS Commission regulation) 1126/2008. According to art. 1 IFRS Regulation, the international accounting standards include the following work of the International Accounting Standards Board (IASB): rules adopted as international accounting standards, as international financial reporting standards, and related interpretations (the SIC-IFRIC interpretations). Also see art. 1 Commission Decision on the equivalence of certain national accounting standards and of IFRS, 2008/961/EC, according to which third country issuers that use IFRS are deemed to use equivalent accounting standards as in the EU (equivalent as in being the same). 133 The ABD, Directive 1986/635/EEC, sets out which provisions of Directive 1978/660/EEC on Annual Accounts and of Directive 1983/349/EEC on Consolidated Accounts apply to banks. It also provides specific provisions on those subjects where banks require more or different rules on their accounts. The legislative technique is different for the Annual Accounts Directive and for the Consolidated Accounts Directive. The latter is applicable to banks since the expiry of its transitional provision contained in art. 40, but art. 42 ABD indicates from which rules banks have to deviate, while the Annual Accounts Directive is explicitly not applicable to banks (see its art. 1.2), but the majority of its provisions are applicable to banks’ annual accounts through art. 1 ABD. The result is the same. The Statutory Auditing Directive 2006/42/EC states how auditors should verify the information provided; see below.

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In addition, there is a separate regime for bank branches. The annual accounting for bank branches directive is applicable to any branch of a bank from another member state, or from a third country. The ABD (and the branch-)regime is specific to the EU. The IFRS regime has been developed to become an international regime, in order to make the numbers of internationally operating companies more comparable, and implemented via the mentioned regulations in the EU. IFRS is applicable to all listed companies, and can be applied to others. All listed banks are thus subject to IFRS, but it may be that individual legal entities within listed banking groups report under the ABD. Most smaller banking groups will report under the ABD, unless the member state has made IFRS applicable to all banks134. Both regimes contain provisions on the annual accounts (on a solo basis per entity) respectively the consolidated accounts (on a group wide basis) of banks. These include rules on the set up of the balance sheet (assets and liabilities) and off-balance sheet reporting, the profit and loss account, valuation regimes, and further information to be disclosed to the public. The obligatory publication of the annual and the consolidated accounts with accompanying reports provide core transparency to investors and counterparties of every company, and especially of banking groups with large (variable) activities in financial markets. The core concept of capital/own funds as used in the prudential capital requirements has been derived from accounting standards. However, as explained in chapter 7.1 and 7.2, the additions and subtractions from the core concept that are made before arriving at the content of the prudential requirements concept are so large, that it is misleading to suggest that, apart from being distant relatives, the accounting concept of own funds/capital and the prudential concept of own funds/capital are similar in any way. Some of the terminology is the same, as adjusted through ‘prudential filters’, but deductions of insurance participations, of securitisation first loss positions, and additions of subordinated loans make the use of this common terminology confusing at best. The Two Accountancy Regimes The International Accounting Standards Board develops the IFRS standards135. The IASB is a worldwide organisation, aiming to harmonise accounting standards. As with the BCBS work, the standards they set are not automatically applicable in the EU or in any EU national jurisdiction. They have to be copied into EU legislation first, and member states

134 Art. 4 and 5 IFRS Regulation 1606/2002. 135 See chapter 3.3, and www.iasb.org.

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can only apply non-copied standards in as far as they fit within existing binding EU legislation (see chapter 3.5). ESMA has a strong role in this process in the context of its market supervision work. For prudential supervision purposes, the standards that are known as IAS 32 and IAS 39 are the most relevant. They deal respectively with the presentation and the valuation of financial instruments. The above-mentioned IAS Commission Regulation consolidates all International Financial Reporting Standards (IFRS) in force in the European Union (EU). The standards are almost always copied in full. Any deviation is heavily contested by internationally operating companies, including banks, and is often only temporary. Under the IFRS Regulation, the Commission can copy all standards it deems appropriate into its IAS Commission Regulation, after which they become binding upon EU companies (including banks) if they have securities admitted to trading on a so-called regulated market136. This already covers most of the medium sized and larger banks. Member states have the option to expand the coverage of the IFRS regulation to all their banks on a consolidated basis, and also to all of the banks they licensed on a solo basis. If they do not, all banks that do not have bonds, shares or other financial instruments admitted to trading at a regulated market in a member state, have to report instead under the rules of the ABD137. The ABD is a home-grown EU regime, that predates the development of IFRS as a worldwide standard. It is roughly based on the company law directives that harmonise accounting regimes for (unlisted) companies, with exceptions and add-ons to account for the financial nature of almost all assets and liabilities of a bank. The two regimes are deemed equivalent, but are based on different underlying assumptions and techniques. The IFRS regime has been adopted in order to permit full(er) comparability of public accounts across all jurisdictions where their use is permitted, which is the case in an increasingly large proportion of the world (the main exception being the USA). The focus is on the consolidated accounts of the listed company, not on the solo accounts of each legal entity within the group. As a national discretion it can also, however, be used for the solo-accounts of each entity, which is important e.g. when the various banking legal entities in a banking group have been licensed in different countries138.

136 Art. 4 IFRS Regulation 1606/2002 refers to the term securities as used in the Investment Services Directive 1993/22/EC. The reference has not been upgraded to the equivalent Mifid terminology when it replaced the ISD. Securities can be shares, bonds or derivatives issued by the bank. Regulated markets are a specific type of trading platform identified in Mifid (see chapter 16.4). Compare on the meaning of this concept Rasdaq market, Court of Justice 22 March 2012, Case C-248/11. Basically, it includes the old national stock exchanges, but not the trading platforms where lesser regulated issuers can be listed: the so-called multilateral trading facilities and systematic internalisers. 137 Art. 5 IFRS regulation 1606/2002. 138 Art. 5 IFRS Regulation 1606/2002.

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The way accounts drawn up under either the ABD or IFRS are audited is the subject of the statutory auditing directive. Under this directive, all banks are considered to be public interest entities to which the highest form of audit should apply, alongside e.g. listed companies139. It thus has a wider scope than the IFRS regulation. The directive requires auditors to be assessed as competent before being allowed to be involved in the auditing process, and requires them to be independent to the point where they should abstain or resign if that independence is threatened too far. The input and role of auditors on the accounts of banks – and their obligatory warnings if they notice dangers – are a key underpinning of banking supervision140. The directive also requires banks to have an audit committee, including at least one independent expert141 It is odd that unlisted banks (or banks listed on other trading platforms than a regulated market) are not automatically subject to IFRS. This creates an unlevel playing field among banks, as well as an arbitrage opportunity. As a result of (at least) the 2007-2013 subprime crisis it could have been considered that any bank can cause a ripple effect in the economy that can contribute to a crisis, and should thus be subject to (proportional but otherwise identical) requirements. The member states collectively have thus far not considered bringing all their banks under IFRS. Instead, changes to accounting rules that will apply from 2015 or 2016 will make banks into public interest entities too, subject to the relatively harsh regime for such entities under the annual and consolidated accounts directives in as far as made applicable via the ABD142. Preferably, the scope of the IFRS regulation should have been widened to all reporting on a consolidated and a solo basis, and the bank accounts directive deleted, similar to the approach taken to the statutory auditing directive. Smaller banks have opposed such a move, as IFRS is pigeonholed to be more drafted with big banks in mind. Other banks can profit from local ‘generally accepted accounting standards’ rules under the more generic bank accounts directive if their domestic legislator allows them, and would have to amend practices and capital treatment if they had to move from the ABD regime143. The upgrade to the ABD referenced directives – even though it does not make the regimes identical, at least gets rid of some of the national discretions.

139 Art. 2.13, 3-25, 39 and 42 Directive on Statutory Audits of Annual Accounts and Consolidated Accounts 2006/43/EC. Only banks without securities listed on a regulated market can be fully or partially exempted from some of the requirements. 140 See chapter 20.2, and e.g. art. 53 RBD. 141 Art. 41 Auditing Directive 2006/43/EC. This ratio of independent members is likely to be reinforced under new Commission proposals; see below. Also see chapter 13. 142 Art. 2.1 Annual and Consolidated Statements Directive 2013/34/EU, as published after the closing of this book; see below under future developments. 143 This hampers work on e.g. the definition of capital, as even crisis work by regulators still has to distinguish between both regimes, see e.g. CEBS-EBA Implementation Guidelines regarding instruments referred to in art. 57(a) of directive 2006/48/EC recast, 2010, www.c-ebs.org, §39.

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Impact Accounting Standards on Prudential Requirements The accounting rules – in addition to fulfilling the role they have for any company – also provide some of the most basic concepts used by banking supervisors and banking regulation. These concepts are at the core of quantitative prudential requirements: – transparency; – comparable financial information and structures to ascertain their validity; – valuation (including when to take losses and when to take profits); – solo and consolidated obligations; – fully paid up share capital and reserves. The overlap with and reliance on accounting information can be explained in part by the fact that prudential requirements were historically derived from the public accounts information. In many countries individual supervisors in the past – even more than today – were primarily drawn from the ranks of accountants. The information to be provided to supervisors (though more detailed for prudential supervision purposes) on good management and controls on the assets and liabilities and the viability of the bank in practice is quite similar to the information needed by the markets and investors to assess the solidity of the undertaking. Working on the basis of structures already in place for public accounting purposes has proven to be the most cost effective way to add quantitative prudential requirements to the legislation already applicable to banks. Especially for valuation purposes, it would be costly to require banks to value their assets differently for accounting and prudential purposes. As a result, the initial banking directives and the current CRD refer to accounting standards for this key component of the calculation of risk weighted assets, which in turn are a key component of the solvency ratio (see chapter 6.2). Some key deviations, e.g. on securitisations, are set out in the CRD and papers issued by supervisors. Prudential supervision builds on the common standards. Apart from using the same or similar concepts as the starting point for the regulation (see above), it also uses the annual and consolidated accounts as important input into its assessment of a bank and banking group itself, and its judgement on its health in comparison with similar banks and banking groups. Reducing the divergence in underlying standards has increased the peer review methodology not only in the numbers but also in the management processes and other structures that are set out in the accounts. Similarly, the information processing structures, including the organisation built up to safeguard its integrity and trustworthiness by internal auditing and controls and external auditors, has been extended and copied into organisational requirements for all areas of the banks business (see chapter 13.3).

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The references in the CRD for valuation or consolidation are specific, and sometimes deviate from the accountancy treatment, e.g. on the deduction of certain subsidiaries (see below and chapter 7.2). In addition to deviations contained in the CRD, both the BCBS and CEBS-EBA have issued guidelines on the application of IFRS to CRD financial buffers; the so-called prudential filters144. In the CRR the deviations from e.g. valuation have been more clearly brought together under such a heading (though other references and usages are spread over the CRR, see below)145. The guidelines supplement some of the rules set out in the CRD itself to amend the treatment of elements of the account directly in the calculation of the solvency ratio. These guidelines serve a dual purpose. They tried to defend the differences between company capital and the much wider core elements of the own funds/capital concept in the banking regulations, but also provide a useful help in interpreting IFRS terminology into the terminology used in the CRD. Fair value changes that result from changes in the own credit standing have been excluded from CRD financial buffers from the start, and the filters provide detail on some trading book assets, as well as own use properties. To the benefit of banks, they deviate from accountancy standards to protect: – the treatment of securitisations under prudential rules instead of under accountancy consolidation (see chapter 8.6); – the treatment of various debt instruments issued by e.g. mutuals as common equity for prudential reasons (see chapter 17.6), continuing the ‘old’ classification in the ABD and the CRD. A key concern of both financial markets in general and supervisors in particular is the fact that the numbers coming out of a company are only as good as the quality of the input, the structures they use to process these, and the certainty that the outcome is comparable to similar outcomes by similar companies. The early drive towards common accounting standards in the EU, and the more recent development of worldwide accounting standards via the IASB, has helped provide comparable financial information as well as common thinking on the underlying treatment of the raw data and valuation techniques. This process is far from final (due to amongst others the considerable national discretions still available in the ABD). The common denominators have already helped in allowing more crossborder trade by increasing cross-border trust. Please note that even with the harmonisation within the EU by the ABD and IFRS and with third countries under IFRS, there can still be significant deviations that hamper 144 CEBS/EBA Guidelines on Prudential Filters for Regulatory Capital, CEBS/04/91, December 2004, currently – without the initial expiry date – chapter 4.3 of the CEBS/EBA Electronic Guidebook. See CEBS/EBA summary of the CEBS public hearing on prudential filters, 16 October 2007, London, www.eba.europa.eu. 145 Part two, chapter 2, section 2 (containing art. 32-35) CRR has as its title ‘prudential filters’.

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comparability. Depending on which capital components are accepted in prudential regulations, and whether the country where the bank has its seat is investor oriented or creditor oriented, valuation and other accounting issues are applied in different manners146. Valuation Both assets and liabilities have a value. The determination of that value is a key component of accounting standards and is a key component in shareholders’ value and solidity/viability for the company as a whole. The proper determination of asset values and liability values in a sound valuation process has also become essential for risk management and investment strategies, as well as for regulatory purposes. Information on values of assets and liabilities is important for risk managers, investment/trading departments, mortgage consultants, executives and internal and external supervisors. If the value of an asset or a liability is stated incorrectly, the users of the financial information will make decisions – that will impact the banks life and profitability – on the basis of invalid data. The 2007-2013 subprime crisis provides a prime example of this, with the value of e.g. subprime mortgages – and the complex instruments built on such and other mortgages – being based more on external ratings than on solid information. This lead to the evaporation of trust in the value of such assets (leading to their market value nose-diving) and in the value of shares of the banks. As the exposures of the banks were unclear, and the information provided was only partly adjusted for the market value adjustments of their assets, the uncertainty on the trustworthiness of the public accounts information lead to mass withdrawals and the evaporation of interbank money markets147. Smoothing the results is more accepted in creditor focused countries, and can have a positive effect on the trust in banks and thus on financial stability. It is still, nonetheless, manipulation of the results, an unwelcome idea for protectors of transparent financial markets (as well as for free market investors and tax authorities). None of the valuation methodologies is, however, free from the possibility of manipulation, as each requires subjective judgement by the bank and its auditors on all assets on which objective prices are not available, while at the same time many market prices are manipulated by central banks and banks due to a lack or surfeit of credit in society148.

146 R. Zhao & Y. He, ‘International Variation in Bank Accounting Information Content’, Journal of International Financial Management and Accounting, Vol. 19, No. 3, 2008, page 236-260. 147 D.R. Van Deventer, ‘Fair Value Accounting, CDOs and the Credit Crisis of 2007-2008’, Bank Accounting & Finance, October-November 2008, page 3-8, in favour of fair value, and R.S. Clarkson, ‘Actuarial Insights Into the Global Banking Catastrophe’, Journal of Financial Regulation and Compliance, Vol. 17, No. 4, 2009, p 381-397, against the use of fair value. Both criticise current models for calculating risk and value. 148 Y. Anagnostopoulos & R. Buckland, ‘Historical Costs vs. Fair Value Accounting in Banking: Implications for Supervision, Provisioning, Financial Reporting and Market Discipline’, Journal of Banking Regulation, Vol. 6, No. 2, 2005, page 109-127.

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The value of all the assets minus the value of all the liabilities is the value of the paid up capital and reserves under accounting standards. Any profits are either distributed to investors or added to capital and reserves. Any losses from adjusted valuation are directly deducted from either reserves or from issued and fully paid up capital. This has a direct (non risk weighted) effect on available financial buffers149. Like public accounting disclosures, the calculation of prudential requirements and the financial buffers that are available to cover those requirements is based on the assets and liabilities of the bank. The starting point for calculating capital requirements is the value of the asset under the accounting standards. The same applies when calculating key components of the financial buffers, including the core-item of fully paid up capital and reserves. Valuation of the assets is thus key to the public perception of the bank and to the assessment by prudential supervisors. For the public accounts, the calculation of the value of off balance sheet potential assets are less important as it concerns potential or future assets that are not on the balance sheet in the reporting period. However, for prudential requirements these off balance items (e.g. guarantees or not yet drawn liquidity facilities) impact on the prediction of the future need for financial buffers too, even though at the time of developing the initial accord such off balance sheet exposures were relatively innovative150. Where the public accounts treat these concepts separately, the credit risk and market risk calculations give a value both to assets and off balance sheets items, and bundles them together as exposures to risk of the bank. In one of the deviations from the accounting concepts, the CRD contains some specific bank accounting valuation rules. These contain some deviations from public accounting valuation rules, as well as some additional requirements for categories that are less important in accounting than in prudential requirements, including additional rules for the valuation of collateral (see chapter 8.5), of counterparty credit risk of derivatives and structured financial agreements (see chapter 8.4) and for the valuation of exposures that are treated under market risk requirements (see chapter 9). Collateral has an impact on prudential requirements as it mitigates risk (which is not taken into account in external financial reporting) and thus has to be valued too by banks if they want to reduce their capital requirements151. 149 Also see recital 25 of CRD III, 2010/76/EU. 150 C. Goodhart, The Basel Committee on Banking Supervision, a History of the Early Years 1974-1997, Cambridge, 2011, chapter 10. 151 Art. 74.1 RBD, with exceptions and specific requirements for the valuation of collateral (e.g. in the form of financial collateral, real estate, receivables and other physical collateral), as collateral has a mitigating effect in prudential capital requirements, which it does not in accounting transparency requirements. Art. 1.1 and 35-39 ABD, art. 31-42f 4th Annual Accounts Directive, art. 29 and 33 7th Consolidated Accounts Directive. The presentation of financial instruments and their valuation are dealt with in IAS 32 and 39 respectively, as made binding on most banks via Commission Regulation 2008/1126. The ABD provisions on transferable securities are no longer compatible with the (more recently introduced) fair value valuation, except for the option to introduce fair value methodologies. See chapter 8.5-8.6, 9.5 and 10.5.

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In order for the use that the markets and supervisors make of the accounting framework to be trustworthy, the valuation must be done correctly and along accepted methodologies. These methodologies are set out in the public accounting standards, and are used also in prudential supervision. The methodology depends on whether IFRS or the ABD is applicable to the bank. Even within each set of standards there are different valuation techniques for assets held for different purposes. The valuation techniques can lead to a very different outcome for similar types of assets. Based on a different valuation technique, a bank can appear super healthy, or super sick. The most accepted valuation techniques still in use are historical or amortised cost value, (i.e. the nominal value of the loan, possibly adjusted for loan losses), and fair value accounting (where the value of the asset or liability in the market has to be used, or modelled). Depending on the regime applicable to the bank, the following general outline applies to valuation of specific items. Please note that the IFRS are continuously being revised. Both sets of accountancy rules require amongst others: – Going concern valuation; – Consistent methods of valuation from one financial year to another; – Valuation on a prudent basis; – Separate valuation of asset and liability items. If the bank drafts accounts under the IFRS regulation: – Non-financial assets and liabilities are valued in a variety of ways (depending on e.g. their nature as a lease, an investment property or employee related rights and liabilities), mostly at fair value or amortised cost, with losses being taken into account if the value on the balance sheet no longer reflects recoverable value152; – Financial instruments, ranging from cash-loans-bonds to shares and derivatives, that are intended to be held to maturity are valued at amortised costs. This captures for instance most loans that banks hold on the balance sheet, long term investments in subsidiaries and hedges of loans. The majority of the assets of banks prior to the 20072013 subprime crisis were held in this category153, where the value is only adjusted if there is objective evidence of impairment (recoverable amount); – Financial instruments that are held for strategic equity purposes have to be valued at fair value, and recorded in equity interests;

152 Most of such assets fall under the impairment rules of International Accounting Standard 36, Commission Regulation 2008/1126, which refers to recoverable amount as the asset value. 153 Report of the Financial Crisis Advisory Group to the IASB, 28 July 2009, page 4. www.ifrs.org.

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– Other financial instruments (e.g. the former categories of available for sale or held for trading) have to be valued at fair value, and recorded in net income (with impairment if there is a objectively known loss that is not reflected in the fair value); – Reclassifications between the categories are possible in extreme circumstances, such as the 2007-2013 subprime crisis, since the amendment of IAS 39 in October 2008154; – Liabilities are valued at fair value if they are embodied in financial instruments. An issue for this category is the fact that if the quality of the bank deteriorates, the ‘fair’ value of its liabilities also deteriorates. This is true for its bonds (which lead to the mentioned rushed adaptation of IFRS in 2008) but also for all its other liabilities. Fair value on this side would lead to a reward for a negative (with the odd counter-effect that in an upturn, the fair value of the liabilities increases). If the bank drafts accounts under the ABD: – A wide range of financial instruments have to be valued at fair value (i.e. mark to market if a reliable market can readily be identified, or mark to model if no such market can be identified)155; – All other assets on the basis of the principle of purchase price or production cost. Accountancy standard setters and prudential supervisors agree that fair value can be useful (it has e.g. since 1993 been part of trading book valuation in the CRD; see below). The supervisors and accountants, however, have different incentives on the way to calculate such fair value and which assets to value in line with fair value. For the assets that are not held with trading intent but with the intent to hold them until maturity156, the introduction of fair value accounting has led to stresses between the interests of the various users of the numbers rolling out of accounting standards. For short term investors, the current value of the assets is extremely important. For long term investors and for supervisors, it may be more important to include in the valuation not only current market value, but also the expectation of a reversal to the median in case the market value drops or increases significantly. One is more transparent but can lead to excesses (for example when there is an incoherent market panic, when there are otherwise unfounded bankruptcy expectations),

154 E.A. Marseille, ‘Financial Crisis in Financial Reporting: Rush Hour for Financial Instruments’, Ondernemingsrecht, 2009, No. 14, page 137. 155 Member states have the option to limit the applicability of fair value accounting for their companies, though note the prudential filters for banks on fair value. This can include its applicability solely to the consolidated accounts. If the model is not able to approximate the market value in a reliable manner, the historical cost and production cost principle is the fall back scenario. Art. 42b 4th Annual Accounts Directive and art. 1 ABD. 156 This is the distinguishing feature between the trading book and the banking book, the first of which is primarily assessed for capital requirements under market risk calculations, the second primarily under credit risk calculations; see chapter 9.2.

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the other may prevent debacles but reduces the usefulness of the numbers for short term investors. Accounting standards have moved towards the use of fair value for certain types of assets157. This applies to financial instruments that a bank intends to trade, as already provided in RCAD, but accountancy standard setters have been willing to also fair value assets that are not intended to be traded. This shift in valuation has led to furious debate between transparency proponents and financial stability proponents. Some indicate that fair value makes banks assets more volatile (both in the upswing and downswing of financial markets), reducing their predictability and trustworthiness, and causing stresses in the markets. Others indicate that if you don’t know what the assets held by a bank will bring when sold, you are taking (investment or prudential) decisions on the basis of faulty information. Both proponents and opponents of fair value accounting contend that ‘garbage in, garbage out’ is a universal concept, but draw different conclusions. The valuation of trading book assets (that are intended to be traded) is locked in at fair value in the RCAD158. RCAD requires daily revaluation at current market values for solvency ratio calculations, even if/when the ABD (or the newer IFRS) did not require it for public account calculations. These rules have been further specified in the wake of the 2007-2013 subprime crisis in the CRD III159. Until end 2011, the prudential supervisors could apply only relatively minor adjustments to the fair value estimation of those assets and the valuation of risk-mitigating collateral. The BCBS – as part of its efforts to mitigate volatility – has started to deviate from accountancy standards (an example of a prudential filter). It limits the use of fair value accounting in the calculation of own funds and of (market risk) capital requirements, and favours a limitation of the use of fair value for credit risk. This has been translated both into its Basel II ½ package and in its subsequent Basel III package (see chapter 2). In Basel II ½ the treatment of illiquid assets softens the impact of value adjustments in crisis times when marking to market is only possible to fire-sale prices or there are no buyers at all. Though this is presented as an item important for market risk, this is particularly important to preserving available financial buffers in the numerator of the solvency ratio as own funds are assets minus liabilities, with a high valuation of assets leading to more available own funds to buffer for the capital requirements in general. There is indeed also a (lesser) impact on the amount of required capital for market risk, which 157 Y. Anagnostopoulos & R. Buckland, ‘Historical Costs vs. Fair Value Accounting in Banking: Implications for Supervision, Provisioning, Financial Reporting and Market Discipline’, Journal of Banking Regulation, Vol. 6, No. 2, 2005, page 109-127; E.A. Marseille, ‘Financial Crisis in Financial Reporting: Rush Hour for Financial Instruments’, Ondernemingsrecht, 2009, No. 14. 158 Art. 33 and Annex VII RCAD. 159 CRD III 2010/76/EU amends Annex VII RCAD as per end 2011. Also see chapter 9.2 on the trading book/banking book differentiation.

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is also calculated on the basis of the (higher) valuation. As of end 2011, banking supervisors have started with this deviation from accountancy standards to be able to mitigate the impact of fair value accounting on assets held either in the banking book or in the trading book that are not liquid (any more), at least in as far as it concerns valuation for prudential purposes160. On the other hand, for the calculation of common equity tier 1, the Basel III version of the capital accord no longer applies a filter on unrealised gains and losses, making this core financial buffer more susceptible to fluctuations following from market price adjustments161. The BCBS gives into consideration to adjust the valuation for totally illiquid assets, taking into account the time needed to sell or hedge the risks of the asset. This is of a relatively low impact compared to the deduction of valuation losses from own funds that would have been the result of marking to fire-sale market values. These deviations from fair value accounting were already allowed under the CRD for the trading book (where the terminology is ambivalent enough to accommodate the BCBS deviations), and have been copied also for the banking book into the CRD, applicable since 31 December 2011162. For illiquid assets valued at fair value, the banks are urged by the BCBS and the RCAD – but not obliged – to consider a lower valuation. Such lower valuation would result in a loss, and would thus be deducted from available financial buffers in full163, making this less than attractive for the bank. The models used if market values are not available (at which time mark to model replaces mark to market within the fair value context) have to be approved by supervisors164. In times of general market stress, please not that those public authorities have a similar incentive as banks to keep valuations relatively high. In Basel III, the BCBS has also come out in favour of a tightening in loan loss accounting standards (see below) for assets that are not in the same grouping as financial instruments (as a preferred alternative to a switch to fair value accounting). Within a cost based valuation, it would reduce the value already if a loss is anticipated, instead of waiting until a loss has actually been incurred. Such forward looking provisioning is limited to realistically expected losses, but still allows some losses to be provisioned against early in the cycle when there are still sufficient buffers. This avoids having to take such losses at the bottom of the cycle, when there is no further capital from which it can be deducted. The support of the BCBS shies back from accepting marking-to-market valuation (the ‘fair’ value in a 160 Art. 64.5 RBD, art. 11.4 and Annex VII part B RCAD, as amended by CRD III, 2010/76/EU in line with Basel II ½, BCBS, Revisions to the Basel II Market Risk Framework, July 2009. 161 BCBS Consultative Document, Fundamental Review of the Trading Book, May 2012, page 11. 162 Art. 64.5 RBD, art. 11.4 and Annex VII part B RCAD, as amended by art. 2 and 3.2 CRD III, 2010/76/EU in line with the content of Basel II ½, BCBS, Revisions to the Basel II Market Risk Framework, July 2009. 163 Art. 64.5 RBD, Annex VII RCAD, and recital 25 CRD III, 2010/76/EU. 164 Art. 33.3 RCAD.

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recession could be substantially lower than actually expected losses when repayment is actually due; which is procyclical), and could provide a compromise solution that combines aspects of the Spanish dynamic provisioning and the likely market reaction on the value of the exposure if it would be aware of such expected losses where e.g. interest is still paid but the main sum is unlikely to be repaid in full165. As set out in chapter 6.2, assets determine the capital requirements for credit risk and market risk. The higher the value of the asset, the higher the potential capital requirements. However, the value of the asset also has a direct impact on the amount of capital available to meet those capital requirements. A change in the value of the asset thus has a double effect. If the value goes up, the capital requirements go up by a percentage of the valueincrease. That is compensated in full or in part by the impact the increase in value has on the core capital, i.e. assets minus liabilities. So far for the upside, which in the boom years up to 2007 lead to ever increasing profits, high capital and low capital requirements. During the start of the 2007-2013 subprime crisis the downside of this cycle came to the fore. If an asset decreases in value, the capital requirement is also reduced (by a percentage of the decrease). The impact on the available capital to meet the capital requirements was, however, larger, as the full amount of the decrease in value impacted on the core capital (lower asset minus continuing liabilities). While the capital requirements largely remain, the available capital fades away. In ‘normal’ times, this effect is blurred by some assets increasing in value and others decreasing. In a financial crisis, almost all assets that are subject to a revaluation decreasing their value, without any compensating upwards effects on the value of other assets. This has been referred to as one of the elements of (accounting and) prudential requirements that lead to procyclicality (see chapter 6.5). A similar effect can be noticed in loan loss provisioning for assets held at historic or at cost amortisation valuations. Fair Value Accounting Fair value accounting on assets makes the balance sheet more volatile. Banks with many assets valued at historical value suffer less form this volatility. Banks with a high proportion of financial instruments among its assets, and which finance themselves through issuance of financial instruments are relatively volatile when fair valuation immediately impacts on the balance sheet. As such, it is an uneasy companion for financial stability in the financial markets. In banking accounts, it has been partially adopted for those areas where market valuations are available and the assets are likely to be traded: mostly thus for publicly traded financial instruments (see above). Variations of historical cost accounting have

165 BCBS, Guiding Principles for the Replacement of IAS 39, August 2009, www.bis.org. Also see the CEBS/EBA letter to support the IASB exposure draft to move in the direction of expected losses, CEBS, Exposure Draft ED/2009/12 Financial Instruments: Amortised Cost and Impairment, 30 June 2010.

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been kept for financial instruments that are not publicly traded, such as individual loans. If objective market valuations are not available (e.g. when they are not regularly publicly traded or where the market has seized up and buyers are absent at realistic prices), the alternative within the fair value methodology is marking to model, or to go for one of the other valuation methods. Modelling values directly impacts on the issue of objectivity, however, allowing gaming the accounts and capital requirements to re-enter the valuation arena. For publicly traded financial instruments assets, fair value information is expected to give a better image of the true health of the institution at that point in time, and ‘fairly’ valuing an asset will help determine whether it should be bought at all. If a bank is highly funded through deposits and does relatively little trading for its own accounts in financial instruments, it is mainly subject to purchase price and production cost valuation. Fair value cannot be determined for such assets on the basis of objective market data, in which case historical cost or amortisation methods provide more objective information than the subjective estimates in mark to model methodologies within the fair value context166. On the other hand, it raises the subjective issue of when to take into account probable losses under loan loss accounting (see below). In a fair value based on market valuations such losses would presumably be reflected in the market price already if such markets are efficient167. This debate is unlikely to be resolved, with investors and market supervisors asking for more assets to be brought into a fair value regime, and banks (at least for as long as the recession lasts) and prudential supervisors asking for further limitations to the gyrations of the balance sheet caused by fair value in its purest forms, and the procyclical effect thereof; see chapter 6.5168. The CRD contains some additional standards on how banks should use fair value when valuing their assets for prudential purposes. These are contained in the RCAD, but are since the end of 2011 also relevant for the RBD; see above169. The bank is expected to have good internal governance for its valuation, including policies, procedures, and reporting to (and awareness of) senior management and risk managers, and valuations by dealers 166 I.K. Khurana & M. Kim, ‘Relative Value Relevance of Historical Cost vs. Fair Value: Evidence From Bank Holding Companies’, Journal of Accounting and Public Policy, Vol. 22, 2003, page 19-42. 167 G.J. Benston & L.D. Wall, ‘How Should Banks Account for Loan Losses’, Journal of Accounting and Public Policy, Vol. 24, 2005, page 81-100. 168 See e.g. the differences of opinion in 2009 on more or less fair value by the IASB and the USA FASB respectively. Also note the Report of the Financial Crisis Advisory Board to the IASB, 28 July 2009, www.ifrs.org. From the bankers’ side see the statement on valuation issues by the Institute of International Finance of 28 May 2008, www.iif.com, and from regulators’ side BCBS, Fair Value Measurement and Modelling: An Assessment of Challenges and Lessons Learned from the Market Stress, June 2008, www.bis.org. 169 Art. 64.5 RBD, art. 11.4 and Annex VII part B RCAD; as amended as per 31 December 2011 by art. 3 CRD III, 2010/76/EU.

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should be subject to monthly verification by an independent unit (see chapter 13.3). For publicly traded financial instruments it also is expected to mark to market whenever possible, and mark to model when it is not possible (‘not possible’ is, however, a wider concept than used in accountancy standards, allowing banks to use modelling e.g. also when markets are there, but subject to panic-selling). Deposits in current or savings accounts at other banks, or loans to customers, are also financial instruments under IFRS, but are likely to be in the amortised costs category (as they are usually held to maturity; see below). The exceptions are mortgages and credit card loans or student loans that are generated to be securitised, which subsequently have to be valued at fair value. Bricks and stones (e.g. office buildings), as well as issues as goodwill, are not financial instruments. Fair value accounting for liabilities is more controversial. Reducing the value of deposits if the bank is unlikely to fulfil its commitments would take away from the protection offered to depositors by public authorities. Deposits, especially from consumers and small- and medium sized enterprises should be paid out at the nominal value plus interest, even if the financial position of the bank is shaky (e.g. because of a reduction in the fair value of its assets). However, if fair value is applied to a large part of the financial assets, and not applied to a large part of the financial liabilities of a bank, this means that the risk in being in the transformation business (transforming long term deposits into loans and other investments) is even more risky than it already was170. Fair value volatility in the assets side is primarily brought upon a small component of the liabilities side (the own funds) instead of being shared over more commitments. This makes own funds exponentially more volatile, as they have to buffer (or are expanded) due to market values on financial instruments, even if they are not actually sold. For transparency reasons (making the decisions of investors easier), general loss reserves or provisions are prohibited. Losses can only be taken when they are likely to occur, not when they theoretically might occur. Those in favour of transparency like a prohibition on smoothing results, prudential supervisors generally oppose the prohibition for financial stability reasons171. Nothing is saved in good times, and in bad times suddenly the losses jump up, scaring all investors away disproportionally to the long term expectations of

170 Also see the debate mentioned in Y. Anagnostopoulos & R. Buckland, ‘Historical Costs vs. Fair Value Accounting in Banking: Implications for Supervision, Provisioning, Financial Reporting and Market Discipline’, Journal of Banking Regulation, Vol. 6, No. 2, 2005, page 109-127. 171 Y. Anagnostopoulos & R. Buckland, ‘Historical Costs vs. Fair Value Accounting in Banking: Implications for Supervision, Provisioning, Financial Reporting and Market Discipline’, Journal of Banking Regulation, Vol. 6, No. 2, 2005, page 109-127.

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losses. Those losses suddenly also have to be deducted from capital, making ‘normal’ capital levels insufficient. The result is a natural tension between investors’ transparency interests, and financial stability interests in times of crisis. A balance has to be struck between growth (for which investors need transparency) and financial stability (for which some smoothing of losses and profits might be beneficial). This continues to be a discussion (see above), where investors’ advocates indicate that the removal of smoothing instruments in accounting standards should continue. In their opinion, any worries supervisors have could easily be compensated by asking for higher capital requirements172. This increase in capital requirements, however, has never been introduced, while the increase in transparency has. Overall, the added transparency and the partial movement to fair value on the asset side only, that was not compensated by higher capital requirements may be one of the causes of the 2007-2013 subprime crisis; also see chapter 6.5 on procyclicality. Loan Loss Accounting (for Assets that are not Valued at Fair Value) Separate attention needs to be paid to the calculation of the value of assets that are in danger of defaulting or have already defaulted. For assets that are valued at ‘fair value’ mark to market methodologies, the market price is assumed to reflect the discount for such default. For assets that are marked to model or under historic cost valuation methods, it is less clear when to assume that a loss is unavoidable and to what extent under so-called loan loss accounting173. Those factors determine the write-down of the value of the asset, which impacts both on the numerator and the denominator of the solvency ratio. By way of example, a mortgage loan that is kept in the books of the bank for the duration of the loan is valued at the full nominal value. If the owner is no longer able to make his interest payments this changes. Any due interest payment is a claim of the bank on the owner, as is the debt of the lump sum of the mortgage loan initially made. Any claim of the bank on the mortgage borrower is reflected in the accounts (and in the risk weighted credit risk requirements, see chapter 8). In principle, all subsequent interest-payments that have become due should be in the accounts, but the accounting standards determine that interest no longer ‘accrues’ if one of its periodical payments is not made. The value of the non-paid – but due – interest is thus not reflected in the accounts as an asset174. This does not automatically impact on the treatment of the main sum of the mortgage loan, that is still in the books of the bank. The value may have to be adjusted, based on the value of the 172 G.J. Benston & L.D. Wall, ‘How Should Banks Account for Loan Losses’, Journal of Accounting and Public Policy, Vol. 24, 2005, page 81-1000. Report of the Financial Crisis Advisory Board to the IASB, 28 July 2009, www.ifrs.org. 173 Y. Anagnostopoulos & R. Buckland, ‘Historical Costs vs. Fair Value Accounting in Banking: Implications for Supervision, Provisioning, Financial Reporting and Market Discipline’, Journal of Banking Regulation, Vol. 6, No. 2, 2005, page 109-127. 174 On the other hand they are thus also not the subject of prudential requirements on the assets.

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underlying mortgaged property (i.e. in the example the house of the borrower) as compared to the loan, and the chance that in addition to not being able to meet his interest payments, the borrower is also not able to make his payments on the main sum under the contract when that becomes due. Depending on this information, the value needs to be decreased. The adjustment of the value has an immediate impact on the available own funds (the value of the assets go down by the amount written off the mortgage loan value, and assuming unchanging liabilities, this means a full deduction from own funds as the numerator of the solvency ratio). A small benefit is that only for the lesser value of the mortgage loan, prudential requirements are calculated for the denominator of the solvency ratio. As this is risk weighted, the full deduction from own funds kicks in much harder than this weighted reduction of the required amount of such own funds. The full deduction of an acknowledged loss in value is a rather abrupt change, which provides an incentive to acknowledge the loss (and write-down) only at a late stage. In the credit risk area, in order to take into account the increased possibility of default, there are measures to increase the risk weighting if the borrower has started to fail in his payments of e.g. interest, even if he is not yet in default on the main sum. If he is late on his payments a certain amount of time – normally 90 days175 – the risk weight percentage goes up, unless the bank has already partially or in whole written the value of the loan down (or in other words: the loan has become impaired). A problem in the 2007-2013 subprime crisis was that many of the mortgage loans on the balance sheet were either not generated by the bank itself or were kept for trading (by bundling them with other mortgage loans in planned securitisation transactions). As a result, they could not be treated along the sedate loan-loss route that is available for the loans generated by the bank itself and intended to be kept. Both mortgages intended to be traded and financial instruments representing a claim in a pool of such mortgage loans generated by another mortgage lender are not subject to loan loss accounting. Such financial instruments held for trade are instead subject to fair value accounting, leading to immediate adjustments in the value (and thus full deduction from own funds) when the market price of such assets went down because there were no longer any buyers or because the quality of the mortgages turned out to be lower than expected; see above. As the timing of loss accounting is key to the regulatory quantitative calculations, banking regulators have taken an active approach to fill in the high level principles set out in accounting standards. The BCBS is for instance continuously commenting on new

175 This depends on specific CRD provisions on different asset types, as well as on some temporary or permanent national discretions; see chapter 8. This treatment is continued in the CRD IV project, though EBA gains additional roles on the definition of default. Art. 101 CRD IV Directive and art. 110 and 178 CRR.

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accountancy standards, to allow more dynamic provisioning (or over-the life provisioning for losses that are ‘expected’, i.e. normal for such type of loan-portfolios). The aim is to go from an incurred loss model to an expected loss model for financial instruments176. Consolidation Under accountancy standards, an entity has to report its numbers both for itself on a standalone basis (solo basis) and on a so-called consolidated basis. In the consolidated presentation of the data, all the data on the reporting entity and of all legal entities owned or otherwise controlled by the reporting entity are added up, and presented as if all these legal entities are in fact one. In this manner, the group or subgroup controlled by the reporting entity presents its financial situation as an economic unit. By presenting both solo information and consolidated information, investors (and the company itself) gain valuable insight into its finances both when it would sell its subsidiaries and as an ongoing concern. It provides insight into the risks and opportunities the group faces and thus for an investor in that group, eliminating some opportunities to hide losses or assets, or to otherwise manipulate the data. Prudential supervision is based on the same combination of solo supervision and group wide supervision (see chapter 17.1). The extent of the group (which legal entities are deemed to be part of it) is largely based on whether or not undertakings are consolidated under accounting rules in the same group as the bank under supervision. If an undertaking is captured in the consolidation, its financial information and structural set-up is taken into account in the supervision of the bank. This applies both to quantitative requirements and to non-quantitative subjects such as organisational requirements and pillar 2; see chapter 13 and 14. Determining which undertakings are captured in the consolidated application of requirements is based on the 7th directive on consolidated accounts. For prudential purposes, the determination of the scope of consolidation as directive is used, regardless of whether the bank drafts its public accounts under the ABD or under the IFRS regulation for its public accounts177. The CRD contains some important adjustments (prudential filters) from the consolidated accounts directive, excluding several controlled entities; see chapter 7.2.

176 For instance BCBS Chair Comment Letter to IASB, Exposure draft (ED/2013/3) financial instruments: expected credit losses, 21 June 2013. I. Anagnostopoulos & R. Buckland, ‘Bank Accounting and Bank Value: Harmonising (D)Effects of a Common Accounting Culture?’, Journal of Financial Regulation and Compliance, 2007, page 360-380. Report of the Financial Crisis Advisory Board to the IASB, 28 July 2009, www.ifrs.org. 177 Where the valuation rules specifically refer to both the ABD and the IFRS regulation, the key consolidation definitions solely refer to the 7th Consolidated Accounts Directive (as applicable via the ABD). See art. 4.12 and 4.13, and 68-73 RBD.

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The joint forum identified several problems with supervisors copying their approach to consolidation from accountancy178, especially in light of the presence of unregulated entities (at the top or elsewhere) in the group: – The assumption in consolidated numbers that intra-group transactions are risk-free179; – Market risks run by different entities can be offset by market risks or mitigations of other entities; – Consolidation can hide the distribution and transferability of risks and resources within the legal entities. These issues are less important for accountancy purposes. Public accounts present data to the board and to investors in a going concern. External investors either lend/invest directly to the top level holding of the group, or are often guaranteed by it. This is different for supervisors. Supervision is of importance both when the banking group functions as a going concern and when in trouble. The supervisors involved are not (only) responsible for the group as a whole but also (and in liquidation primarily) for the individual legal entity they licensed (perhaps saving that legal entity at the cost of killing the group). Such differences in the health of individual entities and the group they belong to tend to surface in a financial crisis. The treatment of securitisation and securitisation vehicles is very distinct between IFRS and BCBS. The BCBS treatment, copied into the CRD, follows the US GAAP treatment in keeping the special purpose vehicles off the consolidated balance sheet and generally recognizing a true sale180. Transparency The accounts can provide external transparency towards investors/creditors to the extent they are distributed to shareholders and/or the general public, and they provide internal transparency to the board. The internal and external transparency provided on the basis of accounting/company law rules also support prudential and conduct of business banking supervision. Financial information (based on accounting standards) provides key input to day-to-day management, for internal supervision by non-executives, as well as for prudential supervisors. Published versions of that information provide key information on (company law) own funds and results to all investors and other counterparties, as well

178 Joint Forum, Review of the Differentiated Nature and Scope of Financial Regulation, January 2010, www.bis.org page 37. 179 This is also assumed if certain conditions are fulfilled on a solo basis; see art. 80 RBD and recital 60 and art. 113 CRR. Also see chapter 17 on asset transferability. 180 See chapter 8.6, and A. Adhikari & L. Betancourt, ‘Accounting for Securitizations’, Journal of International Financial Management and Accounting, Vol. 19, No. 1, 2008 page 73-105.

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as to supervisors. The public accounts are set to be used by the stakeholders in the bank in its going concern modus. The component information is provided on an ongoing basis to the supervisors, and used in its own calculation. In addition to the relative slow publication requirements for annual and consolidated statements that are subject to national discretions181., for banks whose instruments are admitted to trading on a regulated markets the publication obligation is also contained in the transparency directive182. It provides for a regular flow of information including yearly and half-yearly periodic information. Supervisory rules take the company law/accounting rules as the starting point, adding disclosure requirements only where information regulators deem essential to be public is not already contained in the published annual or consolidated accounts. This helps avoid overlap and administrative burdens, and gives the opportunity to build on an already existing structure. Examples are the additional requirements on companies (including, with some exceptions, banks) to publish a prospectus and provide continuing updates on that information under conduct of business rules (see chapter 16). In the context of the Basel II package, another obligation was added. As a so-called ‘pillar 3’ it created an additional obligation for banks to publish prudential information (see chapter 15). Apart from the use made by counterparties of banks and supervisors, banks are also key users of (published or unpublished) information drawn up under accounting rules. The accounts drawn up by their clients and their counterparties allow banks to assess the creditworthiness and reliability of those they do business with or invest in (though they often ask for additional information when the loan or investment is requested by the client). Bank Branches Bank branches have their own dedicated accounting directive183. It focuses largely on the availability of financial information on the full legal entity also in the member state where the branch is located (as drawn up under the laws of the state where the bank has its head office). The host member state can require the financial information to be translated into the local language. Member states are forbidden to require the publication of full annual

181 Art. 44 ABD (also see the similar art. 47 Annual Statements Directive 1978/660/EEC and art. 38 Consolidated Accounts Directive 1983/349/EEC, and art. 30 of the new Annual and Consolidated Statements Directive 2013/34/EU that are applicable to other companies than banks). 182 Art. 4 and 5 Transparency Directive 2004/109/EC. See chapter 15 and 16.5. 183 Directive 1989/117/EEC sets out the obligations of branches of banks based in other member states or in third countries regarding the publication of annual accounting documents.

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accounts relating to activities of the branch, but can require them to publish audited (simplified) overviews in the local language of184: – the income and costs of the branch; – the average number of staff employed by the branch; – the claims and liabilities of the branch; – the total assets and liabilities (plus off-balance sheet items and securities) of the branch (and endowment capital if required from third country banks). Similar to local banking supervisory requirements on branches, accounting requirements on EU branches have to be similar or less stringent than the accounting requirements on third country branches185, as a member state should allow EU branches at least the same trust and leniency as third country branches enjoy. Future Developments The dependency on the IFRS and ABD regimes does not change in the CRD IV project186. The changes following from the Basel III package/CRD IV project are described above187. Especially the impact of fair value accounting on the calculation of own funds and of the value of exposures to be taken into account in the various models for credit risk and market risk will change. The approach to securitised assets will continue to deviate from accountancy standards; where the vehicles used would be consolidated and their assets (mortgages) and liabilities (secured bonds) would thus automatically be consolidated on the balance sheet of the bank. Changes in value in liabilities of the bank that result from changes the own credit standing of the bank are not accepted, neither when the standing goes down (and the value of such debts is thus reduced under fair value) nor when the reverse happens. The CRR specifically allows member states to maintain or introduce dynamic provisioning as a national discretion, in spite of the minimum and maximum harmonisation contained in that regulation188. The CRR/CRD IV directive otherwise continues to rely on definitions and concepts used in the accountancy frameworks, and continues to deviate as it sees fit for prudential calculations (prudential filters)189. 184 Art. 2-4 Bank Branch Public Accounts Directive 1998/117/EEC. Annual accounts on the branch can, however, be required from branches where the annual accounts of the full legal entity are drawn up under accounting standards that are not equivalent to EU accounting standards, or where the third country requires EU bank branches to draw up local annual accounts (reciprocity requirement). 185 Art. 3.5 Bank Branch Public Accounts Directive 1998/117/EEC and art. 38.1 and 38.3 RBD. See chapter 5.3. 186 Recital 39 and art. 24 and 466 CRR. 187 Art. 32-35 CRR. 188 Recital 13 CRR. 189 Recital 39, 65, art. 4 (specifically sub 37, 77, 95, 100, 101, 106-108, 110, 111-113, 115, 117, 121 and 123-125), art. 24, 26, 28, 32-35, 37, 41, 43, 99, 110, 111, 166-168, 246, 316, 429, 434, 436 (that obliges a disclosure of the differences between accountancy and prudential consolidation), 442, 447, 449 CRR and recital 33, art.

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The Commission has published proposals to recast two directives that apply to the annual and consolidated accounts of banks via references contained in the ABD, though the ABD itself is not amended (but refers now to the new rules). It separates public interest entities from others, such as small- and medium sized enterprises. The aim is to reduce administrative burdens for the latter, but it also consolidates the regime for the public interest entities. Purchase price/historic costs remains the main rule, though the member states are allowed to deviate from this for a range of issues190. This directive was adopted after the closing of this book, and will need to be implemented in the laws of the member states by 20 July 2015 (applicable to their accounts from that moment or from the book year starting in 2016, at the discretion of the members state)191. For the auditing of such annual and consolidated accounts, the Commission has published proposals on the statutory audit of public interest entities, and for an amendment of the directive on statutory audits (of annual accounts and consolidated accounts192. Financial services providers such as banks and insurers are deemed of ‘public-interest’ not only for each member state but also for the EU as a whole, and the existing regime for such types of companies will be further harmonised. Banks will be brought into the remit of a directly applicable regulation that attempts to improve the veracity, credibility (and comparability) of the auditing of bank accounts across the EU by amongst others increasing the independence of auditors and of the audit committee of the bank. ESMA will have a key role in supervision of auditing, in cooperation with EBA and EIOPA193. The IFRS framework is continuously in the process of being revised. The decision making process is slow, as noted by amongst others the IASB chair194, but the Commission regulation is revised regularly. The approach between IFRS and US GAAP standards is a particularly slow process. While some hope remains of arriving at a common stance that would allow USA companies to operate worldwide and worldwide – including EU – companies to operate in the USA on the financial markets on the basis of the same information; progress is likely to remain slow. Meanwhile, the changes in IAS 19 on the treatment of pension funds exposures will only gradually be introduced for prudential purposes from

190 191 192

193 194

74, 87, 88, and 123 CRD IV Directive, while allowing EBA and the Commission to specify certain items in level 2 legislation (see e.g. art. 110 that now more explicitly deals with adjustments to exposure value). Art. 6 and 8 Annual and Consolidated Statements Directive 2013/34/EU. Art. 52 and 53 Annual and Consolidated Statements Directive 2013/34/EU. Commission Proposal Amending Directive 2006/43/EC on Statutory Audits of Annual Accounts and Consolidated Accounts COM(2011) 778 final, 30 November 2011; and the Commission Proposal for a Regulation on Statutory Audits of Annual Accounts and Consolidated Accounts of Public-Interests Entities COM(2011) 779 final, 30 November 2011. Commission Proposal for a Regulation on Statutory Audits of Annual Accounts and Consolidated Accounts of Public-Interests Entities COM(2011) 779 final, 30 November 2011, page 9, recital 36 and art. 46-60. Financial Times, IASB Chairman Laments Repeated Delays to Urgent Reporting Reforms, 15 October 2012.

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2014 until 2018, and other exposures and other changes to accounting standards can also be subjected to a particular transitional arrangement for use in prudential rules195. Literature – Moloney, Niamh, EC Securities Regulation, Oxford University Press, Oxford, 2008, page 212-228 on the background of IFRS adoption and the related processes – Anagnostopoulos, Yiannis; Buckland, Roger, Historical Costs vs. Fair Value Accounting in Banking: Implications for Supervision, Provisioning, Financial Reporting and Market Discipline, Journal of Banking Regulation, 2005, page 109-127

6.5

Procyclicality

Introduction The quantitative approach to prudential supervision has been widely accused of being procyclical; i.e. exacerbating both booms and busts. Procyclicality is difficult to disentangle from cyclicality, which is the result of lemming behaviour of humans. Generally, a crowd of humans runs in the same direction if fear or exuberance hits them. As banks (and supervisors) are controlled by humans, this behaviour is typical of banks (and supervisors) too. The natural behaviour of banks and the impact of banking on the valuation of assets reinforces the business cycle both on the way up and on the way down, which may not be sufficiently reflected in risk models196. Smart banks and investors make lots of money by betting on this behaviour at the right time, not so smart banks and investors lose lots of money by not betting on this behaviour, or by betting at the wrong time and just following the herd. The thing this natural cycle, however, does not need is public authorities or obligatory market structures reinforcing this behaviour. This may deepen (or speed up) the inevitable recession or crisis. This additional oomph added to the cycle is called procyclicality; or regulatory/institutional behaviour that heightens the peaks and deepens the troughs of the natural cycle. Prudential requirements play a role in stimulating conservative behaviour in recessions and excessive behaviour in times of economic growth, as do such issues as accounting standards valuations and the use of financial collateral197.

195 Art. 473 CRR reduces the impact on core equity tier 1. Also see the delegation to the Commission of potential adaptations in art. 457 CRR. 196 H. Tomura, Liquidity Transformation and Bank Capital Requirements, Bank of Canada Working Paper 2010-22, Ottowa, 2010, www.bank-banque-canada.ca. L. Allen & A. Saunders, A Survey of Cyclical Effects in Credit Risk Measurement Models, BIS WP 126, 2003. FSF and CGFS, The Role of Valuation and Leverage in Procyclicality, April 2009. 197 FSF-CGFS, The role of valuation and leverage in procyclicality, April 2009.

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Procyclical behaviour at the own initiative of banks includes such issues as expanding the balance sheet to the maximum (un)sustainable levels of leverage (see chapter 6.2 on the proposed leverage ratio), by paying out capital in the form of dividends or buy-backs to shareholders or in the form of bonuses to employees even in times of trouble (see chapter 6.2 and 13 on the proposed countercyclical capital buffers and the recent rules on remuneration), by granting mortgage loans on larger multiples of wages or on combined wages, by reducing reliance on the labour-intensive but sticky deposits in favour of cheap and large size – but eager to ‘run’ – wholesale funding by other banks and non-bank professional market parties (see chapter 12.2)198. Such procyclical behaviour is often welcomed on the way up of the economic cycle as it expands the boom via easy credit, but deeply regretted on the way down as it equally expands the amount of adjustments needed for the cycle to bottom out. Supervisors do not force or require banks to take such procyclical measures on the way up, though some of the hardwired low risk assessments on governments and small- and medium sized enterprises allowed by supervisors and legislators allow banks to leverage their capital manifold. On the other hand supervisors certainly did not stop them sufficiently or in time, arguably because on the way up both supervisors and politicians are under pressure from a powerful lobby from the financial industry and a belief in the goodness of (even excessive) growth and/or the existence of national champions. The focus of this chapter is on regulatory procyclicality, as in measures that exacerbate economic cycles that are built into prudential banking supervision rules and practices. Out of scope are other governmental rules that are procyclical, such as the effects of taxes, including199: – the effect on the economic cycle of the different tax treatment of debt and equity on banks; – the effect of the treatment of e.g. special purpose vehicles in the securitisation context as tax exempt; – the effect on housing markets of subsidies, capital gains taxation and interest rate tax deductibility. Regulatory Procyclicality and the 2007-2013 Subprime Crisis The debate on procyclicality was re-opened in the 2007-2013 subprime crisis. Research is still going on into its nature, and how best to address it. There is a proven correlation

198 H.E. Damar, C.A. Meh, & Yaz Terajima, Leverage, Balance Sheet Size and Wholesale Funding, Bank of Canada WP 2010-39, December 2010; E.J. Kane, Regulation and Supervision: an Ethical Perspective, NBER WP 13895, March 2008. 199 V. Ceriani, S. Manestra, G. Ricotti, A. Sanelli & E. Zangari, Ernesto, The Tax System and the Financial Crisis, Banca d’Italia OP 85. IMF, Debt Bias and Other Distortions: Crisis-Related Issues in Tax Policy, 12 June 2009.

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between capital buffers and cycles, even though they may work differently in different countries at different stages of their economic development200. There is a theoretical discussion whether Basel II added procyclical measures to the existing ones in Basel I. Regardless of the opinions on the effect of Basel II rules on Basel I, the bottom line appears to be that there is a consensus that the supervisory regime laid down in the Basel capital accord and the CRD contained issues that exacerbated the cycle201. The sequence and the exact effect are not yet clear, nor is the interaction with other triggers. If minimum capital requirements become irrelevant for the banks decisions in an upswing, and become binding/restrictive in a downswing, does this mean that the downturn causes the restriction, or that the restriction causes the downturn? The probability of default of a counterparty is higher in a downturn, as reflected in ratings, risk management, valuations, marginrequirements and capital requirement. Regardless of the yet to be delivered final answers to such questions; the correlation between the level of capital at a bank and its behaviour during upswings and downswings will rightly lead to additional (flexible) minimum requirements as envisaged in Basel III (also see chapter 6.2). It is, however, not clear whether such new requirements will be proven effective in the next crisis202. The question whether a bank is well-capitalised may depend in part on regulatory requirements, but to a larger extent on the risk appetite and culture of a specific bank, as well as the willingness of (non-executive) board members, rule makers and supervisors to say no or demand safety measures203, and the trust of investors and depositors to provide funding to the bank. Some banks are more cutthroat and have taken risks that can plummet them quickly through their financial buffers, even if those financial buffers requirements have been increased. Others are more staid, and will have good risk management and a surplus of capital regardless of regulatory requirements. A positive effect of the new measures will be that at least the downward pressure on standards at more staid listed banks will be mitigated to some extent. A similar effect may be the result of added transparency (in annual accounts and pillar 3). The benefit of improved understanding and quantification of the future risks based on the market view of the moment as reflected in ratings and valuations is counterbalanced by

200 A.R. Fonseca, F. González & L. Pereira da Silva, Cyclical Effects of Bank Capital Buffers with Imperfect Credit Markets, International Evidence, Banco Central do Brasil, WP 216, 2010. 201 See e.g. the literature and issues discussed in P. Angelini, A. Enria, S. Neri, F. Panetta, & M. Quagliariello, Pro-cyclicality of Capital Regulations: Is It a Problem? How to Fix It?, Banca d’Italia Occasional Papers 74, October 2010. 202 Heid, Frank, Krüger, Do Capital Buffers Mitigate Volatility of Bank Lending? A Simulation Study, Deutsche Bundesbank Discussion Paper, Series 2 Banking and Financial Studies, No. 03/2011. 203 J. Viñals & J. Fiechter, The Making of Good Supervision: Learning to Say ‘No’, 2010, IMF SPN/10/08, page 13.

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the disadvantage of cyclical results leading to cyclical market (over)reaction. Though good for investors with short term investment strategies, publishing and acting on such short term assessments has led to much less ‘smooth’ results for financial stability. The increased transparency and risk awareness has also lead to increased herd behaviour in a downturn. If values go down due to for example changes in risk perception, changes in monetary policy, currency devaluations, or other changes in the economic environment, this immediately has an impact on the losses of the bank, which are directly deducted in full from available own funds. Financial buffers become more important if the bank has less control over them due to such (increasingly transparent and short term) deductions. Instead of setting their own economic capital levels hopefully well above the binding solvency ratio, suddenly such supervisory capital buffers come into play, as the capital buffers start decreasing towards those minimum levels. A systemic side effect of procyclicality surfaced in the 2007-2013 subprime crisis. After three decades of Basel I type rules, the business of banks had started to show distinct similarities, called herding behaviour. This herding occurred both on the liabilities side (where do banks get their funding to do their business), and on the asset side on the assumed safety of government lending. If all banks have similar (large) components of their balance sheet on either their liabilities side or asset side, and the availability or the safety of that liability or asset dries up unexpectedly, all banks could suddenly be in trouble, even if (or because) each acts individually in a prudent manner by trying to shore up their balance sheets by quickly selling similar assets (e.g. the fire-sales of mortgage backed securities), or scrambling to secure funding from a more limited set of sources (e.g. when the securitisation markets dried up)204. If the models used for the capital requirements calculation predict a reduction in values across the board, all banks will start selling at the same time, when not enough buyers are available. This will automatically lead to the predicted reduced values. If all banks start to behave in a similar manner, this means that the data available from the past are no longer useful to predict future risk205, leading to fear and even lower prices (which again via fair value lead to lower available financial buffers for the now unpredictable future risk). All these trends reinforce each other, leading to a negative and ever speedier negative spiral (and in boom times into an artificial positive spiral). The downside of this collective behaviour that is stimulated by the growing together of business models in good times (and in crises) by either banks or their counterparties that is good individual but not good collectively should be addressed. The same applies to behaviour that is irrational even on an individual basis and disastrous on a collective basis. By way 204 Committee on the Global Financial System, The Role of Margin Requirements and Haircuts in Procyclicality, CGFS papers 36, March 2010, page 11, www.bis.org. 205 U. Nielsen, ‘Measuring and Regulating Extreme Risks’, Journal of Financial Regulation and Compliance, Vol. 17, No. 2, 2009, page 156-171.

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of example, the fear that others may think that a bank will become insolvent, thus leading to pre-emptive withdrawals by the ‘rational’ people who expect irrational behaviour elsewhere in the market, thus leading to a run on such banks, or by such banks on other banks206. If all banks are vulnerable in the same spot, this reduces the chance that one bank will be able to ‘help’ (e.g. make a loan or take over key businesses) the others. In this fashion, making each bank individually safer actually introduced a vulnerability in the banking system as a whole. This type of collective repercussions could be allocated to the macroprudential supervisor207. The models used in Basel II to calculate minimum capital buffers requirements, as well as fair value accounting have been singled out for their procyclical effect208, with attention also being paid to procyclical effects of credit default swaps (especially due to their all or nothing character – ‘jump to default risk’ – of a party either being in default or not, that makes credit default swaps an especially difficult derivative bet to risk manage)209. Supervisory requirements do have clear components that could have a procyclical effect. If losses mount, they impact available capital to cover capital requirements directly, stimulating hoarding behaviour by the banks. Banks, much like people, tend to stock up when bad times are expected to hit, and let the money roll in good times. The capital requirements that are the mainstay of the various Basel accords and European banking directives mostly reinforce the hoarding behaviour in recessions, also because they come into play only when a bank is troubled. In economic boom years, the minimum requirements set for prudential concerns are just that: minimum requirements. Banks in general will have a surfeit of capital at that time, as they set their own desired capital level when risk is low and capital is cheap. Even in such good times some unlucky individual bank may default either due to gross bad luck or due to gross incompetence somewhere in its organisation. In bad times, however, capital is scarce, and banks will operate close to or on the minimum requirements, because they have assets they cannot afford to sell at current values and they cannot afford/manage to attract new capital.

206 D.W. Diamond & P.H. Dybvig, ‘Bank Runs, Deposit Insurance, and Liquidity’, Journal of political Economy, Vol. 91, No. 3, June 1983, page 401-419, reprinted (edited) in Federal Reserve Bank of Minneapolis Quarterly Review, Vol. 24, No. 1, 2000, page 14-23. 207 See chapter 22.5 on the ESRB. See for the thinking behind a macro-systemic regulator e.g. C. Zhou, Why the Microprudential Regulation Fails? The Impact of Systemic Risks by Imposing a Capital Requirement, DNB Working Paper 256/2010, Amsterdam 2010. 208 R.S. Clarkson, ‘Actuarial Insights Into the Global Banking Catastrophe’, Journal of Financial Regulation and Compliance, Vol. 17, No. 4, 2009, p 381-397. E.A. Marseille, ‘Financial Crisis in Financial Reporting: Rush Hour for Financial Instruments’, Ondernemingsrecht, 2009, No. 14. 209 J.C. Kress, ‘Credit Default Swap Clearinghouses and Systemic Risk: Why Centralised Counterparties Must Have Access to Central Bank Liquidity’, Harvard Journal on Legislation, Vol. 48, No. 1, 2011; see chapter 22.4 on the measures contemplated to legislate credit default swaps.

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The main added procyclical effect of Basel II – as implemented in the CRD and applicable from 2008 to the banks – is the reliance on internal or external ratings of risk in the approach to credit risk210. This came on top of procyclical elements that were already part of Basel I, such as the reliance on accounting (including fair value accounting; see below), and increasing requirements for e.g. exposures that are in default. Though stress testing was supposed to be strengthened along with the reliance on ratings, this requirement was not stringent enough to compensate for over-optimistic ratings and valuations in boom times. In a recession, debtors are more likely to fail on their commitments to the bank. This likelihood by itself brings down the external ratings of the clients (used in the standardised approach to credit risk) or their internal ratings (used in the advanced approaches to credit risk). The reduced creditworthiness as reflected in the rating means higher capital requirements for credit risk. At the same time, the number of debtors that have actually failed increases too during a recession, leading to losses on the claims on those debtors or – in accounting and banking supervision speak – a reduction in the value of the asset. Those value reductions are deducted directly in full from the financial buffers (i.e. capital used to fulfil capital requirements). If it has used the assets as collateral for e.g. clearing and settlement, it will be called upon to provide more collateral (margin), potentially when the value adjustment is only expected, not yet realized211. At the same time, capital goes down and capital requirements go up, putting a squeeze on the room for manoeuvre of the bank, leading it to try to preserve capital. The bank either has to attract more capital (not easy and definitely not cheap in a recession) or stop some of the activities that require capital and deleverage. It can for example reduce lending or sell some assets, or claim quick repayment from debtors. All possible actions increase the pressure on the economy, especially if all banks are doing it simultaneously (which they will if the recession is feared to be big and continuing). This again leads to a reduction in the quality of the debtors, and then on from the beginning. The same is true on the way up, where it leads to a reduction of risk awareness, a glut in capital looking for a place to work, and lending/investing to or in those who should not be lent to (at least not against the risk premium available in a booming economy). At the same time the Basel II increased the cyclical sensitivity of the supervisory requirements, an additional procyclical issue was introduced through an existing open backdoor. The capital requirements calculations rely on accounting standards for valuation; see 210 FSB, Principles for Reducing Reliance on CRA Ratings, 27 October 2010. 211 Committee on the Global Financial System, The Role of Margin Requirements and Haircuts in Procyclicality, CGFS papers 36, March 2010, www.bis.org. Arguably, sequentially added charges by e.g. LCH.Clearnet in November 2010 for Irish sovereign bonds proved the last drops in the bucket before its overflowing forced such states to accept an international bailout by the EU and IMF at the end of that month.

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chapter 6.4. Where any value adjustment can already be deemed to be consistent with cyclical behaviour or even be procyclical, fair value accounting increased the fluctuations in the value of assets in line with the economic cycle. Too late loss provisioning for assets that are not subjected to fair value methods lead to cliff effects when the loss finally had to be taken. Though these two dampen each other out somewhat due to less capital needed to be held for assets of lower (market) value, they mostly reinforce each other due to higher losses that have to be deducted from available capital buffers. Other market forces that exacerbated procyclicality include asset bubbles, margin-calls, and interventions to limit market forces in an upswing212. What Can Be Done to Dampen Procyclicality? The Basel III amendment to the capital accord intends to dampen procyclicality. In an ideal world, it should even start to work in a countercyclical manner, dampening the normal cyclicality of the economy. As this would necessitate stimulating banks to save when times are good (and risk looks far far away), and keeping assets when their future true value looks shaky and there is pressure to sell them to maintain capital/leverage ratios, this would require some hefty incentives to go against the grain of the cycle. The work of macroprudential supervisors could also help dampen procyclicality, both in the design phase of regulation and in issuing warnings and – if available – using instruments to dampen swings in the cycle; see chapter 22.5. Existing experience with instruments that can be used for macroprudential purposes – including using microprudential instruments to limit or increase credit growth – does not raise hopes on the extent of the effect of such macroprudential interventions in the long term, especially when other public policy goals such as economic growth undermine the continued use of macroprudential and microprudential tools213. Basel III includes buffers that can be drawn down in a crisis, as well as specific countercyclical buffers. These envisage that a national authority will tell banks (and politicians and everyone else who depends on a growing economy) that they think there are signs that the economy is overheating, and that lending to governments, businesses and consumers should be restricted even though they like being lent to and banks are happy to do so214. To make this work, this is likely to require highly independent, crunchy individuals being

212 FSB, Macroprudential Policy Tools and Frameworks, Update to G20 Finance Ministers and Central Bank Governors, 14 February 2011. Also see chapter 22.5. J. Black, Restructuring Global and EU Financial Regulation: Capacities, Coordination and Learning, LSE Law Society and Economy WP 18/2010, page 13-14. 213 D. Elliot, G. Feldberg & A. Lehnert, The History of Cyclical Macroprudential Policy in the United States, WP 2013-29, 15 May 2013. 214 L.D. Wall, Prudential Discipline for Financial Firms: Micro, Macro, and Market Structures, Federal Reserve Bank of Atlanta WP 2010-9, March 2010.

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appointed for life to such an authority215. Chances are that this will not be the case in all member states nor in the countries the other members of the BCBS come from. The choice for the right indicator to determine the size of the countercyclical buffer is likely to be difficult, and equally likely to be wrongly applied, especially if e.g. a concrete prudential, stimulating or monetary goal will need to be balanced against a guess about the state of the cycle216. Once the current or latest crisis has faded away, someone crying wolf in an upturn is likely to be smothered, and regulatory forbearance applied with a thought to e.g. stimulate the economy or to keep a weakened institution on the right side of regulatory demands. The other buffers that can be drawn down in a crisis appear more likely to be effective, but do not of themselves have a countercyclical effect; see below. These new buffers are lightly based on the Spanish example of provisioning that worked well in the early years 20072013 subprime crisis. In addition to the add-ons to capital, the long term liquidity ratio proposals – if ever implemented despite resistance from the banking sector and several governments who are afraid to turn off the credit boom part of the cycle – might also have a dampening effect on the cycle217. For the period until the Basel III proposals are bedded down in CRD provisions and have become effective (i.e. not before 2014, and for most additional buffers well after 2016), the previous version of the Basel capital accord (after Basel II and Basel II½) as set down in the current CRD already contains two instruments that could meanwhile be used to address procyclicality. These are the pillar 2 instrument for requiring additional measures if the bank or the supervisor feels that not all risks are being covered, and the stress testing in the context of pillar 1 advanced models and in pillar 2 assessments218. Through the cycle stress testing, with elements of true systemic stresses, as introduced to some extent by the 215 A. Houben, R. Van der Molen & P. Wierts, ‘Making Macroprudential Policy Operational’, Banque central du Luxembourg, Revue de stabilité financière, 2012, page 21. C.A.E. Goodhart, The Macroprudential Authority: Powers, Scope and Accountability, LSE FMGPS Special Paper 203, October 2011, page 30-31. Also see chapter 22.5. 216 For instance BCBS, Guidance for National Authorities Operating the Countercyclical Capital Buffer, December 2010 refers to credit/GDP as an indicator, but simultaneously does not think it need be the dominant indicator. Also see M. Drehman, C. Borio, L. Gambacorta, G. Jimėnez, & C. Trucharte, Countercyclical Capital Buffers: Exploring Options, BIS Working Papers No. 317, July 2010; R. Repullo & J. Saurina, The Countercyclical Capital Buffer of Basel III: a Critical Assessment, CEPR Discussion Paper 8304, March 2011. Also see chapter 6.2 and 22.5. 217 M. Mink, Procyclical Bank Risk-taking and the Lender of Last Resort, DNB WP 301, July 2011. 218 See chapter 13.6 and 14 respectively. Another solution would be demanding that the banks use a higher probability of default (or estimation of loss given a default) but this would require a change in the CRD. Also see CEBS-EBA, Position Paper on a Countercyclical Capital Buffer, 17 July 2009, www.c-ebs.org; and P. Angelini, A. Enria, S. Neri, F. Panetta, & M. Quagliariello, Pro-cyclicality of Capital Regulations: Is It a Problem? How to Fix It?, Banca d’Italia Occasional Papers 74, October 2010.

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stressed VAR in market risk internal models and via the EBA stress tests help force banks to look beyond the one year or 10 day time horizons prescribed in solvency ratio calculations and incomplete data collections, and truly plan for bad times. Using either of the instruments would require the bank and its supervisor to go against the flow. In times of an economic boom, they would have to state that for this reason alone, there is a risk that the next recession (either 2 days or 2 decades away) is a risk that requires additional measures under pillar 2 and horrendous scenarios taken into account in the models used in pillar 1. They would need to agree that the data used to stress test the assumptions on the bank would include a severe and prolonged recession, with multiple failures and correlated losses in several sectors that established opinion would consider ultimately safe. Unsurprisingly, in the approach to the 2007-2013 subprime crisis, there was no such willingness, neither at the banks, the supervisors nor politically. The stress tests in the CRD were, to put it mildly, not very stressed; see chapter 13.6. There was considerable debate whether capital measures could be taken on the basis of pillar 2 for individual banks. Several supervisors indicated their reluctance, causing troubles for the level playing field for those who had a slightly higher inclination to force their banks to beef up instead of to leverage up. In the wake of the crisis, the Basel II accord (even though it had not yet been implemented in practice when the crisis started in 2007), the CRD instruments and the attitude of supervisors were criticised. Substantial efforts were undertaken to address procyclicality. There are, however, several structural problems: – For individual banks, procyclical behaviour makes solid sense. It is sound banking practice on an individual basis to buy assets of which prices are rising, and to expand in a booming market. Similarly, it is sound practice to sell assets of which prices are going down and to cut down lending and hoard liquidity when markets are going down. As banking supervision laws are designed around keeping an individual bank (or a specific banking group) safe, the requirements, instruments and attitudes of supervision promote this. The downside being that if all banks do this at the same time, a recession or an expansion becomes a self-fulfilling prophecy. This macro element will be addressed to some extent by the Basel III proposals on counter-cyclicality, as well as by the new macroprudential ESRB; see chapter 22.5. – Though the movement of growth or tightening is clear, and it is thus normally clear whether we are in a phase of expansion or tightening in a particular geographic location, this is normally not aligned across the globe or in different financial markets (with most larger banks operating and/or investing in both different financial markets and around the globe). Even though the current movement is known, nobody knows when either the growth will plateau or reverse, or where the tightening will plateau or reverse. How to make a single line requirement for a globally operating and diverse bank as is part of the countercyclical buffer, or even for a simple local savings bank that has

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investments in a diverse portfolio is quite difficult in those circumstances. If the bank, the supervisor or the politicians have it wrong, they have limited the bank too much or allowed it too much leeway. So-called early warning systems have been much demanded, but those come with a warning that results from the past offer no guarantees for the future. – Any capital/leverage ratios as set out in chapter 6.2 may be procyclical and internationally contagious when faced with large asset value losses219. A binding ratio (capital, solvency, leverage) between the assets and the available financial buffers can force a bank that suffers severe losses on some assets to sell other assets thus depressing prices of those assets, thus reducing the value of such assets held by other domestic and foreign institutions in ever more liberalized/international financial markets (see chapter 4.3), in a vicious circle of downward pressure on the value of financial assets and thus on the capital ratio/leverage ratio, and thus on values of their assets when they are sold under pressure of the ratios and so on. The countercyclical buffers may accommodate some of this, but if the Basel III leverage ratio is indeed introduced as a binding restraint, it might also require a countercyclical zone that can be drawn down. The same applies on the way up, where hunger for assets feeds into higher capital ratios for banks, and thus more room to buy assets, and so on. In the absence of a viable non-procyclical alternative quantitative indicator for the safety of banks, it is unlikely that the current ratios will be abandoned even if they can be procyclical however they are formulated. A full rewrite of the quantitative rules is not part of the CRD IV project. Like the revisions to the Basel Accord agreed by the BCBS in Basel III, procyclicality is addressed by finetuning some elements and an introduction of new elements. A reduction on the reliance on external ratings is requested, and independent thinking on the risk embodied in a loan promoted. This would reduce pro-cyclicality by making sure that the current risk is no longer reflected in risk requirements. This is worrisome as the requirements will no longer reflect risk sensitivity per client, except in as far as acknowledged – without objective external input – by the bank itself. The FSB has stimulated the reduction of the regulatory reliance on external ratings220. This is in line with e.g. the USA move under Frank-Dodd to force deletion from amongst others USA banking supervision rules. The standardised approach to credit risk and the approach to securitisations still heavily rely on such external ratings of credit risk. Until a good alternative is found to assess risk in a more reliable

219 See e.g. M.B. Devereux & J. Yetman, Leverage Constraints and the International Transmission of Shocks, Reserve Bank of Australia RDP 2009-08, December 2009, and R. Kollmann & Z. Enders, Global Banking and International Business Cycles, Federal Reserve Bank of Dallas, Globalisation and Monetary Policy Institute WP 72, January 2011. 220 FSB, Principles for Reducing Reliance on CRA Ratings, 27 October 2010.

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manner, it is unlikely that using the risk assessments by centralised rating agencies is fully deleted; also see chapter 8.1. Reducing reliance on external ratings is in general a good idea, were it not that there are no good alternatives. Internal ratings suffer from the same draw-backs (except possibly for the herd behaviour stimulated by public external ratings). Other good ideas are the introduction of provisioning through the cycle, and beefing up statutory stress tests within the models and across the sector. The above-mentioned countercyclical buffers (see chapter 6.2 and 7) are similarly a valid attempt, which theoretically will allow central banks or similar national bodies to set the capital requirement221 within a range depending on their assessment of the stage of the economic cycle we are in (requiring higher capital requirements and thus dampening growth in boom times, and reducing capital requirements and thus not stimulating tightening in recessions); see above on the structural problems in doing so effectively. Such attempts are both necessary and prone to fail222. As the howls of protest against e.g. discretionary, non-objective increase of capital levels are certain to come from the banks in the good times, and the howls of anguish and fear of investors and lenders to banks when those capital levels are reduced in recessions (as clearly the banks must be in even bigger problems than already known if capital levels are allowed to be drawn down in anticipation), no clear path out of the regulatory and non-regulatory procyclicality discussion has so far been presented. That the counter-cyclical buffers can actually be drawn down (and can continue to be down for the duration of a crisis) is highly questionable. The EBA stress tests that required higher and higher quality financial buffers in the midst of a financial crisis to show the markets that the larger EU banks can be trusted are a case in point; see chapter 6.2 and 13.6. The markets may refuse to fund those banks that actually draw down such buffers in a recession223. Apart from such hopefully flexible regulatory requirements during future crises, and the hope that markets will not demand (or banks maintain) higher capital buffers with the same procyclical effect, the most concrete improvement has been the creation of the ESRB with its macroprudential mandate. Sadly, it lacks any substantive powers except to publicly issue warnings; see chapter 2 and 22.5.

221 Such tightening can of course be fudged from public view by changing not the frontline 8% requirement, but the percentages allocated to the specific risk profile of specific assets or their probabilities of default further down the calculation, as implicitly suggested by CEBS-EBA in its position paper on a countercyclical capital buffer, 17 July 2009, www.c-ebs.org, page 3. 222 Heid, Frank, Krüger, Do Capital Buffers Mitigate Volatility of Bank Lending? A Simulation Study, Deutsche Bundesbank Discussion Paper, Series 2 Banking and Financial Studies No. 03/2011. 223 S.G. Hanson, A.K. Kashyap & J.C. Stein, A Macroprudential Approach to Financial Regulation, Chicago Booth WP 10-29 (Initiative on Global Markets Working Paper 58), November 2010.

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Literature – Crockett, Andrew, Market discipline and financial stability, speech 23 May 2001, London – Angelini, Paolo; Enria, Andrea; Neri, Stefano; Panetta, Fabio; Quagliariello, Mario, Pro-cyclicality of Capital Regulations: Is it a Problem? How to Fix it?, Banca d’Italia occasional papers 74, October 2010 – Benink, Harald; Daníelsson, Jón; Jónsson, Ásgeir, On the Role of Regulatory Banking Capital, Financial Markets, Institutions & Instruments, vol. 17, no 1, February 2008 – UK Financial Services Authority, A regulatory response to the global banking crisis; discussion paper 09/2, March 2009

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7.1

Introduction to CRD Financial Buffers

Introduction Banks are required to have financial buffers. Not only do its clients expect the bank to be a safe haven for their money, but under solvency ratio, financial buffers of specific quality types are required, calculated in relation to the risk the bank runs, in addition to sufficient capital for company law and licensing requirements; see chapter 6.2. Due to the work of the BCBS, the basic formula of the solvency ratio has been rolled out in a reasonably harmonised fashion across the globe, including in the EU. Subject to the availability of financial buffers of at least the amount required for its calculated risk, the bank is allowed to attract money from other companies and from consumers, and to subsequently use that money for its own account by lending or investing it. This chapter 7.1 introduces the concept of financial buffers, its history and why it has been the weakest link of the solvency ratio during its existence. Chapter 7.2 presents the five different types of definitions that are used or referred to in the CRD of which one is relevant for public accounts and company law, two are relevant for market access provisions and two for the solvency ratio. Chapter 7.3 presents the way different quality levels of buffers can be used to cover the solvency ratio. The financial buffers aim to ensure that – even if losses are made from such onwards lending or investment – the money attracted from depositors and regular bondholders can still be repaid. This means such buffers need to have two characteristics: the buffers need to be of sufficient size, and of sufficient quality. High quality buffers are e.g. riskbearing funds made available by shareholders or partners, and retained profits. If there is not sufficient money to pay both the creditors and shareholders back, the shareholders claim is reduced. Only if their claim has been fully written down do the ‘normal’ creditors face losses on their claims. Financial buffers consist of the type of instruments on the liabilities side of the balance sheet that are available to absorb unanticipated losses, preferably on a going-concern basis. The availability of loss absorbing financial buffers was the high level goal of the BCBS capital accords1. In practice, however, the capital accord, the CRD and the wide range of national discretions in both sets of documents allowed other

1

BCBS Revised Framework 2006, page 4.

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instruments to be recognised as financial buffers. Shareholders are risk investors under company law/bankruptcy laws. The capital adequacy requirements increase (and speed up) that risk by forcing a bank into bankruptcy when it still has a decent amount of financial buffers, just to be as certain as possible that unanticipated losses do not impact on the position of normal unsecured creditors, including small depositors; see chapter 6.2 and 18. Smart risk investors are not willing to provide such first loss positions unless they are rewarded for it, or are buffered for losses in other ways. This makes equity for banks rather expensive as the premium for that risk needs to be substantial (either in substantial dividends or share price rises). The attempt to reduce those costs lead to a search for other financial buffer components that are cheaper but still provide safety – a buffer – for ‘normal’ creditors. Subordinated loans and hybrids – e.g. loans that have some characteristics of shares – were accepted into the financial buffer definition for prudential purposes, such as the solvency ratio. However, the 2007-2013 subprime crisis showed undeniably that some of these other components did not serve as an actual financial buffer in a liquidation, let alone on a going-concern basis2. The intended goal was not achieved, leading to a reassessment of several financial buffer components. The prudential preference to have financial buffers in place to protect depositors and other unsecured creditors of the bank both during the lifetime of a bank and in its bankruptcy – even if not fully achieved in Basel or the CRD – has several implications: – Capital is an instrument that absorbs loss to the benefit of otherwise unsecured creditors (e.g. depositors); – Capital is valued assuming the bank is still a going concern (i.e. the assets have the value they would have for an operating bank, not at fire-sale prices); – Anticipated losses have to be taken fully in the balance sheet (and thus deducted from available financial buffers) before determining how much is needed to protect against unanticipated losses; – Holders of financial buffer instruments (e.g. shareholders, subordinated lenders) are not protected by banking supervision. On the contrary, such holders of financial buffer instrument are deemed to provide protection to normal creditors. Banking supervision intends to ensure that they will be wiped out via a bankruptcy or other government intervention at a point in time when there are still sufficient buffers to ensure full repayment to such normal creditors3.

2 3

See e.g. UK FSA, A Regulatory Response to the Global Banking Crisis; Discussion Paper 09/2, March 2009, page 68-70. The advent of consolidated supervision over solo supervision does, however, mean that a sole shareholder that is a licensed bank itself is treated differently in practice than a non-banking shareholder or shareholders in a listed bank; see chapter 5 and 17.

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The items of financial buffers that are recognised in a particular – and particularly wide – definition of own funds contained in the CRD form the numerator for the calculation of the solvency ratio. The original numerator was simple. For credit risk it in principle requested high quality capital like issued and fully paid up shares, but a second category of e.g. long term subordinated debt was accepted as long as it covered only part of the requirement. With the introduction of market risk into the solvency ratio and the development of innovative hybrids, the picture has become even more muddled. In the CRD as valid before and during the 2007-2013 subprime crisis separate capital (financial buffer) requirements are calculated for different types of risk (credit, market and operational risk), which can be covered by three basic quality levels of buffers, with further subdivisions in each quality level; see below under ‘the weakest link’. Though the desirability of high quality financial buffers is the starting point, the BCBS (and the CRD) accept lower quality financial buffers, such as subordinated loans. Subordination works only in a liquidation setting, not in going concern (at least until bail-in provisions become applicable, which are extremely rare at the moment). Subordinated lenders only get a pay out if all higher-ranking creditors are fully compensated out of the estate of the failed bank. These lower quality buffers can supplement – up to certain limits – high quality financial buffers, such as issued and fully paid up shares4. In the Basel III accord, to be implemented in the EU via the CRD IV project in 2014, the number of lower quality financial buffers types is slightly reduced, and the definition of their (high quality) characteristics slightly enhanced, with some further improvements on the overall quality of financial buffers made during the decades long transitional period. The percentages of the solvency ratio that are covered by financial buffer that must conform to the highest set of quality requirements formulated is gradually increased; see chapter 6.2. Basel III also makes explicit that such financial buffers are useful in a going concern situation (common equity tier 1, and to a lesser extent other tier 1 capital), while some other financial buffers only help normal creditors in a liquidation or gone concern scenario (tier 2 capital). The lowest quality (tier 3; see chapter 7.3) will be phased out. See below under Basel III/CRD IV. The gradual enhancement is the result of a compromise between on the one hand improving the safety of the banking system, and on the other hand the certain bankruptcy of many banks if new harsh requirements had been abruptly implemented in 2010/2011. The expected detrimental effect of a reduction in lending capacity of the surviving banks if they would need to reduce their leverage too much too quickly (a so-called ‘credit crunch’) was a factor mitigating a harsh approach.

4

See the notes on tiering in chapter 7.3. The acceptance of low quality financial buffers did not lead to a calculation of available buffers on the basis of liquidation valuation.

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Capital Deduction of Assets Versus Risk Weighting of Assets Assets generally are risk weighted in the CRD before being added via the credit risk or market risk calculation to the denominator of the solvency ratio. In the standardised approach to credit risk, they would most likely be risk weighted at between 0% and 150%, and in exceptional cases 1250%5. The benchmark 100% risk weighting is used extensively in the standardised approach, and used for e.g. loans to public sector entities and for loans secured by non-first residence mortgages. However, under both the CRD and the Basel capital accord, some asset classes are not multiplied by a risk factor, but instead deducted in full from capital; the numerator. If deducted, they do not longer need to be risk weighted6. Deduction (or 1250% risk weighting, which effectively has the same result in the CRD) of the value of an asset is thus a relatively rare alternative treatment, but a harsh one indeed. The 1250% risk weighting will likely become the preferred route under the CRD IV project due to the changes in the treatment of deductions; see chapter 7.2. A full deduction of certain participations and subsidiaries both from the capital side and the (risk weighted) assets side of the balance sheet excludes those companies, such as noncontrolled subsidiaries and some financial subsidiaries that have a different type of risk profile, from the banking prudential requirements, treating them as standalone entities or simple investments. Instead of risk weighting the assets of an insurance subsidiary, the preferred option is a deduction of the interest in the insurer. For such interests in the insurance sector (and vice versa) the financial conglomerates directive adds a layer of supplementary supervision to avoid negative consequences of the relation and the standalone treatment; see chapter 17.The deduction or non-deduction of insurance subsidiaries was ambiguous in the CRD, allowing consolidation and risk weighting the assets instead of deduction interest, which treatment will be codified in the CRR; see chapter 7.2. Risk Requirements or Prohibitions? Some risks are deemed not to be inherent to the business of banks, and are forbidden. This takes the form of limitations on activities, such as the prohibition – with exemptions – to have non-financial subsidiaries (see chapter 11.3). Though the exact reasoning is not clear for this prohibition and there are ways to work around it via for instance holding structures, it can be assumed that the drafters of this prohibition deemed it likely that normal commercial businesses and financial businesses should not be intermingled, as the risk of the

5

6

Zero % risk weighted assets having a zero capital requirement for credit risk and 1250% assets have a risk weighting equivalent to its full nominal value (equivalent to a deduction from own funds). The majority of assets are risk weighted at 100% for credit risk, which will require 8 euro of capital for 100 euro of loans to e.g. commercial companies without an external rating. In the internal model approaches the bank can – within certain parameters – use its own risk weightings. See chapter 8. Art. 90 CRR.

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commercial business could easily infect the financial business, and lending or investment decisions in commercial business should be made at arms’ length to ensure good risk management. Similar, but not absolute, prohibitions are: – the prohibition to have large exposures (see chapter 11.2); – the possibility for member states to limit their own banks to their own territory within the EU (under certain conditions) and to the EU (preventing them from activities they do not know how to handle or to finance, or where they will have no trustworthy control), see chapter 5; – the possibility for member states to limit their own banks as to the types of financial activities they have a license for (see chapter 5.2). The Numerator of the Solvency Ratio: the Weakest Link The 2007-2013 subprime crisis resulted in a slew of initiatives in the area of the definition of capital, and the associated solvency ratio (see below under Basel III/CRD IV). This work was well overdue. Until 2009, no material improvements had been made to the definition of capital since the Basel I accord of 1988. The basic understanding on the definition of capital as laid down in the Basel Accord was both loose and antiquated. The definition is riddled with national discretions to accommodate pre-existing local practices7. There had been no conceptual follow-up to tighten the basic concepts of the BCBS or CRD provisions since the 1988 Basel capital accord was agreed and codified in the predecessor directives of the CRD. On the contrary, the definition was loosened on two occasions: for the market risk addendum and its tier 3 ‘capital’, and for the treatment of hybrids (debt with some equity characteristics) in the so-called Sydney press release and the later CRD II directive. The market risk amendment accepted that some very low-grade liabilities were allowed to partially cover market risk capital requirements. Low quality financial buffers were the norm in some key countries for such requirements on securities firms. The desire to expand and harmonise market risk requirements across banks and investment firms worldwide clashed with the desire not to rock the boat by pushing a whole range of investment firms (and investment focused banks) out of business. The expansion of the Basel-definition of capital was an attempt to reach consensus between the BCBS and the international organisation of securities commissions (IOSCO)8. Additional requirements for market risk could be introduced provided that some low quality capital-categories could be used

7 8

E.g. the deferred tax assets and silent partnerships mentioned in Commission, CRD IV – frequently asked questions, 20 July 2011, memo/11/527. C. Goodhart, The Basel Committee on Banking Supervision, a History of the Early Years 1974-1997, Cambridge, 2011, chapter 7 and 13C.

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EU Banking Supervision to provide the required additional buffers9. Short term subordinated loans became a new ‘tier 3’ of low ranking capital components, specifically to cover the additional requirements on market risk where both banks and non-bank securities firms would need a level playing field (see chapter 7.3 and 9). Tier 3 capital was formally introduced in the EU in the predecessor directive of the RCAD in 1993. The Sydney press release attempted to deliver some high level consensus in an area of irreconcilable differences. The inclusion of hybrid instruments into the concept of high quality financial buffers divided the supervisory community, but the press release tried to define its outer boundaries10. In some countries such hybrids were common, and even encouraged as a relatively cheap source of capital. The text of the CRD with its wide range of national discretions provided ample leeway for each member state to accept – if it wanted to – hybrid capital instruments. Hybrids are bonds that have some characteristics of shares. Such characteristics may include subordination, undated or perpetual timelines for repayment, and/or yields that are not paid if losses are made. Regular shares are relatively expensive for banks to issue, as shareholders want a return (either in value-appreciation or dividend) that is commensurate to the risk of investing in banking (i.e. high). Bondholders require a lower yield, with only a relatively modest add-on if it concerns subordinated or convertible bonds. In the design of these new instruments, banks got the better of two worlds by tweaking the conditions of the bonds. They were designed so that they just satisfied the conditions regulators have made to make them more similar to shares, while giving the future bondholders the feeling that they will be repaid as if they are regular bondholders. Such carefully designed hybrids resulted in instrument that need a relative low yield but can still be used to bulk up the required capital. Prior to the Sydney press release, there was no harmonisation at all of the approach of supervisors to hybrids, neither worldwide nor in the EU. The harmonisation brought by such a communication was nonetheless limited. EU member states took the press release into account in the manner they personally wanted to interpret it (within the loose boundaries of the RBD). Immediately after the press release, there was a mild form of harmonisation, but practices started to deviate more and more between more permissive regimes and more strict regimes. The deviations within the EU were inventoried by CEBS-EBA11. Some member states allowed ‘only’ 15% of original own funds to be covered by hybrids, others up to 50%. CEBS-EBA 9

C.A.E. Goodhart, The Basel Committee on Banking Supervision, A History of the Early Years 1974-1977, Cambridge, 2011, chapter 7 and 13C mention both the continuous involvement of banking groups in the development of the market risk amendment, and – specifically on tier 3 – the less than harmonious negotiations with IOSCO (the securities counterpart of the BCBS). 10 ‘Instruments eligible for inclusion in tier 1’, press release of dated 27 October 1998 of the BCBS. http://www.bis.org/press/p981027.htm and BCBS, International Convergence of Capital Measurement and Capital Standards: A Revised Framework, June 2006 page 4. 11 CEBS, Quantitative Survey on Hybrid Capital Instruments, 13 March 2007.

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managed to reach a common position on maximum amounts of specific types of hybrids, and advised the Commission in 2008 to adopt the newfound consensus into the CRD12. The advice on hybrids was taken on board in the CRD II directive, which also contained some initial band-aids to the crisis; see chapter 2. The consensus on how subsequently to treat hybrids within the context of the Sydney press release and the CRD II texts was also developed by CEBS-EBA, finding a mid-way between the practices of the member states13. The supervisory work on quality demands on hybrids and other going concern financial buffers was tightened (see below under Basel III/CRD IV) when it turned out during the crisis that hybrid loans in practice acted as loans (under pressure of the large market players that invested in such hybrids). They turned out not to be loss absorbent, or at least much less than previously assumed. Banks that wanted to be able to attract more funds via capital or hybrids or bonds, did not want to ‘default’ on expectations in the market of full payback, even if the terms of the hybrid instruments legal documentation did not bind the bank to such a payback. Like all previous EU work on capital, the CRD II amendment contains a lot of words and little actual improvement. It inserted references to hybrids into the actual text of the CRD. This codifies and accepts a weakening practice. The inclusion of several long ‘new’ articles in the CRD II directive – probably to make it appear as if something was being done in the area of financial buffers to handle the outbreak of the financial crisis – nonetheless had as their only new aspect that hybrids are now accepted. The closing off of one wide national discretion was not accompanied by the closing off of other even wider national discretions14. However, in an open invitation to banks to cook the books, the CRD II directive of 2009 allows any item acknowledged locally as own funds and issued prior to 31 December 2010 to be counted as own funds until 2040(!), with some limitations from 202015. The limited changes combined with the long, long, long implementation period, made the CRD II effort on financial buffers hand twirling posing as actually doing something. For instance, the CRD II considerations restate the desirability that member states should not count other items than those mentioned in the directive towards own funds. At first sight, the CRD II provision bravely states that it should no longer be possible for a member state to create or maintain its own regime on what kind of liabilities or assets (such as deferred tax) could be counted to increase the amount of available own funds16. However, these CRD II provisions only restate a previously unenforced limitation of exactly the same 12 Also see under ‘tiers’. See CEBS/EBA Advice ‘Proposal for a Common EU Definition of Tier 1 Hybrids’ of March 2008. 13 CEBS-EBA Implementation Guidelines For Hybrid Capital Instruments, 2009, as applicable since end 2010. 14 CRD II 2009/111/EC deleted art. 61 first paragraph, but kept art. 63 RBD. 15 Art. 154.9 RBD. 16 Reformulation of art. 61 first paragraph CRD by art. 1.8 CRD II Directive 2009/111/EC. CEBS-EBA implementation guidelines regarding instruments referred to in art. 57(a) of directive 2006/48/EC recast, 2010.

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content, leaving the much wider discretions to define what the various items mentioned actually mean. It equally continues to accept the possibility to include any other items into domestic own funds concepts if they fulfil some rather loose criteria that are in line with the previously formulated prudential filters and existing national practice17. When the 2007-2013 subprime crisis continued past 2008/2009, more substantial was undertaken. Regime from 2014-2019 (Basel III/CRD IV) The Basel III amendment may potentially result in a more strict definition of financial buffers if the conditions it imposes are equally strictly applied. In the follow-up to the 2007-2013 subprime crisis, the BCBS has been given a mandate by the national governments of the G20 and the financial stability board to work on the definition and strength of the capital/own funds requirements. The work gained momentum by the fact that some balance sheet items turned out not to have any usefulness as a financial buffer against losses, such as most loans that posed as equity style financial buffers. The failure to act as financial buffers in practice and the public outcry against bank bailouts provided political impetus for a chance of an improved CRD financial buffer definition. Nonetheless, a balance is always needed between safety, economic growth, and the profitability of banks and their willingness to fund the economy. The Basel III amendment to the capital accord of end 2010 contains some key provisions on tightening the definition of capital (and some of its components), and has been endorsed by the G20 heads of state. The EU Commission – heavily involved in the Basel negotiations – announced its support for Basel III, and indicated that has copied most of the Basel III elements on the definition of capital into its proposals for the CRD IV project; see chapter 2. Though correctly criticised for not being fully compliant by the BCBS, the CRR and the CRD IV directive do contain higher quality demands on the financial buffers18. They also demand the relatively highest quality for the additional buffers and relatively more for the solvency ratio itself; see chapter 6.2. The new rules are sketched in chapter 7.3 as they have the biggest impact on the quality levels (tiers) of financial buffers that can be used. This development is groundbreaking. Since 1988 the quantitative risk categories for which capital needs to be held have developed from a very basic calculation on credit risk to the current framework of major and minor risk categories with several options to calculate 17 Art. 61 RBD already contained such a provision on the maximum number of items in the own funds concept. The reformulation retains the delegation to member states to define how each item may be used. Also see the simultaneously expanded national discretion of art. 63.2 RBD. The prudential filters – that apply to reclassified debt instruments – are beneficial to banks using either hybrids and for instruments issued by mutuals; see chapter 6.4. 18 BCBS, Basel III regulatory consistency assessment (level 2), preliminary report European Union, October 2012.

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them; see chapter 6.2, 6.3 and 8-11. The further harmonisation of the financial buffers has however been a political no-go zone. Various good reasons can be put forth for this. These include the Japanese financial crisis of the 90’s, the low capitalisation ratios of smaller banks in continental Europe and the ‘free markets’ approach in Anglo-Saxon minded countries. No matter the reason, in the end it meant that for 30 years no viable progress has been made to tighten up the calculation of the capital buffers that underpin the solvency ratio. The political willingness of the various negotiating countries changed due to the severe crisis of confidence in capital buffers. The market was (no doubt temporarily while the crisis lasts) demanding the highest quality of capital buffers, which allowed/forced supervisors to work in this direction. The new definitions will be very gradually phased in from 201419. All existing capital will be grandfathered as a transitional measure, meaning that it will continue to be accepted as financial buffers if it was issued before the new proposals were made public. This reflects standing practice on decades long implementation terms for tightening of capital definitions of the CRD II directive (running from 2010 up to 2040)20. The BCBS and the Commission proposed different dates for this publication, however21. For tier 1, the BCBS proposed 12 September 2010, when the content of its thinking on the quality demanded was made public in a press release. For tier 2 capital the BCBS was more generous than for tier 1, taking its base for the transitional requirement form the amount issued before 2013 (especially beneficial for mutuals with unpaid commitments from members; see chapter 17.6). The Commission instead proposed taking the preceding day (so year-end 2012) for tier 2, but is more generous for common equity tier 1 capital. In a gift to the banks and a petty stab at the BCBS – where it fully participated in the negotiations – it indicates that it was not certain that Basel III would be applicable in the EU until it had formally adopted that position. As a result, it does not take on the 2010 cut-off date, but proposed to accept any instruments issued before 20 July 2011, including old paid up capital with the easy conditions. This helps the EU banks that issued low quality financial buffers during the worsening crisis circumstances of 2010/2011, but as a strong and purposeful defender of a solid financial system it makes the EU appear less than convincing. The negotiations on the CRD IV project further reduced quality demands for state aid instruments to those issued before end 2013 (allowing member states to bail out their banks with low grade buffers posing as highest grade buffers), and negotiated a further extension of the cut-off date. The grandfathered financial buffers will continue to count as common equity tier 1 and tier 2 until end 2017 if they were granted in the form of state aid to banks before 19 Art. 465-501 CRR contain a wide range of delays for quality conditions and the level of quality required in art. 25-101 CRR. 20 Art. 154.8 and 154.9 RBD, as added by art. 1.37 CRD II Directive 2009/111/EC. 21 §94-96 Basel III and art. 483-501 CRR.

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1 January 2014, and until 2021 if they were non-state aid instruments issued before 31 December 201122. While these relatively relaxed grandfathering clauses are being proposed and further mitigated, EBA had been stress-testing banks – to calm the financial markets – twice in 2011. In spite of the amendments to CRD-capital definitions still remaining at the proposal stage in the legislative process at the time, it has been using strict definitions to see what type of financial buffers can be used to cover the stress-tested scenarios. In the second exercise, it even was allowed to include write-downs on (illegally but politically very important, see chapter 8.1) zero risk weighted government bonds in its stress-test scenarios. It is likely that larger banks – in spite of the leisurely pace set out in Basel III and in the CRD IV project – will need to meet common equity tier 1 requirements faster, even though some components of e.g. tier 2 will no doubt remain less than firm. The prudential filters (i.e. deviations from accountancy standards) on securitisations, on own funds and value adjustment, and on unrealised gains have been introduced or codified in the CRD IV project; see above on the deductions made from financial buffers and chapter 6.4. Literature – Norton, Joseph, Devising International Bank Supervision Standards, Graham & Trotman Ltd, 1995, chapter 1 – Goodhart, Charles A.E., The Basel Committee on Banking Supervision, A History of the Early Years 1974-1997, Cambridge University Press, Cambridge, 2011, chapter 6 and 7 – Pecchioli, R.M., Prudential Supervision in Banking, OECD, 1987, chapter VI

7.2

Five CRD-Definitions – One Numerator

Introduction The CRD contains five different concepts for ‘capital’ and ‘own funds’ for banks. These definitions enjoy a relationship that is not always clear. Initial capital and endowment capital are concepts used in setting up a bank respectively a branch of a bank in another country (see chapter 5.2 and 5.3). It relates to the required financial buffer in absolute numbers used both at the time of authorisation/notification and subsequently during the lifespan of the activities under the license. Original own funds, own funds and capital (the 22 See art. 483 CRR for such instruments if they were part of a state aid package; art. 484 CRR for non-state aid instruments.

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latter is used in various meanings) are not linked to the license requirements but used in the calculation of the solvency ratio (see chapter 6.2). They serve as its numerator in various settings. These concepts do not require a bank to hold a certain absolute number in financial buffers, but to hold an amount of financial buffers that floats in relationship to the calculation of the risk faced by the bank. If the risk increases or decreases, the amount required increases or decreases too. The maximum amount required is unlimited, but always related to the risks faced by the bank. Theoretically, this is the same for the minimum requirement demanded by the solvency ratio. Assuming there are no assets or only zero risk weighted assets, the solvency ratio itself results in a zero requirement for those assets. The absolute number required under the initial capital requirement, however, provides a backstop of 5 million euro. In order of descending conservatism, the different own fund-concepts defined in the CRD are ranked as follows: – capital concept in e.g. accounting or company law with some additional CRD requirements on being fully paid up and loss absorbing; – initial capital for a bank; – endowment capital for bank branches; – original own funds; – own funds. Initial capital and original own funds are relatively conservative concepts. They relate closely to the core elements of loss absorbing financial buffers. Endowment capital can also be, but as it refers to branches it is in practice owned by the foreign legal entity of which the bank is part, and thus provides less local safety than e.g. initial capital. Own funds and capital as used in banking legislation include several items that would not generally be assumed to be ‘capital’ in e.g. accounting or company law. It includes some additions and deductions related to providing safety to depositors (not necessarily to all holders of the banks debt) and for situations where capital may not be depended on for the creditors of the bank itself in a going concern situation. In addition to the above-mentioned defined concepts, the term ‘capital’ is also used throughout the CRD, sometimes in the context of ‘internal capital’. Within the scope of the RBD there is no definition of ‘capital’. The RBD uses it freely in widely differing meanings; e.g. as a generic term to refer to the outcome of the solvency ratio requirements or to the total amount available to serve as the numerator of that ratio. It also uses ‘capital’ as synonymous to fully paid up shares and share premium accounts, by a reference to the accounts of banks directive and by references to shares held in the ‘capital’ of other com-

385

EU Banking Supervision panies23. Even in the RBD, however, the term is most often used in the context of capital requirements, roughly referring to the entire set of financial buffers allowed and needed to cover the solvency ratio. RCAD contains a definition, that is however only applicable within the boundaries of the RCAD; i.e. to market risk financial buffers. In it, ‘capital’ means ‘own funds’24. As such, the word ‘capital’ could have been deleted from the RCAD, and replaced by own funds25. The term internal capital is most prominently used in the pillar 2 context, where it refers to the amount of capital the bank itself thinks it needs, instead of the pillar 1 minimum requirements in the form of the solvency ratio26. As these 5 (or 6) concepts used in the CRD have different meanings and are colloquially used as if they were equivalents (which they are not; see below for the definitions), in this book the term ‘financial buffer’ is used as a general concept covering them all, while using the specific term only when the exact term as defined in the CRD is used. The BCBS revised framework presents the same diversity in capital concepts in relation to the risk a bank runs in a different way. Instead of re-defining capital, the Basel accord subdivides the general concept into three tiers according to the quality of the components of capital that can be used as financial buffers. The content of the tiers is similar to the concepts used in the CRD. So is the acknowledgement that some of the lower quality balance sheet items can be deemed financial buffers, but that their use should be limited. In this chapter the relation between the definitions is demonstrated, by defining each in relationship to the balance sheet items that have to be taken into account according to the CRD. The next chapter 7.3 sets out the maximum use that can be made of the lower quality components under the CRD in relation to the other ‘capital’ concepts used. This is commonly referred to as tiering, in line with the Basel terminology rather than the cumbersome – but more clearly defined and binding – EU definitions. Both the current version of the CRD provisions on capital and own funds – as well as the equivalent Basel capital accord provisions up to and including the Basel II ½ amendment – are riddled with national discretions. See chapter 7.1 on the discretions on the content and use of the components of the financial buffers described below27. This adds to the already understandable misunderstandings inherent in the use of five different concepts for basically the same need to provide financial buffers, and the complex relationships between them. 23 Art. 4.10 and 4.11, 19, 21, 57 sub a, 133 RBD and art. 22 ABD, Directive 86/635/EEC. The term ‘capital requirements’ is used throughout the RBD, and the term capital is used as synonymous with own funds in e.g. art. 101, 123 and 132 RBD. 24 Art. 3(s) RCAD. Art. 3(r) equates own funds under RCAD with own funds under RBD. 25 This would avoid the confusion with the Company law/accounting definition of capital. 26 Art. 123 RBD; see chapter 14.2. 27 Also see art. 61.1 and 63.2 RBD, as further expanded or maintained by art. 1.8-1.9 CRD II Directive 2009/111/EC.

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7

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Many BCBS and EU countries have freely used the discretions to facilitate the peculiarities of their national banking system, making even the comparability per concept across borders within the EU and with third countries dubious. The harmonisation drive on accounting issues via IFRS (see chapter 6.4) has injected some consistency into basic concepts such as equity and goodwill, which are also used in the prudential legislation, but to a limited extent only. Banking law and supervisors have retained (national and EU wide) deviations from the accounting concept. The impact of further harmonisation of the capital and own funds definition on national banking systems could be potentially huge (see ‘the weakest link’ in chapter 7.1). As financial buffers provide the numerator in the solvency ratio calculation, it limits the amount of risk a bank can assume. If more components are in the capital definition, the bank can assume more risk and lend/invest more freely. If the outcome of the solvency ratio calculation has to be 10% instead of 8%, the bank has to limit the amount of risk it has on its books. The bank can lend more at cheaper rates if the definition of capital or the solvency ratio between risk and capital is not too stringent, benefiting economic growth and avoiding a credit crunch. At the same time, a more stringent capital definition or solvency ratio makes the bank safer, as the same risk subsequently leads to a higher financial buffer requirement. As the buffers can be drawn down if risks materialise, the external providers of such buffers (shareholders, long term subordinated lenders) demand a higher reward in the form of interest, dividends or increases in the value than providers of funds that do not have such financial buffer purposes. This demand for reward in line with the risk taken makes the highest quality of financial buffers the most expensive for banks to have. CRD-financial Buffers and the Balance Sheet Approach to Own Funds Simply put, the protected creditors (e.g. depositors, non-subordinated bondholders, trade creditors) are ‘protected’ by holders of risk-bearing instrument issued by banks, as well as by any surplus reserves in the balance sheet of the bank. The loss absorbing liabilities (shares, some types of subordinated loans, other loss absorbing instruments) melt away in a going concern or at the point of bankruptcy if the value of the assets declines. If there are limited losses, only the highest quality risk absorbing capital (shares and reserves) suffer and are wiped out without any losses to the unsecured creditors who are the beneficiaries of prudential banking supervision28. See for example the first balance sheet below. In the second example, where the unanticipated losses were very high, the loss absorbing elements are all used up. Only in that case, the creditors suffer losses as the available assets

28 Please note that the depositor guarantee directive protects a more limited set of creditors. See chapter 4.3 and18.5 on the current and future limits to this protection.

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will no longer cover the protected liabilities. First the low ranking creditors will suffer (the holders of the subordinated loans) and then the creditors of equal rank will suffer in equal amounts. A ‘normal’ company will enter a bankruptcy scenario likely only if the company has run out of cash, unless existing or new shareholders inject cash and capital. Both the initial capital requirement and the solvency ratio put the moment of bankruptcy for banks forward to a different time. If a bank runs out of cash, it will definitely go bankrupt unless saved, but even if the bank still has the cash to pay any creditor that claims repayment on debts that are due, to avoid bankruptcy it will still need to raise new capital if it breaches either initial (and ongoing) minimum financial buffer of 5 million euro, or the solvency ratio that asks for buffers for unexpected losses in relation to the risk of such losses arising in its assets. For a bakery or car-producer, eating through its minimum capital or potential future losses may lead to an internal or corporate governance issue with its non-executives and shareholders, but not yet to a liquidation scenario. Table 7.1 Start balance sheet Assets

Liabilities

Cash

5

Equity

5

loans to banks

5

Reserves

2

loans to customers

20

subordinated loans

3

Investments

20

debts to banks

30

Property

19

debts to customers

30

Goodwill

1

Total

70

70

Table 7.2 Example 1: a loss of 7 in the value of investment assets Assets

Liabilities

Cash

5

equity -5

0

loans to banks

5

reserves – 2

0

loans to customers

20

subordinated loans

3

investments -7

13

debts to banks

30

Property

19

debts to customers

30

Goodwill

1

Total

63

388

63

7

Quantitative Requirements – Capital and own Funds

Table 7.3 Example 2: a loss of 20 on loans and on investments Assets

Liabilities

Cash

5

equity -5

0

loans to banks

5

reserves – 2

0

loans to customers – 10

10

subordinated loans -3

0

investments -10

10

debts to banks -5

25

Property

19

debts to customers -5

25

Goodwill

1

Total

50

50

In a bank, the risk has thus been allocated fully to the providers of financial buffers, before the rights of those who lend money to the bank are impinged. Many other companies can gamble with the funds they owe others (unpaid bills, money raised via bonds) up to the moment – when they run out of cash – that potential losses not only wipe out shareholders, but also these creditors. The resulting higher protection for creditors by failing the bank when its risk-bearing capital will absorb all potential losses balances the fact that banks are the only enterprises that are allowed to raise nominally owed cash not only by bond issues under a prospectus (or by not paying the bills), but also by asking for peoples savings; see chapter 4.4 and 5.6. Company Own Funds are not CRD Own Funds The own funds concept as used by the public and in company/accountancy laws is quite limited. It relates to equity and disclosed retained profits. The CRD and the Basel capital accord accept a much wider range of financial buffers. As the term own funds/capital in the accounting standards has become more harmonised across borders (see chapter 6.4), the discrepancy with prudential definitions has become less easy to explain or defend. Harmonising and tidying up the CRD definitions of financial buffers is, however, difficult. The national definition of such buffers in banks sets out the national consensus on who should be protected at the expense of whom, and international consensus on this question beyond its gross outlines has been lacking29. Even if full agreement can be reached by prudential regulators, it is still likely that the regulatory concept would contain at least some additions and deductions from the ‘regular’ usage of the terminology to reflect the ease at which own funds could be used to protect specifically the debts owed to the public by the entity with the banking license, and for the quantitative calculations of safety.

29 See, however, the laudable but sometimes imprecise progress made in the context of Basel III, which may lead to further harmonisation in the EU. To achieve even this progress required a financial crisis of the magnitude of the 2007-2013 subprime crisis. Basel III, December 2010, www.bis.org.

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EU Banking Supervision

The Basel I agreement included agreement that in a harmonised supervision framework common equity was not the only item that was able to buffer for losses of a bank in the context of the solvency ratio (see chapter 6.2). The solvency ratio is a formula, taking into account modelled calculations of risk as the denominator (initially in the form of credit risk weighted assets) that are balanced by financial buffers (the numerator). It was assumed that for such risk weighted assets other items could be of sufficient quality to buffer for those risk weighted assets in addition to the straight up and down addition of company law own funds as set out above on the basis of the balance sheet. That, however, also opened up the discussion on the exceptions to those additional items: i.e. items that should not be ‘added’ but kept out or even deducted from the additional financial buffer items. No doubt many of the ‘added’ and ‘deducted’ financial buffer items, generally of lower quality than equity, were based on local custom in the domestic supervisory or company law regime of the G10 countries, as represented on the BCBS at the time30. The BCBS also agreed, that the long list of potential financial buffer items that each had brought to the table were not all of the same quality. As a countermeasure, it was thus also agreed that some items provided more safety than others. These should be relatively more important within the mix of financial buffer items that a bank uses to meet its solvency ratio minimum capital requirement. The differences in the content of financial buffer definitions would suggest a need to change to a different terminology for company law respectively prudential usage. So far the use of the terms own funds and capital has proven to be ingrained. A better term for prudential usage would be regulatory buffers, prudential buffers or even regulatory capital if it were essential to borrow the same semblance of solidity in this area. In this book, ‘financial buffers’ is used as a catchall phrase, unless one of the defined terms as used in the CRD for the solvency ratio or for minimum amounts of capital is meant (none of which are identical to company law own funds). Each of the terms used in the CRD has a specific and different meaning; used either in the market access and/or in the ongoing supervision context. They vary as to the number of financial buffer items that can be taken into account when calculating them, and in the types of items that have to be deducted from that calculation. The Basel capital accord introduces tiers within the capital concept, to differentiate between high and low quality components of regulatory buffers. These tiers – set out in a comprehensible manner in Annex 1a to the Basel capital accord – can be equated to some of financial buffer definitions used in the CRD as mentioned in this chapter 7.2; and can be used in different proportions to cover the solvency ratio; see chapter 7.3. 30 See chapter 3.3 on the current composition of the BCBS.

390

7

Quantitative Requirements – Capital and own Funds

The different definitions, or as you like tiers, are used to distinguish between types of financial buffer items that can be used for specific risks, and the maximum amount of lower quality items that can be taken into account for fulfilling financial buffer or so-called capital requirements. After describing the relation between each of the definitions in this chapter 7.2, chapter 7.3 sets out which concept can be used to meet which type of financial buffer requirement, and to what maximum extent the lower quality items can be taken into account to meet the overall financial buffer/capital requirements. ‘Equity’/Subscribed Capital in the Accounts of Banks Directive The annual accounts and the consolidated accounts directives contain rules on the set-up of the consolidated annual accounts regulations for all companies, including for banks an adapted set via the ABD; see chapter 6.4. The ABD and the accounts directives have in general lost importance, however, due to the rise of IFRS. However, the basis of the prudential own funds concept remains the capital concept as used in the ABD31. The annual and consolidated accounts have ‘subscribed capital’ as a post on the liabilities side. Subscribed capital as used in the ABD is a very flexible concept that gives the power to define it to national company law32. If it is deemed to be equity capital in accordance with the domestic legal structure of the institutions concerned, it is also deemed to be subscribed (equity) capital in the ABD, and thus in the CRD. Equity capital from the annual accounts is thus the core elements of financial buffers for solvency ratio and minimum prudential capital requirements; though it is very flexible to national interests. Even banks that report under the IFRS regulation and the IAS Commission regulation still can and have to use the ABD concept as the starting point for their prudential own funds calculations. For most companies own funds are the amount of liabilities that remain if the value of all regular liabilities (e.g. commercial loans or amounts owed to suppliers) is deducted from the value of the assets. The ABD only refers to ‘capital’ obtained from shareholders, not to ‘own funds’. In regular usage, own funds are often referred to as the nominal amount of issued and fully paid up shares, plus reserves that hold any surplus. This total is a rest post in the balance sheet of the bank. The surplus after deducting exposures (passive) from assets is own funds. The company law concept of capital that is used by the CRD is part of this, up to the nominal value paid to the bank for the shares. The difference consists of (published) reserves and non-distributed profits.

31 Art. 57 sub a RBD. 32 Art. 22 of the Council Directive of 8 December 1986 on the annual accounts and consolidated accounts of banks and other financial institutions (86/635/EEC), (ABD).

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EU Banking Supervision

Company own funds = Capital (nominal value paid for the shares) Reserves Non-distributed profits

+ +

The CRD uses the ABD concept of subscribed (equity) capital as the core of its own concepts of initial capital, original own funds, and the CRD versions of own funds and capital definitions. Subscribed capital only requires that shareholders hold the shares – that they have been issued to them – but not necessarily that the nominal value due to be paid for such subscribed shares has been fully paid up. Subscribed shares that have not been fully paid yet are, however, not loss absorbing unless such payment is guaranteed33. The goal of financial buffers is to be loss absorbing. Claims on shareholders – when it is not sure that the shareholder can or will pay up if the payment is called – was never deemed acceptable as a buffer for ‘normal’ liabilities. To be counted as own funds under the CRD, only the part of the subscribed capital that has been fully paid up is taken into account. The CRD II directive made this requirement explicit as per 2010, ensuring that the ABD concept of capital can only be used as part of the financial buffer definitions of the CRD if and in as far as such capital is able to absorb losses in going concern situations, and in the event of bankruptcy or liquidation ranks after all other claims34. To be counted as financial buffers, the CRD does not accept the national discretions that litter the accountancy concept of subscribed capital to their full extent (even though it adds its own national discretions to the other components of financial buffers). On the concept of equity or shareholder capital, the current CRD now pursues a set of demands that are becoming increasingly stricter than the accountancy concept, while at the same time continuing to allow e.g. hybrids and subordinated loans to count as financial buffers too, though of lower rank. To be counted as equity, such subscribed capital (and share premium accounts, i.e. agreed payments over and above the nominal value of shares, if any) that is acceptable under the national ABD compliant rules also needs to meet the following criteria: – they are fully paid up; – they fully absorb losses in going concern situations; and – in the event of bankruptcy or liquidation they rank after all other claims.

33 The treatment of this claim on shareholders to pay-up is also dealt with as a national discretion under the ABD, either as an asset (a claim on shareholders), or as part of equity (if it is already called up but not yet paid). 34 Art. 1.7 CRD II Directive 2009/111/EC, amending art. 57 RBD.

392

7

Quantitative Requirements – Capital and own Funds

CEBS/EBA elaborated guidelines on the criteria for subscribed capital in June 201035. The guidelines contain ten criteria, some of which overlap with or deviate from the references to the accountancy definition (e.g. the first criterion indicates that it must be recognised as equity under ‘the relevant accounting standards’ instead of the ABD as required by the RBD36). As a benchmark, the guidelines refer to the capital qualities of ordinary shares as issued by joint-stock companies. In line with the subsequent CRD IV project, CEBS-EBA indicates amongst others that original own funds only includes instruments that37: – are common shares as issued by joint stock companies; or – are equally simple, easy to understand instruments that equally absorb losses fully and immediately in going concern. To judge whether instruments fit this second category, they have to grant the investor equal rights to shareholders, have to be fully paid, directly issued, be perpetual. It has to lack any legal or moral expectation of buy-back or redemption, lack pay-out rights, any interim payment cannot be linked to the original amount paid (but e.g. to profits), share equally in losses with common shares and be equally most subordinated with common shares in bankruptcy, and cannot be reinforced by guarantees or other credit enhancements. Arguably it is rather a shame that such criteria were not applicable prior to the crisis, and that these only apply to the highest categories of acceptable financial buffers. Several criteria are less geared towards shares, and more on the distinction between subscribed equity capital and hybrid capital or hybrids (e.g. the criterion that to be recognised as high quality the instruments have to rank pari passu with shares; see below)38. The CEBS-EBA guidance makes a common assessment of capital instruments on a solo-basis more likely. The guidelines are, however, non-specific with regard to how it will work on a consolidated basis, or with regard to group entities (e.g. shareholders, participations or insurers) that are not consolidated for banking supervision purposes (see the deductions below and chapter 17), but still are part of the group economically and co-determine its viability in real life39.

35 Art. 57 sub a and 63a.6 RBD, as amended by CRD II 2009/111/EC. Recital 4 of this CRD II Directive provides background that was largely copied into the EBA guidelines. CEBS-EBA Implementation Guidelines Regarding Instruments Referred to in art. 57(a) of Directive 2006/48/EC recast, 14 June 2010; www.eba.europa.eu. 36 This deviates from rather explicit current and future CRD rules; art. 57 RBD and art. 28.1 CRR. 37 CEBS-EBA Implementation Guidelines Regarding Instruments Referred to in art. 57(a) of Directive 2006/48/EC recast, 2010, www.eba.europa.eu. 38 With the introduction of the EBA Regulation national supervisors have to apply the ‘comply or explain’ provision on the guidelines. The Omnibus I Directive 2010/78/EU introduces the obligation for EBA to draft binding standards in the area of hybrids by the start of 2014, but continues to limit EBA to the less binding format of guidelines on the subject of subscribed capital. 39 By way of example, the CEBS-EBA Guidelines only discuss a guarantee by the bank itself, not a guarantee given by a shareholder in the bank to the holders of the instrument.

393

EU Banking Supervision

A particular concern of EU supervisors was the mutual or cooperative banking sector; see chapter 17.6. Mutuals do not have shares with features like ordinary shares, they have members who often do not have rights to vote or to surplus capital. The membership rights are not equivalent to shares, but on the other hand buffers that are available are less likely to leak to shareholders (though they might be leaked to employees or client-members as part of remuneration or favourable terms in purchase agreements). In order to allow the mutuals to continue to be operative, as they are large and influential in many member states and – if well managed – fill a useful role for consumers and/or small- and medium sized enterprises, there is an assumption, even when such shares do not fulfil all criteria, that mutual and cooperative shares by non-joint-stock companies are deemed to be equivalent as long as they fulfil the conditions on loss absorbency. The CRR will now include the list of criteria before a capital instrument is deemed to be equity (but note that in a deviation from Basel III, the CRR does not demand them to be common shares, and has a more favourable treatment for mutuals). Even if the accounting framework or the national law deems something as common shares (or not) the bank can use an instrument as such equity only if they fulfil all of 13 conditions (and please also note the range of deductions discussed below under ‘original own funds/tier 1 capital’ and under ‘own funds’. The quality criteria include40: – being issued and fully paid up by independent third parties; – complying with the ABD definition of capital and are equity under the applicable accounting framework as well as under the applicable insolvency law; – perpetual except in liquidation or on a fully discretionary basis with supervisory approval, and then only out of distributable items; – all common equity tier 1 instruments need to rank equal, though there may be some differentiation of dividend payments or differences proportional to voting rights; – all common equity tier 1 instruments need to rank last, absorbing first losses. The favourable treatment for mutuals is continued in the CRD IV project. Their equivalents of common shares such as membership rights and even some types of hybrids issued by mutuals (and savings banks) do not have to fulfil all conditions; see chapter 6.2, 6.4 and 17.641. It is a main reason why there is no reference to common shares in the CRR definition of common equity tier 1 capital. If state aid is given, the supervisor may count it as equity even if not all conditions are fulfilled, though they do have to be loss absorbing, perpetual,

40 Art. 28 and 77/78 CRR. 41 See art. 27, the deviations by reference to that art. 27 in art. 28, and art. 29 CRR.

394

7

Quantitative Requirements – Capital and own Funds

held by a public authority, and count as equity under local rules42; see chapter 18.4. After end 2014, lists should be drawn up of acceptable types of common equity tier 1 capital instruments per member state, and EBA is to develop regulatory standards and submit them to the Commission by 1 February 201543. Initial Capital The initial capital concept is part of the licensing requirements. For banks, it comprises capital as used in the ABD (subscribed capital in as far as fully paid up) and statutory and legally required reserves. This means that initial capital consists of capital as meant in article 22 ABD (that fulfils the CRD criteria described above) plus some types of reserves44. Initial capital = Paid up capital (within the domestic definition for the type of legal structure of the institution), up to the nominal value of the shares, if loss absorbent The share premium account, reflecting the difference between the nominal value and the original issue price of the shares Profits and losses brought forward from the last profit and loss account (also interim profits if verified by the auditors responsible for the accounts) Any legal reserves obligatory under national law Reserve for own shares, in so far as national law requires such a reserve45 Reserves provided for by the articles of association Other reserves Net gains in profits arising from bringing forward the profit in securitised assets are excluded (deducted), as is credit enhancement in securitisations46

+ + + + + + + Minus -

The initial capital concept is relatively conservative. It is closely linked to the accountancy/company law concepts, and includes only reserves and profits that are obligatory under applicable law. More arbitrary or voluntarily held reserves cannot be taken into account, which e.g. excludes the revaluation reserve and reserves for general banking risk47.

42 Art. 31 CRR for new state aids after the CRR enters into force. The rules for state aid issued under the existing rules prior to 1 January 2014 are and remain more lenient under the transitional rules contained in the CRR, see below. 43 Art. 28.3 and 28.4 CRR. 44 Art. 9.1, 57(a) and (b) RBD. 45 Also see art. 22 (1) (b) of Directive 77/91/EEC on the way to match assets of own shares to reserves of own shares for some (public limited liability) companies. 46 See art. 57 last paragraph RBD, and chapter 8.6. 47 Specified in art. 57 (c) to (h) RBD.

395

EU Banking Supervision

On the other hand, the number of deductions is limited (and more relevant while this ‘initial’ capital is an ongoing requirement than when it is relevant as a condition to be able to gain a license). Several items that are deducted from solvency ratio financial buffers, as they may not actually provide a financial buffer, need not be deducted from initial capital (such as own shares, smaller holdings in other banks48). For non-bank investment firms, the definition is similar. The text of RCAD/RBD is not clear as to whether the requirement is identical. ‘Initial capital’ in the RCAD is defined separately, not by referring to the RBD definition but by referring directly to two of the items from its definition49. Whether meaning should be attached to the choice of the terminology ‘the items’ instead of ‘capital and reserves’ is not clear. However, one could argue that the two should be read as if identical. Most likely, this is one of many signs of unintended different terminology that suffer from a lack of time to check language consistency and proper cross-referencing between the two directives, which checks are part of the legislative process at the end of political negotiations. In the CRR/CRD IV directive the definition cross references to each other50. The interim profits were a national discretion until end 201051. The replacement of ‘may’ by ‘shall’ indicates that the supervisor will have to allow it now even if the national law on accounting or supervision does not. The phrasing of the sentence is equally not a great example of legislative drafting due to the use of the word ‘only’ further down the sentence. A reader unaware of the previous use of the word ‘may’ instead of ‘shall’, could read it as if the member state should definitely not allow it if no auditing is done, but may otherwise still choose to allow it or not. Endowment Capital for Branches This historically important concept is currently only used in a negative way; by forbidding member states a specific goldplating issue. Before the EU was introduced and before it achieved sufficient harmonisation on banking supervision requirements, a supervisor that allowed a branch from a legal entity based in another country to operate in its own territory usually required it to go through a local authorisation process and to have capital available at the branch itself (in some relationship to the amount of deposits it attracted). The RBD bans endowment capital requirements within the EU (and EEA)52. It is forbidden for the host state to demand endowment capital for branches that operate under a home state 48 49 50 51 52

Art. 57(i) to (r) RBD, see below. Art. 4 RCAD and art. 57(a) and (b) RBD. Art. 12 CRD IV Directive, art. 4.51 and 93 CRR. Art. 1.7 CRD II Directive 2009/111/EC, amending art. 57 third paragraph RBD. Art. 16 RBD.

396

7

Quantitative Requirements – Capital and own Funds

notification. This is in line with the Court’s judgement in a company law case that a host member state cannot even demand that the entity as a whole has an amount of initial capital if the home member state did not require this53. Please note that the ban only pertains to endowment capital; liquidity supervision and conduct of business supervision on branches are in the hands of the host state; also see chapter 5.3, 12, 16 and 20. Indirectly, such liquidity and conduct of business requirements could have an impact on the assets in the host country branch, and thus on capital. The outer legal limit on such additional requirements would be (i) if the extra requirement on e.g. liquidity de facto constitute endowment capital, and is only labelled liquidity to circumvent the ban on endowment capital, and (ii) if the extra requirements exceed the boundaries set in the treaty on the freedom of establishment; see chapter 3.4-3.5. The prohibition to require endowment capital held at the branch does not apply to the treatment of third country branches. Such a branch requires a ‘regular’ authorisation. Whether such will be granted, or whether there is pressure to incorporate the branch into a subsidiary – a separate legal entity – is up to the supervisor of the member state where the third country bank wants to establish a branch (the host state). See chapter 5.5. It can be assumed that this will to a large extent depend on the capacity under civil law and bankruptcy law in the host state to ringfence capital in a EU branch of a third country entity, though other public policy goals such as cornering a market or economic growth may play a role too. Original Own Funds (Tier 1 Capital) The original own funds concept provides the EU translation of the tier 1 capital definition of the Basel II version of the Basel capital accord54. Where the BCBS refers to tier 1 capital, the CRD – or at least RCAD – uses original own funds55. The RBD article that enumerates the components of financial buffers does not contain either the term or the definition used in RCAD56. Nonetheless, the content of the RCAD definition is identical to the components mentioned in the RBD as the benchmark highest quality financial buffers used to cover the solvency ratio, though it contains components of various strengths57. The original own

53 Inspire Art, Court of Justice 30 September 2003, C-167/01. 54 §49(i) and annex 1A BCBS Revised Framework. The BCBS also uses the core tier 1 concept to limit the amount of relatively low ranking tier 1 capital that can be used; see below. Please note that Basel III introduces new definitions, which will enter into force from 2014; see chapter 7.3. 55 Art. 12 RCAD, as amended to introduce the hybrids by the CRD II Directive 2009/111/EC. 56 Except in recitals 29 and 30 RBD, referring to art. 66 RBD. Outside of the capital definition articles the concept is referred to in art. 89 and Annex XII RBD, which appear to refer directly to the concept as defined in the RCAD. 57 See below under ‘hybrids’ and in chapter 7.3 on the split between lower quality (mainly hybrid) components and – in BCBS terminology – core tier 1 components of this tier 1/original own funds definition.

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EU Banking Supervision

funds (and within it the lower versus higher quality components) are part of the solvency ratio capital tiering provisions in the RBD (see chapter 7.3). Why the definition and terminology of ‘original own funds’ was not used in the RBD articles is not clear, but the recitals make clear that no difference is intended with the RCAD. The non-binding recitals even use the term explicitly when referring to the tiering provisions. The original own funds provide thresholds to limit the usage of the least solid sources of capital solely to market risk purposes and to provide a threshold all lesser sources of capital cannot surpass; see chapter 7.3. In addition to the various initial capital components, ‘original own funds’ includes the funds for general banking risks58 and – up to a maximum amount – hybrids. On the other hand, some elements not deducted from initial capital need to be deducted from original own funds. These deductions are own shares held by the bank, which are deducted at book value instead of fair value, intangible assets59 and material losses of the current financial year. Original own funds = Paid up capital (within the domestic definition for the type of legal structure of the institution), up to the nominal value of the shares, if loss absorbent The share premium account, reflecting the difference between the nominal value and the original issue price of the shares Profits and losses brought forward from the last profit and loss account (also interim profits if verified by the auditors responsible for the accounts) Any legal reserves obligatory under national law Reserve for own shares, in so far as national law requires such a reserve60 Reserves provided for by the articles of association Other reserves Hybrid instruments of relatively higher quality, up to maxima 61 Funds for general banking risks Net gains in profits arising from bringing forward the profit in securitised assets are deducted, as is credit enhancement in securitisations Own shares at book value held by the bank Intangible assets (including formation expenses and goodwill)

+ + + + + + + + + Minus -

58 Art. 38 ABD. 59 Art. 4(9) ABD. 60 Also see art. 22 (1) (b) of Directive 77/91/EEC on the way to match assets of own shares to reserves of own shares for some (public limited liability) companies. 61 See art. 57, 63a and 66 RBD, and the information under ‘hybrids’ in this chapter.

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Quantitative Requirements – Capital and own Funds

Material losses of the current financial year The differences between original own funds and initial capital are printed in italic. These differences are limited in scope. It is not clear why the two terms have not been aligned. If the wider concept of original own funds is deemed useful to provide the highest tier of financial buffers for the solvency ratio, it is not clear why it would not be acceptable as initial capital for the licensing area and to serve as a minimum absolute number demand for ongoing supervision. The initial capital concept dates from an older version of the banking directives that pre-dates the Basel capital accord. It appears that this has just not been considered in one of the partial revisions that have taken place, nor in the CRD IV project. For banks that are set up by other banks (or split off from existing banking activities) the difference is distorting. For an applicant from outside the banking sector, it would be more transparent to be required to deduct capital that will be used for formation expenses and goodwill already in the authorisation process. Run-up costs resulting in material losses should be deducted. As indicated in chapter 5.2, the end result is, however, already similar. In the programme of activities, such costs need to calculated, and the own funds as a whole need to be demonstrated to be able to remain above the own funds requirements at all times (so including these deductions in the start-up period; see below). Even though the concept of original own funds has been in the directive virtually unchanged for decades, this had not lead to significant harmonisation up to the CRD IV project. The national discretions allowed member states to acknowledge instruments that had grown organically from e.g. the ownership-structures of the banking system in their country, or from their corporate tax regimes as original own funds. During the crisis, not all turned out to be loss absorbing. As described in chapter 2 and 7.1, a tightening of the definition was advertised during the 2007-2013 subprime crisis in 2009. This resulted indeed in some limited tightening of criteria for instruments issued after 201062, though simultaneously hardwiring a wider scope for the use of hybrids (see below) into the definition: – a widening of the definition by formally introducing hybrids that were previously a national discretion used by different member states to different extents (while reducing the range of egregious national discretions in this specific area by one); – the introduction of some (rather self-evident but apparently not widely applied) criteria on some elements of original own funds;

62 The CRD II has an exceptionally long transitional period, partly continuing to accept non-compliant instruments issued before end 2010 until 2040. Art. 154.8 and 154.9 RBD, as added by art. 1.37 CRD II Directive 2009/111/EC.

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EU Banking Supervision

– a mandate to CEBS-EBA to develop a common approach to the assessment of some original own funds instruments (on the equity instruments and on hybrids; see above on accountancy equity and below under hybrids). According to the CRD definition and the Basel definition, intangibles should be deducted from original own funds/tier 1 capital. Along with hybrids (see below) the treatment of intangibles is nonetheless one of the core areas where national discretions could be abused by national legislators to increase the (apparently) available capital in their local banks. When such local banks are core to a systemic country, or grow into internationally active banks, they exported shoddy local standards. In the Basel III proposals the capital definition have been tightened, deleting some of the national discretions. In order to allow a compromise on the issue of intangibles – important for instance in EU member states Italy and Germany – the Basel III amendment formally accepted the usage of intangibles, but limited it to 15%. Such capital components include deferred tax assets, mortgage service rights, and other ‘intangible’ – in the sense that they are not actually available at the bank but depend on future work/profitability – ‘assets’. As such ‘assets’ that actually are intangible are allowed on the assets side of the balance sheet without a corresponding debt liability, they increase the accountancy capital/reserves by the same amount (as those equal assets minus other liabilities). For prudential purposes, they do not provide safety as it is highly unlikely that they can be sold or liquidated for the amount claimed at the moment when unexpected losses would need to be absorbed. In a deviation from Basel III, however, the EU additionally limits this to future tax assets that are dependent on future profitability, treating other types of tax benefits that may have some value as if they have their full face value, and thus equally increase the equity/reserves available in the bank for loss absorption63. The definition of ‘original own funds’ does not return in the CRR, except for the purpose of transitional provisions. It is replaced by the BCBS term of tier 1 capital, composed of common equity tier 1 and additional tier 1 capital; see below64. The funds for general banking risk are explicitly made part of common equity tier 1. Tier 1 capital (common equity tier 1 capital and the additional tier 1 capital composed mainly of hybrids) will be re-categorized to serve as capital that is useful (loss absorbent) in a going concern situation in the Basel III/CRD IV project. The tiering within this concept will become more important; see chapter 7.3. Where there are some limits now on relative use of lower and higher (core tier 1) capital, the new concept of common equity tier 1 is limited to common shares, reserves and similar instruments. This highest quality category will be preferred

63 Art. 36.1 sub c, 39 and 48 CRR. 64 Art. 25, 26 and 52 CRR.

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7

Quantitative Requirements – Capital and own Funds

for a larger portion of the solvency ratio and for all of the additional buffers on top of that solvency ratio; see chapter 6.2 and 7.3. For the leverage ratio, however, the tier 1 capital concept is used instead of only common equity tier 165. Please note the long transitional arrangements. This aligns closer to the Basel III version of the capital accord than was the case in the current and previous versions of the Basel capital accord and the CRD. On the reserves-type of components of common equity tier 1, there is no material change, nor a demand on quality except that they are available for unrestricted use and can immediately absorb losses as these occur66. For the capital instruments that in the Basel III version of the capital accord are defined as being common shares the criteria to qualify as such a high quality capital instrument are defined; see above under ‘equity/subscribed capital’. As the reference to common shares – in a deviation from Basel III – is lacking, these quality criterions can potentially also be fulfilled by membership-rights or hybrids. Importantly, many of the deductions that now only need to take place at the level of own funds (up to 2014 tier 1, tier 2 and tier 3 combined; see below), will from 2014 need to be made at the level of common equity tier 1 instead of at the level of own funds (common equity tier 1, additional tier 1 and tier 2 combined in the CRD IV project set-up). See below under own funds on the controversial decision not to deduct insurance subsidiaries in the EU, in deviation from Basel III67. To harmonise the treatment of associated pension fund obligations, a new deduction has been formulated. For countries where the assets and liabilities of the associated pension fund are not own assets and liabilities of the employer and thus not shown on the annual accounts of the employer, this changes little. If assets and liabilities are on the balance sheet, the assets need to be deducted unless they are truly freely available to absorb general losses of the employer/bank68. Hybrids in Original Own Funds/Tier 1 Capital: Additional Tier 1 Capital Hybrids are bonds with some characteristics of common equity. Common equity is generally deemed expensive; in that dividends need to be paid that are proportionate to the risk the investor runs (i.e. for an investor in a bank running a large risk a large profit should be available). Bond yields are generally lower, and more predictable. An added problem is that many states have skewed tax incentives between interest bearing bonds and dividend 65 Art. 429 CRR. 66 Art. 25.1 CRR. 67 BCBS, Basel III Regulatory Consistency Assessment (level 2), Preliminary Report European Union, October 2012. 68 Art. 36.1 sub e and 40 CRR.

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EU Banking Supervision

paying shares. Many states have a tax statute for all companies including banks that allows interest to be deducted from profits before taxes are calculated. Interest is thus allocated to the category of costs. Dividends are not, and generally can only be paid from profits after taxation69, making it more costly for the bank than interest, even though both sources of funding provide similar input for the work of the bank. For prudential supervision purposes, it would be good to have incentives towards common shares instead, as it has the added benefit of bearing risk. In light of the tax-incentives and the cost benefits of bonds and other sources of debtfunding, banks have effectively lobbied national supervisors and the BCBS to be allowed to use bonds with contractual arrangements that make them more similar to shares as financial buffers. Prior to 1998, this was – subject to easy domestic definitions under the wide range of national discretions – mainly allowed only in the lower quality definition of ‘own funds’ that includes both higher quality items and tier 2 and tier 3 items; see below. In Sydney the BCBS decided to also partially allow it in ‘tier 1 capital’, i.e. original own funds in the EU terminology. They have been used in the EU – within the context of the if possible even wider national discretions on capital in the CRD – with a free hand since the issuance by the BCBS of its Sydney press release in 1998. The subject matter of the press release was only introduced 11 years later in the CRD as part of the 2009 amendments to the CRD under the CRD II directive70. The exercise was started prior to the 2007-2013 subprime crisis to deal with the too wide range of national practices on hybrids that existed in the EU on the basis of the ambiguous texts of the Sydney press release. This hampered the level playing field within the EU. The Sydney press release had only brought a limited harmonisation, reflecting the impasse at the BCBS, which used a low-key instrument such as a press release with vague language to publish a key upgrade of part of tier 2 capital to tier 1. After divergent developments in the member states, the new EU regulatory regime reflected a consensus reached by member states and supervisors on the basis of work of CEBS/EBA. CEBS/EBA had first assessed the use of hybrids in the member states, followed by a study on how a common, harmonised, regime might be introduced to eliminate the unlevel playing field for banks. The work was done before, but finalised during the 2007-2013 subprime crisis, making the restrictions on the use of hybrids slightly stricter than could otherwise have been envisaged71. Still, it is strange that the CRD

69 V. Ceriani, S. Manestra, G. Ricotti, A. Sanelli & E. Zangari, Ernesto, The Tax System and the Financial Crisis, Banca d’Italia OP 85. IMF, Debt Bias and Other Distortions: Crisis-Related Issues in Tax Policy, 12 June 2009. 70 Recital 3-5 and art. 1.7-1.12 CRD II Directive, 2009/111/EC, introduced the hybrids in the new art. 57 sub ca, 63.2, 63a, 66.1 and 66.1a RBD. 71 See chapter 7.1 on the history of the hybrids-discussion.

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7

Quantitative Requirements – Capital and own Funds

II directive that refers to being the first response to the crisis in order to be stricter, in effect codified and accepted the use of hybrids into the CRD instead of abolishing it (or at least restricted its usage). The harmonising effect of the CRD II changes are further hampered by a decades long transitional term (running from 2010 up to 2040 for instruments issued before 31 December 2010)72. The CRD lacks a material definition of hybrids as a clear set of instruments. Any type of instrument can be deemed a hybrid if they meet the following criteria73: – the lender cannot trigger repayment, and the bank cannot repay them without supervisory consent (with a range of criteria on the circumstances in which the supervisor must or can withhold permission); – the loan has to be subordinated to depositors and non-subordinated bondholders; – the debt and interest payments need to be able to be diminished to reflect losses suffered, without triggering bankruptcy proceedings; i.e. the instruments need to be loss absorbing; – the money has to be fully paid up; – the instrument has to be undated, or have an original maturity of 30 years. The amount of hybrids that can be counted towards tier 1 capital is, however, limited by the so-called core tier 1 requirement described in chapter 7.3. Hybrids are effectively capped at 50% of tier 1, because the other half has to be filled with ‘core’ tier 1 components such as equity. In emergency situations, supervisors can give permission to further ease these limits along with similar limits on lower quality financial buffers74. See chapter 7.3 on tiering and chapter 20.3 on regulatory forbearance. Under the rules gradually introduced from 2014 by Basel III/CRD IV regulatory acceptability of hybrid capital in going concern situations will be severely limited by requiring proof that such capital will indeed – contrary to in the crisis – be available in a going concern. Bail-in clauses with strict conditionality gained additional regulatory and political popularity during the 2007-2013 subprime crisis75. The majority of solvency ratio buffers

72 See e.g. art. 154.8 and 154.9 RBD, as added by art. 1.37 CRD II Directive 2009/111/EC. 73 Art. 63.2 and 63a RBD, and the CEBS-EBA Guidelines on Instruments Referred to in art. 57(a) of the CRD, June 2010. These replace the criteria previously used domestically as copied from the Sydney Press Release of 27 October 1998 of the BCBS. 74 Art. 66.4 RBD (as rephrased to also include the new hybrids by art. 1.12 CRD II Directive 2009/111/EC). 75 See the overview in L.D. Wall, Prudential Discipline for Financial Firms: Micro, Macro, and Market Structures, Federal Reserve Bank of Atlanta WP 2010-9, March 2010. Also see C. Pazarbasioglu, J. Zhou, V. Le Leslé & M. Moore, Contingent Capital: Economic Rationale and Design Features, IMF Staff Discussion Note SDN/11/01, 25 January 2011; E.T. Patrikis, ‘Basel III: Near Death Capital’, The Banking Law Journal, Vol. 128, No. 5, May 2011.

403

EU Banking Supervision

and additional buffers will nonetheless be related to core equity tier 1, as bail-in debt also has downsides from a financial stability point of view, especially when the investors start to doubt the financial strength of the issuing bank (and sell as quickly as possible at firesale prices in a ‘run’ to avoid having to write down the investment in full)76. In January 2011 the BCBS published some additional requirements for non-common equity tier 1 and tier 2 capital on triggers via a press release77. Contingent bank capital with automatically triggered bail-in clauses that cannot be gamed by the bank or its investors will be key. In essence, it is a subordinated convertible bond that would embody the politically desirable bail-in of these junior bondholders. It would, however, not convert at the demand of either the investor or the bank. Instead it would convert automatically from debt to capital when certain capital levels (triggers) are breached, or on the basis of a decision of the supervisor that the bank is in mortal danger and/or might need state aid. However, the greater the leeway of the supervisor in this determination (i.e. how subjective or objective this trigger will be formulated), will make the decision more or less likely to be challenged for administrative law safeguards or human rights violations if the bank might have survived without the conversion. The trigger will likely need to be set at the same time as currently the deposit guarantee scheme trigger is set (i.e. unlikely that deposits will be paid out, and perhaps if state aid is paid simultaneously, or would doubtless need to be paid without the conversion)78. The conversion could be either at a pre-set conversion rate or at the market price as at the moment of compulsory conversion79. Either would make it loss absorbent in going concern, but the control of the bank would likely shift to the bondholders if the conversion is against market rates at the time of conversion. Some experimentation (e.g. issues by Credit Suisse, Lloyds, and triple A rated Rabobank in 2009-2011) provided a test on the structure and the – additional – yield that should be paid for this hybrid. The required yield might be prohibitive for this instrument that is more likely to actually be loss absorbing to the detriment of the holders of such instruments than traditional hybrids. A highly capitalised bank will be able to pay a substantially lower

76 BCBS, Globally systemically important banks: assessment methodology and the additional loss absorbency requirement, November 2011. See the discussion of pros and cons on page 17-20. 77 The demands are set out in an annex ‘Minimum requirements to ensure loss absorbency at the point of nonviability’ attached to BCBS Press Release, Basel Committee issues final elements of the reforms to raise the quality of regulatory capital, ref 03/2011, 13 January 2011. 78 See chapter 18 and 20. Also see the proposals contained in R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 3 on liability at the bank and the trigger described there. 79 M.J. Flannery, ‘No pain, no gain? Effecting market discipline via “reverse convertible debentures”’, in H. Scott (Ed.), Capital Adequacy Beyond Basel, New York, 2005, chapter 5.

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7

Quantitative Requirements – Capital and own Funds

yield than a thinly capitalised bank80. Banks whose supervisors activated a bail-in to keep the bank afloat may not be able to issue new bail-in bonds for the foreseeable future at affordable rates, and may prefer to fulfil the requirement via new equity. The Liikanen report notes that smaller banks will also have difficulty to issue bail-in bonds, so may need to fulfil such requirements via equity81. Other hybrids and contingent capital arrangements that do not qualify as capital can still help banks manage their capital requirements by helping them to obtain access to additional financial buffers in times of trouble (on top of or topping up the regulatory buffers)82. The quality demands on tier 1 hybrids (additional tier 1) are set in the CRR, and include83: – obligatory convertibility (into common equity tier 1) or full write down84 of the additional tier 1 instrument when there is a trigger event, which must include if there is less than 5,125% common equity tier 1 (or optionally at a higher amount of common equity tier 1 still being available). This is higher than the minimum amount of 4,5% of common equity tier 1 to cover the solvency ratio, providing both a small cushion in case the value of the assets of a bank decrease rapidly, and a de facto demand of more common equity tier 1; – issued and paid up (by third parties); – unsecured and not guaranteed by a connected party; – perpetual and without any incentive to redeem them at an early stage; – limitations on pay back, even if at the discretion of the issuer, amongst others they should be paid out of distributable items only, without a negative effect on the credit standing of the bank or the group, and only with the permission of the supervisor; – holdings of additional tier 1 instruments issued by financial sector entities need to be deducted in full or with some limitations. If the hybrids are even more stringently worded, they might qualify as common equity tier 1 (as the CRR – unlike the BCBS – does not define it as shares, but only looks at the substance of the demands on the capital instrument. For mutuals, due to the reduced quality demands for common equity tier 1 instruments, more types of hybrids may qualify as common equity tier 1; see chapter 17.6. 80 G. Pennacchi, A Structural Model of Contingent Bank Capital, Federal Reserve Bank of Cleveland WP10/04. A.R. Fonseca, F. González, & L. Pereira da Silva, Cyclical Effects of Bank Capital Buffers With Imperfect Credit Markets, International Evidence, Banco Central do Brasil WP 216, 2010. 81 High-level Expert Group on Reforming the Structure of the EU Banking Sector, Final Report, 2 October 2012 (Liikanen Report), 103-104. 82 See chapter 6.2 and e.g. G.M. von Furstenberg, Contingent Capital to Strengthen the Private Safety Net for Financial Institutions: Cocos To The Rescue?, Deutsche Bundesbank, Banking and Financial Studies Discussion Paper 01/2011. 83 Art. 51-61, 77 and 78 CRR. 84 Please note that the EU allows the writedown or conversion to be on a temporary basis. See art. 52.1 sub n CRR.

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EU Banking Supervision

Own Funds The combination of all components of financial buffers that can be counted in the context of the numerator of the solvency ratio is referred to as ‘own funds’ in the CRD85. These CRD-own funds contain elements that would not normally be counted as loss absorbent either in going concern or in liquidation. They are likely to be repaid before liquidation is set in motion. Several of these will be eliminated in the implementation of Basel III/CRD IV project, but until that full implementation (after the extensive grandfathering regime has expired for pre-issued capital instruments) this expansive definition of own funds remains applicable. Own funds = Paid up capital (within the domestic definition for the type of legal structure of the institution), up to the nominal value of the shares, if loss absorbent The share premium account, reflecting the difference between the nominal value and the original issue price of the shares Profits and losses brought forward from the last profit and loss account (also interim profits if verified by the auditors responsible for the accounts) Any legal reserves obligatory under national law Reserve for own shares, in so far as national law requires such a reserve86 Reserves provided for by the articles of association Other reserves Funds for general banking risks Hybrid instruments of relatively higher quality, up to maxima87 Hybrid instruments exceeding the original own funds criteria Revaluation reserves Value adjustments Items added by member states if they are freely available for normal banking risks, disclosed in internal accounting records, and management, independent auditors agree, and competent authorities know and supervise Commitments of members of cooperative banks and joint and several commitments of the borrowers of institutions organised as funds Fixed term cumulative preferential shares Long term subordinated loan capital

+ + + + + + + + + + + + +

+ + +

85 Art. 57 RBD and art. 3(r) RCAD. 86 Also see art. 22 (1) (b) of Directive 77/91/EEC on the way to match assets of own shares to reserves of own shares for some (public limited liability) companies. 87 See art. 57, 63a and 66 RBD. Hybrids exceeding the criteria and maxima of the original own funds definition can, however, still be counted towards this wider own funds definition (as tier 2, to use the BCBS terminology); see art. 66.1a sub d RBD. For the maximum size of tier 2, see chapter 7.3.

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7

Quantitative Requirements – Capital and own Funds

Short term subordinated loan capital (tier 3)

+ Minus Net gains in profits arising from bringing forward the profit in securitised assets are deducted, as is credit enhancement in securitisations Own shares at book value held by the bank Intangible assets (including formation expenses and goodwill) Material losses of the current financial year Holdings, subordinated debt and other items of equity in another banks and financial institutions of more than 10% in their capital, see however, chapter 17 on the treatment of consolidation Participations and equity instruments held in insurers, re-insurers, and insurance holdings. See, however, the RBD exceptions on the treatment of such participations in the consolidated calculation of own funds. Expected loss amount on equity (only IRB banks) Expected loss amount in as far as not covered by value adjustments or provi- sions (only IRB banks) Securitisation positions in either the banking or trading book, if they would attract a 1250% risk weighting in the banking book, but have not yet been dealt with in that manner 88 At the consolidated level, some types of minority interests held by outside investors in consolidated entities (for instance a listed bank of which a majority of shares is held by the parent bank) The differences between own funds and ‘original own funds’ are printed in italics. There is little to be said on the content of each of these components. The CRD does not provide definitions, leaving member states free to fill them in themselves. Those elements that refer to accountancy standards will change if the bank moves to a different accountancy regime (except for the ‘equity’ component, see above on company law capital), or if the accountancy regime itself is changed (see chapter 6.4). Under IFRS, provisions held for normal banking risk were no longer possible, except in individual cases where a specific event had already taken place (e.g. non-payment of interest). Reserves for such specific cases do not qualify as own funds as they are expected losses and thus not available for

88 The provisions originally only applied to banking book securitizations, but were expanded to the trading book by the CRD III Directive. Art. 57 sub r and 66.2 RBD and art. 1.5 and 1.7 CRD III Directive 2010/76/EU. See chapter 8.6 on securitizations and 9.2 on the trading book/banking book distinction. If the exposure already was risk weighted at 1250%, this in effect is a full deduction from own funds. This provision ensures that it is deducted, but not deducted twice.

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EU Banking Supervision general banking losses89. General provisions are not acceptable under IFRS as they smooth the balance sheet, which is contrary to the transparency thinking that underlies public accounting. Spain had resisted pressure to delete its general provisioning regime, which turned out to be beneficial in the early stages of the 2007-2013 subprime crisis (but insufficient when the crisis went on and on). In the follow-up, the IASB is contemplating a limited adjustment to its prohibition on having provisions for normal banking risk at the request of banking supervisors. This would allow supervisors to require banks operating under IFRS (the majority in the EU) to build up general provisions again. The procyclicality issue (see chapter 6.5) is, however, at stake here too, as provisions tend to be built up when the quality of assets deteriorates instead of during a bubble. The countercyclical buffer may help in this respect when it becomes applicable from 2016; see chapter 6.2. Deductions from Own Funds The majority of such full deductions of the ‘own funds’ definition are derived from the Basel capital accord as applied up to 2013 in the EU. They are set out in the first part of the Basel capital accord; in the chapter called scope of application. This chapter of the Basel capital accord actually is not about the scope of the accord in the sense of ‘which institutions are banks and should be subject to this framework’, but about the scope of consolidated supervision. The intention is to indicate which types of subsidiaries and minority interest should be included in the consolidated calculation of capital; see chapter 17. The starting position is that all subsidiaries and controlling minority interests should be caught in the consolidation, except for a certain defined set subsidiaries and minority interests, such as insurance subsidiaries. For these excepted interests, the Accord sets out for which part and if they should be excluded from consolidation (both assets and capital accounted for on the balance sheet of that subsidiary), and how the capital of the group that is actually invested in an excluded subsidiary should be deducted from consolidated capital. Those deductions have been copied into the CRD, though with a range of national discretions and ambiguous language that allows individual banks and their supervisors to deviate from the intent of the BCBS scope of application compromise90. Some full deductions have been copied in full (goodwill and some securitisation funding commitments) others have not.

89 See §49(vii) – 49(x) BCBS Revised Framework, page 15. 90 Though insurance participations are deducted on a solo basis, the language on deduction of participations in the consolidation is ambiguous. It could be read to allow consolidation, unless there is no controlling influence in which case the value needs to be deducted, with further possibilities for supervisors to allow exemptions of the treatment of such subsidiaries. See also the discrepancies noted between Basel III and the treatment of insurance subsidiaries noted in BCBS, Basel III regulatory consistency assessment (level 2), preliminary report European Union, October 2012. and chapter 2 and 6.

408

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Apart from entities that are not consolidated in the annual accounts, deductions from own funds concerns mostly entities – though consolidated in the annual accounts – of which the capital is not freely accessible for the group as a whole (if it is needed by the parent or by another subsidiary than the one where it currently is kept). This applies for example to insurers (subject to stringent solo entity supervision, under which capital needs to be held at the entity level, and is not available for the rest of the group) and entities where there are large other investors which might not be willing to support the rest of the group to the detriment of the entity they invested in. Most of the deductions are similar in a solo and consolidated context, except for the treatment of minority interests (see below) and of insurance subsidiaries. Though such capital in an insurance subsidiary is neither available on a consolidated nor a solo level, only the deduction on a solo level is reasonably clearly worded in the RBD (with some exceptions). At the consolidated level where a full deduction continues to be part of the Basel capital accord, it appears that the CRD instead allows member states to allow their banks not to deduct consolidated insurance companies91. If the member state does so, insurance subsidiaries that are consolidated for the public accounts may also to be consolidated for prudential financial buffers calculations, failing to apply the mandatory deduction to all controlling participations (and limiting it to noncontrolling large shareholdings in insurers); see chapter 6.2 and 17. The continuation, now more explicit, in the CRD IV project without alleviating measures is a main discrepancy with Basel III92. In principle the main rule on deduction is maintained, and (smaller)holdings in insurers and other relevant entities need to deducted regardless of whether there is a significant investment in such entity or not, subject to calculations set out in the CRR. However, in spite of a commitment to Basel III, the Commission is maintaining the existing possibility to – instead of a deduction – actually just add insurance subsidiaries into the consolidation via reference to the financial conglomerates directive. The financial conglomerates supplementary supervision does, however, not harmonise the view taken in insurance and banking supervision of assets and capital, but instead tries via the supplemental calculation to avoid double counting of risks and having an overview of the health of the insurance/banking group; see chapter 17). If the supervisor agrees, the bank can thus opt to consolidate an insurance subsidiary, and can subsequently even avoid the deduction on a solo basis. Subsequently, it would explicitly no longer need to deduct the capital of the insurance subsidiary both when calculating consolidated financial buffers and solo financial buffers, subject to the minor conditions set in the financial conglomerates directive on such 91 Art. 57 sub o, with the key exception contained in art. 60 RBD. 92 Art. 36.1 sub h, 43-47 and the deviations from the Basel Capital Accord contained in art. 49.1 and 49.2 CRR and BCBS, Basel III regulatory consistency assessment (level 2), preliminary report European Union, October 2012.

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EU Banking Supervision methods93. This is a severe deviation from the Basel capital accord, which intended to harmonise the components and deductions of the financial buffers (after allowing national discretions widely in its initial version). Under the Basel III version of the accord, the EU should have given this national discretion deviation up. In maintaining it, the Commission proposals would help EU banks to include additional capital that is surplus in their insurance subsidiaries into their banking financial buffers, even though the capital is captured in the insurance entity. There does not appear to be a clear pro/con analysis of a consolidation versus an ignoring point of view for the banking group financial buffers, looking at the remaining differences of the capital regimes and whether surplus capital in the insurance subsidiaries would indeed be available to help ‘rescue’ other parts of the wider banking group. Equally, the Commission and the member states that are members of BCBS failed to negotiate a set of conditions under which insurance subsidiaries could be consolidated under the agreed Basel III version of the capital accord. Now that such treatment was not agreed, however, the CRD IV project should reflect that level playing field instead of allowing its banks to treat consolidated insurance subsidiaries much more beneficial than compliant third country banks. Similar deviations that impact on the international level playing field is the treatment of deferred tax assets mentioned above under original own funds/tier 1 capital. On a consolidated basis, also minority interests can be relevant as financial buffers. The CRD adds that they have to be deducted if they are positive items (debit), or that some can be added to reserves if they are negative items (credit)94. Financial buffers provided by outside shareholders in controlled entities within the group do provide for the risk taken on by that subsidiary, which in turn can be a stabilizing influence for other parts of the group (but are rarely useful as directly loss absorbing for risk undertaken elsewhere). Another category of deducted holdings are interests in commercial companies, which are discouraged if they would become a material part of the banks consolidated accounts. Apart from the elimination of capital held in certain subsidiaries or holdings, both the Basel capital accord and the CRD deduct certain types of high-risk positions in securitisation vehicles (as the retained risk on such so-called first loss positions is unlikely to become available again for the wider group); see chapter 8.6. Both also deduct goodwill (as goodwill is not worth much in a loss making situation, at exactly the moment when financial buffers are actually needed); see above under original own funds.

93 Art. 49 CRR. This article maintains the regime of art. 59-60 RBD. See Annex I Financial Conglomerates Directive 2002/87/EC, as described in chapter 17 on solo and consolidated supervision. 94 Art. 57 and 65 RBD.

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Several deductions are obligatory or allowed under the CRD, that are not mentioned in the Basel II version of the Basel capital accord. An example are guarantees on own funds granted by a member state or local authority to its public credit institution (to avoid at least some of the competitive advantage of having a public shareholder). Please note that under the CRD IV project, this treatment will change if the public authority holds the interest in the context of state aid95. Several components of capital concern forms of debt. Instead of being kept in the debt category (to be protected by banking supervision), they are instead allocated to the capital category (to serve as protection to more senior creditors). This may not always be clear to the creditor in question if he is not very financially sophisticated96. An example of debt that is qualified as capital are long term and short term subordinated bonds that have been sold also to retail clients and to investors that may not have been aware that they might lose money even if there is no bankruptcy. The same applies to unsecured bondholders, that in some jurisdictions rank behind other depositors that hold claims not in the form of a financial instrument but in the form of current accounts or savings accounts (also see the developments in that direction discussed in chapter 18). Keeping the components separate – and being fair in selling such instruments to avoid miss-selling claims – is relevant, both for the protection of investors, and as some of these less solid components can only be used up to certain limits (both tier 2 as a whole and certain parts of it, as well as tier 3) or can only serve to fulfil the capital requirements for certain specific risks (tier 3). See chapter 7.3. In the Basel III/CRD IV project the additional components of own funds compared to original own funds undergo relatively the greatest change. Tier 1 (the current original own funds) are designated as useful in a going concern, and tier 2 is re-categorized as instruments that will be useful in a liquidation or ‘gone concern’. The new definition of own funds comprises tier 1 (including both common equity tier 1 and additional tier 1) and tier 2 capital97. Tier 3 capital (the component of ‘short term subordinated loans’, is no longer eligible, not even for the short term market risks it is currently supposed to provide some buffering for. For the background and the effect of this change see chapter 2, 6.2 and 7.3.

95 Art. 31 CRR, though that still demands qualification as equity under all applicable accounting and insolvency regimes, but no such demand is made if the state aid instrument is issued prior to 2014, art. 483 CRR. 96 E.g. Dutch banks had ‘subordinated deposits’ which served as capital. Subordinated depositors claimed upon the bankruptcy of DSB Bank in 2009 that they were not aware of the implications of subordination. 97 Art. 4.118, 25, 62 and 72 CRR.

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To qualify as tier 2, some quality demands will need to be fulfilled, mainly to ensure availability as loss absorbent at least at the moment of non-viability of the bank98. These can be fulfilled by hybrids and subordinated loans that fulfil such conditions as: – issued and fully paid up by independent third parties, not funded or secured by the bank, nor guaranteed by a group entity; – subordinated to all claims of non-subordinated creditors; – they have a original maturity of at least five years, without incentives or other implications to repay early, and in the final five years of their existence they will be gradually written down (amortised slowly so they no longer qualify in full as tier 2); – deductions are made amongst others of some tier 2 instruments issued by financial sector entities. A major change will be that the majority of the own funds deductions under the CRD will under the CRR approach be made from common equity tier 1 instead99. This applies to such issues as insurance subsidiaries/participations, deferred tax assets and minority interests. As common equity tier 1 will be the major part of the type of assets that cover the solvency ratio and the additional buffers on top of the ratio; this is an important improvement in the quality of the financial buffers (if the percentage of high quality buffers required is increased while deducting high risk assets from that category instead of from low quality buffers; the quality of the financial buffers will need to improve from these two pressure points). It equally makes it more difficult for banks to fulfil them (if they cannot deduct some of the deductions instead from additional tier 1 and tier 2), putting additional pressure the scope of the deductions. This has led to the codification of some of the old national discretions into out and clear deviations from Basel III, on for instance consolidated insurance subsidiaries; see above. Deductions will still also take place of additional tier 1 and tier 2 capital, but that is focused to stakes in similar instruments issued by other financial enterprises. To determine the boundaries between similar items that could be common equity tier 1, additional tier 1 and tier 2 issued by other financial entities (especially third country financial entities) and should thus be deducted from the same category by the bank, EBA has been ordered to develop regulatory standards by 1 February 2015100. In some existing CRD provisions, which are maintained and expanded in the CRD IV project101, there is an alternative to deduction of risk weighting an asset at 1250%. In the 98 Recital 45, art. 62-71 CRR. 99 Art. 32-49 CRR, under the prudential filter heading (relating some value adjustments following from accounting standards that are deemed not to impact financial buffers for prudential purposes) and the deductions heading (relating e.g. to some subsidiaries). 100 Art. 36.3 CRR. 101 See above in the deductions from own funds on current examples. A new 1250% risk weighting alternative is introduced in art. 90 CRR for excess holdings outside the financial sector; see chapter 11.

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CRD, a deduction or a 1250% risk weighting are almost equally painful for the credit risk part of the solvency ratio102, but this will change in the CRD IV project. Under current rules, banks are required to hold 8% of the value of the assets in capital to cover credit risk if it is risk weighted at 100%. An asset worth 100 euro would thus normally require 8 euro in capital for its credit risk. However, if the asset is deducted from capital, the bank has to have had the full 100 euro in capital for this asset, prior to calculating whether the remaining capital is sufficient to serve as financial buffers for its risk weighted assets. 100 euro is 1250% of 8 euro. The upper limit of risk weighting is used for those assets which formally are not deducted from capital, but where the regulators deemed these assets to be in the same risk category as the deducted items. This regime requires a full euro of capital for each euro of exposure and means that the asset is basically taken out of the calculation for credit risk as a sure loss. The preferred route will likely become the 1250% risk weighting, if the bank has surplus additional tier 1 or tier 2 capital. Deductions will in future be made from the much stricter defined concept of common equity tier 1 instead of the wider defined concept of ‘own funds’, while risk weighting for the solvency ratio in part will be carried by additional tier 1 or tier 2 capital. These lower quality financial buffer components will carry some of the 1250% risk weighted assets, leaving more common equity tier 1 capital available to the bank to buffer for other risks. Loss Absorbency/Immediate Availability to Buffer for Risks and Losses The loss absorbency requirement for company law own funds and for hybrids has been introduced as per 1 January 2010103. It is a codification of the theory behind capital into the definitions. It replicates basically the still existing requirement that such shares and various other categories are available for unrestricted use to cover risks or losses as soon as these occur104. This requirement was applicable not only to company law own funds, but also to reserves, funds for general banking risks, revaluation reserves and value adjustments (and since the introduction of hybrids into the CRD definition of original own funds, also to those). Introducing the loss absorbency in going concern and in liquidation explicitly into the list of financial buffer items does bring this aspect of the definition of capital more closely to the awareness of the reader. Capital is indeed the financial buffer for the risks the banks

102 Deducting it has the benefit that the asset may also escape from requirements under other risk categories, while some of the ‘newer’ deductions do not impact the own funds thresholds set for the large exposures regime. The bank will make a calculation of costs which route is best suited for it. 103 Introduced in art. 57 sub a and 63a RBD by the CRD II Directive, 2009/111/EC, in response to the 20072013 subprime crisis. 104 The second paragraph of art. 61 RBD and one of the requirements of the gaping national discretion of art. 63.1 RBD.

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run, if and only if it actually absorbs losses. This had been conveniently forgotten sometimes before the 2007-2013 subprime crisis. However, why the loss absorbency requirement is duplicated only in the company subscribed capital reference and for the hybrids does not appear to have an objective reason. Loss absorbency should also be expected of other components that are accepted to function as financial buffers, either in a going concern (original own funds) or at least in a bankruptcy (some of the lesser quality components of own funds). The crisis did, however, bring a focus on the components of capital that were supposed to be relatively high quality. An explicit demand for loss absorbency makes it clearer why these are the only true buffer for losses as risks. In that context, the need of muscular appearing action may have induced lawmakers to put it explicitly in the law, or alternatively the ‘immediate availability’ requirement may not have been stringently applied by supervisors and member states. If the latter reason is important, it is less than clear why the Commission did not start infringement procedures. The other items that are deemed to provide financial buffers under the CRD remain under a general requirement to be available as soon as risks or losses come up. The grandfathering of this loss-absorbency requirement by the CRD II directive was too lenient. Any ‘capital’ that does not fulfil this limited definition of actually being loss absorbent can still count as own funds until 2040 in the definition105. A mistake, as it means that for a long time – way longer than any potential duration of the financial crisis that was present at the time of its introduction – financial buffers that have to be accepted by supervisors do not actually provide a buffer if the bank or the wider economy is in trouble. The loss absorbency quality requirements have been upgraded in the CRD IV for common equity tier 1, see above under ‘equity/subscribed capital’. For state aid instruments, a particularly lenient approach applies currently, which basically amounts to it falling under the existing national discretion (that if the member state says it is high quality capital, it is, even if it fulfils none of the criteria. To avert a collapse of a bank that would have systemic consequences this may have some reasoning behind it – and it works as long as the markets are willing to accept that such instruments or at least the involvement of a credible member state is as good as capital – but it does amount to more favourable treatment allocated to member state financing (which cannot be matched by private sector funding), and it is doubtful whether all member states are equally vigilant to ensure that the capital they themselves provide is loss absorbent. Up to end 2013, this wild west situation continues, allowing member states to deal with any fall-out from the 2007-2013 subprime crisis (and 105 Art. 57 sub a and 154.9 RBD, and chapter 7.1.

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the transitional arrangement is favourable until end 2017; see below). If the crisis continues or in any future crises, a new provision allows state aid instruments to count as high quality financial buffers, with a limited amount of harmonisation of the conditions under which it is acceptable, amongst which that they need to be loss absorbent106. Future Developments See chapter 7.1 on the general developments towards the Basel III/CRD IV project, and the remarks above on specific changes in the CRR in the definition of capital. EBA is obliged to develop regulatory standards on hybrids by 1 January 2014, and on several other issues such as deductible items by 1 February 2015107. A new concept of ‘eligible capital’ is introduced to serve as a benchmark for the large exposures regime and the qualifying holdings outside the financial sector regime, as described in chapter 11. The idea is that the benchmark of ‘own funds’ lead to those regimes increasingly not being restrictive to large banks, which will be adapted by reducing the lower quality capital components that can be taken into account in this new concept after a transitional period (and a review before the stricter requirements enter into force)108. The transitional arrangement proposed by the Commission are very generous indeed. Any capital issued before 1 January 2014 as state aid instruments and end 2011 for non-state aid instruments (in the Commission proposals 20 July 2011), including old paid up capital with the easy conditions, and the former category of unpaid commitments, will continue to count as common equity tier 1, additional tier 1 and tier 2 until end 2017 if they were granted in the form of state aid to banks, and until 2021 if they were non-state aid instruments109. Guidelines – CEBS-EBA implementation guidelines for hybrid capital instruments, 2009

106 Art. 31 and 483 CRR. 107 Art. 63a.6 RBD, as added and amended by CRD II Directive 2009/111/EC and Omnibus I Directive 2010/78/EU. On issues introduced in the CRD IV project, EBA is ordered to submit drafts to the Commission by 1 February 2015 on such issues as the specification of deductible items from core equity tier 1; see art. 26, 27.2, 28.5, 29.6, 36.3, 41.2, 49.6, 53.2, 73.7, 76.4, 78.5, 79.2, 83.2, 84.4 and 110 CRR and chapter 23.3. 108 Art. 4.71, 494 and 517 CRR; see chapter 11.1. 109 Art. 483 CRR for such instruments if they were part of a state aid package; art. 484 CRR for Non-State Aid Instruments. State aid instruments issued after 2014 need to fulfil a limited set of harmonised criteria in order to qualify as a financial buffer; see art. 31 CRR. Also see chapter 2.

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7.3

One Solvency Ratio Numerator – Three Tiers

Introduction Though some low quality components are accepted as providing financial buffers for capital requirements under the CRD solvency ratio (and the Basel capital accord), these are not accepted without boundaries. Banks are prevented from attempting to fulfil all their capital obligations by the lowest quality (generally cheapest) buffers. As absolute numbers are meaningless in the context of the solvency ratio (which is percentage based; see chapter 6.2), the boundaries are also defined as maxima on the use of low ranking components in relation to the availability of other – higher ranking – components. Such tiering of high to low quality buffers intends to ensure an – albeit low in the current version of the CRD – minimum usage of high(er) quality capital components. The basic outline of tiering is set out in one article of the RBD. It refers to various components contained in the definition of original own funds and of own funds110. Tiering (Maxima on the Use of Lower Quality Financial Buffer Items) The Basel capital accord as applicable up to and during the 2007-2013 subprime crisis differentiates between high quality and low quality components of financial buffers. Tier 1 consists of high quality balance sheet items (subdivided between core tier 1 and a maximized amount of other tier 1 instruments), tier 2 of low quality balance sheet items that still, however, have some aspects of buffering capacity, and tier 3 consists of very low quality short term subordinated debt, that can only be used for some very specific (market) risks. Each of these categories is separately calculated. Tier 2 and tier 3 components can only be used by the bank to fulfil supervisory requirements to the extent that the value of such tier 2 and 3 components do not exceed thresholds set by the amount of available tier 1 components. The CRD does not explicitly reference to such separate categories or tiers. As set out in chapter 7.2, the CRD instead defines one of the concepts it uses (original own funds) along the lines of the BCBS tier 1 concept. It subsequently uses the – much wider – definition of ‘own funds’ to capture the tier 2 and 3 components. It ‘tiers’ within this wide concept again by setting maxima for the use that can be made of some low quality components for buffering against the risk in the context of the solvency ratio, and sets out how to calculate these maxima111. Overall, the CRD system with its interlinked system of definitions, components, and internal maxima-calculations is (even) more confusing and impenetrable

110 Art. 57 and 66 RBD, as well as art. 13 RCAD. See chapter 7.2. 111 Art. 66 RBD.

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than the Basel capital accord112. Supervisory explanatory texts thus generally refer to the three tier system of the Basel accords, instead of to the definitions and maxima system used in the CRD. Figure 7.1 BCBS tiers

The quality of the financial buffers is the determinant. In order to be ‘eligible’ to be included in capital, the buffer should be ‘freely available to meet unidentified losses’. Preferably it should be loss absorbent already in going concern, prior to a liquidation situation113. Tier 1 capital was first defined in 1988, and was the only area where the Basel members were largely agreed that its components meet the conditions of availability and loss-absorbency. It concerns issued and fully paid equity capital plus disclosed reserves, as these are in the perception of the markets, through the annual accounts, the only public measure which provide a hint at capital adequacy. As set out in chapter 7.1 and 7.2, several other instruments slipped in from the beginning in national legislation, allowing specific types of instruments to be counted as if they have the same value as a buffer as normal shares. 112 The BCBS, International Convergence of Capital Measurement and Capital Standards: A Revised Framework, June 2006 is no picnic either. It starts with the ‘clean’ concept in its (second) chapter on the constituents of capital, and subsequently differentiates between the term with or without the deductions and between the tiers. The majority of deductions are, however, dealt with in the first chapter called scope of application. 113 See §49vii, xi and xii BCBS, International Convergence of Capital Measurement and Capital Standards: A Revised Framework, June 2006. For hybrids and equity capital, this requirement has been introduced explicitly into the CRD during the 2007-2013 subprime crisis; see chapter 2 and 7.2.

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Other weaknesses are caused by differences in in accounting standards, as well as by innovations in the structuring of shares and companies that expanded the concept of equity beyond its initial intentions114. However, there was a consensus on tier 1 (even with its national peculiarities) that was absent from the start on tier 2, reflecting a wide diversity on capital definitions used115. National supervisors represented in the BCBS were divided as to the instruments that they accepted in this category. The components of financial buffers set out in tier 2 may have some ongoing loss absorbing features or wording, but each of them has downsides that made them unacceptable for some members of the BCBS and some member states. Reserves which are not disclosed, revaluation reserves for ‘historic value’ accounting, general loanloss reserves have all come under attack from accountants standard setters or regulators in various member states or internationally. These components actually only provided some safety for higher-ranking creditors in a liquidation, and tended to be repaid to (powerful) creditors prior to such a liquidation occurring. Whether hybrid debt capital instruments and subordinated term debt (which by definition serves its purpose only in a ‘gone’ concern situation even if it is long term available) can be deemed loss absorbing is highly debatable, but for the purposes of regulatory financial buffers they are allowed to count as loss absorbing capital. The lack of agreement on the lower grade components of the financial buffers automatically makes the numerator of the BCBS and CRD solvency ratio one of the least harmonised core parts of banking regulation116. As banks in some states relied heavily on some – but different – lower grade constituents of capital in order to fulfil their obligations, this is a difficult area to make progress on harmonisation for their supervisors117. The inclusion or exclusion of these constituents is therefore a matter of national discretion. This applies even after the slight improvements made in the context of the CRD II amendment that entered into force in 2011. For the Basel III version of the capital accord to be relevant, it will need to deliver an effective and efficient tightening of the capital that is defined to be loss absorbent in a going concern and a gone concern, both when comparing its members (including the EU as a whole), and between the member states of the EU.

114 Some of the worst innovations in weakening equity will be filtered out by the introduction into the CRD as per end 2010 of a high level definition of some components of ‘original own funds’ and the work by CEBS on harmonising its application by supervisors; see chapter 7.2. 115 For this diversity see R.M. Pecchioli, Prudential Supervision in Banking, OECD, 1987, chapter VI. 116 R. Zhao & Y. He, ‘International Variation in Bank Accounting Information Content’, Journal of International Financial Management and Accounting, Vol. 19, No. 3, 2008, page 236-260. 117 Also see the debate about the EBA stress tests in 2011; see chapter 13.6.

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The impact of changes in the regulatory framework on the amount of capital that banks are required to have has been a key issue in BCBS work. In the 1988 Basel I version it focused on the compromise to demand 8% capital ratio, in the market risk amendment the additions to the capital requirement lead to additional categories of funds being added to the capital definition, and in the 2004 Basel II version it focused on maintaining the same level of capital as an end result regardless of the changes made. In emergency situations, i.e. if the bank is in trouble, or if the banking system is in trouble, the supervisor can relax the tiering limits118. This legal regulatory forbearance relates to both the formal three tiers, and to the threshold imposed on the use of hybrids within the context of tier 1. The possibility that supervisors relax requirement on high quality financial buffers helps to ease procyclicality of the requirements (high grade capital is difficult to obtain if the bank is in crisis, which would accelerate its demise even if other types of financial buffers are still available), but on the other hand reduces the trustworthiness of the published numbers of a bank in crisis in order to allow it to continue operating in an explicit example of regulatory forbearance; see chapter 18 and 20.3. Internal Limitations within Tier 1 (Hybrids vs. Core Tier 1) The BCBS indicates in the Basel II version of the capital accord that “the key element of capital on which the main emphasis should be placed is equity capital and disclosed reserves”. This is a more limited concept, often also referred to as core tier 1 capital. It excludes such items as hybrids or other national discretion-items. In the tiering concept, these highest quality items have to be at least 50% of all tier 1 capital. This has been copied into the CRD, which requires that at least 50% of original own funds needs to be covered by equity and obligatory reserves119. Core tier 1 capital is therefore – unlike other financial buffer concepts – still closely related to the company/accounting equity definition. In the Basel capital accord the CRD-deductions of own shares at book value held by the bank and material losses are not mentioned. It limits itself to indicating paid-up share capital/common stock, disclosed reserves, minus goodwill and the mentioned increase in equity capital resulting from the securitisation exposure. The deviation in the CRD is well within the wide variation allowed for in the capital accord. A more material deviation is that in the BCBS capital accord the securitisation gains are also deducted from paid up capital, and share premium accounts. According to the text of the CRD, these securitisation gains need only be deducted from profits and losses and the reserves, not from paid up capital. In case the other elements of common equity tier 1 within the original own funds definition

118 Art. 66.4 RBD (as slightly rephrased to include a reference to the hybrids system by art. 1.12 CRD II Directive 2009/111/EC). 119 Revised BCBS Framework page 14, and art. 66 RBD.

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have been depleted, in the CRD there is no longer an obligation to deduct. This may be a mistake, or may be intended. As there is still substantial freedom to deviate from the CRDown funds concepts120, the Member States can implement the BCBS version if they so desire. Hybrids are part of original own funds, but within this tier 1 they are part of the lower quality items, and can thus only form a maximum of 50% of original own funds. If the other components of original own funds as defined in the CRD (basically similar to core tier 1 in the Basel terminology; see chapter 7.2) added up are not equal to the hybrid capital, the remaining amount of hybrid is no longer counted as original own funds (tier 1). If there are limits to the usefulness of the hybrids (such as that it is dated) the maximum percentage is further reduced (see the overview below). The remaining amount of hybrids that cannot be taken into account in tier 1, is instead counted as own funds (but not original own funds) in the tier 2 category in Basel terminology. This in turn is limited in relation to the available total amount of tier 1/ original own funds as set out below. A specific sub-set of hybrid capital that has gained additional regulatory and political popularity during the 2007-2013 subprime crisis is contingent bank capital with automatic bail-in clauses (for instance in the form of contingent convertibles or ‘coco’s’); see chapter 18 on bail-ins. The senior unsecured debt that may play a role in future plans for resolutions as a condition for state aid (a bailout) is at the moment part of the protected creditors, instead of being allocated a status of financial buffers; see chapter 18.3-18.4. They are not hybrid debt but basically just debt. Such future convertibles were deemed to continue to be counted as tier 1 capital in the EBA recommendation) for a temporary increase of capital buffers in the context of its stress testing exercises; see chapter 13.6. EBA set up a format for a convertible that would be acceptable for that temporary additional buffer as per mid2012, though it dutifully pointed out that the Council and Parliament would have to set the final form of such convertibles under the yet to be agreed new CRD IV rules121. The Liikanen review correctly points out that bail-inable debt should be identified ex ante, instead of senior creditors being surprised by being treated as risk-capital providers instead of as depositors122. This would spur anyone who is or may not be treated as a senior creditor to ‘run’ otherwise at a much earlier point in time123.

120 Art. 61, 62 and 63 RBD, see chapter 3.5 and 7. 121 EBA, Recommendation on the Creation and Supervisory Oversight of Temporary Capital Buffers to Restore Market Confidence, EBA/REC/2011/1, 8 December 2011 (with accompanying ‘questions & answers’). 122 High-level Expert Group on Reforming the Structure of the EU Banking Sector, Final Report, 2 October 2012 (Liikanen Report), page 103-104. 123 See chapter 18, and R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 2 and 3.

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Limitations of Tier 2 and Tier 3 in Relation to Tier 1 The compromises made in the original Basel accord on the relation between the three tiers has led to the establishment of a complicated formula of different quality levels of financial buffer components that can be used. Like for the maximum amount of lower quality items within tier 1 in relation to core tier 1 items within the definition of original own funds, the maximum use made of the additional components of ‘own funds’ as defined in chapter 7.2 is calculated in relation to the total amount of eligible components of tier 1/original own funds as defined in chapter 7.2. Tiering allows banks to use its most trustworthy financial buffers in full, and percentages thereof only for the less trustworthy financial buffers. The total value of original own funds (tier 1) is thus used as a benchmark to limit the maximum use that can be made of tier 2 and tier 3 components. Tier 2 capital instruments cannot be taken into account for the calculation of financial buffers in as far as tier 2 capital exceeds original own funds. The lesser components allowed as capital may be used to fulfil capital requirements only up to the same limit, as there are high quality financial buffers available. Surplus tier 2 is not relevant for the fulfilment of the solvency ratio, unless tier 1 capital is increased. This deviates from the rule for surplus hybrid tier 1 components. These can be used as tier 2 capital to the extent they are surplus in tier 1, see above. The lesser quality components of the financial buffers (CRD-own funds) contained in tier 2 are subsequently again divided into two categories. They are sometimes referred to as upper tier 2 and lower tier 2. Upper tier 2 elements are expected to be available for use for loss absorption by the group when in a going-concern basis; see chapter 7.2. Undisclosed reserves are considered closer to the characteristics of company law/accounting capital as they can become effective during the lifespan of the institution instead of only during its liquidation. The lower tier 2 elements do not help prevent the institution going down, but will at least help to ensure that depositors and ‘normal’ bondholders and creditors will be repaid in full from the estate of a liquidated bank. Subordinated long term bondholders for instance provide some buffering for normal depositors and bondholders, but only in the context of a liquidation process where subordinated loans rank last before equity in a pay-out. Subordinated loans can sometimes become more useful in going concern, if supervisory or other public authorities are allowed to trigger their conversion or expropriate them (but note the protection offered by administrative law and human rights discussed in chapter 20.4-20.5. Such government intervention would make them effectively similar to hybrids instead of a pure subordinated loan. If tier 2 is used to the maximum extent (i.e. up to an amount equal to tier 1 capital), there are additional restrictions on some of its lowest quality components in relation to its slightly higher quality components. Longerterm subordinated loans or unpaid commitments of the members of cooperative banks

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or funds can only serve within the space allowed for tier 2 capital to fulfil capital requirements up to half the amount available as original own funds124. In the RCAD provisions on the solvency ratio and own funds as defined in chapter 7.2, the balance sheet component of short term subordinated debt is added as an accepted financial buffer. Though it is included in the general definition of own funds, it can – in line with the BCBS revised framework limitations on tier 3 – only be used for market risks. The tier 3 capital used for market risk is limited to a maximum of 150% of the value of original own funds used for market risk125.

124 The constituents mentioned in art. 57 (d) to (f) are required to be larger than or equal to those mentioned in art. 57 (g) to (h), in effect indicating that the highest quality tier 2 components should dominate within the tier 2 category. 125 See chapter 7.1 for some background on the introduction of tier 3. The market risk solvency requirement can thus be met by tier 1, tier 2 and tier 3 capital, in a composition of 1 to 1 to 1.5. Even if more tier 2 or tier 3 is available, it can only be used to meet regulatory requirements if the tier 1 capital available for market risk is also increased. See chapter 6 and 9.

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Tabel 7.3 Overview of the tiering system up to 2014

Automatically convertible hybrids in crisis situations and debt instruments that are convertible at the upervisors’ discretion:

up to 50% of original own funds.

Other hybrids:

up to 35% of original own funds.

Dated hybrids:

up to 15% or original own funds

Relation tier 1 and tier 2: Original own funds ≥ low quality and/or surplus hybrids Revaluation reserves value adjustments under the ABD domestically allowed reserves commitments of the members of cooperative banks subordinated loan capital. With as an additional requirement for the lower quality components of tier 2: 50% of Original own funds ≥ commitments of the members of cooperative banks subordinated loan capital.

+ + + + + +

+ +

requirement: Original own funds already used to cover market risk x 150% ≥ tier 3 used to cover market risk

2007-2013 Subprime Crisis Related Developments – Loosening and Tightening As referenced in chapter 2 and 7.1, the definition and quality of financial buffer components has gained substantial attention. Early in the crisis the definitions were relaxed in two important manners in CRD II126: – the hybrids regime was harmonised, hardwiring a very flexible regime to shore up capital; see chapter 7.2; – the power to relax the tiering requirements – a form of legal regulatory forbearance – was codified in the RBD. This was used amongst others to allow the many forms of state aid to qualify as core tier 1 in spite of not being e.g. equity injections but instead rather low-quality hybrids127. 126 CRD II Directive 2009/111/EC. 127 Art. 66.4 RBD transformed this from a decision not to sue to the possibility to explicitly grant an authorisation to use more lower quality financial buffers components to fulfil requirements that under the tiering concepts

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In the wake of the 2007-2013 subprime crisis, the tighter approach to capital requirements has gained momentum. Especially in the definition of capital this has been long overdue. The main conclusion from the crisis was that the only form of capital that truly absorbed losses was common equity128. As a result of Basel III amendment to the capital accord, several of the more controversial components of bank capital will be eliminated or downgraded. Especially hybrids and subordinated loans have borne the brunt of the attention. Within the tiering system the relative importance of company law own funds is increased, while tier 3 will be eliminated from the financial buffers. The composition and deductions from the tier 1 and tier 2 financial buffers will be strengthened. In tier 1, only financial buffers that absorb losses on a going concern basis will be permitted. It is subdivided in common equity tier 1 (similar to the core tier 1 concept). Under Basel III, it is basically common shares that fulfil a set of conditions. The lower segment of tier 1 remains basically hybrids, with an extensive set of demands to ensure they are loss absorbent in going concern. Some deductions are ‘upgraded’ to be deducted from these highest quality financial buffers, instead of a deduction from the amounts of tier 2 that served as financial buffers; see below. The strict approach to common equity tier 1 components combined with the upgraded additional deductions and filters turns out to have the highest impact (especially on the larger groups that have more to deduct) according to the impact assessment by CEBSEBA129. The new tier 2 financial buffers will continue to be required, but are now specifically (and correctly) targeted to provide support in a gone concern basis, when the bank fails and is liquidated or is rescued via government intervention. This leads to a simplified financial buffers schematic, in which the term common equity tier one capital will become much closer linked to the company law concept. This is in line with lessons from the 2007-2013 subprime crisis to rely mainly on common equity and similar reserves and in line with the behaviour of the markets, which in crisis times mainly looked at the highest quality of capital available to determine which bankshares they would buy or retain130.

should be fulfilled with high quality components. The CRD IV project for this reason differentiates between state aid financial buffers and instruments that are counted in tier 1, and non-state aid forms. See below. 128 C. Roxburgh, Debt and Deleveraging: the Global Credit Bubble and its Economic Consequences, McKinsey Global Institute, London, January 2010. 129 CEBS, Results of the Comprehensive Quantitative Impact Study, 16 December 2010, www.eba.europa.eu, page 9, 12 and 14. 130 A. Demirguc-Kunt, E. Detragiache & O. Merrouche, Bank Capital, Lessons From the Financial Crisis, World Bank Policy Research Working Paper 5473, 2010. Also see chapter 2, 6.2 and 7.2.

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Most of the deductions that are in the CRD made at the level of original own funds (e.g. goodwill) and some made at the level of the CRD definition of own funds (e.g. financials), in the Basel III amendment are to be made at the level of common equity tier 1. This is a substantial change. By way of example, if a bank has 90 in shares, 70 in hybrids, 10 in goodwill and 10 in financials, under the old calculation it meant it had 90 + 70 – 10 – 10 = 140 in tier 1. It could use the 140 in full, as its shares were more than 50% of this 140 (as they were more than 70 by a wide margin of 20. In the new calculation, it has 90 – 10 – 10 = 70 in common equity tier 1, and 70 + 70 = 140 in tier 1. In tier 1, there is no change, and the bank can use it in full. But when it has to raise new capital due to either losses or anticipated expansion of its assets (denominator; see chapter 6.2), it can no longer raise hybrids (as there is no margin left between the amount of shares and of hybrids), and it will need to raise common equity at least in the same proportion as it raises hybrids. Changes in the fair valuation of assets will also impact directly on financial buffers. The BCBS previously filtered unrealised gains and losses out of the buffers, but these accountancy valuation adjustments will in the future impact directly on common equity tier 1 capital131. The Basel III version of the capital accord is substantially more detailed and contains substantially less national discretions in its definition of capital and its tiering than the CRD as applicable in 2013. The CRD IV project largely copies the Basel III accord. Some of the key deviations focus on the definition of capital; see chapter 2. The CRD IV deviates from the worldwide level playing field on the deduction of insurance subsidiaries (which the Commission does not require), on the acknowledgment of deferred tax assets (which the Commission wants to continue to allow as capital ‘unless they depend on future profitability’) and on the lack of reference to ‘common shares’ in the common equity tier 1 definition, which in principle allows other instruments that fulfil the criteria – such as some types of hybrids – to qualify as common equity tier 1132, see chapter 6.2 and 7.2. These substantially increase the amount of common equity tier 1 capital for EU based banks when compared to a strict application of Basel III, important to fulfil the higher proportion of common equity tier 1 capital to fulfil solvency ratio requirements in part, and for the additional buffers on top of that.

131 BCBS Consultative Document, Fundamental Review of the Trading Book, May 2012, page 11. See chapter 6.4 on the treatment of fair value. 132 EBA noted in its 2011 stress test results that the – still accepted – deferred tax assets amounted to around 10% of total core tier 1 capital at the start of its exercise and become larger if the bank is under pressure. Hybrids – which were excluded in the exercise – amounted to 17%. EBA, European Banking Authority 2011 EU-wide Stress Test Aggregate Report, 15 July 2011, page 27. As both categories are low quality and rarely useful in a crisis, the Basel III package phases them out over time; though the EU is deviating on deferred tax assets in some respects. Art. 26-50 CRR, and page 10-12 of Commission, proposal for the CRR, COM(2011) 452 final.

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The two remaining tiers (with a sub-division within tier 1 between the highest quality financial buffers and other components that also provide loss absorbency in going concern) play a key role. The minimum solvency requirement remains 8%, as indicated in chapter 6.2, supplemented in future with the additional (and more flexible) buffers on top of this minimum. 4.5% of the minimum 8 has to be fulfilled by common equity and public reserves (common equity tier 1), up from 2% (with another 2% hybrids and 4% tier 2 and/or 3). Another 2.5% has to be fulfilled by such common equity, or by other tier 1 high-grade capital that provides loss absorbency in going concern (such as contingent capital/hybrids that fulfil strict requirements; see chapter 7.2). The remaining 2% of the minimum 8 can be fulfilled by such high-grade quality, but can also be filled by the type of financial buffers that is only useful to provide additional relief to creditors during liquidation in a bankruptcy (gone concern capital; the new tier 2). The CRD IV project copies Basel III in its deletion of low quality tier 3 capital. The proposals of the Commission on a recovery and resolution directive and a Eurozone single resolution mechanism, however institutes a low quality additional buffer requirement. Any bank should not only have financial buffers in the sense of capital instruments or near-capital instruments mentioned above, but also to have additional ‘buffers’ in the sense of debt instruments that can be bailed in (ranging from subordinated loans to senior unsecured debt). To avoid no such buffer being available if a bank e.g. only has secured liabilities or deposit that are covered under the deposit guarantee directive, the Commission proposes obligation to have at least a bail-inable set of instruments for an additional percentage of total liabilities (excluding regulatory capital) to be set by the new resolution authorities per bank on the basis of its profile. The Commission may specify criteria and percentages, and in its proposal is thinking in terms of around 10% of such total liabilities excluding regulatory capital133. All secured bonds and insured deposits are excluded from eligibility for a bail-in, so that a bank will have to issue unsecured debt (either subordinated or senior) on which the lender is informed that the supervisor/resolution authorities may transform it into capital or write the debt down in full. The write down would be first on the higher forms of capital (common equity tier 1, then additional tier 1 and tier 2 proportionally on liabilities of the same rank, then on subordinated debt that is not tier 1 or tier 2, and then on any eligible bail-in debt instruments up to the amount needed to ensure the continued existence of the institution or to provide a bridge bank (that has taken over the business of the bank) with sufficient capital134. 133 Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. See page 13 and the proposed art. 39 and 40. Art. 10, 15, 18 and 24 of the Commission Proposal for a Regulation on a Single Resolution Mechanism, COM(2013) 520 final, 10 July 2013. 134 See chapter 18.3 on the procedures and safeguards. Proposed art. 37-51 and 65-73 of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. Art. 39 refers to the minimum

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In the period 2014-2019 the CRD IV project intend to gradually increase common equity tier 1 components to cover more of the 8% capital requirements, up from the current quarter (see chapter 6.2 on the solvency ratio). This increase in the proportion of high quality financial buffer items in the mix of financial buffers used to cover the solvency ratio minimum capital requirement is feared by the banking industry, especially if such a demand would no longer be required to be able to fund themselves in the market in periods between crises. Its main argument against it has been that it will not only hurt them, but indirectly also economic activity in general due to reduced lending to other commercial enterprises and individuals (especially in the EU, as commercial activities here are relatively more reliant on bank financing as opposed to market financing in the form of bond issuance). The BCBS, CEBS and other banking supervisors have responded by publishing, alongside the new Basel III proposals that will be phased in over a very long period of time, the results of their own research that assumes a lower impact135. The harmonisation of the capital definitions and tiers necessitated a consensus also on the type of capital instruments possible for cooperatives and other mutuals. These and saving institutions can issue a wider range of instruments, including such that in principle have to be redeemed, even into common equity tier 1 capital136. For the conditions and further work needed in this area see chapter 17.6. Any capital issued before 1 January 2014 for state aid instruments and end 2011 for nonstate aid instruments (in the Commission proposals 20 July 2011), including old paid up capital with the easy conditions, and the old unpaid commitments, will continue to count as common equity tier 1, additional tier 1 and tier 2 until end 2017 if they were granted in

amount of eligible liabilities needed. Art. 43 relates to the hierarchy of claims, art. 50 to the contractual acknowledgement. The Commission accepts that this role of unsecured debt will make such debt more expensive, in line with the increased/explicit risk-profile. The information on its bail-in status is mandatory, but the absence of the information does not mean that the authorities cannot bail in such lenders. Also see FSB, Key Attributes of Effective Resolution Regimes for Financial Institutions, October 2011, page 9. 135 BCBS, An Assessment of the Long-Term Economic Impact of Stronger Capital and Liquidity Requirements, August 2010, www.bis.org. CEBS, Results of the Comprehensive Quantitative Impact Study, 16 December 2010, www.eba.europa.eu. Macroeconomic Assessment Group established by the FSB and the BCBS, Final Report Assessing the Macroeconomic Impact of the Transition to Stronger Capital And Liquidity Requirements, December 2010, www.bis.org; J.M. Berrospide & R.M. Edge, The Effects of Bank Capital on Lending: What Do We Know, and What Does It Mean?, Federal Reserve Board 2010-44. The importance of getting e.g. the design and timing right to minimize negative effects is also shown in central banking publications, e.g. I. Agur, Capital Requirements and Credit Rationing, DNB Working Paper 257/2010, www.dnb.nl. Also see the follow-up assessment (including the additional buffers for globally systemically important banks) in: Macroeconomic assessment group established by the FSB and the BCBS, Assessment of the macroeconomic impact of higher loss absorbency for global systemically important banks, 10 October 2011. 136 Art. 27 and the range of reduced quality demands in favour of mutual banks in art. 28.1 sub g, h and k specifically for mutuals, the general exceptions of 28.2 and 28.3, and the specific exemptions in art. 29 CRR.

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EU Banking Supervision the form of state aid to banks, and until 2021 if they were non-state aid instruments137. State aid instruments issued after 2014 still get a preferential treatment, but will need to meet at least some quality demands, and have to be held by public authorities138. Table 7.4 Pre-crisis tiers within capital CRD 2006 version

Basel Revised Framework 2006 version

The highest quality of ongoing Original own funds, (including Part of tier 1 capital (the part of loss absorbing financial buffers many national discretions) tier 1 now sometimes referred to as core tier 1 capital) Hybrid capital and contingent capital (debt instruments that are assumed to have loss absorbing qualities similar to shares)

Not mentioned, but possible Sydney press release (also nonwithin the national discretions core tier 1 capital)

Lesser quality ongoing loss absorbing financial buffers plus some long term available instruments that rank low in a liquidation

Additional own funds139 (Own Tier 2 capital funds minus original own funds minus short term subordinated debt and unpaid commitments of members of cooperatives and funds), split in 2 sub-tiers by art. 66.1 sub b RBD

Low quality financial buffers

Short term subordinated debt and unpaid commitments of members of cooperatives and funds

Tier 3 capital

Table 7.5 Tiering upgrades as a result of the 2007-2013 subprime crisis

The highest quality of ongoing loss absorbing financial buffers

CRD end 2010 version

Basel Revised Framework 2010 version (Basel III)

CRD IV project starting to be applied from 2014-2019

Original own funds, with some clearer descriptions on content in law plus in CEBS-EBA guidelines, excluding mainly hybrids

Part of tier 1 capital (this part is also known as ‘core tier 1 capital’), deleting many of the national discretions, but not all, with a higher proportion of the solvency ratio to be fulfilled by this category

Common equity tier 1 is defined along the lines of Basel III, without explicitly mentioning common equity.

Hybrid capital and con- Common definition in tingent capital (debt CRD. Part of Original

Sydney press release Differentiates (non-core tier 1 capital), between newly

137 Art. 483 CRR for such instruments if they were part of a state aid package; art. 484 CRR for Non-State Aid Instruments. See chapter 2 and 7. 138 Art. 31 CRR. 139 This term is used in recital 29 and 30 of the RBD, not in the RBD text itself.

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CRD end 2010 version

Basel Revised Framework 2010 version (Basel III)

CRD IV project starting to be applied from 2014-2019

instruments that are assumed to have loss absorbing qualities similar to shares)

own funds sub-tiers with but see the new requireeither 50% or 35% thresh- ments on bail-in clauses olds depending on characteristics of the debt instruments

issued (relatively higher quality) hybrids and relative low quality state aid instruments that will be accepted

Lesser quality loss absorbing financial buffers

No change: Additional own funds140 (Own funds minus original own funds minus short term subordinated debt and unpaid commitments of members of cooperatives and funds)

Similar to Basel III

Low quality financial buffers (tier 3)

No change in the defini- Abolished tion: Short term subordinated debt and unpaid commitments of members of cooperatives and funds, but more needs to be held for this risk in the trading book as the risk requirements are increased (see chapter 9)

Tier 2 capital is tightened. Accepted not to absorb losses in going concern, but should buffer losses in gone concern

140 This term is used in recital 29 and 30 of the RBD, not in the RBD text itself.

429

Abolished in the CRD IV, but to be reinstated in an adapted manner in the Commission proposals on a minimum amount of bail-in debt

8 8.1

Quantitative Requirements – Credit Risk Introduction

The first quantitative risk category that was fully developed at the international level was credit risk. Like financial buffers, it was part of the initial 1988 Basel capital accord (Basel I). Now accompanied by operational risk and market risk, it still is the largest part of the denominator of the solvency ratio; see chapter 6.2. The credit risk calculation aims to predict the potential for losses due to non-repayment for assets (e.g. investments and loans) and for off-balance sheet items (e.g. guarantees or liquidity facilities). Even with the rise in income generated by advice or provisions, the business of many banks is still focused on investing in financial assets, ranging from mortgage loans, personal loans to providing bank guarantees for debts of clients to another party. The financial health of the bank can be threatened if it makes such loans or investments to too risky counterparties, or if it does not have financial buffers to cover the loss if increasing numbers of counterparties are not able to fulfil their commitments to (re-)pay the bank. The 1988 Basel I version of the capital accord dealt primarily with this risk category, an approach copied by the EU. The original rules on credit risk determined the content of the solvency ratio directive of 19891. Previous EU directives only required member states to ensure that banks have adequate minimum own funds and to establish – non-harmonised or defined – ratios between assets and/or liabilities2. The Basel I framework as translated into the solvency ratio directive and the own funds directive was a huge step forward on convergence in standards of banking supervision. It set a relatively straightforward mechanism for determining how much capital a bank must have for the single most relevant risk category for banks: the risk that the value of its asset will deteriorate due to a decline in the creditworthiness of its counterpart and the resulting increase in the chance that the counterparty will not be able to fulfil its obligations (for instance to honour the contract by repaying a loan). The initial calculations were simple. The 1989 solvency ratio directive dealt with both the ratio and the credit risk treatment, and consisted of a total of 13 articles and 3 one page annexes. The definition of own funds (the numerator of the ratio) was dealt with separately in the own funds directive, which consisted of 10 articles3.

1 2 3

Solvency Ratio Directive 1989/647. Art. 3 and 6 First Banking Directive 77/780/EEC. Own Funds Directive 1989/299. The Second Banking Directive 1989/646 was used to deal with other issues (not covered in the Basel Accord), such as market access. For the current rules see chapter 7.

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Capital accords deal with the shape of the financial markets and the business of banks at the time of development. The original Basel capital accord was developed at a time when banks were still more or less limited to traditional banking services, and amongst others the financial instruments traded on stock markets were less complicated than they are now (as to size, territorial reach and complexity of the underlying value). New types of risks as well as risk mitigation methods follow from such developments as the rise of securitisation, credit risk derivatives trading, the cross-border integration of (wholesale) capital markets and the increase of cross-border lending to small- and medium sized enterprises and consumers via subsidiaries and branches. As the banks and the financial markets grew in size and sophistication and their business expanded into new areas, the credit risk calculation of the original capital accord of 1988 was increasingly gamed by banks. The categories were broad, and did not allow for differentiation in the risk profile of the counterparty. All loans to corporates were treated in the same way, as were all loans to G10 countries, while the risk premium asked in the actual financial markets of corporates or G10 countries could vary wildly. As the risk premium changed while the supervisory burden did not, it became an incentive to invest in riskier assets. The same applied to securitisation. This was an unknown phenomenon when the original capital accord entered into force. After it was developed as a tool to gain liquidity and reduce capital requirements (see chapter 8.6), the size of the securitisation market grew fast in the nineties of the last century. Basically it took assets for which capital should be held by the bank off the balance sheet by offering them to new investors (which lead to a reduction in capital requirements), and replacing those assets with contractual commitments to the new investors. Those commitments were drafted to ensure that either no or a lower amount of capital was required. Gaming the old capital accord became a driver in the structure of the financial markets, and reduced the effectiveness of Basel I as a restraint and a controlling force. Though a crisis had not – yet – occurred, the BCBS started its Basel II project to address the reduced usefulness of the original credit risk provisions. The goal was to make the treatment of credit risk more flexible and proportionate to the size and complexity of the institutions, and hopefully less easy to game. The credit risk segment of the capital accord was completely revisited. The new provisions on credit risk became a large part of the modernisation of the EU banking regulations, as laid down in the 2006 CRD. The total package of credit risk provisions in the directive, the annexes and CEBS/EBA guidance is now many times the original size referred to above, as is the treatment of credit risk in the CRR. The sheer size of EU level regulation is intimidating, and the way it interacts with the treatment of market risk makes it a complicated subject. For instance, the exposures for which capital must be held for credit risk purposes are also subject to capital requirements under some subcategories of market risk, such as foreign exchange risk. A more fundamental issue is the split made in the exposures between exposures in the banking book and the

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trading book. If exposures are deemed to be held for trading purposes, they are no longer risk weighted for credit risk. Instead, they are transferred to a specific capital requirements regime called position risk, which is a sub-category of the market risk regime, which calculates credit risk in a slightly different manner. Exposures are either subject to position risk (if they are in the so-called trading book) or to the credit risk treatment (if they are not in the trading book but intended to be held to maturity), never both. See chapter 9.2. Exposures The credit risk calculation looks at both on balance and off balance sheet items in a deviation in approach to the accounting rules. The risk that a claim on a counterparty is not paid back is the core of the calculation for prudential purposes. This looks at both existing claims (loans outstanding, financial instruments bought) and future claims to which the bank is committed that are not or not yet on the balance sheet (e.g. liquidity facilities or guarantees that have not yet been drawn down, or other potential commitments of uncertain impact under e.g. derivatives)4. Assets and off balance sheet items are collectively referred to as ‘exposures’. The calculation of the minimum capital requirements for credit risk for each of the exposures of the bank starts by looking at its value under the accounting framework (ABD and the IFRS regulation; see chapter 6.4). This applies to all exposures. The treatment under credit risk calculations nonetheless is slightly different for the two main categories of assets and off-balance sheet items, as the accounting framework remains the starting point. The only exposures not captured by credit risk requirements are: – the exposures which have already been deducted in full from own funds5; – the exposures allocated to the trading book (i.e. held with ‘trading intent’) which are subject to position risk instead (market risk; chapter 9); Even though all exposures are thus considered in one of these calculations, for the exposures allocated to the credit risk treatment there is also a requirement for supplementary considerations. Some aspects of credit risk on exposures may not be fully captured in the models (standardised or internally developed) for credit risk. Some subsets of market risk requirements (such as foreign exchange risk; see chapter 9) are relevant both to the trading book and the non-trading book exposures, and some aspects are not modelled yet, but still

4 5

C. Goodhart, The Basel Committee on Banking Supervision, a History of the Early Years 1974-1997, Cambridge, 2011, chapter 10. A deduction from financial buffers is a much harsher treatment than the treatment under credit risk. If this has already been done, there is no reason to count it also in the calculation of credit risk. See e.g. art. 80.1 RBD and chapter 6.4 and 7. If an asset has been written off in full (e.g. a loan that has not been repaid after the due date), there are no capital requirements for it any more, but on the other hand its value no longer enhances the own funds (or in CRD terminology: has been deducted from own funds).

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captured in supplementary requirements under the self-assessment/supervisory review process that aims to assess all present and potential risks under pillar 26. The most common assets of banks are loans given to its customers. Banks, however, have a much wider range of assets, including the bricks and stones of its offices, shares in its subsidiaries and shares held in its own account as bought on the stock markets. Common off-balance sheet items are bank guarantees that it has given to third parties on behalf of clients, or credit facilities given to clients in as far as they have not yet been drawn down fully. When the bank pays out cash to fulfil such a commitment, the claim to repayment on the client will automatically become an asset, but until that time it does not yet appear on the balance sheet as shown in the public accounts (see chapter 6.4). As it is nonetheless a potentially bad asset that will become on balance as soon as the commitment is invoked, financial buffers should be available to cover the risk embodied in the off balance sheet commitment. After determining the value under the accounting standards applicable for each asset and off-balance sheet item, a bank needs to calculate the risk weighted exposure amount for the purpose of establishing the amount of regulatory financial buffers required for that exposure. For credit risk purposes this is set at 8% of each risk weighted exposure (see chapter 6.2 and 8.2-8.3). The more advanced banks developed their own internal models in addition to the requirements of the 1988 Basel accord to get a better understanding of their risk position for management purposes. For credit risk, these internal models have become fairly sophisticated. Since the introduction of the Basel II amendment to the capital accord, the capital requirements for credit risk can be calculated on the basis of internal models if the model fulfils the supervisory minimum requirements; see chapter 6.3. For smaller institutions, this can be too complicated or too expensive to set up. Even for some of the larger or medium sized institutions, the most advanced models could be unnecessarily complicated or expensive. The CRD (following the Basel II amendment to the capital accord), therefore gives three options to banks to calculate the risk weighted exposures for credit risk: – the standardised approach (chapter 8.2); – the internal rating based or IRB approach (chapter 8.3), which is again subdivided in (i) the Foundation IRB approach, and (ii) the Advanced IRB approach.

6

See chapter 9.2, 13.6 and 14. As an example for pillar 2, see CEBS-EBA, Guidelines on technical aspects of interest rate risk arising from non-trading activities under the supervisory review process, 3 October 2006. The CRD IV project did not really touch the subject of such guidelines. EBA launched a consultation process to update these guidelines on 27 June 2013.

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Self-developed models are part and parcel of the IRB approach, but even in the standardised approach a self-developed model is optional for derivative instruments. For the use of these models, a bank needs permission of its supervisor. Reference is made to chapter 6.3 for remarks on models, and to chapter 17.2 and 21.6 for the process if the model is used by a banking group, respectively the added responsibilities and powers for the consolidating supervisor in the context of the approval of the internally developed model7. In this chapter 8, the content of the approaches and the extent they allow the use of the own input of the bank is set out. It should be noted, however, that the administrative organisation requirements and pre-conditions increase exponentially when a bank wants to use the more risksensitive IRB approaches, as set out in chapter 13.5. The three approaches accommodate most types of exposures on and off the balance sheet. It is, however, based on the assumption of a more or less clear value-allocation of more traditional assets and commitments. Derivatives and especially ad hoc designed over the counter derivatives (i.e. derivatives that are not traded on exchanges) do not fulfil that description. They are excluded from the normal exposures treatment and put through a separate calculation, that supplements the three approaches. This ‘counterparty credit risk’ or CCR treatment is designed to deal with similar types of derivatives both in the trading book and non-trading book, so complements with minor adjustments both the credit risk and the market risk treatment (regardless whether the derivatives are held with the intention to sell them or to keep them until maturity); see chapter 8.4 and 9.2. One of the clear distinctions between the standardised approach and the IRB approach is the use of internal or external ratings. In the standardised approach, the bank builds on the different ratings given by external credit assessment institutions (ECAIs, the rating agencies). This results in a more risk-based approach, but is still fairly inflexible. In the IRB approach, the bank acts itself as a credit assessment institution on certain aspects of the calculation, and needs to put data, research and methodologies in place to be allowed to do so. In each of these approaches, the face value of the exposure of the bank can be effectively reduced. This can happen through a variety of means, such as netting, securitisation arrangements, recognition of received collateral or of received guarantees as reducing the de facto exposure of the bank in all of which cases the capital requirement for the total value of the exposure now only has to be calculated over the lower face value8. This general

7 8

Art. 129 RBD. Less favourable to the bank is a reduction of the face value by accepting that a loss has been suffered and deducting the amount of that loss from own funds; see chapter 6.4.

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phenomenon is often referred to as credit protection or as the mitigation of risk faced by the bank. Most protection is dealt with within each of the three approaches to calculation, by for instance reducing risk weights for mortgage loans. However, there is a process applicable to both the standardised approach and to the Foundation IRB approach called credit risk mitigation, which deals with the credit protection not already dealt with in the approaches themselves. These overarching issues include netting and similar arrangements. The treatment of credit protection in the credit risk mitigation process is described in chapter 8.5. An alternate form of protection is selling the asset, which should take away all risks of further loss of value except in as far as any liability of the seller can be invoked by the buyer. An alternative to the sale of an asset is selling (parts of) the risk embodied in the asset. The securitisation arrangements as designed by banks while Basel 1 was applicable were geared towards achieving maximum downsizing of the on balance assets while incurring a limited off balance exposure value. This provided an interim stage between credit risk protection and an actual sale of the asset. A separate set of requirements was developed to deal with the risk reducing and risk heightening effects of securitisation, applicable to all three approaches to credit risk. The treatment of securitisation and similar ‘sale’ techniques is described in chapter 8.6. Some exposures are thus exempted from the credit risk treatment via the standardised approach or the IRB approaches. The normal credit risk treatment is in that case replaced by a specialised regime. The separate categories are: – the so-called OTC-derivatives9, dealt with via the so-called ‘counterparty credit risk’ methodology described in chapter 8.4; – exposures related to securitisations, dealt with in the securitisation methodology described in chapter 8.6; – exposures kept in the trading book, dealt with via the position risk treatment (a component of market risk) as described in chapter 9. Level of Certainty and Time-Horizon Set The ‘value at risk’ or VAR analysis gives a quantitative number for the risk the bank faces in a certain area, based on the assumptions on which the model is built; see chapter 6.3. The specific outcome can however vary wildly both for the certainty you want to have; the confidence level. Is it for instance enough that there is a 50% chance that buffers covering the calculated risk suffice, or should it be 100% and if so what will that mean for the availability of loans to the economy; is the likelihood that the risk materialises only calculated for the next week, for the next year, for the lifetime of the asset, etcetera? Setting the

9

Annex IV RBD and art. 3 RCAD; see chapter 8.4. These articles use a different definition than used in EMIR as discussed in chapter 16.4 and 22.4.

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time horizon for the potential of risk materializing within the period set, and how confident you want to be that if that risk materialises the number calculated will actually reflect the full cost (i.e. that the loss given the risk will wipe out the capital set aside for it, but will not cost more), both have an impact on the calculation, though without complete historic data and a well working crystal ball there is no certainty that the result is reliable10. Both variables are set by lawmakers, based upon recommendations made by supervisors (e.g. via CEBS-EBA or via the BCBS) and the industry (e.g. via its lobbying organisations or the consultative panels established by the EU). Clients of banks are generally not active when input is needed on these calculations; see chapter 2, 3.2 and 23. The VAR, and thus also the regulatory models based on VAR for credit risk, market risk and operational risk, provide a number for value at risk that is based on a certain confidence level. There are competing goals that pull at lawmakers when considering at what level to set confidence levels, that lead to conflicts in the priorities depending on whether prudence or economic growth or stability are more favoured than the others. The higher the confidence level set, the lower the remaining risk and the smaller the chance that that risk will materialise and thus the smaller the chance of the bank failing. However, the higher the confidence level set, the more restrictive the requirement, and the more dampening on the business of the bank and on the businesses that are dependent on bank-loans. If set at the highest levels of confidence, there would be no way to profitably operate a bank, and commercial businesses and consumers would feel a substantial credit crunch. The same applies to the time horizon. None of the methods used to calculate capital requirements looks at the lifetime of the asset. It thus deviates from the ‘normal’ long term investment attitude of consumers, who likely want to be as certain that they will be repaid in five years as next year. The models (either the standardised or the internal rating based approaches) define an assessment of risk in a certain portfolio for a specific type of risk only over the next year, at a 99% level of confidence11. At this level, once in 100 years the calculated number set aside in capital buffers will be insufficient under the assumptions on which the model is based. In the insurance sector, the Solvency II directive has indicated a different level. Insurers need to calculate their capital requirements at a 99.5% confidence level (i.e. in theory once in 200 years the expectations will not be met). But such confidence level assumptions all suffer from the lack of data over 200 years on the products traded, as many 10 P. Jorion, Value at Risk, 2007, 3rd ed, New York, chapter 5 and 6, and 18 as to the limitations of backtesting for lending in the credit risk context. Also see J. Daníelsson, Blame the Models, June 2008, www.riskresearch.org. 11 Normally, banks that use internal models for capital requirements also have to use it for their other decision making. The short time horizon necessitated an exception to this use-test (see chapter 6.3). For e.g. pricing decisions banks may deviate from their year-risk assessment to set prices for longer term assets (e.g. by setting interest rates for multiyear loans). BCBS, The IRB Use Test: Background and Implementation, Newsletter no.9 (September 2006), Basel, 2006.

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were only invented, or traded in such volumes across so many borders for very short timeframes. The time period for which a prediction is made is chosen to be a year, but it could also be set for 10 years. This would, however substantially increase required capital to be able to cover for the potential gyrations over such a long period. The year is chosen on the assumption that the value at risk is calculated continuously. The most recent information gives the bank and its supervisors the possibility to oversee a reasonable future (and time to e.g. issue new equity), and always think about the upcoming year, without stifling the business of the bank. Setting these levels for the various models used by the banks to calculate the denominatorelements of the solvency ratio thus defines the risk appetite of the regulators/supervisors. They accept that the required financial buffers will be insufficient once every x years even under the assumptions made (which may not be borne out in practice), and that damaging events that are 1.1 year onwards may be ignored until next month, in return for allowing the banks and their customers to continue operating on the assumption that the next year (and implicitly the period following that year) will be one of the years in which the risk of insufficiency will not actually materialise. If lawmakers gamble right, the buffers should be sufficient, if they gamble wrong, the buffers are not sufficient, and the bank, or in a worst case scenario the banking sector, would fail unless it is bailed out by market participants or by the state (i.e. taxpayers). A bank (or its customers/rating agency) can opt to be more conservative than required by the CRD. In good times, they regularly do opt for such conservatism, especially if the public requirements are known to be dated (e.g. in the years before the Basel II amendment entered into force banks regularly operated above minimum capital levels, either at their own behest or at the behest of rating agencies or clients). However, if they are too conservative, they may lose investors, lenders and borrowers to competitors who sail closer to the wind. As these calculated financial buffers and the level of confidence that those will be sufficient are based on assumptions, any realisation in practice will serve as input on the correctness of the assumptions. The process to check whether the actual outcome in real life is within the calculated variation of the model is called backtesting12. The predictions made by the model are subsequently evaluated against what actually happened. The assumptions (and the calibration thereof) then can be adjusted if it turned out to be overly optimistic or overly pessimistic. Stress testing requirements will normally try to prevent too optimistic outcomes. Otherwise a relatively sunny period could lead to adjustments that lead to the 12 P. Jorion, Value at Risk, 2007, 3rd ed, New York, chapter 5.

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conclusion that umbrellas are no longer necessary, just because it did not rain the previous period. Stress testing requirements as included in the CRD prior to the 2007-2013 subprime crisis however turned out not to be particularly stressful, and are being upgraded (see chapter 13.6). Default The starting point of the calculation of capital requirements is the value of assets and of the off balance sheet commitments. The accounting standards are particularly important for the determination of that value. Accounting principles determine how to treat performing assets and how to treat assets where the debtor has gone into default (or the asset should for other reasons be written down). See chapter 6.4 for both fair value accounting and loan loss accounting for different categories of assets. The underlying thought is that if an exposure is fully and definitely likely not to be paid, the value adjustment will be processed via an equivalent reduction in the financial buffers (reduced value of all assets minus an unchanged number of liabilities leads to an equivalent reduction of the financial buffers by reducing the equity component or reserves components; see chapter 7.2). If the asset still has value (e.g. there may be a partial pay-out by the liquidator of the borrower), the asset will for that remaining value be subject to credit risk calculations (and for the written down part it will be channelled via a deduction from the financial buffers). Where the loss is fully deducted/provisioned, no capital needs to be held for the lost value of the asset. The CRD does, however, have specific provisions relating to positions that are in default, but have not yet been written down (fully) under the applicable accounting standards. When these were introduced, national accounting systems were still wildly different, as were the definitions of when an asset is deemed to become defaulted. The consensus of that time between prudential supervisors has now been hardwired in the CRD. As it has become ingrained in prudential calculations, it is difficult to change even where accounting standards have since been harmonised. The definition of default is different in member states depending on the local market payment culture. Most member states have opted to use the same definition of 90 days non-payment period after the due date before an exposure is deemed to be in default, but in some member states 180 days is still applied as long as possible under the various national discretions. Default on a delivery obligation due to a system wide failure of a settlement or clearing system, which system wide failure is recognised as such by supervisors, is not considered to be a default for credit risk purposes13. The full value of the asset under non-default assumptions still needs to be held capital for, but at least the actually occurring (hopefully temporary) losses do not have to be deducted from own funds. 13 Annex II §4 RCAD.

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Supervisors have the possibility to determine for which assets defaults need to be monitored on an ongoing basis. If the loss of the asset is negligible, the costs of monitoring that specific asset could otherwise be too high. There is no common approach to determine the threshold, but the intent appears to be limited to providing an exception for small claims on an absolute basis, not also claims that are small when compared relatively to the balance sheet size of the bank14. The main consequence of the determination that an asset is in default is that for the part of the loan that is not written down, and not secured by e.g. collateral, a higher risk weight needs to be used for the remaining value of the asset. In the standardised approach, the risk weight of the remaining value of the asset goes up to 150% (if the losses already written down by the bank are less than 20% of the value of the unsecured exposure), or 100% (if first losses of more than 20% have already been taken). For an unrated exposure to a corporate this is a relatively insignificant increase. For a 0% risk weighted exposure to an EU sovereign where prior to the default no financial buffers would be required, this would be a huge increase. ECAI/Credit Rating Agency Ratings have been increasingly built into the quantitative requirements by regulators15. The ECB/ESCB is a prominent user of ratings in its collateral regime, indicating that financial instruments that have been rated to a certain standard will be accepted by the ECB for its loans to banks16. This gives a competitive advantage to a credit rating agency, and means that the prudential assessment is in part built on their judgement. Banks are forced to use them, increasing the premium issuers are willing to pay to be rated. External ratings issued by credit rating agencies on the credit risk of assets (bonds, shares, have increasingly played a role in credit risk requirements. They can be used to assess the risk in the standardised approach and securitisations, and in addition can be built into the model used by banks under the IRB approaches. In the CRD, such credit rating agencies go under the acronym ECAI that stands for ‘external credit assessment institution’. Under the CRD, ratings have an impact on the risk allocated to an exposure, and thus to the amount of own funds to be held under the solvency ratio. Before they can be used in that manner, the merit of the rating has to be assessed. Before a bank can use a rating allocated to a specific company or other entity as issued by an external credit rating agency, 14 Annex VI §10, Annex VII §44 RBD; art. 127 and 178 CRR. Also see art. 101 CRD IV Directive on the potential for EBA to monitor the consistency of the definition of default, and art. 110 and 178 on the definition of default. 15 Joint Forum, Stocktaking on the Use of Credit Ratings, June 2009, www.bis.org. 16 See chapter 22.3 and the ECB opinion of 21 April 2009, (CON/2009/38) on the regulation, §5.

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the ECAI has to be vetted as to the process it uses to arrive at its ratings. The ratings of each approved ECAI also have to be translated into the risk language of the CRD, i.e. they have to be equalized to a risk percentage in the standardised approach, and the conditions under which it can be built into a banks IRB-models have to be clarified. This vetting process is in principle performed by the bank’s supervisor. As the ratings of any credit rating agency are normally used not by only one bank but by many banks from that jurisdiction or even by banks across the EU, the vetting process has been integrated by the EU banking supervisors through their cooperation in CEBS-EBA17. To ensure that the rating process happens in a ‘prudent’ way, and the ECAI deserves the trust given to it, the credit rating agency needs to apply to the supervisory authorities to become an eligible ECAI under the standardised approach to credit risk18. The various rating agencies use (slightly) different acronyms to denote differences in quality steps of the credit risk embodied in claims on institutions or in some or all of their securities. The standardised approach sets out its own number of quality steps, each with a different risk weight allocated to the rated debtor, and allows the banking supervisor to determine which external rating can be equated to which quality step. CEBS-EBA has developed a process to recognise ECAI’s which would like to be recognised by multiple banking supervisors across the EU, and to ensure a consistent approach to the mapping of their ratings to the credit quality steps in the various tables. The CEBS-EBA process brings together the credit rating agency with one application and all banking supervisors that want to be involved in the vetting process (which they normally will be if their banks make extensive use of the credit ratings issued by the credit rating agency that applies for approval). It is not entirely clear why the terminology of ECAI was chosen for the CRD. The assumption may have been that not each credit rating agency would want to or would need to be assessed. If ratings were not used by banks in order to comply with prudential supervision purposes, they would not need to go through the vetting process of banking supervisors. As there was not yet a supervision regime for credit rating agencies at the time, ECAI could be used to designate those rating agencies that were vetted. In that case, it becomes reasonable to introduce a separate term for a subcategory (those credit risk agencies that have been assessed also by banking supervisors) of the wider group of unregulated credit risk agencies. The independently developed CRD-process for credit rating agencies that want their ratings to be used in prudential supervision started to overlap with a market supervision regime

17 CEBS-EBA Guidelines on ECAI. 18 See art. 80.1 and 81-83 RBD, and Annex VI part 2 and 3 on the use made of ECAI’s.

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that was developed in response to the 2007-2013 subprime crisis. Since end 2010, credit rating agencies have to be registered and made subject to requirements and some form of oversight19. As one of the few actual powers directly conferred on the new European supervisory authorities, the European securities and markets authority (ESMA; the successor to CESR) has been allocated this task. Since the introduction of the new regulation, banks are only allowed ratings that – in addition to being certified by CEBS-EBA members as a result of the RBD provisions – have also been registered at ESMA20. This new regulation requires credit rating agencies to obtain a registration before starting to issue credit ratings21. The primary purpose of ratings was to guide investors in their investment decisions, not in their decisions on how much capital to hold for the (rated) instruments once they have bought them. For that more limited purpose, there would be no need to force rating agencies – in addition to the quality requirements as set out in the new regulation – through the mangle of a banking supervision assessment. Only for those rating agencies whose users also would like the rating to be used for ongoing banking supervision purposes, this would become useful. In practice, this means that all users demand this, as banks are large investors in issued financial instruments (and the lack of a rating would be a disincentive for the bank to invest in a loan or risk-investment in a debtor). The credit risk agencies regulation does not make the distinction. It will underpin not only the use made for regulatory purposes under the CRD, but also the use banks and other investors make when buying financial instruments and when accepting them as collateral. The vetting process by banking supervisors could thus become more limited, as it can build on general work already done by ESMA, and is obliged to rely on ESMA-work if that has already been done on the issues of objectivity, independence, ongoing review and transparency on the assessment methodologies22. Once a rating agency is an eligible ECAI, credit institutions supervised by one of the approving banking supervisors can elect to use their ratings. They cannot cherry-pick the most favourable ratings however, they are bound to use the ratings of an ECAI consistently over time. The ratings of ECAI’s can relate to the general creditworthiness of a debtor, or can relate specifically to certain types of (secured) bonds, such as securitisation bonds. As securitisations were quite important and had an innovative structure when the Basel II version of the capital accord was implemented in the CRD, ECAI’s are separately approved (oddly under different RBD articles that are largely identical) for credit risk in general and for

19 Credit Rating Agencies Regulation 1060/2009. See for a description J. De Haan & F. Amtenbrink, Credit Rating Agencies, De Nederlandsche Bank WP 278, 2011. 20 Art. 4.1 Credit Rating Agencies Regulation 1060/2009. 21 Existing credit rating agencies had to apply for registration between 7 June 2010 and 7 September 2010. 22 Recital 23 and art. 1.15 CRD II Directive 2009/111/EC amended art. 81.2 RBD, introducing this provision to avoid double testing of the same issues at rating agencies.

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credit risk embodied in securitisations; see chapter 8.6. The process and criteria are similar, the separate approvals reflect the fact that the type of expertise needed for such structured products is different than for ‘regular’ bonds issued by companies or governments23. For securitisations approval, the ECAI needs to have a demonstrated ability in the area of securitisations. This threshold is low, as it is enough that there is a strong market acceptance for their ratings in this area; with the market being notoriously generous with such acceptance in the run-up to the 2007-2013 subprime crisis (and likely again as soon as that crisis has slightly faded away). For both assessment procedures, EBA has been invited to develop draft technical standards in consultation with ESMA by 201424. Formally, the requirements banks have to fulfil when using ratings of ECAI’s, (e.g. consistency) are formulated in the CRD as a burden on the banks (and on its supervisor). Indirectly, those requirements put a burden on the ECAI to ensure that their qualify processes and consistency are up to the standards required (in order for their ratings to be able to be used by their clients, the banks). Since the start of the 2007-2013 subprime crisis the quality of the credit ratings published by rating agencies has been criticised. Especially for structured products (e.g. securitisations) the quality was suspect, while at the same time many investors relied mechanically on such ratings without doing any research of their own25. This lead to changes in the CRD in addition to the regulation administered by ESMA. The Basel II ½ amendment of the capital accord requires banks to perform their own due diligence of securitisation investment, with non-compliance punished via pillar 2 add-ons26. In spite of – or in addition to – the regulation on credit rating agencies that mandates supervision by ESMA and the required due diligence, the use of external ratings remains under attack. The FSB favours the deletion of references to credit ratings in government rules wherever possible27. This includes the continued use of external ratings in the standardised approach to credit risk. The preferred solution is to delete all references to external ratings, but there is as yet no credible alternative measurement system has developed (and it is inadvisable to hold your breath until it has). Apart from the quality issues as shown in the securitisation market in the run-up to the 2007-2013 subprime crisis, there is a critique made of the procyclical effect of rating downgrades and of using ratings in laws, as well as of the mechanistic (over)reliance on

23 See art. 97-98 and Annex IX part 3 RBD. Compare the separate approval in art. 135-141 and 267-270 CRR. 24 Art. 81.2 and 97.2 RBD, as amended by art. 9.22 and 9.24 Omnibus I Directive 2010/78/EU. Also see chapter 23. Please note that art. 136 and 270 CRR set the deadline at 1 July 2014. 25 Joint Forum, Credit Risk Transfer, developments from 2005 to 2007, July 2008, www.bis.org. IOSCO technical committee, The role of credit rating agencies in structured finance markets, May 2008. 26 BCBS, Enhancements to the Basel II Framework, July 2009, page 18. See chapter 8.6. 27 FSB, Principles for Reducing Reliance on CRA Ratings, 27 October 2010.

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EU Banking Supervision opinions issued by essentially private parties28. A problem is that there are no clear alternatives available that have the same risk sensitive qualities but do not have the same procyclical or other equally undesirable traits (e.g. relying on market spreads, or necessitating supervision of internal rating processes with the same flaws that external ratings possess, e.g. lack of upkeep, sudden drops in ratings, lack of skills or methodology, lack of credibility for innovative debts or debtors). The Commission is reviewing the use made of ratings in financial regulations, and may bring forward legislative proposals to eradicate some or all such from EU supervisory standards29. These hesitations are reflected in the CRD IV project. The Commission proposals acknowledged that there is no good replacement. In line with the FSB principles banks will be required to have a good look at what you buy even if there is an external rating. Banks will also be obliged to develop an internal rating for any portfolio containing material exposures, even if an external rating is available. For smaller portfolios such an obligation would be both too costly to develop for the bank, too costly for the supervisor to supervise, and difficult to prevent similar concerns as apply to external ratings to slip into the usage of internal ratings. For less important portfolios, the bank will be allowed to continue to – cautiously – rely on external ratings30. In the finest tradition of creating irrelevant reports the CRD IV directive also mandates that EBA should (every year) report on efforts of banks and supervisors to reduce overreliance on external ratings. The FSB adds that banks should be pushed to develop internal ratings and use internal ratings based approaches. Though there is no proof that such are better, at least there will be less risk that the entire market moves simultaneously on downgrades or upgrades (where such a procyclical impact may be the result of using external ratings). Officially, the rating agencies of course never asked their ratings to be relied upon mechanically in public rules. For instance for the banking sector, the rating agencies could, however, as easily decrease the use of their ratings by no longer applying to be an ECAI, or even – with e.g. a delay of 6 months – rescinding their registration. I hope to be forgiven that as long as rating agencies allow their ratings to be used by explicitly applying to be approved for that purpose, they prefer the privileged position this gives them vis-à-vis their clients who are dependent on bank funding/investment. 28 A. Ashcraft, P. Goldsmith-Pinkham & J. Vickery, MBS Ratings and the Mortgage Credit Boom, FEDNY Staff Report 449, New York, 2010. R.H. Weber & A. Darbellay, ‘The Regulatory Use of Credit Ratings in Bank Capital Requirements Regulations’, Journal of Banking Regulation, Vol. 10, No. 1, 2008, page 1-16. Also see chapter 6.5 on procyclicality. 29 Commission Communication of 2 June 2010 on regulating financial services for sustainable growth, COM(2010) 301 final. 30 Commission, CRD IV – frequently asked questions, 20 July 2011, memo/11/527. Recital 70-73 and art. 76.2, 77.1, 77.2, 79 and 161.2 CRD IV Directive.

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Illegal Underestimation of Sovereign Risk An assumption in all the calculations on which the solvency ratio is based is the risk weighting of exposures. The asset value is combined with the risk weight in order to determine for what value financial buffers should be kept. The fall-back position in the standardised approach to credit risk is a 100% risk weight, with higher or more frequently lower risk weights for high-risk respectively lower risk assets. This possibility to differentiate existed in the Basel I credit risk approach, and has been copied into every updated version of the Basel capital accord. Equally ingrained in all approaches to credit risk, market risk – and in future times also the new liquidity rules proposed under CRD IV/Basel III rules – is a low or even 0% risk weight for the treatment of most exposures to EU central governments, sometimes referred to as sovereign risk31. This is often expanded to other public bodies in a national discretion, provided some criteria are met. For all exposures to third country central governments and central banks for which a rating is applicable, there is a regime that allocates a risk weight depending on the rating given by one of the external credit assessment institutions (or by export credit agencies, as they look at central governments too). This is not the case for exposures denominated in their domestic currency to central governments and central banks of member states. These benefit from a 0% risk weight irrespective of ratings, as does the ECB. This means that EU government bonds held by banks are deemed so safe under the standardised approach to credit risk that they do not need to hold any capital at all for the risk that a government defaults. Worse, as a ‘transitional’ measure the same treatment applies even if the debt is not denominated in their own currency but in the currency of another member state (e.g. Greek bonds denominated in UK pounds). This transitional measure was to expire as per end 2012, but in the midst of the 2007-2013 subprime crisis was extended until end 201532. As the CRD is applicable to all EU and EEA member states, the domestic currency rule and the transitional measure apply to member states irrespective of the credit rating of the sovereign. Not all EU and EEA member states are deemed in the market to be of the same low risk category (to put it mildly), but agreeing to the identical treatment of the member states appears to have been a political necessity to be able to agree identical treatment of banks. This preferential treatment is to continue under the new CRD IV project33. The Commission refers to a similar rule in Basel III, and to a temporary Council agreement to this effect (zero capital requirement). The treatment of sovereign exposures in any currency as if

31 See chapter 8, 9 and 12. 32 Art. 153 RBD, as amended by art. 1.36 CRD II Directive 2009/111/EC, and annex VI, part 1 §4 RBD. 33 Art. 114-118 CRR.

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member states are by definition zero risk will continue until the end of 2017, after which a risk weight dependent on their rating will be gradually introduced over 2 years for foreign currency denominated debt, becoming fully applicable in 202034. This may still be too low in relation to the actual sovereign risk run on foreign denominated debt; and retains the 0% risk weight for domestic currency denominated debt35. Government accounting is not always clear, and the ratings of sovereigns may depend on the ratings of state bailout mechanisms of the IMF and within the Eurozone on the rating of the ECB and of other Eurozone member states; see chapter 18.4. This leads to the same problems as the ‘too big to fail’ benefit allocated to systemic banks; see chapter 18.2. Other proposals – such as the investment of resolution funds if agreed under the single resolution board (see chapter 18.5 and 22.3) also single out member state sovereign bonds as one of the main investment categories, instead of focusing only on qualitative criteria (under which some but not other sovereign bonds of member states may qualify)36. This treatment and the agreement on it is illegal under the EU treaties. The TFEU forbids EU rules to grant preferential treatment to governments unless this is backed by inherent safety37. Though it could be defended that some member states have a low risk of default, a zero percentage risk – possibly a political desirability – is not backed up by such inherent safety. The 0% risk weight cannot be based on fact, as governments do default. A full default was frequent in the second half of the last century in Latin American countries. During the 2007-2013 subprime crisis, several countries in effect defaulted, and had to receive foreign aid from the IMF. EU member states, such as Eurozone countries such as Greece, Ireland, and Portugal required a bailout, as well as non-Eurozone countries such as Hungary received bailouts from the IMF and from other EU countries, and Greece had debt written down, thus negating the theory that such things would not happen to the sovereign debt of Western countries38. The UK devalued its currency to the tune of a third (and thus also its government bonds denominated in its currency when held by non-UK banks). Even the EU member state considered most safe in the EU when this book was written, Germany, has basically ‘failed’ twice in the last hundred years, in the sense of the actuality or potential 34 Art. 114.5 and 114.6 CRR; and Commission, CRD IV – frequently asked questions, 20 July 2011, memo/11/527. 35 Art. 114.4 CRR. 36 Art. 70 of the Commission Proposal for a Regulation on a Single Resolution Mechanism, COM(2013) 520 final, 10 July 2013. Art. 22 ESM Treaty on the other hand mandates a prudent assessment of ESM funds, without favouring sovereign bonds. The ESM equally benefit from the preferential treatment; see art. 118 CRR. 37 Art. 124 TFEU indicates that any advantageous treatment given to EU governments has to be well founded. See chapter 4.5 and 6.2. The 0% risk cannot be based on prudential considerations, as governments do default. 38 See the adapted economic literature on sovereign default following the latest crisis discussed in N. Stähler, Recent Developments in Quantitative Models of Sovereign Default, Deutsche Bundesbank, Economic Studies 17/2011.

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for hyperinflation followed by a replacement of the old currency by a new currency. In 1923/24 each new Rentenmark/Reichsmark replaced 1012 Papiermark and in 1948 the Reichsmark was replaced by the Deutsche Mark at a rate of 1 DM to 10 RM in West Germany (and until reunification by the Ostmark in East Germany). As it in the best interest of both banks and governments not to challenge the 0% risk weighting too much, it is unlikely that the Court of Justice will get the opportunity to challenge the relevant CRD provisions, even though this puts a hole in the resilience of bank financial buffers. Though the expiry of the foreign currency denominated bonds treatment by 2020 can be applauded, it actually stimulates local banks to stock up in local sovereign bonds that will retain the 0% risk weight, increasing the co-dependency of local banks and their local government. In the 2007-2013 subprime crisis, the governmentinduced underestimation of sovereign risk lead to overstocking by banks on government bonds, leaving them ill prepared for reductions in the fair value of those bonds (and pressuring their own governments to step in to prevent a state defaulting, e.g. in the case of Greece, Ireland and Portugal in the EU). Even a low capital requirement, even only a few per cent, would have reduced the glut of government bonds on banks’ balance sheets. Future Developments The outline of the credit risk provisions has been copied largely unchanged, with some clarifications, into the CRR39. A key change will, however, be the lower risk weight given to small- and medium sized enterprises, to stimulate lending to this sector. Though this change may be temporary as a crisis-measure pending a review in 2017, the provision reduces the risk weight attached to lending to smaller companies, in spite of the potential risk to banks and to the effectiveness of the capital requirements directive. In addition, member states can opt to exclude lending to smaller companies from the additional countercyclical and capital conservation buffers, that would otherwise have started to be applied from 201640.

39 Art. 107-110 and Annex I CRR contain some general provisions, art.111-141 CRR focus on the standardised approach, art. 142-191 on the IRB approaches, art. 192-241 CRR contain the risk mitigation provisions, and art. 242-270 and 404-410 CRR contain the provisons on securitisations. The derivatives regimes (counterparty credit risk) is contained in art. 271-311 and Annex II CRR. Also see above on art. 114 CRR, which provision in due course will introduce a risk weighting for some sovereign risks. 40 Recital 44 and art. 501 CRR, and art. 129 and 130 CRD IV Directive. Also see European Parliament, Press Release on EU Bank Capital Requirements Regulation and Directive, 15 April 2013 and the assessment of EBA on the riskiness for banks of lending to smaller enterprises in EBA, Assessment of SME Proposals for CRD IV/CRR, September 2012.

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Literature There are several publications on credit risk from an economic perspective. I note the literature on credit risk modelling mentioned in chapter 6.3, and: – Duffie, Darrell; Singleton, Kenneth J., Credit Risk, Pricing, Measurement, and Management, Princeton University Press, Princeton USA, 2003 – Jorion, Philippe, Value at Risk, The New Benchmark for Managing Financial Risk, 3rd ed., McGraw-Hill, New York, 2006, (especially chapter 6 and 18) – Daníelsson, Jón, Blame the Models, Journal of Financial Stability, Volume 4, Issue 4, December 2008, p. 321-328 www.risk research.org

8.2

Standardised Approach

Introduction The standardised approach is closely related to the initial approach to credit risk set out in Basel I. Basically it is the old Basel I approach with a paint job and some new electric wiring. Like Basel I, it is well suited to the business of smaller, more traditional and less complicated banks, for which the investment in models and the data gathering needed for the self-developed models of the IRB approaches to work is too costly; see chapter 6.3. This remains the case for the standardised approach to credit risk in the CRR from 2014. The theory behind the standardised approach is that for everything the institution owns, a ‘standard’ risk percentage is set to cover the credit risk of it not being worth in the end what it is worth now (e.g. due to a creditor not being able to repay a loan made to the bank). Such a reduction in value would diminish the chances of the bank being able to honour its own commitments. When each exposure has had its percentage allocated to it, the total minimum need for own funds to cover credit risk is known. Outline of the Calculation for Exposures As noted in chapter 6.4 and 8.1, the value of each exposure needs to be determined in line with the accounting standards. From this value, an exposure value is derived. This is the value the bank could lose if the counterparty is no longer creditworthy. If it were a one of a kind type of exposure, the risk could be quite high, as the one customer could go bankrupt and the full value of the exposure would be lost. Mostly, banks do not lend to ‘one of a kind’ customers, but can group similar clients and the exposures to them in large quantities into categories. The risk that all the clients in a specific category go bankrupt at the same time is small, and a percentage of chance can be allocated to the likelihood that a certain

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number of clients within that specific group would forfeit on their commitments within the next year. In the standardised approach, each individual exposure is allocated to one of a total of 16 classes of exposures. Examples are41: – claims on central governments or central banks (see chapter 8.1); – claims on banks or investment firms, regional governments and local authorities42; – claims on corporates; – retail claims; – claims secured on real estate property; – past due items; – securitisation positions (see chapter 8.6); – short term claims on institutions and corporates. There is also an ‘other items’- category for those exposure that do not fit well into any of the mentioned groupings. For the way exposures to collective investment undertakings are treated (or when the bank can look-through to the underlying exposures held by the investment fund) see chapter 19.5. Within each exposure class the exposures are allocated in the CRD a ‘standard’ weight, unless there is a reason to deviate (due to e.g. protection or an external rating from an approved credit rating agency; see chapter 8.1). This generic risk weight is the lowest for retail claims and for claims secured on real estate property. For exposures that are unrated, it is therefore often favourable to the bank to allocate them to these categories. Small- and medium sized enterprises can be treated by banks as if they are retail clients if the bank wishes to do so. However, the differentiation between subclasses of exposures within other classes can be very high, resulting in low to nil risk weights if highly rated to up to 150% in other classes (except securitisation positions). Such differentiation was already possible in Basel I, but the possibilities to differentiate between groups of clients have increased. The reasoning is that some subgroups of clients will have a lower risk than average within the larger category. By way of example, within the class of exposures to corporates, there are corporates that are unrated, corporates with a junk bond rating and corporates with the highest credit ratings. Each gets a different treatment, even though they belong to the same class. External ratings are only (commonly) available for certain types of exposures. The standardised approach recognises the validity and availability of high quality external

41 The exposure classes are set out in art. 79 RBD. Both actual claims and contingent claims are included in the classes. 42 Art. 4.6 and Annex VI part 1 §8-11a RBD and art. 3.1c and 40 RCAD.

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ratings in the classes of claims on central governments and central banks, of institutions (banks and investment firms), corporates, short term exposures (with a specific rating) on other banks and corporates and exposures in the form of collective investment undertakings. For these, if available, the judgement of ECAI’s has a direct effect on the risk weight applicable. To establish the exposure value, the RBD effectively distinguishes methods for three categories of exposures43: – on balance sheet assets; – off balance sheet assets, including credit derivatives; – a special arrangement for derivatives mentioned in Annex IV of the RBD44. The exposure value of on balance sheet item is its balance-sheet value, calculated in line with standard accounting requirements (see chapter 6.4). The value and the exposure value in the context of the regulatory approach is therefore identical for assets (for off balance items the value and the exposure value can be different, see below). The value of the exposure is an absolute starting point, set in accordance with accounting standards, sometimes depending on market value, modelled valuations or historic value (see chapter 6.4). The exposure value can subsequently be adjusted to reflect reductions of risk from a prudential point of view. There are four options: – contracts of novation and other netting agreements45, under which opposing obligations between counterparties are taken into account to reduce the total owed; – funded credit protection recognised under credit risk mitigation (see chapter 8.5) such as collateral posted; – unfunded credit protection recognised under credit risk mitigation, such as third party guarantees; – securitisation (see chapter 8.6).

43 Art. 78 RBD. 44 Counterparty credit risk, see below and chapter 8.4. See Annex II CRR. 45 See art. 78.2 RBD, which refers to Annex III for derivatives. For certain derivatives such as repurchase transactions or securities lending banks have a free choice to use either the counterparty credit risk method of Annex III or the credit risk mitigation (often referred to as CRM) method of Annex VIII; see respectively chapter 8.4 and 8.5. Also see art. 78.4 RBD, which makes the favourable treatment for exposures to central counterparty applicable regardless of the choice for Annex III or VIII.

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Table 8.1 Standardised approach applied to an asset Schematic

46

Example 1

Example 2

1 The first step in the standardised For both examples assume a 1 million euro loan. In these approach is to determine the expo- examples, no netting or other credit risk mitigation techsure value of an exposure. For nique is available. assets, this is the value as determined under accountancy standards.Any credit risk mitigation (credit protection) is taken into account as described in chapter 8.5, potentially leading to an exposure value adjustment 2 The second step is to allocate each For both examples assume that this loan is a claim on a exposure to an exposure class corporate. 3 The third step is to calculate the risk weighted exposure amount by looking up within the provisions on the exposure class the exact percentage allocated to the specific exposure, which can e.g. depend on rating or relevant country. Subsequently, the solvency ratio calculation leads to a required capital of 8% for the risk weighed exposure amount (see chapter 6.2)

The risk weight of a claim on a unrated corporate in a solvent member state would be 100% times 1 million euro is 1 million euro.

If the corporate is rated with the highest available credit quality assessment it could be as low as 20% of 1 million euro is 200.000 euro.

The required capital The required capital for the credit for the credit risk of risk of this specific exposure is 8% this specific exposure of 200.000 euro = 16.000 euro is 8% of 1 million euro = 80.000 euro

The exposure value of an off balance sheet item depends on the level of risk formally attached to it47. The reasoning is that if there is a high risk embodied in the off balance exposure, it should be treated as if it were already an asset. If there is no risk embodied in the off balance exposure, there is no need to treat it as an asset yet. As a result, for off balance sheet item the above-mentioned first step that is used for assets is cut in three. In step 1a the value of the off balance exposure is determined, step 1b is to assess the risk category, and step 1c multiplies the value by the percentage allocated to its category. The categories are as follows: – 100% of the value if it is a full-risk (i.e. high risk) item. These include guarantees that act as a credit substitute, credit derivatives, and irrevocable standby letters of credit that act as a credit substitute; – 50% of the value if it is a medium-risk item. These include the above-mentioned if they do not act as a credit substitute, and undrawn credit facilities (for instance agreements to lend) with an original maturity of more than one year;

46 Based on art. 78, 79 and annex VI RBD. 47 Annex II of the RBD.

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– 20% of the value if it is a medium-low-risk item. These include undrawn credit facilities with an original maturity of up to and including one year that cannot be cancelled unconditionally48; – 0% of the value if it is a low-risk item. These include undrawn the mentioned short undrawn credit facilities that can be cancelled unconditionally or are cancelled automatically if the borrower’s creditworthiness deteriorates. It also includes most exposures to member states, as well as many exposures to public bodies; see chapter 8.1. In a group context and within so-called institutional protection schemes, this can also include intra-group exposures. Though this may be fine as long as the bank is in good economic health, it means that when a banking group is failing, there are no financial buffers to compensate for losses on intra-group loans49. Table 8.2 Standardised approach for an off balance sheet item Schematic

50

Step 1a in the standardised approach is to determine the value of an off balance sheet item exposure

Example 1

Example 2

For example a 1 million euro For example the same loan, loan facility for 2 years that can which, however, cannot be canbe cancelled at any time. celled nor is it dependent on the creditworthiness of the borrower at the time it wants to draw on the facility

Step 1b is to allocate the off bal- It would be low risk ance sheet item to a risk category

It would be medium risk (medium/low risk if it were a one year facility)

Step 1c is to calculate the exposure value. Any credit risk mitigation (credit protection) is taken into account as described in chapter 8.5, potentially leading to an exposure value adjustment

50% (the medium risk percentage value adjustment) of 1 million euro is 500.000 euro (20% or 200.000 euro if it were a one year facility)

0% (the low risk percentage value adjustment) of 1 million euro is 0 euro. In this example, no netting or other credit risk mitigation technique is available.

48 One of the main weaknesses in Basel I was that it allocated all short term undrawn credit facilities as lowrisk, with a 0% exposure value. This was gamed by the banks extensively in securitisation transactions. A liquidity facility would be granted to the special purpose vehicle facilitating the securitisation transaction, which would be one year minus one day, but which would be renewed automatically time and time again. As the original maturity was less than a year, no capital needed to be held, adhering to the letter but not the spirit of the requirement. To ameliorate this, a new securitisation regime was brought into Basel II/CRD, and the item was split over the medium-low-risk and the low-risk categories depending on the features of the facility. 49 Art. 80 RBD, and recital 60 and art. 113 CRR. See chapter 17 on solo and consolidated supervision, as well as on asset transferability assumptions; and chapter 18 on failing banks. Institutional protection schemes are officially not ‘groups’ but provide mutual support in case one of them is in danger of failing; also see chapter 17.6. 50 Based on art. 78, 79 and Annex II and VI RBD.

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Example 1

Example 2

The second step is to allocate each exposure to an exposure class

For example it is a claim on a corporate.

The same as in the first example

The third step is to calculate the risk weighted exposure amount by looking up within the provisions on the exposure class the exact percentage allocated to the specific exposure, which can e.g. depend on rating or relevant country.

The risk weight of a claim on a unrated corporate in a solvent member state would be 100% times 0 euro is 0 euro,

If the corporate is rated with the highest available credit quality assessment it could be as low as 20% of 500.000 euro = 100.000 euro. If unrated, it would be 100% of 500.000 euro is 500.000 euro.

The subsequent step under the solvency ratio calculation is to require capital of 8% for the risk weighed exposure amount

The required capital for the credit risk of this specific off balance sheet exposure is 8% of 0 euro = 0 euro

The required capital for the credit risk of this specific exposure is 8% of 100.000 euro = 8.000 euro. For the unrated corporate, it would be 8% of 500.000 euro is 40.000 euro

The exposure value of derivatives (counterparty credit risk or CCR) is treated differently. Their value is to be calculated under one of the methods provided in annex III of the RBD; see chapter 8.4. Calculation All exposures are treated in this manner, and subsequently added up. After adding the capital requirements for OTC derivatives (chapter 8.4) and securitisation positions (chapter 8.6), the total capital requirement under the solvency ratio for (unexpected losses under) credit risk can be calculated. The expected losses are deducted from the financial buffers as set out in chapter 6 and 7. Future Developments In Basel II ½ no changes were made to the manner in which credit risk was calculated in the standardised approach, except indirectly through the changes in the use of ratings of ECAI’s; see chapter 8.1.The standardised approach has equally not been the focus of the Basel III/CRD IV revision51. Small changes have nonetheless been made in the CRD IV project. This includes the 0% risk weighting of member state central governments that will very very gradually be phased out for foreign denominated debts52. Equity exposures have been given a separate exposure class (previously primarily dealt with under ‘other items’)53. The 150% ‘high risk’ exposure class has equally gained some attention54. It remains largely 50 51 52 53 54

Based on art. 78, 79 and Annex II and VI RBD. The main provisions on the standardised approach are contained in art. 111-141 CRR. Art. 114-116 CRR. See chapter 8.1. Art. 112 and 133 CRR. Art.128 CRR.

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at the discretion of the institution and its supervisors, but investments in venture capital firms, in AIFM funds and in speculative immovable property financing will at a minimum need to allocated this higher risk weight. For trade finance, a special regime has been introduced to both acknowledge the level of risk embodied in it, as well as the positive influence it has on international trade55. On default, EBA has been more clearly allocated a role in harmonising the concept (to which references are modernised from the RBD terminology of ‘past due’ exposures to exposures in default as an exposure class)56. For other assets, some criteria are set to ensure a more conservative allocation to risk categories, and EBA is required to issue guidelines (though no date is set for their issuance). Specifically for the mapping of ECAI ratings (see chapter 8.1), EBA has to issue implementing standards by 1 January 201457.

8.3

Foundation and Advanced IRB

Introduction Banks can opt to not follow the standardised approach by applying for the more complex internal ratings based approach (IRB). The relative simplicity and ease of application of the methodology set out in detail in the directive for the standardised approach is in that case abandoned in return for the possibility to develop their own system to calculate the required financial buffers for the credit risk faced specifically in the business of the bank, albeit under a wide range of restrictions. If they build a model that takes into account the restrictions and requirements set out in the CRD, they can apply for approval of that model; also see chapter 6.3 and 21.7. If the supervisor approves it (both as to its content and as to its future application), the credit risk of the bank will be judged on the basis of that model (with a ‘temporary’ minimum under the so-called Basel I floor; see chapter 6.2). Within the IRB, the bank can opt to go for the maximum of potential ‘own’ aspects in the model (the advanced IRB approach), or limit itself to a few, and follow standard CRD mechanisms for others (the foundation IRB approach). The foundation and advanced IRB approaches are identical in key aspects. Both require a high investment in data gathering and systems, with the advanced IRB approach requiring additional investment by the bank to be able to use its own estimates on a wider range of allowed asset-categories. The foundation IRB approach foregoes this investment and instead for some areas uses standard-figures set by the RBD.

55 Recital 73 and art. 4.1 sub 80, 4.5, 121.4 and annex I CRR. BCBS, Treatment of Trade Finance Under the Basel Capital Framework, October 2011. 56 Art. 110, 112, 127 and 178 CRR, and art. 101 CRD IV Directive. 57 Art. 150.3 RBD, as introduced by art. 9.40 Omnibus I Directive 2010/78/EU. See chapter 23.3.

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Calculation The capital requirements of IRB banks result partly from CRD-based calculations where no power is transferred to the bank, and for the categories for which this is possible, from its models and measurements process as approved by the supervisor. The end-result will be taken into account in the solvency ratio (with the long running ‘transitional’ Basel I floor to avoid capital requirements being eviscerated by too rosy models; see chapter 6.2). This deals with unexpected losses. Like banks on the standardised approach, they will also have to deduct incurred losses – under fair value or loan loss accounting standards – from own funds; see chapter 6.4. In addition to these two requirements, IRB banks have a third category of ‘expected losses’. These are statistically likely losses on a portfolio, which have however not yet resulted in a write-down under accounting standards. Such expected losses have to be modelled too, but are not channelled through the solvency ratio, but instead result in a deduction from own funds; see below. Additional Organisational Demands for IRB banks The model approval process (also see chapter 6.3 and 21.7) has specific conditions on the internal organisation, the experience of the bank with internal ratings and the use-test. These apply on top of the internal organisation and corporate governance issues that all banks are subject to, and have to be fulfilled on a continuous basis by banks that operate self-developed models; see chapter 13. The additional demands are set out in the RBD and its annexes58, and are developed in even more detail in guidelines – on the interpretation/application of the various open norms and vague terminology in the RBD texts – in of CEBS-EBA and background material of the BCBS (see chapter 6.3). The conditions include that: – The bank needs to demonstrate that it has been using rating systems that are broadly in line with the IRB minimum requirements for internal risk measurement and measurement purposes for at least three years prior to qualification to use the IRB approaches for prudential supervision purposes. – If the bank also wants to use own estimates of LGDs and conversion factors59, it has to demonstrate that it has been estimating and employing own estimates of these in a manner broadly consistent with the IRB requirements for at least three years prior to qualification to use own estimates of LGDs and/or conversion factors.

58 Art. 84 RBD, in more detail in Annex VII, part 4 RBD. Also see the EBA-CEBS Guidelines on Model Validation, Chapter IV of the EBA Electronic Handbook. 59 See below, and art. 84.4 and 87.7-87.9 RBD.

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– The use-test requires the bank to convince supervisors that not only will it use the model and its outcomes for the calculation of prudential requirements, but that it will also use it for its own intents and purposes. This to avoid that banks use one set of data or assumptions in its calculation of solvency requirements and a (more pessimistic or more updated/accurate) set of data or assumptions in its own business assumptions. Banks can use their internal models, but only if those are actually the internal models used also for its own purposes60. For example to guide decisions on pricing there can be deviations, but only if sufficiently explained. The use-test requires the bank to use the internal ratings and the default and loss estimates, as well as the systems and processes, to play an ‘essential role’ in (a) the risk management and decision-making process, (b) the credit approval functions of the bank, (c) the internal capital allocation functions of the bank, and (d) the corporate governance functions of the bank. – In additional to the regular organisational requirements applicable to all banks, the IRB requires the bank to have in place (a) a credit control unit responsible for the rating system and that is ‘appropriately’ independent and free from ‘undue’ influence, (b) to collect and store all relevant data to provide effective support for credit risk measurement and management process61, (c) documentation on the rating systems and their rationale, as well as validation processes (also see chapter 13.4). Outline of the Calculation for Exposures If the bank has permission to use the IRB approach, it has to calculate the risk weighted exposure amount per exposure like in the standardised approach, but now using its selfgenerated or internal ratings, instead of the ratings by the standardised model (the standard risk weights) or by external credit risk agencies. The internal ratings are based on parameters which it can estimate itself using the approved model, within the minimum requirements and general lay-out requirements of the IRB. Though the bank has more liberty to assess their own risk estimates, the CRD allows this only within a tightly set framework with defined open spaces and minimum conditions. Like the standardised approach, the IRB approaches start by requiring the banks to allocate each exposure to exposure classes62. The IRB approaches, however, only have 7 exposure classes as opposed to the standardised approach having 16. Some classes known in the 60 Also see BCBS The IRB Use Test: Background and Implementation, Newsletter no.9 (September 2006), Basel, 2006. 61 To be allowed to use the operational risk model, a bank needs to have at least five years of historical data. Such a requirement is not set for the IRB approach, only that there are sufficient data to support measurement and management. A possible explanation is that for operational risk, relevant data are scarce and far between, but have a high impact, while for credit risk, data are more readily available and have a lesser impact per event. 62 Art. 86 RBD.

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standardised approach have been grouped together. By way of example, the exposure class of central governments and central banks includes those regional governments and similar bodies that are treated the same way in the standardised approach, as well as multilateral development banks which have a 0% risk weighting under the standardised approach, while non-qualifying regional governments and multilateral development banks are grouped with the exposure class of banks and investment firms. The exposure classes are: – claims on central governments and central banks; – claims on banks and investment firms (as well as recognised clearing houses and exchanges, as well as recognised third-country investment firms)63 ; – claims on corporates; – retail claims; – equity claims64; – securitisation positions; – other non-credit obligation assets. Exposure classes such as covered bonds, which get an beneficial treatment in the standardised approach are not needed in the IRB approaches, as the ‘own’ models of the bank will take account of the additional risk mitigation embodied in such categories. The rest-category of other items is equally left out. Its function is taken over by the exposure class of claims on corporates. The methodology used for allocating assets to categories by a bank has to be ‘appropriate’, which no doubt will be determined by it being approved by the supervisor in the model approval process. It also needs to be consistent over time, avoiding cherry picking. After allocating each exposure to an exposure class, the risk weighted exposure amount of each exposure will need to be calculated with the methodology and model approved by the supervisors. The conditions for such a model are different for each exposure class. Even though the outcome is different per exposure class, the architectural requirements for the models contained in Annex VII are differentiated around four items only, grouping some of the exposure classes together: – corporates, institutions and central governments and central banks (to which also the dilution risk of purchased corporate and retail exposures is allocated65); 63 Art. 4.6 RBD and art. 3.1c and 40 RCAD. 64 All non-debt exposures of a subordinated, residual claim on the assets or income of the issuer, as well as all debt exposures with a similar economic substance. This is the other side of the medal of some debt instruments being given own funds status when received, which means that such debt instruments when given are also considered as equity. 65 Dilution risk means the risk that the obligor will be allowed to pay less than the face value of the exposure, as a result of cash or non-cash credits. This is especially relevant for the specialised lending and purchased receivables areas. An example is an investment in asset backed securities resulting from securitisations,

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– retail exposures; – equity exposures; – other non-credit obligations. The RBD contains formulae to determine the risk weighted exposure amount. This limits the scope of the freedom allocated to banks, leading to similar and comparable – but also perhaps more herd-like – behaviour. The formulae are different for the four categories mentioned. For the econometrists for information – and for all others for amusement value – the formulae for exposures to corporates, institutions and central governments and central banks if the probability of default is neither zero nor 100% is66: Figure 8.1 Risk weighted exposure amount for exposures to amongst others corporates Risk weighted exposure amount for exposures to amongst others corporates: Correlation (R) = 0.12 x (1-EXP(-50*PD))/(1-EXP(-50)) + 0.24*[1-(1-EXP(-50*PD))/ (1-EXP(-50))] Looptijdfactor (b)=(0.11852-0.05478*ln(PD))2 (LGD*N[(l-R)-0.5*G(PD)+(R/(l-R))0.5*G(0.999)]-PD*LGD)*(1-1.5*b)-1*(1+(M-2.5)*b)*12.5*1.06

No doubt such formulae were well understood by all legislators involved in codifying them into the RBD. Within these formulae, the actual ‘model’ or methodology that the banks can structure themselves focus on: – the probability of default of a counterparty over a one year period (PD); – the expected percentage (ratio) of loss67 given a default (LGD) to the amount outstanding at the moment of default; – risk weight (RW);

where the investing bank has little say in the underlying asset; the contract between the original creditor and obligor when being renegotiated for any reason, which will impact on the amount due under the asset backed security. 66 Annex VII, part 1, §3 RBD, where the various symbols are given specific meanings. For instance “N(x) denotes the cumulative distribution function for a standard normal random variable (i.e. the probability that a normal random variable with mean zero and variance of one is less than or equal to x).” In a slightly different notation these formulae were copied into the CRD IV project into the level 1 texts: article 153.1 CRR. 67 The loss term is not limited to the individual exposure as such as reflected in the accounts. It also includes other effects on the overall value of the bank, such as discounts given and recuperation costs.

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– conversion factor (ratio) of the funds the obligor is likely to draw additionally under a flexible loan facility prior to the default of the obligor, to the currently undrawn funds of that loan facility. A key issue is to determine when a default occurs; see chapter 6.4. This has a direct impact on each of the ratio’s and values mentioned above, and thus on the capital requirements (and/or on deductions from own funds of the write down of the value of the defaulted exposure). Even with the structure for the approval process set out in the CRD, the approval by the supervisors remains highly subjective due to undefined concepts and the requirement for subjective assessments. By way of example the possibility exists that the supervisor can allow the bank to assign preferential risk weights for specialised lending provided the bank has underwriting characteristics and other risk characteristics are ‘substantially strong’ for the relevant category68. Whether this requirement is fulfilled will be differently interpreted by each individual employee of a supervisor. In part this type of ambiguity is to allow for cultural differences and domestic political necessities (and the need to achieve a consensus on legislative proposals), in part it is the result of the lack of knowledge about the modelling and measurement systems being approved and the effect (heightening or lowering) of capital requirements it might have. Where a lack of experience, cultural practices or even political issues could be reduced, work has subsequent to 2006 been done both by the BCBS and CEBS-EBA, as well as in a joint Commission/CEBS-EBA transposition group. The intent of their guidelines, studies and interpretations is to give clarity or common assessment methods for both the IRB, and for operational risks’ advanced measurement approach (see chapter 10.4). Specifically, guidance was developed on the assessment criteria on a wide range of issues such as the quality of data, the internal governance surrounding the working of the model and its checks and balances, and providing detail on definition issues such as the definition of default or of loss, as well as the roll-out period and the use-test69. Nonetheless, the EBA has noted that the probabilities of default and loss given default estimations used by the larger banks in the EU show material differences for the same regulatory portfolios and located in the same member states, which it will need to focus on in further analysis of the (lack of) reasons for these discrepancies70. Similar conclusions have now been publicly drawn by the BCBS; see below under future developments.

68 Annex VII, part 1 §6 RB. 69 See e.g. CEBS-EBA, Model Validation Guidelines (CP03), April 2006, and the other guidelines referred to at the end of this chapter and chapter 6.3. 70 EBA, European Banking Authority 2011 EU-wide Stress Test Aggregate Report, 15 July 2011, page 25-26.

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Apart from calculating the capital requirements on the unexpected losses on all exposures, within the context of the IRB approach there is a harsh treatment of expected losses within a one year period. A (low) percentage of each category of receivables is certain to default (or diluted due to cash credits to the obligor). This amount has to be calculated in a very standardised manner, and deducted from own funds71, unless credit risk mitigation techniques (see chapter8.5) fulfil the highest standards. The expected loss amount to be deducted is the probability of default (PD) times the percentage of loss given a default (LGD) times the total exposure value, minus value adjustments and provisions already taken (see chapter 7.2). Both the treatment of expected losses and of loss given default are built to take account only of the near future; a one year time horizon. These factors are allowed to be based on an estimation of the likelihood/expectation that an obligor can be expected to default within the next year (expectations on longer term viability of the obligor, e.g. on the possibility to obtain new short term debt in the future replacing existing short term debt, need not be taken into account). This gives an incentive to short term thinking, even though there is an adjustment for risks with a longer maturity in the IRB model requirements. As long as the default is not expected within one year, the likely default of an obligor is not relevant for the quantitative supervisory requirements. It depends on the conservatism of the bank and its auditors whether defaults expected over a longer term are provided for or result in value adjustments (which would then indirectly result in lower available own funds to cover capital requirements; see chapter 6.2 and 7). On the other hand, the confidence level expected for this one year period is very high, set at 99.9%. This compensates for the short time horizon, and for the fact that the model assumes ‘normal times’ in line with available recent data72. In the follow-up to the 2007-2013 subprime crisis, this has been improved by also requiring ‘through the cycle’ stress testing, though this does not directly result in a higher capital requirement; see chapter 13.6. For the impact of credit risk mitigation on the exposure value and on the expected losses, see chapter 8.5. As indicated before, the difference from the foundation to the advanced IRB approach is more gradual than a quantum leap. In the foundation IRB, own estimates are used for the probability of default (‘PD’) and expected losses (‘EL’) for all asset categories, and set values for the amount of loss given default (‘LGD’) and conversion factors of central

71 Art. 57q and Annex VII part 1 §29- 36 RBD. If the bank has already made value adjustments or enlarged provisions related to these exposures, these have already impacted on own funds. In that case, the bank does not need to take the deduction twice, except to the extent the calculated expected losses exceed provisions and value adjustments. 72 H. Thomas & Z. Wang, ‘Interpreting the Internal Ratings-Based Capital Requirements in Basel II’, Journal of Banking Regulation, Vol. 6, No.3, 2005, page 274-289.

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governments, other banks and investment firms and for corporates73. All requirements are therefore the same, except for an added set of conditions to be fulfilled on the estimation of LGDs and conversion factors for these three categories. Transitions and Partial Use Transferring to the IRB approaches is worthwhile mainly for the larger and/or more complex institutions, that have or should have a business model building on a correct and sophisticated understanding of risk, and can handle the change-over process. Developing an IRB approach is stimulated for any complex or large business, but there may be benefits for any bank where there are incentives to better assess the credit risk in the specific circumstances to which a bank is subject. The costs for a smaller bank can even proportionally be lower, if it has a simple business that can be easily modelled, possibly with the help of external developers of the software and underpinnings of the model. The main rule is that banks need to apply the IRB approach to all their exposures if they use it at all. A big bang change is however not required; they can partially use the IRB for some categories while delaying the development of internal models for other categories. Moving from the standardised approach to the foundation IRB approach or to the advanced IRB approach (or from the foundation to the advanced approach) requires a large investment by the institution. It may also involves a high risk of failure and costs if the whole organisation would need to change at one specific moment due to scarce change-management, training and other resources. To stimulate moving up the sophistication ladder, the standardised approach is supposed to be relatively heavy handed. On the other hand, the IRB contains provisions which in certain negative market circumstances can work out as being heavy handed too, including the deduction of expected loss amounts from own funds even when a write down would not yet be required by accounting standards. Shifting between the various approaches for the whole bank or for certain exposure classes whenever that best suited the bank would result in the lowest capital requirements. The same applies to applying the IRB approach to the best parts of the bank or banking group, while retaining the standardised approach for those units that are, to put it politely, less developed. Such cherry picking is not acceptable as it would result in too low capital requirements on average. Combined with the desire to have the banks operate under the most sophisticated mechanism to understand the risks they are subject to, this has led to a mechanism under which banks are allowed

73 Corporates can be understood to include all commercial entities, corporations, including SME’s (see e.g. art. 145.4 RBD). However, for the purposes of the IRB approach, some exposures to SME’s are instead allocated to the retail category under art. 86.4 RBD.

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to gradually move into the IRB approaches, but are not allowed to move back to a simpler approach. In principle, banks can move from the standardised approach to the IRB approaches sequentially74, both within the same business unit as well as across different business units in the same group: – across different exposure classes, provided that the equity exposure class is always included in the first batch (being the most likely to ‘cherry pick’75); – within the retail exposure class, across certain categories of exposures; – for the use of own estimates of Loss Given Defaults or conversion factors for the calculation of risk weights for exposures to corporates, institutions and central governments and central banks (i.e. moving to the advanced approach). When starting such a sequential moving across these exposure classes and business lines, banks need to agree a timeline with the supervisors. The term ‘agree’ is relatively soft, as is the condition that the implementation of the more advanced approaches needs to be carried out ‘within a reasonable period of time’. As most banks will opt for a group-wide movement to the more advanced approaches, differences of opinion and policy between supervisors will generally be smoothed out in the model approval process (see chapters 6.3 and 21). Tougher language is used on the anti-cherry picking conditions to be added to the roll-out agreement by the supervisor. The conditions “shall be designed to ensure that the flexibility (…) is not used selectively with the purpose of achieving reduced minimum capital requirements in respect of those exposure classes or business units that are yet to be included in” the foundation or advanced IRB approaches76. A bank or banking group that has been granted approval for its IRB models can thus still be on the standardised approach for large parts of its business. Apart from the ‘reasonable’ short term roll-out plans, which can take several years, there are other categories of exemptions or overlap with the standardised approach: – a banking group on the IRB approach on a consolidated basis can opt to remain on a solo basis on the standardised approach for the holding-bank, and can equally opt to have all or some of its bank-subsidiaries to remain on the standardised approach on a solo basis (see chapter 17);

74 Art. 85 RBD. 75 See, however, the ‘level playing field’ provision at the end of Art. 89.1 RBD, which allows equity positions to remain on the standardised approach if such equity position would in its country be allowed to local banks for this preferential treatment by the local member state. 76 Art. 85.2 RBD.

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– the IRB approach for some categories borrows the regime for such exposures from the standardised approach, e.g. for collective investment undertakings77, and some categories of exposures are subject to a separate joint regime, e.g. securitisations; – large swathes of business lines and exposures can remain on the standardised approach on a permanent basis if the bank obtains approval by their competent authorities78. The latter approval to remain on the standardised approach can be given for activities that are relatively small in relation to the investment needed to do a good model. It concerns for example exposures to banks, investment firms, central governments and central banks for a bank that is focused solely on deposit taking and mortgages. The criteria for such permissions include cases where it would be ‘unduly burdensome’ to implement a rating system for these counterparties and there are a ‘limited’ number of exposures within those exposure classes, or if the central government in case is 0% rated under the standardised approach. In addition to having smaller business units remain on a solo basis on the standardised approach as set out above, even within the consolidated IRB approach such business units can be carved out and their numbers added as calculated under the standardised approach. Approval can also be given for exposure classes that are immaterial in terms of size and perceived risk profile, such as exposures to prudentially supervised group companies and to banks which belong to the same institutional protection scheme79 as the bank itself; equity exposures to entities which are in some publicly sponsored area, such as investment/subsidy vehicles; or minimum reserves held at other banks as required by central banks. Future Developments In Basel III/CRD IV, the main outline of the IRB approaches is unchanged. The major impact derives from changes in the derivatives calculation described in the next chapter, and the fact that more of the capital requirements for credit risk and its sister categories will need to be fulfilled gradually by higher quality financial buffers; see chapter 6.2. EBA initially was allowed, but not obliged to draft regulatory standards to specify assessment methodologies for the IRB internal models, but the CRD IV project made such standards obligatory. The standards have the potential to upgrade and further harmonise the model

77 The treatment of exposures in collective investment undertakings borrows from the standardised approach, but with modifications. See art. 87.11 and 87.12 RBD, and chapter 19.5. 78 Art. 89 RBD. 79 Such schemes operate in Germany, and the participating banks benefit from Art. 80.8 and 89.1e RBD, effectively making such exposures, including the guarantee itself, carry zero capital requirements, with the exception of own funds positions in each other. See art. 4.127, 8.4, 49.3, 84 and 113.7, 422.3, 423.8, and 425 CRR.

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EU Banking Supervision validation guidelines, and will harmonise the supervisory approach on a range of variables80. On the future developments on models; see chapter 6.3. Amongst others the BCBS has reported on the different outcomes of the internal models when looking at similar borrowers, depending on for instance the loss given default and probability of default estimates used81. This results in (sometimes very) different capital requirements dependent on the choices made by the institution in its internal model and the way it applies them. The BCBS has started a benchmarking exercise, but follow-up action is likely needed in the design of the approval process too. Literature – Thomas, Hugh; Wang, Zhiqiang, Interpreting the internal ratings-based capital requirements in Basel II, Journal of Banking Regulation, vol. 6 no.3, 1 May 2005, page 274-289 – Lelyveld, Iman van (ed.), Economic capital modelling, London, 2006 Guidelines – CEBS-EBA, Guidelines on the implementation, validation and assessment of Advanced Measurement (AMA) and Internal Ratings Based (IRB) Approaches, 4 April 2006 – Basel Committee on Banking Supervision, The Use Test: Background and Implementation, Newsletter no. 9 (September 2006), Basel, 2006

8.4 Derivatives and Related Products in the Standardised and the IRB Approach (Counterparty Credit Risk) Introduction The calculation of the exposure values of most assets and off balance sheet items is set out above in chapters 8.2 and 8.3 for respectively banks on the standardised approach or on one of the IRB approaches. For derivatives and for a defined range of other structured financial markets transactions, however, the CRD contains specific provisions on the determination of the exposure value. The regime is called the counterparty credit risk methodology; often referred to as CCR82. In a carve-out of the separate treatment for the 80 Art. 84.2 and 129.2 RBD, as added by art. 9.23 and 9.32 Omnibus I Directive 2010/78/EU. See e.g. art. 20, 143, 144, 148, 164 and 180-183 CRR. 81 BCBS, Regulatory Consistency Assessment Programme (RCAP) Analysis of Risk-Weighted Assets for Credit Risk in the Banking Book, July 2013. UK FSA, A Regulatory Response to the Global Banking Crisis; Discussion Paper 09/2, March 2009, page 71-73. See chapter 6.3. 82 Counterparty credit risk is set out in Annex III and IV RBD, and – for the trading book as part of the market risk calculation – in art. 18 and Annex II RCAD. Also see chapter 9. Where exposures to banks and invest-

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trading book (exempted from credit risk requirements but subject to market risk requirements for position risk (see chapter 8.1 and 9); and the rest of the exposures of a bank, the treatment for these financial instruments held in either trading book or non-trading book is closely linked, if not identical. As it deals with complex financial market transactions, there is a logical overlap with the market risk regime. The two regimes in the RBD and RCAD cross-refer and build on each other continuously, and have to be applied in an integrated manner (made difficult by the slightly different terminology used)83. Perhaps in line with the complicated nature of the transactions, the description of counterparty credit risk methodology uses a complicated structure and complicated terminology (e.g. in the description of aspects which together determine the value of a derivative at a certain date). The calculation of the exposure value is applicable both under the standardised approach and under the IRB approach84, though the subsequent treatment once the exposure value has been calculated is of course quite different (standard risk weighting or treated under the IRB model). It is applicable to all derivatives and similar instruments, taken together defined as OTC derivatives. The annex to the RBD85 mentions in a slightly dated list: – interest rate contacts; – foreign-exchange contracts; – contracts concerning gold; – contracts similar to the above; – derivatives for the transfer of credit risk (only for such derivatives in the trading book). Apart from these derivatives, counterparty credit risk is also calculated under market risk rules for86: – credit derivatives (trading book);

83

84 85

86

ments firms are included, those also include recognised clearing houses and exchanges, as well as to recognised third-country investment firms as a result of art. 40 RCAD. The CCR calculation does, however, import the concept of the trading book into the credit risk area; see chapter 9.2. As a result, the purpose for which these financial instruments are held by the bank does influence the capital requirements calculations. Art. 78 RBD for the standardised approach, and Annex VII part 3 §5 for the IRB approach. Annex IV to the RBD and definition of ‘over-the-counter (OTC) derivative instruments’ of art. 3 RCAD. Examples of interest rate contracts mentioned are single-currency interest rate swaps, basis-swaps, forward rate agreements, interest-rate futures and interest-rate options purchases. Examples of foreign-exchange contracts are cross-currency interest-ate swaps, forward foreign-exchange contracts, currency futures and currency options purchased. These are mentioned for the trading book in Annex II §5 RCAD, and Annex III part 2 §2 RBD. Definitions of key terminology for determining the scope and application of credit counterparty risk (such as long settlement transactions and margin lending transactions) are contained in Annex III part 1 RBD and in art. 3 RCAD.

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– repurchase agreements, reverse repurchase agreements, securities or commodities lending or borrowing transactions based on securities or commodities included in the trading book; – margin lending transactions based on securities or commodities; and – long settlement transactions. Building on the value of the financial instrument under the accountancy standards, the calculation of counterparty credit risk takes into account the effect of settlement risk on the exposure value. This is the risk that the counterparty under the OTC transaction could default before the final settlement of the transactions’ cash flows and delivery of underlying instruments. There are four different methods to calculate the exposure value of a derivative both inside and outside of the trading book. A bank can choose the method it wants to apply (some can be used in combination for different types of contracts). However, if it opts to use the most advanced (internal model) method for some or all of the categories mentioned above, it needs supervisory approval (to be given in a similar but separate approval as to be allowed to use the IRB approaches). The four methods are: 1. The mark to market method: the current replacement cost of all contracts with a positive value is determined (the market value). For each of these positive value contracts, the exposure (‘potential future credit exposure’) is determined by multiplying the positive value with a percentage between 0% and 15%, depending on the type of contact and the residual maturity (with higher risk and longer remaining maturity having a higher percentage). The supervisor can require higher than the notional amounts to be taken into account if the contract contains multipliers. 2. The original exposure method: The original exposure method applies a crude, unsophisticated mechanism. It multiplies the notional principal amount of each instrument (the face value) by a percentage set out in a table with six full options, three for interestrate contracts, three for foreign-exchange rates and gold. If a bank has a sizeable trading book, it is not allowed to use it, and even if it has a tiny trading book and benefits from the trading book exemption described in chapter 9.2, it is still only allowed to use it for the types of contracts mentioned. 3. Standardised method87 for CCR: This method is only available for OTC derivatives and long settlement transactions. It calculates the exposure value through a formula taking into account the current market value of the transaction and of the related collateral, the risk position of both the transaction and of the related exposure, and whether

87 Not to be confused with the standardised approach of credit risk as a whole, of which all four CCR methods are part.

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transactions (and related collateral) belong to the same hedging set. The risk positions take into account the market price and quantity of the underlying financial instruments, and issues such as duration and cash payments. The risk positions are then grouped into hedging sets if they are e.g. issued by the same issuer or related to the same commodity. Per hedging set, a multiplier is specified (higher if the category is deemed riskier), varying from interest rate category (0.2%) to 10% to all commodities and instruments not fitting in one of the safer categories. 4. Internal model method88 for CCR. The internal model method for CCR works as follows: – The exposure value will be determined for groups of connected transactions with a single counterparty, subject to a netting agreement (the ‘netting set’). The model needs to take account of market variables, and determine the exposure value for the netting set at every date for the next year (or less if none of the transactions will last for that period of time). The exposure value will be determined as the average during this year, multiplied by a factor of 1.489. The bank can choose to take collateral into account in the model (fulfilling some conditions), but it can also choose to deal with collateral under the credit risk mitigation methodology (chapter 8.5). Volatility and correlation in an economic downturn needs to be taken into account. – An extensive set of additional internal organisation requirements is applicable, surrounding amongst others (a) the integration of the model into the normal decision making processes on the contracts within the scope of the counterparty credit risk methodology, (b) involvement of management, (c) the adequacy of all processes and systems surrounding counterparty credit risk, as well as their regular review through its internal auditing process, and (d) validation requirements, of which the qualitative components are linked to those for the use of the market risk internal model (see chapter 13.5). – If the bank wants to apply this method to either repurchase transactions, margin lending transactions or to securities/commodities lending/borrowing transactions, it has to apply it to all three90. If it opts to use this method, it cannot revert to one of the simpler methods (except with the permission of the supervisor). 88 Not to be confused with the internal models used in the internal ratings based approach of credit risk as a whole, of which all four CCR methods are part. The internal model method can be chosen by a bank on the standardised approach, though it is more likely to fit well with a bank on IRB. 89 This factor, the alfa factor, can also be higher if the supervisor requires this. The bank can also calculate its own alfa factor under the internal model method, but it cannot be lower than 1.2. Annex III part 6 §7-13 RBD. 90 See Annex III part 2 §2 and part 6 RBD. It can apply the model also (only) to derivatives, and to long settlement transactions only if it already applies it to one of the other categories. It can move sequentially to the model

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A bank has to choose a specific method and stick to it, though it is allowed to combine the mark to market method and the standardised method. For consolidated supervision (see chapter 17), banks within the same group are allowed to use different methods per entity. The results for the various entities are added together to obtain the consolidated exposure value. It was deemed not fair to ask a banking group to implement the same method across the group, considering that some entities in the group have little or no derivatives and other structured financial market agreements on their solo-books. This is no longer in line with the solo/consolidated division for IRB approaches (where entities can remain on simpler methods but if the bank ‘models’ at the consolidated level it has to do so on the basis of the actual underlying data; see chapter 8.3 and 17). The continued availability of this adding-up method can only be deemed a mistake. It allows banks to game the calculation, and hide the worst derivatives exposures in less regulated entities. An ‘adding-up’ total does not provide insight into the full derivatives position of the group, especially when multiple entities within the group can have different exposures to similar derivatives, and can even be each other’s counterparty. Future Developments: Basel III / CRD IV The treatment of counterparty credit risk for derivatives had not been changed in Basel II½, even though some of the provisions on the trading book had changed that also touched upon derivatives (see chapter 9). Basel III provided follow up to upgrade the credit risk treatment of derivative contracts entered into by the bank (or bought or sold by the bank)91. As with the Basel II ½ trading book changes, the proposals accept that some types of financial contracts will become more expensive for banks to engage in, perhaps prohibitively so, because the pricing of such instruments will now need to take into account the true risk embodied in them (instead of the underestimating old Basel I/II treatment that had lagged the innovation in the markets on these instruments)92. The basic regime proposed by the BCBS was finalised end 2010, pending an impact assessment. The treatment in the standardised approach of certain higher risk counterparties was subsequently eased slightly to align it better with the treatment in the advanced approaches93. Under the Basel III amendment to the capital accord, a charge is added for the default risk of the counterparty (similar to the changes made in the market risk treatment; see chapter 9). Per type of derivative-counterparty (and the type of risk mitigation tool available) a per category, and for the remainder it has to apply either the mark to market method or the standardised method. 91 The BCBS also publishes (and updates) documents containing ‘frequently asked questions’ on its website on amongst others counterparty credit risk, which provide further guidance to the accord. 92 Commission, CRD IV – frequently asked questions, 20 July 2011, memo/11/527. 93 BCBS press release, Capital treatment for bilateral counterparty credit risk finalised by the Basel Committee, 1 June 2011, www.bis.org.

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calculation is made under new formula. This credit valuation adjustment (sometimes referred to as CVA) risk capital charge directly is a capital requirement (with a multiplication by 12.5 resulting in a risk weighted assets equivalent, in the reverse of the 8% capital charge on assets that are not the subject of the counterparty credit risk calculation). It intends to adjust the mid-market valuation reflecting the current market valuation of the credit risk of the counterparty to the bank in portfolios of transactions. These concepts are not defined in the CRR, leaving scope for different approaches. The regime exempts exposures that may or may not be presumed to be risk-free exposures, such as exposures to central governments, pension funds and central counterparties (and clearing members who are intermediating for central counterparties). Some of these exemptions may have been included due to special interests during the negotiations on the CRD IV project. Depending on the sophistication of the bank (e.g. whether it has permission for the use of a specific market risk internal model and the counterparty credit risk internal model), it can apply either an advanced method (with some opt-outs for small portfolios) and a standardised method. The credit valuation adjustment regime also allows alternative treatment in an adjustment of the counterparty credit risk regime (by multiplying by 10 the CRR exposure amount for these exposures). The calculation is calibrated to establish the appropriate level of requirements within the wider credit risk and market risk landscape94. EBA is to develop standards for the more advanced method to calculate this capital requirement by the start of 2014, and report on the regime by the start of 201595. The counterparty credit risk regime is contained in the CRR96. The CRD IV project focuses on increasing capital requirements for over the counter traded derivatives and on repurchase agreements (a form of securities financing, that in this case provides banks with money market access by temporarily ‘selling’ financial instruments to the lender). In non-cleared circumstances, additional capital charges looks at potential losses that result from the reduction in the creditworthiness of the counterparty of derivatives, while exposures cleared from central counterparties that comply with the EMIR regulation benefit from exemptions or lighter requirements97. The treatment of the trading book is one of the open issues identified in the Basel III package. The BCBS is consulting on a new approach98, that may be especially relevant to 94 See the November 2011 version of the BCBS, Basel III Counterparty Credit Risk – frequently asked questions, November 2011, page 5 (chapter II question 13). The credit valuation adjustment risk regime is contained in recital 83, art. 92, 162.2 sub h, 273.6, 381-386 and 482 CRR. 95 Art. 383.7 and 457.2 CRR. 96 Art. 271-311 and Annex II CRR. 97 Recital 81-87 and for example art. 107, 300-311, 382.3 and 400.1 sub j, 497, and 520 CRR. Also see chapter 22.4. 98 BCBS Consultative Document, Fundamental Review of the Trading Book, May 2012.

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derivatives as they are so similarly treated in both the credit risk and market risk treatments. See chapter 9. The trades of banks in derivatives will also be impacted by intensified legislation on the markets in ‘over the counter’ derivatives (off exchange traded derivatives) and on central counterparties (the ‘counterparty’ of trades during the risk-reducing clearing and settlement process for all on exchange traded products and ever more off exchange traded financial instruments). Both are part of the European markets infrastructure regulation or ‘EMIR’99. Under no circumstances will such exposures be zero risk weighted. Even with a central counterparty a risk remains in any open transaction or collateral posted, but depending on the asset the treatment is very beneficial for centrally cleared assets that are a pure exposure on the central counterparty (e.g. collateral posted to the central counterparty). The treatment is less beneficial if the exposure is determined also by the creditworthiness of other members of the clearing structures (e.g. an exposure to a default fund that provides protection to the central counterparty in case one of its members fails to fulfil its obligations), and high if it concerns a non-centrally cleared asset (e.g. a claim for delivery of payment or for delivery of financial instruments directly on a ‘normal’ counterparty). EMIR contains such an exception for the clearing obligation and collateral requirement for many non-financial institutions. As EMIR does not apply, this automatically means that such non-cleared and uncollateralized claims on such exempted counterparties are high risk for the bank, and thus require higher capital to buffer against that risk. If a bank is the counterparty in a trade with such an EMIR-exempted party, it will likely mean that the price will rise in line with the (true) risk for the bank. The CRD IV project complement EMIR in this regard, by requiring banks to hold more capital if certain exposures do not benefit from the additional safety measures contained in EMIR100. The treatment of claims on central counterparties and on the counterparty in trades that cannot be centrally cleared via a central counterparty will also change. These new texts on counterparty credit risk contained in the CRD IV project pertain specifically to credit risk. The treatment of settlement risk for those same exposures remains unchanged in the market risk calculations (see chapter 9.3).

99 See chapter 22.4 (and for the over the counter market chapter 16.4). 100 See chapter 8.4 and 22.4.

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Credit Risk Protection

Introduction Capital requirements for the credit risk related to all exposures of a bank can be substantial. The purpose is to ensure that sufficient capital is held in the event the value of the exposure is lost, for instance because the obligor cannot fulfil its obligations to the bank. As an alternative to holding capital, the risk to the bank of such event can also be reduced in other ways: – Investment in measures to manage risk and invest in models predicting losses can reduce the risk for a bank (and improve the pricing of risk consciously taken on board). The reduction in risk is recognised by supervisors if the bank qualifies for the IRB approach instead of the standardised approach, or start to apply the more advanced models within the IRB, and leads to an effective reduction in capital requirements. See chapter 6.3, 8.3 and 13.5. – A reduction in the credit risk can also be achieved in a more prosaic but effective manner. Legal techniques provide credit risk protection to the bank for the credit risk embodied in a specific exposure or set of exposures. These techniques are based on traditional measures taken by banks to reduce their risk: by contractual arrangements with the counterparty or with third parties, by requiring collateral or by obtaining guarantees. Newer techniques have been added, e.g. derivatives that provide insurance against a decline in value of an asset (such as holding a credit default swap if the bank also holds the bonds on which the swap provides for a payment if the original debtor does not fulfil its obligations under the bonds). The legal techniques are partially recognised for supervisory purposes. They provide a similar or better buffer against a reduction in the quality of that exposure than a more general purpose financial buffer would do. If protection is recognised, it reduces either the size of the exposure involved or the risk weight applied to that exposure. However, under public accounting standards (see chapter 6.4) the full value of mutual exposures and the full value of an exposure covered by collateral still has to be presented for public transparency purposes101. Normally prudential calculations of value rely on public accounting rules. In order to allow supervisors to recognise risk mitigation, leading to reduced valuations of the banks’ exposures (or reduced risk weights for some specific categories) and thus to reduced capital requirements, the CRD needed to contain a comparatively extensive set of rules on when these techniques are recognised.

101 See e.g. art. 7 4th Annual Accounts Directive (applicable to banks via art. 1.1 ABD) that prohibits set-off between asset and liability items.

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The main CRD-methodology under which such contractual arrangements are recognised is called ‘credit risk mitigation’; often referred to as CRM102. CRM is the main methodology, but by no means the only one. Special regimes have been created. Risk protection is recognised in: a. credit risk mitigation recognition (i) for funded credit protection via e.g. netting103 arrangements or financial collateral, (ii) for unfunded credit protection via e.g. guarantees or insurance, or (iii) for credit derivatives104; b. recognition of netting agreements for derivatives, repurchase transactions, securities or commodities lending or borrowing transactions, long settlement transactions and margin lending transactions, where the bank can either choose the credit risk mitigation methodology that deals specifically with this type of arrangements under the ‘counterparty credit risk’ methodology set out in chapter 8.5105 or under the netting rules for these same arrangements set out in the credit risk mitigation methodology; c. reduced risk weighting for exposures secured by mortgages on residential and on commercial real estate property in the standardised approach (with the equivalent preferential treatment available for banks operating under the IRB approach under the credit risk mitigation methodology)106; d. selling the asset ‘reduces’ the credit risk in full if the asset is truly sold in a normal sales transaction (e.g. by spinning off a business or selling part of an exposure), so that it is no longer held by the bank nor implicitly or explicitly guaranteed; in the latter case it may still be considered a sale by the bank and supervisor, though the guarantees given may be categorized as off balance sheet exposures); e. selling the asset ‘reduces’ the credit risk in part if the asset is securitised, as a result of which the selling institution retains an interest and liability with regard to the ‘sold’

102 Set out in art. 90-93 and Annex VIII RBD. 103 In netting, two opposing claims of a similar nature (e.g. dollar payments) between the same counterparties are set off against each other up to the amount of the lowest claim. Only the remaining part of the highest claim subsequently needs to be paid (or is ‘unsecured’. Netting can be expanded or limited via contractual arrangements. Novation (often used in clearing and settlement) is different, in that it replaces two opposing commitments by one new, reduced, agreement. In netting, the old agreements continue to exist, counting as support for each other. 104 For credit derivatives, please also see the counterparty credit risk framework of chapter 8.4 and the similar regime for credit derivatives held in the trading book of chapter 9. As set out in chapter 8.2 and 9.2, sometimes the bank can choose for particular derivatives to put them in the banking book or trading book (i.e. apply credit risk or market risk rules) and within the banking book to take them into account in the counterparty credit risk regime or the credit risk mitigation regime. 105 See below under ‘special netting regime for CCR’. For banks under the standardised approach, see art. 78.1 RBD. For banks under the IRB approach, see Annex VII part 3 §7-8 RBD. 106 Banks under the standardised approach have to use the low risk weight of annex VI part 1 §44-50 and §5160 RBD. Banks under the IRB approach can (only) use the credit risk mitigation methodology, where real estate collateral is eligible as credit protection for their use only (Annex VIII, part 1 §12-19 RBD).

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exposure, and part of the credit risk lingers with the selling institutions (exclusively dealt with in the securitisation regime described in chapter 8.6). As credit protection is dealt with in various ways, there is a danger of recognising credit protection both in the main provisions of the standardised approach/IRB approach as well as in the determination of the effect of credit risk mitigation under the separate methodology. If double counting occurs, the bank is no longer allowed to take the credit risk mitigation effects into account, though the determination of such overlap may be difficult107. Effect and Scope of Credit Risk Mitigation Lending without mitigating measures can be a big cause of losses for a bank. If it becomes standard market practice to lend without good risk management – for example by demanding collateral – the risk can become systemic if the assumptions about creditworthiness of the counterparty or market are based on faulty assumptions or lack of research. The LTCM near-failure in 1998 (which had benefited from uncollateralized swap credit), subprime lending to not-creditworthy consumers, and the credit derivatives market at the beginning of the 2007-2013 subprime crisis (where triple A rated counterparties such as monolines and the AIG financial products subsidiary provided protection without collateral) can be blamed in part on faulty risk management procedures of their counterparties108. The rope provided to each other could be used to hang both debtors and lenders, leading to state intervention of unprecedented size. Credit risk mitigation is thus rightly stimulated as much as possible by providing (partial) relief from capital requirements. Credit risk mitigation impacts on the risk weighted value of the exposure and (for IRB banks) of the expected loss amount. If credit protection is recognised for (a portion of) the exposure, either: – for that portion a lower risk weighting is applicable (sometimes down to 0%); or – the value of the exposure to the counterparty is reduced (in that case for the remaining value subject to ‘normal’ risk weighting), as is the expected loss amount for IRB banks. Only for the reduced risk weighted value of the exposure the bank needs to hold the capital requirement of 8% for credit risk (as set out in chapter 8.2 and 8.3). Credit risk mitigation potentially could eviscerate the capital requirements for credit risk by taking away all the 107 Art. 93.3 RBD. See e.g. the standardised approach to counterparty credit risk, where the collateral used in OTC derivatives and long transactions is already taken into account in determining the exposure value, or the internal model method, where the inclusion of the treatment of collateral is optional. Collateral already taken into account in the counterparty credit risk methodology can not be used again, subsequently, to further reduce exposure values. See chapter 8.4 and Annex III part 5 RBD. 108 A.W. Glass, ‘The Regulatory Drive Towards Central Counterparty Clearing of OTC Credit Derivatives and the Necessary Limits on This’, Capital Markets Law Journal, Vol. 4, 2009, S79-98.

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risk in the banks’ exposures, regarding both expected and unexpected loss. As there is an incentive for the bank to deem the impact of credit risk mitigation high, and the remaining risk weighted value of the exposure low, the CRD sets out conditions under which supervisors will recognise the mitigating effect. These apply both to the standardised approach and to the IRB approach109. According to the – slightly ambivalent – text of the RBD, the main methodology for credit risk mitigation does not apply to an IRB bank that uses its own estimates of LGD and conversion factors for the calculation of capital requirements and expected losses. As all IRB banks have to perform such calculation – for foundation banks limited to retail exposures – the wording could lead to the conclusion that no IRB bank can apply credit risk mitigation (for all of its business). However, the intention appears to be to limit the use of the general approach to credit risk mitigation to those business lines where those specific own estimates are not used. The business lines where own estimates of LGD and conversion factors are used (retail for all IRB banks, and government and corporates for advanced IRB banks) are subject instead to a specialised regime on credit risk mitigation as described below under ‘business lines subject to own estimates of LGD and conversion factors’. General Aspects of the Regime on Credit Risk Mitigation The credit risk mitigation methodology differentiates between three forms of credit protection. Within these three forms, several forms or protection are deemed eligible110 to be recognised as mitigating credit risk for supervisory purposes. It concerns: a) funded credit protection; b) unfunded credit protection; c) credit derivatives. Examples of funded credit protection include: – bilateral netting of reciprocal cash balances between the bank and its counterpart; – multilateral netting agreements; – financial collateral, including111 (i) cash on deposits or cash assimilated instruments held by the counterparty with the bank itself (ii) highly rated bonds, (iii) equities or 109 In the standardised approach, the use of credit risk mitigation is based on art. 78.2, 78.3, 80.4 and 91 RBD. In the IRB, the use of credit risk mitigation is based on Annex VII, part 1 §4, 11 and part 3 §2-3 RBD, art. 91 RBD, and parts of it are referred to for specific purposes in Annex VII part 2 §8, 13, 16, 20, and 22 RBD. 110 Art. 92.3 and 92.4, and Annex VIII, part 1 RBD. For the definition of funded and unfunded credit protection, see art. 4.31 and 4.32 RBD. 111 If the more advanced method to deal with credit risk mitigation on financial collateral is chosen, also equities and convertible bonds that are not part of a main index but are still traded at a ‘recognised exchange’ (see chapter 16.4 and 22.4), and units in collective investment undertakings that invest in those shares and con-

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convertible bonds that are included in a main international or national market index, (iv) units in collective investment undertakings (such as UCITS) that have a daily public price quote and invest in eligible instruments themselves, (v) some financial instruments and commodities in the trading book (but only as collateral for other trading book exposures); real estate collateral (for IRB banks only; standardised banks benefit from a lower risk weighting already for loans backed by mortgages); other physical collateral (for IRB banks only); pledged cash on deposits or cash assimilated instruments held by third party banks or investment firms; pledged life insurance policies; instruments that will be repurchased by the issuing bank or investment firm upon request.

Examples of unfunded credit protection include (e.g. guarantees or insurance contracts) by: – central governments, central banks, regional governments and local authorities, (and public sector entities treated as governments or banks under the standardised approach); – multilateral development banks; – international organisations that are 0% weighted in the standardised approach; – banks and investment firms (and as a national discretion financial institutions supervised as banks, see chapter 5); – highly rated corporates (including insurers and group entities of the bank); – for IRB banks that want to apply the probability of default of the protection provider instead of that of the obligor, they can do so if the credit protection is provided by an above average rated insurer, bank, investment firm or export credit agency that has experience in providing unfunded credit protection. Examples of credit derivatives are: – credit default swaps; – most total return swaps; – credit linked notes to the extent of their cash funding – instruments that are composed of the above or that are economically effectively similar; – some credit derivatives used for internal hedges112.

vertible bonds can be eligible collateral. For the extended range of instruments eligible in the trading book, see Annex II §9 and 10 RCAD. 112 For the additional conditions on eligibility of total return swaps and internal hedges, see Annex VIII part 1 §31 and 32 RBD.

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Credit derivatives are treated as either funded or unfunded credit protection, depending on the specifics of the derivative113. For example, credit linked notes with cash funding are treated as funded credit protection, but credit derivatives that only give a promise to pay out in the event of a credit event are treated as unfunded credit protection. As credit derivatives are themselves an exposure of the bank (it is also a potential claim by the bank on the protection provider), they normally would have to be risk weighted themselves. If the bank can show that it uses the credit derivative not as an investment but as a way to protect an existing exposure, it does not need to hold capital for it114. Each eligible form of credit protection subsequently is subjected to a different set of requirements – depending on whether it is categorised as funded respectively unfunded – on: – risk control minimum requirements on the risks to which the bank is exposed as a result of carrying out credit risk mitigation practices (as part of the internal governance requirements; see chapter 13); – calculating the effect on the risk weighted exposure amount and (for IRB banks) on the expected losses. The risk control minimum requirements focus on: – risk management (e.g. monitoring and controlling both the assets that are protected and that give the protection115); – legal and practical enforceability of the protection, including e.g. enforceability in bankruptcy and enforceability in the jurisdiction where the assets are located116. These are worked out in detail, with specific requirements for each form of credit protection eligible under the credit risk mitigation methodology. Examples of requirements for funded credit protection are to have the real estate that serves as collateral insured, to have proper documentation for financial collateral and policies for their liquidation, and to have pledges of cash on deposit and life insurance policies known to all involved parties (open pledge). 113 Most of the specific provisions deal with unfunded credit derivatives. See Annex VIII part 2 §14-22 and part 3 §3 and §83 RBD. There are also some specialised forms of credit derivatives (first to default and n’th to default credit derivatives, which trigger pay-out of a basket of exposures based either on the first default in the basket, or at the default of a certain number of exposures within the basket) in Annex VIII, part 6 RBD. 114 See e.g. Annex III part 2 §3 and 4 RBD. 115 See art. 92.1 and 92.2, as well as Annex VIII part 1 RBD. Another example is the requirement to manage the correlation between the exposure and the protection giver (e.g. if both are the same of heavily interlinked) or the exposure and the assets that give the protection (if the market to which both belong collapses, neither will be worth much); see e.g. art. 92.4 RBD. 116 E.g. by being allowed to liquidate or retain, in a timely manner, the assets that serve as collateral in the event of the default, insolvency or bankruptcy of the obligor or of the custodian holding the collateral. Art. 92.4 and Annex VIII part 2 RBD.

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Examples for unfunded credit protection are to ensure legal enforceability of guarantees and credit derivatives and to have the guarantee explicit in documentation signed by the guarantor. Though these could already be deduced from the general obligations to have a good internal organisation (see chapter 13.3), these specific organisational requirements have been added as a condition for using the credit protection. Determining the Risk Weighted Exposure Value and (for IRB Banks) Expected Losses Calculating the effect of credit risk mitigation can be complicated for two of the funded credit protection methods117. Within the calculation for master netting agreements and for financial collateral, different methods and models are available. These can be chosen independently of the bank being on IRB or standardised approach (though the simpler methods on financial collateral are not available to IRB banks)118. For other credit protection (both funded and unfunded) the methods are relatively simple, in line with their more straightforward nature and less volatile value. Master netting agreements covering collateral119 in repurchase transactions, securities lending/borrowing transactions and other similar market-driven transactions as well as financial collateral are subjected to a volatility adjustment. This volatility adjustment is calculated via different methods to estimate the impact on the value of the collateral (and thus the protection given by the collateral) of fluctuations of the value of currencies and securities that are the subject of the transaction. Such volatility might impact negatively on the actual protection given by the arrangements to the bank, as a result of which the full face value of the collateral cannot be taken into account. Changes may be made to this regime to reduce the procyclicality of extra calls for collateral due to changes in valuation or risk perception120. For financial collateral, the choice is between a simple method and a comprehensive method. The comprehensive method builds on either (i) the so-called supervisory volatility adjustment approach, or the (ii) own estimates volatility approach. For netting under the contracts mentioned, the choice is between: – the equivalent of the above-mentioned comprehensive method, building on the same two approaches: or – an internal models approach, similar to the internal models approach to market risk.

117 For the others, see ‘treatment of other types of funded and unfunded protection’. 118 See for financial collateral Annex VIII, part 3 §24, 35 RBD. 119 Cash, securities or commodities purchased, borrowed or received under a repurchase transaction or under securities/commodities lending or borrowing transactions are treated as collateral, Annex VIII part 3 §2. 120 See chapter 6.5. Committee on the Global Financial System, The Role of Margin Requirements and Haircuts in Procyclicality, CGFS papers 36, March 2010, www.bis.org.

477

EU Banking Supervision If the volatility adjustment is 0%121, for the secured part of the exposure the value is zero. In that case, the unsecured portion of the exposure is the fully adjusted exposure value. If the volatility adjustment is more than zero, also of the secured part a part will need to remain in the fully adjusted exposure value as it may not provide full protection of the potential future losses due to swings in the value of the collateral. After adjustment for likely volatility, the fully adjusted exposure value is subjected to the normal risk weighting processes122. The supervisory volatility adjustment approach and the own estimates volatility adjustment approach are used both for netting and for financial collateral (as well as for currency mismatches with unfunded credit protection)123, and are available at the option of the bank. Under the supervisory volatility adjustment approach, the volatility of values of the currencies and the securities involved in the financial collateral or netting agreement is calculated on the basis of the specific information, adjusted for standard volatility quotients124. Subsequently: – for financial collateral the value of the original exposure and the value of the collateral are subjected to a formula calculating the fully adjusted exposure amount, taking into account volatility of currencies and securities, maturity mismatches, but basically deducting the adjusted value of the collateral from the adjusted value of the exposure; – for master netting agreements both the net position on each separate currency and each separate type of security that are issued by the same entity and have exactly the same characteristics and timelines are calculated as well as the exposure value of each netted exposure. These are subjected to a formula calculating the fully adjusted exposure value, taking into account volatility of currencies and securities, as well as the separate positions within the netting agreement. Under the own estimates volatility adjustment approach, the volatility of values of the currencies and the securities involved in the financial collateral or netting agreement is calculated on the basis of own estimates on the volatility on both collateral and the collateralised exposures. Both for financial collateral and master netting agreements, the calcu-

121 For a large component of daily settled transactions and daily re-margined transactions between core market participants, there is a 0% volatility adjustment. For the fully collateralised exposure, the value is 0, and thus the risk weighted exposure and the capital requirement for it is also 0. See Annex VIII, part 3 §11, 27, 58 and 59, as well as other examples in this part 3 of Annex VIII RBD. 122 Annex VIII part 3 §22 and art. 80 RBD for the standardised approach, and Annex VIII part 3 §23 and Annex VII RBD for the IRB approach. 123 See Annex VIII part 3 §34-59, and §5-11, 85 RBD. 124 Set out in tables in the RBD depending on amongst others the type of the asset, the residual maturity, liquidation periods and credit quality steps.

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lation of the fully adjusted exposure value is subsequently the same as in the supervisory volatility adjustment approach. Under the financial collateral comprehensive method125, the bank has to subject the outcome of the applicable approach to a formula that takes into account the price volatility, currency volatility, maturity mismatches (where the collateral may have lapsed before the exposure is scheduled to be repaid at the latest) and the current value of both the exposure and the collateral. If both the exposure and the collateral would fall under the financial collateral definition (in repurchase agreements, securities lending and margin lending and such), the original exposure has to be increased by this same volatility adjustment126. A core component is, however, the set of conditions under which a 0% volatility adjustment can be used (resulting in value of zero for the collateralised exposure) for repurchase transactions and securities lending or borrowing transactions. The remaining value is 0% if, amongst others, (i) the transactions are daily marked to market or daily re-margined, (ii) it involves cash or government bonds that are 0% risk weighted, (iii) is settled across a proven settlement system and (iv) the counterparty is considered a core market participant. This beneficial treatment makes the use of this complicated instrument with a high effect on market trading rather cheap for the bank from a capital requirements point of view. Choosing to use the financial collateral comprehensive method can also lead to an increase of the exposure value instead of a reduction. This is due to the volatility adjustments for e.g. securities subject to a repurchase transaction or under securities lending transactions127. The financial collateral simple method128 for standardised approach banks is set up in a very different manner. It does not take volatility into account, except to the extent it requires the use of market values. The market value of the collateral is to be determined at least every six months and more often if a significant decrease in the market value has occurred. To the extent the market value of the collateral covers the exposure, the risk weight of the collateral replaces the risk weight of the exposure, with a minimum of 20% (and the uncollateralised portion treated with the regular risk weight of the counterparty). The 20% can be adjusted to 0% if it would have qualified for a 0% volatility adjustment under the comprehensive method (or 10% if it does not concern a core market participant). The 20% can also be reduced to 0% if additional conditions are met on e.g. daily marking to market 125 126 127 128

Annex VIII part 3 §30-33, §60-61, and part 4 §7 RBD. Art. 78.1 RBD. Art. 78 and Annex VIII, part 3, points 34 to 59 RBD. Annex VIII part 3 §24-29, and part 4 §5 RBD.

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for OTC derivatives and/or on the type of low risk collateral. Collateral is not recognised if there is a maturity mismatch, i.e. the collateral expires or is likely to expire before the exposure is scheduled to be fulfilled at the latest. This simple method is only available to banks on the standardised approach and only in as far is it concerns financial collateral outside of the trading book129. Its main purpose is to allow the simplest of banks to use an equally unsophisticated method under which it can replace the risk weight of the exposure with the risk weight of the collateral, with some constraints instead of with volatility adjustments. The bank in that case does not have to invest in more sophisticated requirements needed to treat a more extensive financial market trading business correctly, as set out in the financial collateral comprehensive method. A bank is not allowed to use both methods at the same time130. The internal models approach of credit risk management (as indicated above only developed for master netting agreements, not for financial collateral)131 is available by definition to banks that apply the internal models approach under market risk, and can be applied by other banks (only) if the supervisor gives separate permission; see chapter 6.3 and 21. Such permission is dependent on amongst others substantially higher internal organisational requirements, including the institution of a risk control unit independent from business trading units). If this model is chosen, it has to be applied to all material portfolios by the bank. For netting, as an alternative also either the comprehensive or simple method can be used (similar as for financial collateral). Special Netting Regime for CCR The counterparty credit risk regime (see chapter 8.4) contains a specific regime on the treatment of netting agreements. It concerns an alternative – for these types of agreements – to the treatment of netting in the credit risk mitigation methodology132. The bank has the option to either use this counterparty credit risk methodology or the credit risk mitigation methodology set out above. The two regimes are essentially alike in the results and contents. Both lead to a bundling of a large number of exposures between two institutions into one remaining exposure. If positive, only for that remaining exposure capital requirements need to be fulfilled. The conditions include attention to the administrative organisation surrounding the proper use of netting, legal certainty in all the relevant jurisdictions that

129 130 131 132

Annex VIII part 3 §24 RBD and Annex II §8 RCAD. Annex VIII part 3 §24, as amended by level 2 Commission Directive 2009/83/EC. Annex VIII part 3 §12-23 RBD. If the bank operates under the advanced IRB approach, it cannot use the credit risk mitigation methodology, but can instead choose to deal with netting within the context of the model, if it fulfils the conditions for this type of model. Annex III part 2 §3 and part 7 RBD.

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the netting results in one remaining legal obligation. On two issues the regimes differ materially in content: – Under the counterparty credit risk regime, only a limited number of cross-product netting agreement are recognised and only a bilateral basis, while this limitation does not exist in the credit risk mitigation regime. – Under the counterparty credit risk regime, the bank has to provide the supervisor with legal opinions on the legal certainty issue, while under the credit risk mitigation regime it is the responsibility of the bank to ensure the legal certainty, without a requirement on legal opinions (nor a corresponding task for the supervisor to check legal opinions). Both restrictions were not introduced in the credit risk mitigation rules when the CRD was revised for Basel II, despite being there already at the time in the counterparty credit risk rules (that were not changed at the time). This provides a – perhaps unintended – incentive to shift from the counterparty credit risk regime to the normal credit risk mitigation rules on netting. Treatment of Other Types of Funded and Unfunded Protection Cash collateral, credit linked notes and on balance sheet netting are treated within the financial collateral method as cash, and result (to the extent of the cover) in a 0% risk weight if in the same currency as the corresponding asset133. Deposits with third party banks, pledged life insurances and instruments repurchased on request by the issuing bank or investment firm, though officially categorized as funded credit protection, are treated as an (unfunded) guarantee by the insurer, bank or investment firm. For receivables and real estate property collateral (solely recognised in the IRB approach), the determination of the exposure value is directly linked to the market value as for instance set by an independent valuer for real estate, or the value of receivables. The determination of expected losses is subjected to minimum percentages, even for the secured part of the exposures. Please note that for real estate property, a national discretion is available that in essence allows the member state to use an approximation of the standardised approach to real estate by an (otherwise) IRB bank (applying a 50 risk weight to exposures covered by real estate) if and as long as losses on the portfolio of such exposures are negligible134.

133 Annex VIII part 3 §2-4, 29, 36 and 58 RBD. 134 Annex VIII part 3 §73-75 RBD.

481

EU Banking Supervision On unfunded credit protection135, the valuation is the amount that the protection provider has undertaken to pay in the event of the default of the borrower136, minus a discount for any currency mismatch (calculated in accordance with the supervisory estimates or own estimates approach set out above). In the standardised approach, the risk weight of the protection provider is then allowed to replace the risk weight of the borrower up to the value of the protection (subject to maturity mismatch). If only partial coverage is available, for the uncollateralized remainder of the exposure the risk weight of the borrower is applied. In the IRB approach, for the collateralised portion of the exposure the probability of default and the loss given default are calculated bearing in mind the calculation for the protection provider (in as far as it has a better risk rating). Apart from calculating the risk weighted exposure amount and (for IRB banks) the expected losses, credit risk mitigation also has an impact on the IRB models and on the standardised approach, on issues such as partial coverage by unfunded credit protection, and the probability of default and loss given default137 (that impact on the expected losses). Finally, it is important to note that if credit risk mitigation results in a higher capital risk weighted exposure amount or expected loss (e.g. when a low risk weighted exposure is protected by a higher risk weight collateral or by a guarantee by a failed bank) the lower of the two applies. Having additional protection, even if of lower quality than the original asset, should not work counter to the interest of the bank138. Business Lines Subject to Own Estimates of LGD and Conversion Factors in the IRB IRB banks must apply their own estimates of LGDs and conversion factor to the retail business line and some can also do so for their business lines of exposures to governments, to banks and investment firms and to corporates (partial or full use of the advanced IRB approach). For each business line where it does so, it cannot use the standardised credit risk mitigation regime (see above). It has to put its own calculation of the mitigating effects into its model used to make those estimates. In doing so, it has to fulfil the conditions set

135 Annex VIII part 3 §83-92 and part 4 §8 RBD. 136 It concerns defaults or non-payment, or other contractually agreed credit events that lead to pay-out. The only exception to this rule is that a discount on the value of the credit protection has to be taken if the unfunded credit protection is a credit derivative that does not pay out in the event of a credit restructuring agreement. 137 On the way the results of the credit risk mitigation methodology are taken into account in slightly different ways under the standardised respectively the IRB approach, see Annex VIII part 3 §22 and 23 (on netting), 60 and 61 (on financial collateral), 62-75 (on the IRB provisions on real estate and receivables collateral) RBD. On unfunded credit protection see Annex VIII part 3 §87-89 and 90-92 (as well as Annex VII part 1 §4) RBD. 138 Art. 93.2 RBD.

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out in a specialised credit risk mitigation regime139. This in addition to the conditions set in general for the models as described in chapter 6.3 and 8.3. However, it can be expected that such calculations are developed together in an integrated manner. The relevant aspects of the model are mostly focused on the own estimates of LGD, and include several requirements: – The model needs to set out how and when the use of mitigation techniques should be adjusted upwards or downwards and which plausible, intuitive and clearly specified criteria shall be used. – Additional organisational requirements similar to those applicable under the general approach to credit risk mitigation. – The model can only recognise guarantees if they are (a) in writing, (b) non-cancellable on the part of the guarantor and in force until the obligation is satisfied in full, (c) legally enforceable in a country where there are assets to attach and a judgement can be enforced, and (d) unconditional (unless the supervisor agrees that certain conditions are allowed and still lead to – some – risk mitigating effect). – The model needs to take into account which guarantors and single-name credit derivatives are recognised, whether the guarantor’s health is dependent on or linked to the health of the obligor, the assignment of recognised guarantors to grades, pools and exposures, identical to the assignment of primary obligors, currency mismatches between the obligation and any collateral, the ability of the bank to gain control of the collateral and liquidate it, and the avoidance of double counting of the benefits of collateral140. – The model does not need to be applied if a bank, in spite of being on IRB, has the approval of its supervisor to apply the standardised approach on exposures to the categories ‘governments’ and ‘banks and investment firms’. This is a supervisory discretion; the bank cannot demand permission to be given. If it can apply the standardised approach to these exposures, it can also apply the general regime to credit risk mitigation set out above to guarantees by these governments, or banks and investment firms. Credit Risk Protection Given by the Bank Guarantees and other unfunded credit protection given to others are treated as an off balance sheet item under the standardised approach. Collateral given is not treated separately, but the asset itself is risk weighted. It is still an exposure of the bank, regardless of

139 Art. 91 RBD and Annex VII, part 4 §75-80, 96-104 RBD. It also helps that banks are required to build their models on the basis empirical historical data on actual losses, Annex VII, part 4 §38 RBD. 140 In the treatment of derivatives counterparty credit risk, both in the standardised method and the internal model method collateral is already taken into account to determine the exposure value. In that case, that collateral shall not be used to reduce the LGD estimation. See Annex III part 5 §1and 6 §5-16, and Annex VII part 4 §79 RBD.

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it being given as collateral for its obligations. If the credit protection is given in the context of a securitisation, it may be ‘credit enhancement’. If so, a harsh treatment is applicable under the securitisation rules, in the form of a deduction from own funds; see chapter 7 and 8.6. If deducted, the enhancement given need not be risk weighted separately. Future Developments The credit risk protection regime will be part of the CRR141. The basic outline and options remain similar, but EBA will be required to develop (relatively few) standards, primarily on the internal model142.

8.6 Securitisations, Covered Bonds and Syndicated Loans Introduction Banks generate assets, many of them very illiquid such as personal loans, overdrafts, mortgage loans and loans to companies. Liquid assets can easily be sold or used as collateral, and are thus an easy source of cash. The fact that they can be sold also allows banks to reduce their holdings quickly if the quality deteriorates. How to transform illiquid assets into liquid assets where risk can be transferred, or used as a source of funding was bound to be a subject of study, especially when some illiquid assets started to attract (by comparison high) Basel I capital requirements. Some of the instruments for such transformation were already available prior to Basel I. Illiquid assets can be sold outright in exchange for a highly liquid cash payment if a buyer can be found (though this takes away the upside as well as the downside of the asset). In addition, in some member states there was a tradition of bonds issued by banks that were secured by collateral of illiquid assets; in EU terminology referred to as covered bonds. Examples are the Pfandbriefen in Germany or the cedulas in Spain. Syndication of large commercial loans was also common. In syndicated loans, banks jointly entered into a contract to lend a large sum to e.g. a single borrower, in which participations could be sold onwards. It was left to the bank and its accountants to determine whether an asset was owned fully, in part, or not at all by the bank, and the banking capital requirements took it from there. These methods to transfer illiquid assets into cash (or into easy collateral for cash) inspired the development of securitisations, whereby cash is generated by using assets as collateral for bonds (as with covered bonds and sales), and the assets are taken off the balance sheet (unlike for covered bonds, and similar to a sale).

141 Art. 106, 108, 192-241, 247, 257, 282, 296-298 CRR. 142 See for instance art. 194 and 221 CRR. ESMA will develop standards under art. 197 CRR on indices and recognized exchanges in the context of assessing the quality of risk mitigation instruments.

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Quantitative Requirements – Credit Risk

Selling assets or partial interests in assets in its different formats has not attracted equal attention in the CRD nor are they subject to an even-handed regime. Syndications and covered bonds are deemed to be beneficial. Covered bonds are given a preferential risk weighting to allow banks (and other financial institutions) to invest in such covered bonds issued by other banks on easy terms. The risks for the issuing bank and for its general creditors (as the collateral used for the bonds is no longer available for the creditors) are not subject to a separate regime, such as the highly detailed and recent regime for securitisations. Where covered bonds are ‘covered’ by assets that are and remain on the balance sheet of the bank, and are risk weighted accordingly, the securitisation adds the twist of a ‘true sale’. Even though the bond investor ultimately only obtains a right to repayment secured by the underlying illiquid assets, the structure is set up to resemble (but not equal) an actual sale; a phenomenon for which the disturbingly confusing term of ‘true sale’ was thought up. Illiquid assets such as mortgage loans are ‘sold’ to a specially incorporated vehicle, that issues bonds secured by the ‘ownership’ of the loans, and uses the proceeds to pay the bank for the assets. If the bank can convince its regulator it qualifies as a ‘true sale’, it is assumed to no longer be exposed to the sold assets, and allowed to no longer hold financial buffers for them. Up to the introduction of Basel II in the CRD in 2006, there was no harmonised regime at the EU level on the treatment of securitisations143. Below, the securitisation regime is set out, followed by a description of covered bonds and syndicated loans as examples of similar structures that lead to similar economic realities (but are treated differently). As the securitisation regime cannot be understood without its context, first the distinction between a ‘true sale’ and an actual sale is briefly introduced, and the history of the regulatory response to this innovative instrument set out. True Sale or an Actual Sale? A bank can sell a building, a loan portfolio, a subsidiary, a participation in an undertaking, a loan or securities it holds. Traditionally, if an asset was sold, it was sold, and capital no longer needed to be held for the asset, except perhaps for off balance sheet obligations accepted in the sale agreement (such as guarantees as to credit quality). The acceptance of securitisation during the last two decades has thrown the issue of ‘sale’ into doubt. If it looked like a sale, but was done in a very specific format suddenly this could be subject to demands on the organisation and the capital to be held by those assets if the sale was deemed only a securitisation ‘true sale’. The format was that the asset was sold to a special purpose vehicle, that issued bonds against them as collateral, in a structure set up by or

143 For a description of the BCBS negotiations on the securitisation framework of Basel II and some of its effects, see A.A. Jobst, ‘The Regulatory Treatment of Asset Securitisation: The Basel Securitisation Framework Explained’, Journal of Financial Regulation and Compliance, Vol. 13, No. 1, 2005, page 15-42.

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for the bank, with – weirdly – importance attached to the fact that the bonds issued by the special purpose vehicle should be ‘tranched’ in different types of bonds of varied credit quality ranking (which is important for the investor, not for the health of the issuing bank). A true sale was however described as a clean break with the transferred assets, which implies that the risk is gone. The securitisation regime was invented because it turned out that the risk actually was not gone, both due to explicit undertakings, a continued role in servicing and administration of the assets (both vis-à-vis the investors in the bonds but also vis-à-vis the counterparty in the asset, e.g. the borrower of a mortgage loan), but importantly due to implicit undertakings and expectations. If a bank wanted to continue to be active in this market and raise cash in future securitisations, it had better make sure that bondholders did not suffer a loss on bonds issued by a special purpose vehicle on the basis of assets originally held by the bank. This in spite of undertakings to not do so to regulators that approved the ‘true sale’ on that basis. How, however, now to distinguish between a clean break for securitisation purposes (where it has turned out not to be an actual break for credit risk purposes for operational and reputational reasons) and an actual clean break, an actual sale? Such sales happen quite a lot, e.g. whole subsidiaries or whole portfolios of tainted real estate loans or of types of securities were transferred to so-called ‘bad banks’ maintained by governments in the context of the resolution of the 2007-2013 subprime crisis. That would not work if these were deemed to be a ‘true sale’ subject to the securitisation regime instead of an actual sale. Instead, such sales outside of the securitisation context are done in the old-fashioned way still. It is taken off the balance sheet (both for accounting and regulatory purposes) and a loss or a gain is booked against the value it previously had in the books of the bank as compared to the actual sale price. Guarantees or sale-undertakings are booked as off balance sheet items, if they fulfil the ‘normal’ accounting criteria for those. Sadly, this means that the formality to recognise a securitisation (e.g. the tranching mentioned above) are now used to distinguish between a strict regime for the bank, and an easy-does-it regime if structured so that the formal definition of a securitisation does not apply. Regulatory Developments on Securitisations – A History Securitisation is an innovative type of contract(s) developed by the financial market to take the best of all worlds. After first being developed in the USA144, it took off on a grand scale in the EU around the turn of the century. Securitisation allows a bank to take illiquid assets from the balance sheet, put them into a specialized legal entity that would issue bonds – secured by the illiquid assets such as mortgage loans – and use the proceeds to 144 M. Dewatripont & J. Tirole, The Prudential Regulation of Banks, Cambridge, 1994, chapter 9.

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pay the bank (i) for the transfer of the illiquid assets with a discount for future losses on those assets due to e.g. non-payment of interests and repayment of mortgage loans, and (ii) to service the assets on behalf of the specialized legal entity in return for a fee. When the bonds are due, the bank (or another specialised entity) buys the assets back, and any surplus cash after paying bond investors in full is transferred to the bank as a dividend. The balance sheet of banks would be reduced, thus reducing capital requirements and raising cash by ‘selling’ illiquid assets such as mortgages without the bank guarantee that was part of covered bonds; combining the best aspects for the bank (and the bond-buyers/lenders) of a covered bond and a sale. The cash raised could be used to generate new mortgage loans or other new assets; generating economic growth. For outside investors, new tradable and liquid bonds were created with recourse only on those illiquid assets, but with such high buffers available that high credit ratings were allocated. Supervisors had no real defence to something that made use of the existing rules so well, and with such clear benefits for the banks and for the economy. Mortgages could be cheaper, as they did not have to be kept on the balance sheet of the bank nor funded by relatively expensive deposits, but by low interest rates on professional money markets for the secured bonds145. Their only remaining hesitation was whether the risks were truly gone, and what to do with any retained parts of the risks in the new deal. Prior to the development of the securitisation on the financial markets as a tool for reducing capital requirements and obtaining funding, banks either had or did not have an exposure. If they had it, it had to be risk weighted, if not, there were no capital requirements. If they sold it, they no longer had to have it on their balance sheet. If they put it forward as collateral instead (to the central bank or to a covered bond investor), they had to fully account for it in its own right on the balance sheet. Securitisation allowed the exposure to be ‘sold’ to a controlled entity (taking it off the balance sheet where it was originally booked or ‘originated’, and off the prudential radar as long as the vehicle need not be consolidated), and served as collateral for bonds. When the bonds were repaid, any remaining positive value in the exposure was returned to the ‘seller’. For the bank there was an upside in each of the segments of the securitisation of the exposure: – When the exposure is created (e.g. a mortgage is given) the bank benefits from e.g. fees, the relationship, interest income, potential premiums for related insurance contracts).

145 A. Maddaloni & J. Peydró, Bank Risk-Taking, Securitization, Supervision and Low Interest Rates, ECB WP 1248, October 2010.

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– By securitising the exposure, i.e. selling it to a special purpose vehicle that funded this by selling securities (bonds) to investors, which bonds were collateralized by the exposures bought, the exposure was taken off the balance sheet of the bank (known in this context as the ‘originator’ of the exposure). The vehicle paid for the exposures with the money raised by issuing the bonds, paying cash for illiquid assets. This improved the liquidity position of the bank. Any ‘profit’ on this ‘sale’ was recognised for accounting purposes, and often lead to an increase of dividends and of bonuses. Taking the asset off the balance sheet t allowed for some form of regulatory arbitrage out of the inflexible Basel I regime in place at the time (see below). The liquidity was used to fund the creation of new exposures (e.g. giving other mortgages), and to cover short term liquidity facilities to the vehicle (so it would have a buffer for any temporary shortage of cash needed to pay interest or fees, which facility the bank did not need to hold capital under Basel I rules for as long as they were for less than 1 year and not yet drawn upon). – At the same time the bank starts earning fees for managing the securitised exposures for the vehicle to which it had ‘sold’ them (another profit moment, now as the so-called ‘servicer’ of the exposures). – Often, the bank also retained a claim on any remaining funds after paying the investors in full on the special purpose vehicle (e.g. via a clean-up call option or via liquidation of the vehicle in which the bank had retained economic but not formal ownership). The upside of a full repayment was thus as much as possible retained. – In an alternative, similar results could be achieved by selling a derivative on the value of the exposures instead of selling the exposures themselves. Some banks started to provide specialised services to banks that were too small to set up a securitisation themselves. Known as a sponsor bank; i.e. a bank that did not hold the exposures itself originally, but set up the securitisation for exposures of third parties and is involved in it as if it is an originating bank146. If structured carefully, a securitisation was fully compliant with the letter of the rules of the predecessor directives of the CRD and of the Basel I version of the capital accord, while in effect the bank remained involved much more than would have been the case in an outright sale of the exposure. The lack of a formal guarantee as exists in covered bonds that the assets will be sufficient to provide cover for the bonds, and the lack of government 146 See art. 4.41-4.42 RBD for the definitions of originator and sponsor banks. A bank can also be the originator if the original assets were created via related entities, as long as the bank was involved in the original deal, or if it buys the assets from the original lender, puts them on its balance sheet and then securitises them. Also see CEBS/EBA, Guidelines to art. 122a of the Capital Requirements Directive, 31 December 2010, page 15-17.

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oversight on behalf of the bondholders, was supposed to result in a ‘sale’ instead of a secured bond issue by the bank. The story for the supervisor was that the exposures had been sold; the story for the investors was that the bonds would be repaid in full, regardless what happened to the vehicle or the collateral, as the reputation of the bank was involved. In an actual sale, the reputation of the bank is not involved in this manner. Any representations made are in the contract, and the bank is only liable if those covenants are breached and the exposures sold are not as good as promised. The seller does its own assessment, and decides independently to buy the exposures. In a securitisation the vehicle is not independent (but set up on behalf of the bank in order to buy those exposures) and the bondholders do not want to buy the exposures, but want to buy (albeit collateralized) bonds that are backed by the reputation of the bank (as the vehicle does not have any reputation of its own). When securitisations were first submitted to EU supervisors for their opinion around the turn of the millennium, the initial treatment of securitisations for accounting purposes was partly to blame for the difficult position in which supervisors found themselves. Different accounting systems across the globe took different positions on whether a sale for securitisation purposes (or taking the risk away by covering it by credit risk derivatives in a so-called synthetic securitisation) was really a sale, and whether the special purpose vehicles created to house the assets (and to issue bonds backed by those assets in order to obtain funds to ‘pay’ for the assets) should be consolidated or not147. Partly the supervisory community was itself to blame for the confusion, as they let themselves be drawn into a discussion that securitising an asset had many characteristics of selling them, and other supervisors would or had already okayed such treatment148. Even where accounting setters slowly went for a more conservative treatment (no, it is not a sale, and yes, it should be consolidated is the current position under IFRS, applicable since 2005), regulators went into the other direction, by accepting and continuing to accept the benefits for funding, for the economy at large (as banks were able to make more loans to consumers and businesses than if they had not been able to securitise such loans) and for risk diversification, while trying to mitigate the negative effects by setting organisational and capital requirements. The capital requirements turned out to be ineffective, while the organisational requirements on sellers turned out to be valuable for securitisations set up in countries where such requirements were paid more than lip-service (e.g. on retaining high risk management standards when providing loans that would later be securitised).

147 See e.g. on the USA situation, J.R. Mountain, ‘Securitization Accounting: Are You Ready for the Credit Crunch Challenge?’, Bank Accounting & Finance, April-May 2008, page 3-10. 148 The blame for this is shared by the author of this book.

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EU supervisors built upon the existing banking directives to take account of this new development and to take care of the above-mentioned hesitations. The EU banking directives were at the time based on Basel I plus the market risk amendments; see chapter 2. Supervisors had various options in that regime, including: – not recognising the sale to such a special purpose vehicle as a full or true sale, leading to the continuing obligation of the bank to risk weight the exposures; – recognising the sale as a full or true sale, ending any obligation to hold capital requirements regardless of the retained interest and risk; – recognising the sale, but instituting penalties if some of the retained interests and risks were (relatively to the exposures) high risk. The latter solution gained prominence. Based on the experience gained and feedback received at domestic levels, in the context of the Basel II framework a new chapter on securitised assets was added to the existing credit risk treatment. Apart from the traditional securitisations with a ‘sale’ of the illiquid assets, it also dealt with a newer form of securitisation where the exposures are not sold, but the credit risk is split off through credit derivatives or guarantees (so-called ‘synthetic’ securitisation). Though loosely attached to the credit risk framework, it contains a complete in itself reasoning not encountered elsewhere in the approach to credit risk. It is applicable both in the standardised approach and in the IRB approach to securitisation positions, though there is some differentiation in the way the results have an impact on the approaches. The IFRS introduction in 2005 meant that for accounting purposes, the assets transferred to controlled special purpose vehicles were no longer derecognised and the special purpose vehicle itself consolidated149. Prudential rules continued to go in the other direction150. In a marked deviation from IFRS accounting standards, the securitisation regime introduced via Basel II excluded the special purpose vehicle from consolidation, and facilitated derecognition of the assets (by recognising the ‘sale’) for prudential capital requirements. To balance this, it intended to risk weight quite heavily (or deduct from financial buffers) any remaining exposures of the bank to the special purpose vehicle, to the bondholders and to the sold exposures. The Basel committee, and the EU by copying this treatment in the CRD, thus followed the treatment under US GAAP accountancy standards, which also was friendly on securitisations151.

149 Also see chapter 6.4. Whether a securitisation vehicle is consolidated and – if not – the sale is recognised for accounting purposes is dealt with in International Accounting Standard 39 Commission Regulation 2008/1126. 150 CEBS/EBA Guidelines on Prudential Filters for Regulatory Capital, CEBS/04/91, December 2004; see chapter 6.4. 151 A. Adhikari & L. Betancourt, ‘Accounting for Securitizations’, Journal of International Financial Management and Accounting, Vol. 19, No. 1, 2008 page 73-105.

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During the early parts of the 2007-2013 subprime crisis, neither the banks (who pledged the credit risk had been transferred) nor the supervisors (who pledged to act harshly if a bank transgressed on its commitment to not support the assets any more) had their finest hour. Except for a few instances, all banks stood by their special purpose vehicles152. Supervisors did not appear to react harshly at all, except perhaps orally, as these banks were not forced to take all securitised assets back onto the balance sheet (except for the individual damaged transaction). The losses ‘voluntarily’ taken back by the banks on those assets were, however, not taken account of in prudential rules, and were thus not backed up by financial buffers built up before the losses occurred. As a mitigating point it has to be noted that supervisors were backed into a corner. Banks had become increasingly dependent on securitisation transactions for both funding purposes and in order to fulfil solvency requirements, and taking back the assets for regulatory purposes would have meant causing their immediate failure due to being heavily undercapitalised, potentially causing or deepening the systemic crisis in 2007 and 2008. To keep securitisation markets as a source of funding for banks open while allaying prudential concerns, the BCBS started work immediately, resulting in a common position on July 2009. The EU worked simultaneously and put the July 2009 Basel II ½ work into the so-called CRD III directive and in a Commission directive, after already putting some key embellishments on the credit risk on securitisation and the related governance into its CRD II directive153, including a clarification of the ‘significant transfer of credit risk’ that would result in a ‘true sale’ and putting a stop to keeping liquidity facilities totally off the radar. These revisions are applicable to all new securitisations issued after the start of 2011154. Rather than a real departure from the basics of the US-style treatment, the treatment of the retained interest has been introduced to align the interests of the banks involved in setting up the securitisation and the banks investing in them, as well as making explicit and beefing up specific risk management requirements surrounding a securitisation (and the related assets). In addition155:

152 The known exception being Deutsche Bank, which actually appears to have done what it promised, to the shock and horror of the investors in the bonds of its special purpose vehicle. 153 Basel II½; BCBS, Enhancements to the Basel II Framework, July 2009, in combination with BCBS, Revisions to the Basel II Market Risk Framework, July 2009. Recital 24-27 and art. 1.30 CRD II Directive 2009/111/EC; art. 1.1 and Annex I §4 CRD III 2010/76/EU on re-securitisations, as well as the added detail on significant transfer of credit risk in Annex IX part 2 RBD introduced by art. 9 Commission Directive 2009/83/EC. See chapter 13 on the simultaneously provided detail by the BCBS on the existing high level principles on organisation and control of banks. 154 Art. 122a.8 RBD. 155 Art. 122a.4 and further RBD, introduced by art. 1.30 CRD II Directive 2009/111/EC; and see the changes in Annex IX part 4 RBD introduced by level 2 Commission Directive 2009/83/EC. The CRD III Directive 2010/76/EU focuses on re-securitisations. Also see BCBS, Enhancements to the Basel II Framework, July 2009, page 2.

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EU Banking Supervision

– the treatment of investments in re-securitisations was enhanced (higher risk weights would apply in both the standardised approach and the IRB approach to securitisations in which the assets were bonds issued by other securitisation vehicles). The complexity added by a securitisation on top of a securitisation meant that the risk embodied in the bonds was difficult to assess, and underestimated prior to the crisis156; – banks that invest in securitisation-bonds can only rely on external ratings if they also perform their own due diligence, and cannot rely at all on ratings that are based on guarantees provided by the bank itself; – the treatment of liquidity facilities given to securitisation vehicles was enhanced. This included closing a loophole (of previously 20% risk weighting for liquidity facilities of shorter than one year instead of 50%) for standardised approach banks, closing the loophole for general market disruption liquidity facilities for both standardised and IRB banks, and clarifying when liquidity facilities qualify as senior claims for IRB banks. There is a conflict between the required true sale of the exposures and the new retained interest requirement: – if a bank wants other banks to invest in its securitisations, it is obliged to retain an explicit interest in the assets ‘sold’ in the securitisation, to incentivise the bank to perform high quality risk management in the underlying assets and thus ‘align’ his interest with the investing bank157; – to show that they will in no circumstances step in for the part of the interest in the assets that was sold to other investors (i.e. the part that was not explicitly retained). This latter part is, however, still ambivalently part of both pillar 1 (with ambiguous language on the requirement to invest only at arm’s length, punishable by the transaction not being recognised as a securitisation, with the risk that bringing such assets back may lead to a failure of the bank) and in estimates of the risk that the bank might nonetheless bail out the investors in pillar 2158. The reduction in the quality of the underlying assets, especially in the USA, where lending to alternative-A or subprime borrowers had been made by lenders who did not perform the same due diligence as had been standard practice for mortgage loans, and who had immediately sold the majority of those badly screened loans onward via securitisations (i.e. a reduction in risk management and an increase in risk appetite in the primary market as there was ample demand – without detailed scrutiny – in the secondary securitisation

156 Art. 4.40a and 4.40b and Annex IX part 4 §6 and 46-53 RBD. 157 Art. 122a.1 to 122a.3 RBD, see below. 158 Art. 122a.6 RBD, and BCBS, Enhancements to the Basel II Framework, July 2009, page 19-20.

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market)159. To address the loss of quality assurance on new assets, the organisers of the securitisation have now been obliged to retain a partial explicit interest in the securitisation. Unless retention is hard-wired into the deal (e.g. by a contractual obligation or by the new CRD requirement), there are generally more incentives to sell than to keep an interest in the assets, due to accountancy, regulatory and short term funding/profit concerns. Unlike in syndicated loans (see below) the link between the ultimate investors and the ‘sold’ assets is tenuous in securitisation structures, and the composition of the pool of ultimate investors is often not so sophisticated or concentrated so as to be able to require retention of an interest in the transaction by the bank that set the transaction up before those investors would be willing to invest (at least; this was the case prior to the 2007-2013 subprime crisis). In the EU, after a debate on forcing the banks to retain part of the risk (with input from Commissioner McGreevy on 10% and from the industry and member states governments on 0%, with regulators and central banks chipping in via research160), the Parliament proposed 5%, which proposal became part of the compromise between Council and Parliament. The reasoning is that forcing the originator/arranger to retain ‘skin in the game’ will lead automatically to a stricter screening of the assets. The expectation is that the bank that has to retain part of the credit risk will engage in a stricter screening of the credit risk of the borrower of mortgages, personal loans, credit card loans or other loans, and will not loosen this screening during the economic cycle. The acceptance of securitisation as a full or true sale, and the lack of regulation on exposures to constructs that are quite similar to securitisations, leads to diversified treatment of credit risk for assets that initially are quite similar. It makes a difference whether it is a ‘true sale’ for securitisation purposes, whether it has actually been sold, or formally retained but used as collateral, whether the bonds issued by the special purpose vehicle are guaranteed by the bank (covered bonds; see below) or not (securitisations), whether risk protection has been bought for the underlying assets or for the bonds issued by the special purpose vehicle, or combinations of these, and whether the original asset ever arrived on the balance sheet or was only ‘arranged’ by the bank to be held by third party investors directly. The discrepancies do not appear to be justified by the actual differences in the risk faced by the bank. The Prudential Securitisation Regime The treatment of securitisation positions under both the IRB and the standardised approach is subject to neither approach. As a pure add-on, it takes assets that are brought under the 159 T.D. Nadauld & S.M. Sherlund, The Role of the Securitization Process in the Expansion of Subprime Credit, Dice Centre WP 2009-9, 26 May 2009. A. Kara, D. Marqués-Ibáñez & S. Ongena, Securitization and Lending Standards, Evidence from the Wholesale Loan Market, ECB WP 1362, July 2011. 160 See e.g. I. Fender & J. Mitchell, Incentives and Tranche Retention In Securitisation: A Screening Model, NBB Working Paper Research 177, Brussels, 2009.

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EU Banking Supervision

securitisation regime out of the regular (standardised or IRB) credit risk treatment, and into a separate regime. The replacing treatment is, however, to a large extent based on the standardised approach. The main difference is that IRB banks are allowed to use own assessments for securitisation positions that are not recognised by an eligible ECAI. The process to recognise the ECAI itself is similar to the standardised approach recognition process (see chapter 8.1), as is the allocation of their ratings by the supervisor to credit quality steps set out in the respective regimes. ECAI’s require a second, separate assessment for securitisation purposes as not all ECAI’s are specialised in this area161. Also, the credit quality steps may be differently linked to the letters used by a rating agency if it relates to a securitisation rating. Both IRB and standardised approach banks rely on ECAI-ratings in the securitisation regime. Such external ratings thus have a high impact on bank capital. The ratings for structured products such as securitisation proved to be of low quality during the crisis. This is one of the main criticisms of rating agencies. Meanwhile their ratings of enterprises were relatively spot-on. Though supervision on their rating process has been beefed up, the credit risk requirement on securitisations continue to be built on this relatively shaky and untested foundation. This may be subject of future work on reducing the reliance on external ratings, though also here there is no good alternative. Additional due diligence by the bank itself when building on the external ratings is of course recommended. The BCBS has also announced future work on mitigating ‘cliff effects’ of ratings (if the external rating goes down, suddenly capital requirements go up at all banks holding that instrument, which can be significant especially if the rating is reduced to a low quality rating, below investment grade)162. The regime163 is based on: – defining what a securitisation is;

161 See the nearly identical provisions as to content on ECAI’s of art. 81-83 and Annex VI part 2 and 3, respectively art. 97-99 and Annex IX part 3 (and the definitions of rated and unrated positions in part 1) RBD. The only material difference regards the use of unsolicited ratings, which is implicitly allowed in securitisations, and forbidden under the general standardised approach. For this difference, there is no apparent justification, except that most securitisations in practice so far have been set up with solicited ratings for their higher tranches. It is unclear why the wording has not been brought into closer harmony (or even replaced by one coherent set of rules) as there is no material difference between the recognition processes. E.g. the content of art. 97.5, which is not copied in art. 81, is for the standardised approach laid down in Annex VI part 2 §8-11 RBD. The provisions were updated both in the CRD II Directive and in the Omnibus I Directive to take account of Credit Rating Agency Regulation 1060/2009, and to instruct EBA to develop technical standards by 2014, identical to the provisions described in chapter 8.1. 162 BCBS, The Basel Committee’s Response to the Financial Crisis: Report to the G20, page 13. 163 The regime for securitisation is set out in art. 3.36-3.44, 57.r, 66.2, 94-101, 122a and Annex IX RBD.

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Quantitative Requirements – Credit Risk

– defining preconditions for the recognition for supervisory purposes of a securitisation (distinguishing between ‘traditional’ and ‘synthetic’ securitisations) as a type of sale that to some extent reduces risk for the bank; – establishing internal organisation requirements for both banks involved in setting up the securitisation and banks that want to invest in the securitisation; – a disclosure regime for both banks and supervisors; – the use by banks of ratings by eligible ECAI’s; – the subsequent calculation for (i) banks operating under the standardised approach, or (ii) banks operating under the IRB approach using the ratings based approach for rated positions, and the internal assessment approach or the supervisory formula method for unrated positions. In both approaches, the securitisation regime leads to a reduction of capital requirements when the risk of ownership of the exposures that are ‘sold’ is replaced by the exposures it has as an originator, sponsor, servicer and/or investor in the vehicle now holding such exposures (see below on the treatment of the various roles). A securitisation is a transactions that fulfils three separate conditions: – either (i) economically transfer (as in that it does not require a legal transfer) an exposure or pool of exposures to a special purpose vehicle164 that issues securities (‘traditional’), or (ii) uses credit derivatives or guarantees to take the credit risk out of an exposure or pool of exposures on the balance sheet of the bank (‘synthetic’); – segment the credit risk of the exposure or the pool of exposures in tranches that contractually have (in descending order) more credit risk, as the lower tranches are paid out only if the higher have been fully paid165; – makes payments to the buyers of the securities or synthetic owners of the credit risk dependent upon the performance of the exposure or pool of exposures. The regime differentiates subsequently between securitisation transactions leading to a significant transferral of credit risk or not. If a securitisation transaction leads to a significant transfer of credit risk on the securitised exposures, a so-called true sale in traditional BCBS terminology, the securitisation regime becomes applicable and leads to changes in the

164 In order to qualify as a special purpose vehicle for securitisation purposes, it has to be a corporation, trust or other entity, not a bank itself, and specifically organised for a securitisation and structured to isolate its obligations from the obligations of the bank (i.e. the bank should not be liable for the debts of the special purpose vehicle). Art. 3.27 and 3.44 RBD. 165 There does not appear to be a reason why the tranching is a requirement. Tranching does not increase or limit the risk for the bank that ‘sells’ the exposures (though the cascading of pay-outs does affect the riskiness of the various bonds for investing banks). It appears to be a requirement because securitisations had been set up to include tranching in order to create high ranking bonds, not because it is intrinsic to the risk transfer by the selling bank.

495

EU Banking Supervision prudential treatment of the exposures166. The bank that held the securitised transactions (the ‘originator’) can: – in a traditional securitisation, instead of risk weighting the securitised exposures, start risk weighting the position it holds in the securitisation (i.e. the newly created exposures as a result of the securitisation transaction), and for an IRB bank assume that not only risk weighting but also the expected losses on the securitised exposures is zero; – in a synthetic securitisation recognise the funded and unfunded credit protection offered by the derivatives or guarantees reduces the risk weighted exposure amount along the lines of the credit risk weighting methodology (for the standardised approach) often to zero or 20%, risk weight the securitisation positions it holds167, and for an IRB bank assume that the expected losses are zero. As the beneficial consequences of achieving the threshold of ‘significant credit risk transfer’ can be large, criteria have been developed under which this threshold can be judged. The assessment is primarily the responsibility of the bank itself, but its policies and practices are likely to attract supervisory interest. The conditions include: – transaction documentation reflecting the economic substance, including the limitation of further safeguarding, fees or rates increases linked to changes in the economic value of the underlying exposures (except for early amortisation clauses); – in a traditional securitisation: (i) mutual bankruptcy remoteness of the assets and special purpose vehicle on the one hand and the bank on the other hand, including the bank not being liable for the securities issued by the vehicle (differentiating it from covered bonds, where the bank is one of the obligors under the securities covered by the assets), and (ii) the bank should not maintain effective or indirect (ownership) control over the transferred exposures, though strangely it is explicitly allowed that the bank becomes the servicer/manager of the exposures on behalf of the special purpose vehicle (another profit moment for the bank); – in a synthetic securitisation: that the credit protection complies with the requirements under the credit risk mitigation methodology (see chapter 8.5); – legal enforceability of the limitations of liability and a prohibition for sponsors or originators to provide support beyond contractual obligation168. If the originating bank fails these thresholds of a significant transfer of credit risk, those securitised exposures are deemed still to be held in full and are risk weighted accordingly. 166 The criteria and assessments by supervisors of a significant transfer of risk as contained in Annex XI part 2 RBD were substantially tightened by art. 9 Commission Directive 2009/83/EC. 167 The securitisation positions in a synthetic securitisation generally do not include liquidity positions, but can include the highly risk weighted first loss positions. 168 Art. 95-101 RBD, as amended by art. 1.9 CRD III Directive 2010/76/EU.

496

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Quantitative Requirements – Credit Risk

However, the new exposures created as a result of the (failed) securitisation transaction need not be risk weighted (avoiding double counting, but also avoiding taking into account the additional risk in the – for regulatory purposes failed – securitisation transaction). If at a later time the actions of the originating bank to support the special purpose vehicle beyond its contractual obligations, this leads to the conclusion that the credit risk in fact has not been transferred, and that the exposures in that transaction go back on the balance sheet of the bank. The CRD is not specific as to whether this happens retro-actively (leading to the bank being undercapitalised during the lifetime of the securitisation, adding a capital and misreporting transgression to the transgression of the securitisation conditions) or from the moment the bank transgresses one of the key conditions for recognition (‘only’ leading to capital consequences from that moment in addition to potential other disciplinary reactions to the transgression of the securitisation rules; see below and chapter 20.3). It can be debated whether supporting one special purpose vehicle beyond the contractual obligation automatically infects all securitisation transactions the bank is involved in. Will the market and should the supervisor automatically deduce from one transgression that the bank will be unable to distance itself from any of its securitised exposures in any securitisation transaction it is involved in? Prudential supervisors find themselves in a catch-22 situation. Clearly, the bank will only step in beyond its contractual obligations if it is forced by the market to do so. If the supervisor does not allow that, the bank may lose support and funding from the market, and thus very likely go bankrupt. If the intervention by the bank to save its reputation in the market would be deemed to mean that none of its securitisation transactions have successfully transferred credit risk, which cannot be doubted in practice by the supervisor, it would mean that the bank is again likely to go bankrupt because taking substantial exposures back on its balance sheet leads to substantial additional capital being needed, which it is likely to lack. The compromise as laid down in the capital accord and the CRD is that at least the exposures directly involved need to go back to the balance sheet, and that the bank and its management are punished for their lack of trustworthiness and/or expertise (vis-à-vis the supervisor when stating that the credit risk had been transferred) either by bringing more assets back if that is sustainable or by other means.169 If the bank gives support more than once, however, under the supervisory review and evaluation process (pillar 2, see chapter 14), the supervisor is forced to take ‘appropriate measures’ reflecting the increased market perception that future support to securitised 169 Art. 95 and 101 RBD. The RBD also provides that the bank will need to disclose that it has provided noncontractual support and the regulatory impact of having done so. This just gives incentive to the market to pressure banks to save their special purpose vehicles, and assurance to investors that special purpose vehicles are covered not only by the exposures they own but also by the bank that set the securitisation up.

497

EU Banking Supervision assets will be provided170. In that case, supervisors have to find that significant transfer of risk has not been achieved. Though the text is clear that this means that all securitised assets should flow back to the balance sheet, in practice this can be mitigated. Appropriate measures can take into account the impact on the viability of the bank, and also other measures to redress this market perception, e.g. by replacing all executive and non-executive directors for this reason171. Supervisors in practice did not force banks to take all securitisations back on their balance sheet. The solution is instead sought in mandatory better risk management, incentivised by e.g. the new retention requirement172. The above-mentioned retention requirement is introduced as part of a package to ensure that the bank will have and retain skin in the game, and thus will more likely exercise good risk management when originating the underlying assets (for instance when making the mortgage loan, and when structuring the transaction). The RBD does in fact not force a bank to retain such an interest in all its securitisations. If the bank can sell a 100% securitisation to for instance retail investors, insurers or public authorities, it is free to do so. However, other banks are not allowed to invest in such a deal173. Banks are prohibited to invest in a securitisation transaction unless one of the banks that set up the securitisation (either as a sponsor, original lender or originator) has undertaken to retain an interest of 5%174. There is no proof available that the new retention requirement will align the interests of the investing bank and the entities setting up the transaction, and force such to improve their risk management. In general, indeed it can be expected that someone who retains an interest in an asset will screen it more tightly than someone who will not. However, there are two downsides: – If a bank can sell 95% of the credit risk, it is still 95% less interested in the quality of the asset than when it retains those exposures in full. This percentage was, however, deemed large enough to induce tighter screening while a higher percentage may have killed the economic rationale for the bank to perform a securitisation. – The improvement is relative, not to the business cycle but to general screening practices. It is more likely that screening of assets that will be kept on the books and those that will be securitised will be similar, but in an upturn of the economy, with memory of

170 If it does not, the CRD has not been properly implemented or applied, leading to potential liability of the member state and/or its supervisor; see chapter 20.10. 171 Annex XI §2 RBD. 172 Art. 122a RBD. 173 Explicit exemptions exist for types of transactions that are not considered securitizations, such as securitizations that are guaranteed by a government, or syndicated loans that are not used to create exposures to securitizations; see chapter 122a.3 RBD. 174 Recitals 24-26 and art. 1.30 CRD II Directive 2009/111/EC, which introduced art. 122a RBD.

498

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Quantitative Requirements – Credit Risk

the last crisis fading, those screening procedures may well be relaxed again both for kept assets as well as for assets that will be securitised175. – Even prior to the new obligation it was not unusual for banks to retain some of the first loss positions176 in any case (either in the books of the bank itself or in the books of a related bank or insurer) as they cannot find neutral investors for high risk first loss positions who are willing to pay an amount close to the potential – if all goes well – nominal value. Also, banks already traded in the bonds issued by their securitisation special purpose vehicles. – The compulsory undertaking from one bank (the originator/sponsor) to another bank (the investing bank, who can only invest if there is such an undertaking) results in undesirable additional liability links between banks. It also leads to a procyclical effect on securitisation-prices. Investing banks – under the current phrasing of ‘shall be exposed only’ – are forbidden to invest but also obliged to sell exposures to securitisations if the bank that gave the undertaking goes under and the liquidator sells these retained assets. Even if the securitisation vehicle and assets are still of good quality, if the organising bank goes under, the mandatory retention ‘on an ongoing basis’ is no longer fulfilled, leading to mandatory fire-sales under this binding obligation at a time markets are already spooked by the demise of the bank itself177. Once this has led to general market liquidity stress (which is a bit late), supervisors are, however, allowed to suspend the retention obligation. This in turn, however, creates uncertainty as to whether originators/sponsors will try to dump their retained interest on the market. How the retention should be set up and calculated is the subject of a set of guidelines issued by CEBS/EBA end 2010, and will become the subject of binding standards before 2014178. The standards aim to ensure that banks fulfil the obligation both in the legal and economic sense (by e.g. not trying to insure the remaining interest via a derivative). The onus is primarily put on the investing bank (to not invest unless they obtained an undertaking of the

175 R. De Haas & N. Van Horen, ‘The Crisis as a Wake-Up Call. Do Banks Tighten Screening and Monitoring During a Financial Crisis?’, DNB Working Paper 255, Amsterdam, 2010. 176 The tranche of lowest quality – in effect a financial buffer – that will absorb the losses on the assets first, before tranches with a higher ranking (and rating) will be forced to suffer losses under the contractual subordination rules agreed. 177 CEBS/EBA has a different opinion, indicating that such a bankruptcy would be beyond the control of the investing bank. Its guideline in this respect can, however, not be relevant as it goes against the explicit text of art. 122a.1 RBD, which differs in this respect from the separate obligatory punishment contained in art. 122a.5 RBD, which is indeed linked to own faults. CEBS/EBA, Guidelines to art. 122a of the Capital Requirements Directive, 31 December 2010, page 46. Only when art. 122a.8 RBD applicable (during general market liquidity stress) can the obligation of the first paragraph be suspended. 178 CEBS/EBA, Guidelines to art. 122a of the Capital Requirements Directive, 31 December 2010. See art. 122a.10 RBD (as amended by art. 9.29 Omnibus I Directive 2010/78/EU, recital 24-27 of CRD II Directive 2009/111/EC, and chapter 23.3.

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EU Banking Supervision

originator/sponsor), meaning that other investors are not protected by this rule, and there is no direct effect obligation on the originating bank; see chapter 3.5. Whether supervisors should supervise the undertaking of the originator or sponsor has been left carefully unclear (whereas for covered bonds the supervisor takes on an obligation towards the covered bond-investors; see below). The CEBS/EBA guidelines, however, provide quite a lot of guidance on how the retained interest should be put together by the issuing bank (not how it should be checked by the investing bank). Non-bank investors appear not to be protected, unless they refuse to invest unless they have a similar undertaking offered to them by the originating/sponsoring banks. An associated obligation is for the investing bank to check the securitisation and the underlying assets diligently, to apply the same lending standards to assets that are due to be securitised and all other assets (loans made that are retained), and for the originator/sponsor/original lender to publish information to investors that allows all checks they may need to do to make their own assessment – including a comprehensive stress test – of their securitisation positions179. The information to be disclosed to investors refers both to the commitment and monitoring of the retention requirement, and such disclosed information should allow the investing bank to make a good assessment of the credit quality and performance of the individual underlying exposures, cash flows, and be so detailed that it will allow investors to stress test such exposures. These internal organisation obligations (see chapter 13) may impact on better risk management by the original lender of the assets and by the investor in such securitisations, and reduce the uncritical reliance on ratings issued by credit rating agencies by investors (see chapter 8.1). These internal governance obligations are subject to automatic sanctions180. For the investing bank that infringes them these result in increased risk weights between 250 and 1250%, and the same applies to the organising bank that fails to disclose. If the latter applies unequal lending standards, the punishment is that the assets are not deemed to be truly sold (the assets remain on the balance sheet). This makes these internal governance requirements one of the few that have an automatic punishment that should be applied by the bank and by the supervisor (likely with direct effect; see chapter 3.5). Credit risk mitigation is recognised if it would also be recognised in the standardised approach181 and the valuation of any derivatives included in the securitisation will be done in line with the counterparty credit risk methodology (see chapters 8.4-8.5).

179 Art. 122a.4-7 RBD, with the mandatory interventions by the supervisor in the paragraphs 5 and 6. For stress tests also see chapter 13.6. 180 Art. 122a.5 last paragraph, and 122a.6 last paragraph RBD. 181 Annex IX part 4 §60-67 RBD.

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Quantitative Requirements – Credit Risk

Banks involved in the setting up of the securitisation transaction are required to risk weight exposures for securitisation positions following from: A. first loss or similar positions182 though investments or retained interests or other credit protection (credit enhancement): – full deduction from own funds if the bank chooses this instead of applying a 1250% risk weight (which has the same effect on available capital for other purposes; see chapter 7). Such retention of the first loss by the bank or by e.g. a related insurer was quite common, but this was generally a fairly thin slice of the total exposure183. B. all other investments in a securitisation, including those that provide second loss and better credit protection (credit enhancement)184: – If rated, in line with the risk weighting attached by the supervisor to that rating (ranging from 20% for the highest rated and 1250% to the lowest for a bank under the standardised approach, and ranging from 7% to 1250% in line with the ratings based method for a bank under the IRB approach). – If an investment is unrated, a bank under the standardised approach will treat the position as the lowest rated or first loss positions at 1250%, or if enough other credit enhancement is available for that portion, it can be treated more favourably under formulae taking into account the risk weight of the underlying exposures, the total exposures and/or the total nominal amount of all the tranches and the total amount of the tranches higher ranking than the tranche invested in. If the investment obtains a risk weighting of 1250%, the bank can opt to deduct it from own funds instead.185 – If unrated, a bank under the IRB approach will treat it under the supervisory formula method, unless its supervisor authorises it to use the internal assessment approach for asset backed commercial paper securitisations (i.e. if it fulfils fulfilling numerous conditions to satisfy the supervisor that its own assessments on this type of paper are as well founded as the ratings by an ECAI), or a rating can be ‘inferred’ (if a rating can be deduced from subordinate positions that are rated, in which case it is treated as a rated position with the same rating as the subordinate tranche). The supervisory formula method calculates the risk weight, with a minimum of 7%, on the basis of a complicated formula that takes into account amongst others the size of the tranches, the total value of exposures securitised, the credit enhancement

182 Annex IX part 4, §6-12. Credit enhancement can be anything that improves the credit quality of the higher tranches when compared to the quality it would have had without it. This can include junior tranches, but also any credit protection offered to the position/senior tranch. 183 See e.g. A.A. Jobst, ‘The Regulatory Treatment of Asset Securitisation: The Basel Securitisation Framework Explained’, Journal of Financial Regulation and Compliance, Vol. 13, No. 1, 2005, page 15-42. 184 Such protection can be provided through derivatives and guarantees in a synthetic securitisation, but can also be part of the arrangements of a traditional securitisation (e.g. in the form of interest rate or currency derivative contracts), and through e.g. lower tranches in any securitisation. 185 Art. 57.r, 66.2 and Annex IX part 4 §35, 36 RBD.

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EU Banking Supervision

level, and the loss given default. The credit risk mitigation methodology can be applied. C. provision of liquidity facilities to the special purpose vehicle186: – If rated, they can be treated in line with their rating as translated in the ECAI approval process. – If unrated, a bank under the standardised approach can risk weight it at the risk weight of the highest risk weight of the underlying exposures under the standardised approach if it fulfils the conditions on not being able to be used as credit enhancement, plus a conversion factor. Prior to end December 2010, and in one of the important gaps in the pre-crisis regime, it could apply a 20% conversion factor to a general market disruption liquidity facility and 0% to a cash advance liquidity facility. The conversion factor can still go down to 0% in which case no capital needs to be held for the liquidity facility – though the conditions for this have been strengthened – for liquidity facilities that are unconditionally cancellable. – If unrated, a bank under the IRB approach has to treat it as an investment (see above). Since 2011 banks have to risk weight the liquidity facility at 50% or 0% for unconditionally cancellable, partly referring to the standardised treatment. The bank can also apply the approach used by standardised approach banks if it is unable to apply the methodology for unrated investments to its unrated liquidity facility that fulfils the conditions described above187. D. Only the originator: if the underlying exposures are subject to customers’ decisions to borrow and repay up to an agreed limit, and the securitisation can be cancelled by the investors before the agreed repayment time if credit events occur under the contractual arrangements, the originating bank has to hold additional capital for the risk weighted exposure amount for the potential increase of credit risk after the early repayment and termination of the securitisation transaction (leading the underlying exposures to come back to the balance sheet). These are treated as an off balance sheet item, and conversion factors are applied ranging from 0% to 100% depending on the exact potential commitment.188 In no case can the originating bank be required to hold more capital for its positions in a securitisation than it would have had to hold for the underlying exposures189. Though this seems fair when looking at the starting position, it also means that complications created by the securitisation itself are not provided for. The same applies to a sponsor bank. 186 Annex IX part 4 §11-15 and 55-59 RBD, as amended by art. 10 of the level 2 Commission Directive 2009/83. 187 The conversion factors are different though, at 50% for liquidity facilities of one year or less, and 100% for longer term facilities. 188 Art. 100 and Annex IX part 4 §16-33 and 68-71 RBD. 189 Art. 66.2, 95.2 last sentence, and Annex IX part 4 §8, 22, 45 and 72-76 RBD.

502

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Quantitative Requirements – Credit Risk

The regime is also applicable to so-called synthetic securitisations. Where in traditional securitisations the assets are transferred to a special purpose vehicle, in a synthetic securitisation only the risk in the assets, not the ownership, is transferred via a derivative contract. The contract itself does not appear to be different from any derivative or guarantee recognised under the credit risk mitigation methodology. However, only if the derivative or guarantee is part of a securitisation, it needs to hold capital for first loss positions, leading potentially to a full deduction from capital. The reasoning might be that the added involvement of the bank in various roles in setting up securitisation transactions and the added market expectations on its role lead to the necessity of added requirements above and beyond a regular exposure covered by a guarantee or derivative. However, it is more likely that the credit risk mitigation methodology was not changed for political and pragmatic reasons when the securitisation arrangements were added to it in the context of the Basel II framework. If similar risks occur in other derivatives, those should have been taken into account too, to ensure a proportional treatment. It is, however, unlikely that there would have been support for a change without a full impact analysis, while on securitisations it was accepted that a harder treatment should be imposed. Synthetic securitisations are based on derivatives. Whether these will be pushed onto exchanges, or at least into clearing and settlement processes will depend on the question whether they are ‘standardised’. If all synthetic securitisations were to be heaped together, they are unlikely to be deemed standard. Who originates and services them are key determining factors, and each deal relates to a specific pool of assets on which only the arranging banks have detailed information190. Per pool, however, they can be deemed standard, if there is an obligation by the originating/servicing bank to provide transparent information (such as by companies whose shares are traded on a regulated market). See chapter 16.4 and 22.4. The normal risk weighting is applicable to any bank that has bought a position in a securitisation transaction as a pure investor, without involvement as a sponsor or originator191. An investing bank will thus have to risk weight separately investments in each tranche by multiplying the exposure value with the percentages set out in annex IX part 4, as set out above. Only some of the additional requirements on the originator and the sponsor do not apply, as a pure investor will enter into an early amortisation contract only on commercial terms and will not be expected by the market to have additional duties vis-à-vis the underlying exposures or the transaction as a whole. As an investor, however, they also

190 See for this argument A.W. Glass, ‘The Regulatory Drive Towards Central Counterparty Clearing of OTC Credit Derivatives and the Necessary Limits on This’, Capital Markets Law Journal, Vol. 4, 2009, S96. 191 Art. 96 RBD.

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EU Banking Supervision

do not benefit from the maximum capital requirement offered to originating and sponsoring banks, but are by the same measure less likely to need it. Covered Bonds Certain types of bonds that are supported by collateral benefit from a special regime in the CRD. Both bank-investors and undertakings for collective investment in transferable securities (UCITS; see chapter 19.5) profit from a beneficial prudential regime when investing such bonds, To qualify for this beneficial treatment as a ‘covered bond’ the bond has to benefit from a security right on specific assets for the benefit of the bondholder in case the primary debtor, the bank who issued the bonds, goes bankrupt. In addition there has to be specific supervision (in addition to general banking supervision) to monitor that the bond is at all times fully covered by the specific assets set aside for that purpose. References to covered bonds were originally introduced in the CRD and in the UCITS directive192 to accommodate the German ‘Pfandbrief’ market and the Danish market in such covered bonds. The regime is based on the standing practice for such traditional Pfandbriefen, established in both countries for centuries. These domestic markets allowed local banks to issue bonds to generate cash, while providing professional and retail investors with a safe investment opportunity. Later entrants to the EU had similar structures, such as the Spanish ‘cedulas’ market. During the 2007-2013 subprime crisis, the covered bond national discretion was implemented widely in local legislation in EU member states193. This allowed banks from countries where Pfandbriefen were not previously known, to start issuing such secured bonds. Not only was this one of the few funding markets for banks that continued to be open (with some fluctuations when trust was at its lowest ebb) when for instance the unsecured money markets and the securitisation markets had shut down completely. Also, covered bonds, even when issued by the bank itself, were accepted as collateral by the ECB. This allowed the ECB to lend against covered bonds to cash stricken banks that might otherwise have gone bankrupt (collectively). The references in the CRD to covered bonds are limited. It concerns the conditions a covered bond has to fulfil in order for a bank investing in those bonds to be allowed to weigh them at a reduced risk percentage, or to apply a reduced LGD (as well as benefit from a partial exemption from the large exposures regime). The UCITS directive contains

192 Annex VI part 1 §68-71, Annex VII §8 sub d RBD and art. 22.4 undertakings for collective investment in securities (or UCITS) Directive 1985/611/EEC; see chapter 19.5. Covered bonds also benefit from a large exposures exemption and a separate regime in the market risk area for covered bonds held in the trading book; art. 113.4 RBD and art. 19.2 RCAD. 193 Covered bonds in the EU financial system, ECB, December 2008, www.ecb.int.

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Quantitative Requirements – Credit Risk

similar provisions that allow the collective investment undertakings that operate within its restrictions to invest a larger proportion of their funds in such covered bonds. The similarities between covered bonds and securitisations are striking. A bond is issued to investors, which is backed by a security right on certain assets. The bank obtains relatively cheap liquidity in return. The collateral generally consists of loans secured by mortgages as originated by the bank. Even for covered bonds it is often desirable to segregate the assets by transferring them to a separate legal entity. The differences are: – the assets are not ‘sold’ for accounting nor for regulatory purposes, they stay on the balance sheet of the bank (i.e. there is no risk transfer, nor a misrepresentation of the size of the balance sheet); – if the assets do not generate sufficient cash to pay the investors, the bank is still legally liable itself for payment of the bond; – the supervisor takes on obligations to ensure to the subset of creditors involved that there is and continuous to be high quality collateral (even when this might clash with other goals such as general creditor protection); – the covered bonds are not necessarily sold in tranches. Though this is important for the investor who wants to decide how much risk he wants to take, from the viewpoint of prudential supervision on the issuing bank this is irrelevant. Covered bonds are thus ‘dual recourse’ against the bank and against the collateral, while securitisations are officially single recourse (against the collateral) but dual recourse in practice. The treatment of the issuing bank for covered bond transactions is quite different than for securitisation transactions. The assets are kept on the balance sheet, even though there is an economic interest of third parties in those assets, who can demand additional assets as collateral if there are losses on the assets. The bank does not need to deduct first loss positions and such (because the assets remain on their balance sheet in full). For prudential purposes on the issuing bank, it is as if no covered bank has been issued, even though the assets are segregated for a specific set of investors to the detriment of the general creditors of the bank. The treatment is provided to produce a lighter risk weighting for the investing bank (and for the issuing bank to attract funding from banks, UCITS and other entities that can only or want only to provide secured lending). Syndicated Loans A syndicated loan generally concerns a large loan made to a single creditor or group of creditors, of which a bank is not willing to take the risk for the full loan. From the start, it can be made by a group of banks directly to the creditor, or made pro forma by one bank

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EU Banking Supervision

but with the understanding that it will immediately or over time be sold onward to other banks, who will have direct rights under the loan agreement. A syndicated loan is generally set up by one or two arrangers, who are banks that take on the responsibility against a fee for the assessment of the creditor, the negotiations, the search for the other participating lenders and the ongoing contacts and collection of repayments and interest. The differences with securitisations are: – the ‘buyers’ of the loan are generally sophisticated investors (other banks, insurers, pension funds, governments or investment vehicles); – it generally does not involve the issuance of a bond, but a similar situation is created by selling portions of the loan for which the administration and servicing is retained; – the role of the collateral in the bond issues for securitisation or covered bonds is played by a large loan to a single company or group, instead of by a large group of relatively small loans. The similarities between securitisations and syndicated loans are less striking than between securitisations and covered bonds, but they do exist. For instance, the retention that is enforced upon banks in the context of the CRD treatment of securitisations is often demanded by sophisticated investors in syndicated loans. These appear to demand a larger retention of a share in the loan (‘skin in the game’) by the arranger(s) depending on the reputation of the arranger as to its own solidity as well as the depth of its research and understanding of the lender, the level of sophistication of the investor, and depending on the business cycle194. At the moment, there is no proposal on the table to introduce a retention obligation on arrangers of syndicated loans in EU legislation. Future Developments The FSB and Commission work on shadow banking also looks at links between the ‘normal’ banking sector and the shadow banking sector195. Apart from looking at consolidation (securitisation vehicles remain outside the consolidation for prudential purposes, as do some other non-regulated and regulated entities; see chapter 17), the focus is also on securitisations and other channels that lead to regulatory arbitrage and/or incomplete credit risk transfer. In addition to the changes gradually introduced on risk retention and improved risk management, additional measures may follow from the review by the FSB, BCBS and IOSCO on such issues as securitisation.

194 R. De Haas & N. Van Horen, ‘The Crisis as a Wake-Up Call. Do Banks Tighten Screening and Monitoring During a Financial Crisis?’, DNB Working Paper 255, Amsterdam, 2010. 195 FSB, Report on Shadow Banking: Strengthening Oversight and Regulation, 27 October 2011; and the related progress report FSB, Strengthening the Oversight and Regulation of Shadow Banking, 16 April 2012. Commission, Green Paper, Shadow Banking, COM(2012) 102 final, 19 March 2012.

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Quantitative Requirements – Credit Risk

EBA is obliged to draft regulatory standards – to be developed with ESMA – on the assessment methodology relating to credit assessments on securitisations by ECAIs by 1 January 2014196. As per the same date, it also needs to submit drafts for regulatory standards on exposures to transferred credit risk197. The regimes for covered bonds198 and for securitisations199 are contained in the CRR, leaving less scope for deviations by national legislators. The covered bond provisions refer to a review by end 2014 of the credit risk of the issuing (and its general creditors) and of the investing bank, across jurisdictions; while they are also part of reviews of the leverage ratio and liquidity ratio reviews. Literature – ECB, Covered Bonds in the EU Financial System, December 2008 – Basel Committee on Banking Supervision, The Joint forum, Credit Risk Transfer from 2005 to 2007, July 2008, www.bis.org Guidelines – CEBS/EBA, Guidelines to article 122a of the capital requirements directive, 31 December 2010

196 Art. 97.2 RBD, as added by art. 9.24 Omnibus I Directive 2010/78/EU. Please note that art. 136 and 270 CRR set the deadline at 1 July 2014. 197 Art. 122a.10 RBD, as amended by art. 9.29 Omnibus I Directive 2010/78/EU; and art. 410 CRR. Also see chapter 13.3. 198 Art. 129, 336.3, 496, 503 CRR on covered bonds, though recital 13 refers to national discretions for types of covered bonds that are not facilitated in the prudential requirements for banks. 199 Art. 4.61-4.67, 32, 36 sub k, 109, 112, 130, 147, 242-270, 326, 337, 364, 373, 404-410 CRR contain the quantitative requirements for issuer and for investor banks; some additional governance requirements are contained in art. 79, 82 and 98.3 CRD IV Directive.

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Quantitative Requirements – Market Risk

9.1

Introduction

The quantitative requirements on market risk have been available in the EU since the introduction of the original capital adequacy directive (CAD) in 1993, as a complement to the existing (Basel I-based) credit risk requirements. It is assumed that market risks are quick to materialise, while credit risk will lead to losses over a longer time horizon1. In 1998, a treatment of commodities risk was introduced as well as the possibility for banks to use internal models as an alternative method to calculate market risk2. The changes in RCAD in 2006 vis-à-vis the original CAD did not focus on the content. It can be characterized as mainly a rearrangement exercise. Some own funds provisions were upgraded from an annex to the main provisions of the directive, and the annexes and the description of the trading book were arranged into a more logical order. On substance it introduced some further details on market risks as agreed in Basel in the context of the Basel II amendment, including a rather timid default risk requirement to cover credit risk on assets in the trading book3. In the wake of the 2007-2013 subprime crisis a more substantial change was made in line with the Basel II ½ amendment, not so much on the methodology of calculating market risk but on the resulting capital requirements. Those had turned out to have been too light to be able to fulfil their financial buffering function in the crisis, and were substantially recalibrated4.

1 2 3 4

BCBS, Principles for Sound Stress Testing Practices and Supervision, May 2009, www.bis.org, page 13. Bringing the EU rules in line with the compromise reached in Basel on the market risk amendment of 1996 to the Basel Accord, www.bis.org. In the Basel II amendment to the accord and in the 2005 paper ‘The Application of Basel II to Trading Activities and the Treatment of Double Default Effects’; www.bis.org. See chapter 9.4. Basel II½, BCBS, Revisions to the Basel II Market Risk Framework, July 2009 (in combination with BCBS, Enhancements to the Basel II Framework, July 2009); the date of implementation was later adapted to end 2011 via a press release, which also made some minor changes to the market risk paper, BCBS, Adjustments to the Basel II Market Risk Framework announced by the Basel Committee, 18 June 2010. A stress testing annex was added in a later revision incorporating all changes in the market risk paper, published in BCBS, Revisions to the Basel II Market Risk Framework, updated as of 31 December 2010, February 2011. The BCBS updates a frequently asked questions document regularly, see BCBS, Interpretative Issues with respect to the Revisions to the Market Risk Framework, November 2011-version. Basel II ½ was implemented in the EU by Directive CRD III 2010/76/EC, applicable since end 2011 in line with the revised Basel timetable. Some first aid measures were already taken early 2009 in the EU via the amendments contained in CRD II 2009/111/EC and in level 2 Commission Directive 2009/27/EC, both applicable since end 2010.

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EU Banking Supervision

Like credit risk and operational risk, market risk results in capital requirements that help set the minimum level of financial buffers in the context of the solvency ratio; see chapter 6.2. For market risk, this is subdivided into : – capital requirements for position risk, counterparty credit risk and for the specific large exposures regime in relation to all exposures belonging to the trading book; – capital requirements for foreign-exchange risk, settlement risk5 and for commodities risk for all exposures (both in and outside of the trading book). The trading book concept is a core part of the regulatory approach to market risk (see chapter 9.2). It provided a compromise when the new market risk regime was developed. The capital requirements for position risk on the one hand were lower than they would have been if the exposures were treated under credit risk, but were on the other hand more targeted to the specifics in the market environment. As long as there was no full market crash, the low buffers were balanced by the added understanding by the bank of the risk encountered, and (slightly) supplemented by the other market risk components. The trading book exposures are carved out of the credit risk treatment. Instead of a calculation in line with chapter 8, they are instead subjected to the market risk treatment on position risk6 and counterparty risk. Both credit risk and the position risk/counterparty risk calculations are supplemented by some market risk requirements that apply to all assets, such as foreign exchange risk. The lighter touch regime for credit risk was deemed opportune on the understanding that trading book exposures are held only short term by the bank, or at least can be traded away quickly if their value deteriorates. It is an either/or regime, under which exposures that have the same characteristics are treated in very different ways because of the intent of the bank to have them available either for trade (in which case it belonged in the trading book) or for long term investment. Assets held for long term investment (sometimes referred to as the banking book) are more important from a credit risk perspective. For such, it is more important that the debtor will repay the main sum, than what the market will pay at any given time for that loan in the meantime. The reverse is true for assets that banks intend to trade, and do not expect to hold to maturity. The trading book concept helped in striking a deal between those who wanted the most prudent treatment for all financial market exposures and those who wanted an

5

6

Art. 18 RCAD and 57 RBD. Until end 2011, banks only needed to apply settlement risk to the trading book. This was changed in order to tighten market risk requirements, especially as settlement risk applies to an expanding number of exposures held in the banking book. See recital 27 and art. 1.8, 2.3 and 3 CRD III, 2010/76/EU. If it is a commodity instead of another financial instrument, it is not treated under position risk, but under commodity risk instead.

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Quantitative Requirements – Market Risk

exemption or favourable treatment at least for all financial market instruments that are frequently traded. The requirements were geared by the BCBS (and the EU) to result in a proportional way to capital requirements in relation to the “8%’ requirement for credit risk. The 8% requirement for credit risk was at that time already in the original version of the capital accord (Basel I). The 8% is not applied in the same manner in the market risk context. The percentage has been used instead as part of the calculations within market risk for the market risk categories developed at the time, i.e. foreign exchange risk, position risk, settlement risk and counterparty credit risk7. The BCBS indicated “In order to ensure consistency in the calculation of the capital requirements for credit and market risks, an explicit numerical link will be created by multiplying the measure of market risk by 12.5 (i.e. the reciprocal of the minimum capital ratio of 8%) and adding the resulting figure to the sum of risk weighted assets compiled for credit risk purposes. The ratio will then be calculated in relation to the sum of the two, using as the numerator only eligible capital.”8 The CRD calculation achieves the same goal. As indicated in chapter 7.1 and 7.3 tier 3 capital is solely intended for market risk. Market risk capital requirements can also be covered by higher quality financial buffers. Tier 3 can only be used if sufficient tier 1 and tier 2 financial buffers are available. The BCBS market risk amendment left it to national discretion whether or not the tiering limits were applicable, as there was no consensus on a common approach. Both the calculation of market risk and the use of tier 3 financial buffers to cover such risks were discredited in the 2007-2013 subprime crisis. The level of required capital has been recalibrated, as indicated above. However, tier 3 is currently still allowed. It will be phased out in line with the Basel III amendment under the CRD IV project (see chapter 2 and 7). The market risk capital requirement can be calculated in two ways: – the standard treatment (see chapter 9.3); – by using internal models, if the supervisor has approved those (see chapter 9.4 and 6.3).

7 8

See Annex I §36, Annex II §1 and 12, Annex III §1 RCAD. Commodities risk was developed subsequently and introduced in 1998, and does not have the reference to 8%. BCBS, Amendment to the Capital Accord to Incorporate Market Risk, II §3, updated version of November 2005. On the numerator and denominator of the solvency ratio see chapter 6.2 and 7. Please note that this is not a reference to the new CRR definition of ‘eligible capital’ used in the large exposures and qualifying holdings regimes described in chapter 11, but to the wider own funds definition used in the versions of the Basel Capital Accord prior to Basel III; see chapter 7.

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EU Banking Supervision

Relation to Mifid RCAD, like its predecessor the CAD, is applicable both to banks and investment firms. Both types of business are susceptible to market risk and should compete in the market on equal terms9. Market risk is common to the activities of both types of institutions. The intention both in the BCBS and in the EU was that prudential requirements should be identical for this risk. Non-bank investment firms do not face the same type of credit risks, as they generally do not generate long term loans to customers outside the trading context. The RCAD contains – in addition to the market risk regime for both types of institutions – an adapted regime on the way other aspects of the prudential regime apply to non-bank investment firms; see chapter 19.2. Where the level playing field on prudential rules is maintained in RCAD, the level playing field on conduct of business rules is maintained in Mifid. The conduct of business rules relating to investment activities as stated in Mifid are applicable to all banks too; see chapter 16.2. Banks fall under the definition of investment firm as used in Mifid; though any reference to investment firm in RCAD excludes the banks. This is not the only discrepancy in terminology between RCAD and Mifid. There are several definition discrepancies with Mifid, that impact on the treatment of key aspects of the prudential and conduct of business regimes: – ‘Financial instruments’ in the RCAD10 means ‘any contract that gives rise to both a financial asset of one party and a financial liability or equity instrument of another party. Not a bad definition by itself if used by a legal expert in the field of banking and securities law and not interpreted too broadly (even a savings account contract could be a financial instrument if the definition is interpreted broadly), and it only requires an hour of explanation or receives an uncomprehending glance for anyone else. However, the definition chosen in the aptly named Mifid (markets in financial instruments directive) or uses a different system, in which the possible types of financial instruments are named in a limited list, including transferable securities, money-market instruments, derivatives on securities or commodities, credit risk derivatives and weather derivatives11. Apart from legislative inertia, there is no discernable reason to use a different definition, and there is no indication that a difference is intended. However, due to the discrepancy, the capital requirements for financial instruments held by the bank may apply also to a broader category of agreements. – ‘Regulated market’ has – on the other hand – been correctly defined in RCAD by reference to Mifid. This replaces the former text in the 1993 CAD that referred to regulated

9

The implementation of the original CAD 93/6/EC was linked to the Investment Services Directive 93/22/EEC, the predecessor to Mifid. CAD provided prudential supervision rules for investment firms (and banks), while the ISD, like Mifid, provided conduct of business rules for investment firms (and banks). See chapter 16.2 and 19.2. 10 Art. 3 sub e RCAD. 11 Art. 4.17 and Annex I, section C Mifid.

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markets that were at the time the only type of trading venue regulated at the EU level12. Sadly, when the reference was changed in RCAD, it was not broadened to refer to the broader concept of trading platforms that had been regulated since 1993 in Mifid13. Along with the regulated markets, including the traditional exchanges, the multilateral trading platforms and systematic internalisers introduced in the Mifid in 2004 to introduce more competition to the traditional market structures are also trading platforms. Secondly, in the RBD a different term is used, which does not refer to Mifid at all. It indicates ‘recognised exchanges’, as recognised by competent authorities (it is unclear whether these are the RBD or the Mifid competent authorities), which in addition function regularly, are subject to clear conditions of trading and have a daily margining requirement in a clearing mechanism. This describes all types of trading platforms set out in the Mifid, so it is unclear why (a) a different definition than in RCAD is needed, and (b) why a different definition than in Mifid is needed. Luckily, this point is sort of irrelevant, as the definition of recognised exchanges in the RBD is used fully three times, all of which in annex VIII on credit risk mitigation. The RBD does, however, uses – in addition to the defined term of ‘regulated market’ – undefined terms such as ‘listed on stock exchanges’, ‘exchange-traded’ and the almost poetic ‘either traded on a stock exchange or effectively negotiable and regularly quoted on a market operated under the auspices of recognised professional operators’14. In the CRD IV project, these definitions are integrated15. Lots of Risks; No Definitions Apart from inconsistent usage of terminology with Mifid, the market risk provisions are also rife with terminology (jargon). Market risk is subdivided into different risk types (position risk, settlement risk, foreign exchange risk, commodities risk, counterparty credit risk, incremental risk), which are subdivided into many more subcategories (specific risk and general risk/interest rate risk for position risk, default risk and migration risk for the incremental risk, and those again contain references to e.g. event risk, name-related basis risk, residual risks, trading risks, basis risk, credit spread risk and so on). None of these terms are defined in the CRD, nor in the various versions of the Basel accords. The assumption of the legislator could either be that the meaning is clear, uncontroversial and not subject to interpretation, or alternatively that the definition of such terms is left to the bank. This might be true – though unlikely – but sadly there is no way to check it16. In this 12 Art. 3 sub I RCAD and Art. 2.10 of the 1993 CAD. 13 Rasdaq Market, Court of Justice 22 March 2012, Case C-248/11. 14 See respectively art. 21 RBD, art. 87 RBD (and Annex VII and XII), and art. 113 RBD in the third to last paragraph. 15 Art. 4.92 CRD IV Directive, which refers to the regulated market concept of Mifid. 16 Rare exceptions are e.g. the term migration risk. A separate document with frequently asked questions published by the BCBS clarifies that it relates to the risk of (internal or external) credit rating migrations,

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book no attempt is made to define those terms, except in as far as there are official sources and references in e.g. the CRD. The terms appear to be defined not as legal terms but as economic theory terminology, which does not provide generally accepted definitions for most concepts either, and their use in legal texts provides enormous scope for gaming the rules by both banks and supervisors. Future The 2009 Basel II ½ market risk amendment only reflects first aid measures in the context of the handling of the crisis; mainly boosting the existing requirements. The root of the problems on capital requirements is the trading book itself, which allows identical exposures to be treated differently due to an ‘intent’ to trade. Even with the new amendments of the CRD under the CRD III amending directive – phased in as per end 2011 – it grants a much lighter requirement on banks for those assets on the basis of this ‘intention’ instead of on the basis of observable facts or even accountancy data. This creates an incentive to manipulate with huge benefits at no cost (except to the integrity of the bank). Even where no such manipulation takes place, the different treatment of the trading book and the banking book does not change the fact that the risk incorporated in the asset itself does not change due to the intent of the holder, except for the (higher, not lesser) risk of not being able to sell even though there is an intention to do so. After the publication of Basel II ½ a – as since implemented via the CRD III amending directive – the Basel III package did not contain substantial new rules on market risk that addresses the remaining problems. It does, however, delete tier 3 capital as a specific low quality financial buffer, and changes some aspects of credit risk calculations that also impacts on instruments held in the trading book17. These changes are reflected CRD IV project, making financial buffers for market risk more expensive for banks; see chapter 2 and 7. The market risk provisions will be contained in the CRR, leaving less scope for deviation18.

and simultaneously indicates that beyond this the exact definition is left to the bank even though it must be acceptable to supervisors. See BCBS, Interpretative Issues with respect to the Revisions to the Market Risk Framework, November 2011-version, page 10-11 (chapter 2.2, question 12 and 16). 17 BCBS Consultative Document, Fundamental Review of the Trading Book, May 2012, page 11. 18 Art. 325 CRR contains the general lay-out of the market risk calculation, art. 94 and 102-106 CRR deal with the trading book and valuation. For the standardised approach, the position risk treatment is contained in art. 326-350 CRR, foreign exchange risk in art. 351-354 CRR, and commodities risk in art. 355-361 CRR. The internal model approach is contained in art. 362-378 CRR. Settlement risk is dealt with in art. 378-380 CRR, and art. 381-386 with credit value adjustments for portfolios of transactions with a counterparty (in the context of derivatives; see chapter 8).

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The BCBS indicated it will start a full review of the approach to market risk, including the distinction between the banking book and the trading book (see chapter 9.2). It published a consultation paper in May 2012, with the aim to revisit the internal models banks use, and upgrade the standardised approach to market risk calculation. The Liikanen review is supportive of the BCBS work, but also notes that financial buffers are too low, and that the Commission may want to add requirements and/or segregate trading activities19.

9.2 The Trading Book Introduction The trading book concept helps differentiate the treatment of certain exposures. Exposures are for instance treated for the risk that the debtor will not fulfil its obligations either under position risk and counterparty risk if the exposures are held in the trading book, while exposures not held in the trading book (the non-trading book is sometimes referred to as the banking book) are subject to the credit risk requirements described in chapter 8. In general the treatment of position risk is lighter than would be applicable if these exposures were treated under credit risk, though an attempt was made to make the treatment of position risk harsher since the crisis; see chapter 10.3. The lighter touch regime is based on the assumption that exposures in the trading book are not ‘bound’ to the bank in the same way as exposures held for long term investment purposes. Trading book exposures are being held for trading purposes and are supposed to be easily traded on liquid financial markets, even when risks materialise. For several other types of market risk calculations, the distinction is not relevant. For instance foreign exchange risk calculations apply to all exposures, such as foreign exchange risk. The counterparty credit risk treatments of OTC derivatives is quite integrated regardless of their placement in the trading book or not (see chapter 8.4). The trading book regime – allocating some exposures to the trading book and others not – is based on the ‘intention’ of the bank to trade. This definition has not been materially changed since its introduction, though some clarity has been added on allocation procedures. The basic concept of trading intent is ambiguous and results in an unlevel playing field across the EU. Depending on the strength and the conservatism of the supervisor, banks have been forced to keep assets outside of the trading book (in its banking book). This type of arbitrage has led to competitive disadvantages for banks from more conservative

19 High-level Expert Group on Reforming the Structure of the EU Banking Sector, Final Report, 2 October 2012 (Liikanen Report), page 71-73, and chapter 5.4. For the segregation, see chapter 13.4 and 16. Also see R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 2 and 4.

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countries in boom times, who have contrariwise benefited from improved capital ratios and less devaluation of assets in bust times. Banking regulators adjusted the trading book regime several times; see chapter 2). After the introduction of the trading book regime in 1996 in the market risk amendment, Basel updated the regime in 200520. Especially the processes to select assets for the trading book were clarified, as well as some measures to deal with default risk (a type of credit risk) for assets held in the trading book. When financial instruments held in the trading book lost their value at unanticipated speed in the 2007-2013 subprime crisis, and the capital requirements held specifically for them vanished in the blink of an eye, the regime was again upgraded in Basel II ½ in 2009, a quick fix amendment (see chapter 9.1), that has been applied by banks in the EU since end 201121. As long as the treatment is different between the trading book and the banking book, however, there will remain room for arbitration. It would probably be better if all assets were subject to credit risk, and also to an add on for those aspects of market risk for each exposure that is exposed to it. Allocation to the Trading Book The trading book consists22 of assets that fulfil all of the following conditions: 1. It relates only positions in financial instruments and commodities. These positions can be the result of e.g. proprietary trading, client servicing or market making, or – under conditions – internal hedges for risks23. 2. Held with trading intent or in order to hedge trading book elements. This key aspect is a subjective statement in and of itself, and the bank needs to be able to motivate its allocation on the basis of pre-set processes and policies. In order to qualify as being held with trading intent, the exposures have to be held for short term resale and/or with the intention of benefiting from short term market price advantages. The bank has to set its processes and policies in writing, both on the trading strategy, the active management of positions (including limits) and the monitoring of positions against the trading strategy.

20 The application of Basel II to trading activities and the treatment of double default effects, developed jointly with IOSCO, BCBS 2005, consolidated into the BCBS, International Convergence of Capital Measurement and Capital Standards: A Revised Framework, June 2006. This became part and parcel of the recasting of the original CAD into RCAD. 21 Art. 2 and 3 CRD III, 2010/76/EU. 22 Art. 18 and Annex VII RCAD. Compare art. 4.1 sub 85-86 and 96, 94 and 102-104 CRR. 23 Internal hedges, i.e. an internal contract that materially or completely offset a non-trading book position, but does not qualify as credit risk mitigation as it is not held by a third party, can be included in the trading book. They cannot be primarily intended for a reduction in capital requirements, and have to be managed in the same way as any trading book position.

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3. Which positions are either free of any restrictive covenants on their tradability or able to be hedged. The BCBS indicates that open equity stakes in hedge funds, private equity investments, positions in a securitisation warehouse and real estate holdings cannot be easily liquidated nor valued on a daily basis, and thus should not be in the trading book24. However, the CRD holds no requirement that assets allocated to the trading book are liquid (or should be transferred to the banking book once they are illiquid). The BCBS acknowledges that illiquid – credit risk related – positions have been built up in the trading book, and that its trading book requirements prior to Basel II ½ were not adequate25. In addition to the internal organisational requirements to determine whether an exposure belongs to the trading book as well as their subsequent management, a specific set of organisational requirements is linked to the valuation of those exposures in the trading book26. The department responsible, and the reporting line to an executive director from that department, needs to be separate and independent from the front office. Mark to market valuation needs to be applied. Especially the area of valuation was the focus of the upgrade in Basel II½/CRD III. Fair value valuation had already become the norm for assets in the trading book as these were presumed to be sold in direct response to market movements; also see chapter 6.4. During the 2007-2013 subprime crisis, markets that had previously been liquid ground to a halt. Market prices were no longer available, as no trading took place. When trading resumed, it was often a forced sale by an institution desperate for cash or in liquidation, establishing fire-sale prices. The whole concept of assets held for trading was quaint, as no solvent bank was willing/eager to trade at such prices. Valuation was subsequently done either on the basis such fire-sale prices, with amendments or not, or on the basis of models with a high level of wishful thinking, and lacking a consensus market practice. After the amendments of the RCAD annex on valuation as applicable since end 2011, mark to market is still the main rule on the basis of the ‘prudent’ side of bid/offer prices. Where market prices are not available, the value needs to be ‘conservatively’ marked to model. If a model is used, all responsible persons (senior management and risk management) need to be aware of the limitations inherent in using a model to establish current values. Senior management specifically has to be aware for which portfolios exactly it is used, and the 24 BCBS, International Convergence of Capital Measurement and Capital Standards: A Revised Framework, June 2006, page 4 and Basel II ½, revisions to the Basel II Market Risk Framework, July 2009, §14. 25 See e.g. Basel II ½, revisions to the Basel II Market Risk Framework, July 2009, §3. 26 Art. 11.4, 33 and Annex VII part B and D RCAD, and compare for instance art. 105 CRR. See chapter 6.4 on valuation and chapter 13 on organisational requirements.

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uncertainty this creates in the reporting; see chapter 13.2. Models can be bought or developed, but they have to be based on appropriate assumptions, that are assessed, challenged and periodically reviewed by the bank, with adjustments considered under established procedures. They have to be benchmarked, extrapolated or otherwise calculated from a market input. The bank needs to consider adjustment of valuations for a wide range of reasons, including close-out costs, operational risks, and model risks. This applies especially for trading book exposures that have grown stale, or are less liquid following from other market events or debtor or bank driven events, or to securitisation and low ranking derivatives. Exemption After determining what goes into the trading book, subsequently the market risk calculation needs to be applied under the standard or internal models approach; see chapter 9.3 or 9.4. However, in some cases a bank may wish not to do a separate market risk calculation. Most banks trade extensively for their own account and to assist clients, and their trading book is complex and large. If so, the bank will have to apply the regime (even if it would not want to invest in the additional costs to gain the associated benefits). However, there are cases when the trading book of a bank is neither complex nor large, and when the investments in systems and models exceed the expected benefit of lower capital requirements for the bank. Such a bank can apply for permission of the supervisor to be exempted from the trading book regime and the market risk calculation. The threshold is that the size of the trading book is and remains small both in relative and absolute terms27. This is the case if: – the trading book business of the bank normally does not exceed 5% of their total business, and never exceeds 6%; and – the total trading book positions normally do not exceed 15 million euro, and never exceed 20 million euro. The supervisor can choose to allow this (the RCAD gives this as a discretionary tool to the supervisor). If the supervisor uses this discretion, the credit risk requirements are applicable to the trading book of the bank too, instead of the market risk provisions. The exemption does not extend to the full market risk treatment. Even when the trading book distinction is set aside, those portions of market risk that are not dependent on the 27 Art. 18.2-18.4 RCAD; respectively art. 94 CRR. Short term excess over the limits set for the size of the trading book is allowed, but if it persists, the bank will need to start applying the trading book regime, and inform the supervisor accordingly. Please note that the supervisory permission need not be withdrawn for this consequence to be applicable. The calculation of what the ‘business’ of a bank is not fully harmonised, though the directive gives some indications of the factors the supervisor is allowed to include.

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trading book/banking book distinction apply. The bank will need to calculate the capital requirements for commodities risk, settlement risk and foreign exchange risk, which are applicable regardless of whether the exposure is booked in the trading book or not28. Future Developments The trading book approach is unchanged in the Basel III/CRD IV project, after the changes made in Basel II ½. The BCBS has announced its intention to revisit the distinction between the banking book and the trading book, the definition of trading and how those risks should be translated in capital requirements, and published a consultation in May 201229. In the consultation paper and its annex 1 the BCBS notes a series of problems with the trading book concept, including arbitrage at the height of the crisis to minimize capital requirements. The BCBS appears to have been scared of the consequences of pulling back from the trading book concept that it admits has been the basis of too low capital requirements. The ‘trading book’ concept differentiates between assets that are primarily put under the credit risk or under the market risk (position risk) calculations for the estimation of the required amount of financial buffers. Instead of abandoning it (with unknown consequences on capital levels, it proposes to keep it but make the delineation slightly clearer and better policed, though it struggles with credit risks that are embodied in many instruments that are held in the trading book30. It shies away from abandoning the concept, apparently mainly due to the additional costs/work and uncertainty. The BCBS refers to ‘practical reasons’, that in one brief paragraph are linked to difficulties in designing and implementing an expansion of credit risk calculations31. Instead, the BCBS proposes to make the boundary between the trading book and the banking book concepts more objective, reducing the scope for regulatory arbitrage (gaming the requirements). However, unless the concept is fully abandoned, the increased policing it proposes and the slightly clearer criteria do not appear sufficient to take on pressure from the banks to use the most beneficial regime, or design instruments that make use of the lowest capital requirements calculations. It also continues a struggle to put credit risks embodied in an ever increasing number of financial instruments into a market risk (more specifically position risk) framework. It may have been better to abandon the current concept of position risk, and decompose it into its components. This would have allowed each exposure that has credit risk in it to be treated under the credit risk calculation described in chapter 28 Art. 18.2 RCAD refers to ‘the trading book business’, which is dealt with in art. 18.1a RCAD. Commodities and foreign exchange risk are applicable to ‘all of their business activities’ and dealt with in art. 18.1b RCAD. The CRD III change in art. 18.1a expanded the settlement risk calculation to non-trading book business. 29 BCBS, The Basel Committee’s Response to the Financial Crisis: Report to the G20, page 13. BCBS Consultative Document, Fundamental Review of the Trading Book, May 2012. See chapter 9.1. 30 BCBS Consultative Document, Fundamental Review of the Trading Book, May 2012. 31 BCBS Consultative Document, Fundamental Review of the Trading Book, May 2012, page 2 and 13.

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8, with add-ons for all relevant market risk components (in the same manner as used for those market risks that are not limited to the trading book, such as foreign exchange risk). In proposing to maintain the dilapidated trading book concept and hammering a piece of mangy wood across the most blatant gaps, the review does not deserve the word ‘fundamental’ that is used in its title.

9.3

Standard Treatment of Different Market Risks

Introduction The standard treatment of market risk is sub-divided into separate calculations of the capital requirements for specific sub-categories of market risk. Some of these calculations only apply to assets held in the trading book. On these assets, in return, the credit risk treatment of chapter 8 does not apply. To some other market risks, however, both trading book assets and banking book assets are equally susceptible. For trading book exposures specifically, banks have to calculate: – position risk; – counterparty credit risk; – large exposures in the trading book. For both trading book and banking book exposures, banks have to calculate: – commodities risk; – foreign exchange risk; – settlement/delivery risk. To determine the capital requirement for market risk, the requirements have to be calculated per sub-risk. The results per sub-risk are added up to establish the total capital requirement for market risk32. For the quantitative limits and capital requirements following from the treatment of large exposures in the trading book, see chapter 11.2. For position risk, foreignexchange risk and/or commodities risk banks can also use a pre-approved ‘internal model’ instead of the standard approach set out in this chapter33. Position Risk Under the term position risk the risk contained in each position in certain exposures contained in the trading book is calculated. The treatment is subdivided into three categories: a. traded debt instruments; 32 Art. 75 RBD and art. 18.1 RCAD. 33 Annex V §1 RCAD. See chapter 9.4.

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b. equities; c. collective investment units in the trading book. Commodities and commodity derivatives are out of the scope of the calculation of capital requirements for position risk, and dealt with in a separate capital requirements regime for commodity risk (see below). Derivatives are ‘translated’ into their underlying positions and treated as such. Stock index futures are treated as equity positions34. However, as an exemption, the supervisor can agree that certain types of derivatives need not be subjected to position risk calculations. It relates to (i) for exchange traded futures and written options, nor (ii) for OTC derivatives contracts or OTC options cleared by a recognised clearing house35. The supervisor can only give his permission if the margin (i.e. collateral for any open obligation under these derivatives) provided by the bank to the exchange or clearing house is higher or equal to the capital requirement expected under the position risk calculation, and the margins reflect accurate measures of the risk. In that case the margin given to the exchange/clearing provider can be deemed to be the capital requirement. A similar treatment is available for this type of derivatives on commodities under the regime for commodity risk. The position risk capital requirements for debt and equity instruments are subsequently built up from two components: A. Specific risk; the risk of a price change in the instrument due to factors related to its issuer or, in case of a derivative, the issuer of the underlying instrument. This risk category was boosted under both CRD II and CRD III: – For debt instruments, the net positions receives a specific risk capital charge of between 0% and 12% depending on the rating36 of the issuer or guarantor under the standardised approach to credit risk. Supervisors can require the bank to use the charge of 12% for any debtor that has insufficient solvency, regardless of the rating. If there are securitisation exposures in the trading book that are deducted from own funds or a 1250%, they shall be treated in the same way as they would have been treated under credit risk37. – Exchange traded stock-index futures do not attract specific risk capital requirements if they represent broadly diversified indices according to the supervisor.

34 Annex I §1-7, 37-40 RCAD. See the last paragraph of §5 for the exemption on margins. See the remarks on the definition of exchange in chapter 9.1. 35 This exemption will become more important under EMIR. See chapter 22.4. 36 See chapter 8.1 on the use of external ratings in the standardised approach to credit risk. Joint Forum, Stocktaking on the Use of Credit Ratings, June 2009. 37 Annex I §12-14, 15, 16, 33-34 RCAD.

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– Securitisation positions are calculated on a net basis (irrespective of short or long) in line with the banking book treatment under credit risk standardised or IRB treatment, risk weighted at 8% (see chapter 8.6) unless they fall within a ‘correlation trading portfolio’ set up by the institution under the next dash, or are already deducted from own funds, see above38. – For the correlation trading portfolio (containing a subset of securitisation positions and directly related derivatives that provide protection on those specific positions; see below and chapter 9.5), the institution can instead opt to calculate it under a different calculation, under which the specific risk requirement for the net long positions is calculated separately from the same for the net short positions, and the larger of the two is the specific risk capital charge, per individual position capped at the maximum loss the institution can suffer39. – For equity instruments the overall gross position (all net long positions and all net short positions added together) shall be multiplied by 8%40. B. General risk; the risk of a price change in the instrument due to a change in the level of interest rates or to a broad equity-market movement unrelated to any specific attributes of individual securities (interest rate risk in the portfolio). This approach was not changed as a result of CRD II nor CRD III. – For equity instruments, the overall net position (the difference between all net long positions and all net short positions) shall be multiplied by 8% for this risk41. – For debt instruments, either a maturity based approach needs to be taken or with the approval of the supervisor, a duration based approach, see below42. In both cases, netting is applied and trading book positions hedged by credit derivatives benefit from a reduced ‘specific risk’ capital charge; see chapter 9.5. There are two main approaches to calculate the risk embodied in debt instruments for the general risk part of position risk: – The maturity based approach for debt instruments allocates all instruments to maturity bands, which in turn are divided into three zones (up to 1 year, up to 3.6 or 4 years depending on the interest paid, and longer maturity bands). Each of these are risk weighted, ranging from 0% for exposures of less than 1 month maturity, to 6% for high interest debt instruments and 12.5% for low interest debt instruments of more than 20 38 Annex 1 §14, first, second and last paragraph, 14a-14c, 16a RCAD. 39 Annex I §14a-14c RCAD. Basel II ½, revisions to the Basel II Market Risk Framework, July 2009, §15-19; BCBS, Adjustments to the Basel II Market Risk Framework announced by the Basel Committee, 18 June 2010. 40 Annex I §1 and 33-34 RCAD. Under the previous regime 4% or even 2% was allowed. 41 Annex I §33, 36-40 RCAD. 42 Annex I §17-32 RCAD.

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years maturity. If weighted long positions in a maturity band match with weighted short positions in the same band, these attract the lowest capital charge by multiplying the matched weighted position by 10%. Surplus weighted long and short positions can be matched within each zone, to which a higher percentages applies. The same applies for matching surplus weighted short and long positions between zones. The residual unmatched weighted position attracts a capital requirement of 100% (but matched positions between zone 1 and 3 attract 150%). – The duration based approach depends on a formula to determine the actual duration of the debt instrument taking into account market value, yield to maturity, dates of cash payments and total maturity. Like in the maturity based approach, it divides them subsequently in three zones of less than 1 year, up to 3.6 years and longer duration. It determines the duration weighted position subsequently by multiplying the market price by the duration and by the assumed interest rate change (of between 1 and 0,7%). Matched weighted short and long positions in each zone attract a 2% capital requirement, between zones 40% (or 150% if between zone 1 and 3), and residual unmatched weighted position attract a capital requirement of 100%. For both debt and equity instruments, an alternative method is available for instruments held by the bank when underwriting an emission43. It only needs to hold financial buffers for the instruments that are not (bindingly) subscribed or sub-underwritten by third parties. The remainder of the position is equal to the capital requirement after 5 working days have passed since the bank became unconditionally committed to accept the securities at an agreed price. The first 5 working days, a reduction is applied to the net position/capital requirement. On the first day, the capital requirement is reduced by 100%. The reduction gradually decreases until on the fifth day the capital requirement is reduced only by 25%. Capital requirements for units in collective investment undertakings44 (or ‘CIU’) in the trading book are 32% for (specific and general) position risk, unless the collective investment undertaking qualifies for a look through approach. This approach is available to any collective investment undertaking set up by companies supervised or incorporated within the EU. This includes EU harmonised regulations for UCITS and the alternative investment funds covered by the AIFM directive, but also includes domestic, non-harmonised, supervision on collective investment undertakings that invest in other items than transferable securities; see chapter 19.5. The bank needs to have an adequate risk assessment of the collective investment undertaking, and the collective investment undertaking needs

43 Annex I §41 RCAD. 44 Annex I §47-56 RCAD.

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EU Banking Supervision to fulfil similar conditions to those under the standardised approach to credit risk45. If these conditions are fulfilled, the underlying instruments can be included in the treatment of position risk directly as if the position in the collective investment undertaking units is instead a position in the underlying financial instruments. The maximum capital requirement under this approach is capped at the 32% requirement. An additional cap under market risk is a cap of 40% for (specific and general) position risk and the capital requirement for foreign exchange risk for collective investment undertakings as described below. Settlement Risk and Counterparty Credit Risk Settlement risk deals with the increase in the risk profile of a transaction if it fails to settle (payment made and/or the legal transfer of ownership of the financial instruments involved as promised in the transaction) within the time agreed, i.e. before the due delivery date46. If the transaction is left unsettled more than 5 days after the due delivery date, the bank has to calculate the price difference to which it is exposed. This is the difference between the price agreed (the settlement price) and the current market value. The price difference is multiplied by 8% if it has been left unsettled at the date of calculation between 5 and 15 working days, and rises up to 100% if it has been unsettled after the due delivery date for 46 days or more, which equates to 1 on 1 capital requirements, or a full deduction from own funds of the price difference. This assumes that the bank will only fulfil its part of the deal upon settlement, and/or will be refunded by a clearing and settlement institution if the counterparty does not fulfil its part of the agreement. If, however, the bank has already fulfilled its part of the agreement and it has not yet received the delivery by the counterparty (the so-called ‘free delivery’ situation), it also has to calculate a capital requirement for the value of its payment or delivery too. Up to the due delivery date it does not need to hold capital. From that moment until 4 days after a second due delivery date, it has to treat it as an exposure and calculate capital requirements for it under credit risk. If no payment or delivery has been received after that, it has to be deducted in full from own funds, including the current positive value of the contract, like an exposure in default; see chapter 8.2. Up to end 2011, the RCAD only obliged the calculation of settlement risk for financial instruments that banks had allocated to the trading book47. In addition to the changes in 45 See chapter 8.2 and 19.5. 46 Annex II §1-4 RCAD. As such risk is mitigated by the structure of such deals, no separate settlement risk is calculated for repurchase and reverse repurchase agreements, and securities or commodities lending or borrowing. 47 Art. 18.1 sub a RCAD, as amended by CRD III 2010/76/EC.

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the market risk framework proposed by the BCBS, the CRD III also expanded the settlement risk capital requirement to the banking book. As a result, all unsettled deliveries of financial instruments need now to be provided for. This expansion was not undertaken for counterparty credit risk. The regimes inside and outside of the trading book were already largely harmonised. For the description of the treatment of counterparty credit risk reference is made to chapter 8.4. Foreign Exchange Risk Foreign exchange risk is present across the business of the bank, also outside of the trading book. The calculation of this market risk deals with risk that exposures denominated in other currencies than the reporting currency will decrease in value not because the counterparty is no longer good for the money, but because the transaction currency is devalued. The reporting currency is taken as the base or the ‘own’ currency of the bank, in which there is no risk of decreasing value (in the books of the bank). Per category of exposures set out below – with the positions denominated in the reporting currency – each foreign currency and gold48 position is taken into account: – the amount of all asset items49 less all liability items, including accrued interest is determined (the net ‘spot’ position); – all amounts to be received less all amounts to be paid under forward exchange and gold transactions (the net ‘forward’ position); – the amount of irrevocable guarantees (and similar instruments) that are certain to be called and likely to be irrevocable (i.e. certain off balance items that will almost certainly go on balance); – the expected positive change (the net ‘delta’ or expected change as a result of changes in the price of the underlying instrument can be high) in the option price of gold and currency options minus the expected negative change thereof; and the market value of all other options;

48 Gold is treated as a currency instead of as a commodity. It is exempted from the commodity risk capital requirement calculation. Annex III §1 and Annex IV §2. 49 Two remarks. (1) Hedging instruments of a non-trading or of a structural nature that are entered into solely to limit the impact of foreign exchange risk on its capital ratio need not be taken into account if the supervisor agrees. Also items that have already been deducted from own funds (defaulted exposures or exposures that always have to be deducted such as participations in insurance undertakings) need not be taken into account. (2) positions in collective investment units are not taken into account on the basis of their own denomination but on the basis of the foreign exchange position in the collective investment unit (of the underlying instruments). This shall be done on the basis of the actual position if known, or the maximum position possible under the investment policy of the CIU if it is not known.

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– net future income and expenses not yet accrued (not paid yet) but already fully hedged (managed by taking risk measurement measures). The net positions mentioned can both be a positive amount (a net exposure to the foreign currency or to gold), or a negative amount (a net exposure to the reporting currency instead of to the foreign currency or to gold). The net short and long positions (negative and positive amounts) are converted at spot rates into the reporting currency. All the positive amounts are summed together, delivering the net long position, and all the negative amounts are summed together, delivering the net short position in terms of the reporting currency. The higher of the two (net short respectively net long) is the overall net foreign exchange position50. The difference between the two is equal to the risk the bank runs. If the sum of the banks’ overall net foreign exchange position and its net gold position exceeds 2% of the own funds of the bank, additional capital to credit risk or position risk capital requirements needs to be held for this exposure. If it does not exceed this threshold of 2%, there is no additional requirement. If it does, it needs to hold additional capital of 8% of the overall net positions (for the full amount, not only for the amount above the threshold). Domestic lawmakers can – as a national discretion – apply several exemptions for all their banks or for those for whom they consider it is most relevant. Supervisors can also grant such an exemption as a supervisory discretion, at the request of the bank. The potential exemptions are: – a lower capital requirement for matched positions in currencies that have proven to be closely correlated in practice; – a lower capital requirement for matched positions in currencies that are subject to a binding intergovernmental agreement to limit their variations relative to each other; – a capital requirement of only 1,6% for matched positions in the currencies of member states that are participating in the second stage of the economic and monetary union.

50 The annex is ambiguous on whether or not gold positions are included in this. According to §2 and 3, gold positions are included, but in §1, the net overall foreign exchange position and the net gold position are mentioned separately, and added to each other separately. As including gold positions in the foreign exchange positions can determine whether the net short or the net long positions are higher, this makes a difference. It can be argued that §2 and 3 provide the clearer process, and are more consistent with the treatment of gold as a currency.

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Commodities Risk The regime on commodities risk51 is applicable across the business of the bank, also outside of the trading book. It was introduced in 1998 as a first step of a process in which full harmonisation and equal treatment would be applied across the EU and across participants in the commodities market. As a first step, it was reasonably successful in providing common terminology and some harmonisation. It is, however, riddled by national discretions and (originally) transitional provisions. These became fixed features when the planned next step failed to materialise in 2006.The work was pushed to the backburner in favour of the work on the Basel II framework, which did not include new work on commodities risk. The calculation of the capital requirements can be done under one of three different approaches. Each adds certain factors to the calculation, but parts of those in all three are: – the spot price (in the reporting currency) per standard trading unit in that commodity; – the calculation of the exposure in the number of standard trading units in that commodity, both long (more owned than sold, betting on a rise in prices) and short (less owned than sold, betting on prices going down); – with options on commodities or on commodity derivatives being counted as the full value of the underlying commodities or derivatives, multiplied by the expected change as a factor to price changes in the price of the underlying commodity or derivative (the leverage). The RCAD does not indicate which bank should apply which of the three approaches. Member states appear to be free whether to prescribe either the first or the second as the standard (for all or for some categories of banks), with the third being available only to banks that apply for supervisory approval. It concerns: Maturity ladder approach: – per commodity, all positions in the commodity shall be assigned to maturity bands varying from less than 1 month to more than 3 years; – netting is possible for contracts maturing on the same date; – within each maturity band, to the extent short and long positions are matched, those are multiplied by 1.5% and by the spot price of the commodity; – the unmatched part (short or long position) of a maturity band can be matched with an opposing position in a maturity band further out. This is (1) multiplied by 1.5% and by the spot price like for any matched position, and (2) multiplied by 0,6% and by the spot price to compensate for the carry element; – the remaining unmatched positions are multiplied by 15% and by the spot price; 51 Annex IV RCAD (previously art. 11a and Annex VII of the original CAD, introduced by 1998/31/EC).

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– the sum of these requirements per commodity being the capital requirement for that commodity, and those added up the total capital requirement; – this method is similar to the position risk maturity based general risk calculation for debt instruments. Simplified approach: – 3% of both the long and the short gross positions per commodity, multiplied by the spot price for that commodity; – 15% of the net position (either long or short) multiplied by the spot price for that commodity; – the sum of these requirements per commodity being the capital requirement for that commodity, and those added up the total capital requirement; – this approach requires more capital, but less investment in management systems and does not take into account the impact of differing maturities. Extended maturity ladder approach: – supervisors can allow banks that have significant commodities business, have a diversified commodity portfolio, and are ‘not yet’ in a position to use the internal model (see chapter 9.4) method to use this approach; – the methodology and calculation of the capital requirements is identical to that of the maturity ladder approach, but with lower percentages applied to the matched and unmatched positions, resulting in reduced capital requirements; – differentiating between precious metals, base metals, agricultural products and others (including energy products); – instead of the standard 1.5% for matched positions spread rates of between 1 and 1.5 are used; – instead of the standard 0.6% for different maturity matched positions carry rates of between 0.3 and 0.6% are used; and – for remaining unmatched positions instead of the standard 15% outright rates of between 8 and 15% are used. As in the calculation for position risk, the commodity risk calculation need not be used (at the discretion of the supervisor): (i) for exchange traded futures and commodity options, nor (ii) for OTC commodity derivatives contracts or OTC commodity options cleared by a recognised clearing house. The supervisor can only give its approval if the margin provided to the exchange or clearing house is higher or equal to the capital requirement expected under the above methods, and the margins reflect accurate measures of the risk. In this case the margin can be deemed to be the capital requirement. This same treatment is also available for similar non-commodities instruments as part of the position risk regime.

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Even though commodity risk is calculated for all positions, regardless whether they are in the trading book or not, commodities inside and outside the trading book may still be treated differently, depending on national implementation. This is a result of the fact that commodity risk is an alternative to position risk (position risk is not calculated on commodities). If outside the trading book, they may be subjected to credit risk as ‘other items’ in the standardised and IRB approach as well as to commodity risk. In the trading book they are subject also to commodity risk of course, but not to position risk (which would have been necessary to even out the treatment outside the trading book). In both cases, counterparty credit risk, foreign exchange risk and settlement risk are calculated additionally if applicable to the commodity or commodity derivative. Future Developments The current commodity risk regime is not particularly heavy handed yet. In one of the examples that prudential concerns should be set aside for industrial market development concerns, the RCAD gives the instruction not to interfere ‘unduly’ with the European goal of the liberalisation of commodity markets in gas and electricity. Some follow-up work has been done, but there has been little or no priority allocated to it by banking supervisors (for most banks, commodity business is a relatively small proportion of its business, with a limited impact on their stability). The work has been done at the instigation of the European Commission, responding to a mandate in the directive52. The CEBS-EBA and CESR-ESMA advice of 2008 was not incorporated in the CRD II or III directives. For changes to the treatment of derivatives and the lighter but targeted approach to settling such transactions and other types of transactions via central counterparties, reference is made to chapter 8.4, 16.4 and 22.4. In the BCBS consultation document on the trading book53, proposals include changes in the standardised and internal models, in order to reflect tail-risk to a larger extent. Value at risk style calculations would be abandoned for an expected shortfall calculation. Estimations of expected shortfalls should shift the estimation of financial buffers for market risks away from a focus on recent data but focus more on stressed calculations and tail end risks. The standardised approach was deemed inadequate in the crisis, and – in addition to the Basel II ½ measures that have already been introduced, and the deletion of tier 3 capital in Basel III – it is proposed to make it more risk sensitive. The BCBS is contemplating various measures that appear to focus mainly on the calculation of position risk, with dif52 Art. 48, 41.1h and recitals 21 and 22 RCAD, as well as art. 65.3 Mifid. CEBS-EBA published a survey and an assessment of risks in January 2007 and October 2007. A joint advice of CEBS and CESR (EBA and ESMA) was published in October 2008. 53 BCBS Consultative Document, Fundamental Review of the Trading Book, May 2012.

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ferent degrees of complexity and regulatory input for the standardised model. Each contemplated alternative has significant problems in risk sensitivity or in the role of rule makers or supervisors in setting risk weightings or policing the consistent application of the calculation across banks. The calibration is left to future work, which will also determine whether the standardised approach model will be a credible alternative to internal models calculations, and whether it would allow model approval to be withdrawn in a crisis. The paper notes that such approval could not be withdrawn during the 2007-2013 subprime crisis, as that would have resulted in additional or too low capital requirements on the bank, that could have resulted in ever more financial markets panic. A floor based on the standardised calculation could be part of future internal model rules.54

9.4 Internal Model Approach (and Scope) Introduction Banks can ask for permission to use a self-developed model for the calculation of market risks; see chapter 6.3. The internal model for market risk is limited to certain areas55. It can be used as an alternative to the standard method only for position risk, foreign exchange risk and/or commodities risk. The use of market risk internal models for settlement is not allowed, and for counterparty credit risk there is a separate type of internal model described in chapter 8.4. The internal models approach was introduced in the EU in 1998, based upon the BCBS market risk amendment of 1996. The model requirements for such bank-developed calculations were the precursor to the formulation of similar ‘own’ modelling by the bank of risks in the credit risk and operational risk area; see chapter 6.3. The market risk modelling requirements can feel slightly dated compared to the model requirements contained in the RBD, when compared to those ‘newer’ areas of prudential risk calculation. The VAR model it uses (with all its downsides56) is also used as the basis for credit risk modelling. But when credit risk rules were updated and the model introduced in Basel II, the market risk modelling provisions were not modernised simultaneously. The risks of using internal models to calculate capital requirements were well understood by the BCBS even before the 1996 market risk amendment. The same applies to the risk that the calculation would be too kind or the underlying assumptions too optimistic, and

54 BCBS Consultative Document, Fundamental Review of the Trading Book, May 2012, page 4, 25-27. 55 Annex V §1 RCAD. 56 J. Daníelsson, ‘The Emperor Has No Clothes: Limits to Risk Modelling’, Journal of Banking & Finance, Vol. 26, 2002, page 1273-1296. Also see chapter 6.3.

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to the fact that the model would not cover a crisis or other so-called fat tail events. Fat tail events are unlikely to happen within the assumptions of the model, but will cause high losses if they do occur nevertheless. Such fat tail risks were pointed out to defend the – currently considered too optimistic – regime introduced in 1996, that was at the time under attack for being too stringent.57 On some aspects, such as the observation period for the data that have to be built into the calculation, the BCBS softened its approach during the consultation on its 1996 work in response to complaints. Even admitting this, it cannot unequivocally be said that the market risk amendment of 1996 was badly calibrated for the market risks that existed at the time. During the 2007-2013 subprime crisis huge losses in the trading books turned out to be even less than inadequately buffered by the amount of available capital at the larger trading banks that were operating under their own models. This could, however, be blamed on the fact that the calculation introduced in 1996 did not foresee or provide for the type of complex instruments and the expansion of the trading book since it was introduced. It was in any case presented as a step in a longer road to capture market risks when it was introduced, and part of the blame may be that it did not foresee changing market circumstances, and that the BCBS and the legislators backing (or not backing as the case may be) their representatives at the BCBS. The rather timid default risk treatment introduced in Basel II – which entered into force in the EU after the crisis had already started – was equally deemed inadequate in light of the amount of losses suffered on amongst others credit risk derivatives58. The Basel II default risk treatment was known as the ‘incremental default risk’. It contained a additional credit risk requirement to the existing calculation. The Basel II ½ work of the BCBS contained some quick-fix updated provisions on the market risk internal model. Basel II½/CRD III tried to address the fact that the capital requirements for market risk were by far insufficient to cover the type of losses suffered in the 2007-2013 subprime crisis especially for the larger banks that typically used their own models; see chapter 2 and 9.1. This interim work focused more on adding calculations and increasing overall capital requirements rather than on modernisation of the provisions on the functioning of the existing internal model. The relevant provisions of CRD III are applied since 31 December 2011. The core of the market risk calculation via an internal model remains a value at risk or VAR model (see chapter 6.3). Until end 2011, a VAR calculation based on so-called recent market developments was the only calculation required under the CRD. Since end 2011, the CRD III posed additional requirements if they want to continue using internal models for market risk. These include the calculation of a so-called ‘incremental risk charge’ to 57 Feedback on industry comments is contained in BCBS, Overview of the Amendment to the Capital Accord to Incorporate Market Risks, January 1996. See §9 on the defence of its multiplication factor due to model risks; and e.g. §11 and 14 on softening the requirements. 58 Also see chapter 8.6. Similar default losses on re-securitisations were also not covered by reserved capital.

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capture credit risk in trading book assets. This can be included via a separate calculation on top of the traditional calculation and/or by setting up a new comprehensive model. They also include a new requirement to run stressed conditions through the VAR based model. The majority of the changes in CRD III were copied from the BCBS Basel II ½ package that amended the capital accord; see chapter 2.In response to the first events in the 2007-2013 subprime crisis, the BCBS decided to leave the available regime with its VAR-based calculation in place, with minor refinements, but to quickly beef up its default risk capital requirement into the new ‘incremental risk charge’, and to further add a ‘stressed VAR’ capital requirement. This additional value at risk calculation is based not on recent market data like the pre-existing value at risk calculation, but on data derived from worst historic cases, such as the 2007-2013 subprime crisis. It thus incorporates stress testing into pillar 1 for market risk capital calculation purposes, in addition to the more voluntary stress testing that banks were urged to undertake on the ‘normal’ VAR calculation (also see chapter 13.5). Except for these add-ons, the changes are very limited. The types of models allowed are not changed, nor the types of assets in the trading book. For the position risk of assets, the Basel II ½ market risk treatment59, can be summarised as: Standardised approach position risk

Internal model position risk

Unsecuritised – Standardised approach (exist- – VAR (existing, with some upgrades) assets in the trading, but with a doubling of the – Incremental risk charge, including ing book specific risk charge for equities default risk and migration risk for in a diversified portfolio and a credit products (expanded)60 change in the treatment of cer- – Stressed VAR tain credit risk derivatives) – No additional ‘stressed’ capital requirements. Securitised assets – For specific risk: treatment – Same as in standardised approach, but in the trading under the banking book rules as a possible alternative for the correlabook set out in chapter 8.6 (for gention trading portfolio an internal model eral risk and other market risks based calculation that was made subject the ‘normal’ market risk treatto a floor in a separate Basel press ment applies) (existing, with release61 some minor amendments) – Except that also specific risk can be calculated under market 59 Basel II ½, revisions to the Basel II Market Risk Framework, July 2009. 60 As an alternative, the bank can have a comprehensive approach to both incremental risk and to the correlation trading portfolio of securitised assets, if it captures all price risks and the supervisor approves. Basel II ½, revisions to the Basel II Market Risk Framework, July 2009, page 21-23. Also see BCBS, Guidelines for Computing Capital for Incremental Risk in the Trading Book, July 2009, which was published simultaneously. 61 BCBS, Adjustments to the Basel II Market Risk Framework announced by the Basel Committee, 18 June 2010. The floor is the standardised calculation.

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Standardised approach position risk

Internal model position risk

risk if they are part of the correlation trading portfolio (securitisation positions and directly related derivatives that provide protection on those specific positions)

The EU CRD III directive62 accordingly introduced the changes to the modelled VAR, the expanded incremental risk charge as well as the modelled stressed VAR requirement. They have to be applied to and by all internal models-based banks since end 2011. The three requirements taken together (plus the securitisation capital charge for specific risk as calculated under the banking book for securitisation positions held in the trading book) are added up to form the market risk capital requirement for position risk. Reference is made to the remarks made on the lack of definitions on various types of risks (see ‘lots of risks; no definitions’ in chapter 9.1). Especially the model-provisions are rife with possibilities to game the ‘requirements’ for both the bank and e.g. a lenient supervisor that wants to accommodate a national champion due to the lack of definitions and clear thresholds. The possibility for EBA to develop regulatory standards is particularly welcome to bring some harmonisation (and tightening) in the assessment of compliance with the various risk types63. The EBA is allowed – but not required – to develop regulatory standards on the assessment process by the supervisors64. Inevitably, any such standards would fill in some of the loose terminology and loosely worded requirements in the CRD on the model. Model Approval To be allowed to use internal models, the bank has to have permission of the supervisor65. This decision can be positive if some conditions are fulfilled, which in practice means that the model has to be accurate and sound, it actually has to predict the capital needed without too many overshootings, and it has to cover all the risks it promises to cover (e.g. specific position risk, interest rate risk, foreign-exchange risk, equity risk and/or commodity risk), especially for all relevant markets for the bank. In principle this is a decision by the licensing supervisor, but if the group (or parts of the group) request permission for the use of the model on a consolidated basis, the same model approval process as for credit

62 63 64 65

Art. 2 and Annex II CRD III Directive 2010/76/EU, containing the changes to the RCAD. Art. 18.5 RCAD. Art. 18.5 RBD, introduced in the Omnibus I Directive 2010/78/EU as per early 2011. See chapter 23.3. Art. 18.1 and 18.5, Annex V §1, 5, 5l, 6, 8, 10c, 11, 12, 13 RCAD.

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EU Banking Supervision risk and operational risk applies66. If the model is used on a consolidated basis, an arrangement will need to be included on how to allocate the capital to the various entities on a solo basis. The bank has to have good internal governance, especially on risk management (see chapter 13.3. This includes integration of the model into risk management (use test), the establishment of an independent risk control unit, back-testing to test the predictive value of the model and stress testing of the model with unusual events, involvement of the board and a review process that includes e.g. verification of good data and back-testing. If the model does not work well, permission to use it can be partially or fully withdrawn67. If the bank also wants to model specific risk for its position risk capital requirement (the risk of a price change in the instrument due to factors related to its issuer), it has to fulfil additional conditions. Those include that the model actually explains past price movements and captures differences in risk between similar but not identical positions (to different counterparties). The model also is obliged to be conservative on the risk assessment of illiquid assets, and of assets where price transparency is or can become limited. EBA is allowed – but not required – to develop regulatory standards on the assessment process by the supervisors on market risk internal models68. VAR Calculation The VAR calculation is built on a different confidence level (99%) and period of data gathering (1 year) than the credit risk and operational risk models. Markets move quickly, and the assumption is that more recent data predict the (near) future better. Banks are required to have market data of at least one year, and to update this regularly. The calculation has to be made on a daily basis to reflect the changes in the portfolio and prices. This single mid-term baseline of data was decided upon by the BCBS to save costs at the banks. The one year compromise (instead of dual observation periods with a short period and a longer period being fed into the calculation) tries to balance the downsides of capturing only recent market shocks and seriously underestimating risk in a long stable period in the market, against the upside of responding more rapidly to changes in the market69.

66 Art. 129 RBD and art. 37.2 RCAD. Chapter 6.3, 18.2 and 20.6. The CEBS-EBA, Model Validation Guidelines (CP03), April 2006 provide useful hints, but are officially not applicable to the market risk internal model. 67 Annex V §8 RCAD. 68 Art. 18.5 RCAD, introduced in the Omnibus I Directive 2010/78/EU as per early 2011. See chapter 23.3. 69 Annex V §10 RCAD. BCBS, Overview of the Amendment to the Capital Accord to Incorporate Market Risks, January 1996 §11.

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The model has to assume that it the trading position will be held at least 10 days (e.g. due to delays in trading decisions and limited possibilities to unload the positions). The collected data are used to calculate an instantaneous shock equal to the price movement over 10 days over the observation period. If the financial instrument in question has different characteristics (for example options that can move on different timescales and in an escalated manner), the banks can adjust for instance existing one day VAR calculations and multiply it by a factor that achieves equivalence to the 10 day holding period. Stress testing becomes more important in that case; see below and chapter 13.6. For securitisation positions70 an additional capital charge can be calculated instead of the treatment of securitisations under position risk if a series of conditions are fulfilled, which are similar to the credit risk IRB approaches of 99,9% confidence level over a capital horizon of 1 year, under an ‘assumption of constant level of risk’. The conditions include the level of capital, weekly calculation, the coverage of multiple types of risks and regular stress testing. Stressed VAR In addition to the daily VAR calculation, every bank has to calculate a ‘stressed value at risk’ once a week71. Like the VAR calculation, it is based on a 10-day, 99 per cent, onetailed confidence interval. However, instead of being based on the last year of historic data, the calculation is performed on the basis of historical data of a continuous 12-month period of significant stress that was relevant to the specific portfolio of the bank. By way of example, if the bank invests mainly in sovereign bonds it is more likely to have to choose a period of time late in the 2007-2013 crisis, if it heavily invests in mortgage backed securitisation bonds it is more likely to have to choose an early period of that crisis. The bank has to review every year whether a more appropriate choice of the 12-month period has to be made, subject to supervisory approval. CEBS-EBA has to publish guidelines to ensure that banks and supervisors converge on the way to choose the most appropriate period. The risk of an disturbances in the level playing field would otherwise be high. Incremental Risk Charge If the model is approved for the specific risk of traded debt instruments (part of position risk), the bank also becomes obliged to calculate the incremental risk charge72. If the model

70 Annex V §5l RCAD. It refers only to the correlation trading portfolio, which may be a mistake. The main treatment of securitisation is currently set out in Annex 1 §14 and 16a RCAD, not (only) in the optional correlation trading portfolio of §14a. 71 Annex V §10a RCAD. 72 Annex V §5a RCAD. Also see BCBS, Guidelines for Computing Capital for Incremental Risk in the Trading Book, July 2009.

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is not approved for specific risk, the bank has to apply the standardised approach to specific risk (and the incremental risk charge is not applicable). The incremental risk charge is a patch on the underestimation of risk by banks that use internal models for market risk. The incremental risk charge differentiates between default risk/migration risk already captured in the model for specific risk (e.g. the impact of bad news on the issuer on the value of the instrument), and default/migration risks not yet captured in the model. For this – not yet captured risk – the bank needs to model an incremental risk charge. Migration risk relates to changes in credit ratings (either internal or external)73. It can choose to exclude all components of default risk and migration risk from its specific risk model, and include those (together with aspects not captured in the specific risk model) into its ‘incremental’ default and migration risk calculation74. The incremental risk charge calculation is not based on market risk parameters, but on IRB approach parameters. The calculation has to have the same quality as an IRB model (see chapter 8.3), and based on a 1 year horizon, 99.9% confidence level basis (instead of the market risk 10-day horizon 99% confidence level basis75). For incremental risk, on top of those requirements the model is required to fully account for nonlinear movements in the price of e.g. derivatives, and it has to be up to date and objective. A liquidity horizon can be built in (as it concerns tradable assets), but is subject to a floor of 3 months or longer if more time is likely to be needed to sell or hedge the position in a stressed market. Supervisors can allow deviations from the requirements if the calculation used results in a higher charge than required in a compliant calculation76. The charge does not cover securitisation exposures nor all ‘n-th-to default’ credit derivatives as these are also in principle excluded from specific risk. However, for so-called correlation trading portfolio a model can be developed by the bank that covers the specific risks of these instruments, along similar lines as the IRB model (99,9% confidence level and a 1

73 The BCBS frequently asked questions indicates that migration risk relates to the risk of (internal or external) credit rating migrations, and simultaneously indicates that beyond this the exact definition is left to the bank even though it must be acceptable to supervisors. See BCBS, Interpretative Issues with respect to the Revisions to the Market Risk Framework, November 2011-version, page 10-11 (chapter 2.2, question 12 and 16). See chapter 9.1 on definitions. 74 Annex V §5 last sentence RCAD. The language is ambiguous, and is interpreted above in line with the BCBS approach. The RCAD sentence could in an alternative manner be interpreted to allow all default risk/migration risk, including the ‘incremental’ part, through its specific risk model. This would, however, defeat the purpose of attacking credit risks with credit risk IRB standards. 75 The BCBS wanted to achieve consistency for the financial buffers held for similar positions in the banking book and trading book. BCBS, Guidelines for Computing Capital for Incremental Risk in the Trading Book, July 2009, page 3 (published with the Basel II ½ amendment to the Capital Accord). 76 Annex V §5a, 5c, 5d, 5f, 5g and 5j RCAD.

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year horizon)77. The bank can opt to include all listed equity positions and equity derivatives into its model for incremental risk (regardless where they are booked), but it needs to have specific supervisory approval on this aspect of the model. Calculation and Scope The VAR calculation has to done on a daily basis, the stressed VAR and the incremental risk charge each at least on a weekly basis. This deviates from – or in a more benevolent reading fills in – the requirement to ‘always’ meet the market risk capital requirements, which would include intraday calculations78. This periodicity can hide significant bumps in risk encountered by the bank. The most recent data (of the same day for VAR, and the last result for both other components) as well as recent historic data on capital requirements a daily basis to calculate the model-based capital requirement for that day on the market risk components captured by the model. The amount of capital to be held for the market risk parts that are calculated via an internal model is79: – the higher of either the VAR calculated the previous day or the average over the last 60 days, multiplied by (at least) a factor of 3; plus – the higher of the latest available stressed value at risk number, and an average of such calculations during the last 60 days, multiplied by (at least) a factor of 3; plus – a capital charge for securitisations and similar positions that are not covered by the model (approval) under a standard position risk calculation; plus – the higher of the latest available modelled securitisation position under VAR and its 12 week average measure thereof; plus – the higher of the latest available incremental default and migration risk and the 12 week average measure of such risk; plus – any other risks not captured by the model have to be covered ‘adequately’ by own funds. The result for VAR and stressed VAR is multiplied by the factor of (at least) 3 to provide a buffer compensating for the known faults of the assumptions of the model, e.g. that they do not predict what happens in times of stress. The factor is enlarged by a plus factor if 77 Annex I §14a, Annex V §5, 5b and 5l RCAD. See chapter 8.6. n-th to default derivatives have a value depending on the default of a specific number of defaults in a pool of assets (e.g. how many mortgages default). These have some similarities to positions in a securitisation pool. 78 Art. 18.1 and Annex V §5k, 10 and 10a, and 11 RCAD. 79 Annex V §8, 10-10b. Also see BCBS, Interpretative Issues with respect to the Revisions to the Market Risk Framework, November 2011-version, page 13 (chapter 2.4, question 1) on the additive character of the various components.

537

EU Banking Supervision there are many overshootings shown in backtesting (unless the supervisor waives this)80. The multiplication by 3 or more, however, also did not provide cover against the potential swings of the markets, as shown in the 2007-2013 subprime crisis in relation to the VAR calculation81. To the outcome of the internal model calculation is added the standard calculation for the risks not covered by the banks internal model. Transitions and Partial Use The bank can choose to cover all three areas where a model is allowed, or only one of them or even partially, in combination with the standardised approach. Within position risk, it can e.g. choose to apply the specific risk standardised approach, in addition to modelling general risk82, or choose to apply for approval for its model foreign exchange risk, but not on commodities risk if it has only a small position on commodities (on which it can instead apply the standardised treatment described in chapter 9.3). Unlike for credit risk and operational risk, the market risk requirements do not contain incentives to upgrade to a model based approach, nor prohibitions to go back to the lower level of calculations. It should be noted nonetheless that the stressed-VAR and the incremental default charge are part only of the model based approach, and nevertheless banks opt to (continue to) calculate market risk requirements in this manner. This suggests that models continue to very flexible due to imprecise terminology and intentional flexibility. Apparently it is worthwhile – even with the strengthening of the internal model approach by the incremental risk charge and the stressed VAR requirement – for banks to invest in the model instead of going to or remaining on the standardised approach. An alternative explanation is that supervisors do not allow such a backward slip away from the model, even though this is not harmonised at the EU level. Future Developments The market risk treatment was upgraded in Basel II ½ /CRD III. EBA did become allowed, but not obliged to draft regulatory standards to specify assessment methodologies for the market risk internal models, with the potential to upgrade and further harmonise the model validation guidelines83. Basel III did not focus on the trading book, nor on its internal model. Updates were made to related areas, such as counterparty credit risk (and 80 81 82 83

Annex V §8 RCAD. Also see chapter 6.3 on general aspects of models. Annex V §1 RCAD. Basel II ½, revisions to the Basel II Market Risk Framework, July 2009, §7. Art. 129.2 RBD and art. 18.5 RCAD, as added by art. 9.32, and 10.1 Omnibus I Directive 2010/78/EU. See CEBS-EBA, Model Validation Guidelines (CP03), April 2006.

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its model), which impact on market risk indirectly; see chapter 8.4. As a result in CRD IV – except for additional charge for derivatives counterparty credit risk – no major changes are made that directly impact on the substance of market risk capital requirements, though EBA has now become obliged to develop standards on models84. Also see chapter 6.3. The lay-out is changed materially, as the RCAD – containing the rules on market risk internal models – is integrated with the RBD. The two directives structure with its mismatch of definitions and cross-references is abolished, though the formulation of market risk requirements, its models and mitigation remain separate such formulation of conditions for credit risk and operational risk requirements. The BCBS conducted a benchmark exercise, which showed relevant variations in required capital due to different supervisory requirements and different assumptions used by the bank, on top of differences that could reasonably be explained by different business models85. This may lead to follow-up action on model requirements and supervisory approvals. The full review of market risk by the BCBS also impacts on the internal models, and deal with some of the double counting issues in the various components of the calculation of capital requirements86. The BCBS notes insufficiency of capital and disparate approaches to risks across banks and across jurisdictions, as well as disparate results of standardised and internal model based calculations that did not appear to be based on actual lesser or more riskiness of the portfolio. The BCBS wants to align the model approvals process across borders, and shifts to ‘expected shortfall’ models that – once developed – should better take into account stressed circumstances and tail end risks87. The thinking is to align the calibration better to a new standardised calculation (also based on expected shortfall thinking), as these had drifted apart in many countries. Also, a floor or surcharge based on a standardised calculation is contemplated, though it is unclear why banks would invest in an internal model for prudential purposes if the standardised calculation would be equally harsh/lenient and closely linked. The complexity of the proposals to achieve risk measurement is, however, a cause of concern, as is the amount of regulatory input contemplated88.

84 The trading book distinction and the market risk rules are contained in art. 92, 94, 102-106, 325-386 CRR. 85 BCBS, Regulatory Consistency Assessment Programme (RCAP) Analysis of Risk-Weighted Assets for Market Risk, January 2013 (rev February 2013). Also see chapter 6.2 and 6.3. 86 BCBS, Interpretative Issues with respect to the Revisions to the Market Risk Framework, November 2011version, page 13 (chapter 2.4, question 1). 87 BCBS Consultative Document, Fundamental Review of the Trading Book, May 2012. See chapter 6.2 and 6.3. 88 BCBS Consultative Document, Fundamental Review of the Trading Book, May 2012. See page 20-41, including the references to the difficulties for supervisors to assess the added complexity of the new models on page 35.

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9.5

Market Risk Protection

Introduction The market risk protection framework is rudimentary in comparison to the extensive arrangements available to mitigate credit risk. The treatment of ‘protection’ in the context of market risk falls into two categories: – protection that reduces the market risk capital requirement for position risk and counterparty credit risk through netting; – such protection through hedging. Protection to Reduce Market Risk Requirements The standard approach to position risk calculation embraces both protection bought and protection sold. The two are balanced in the trading book. Netting is applied to reduce the gross position in financial instruments for which capital needs to be held, which takes into account both positions in the main shares, debts etcetera, and the underlying position in such instruments in either derivatives to sell or to buy those instruments (with an exception for convertibles)89. The treatment of protection sold to others and of protection bought from others has been brought more in line with each other during the 2007-2013 subprime crisis, as well as across the banking and the trading book.90 The netting thus reduces the total position in line with actual exposure to the underlying position in shares or bonds. Hedging, where the underlying position is risky, and this risk is insured by a credit derivative claim on another party or with a value development that is linked, is treated differently. Trading book positions hedged by credit derivatives benefit from a reduced ‘specific risk’ capital charge91. There is a full dispensation for the specific risk charge if the two ‘legs’ (of the position and its hedge) always move in the opposite direction and ‘broadly’ to the same extent. This treatment is effectively the same as for netting. If there are discrepancies in the size of the movement (but there are key similarities on reference obligation, maturity and currency, and lack of infection) the reduction is still 80%. Partial allowance – so that only the higher of the two capital requirements apply – if there are e.g. asset mismatches, asset/maturity mismatches, but the movement is nevertheless normally in the opposite direction and some additional provisions apply. In all other cases, both the position and 89 Annex I §1-3, 4-10 RCAD. 90 Annex I RCAD, §8, as amended by level 2 Commission Directive 2009/27/EC. That Commission Directive also repaired some minor glitches in the annexes to RCAD. 91 Position risk treatment of hedging Annex I §42-46 RCAD. Annex VII part C RCAD sets out whether an internal hedge can be kept in the trading book, and can still be used for credit risk mitigation purposes of an exposure in the banking book; and under which conditions such internal hedges are not considered part of the trading book for the purpose of trading book capital requirements calculations.

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the hedge are charged with a specific risk capital charge. There are limits to the extent to which internal hedges for non-trading book positions within the group can be accepted in the trading book, and subjected to the lighter trading book requirement. If the internal hedge is supported by external protection bought and recognised as protection for a nontrading book credit risk exposure, both the hedge and the external protection do not attract a trading book capital requirement92. The reduced – netted or hedged – exposure is subjected to position risk calculations under the standard approach; see chapter 9.3. If the bank applies internal models it can propose taking account of risk reduction in any way it likes in the VAR and stressed VAR calculation, though the internal model provisions do require stress testing and backtesting. The new incremental risk charge used in the internal models approach has an additional provision on netting and hedging93. Both are allowed if it relates to the same financial instrument, and – under additional conditions on the model – hedging is allowed in different instruments issued by the same obligor and or even by long and short positions in different issuers. A hedge is only recognised to the extent that it is available also if the obligor is in trouble. Dynamic hedging strategies (not a fixed hedge, but continuously changing hedges) are allowed if the additional risks in such strategies (consistency, residual risk) are manageable and it results in improved risk management. Counterparty Credit Risk For the treatment of protection for counterparty credit risk, reference is made to chapter 8.4. A redrafted provision in the RCAD aligns the treatment of internal hedges in the form of credit derivatives for the purposes of counterparty credit risk with the treatment under the RBD calculation for credit risk94. Foreign Exchange Risk and Commodity Risk Foreign exchange risk and commodity risk are calculated across the trading and banking book, on a net basis (for commodity risk if the supervisor agrees with the way the netting is performed). Netting is thus fully integrated as protection into the calculation of these types of market risk requirements. Hedges of a structural, non-trading nature against the adverse effect of exchange rate movements to the capital ratio can be excluded from the

92 Annex VII part C §1-3 RCAD. See chapter 8.5. 93 Annex V §5e RCAD. This treatment is less strict than the one proposed by the Basel Committee. See BCBS, Guidelines for Computing Capital for Incremental Risk in the Trading Book, July 2009, page 5-6 (published with the Basel II ½ amendment to the capital accord). 94 Annex II §11 RCAD, as amended by level 2 Commission Directive 2009/27/EC.

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calculation, if the supervisor agrees. The same applies if the risk has already been deducted from own funds (also if the supervisor agrees)95.

95 Annex III, §1 and 2.1, Annex IV §14-17 RCAD. Also see chapter 6.2, 6.4, and 9.3.

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10.1 Introduction Operational Risk The profitability and continuity of the bank can be threatened by operational risk too. Such risk is not inherent in the credit risk or market risk of the asset (dependent on for example the quality of the counterpart or on fluctuations in the market prices). The supervisory requirements on operational risk try to measure the risk of loss that follows from non-financial markets events. Operational risk follows from external events (earthquakes, nationalisation, political unrest, hackers or other attacks) or from the inadequate or failed internal processes, people and systems at the bank itself (fraud, badly drafted contracts, liability for duty of care mismanagement, or other risk management failures)1. Prior to Basel II amendment, this was not covered by a quantitative requirement to hold financial buffers. The BCBS developed the approach in consultation with the banking sector. The Basel II amendment was nonetheless criticised for failing to include normal business risk, such as derived from new regulatory requirements, and for excluding the follow-up costs of operational events (e.g. loss of reputation or loss of opportunity), simultaneous as for introducing a quantitative capital charge for something which is primarily a management and risk mitigation issue2. Operational risk financial buffers complement pre-existing requirements on internal governance, see chapter 13.The CRD copied the operational risk treatment from the Basel II amendment. Both the BCBS and CEBS/EBA continued to work in parallel to provide content and detail to the main outline provided in Basel II and the CRD pending their implementation in 2006-2008. Damages resulting from materialised operational risk are often inconsequential when compared to the overall balance sheet of the bank (e.g. the fraud in one or a few bank accounts at a branch of a multinational bank). However, a string of incidents can reduce the viability and reputation of the bank, and large – once in a lifetime – incidents have

1

2

Art. 4.22 RBD. In addition to the RBD definition, all banks have to articulate what they mean by operational risk in the policies an processes they need to set up to evaluate and manage the exposure to operational risk, see Annex V §12 RBD. A. P. Kuritzkes & H.S. Scott, ‘Sizing Operational Risk and the Effect of Insurance: Implications for the Basel II Capital Accord’, in H. Scott (Ed.), Capital Adequacy Beyond Basel, New York, 2005, chapter 7.

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been known to cause the failure of banks (e.g. the fraud and failure of internal controls in the Singapore office of Barings). Whether certain subsets of operational risks are excluded from the quantification process is relevant for the management of operational risk, and for the measurement within an internal model (see chapter 6.3 and 10.4). The concept is not clearly delineated, except in the non-binding texts of the BCBS and CEBS/EBA. EBA does not have the authority to set a definition3, but its non-binding delineation is important guidance on how supervisors (and thus banks) will look at the obligatory management systems and the advanced measurement models. Operational risk can be divided in several root causes of losses resulting from it. The most advanced quantification formula requires such subdivision; while for the simple formulas the subdivision is not mandatory4. The potential subdivisions are: – internal fraud (with losses resulting from internal parties – sometimes together with third parties – intentionally defrauding, stealing or circumventing internal or external laws and regulations5); – external fraud (with losses from third parties intentionally defrauding, stealing or circumventing the law); – inconsistency with employment practices and workplace safety (with losses resulting from e.g. payment for non-compliance with the relevant laws or for personal injury claims or for diversity/discrimination events); – clients, products and business practices (with losses arising from an unintentional or negligent failure to meet professional obligations to clients or from the nature or design of a product6); – damage to physical assets (losses from damage to e.g. buildings as a result natural disasters, terrorism, fire); – business disruption and system failures; – execution, delivery and process management (losses from e.g. failure to follow-up on sales agreements with the actual payment and delivery of the assets sold or bought).

3

4 5

6

The Commission could add a binding definition via a technical change to the directive, or add a non-binding interpretation in e.g. a recommendation. It has not done so. The final say on interpretation remains in the remit of the Court of Justice. See Annex X, part 5 RBD. This part 5 is only applicable to the advanced measurement approach, but it captures the whole range of events that cause operational risk. Both the collapse of Barings and the large losses of Société Générale in 2008 are examples where initially internal and external processes were circumvented, resulting in (increased) losses. This in combination with the system failures of internal controls, lead to the losses going to a higher level than otherwise necessary. Examples include non-compliance with the Mifid’s duty of care obligations, see chapter 16.2, or advertising on benefits or protection ingrained in a product which subsequently is not delivered upon.

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According to CEBS/EBA, strategic risk and reputational risk are excluded from the scope of operational risk in the CRD (in line with the BCBS accord). Being stupid is thus not part of operational risk (e.g. when overpaying for a takeover at the top of the market without arranging for long term funding, or when intentionally exploiting clients), unless the bank simultaneously also breaches regulations, internal rules or ethical conduct. Flawed implementation of a strategy is included, but implementation of a flawed strategy is not. Stupidity, with the rest of strategic risk and reputational risk, is instead covered in pillar 2, organisational requirements and in the assessment of management on an ongoing basis (see chapter 5, 13 and 14). Relation to Credit Risk, Market Risk, and Pillar 2 The treatment of operational risk is a totally different bird than the treatment of credit risk and market risk. It is not specifically linked to the individual exposures of the bank. Though credit risks and market risks embodied in the exposures of the bank thus are not the target the focus of operational risk, there is some overlap. Operational risk includes the failure by the bank to accurately assess the credit risk of a counterparty either as a result of mistakes, through internal fraud or through fraud by the counterparty, and it includes failures in selecting the right model or failure to implement it correctly. For the overlap there is a conflict rule, determining which treatment prevails (to prevent double capital requirements), at least when using the relatively most sophisticated calculation methods. The boundaries are, however, not very clear. For the issues that might be covered both under credit risk and operational risk, and the boundary is unclear, the CRD indicates that in that case it is taken care of within the credit risk scope. For the market risk demarcation it instead is taken into account in the operational risk scope. This apparently raised questions, as CEBS/EBA issued guidance on the scope of operational risk in relation to market risk7. The guidelines give examples to determine what is still market risk, and which overlapping aspects are taken care of in the operational risk framework. These statements are relevant to the advanced measurement approach most directly; the two simpler approaches are based on total net income, not exposure values so that the overlap in especially the calculation methods is less obvious. In addition to helping demarcate between operational risk and market risk, the intention of CEBS/EBA is to demarcate operational risk also from other risks, for which a quantitative measurement system to calculate capital requirements is not available.

7

Annex X part 3 §14 RBD. CEBS, Compendium of Supplementary Guidelines on Implementation Issues of Operational Risk, September 2009/July 2010. See e.g. S. Manning & A. Gurney, ‘Operational Risk Within an Insurance Market’, Journal of Financial Regulation and Compliance, Vol. 13, No. 4, 2005, p 293-300.

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There is an overlap between operational risk and the pillar 2 requirements described in chapter 14, especially where pillar 2 assesses risk measures taken under internal governance requirements described in chapter 13. Under pillar 2, all risks not fully covered by pillar 1, of which operational risk is part, should be covered by additional measures taken by the bank. If the bank does not do so voluntarily, the supervisor can add such measures. According to CEBS-EBA, this also includes measures to cover ‘extreme events’ that are not adequately covered by the operational risk financial buffers8. Purpose and Measurement Methodologies The capital requirements for operational risk try to provide buffers against both extreme events and small events. Part of the usefulness of capital requirements for operational risk is that it keeps the potential of small and of severe events front and centre in the eyes of the institution, so that they not only have the theoretical knowledge that it is important, but that it ‘hurts’ on a daily basis in the form of financial buffer requirements. This can be alleviated by opting for taking control of the issue themselves, by upgrading to a more advanced organisational set-up and calculations. Taking control of the issue is arguably more important than the rough and ready methods available to calculate the actual capital requirement at this stage of play9. The three possible approaches to operational risk are, in rising order of complexity: – the basic indicator approach (BIA), see chapter 10.2; – the standardised approach (SA10), with an alternative standardised approach (ASA), see chapter 10.3; and – the advanced measurement approach (AMA), see chapter 10.4. The latter approach is the only one in which risk mitigation techniques such as insurance are taken into account to limit the quantitative requirement; see chapter 10.5.The transitions and partial use of the various approaches are described in chapter 10.4. The lowest, least technical, rough and ready approach is the basic indicator approach. This is basically a piece of fluff11. It does not actually address operational risk at all, and its only raison d’être is to give an incentive to any bank who can afford to upgrade to the next level of sophistication as for wealthy and profitable banks it – instead of fluffy – becomes needlessly expensive. If a bank has negative income, there is no requirement at all under 8 9

CEBS-EBA, Position Paper on a Countercyclical Capital Buffer, 17 July 2009, www.c-ebs.org, page 3. A.A. Jobst, ‘The Treatment of Operational Risk under the New Basel Framework: Critical Issues’, Journal of Banking Regulation, Vol. 8, No. 4, 2007, p 341-343. See chapter 13.3. 10 Sometimes also abbreviated as TSA (where the T sometimes is referred to as ‘the’ or as ‘traditional’ standardised approach). 11 A.A. Jobst, Operational Risk – the Sting is Still In the Tail But the Poison Depends on the Dose, IMF WP/07/239, November 2007, page 10.

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this approach, but if it has positive income, a standard percentage of income has to be kept as capital that may be too high for the majority of small, simple and profitable banks. A bank that is consistently loss-making is therefore not required to hold capital nor to invest, which might have increased its cost base enough to help it on its route to bankruptcy. This is a shame as exactly at loss-making banks there is a high incentive to cut corners and to enter into deals that are not appropriate to the long term interests of the bank nor of its clients. Banks with a higher complexity than small scale lending and deposit taking should never be allowed to be in the fluffy basic indicator approach, as it does not capture their potential losses from managing a complex organisation involved in a by definition high risk industry such as banking. There is currently, however, no clear incentive to upgrade if the bank is in a loss-making scenario (perhaps due to the bank experiencing losses caused by high risk behaviour or failure to properly manage that behaviour). If a bank is profitable, and thus can afford to invest in systems to monitor and affect its operational risk profile, they should and are expected to upgrade. The standardised approach is not much better than the basic indicator approach. It remains volume-based, which is not aligned with the actual operational risk a specific bank faces, nor does it take into account how active the bank is in mitigating these risks. Compared to the basic indicator approach it nonetheless benefits from some further detail and risk awareness12. Relatively most complex is the advanced measurement approach, which relies in some respects on own internally developed models by the bank; see chapter 6.3. Like the models/calculations of the basic indicator approach and the standardised approach, they are rudimentary compared with the internal models used for market risk and credit risk. This can be explained by the circumstance that the operational risk provisions/calculations are very new indeed, and invented in the context of the Basel II process. There is little or no experience with the requirements, neither at the banks nor at the supervisory authorities. Good quality internal models and data on events and potential losses are still being developed and gathered13. While for general credit card fraud predictions can be made, such may be more difficult for a large scale hack and theft of the data in the credit card system of the bank.

12 See the descriptions in chapter 10.2 and 10.3, as well as the introductory remarks in chapter 10.5. Also see A.A. Jobst, ‘The Treatment of Operational Risk under the New Basel Framework: Critical Issues’, Journal of Banking Regulation, Vol. 8, No. 4, 2007, page 338-341. 13 See e.g. G.J. van den Brink, Operational Risk: The New Challenge for Banks, Palgrave Macmillan, 2001, page 69.

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The provisions relating to the advanced measurement approach are short and high level, and contain an endless barrage of abundantly vague terminology that the model needs to be ‘eligible’, ‘qualify’, ‘reviewed’ and ‘be satisfactory’, and that the supervisors need to ‘verify’, ‘validate’, and ‘be satisfied’14. Unlike the CRD-rules on operational risk itself, the models developed under those rules are also required to be clear. Such terminology is an indicator of a lack of experience when the provisions were drafted, combined with the assumption that the internal and external auditors and supervisors will be able to know that the model is good when they see it. Compared to the credit risk approaches, the advantage is that the regulation is perhaps not well drafted, but at least principle-based, flexible and high level, and leaves the responsibility for having and/or building the technical expertise where it belongs: not with legislators but with the banks that use it and the supervisors who supervise them. Awareness of operational risk and allocation of some capital to it appear to be the main reason for its introduction in such an underdeveloped state15. Such risk awareness backed up by a quantitative incentive is helpful in view of the considerable hesitation as to whether operational risk should be ‘measured’ or mainly ‘managed’, even when there is sensitivity to the fact that capital may need to be allocated to it16. Future Developments The operational risk regime has been copied in outline unchanged, with some clarifications, into the CRR17. Literature See the literature on operational risk modelling mentioned in chapter 6.3, and: – Brink, Gerrit Jan van den, Operational Risk, The New Challenge for Banks, Palgrave Macmillan, 2001. – Jobst, Andreas A., ‘The Treatment of Operational Risk under the new Basel Framework: Critical Issues’, Journal of Banking Regulation, Vol. 8, No. 4, 2007, page 316-352. – Goodhart, Charles, Operational Risk, LSE Financial Markets Group Special Paper 131, September 2001. – Power, Michael, Organized Uncertainty: Designing a World of Risk Management, Oxford University Press, Oxford, 2007, chapter 4 14 See Annex X part 3 §1 to 7 RBD, and chapter 6.3 and 10.4. 15 C. Goodhart, Operational Risk, LSE Financial Markets Group Special Paper 131, September 2001. 16 See e.g. S. Manning & A. Gurney, ‘Operational Risk Within an Insurance Market’, Journal of Financial Regulation and Compliance, Vol. 13, No. 4, 2005, page 293-300; and J. Daníelsson, & W. Perraudin, Examination of Witnesses (questions 105-119) on Banking Supervision and Regulation Before the UK House of Lords Economic Affairs Committee, 27 January 2009, www.publications.parliament.uk. 17 Art. 312-324 CRR.

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Guidelines – CEBS-EBA, Model Validation Guidelines, April 2006 – CEBS-EBA, Compendium of Supplementary Guidelines on Implementation Issues of Operational Risk, September 2009/July 2010 – BCBS, Operational Risk – Supervisory Guidelines for the Advanced Measurement Approaches; June 2011 – BCBS, Principles for the Sound Management of Operational Risk, July 2011 (replacing BCBS, Sound Practices for the Management and Supervision of Operational Risk, 2003)

10.2 Basic Indicator Approach The simplest of the three approaches – the basic indicator approach – requires a capital requirement for operational risk of 15% of a ‘relevant indicator’18. The indicator is the average net income over the last three years. Set in the terms of the ABD19, net income is the result of the following elements, using ‘its’ positive or negative sign (so adding and subtracting as appropriate): – Interest receivable – Interest payable – Income from shares and other variable/fixed-yield securities – Commissions/fees receivable – Commission/fees payable – Net profit (+) or net loss (-) on financial operations – Other operating income This covers all net interest income and net non-interest income of a bank. Other factors which lead to profit and losses of a bank are however not taken into account, including e.g. the payment systems20. Net income has to be calculated on the last three fully ended financial years. The average is taken, to even out spikes or troughs. However, loss making years are not taken into account. The positive net incomes are added up, and divided by the number of years in which there was a positive income. If there is a long losing streak by the institution, it will have to hold no capital at all for capital requirements. If only one or two years out of the 18 Art. 103 and part 1 of Annex X RBD. 19 If a bank does not report under the ABD, the equivalents can be chosen of the above categories under the IFRS Regulation or third country accounting standards to which its reporting is subject instead. The audited figures have to be used, unless they are not yet available. In that case, business estimates may be used. Annex X part 1 §3, 5 and 9 RBD. 20 G.J. van den Brink, Operational Risk: The New Challenge for Banks, Palgrave Macmillan, 2001,page 73-75.

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last three were loss-making, the remaining years determine the operational risk basic indicator. As 15% can in that case be substantial, for profitable banks this leads to an incentive to upgrade to one of the sturdier approaches.

BIA capital requirement =

net income last 3 financial years x 15% 3

Reference is made to the introductory chapter 10.1 for an opinion on the strength and relevance of this calculation. The basic indicator approach is a piece of fluff amongst others because it is not risk sensitive in any way. The deduction of any provisions and operating expenses is not allowed, nor is income derived from insurance or extraordinary or irregular items included (such as the sale of a large part of the business). Future Developments The approach is not changed in the CRD IV project21. However, EBA is obliged to develop regulatory standards on how to apply IFRS on the calculation of the relevant indicator (for banks that do not operate under the ABD on a consolidated basis and possibly not on a solo basis; see chapter 6.4 and 17 on the different accounting standards) and on consolidated supervision, and submit them to the Commission by end 201722.

10.3 Standardised Approach and Alternative Standardised Approach Introduction The standardised approach is slightly more sophisticated than the basic indicator approach, but still very rudimentary. It divides the activities of the bank into business lines, looks at data from the last three years, and applies a simple calculation to the data. The outcome is the capital requirement for operational risk. Though there is no approval process on the way banks apply the standardised approach – such as applies to the use of internally developed models – banks on the standardised approaches will need to fulfil certain additional internal governance requirements to be able to operate under these approaches23. These are not necessary for the basic indicator approach banks. Still, the requirements are much less complex than the internal governance requirements that are put on AMA banks (see chapter 13.3 and 13.5). The additional governance includes: 21 Art. 315-316 CRR. 22 Art. 316.3 CRR. 23 Additional to the governance requirements valid for all banks; see chapter 13.3.

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– banks on the standardised approaches will need to ensure that their assessment on operational risk also feeds back into the risk management process, and that the assessments are used to monitor and control the (operational) risk profile of the bank24; – an operational risk assessment and management system, identifying exposures and collecting risk, subject to independent review; – a reporting system that feeds operational risk reports to all relevant management functions. There are two variations of the standardised approach. There is a basic formula regarding the calculation of operational risk on eight business lines. An alternative standardised approach can be applied to two of those eight business lines (retail banking and commercial banking) if the standardised approach-bank is focused to the tune of more than 90% of its income on those business lines. The alternative approach requires a separate authorisation of the supervisor. The bank will need to demonstrate the relative size of those business lines in the income of the bank, that it actually fulfils the above-mentioned governance requirements, and that a ‘significant proportion’ are loans that are associated with a high probability of default (such as credit cards), and that the alternative calculation is better suited to the calculation of the operational risk. Calculation Standardised Approach Like in the basic indicator approach, the calculation of capital requirements is related to the average over three years of the risk weighted relevant indicators25. Unlike in the basic indicator approach, a lossmaking year is still taking into account in the calculation, at a zero value. The risk weight percentage to calculate the capital requirements is differentiated over eight categories (business lines), with a requirement of 18% for the high risk elements, 15% for the medium risk elements and 12% for the low risk elements. Business line High risk 18%

Examples

i. Corporate finance – Investment advice ii. Trading and sales – Operation of multilateral trading facilities iii. Payment and settlement – Underwriting and/or placing financial instruments on a firm commitment basis – Advice on capital strategy – Advice and services on mergers and takeovers – Investment research – Dealing on own account – Money broking – Money transmission services

24 Annex X part 2 §12 RBD, a precursor to the use-test in the AMA approach; see chapter 10.4. 25 Like in the BIA, also here the basis for the calculation are the last three completed financial years. When audited figures are not available, business estimates may be used. Annex X part 2 §2 RBD.

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Business line

Examples

– Issuing and administering means of payment To or on behalf of non-retail clients: – execution, reception and transmission of orders – placing of financial instruments without a firm commitment Medium risk 15%

iv. Commercial banking v. Agency services

1 To or on behalf of non-retail clients: – acceptance of deposits – lending – financial leasing – guarantees 2 Safekeeping financial instruments for the accounts of clients, including custodianship and related services.

Low risk 12%

vi Retail26 brokerage vii Retail banking viii Asset management

1 To or on behalf of retail clients: – execution, reception and transmission of orders – placing of financial instruments without a firm commitment – acceptance of deposits – lending – financial leasing – guarantees 2 Portfolio management 3 Management of UCITS

These examples mentioned in the third column are given in the directive, in addition to some criteria on how to map the actual activities of a bank into these eight business lines. Within this basic outline, the institution using the standardised approach needs to set up its own consistent process on how it allocates each activity to the most appropriate business line, subject to independent review. The mapping used for this allocation has to be consistent with the categories used for credit and market risk27. The operational risk capital requirement is the average of risk weighted relevant indicators per year over the last three years. Implementation of this approach is thus relatively low cost for a bank moving from the basic indicator approach. It is first calculated per business line, per year. The risk weight for the business line is applied to the relevant indicator (see below) for that business line, ranging from 12 to 18%. The outcome per business line can be a negative value. The negative capital requirements are deducted from the positive capital requirements for other business lines to obtain the capital requirements for operational risk for each year. If the overall outcome of the sum of risk weighted relevant indicators of the business lines for the year is negative, however, this negative value is not taken

26 See chapter 4.4 and 16.2 on the definition of retail clients. 27 See chapter 8.2-8.3, and 9.3-9.4 on the related categories. The bank is prohibited from cherry picking the most favourable allocation of activities depending on the quantitative capital requirements for each risk category.

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into account for calculating the average over three years. Instead, that year is given a zero value. The positive risk weighted relevant indicators for the last three financial years are added up (with a zero requirement being ‘added’ for the negative years, and divided by three to obtain the average over the last three years. This is the sum taken into account as the capital requirements for operational risk in the solvency ratio28. For retail banking and commercial banking an ‘alternative’ indicator approach can be used by banks that have received permission to use the alternative standardised approach. For the two business lines it is the normalised income indicator equal to the total nominal amount of loans and advances multiplied by 0.035. The alternative approach can be seen as an intermediate step towards the more advanced approach in the sense that there are additional organisational requirements and the permission of the supervisor needs to be obtained. If 90% of the business of a bank is in the retail banking and/or commercial banking business lines, the bank can choose to apply for authorisation to use an alternative indicator within the standardised approach. If the bank is allowed to use it, the indicator is based primarily on lending volume instead of gross income/relevant indicator29. However, there is no real choice as to the percentage taken, nor is any additional model used in the calculation. It is used for the two most traditional banking business lines to be able to benefit from a reduction in requirements if the bank is largely focused on these most traditional activities and additional measures are taken to control operational risk. The requirement that a significant portion of these business lines has a high probability of default, also means that there are already high credit risk capital requirements applicable, while high risk normally also translates in high interest income. This income feeds into the operational risk requirement, and would otherwise result in higher requirements in both quantitative requirements areas.

28 Art. 75 RBD (see chapter 6.2). 29 Art. 104 RBD refers to the relevant indicator, Annex X part 2 §1 RBD refers to gross income (since the amendment by level 2 Commission Directive 2009/87/EC), art. 318 CRR to the relevant indicator; all of which is the same concept as the income/outgoing payments calculation used under the relevant indicator defined for the basic indicator approach, but now calculated per business line (and then added and deducted); see chapter 10.2 and art. 316 CRR/Annex X part 1 RBD.

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Table 10.2 Comparison BIA and the two standardised approaches Approach

Risk weight Relevant Risk weighted Correction for Capital requirement per busiindicator annual rele- annual neganess line per year: vant indicator tive value annual income for last 3 financial years

Basic indicator approach

15%

The positive net interest income + non-interest income

Outcome of risk weight times the relevant indicator

If one or more of the last 3 years, has a negative risk weighted relevant indicator, that year is not taken into account at all in the calculation of the (average) capital requirement

Risk weighted relevant indicator of the last 3 years for those years where there was a positive value 3 (or divided by the number of positive years in the last 3 years)

Standardised approach ‘normal’ relevant indicator

18% 15% 12% depending on the allocation of the income to a high, medium or low risk business line

The net interest income + non-interest income per business line (both positive and negative values per business line)

Outcome of risk weight times the relevant indicator per business lineAdd or deduct the risk weighted relevant indicator per business line to obtain the risk weighted relevant indicator for the year

If in one of the Risk weighted relerelevant years, vant indicator of the the sum of the last 3 year capital requirements over all 3 business lines result in a negative value for that year, that year will be taken account with a risk weighted relevant indicator of zero

Standardised approach ‘alternative’ indicator for retail banking and commercial banking

18%, 15%, or 12% depending on high, medium or low risk business lines For retail banking and commercial banking: multiplied by 0,035

Same as above for 6 out of 8 business lines, but: For the retail and commercial banking business lines: Total nominal amount of loans and advances

Outcome of risk weight times the relevant indicator per business line Add or deduct the capital requirements per business line to obtain the full capital requirement

If in one of the Risk weighted relerelevant years, vant indicator of the the sum of the last 3 years capital requirements over all 3 business lines result in a negative value for that year, that year will be taken account with a risk weighted relevant indicator of zero

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The CRD IV project has copied the standardised approach and its alternative largely unchanged, but in a new order integrating the RBD articles with the annex previously containing the detail30. EBA is required to send a draft for regulatory standards on business line mapping to the Commission by end 201731.

10.4 Advanced Measurement Approach (AMA) Introduction For larger and more complex banks, it is beneficial to invest in the more advanced models to measure operational risk and in additional organisational controls. These relatively more sophisticated models – even though as indicated in chapter 6.3 they are still in their infancy – are referred to as the advanced measurement approach or ‘AMA’. A bank needs to apply to be allowed to use the advanced measurement approach models instead of the standardised approach under the model approval procedure. A bank can apply for approval on a solo basis, but generally the advanced measurement approach is most helpful (on a cost/benefit basis) if it can be applied to all entities within a group, on a consolidated basis. For the application process if more supervisors are involved, see chapter 21.7. If the application is meant for the whole group, it will also need to specify how operational risk capital will be allocated between the different entities of the group, in order to fulfil their solo and sub-consolidated capital requirements for operational risk. In the approval there will be a separate sub-approval for the overall model, and a separate sub-approval for the allocation of the actual capital, with an active role of host supervisors also in the latter decision; see chapter 17.2 and 21.7. Model Requirements The application needs to show that the bank fulfils both qualitative and quantitative criteria. The qualitative criteria refer to the set-up of a risk measurement and management system that are part of internal governance, but come on top of such requirements for banks that use simpler approaches to operational risk (see chapter 13.3). The quantitative criteria refer to the data content and process of the measurements and the risk assessment methodology. Together these are the composites of the advanced measurement approach32. The outcome of the (approved) models determines the capital requirements for operational risk. No set formula is available, allowing banks freedom to set it up in line with their particular business. The downside of the lack of a set formula is that the bank has barely 30 Art. 312, 317-320 CRR. 31 Art. 318.3 CRR. 32 Art. 105 and Annex X part 3 and 5 RBD.

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any guidance on the direction the model should go, at least such guidance cannot be derived from the CRD provisions. The CRD only states the kind of factors that need to be taken into account. There is no real legal benchmark. To fill in this gap, a substantial amount of BCBS and CEBS-EBA guidance and papers have focused on the implementation of advanced measurement approach requirements, see below. This has been a running show, to keep up with the learning curve at both the banks and the supervisors33. Fulfilling the qualitative and quantitative criteria for the model and its application requires a substantial investment; see chapter 6.3. The qualitative requirements focus on the organisation, and include the type of buy-in needed by management (always difficult to assess), and some verifiable features such as the establishment of an independent operational risk management function; see chapter 13.5. If the advanced measurement approach is applied by the whole banking group, with allocation of capital to the component entities of the group, implementing the model and its support systems within each entity could even be unduly burdensome. If the supervisors agree, the bank can be allowed to meet the additional organisational requirements by the parent and subsidiaries considered together; see chapter 17.2 and 21.7. The quantitative criteria focus on: – the process (operational risk measurement system); – the internal and external data used; – scenario analysis; – the business environment and internal control factors; and – the impact of insurance and other risk transfer mechanisms (see chapter 10.5). Both the process and the data need to be comprehensive. The process needs to capture the major drivers of operational risk, and the data need to capture all material activities and exposures from all appropriate parts of the bank. A bank needs to show that any excluded activities or exposures will not have a material impact (neither singly nor taken together) on the overall risk estimates. The operational risk AMA models have to cover both expected losses and unexpected losses. Expected operational risk losses remain part of the operational risk quantification, unless deductions from capital, established provisions or substitutes with a high certainty over the one year time horizon are available under accountancy standards, and the bank can show that the expected losses are highly predictable and stable over time34. 33 See CEBS-EBA, Model Validation Guidelines of April 2006, as well as CEBS, Compendium of Supplementary Guidelines on Implementation Issues of Operational Risk, September 2009/July 2010, as well as other guidance mentioned at the end of chapter 10.1. 34 Annex X part 3 §8 RBD. BCBS, The treatment of expected losses by banks using the AMA under the Basel II Framework, Basel Committee newsletter 7 (2005).

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Unexpected losses are always part of the operational risk model/calculation. The operational risk measurement system (the process) needs to predict on the basis of five years’ worth of historical data the statistical likelihood of such unexpected losses materializing, taking into account all relevant factors and scenario analysis, as well as the capital necessary to provide sufficient buffers to allow the bank to survive such a loss event. The statistical likelihood needs to be calculated to a very high confidence level percentage (99.9%) but over a limited time (1 year time horizon). The high confidence percentage means that even rather unlikely events are taken into account. Such may correlate to a large extent with simultaneous other factors and can lead to potentially existence threatening loss events. However, the 0.1% lack of confidence, the absence of historical (internal and external) reliable and applicable data and the short term focus of the model (as well as the inconvenient truism that the results of the past are not a guarantee for the future) mean that the statistical confidence does not actually translate into an actual lack of risk, or certainty that the capital requirements calculated will actually be sufficient. If certainty were however needed, neither businesses nor governments would be able to function (a bank cannot continuously be buffered so that it can shrug off the loss of its headquarters and key staff, or of fraud by key trading personnel). Correlations between operational risk categories can only be used in the operational risk measurement system by the bank if their use is validated by the supervisor. This assumes that correlations are built into the models only to alleviate the risk in one sector if the risk in another sector is dealt with. The stress tests will need to show that the correlation is not actually negative. The historical data which the measurement systems use to make its predictions need to be differentiated. The CRD requires that they are allocated both to the eight business lines as set out in the standardised approach (the difference being that there is no set risk weight per business line) and across the loss event types such as fraud or employment practices35. The data shall include gross loss amounts, the date of the event, any recoveries of gross loss amounts, and descriptive information about the drivers or causes of the loss event. These need to be built per business line per loss event type, but the process also needs to allocate such data to activities that span across more than one business line, and related events over time. Apart from the five year historical internal data (even assuming that it is detailed enough), external data also needs to be used. Especially banks that are active in trading will need to take account of their exposure to infrequent, yet potentially severe, losses. They may not yet have happened within the bank itself, but historical data of similar 35 Annex X part 5 RBD. Also see chapter 10.1.

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events happening at other banks are available which will need to be built into the measurement system. Those external data will also need to be put through a scenario analysis to assess what might happen if such an event would happen at the bank itself, though this is likely to be a difficult process, the outcome of which may not be reliable for the bank36. The risk assessment methodology must take into account all business environment and internal control factors that can change its operational risk profile. This is a two way street. Internal controls can improve the operational risk profile (and thus reduce the need for high financial buffers) but it can also negatively impact the operational risk profile when the activities of a bank grow in size or in complexity. Part of the internal controls will be that the process to establish the operational risk requirements will need to be validated and re-assessed through comparison of the statistically expected loss experience with the actual internal loss experience and relevant external data. The timing of the 2007-2013 subprime crisis prevented such a reality check on the first approved models that were only just being implemented when the crisis hit. The crisis itself will now serve as a reality check for the re-assessments. Only under the advanced measurement approach there are references made to the potential double counting of operational risk components with similar provisions in the credit risk and market risk capital requirements37. This regards both process provisions and internal data provisions. If a bank can show that expected losses are already sufficiently taken into account elsewhere (e.g. deduction from own funds or being taken into account in the credit risk requirements), it does not need to take those expected losses into account in the calculation of the AMA capital requirements. On the other hand, if an insurance contract or other risk reduction mechanism has already been used to mitigate the risk and thus the capital requirements for credit risk, it can no longer be used to mitigate the risk and thus the capital requirements for operational risk. If data can be put both in the credit risk and in operational risk categories (see chapter 8.5 and 10.5), such data will not be subject to an operational risk charge (though they have to be subject to the credit risk charge and they do need to be recorded for operational risk overview purposes). If data belong both in the operational risk and market risk categories, they will be used in the operational risk charge.

36 A.A. Jobst, ‘It’s all in the data – consistent operational risk measurement and regulation’, Journal of Financial Regulation and Compliance, Vol. 15, No. 4, 2007, page 423-449. 37 See e.g. Annex X, part 3 §8, 12 and 14 RBD. The basic indicator approach and the standardised approach are more rough and ready, and the finetuning possible and necessary under the advanced measurement approach is assumed to be captured already under the percentiles set as a capital requirement.

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The operational risk management system has to be integrated into the risk management process of the bank. The RBD text is less clear on this point than in the IRB approval process; see chapter 8.3. In the IRB, the bank is obliged to show that the IRB estimates have been used by the bank for years and will continue to be used for internal capital purposes. The CEBS/EBA guidelines on operational risk expand on this integration as a basic form of a ‘use-test’ too38, where the measurement of operational risk feeds into the day to day risk-management and control functions, as well as into decisions on remedial action. CEBS-EBA indicates that this is a problem, especially as long as operational risk models are still in their early stages of development, and not yet sensitive nor perfectly aligned to the risk profile of the bank. Transitions and Partial Use As indicated in chapter 10.1, the approaches contain incentives to move towards more sophisticated methodologies for capturing operational risk. A bank can choose the approach it desires. However, in principle, the only way is up. Once a higher approach has been adopted and approved by supervisors, the bank cannot opt to go for a simpler approach again. This to prevent arbitrage, where for lossmaking parts of the bank the approach is chosen that requires little or no capital. In the spirit of compromise, the supervisory authorities have, however, been given the right (but not the obligation) to grant permission to slip down the ladder to a bank that shows ‘demonstrated good cause’39. Such ambivalent wording would allow some supervisors to judge the statement of a bank ‘I am loss making, politically connected and don’t want to hold capital no more’ a good cause, while others could institute harsh tests or would never grant this permission. The availability of data is a large stumbling block for banks wanting to move to AMA for the calculation of their operational risk capital requirements. The five year minimum requirement on data for the generation of internal operation risk measures is difficult and leads to a very long introductory process. For this purpose, for banks that start to use the AMA, the five year minimum requirement is reduced to three years of historical observations40. This will only apply of course for the first two years, after which a full set of five year data will be available.

38 Annex X part 3 §2 RBD, CEBS-EBA, Compendium of Supplementary Guidelines on Implementation Issues of Operational Risk, September 2009/July 2010. 39 Art. 102.2 and 102.3 RBD. 40 Annex X part 3 §13 RBD.

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EU Banking Supervision A combination of approaches (partial use) is possible under certain conditions41. This flexibility facilitates the transfer to more sophisticated approaches. A big bang transfer can be operationally difficult, and actually increase risk for institutions with a complex, large and cross-border set-up. Approvals may need to be obtained from supervisors around the globe if the bank has relevant activities in many countries, necessitating a gradual roll-out. It also allows banking groups that apply the approach on a consolidated manner to absorb other banks they are merging with or taking over which are on a different approach at the time of the absorption. The conditions for using the advanced measurement approach in combination with the other approaches, relate to the full capture of all operational risks to which the institution is subject. Within the area covered by either the advanced measurement approach or the standardised approach, all conditions need to be fulfilled for the applicable approach. The competent authority needs to be satisfied with the methodology used by the bank. Supervisors are also allowed on a case-by-case basis to require that ‘a significant part’ of the activities are captured by the advanced measurement approach, or that the bank commits to roll out this approach across ‘a material part of its operations’ within a time line agreed with the supervisor. Strangely, the wording of the directive makes it easier to combine the advanced measurement approach with either the standardised approach or de basic indicator approach (on an equal footing), while a combination of the standardised approach with the basic indicator approach is only allowed in the exceptional circumstance of a takeover with the commitment to go to the standardised approach in full within a short time frame. No doubt the intention is for the basic indicator approach only to be allowed in combination with the advanced measurement approach for the same limited purpose, but that has not been explicitly stated in the CRD. A similar outcome can be achieved by the supervisors by setting conditions on a takeover of a bank which is on the basic indicator approach by an bank using a self-developed model (see chapter 5.4, 17 and 20), or when re-assessing the conditions for using the internal model under the advanced measurement approach. Future Developments The advanced measurement approach has been copied largely unchanged into the CRD IV project; with improvements and clarifications, such as on the integration of the system into its risk management processes and including some minor but improved criteria on reverting to a simpler approach42.

41 Art. 102.4 and Annex X part 4 RBD. 42 Art. 312-314 CRR on the transitions and partial use, and art. 321-324 CRR on the model-requirements and calculations. See art. 313.3 and 321 sub a CRR for the examples mentioned.

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Under the Omnibus I directive amendments, EBA was allowed, but not obliged to draft regulatory standards to specify assessment methodologies for the AMA internal models, with the potential to upgrade and further harmonise the model validation guidelines43. This has now been upgraded in the CRD IV project into an obligation to deliver such draft regulatory standards to the Commission by end 201444. Also see chapter 6.3. EBA will also need to deliver draft regulatory standards, but only by end 2016, on the partial use criteria45. The BCBS is conducting a benchmark exercise, similar to those published in 2013 for market risk and credit risk internal models. Those showed relevant variations in the assumptions underpinning the capital requirement calculation46.

10.5 Operational Risk Protection in the AMA Introduction Risk transfer and risk mitigation is recognised only to a limited extent in the operational risk area. Unlike in the quantitative requirements to credit risk, in the quantitative requirements to operational risk, risk mitigation is only directly recognised in the most sophisticated approach, the advanced measurement approach. For the two simpler approaches, it has no role47 though the calculation method for the relevant indicator in basic indicator approach and the standardised approaches implicitly uses netting of income; see chapter 10.2 and 10.3. The percentiles set in the simpler approaches are assumed to take into account insurance taken out for normal commercial reasons. This lack of recognition of insurance provides a disincentive to insure as banks and their investors can be forced to think (wrongly) that the capital requirement is sufficient cover48. It is a key example for a wrong incentive built into the capital requirements, as insurance or other risk mitigants might be more appropriate than the (low) level of capital reserved in relation

43 Art. 105.2 and 129.2 RBD, as added by art. 9.25 and 9.32 Omnibus I Directive 2010/78/EU. CEBS-EBA, Model Validation Guidelines, April 2006. 44 Art. 312.4 CRR. 45 Art. 314.5 CRR. 46 BCBS, Regulatory Consistency Assessment Programme (RCAP) Analysis of Risk-Weighted Assets for Market Risk, January 2013 (rev February 2013); BCBS, Regulatory Consistency Assessment Programme (RCAP) Analysis of Risk-Weighted Assets for Credit Risk in the Banking Book, July 2013. See chapter 6.2 and 6.3. 47 Any insurance pay-out would of course still be beneficial to the bank for commercial reasons, and the percentages set can be assumed to be set taking into account any ‘normal’ insurance taken out for commercial reasons. For the basic indicator approach the prohibition is explicit (annex X part 1 § 8 RBD), while insurance and other mitigating issues are not mentioned in the requiremets for the standardised approach (Annex X part 2 RBD), leaving some scope for different opinions on a potential impact of risk-mitigating factors. 48 See A. P. Kuritzkes & H.S. Scott, ‘Sizing Operational Risk and the Effect of Insurance: Implications for the Basel II Capital Accord’, in H. Scott (Ed.), Capital Adequacy Beyond Basel, New York, 2005, chapter 7.

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to potential operational risk. Arguably, for larger losses the insurance sector or derivatives counterparts would not be able to fully bear the claims as shown e.g. by the demise of AIG financial products in the 2007-2013 subprime crisis, but this does not apply to smaller claims outside of systemic crisis (when capital buffers for operational risk also melted away)49. If legislators suggest that no insurance or other mitigation behaviour is required (by not even recognising it when it has been arranged) why would the bank e.g. pay insurance premiums or invest in backup facilities? With the CRD requirement on internal organisation for the basic indicator approach and the standardised approaches a bare minimum especially if the bank is not very profitable, some banks can be excused to think that to write something down about how important fraud prevention and ethical behaviour are can be deemed sufficient. The lack of attention for mitigation techniques (except in the internal model approach), can perhaps be explained by the low amount of capital requirements when compared to more extreme events. The amount of financial buffers for operational risk is calibrated to be lower than for credit risk. Like with credit risk, it does not cover the tail risk. However, where banks can be expected to have to weather a recession or even a credit crisis relatively regularly (see chapter 18 and 22.1), the same cannot be said about the realisation of extreme operational risks, especially on a system-wide basis. Smaller unexpected losses are normal, ranging from small time fraud in a consumer bank subsidiary or liability for bad execution of foreclosure procedures in a mortgage subsidiary. The type of fraud, attack or theft that can push the bank into comparatively high losses is more rare, and often focused not on the financial system but on a single bank. For such losses the capital requirement is a drop of water on a hot plate. If the requirement were high enough to cover such extreme events, no bank would be able to do business in a profitable manner. It could have been reasoned that is would be strange to allow a further reduction of the capital requirement when the calculation itself, like in the basic indicator approach and standardised approach, is also not risk sensitive. At the same time such infrequent but high impact event risks can be easily unmanageable for small- and medium sized banks. Even under the advanced measurement approach, the potential effect of the rough and ready risk mitigation regime set out below is subject to boundaries in the RBD. However, it can help pull banks into (the investment needed for applying for) AMA, with its benefits on risk measurement, awareness and management50.

49 M. Power, Organized Uncertainty, Designing a World of Risk Management, Oxford, 2007, chapter 4 (page 118). 50 A.A. Jobst, ‘The Treatment of Operational Risk under the New Basel Framework: Critical Issues’, Journal of Banking Regulation, Vol. 8, No. 4, 2007, page 318, 330, 336 and 341.

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Risk Mitigation in the Advanced Measurement Approach The advanced measurement approach does contain a supervisory incentive to take risk mitigation measures. There are two categories of measures that can reduce the operational risk to which a bank is exposed up to 20%: – insurance; – other risk transfer mechanisms. If recognised, either of these reduces the exposure and thus the capital requirement. The effect of recognition of operational risk mitigation is thus quite similar as for credit risk mitigation works, but the process is different51. There is a maximum deduction from the operational risk capital requirement. Compared to the calculation without recognition of risk mitigants, there is a maximum level of 20% for which such mitigants can be recognised (originally this applied only to the insurance component, but during the 2007-2013 subprime crisis this was tightened to limit recognition of all risk mitigants)52. Please note that if acknowledged as part of the model approval process, any diversification benefits built into the model can also be seen as a ‘risk mitigant’ and would help reduce capital requirements53. To be accepted as operational risk protection, a noticeable risk mitigating effect needs to be demonstrated to the supervisor. For insurance contracts, the CRD requires several aspects to be demonstrated as set out in the directive. It includes showing that the third party provider is authorised to provide insurance or re-insurance, and is a highly rated entity (under reference to the ECAI arrangements for standardised credit risk, the provider needs to have a rating of credit quality step 3 or above54). The policy has to have an initial term of one year, and the amount for which it is taken into account run downs, reaching zero at 90 days before the end of the validity of the policy. The BCBS has issued a discussion/guidance paper on the recognition of insurance in the model, also because some supervisors did recognise it while others do not, or under more strict conditions than were contained in the accord (as also copied in the CRD)55. In addition to the limitation under the capital accord to a maximum deduction of 20% if insurance is recognised by the supervisor, it appears that the BCBS is rather negative on the potential benefits of insurance (referring amongst others to experiences in 9/11 coverage 51 See e.g. the prevention of double counting described in chapter 10.4. Even aside from the fact that the RBD contains only 5 paragraphs on operational risk mitigation, compared to 4 Directive level articles and a full annex with 158 paragraphs on credit risk mitigation. 52 Annex X, part 3, §29 RBD, as amended by level 2 Commission Directive 2009/83/EC. 53 See chapter 6.3. 54 See chapter 8.1, and Annex VI RBD. 55 BCBS, Recognising the Risk-Mitigating Impact of Insurance in Operational Risk Modelling, October 2010.

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and the downrating of monoline insurers during the 2007-2013 subprime crisis). For the conditions for recognition to be fulfilled, there has to be certainty at the level of the supervisor that the insurance company will pay out, will do so in time and not exercise delaying tactics, will not (be able to) contest the claim, will not be bankrupt or otherwise unable to pay out by the time such payment becomes relevant, clarity on how the policy will work in this specific case for this specific bank, whether the insurer will continue to provide cover, will do so at reasonable prices, and that having the insurance will not lead to moral hazard in any way at the bank (under a ‘well, we have cover so let’s leave the keys in the lock’ reasoning). And even if the cover is good, banking supervisors should consider warning insurance supervisors on the negative consequences of such cover for the insurer. An interesting read on the value of insurance for anyone considering taking out a policy, the paper reflects that most bank supervisors on the BCBS are not keen on allowing risk mitigation in the context of operational risk. On the second category, the directive provides no further harmonisation than that it can be recognised if the bank can demonstrate to the satisfaction of its supervisor that a noticeable risk mitigating effect is achieved. This has to go further than the organisational requirements that the bank has to fulfil in any case in order to be allowed to apply the advanced measurement approach. CEBS-EBA has worked in this area56. Apart from improvements in the operational risk profile as a result of (further) improved internal controls, it can also be improved due to the transfer of risk57 to third parties as a result of derivatives contracts or even securitisation. The treatment of operational risk protection does not appear to change materially in the CRD IV project58. Literature – Basel Committee for Banking Supervision, Recognising the risk-mitigating impact of insurance in operational risk modelling, October 2010

56 Annex X part 3 §25-29 RBD, CEBS, Compendium of Supplementary Guidelines on Implementation Issues of Operational Risk, July 2010, page 24-30, initially published as a stand-along paper in April 2010. 57 Annex X, part 3 §25-31 and recital 45 RBD. 58 Art. 323 CRR. See for the ‘netting’ of the relevant indicator art. 316 CRR.

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11.1 Introduction Two regimes provide maximum limits to certain exposures. These are the large exposures regime and the limits to qualifying holdings. The large exposures regime aims to limit the maximum damage the failure of one client can do to the bank. Some banks become overly dependent on one client to the extent that if the client fails, the banks fails automatically too. For this purpose, the large exposure regime was introduced in addition to the risk weighted approach to credit risk. It is a relatively simple requirement. In its most basic form, it obliges a bank to: – add up all exposures to one client, and add to this number all exposures to other clients which are so interconnected with the one client that if he fails, all these other clients can be expected to fail; – to monitor all substantial (‘large’) exposures, meaning that all exposures to a client or group of interconnected clients that exceed 10% of the banks own funds; – not to allow any such large exposure to exceed a quarter of the banks own funds; – not to allow all large exposures to groups of connected clients taken together to exceed a total of 8 times the banks own funds. The qualifying holdings regime limits the bank in its investments outside the financial sector, and provides for approvals of having such large participations within the financial sector. Unlike the approaches to credit risk, operational risk and market risk, the large exposures and qualifying holdings regimes does not primarily rely on capital requirements to limit/manage risk. In this sense it is the odd one out of the quantitative requirements. The large exposures regime works from the premise that even if capital requirements cover the other risk categories, it is still not a good idea to put all the eggs of the bank into one basket. The large exposures regime complements the capital requirements by providing barriers to overinvestment (e.g. by lending) in any specific counterparty or group of connected clients, except where the risk is limited by protection measures or where it is part of normal trading policies for a limited time. In the area of the trading book, the limits set may be exceeded if capital is maintained for the excess. For banking book assets, the limits may not be exceeded. The large exposures regime contains a financial buffer requirement for

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the trading book in addition to the basic limits set out above, if the basic limits are exceeded; see chapter 9.3, and below. The required capital is calculated as if the institution is operating under the standardised approach to credit risk. The large exposures regime is an example of goldplating on the worldwide consensus on banking supervision at the EU level. It is not part of the Basel capital accord. The accord only explicitly mentions in the introductory text as one of the potential add-ons at the domestic level1. It provides a supplementary quantitative regime to the solvency ratio regime to impose limits on the maximum exposure a credit institution may have to a specific client or group of connected clients. As the large exposure regime was not revised when the Basel II amendments were introduced in the CRD, its relation to similar requirements within the Basel capital accord is not clear. The overlapping concept of concentration risk in general is since Basel II for example also taken into account in the qualitative add-on of pillar 2; see chapter 14. As it stands, the large exposure regime stands partly next to, partly intertwined with the quantitative parts of pillar 1, and partly adds a quantitative limit in the specific area of concentration risk on clients to the pillar 2 concentration risk treatment2. The large exposures regime contained in the 2006 version of the CRD was both convoluted and dated. It had in essence been copied unchanged into new versions of the prudential rules for banks since its introduction in 1992; see chapter 2. The language was complex, and it did not establish a level playing field due to the large number of national discretions contained in the regime. The CRD required the Commission to report to Parliament and Council on the functioning of the regime, with any appropriate proposals, by end 20073. Rather than overhauling the regime at the same time as introducing the Basel II elements into the CRD, necessitating the use of the same scarce resources, the review was delayed until after the 2006 CRD was issued. The Commission subsequently called for an advice from CEBS-EBA. The report of CEBS-EBA was delivered in March 2008, and the Commission delivered its proposals to Council and Parliament in October 2008. These have since been issued as CRD II, together with the work on hybrid capital, as well as some post-crisis work; see chapter 2 and 7.

1

2 3

See the introductory remarks to the Basel Capital Accord. Up to the Basel III Amendment, the EU large exposures regime was balanced by the USA minimum leverage ratio. See chapter 2 and 6.2 on the parts of the leverage ratio regime that were copied from the USA into the Basel III regime (and the CRD IV project). The general concept of concentration risk also relates to e.g. concentrations of exposures to counterparties in certain sectors or countries. See chapter 11. Art. 119 RBD and art. 28.3 RCAD, as deleted by the CRD II Directive 2009/111/EC.

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The adapted regime is partly streamlining, partly a deletion of national discretions, and partly a reduction of administrative and material requirements. This benefits banks. They no longer have to apply different regimes for large exposures that arise in different subsidiaries. Also, the thresholds have been made significantly less limiting. Though the amount of a large exposures continues to be limited, the new regime has a lighter touch to small banks (replacing a percentage of own funds for a more loose absolute number of maximum exposures; see below), the stricter cap of exposures to parent entities at 20% of own funds has been deleted and the regime no longer has an overall maximum of large exposures (previously capped at 800% of own funds)4. The streamlined regime has been applicable since end 2010. Like the hybrid regime, the large exposures regime has relaxed requirements on banks (contrary to the statements made in the ambiguous recitals of the CRD II directive5). Future Developments The regime for qualifying holdings outside the financial sector has essentially not been changed since its introduction, and will not be amended in the CRD IV project with one main exception; see chapter 5 and 11.36. The outline of the large exposures regime was equally not amended in the CRD IV project7. In both cases, the references to the ‘own funds’ of an institution as the benchmark for the various maximum limits set, are replaced by references to so-called ‘eligible capital’; 1,333 times available tier 1 capital (1 part tier 1 plus a third of that amount that a bank may fulfil by tier 2 capital). This means that the maximum limits are planned to become stricter/more relevant, as the current reference is to the wider tier 1, tier 2 and tier 3 encompassing concept of own funds (see the remarks in chapter 11.2 and 11.3 on the way that concept is currently adapted). Please note that in 2014, this tightening is not yet in place except to the extent tier 3 is excluded. Eligible capital will include tier 2 up to the full amount of available tier 1 capital, leading to a still very high benchmark for the thresholds and maximum limits set. This will decrease in 2015 and 2016, fully becoming in force in 2017. This of course unless the review the Commission is ordered to undertake before the end of 2014 leads to adaptations/reversions to a version of the old looser regime8.

4

5 6 7 8

The three separate restrictions have been replaced by a single restriction, with the looser regime for small banks. See art. 111 RBD both before and since the adoption of the CRD II Directive 2009/111/EC. At the same time the national discretion to delete any cap on intra-group exposures is maintained if both lender and borrower fall within consolidated supervision. See the identical old art. 113.2 RBD and the new art. 113.4 sub c RBD. Recital 1 CRD II 2009/111/EC named it the first important step to address shortcomings of the crisis ‘and further initiatives’. Art. 4.36, 89-91 CRR. Art. 387-403 CRR. Art. 4.71, 494 and 517 CRR.

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11.2 Large Exposures Regime Introduction The thinking behind the large exposures regime is quite simple. Select all exposures which are large in comparison with your own funds, and do not let an exposure become too large towards a single client (or group of clients), as that would expose the bank to failure if the client fails (or moves to another bank). This is a sub-set of the concentration risk that is taken into account in stress testing under the credit risk advanced approaches and in pillar 2 (see chapter 13.6 and 14). The hard wiring of absolute limits does not hamper the banks too much (as they still allow sizable loans to be made), while it attempts to limit the potential damage resulting from concentration risk to a client. Though this basic thinking is simple, and attempts have been made to implement or make the regime in such a straightforward and reduce the number of national discretions, it remains riddled with exceptions, discretions and supervisory decisions, reducing its usefulness as a risk reducing factor9. By way of example, exposures to a member state are exempted from the regime, which lead to problems in the 2007-2013 subprime crisis for a wide range of banks that had excessively large exposures to their own member state or other member states or related municipalities. The large exposures regime borrows from the standardised approach to credit risk. For the majority of exposures, the value is determined in line with the standardised approach to credit risk valuation criteria for the different types of exposures and credit risk mitigation measures (see chapter 6.4 and 8). More complex banks are obliged to calculate large exposures for all exposures outside the trading book and in the trading book separately. The demarcation between the banking book and the trading book is borrowed from the market risk provisions (see chapter 9.2). Large exposures in either book are subject to limits in relation to the size of financial buffers. The definition used is the ‘own funds’ concept, see chapter 7.2), but with some adjustments. Large exposures have to be reported10. The large exposures limits set for the banking book are binding. If the banking-book exposure is limited, and the trading book exposure remains within certain (wide) boundaries, the bank can hold own funds for the additional risk under the solvency ratio instead of being bound to the trading book large exposure limits.

9

For instance the Icelandic banks made large loans to connected parties, leading to increased exposure to each other and leverage; see T. Thorgeirsson & P. Van den Noord, The Icelandic Banking Collapse: Was the Optimal Policy Path Chosen?, Central Bank of Iceland WP 62, March 2013, page 4. 10 Art. 110.2 RBD. See chapter 20.2, also on the current EBA Guidelines and the Future Technical Standards for such reporting.

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The bank has to have a specific internal governance procedures to monitor and manage the large exposures and changes in them11. This includes determining which exposures are to which client, and which clients are part of a ‘group of connected clients’ so that all exposures to them has to be added up for the determination of whether it exceeds large exposures limits12. A group of clients is connected if one has control over the other (e.g. in a banking group) or if they are interdependent in another manner. Exposures to them can be both directly (a loan to one of them) or indirectly (an investment in a fund that in turn provides a loan to one of them). Even if there is no ‘control’, they can be deemed to pose a single large exposure if they are so interconnected that if one experiences financial problems, the others will most likely also experience problems13. Determining the Exposures Value For the Large Exposures Calculation The value of the exposures that are part of the banking book is established using the standardised approach to credit risk, without applying any risk weighting or degrees of risk14. If the exposures implicitly contain an exposure to underlying assets (e.g. for some collective investment undertakings) those assets shall be taken into account if that reflects better the economic substance and risks15. For exposures in this non-trading book, the value of the exposure can be reduced along similar lines as allowed under the credit risk mitigation methodology. This may help in keeping an exposure below the demarcation line with ‘large’ exposures. Risk mitigants intend to compensate for the fact that a large single name exposure automatically means that a bank is less-well diversified16. All banks that calculate capital requirements for trading book exposures under RCAD are also subject to the additional rules on large exposures calculation in RCAD. Banks that benefit from a supervisory exemption17 of the market risk regime, are automatically also exempted from the large exposures requirements under RCAD. An institution which would need to invest in its systems disproportionally in relation to the lower capital requirements under the market risk treatment would apply for this, and would be granted

11 Art. 109 RBD. See chapter 13.3. 12 CEBS-EBA, Guidelines on the Implementation of the Revised Large Exposures Regime, 11 December 2009. Article 4 RBD. 13 Art. 4.45 RBD. The second criterion was tightened as a result of the CRD II Directive 2009/111/EC. 14 Art. 106 and 114 RBD. 15 Art. 106.3 RBD. 16 See art. 112, 114, 115 and 117 RBD for some specific provisions on mitigation, re-allocation of the exposure to the guarantor, and the calculation of the value of the remaining exposure to the original client. See chapter 8.5 for the general treatment of credit risk mitigation. Recital 21 CRD II 2009/111/EC provides this reason, with reference to the more urgent need to have adequate recovery possibilities. 17 Permission to calculate capital requirements also for their limited trading activities solely under the credit risk and operational risk approaches. See art. 18.2 and 28.2 RCRD, and chapter 9.2.

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it if its trading book business is indeed relatively insignificant (see chapter 9.2). The exposure value of trading book positions is18: – the positive excess of the banks’ long positions over its short positions in all the financial instruments issued by the client; – the net exposure if the bank has underwritten a debt or an equity instrument; – exposures due to non-settled or non-delivered net positions in debt instruments, equities, foreign currencies and commodities, with the client; – exposures due to derivatives and other structured financial instruments with the client. The exposures of the trading book and the non-trading book are subject to separate limits, but are also added up, disregarding any credit risk mitigation (so the full value, without discounting that for collateral or insurance obtained) so that a full overview is obtained; see below. An exception applies if it concerns repurchase transactions and securities or commodities borrowing or lending transactions, which should provide their own in-built protection against over-exposure to a single client within each transaction19. Determining ‘Own Funds’ for the Purpose of Defining Large Exposures and Its Thresholds An exposure is a ‘large’ exposure if it exceeds 10% of own funds. The thresholds of a maximum non-trading book exposure is also set in relation to own funds (for larger banks the cap for banking book exposures is set at 25%). These thresholds are relevant both as a prohibition in the non-trading book area, as well as for the calculation of the excess in the trading book area that is input for the solvency ratio. A key part of the calculation to determine large exposures thus is the calculation of the absolute level of available own funds and thus what 10% (or 25% or 500/600%; see below). The widest set of financial buffers is used for this purpose, referring to the definition of ‘own funds’ without differentiating on the tiering of various quality levels within the own funds definition. The calculation is performed under a slightly different methodology than normally (deviating from chapter 7.2)20. The calculation disregards some of the deductions normally made from own funds. Even though tier 3 normally cannot be used for calculating non-trading book exposures, to the benefit of banks that use tier 3 capital for market risk they can – up to the allowed maximum – take tier 3 capital into account to enlarge the value of the own funds of the institution even when looking at the combined large exposures resulting from both the trading

18 Art. 29 RCAD. 19 Art. 30.2 RCAD. See chapter 8.5. 20 It does not differentiate between the various tiers; see chapter 7.3.

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book and banking book21. This increases the amount of large exposures that a bank can have, even for exposures that are not held for trading purposes. In a similar lighter touch approach to large exposures than to other components of the solvency ratio calculation, some of the newer adjustments to the ‘own funds’ definition are excluded from the calculation for the purposes of the large exposures requirements. With the introduction of the new IRB and securitisation regimes, some IRB/securitisation risks lead to a full deduction from own funds. In order to maintain the previous requirements calibration – as there had been no intention at the time to make the large exposures regime more restrictive – the RBD specifies that the IRB or securitisation related deductions do not count towards the own funds as meant in this regime22. Negative amounts and expected loss amounts nor positive amounts calculated under the IRB which normally would be deducted respectively added to own funds are not taken into account, and the exposure amount of securitisation positions which are risk weighted at 1250% are not deducted from own funds when looking at large exposures. To avoid double counting, an exposure of the bank that is already fully deducted from own funds under another part of the quantitative regime is not counted towards the large exposures regime any more23. Thresholds, Reporting and Maximum Exposures Sizes (Limits). To be counted as a large exposure, the exposure to a client or a group of connected clients needs to be substantial in terms of the own funds of the bank. If the value of the exposure in either the banking book or the trading book exceeds 10% of own funds, it is a large exposure for the bank. It has to be reported to the supervisor at least twice a year, including some detailed information: – who is the client or group of connected clients; – what is the exposure value, and for banking book exposures also the exposure value before taking into account credit risk mitigation; – for banking book exposures the type of funded or unfunded credit risk mitigation; – plus every quarter the bank has to report any excess that exists or existed in the trading book exceeding a threshold of 25% (see below).

21 See art. 32.2 RCAD. The article limits tier 3 being taken into account for the large exposures deriving from non-trading book activities. See chapter 9.2 on the trading book definition. 22 See art. 66.3 RBD. 23 Art. 30.1 RCAD and art. 106.1 RBD. See for such deductions e.g. art. 13.2 and 15 RCAD, and chapter 7.

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The reporting regime – at least for the banking book exposures – is to be harmonised by EBA24. It has to draft standards on joint reporting forms and frequencies (and an IT solution) in time for them to become effective, initially envisaged by year end 2012, since delayed until 2014 or 2015; see chapter 20.2 and 23.3. In addition, banks have an obligation to inform the supervisor if they have ‘significant findings’ on their exposures to collateral issuers, providers of unfunded credit protection and underlying assets, or if they – in exceptional cases – exceed the maximum limits25. These obligation were strengthened to stimulate banks and supervisors to prevent unhappy surprises, such as the concentration of uncollateralised guarantees on exposures given by AIG prior to the 2007-2013 subprime crisis. All exposures (after risk weighting and application of risk mitigation techniques) that exceed 10% of its own funds are large exposures for that institution26. For small institutions, this can actually occur quite quickly (e.g. for a bank with own funds of 10 million euro this is a loan of 1 million euro). For larger institutions the 10% threshold is such a substantial amount that large exposures occur infrequently. When they do, the absolute numbers involved are equally large. All exposures that pass the 10% threshold need to be reported to the supervisory authorities, even if such exposures are exempted from the large exposures regime, such as exposures to member states27. All this is not yet limiting for the bank, but there are some maximum limits28: – each exposure in the non-trading (banking) book to a client or a group of clients is not allowed to be higher than 25% as an absolute limit, after taking into account credit risk mitigation, except for small banks; – small banks can lend either up to 25% of own funds to such a client or a group of clients in the non-trading (banking) book, or if such amount is higher, it can lend up to 150 million euro to them if that client/group are banks or investment firms (though not more than 100% of its own funds, unless the member state sets a lower limit in a national discretion). This alleviates the restrictions for small banks with own funds up to 600 million euro substantially when lending in the interbank market29; – a large exposure is subject to a ‘soft’ limit of 25%, see below;

24 Art. 110.1 and 110.2 RBD. The latter article does not refer to the reporting obligation contained in art. 31 sub e and last sentence RCAD. See chapter 20.2, 21.4 and 23.3. 25 Art. 110.3 and 111.4 RBD and art. 31 RCAD, as amended by CRD II Directive 2009/111/EC. 26 Art. 108 RBD. 27 Art. 110 RBD and art. 31 RCAD; for the exemptions see art. 113 RBD and 31 RCAD, as amended by the CRD II Directive 2009/111/EC. 28 Art. 108, 111.1 RBD and art. 30 and 31 RCAD, as amended by the CRD II Directive 2009/111/EC. 29 For the entities that are part of ‘group of connected clients that are not investment firms or banks, the 25% limit continues to apply. The loan in excess thus has to be made directly to these supervised entities. Art. 4, 107, 111.1 RBD, and art. 3 sub c RCAD.

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– a single large exposure in the trading book should not be higher than 500%, and any excesses that occur longer than 10 days must in aggregate not exceed 600% of own funds (these high exposures are to some extent balanced by a capital requirement and a reporting obligation). Supervisors can thus allow the 25% limit to be exceeded30 to the extent the excess is fully part of the trading book (for holdings in the non-trading book, the limits are absolute, though the supervisor can grant temporary leniency; see above). Even with supervisory permission, the large exposure in question cannot exceed 500% of own funds if only 10 days or less have passed, and 600% if they have persisted longer. If the maximum limits are exceeded, the general instruments of the supervisors are applicable that aim to ensure that the bank takes immediate action to become compliant again31. However, there are four exceptions32: – a limited period of time in which to comply with the limits can be granted by the supervisor; – for any excess solely following from the trading book exposures, a supervisor can allow a bank to exceed the limits, provided they instead hold capital for the excess as if it were a credit risk exposure in the standardised approach; – some exposures related to clearing and settlement of financial instruments, forex, and money transmission are excluded from the large exposures regime in full (both reporting, thresholds and capital requirements)33; – some exposures are exempted from the maximum thresholds and the capital requirements (but not from the reporting requirement). Supervisors have to have procedures to prevent avoidance of the 10 day limit34.

30 Art. 111.1 RBD and art. 31 RCAD. 31 See chapter 20.1 and 20.3, and art. 136 RBD, with art. 109 and 136.2 RBD providing a specific instruction to supervisors if the internal organisation of the bank does not allow for adequate monitoring of (potential) large exposures. Measures to reduce the excess exposures can include selling the asset, imposing limits on undrawn commitments, taking risk mitigating measures such as taking out insurance. 32 See respectively art. 111.4 RBD, art. 31 and 32 RCAD, art. 106.2 RBD and 30.2 RCAD, and art. 113 RBD, all as amended by CRD II Directive 2009/111/EC. 33 Art. 106 and 111.1 RBD and art. 30.4 RCAD, as amended by CRD II Directive 2009/111/EC. CEBS-EBA implementation guidelines on art. 106(2)(c) and (d) of directive 2006/48/EC recast, 28 July 2010. Also see chapter 16.4 and 22.4. 34 Art. 32 RCAD as amended by art. 2.5 CRD II and art. 10.3 Omnibus I Directive 2010/78/EU, which introduced information on the procedures to be sent to EBA, and orders EBA to issue guidelines.

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The second exception leads to additional capital requirements for part of the trading book exposures that exceed the limits, which are taken into account when calculating the solvency ratio35. This is the only direct link of the large exposures regime to the capital requirements. There are several exemptions for specific exposures (in addition to excluded exposures related to clearing and settlement). Some have been harmonised, but others remain national discretions36. They include: – exemptions of exposures to certain types of clients. Examples include (a) claims on central governments, international organisations or multilateral development banks which would have a risk weighting of 0% in the standardised approach to credit risk, (b) 50% of the medium/low risk off balance sheet items as defined in the approaches to credit risk (see chapter 8); – exemptions to exposures secured by certain types of collateral. Examples include (a) claims guaranteed by central governments, international organisations or multilateral development banks which would have a low risk weighting in the standardised approach to credit risk (b) exposures secured by collateral in the form of cash deposits placed with the bank (or with the parent or a subsidiary of the bank), (c) covered bonds which benefit from the light treatment in the standardised approach to credit risk, (d) assets secured by collateral in the form of securities; – exemptions that allow exposures not to be fully counted but in a weighted manner only37, including e.g. the impact of mortgages. Quantitative Requirement for Excess Trading Book Large Exposures (Solvency Ratio) The large exposures regime is focused on limiting the absolute size of counterparty risk, taking into account both exposures in the banking book and the trading book. Outside of the trading book, this is a requirement to limit the size and number of large exposures (though with many exceptions, to which the regime does not apply; see above). For exposures in the trading book, some additional exemptions are possible if the supervisor agrees. The assumption is that (too large but often temporary) investments can be part of a ‘normal’ trading activity; e.g. when underwriting an emission. Apart from having to report any excess (all cases, including the amount of the excess and the name of the client) to the supervisor, a bank that is allowed to have such excess in its books also has to calculate capital requirements over that excess38. Based on the specific 35 Art. 75 RBD. See chapter 6.2 and 9.3. 36 The harmonised ones are contained in the re-drafted art. 113.3, the national discretions have been re-allocated to a new art. 113.4 RBD. 37 Art. 115 RBD. 38 Art. 31 RBD.

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risk market risk requirements, up to the amount of the excess the highest specific risk components are chosen39. The specific risk requirements for those are added up. If the excess has lasted 10 days or less, the additional capital requirement for large exposures is 200% (which means that they are once taken into account under the market risk requirements, and subsequently an additional two times for the excess over the large exposures limits). If the excess remains in place after 10 days have passed, the requirements become based on the amount of the excess. If less than 40% of own funds, the requirement remains 200%, but the requirement rises the larger the excess as a component of own funds, rising to a maximum of 900% if the excess exceeds 250% of own funds of the bank. The bank is prohibited from cooking the books (e.g. by artificially transferring the exposure that is in excess, or by rolling the exposure over to stay out of reach of the ‘over 10 days’ regime), and supervisors are required have a process in place to check this40. If the bank has to calculate market risk for its trading book business, the value of certain large exposures following from open trading positions in the trading book may need to be added to the solvency ratio calculation41. Review and CRD IV The CRD II proposals on large exposures remain an interim step, as the negotiators failed to fully harmonise the exemptions. The Commission was to review and report on the remaining national discretions by end 201142. The CRD IV project of the Commission do not include such a review. They basically copy the existing regime unchanged. The main improvement is the replacement of the ‘own funds’ benchmark as used in an even more dated version in the large exposures regime as described above, by the – very gradually tightened – concept of ‘eligible capital’ which will be reviewed by end 2014; see chapter 7.2 and 11.1. In addition, the quarterly reporting of excess large exposures to clients in the trading book has been replaced by an ad hoc reporting obligation ‘without delay’43. Meanwhile, EBA is obliged to draft regulatory standards to specify some of the exemptions to the large exposures regime, as well as the conditions to determine the concept of connected clients, technical standards on reporting, and issue guidelines on the avoidance of

39 40 41 42 43

Art. 31 sub b and Annex VI RCAD. Art. 32.1 and Annex VI RCAD. Art. 75 sub b RBD, and art. 18, 28.2, 29 and 30.1, and Annex VI RCAD. Recital 19 and 36 CRD II 2009/111/EC. Art. 156 RBD. Art. 387-403 CRR. See 395.5 CRR, and art. 31 RCAD for the reporting change.

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EU Banking Supervision the quantitative requirements44. The latter was not copied into the CRR. The content and timelines for the regulatory and technical standards have become more specified in the CRR; both to be sent to the Commission by the end of 201345. In the context of the concerns about the relations between banks and shadow banks (see chapter 4.4 and 22.1), EBA is to issue guidelines on how banks should approach their (large) exposures to shadow banks, which may include further (comply or explain) limits to such exposures. EBA is to take into account contradictory goals such as the impact of any action on the provision of credit to the economy and the stability of the markets. By the end of 2015 should follow-up with a report on this same issue, possibly accompanied by a legislative proposal46. In the context of future recovery and resolution plans and concrete measures under the proposals for such a directive, it may be necessary to limit intra-group large exposures. The CRR provides a possibility (but not an obligation) for supervisors to add this large exposure limit to structural measures taken now already or in future recovery or resolution plans if the bank in question has deposits covered by the deposit guarantee directive, with some checks to avoid disruptions of the single market47. As the CRR is a maximum harmonisation EU law, this permission may have been needed, as the member state would otherwise be in violation of the CRR if it goldplated the existing requirements; see chapter 3.5. The intra-group exposures are in any case a supervisory discretion to allow it, but under local administrative law such permission once given may be difficult to withdraw48. Guidelines – CEBS-EBA, guidelines on the implementation of the revised large exposures regime, 11 December 2009 – CEBS-EBA implementation guidelines on article 106(2)(c) and (d) of directive 2006/48/EC recast, 28 July 2010

44 45 46 47

Art. 106.2 and 110.2 RBD and 32 RCAD, as amended by the Omnibus I Directive 2010/78/EU. Art. 390.8 and 394.4 CRR. See chapter 21.4 and 23.3. Art. 395.2 CRR. Art. 395.6-395.8 CRR. Please note that according to recital 60, the intra-group rules do not apply within the scope of consolidation (even though this means that there can be large intra-group exposures when a group needs to be dissolved; see chapter 18. 48 Art. 400.2 and 400.3 CRR.

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11.3 Limitations on Qualified Holdings Outside Financial Sector Introduction The large exposures regime applies to all types of exposures, including equity exposures. In addition to the maximum investment possible under the large exposures limitations, the CRD also contains a separate regime limiting the total exposure of qualified holdings of the bank outside the financial sector (i.e. how much it can invest in non-financial enterprises for non-trading purposes). The regime is premeditated on the assumption that non-financial companies and persons can have holdings in banks, but that banks should remain focused on the core business and expertise of lending funds and other financial services to non-financial companies, and thus have a limited amount of equity interests only in such non-financial companies. Banks can invest in financial instruments outside the financial sector, but long term investments are deemed undesirable. For such larger investments inside the financial sector such as in another bank, approval needs to be sought from the supervisor of the target. The same definition is used to limit holdings held by a bank outside of the financial sector, as are used in the approval of qualified holdings in a bank. For that approval process reference is made to chapter 5.4. A qualified holdings means a holding of more than 10% in the target company49. Though a qualifying holding becomes it due to the position in the target, the maximum limits for all qualifying holdings held by the bank outside of the financial sector are subsequently set in relation to the own funds of the bank itself50. The absolute limits focus on qualified holdings outside of the financial sector. Banks face no absolute maximum on potential qualified holdings within the financial sector. Within the financial sector they will still need approval from the supervisor of the target company, and will need to convince their own supervisor that they can afford and manage such qualified holdings in the financial sector (in the context of internal governance and pillar 2 assessments, if not under national discretion approval processes). The financial sector can either be all banking related service-providers, and (optionally for the member state) insurers. It thus includes: – banks; – e-money institutions;

49 Art. 4.11 RBD. 50 Art. 120.1 RBD.

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EU Banking Supervision – financial institutions51 (i.e. subsidiaries of banks that provide ‘banking’ services, see chapter 5); – an undertaking carrying on activities that are a direct extension of banking or concern services ancillary to banking52; – if a member state uses the national discretion, non-life direct insurers, life assurors as well as reinsurance companies can also be kept outside of the regime for banks in its jurisdiction53. Limits For holdings below the threshold of 10% of the own funds of the target – as a result of which it does not constitute a qualifying holding – the bank has complete discretion to invest54. The bank can even have some qualified holdings outside the financial sector as defined above, but two maximum limits apply: – the value of each individual qualifying holding in a non-financial company cannot exceed 15% of the own funds of the bank; – the total amount of all qualifying holdings in non-financial companies cannot exceed 60% of its own funds55. For a large bank, these restrictions still allow some equally large investments in nonfinancials, but small banks will be restricted from significant investments. The supervisor can allow a temporary excess of these limits in exceptional circumstances (for instance when the own funds of the bank fall rapidly, or the value of the qualified holding rises rapidly, or the bank has to subscribe to a rights issue to maintain the value of the stake), but in that case the bank will be required to attract additional own funds until it is compliant with the limits again. Alternative measures – such as a divestment of the stake – are also possible.

51 One of the requirements for accepting market access of financial institutions in the same way as its parent bank, is that the financial institutions are fully subject to the limitations on having qualified holdings outside the financial sector. See art. 24.1 RBD. 52 Art. 120.1 gives examples, which are ‘leasing, factoring, the management of unit trusts, the management of data processing services or any other similar activity’. Investment firms and UCITS managers are good examples of such undertakings, however, insurance activities are not. 53 Only if a member state has done so, it eases the way for a bank to be the parent of a financial conglomerate as meant in the FCD. Otherwise, in addition to the deduction of equity stakes in insurance companies from own funds (see chapter 2 and 7.2) it is limited in the total interest it has in the insurance sector. It can still belong to a financial conglomerate, but in that case mainly as a subsidiary or subholding of the banking interests. 54 Art. 4.11 and 120.1 RBD. 55 Please note that this applies only to holdings that are larger than 10% on an individual basis, and are thus ‘qualifying’. Other holdings need not be taken into account in this addition.

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The regime for qualifying holdings does not make explicit which definition of own funds it is using (unlike e.g. the large exposures regime as described in chapter 11.2). It is therefore not clear whether it refers solely to tier 1 and 2 financial buffers that are defined in the same directive (i.e. in the RBD), or whether it includes tier 3 as added via the RCAD. The articles refer also to temporary holdings in the context of underwriting, which would often be booked in the trading book. Lacking a definition, and based on such references, it is likely that the widest definition of own funds is used as defined in RBD and RCAD in combination, including tier 3 capital. This would be similar to the large exposures regime. As an alternative to the above-mentioned absolute limits of 15% and 60%, member states can use a national discretion to allow unlimited qualified holdings in non-financial companies56. The value of the excess in that case, however, has to be fully covered by (i.e. deducted from) own funds. These funds then cannot be used for the solvency ratio any more. There is no explicit prohibition to allow banks to use tier 2 or tier 3 capital (or hybrid tier 1 capital) that is surplus to requirements, e.g. because it could not be used for the solvency ratio in any case due to the restrictions of their use in relation to core tier 1 capital, but using it would be contrary to the way the financial buffers can be used for the solvency ratio; see chapter 6.2 and 7.3. The bank does not have to cover both the excess over 15% of the single investment and the 60% of all such holdings, but only sufficient own funds to cover the excess over the limit that is exceeded by the largest amount. Qualifying holdings outside the financial sector can, for credit risk and market risk purposes, be booked either in the trading book (dealt with under the market risk requirements) or with the ‘normal’ equity positions (dealt with under the credit risk requirements). It depends on whether they are held with trading intent; see chapter 9.2. Some equity positions, even sizeable, can be held quite long in the trading book. By way of an example, after a market making commitment backfires or as a result of a (failed) guaranteed emission the position is likely to (continue to) be held for trading purposes. The quantitative requirements for large exposures in excess of 25% in that case applies in spite of the potential exemption for the qualifying holdings regime; see chapter 11.2. The limits described do not apply to certain specific types of qualified holdings, such as shares held temporarily for rescue operations, during the normal course of underwriting, or for the account of others57. These can be considered normal short term banking business. No definition of ‘temporarily’ is provided, however, leaving scope for considerable discretion at the bank and by the supervisor. Its scope is also unclear (the text implies that it also

56 Art. 122 RBD. 57 Art. 121 RBD.

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applies to holdings held in the name of the bank but for the account of others). This broad extension of the temporary-requirement would negate the purpose of holding such shares for others. This appears also to be the opinion of the Commission, which proposed a clearer text in the CRD IV project. CRD IV The qualifying holdings regime is maintained but slightly rephrased in the CRD IV project58. ’Eligible capital has been introduced as the new benchmark for the maximum limits (and the treatment of excess), replacing the wide concept of own funds; see chapter 11.1. Eligible capital, which, though a lower quality concept than common equity tier 1 or even tier 1, will at least gradually reduce the amount of tier 2 that can be taken into account in setting the benchmark. As a result of the decline of the benchmark, the limits set will kick in sooner, making the regime more relevant to mid-sized and larger banks; see the remarks in chapter 11.1 and 7.2 on the gradual tightening of this benchmark concept over 20142017. To the two existing (prohibitions or deductions) a new alternative is added of risk weighting at 1250%59. This alleviates part of the burden of the stricter definition used for the banks. The deduction alternative under the CRD IV project will be set to be vis-à-vis common equity tier 1, the highest quality of financial buffers under the new regime; while the 1250% risk weighting can also be carried in part by additional tier 1 and tier 2 capital; see chapter 6.2 and 7.

58 Art. 4.36, 89-91 CRR. 59 Art. 90 CRR.

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Liquidity Requirements

12.1 Introduction Liquidity risk is the chance that a bank has insufficient cash to meet planned or unplanned demands for cash from persons to whom it has an obligation to pay. Please note that this type of liquidity risk (to be able to honour commitments to clients to provide cash) is a different concept than the liquidity demands in the context of conduct of business supervision on regulated markets (deep and liquid markets meaning that there are ‘always’ enough buyers and sellers to be able to trade in a certain stock), or in the context of the substance of solvency supervision, where liquid usually refers to easily tradable at market value, and thus can be deemed a cash equivalent1. Liquidity risk is more acute at banks than at many other financial institutions, due to the unpredictability of the cash flow. Outflows can occur for instance due to: – demands2 from depositors and other lenders to the bank, who have lent money to the bank (deposits, central bank loans, liquidity facilities, short term bonds) that is or can become due at the option of the lender; and – lending arrangements that the bank has committed to3 and the client can draw down at their option. It is normal business of a bank that a proportion of deposits and professional funds lent to it are withdrawn, e.g. by withdrawal via ATMs, used for payments in shops, by being paid into an account at another bank of the client or when a bond repayment is not rolled over into a new loan but reinvested elsewhere by the lender. However, there is also an expectation that a large proportion of such loans, despite being available on demand to the depositor or lender, are left at the bank understanding savings arrangements or under new loans (a so-called ‘roll-over’ of the loans to the bank). Most banks will ensure that they have cash to meet the ‘normal’ level of such withdrawals at their own initiative. Cash reserves will generally only be needed to the extent obligations to pay cannot be covered 1 2

3

Easily tradable assets attract lower credit risk requirements, are accepted by central banks as collateral, and are accepted as cash equivalent under liquidity management rules; the subject of this chapter. A demand by depositors can be made in various formats, for example withdrawing cash at an ATM, paying money from a current account to a landlord or creditor. These are all ‘normal’ business, but can in a bank run be induced by a lack of trust in the viability of the bank; see chapter 18. Commitments are off balance sheet items, treated under credit risk calculations for the risk of non-repayment by the future borrower. The risk meant here is that the bank is not able to provide cash as promised to the future borrower, in a reversal of the credit risk situation.

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by cash generated by deposit taking, by the ongoing receipt of funds due to repayments by customers to the bank of loans or payment by customers of by fees for e.g. advisory business. Keeping cash lying around on top of projected requirements is an expensive hobby, as cash in hand does not generate returns. To be able to meet unexpected demands for additional cash that they do not have at hand, banks have several options: – hold cash equivalent excess reserves at the central bank (also a no or low revenue generating activity); – hold assets that can easily be liquidated or that can be used as collateral for borrowing facilities at the central bank (e.g. government bonds); – borrow (i) at the open interbank market, or (ii) by using pre-arranged borrowing facilities with other banks, or (iii) from other professional market parties, either bilaterally or through the issuance of bonds, or (iv) attract more deposits (e.g. by increasing the deposit interest offered); – call in loans made to other banks or to clients that are due for payment, and where the bank is not under an obligation to continue or renew the loan (at the danger of causing problems in the relation with the counterparty). In addition to solvency supervision (to which the solvency ratio, own funds and quantitative risk calculations are normally allocated), liquidity risk has been a core component of the discussion on prudential supervision set out in EU directives and Basel texts from the start. An agreement on a quantitative regime has been lacking, however, but liquidity management requirements have met with a growing consensus. Liquidity management in this context means ensuring that a bank itself pays management attention to the need to have sufficient cash and cash equivalent funds to be able to honour its (expected) obligations to pay back to its lenders (creditors, including depositors). What ‘sufficient’ means is left to the bank and its national legislator/supervisor, as no consensus was available on the regional (EU) or worldwide (BCBS) level. The 2007-2013 subprime crisis has changed the dynamic. Internal governance measures on liquidity management have been made more explicit, and new legislative measures are coming on the books soon following equally crisis-driven work at the BCBS level on the Basel III amendment to the capital accord (see below). Why Are There No Liquidity Risk Quantitative Requirements Yet at the EU Level? Even though both solvency and liquidity have been part of the discussion on buffers from the early stages of international policy development, liquidity has been a short-changed subject in the BCBS and in the EU. It has been asserted that capital ratios improved upon the agreement of supervisors on capital ratios, but lacking such cross-border work on liq-

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uidity, the relative level of liquidity continued to go down4. This in spite of the fact that the potential problems of a lack of liquidity and the interaction between reputation and continued access to liquidity were not unknown factors5. Prior to the 2006-2013 subprime crisis, the CRD provision had been virtually unchanged since 19896, as no consensus could be reached on a quantitative regime, and even liquidity management policies have been scanty at best until very recently. Where consensus could be reached on solvency issues, this has previously not been possible for liquidity because7: – any amendments would mean an increase in the regulatory burden on institutions of most member states; – liquidity remains a nationally supervised subject that triggers directly into the fiscal responsibility of the local member state/central bank to use funds of the local taxpayer to help local accountholders (see chapter 18.4 and 18.5); – there is no consensus – at least not until the Basel III package was negotiated and as set out below and even there it remains controversial – on the content of the concept of liquidity, on what is a good amount of liquidity is and how liquid assets should be designated; – a definition of liquid assets interlinks with the equally national definitions of what acceptable collateral is for central bank loans; – liquidity links to domestic monetary considerations and economic policy (cash that has to be held by banks is not lent to companies or private persons); – it has been assumed that any solvent institution would be able to obtain liquidity support – especially as the capital requirements reduce capital requirements for liquid instruments to ridiculously low levels with positive effect on for instance sovereigns issuing them and to the amount of such assets that banks can hold – supposedly making it much less important than solvency. As a result, liquidity supervision has mostly been left to the member states, with minor obligations on information exchange and cooperation, and rather vague requirements in the context of pillar 2 and organisational requirements (see chapter 13, 14 and 21). The directive does not even oblige member states to have quantitative liquidity requirements, it just implies that member states can have such requirements for banks they have licensed themselves. The RBD only states the possibility to have local liquidity rules explicitly for branches of banks licensed in other member states. This chapter is thus more of a stub, as

4 5 6 7

C. Goodhart, The Basel Committee on Banking Supervision, a History of the Early Years 1974-1997, Cambridge, 2011, page 333. R.M. Pecchioli, Prudential Supervision in Banking, OECD, 1987, page 17. Art. 14.2 of the Second Banking Directive (1989/646/EC) is identical to art. 41 RBD. Also see C. Goodhart, The Basel Committee on Banking Supervision, a History of the Early Years 1974-1997, Cambridge, 2011, chapter 9.

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there is currently no lawful and binding EU quantitative liquidity regime, nor will there be one until after the changes agreed in the Basel III amendment to the capital accord are fully implemented over the next decade. A complicating issue in drafting liquidity risk requirements (quantitative or qualitative) is that cash and similarly liquid instruments are the most likely assets to be transferred between group entities in a manner that makes the group more robust than the individual components. The assumption that some assets can be easily transferred from one legal entity to another within the group to improve its financing underpin some of the waivers of consolidated/solo supervision; see chapter 17. Many assets are by definition difficult to transfer (real estate, mortgage loans and rights) and cannot be assumed to be easily transferred across legal entities. This does not apply to liquid assets such as cash, gold, listed equities/bonds, for which the easy transfer to and from group-entities can easily be assumed in normal times. This easy transfer even standard practice for issues such as central liquidity management within a group; and a key cost-saving benefit for banks operating in a group. If liquidity requirements are quantified at a self-sufficient level on a solo basis per legal entity, this will even further prick the balloon of assumptions on asset transferability (see chapter 17 and 18.3), as the cash management currently undertaken by group treasuries would no longer be able to draw in cash that is needed to fulfil per entity liquidity requirements8. Protectionist use of liquidity requirements was and continues to be a concern. The deepening of the consensus on harsher liquidity requirements and the expected harmonisation and implementation thereof during the crisis reinforced the possibility of protectionist barriers between member states. The collapse of the Icelandic banks in 2008 and the treatment of their large branches in Germany, the UK and the Netherlands has led to calls in e.g. the United Kingdom to require substantial capital to be held in branches that focus on deposit taking business. Too harsh ‘liquidity’ requirements by a host member state on branches could be interpreted to be endowment capital requirements, that are forbidden for EU branches under the CRD; see chapter 5 and 7.2. Too harsh requirements on subsidiaries and branches can also be a problem under the treaty freedoms, needing a ‘general good’ justification; see chapter 3.5 and 5.3. A better solution would be harmonisation of liquidity requirements, though the incentives to prevent this mentioned above remain in place.

8

Commission, Commission Services’ Report on ‘Asset Transferability’, 14 November 2008, DBB Law, Study on the Feasibility of Reducing Obstacles to the Transfer of Assets Within a Cross Border Banking Group During a Financial Crisis, Final Report, contract ETD/2008IM/H1/53, 20 April 2010.

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Prior to the 2007-2013 subprime crisis, the thinking on liquidity requirements was already changing. Most banking groups started to manage liquidity on a group wide international basis, not on an entity basis or a country-limited basis. Host liquidity requirements on branches and on subsidiaries were largely considered not to be important prior to the crisis. Perhaps a hassle if a particular member state had some demands that exceeded cash management or reputation demands from the market; but not a true barrier to cross-border services in the single market. For those countries without effective ring fencing legislation, supervising liquidity on branches could even appear to be a useless expenditure of resources; see chapter 5.3 and 5.5. First steps were taken by individual member states towards entity wide liquidity supervision and/or towards consolidated liquidity supervision. Potential problems for the liquidity position of a bank resulting from rating downgrades or loss of market confidence, including securitisation markets closing or new or triggered collateral requirements for a troubled firm were identified well before the crisis; e.g. by the Joint Forum9. International work on liquidity focused primarily on liquidity risk as a factor in pillar 2 assessments, and on liquidity risk in the context of organisational requirements (also see chapters 13 and 14). The lag in the development of sound quantitative liquidity requirements helped cause the crisis. Neither the institutions nor the supervisors had a coherent overview of the liquidity risk that the banks faced. When interbank lending markets dried up, the impact was much larger than expected. The liquidity facilities normally available on the basis of available assets (solvency) did not materialise in the normal markets (see below). Available guidance on liquidity management had not been well implemented, neither by legislators, supervisors nor banks, and the available meagre internal governance binding EU requirements to have ‘procedures’ did not deliver results. Central bank funding as lender of last resort (either in explicit individual liquidity support or in the loosening of collateral requirements; see chapter 18.4 and 22.3) had to be brought into play quickly. Perhaps sooner than if short term or long term liquidity buffers had been required10. The 2007-2013 subprime crisis proved that there is a clear interaction between solvency and liquidity. However, not as expected in the way that a solvent institution would be able to obtain liquidity, but in the way that any institution of which the solvency numbers were not trusted, could not obtain liquidity. As nobody knew where the risk of investments in securitisation bonds had gone or to which wobbly sovereigns any bank was exposed, no bank was trusted. Liquidity markets dried up fast and frequently for the whole EU banking

9 Joint Forum, The Management of Liquidity Risk in Financial Groups, May 2006, page 7 and 10. 10 J. Cao & G. Illing, ‘Endogenous Exposure To Systemic Liquidity Risk’, International Journal of Central Banking, Vol. 7, No. 2, 2011, page 173-216.

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sector or for specific portions (e.g. for Greek banks). For the large proportion of banks that had built their business models around access to cheap credit in the wholesale interbank or professional money markets (either through unsecured loans or through securitisations of illiquid assets such as mortgages) this meant the end of their existence, even when they were solvent. Central banks had to step in to take over the function of liquidity provider to prevent this; taking over the position previously held by private sector wholesale lenders. To increase the certainty of available liquidity at banks, banks have now been asked to improve their management of liquidity with attention to the quantification of that risk (under CRD II amendments that became applicable end 2010)11. Banks will in due course also become subject to quantitative requirements on short term and long term funding needs. Such quantitative liquidity buffers have been agreed in the context of the Basel III negotiations12. They remain the subject of intense lobbying by the banks. Only the short term funding buffer developed by the BCBS work has been copied into the CRD IV project, subject to a Commission delegated act to be developed in 2014, and a placeholder for the long term demand; see chapter 2. Both the short term and the long term quantitative requirements are the subject of ongoing impact testing, and will likely be extensively redrafted before they become applicable in practice to banks; with the exception of a reporting framework. This reporting does not lead in itself to a minimum demand, but will increase the visibility of the discrepancies per bank and per member state. EBA has anticipated on quantitative demands in its work on (internal governance based) liquidity guidelines; see chapter 12.2. Banks have emphasised the impact on the volumes of lending by the banks to companies and consumers if they have to hold more cash for potential withdrawals by their depositors and other lenders. In the cross-border market access context, the CRD IV foresees a gradual movement from host responsibility for liquidity to home supervision of liquidity, simultaneous with further harmonisation of the content of the requirements13. Literature – Cecchetti, Stephen G., Money, Banking and Financial Markets, 2nd ed., McGraw-Hill, New York, 2007, chapter 12 – Joint Forum, The management of liquidity risk in financial groups, May 2006 – Pecchioli, R.M., Prudential Supervision in Banking, OECD, 1987, chapter V 11 CRD II Directive 2009/111/EC; see chapter 12.2. 12 BCBS, Basel III: International framework for Liquidity Risk Measurement, standards and Monitoring, 16 December 2010. The BCBS also publishes (and updates) documents containing ‘frequently asked questions’ on its website, which provide further guidance to the accord. 13 Recital 76 CRD IV Directive.

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12.2 Quantitative Requirements on Liquidity? Introduction There is currently no quantitative model available that is harmonised and binding across the EU. The CRD contains a qualitative requirement to manage liquidity risk, but lacks a quantitative regime. Since end 2010, the mandatory organisational requirement on liquidity risk has been upgraded with a limited set of detail on the management structures necessary14. The upgrade of the qualitative legal basis in the CRD is one of the parts of the CRD II directive that indeed actually was a reaction to the 2007-2013 subprime crisis15. The placement in an annex under the organisational requirements provision of the RBD is problematical, as it only requires banks to take such technical provisions ‘into account’. Supervisors are, however, likely to monitor liquidity management rather closely as the crisis continues, and member states may have increased the binding status of these requirements in their implementation of the CRD II; in line with the non-binding guidelines described below16. Unlike the more political remuneration provisions that are part of the subsequent CRD III amending directive, the supervisors have not been ordered by the legislators to specifically follow-up on the liquidity management by the bank17. Except for the harmonised qualitative requirements, liquidity remains an unharmonised area, where the member states retain full competence to legislate their independent regimes on liquidity for the banks that operate in their territory either harshly or leniently as they see fit for their banks and for the economy in their territory. This applies both to banks they license and to third country branches. Under the EU passport market access provisions, it even applies to branches of banks that have a license in another member state. The host member state – within the boundaries set in the EU treaty for limitations on the freedom of establishment – can set their own rules for both subsidiaries and branches of banks that are based in another member state. See chapter 3.4-3.5 and 5. CEBS-EBA has worked extensively on the issue of liquidity during the 2007-2013 subprime crisis; expanding upon the qualitative CRD-basis. They have issued guidelines that contain both qualitative and quantitative aspects18. Banks are expected to be compliant even with 14 Recitals 21 and 69, art. 22, 123 and 124, and Annex V §14-22 and Annex XI §1 sub e and 1a RBD; and recital 30 and art. 1.40 and 1.42 CRD II Directive 2009/111/EC. 15 See chapter 2; and CRD II Directive 2009/111/EC. 16 Art. 22.2 RBD has been left unchanged since its original introduction in the last century. 17 See the amended art. 22.1, 22.3, 22.4, and 22.5 RBD, as introduced with the details on remuneration policy in Annex V via CRD III 2010/78/EU. 18 CEBS-EBA, Recommendations on liquidity risk management, contained in CEBS-EBA, Second part of CEBS’s technical advice to the European Commission on liquidity risk management, CEBS 2008 147, 18 September 2008, later supplemented by CEBS-EBA, Guidelines on liquidity cost benefit allocation, 27 October 2010, was published simultaneously with the BCBS, Principles for Sound Liquidity Risk Manage-

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such quantitative aspects since mid-2010, regardless of the absence of a binding legal basis in the CRD. The liquidity management required by CEBS-EBA operates under the premise that good ‘management’ of liquidity by the bank can only be shown through actually having cash and surplus cash to cover – short term – liquidity outflows, i.e. a quantitative requirement that is based on a purely qualitative legal basis. The guidelines are based extensively on the simultaneous work at the BCBS on Basel III on a short term liquidity requirement. The simultaneously finalised Basel III amendment to the capital accord contains the outlines – subject to revision – of a future quantitative liquidity risk requirement both for the short term of a month and the longer term of a year. In this chapter, the following subjects are covered: – the current qualitative regime in the CRD, following the amendment by the CRD II directive the binding/non-binding quantitative regime of CEBS-EBA that is based on the internal governance liquidity risk management requirement; – the specific provisions for branches, allowing host member states to set their own local liquidity requirements on branches even when they operate under the EU passport; – the future Basel III/CRD IV quantitative liquidity regime. CRD II Organisational Regime Since End 2010. Until 2010, the liquidity risk provision in the CRD was basically limited to a polite request to pay attention to liquidity management. The BCBS had done more work in 2000 and 2008 – though it apparently could not agree on quantitative requirements – with its principles for liquidity risk management19. The CRD-request was upgraded in 2010 and replaced by 9 technical criteria that set out in some detail how the bank should pay attention to liquidity risk. Banks have to define their own risk appetite for liquidity and funding, and identify, measure, manage and monitor it over various time horizons, including intra-day. These have to ensure that liquidity buffers are ‘adequate’ – an undefined concept in the CRD – and that cash-flows are measured in the context of monitoring funding positions. The mitigation of the liquidity risk includes according to these governance requirements having both limits to liquidity risk appetite, and more importantly liquidity buffers in order to be able to withstand a range of different stress events20.

ment and Supervision, September 2008. Also see CEBS-EBA, Guidelines on Liquidity Buffers and Survival Buffers, 9 December 2009. 19 BCBS, Principles for Sound Liquidity Risk Management and Supervision, September 2008, which replaced the BCBS, Sound Practices for Managing Liquidity in Banking Organisations, 2000. Also see Joint Forum, The Management of Liquidity Risk in Financial Groups, May 2006. 20 Annex V §14-22 RBD. See chapter 13.3.

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The provisions anticipate the new Basel III regime (see below) in the sense that they – like the BCBS sound principles – indicate that part of management is the build-up of sufficient liquidity in the form of a cushion. This implicit requirement to have ‘adequate’ liquidity buffers, however, cannot be deemed a replacement for quantitative requirements as developed in the Basel III regime, nor – from a legal perspective – sufficient basis for the EBA guidelines on such a the calculation of such a buffer (see below). What they do is increase the pressure on banks and supervisors. Supervisors have been explicitly required to take the liquidity preparations into account in their pillar 2 assessments, assess such regularly, and take into account any impact of their decisions on liquidity in a cross-border context21. In the absence of binding rules there is, however, no level playing field within the EU or with third country banks, and technocratic institutions have been left to define politically sensitive issues balancing growth versus stability. Banks are for instance expected to take on board systemic aspects in the calculation of their buffers. The impact of such factors should actually be set by EU legislators in line with the risk appetite and appetite for economic growth of such legislators. Organisational/Quantitative guidelines for a Survival Period Buffer The CEBS-EBA 2009 guidelines are loosely based on the internal governance requirements of the CRD under the ongoing licensing conditions, with a hint that they might also be taken into account in the pillar 2 assessment22. The guidelines expect that banks from mid2010 ‘manage’ liquidity risks by having a liquidity buffer that is available outright to cover a lack of funding over a one month period, and which should allow the bank to survive in good shape. That buffer should be calculated on the basis of stress scenarios that are based on troubles at the bank, troubles in the market and a combination of the two. The guidelines focus on the short term (up to at least a month), taking into account the severity of that scenario and its development over the timeline set. It ‘requires’ (not guides or recommends) that especially the assets needed in the first two weeks should be cash or other assets that can be given as collateral to the central bank in return for cash-loans. For the later stages of the scenario, other highly liquid assets may be used. Like the countercyclical capital buffers contemplated in CRD IV/Basel III (see chapter 2 and 6.2), the guidelines-buffer can be drawn down when a stress scenario actually occurs. If there are also minimum liquidity requirements applicable that have to be maintained at all times (e.g. in national liquidity supervision regimes) the buffer must be calculated on top of the minimum level that is set by such other requirements. The liquidity buffer

21 Annex XI §1 sub e and 1a RBD, as amended by art. 1.42 CRD II Directive 2009/111/EC. Also see chapter 14. 22 CEBS-EBA, Guidelines on Liquidity Buffers and Survival Buffers, 9 December 2009.

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calculation is not set in the form of a formula. It is thus not similar to the standardised approaches to quantitative requirements for solvency risk, but more akin to the institutionspecific models that banks can use in the advanced approaches to market risk, operational risk and credit risk. It adds the twist that it should be calculated for stressed scenarios, similar to the stressed VAR calculation that was made part of the market risk requirements (see chapter 2, 6.3, 9.4 and 13.5-13.6). Though posing as ‘guidelines’ the phrasing of the paper is riddled with ‘must’, ‘should’ and ‘requirement’-terminology. It focuses heavily on the comply or explain requirement that has since become part of the EBA regulation, even for the quantitative aspects that go beyond the qualitative legal basis in the CRD; see chapter 23.3. In essence, the CEBS-EBA guidelines introduce a quantitative regime that is remarkably similar to the – simultaneously developed – Basel III proposals on a short term liquidity buffer, mixed together with the 2008 BCBS principles on liquidity risk management. Whether this is ‘legal’ is debatable. It may be illegal in the EU context as the guidance is formally based on organisational issues, while the type of calculation, composition of assets and its draw-down character are not qualitative but quantitative. CEBS-EBA did not at the time nor now have scope to issue binding (‘must’) texts on liquidity calculations. The guidelines also prescribe harmonised treatment of an unharmonised area, in the absence of a legal basis. The only mention in prudential supervision legislation of liquidity supervision allocates the power to individual member states; see above. It is nonetheless certainly desirable that somebody – where EU legislators appear unable to act at short notice – at least demand liquidity buffers immediately, as such can help banks survive immediate stress. The Basel quantitative calculations – even with their tentative and subject to testing character – are yet to be fully agreed at the EU level for mandatory application, let alone implemented; see below. Forcing EU banks to have similar practices to calculate the amount of liquidity needed in stressed circumstances for a survival period of up to one month is desirable. Why this route was chosen instead of a fast-tracked introduction of quantitative liquidity supervision by Council and Parliament is unclear, except if it is explained by an inability to make this happen. European Passport Regime/Freedom of Establishment The European passport for banks leaves aside monetary policy and liquidity as the two areas where host authorities have retained their competence. As a result, regardless of whether a bank active in its territory is a local legal entity or a branch of a legal entity licensed elsewhere, the member state can impose quantitative or qualitative liquidity requirements on banks and can authorise its supervisory authority to supervise the banks’

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liquidity under those requirements. The CRD indicates that ‘pending further coordination23’ host member states retain the responsibility for the supervision of the liquidity of the branches of credit institutions. Except for the above-mentioned supervision of ‘adequate’ liquidity buffers, the CRD does not require supervision of minimum levels of liquidity, neither for branches nor for legal entities, but the responsibility to do so or not lies squarely with the member state in which a bank or banks’ branch is located24. The EU freedom of capital has brought many advantages to the EU. It has, however, played havoc with the possibility to perform liquidity risk supervision. Capital flows rapidly, and a bank branch or subsidiary with a cash surplus can – by transferring the money across borders to its head office or parent company – rapidly become a bank with a stretched liquidity position. Member states can require branches to report on their liquidity regularly25, though they cannot ask more information from branches than they do from local banks. If these reports indicate a steady deterioration of the liquidity situation, the local supervisor – if equipped with the instruments necessary by its legislature – can step in to prevent a further outflow of liquidity, or to demand an increase of liquidity held at the branch (and localised in the member state). For those purposes, a branch can be treated as a separate bank from its head office. Member states that also have bankruptcy or company law provisions allowing them to ring fence assets of a branch in certain circumstances have an easier time to ascertain the compliance, but each member state has the power to instruct local management to comply with its local liquidity rules (if and in as far as they are equally strict on local banks as on branches). The liquidity rules can include requirements on the localisation of the assets (e.g. highly liquid instruments and cash). They can require those assets to be held in the host member state for a branch26, or in the member state for a locally licensed (subsidiary or holding) bank.

23 See art. 41 RBD. To support the allocation to the host authorities recital 21 indicates that liquidity of the branches should be the responsibility of the host member state’s supervisor, without substantiating this statement. However, recital 69 indicates that the arrangements necessary for the supervision of liquidity risks should (also) be harmonised. Such harmonisation may or may not include a change in the allocation of the supervisory responsibility. 24 Art. 41, 42 and 45 RBD. 25 Art. 29 RBD. 26 See e.g. the German Insurance Case, Commission/Germany, Court of Justice 4 December 1986, Case 205/84, where in an unharmonised (at the time) area of insurance supervision, such localisation requirements were deemed acceptable by the Court of Justice. In the harmonised area of assets to cover technical provisions, however, the requirement can only be to maintain the assets within the EU where they cover provisions for EU insurance policies.

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There are, however, several restrictions with direct effect (see chapter 3.5) on liquidity rules set by member states on branches or subsidiaries of banks established and licensed in another member state: – The freedom of establishment in principle forbids discrimination against foreign undertakings from other member states, and forbids restrictions on cross-border activities. The freedom is applicable to both branches and subsidiaries (see chapters 3.4-3.5 and 5). In an as yet effectively non-harmonised area such as liquidity, the host member state has leeway to make exceptions to this freedom for public policy/general good reasons. Liquidity supervision qualifies as such a public policy/general good reason. This follows both from the directive (the EU passport exception) and could be argued even without the directive based on the experience in the 2007-2013 subprime crisis. Conditions for general good exceptions still need to be fulfilled (not exceed what is necessary to protect the specific policy need, the policy needs to achieve it and it cannot be achieved in a less restrictive manner, and it is not already safeguarded by the home state). – The CRD explicitly forbids the requirement of endowment capital for a branch of an EU licensed bank27. This is a fully harmonised prohibition, meaning that no exception is possible, not even for public policy concerns. Though the host supervisor on the branch is free to set liquidity rules – even in combination with a requirement to keep such asset locally – if those rules go beyond liquidity purposes and in effect require a bank to hold capital at its branch, such liquidity rules would be void as incompatible with the CRD. – Any liquidity requirement requiring or making it more favourable to invest in government bonds will need to be based purely on prudential considerations, and cannot be inserted to e.g. stimulate banks to help finance the deficits of any member state28. – Under the freedom of capital, the right to set liquidity measures on banks is respected. However, the applicable directive29 indicates that liquidity measures that have a specific impact on capital transactions of banks with non-residents have to be confined to what is necessary for the purposes of domestic monetary regulation. Any such measures have to be reported to the EU monetary authorities. Basel Liquidity Ratios in the CRD IV and Beyond When liquidity shocks arrive, depositors and lenders often try to run for the door. They try to get their money repaid as soon as possible, to avoid being caught by a potential bankruptcy (by their action at the same time increasing the chance of such a bankruptcy

27 Art. 16 RBD. 28 Art. 124 TFEU. Also see chapter 8.1. 29 Art. 2 Directive 1988/361/EEC.

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and negative consequences for those creditors that do not run). In response to the 20072013 subprime crisis, the BCBS has developed two liquidity ratios in the context of its Basel III amendment30. They aim to ensure that a bank will be well funded for a short term crisis that lasts up to one month, and for a long term funding crisis of a year, respectively referred to as the short term liquidity coverage ratio and the net stable funding ratio. The ratios would apply both for each licensed bank and on a group-wide consolidated basis; see chapter 17. For other time horizons no liquidity ratios were drafted. These remain subject to liquidity risk management rules; see above. Amendments and reviews have been preannounced, and banks protest its negative impact on future economic growth; a key concern of legislators. Its full implementation in the format as initially agreed in the BCBS across the EU is not to be expected. The short term liquidity coverage ratio as developed by the BCBS (sometimes referred to by its acronym LCR) aims to ensure that even if there is a market expectation of problems at a bank (or at several banks at the same time) the bank would be able to show for a reasonable period that it can fulfil all its commitments, even to panicked people who have lent it money (e.g. depositors and bondholders) and are likely to demand their money back in case either the bank or the markets become stressed. Different types of creditors are allocated different percentages of ‘stickiness’ likelihoods; i.e. the likelihood that they will leave their money in the hands of the bank even if the bank is troubled. Unsecured wholesale funding is expected to run for the door at the first sign of stress at the bank; taking any due funds with them and selling any not yet due bonds in the financial markets. ‘Normal’ depositors are expected to only withdraw limited amounts on average. The ratio requires 30-day liquidity coverage, based on a significant short term liquidity shock that is similar to the 2007-2013 subprime crisis. The bank continuously needs to calculate total net cash outflows over the next 30 days in a stressed scenario (with a combined institution-specific and market-wide shock), and has to have cover for that net amount of outflows minus expected inflows of funds during that same crisis. The cover can be provided by available cash and cash equivalents such as reserves held at central banks, low risk weighted sovereigns and central bank debt and highly rated bonds. On the type of assets that can provide cover a continuous dialogue is evolving, especially on the impact of non-recognition or limited recognition of certain types of assets (i.e. claims on states, banks, insurers, including e.g. covered bonds issued by other banks) on the funding of such other banks, governments. The BCBS framework was amended to accept a wider

30 BCBS, Basel III: International Framework for Liquidity Risk Measurement, Standards and Monitoring, 16 December 2010. Also see the frequently asked questions documents on the accord published (and updated) by the BCBS.

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range of assets as liquid assets, which has been and will be taken into account in the CRD IV rules31. Liquid high quality assets will increase in demand, even though not all of them are equally ‘safe’ in a specific type of crisis (e.g. sovereign bonds, foreign currencies and mortgage backed bonds have been known to fluctuate in value). The scarcity of high quality collateral will further increase due to the likely increase in their use of collateral in wholesale markets (unsecured funding for banks will likely continue to be scarcer on a permanent basis after the 2007-2013 subprime crisis) and in the push of regulators of over the counter derivatives and other financial payments into central clearing systems, with central counterparties and their demands for margin (i.e. collateral)32. The assets have to be available at day one of the stress period. Any such types of assets incoming during the 30 day period are ‘inflows’ that can be netted against the outflow of liquidity during that same period, but cannot serve as cover. Qualifying assets have to be held by the bank itself, and cannot include e.g. equity issued by collective investment institutions that in turn invest in qualifying assets (see through is prohibited as those assets are not certain to be available to the bank; certainly not at short notice). The impact assessment of the short term ratio showed that – even when liquidity was cheap due to almost limitless available central bank liquidity, all banks were at the time underfunded for a short term liquidity shock (as per end 2009 larger banks by 33.3% and smaller banks by 13%). The anticipated consequence of implementation in the EU (the BCBS agreed a timeline for implementation by 2015 which is in agreement with the planning in the CRD IV project; see below) would likely include scaling back vulnerable business activities, lengthening the term of funding beyond thirty days, and/or increasing holdings of liquid assets to cover the ratio. This would have an impact on the financial markets and the role of banks in them, but the likely additional safety (and reduction of the need for central bank and government intervention that puts taxpayers’ money on the line) is expected to be well worth this33. In addition to short term funding ratios, the BCBS has also developed a long term liquidity requirement; the net stable funding ratio (sometimes referred to by its acronym NSFR). Instead of allowing a bank to survive extreme stress for 30 days, the longer term ratio wants 31 BCBS, Basel III: the Liquidity Coverage Ratio and Liquidity Risk Monitoring Tools, January 2013. 32 See chapter 22.4. Also see J. Capel, ‘The Post-Crisis World of Collateral and International Liquidity’, DNB Occasional Studies, Vol. 9, No. 3, 2011. 33 CEBS, Results of the Comprehensive Quantitative Impact Study, 16 December 2010, www.eba.europa.eu, page 18.

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to align long term investments with long term funding (and limit gaming the short term ratio by e.g. rolling over 31-day funding)34. The crisis showed an overreliance on (cheap but flighty) short term wholesale funding and an underestimation of funding risks; see chapter 2. Unlike the short term ratio, the long term ratio is more similar to the solvency ratio. The assets of the bank are risk weighted (not depending on for instance the credit risk in the obligor, but depending on how liquid they are; i.e. how easy they can be sold for cash). Their risk weighted value has to be covered by equally risk weighted long term debts (capital and other likely long term funding facilities, which are ‘risk’-weighted depending on their likely availability in one year time in a stressed scenario). The impact assessment of the long term liquidity ratio showed that as per end 2009 banks had a relatively small average shortfall of below 10%. Banks with a relatively high shortfall could in an anticipated manner increase their net stable funding ratio by before 2018 (the implementation date announced by the BCBS) e.g. by lengthening the term of funding, reducing maturity mismatch or by scaling back vulnerable business activities35. Introducing this requirement would likely reduce the reliance on fleeting short term wholesale funding with its procyclical nature36. On the other hand, it could also reduce the balance sheet size of banks similarly as the leverage ratio (and thus reduce funding availability)37. In addition to the two ratio’s that have to be fulfilled continuously, the BCBS Basel III amendment also proposes a range of monitoring tools, to identify and manage potential mismatches in the maturity of loans and debts, mismatches in currencies, the concentration of funding and how many unencumbered assets are available (i.e. not already used up as they are sold (but not yet delivered, or provided as collateral to cover obligations), and market related liquidity stress indicators such as credit derivative prices, equity prices, bond prices, changes in the types of funding and prices available to the institution). The BCBS Basel III framework contains a range of promised follow-up work, monitoring and adjustments to both ratios. Whether and how the short term liquidity ratio and the long term liquidity requirements will be implemented in the EU is largely dependent on the size of the economic adjustment that is deemed politically and economically acceptable, and the size of unanticipated con34 BCBS, Basel III: International Framework for Liquidity Risk Measurement, Standards and Monitoring, 16 December 2010, page 25. 35 CEBS, Results of the Comprehensive Quantitative Impact Study, 16 December 2010, www.eba.europa.eu, page 21. 36 E.J. Kane, Regulation and Supervision: an Ethical Perspective, NBER WP 13895, March 2008. Also see chapter 6.5. 37 H. E. Damar, C.A. Meh, & Yaz Terajima, Leverage, Balance Sheet Size and Wholesale Funding, Bank of Canada WP 2010-39, December 2010.

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sequences due to e.g. potential shifting of activities into unregulated sectors (and shifting importance of those sectors for financial stability reasons.38. EU legislators have for now copied the short term ratio and the reporting regimes necessary for monitoring. Under the liquidity coverage ratio, banks will be required to have their potential liquidity outflows covered ‘fully’ by (i) liquidity inflows under stressed conditions plus (ii) liquid assets. This should cover the outflows in gravely stressed conditions for a period of 30 days, but what exactly is that level required is not (yet) set. The banks are required to report on liquid assets, and their valuation, as well as liquidity inflows, and provisionally defined liquidity outflows. In 2014 it will thus mainly be a monitoring tool, and the Commission stresses that the ratio is likely to be amended before it becomes a binding quantitative requirement by 2015 on the basis of a yet to be developed Commission delegated act39. Once that act is available – with a deadline set for the Commission of 30 June 2014 – the requirements up to the level to be set will be phased in gradually from 2015-201840. The final CRR text includes reviews on aspects and at various stages, including on such issues as the detrimental impact on lending to small- and medium sized enterprises by having liquidity reporting on a liquidity coverage ratio in place41. The application on a solo and on a consolidated basis will no doubt also play in role in determining the definitive form of the requirements42. The range of qualifying liquid assets is wide, with follow-up work planned43. EBA is requested to take into account also the BCBS work on the types of qualifying assets in its subsequent monitoring44. In a deviation from Basel III, the net stable funding ratio is not part of the CRD IV project; though it requires institutions to ensure that long term obligations are adequately met (a qualitative, not a quantitative requirement), and to report on items providing and requiring stable funding45. The CRR indicates that the net stable funding ratio will be revisited prior to its 2018 agreed implementation date; though it allows member states to goldplate the liquidity requirements to a higher level during the phase-in period46. EBA is to report by 38 See chapter 22. Also see R.J. Theissen, Are EU Banks Safe?, The Hague, 2013. 39 See art. 412, 415-426 and 460 and Annex III CRR, and page 13-14 of Commission, Proposal For a Regulation as part of CRD IV, COM(2011) 452 final. 40 Art. 460.2 CRR. Also see BCBS, Basel III: the Liquidity Coverage Ratio and Liquidity Risk Monitoring Tools, January 2013. 41 See art. 8, 21, 460-461, 509 and 521 CRR. The Commission will also look at consolidated issues, especially the transfer of funds between entities (art. 8.1 CRR), and EBA will review the liquidity coverage ratio halfway through its implementation in mid 2016, as well as annually on the items reported (art. 460-461 and 509 CRR). 42 Art. 6.4, 11.3, 20, 21 and 412-413 (part six) CRR. See chapter 17. 43 Art. 416, 417, 426 and 460 CRR. 44 Recital 102, art. 426 and 510 CRR. BCBS, Basel III: the Liquidity Coverage Ratio and Liquidity Risk Monitoring Tools, January 2013. 45 Art. 413, 427-428 CRR. 46 Art. 412.5, 413.3, and 510 CRR.

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end 2015, and the Commission is to send possible legislative proposals by end 2016, but can opt to not send proposals if it does not find a net stable funding ratio appropriate in light of the ‘diversity’ of the EU banking sector. The main reason for delaying an article with a specific quantitative requirement that was given by the Commission is that the monitoring and promised renegotiations within the BCBS, in which the Commission takes part, is likely to substantially rephrase the ratio well before the likely implementation date; see chapter 2. The cost of liquidity requirements for banks and to the economy may also have played a role in the delay, as well as criticism on the lack of a macroprudential component47. If the CRR obligations on the short term liquidity requirements or the general obligation to have long term funding in place are not met, the follow-up obligation is to submit a plan ‘without undue delay’ in order to ‘timely’ comply again48. This allows quite a lot of leeway for supervisors and banks to agree on (legal) regulatory forbearance; see chapter 20. The monitoring of both short term and long term liquidity is, however, useful in and of itself to harmonise terminology and achieve a common understanding of the liquidity risk factors that differ across the EU, as a basis for the national regimes in this unharmonised area49. The reporting is reasonably detailed, providing future insight into liquidity at banks that can be useful both for micro and for macroprudential purposes, as well as for crisis management50. A quantitative version of the longer term regime would be useful to predict larger repayment dates. These are not only key for individual banks, but especially at a ‘macroprudential’ level if multiple banks will need to repay debts at the same date. As an example, this will be the case with the 1 trillion euro three year loans made to the Eurozone banking system under the longer term refinancing operation or ‘LTRO’ of the ESCB/ECB end 2011 and early 2012. It is likely, however, that such large repayment dates will be a subject of monitoring by the ESRB in any case (and potential supervisory follow-up action). If the banks do not prepare well in advance for this type of repayment dates liquidity may drain from the financial system; see chapter 22.5. An additional negative side effect of the liquidity ratios as drafted is that they further invigorate and rely on the myth that government bonds are ‘safe’ and liquid. Where in the

47 See e.g. the issues raised in S. Nicoletti-Altimari & C. Salleo, Contingent Liquidity, Bank of Italy Occasional Papers 70, September 2010. 48 Art. 414 CRR. 49 Recital 18 and 111 and art. 412.5 and 413.5 CRR explicitly allows national regimes. For the liquidity coverage ratio this would be possible until harmonisation in 2015. Also see chapter 3.5. 50 Art. 415-428 CRR.

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capital requirement proposals (see chapter 8.1) the sovereign risk embodied in government bonds will gradually face a more appropriate risk weighting for at least foreign denominated sovereign debt, in the liquidity ratios the main asset that is deemed liquid is a government bond, in spite of evidence in the subprime crisis that even the safest asset is not risk-free, and sometimes not even liquid51. Guidelines – BCBS, Principles for sound liquidity risk management and supervision, September 2008 – BCBS, Basel III: the liquidity coverage ratio and liquidity risk monitoring tools, January 2013 – Recommendations on liquidity risk management, contained in CEBS-EBA, Second part of CEBS’s technical advice to the European Commission on liquidity risk management, CEBS 2008 147, 18 September 2008 – CEBS-EBA, Guidelines on liquidity buffers & survival periods, 9 December 2009 – CEBS-EBA, Guidelines on liquidity cost benefit allocation, 27 October 2010

51 B. Allen, K.K. Chan, A. Milne & S. Thomas, Basel III: is the Cure Worse Than the Disease?, Cass Business School, City University London, 30 September 2010. Also see chapter 8.1.

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13.1 Introduction Organisational requirements are important. Without a good organisation, the bank has no clue on what it is doing and why, nor can it verify whether what it plans to do (and not to do) is actually happening. Without internal governance, the data coming out of the organisation for risk management, public accounting and regulatory purposes cannot be trusted, and the management will not be in control (nor can they be considered competent if they fail to address organisational gaps). The data generated by a badly organised bank are more likely to be too optimistic than too pessimistic, meaning that necessary measures to prevent risk are not taken. When restatements are necessary, the main causes will be malfunctioning internal procedures (including in this case the wrong assessments of risk of the business the bank has engaged in) and deliberate misconduct1. Without good corporate governance, the checks and balances required to keep a bank on the road in the long term and to respond well in the short term to new developments is likely lacking. In practice, the organisational requirements are the cornerstone on which ongoing supervision is based. If the organisation does not conform to the highest standards, the board cannot be in control of the company and the accurateness of the financial reporting cannot be trusted. If the data cannot be trusted, both investors and supervisors are likely to base their decisions on quicksand. Despite this importance, the CRD contains only a limited set of provisions on organisational requirements on institutions. The governance requirements of prudential supervisors are expected to be supplementary to the company law and corporate governance requirements as applicable to the legal form chosen by the bank, as well as to applicable accountancy or market disclosure rules, and places trust in the quality of such elsewhere developed laws. The accounting side of these provisions has been largely harmonised (see chapter 6.4), but the organisation side of company law provisions are still very dissimilar across the member states. The existing CRD provisions on management build upon the existing rules in the member states, in all their glorious diversity.

1

V. Valdivia, ‘Restatements at Financial Institutions: Lessons Learned’, Bank Accounting & Finance, JuneJuly 2008, page 3-10; W.P. Woodbridge, M. Carducci & D.C. Dipillo, ‘Managing Difficult Financial Reporting Situations’, Bank Accounting & Finance, June-July 2008, page 11-14 and 50-51.

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Various terms are used to describe subsets of governance, especially in the area of risk. By way of example, the joint forum in its critique of credit risk transfer products2 distinguishes between risk governance (was the risk measured and assessed), risk management (was the risk manageable within the operational infrastructures) and use of collateral (not requiring adequate collateralisation). Though organisational requirements can be split up in many different ways, all relate to being in control of the business, and to ensure that risks are managed and priced in line with the stated and allowed risk appetite of the bank. The CRD organisational requirements are generally formulated in a principle-based manner (with some oddly detailed add-ons3). Detail is in most cases provided instead in non-binding documents provided by the BCBS, by CEBS-EBA and/or by national supervisors. Banks are required to apply the law under the best practices available and as good as they can, even if the supervisory guidance provided has not yet been updated. The benefit of this system is that newly established best practice – within the boundaries of the EU or national binding rules as set down in e.g. the CRD – can be applied immediately. The downside is that supervisors and banks may not be up to speed on best practice (or on the application of the abstract rules on concrete cases), and the rules may be difficult to enforce if the supervisors cannot prove non-compliance. Upholding the organisational requirements in court can be difficult if bad or below-standard behaviour is not explicitly forbidden by the law, and depends upon a supervisory interpretation of the law. Local laws and customs will then determine how its interpretation should be upheld. After a long period of legislative inattention4, the core organisational requirements were upgraded in the first aid repairs made in the wake of the 2007-2013 subprime crisis. Some detail was added to the RBD annex on organisational requirements on securitisations, liquidity risk and remunerations, in line with the wider BCBS Basel II ½ work on board involvement, risk management, risk concentration, off-balance sheet risks and securitisation risk, reputational risk, valuation practices, stress testing, and compensation practices5.

2

3

4

5

Joint Forum, Review of the Differentiated Nature and Scope of Financial Regulation, January 2010, www.bis.org page 10. Also see Joint Forum, Credit Risk Transfer, Developments from 2005 to 2007, July 2008. For example the provisions on ‘risk functions’ in the model validation requirements are extremely detailed and specific, while the pillar 2 and licensing requirements are of an almost stratospherically high level of principles, except for the recently adapted liquidity risk and remuneration provisions. See 22, 123/124, and Annex V RBD. The exception being some detailed internal governance requirements that have to be fulfilled if the bank wants to apply its self-developed internal models for the solvency ratio as added in 2006 when the Basel II Amendment to the Capital Accord was implemented in the CRD; see chapter 13.3 and 13.5. BCBS, Enhancements to the Basel II Framework, July 2009, which is part of the Basel II ½ Amendment to the Basel Capital Accord, CRD II Directive 2009/111/EC and CRD III Directive 2010/76/EC.

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Most of the ideas and/or gist of the Basel work on internal governance have in practice been allocated to CEBS-EBA guidelines instead of to binding CRD provisions. The CEBSEBA guidelines build upon the more general RBD obligation to have a good organisation, and to do a self-assessment of risks under pillar 2. EBA consolidated most of its internal governance work in 2011 into a set of ‘EBA guidelines on internal governance’, but kept separate the organisational requirements relating to the use of internal models, on stress testing and on outsourcing6. In spite of its recently introduced power to issue draft binding standards on internal governance, EBA chose to issue the combination of its older work in the form of non-binding guidelines (on which the preparatory work had been done by its predecessor CEBS). The guidelines are not fully compatible with the rather simplistic CRD provisions (e.g. on the extent of obligations of the bank, on the existence of nonexecutive board members and on the existence of a remuneration committee; see chapter 13.2). The guidelines also repeat issues that are already codified in current or future versions of the binding CRD provisions, or ‘complement’ them extensively, even in the absence of a clear political mandate or legal basis. On the other hand, the guidelines sometimes struggle (especially in ‘new’ areas, on which there is no supervisory experience nor relevant literature, let alone consensus in the literature) to add more than a clarification of initial understanding or potential avenues of exploration and acknowledgements of difficulties for banks by the supervisory side7. Seen in this light the issuance as guidelines is understandable, but still a missed opportunity. Corporate Governance in the Interest of the State? The content of the governance requirements contained in the CRD increasingly overlaps with company law requirements, self-regulatory codes for public or financial companies, requirements for transparency under listing rules. The original set of rules was limited in scope precisely because it only wanted to add those aspects that were essential for prudential purposes. With the expanded set of CRD rules and EBA guidelines – since the introduction of CEBS/EBA and the reactions to the 2007-2013 subprime crisis – this supplementary character has been abandoned in favour of setting out a full set of corporate governance requirements supervised to achieve prudential goals. Simultaneously, the company laws and self-regulatory codes have been refined or expanded too. Though these may sound identical, there may be a discrepancy between company law and the BCBS principles in the type of ‘stakeholder’ interests the board (or the non-executives) should take into 6 7

EBA, Guidelines on Internal Governance (GL44), 27 September 2011. Also see the separate guidelines mentioned at the end of this chapter. See e.g. some aspects of the CEBS-EBA, Guidelines on the Management of Concentration Risk under the Supervisory Review Process (GL31), 2 September 2010. These are officially based on two words in art. 123 (and a few more in Annex V) RBD, are vague on e.g. the relation to market risk or operational risk, overlaps with liquidity risk issues, and so on. Nonetheless they provide insight into supervisory thinking and some comfort (true guidance or sometimes shared and acknowledged difficulties) for the banks.

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account. Under company law, this will generally amount to the interests of the company and the shareholders8, and depending on local laws possibly the creditors (all creditors, not limited to depositors), the employees and the group to which the company belongs. The BCBS is eager to stipulate that for banks the group of stakeholders whose interests should be taken into account also includes supervisors and governments. Without a specific – binding – company law or supervisory law provision it is doubtful whether this desire of the BCBS that supervisory interests are key to interpret the banks governance requirements is indeed implicit in the CRD rules or the company laws/codes. The BCBS defends its interpretation by referring to the unique role of banks in economies and financial systems, and implicit or explicit deposit guarantees9. These would indeed suffice as a reason to put such interests into the law, but are not sufficient reason to interpret ‘normal’ company law provisions so extensively. On the contrary, e.g. the deposit guarantee and the implicit state guarantee enjoyed by big banks is generally assumed to cause moral hazard precisely because the interests of creditors are already covered by the state, reducing the pressure on boards (see chapter 4.3). That this is wrong from the point of view of the state may well be correct, and it is reason to legislate. It is, however, insufficient reason to enlarge the task and liability of board members without telling them. In the CRD IV project, in addition to internal governance rules, corporate governance rules that are important for financial stability or depositor protection (and the single market) are explicitly identified and codified for all banks, regardless of the national company laws or self-regulatory codes10. These new rules will enter into force in 2014 after being implemented in national laws. The new corporate governance CRD rules serve the purpose of putting the board on notice. Each set of rules is applicable separately. Any binding CRD and company law requirements are applicable regardless of what other rules indicate. For instance he comply or explain rules (the EBA guidelines and e.g. self-regulatory codes) allow banks to deviate if needed due to CRD and company law rules. Even those binding rules may lead to conflicts, for instance if the interests of shareholders and of the supervisor, financial stability or depositors clash11. The CRD does not contain the possibility to exempt banks and their officers from the applicability of the internal governance rules that it sets in the public interest, but does allow supervisors to target their instruments so that banks will become compliant again in due course, unless one of the over-arching goals of the CRD necessitates immediate

8 9 10 11

See the ‘duty of loyalty’ referenced in §24 of the BCBS paper. BCBS, Principles for Enhancing Corporate Governance, October 2010, §14. Art. 88-96 CRD IV Directive. See chapter 3.4. Also see R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 2.

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compliance (e.g. in a crisis, or if the trustworthiness of the board is questionable). See chapter 20. In addition to the organisational requirements laid down in prudential laws such as the CRD, banks are and will likely continue to be subject to a range of mandatory or factual checks and balances, deriving from e.g. listing rules, company law, and statutes12. These are not part of prudential rules, and not part of prudential supervision, except to the extent they overlap with CRD-rules (as envisaged amongst others in the CRD IV directive in 2014). They do, however, interact with and support the prudential requirements. Similarly depositors, bondholders, wholesale lenders can individually or collectively ‘vote’ on practices at the bank at shareholders meetings or by walking away, challenging practices or suing if there is misbehaviour. Some of such rights of shareholders or other investors are stimulated by prudential rules (e.g. pillar 3 transparency requirements stimulate investor/depositor activism) or relied on by prudential rules (e.g. annual accounts, and the checks by non-executives and external accountants made as required under company laws). Rating agencies, consumer organisations and banking organisations perform similar roles to keep the bank well managed, as does the media (both consumer programmes and business programmes) for analysing and distributing newsworthy information. Each should and can fulfil its own role, with its own goals. These may or may not overlap or contradict prudential supervisory rules. A separate category are conduct of business rules. If they are focused on the service provider, they often contain overlapping organisational requirements. As most banks provide these types of regulated services, they are subject to the associated conduct of business supervision. The internal organisation rules derived from the most relevant conduct of business supervision are covered in chapter 13.4; the conduct of business rules themselves in chapter 16. This Chapter and Its Relation to Capital Requirements and Corrective Instruments The CRD does not contain a focused approach on the organisation of banks. Apart from some core provisions13, organisational requirements are scattered over the CRD, including of supplementary detail on specific issues in almost all chapters and annexes. The status of such specific requirements is sometimes unclear. In some cases they contain real additional requirements in order to be able to benefit from a more lenient option for the credit

12 BCBS, Principles for enhancing corporate governance, October 2010, §145-147. 13 Art. 22, 109 and 123 as well as Annex V RBD.

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institution in specific circumstances; such as using internal models for aspects of the capital requirements calculations. In other cases, they explain how the general organisational requirements should be read in a specific case, or who specifically is responsible for an aspect. Chapter 13.2 intends to provide insight on who bears responsibility for aspects of the requirements, chapter 13.3 sets out the various requirements that are applicable to all banks, chapter 13.4 and 13.5 sets out the various requirements that are applicable to a bank if they want to enter into specific types of businesses or into more advanced approaches, and chapter 13.6 discusses stress testing requirements. In addition to qualitative requirements, there may also be a quantitative follow-up. The operational risk capital requirements and the pillar 2 self-analysis/assessment cycle provide amongst others for (some) financial buffers for the results of bad risk management (as well as for external events); see chapter 10 and 14. The operational risk requirements set such in a (rough) pre-calculated manner; while pillar 2 focuses on the gaps in the overall risk assessment and preparation. These gaps often have an organisational component. Pillar 2 measures do not necessarily correct organisational mistakes. If persuasion does not suffice to convince the bank that it is in their own best interest to improve the organisation in a certain manner14 the supervisor can and should use the lower key corrective instruments described in chapter 20.3 that focus on ensuring that a bank immediately corrects a lapse in fulfilling a requirement. Pillar 2 comes into play if the organisational requirements are not fulfilled to the extent that this should be compensated for – in addition to remedial measures also – by high level measures such as an increase in financial buffers. Even when the organisation works perfectly in practice it can be used to show that the bank is exposed to certain risks that are not yet provided for (e.g. concentration to small farms in the region close to the banks premises, or to traders on a particular trading platform15). Future Developments: Basel Principles / CRD IV In the follow-up of the 2007-2013 subprime crisis, governance has gained more focused attention. The desire to clarify and upgrade governance is reflected in the BCBS principles16. For prudential purposes the focus is on executives and non-executives, and on the checks

14 A common interest often is most effective. See for instance H. Richards, ‘Influence and Incentive in Financial Institution Supervision’, in A.J. Kellermann, J. de Haan, F. de Vries, (Eds.), Financial Supervision in the 21st century, Amsterdam, 2013, chapter 5. 15 CEBS-EBA, Guidelines on the Management of Concentration Risk under the Supervisory Review Process (GL31), 2 September 2010. 16 BCBS, Principles for Enhancing Corporate Governance, October 2010.

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and balances and flow of trustworthy information within the bank (and to the supervisor). The Commission has published a green paper on corporate governance in financial institutions17. It announced its intent to follow this consultation paper up by legislative proposals in 201118. For banks, it integrated its proposals on corporate governance CRD IV project, building upon the results of its green paper consultation and upgrading some of the requirements that are (also) part of CEBS/EBA guidelines19. The CRD IV directive contains the core and the majority of the governance articles, both the existing internal governance and the new corporate governance requirements20. It contains more coherent view forward than could be derived from the former CRD provisions, and makes it indisputable that corporate governance also serves the goals of the CRD and thus is under the purview of the supervisor. It copies the new requirements in part from more advanced insurance regulations contained in Solvency II, and in part from the BCBS. The directive contains requirements on e.g. the time commitment needed of management body members (both executives and non-executives). The focus on governance is general is made part of pillar 2 even more explicitly than in the current CRD, where the internal governance provisions of the licensing process and of the pillar 2 assessment were equally important but not integrated sources of internal governance rules for banks. The licensing process on governance structures has been integrated with the existing ongoing supervision internal governance requirements. This even though the less explicit attention on governance in the licensing process is regrettable (though in practice governance can still be assessed as part of the business plan provision)21. A more controversial element is the new cap on bonuses contained in the new corporate governance provisions at the instigation of Parliament; see chapter 13.3.

17 Commission, Green Paper Corporate Governance in Financial Institutions and Remuneration Policies, COM(2010) 284 final, 2 June 2010. 18 Commission, Communication on Regulating Financial Services for Sustainable Growth, COM(2010) 301 final, 2 June 2010. 19 Corporate governance was part of the Commission proposal for the CRD IV Directive of the CRD IV project. The background (and relation to the green paper consultation) is described in part II of the accompanying impact assessment for the directive plus annexes, page 91-225: Commission, Impact Assessment accompanying the Proposal for a Directive as part of CRD IV, COM(2011) 952 final, 20 July 2011, as contained in Commission, Proposal for a Directive as part of CRD IV, COM(2011) 453 final, 20 July 2011. Also see the proposals strengthening the role of auditors and the research into the duties and liabilities of directors mentioned in chapter 6.4, 13.2 and 21.10. 20 See art. 74-96 CRD IV Directive, with the definitions contained in art. 4. 21 The old art. 22 and Annex I RBD are now part of the ongoing supervision requirements in the new art. 74 CRD IV Directive. The business plan with its description of the structure remains in the licensing requirements; now art. 9 CRD IV Directive.

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Shareholders continue to be ignored as a source of proper governance in banks for prudential purposes, possibly because they ignored such obligations at the large listed banks22. This aspect is left to company law, with prudential attention for shareholders continuing to be primarily negative. Shareholders are prohibited from having a qualifying holding or close links unless checked for the absence of negative influences, and shareholders provide and will to even larger extent provide the equity that is the core of the financial buffers that ease the pain for more privileged investors and depositors in a troubled bank; see chapter 5.2, 5.4, 6.2, and 7.1. Though the (minimum harmonisation) CRD IV directive contains the main outline of internal and corporate governance requirements, the CRR contains all provisions on e.g. model approval, on large exposures, and on leverage. These provisions currently are contained in the level 1 directives and their annexes. These could be implemented, read and applied jointly in the manner best suited to the national legislators/supervisor and the bank. The add-ons on technical issues have, however, been copied unchanged into the (minimum and maximum harmonisation) regulation; which is not flexible at all23, while the directive retains the flexibility inherent in the implementation and its minimum harmonisation character. This may in practice lead to ambiguity. Some of the governance terminology is vague, so probably can be elucidated or filled in by supervisors and banks. However, where the text of the CRR is clear, e.g. on the governance requirements for IRB banks24, the provisions contain both minimum and maximum harmonisation, and thus cannot be expanded or deviated from. As the substance is the same as some of the CRD IV directive provisions on the reporting lines and type of control needed, these minimum/maximum organisation-parts may fit awkwardly in an evolving more flexible general framework for governance for – in this example – non-IRB related governance requirements that are part of the national implementation of the CRD IV directive. Improvements have been made, if only by moving the principles on internal governance from the annex into the directive, and upgrading their states to binding rules instead of technical issues that can be taken into account (or not).

22 High-level Expert Group on Reforming the Structure of the EU Banking Sector, Final Report, 2 October 2012 (Liikanen Report), page 50-51 and 79. Rather naively, it also notes that holders of bail-innable debt will have incentives to monitor banks more closely (see page 92). If shareholders at listed banks do not even feel such an incentive, it is not likely that holders of more senior debt will. 23 See chapter 3.5, and art. 1-3 CRR and art. 1 CRD IV Directive. 24 Art. 144 and 197-191 CRR.

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Literature See in addition to books on company law and corporate governance that relate to all undertakings also for example: – Walker, David, A review of corporate governance in UK banks and other financial industry entities – Final recommendations, 26 November 2009 (the Walker review) www.hmtreasury.gov.uk – Ladipo, David; Nestor, Stilpon, Bank boards and the financial crisis, a corporate governance study of the 25 largest European banks, London, May 2009 Guidelines – EBA, Guidelines on internal governance (GL 44), 27 September 201125 – CEBS/EBA, Guidelines on stress testing (GL32), 26 August 2010 – CEBS/EBA, Guidelines for the joint assessment of the elements covered by the supervisory review and evaluation process (SREP) and the joint decision regarding the capital adequacy of cross-border groups (GL39), 22 December 2010 – CEBS-EBA, Guidelines on the application of the supervisory review process under pillar 2 (GL03 revised), 25 January 2006 – CEBS-EBA, groupe de contact, paper on the internal capital adequacy assessment process (ICAAP) for smaller institutions, CEBS 2006 76, 27 March 2006 – CEBS-EBA, guidelines on the management of concentration risk under the supervisory review process (GL31), 2 September 2010 – CEBS-EBA, guidelines on liquidity buffers and survival buffers, 9 December 2009 – Recommendations on liquidity risk management, contained in CEBS-EBA, Second part of CEBS’s technical advice to the European Commission on liquidity risk management, CEBS 2008 147, 18 September 2008 – CEBS-EBA, Guidelines on liquidity cost benefit allocation, 27 October 2010 – CEBS-EBA, Guidelines on remuneration policies and practices, 10 December 2010 – CEBS-EBA, High level principles for risk management, 16 February 2010 – CEBS-EBA, Model validation guidelines, April 2006 – CEBS-EBA, Guidelines on outsourcing 14 December 2006 – CEBS-EBA, High-level principles for remuneration policies, 20 April 2009 – BCBS, Principles for effective risk data aggregation and risk reporting, January 2013 – BCBS, Core principles for effective banking supervision, September 2012 – BCBS, Principles for the sound management of operational risk, July 2011 (replacing BCBS, Sound practices for the management and supervision of operational risk, 2003)

25 According to §34 of these Guidelines, they replaced the internal governance part of the 2006 pillar 2 guidelines, the 2009 high-principles for remuneration policies (but not the 2010 guidelines), and the 2010 high level principles for risk management).

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– BCBS, Range of methodologies for risk and performance alignment of remuneration, May 2011 – BCBS, Principles for sound liquidity risk management and supervision, September 2008 – BCBS, Compliance and the compliance function in banks, April 2005 – BCBS, Principles for enhancing corporate governance, October 2010 – BCBS, Banks’ interactions with highly leveraged institutions, January 1999 – BCBS, Principles for the management of credit risk, September 2000 – BCBS, A framework for internal control systems in banking organisations, September 1998 – FSB, Principles for sound compensation practices, 2 April 2009 – FSB, Principles for sound compensation practices, implementation standards, 25 September 2009 – BCBS, Compensation principles and standards assessment methodology, January 2010 – Joint Forum, Outsourcing in financial services, February 2005

13.2 Who is Responsible for What? Introduction Most organisational obligations are addressed to the bank; i.e. to the legal entity with the banking license. Some obligations instead are specifically allocated to specific persons or functions. There is no apparent/objective reason for the differences in targeting obligations. Most likely, different drafters with different backgrounds and domestic corporate backgrounds used different terminology. This causes several problems: who is responsible for what, who should be addressed by supervisory instruments if the task is not fulfilled (the bank, the board, or the specific persons who fulfil a certain function at a specific point in time??). Where obligations have been allocated to a specific organ or officer within the bank, it is not clear who is meant by the different terms used as such are not harmonised in the CRD nor in company laws, and whether those terms are mutually exclusive or overlapping. No clear definitions have been provided, except for the cumbersome ‘control functions’ that have to be instituted by IRB and AMA banks before the models are approved (see chapter 13.5), and an attempt at defining the addressees in the new internal governance guidelines of EBA. The CRD terminology used to allocate specific tasks includes: – the bank; – persons who effectively direct the business of the bank (art. 11 RBD, requesting a minimum of two of such persons);

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– the management body (annex V RBD and in the EBA guidelines); – the management body in its supervisory function (annex V RBD and in the EBA guidelines); – the management body in its management/managerial function (EBA guidelines); – the board of directors (annex V §2(c) RCAD); – senior management (amongst others annex V RBD, and annex V §2 RCAD), CEBS/EBA guidelines (as distinct from the management body), as well as BCBS documents as distinct from the ‘board’ (the oversight function in BCBS documents); – remuneration committee in the RBD and similar committees under EBA guidelines26. These concepts are either not or not very clearly defined. It is likely that ‘board of directors’ as used in RCAD refers to the same set of officers as the term management body (possibly only in its management function), and the difference in terminology is solely the result of bad quality control in the legislative process (the initial versions of the various RCAD and RBD provisions being introduced at different moments; see chapter 2 and 23). The term ‘management body’ in the organisational requirements of annex V RBD has been defined as the persons who effectively direct the business of the bank27. The CRD does not define the concept of senior management, but nonetheless uses it in e.g. the annex to the RBD on operational risk (see chapter 13.3. EBA subsequently defines ‘senior management’ as the layer below the management body28. Sadly, this deviates from the definition in Mifid (which directive is equally applicable to banks as most banks provide investment services), which defines ‘senior management’ as the persons who effectively direct the business of the investment firm (in the context of allocating internal governance tasks irrespective of whether that firm is a bank or a non-bank investment firm)29. The overlapping and incompatible definitions in the CRD – as well as their incompatibility with the Mifid definition – are unfortunate. ‘Effectively directing the business of the bank’ appears to refer to the executive function. This is also in line with the four eye principle needed in any bank, where one executive checks and is able to stand in for another executive. Since 1 January 2011, this tentative conclusion has, however, been negated by the new CRD-definition of ‘the management body in its supervisory function’ that has been

26 Annex V §24 RBD. EBA, Guidelines on Internal Governance (GL44), 27 September 2011, page 27. 27 Art. 11.1 RBD and Annex V §1 and 2 RBD. Also see CEBS-EBA, Guidelines on Stress Testing (GL32), 26 August 2010, page 7. 28 See e.g. CEBS-EBA, Guidelines on Stress Testing (GL32), 26 August 2010, page 7, and CEBS-EBA, Guidelines on the application of the supervisory review process under pillar 2 (GL03), 25 January 2006. Annex X part 2 §4 f RBD. 29 Art. 9.1 and 13 Mifid 2004/39/EC and art. 2.9 Mifid level 2 Commission Directive 2006/73/EC that refers to the Mifid definition in the authorisation process for non-bank investment firms, not the bank definition. See chapter 13.4.

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introduced with the new remuneration requirements. According to this definition, the remuneration committee of a ‘significant’ bank (though nobody knows exactly when a bank is ‘significant’; see chapter 18.2 on systemic banks), has to be composed of a chair and of members without any executive function, but who simultaneously have to be members of the management board. Implicitly, at least for these ‘significant’ banks and most likely also for insignificant banks, a new requirement has been slipped in that a bank has to have a non-executive board (or non-executive members of the board). This was previously not required in the EU under EU rules30. The EBA guidelines indicate for all banks that they should have a fully-fledged management body, but that banks that are subsidiaries only are bound to ‘consider’ having independent non-executive directors on the management body31. The definitions used in the RBD are contradictory, unless ‘persons who effectively direct the business of the bank’ includes non-executives. This also implies that – according to the literal text always, but at least since 1 January 2011 when this new definition was included with the remuneration rules – non-executives have to be checked both as to their reputation and their experience; see chapter 5. It can be applauded if the CRD would include the introduction of a non-executive, or as you like supervisory, board or board members, as well as an obligatory verification of the reputation and skillset of such a non-executive. From a corporate governance point of view, a good non-executive board (or set of board members) is invaluable. Still, this messy cross-reference as a potential route to introduce such is troubling, mainly because it also implies that a license can be given to a bank that has one executive and one non-executive board member32. A non-executive does not necessarily have the time and skillset to be an executive, so may not be as effective a check and balance to limit fraud and to be able to stand in during illness or death as a second executive board member would have been able to do. And one nonexecutive appears too few in any case to provide a good sounding board and controller of the executive(s) of a bank. Otherwise, he alone is also likely to be the above-mentioned remuneration committee if the bank is ‘significant’; also see chapter 18.2. Mifid appears to equate the executive board members with ‘senior management’ and the ‘supervisory function’ with those responsible for the supervision of senior management33. This is more in line with a clear division between executives and non-executives, but leaves non-board members outside of the responsibilities allocated to senior management in the CRD (even if such sub-board senior managers may have effectively more power and understanding regarding the relevant substance). This is contradictory with the usage of

30 31 32 33

See Annex V §23.f and 24 RBD. EBA, Guidelines on Internal Governance (GL44), 27 September 2011, page 18. Art. 11 RBD only requires a minimum of 2 persons who effectively direct the bank. Art. 1 and 9 Mifid level 2 Commission Directive 2006/73/EC.

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that term by EBA, which indicates that senior management is the level below the management body34. Part of the reason for the fuzzy terminology in the CRD is the introduction at different dates in the CRD as mentioned above. Another reason is the different board structures in EU member states. The board structures are still largely non-harmonised across the EU in national company laws, as are their duties and liabilities35. Some member states have introduced a one tier board for their companies, others a two tier board. Whether nonexecutives have a task in day-to-day management, in long term strategic decisions, or only as an ex post check/sounding board on decisions made by executives can vary. Neither the CRD nor the harmonised aspects of company law is explicit on this. How the CRD is interpreted varies along with these domestic traditions. The BCBS and EBA, or at least its predecessor CEBS, was not in a position to challenge these domestic traditions as legislated for all companies by the member states36. It appears that in current discussions on the follow-up to the crisis, the existence of non-executives is expected, and especially for banks that employ more advanced models (see chapter 13.5) they have some more explicit roles, as well as for relatively new-fangled subjects such as remuneration structures (see chapter 13.3)37. However, it is unclear why the Commission/Parliament/Council chose to deviate from such company law definitions that are part of the existing EU level company rules such as on the European company (albeit prepared by other parts of the Commission, the Council and the Parliament). Those have a clearer link to the two tier and one tier systems that appears to bother supervisory legislators so much, which could have been supplemented with a wider or narrower senior management terminology (regardless of whether that includes or excludes members of a unitary board)38.

34 CEBS/EBA, Guidelines for the Joint Assessment of the Elements Covered by the Supervisory Review and Evaluation Process (SREP) and the Joint Decision Regarding the Capital Adequacy of Cross-Border Groups (GL39), 22 December 2010. 35 M.J. Kroeze & H.M. Vletter-van Dort, ‘History and Future of Uniform Company Law in Europe’, European Company Law, Vol, 5, No. 3, 2008. C. Gerner-Beuerle, P. Paech & E.P. Schuster, Study on Directors’ Duties and Liability, April 2013, www.ec.europa.eu. 36 EBA, Guidelines on Internal Governance (GL44), 27 September 2011, page 10 and 21-32. 37 H. Davies, The Financial Crisis, Who is To Blame?, Cambridge, 2010, chapter 27 and 28. 38 Compare art. 38-51 Council Regulation on the Statute for a European Company (SE) 2157/2001. Sadly, though the Commission did a self-justifying study on differences in terminology used in various pieces of financial legislation and even identified the ‘senior management’ term, it failed to include references to the usage in the context of the CRD. Commission, Cross-Sectoral Study on Terminology as Defined in the EU Financial Services Legislation, Annex 2, 27 November 2009.

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BCBS Terminology on Addressees The BCBS has – like the Commission – issued a paper on corporate governance for banks39. Amongst others it is helpful in distinguishing the various management functions. It acknowledges that every country thinks it has the best company law system, and refuses to take a position on what is best (reflecting that supervisors generally have little influence on company law). It subsequently draws a picture of the type of corporate governance structures that can be translated into any company law system, and relates it to the type of control functions the Basel accord demands for banks using advanced models. Those control functions are copied from the accord into the annexes to the RBD (see chapter 13.3 and 13.5). The BCBS differentiates between a board (defined as the internal oversight function) and senior management (defined as the management function in general). The board is composed of non-executives and executives, and provides oversight also over the senior management. Senior management can include executive board members. Part of the nonexecutives board members should be ‘independent’. This means that they should have the ability to exercise objective independent judgement after considering all information and opinions and without undue influence from executives or other (external) parties or interests. The board should strive to enhance its overall independence40, for instance by having non-executives as the majority on key subcommittees, having direct access by nonexecutives to outside expert advice, and to have independent non-executives (also) meet separately among themselves and with those employees providing relevant information. The BCBS recommends that the heads of important control functions such as the chief risk officer (responsible for risk management), should be of high statute and relevance in internal decision making (so probably part of senior management at least, though this is not made explicit and thus left to the members), and should be independent from the business lines. These important control functions should be able – in addition to reporting lines to the full senior management – to report to the (independent members of the) board and any non-executive subcommittee on risk management directly. This also applies to some other high level control functionaries, such as the internal audit and compliance41. Senior management is defined as the core group of individuals who oversee the day-today management of the bank. They are accountable to the board, though individuals can be a member of both. The senior management definition rings close to the CRD licensing requirements of fit and proper persons who effectively direct the business of the bank.42 39 BCBS, Principles for Enhancing Corporate Governance, October 2010. 40 BCBS, Principles for Enhancing Corporate Governance, October 2010, §12, 18, 38, 51, 52, 54. 41 BCBS, Principles for Enhancing Corporate Governance, October 2010, §28 and 50. BCBS, Compliance and the Compliance Function in Banks, April 2005. 42 BCBS, Principles for Enhancing Corporate Governance, October 2010, §65. Art. 11 RBD. See chapter 5.2.

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The way the BCBS formulates it is not mandatory in the context of the badly dated and high level remarks contained in the CRD. The BCBS principles can, however, be taken into consideration by the banks and supervisors as to what ‘good’ practices and procedures are, and member states can opt to make the principles binding in national legislation43.

43 Either as an interpretation of the CRD provisions, or as ‘goldplating’ on top of these CRD provisions (as the CRD contains minimum harmonisation rules; see chapter 3.5).

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Figure 13.1 BCBS terminology Board (oversight)

(non-executives and executives)

Senior management

(executives and other key managers)

Control functions Business

The Basel principles are already part of binding RBD rules in as far as it concerns the corporate governance aspects of liquidity risk management, of remuneration policies and of modelling the calculation of capital requirements.

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Time Commitment The RBD does not indicate how much time executives, non-executives or senior management or key personnel (such as risk officers) should have available for their jobs. For a small bank, there have to be at least two executives (see the discussion in chapter 5.2), for a large bank there will need to be more, in proportion to the complexity of the bank as well as its statutory and practical independence from the group at the moment of assessment (e.g. if the parent goes bankrupt, the board of a suddenly standalone subsidiary may need to be expanded rapidly to deal with the added difficulties and lack of strategy). There is no indication anywhere that such executives cannot work part time, though in case of an emergency they will need to be available at once and in full to be able to fulfil the tasks given to them under the RBD. The same applies to senior management and key personnel, who all have an ‘executive’ role. Good industry practice will likely be important to assess whether available time is sufficient. The Walker review44 indicates for the UK that a non-executive chairman will need to spend two thirds of his time on the entity if it is a major bank there. For other non-executive directors it indicates 30 to 36 working days availability. For smaller banks (and likely for subsidiaries) the amount of time can be reduced proportionally. The CRD IV project includes rules on the limitations of directorships (and on the use of committees in the board)45. CRD IV Project For reasons surpassing understanding, the terminology of the CRD IV project of the Commission still lives in the past century on the licensing requirements (information has to be provided on the ‘structural organisation’, only two persons are needed to effectively direct the bank), and regarding the fact that a bank need not be a legal entity46. Confusingly the CRD IV project also continues to simultaneously use management body, its supervisory function, and senior management, as well as references to executive and non-executive directorships47. The main improvement in the terminology is that it has been clarified that the ‘persons who effectively direct’ the business of the bank are part of the management

44 D. Walker, A Review of Corporate Governance in UK Banks and Other Financial Industry Entities – Final Recommendations, 26 November 2009 (the Walker Review) www.hmtreasury.gov.uk. Recommendation 3 and 7. 45 EBA, Guidelines on Internal Governance (GL44), 27 September 2011, page 51. The guidelines anticipate on some aspects of the CRD IV project, e.g. on the time commitment on page 24 of the guidelines. 46 See chapter 4.4 and 5. 47 Art. 3.7-3.9 CRD IV Directive provides some definitions, that are cross-referred to in art. 4 CRR. The terms are used extensively in both parts of the CRD IV project in the various general and specific governance requirements. The term ‘effectively direct’ is now limited to the licensing process only. See e.g. art. 11, 23, 76, 86 and 88 CRD IV Directive and art. 189, 221 and 286 CRR.

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body. It remains unclear, however, whether such persons are deemed executive or nonexecutive, and the requirement to have two such persons continues to be unclear on whether one executive and one non-executive is enough for some banks. The definition and description of senior management in the context of the qualified holding assessment simultaneously uses terminology that sounds remarkably like persons who effectively direct the business of the bank. This continues the existing an overlap between management body and senior management; even though several provisions distinguish between the two in the hierarchy of the reporting line (when certain information may need to be escalated upwards). The interaction between the various bodies thus remains unclear, and will likely continue to be determined not by the bank supervisor or actual competences, but by the company law applicable to the bank (or to the parent bank of the group). The relevance of the arbitrary and fuzzy lines is, however, reduced. The suitability test is transferred from the (two) persons who effectively direct the business to the full management body in a major improvement and clarification48. All such should be suitable, or in the antique language that continues to be used: have sufficient good repute and sufficient knowledge, skills and experience; see chapter 5.2. Strangely, in the licensing and ongoing supervision senior management is not assessed, but in the context of a takeover, the skillset of senior management can be as important as the skillset of the management body49. Additional clarity is also provided on the tasks of non-executives, and about the wider corporate governance structures within the bank. Under the CRD IV project, non-executives should constructively challenge the strategy of the institution, scrutinise the performance of executives, satisfy themselves that financial information is accurate and that financial controls and systems are robust and defensible, as well as looking at remuneration, resources, appointments and ethics; while ensuring sufficient time is available by limiting the number of directorships, as well as to foster diversity50. The terms used in the CRD IV project could be broadly interpreted as corresponding to the BCBS terminology. The management body in its supervisory function are non-executive directors. Executive board-members are the management body in its management function. These executive board members are part of both the management body and of senior management, to which also non-board members can belong.

48 Art. 13 and art. 91 CRD IV Directive; compared with art. 11 RBD that referred to the effectively directing persons to be tested, making that a more relevant term than it is under CRD IV. 49 Art. 23 and 91 CRD IV Directive. 50 Recital 57-60 and art. 91 CRD IV Directive.

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13.3 Organisational Requirements on All Banks Introduction The organisational rules are not written with the intent to eliminate risk. Risks are unavoidable in banks. A bank does need to be in control of those risks. The organisational requirements on banks – and even the quantitative rules applicable to banks – are all geared towards such control. The services banks provide are inherently risky (e.g. borrowing short term money and lending long term). The fact that a bank provides these risky services is the reason they are of importance to the financial system and society. Within its chosen trade, a bank is more or less free to do as it pleases, as long as (i) it is aware of the risks it runs with its own and other people’s money, (ii) those risks are within its explicitly chosen risk appetite and (iii) the bank can prove to the supervisor that it is aware of those risks and has taken measures to limit those risks or at least the impact of those risks on its survival (by quantitative and qualitative measures). Investing in a good organisation makes sense both commercially and for prudential reasons. However, in day-to-day business, short term profit can overrule investment in long term safety. For prudential reasons this cannot be allowed. Financial buffers limit the risk that a bank will collapse due to risks in its business materialising. They limit the risk for creditors of the bank that they will not retrieve their money from the bank (or from its estate). It is thus a cure for a disease in the bank that has to be able to be taken out of the medicine cabinet once that disease becomes known. Organisational requirements have a slightly different target, and have a more supportive role. They try to prevent risks from developing into diseases, and try to prepare a bank so that it has the management tools to address diseases that do develop, so that the bank will be able to survive. Effective action can limit and even prevent losses from occurring. A good organisation, which manages the risks in each and every transaction, on each portfolio of assets or liabilities, and on the business of the bank as a whole ensures that risk mitigants are sufficient51. Such mitigants solvency and liquidity, but also collateral, checks and balances, bad loans departments, stress analysis, decisions on timing and pricing of its services. Without good screening and risk assessment of the borrower, the risk weighting and the modelling of the quantitative requirements become worthless. As such, a solid organisation with the availability of sound risk measurement and management and subsequent monitoring is essential for the quantitative requirements to work, and for the bank to be as possible as safe. Good organisation allows the bank to be in control of its risks and profits,

51 The existing controls did not always allow this. Especially for systemic institutions, it is difficult but at the same time most relevant to get a good overview. See for instance BCBS, Principles for Effective Risk Data Aggregation and Risk Reporting, January 2013. On systemic banks also see chapter 18.2.

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and allows the supervisors to trust in the banks health or – whenever necessary – its recuperative capacity. Overview The internal governance provisions that banks are subject to are spread over a range of directives, annexes and guidelines/non-binding papers. The latter provide the best overview, but are only ‘binding’ if and in as far the underlying requirement is part of the directive or if the requirement has been goldplated to a binding status in national legislation. Type

Legal basis Content

Binding detail?

Non-bind- Chapter ing detail?

License require- RBD ments (applicable on an ongoing basis)

Have documenta- Annex V has to be tion and procedures taken ‘into account’. Extremely high level, except for liquidity and remuneration

EBA guide- 5 and below lines and BCBS papers

Pillar 2

Have good organisa- No tion

EBA guide- 14 and lines below

Requirements to Mifid support conduct of business in the investment area

High level require- Yes, in level 2 ments Commission directive

ESMA and 13.4 IOSCO papers

Detailed scatter- RBD and shot applicable to RCAD, and all banks sometimes in annexes

For specific subjects Generally not Not (e.g. pillar 3 or secu- beyond the main always. ritisations) ad hoc obligation obligations are part of the provisions for that subject

Detailed scatter- RBD and shot applicable to RCAD specific banks that want to use internal models in quantitative calculations

General modelling obligations plus some ad hoc obligations are part of the requirements to gain approval to use the model

Operational risk

Requirement to Yes, on the have a financial generic calculabuffer for amongst tion others organisational failures that result in losses

RBD

RBD

Yes, on the general modelling obligations in the annexes on market risk, operational risk and credit risk internal models

Below. Also see the chapters on the referenced subjects

Yes, in 13.5 CEBS-EBA guidelines and BCBS papers

Yes in 10 CEBS-EBA guidelines and BCBS papers

The importance of good governance is increasingly recognised. An initial sign of its increased importance was the introduction of pillar 2 and the model validation process in the Basel II context (see chapter 2 and 6), both of which explicitly build on good organisa-

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tion and control52 and on existing company law requirements53. Both are, however, equally clearly an adjunct to the quantitative regime (respectively checking whether the quantitative regime captures all risks and whether the models can support trustworthy quantitative calculations). A further shift in emphasis from numbers to control was delivered in the follow-up of the 2007-2013 subprime crisis. Risk management, the control by the board and the application in practice of what is laid down in the law were scrutinised in light of recurring bankruptcies and bailouts; see chapter 2 and 18. Both the internal organisation at banks and the supervisory attention to the banks’ practices attracted heavy criticism54. The BCBS developed a paper that sketches how risk awareness, control and management can help ensure the safety of individual banks (and by extension the banking system). This includes views on for example the involvement of the board of directors and senior management in defining the firm’s risk appetite and the procedures to ensure that the actual practices of the bank are in line with it55. The new narrative does not automatically translate into new binding obligations for the banks. CEBS-EBA took on board most of the BCBS work in updated versions of its guidelines that reference internal governance (see the list at the end of chapter 13.1). Most of the added detail could have been applied already on the basis of the previously existing high level texts available in the CRD. However, they were not so interpreted prior to the crisis. On the contrary, the crisis had shown that (some) banks and (some) supervisors had not applied the – admittedly inconsistent and non-specific – principles contained in the CRD to the detailed practices of the banks in such areas as remuneration or stress testing. The new and wider interpretations in new guidelines of the BCBS and CEBS-EBA thus expanded the binding obligations of the banks to invest in good internal processes compared to how they were applied prior to the crisis. In addition, from 2010 slightly more issues have been put explicitly into the CRD, clarifying how e.g. liquidity and remuneration

52 See CEBS-EBA work in its guidelines on model validation and on the supervisory review process, www.cebs.org. 53 Such as the requirement to have an audit committee of art. 41 Auditing Directive 2006/43/EC. Some of the national discretions contained in this directive may be deleted as part of an upgrade proposed by the Commission; see chapter 6.4. 54 See e.g. W.K. Kross & W. Gleissner, ‘Ineffective Risk Management in Banking: Bold Ignorance or Gross Negligence?’ in G.N. Gregoriou (Ed.),The Banking Crisis Handbook, 2009, chapter 4. 55 See BCBS, Enhancements to the Basel II Framework, July 2009, page 13. The CRD II Directive 2009/111 and CRD III 2010/76/EC failed to take such enhancements on governance on board, meaning that they were reduced to continue as supervisory guidance instead of binding rules in the EBA-CEBS work on internal governance.

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should be dealt with, and allocating that obligation to the highest management levels at the bank56. Internal Control, Risk Management, Uncertainty Management, Risk Analysis/Governance Internal Governance and Other Fluid Terms The internal governance area is thick with terminology with shades of meaning. In essence, terms like internal control, risk management, uncertainty management, risk governance and the underlying analysis and follow-up processes are part and parcel of the same issue, slowly being invented and evolving in an economic/accountancy/governance theory57. They are used when the CRD intends to set out what the bank should do itself to handle the risks it is exposed to. None of these terms are defined in the CRD, and clear-cut definitions do not appear to be widely accepted elsewhere (as with the wide array of ‘risks’ referred to but not defined in the context of market risk; see chapter 9.1 under ‘lots of risks; no definitions’. The terms are sometimes used as synonymous in the CRD, while at other times differences are made where some terms are used as a subset of another term or as the task of lower level employees within the bank or instead of the board. The underlying focus remains the same: how should the bank be organised so that it can see, investigate, and act upon risks in a consistent, effective and efficient manner with defined responsibilities within the bank. If this internal set of checks and balances works well, it is a remaining area of self-regulation by the bank58. If the bank does it conscientiously, the supervisor can graft its work and quantitative and qualitative analysis onto the same basis. If the bank shows it is not able to do so, first this governance regime must be enforced. If a bank cannot govern its own organisation, not even when this has been forcibly pointed out as a key task of the bank itself, where necessary by replacing management, the supervisor either has to take over the risk analysis that should have been done within the bank as a backseat driver, or build its work (even more) on quicksand. The quantification of operational risk has tried to put an additional layer of safety on top of the qualitative organisational requirements, even though its models are still in their infancy, and in no way approximate reality with its various uncertainties. The extra 56 Both the CRD II Directive 2009/111 and the CRD III Directive 2010/78/EU expanded Annex V of the CRD to a limited extent by rephrasing the securitisation risk language in it and adding language on liquidity risk and remuneration risk management. Also see chapter 13.2. 57 See e.g. the description in M. Power, Organized Uncertainty, Designing a World of Risk Management, Oxford, 2007, chapters 1-3. 58 See chapter 4.3. I. Ayres & J. Braithwaite, Responsive Regulation: Transcending The Deregulation Debate, Oxford, 1992, chapter 1 and 4; M. Power, Organized Uncertainty, Designing a World of Risk Management, Oxford, 2007, chapter 2.

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financial buffers can never compensate for the risk that both the board, all the decisions of its traders and sellers, its pricing and the actions (or lack of action) of its supervisor are built around mistaken conceptions or unnoticed risk. Those mistakes or misunderstandings can be excusable if they could not be prevented using the best practice available, but even so are still an easy route to large or even crippling losses. A qualifying remark is that even if best practice in this area is actually performed, this will limit risks, not eliminate them. Even with top notch work, top notch actions, crises will nonetheless occur59; see chapter 18 and 22. Organisational Requirements to Obtain and Maintain A License, Supported By Pillar 2 The basic set of organisational requirements is part of the licensing process. The applicant will need to comply with the requirements before a bank can obtain a license (see chapter 5.2). These provisions also apply on an ongoing basis during the lifetime of the bank. Noncompliance can lead – as an ultimum remedium – to withdrawal of the license. See, however, below on enforcement-problems with internal governance specifically, and chapter 20 on the administrative and human rights protection of a bank against (disproportional) enforcement by the supervisor. Since the introduction in 2006 of pillar 2, all banks also need to perform a general self-assessment of amongst others the way they have organised themselves in light of the risks they run; see chapter 2, 5.2 and 14.2. The underlying requirement is to have robust governance arrangements that are comprehensive and proportional in relation to the business of the bank60. According to the RBD this includes several subjects. Robust governance includes: – a clear organisational structure; – well defined, transparent and consistent lines of responsibility; – effective processes to identify, manage, monitor and report actual or potential risks; – adequate internal control mechanisms, including sound administration and accounting procedures; – remuneration policies and practices that support risk management; and – strategies and processes to assess and maintain on an ongoing basis the amounts, types and distribution of adequate internal capital to cover actual or potential risks. In addition each bank has to take several ‘technical criteria’ as laid down in an annex ‘into account’ when designing its own internal governance structures and procedures61. The annex urges banks to have good procedures on a range of issues, such as liquidity, remu59 See chapter 18 and M. Power, Organized Uncertainty, Designing a World of Risk Management, Oxford, 2007, chapter 1 and 7. 60 Art. 22 and 123 RBD. 61 Art. 22 and Annex V RBD.

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neration, operational risk and market risk; see below. Though these criteria are not enforceable in and of themselves (the status of the annex is comparable to guidelines), their importance and enforcement has been improved since their original introduction. The majority of the annex ‘considerations’ can be summarised as a requirement that the bank has documentation on how it wants to deal with a range of specific subjects, and subsequently actually apply what it has written down that it wants to do. Except for the recently recast or introduced provisions on liquidity and remuneration, the CRD does not actually set out what the content of such documentation should be. Except for the remuneration technical criteria, the issues set out in the annex are left in principle to the bank. On the remuneration issue supervisors have been ordered to follow-up continuously and disclose aspects. Other risks, such as liquidity risk, have to be taken into account by the supervisor in its supervisory review (the second stage of the pillar 2 process)62. Sometimes the annexes to the RBD contains some minimum conditions on e.g. the amount of senior management buy-in, or on specific roles of employees to check on each other or report information. The BCBS similarly indicates that information should reach the management in timely, complete, understandable and accurate manner, to allow them to make informed decisions63. There is a dual task for those in charge to ensure that they get the information, and to respond to it in a well-organised manner. Lack of information indicates a failure to fulfil the obligation to set up a good organisation, while acting wrongly or inexpertly on the basis of the information received impinges on their fitness and propriety as managers of the bank; also see chapter 5.2 and 13.2 on the various types of management groupings allocated responsibility. The subjects on which each bank has to set up documentation and execution under the annex include64: – treatment of risk, including all risks the bank willingly or unwillingly is subject to during the business cycle65; – criteria for the extension of credit, its monitoring and administration and the spreading of credit risks via diversification, irrespective of whether such assets are bought or subsequently securitised66; 62 Art. 124 and Annex XI RBD; as amended by the CRD II Directive 2009/111/EC. 63 BCBS, Principles for Enhancing Corporate Governance, October 2010, §94, as part of the wider task to interact with the organisations risk management and control functions. 64 Annex V RBD and Annex VII part A and B RCAD. 65 This likely includes strategic and reputational risk. These are excluded from the capital calculation described in chapter 6-10, but are nevertheless – difficult to quantify – risks any bank is subject to. M. Power, Organized Uncertainty, Designing a World of Risk Management, Oxford, 2007, chapter 5. 66 EBA, Guidelines on Internal Governance, 27 September 2011. Art. 122a.6 RBD. If this provision is not lived up to, assets cannot be securitised, at least not taken off the balance sheet in one of the few internal governance

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– segregation of duties and prevention of conflicts of interests; – credit risk mitigation strategies and the residual risk that the risk actually turned out not to have been mitigated; – concentration risk both on exposures and on risk mitigations67; – risks, including reputational risks and liquidity risks, related to being involved in securitisations as investor, originator or sponsor, especially if the structure is complex68; – management and measurement of market risk; – interest rate risk from non-trading activities (banking book; also see pillar 2 in chapter 14); – trading strategy, active management of trading positions and monitoring of both; – valuation (see chapter 6.4, 9.2, and below)69; – evaluation and management of operational risk70, including setting up contingency and business continuity plans; – liquidity and funding risk (see chapter 12.2 and below); – remuneration. For liquidity and remuneration slightly more detail is available; see below. The application of such self-developed procedures by each and every employee, each and every person working for or on behalf of the bank is key for the procedure to be worth the paper it is written on. Ensuring such compliance with the procedures is difficult and expensive in resources, and will need to be monitored continuously. This will likely be easier if these rules are part of the own business culture of the bank and fit their own perceptions of their risks, instead of a policy enforced by the legislator/supervisor and complied with grudgingly by the bank71. This may explain the principle based nature of the rules (and the legislative detail on those remuneration limits that are purely introduced for political reasons; see below). An unintended side-effect may be that if principles are paid lip service to and the supervisor does not intervene, the bank may say – and even think –

67

68 69 70 71

provisions that come with a penalty. Also see BCBS, Principles for the Management of Credit Risk, September 2000. Also see CEBS-EBA, Guidelines on the Management of Concentration Risk under the Supervisory Review Process (GL31), 2 September 2010. An example mentioned in Annex V §7 RBD is the concentration of indirect credit exposure to a single collateral issuer. Such documentation turned out to be an inadequate limiting factor in the build up of the 2007-2013 subprime crisis in e.g. the securitisation market or the derivatives market, where a limited number of parties provided guarantees on large numbers of assets that were perceived to be safe, such as AIG. Annex V §8 was broadened by the CRD II Directive 2009/111/EC. Annex VII part B RCAD and art. 64.5 RBD. G.J. van den Brink, Operational Risk, The New Challenge for Banks, Palgrave Macmillan, 2001, chapter 3. J. Edwards & S. Wolfe, ‘The Compliance Function in Banks’, Journal of Financial Regulation and Compliance, Vol. 12, No. 3, 2004, page 216-224.

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that it is well organised. However, even with well monitored procedures at a well-managed bank, human error, a faulty compliance culture, underestimation of risks and accidents do happen72. The purpose of the requirements and the pillar 2 self- and supervisory assessments is to reduce the frequency, and have the institution catch and address transgressions or faulty reasoning when they occur. With the inclusion of pillar 2 in the Basel II framework, as introduced into EU legislation in 2006, supervisors check via the so-called supervisory review and evaluation process whether the goals of internal governance (as contained in this annex belonging to the licensing requirements but applicable on an ongoing basis) have been taken into account by the bank sufficiently to deal with all the risks the bank is exposed to. If the supervisor does not agree with the bank that it has done sufficiently to handle all the risks it is exposed to, it can take measures. Such measures are in addition to the possible withdrawal of the license (if that is a proportional action) and the general instruments the supervisor has at its disposal to ensure that CRD obligations are effectively and efficiently maintained; see chapter 20. The pillar 2 measures address the general risk profile of the bank. Though the highest profile pillar 2 measure is an additional capital requirement, they can also include for example instructions to reinforce internal governance structures. CEBS-EBA has worked extensively in this area from the moment the pillar 2 concept was introduced in the CRD in 2006. Its efforts have been further strengthened since the crisis. Specifically, it has delivered both detailed guidelines in various sub-areas, as well as – sadly ambiguously named – high level principles for risk management73. It can be assumed that these are guidelines of the variety that supervisors have to apply (or explain why not) under the EBA regulation. Ad hoc Additional Requirements Additional specific requirements scattered over the RBD and RCAD, that are nevertheless applicable to all banks include: – senior management is responsible for the mapping policy on how to allocate exposures to specific business lines in operational risk under the control of the governing bodies of the credit institutions, and it must be subject to independent review74; – banks have to set an internal governance regime to manage and monitor their large exposures, and have a specific system to monitor and control their underwriting exposures between the time of the initial commitment and working day one to be able to assess the net exposure for the large exposures regime75; 72 73 74 75

BCBS, Compliance and the Compliance Function in Banks, April 2005. See the list at the end of chapter 13.1. Annex X part 2 §4 f and g RBD. Art. 109 RBD and art. 28.1 and 29.1 RCAD.

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– banks that want to invest in securitisations have to set up an internal governance system to monitor both the transaction structures and the underlying assets that are securitised. Banks that want to set up securitisations have to publish information that will allow investors to perform such checks. If they do not perform this duty there is an obligation for the supervisor to impose a higher risk weight, making this one of the few internal governance requirements with a clear incentive for compliance76; – banks have to have internal control mechanisms and administrative and accounting procedures that permit the verification of compliance with market risk77, as well as systems and controls that support its allocation to, valuation and management of its assets in the trading book78; – banks that have to publish prudential information under pillar 3 (parent banks and significant subsidiaries; see chapter 15.2 and 17.2) have to have policies to comply with the disclosure requirements, and to assess the appropriateness (including verification and frequency) of such disclosures, as well as on whether the disclosure conveys the risk profile comprehensively to market participants79; – organisational requirements in some cases can be met by the banking group on a consolidated basis instead of on a solo basis80. On the other hand, branches in other member states will have to fulfil some organisational requirements themselves81; – all banks that are investment firms or perform investment services/activities (most), are also subject to the organisational requirements of Mifid; see chapter 13.4; – all banks that conduct payments (most), or issue electronic money, are also subject to the specific organisational requirements for such institutions; see chapter 19.3; – banks that provide specific services that are separately regulated in conduct of business legislation may be subject to specialised rules on internal governance applicable to those. These range from record keeping to being able to verify transgressions of the bank or of its clients, to managing complex obligations; see chapter 16. For services provided by banks, e.g. being a depository for collective investment undertakings, this basically means having an organisation to manage its tasks (to prevent the civil liability provisions to trigger). For services provided by subsidiaries of banks (e.g. management companies of collective investment undertakings), this will need to be taken into account in group-wide governance; see chapter 17 and 19.

76 Art. 122a.4, 122a.5 and 122a.7 RBD. CEBS/EBA, Guidelines to art. 122a of the Capital Requirements Directive, 31 December 2010. Internal governance requirements on credit granting apply both to assets that will be kept, as to those bought or subsequently securitised, see above under general requirements, and art. 122a.6 RBD. Also see chapter 8.6. 77 Art. 35.1 RCAD, which corresponds to art. 22 RBD. 78 Art. 19 and Annex VII RCAD. See chapter 9.2. 79 Art. 145.3 RBD, as amended by art. 1.11 CRD III Directive 2010/76/EU; see chapter 15. 80 Art. 68 to 73 RBD and 34 RCAD. See chapter 17. 81 Art. 16, 22 and 25 RBD.

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Additional requirements apply if the bank wants to model their own risks on credit risk, operational risk and market risk; see chapter 13.5. Available Guidance The system set out in the EBA guidelines on internal governance complements this range of CRD provisions. In principle risks should be set and handled by the business itself (within the boundaries and under the overview of the management body). This is checked by both internal control and compliance functions, to see whether risks are identified and managed correctly, legally and in their interdependent context (and reported to the management body). The internal audit subsequently assesses whether the internal control is done in an effective and efficient manner. The reports from the various officers (commercial, back office, and back office of the back office) should enable the management body to have responsibility and to manage the organisation, taking into account the wide range of inputs on specific operations of the bank. The Basel principles82 are more detailed and demanding than the CRD. They for example demand the existence of (independent) non-executives as part of the governance structure, clarifying the role of non-executives, the importance of independence of (a majority of) non-executives and the board as a whole, and the importance of direct access to information and key personnel of such independent non-executives, approval of new products or significantly changing products, the amount of information board members/senior management should receive and so on; see chapter 13.1 and 13.2. Parts of such BCBS work is reflected in CEBS/EBA work (but not all), and all of such work is non-binding. It is thus difficult to apply in day-to-day supervision, though they can be taken into account in the form of best practices and/or the assessment of risks under pillar 2. The BCBS also requires all large banks and internationally active banks to have subcommittees of the board of specific tasks (in principle in its oversight function, though these can be staffed in part by non-independent non-executives and executives). The BCBS requires: – an audit committee responsible for financial reporting, and overseeing e.g. the internal and external auditors, as well as the actions managers take to control weaknesses identified by auditors and accountants83; – a risk committee, responsible for preparing proposals on the risk tolerance/appetite and strategy, and overseeing the implementation thereof.

82 BCBS, Principles for Enhancing Corporate Governance, October 2010. 83 In the EU this is already part of the Auditing Directive 2006/43/EC, and will be further reinforced in new proposals for amongst others banks; see chapter 6.4.

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They also recommend considering a compensation committee (currently already obligatory for larger banks in the EU in the form of a remuneration committee), a committee for assessing management and to handle succession issues, and an ethics/compliance committee. Corporate governance has been part of the CRD IV project too, to be effective from the start of 2014. The CRD IV directive stresses84: – additional demands on diversity issues, where the EU – in one of the issues that are not bank related but are aligned with other purposes of the Commission – tries to avoid group think and improve the position of especially women, and thus demands a balanced and diversified composition of the boards; – an additional limitation in the number of mandates, providing detail on the amount of time that should be spent on the bank by executive and non-executive board members. The BCBS and the CRD IV project85 also require – in great detail – all banks to have a risk management function (including a chief risk officer) and effective risk control systems. A chief risk officer is not required under the current RBD for all banks, nor are many of the risk control functions mentioned, except in the context of some of the model approval provisions; see chapter 13.5. Though not explicitly mentioned in the RBD or its annex, banking supervisors in CEBSEBA have taken it upon themselves to develop guidelines on how to deal with the risk embodied in outsourcing. They are based on the general requirement to have a good internal organisation. The management body is expected to approve and review the outsourcing policy86. This policy is expected to fulfil certain requirements87, but it should be noted that not all national supervisors have the power to inspect service providers to banks, not even if key functions are outsourced88: – It is expected that the management body approves and reviews the outsourcing policy, while management of the associated risks is attributed to senior management, and these responsibilities cannot be outsourced.

84 85 86 87

Recital 53-66 and art. 88-96 CRD IV Directive. BCBS, Principles for Enhancing Corporate Governance, October 2010, §69-104. EBA, Guidelines on Internal Governance (GL44), 27 September 2011, page 31. CEBS-EBA, Guidelines on Outsourcing 14 December 2006, and for the role of management paragraph 18 (page 31-32) of EBA, Guidelines on Internal Governance (GL44), 27 September 2011. Also see Joint Forum, Outsourcing in Financial Services, February 2005. 88 CEBS-EBA, Mapping of Supervisory Objectives, including Early Intervention Measures and Sanctioning Powers, 2009/47, March 2009, page 20.

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– It is expected that combined deposit taking and lending activities are not outsourced, except to another licensed bank, and that any material activities that – if longer provided or no longer provided well by an outsourcing services provider – would hamper the continued existence of the bank. – Non-material activities can be freely outsourced, as can purely advisory work on tax or legal issues. – It is expected that outsourcing can only take place if it does not hamper internal and external supervision. Any outsourcing should be the subject of a formal and comprehensive contract on the substance of the outsourced activities and the exact services that should be provided, the quality level provided and how they are monitored, that includes arrangements on the protection of confidential information. Even though there are no binding requirements on outsourcing under the CRD that apply to the bank (and the banking group) as a whole; for certain business areas binding requirements relating to outsourcing apply. For any activities regulated under Mifid, the Mifid outsourcing rules apply, and for any activities regulated under the payment services directive (such as offering and managing current account facilities, or offering money transfer activities) the outsourcing rules of that directive apply; see chapter 13.4 and 16. These requirements are similar to the guidelines mentioned above; basically meaning that the bank needs to be in control and responsible for the fulfilment of supervisory requirements, even if parts of the work is outsourced. The guidelines (and for the mentioned business areas the requirements) apply both to intra-group and to third party outsourcing. Intra-group outsourcing should not be used to escape supervision or to hide problems from supervisory scrutiny. Intra-group outsourcing can be a problem when activities are sold voluntarily, but also when they are sold or saved involuntarily in the context of crisis management applied to the entity or to the group, if the outsourcing entity and the entity to which the activities are outsourced are not both equally important to the economy. For instance cash management, personnel services or IT services that are provided by a non-regulated group entity such as the parent financial holding or a specialised funding vehicle that belongs to the parent bank or parent financial holding may result in a bailout of the group, instead of only of the relevant banking entities89. The outsourcing guidelines also invite the supervisor to monitor concentration risk at the sectoral level, as outsourcing by all banks to a few service providers would make the sector or group overly dependent on one provider, perhaps also leading 89 An example is the bailout of the SNS Reaal Group NV, where the parent of a financial conglomerate was not a regulated entity itself – captured in upward consolidation but not supervised on a solo basis – yet provided outsourcing services to all its banking and insurance subsidiaries that were essential to their continued functioning.

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to a loss of the skills to monitor such activities and to start manage them in house again if the service provider fails or stops to provide the services. This is a macroprudential concern, similar to the concerns on over-exposure to a few dominant accountancy and credit rating services providers. Liquidity and Funding Risk A key default in the CRD was the lack of a harmonised treatment of liquidity risk, including of consolidated cross-border liquidity requirements. The resulting patchwork of local requirements – and at the EU level a requirement to have documentation on how to manage liquidity risk in normal times and crisis times90 – was no match to the funding pressures in the 2007-2013 subprime crisis (see chapter 2 and 12). In one of the first aid reactions to the subprime crisis, the CRD II contained a new set of requirements on liquidity risk management91. In addition to the existing documentation requirement, it set out a range of criteria such documentation needs to fulfil, including for the bank to formulate its risk tolerance. Though not quantified and thus difficult to enforce, the new organisational requirements demand that the bank sets itself target (minimum) liquidity levels, with different levels set for different time horizons (starting from intra-day). See chapter 12.2 on the quantitative calculation that EBA has inserted in its guidelines. The CRD II requirement in the RBD annex references allocation of minimum levels and of liquidity to business lines, currencies and to legal entities within the group. A specific problem during the 2007-2013 subprime crisis was the shortage of dollar funding for dollar commitments of EU banks and the quick movement of liquidity between soon to be defunct group entities in Lehman. The attention to this mismatch is thus very welcome. Stranger is that this ‘governance’ requirements demands higher levels to be set by the bank for itself (and/or allocated to other group-entities) if it is important in a member state. Though this is understandable, this is hardly something that can fairly be left to the bank, and such differentiation should have been left to legislators instead (see the discussion on systemically important banks in chapter 18.2). The terminology not only includes ‘liquidity’ but also ‘funding’. Funding has a long term connotation (where liquidity is often associated with short term cash management; though neither connotation is based on a definition in the CRD). If read in this way, it anticipates the introduction of differentiated short term and long term quantitative liquidity require-

90 Annex V §14 and 15 in the original version of the RBD, 2006/48/EU, since amended by CRD II 2009/111/EU. 91 Annex V §14-22 RBD, as introduced by CRD II 2009/111/EU.

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ments under Basel III/CRD IV; see chapter 2 and 12. The funding issues include current and projected material cash-flows arising from assets and liabilities, as well as off balance sheet commitments or rights. Issues such as funding sources drying up at short notice have to be taken into account. This can for example be the result of damage to the reputation of the bank or its sovereign, or in response to market failures of a source of liquidity that was frequently used (e.g. securitisations, uncollateralised money markets). The risk that ‘liquid’ assets turn out not to be liquid at all also has to be planned for. The internal governance requirements contain a requirement to stress test the requirements and to have contingency plans to deal with possible liquidity crisis. These obligatory stress tests by the bank will be taken into account in the pillar 2 own assessment and supervisory review of capital requirements, and in other measures that can be taken to mitigate risk (see chapter 13.6 and 14). See the principles on liquidity developed by the BCBS in 2008 and by CEBS-EBA in 2009/2010. These provide some tentative background on at least the short term liquidity issues that have to be ‘managed’ – in the absence of quantitative requirements until Basel III is implemented – via the organisational requirements92. Remuneration The subject ‘du jour’ during the 2007-2013 subprime crisis – arousing particular public and thus political attention – is the remuneration (salary, bonuses, pensions, dismissal compensation, hiring fees and so on) of bankers. This focused both on the size and on the design of payments, and were especially politically sensitive on salaries and bonuses earned at subsequently or previously bailed-out banks93. Over the years many banks had introduced variable components into their salary structures that far outweighed any dividends paid to shareholders, making it questionable whether the business of a bank was run for the benefit of traders and other bonus-earners, or for the benefit of those providing risk bearing capital (risk-investors). Competition on being the best paid bank executive was intense, with transparency on salaries having the unintended consequence that a race to

92 Art. 22, 123 and Annex V RBD. CEBS-EBA, Guidelines on the Management of Concentration Risk under the Supervisory Review Process (GL31), 2 September 2010, page 19-23; CEBS-EBA, Guidelines on Liquidity Buffers and Survival Buffers, 9 December 2009; and see chapter 12. Also see BCBS, Principles for Sound Liquidity Risk Management and Supervision, September 2008, critically discussed in H. Davies & D. Green, Banking on the Future, The Fall and Rise of Central Banking, Princeton, 2010, chapter 4. The liquidity internal governance recommendations of CEBS are contained in CEBS-EBA, Second part of CEBS’s technical advice to the European Commission on liquidity risk management, CEBS 2008 147, 18 September 2008, later supplemented by CEBS-EBA, Guidelines on Liquidity Cost Benefit Allocation, 27 October 2010. 93 See e.g. recital 1 and 3-22 CRD III Directive 2010/76/EU, meaning that in a directive on the implementation of Basel II ½ market risk repairs, almost half the recitals discussed remuneration. Also see the discussions in the European Parliament on CRD IV bonus limits mentioned under ‘further developments’, and discussions on salaries at ING or RBS in the Netherlands and the UK respectively.

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the top was started94. Non-executives and human resources departments had few arguments to say that a salary was too high if other, similar, banks paid more. Misaligned incentives and possibly rent seeking was inherent in a system in which collegiate boards set the pay structure of one of them, even if some or all involved in this decision making process were to some extent independent95. Shareholders did not protest as long as the profits made still allowed handsome dividends. For many of the larger banks shareholders often failed to provide a restricting influence at all. Prior to the crisis, no mention was made of remuneration in the internal governance provisions in the RBD, except high level exhortations to perform risk management and to avoid conflicts of interest (see above). Conduct of business provisions that specifically mentioned remuneration dealt with client/employee conflicts of interest, and did not consider shareholders (or the wider public or potential state aid providers) to be clients96. The primary purpose of many shareholders and bankers (increase profit and share prices respectively pay bonuses) clashed with financial stability and safety considerations if they encouraged excessive risk taking, and stimulated a too short term focused high risk appetite of the bank97. Performance related incentives were thought to enhance profits for low-level bankers, executives and shareholders alike. Especially in banks with diversified shareholdings, or sun-king type executives, this was not necessarily balanced by an active and long term concern for the safety of the institution. Competition for short term profit makers put additional upward pressure on salaries for those that could deliver such immediate satisfaction of high dividends or a rise in value to shareholders, while long term analysis was largely lacking. In the crisis, the absolute height of payments to bankers came under political and popular attack, and the incentive structures towards high risk and short termism came under supervisory attack. New rules and taxes on bonuses helped channel public anger on high salaries and bonuses paid to bankers while the banks they or their colleagues worked at were being bailed out by the governments98. The incentive issue was already covered by the principles of organisational requirements to avoid conflicts of interest within the bank; though admittedly as a principle, without specifying that this included salary-incentives. There was little or no details on how the conflict of interest applied in practice to salaries and bonuses. Especially as the conflict of interest was not so much with the banks risk appetite as defined by what banks actually did (instead of their risk appetite 94 Hopefully the added disclosure under pillar 3 will not have the same effect when the 2007-2013 subprime crisis is finally resolved. See chapter 15.2. 95 L. Bebchuk & J. Fried, Pay Without Performance, the Unfulfilled Promise of Executive Compensation, Cambridge, 2004. 96 Art. 18 Mifid, art. 22 Mifid level 2 Commission Directive 2006/73/EC. 97 See recitals 3-22 CRD III Directive 2010/76/EU. 98 C.A.E. Goodhart, The Macroprudential Authority: Powers, Scope and Accountability, LSE FMGPS Special Paper 203, October 2011, page 21.

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as defined on paper). It turned out that absent such detail the conflict was not recognised sufficiently, also because short term profits rose due to the risky activities, as desired by e.g. shareholders as well as by supervisors eager to know that profits were high enough to allow financial buffers to grow. Political attention based on taxpayer and shareholder activism lead to ongoing pressure on detailed work by prudential supervisors on remuneration issues and the disclosure thereof99. The work was driven by a wide range of drivers, some based on outrage at misaligned income/input levels, some driving at social goals such as closing a too wide gap between top-earners and low-earners at individual companies or within societies, or driven by a desire to correct for instance a misalignment between benefits and risks, or badly designed/supervised incentive structures. Some of these drivers are related to corporate governance, including the misalignment of the interests of shareholders and managers at larger companies in a prime example of the so-called agent/principal problem100. Others are more social policy, or even punitive when blame is allocated solely on bankers who profited most from the liberalisation and single market drives. The latter may reflect a sense of disbelief that some benefitted knowingly or unknowingly and did not feel or did not feel sufficiently that they also should behave in the public trust if allocated such liberties (even though that public task was not explicitly allocated)101. The focus of prudential supervisors responsible for the continued survival of an individual institution is, however, not on the overall level of remuneration (which is an issue for shareholders/risk investors or creditors, who can take their business away from a particular bank if they do not like the effect such salaries have on the risk-profile, dividends and interests paid), nor on social policy but on the incentives given to senior management and to traders and the impact thereof on the survival of the bank and financial stability in general102. Other potential public policy goals such as using the profit incentive as a driver for economic growth on the one hand or limiting such profit incentive in light of social policy or tax policy on the other hand may be allocated to prudential laws or supervision as add-ons, but do not in themselves impact the survival of the bank (unless such other public policy goals in turn threaten the continued functioning of the bank). The bonusstructures developed before the crisis had provided incentives to favour short term profit in the particular area where a person was working, instead of to long term safety of the 99 BCBS, Range of Methodologies for Risk and Performance Alignment of Remuneration, May 2011; BCBS, Pillar 3 Disclosure Requirements for Remuneration, July 2011. 100 L. Bebchuk & J. Fried, Pay Without Performance, the Unfulfilled Promise of Executive Compensation, Cambridge, 2004. 101 See R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 3. 102 See e.g. BCBS, Range of Methodologies for Risk and Performance Alignment of Remuneration, May 2011, page 9.

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bank as a whole. The focus for prudential purposes was on aligning remuneration structures with the long term survival of the bank103. After work by the FSB and BCBS, the Commission and CEBS104, detail has been added to the RBD on a required policy on remuneration via the CRD III amending directive, in order to prevent or limit a short term focus to the detriment of long term stability. These CRD III provisions have been applicable since 1 January 2011, and force banks to have remuneration policies and practices that ensure sound and effective risk management105. The focus is both on the theoretical approach of the banks to remuneration as well as to how they apply their policy and the incentives in practice. The rules do not cover all staff. If employees only execute existing policies, without making their own assessment as to what risks are acceptable to the bank or not, they will generally not be subject to the new policies. It applies to senior management, employees with control functions, and especially risk takers including all people who take risks on behalf of the bank (e.g. traders). Anyone with the type of remuneration that is also given to senior management or risk takers is also covered106. It is not clear whether this also extends to non-executives, as the terminology of senior management generally excludes them. However, it would be strange if their incentives were not captured in payment policies, when they provide a key influence on risk taking and control (see below on the incentives for control-functions). The main goal (from a supervisory perspective) remains that the remuneration paid is consistent with sound and effective risk management and limitation. The policies that banks need to develop are subject to a detailed list of requirements (sadly also riddled by a range of ambiguous qualifiers such as. the use of non-specific words such as ‘justified’, ‘substantial’, and ‘appropriate’). The remuneration requirements relate payment incentives to the risk appetite of the bank. The interests of a safe banking sector need not be taken into account; though this may be vague, and the calibration of this goal should have been

103 See e.g. BCBS, Principles for Enhancing Corporate Governance, October 2010, §107-113; BCBS, Range of Methodologies for Risk and Performance Alignment of Remuneration, May 2011. 104 Commission Recommendations C(2009) 3159 and C(2009) 3177, 30 April 2009, and CEBS-EBA, Guidelines on Remuneration Policies and Practices, 10 December 2010. Also see FSB, Principles for Sound Compensation Practices, 2 April 2009; FSB, Principles for Sound Compensation Practices, Implementation Standards, 25 September 2009; BCBS, Compensation principles and standards assessment methodology, January 2010; BCBS, Range of methodologies for risk and performance alignment of remuneration, May 2011. 105 Art. 22.1 last subsentence, 22.3 and 22.5 RBD and Annex V sub 23 and 24. These rules have been expanded upon in CEBS-EBA, Guidelines on Remuneration Policies and Practices, 10 December 2010. 106 In line with recital 3 CRD III 2010/76/EC, both Annex V §23 RBD and CEBS-EBA, Guidelines on Remuneration Policies and Practices, 10 December 2010, identify some employees by this supplementary criterion of high remuneration. Like executives, such identified staff are the subject of risk management requirements in remuneration policies.

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set by legislators (see above). In a separate goal that is aligned more specifically to prudential supervision of the individual institution, the remuneration paid has to be in line with the long term interests of the bank, with its business strategy and objectives and values. It is unlikely that all banks have an inherent strategy, objectives and values that limit risk taking. The main benefit is that the banks will have to formulate the tolerated risk, and will have to reward those that stay within its boundaries (instead of rewarding those that made huge profits for the bank, even if they exceeded risk appetite and thus created huge risks for the bank). In this way the formal risk-appetite will gain a bite, instead of just being a piece of paper. However, as long as a bank complies with the minimum safety requirements they can have a huge risk appetite and still remain within the boundaries of the CRD. With ever increasing quantitative and qualitative requirements in combination with an impact on rewards for the risk-takers, some may opt out of the banking status for the whole or for part of the group and perform the same activities as a non- or less regulated shadow bank. That may be deemed good riddance on the one hand for the banking sector, but on the other hand the risk to the financial system and financial stability does not diminish if a high risk financial institution moves from the banking sector into a less regulated environment107. The remuneration of the persons involved in control functions has to be independent from the financial results of the departments they control. Even further goes the requirement that the remuneration of the senior officers in the risk management function and in the compliance function is overseen by non-executives (either in the form of a subcommittee called the remuneration committee if it is a significant bank (see chapter 18.1), or by the complete set of non-executives in the board). How this relates to setting the rewards for the senior management/executives is not very clear. Part of the task of managers is profit making, and part is controlling the risks in the business parts they manage. Banks have to limit exit premiums so that they do not reward failure, and guaranteed bonuses are to be severely limited (they are forbidden, except for the first year of employment at the bank). Variable remuneration (bonuses) has to be based on criteria, relating to personal, business unit, and the overall results of the bank, taking into account both financial and non-financial criteria, within a multi-year framework, adjusting for all types of current and future risks and costs. Variable remuneration even then should not be paid to board members unless justified, and appropriate ratios must be set between fixed and variable components of remuneration (see the ‘future developments’ section on this ratio).

107 This would be in line with the proposals of the Liikanen Report to some extent, but not in line with the concerns about the risk embodied in the shadow banking sector; see chapter 4. Also see R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 4.

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At least half of variable remuneration has to consist of shares and similar instruments that have to be retained by the recipient (ensuring a link between the financial well-being of the bank and of the employee). These shares cannot be hedged or insured in any way, as in that case the incentive to safeguard the continued existence of the bank is no longer effective. The rules are to be applied at group level, parent level, and subsidiary level, including by third country subsidiaries, e.g. in offshore financial centres. In a pre-cursor of the Basel III anti-cyclical buffers and their effect on the pay-out of bonuses and dividends (see below on ‘future developments’), the remuneration policy stipulates that variable remuneration is not allowed when it would limit the ability of the bank to reinforce its financial buffers. Like the rules on liquidity management (see chapter 12.2), these detailed requirements fit awkwardly into annex V of the RBD, which generally contains high level principles on internal organisation that have to be taken ‘into account’ by the bank108. Unlike the liquidity rules, the remuneration details are backed up by directive level obligations on the supervisors to follow-up and disclose109. The new additions are more detailed, similar to the rules on supporting internal structures that are pre-conditions for being allowed to use advanced models for the calculation of quantitative capital requirements (see chapter 13.5). However, the tone of the rules reflects that this is something forced on banks, rather than something they find sensible themselves. It sets out the core of remuneration policy, rather than criteria that the bank needs to take into account in policies it would draft itself. This makes the rules inflexible, and leads to herd behaviour by the banks. Whether this is useful in light of making the banks long term safer and able to provide the type of functions banks currently do (and for which they are supervised) is debatable. More likely is that both riskier behaviour as well as the type of functions banks now fulfil (except those contained in the definition) will migrate to less regulated entities, making the overall financial system perhaps less safe. EBA was required to issue guidelines on specific aspects of the remuneration provisions as contained the annex to the RBD, and cooperate with ESMA on the remuneration of staff working in investment services110. EBA can draft regulatory standards on internal governance, including on remuneration111. In addition and as part of this work, EBA is 108 Annex V §1-13 contain mostly admonishments to think about policies and write them down, compared to §14-24 that set out more detailed requirements. 109 Art. 22.2-22.5 RBD. On liquidity, the supervisors are invited in an annex to ‘regularly’ assess the liquidity arrangements of the bank. 110 CEBS-EBA, Guidelines on Remuneration Policies and Practices, 10 December 2010. 111 Art. 22.3-22.6 RBD, as added by the CRD III Directive 2010/76/EU and the Omnibus I Directive 2010/78/EU. The CRD III-order was addressed to CEBS, which was almost simultaneously replaced by EBA in the EBA Regulation 1093/2010. See chapter 23.3.

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also to collect information on remuneration, and to disclose in an additional supervisory disclosure per member state on an aggregate basis the number of people earning over 1 million euro, and the components thereof. Business Cycle and Valuation A large part of the internal structures will be superfluous in good times, when everything is running smoothly and there are no risk-clouds on the horizon. This may lead banks to under-invest in such functions if supervisors did not make these investments mandatory. An area underestimated by many banks and supervisors alike prior to the 2007-2013 subprime crisis was for instance the need to beef up staff involved in valuation issues; used as they had become to very predictable valuations in a stable market. This in spite of the above-mentioned obligatory documentation112. When the customary valuation methodology could not be used (e.g. because market prices in liquid markets were no longer available for many assets) banks that had invested in such staff and working methods/data collection were better able to handle this than banks that did not (and may thus have under- or overvalued its assets)113. The cyclical nature of optimism/pessimism is a problem for the good prudential supervision on banks. In bad times, banks are rigorous and conservative in their management of risks and the screening of borrowers or assets bought. However, in an upturn, such screening starts to include expectations of ever-rosier future prospects, as well as competition between investors for a limited amount of investment opportunities. In these circumstances (a borrowers’ market), screening standards go down. Prior to the 2007-2013 subprime crisis this was most pronounced in the securitisation markets, where not only there was a magical faith in ever increasing values of the security offered (future income or future house prices), but also a faith in ever increasing economic growth and availability of ready cash for investment. Screening standards went down in booming markets such as for mortgages in the USA market. The USA had not faced a nationwide downturn in housing prices for seventy years. As large portions of such mortgage loans were subsequently sold on via securitisations, the initial lender also did not have a large incentive to screen and monitor the persons they lent to114. Screening standards went down subsequently for investors, including many EU banks, who invested in such mortgages via securitisation bonds issued with as sole security the value of those substandard mortgage loans. Good stress testing could have prevented this, but prior to the crisis the stress testing requirements were there 112 E.g. Annex V §2 RBD and Annex VII part B RCAD. 113 BCBS, Fair Value Measurement and Modelling: An Assessment of Challenges and Lessons Learned from the Market Stress, June 2008. 114 See e.g. I. Fende& J. Mitchell, Incentives and Tranche Retention in Securitisation: a Screening Model, NBB Working Paper Research 177, Brussels, 2009.

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mostly for appearances, not for substance (see chapter 13.6). The quantitative capital requirements in the 2009 and 2010 amendments to the Basel capital accord aim to address it. Reputation – Conflict of Interest, Abuse, Ethics The CRD only tiptoes around the edges of the issue of reputation. Reputational risk is mentioned as a cause for problems in securitisations or liquidity management, but is outside of the scope of specific requirements on e.g. operational risk; see chapter 10. The issue is important nonetheless, and has gained importance in a series of larger and smaller scandals that have tainted the banking sector in general and specific banks. Examples surfaced during the 2007-2013 subprime crisis such as lax lending standards, not taking the interests of clients into account, unfair treatment of clients, interest rate fixing for Libor, money laundering and tax evasion. None of these issues are new, but they have landed particularly hard in the middle of a crisis and in the context of increasing standards of consumer protection. The Basel core principles indicate that supervisors should check that banks adhere to high ethical and professional standards, and cannot be abused for criminal purposes115. This does not appear – in hindsight – to be a principle that has been particularly valiantly defended by banks or their supervisors, though the fact that such scandals have come out and elicit denunciations is an indication of changing morals. Part of the area is not within the scope of prudential supervision, but of conduct of business supervision; see chapter 16. Ethical behaviour, and the protection of the reputation of the bank, also impinges directly on the continued existence of the bank (loss of clients and the payment of damages or write-downs of claims all impinging on the viability of the business of the bank). The prudential rules are, however, scant, and focus on conflict of interest and compliance in general. The RBD only indicates that there should be procedures to deal with conflict of interest, without giving an indication on what this should entail or achieve. The BCBS has provided some (non-binding) guidance on what supervisors should expect from such policies116. The conflicts can arise in many relations the bank has, including with group-companies or controlling shareholders, between its own interests and those of clients, when lending to companies that are e.g. owned by a board member, when dealing with confidential information and when both lending to a firm and buying or selling its shares or bonds (or speculating on those via e.g. derivatives). The policies should be broad enough (and at the same time specific enough) to deal with all, and provide clear rules for how those conflicts

115 Art. 29 of BCBS, Core Principles for Effective Banking Supervision, September 2012. 116 BCBS, Principles for Enhancing Corporate Governance, October 2010, §55-60. BCBS, Principles for the Management of Credit Risk, September 2000, page 6 and 12.

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should be dealt with, including an objective compliance process to ensure implementation. More detailed rules apply in conduct of business areas such as investment services, in that case specifically targeted to protecting the client, instead of the protection of the solidity of the bank and compliance (see chapter 13.4 and 16.2). Consolidated/Solo In addition to applying at the solo level, internal governance also applies at the consolidated level, to allow and support group-wide internal monitoring and external supervision of risks. Reference is made to chapter 17 on consolidation. If a bank is part of a banking group or financial conglomerate, capital adequacy, risk management and internal control mechanisms and processes at the level of the group and the sub-groups of which the bank is part are important for the continued survival of the bank117. Please note the difference in the focus of Basel and EU requirements, where Basel has drafted organisational requirements focusing on group-wide arrangements for e.g. the internal governance needed for model approvals, and the EU has implemented them on a legal entity basis, with some additional provisions/exemptions in relation to such entities being part of a wider group. In its corporate governance principles, the BCBS has given more attention to the position of the subsidiaries (and its host-supervisors if the subsidiary e.g. has a bank license itself)118. It emphasises the group wide control necessary, but indicates that there should be respect for local rules (but appears to want to limit those to clear breaches of local laws, not respect for the spirit of local laws that may envisage such boards of subsidiaries to be independent guardians of local – possibly systemic – importance). On such issues the local supervisory and company law rules will govern how much independence the subsidiary and its executives and non-executives should have; an issue on which the RBD takes the legal entity approach (with consolidated requirements as an additional safeguard instead of the other way around). Proportionality, Imprecise Requirements and Enforcement Particularly in the area of internal governance, proportionality is very important; also see chapter 3.4. The RBD requirements allow plenty of scope for such proportional application, as they do not force the banks to have specific structures, but to develop specific processes and procedures that fit its own business. Prosecuting on non-compliance is difficult as a result, as even the flexible language used has to be applied explicitly on a proportional basis. As both the RBD and the BCBS put it, the application of corporate governance should be proportionate to the size, complexity, structure, economic significance of the bank (and

117 Art. 6.2 and 9 Financial Conglomerates Directive and art. 22, 73.3, 123, 129.3, 132.1 RBD. 118 BCBS, Principles for Enhancing Corporate Governance, October 2010, §61-64.

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the group to which it belongs)119. The combination of very imprecise requirements (according to the phrasing of the RBD almost any written policy is fine, as long as there is one), and the flexibility on the implementation of those imprecise requirements required under proportionality120, conspires to make the rules almost unenforceable. It would have been better perhaps to phrase minimum requirements, and indicate that large banks need to follow these (in a proportional – i.e. heavier – manner) and adhere to best practices that govern industry wide. There appears to be a learning curve, as specific requirements have been introduced for liquidity risk management and remuneration policies (after the barn had been burned in the 2007-2013 subprime crisis). Even though qualitative requirements are by nature imprecise, even internal governance rules could be formulated in a manner that allows them to be enforceable as to the aspects that are key to the safety of the financial system (see chapter 20.3). Future Developments The CRD II changes on liquidity became effective in the member states and on the banks as per 31 December 2010, the changes in organisational requirements on remuneration and on trading book management/valuation as per 1 January 2011. Since the adoption of CRD II and III, work has continued at the international level. The BCBS has issued further detail and reports on remuneration, which can be applied in as far as consistent with the amended RBD. The same applies to the more general principles on corporate governance of the BCBS121, that can be applied in as far as consistent with EU (and national) rules on licensing and governance (both in company law directives and in the RBD); see chapter 13.1. EBA has been charged to provide implementing standards for some aspects of organisational requirements122. It concerns some aspects of liquidity risk management, of remuneration policies, including the relation between fixed and variable remuneration and the types of instruments that can be used in variable remuneration (to enforce a link between the long term interest of the bank and the long term value of the variable remuneration). These technical standards need to be submitted for endorsement by the Commission at the latest on 1 January 2014. EBA is allowed, but not obliged to draft regulatory standards on internal governance in general, and obliged to draft such standards on the

119 See art. 22.2 and 123.2 RBD, and BCBS, Principles for Enhancing Corporate Governance, October 2010, §8. 120 As emphasised in CEBS-EBA Guidelines, in addition to the liberal use of words such as ‘adequate’, ‘appropriate’ and ‘where relevant’. See e.g. CEBS-EBA, Guidelines on the Management of Concentration Risk under the Supervisory Review Process (GL31), 2 September 2010. 121 BCBS, Principles for Enhancing Corporate Governance, October 2010. 122 Art. 150.3 RBD, as added by art. 9.40 Omnibus I Directive 2010/78/EU. These partly overlap with the guidelines mentioned in art. 22.4 RBD.

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supervisory practices in relation to the provisions on transferred credit risk and the related internal organisation provision by 1 January 2014123. The CRD IV project contains incremental improvements on internal governance and adds some rules on corporate governance, ranging on the diversity of board composition, requirements on the time spent by the management body, and similar issues that were traditionally more in the remit of company law requirements124. Such added detail has been allocated to the CRD IV directive, to allow member states to align it with its domestic terminology and company law in their implementation of the directive. For instance on trade finance, additional documentation and contractual arrangements are required125. In the negotiations on the CRD IV project, additional strictures on remuneration have been demanded and achieved by the Parliament on top of the existing prudential alignment with long term goals and the disclosure requirements already contained in previous versions of the CRD126. Bonuses will be restricted in relation to the permanent components of remuneration in a one-to-one relation, though this does not appear to be necessary for one of the prudential goals (financial stability and counterparty protection), and is not copied into other prudential regimes127. It appears driven more vindictive, with as the main effect that fixed salaries (and thus fixed costs of the bank) will suffer from upward pressure. Even as a social fairness or redistributive income policy it does not appear convincing, especially as the policy is not rolled out to hedge funds, insurers or any other grouping in society than banks and their subsidiaries128. If the board agrees, the bonuses can be raised to a maximum of twice the permanent components of remuneration. This will still reduce the flexibility of the remuneration packages especially in Anglo Saxon style banks (where this is a more usual risk sharing mechanism between banks and employees, going up and down with the profits) and then especially in investment banking based on the Anglo Saxon business model.

123 Art. 22.6 and 122a RBD, as added by art. 9.6 and 9.29 Omnibus I Directive 2010/78/EU. Also see art. 410 CRR. 124 Recital 52-69 and art. 88-96 CRD IV Directive. 125 Article 4.1 sub 30 and 4.3 CRR. Still, these requirements are more lenient than originally envisaged in Basel III. See the relaxation of the relevant Basel III rules in BCBS, treatment of trade finance under the Basel capital framework, October 2011. 126 Art. 74-76, 92-96, 104 and 141 CRD IV Directive and art. 450 CRR. See chapter 13.1. Also see High-level Expert Group on Reforming the Structure of the EU Banking Sector, Final Report, 2 October 2012 (Liikanen Report), page 79. 127 Art. 94.1 sub g CRD IV Directive. 128 The governance requirements, including this cap, applies both on a solo and a consolidated level, creating an unlevel playing field between bank owned companies such as asset managers and their peers. Art. 109 CRD IV Directive.

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The CRD IV directive will make having a recovery and resolution plan or ‘living wills’ obligatory; except for banks that are not considered systemic by its own supervisor; adding to the existing obligation for financial conglomerates; see chapter 17 and 18. However, it does not provide detail on the content thereof, nor the repercussions on the general structure of the bank. Further detail impacting on the organisation of a bank will be contained in the proposed recovery and resolution directive129. Literature – Power, Michael, Organized Uncertainty, Designing a World of Risk Management, Oxford University Press, Oxford, 2008 For the relevant guidelines see chapter 13.1.

13.4 Additional Requirements for All Banks that Qualify as Investment Firms Introduction Many banks also fall within the definition of ‘investment firm’, as they provide investment services and/or perform investment activities as regulated in Mifid. Banks that fall within the scope of the Mifid are subject to two sets of internal governance requirements, having equal force. Both the CRD rules on internal governance and the Mifid organisational requirements are applicable130. The Mifid rules serve to strengthen the Mifid conduct of business requirements that are described in chapter 16.2. In spite of cooperation between the relevant units in the Commission and the supervisors in the EU Lamfalussy/Larosière process, both the details and the intent of the requirements are different. Even when the rules sound similar, the application may be different. Both sets of rules have to be complied with in line with their respective intent. The CRD rules are set to ensure prudential trustworthiness of the numbers and procedures for the bank and its supervisor. This includes compliance with other rules, but prudential supervisors are mainly concerned with the prevention of liability and reputational risks to the solidity of the bank. The Mifid organisational rules are geared towards conduct of business settings. The protection of the clients is the foremost goal there, not the solidity or continued profitability/existence of the bank. By way of example, the conflict of interests rule of CRD is geared equally to the protection of the bank and the protection of its clients, while the 129 See chapter 18.3 on Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. Also see BCBS, Principles for Enhancing Corporate Governance, October 2010, §114-119. 130 Art. 1.2, 4.1, 13 and 18 Mifid, as well as Mifid level 2 Commission Directive 2006/73.

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conduct of business conflicts of interests requirement is geared solely to the protection of the interests of the client. Another example is the requirement on bookkeeping. In the CRD organisational requirements serves information to the management and to the supervisor, so that they can be sure that the bank is solid. In Mifid similar rules serve to segregate the financial instruments of the client from the assets of the bank/investment firm, so that the client can always know to what he is entitled. Prudential and conduct of business supervisors agree that one set of these organisational requirements is more important than the other and should thus overrule the other set, but sadly they do not agree on which set is dominant. For non-bank investment firms the same overlap between CRD and Mifid requirements exists. They are subject to both Mifid and RCAD. The RCAD cross-refers for non-bank investment firms to the RBD organisational requirements as applicable to banks; see chapter 19.2131. Mifid Level 1 and Level 2 Requirements The provisions in the level 1 text of Mifid are of an equally high (and thus relatively vague) level as the main provisions in the CRD and its annex; see chapter 13.3. The Commission has, however, used its competence to provide further detail in a level 2 Commission directive, which provides detail. Each investment firm, including banks, should have a high level of integrity, competence and soundness. Specifically they are obliged to have policies, procedures, mechanisms arrangements, or to take steps132: – to ensure compliance by itself and all persons working with it or on its behalf with conduct of business rules; – to ensure that personal transactions are subject to rules; – to prevent conflicts of interests from harming the interests of clients; – if it executes orders on behalf of professional or retail clients (not for eligible counterparties), it has to have a ‘best execution’ policy in line with the best execution requirement (see chapter 16.2), that is regularly (at least annually) checked whether it is correct and complete (e.g. includes the best venues) to achieve the best result for the client, and the client needs to give its consent to the policy before the firm can start executing his orders. The way the service provider implements the policy needs to enable the 131 Art. 34 RCAD refers to the requirements of art. 22 and 123 RBD. These apply to both bank (directly) and via RCAD also to non-bank investment firms. Art. 13 Mifid is applicable to all banks that are also investment firms. 132 Art. 13, 19.7, 21, 22, 23, 25, Mifid and recital 2, art. 1, 5-25, 32, 44-49, 51 Mifid level 2 Commission Directive 2006/73.

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firm to show that it has applied that policy to each order of any retail or professional client; there have to be procedures in place to ensure prompt fair and expeditious execution of orders of retail and professional clients to protect their interests, both relative to the interests of the firm itself and to the interests of its other clients; to ensure continuity and regular service; when it outsources or relies on others (inside or outside of its group, and inside or outside of the EU, including to group entities, tied agents or others) it has to limit operational risks. Outsourcing is not allowed to impair materially the quality of internal controls and or the possibility for the supervisor to check compliance; ensure that its administration and accounting, internal control and risk assessment, and information processing systems are all in good order; that records are kept that allow verification that the investment complied with all obligations towards its clients, kept for at least five years; that records are kept that allow verification of all transactions in any financial instruments (for their own account or for the account of clients) and that allow verification of the transactions for honesty, fair and professional conduct, as well as for integrity requirements such as contained in the anti-money laundering and market abuse legislation, for at least five years133; if services are provided to clients, those records have to contain a document with the rights and obligations of the client and of the firm; to segregate all financial instruments from its own assets, so that the clients’ ownership rights are safeguarded in case the firm goes bankrupt, and inform the client of risks if third parties hold the assets; to prevent the use of financial instruments that belong to the client for its own purposes, except if there is express consent; to safeguard the rights of clients to funds, and – if it is a non-bank – not to use any such money of clients entrusted to them.

The Commission level 2 directive provides the detail on for instance the awareness all relevant persons have to have of the above-mentioned procedures, the availability of continuity systems, and the duration of the record keeping obligation (the five years mentioned above). The Commission directive also specifies potential areas of goldplating by member states134. Member states can in principle not adopt goldplating rules on Mifid, except where specifically allowed as the directive is maximum harmonisation135. In the area of internal 133 This is the same term as set in the regulation on information on the payer accompanying transfers of funds, 1781/2006. See chapter 16.3. 134 See for these examples art. 4, 5 and 51 Mifid level 2 Commission Directive 2006/73/EC. 135 Art. 4 Mifid level 2 Commission Directive 2006/73/EC. See chapter 3.5.

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governance, the Mifid gives leeway to member states to specify their rules. The Commission directive seeks to limit this in line with the delegating text at level 1, by ensuring a uniform application136. The supervision of compliance of the Mifid organisational rules is in principle allocated to the home supervisor, but the host supervisor of a branch can (also) enforce the obligation to have records that allow supervisors to monitor compliance with Mifid rules, in particular all conduct of business rules that protect clients137. Conflict of Interest Mifid contains some additional conflict of interest rules on top of the procedures needed to minimise the risk that such conflicts adversely affect the interest of its clients. These require the bank/investment firm to take all reasonable steps to identify conflicts of interest between on the one hand itself and all its related persons (employees, owners), and on the other hand their clients, as well as between different clients. This can relate to such issues as fair treatment (the order in which orders are handled), but also on issues of abuse such as the use of insider information, churning or frontrunning. If organisational measures cannot take these concerns away, the client has to be informed of the conflicts prior to taking his business138. A specific form of conflict of interest is created by so-called ‘inducements’. This concerns the treatment of fees, commissions and other benefits given or received by the firm by or to others than the client. In Mifid, these are part of the ‘fair treatment’ provisions instead of the conflict of interest provisions. They nonetheless provide detail on potential conflicts of interests with retail and professional clients (but not for the less protected ‘eligible counterparties’, which are only protected by the general conflict of interest requirements139). Any inducement is considered to be a violation of the fair treatment or duty of care provision, unless140: – it is given/received directly in the relation with the client or on its behalf; – it is fully and clearly disclosed to the client, and is designed to enhance the quality of the service to the client, and does not impair the duty of the firm to act in the best interest of the client;

136 137 138 139

Art. 13.10 Mifid. Art. 13.1, 13.6 and 13.9 Mifid. Art. 18 Mifid, and recital 27, art. 21-22 Mifid level 2 Commission Directive 2006/73. See chapter 16.1 on the different protection levels. Also see R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 2 and 3. 140 Art. 19 Mifid and art. 25.2 and 26 Mifid level 2 Commission Directive 2006/73/EC.

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– proper fees that are paid for the provision of investment services (e.g. clearing, custody fees, or regulatory levies) and by their nature cannot give rise to conflicts with the duty of care. Trading Venue Services Much like specialised market operators, investment firms (bank and non-bank) are allowed to operate trading venues; see chapter 16.4. If they choose to do so, an additional set of requirements starts to apply that serve to monitor the integrity of the venue (e.g. to prevent market abuse by clients) and ensure the good organisation of that venue, especially on transparency on order prices and sizes and on transactions (pre-trade and post-trade transparency) in shares that are admitted to trading on a regulated market141. Other Investment Area or Consumer Protection Organisational Rules that May Apply In addition to the above-mentioned Mifid rules that apply to most banks because they fall within the scope of the definition of investment firm, there are also other types of financial services that banks can be involved in. Banks can be depositories for collective investment undertakings such as UCITS or for alternative investment funds, they can be clearing members, central counterparties, or trading platforms. If they perform services, they are also subject to specialised organisational requirements that apply to such services under the relevant directives. Banks are generally exempted from having to obtain a separate license for being allowed to perform such services, but that exemption does not extend to the ongoing requirements and supervision for such services. The conduct of business and the (non-own funds) requirements are applicable nonetheless. The most common types of financial services banks are involved in are described in chapter 16, while any prudential requirements for such service-providers that may also apply to banks if they qualify as such a provider are described in chapter 19.

13.5 Additional Requirements for Banks that Apply Internal Models to Calculate Quantitative Requirements Introduction Apart from the core requirements on internal organisation, targeted requirements are spread over the CRD. Like the core provisions, some apply to all banks; see chapter 13.3. Others are part of the set of conditions that need to be fulfilled to be able to benefit from certain treatments or to be able to get certain authorisations. A relatively simple example is the set of qualifying criteria to be able to use the alternative indicator in the standardised

141 Art. 25, 26, 27, Mifid. For specialised market operators of regulated markets, also art. 43. See chapter 16.4.

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approaches to operational risk. They require the type of organisation that allows the bank to have a true grip of the operational risk. Compliance with these qualitative demands is arguably more important than the rather rough and ready estimation of financial buffers for operational risk142. For the smaller group of banks that want to apply for the more advanced approaches to quantitative risk in which they can use self-developed models to calculate the capital requirement, an expanded set of organisational requirements have to be fulfilled before they can gain approval to use their own calculations, and to retain that approval. Unlike the rules described in 13.3, these conditions have a clear subsidiary purpose, they aim to facilitate the quality of the calculation. The BCBS formulates it as follows: ‘The Committee expects national supervisors will focus on compliance with the minimum requirements as a means of ensuring the overall integrity of a bank’s ability to provide prudential inputs to the capital calculations and not as an end in itself’143. This goal is not so explicit in the CRD, but the BCBS position is likely to drive supervisors to a more flexible approach to compliance with these supporting requirements, as long as the quality is ensured. The BCBS statement also makes it less likely that these rules can be enforced, as not only non-compliance will need to be proven, but also the impact of such non-compliance on the quality of the calculation; see chapter 13.1 and 20. Credit Risk The IRB models to calculate credit risk capital requirements requires extensive data storage, and the setting up of very specific and extensively documented systems and controls to indicate how the data and the assumptions in the models used lead to the establishment of the parameters in the IRB capital requirement calculation. Additional organisational requirements for IRB banks demand that the rating system has to be built on methods, processes, controls, data collection and IT systems that support the assessment of credit risk and its component processes144. Apart from the content, assumptions and data going into the model, it is essential that the bank safeguards the correctness, proper use and verification of the use made thereof. The requirements include: – explicit board and senior management approval and understanding of the model and modelling process, including its limitations (§124); – documentation and validation of the rating system (§31-35, §92, §110-114); – documentation and validation of the internal models and modelling process as a whole (§117-123); – additional risk management requirements (establishment of policies, procedures and controls) to ensure the integrity of the model and the modelling process, including 142 See chapter 10.1, and Annex X part 2 §12, part 3 §2-7 RBD. 143 Page 2 Revised Framework. 144 Mostly in part 4 of Annex VII RBD, unless stated otherwise. These organisational requirements will become part of the CRR; see mainly art. 169-191 CRR.

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requiring independence of key persons and units and integrating the internal model into the standard risk management process (use test) (§26, 116, 128, 131); if it uses statistical models or mechanical methods for assigning exposures to grades of riskiness, it has to have a regular cycle of model validation on this specific subset; having effective processes to obtain, monitor and update accurate relevant information (e.g. §28, §30.b and c, §36-39, §91, §106-107, §129-130); credit risk stress testing procedure (§40-42); see chapter 13.6; establishing the frequency of updates (with a minimum of annual updates) of all assignments of exposures (e.g. §27 and 29); documenting the situation in which human judgement may or must override assignment of exposures to grades of riskiness of obligors (§25, §30.e); have effective compliance and resolution of problems processes (§107-109, §114).

Market Risk In the area of market risk, some such general risk management demands are already slightly more detailed in RCAD; see chapter 13.3.The separate additional set of requirements for market risk internal models (that model the value at risk for position risk (specific and general), foreign exchange risk and commodities risk) include145: – the risk measurements of the internal model are used in the day to day management of risk, and are the starting point for all internal risk reports (use-test); – a market risk control unit independent from the business and reporting to senior management, responsible for designing/implementing the system, and producing/analysing the daily reports and the follow-up measures, and validating the model (see below); – active involvement of the ‘board of directors’ and senior management in the market risk control process and daily review by a manager with the power and instruments to reduce the risk taken by traders and the banks overall risk exposure; – validating the model by the market risk control unit, independent from the model developers, on an ongoing basis and after big changes in the model or in the market, including backtesting, the use of hypothetical portfolio’s, testing of assumptions made, (with additional validation for ‘specific risk’ modelling); – monitoring the model via daily backtesting; comparing the generated one day valueat-risk (VAR measure) to the actual position at the end of the next business day146; – market risk stress testing, addressing amongst others illiquidity in stressed markets and non-linear price development (of e.g. derivatives); 145 Annex V §2-4, 5 sub d and 10c RCAD. 146 Backtesting is deemed especially important for market risk models, and the RCAD mandates the supervisor to check this and intervene when it is done insufficiently. The supervisor has little or no leeway on this issue, and thus neither has the bank. See chapter 20.3, and Annex V §4 RCAD.

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– reverse stress testing (see chapter 13.6); – ‘sufficient’ numbers of staff with skills to handle the model in trading, in risk control, in audit and in the back-office areas of the banks’ organisation; – document how to operate the risk measurement system, and procedures to monitor and ensure compliance with such documented policies; – a track record of ‘reasonable’ accuracy in measuring risks; – internal auditing must include an independent review of the risk measurement system, including the business units and the risk-control unit at least each year, considering such issues as documentation, use-test, risk-pricing models and valuation systems, accuracy and completeness of data and assumptions, verification procedures on data and on back testing; – a requirement to upgrade to new techniques and practices for specific risk modelling and for the model in general147. The model to calculate the recently added incremental risk charge to capture default risk and migration risks not captured by the internal model for market risk builds on the IRB requirements. Specific requirements on up to date data and the nonlinear character of e.g. derivatives are added, and it repeats requirements on validation, including stress testing and documentation. Supervisors can grant annual exemptions from all these requirements if the calculation (and organisation) used results in a higher incremental risk charge than a compliant calculation would have148. Operational Risk – Additional Requirements for Standardised and AMA Banks In the operational risk area, there are additional requirements even for the standardised approach (to allow the bank to upgrade from the basic indicator approach). These are added to the very generic operational risk organisational requirements described in chapter 13.3. The additional requirements focus amongst others on requiring an assessment and management system for operational risk and close integration into the risk management processes of the bank (see chapter 10.3). The risk management processes need to contain regular reporting of operational risk exposures and loss experience, as well as commitments to take corrective action whenever necessary. The idea is to build awareness of operational risk into the structures of a bank, as well as an awareness of the types of instruments available to a bank to limit damages from incidents such as fraud or over-exposure due to

147 Annex V §3 (fourth sentence) and 5 (next to last sentence) RCAD. 148 The normal VAR model for specific risk in the context of position risk (one of the five components of market risk) does not capture credit risks sufficiently. See chapter 9.4. Annex V §5a, 5f-j RCAD.

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failing internal controls. These in combination with the institution of an independent risk management function for operational risk ensure that operational risk receives attention. The conditions, however, are not very strongly worded on the responsibility of the highest management levels to take action. A second additional set of requirements applies if the bank wants to apply the advanced measurement approach. These qualitative criteria focus on internal organisation and control, specifically on the existence and functioning of an internal operational risk measurement system and the institution of a responsible person within the organisation of the bank. The internal operational risk measurement system requires149: – an independent risk management function for operational risk; – a well-documented risk management system, with routines in place for ensuring compliance; – subject to regular reviews by internal and/or external auditors, including all accompanying processes150; – internal validation processes (in addition to the supervisors’ validation process described in chapter 6.3 and 10.4); – transparent and accessible data flows and processes; – the process to be fully part of the day-to-day risk management processes of the bank. Compared to the credit risk organisational requirements, these remain relatively low-level, reflecting the fact that operational risk modelling is still a ‘young’ and underdeveloped area151. The BCBS and EBA have noted, however, that progress is being made, and continues updating its observations and guidance mentioned below. EBA Guidelines In addition to the general model validation guidelines that provide further detail on the additional demands, EBA published guidelines on how the bank should to deal with the inevitable changes and upgrades needed on the approved models152. These clarify which changes only need to be notified to the supervisors, and which would need a pre-approval before the more significant adaptations of the model can be rolled out. Each bank that is allowed or wants to use the advanced measurement approach, has to have a policy on how to deal with changes, including ensuring an awareness of when to trigger a notification or 149 Annex X, part 3 §1-7 RBD. 150 A. Fernández-Laviada, ‘Internal Audit Function Role in Operational Risk Management, Journal of Financial Regulation and Compliance, Vol. 15, No. 2, 2007, page 143-155. 151 See chapter 6.2 and 6.3, and e.g. BCBS, Operational Risk – Supervisory Guidelines for the Advanced Measurement Approaches, June 2011, page 1. 152 CEBS-EBA, Model Validation Guidelines, April 2006; EBA, Guidelines on Advanced Measurement Approach (AMA) – extensions and changes (GL45), 6 January 2012.

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an (amended) application for model approval. Such guidelines are not (yet) available for credit risk and market risk models. Literature – Power, Michael, Organized Uncertainty, Designing a World of Risk Management, Oxford University Press, Oxford, 2007, chapter 3 Guidelines – CEBS-EBA, Guidelines on model validation guidelines (CP03), April 2006 – EBA internal governance guidelines – EBA, Guidelines on advanced measurement approach (AMA) – extensions and changes (GL45), 6 January 2012 – BCBS, Principles for the sound management of operational risk, July 2011 (replacing BCBS, Sound practices for the management and supervision of operational risk, 2003) – BCBS, Operational risk – supervisory guidelines for the advanced measurement approaches, June 2011

13.6 Stress Testing in Pillar 1, Pillar 2, and in EBA Introduction The quantitative and qualitative assessments of both pillar 1 and 2 are primarily based on current or recent financial data. It relates to an assessment of e.g. the value of an asset or of the business or markets on a specific day, or of the relatively short timeframe of a quarter or of a year. Neither potential risks nor potential profits can be based only on such point of time information influencing the predictions in the near future. Pricing of services on the basis of short term profits and recent cost-information without taking into account long term risks is a sure method to go bankrupt (after having paid high dividends and bonuses in the first years); and adjusting capital requirements and management to short term experience is a sure method for the same. Stress testing partially correct this. Stress testing requires that a bank assesses its required level of capital on the basis of long term – through the economic cycle of boom and bust – calculations, by applying worst case scenarios to its current information. Stress testing has not been dealt with in one central place in banking legislation, but has been added to the requirements on: – models used for the calculation of quantitative requirements (IRB models, counterparty credit risk internal model, operational risk advanced measurement approach, market

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risk (specifically for the – normal and stressed – VAR model and for the incremental risk charge) in pillar 1 solvency ratio calculations153; internal governance/pillar 2 self-assessment (ICAAP)154, though there is little or no guidance on exactly what the stress test should entail, nor what the specific and harmonised response should be if the stress test is not strict enough or if it is failed; the collateral used to reduce the value of large exposures contained in the banking book has to stress tested, which may result in reductions of the realisable value of any collateral155; general stress tests of the banking sector by EBA156; for liquidity buffers calculations – in guidance now, and in the expected format of the final liquidity rules – the calculations will be based on stressed scenarios. In the CEBSEBA non-binding guidelines the liquidity buffers the supervisors deem sufficient are calculated in stressed scenarios for the short term liquidity needs since end 2010157. No bank is as yet obliged to stress test their long term funding.

Goal of the Diverse Stress Tests Though the scenarios used and the execution of the stress tests can be quite similar, the impact of their results is different. In the majority of stress tests, the primary goal is awareness. For market risk and for the EBA stress tests, a specific follow-up is required (which is not the case for pillar 2 or credit risk stress tests). The new stressed VAR requirement has given the stress testing of market conditions an additional bite in the form of higher capital requirements. For pillar 2 stress tests, supervisors have an option to impose measures if they do not like the outcome of stress test exercises, but this depends heavily on the subjective judgement of the supervisor (and the relative political power and authority of the supervisor vis-à-vis the bank). The EBA stress tests are geared towards identifying systemic risks, and monitoring systemically relevant banks. EBA was not granted any follow-up authority, but it has grasped this nonetheless, requiring individual banks to increase their financial buffers; see below. If a bank functions under the standardised approaches of credit risk or operational risk, the standardised model sets financial buffers at a level that intends to cover both good times and bad times (being a little harsh in good times, and perhaps too light in the worst 153 IRB models (Annex VII, part 4 §40-42 and §115g RBD for credit risk stress testing to assess capital adequacy), counterparty credit risk internal model (Annex III part 6 §14, 24, 32, 33 and 42 RBD), operational risk advanced measurement approach (Annex X part 3 §20 RBD), market risk (Annex V §2(g), 5h(ii), 5l and 10c RCAD). 154 Internal governance (Annex V RBD), pillar 2 (art. 124.5 for interest rate risk and Annex XI §1 and 3 RBD). 155 Art. 114 RBD. 156 Recital 43 and art. 21.2 sub b, 32.2 and 35 EBA Regulation 1093/2010. 157 CEBS-EBA, Guidelines on Liquidity Buffers and Survival Buffers, 9 December 2009; see chapter 12.2.

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of times). Banks on the standardised approaches to credit risk, operational risk and market risk do not have to stress test the way they calculate their financial buffers under pillar 1. The awareness benefit for standardised banks – and for all banks on their capital management – is solely part of the overall look at future risks that the bank might be exposed to under pillar 2. No such built-in buffer is available in the home-grown models used by banks under the models used in the internal ratings based approach and the advanced measurement approach models. The stress test is in that case intended to ensure that the calculation of required capital does not reflect only the limited set of data based on recent history at a given moment, but leads to a viable capital buffer both in good times and in bad times. The purpose of stress testing requirement on models is to validate the (qualitative and quantitative reasonableness of the) model158 and to increase awareness of possible effects on the bank if market conditions deteriorate. When pillar 2 (own assessment of all risk faced by the bank followed by a supervisory assessment; see chapter 14) became obligatory as per 1 January 2007, this introduced a requirement to look at future risks that the bank might be exposed to. The stress testing that is part of the pillar 2 self-assessment has a different goal than the stress testing requirements for aspects of credit risk and market risk calculations. Its primary purpose is to inform the bank itself. Basically, a bank and its management are required to engage in a ‘what if’ analysis, hopefully shaking the all too comfortable assumption that nothing ever goes wrong. Especially in long economic upturns, memory is short and both risk taking and under-pricing of that risk generally increases, as shown in the period prior to the 2007-2013 subprime crisis. The results of a stress test that looks at how the internal organisation and the bank as a whole would be able to deal with unexpected worst case events should thus feed both into some detailed decisions such as pricing of risk, but also into longer term strategic planning. All the stress tests performed on the own models for credit risk, operational risk and market risk approved for use in pillar 1 are in addition likely to be taken into account in the overall assessment of all risks required under pillar 2, but they do not define it. The goal is to help get a grip on all risks, not only to deal with one specific aspect of risk. Prudential stress testing requirements partly compensate for the lack of provisioning in good times (and thus the artificial pumping up of profits in the short term quarterly or annual public accounting publications), by providing useful information on potential risks to the bank and the supervisor.

158 E.g. see Annex V §5h(ii) RCAD.

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What is Stress? Stress testing is less than useful if performed based on too mild scenarios. Testing a scenario of a 1 or 2 per cent decline in a key market is more of a mild shower than facing a hurricane. Arguably, such mild scenarios are harmful to the risk perception at the bank, as they shore up any existing unfounded optimism that it is able to withstand stress. To actually test the outcome of models or the behaviour of the bank, and try to capture for instance the fat tail-events of the models used in the various approved internal models (see chapter 6.3, more extreme occurrences would need to form the basis of stress testing. In the run up to the 2007-2013 subprime crisis, the regulatory requirements and the practices at larger groups were dismal. The only explicit reference in the CRD to the strength of the scenario tested only required the stress test of a ‘mild recession’159. Shamefully, this requirement in the IRB approach was not upgraded during the crisis160. The joint forum interviewed large financial groups during the early stages of the crisis. Their stress testing had not anticipated nor allowed them to prepare for the crisis, and in general did not truly take into account systemic market shocks, were based on optimistic assumptions, underestimated risks, and totally ignored the effect of reputational issues161. Despite the loud trust placed in stress testing requirements, the CRD has always been surprisingly light on what a stress test should encompass, and banks have little incentives to go for a worst case scenario in any case (as it might likely be the end of the bank – and their job – if the scenario were to come true)162. Even the references to stress testing in the CRD are sometimes euphemistic. Apart from some forthright obligations to stress test, similar requirements are ‘scenario analysis to evaluate the exposure to high severity events’ (operational risk), ‘how to deal with shocks’, ‘how to deal with an economic downturn’. The legal requirements as to the shock that needs to be applied were extremely light, ranging from analysing the banks performance in a mild recession to more useful recently introduced stress testing requirements that require a bank to assess the performance of the bank under historical and theoretical shocks. Requirements include163:

159 Annex VII, part 4 §41 RBD. Other references include non-specific terms such as ‘adequate’ or ‘sound’ stress testing. 160 In the CRD IV project it will at last be replaced by a requirement to test ‘severe, but plausible recession scenarios’; art. 177.2 CRR. 161 Joint Forum, Cross-Sectoral Review of Group-Wide Identification and Management of Risk Concentrations, April 2008, page 32, www.bis.org. 162 A.G. Haldane, (Bank of England), Why Banks Failed the Stress Test, 13 February 2009. 163 Annex V §2(g), 5h(ii), 5l, and 10a RCAD; art. 114, 122a.4, 122a.7, and 123-124, Annex III, part 6, §24 and 32-33, Annex V §18 and 20, Annex VII, part 4 §40-41 and 115, 127, Annex VIII, part 3 §16 sub g and Annex X part 4 §20 RBD. For the impact of pillar 1 stress testing on the supervisory review and evaluation process of pillar 2, see Annex XI §1 RBD. Also see the CRD II Directive 2009/111/EC and the CRD III Directive for the changes made end 2010. See for comments on the EBA Liquidity Guidelines chapter 12.2. Stress testing requirements remain diverse, and spread over the CRD IV project. See e.g. art. 177 and 290 CRR.

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– for the internal ratings based approach to credit risk (IRB), the test has to be meaningful and reasonably conservative, including at a minimum a mild (!) recession, taking into account also the creditworthiness of protection providers under credit risk mitigation requirements. However, it does not lead automatically to a required improvement in pillar 1 calculations, and banks and supervisors are not required to impose pillar 2 capital requirements if they choose not to do so164; – banks that use the financial collateral comprehensive method for credit risk mitigation need to stress test to address risks arising from market circumstances to the capital adequacy of the bank, and on the potential for the collateral to be sold during stressed circumstances under ‘adequate and appropriate’ scenarios, with an impact on the amount of collateral that can be taken into account, while banks that rely on master netting agreements as a credit risk mitigation tool need to have ‘rigorous’ stress testing in place; – for banks that calculate counterparty credit risk for derivatives (CCR) using an internal model, the stress testing needs to be ‘routine and rigorous’ and – within the pillar 2 assessment of capital sufficiency for CCR – have to consider ‘economic conditions that could have unfavourable effects’; – for banks that calculate operational risk financial buffers under the advanced measurement approach in an internal model (AMA), the test has to take into account ‘high severity events’; – for the internal models of market risk, the stress test needs to be ‘rigorous’. The shocks differ per type of assets and depends on the time needed to manage risks under severe market conditions, while for stressed VAR calculation the time period can be chosen by the bank, and it is not clear (yet) whether they have to pick the worst of times or ‘only’ bad times; see below. The internal model stress test does have to address a range of circumstances, amongst others market illiquidity. An additional (undefined) stress test series has to be performed for the correlation trading portfolio, that may determine a supplementary capital charge under pillar 2. The CRD III amendment only specifies historical data from a continuous 12-month period of significant financial stress relevant to the institution’s portfolio, subject to supervisory approval165. For the obligatory reverse stress tests, no further detail is given; – the stress tests on the incremental risk charge – obligatory as per end 2011 via CRD III – shall ‘not be limited to historical events’; 164 IRB banks need to take the credit quality of protection providers into account in their stress testing if they want to apply the preferential treatment of Annex VII part 1 §4, part 4 §40-42, and Annex VIII art 1 §29 and part 2 §22 RBD. Also see CEBS-EBA, Guidelines on Stress Testing (GL32), 26 August 2010, page 17. Compare art. 177 CRR, that requires a test of ‘severe, but plausible, recession scenarios’ in the IRB context. 165 The BCBS has, however, developed stress testing guidance for the correlation trading portfolio. It was added in 2010 as an annex to the Basel II ½ paper on market risk. See BCBS, Revisions to the Basel II Market Risk Framework, updated as of 31 December 2010, February 2011.

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– for securitisations, any investing bank will need to perform their own stress test on the positions they take ‘appropriate to the positions’, and based on the information disclosed by the sponsor/originator bank. The obligation to disclose is benchmarked at allowing a ‘comprehensive and well informed’ stress test. The investor-bank can rely on the outcome of models used by ECAI’s, if the bank validates and understands that model; – for liquidity management the expanded number of requirements since end 2010 as introduced via CRD II require the banks to consider institution specific, market wide and combined scenarios with different time horizons and different degrees of stress; but no mention is made of obligatory quantitative buffers. In the CEBS-EBA 2009 liquidity buffer guidelines166, the stress scenarios include institution-specific shocks to the bank, shocks to the markets, and shocks to both, which all are relevant for calculating liquidity buffers; see chapter 12.2; – for pillar 2, the bank and the supervisor need to assess the risks to which the bank is or might be exposed. Stress testing can lead to higher capital requirements, which is an unwelcome dancing partner in good times as it restricts the desire to lend/invest, and in bad times as it may tip a bank into bankruptcy. But even apart from the ‘mild recession’ terminology in the IRB context, most of the terminology used to describe mandatory stress tests has no objective reference or meaning, except where historic data are required to be tested. Generic obligation to stress test lack specificities on the types of shock to be applied. Their validity and strength can thus not be ‘enforced’ by the Commission on the member states, nor by the supervisors on the banks, unless those largely empty terms have been filled in by concrete standing policy. The BCBS and CEBS-EBA have since tried to fill in the void by publishing guidelines including a largely coherent approach to stress testing that includes multiple scenarios. The BCBS and CEBS-EBA guidelines of 2009 respectively 2010 contain substantial pieces of guidance that might prevent a similar crisis as the 2007-2013 subprime crisis167. CEBS-EBA had already provided some guidance on stress testing in the context of primarily pillar 2 work in 2006168. This appeared to have been widely ignored except as a cumbersome compliance exercise. CEBS-EBA politely indicated that its 2006 work did not appear to be sufficiently integrated in risk management nor decision making at the

166 CEBS-EBA, Guidelines on Liquidity Buffers and Survival Buffers, 9 December 2009. 167 BCBS, Principles for Sound Stress Testing Practices and Supervision, May 2009, www.bis.org. CEBS-EBA, Guidelines on Stress Testing (GL32), 26 August 2010. 168 CEBS-EBA, Guidelines on the Application of the Supervisory Review Process under pillar 2 (GL03), 25 January 2006; complemented By CEBS-EBA, Technical Aspects of Stress Testing under the Supervisory Review Process – CP 12, 14 December 2006. Also see CEBS-EBA, Guidelines on technical aspects of interest rate risk arising from non-trading activities under the supervisory review process, 3 October 2006. These guidelines will be updated by EBA (the consultation started on 26 June 2013) to add stress scenarios and thresholds.

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EU Banking Supervision banks169. The CEBS-EBA guidelines of 2010 replaced the 2006 guidelines. These are expected to be applied since end 2010. CEBS-EBA has for instance ignored the mild recession guideline given in the RBD annex for IRB banks, at least to the extent that it could be a limit to the types of stress a bank has to take into account. For its guidelines on stress testing it built instead on terminology such as the generic demand for ‘sound’ stress testing in IRB. On that basis banks are required to assess the banks performance under scenarios including a severe economic downturn170. Even with such relatively much higher stresstesting assumptions, truly incidental events would not be captured, as they are not represented in the data available171. According to the EBA (and the BCBS) guidelines: – banks should develop and perform different types of stress tests, ranging from sensitivity tests to complex and severe stress tests, and ranging from portfolio tests to group-wide tests, and check the impact on capital and earnings; – the stress tests should take into account correlations, reputational risk and the behaviour of structured products such as derivatives or securitisations; – the scenarios tested should be exceptional but plausible, including a severe economic downturn; – the scenarios tested can include anything, including a downgrade of several large counterparties172; – the bank should also engage in reverse stress tests, by asking which events could lead to failure of the bank (instead of whether a given event would lead to failure). EBA ameliorates the power of reverse stress testing, however, by indicating that such reverse scenarios do not lead to a need for capital buffers under pillar 2, but only serve for senior management to understand potential fault lines. The guidelines also indicate that banks should involve the board and senior management in the stress tests, and actively respond to the lessons from the stress tests in strategic decision making processes. Supervisors should check whether a bank performs the right stress tests and reacts to them in the right way. The BCBS indicates that supervisors should organize multi-bank stress tests to complement the firm-specific stress tests by the banks. Within the EU context this is part of the wider CEBS/EBA stress tests, as well as the work of the IMF and ESCB/ESRB on financial system stresses.

169 CEBS-EBA, Guidelines on Stress Testing (GL32), 26 August 2010; §2. 170 Annex VII part 4 §41 RBD. CEBS-EBA, Guidelines on Stress Testing (GL32), 26 August 2010, page 18. 171 Also see chapter 6.3, and L. Matz, ‘Market Turmoil: Are Our Models Letting Us Down?’, Bank Accounting & Finance, October/November 2008, page 41-43. 172 Joint Forum, Stocktaking on the Use of Credit Ratings, June 2009, www.bis.org.

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The CEBS-EBA stress tests performed in 2010 and 2011 (see below) were based on more rigorous scenarios than required by the CRD, though even those were criticised for being overly optimistic. They did not include worst case scenarios on sovereign default, but the 2011 EBA stress test did include haircuts on sovereign exposures in the trading book, and – even though the CRD does not prescribe this – impairments based on expected losses in line with existing external ratings for the non-trading book (banking book)173. Quantitative Consequences of Market Risk Stress Testing for Internal Model-Banks The one exception where stress-scenarios actually has a direct and harmonised impact on quantitative requirements is the recently introduced stressed VAR calculation in market risk, applicable as per end 2011 to banks that calculate market risk capital requirements under an approved internal model174. This first aid measure in response to the 2007-2013 subprime crisis is an upgrade for the capital requirements in the trading book175. The stressed VAR capital requirement comes on top of the stress testing that the banks were already urged to perform on the normal VAR, but which did not (and does not) feed into the capital requirements calculation. The BCBS urges stress test on at least a weekly basis, and has issued some guidance on the stress testing of the correlation trading portfolio for banks on the internal model approach176. In the stressed VAR, the bank has to select a period of stress relevant to its assets. The data of this historical period is applied to its exposures. Instead of applying the data of the recent past, it has to apply – on the basis of the normal VAR criteria of a 10 day 99 percentage confidence level – the historical data of that continuous 12 month period chosen to its calculations177. The period has to be reviewed regular (and is part of the approval process, for which EBA has to develop guidelines). This stressed VAR calculation is added to the pre-existing VAR calculation and the incremental risk charge to determine the capital requirements for market risk for an internal model bank; see chapter 9. Both the VAR calculation and the stressed VAR calculation are subject to the more general stress testing requirements that are part of the model approval process, though the period chosen for stressed VAR obviously is superfluous for stress testing purposes. The BCBS

173 EBA, 2011 EU-Wide Stress Test, Aggregate Report, 15 July 2011. 174 CRD III 2010/76/EU introduced the stressed VAR calculation in Annex V RCAD; see chapter 9.4. 175 Though the impact assessment showed that this is by far not the greatest driver for an increase in capital requirements, it still increased risk weighted assets by two per cent for the larger banks. CEBS, Results of the Comprehensive Quantitative Impact Study, 16 December 2010, www.eba.europa.eu, page 15. 176 The guidance was added in 2010 as an annex to the 2009 Basel II ½ paper on market risk. See BCBS, Revisions to the Basel II Market Risk Framework, updated as of 31 December 2010, February 2011. 177 See chapter 13.2 on the content of liquidity management. Stress requirements are contained in Annex V §18-22 RBD.

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EU Banking Supervision recommends a range of historical crises to select scenarios from178. For the incremental risk charge, the RCAD requires that the scenario’s also include theoretical scenario’s, in addition to historical stress scenarios. A new requirement on reverse stress testing of the VAR calculation was introduced for the market risk stress test at the same time the stressed VAR was introduced179. In addition to a rigorous and economically meaningful but flexible institution-specific stress testing programmes, a bank also would have to handle some prescribed stress tests, including multiple tests on the basis of data from historical reference periods where e.g. interests spreads rose of fell sharply during the 2007-2013 subprime crisis, as well as scenarios where large debtors suddenly default. EBA Stress Tests The stress test instrument of EBA has been applicable since the start of 2011180. Its predecessor CEBS – without such a legal basis – coordinated a similar event in 2010 for 91 banks, and published the results in July 2010181. It forced a calculation of capital levels following a macroeconomic scenario that – even though this did not include a sovereign default scenario – was much stricter than any required in the CRD. The 2010 CEBS stress test was an attempt to provide the markets with more trustworthy information on the solidity of key EU banks during the 2007-2013 subprime crisis. It asked a selection of banks to run a common stress scenario through their systems, compared and published the aggregate results, and forced banks to publish the individual results. The participating banks reported to CEBS via their national supervisors, and aggregated information was published alongside individual disclosures by individual banks. This convoluted publication was chosen to formally stay in line with the secrecy obligation of CEBS-EBA and its member-national supervisors. The pressure was nonetheless high on participating banks to publish the information, making adherence to the secrecy obligation more lip-service than actual protection of individual information; see below and chapter 15.2 and 20.2. Though it did provide information, the underlying goal to restore trust in the banking sector was not achieved; particularly because the scenario – though harsher than the CRD required – was not deemed credible by the market. Though the scenario as tested would be survived by most, some banks did not survive unscathed in the real life scenario played out after the stress test. EBA used its new authority in 2011 to call for a further stress test, setting an even stricter scenario and conditions. It forced some harmonisation in the data to be provided, and 178 179 180 181

Basel II ½, revisions to the Basel II Market Risk Framework, July 2009, page 16. Annex V §10c RCAD, introduced by the CRD III Directive, 2010/76/EU. Recital 43 and art. 21.2 sub b, 32.2 and 35 EBA Regulation 1093/2010. CEBS-EBA, Statement on Key Features of the Extended EU-Wide Stress Test, 7 July 2010. CEBS-EBA, Aggregate Outcome of the 2010 EU Wide Stress Test Exercise, 23 July 2010.

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asked for a write down on sovereign bonds (neither of which is in any way part of the CRD)182. The 2011 EBA stress test exercise captured a wider set of 90 banking groups. The 90 were selected to cover both a majority of banking assets in the EU (in the end 65%) and at least 50% of the banking sector in each member state. The 2011 stress test banking groups were headquartered in 21 member states, and they and their subsidiaries controlled the banking sector of all EU/EEA member states. Some member states allowed other banks to be included in the 90 banks even if the 50% had already been achieved, with the aim to enhance their individual reputation183. EBA benchmarked the initial results as transferred via national supervisors by the participating banks (90 banking groups headquartered in 21 member states), when they did not prove to be fully comparable. The results were published in July 2011. The EBA stress test – like the stress test by its predecessor – has been criticised for not being stringent enough. Specific attention was paid to the lack of a default scenario of an EU member state sovereign (at a time when e.g. Greece was likely to default), and for keeping most of the banking book outside of the exercise. Even though criticised for being weak or excluding some main risks (for which inclusion there was apparently no majority of EBA and/or ESRB members), EBA and its predecessor CEBS have at least coordinated EU wide stress tests of the biggest banks in all member states on the basis of a harmonised scenario. When banks and national supervisors were not sufficiently strict, the methodology was tightened and the results peer reviewed in its June 2011 paper with ‘additional guidance’ on issues such as the probability of default under diverse ratings, and the cost of funding to assist supervisors and banks in coming up with comparable results. The results of this stress test are published, leading to both market pressure (see below) and pillar 2 supervisory pressure to beef up financial buffers if these prove to be insufficient. The types of requirements and scenarios have been gradually tightened; which has proven to be a key driver for larger banks to start anticipating Basel III requirements of high grade financial buffers, the new common equity tier 1; see chapter 7.2. Compliments were on the other hand paid to the added disclosure that was part of the 2011 exercise, under which everyone received the data on which the analysis was made, allowing for alternate stress scenarios to be run by outsiders, and for the requirement of high grade financial buffers (though this was not to the delight of Germany, where many banks rely on e.g. silent participations, that are 182 EBA, Overview of the EBA 2011 Banking EU-wide Stress Test, 18 March 2011; EBA 2011 EU-wide Stress Test, methodological note version 1.1, 18 March 2011; EBA, Supporting Document 2: capital definition criteria (and the accompanying press statement and ‘questions and answers’); EBA, Supporting Document 1: banks participating in the 2011 EU-wide stress test, 21 April 2011; EBA, 2011 EU-Wide Stress Test, Methodological Note – Additional Guidance, 9 June 2011; EBA, European Banking Authority 2011 EUWide Stress Test Aggregate Report, 15 April 2011. 183 EBA, Supporting Document 1: Banks participating in the 2011 EU-wide stress test, 21 April 2011. EBA, 2011 EU-Wide Stress Test, Aggregate Report, 15 July 2011.

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still allowed in the current CRD, but are likely to be phased out when Basel III is implemented184). In the report on the stress test results, EBA ordered supervisors and the banks involved in the exercise to add capital if they faced a shortfall under the stress test two years in the future. This demand (more capital as calculated both for the trading book and the banking book, calculated with a two year horizon) is neither part of the current CRD nor of the EBA regulation; see chapter 6.2. Even the CRD IV project still only demands a gradual build-up of the solvency ratio until 2019; not already as per 2011, which continues to be based on a shorter time horizon. The same applies to its decision to implement some of the improvements in the quality of capital already in 2011, instead of in the timeline proposed by the Basel III amendment and the CRD IV project; see chapter 6.2 and 7. The initial methodology note denied anticipation on Basel III/CRD IV on 18 March 2011, but within a month the capital benchmark was set at a very high level consistent with the Basel III amendment. This change in position was a response to the deteriorating 20072013 subprime crisis at that time in the EU. The benchmark was set at 5% of core tier 1. The core tier 1 definition used was not based on the CRD as in force during the crisis, but in a special definition that focused on the (Basel III) version of shares and similar instruments, and excludes hybrids and preference shares as accepted under CRD-calculations and in the long transitional period in the Basel III/CRD IV; see chapter 6.2 and 7. On the other hand EBA still acknowledged the sometimes rather poor quality hybrids that were given to banks by their governments as state aid. The 5% core tier 1 benchmark under the stressed scenario published on 8 April 2011 was acknowledged not to be a legal requirement, but EBA nonetheless quite explicitly expected shortfalls to be made up – in spite of there being no legal requirement to do so – within a short timeline. The required amount of capital was carefully presented as being of a temporary nature; to restore confidence in the EU banking sector. The use of this type of market pressure, however, is not legal in any sense of the word; see chapter 6.2 and below. When it failed to restore confidence in light of a further deteriorating trust in sovereign issuers, the subsequent recommendation to obtain 9% core tier 1 capital by mid-2012 (in a non-stressed scenario based on data as per September 2011) was equally without a legal

184 Bafin Annual Report 2010, preface by Jochen Sanio, April 2011, who indicates the lack of legal authority and legitimation for changing the agreed BCBS definition by EBA. One of the German banks withdrew at the eleventh hour from the exercise; see the July aggregate report. Silent participations are not mentioned in the CRR, leaving it up to the interpretation of the CRR by the supervisor competent in Germany whether this local instrument qualifies as common equity tier 1, additional tier 1 or tier 2 capital; see chapter 7.

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basis in EU level legislation185. To support its orders, EBA references its power to issue recommendations. However, these are limited to effective supervision of and ensuring the correct application of EU law. EBA also refers to its power to perform stress tests and make recommendations, and to coordinate actions, but such are equally limited to valid EU law, and recommendations are non-binding. The level and type of capital required deviates from that law. Even the – potentially more relevant and definitely more far-reaching – power to facilitate and coordinate in emergency circumstances – if and in as far as such a situation has been determined by Council decision – is limited to good application of existing EU provisions186. From a pragmatic point of view, the stress test of CEBS in 2010 and of EBA in 2011 have to be applauded187. They could be critiqued for being too lenient, but still brought forth results that were remarkably transparent and relevant at a time when trust in banking (and supervisors) was collapsing all over the EU. From a pragmatic point of view, the same can be said for the follow up to the 2011 EBA stress test (with the 5% core tier 1 requirement in a stressed scenario) and the follow-up of the recommendation to have a one-off 9% core tier 1 requirement in a non-stressed scenario, which appears to have been reached without increasing the credit crunch by major bank deleveraging188. Pragmatism aside, however, the lack of democratic and legal legitimacy is alarming. For the 2011 stress tests EBA could build on the EBA regulation to perform a stress test, and to make non-binding recommendations to correct issues identified in the stress tests189. Nowhere, however, does it say that it should put banks under pressure to publish their individual results, that the correction should go over and beyond the minimum level set out in the CRD, and to use market pressure to make its non-binding recommendations into a binding set of rules. This criticism was put forth by some of the subjects of the stress tests as well as (outvoted) EBA members, see above on the 2011 stress test exercise. They received little sympathy, as their actions could well be painted as wanting to hide too thin financial buffers and significant exposures to risky assets. That an EU institution, prompted and applauded by the market and EU institutions, went far beyond its mandate to blackmail banks into

185 EBA refers to art. 16, 21 and 31 EBA Regulation 1093/2010, but these cannot support these recommendations. EBA, Recommendation on the Creation and Supervisory Oversight of Temporary Capital Buffers to Restore Market Confidence, EBA/REC/2011/1, 8 December 2011 (with accompanying ‘questions & answers’). 186 Art. 17 EBA Regulation 1093/2010. 187 See J. De Larosière, Keynote Speech at the public hearing ‘Financial Supervision in the EU’, 24 May 2013. 188 EBA, 2011 EU-Wide Stress Test Aggregate Report, 15 July 2011; Final report on the implementation of capital plans following the EBA’s 2011 recommendation on the creation of temporary capital buffers to restore market confidence, EBA BS 2012 188, October 2012. 189 Art. 21.2 sub b EBA Regulation 1093/2010. Also compare the new Art. 9b Financial Conglomerates Directive 2002/87/EC, introduced by FCD II Directive 2011/89/EU.

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participation and disclosure of a stress test that is based on requirements that have no base in applicable prudential legislation – abandoning national discretions and rules set out in current legislation – is nonetheless deeply disturbing from both a legal and a democratic point of view. If stronger requirements and harmonisations are needed – which they are – why was the extensive possibility to adapt technical parts of the CRD not used via the Lamfalussy/Larosière process190? These were supposed to enable quick and decisive changes when needed, instead of going to this circumvention of the legislation procedure. In effect, parts of the CRD and the EBA regulation that intend to safeguard the interests of the banks and of national supervisors have been superseded by requirements set by a public body that is using market discipline in a manner unintended by pillar 3, as a tool to punish banks that do not cooperate ‘voluntarily’ even though they fully comply with all currently applicable EU binding legislation. EBA announced in its report that it will scrutinise 30 banking groups bi-annually. The criteria to select these are asset size, cross-border importance and use of IRB models, which are similar criteria as relevant for the identification of EU wide systemically important banks; see chapter 18.2. Future Developments The anticipated liquidity ratios as designed by the BCBS are to be based on stressed scenarios. After initial plans to require very heavy shock-testing, the calculated cash requirements were so large that the BCBS downsized the liquidity requirements. They will be based on a stress test based on a severe scenario, but not a worst-case scenario. Further changes are likely based on a series of reviews. See chapter 12. Though a stress test was expected in 2013 (on 2012 data), this has been impacted by developments surrounding the banking union in the Eurozone. Pending an expected asset quality review by the ECB of the banks it will likely start to supervise, EBA decided to recommend all competent authorities (for the Eurozone the ECB and its members, for the non-Eurozone the existing national supervisors) to perform an analysis of the valuations of assets used by banks, and to postpone a stress test until 2014191. Literature – Haldane, Andrew G. (Bank of England), Why Banks Failed the Stress Test, 13 February 2009

190 See chapter 23.3. 191 EBA, EBA recommends supervisors to conduct asset quality reviews and adjusts the next EU-wide stress test timeline, press release 16 May 2013.

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14.1 Introduction Even with (i) the expanded scope of the quantitative capital requirements for credit risk, (ii) the added capital requirements for operational risk and market risk, and (iii) the future quantitative liquidity requirements, no formula truly captures all risks a bank is subject to. The quantitative calculations described in chapter 6 to 12, and supported by the internal governance requirements of chapter 13, set out the minimum a bank has to comply with for those risks that can be predicted. Some other risks are assumed to be impossible to capture fully in a calculation (e.g. reputation risk), others might be captured in the future if both a theoretical model and a supervisory consensus could be developed. With the introduction of pillar 2, a catchall or fall-back requirement to look at non-quantified risks was put into the Basel accord and subsequently copied into the CRD. Pillar 2 is a two-step process, consisting of a requirement on the bank itself (chapter 14.2) and a requirement with a different scope on the supervisor (chapter 14.3). The second pillar requires in a first step banks to assess whether they are sufficiently capitalised to be prepared for all risks they are subject to. They have to make this self-assessment regardless of whether these risks are already captured with minimum requirements in pillar 1, the capital requirements for the credit risk, operational risk and market risk (and large exposures restrictions and requirements). The question they have to answer is whether all measures have been taken to be able to sustain the quantifiable and all other risks the bank is exposed to. The supervisors are in a second subsequent step separately required: – to review the arrangements, strategies, processes and mechanisms implemented by the bank to comply with the CRD (not limited to capital); and – to evaluate the risks to which the bank is or might be exposed, including but not limited to credit risk, operational risk and market risk1. The scope and consequences of the requirements on the banks and supervisors under pillar 2 lacked detail when it was issued as part of the Basel II amendment. It was implemented in the CRD without providing further detail. The pillar 2 legal provisions consist of fully two articles: one for the obligation of the bank and one on the obligation of the supervisor;

1

Art. 124 and Annex XI §1 RBD.

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EU Banking Supervision with a one page annex on the supervisory review and evaluation process2. CEBS-EBA has since worked extensively in this area. Its guidelines have added some of the needed clarity on the BCBS work, which has been fed back into the international process. Several risks to which a form of quantitative requirements could have been allocated were worked on in this context. Those have not been added to the quantitative risk calculations when they were developed. Instead pillar 2 has become a stepmother of various semi-official quantitative risk categories, such as for interest rate risk in the banking book and concentration risk3. General guidance was also developed on how the banks should do their self-assessment, and how the supervisor should check this and how it can respond. There appears to be no consensus on how the supervisor could best respond, leaving them with a range of options. The review and evaluation can lead to the conclusion that the bank is insufficiently compliant with the CRD or insufficiently prepared or capitalised to deal with the risks that it can encounter. In that case the supervisor can intervene to force the bank to become compliant, to increase its financial buffers or to take steps to reduce the risks it might encounter. The RBD contains specific references on the obligation of member states to give their supervisors the instruments to effectively address non-compliance or insufficient compliance with the obligations under pillar 2. It also contains an explicit obligation of supervisors to use them. See chapter 20 on the instruments of supervisors, and chapter 21.10 on liability of the supervisor and/or the member state if it did not use such instruments when it should have to make the CRD effective and efficient. One of the main benefits of pillar 2 – if correctly implemented in domestic regulation – is that it will give supervisors the opportunity to tackle banks that are particularly vigorous in their use of loopholes in the detailed pillar 1 requirements, or that have developed innovative products of which the risks are not yet or fully addressed in pillar 1. If they fail to provide for all risks they encounter, they are equally non-compliant as when they fail to fulfil the quantitative requirements. In the battle between prudence and profitability, this may prove a restraining influence against banks that are too smart or too desperate to be safe4. Pillar 2 cannot fulfil its purpose to help keep the bank safe if it is not imple-

2 3

4

Art. 123 and 124 and Annex XI RBD. See chapter 9 on the treatment of interest rate risk in the trading book, which has been captured in the market risk models. This is not the case for the non-trading book credit risk calculations discussed in chapter 8, even though interest rate risk can also be important also for exposures that are intended to be kept to maturity. These were left to the rest-category of the pillar 2 assessments: CEBS-EBA, Guidelines on technical aspects of interest rate risk arising from non-trading activities under the supervisory review process, 3 October 2006. Also see chapter 11 on large exposures, which is an aspect of concentration risk. F.S. Mishkin, The Economics of Money, Banking and Financial Markets, 8th ed., Pearson Adisson Wesley, Boston, 2006, chapter 11.

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mented with this flexible feature, or if supervisors use regulatory forbearance to ‘help’ the bank survive a bad patch of losses by lowering their demands at a time when the bank is actually in a high profit/high risk mood to make up for those losses, or if they are not politically powerful enough to use the instruments it has; see chapter 20.3). Another risk is that is that if the bank is in the high profit/high risk mood as a result of a wider macroeconomic growth trajectory, the supervisor may well be too ebullient too as it operates in the same macroeconomic environment. A new working group of EBA on innovative products and consumer protection may play a useful role in identifying new products with possible negative side-effects. The working group has indicated that it will look at financial innovations that might harm banks or the markets and systems of which banks are part5. Future Developments Under the CRD IV project, pillar 2 will be part of the CRD IV directive – so slightly more flexible as it relates to minimum harmonisation under rules adapted to member state specificities in its national laws6. The follow-up will nonetheless be reinforced. The assessment by the supervisor is proposed to automatically lead to higher capital requirements, giving banks and supervisors less room to abstain from intervention, though the threshold (to decide that the bank has not sufficiently provided for all risks it encounters in pillar 1 or in the self-assessment step of pillar 2) remains flexible and difficult to prove in a hostile environment to intervention7. The CRD IV will also likely lead to higher capital requirements under pillar 2 due to the introduction of a monitoring period for the leverage ratio; see chapter 7. The leverage ratio is intended to be part of binding pillar 1 requirements as of 2018. In the interim – similar to all other risks that are not sufficiently captured by pillar 1 – it is intended to be explicitly part of deliberations on pillar 28. The data gathered on leverage and on the ‘normal’ additional capital offered by banks under their own pillar 2-assessment (or required by supervisors under their part of the pillar 2 review) will provide important input for the calibration of the final leverage ratio. The BCBS has announced that it may work on pillar 1 requirements for interest rate risk in the banking book. This to limit the potential for arbitrage between the trading book and

5 6 7 8

EBA, Financial Innovation and Consumer Protection, an Overview of the Objectives and Work of the EBA’s Standing Committee on Financial Innovation (SCFI) in 2011-2012, 1 February 2012. Art. 73 and 97-100 CRD IV Directive, backed up by the internal and corporate governance requirements, and a mandatory annual examination and stress testing. Art. 104 CRD IV Directive, with the circumstances under which own funds requirements need to be made – based on amongst others pillar 2 – set out in paragraph 2. Art. 87 and 98.6 CRD IV Directive.

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banking book (there is already a pillar 1 requirement for interest rate risk in the trading book)9.

14.2 ICAAP – the Banks Own Assessment The CRD provides little or no detail on how pillar 2 should function. This is copied from (the lack of detail contained in) the Basel II accord. Though the CRD provisions remain rudimentary, follow up work has been done by CEBS-EBA that provide guidance and examples to the industry. Still, that has left the banks to innovatively address their task of looking at the full range of risks they encounter, not for commercial reasons but for prudential reasons. Since 2008 it has been a ‘learning by doing’ exercise both for supervisors and for banks. The CRD requires banks to have procedures in place to assess on an ongoing basis whether it has sufficient capital to cover the nature and level of the risks that they face or might face10. This responsibility of the bank is generally referred to as the internal capital adequacy assessment process or ICAAP, in line with terminology of the CEBS-EBA guidelines. Split up into its components, this process means that banks must analyse and have a view on: – sound, effective and complete strategies and processes. This is a key component of internal governance. The requirement to have ‘sound’ governance under the supervisory review process is subsequently the main channel for supervisory action on the internal procedures within a bank. The banks are also obliged to subject the strategies and processes specifically on pillar 2 to regular internal review. The goal is to ensure that they remain comprehensive and proportionate to the nature, scale and complexity of the activities of the bank; – how to assess and maintain on an ongoing basis a view on capital and risks; – what are the amounts, types and distribution of internal capital. The recitals to the RBD rephrase this slightly to emphasise quantity, quality and distribution. As regards the quality of financial buffers; this is an implicit reference to the various tiers of capital. The RBD sets minimum requirements on an ongoing basis, but it is generally deemed wise to ensure availability of higher quality financial buffer components rather than types of accepted capital belonging to a lower tier.

9

BCBS Consultative Document, Fundamental Review of the Trading Book, May 2012, page 6. Also see chapter 9.2. EBA meanwhile started on 27 June 2013 to consult on an update of CEBS-EBA, Guidelines on technical aspects of interest rate risk arising from non-trading activities under the supervisory review process, 3 October 2006. 10 Art. 123 and recital 53 RBD.

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– what the bank itself considers an adequate capital position to cover the nature and level of the risks to which they are or might be exposed. This part is subsequently the main subject of the supervisory review and evaluation process set out in chapter 14.3. The identification of the types of risk the banks should take into account has been left to the bank, though the RBD does contain some clarification of risks that should at a minimum be taken on board. The pillar 1 risks (credit risk, market risk, operational risk and – parts of – the large exposures regime) are also part of the self-assessment. For these risks, the question is whether the pillar 1 calculation is sufficient, or whether the financial buffers have been calculated in a too optimistic or opportunistic manner. For other types of risks, the assessment is more abstract in the sense that there is no baseline against which to assess the preparedness of the bank. The bank can come up with its own set of risk types, but for some the supervisors have issued guidance. Risks that could be included are11: – interest rate risk in the banking book; – real estate; – pension; – settlement; – securitisation; – business risk. Some of these categories may require less attention (or supporting measures) under pillar 2 if and when such risks are added to pillar 1, or if their treatment in pillar 1 gradually becomes more adequate (as has happened e.g. on market risk and securitisations)12. Pillar 2 is supplementary. The increases in pillar 1 as made obligatory in for instance the CRD II and CRD III directives thus eat into the area allocated to pillar 2, unless additional information or assessments are available to underpin reasoning to add similar or proportionally higher or lower pillar 2 requirements nonetheless The CEBS-EBA guidelines13 contain guidance to institutions and for supervisors. The guidelines for banks focus on internal governance (and have been recently recast into an integrated set of rules on internal governance14), and on the banks’ assessment of its capital needs. The banks are advised to set up a fully specified and documented risk-based, com11 Art. 123-124 and Annex XI RBD. Also see the CEBS-EBA, Guidelines on the application of the supervisory review process under pillar 2 (GL03 revised), 25 January 2006. CEBS-EBA, Position Paper on the Recognition of Diversification Benefits Under Pillar 2, 2 September 2010, page 9. CEBS-EBA, Guidelines on technical aspects of interest rate risk arising from non-trading activities under the supervisory review process, 3 October 2006. 12 See chapter 2, 8.6 and 9. 13 Currently contained in chapter 5 of the EBA electronic guidebook. 14 EBA, Guidelines on Internal Governance (GL44), 27 September 2011. See chapter 13.

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prehensive and forward-looking policy. The internal assessment of the total amount of financial buffers the bank thinks it needs has to deliver a ‘reasonable outcome’. The assessment is firmly put into the own responsibility of the bank (subject to the review set out in chapter 14.3. The answer ‘I don’t know’ is unacceptable, as part of the reason for this first step of pillar 2 is that a bank should come up with its own reasoned assessment, and thus has to actively look at its own risks and its preparedness. The RBD article on the self-assessment under pillar 2 highlights proportionality; also see chapter 3.4. CEBS-EBA has done some unofficial work on this issue. Its paper on small banks guidance is not published on its own website, but it has been published on the websites of some national supervisors15. Small banks should be subject to less stringent/less detailed rules than large banks16. Proportionality for the bigger banks is the reverse as for small banks. With size and complexity come more requirements but also more flexibility, possibilities and rights. The parallel for such proportionality as applied to large banks in pillar 1 is laid down in the flexibility allowed them in e.g. internal models. Guidelines – CEBS-EBA, Guidelines on the application of the supervisory review process under pillar 2 (GL03 revised), 25 January 2006 – CEBS-EBA, groupe de contact, paper on the internal capital adequacy assessment process (ICAAP) for smaller institutions, CEBS 2006 76, 27 March 2006 – CEBS-EBA, Guidelines on technical aspects of interest rate risk arising from nontrading activities under the supervisory review process, 3 October 200617 – CEBS/EBA, Guidelines for the joint assessment of the elements covered by the supervisory review and evaluation process (SREP) and the joint decision regarding the capital adequacy of cross-border groups (GL39), 22 December 2010 – CEBS-EBA, guidelines on the management of concentration risk under the supervisory review process (GL31), 2 September 2010 – EBA, Guidelines on internal governance (GL44), 27 September 2011 (which replaced section 1.2 of the 2006 pillar 2 guidelines (GL03)

15 CEBS-EBA, Groupe de contact, paper on the internal capital adequacy assessment process (ICAAP) for smaller institutions, CEBS 2006 76, 27 March 2006, can be found for instance on the website of the Danish, Dutch and Irish supervisor. 16 T. Poole, Proportionality in Perspective, LSE Law, Society and Economy WP 16/2010. 17 EBA launched a consultation process to update these guidelines on 27 June 2013.

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14.3 SREP – the Supervisory Review In the supervisory review step of the pillar 2 process, the supervisor assesses all the information it has related to the bank and its profile. It reviews information from all sources available to it, including on the economy, information gathered from the bank and from other banks, from public authorities such as foreign and domestic supervisors and central banks. This can include relatively objective information (such as public accounts and financial reporting) and relatively subjective information (such as impressions on the flow of information and competency of the officers of the bank). The goal of the review is to form an opinion on whether the bank has made a good assessment of its own risk, and – if the risks are larger than covered by other prudential requirements – whether it has taken sufficient additional measures to ameliorate the extra risk at its own initiative as a result of the self-assessment. This subjective supervisory review – even if based on experience and partly on objective information and peer review of banks – is controversial. It can be easy to abuse, and it can easily be wrong. Abuse can be in the form of too heavy or too light requirements, or by favouring some banks over others on the basis of non-relevant factors (political power, systemic relevance, or who plays tennis with whom). It is a rather arbitrary administrative powers for the supervisor that can be a difficult trade-off between added safety and administrative and human rights protection (see chapter 20.4 and 20.5. It can also easily be wrong, as it involves predicting the future and relying on receiving honest information and having experienced and knowledgeable staff that may not be present due to e.g. funding concerns, or due to the absence of a theoretical or practical framework for assessment. The pillar 2 review and evaluation obligation is just one of many tasks of the supervisor that involves judgement (model validation, licensing, approvals for mergers and acquisitions). This particular addition – introduced in the context of the Basel II amendment in 2006 and effective since 2007 – is intended to be a centrepiece of the work of the supervisor. A difficulty in the negotiations was that not all member states and definitely not all banks wanted to give supervisors too much discretionary power to follow up on findings on individual banks. Another difficulty was that there was little or no detail in the Basel documents; precisely to give a wider scope to supervisors to deal with unexpected innovations. Supervisors on the other hand hesitated to take on board the unlimited responsibility if a bank subsequently fails, if it had not taken measures that would no doubt be heavily contested by the bank up to the moment of failure. Considerations on the relative political power of banks and supervisors, the relative conservatism or leniency of banks and supervisors, on unequal treatment of banks by different individual supervisors if no objective criteria could be developed and on the liability of supervisors lead to a compromise text, containing ambiguous wording. A level playing field across the EU as a result is in

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no way guaranteed. After the negotiations were finalised and the new CRD provisions established, these still contained only limited detail. Most efforts had been put into the revision of pillar 1 (the recasting of credit risk and the introduction of operational risk). CEBS-EBA started to work to provide guidance to banks and supervisors on the rudimentary articles, which contained only the start of some indicators and limitations. The intent was to develop a learning by doing process, which should aim to be applied in a harmonised, consistent manner. In line with the CEBS-EBA guidelines, the process is generally referred to as the supervisory review and evaluation process or SREP (the overarching supervisory review process or SRP includes all pillar 2 components, including the banks’ internal capital adequacy assessment process described in chapter 14.2). The RBD states that the scope of the review and evaluation shall be whether the banks comply with ‘this directive’ and to evaluate the risks to which the banks are or might be exposed; indicating that the requirements of ‘this directive are the scope of the verification18. The term ‘this directive’ may refer solely to the RBD, though likely the legislators meant to refer to the CRD as a whole, so including the RCAD; though there is little substantiation of this (though this example of unclear referencing as a result of the two-directive structure of the CRD is not unusual; see chapter 2). National legislators would normally be empowered to expand the review to such other risk, except if the text of the provision intends to limit the supervisor in order to protect the bank, and such limitation to the RBD requirements is meant to have direct effect; see chapter 3.5. In that case the text would have to be interpreted as: the scope is limited to the review and evaluation of compliance and risks that are obligatory under in the RBD. The word limitation is, however, not present in the text, which means that the statement on the scope could be read in the exact opposite manner: the scope has to include at a minimum compliance with each and every one of the requirements of the RBD and all other risks a bank may encounter including but not limited those referenced in RCAD. This to avoid supervisors being too lenient (or ineffective/powerless) and only looking at some of the aspects regulated in the RBD, such as the solvency ratio or the organisational requirements, but at all aspects including e.g. the licensing requirements at a minimum. A limited interpretation would result if this provision were intended to protect the banks against an intrusive supervisor; a worthy goal under administrative law and human rights safeguards; see chapter 20. Even in that case, however, the requirements under the directive include the duty under the first step of the pillar 2 to take all risks the bank faces or might 18 Art. 124 RBD.

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safe into account in the self-assessment19. However, if the text does not intend to limit the supervisor, but to exhort it to at a minimum cover the entire set of RBD-requirements, in order to achieve the goals of the CRD, the second interpretation becomes more likely. As ‘this directive’ has the goal to protect depositors and financial stability, it becomes equally defensible to take the second wider interpretation in the interest of public safety, and look at the competence of the bank to manage all the risks that the bank encounters that may impact on its viability. CEBS-EBA implicitly takes the second approach in its guidelines. This appears to be one of the areas where a compromise text could be agreed on by the negotiating member states and the Commission, which would allow all to implement the obligation as they see fit. One item is however clear, the review and evaluation has to include at least all requirements under the RBD, regardless of whether supervisors can go beyond20. Supervisors are required to review ‘the arrangements, strategies, processes and mechanisms’ that the bank uses to implement the directive. These terms basically all mean the same thing: internal procedures to fulfil a prudential obligation. Such internal governance procedures range from21: – the internal capital adequacy assessment process set out in chapter 14.2; – the internal organisation requirements in general and specifically for e.g. IRB banks or for banks using collateral to reduce capital requirements (see chapter 13); – the related group wide requirements (see chapter 17); – the large exposures procedures and adequate internal control mechanisms set out in chapter 11.2; – all arrangements to comply with obligations under the directive, e.g. to calculate pillar 1 obligations or to send information to the supervisor. The review and evaluation is carried out on the basis of technical criteria mentioned in the directive. These set out some minimum areas of attention, and provide some added instructions to supervisors on the review and evaluation in specific cases, especially interest rate risk in the banking book and securitisation22. The following risks and issues explicitly have to be included in the review and evaluation: 19 Art. 123 RBD on the internal capital adequacy assessment process step of pillar 2 is not linked in any way to compliance with ‘this directive’ so that it is relatively clearly linked to any risks the bank faces or might face. 20 Art. 124.1 and 124.2 RBD. 21 See respectively art. 123, 22 and 84, 73 and 138, 109 and 114 RBD as the most central art. containing such requirements, as well as the provisions in annexes based on these articles, as well as the minimum requirements to be able to use models or risk protection; see chapter 13. 22 See art. 124.1 and 124.5, as well as Annex XI RBD. Paragraph 5 orders supervisors to take measures if stress tests result in large jumps in own funds if interest rate risk outside the trading book are stressed (see CEBS-

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– credit, market and operational risk; – stress testing results under the market risk internal models and the credit risk IRB approach; – concentration risk, including large exposures compliance; – residual risk after using credit protection techniques; – securitisation leading to too little capital being held23; – the exposure to and management of liquidity risk24; – the availability of liquid markets to sell or hedge trading book positions at short notice under normal market conditions; – interest rate risk from activities outside of the trading book; – the impact of diversification effects25 (leading to either the need for additional measures for institutions which have a strong focus in certain markets or countries, or may lead to a reduced need for surplus capital above and beyond the minimum requirements for well diversified banks). The supervisory review and evaluation is focused on finding whether the bank the processes of and own funds held by the bank ‘ensure a sound management and coverage of their risks’. This requires both a detailed and overall assessment of amongst others the abovementioned technical issues. A full review and evaluation process is quite labour intensive, both for the bank and for the supervisor. The associated costs are substantial, and EU or joint funding is not provided for; see chapter 21.9. The various CEBS-EBA guidelines provide a context for supervisors (and banks) on the way this can be achieved. In principle the assessment obligation is an ongoing process. However, the frequency and intensity can be differentiated to be proportional to the size, systemic importance, nature, scale and complexity of the activities of the bank. Upon completing the first review and evaluation,

EBA, Guidelines on technical aspects of interest rate risk arising from non-trading activities under the supervisory review process, 3 October 2006). The annex also sets out an instruction for supervisors on how to deal with repeated transgressions on the prohibition to provide support for securitised assets; see chapter 8.6. These instructions fill in some of the measures supervisors have to be able to take art. 136 RBD; see chapter 20. 23 The Basel II ½ amendment to the Basel Capital Accord goes further in some respects, by indicating that the likelihood of potential implicit support and reputational risk leading to the bank taking back assets onto its balance sheet in order to uphold its reputation or maintain its sources of funding should be estimated by the supervisor and measures should be taken in the banks’ ICAAP, and thus also the supervisory review and evaluation. BCBS, Enhancements to the Basel II Framework, July 2009, page 19-20. See chapter 8.6. 24 These have been strengthened and given more detail when the liquidity risk organizational demands were upgraded. See chapter 12.2, and Annex XI §1 sub e and 1a RBD, as amended by the CRD II Directive 2009/111/EC. 25 The only case where diversification effects are recognised, aside from operational risk group wide application as set out in Annex X part 3 §31. See chapter 6.2 and 10. CEBS/EBA, Guidelines for the Joint Assessment of the Elements Covered by the Supervisory Review and Evaluation Process (SREP) and the Joint Decision Regarding the Capital Adequacy of Cross-Border Groups (GL39), 22 December 2010, page 24, 37-38.

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supervisors are required to update their findings at least once a year, which will likely be a light touch update for non-important banks, and a full review and evaluation for the largest and most systemic banks26. For liquidity, the supervisors have to ‘regularly’ carry out an assessment of the liquidity risk management, taking into account the role banks play in the financial markets and – when taking measures in this still largely unharmonised area – take into account the potential impact of their measures on financial stability in other member states27. Decision Making Process in a Group-Context Pillar 2 is de facto applied both on a consolidated and a solo basis28. The consolidated review by the college of supervisors sets the tone, but the supervisors of subgroups and individual banks have retained important carve outs; also see chapter 17.2 and 21.7. In the follow up to the 2007-2013 subprime crisis, the inconsistent treatment across supervisors was highlighted as one of the areas of concern. The decision making process for the groupwide pillar 2 assessment has as of end 2010 been centralised due to the introduction of the CRD II. It allocated more power in the hands of the consolidating supervisor (the licensing supervisor of the parent of the group). EBA subsequently gained a key-role since end 2011, including taking over some of the new tasks of the consolidating supervisor29. Starting in 2012, the supervisors have a clear decision making and appeal process, with clear timelines30. The consolidating supervisor and the supervisors responsible for the subsidiaries have to try to reach a joint decision on the application of pillar 2. This includes the adequacy of the consolidated level of own funds at the level of the parent and at the level of each subsidiary entity, as well as on a consolidated basis. If they do not agree within four months, the consolidated supervisor can decide unilaterally on the application of pillar 2 and any corrective measures to the banking group on a consolidated basis (taking into account all input from the other supervisors). This part of the process has some similarities with the model approval process (see chapter 6.3 and 21.7), but – as it can include measures that directly impact the financial buffers and organisation of the bank – there are some key carve-outs for licensing supervisors of individual entities in the group.

26 Art. 124.4 and 129.3 RBD. Also see chapter 18.2. 27 Annex XI §1 sub e and 1a RBD, as amended by the CRD II Directive 2009/111/EC. 28 At the consolidated level this is mandatory, at the legal entity level this could be evaded for some of the licensed entities in the group as it is not prescribed in art. 68-73 RBD. Art. 129.3 and 136.2 RBD, however, assume that all supervisors of legal entities in the group will want to be involved, and will want to set level 2 requirements at a solo and/or sub-consolidated level (or at least be involved in the distribution of demands to the legal entity they supervise). 29 See the new art. 129.3 RBD, introduced by CRD II, 2009/111/EC, and amended in this respect by the Omnibus I Directive 2010/78/EU. 30 Art. 129.3 RBD and chapter 20.7.

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The sub-consolidated and solo supervisors of entities in the group can if they disagree with the consolidating supervisor subsequently take their own decision, but with some restraining influences31: – for the deliberation on a potential capital requirement – the most controversial instrument – the directive since 2012 spells out that the supervisors have to explicitly address the question on its necessity, and the issues that have to be taken into account in the negotiations; – they have to ‘duly consider’ the views and reservations of the consolidating supervisor (which will need to be reflected in the written decision); and – they have to send the written decision to the consolidated supervisor, who will put it together with its own decision on a consolidated basis and the decisions of other subconsolidated or solo supervisors into a single document, which will be sent to the parent of the group and to all other supervisors involved (including EBA as a member of the college). For the decision on extra capital requirements, the supervisors are obliged to assess whether it is necessary to capture risks the bank is or might be exposed to on the basis of the ICAAP described in chapter 14.2, the internal governance requirements that apply under the licensing conditions as described in chapter 5.2 and 13, and the full review and evaluation under the SREP. EBA can be asked for its advice (to which a ‘comply or explain’ rule applies), or for a binding ruling before the expiration of the four month period. If a ruling is applied for, the consolidated supervisor has to await the ruling of EBA, and subsequently take its decision on the consolidated application of pillar 2 in line with that ruling. The reverse applies to the decisions of sub-consolidated and solo supervisors, that can also be appealed by other supervisors involved in the supervision of the group at EBA for a binding ruling. See chapter 21.7. EBA is allowed – but not obliged – to draft regulatory standards to specify the supervisory review process and a common risk assessment procedure and methodology, as well as to develop implementing standards for the joint decision process. For the time being groupsupervisors work with the guidelines CEBS developed in 201032.

31 Art. 129.3 and 136.2, the latter as amended by art. 1.10 CRD III Directive 2010/76/EU. 32 Art. 124.6 and 129.3 RBD as added by art. 9.30 and 9.32 Omnibus I Directive 2010/78/EU. Also see CEBS/EBA, Guidelines for the Joint Assessment of the Elements Covered by the Supervisory Review and Evaluation Process (SREP) and the Joint Decision Regarding the Capital Adequacy of Cross-Border Groups (GL39), 22 December 2010.

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Guidelines – CEBS-EBA, Guidelines on the application of the supervisory review process under pillar 2 (GL03 revised), 25 January 2006 – CEBS/EBA, Guidelines for the joint assessment of the elements covered by the supervisory review and evaluation process (SREP) and the joint decision regarding the capital adequacy of cross-border groups (GL39), 22 December 2010

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15.1 Introduction Banks are not by nature transparent organisations. Apart from the complexity inherent in their business, a main reason for being opaque has long been the issue of trust. If anything frightens the clients and counterparties of the bank, they may react disproportionally by withdrawing all their money. Clients may prefer to receive warnings and to err on the side of caution, but if many clients do so, even a perfectly healthy bank will fail if it is the subject of a false rumour or of a true but relatively unimportant rumour or event. Both banks and prudential banking supervisors have a tradition of trying to keep bad news away from the public, at least until the issue has been resolved1. Examples are attempts to ‘rescue’ a bank by a takeover or state aid over the weekend, when the banks counterparties and the broader market cannot react until the markets open again and the bank is either safe and sound again or has failed; see chapter 18. Other examples are interventions in the bank, ordering or nudging the board to fire executives before negative reputational news becomes public or before such can overwhelm the standing of the bank. This hesitancy of banks and prudential supervisors has not stopped legislators from subjecting banks to disclosure obligations for e.g. company law or conduct of business reasons. Banks have long been subject to transparency obligations that are obligatory for all institutions that issue financial instruments, and for all registered companies; see chapter 6.4 and 16.5. Over the last decades, those obligations have increased. The amount and detail of disclosure required has increased, and new obligations to keep the information updated if new events occur that are important for the markets have been introduced. On the prudential side, some of the market power to restrain less safe behaviour of the banks has been acknowledged. With the decrease of relative size (and thus power) of prudential supervisors vis-à-vis some of the banks they have to supervise, additional measures have been sought to force banks into a safer, more prudent, path. One of these measures has been mandatory disclosure of prudential information. The hope is that market pressures and public shaming will lead to banks retaining additional safety cushion in the form of e.g. additional financial buffers on top of the minimum requirements that can be drained in times of crisis.

1

This leads to an automatic struggle with markets-supervisors, who generally want to achieve full transparency as soon as possible for the benefit of investors. See e.g. T. Padoa-Schioppa, Regulating Finance, Oxford, 2004, page 35 and chapter 5.4.

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Whether this works is as yet an open question. The 2007-2013 subprime crisis did not provide a beneficial testing ground for preparedness for crises (more for dealing with crises), and transparency may have actually increased the cyclicality of the markets instead of disciplining them2. The sort of discipline exerted by markets on banks appears closer to decapitation ex-post than a warning ex ante. Market participants will need to make a substantial investment to properly investigate, compare, understand and respond to the information disclosed, if the malfunction at or too high risk appetite of a bank is not already obvious and over-reported3. Some of the information is disclosed months later, and thus of doubtful relevance as to the current situation at the bank. Even though the sometimes erratic reactions of markets to bad news is still mistrusted, a positive side effect has been that banks tend to fear the markets more than they do supervisors. Forced disclosure can mean that the markets can react to prudent and non-prudent practices of banks; though this protects wholesale creditors and investors (who have the funds and expertise to monitor such disclosures) more than retail depositors and investors. Prudential regulators hope that banks will try to avoid having to disclose non-prudent practices, and thus hope to use potential market reaction as a stick to hound banks towards safer buffers and systems and controls. This regulatory disclosure of risk has been introduced as the third pillar in the Basel capital accord via the Basel II amendment4. In the EU, it has been taken on board in the CRD and became applicable to EU banks in 2008, sadly in the middle of the 2007-2013 subprime crisis. The disclosure of types of capital and amount of prudential financial buffer did have an effect on the market perception of the solidity of banks5. The effect was noticeable in hindsight and perhaps exacerbated the crisis by closing the route to the markets for exactly those institutions that needed additional financial buffers the most (which had negative consequences for depositors and financial stability; but may be good news for those people who did as a result not invest in a weak bank that would have failed nonetheless). In good times, the existing knowledge about financial buffers appeared less relevant to market appreciation of the shares issued by banks.

2 3

4 5

UK FSA, The Turner Review, March 2009, page 45-47. A correlation of high disclosure requirements with less crises was found by S. Tadesse, ‘The Economic Value of Regulated Disclosure: Evidence From the Banking Sector’, Journal of Accounting and Public Policy, Vol. 25, No. 1, 2006, page 32-70. On the other hand, no evidence of usefulness to investors of value at risk disclosures was found by N. Chipalkatti & V. Datar, ‘The Relevance of Value-At-Risk Disclosures: Evidence From the LTCM Crisis’, Journal of Financial Regulation and Compliance, Vol. 14, No. 2, 2006, page 174-184. M. Frolov, ‘Why Do We Need Mandated Rules of Public Disclosure For Banks?’, Journal of Banking Regulation, Vol. 8, No. 2, 2007, page 177-191. A. Demirguc-Kunt, E. Detragiache & O. Merrouche, Bank Capital: Lessons From the Financial Crisis, IMF WP/10/286, December 2010.

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Overview of Transparency Obligations on Banks Transparency obligations have been introduced from several angles. Some of the wideranging obligations include: – obligations to publish annual accounts (see chapter 6.46; – pillar 3 obligations as introduced as part of the Basel II package, effective in the EU since 2008 (with upgraded disclosures introduced in 2009 from end 2010 as part of the Basel II ½ amendment of the capital accord)7; – obligations under the conduct of business directives, including Mifid, Prospectus directive, and the Transparency directive, if they perform activities regulated under them. These include (i) transaction reporting and market transparency if they offer trading venue services (Mifid; see chapter 16.4), and (ii) the obligation to publish a prospectus when issuing financial instruments to be traded on regulated markets, updating these, though there are some exceptions for debt issuance that is very similar to deposit taking, see chapter 16.5. Separately, banks are under several limited obligations to give information to specific groups of clients and/or counterparts, or to the market if they attract funds through public offerings of bonds or shares. Reference is made: – to the obligation of banks to inform their depositors as to the deposit guarantee scheme that covers their claims on the bank; see chapter 18.5; – the information obligations under Mifid when advising clients or executing orders for them; see chapter 16.2; – the information to be provided to consumers when engaging in e.g. mortgage finance or distance selling; see chapter 16.6. The wide – and growing – range of transparency obligations on banks has led to significant overlap. Prudential supervisory requirements under pillar 3 tend to indicate that, where possible, it can be combined with publications under other transparency obligations such as the annual accounts publication. As a result it is not always clear which purpose a particular disclosure serves and thus whether it is understandable/appropriate for the targeted purpose and reader. An example of such confusion are the CEBS-EBA guidelines for dis-

6 7

Most larger banks publish under IFRS Standards, where IAS 32, IAS 39 and IFRS 7 determine the presentation, valuation and disclosure on financial instruments respectively. Basel II Framework part 4; and Basel II½ (BCBS, Revisions to the Basel II Market Risk Framework, and BCBS, Enhancements to the Basel II Framework, July 2009, page 28 and further), with additional own-EUinitiative disclosures on remuneration. The revisions were implemented via the CRD III Directive 2010/76/EU. Some technical revisions on operational risk and hybrids were introduced in the CRD II Directive 2009/111/EC and the Commission Directive 2009/83/EC. See chapter 2 and 15.2.

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EU Banking Supervision closures in times of stress8. These officially encourage enhanced quality of disclosures, but are not able to specify whether there is an obligation to publish on all of its principles, nor – if so – whether it is an IFRS, pillar 3, listing rules or other transparency obligation. In theory it would be useful to have a unified transparency regime for banks, developed jointly by accountancy and conduct of business/prudential supervisory authorities. As the purposes of the drafters of such standards still appear to deviate on to the use made of information (e.g. usefulness for short term investors or contractual counterparties or these plus long term financial stability) it is unlikely that this will be resolved in the near future. The consensus appears to be that more transparency leads to benefits for all users, even though there are significant differences of opinion on how to deal with core issues such as valuation (see chapter 6.4) or the transparency on fines or other interventions (see chapter 20.2 and 20.3). The various transparency obligations laid on banks effectively constitute an exemption to the secrecy obligation of supervisors regarding the current status of the bank (see chapter 20.2). Once information has to be disclosed by the bank under e.g. pillar 3 or annual accounts obligations, it is or should be ‘public’ and no longer falls under the secrecy obligation of the CRD. Other Prudential Issues on Disclosure There is an increased awareness of the importance of disclosed information on the health of a bank or of the financial sector as a whole. In normal times, rare events can trigger extreme reactions by investors, depositors and professional lenders, but in stressed times even relatively mundane disclosures and the completeness thereof can trigger such reactions. With the increased usefulness and use by market participants of information as published by banks, publication has an equally increased impact on the viability of the bank. The management of disclosures has become of interest to prudential supervisors; no doubt to the immense but easy to hide pleasure of the drafters of many of the transparency requirements for accountancy, company law or conduct of business purposes who – like prudential supervisors – never mind if another authority unilaterally tries to become involved in the area of their assigned competencies. Nonetheless, this has led to input written in consultations by accountancy standard setters by prudential supervisors; see chapter 6.4. Both the BCBS and CEBS-EBA comment on new proposals for accountancy standards from a prudential point of view. These standards impact in several ways on the way banks

8

CEBS-EBA Principles for Disclosures in Times of Stress (lessons learnt from the financial crisis), 2010, www.c-ebs.org.

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are supervised. For example, the core issues of valuation for prudential purposes derived from these annual accounts, as is the core tier 1 capital concept. See chapter 6.4. CEBS-EBA has also started work on the compliance and best practices on disclosure in the form of annual accounts in 2008. Apart from the work done in the context of pillar 3, especially the communication strategy of banks in times of stress was deemed important. Without ‘amending, duplicating or adding’ to the binding legal disclosure requirements, CEBS-EBA has published non-binding guidelines on the communication strategy of banks in times of stress. It issued so-called ‘good practices’ as part of its work on the transparency of banks in the first stages of the 2007-2013 subprime crisis, and updated these in the form of revised and updated principles for disclosures in times of stress in 20109. The legal basis of these principles is murky, as the CRD provision on supervisory instruments on disclosure excludes statutory audits (see chapter 15.2. The best route to establish competency for CEBS-EBA is via the compliance angle, as well as the use made by supervisors of annual accounts information. Regardless of the legalities, the principles provide useful harmonisation of disclosures in annual accounts specifically by banks. The principles stimulate: – timely, up to date, comprehensive disclosures – that focus on the areas of uncertainty and provides detailed information on the plans, (lack of) exposure, cover and impact on the banks position – which take into account the newest standards, and allow comparability over time and with other banks – and are easy to find and easy to collate with other relevant future and past information provided by the bank – and that tell the story of the performance of the banks and its future risks to the education of the reader. The bite is in the follow-up. CEBS-EBA has annually reviewed the compliance with its principles by more than 20 EU banks and has published its findings. It includes descriptions of what it deems best practice in its public reports. Like with pillar 3 disclosures and the published reports on such disclosures (see chapter 15.2), compliance and the envisaged harmonisation can be seen to be improving, though full compliance has not been achieved10.

9

CEBS-EBA, Report on Banks’ Transparency on activities and products affected by the recent market turmoil, 19 June 2008; replaced by CEBS-EBA, Principles for Disclosures in Times of Stress (lessons learnt from the financial crisis), April 2010. 10 See e.g. the overview in CEBS-EBA, Assessment of Banks’ Transparency in Their 2009 Audited Annual Reports, 30 June 2010.

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Future Developments The pillar 3 provisions are allocated to the CRR, and continue to be expanded upon11.

15.2 Pillar 3 Introduction As a relative late addition to prudential banking supervision (introduced as part of the Basel II package, the pillar 3 requirements12 build on the assumption that market discipline based on additional transparency requirements on previously internal risk exposure and risk management assessments will help peer pressure to exert itself to ensure that a bank will: – keep themselves as solid as possible in spite of the liberalisation of markets13 and possibly too low minimum prudential calculations; and – invest in sophisticated models and mechanisms. Pillar 3 has been a new element in the CRD, and entered into force with effect as per 200814. Due to the financial crisis, it was actually pre-empted by an ad-hoc obligation imposed on financial undertakings. Previous research indicated that disclosure by banks during earlier crises was not destabilising and provided market discipline15. This conclusion appears to be supported by the experience in the 2007-2013 subprime crisis, where the main freezes in interbank markets were in part the result of a lack of information on where risks embodied in securitisation bonds and derivatives had ended up. Disclosure on stress test results and types of exposures appear to help unfreeze financial markets, at least to the extent the numbers published and the losses provided for are deemed credible by the market. The lack of a common format and the lack of a comparability requirement (as opposed to the supervisory disclosure requirements16 are – along with a wide range of exemptions – limits to the usefulness of the pillar 3 disclosures and to a level playing field.

11 Art. 431-455 CRR. See chapter 15.2. 12 Recital 62, art. 145 and Annex XII RBD. Also see the overview in CEBS-EBA, Assessment of Banks’ Pillar 3 Disclosures, 24 June 2009, page 16-18. See the recommendations to introduce such transparency for regulated and unregulated financial intermediaries in BIS, Discussion paper on public disclosure of markets and credit risks by financial intermediaries, September 1994, Euro-currency Standing Committee of Central Banks of G10 countries (‘Fisher group’). 13 R.M. Pecchioli, Prudential Supervision in Banking, OECD, 1987, page 18-19. 14 Art. 145, 152.8, 152.14 and 157 RBD. 15 J.S. Jordan, J. Peek & E.S. Rosengren, The Impact of Greater Bank Disclosure Amidst a Banking Crisis, Federal Reserve Bank of Boston, 9 February 1999. 16 Information published by supervisors under the supervisory disclosure framework needs to be in the same format for each national supervisor, and comparable. See chapter 20.7.

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The low key assessment reports published by EBA try to ameliorate this in a learning by doing approach. Goal and Content The stated goal of the pillar 3 disclosure is to give insight into market strategy, risk control and internal management organisation. As a result, it could be expected that many of the pillar 3 requirements would be closely linked to internal organisation requirements. The scope is, however, much wider. It includes aggregate information on the numbers, main components and on the policies regarding17: – risk management objectives and policies; – prudential consolidation; – prudential own funds; – capital requirements and internal capital adequacy assessment; – counterparty credit risk; – credit risk and dilution risk (in general, plus per exposure class, plus for standardised approach banks the use of ECAIs in the standardised approach, plus for IRB banks the use of amongst others models in the IRB approach, and the components thereof, as well as the supervisor’s approval; – market risk (either per component or under the internal model, and with additional detail to be published as a result of CRD III); – operational risk; – equity exposures outside of the trading book; – interest rate risk on positions outside of the trading book; – securitisations (significantly expanded by CRD III18); – recognition of IRB, credit risk mitigation and operational risk (for insurance) advanced instruments and methodologies (internal models) by the supervisor; – remuneration practices (introduced by CRD III)19; – a description of the legal structure of the banking group, and its governance and organisational structure20.

17 Art. 145 and Annex XII RBD. Introduced in the 2006/48/EC version of the RBD, and enhanced in the wake of the 2007-2013 subprime crisis; see below. 18 Also see recital 27 CRD II Directive 2009/111/EC, and recital 32 CRD III Directive 2010/76/EU. 19 The remuneration practices are part of Basel II ½, introduced in the EU as Annex XII §15 RBD via the CRD III Directive 2010/76/EU (in this specific case as per the start of 2011). The BCBS has since published additional detail on the pillar 3 disclosure of remuneration, with an expectation that banks comply by 1 January 2012. The additional detail does not appear incompatible with the CRD requirements in Annex XII part 2 §15 RBD, so could be complied with by banks and supervisors. Until copied into EU (or national) laws, it cannot, however, be considered binding. BCBS, Pillar 3 Disclosure Requirements for Remuneration, July 2011. 20 Applicable as of 10 June 2013 as a new art. 146a RBD, introduced by art. 3.26 FCD II Directive 2011/89/EU.

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In addition, upon request of small- and medium sized enterprises and other corporate applicants of loans they need to disclose21 their rating system as applied to them. This covers the main areas prudential supervision focuses on, and involves information previously only available to the bank and to its supervisor. There is one exception: liquidity risk. The BCBS sound principles also call for public disclosure of the soundness of the liquidity risk management framework and liquidity position, including details on e.g. diversification, stress testing, reserves and frequency of internal reporting22. These have not yet been made part of the pillar 3 framework, and have not been copied into the CRD, in the absence of harmonised requirements; see chapter 12. Of course, the disclosure obligation is not at the level of detail or frequency of the information that supervisors have access to or that they receive through supervisory reporting requirements; see chapter 20.2. However, it is still specific, and the relatively frequent. The requirement is to publish it at least annually and as soon as possible after the information becoming available. A perhaps unintended consequence is that it also reduces the secrecy obligation of the supervisor. After a bank has published its pillar 3 disclosures, that information becomes part of the public domain and thus exempted (to the extent published) from the secrecy obligation of the supervisor; see chapter 15.1 and 20.2. As a lesson learned in the crisis, a general catch-all provision was added by the Basel II ½ amendment to the Basel capital accord that banks should convey their actual risk profile in the disclosure23. This in addition to the added detailed requirements for pillar 3 disclosures (see the list above on the content of new or upgraded requirements such as market risk calculations or remuneration24. The beneficiaries of such disclosure are rather unclear, even though the disclosure is targeted at market participants. Depositors are unlikely to benefit25. Without a full understanding of the accounting and transparency issues involved (see chapter 6.4 and 16.5) as well as of the content of prudential supervision and its differences in calculating e.g. own funds from

21 Art. 145.4 RBD, and art. 431.4 CRR. This does not appear a ‘pillar 3’ disclosure, but a stick to force banks to treat the corporate sector and SME’s in particular favourably. The RBD article states that if the voluntary undertaking on the explanations proves inadequate, national measures shall be adopted. 22 BCBS, Principles for Sound Liquidity Risk Management and Supervision, September 2008, page 31-32. 23 Art. 145.3 RBD, as amended by art. 1.11 CRD III Directive 2010/76/EU. BCBS, Enhancements to the Basel II Framework, July 2009, page 29. 24 Annex XII RBD, as amended by art. 1.43 CRD II Directive 2009/111/EC and by Annex I.5 CRD III Directive 2010/76/EU. 25 L. Dragomir, European Prudential Banking Regulation and Supervision, the Legal Dimension, 2010, page 305.

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the other disclosures made by banks, it may well add just another large block of information, the use of which will be limited to rating agents and those counterparties that have the required expertise and bother to invest resources to analyse the published information on the previous year of this specific bank. To prepare for a failure of a banking group and to assess which entity is more likely to repay its depositors and creditors than others, pillar 3 is not very useful. This neither to depositors nor to market participants as the information is largely based on consolidated information, not on solo information (at the level at which a bailout or bankruptcy regime determines who gets which pay-out); see chapter 17 and 18. The significant subsidiaries within a group have to publish some information too, but they can opt to do this on either an individual (solo) basis or a sub-consolidated basis26. There is no definition of what a significant subsidiary is (see chapter 18.2), but it is unlikely to include every deposit taking bank in the group (also see the discussion on significant branches in chapter 5.3 and 21.6-21.7 in a cross-border setting). On the other hand, the obligation is laid on any subsidiaries in a banking group that are significant, regardless of whether that subsidiary is a bank or regulated entity. It may thus capture vehicles that are used for bond emissions (if they are significant in the group). Exemptions Many banks do not have to comply with the disclosure obligation, or at least not in full. Six main exemptions27 are applicable: – only the consolidated information of the whole group the bank is part of needs to be published (see above on the usefulness of the disclosure to depositors and market participants). The duty to publish it lies on the highest bank in the group (so the parent if that is a bank, or a subsidiary bank if the parent is a financial holding company, or the bank itself if it is a standalone entity; see chapter 17). If the bank is part of an EU subgroup of a third country banking group, the obligation does not extend to information on the whole third country banking group, but to the consolidated information of the whole EU subgroup and its subsidiaries outside the EU, unless supervisors agree that the bank is included within comparable disclosures provided on a consolidated basis by the third country parent (see chapter 17.5). Significant subsidiaries also have a publication obligation, but only on a limited subset of information28; – only material issues need to be included. Information is material if its omission or misstatement could change or influence someone’s economic decision (e.g. to invest, to buy or to become a client). Whether or not some of the information of pillar 3 would influence a buyer from, saver at or investor in a bank is an issue on which opinions

26 Art. 72 RBD. 27 Art. 68.3 and 72, 145.3, 146, 148 and Annex XII part 1 RBD. 28 Art. 72 RBD.

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–

–

– –

can be divided. Especially for the larger banks the materiality can lead to a limitation in the disclosure; proprietary information can be left out. Information is considered proprietary if sharing this information publicly undermines its competitive position. The phrasing is quite wide, and could theoretically include information on large losses that endanger the solvency or liquidity position of the bank. This runs counter, however, to the idea behind pillar 3, so it is likely it should be interpreted in a limited way. Material information would in that case need to be included, but the exemption could still be used for e.g. plans to branch out into a market where early entrants would gain a competitive edge, for planned takeovers or for new innovative products. Information is also considered proprietary if it involves information on products or systems that if shared with competitors would render the banks investment therein less valuable. If the specific information is proprietary, high level information still needs to be provided (unless that is proprietary too); confidential information can be left out. The definition of confidential is both wide and narrow. Wide in the sense that any obligation to keep something confidential to customers or other counterparty to keep binding on the bank is automatically deemed confidential. This makes it easy to escape having to disclose e.g. models bought from providers, as long as a confidentiality clause is stuck in. Narrow in the sense that obligations to public authorities do not count. If the specific information is confidential, more high-level information still needs to be provided (unless that is confidential too); disclosure in one location is only necessary ‘to the extent feasible’. Having disclosures in several places reduces comparability and usefulness; ‘equivalent’ disclosure of the pillar 3 information that is made under accounting, listing or other requirements constitutes compliance with the pillar 3 requirement. Equivalence is a difficult item. At the least, none of the information on e.g. prudential own funds and internal adequacy is required as such under accounting standards, but ‘normal’ own funds are. Whether this is an equivalent disclosure is open for debate. Regardless, this exemption further declines comparability.

The frequency of the obligatory report in principle is once a year. Several factors may lead to a higher frequency for all or for the most volatile information29. The factors are quite similar to those used to assess systemic importance of a bank (see chapter 18.2, and include: – the scale of operations;

29 See art. 147 and Annex XII part 1 §5 RBD, which refers to more frequent information on issues ‘prone’ to rapid change. Examples given are total eligible own funds and the capital requirements for credit risk per exposure class.

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– range of activities, presence in different countries, and involvement in different financial sectors; – participation in international financial markets and payment, settlement and clearing systems. Supervisory Instruments and CEBS-EBA Assessments The CRD sets out specific instruments member states have to give to supervisors in the area of pillar 330. These include the right to give banks instructions on disclosures, the frequency, and the location of the disclosure and means of verification for disclosures not covered by statutory audit. Also see chapter 20.3. However, a common format is not prescribed and the disclosure is riddled with exemptions31. Banks are for instance free to disclose the combination with other types of disclosures (e.g. with the annual accounts publication), both to reduce the administrative burden put on banks, and to experiment with the best way to disclose the pillar 3 amendments. If other disclosures already provide the required information, no additional pillar 3 publication is necessary. To ameliorate the downsides of a lack of comparability, EBA has published reports on how banks publish pillar 3 information, and tries to tease out best practices and attempt to level the playing field. CEBS-EBA publishes pillar 3 assessment reports on an annual basis on the practices of banks on its website (similar to the assessments of annual accounts disclosures mentioned in chapter 15.1). Its report in 2009 on the initial pillar 3 disclosure reports of the banks in 2008 showed an industry that was still trying to find its footing in what to disclose and what not32. This was to be expected under the CRD rules, absent examples/templates and using high level terminology in defining the content and process of the obligation. The 2010 report on the 2009 pillar 3 disclosures published noted improvements, but equally still noted room for improvement in areas such as the components of capital, securitisation, the timeliness of publication, and differences in the level of detail provided33. Both reports indicate that supervisors commit to discuss all the ‘rooms for improvements’ with their banks. To the best of my knowledge, none of the identified improvements lead to subsequent updates of pillar 3 disclosures by such banks in the same year. This indicates that the assessments are part of a learning by doing exercise, but also that supervisors apparently still find it hard to force banks to apply legally binding CRD provisions; see chapter 20.3.

30 Art. 149 RBD. Please note that supervisors can not give instructions to publish information covered by confidentiality, any proprietary information nor non-material information. 31 Art. 148 RBD. 32 CEBS-EBA, Assessment of Banks’ Pillar 3 Disclosures, 24 June 2009. 33 CEBS-EBA, Follow-up Review of Banks’ Transparency in their 2009 Pillar 3 Report, 30 June 2010. See chapter 15.1 for the simultaneously published assessment of annual accounts disclosures.

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The 2010 report reiterates the goal of pillar 3 reports: that market discipline relies on the idea that well-informed stakeholders are capable of putting pressure on the banks management, forcing it to act in their best interest. The report does not, however, indicate whether that goal has been achieved, nor – assuming it does – whether all stakeholders profit equally from the additional insight given. An open issue is also whether investors that have or consider investing in the bank indeed read the full disclosure, or focus on the bottom line of the percentage of prudentially required capital. If that is the case, an unintended consequence may be to stimulate banks to hold capital on top of the supervisory thresholds34, even when those are meant to be flexible. Especially if the bank dips (with permission and a plan to recuperate) below the current 8% or below the future flexible countercyclical and similar buffers, such a limited focus of the financial markets would eviscerate the intended balance between continued lending by troubled banks and countercyclical buffers; see chapter 2 and 6.2. The report on 2011 disclosures noted improvement in the reports and evolving best practices, but also continued divergence, non-compliance and unclear disclosures, in part resulting from the introduction of new (disclosure) requirements on market risk and securitisations, but equally applying to the financial buffers and credit risk calculations35. The lack of comparability between banks (not aided by the fact that some banks did not provide an English language report), and inconsistent usage of terminology were identified as problems. Future Developments The outline of pillar 3 requirements is unchanged36. As part of the Basel III package, the CRD IV project does contain additional provisions to strengthen the potential impact of pillar 3 disclosure, more specifically by adding details on the composition of financial buffers and indirectly as a result of the further harmonisation introduced on the content of such buffers. Please note that the disclosure on own funds is subject to a transitional regime from 2014 until 2021, as is the publication of the leverage ratio37. Apart from the added gradual disclosure on financial buffers, several other disclosure obligations can be considered new. These include obligations38:

34 See chapter 6.2. Also see S.A. Alexander, ‘Why Banks Hold Capital in Excess of Regulatory Requirements: The Role of Market Discipline’ (Editorial), Journal of International Banking Regulation, Vol. 6, No. 1 2004, page 6-9. 35 EBA, Follow-up Review of Banks’ Transparency in their 2011 Pillar 3 Reports, 12 October 2012. 36 Art. 13 and 431-455 CRR. 37 Art. 492 and 499 CRR. 38 Recital 52 and art. 89-90 CRD IV Directive, 450.1 sub i and j, 451, 473 and 499 CRR.

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– to publish the results on the calculations of the leverage ratio well before it becomes binding on the bank, though with a transitional regime until 2021 on the manner of calculation of the disclosed number; – to disclose defined benefit pension assets and liabilities; – to disclose the turnover number of employees, profits, taxes paid and subsidies received per member state and per third country. The aim officially is a corporate governance disclosure to regain trust, but the aim appears to be increase corporate responsibility to ensure that taxes are paid where profits are made, and resulting in a clearer picture of the impact and costs per member state if a crisis occurs. This would align benefits and risks better per country. This should be published alongside the annual report. It is an obligation laid on each bank, on a consolidated basis; – to publish the return on assets in the annual report (determined as the net profit divided by the total balance sheet); – more information on macroprudential relevant information; – to publish more individual information on remuneration, building on the existing obligation for supervisors to collect and disclose on an aggregate basis information on high earners at their banks. EBA is to develop a range of implementing standards and guidelines; including: – guidelines on several issues relating to exemptions to disclosure or increased frequency of disclosures by the start of 2014; – guidelines on unencumbered assets by end June 2014, to be followed in 2016 by implementing standards; – by 1 February 2015, uniform templates on own funds disclosure are to sent to the Commission; – by end 2014 implementing standards on countercyclical buffer calculators; – by July 2014 implementing standards for the G-sifi’s disclosure on indicators; – by June 2014 implementing standards on leverage disclosure39.

39 Art. 144 RBD, as amended by art. 9.39 Omnibus I Directive 2010/78/EU. See art. 432-433, 437, 440, 441 and 451 CRR. See chapter 20.2 and 23.3.

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16.1 Introduction Attracting deposits and making loans are the core activities of banks under the EU definition of a bank (credit institution)1. But banks are also key-players in other areas of financial services. The list of financial services that can be provided by banks within the context of their license has been discussed in chapter 5. Since the eighties, banks have started to become ever more oriented towards the (high margin) business in areas such as investment advice, asset management, trading for their own account and advising companies on public offerings. Banks were able not only to provide the service, but due to their banking license also to include the funding, they could leverage from existing financial systems and clients, and they were subject to the highest standards of prudential supervision available, meaning that their clients trusted them and did not require them to prove their solidity by additional measures. The financial services that amongst others banks provide have become the subject of consumer protection and of conduct of business supervision. The rationale for such regulation of the behaviour of banks and other key players in the financial markets are: – ethics (in the sense of fair markets, fair treatment of counterparties, fair treatment of clients); – fiduciary and contractual duties, to stimulate behaviour vis-à-vis those whose interests the bank or other key player is legally or contractually obliged to take care of (so-called principal/agent problems2), such as (a) giving good advice in the interest of the client (instead of nudging them in the direction of high margin business for the bank), (b) handling the assets of the client in the interests of the clients (so e.g. no ‘churning’; unnecessary transactions to increase the fees levied), (c) not taking advantage of information given to the bank for other purposes (such as frontrunning on buy or sell orders executed for clients), and (d) for insiders at banks, issuers or other key players not to treat the assets and information available at their employer as their ‘own’ assets, to the detriment of other stakeholders (the so-called ‘agency’ problems)3; 1 2 3

Art. 4.1 RBD. See chapter 4.4. See e.g. C. Goodhart, Some Regulatory Concerns, LSE Special Paper 79, December 1995. The agent/principal problems between the board/management and shareholders are generally allocated to company law/corporate governance regulations, though aspects of it have been allocated to transparency obligations for listed companies, and remuneration and other internal governance as well as pillar 3/supervisory disclosure requirements. See chapter 13, 15, 16.5 and 20.7. Also see L. Bebchuk & J. Fried, Pay Without Performance, the Unfulfilled Promise of Executive Compensation, Cambridge, 2004.

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– levelling the playing field between large, well informed and specialised key players and other investors in the market; – providing an efficient, safe and trustworthy environment for trading; – preventing financial crime. Prudential supervision does support some of these goals, especially the prevention of crime and providing a safer environment for trading. This support is a consequence of the organisational and financial requirements on banks (and on other prudentially supervised institutions such as insurers, UCITS, and non-bank investment firms; see chapter 19). However, prudential supervision cannot achieve all of these goals, and can even be at odds with consumer protection or conduct of business goals. Profits from insider dealing, or selling unbalanced financial products to the detriment of e.g. consumers does help keep the trader well-funded, which is beneficial for short term prudential purposes. For longer term prudential purposes unfair behaviour of banks is likely detrimental as clients/counterparties may walk away, and in a high-protection environment clients may be able to claim reimbursements and conduct of business supervisors may sue. The EU is since the last years of the twentieth century slowly becoming such a high-protection environment. The traditional core business of banks (deposit taking, making loans) is still only lightly regulated from a conduct of business or consumer protection point of view, though even here legislative developments are under way. Issues addressed are consumer credits, deposit guarantee protection information, and anti-money laundering requirements. Apart from the information on deposit guarantees (and the linked prohibition for non-banks to hold deposits, even if a client would like to entrust his deposit to a non-bank; see chapter 5.6), these are not bank-specific rules, but apply to anyone performing financial services and happen to e.g. provide payment services, investment services or consumer credit4. An avalanche of directives has materialised to regulate how financial undertakings performing certain other services need to behave vis-à-vis their clients. As banks now perform almost any role imaginably on the financial markets that is not expressly prohibited to them, they are subject to these directives if they provide the service covered by them. The conduct of business rules described in this chapter 16 are all relevant for banks, if they perform the type of services or have the type of activities covered by one of the relevant set of rules. The main types of conduct of business rules are:

4

Banks can provide all of these services, but others who fulfil certain criteria set out in the relevant EU legislation can do so too.

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– conduct of business in the primary market for financial instruments (when they are first issued or created; similar to a new car), covered in the UCITS, AIFM and prospectus directives; – conduct of business in the secondary market for financial instruments (when they are traded onwards after being issued or created; similar to a used car), covered in Mifid, the takeover, market abuse and transparency directives; – conduct of business in the consumer market. These areas are covered in the consumer credit and distance selling directives and the work on the mortgage market; – aspects of deposit guarantees and investor guarantees when a bank goes bankrupt also protect clients; see for a description chapter 18 on bank termination. Directives that focus on preventing the abuse of the financial system such as the anti-money laundering directives impact on the way banks operate by requiring banks to scrutinise their clients before offering or executing financial services on their behalf. As this is not done to protect the client but the financial system as a whole, this is sometimes not considered to be within the conduct of business area. As it covers the way the financial markets operate and how banks should conduct their business vis-à-vis their clients, it is nonetheless covered in this chapter. The distinction between consumer protection and conduct of business is not always clear. Chapter 16.6 describes both some finance related consumer protection directives that may or may not be subject to supervision, as well as client protection under conduct of business rules that are supervised by the members of ESMA. The legislative techniques are the same, and even some of the terminology and reasoning. Unlike conduct of business regulation where all market participants are provided at least with some protection, under consumer protection regulation only a limited subset of clients are protected. Consumers are (only) those natural persons who for the issue at hand are acting outside of their trade, business or profession5. Some depositors and investors are also consumers, and benefit from all protection on offer against banks. However, retail depositors and investors who have commercial activities (e.g. a baker) are not consumers, and lack the associated protection if they need a loan that covers the business6. The consumer directives on the other hand lack a dedicated supervisor. There does not appear to be a clear underlying reasoning

5 6

See art. 3 Consumer Credit Directive 2008/48/EC. See the definition of consumer in e.g. the Consumer Credit Directive 2008/48/EC, and the wider range of natural and legal entities that are caught under the definition of depositor in the Deposit Guarantee Directive 1994/19/EC. See chapter 16.6 and 18.5. L. Dragomir, European Prudential Banking Regulation and Supervision, the Legal Dimension, 2010, page 306, favours a wider definition of ‘consumer’ to include all depositors, but this is not (yet) consistent with EU law. See R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 2 and 3.

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dividing them, except possibly that they are in the remit of different directorates of the EU Commission7. Though the protection of clients is key to both prudential and conduct of business legislation, and their rights to go across borders to providers in other member states is safeguarded by the treaty itself (see chapter 3.4 and 5), there is no obligation for financial service providers such as banks to actually accept any client pounding on their door. Access to basic services such as a bank account, a savings account, buying financial instruments is therefore not guaranteed, at least not yet under EU law. For loans or credit such an obligation would impinge on the rights of banks as providers of such services (they may make a loss if they are forced to lend). This is different for access to basic services that guarantee that people can transfer money (that they actually have) to tax authorities, landlords or others via the normal financial channels, to have their money safely kept by a supervised bank instead of under the mattress, and to access financial markets with funds they already have. On the contrary, several conduct of business rules set out in this chapter actually stimulate banks to deny such services, e.g. if the person lacks proper identification, or is connected e.g. to a member of a government (see the anti-money laundering rules). The Commission initially did not opt for legislation, but in 2011 issued a non-binding recommendation, asking banks to grant anyone a bank account for basic services, with government monitoring8. These services will likely not be risky for the bank from a commercial point of view, but there are likely to be no commercial reasons to offer such accounts, or reputational reasons not to offer them. Banks may not wish to be associated with convicted felons, bankrupt persons or others with a less than fine reputation, or without funds. Even they, however, in most western countries need a bank account to pay for electricity, rent or child-support, and their access to such services may need to be further guaranteed in law if not provided voluntarily by the banks. The Commission published legislative proposals in May 2013 to enforce such access, as well as to improve transparency of payment account fees (complementing the payment services directive) and facilitate payment account switching9. Please note that both traditional banking services and other financial services provided by banks related to any financial services are excluded from the scope of the so-called services directive10. It defines (and excludes) financial services by way of a non-limitative list, and 7

On the different levels of protection and the unclear reasoning behind this, also see R.J. Theissen, Are EU Banks Safe?, The Hague, 2013. 8 Commission, Recommendation on Access to a Basic Bank Account, 2011/442/EU, 18 July 2011. Also see chapter 16.3. 9 Commission, Proposal for a Directive on the comparability of fees related to payment accounts, payment account switching and access to payment accounts with basic features, COM(2013) 266 final, 8 May 2013. 10 Art. 2.2 services directive 2006/123/EC.

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mentions banking, credit, insurance and re-insurance, occupational or personal pensions, securities, investment funds, payment and investment advice, including the services listed in Annex I to the RBD. This is understandable for the provisions on the freedom of establishment and of services and the supervision/cooperation on such services. However, also various rights of the recipients of services (e.g. non-discrimination, information rights) and on the quality of the service are as a result not applicable, unless specifically provided for in one of the directives covering financial services. Prudential Versus Conduct of Business and Consumer Protection To understand the difference between the regulatory approach to conduct of business supervision and prudential supervision and the resulting differences in style, approach and publicity of their supervisors, it is necessary to look at the goals that are intended to be achieved. As discussed in chapter 4.3, prudential supervision aims to support financial stability and depositor protection by ensuring that individual banks are able to handle the risks they are subject to and are financially solid. Though banks will generally indicate that they need less capital and processes to ensure this while supervisors will ask for more, they basically have the same interest which is to ensure the continued existence of the business of the bank and its financial ability to fulfil all its financial obligations towards its clients. The overlap in interest in compliance by the bank is less true for conduct of business supervision. The main common goal of conduct of business rules is to ensure an open and equal opportunity market for all players on the financial markets. Banks are required to provide any activities or services to other market players with the obligation to ensure such an fair market. This benefits (other) banks too, as they have equal access to all opportunities and information, but its own compliance to benefit its counterparts does not necessarily benefit the bank itself. As key players in investment advice and asset management as well as traders for their own accounts, they are nonetheless subject to some of the strictest rules on their conduct of business, in order to protect the other players and clients against abuse of the possibilities created by having such a strong position in the market. To generalise scandalously, prudential supervision is aimed at protecting the business of a bank and conduct of business supervision is aimed at protecting against the business of banks and other strong players on the financial markets. On a macro level, banks profit from both by having stronger solidity and more opportunities on the markets, on a micro level they endure the disadvantages of both types of supervision by being required to be perhaps more conservative than some would opt to be themselves and by having to bear in mind the interests of other, less informed and less financially astute, counterparts. Conduct of business supervision focuses on setting minimum conditions for good behaviour, checking on behaviour and investigating actual misconduct. This brings with it more of an adversary approach than with prudential supervision, which are more of a

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tolerated nuisance (like all internal and external solidity controls). Both for prudential supervisors and prudentially supervised banks good relations ease the burden of their work. A core difference between conduct of business supervision and prudential supervision is the importance attached to group-wide supervision. The risks contained in related entities is much less important to conduct of business rules and supervision, as long as the entity providing the services does this correctly. For prudential regulation and supervision, the risks (and rewards) entailed in being part of a banking or insurance group are much larger, as the financial solidity and continued existence of one entity is to a large extent dependent on the same qualities of other group-entities11. How to Shape Conduct of Business and Consumer Protection Rules There can be a discussion as to how stringent conduct of business and consumer protection should be, what the most effective and efficient way is to achieve the goals thereof, and whether it should protect persons even against themselves. The choices made in the EU focus on a variety of measures. These include: – obligatory public disclosure (e.g. for those whose financial instruments are traded on regulated markets); – obligatory disclosure to clients (e.g. of information on contractual terms, of participation in deposit guarantee schemes, of supervision or of the riskiness of the contract for the client); – institutional requirements on trading venues (regulating some of the underpinnings of the markets, both within the market itself, and within some of the main market participants); – duty of care obligations, including protection of the client against his own lack of knowledge or inappropriate risk appetite (suitability assessments and comprehensibility of the information provided). Curing information asymmetry and levelling the playing field between all buyers and sellers of financial services or products will prevent abuse, unfair trading, and allow markets to operate as efficiently as possible. When selecting the type of protection offered and to whom, lawmakers needs to strike a careful balance:

11 Joint Forum, Review of the Differentiated Nature and Scope of Financial Regulation, January 2010, www.bis.org page 6. Also see chapter 18 and 19.4 for banks and insurers respectively.

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– if so much information is given that the client or other market participant drowns in it, it is counterproductive; – information can turn into the type of disclosure that intends to limit liability, which is the opposite of the client protection sought; – financial service providers are commercial ventures, where protecting the clients interests and the urge to raise profit margins and provisions are at odds; – especially for retail clients (small- and medium sized enterprises and consumers), but also for professionals with expertise in limited niches of the financial markets, information provision does not help if the terminology used and some normal characteristics of the financial markets are not understood. Almost all conduct of business supervision directives have been overhauled within the context of the EU Financial Services Action Plan and have become Lamfalussy directives (see chapter 2 and 23.3). As financial markets and products evolve and political choices on who to protect against what shift, many protection rules are almost continuously under review, amended or even fully recast. Which EU Authority: ESMA and the Consumers Directorate of the Commission The subject of this chapter is outside of the area of prudential supervision, and is not part of one of the directives allocated to EBA in the EBA regulation (with the exception of some parts of the deposit insurance directive and of anti-money laundering). The Mifid, AIFM directive, UCITS directive, prospectus directive, transparency directive and market abuse directive all belong exclusively to the remit of ESMA instead of EBA; as does the investor compensation directive discussed in chapter 18.5. This sister authority of EBA also has joint custody of the anti-money laundering directive together with EBA and EIOPA. The Omnibus I directive and the proposed Omnibus II directive provide the competent authority with similar rights to information and to issue regulatory and implementing standards as have been given to EBA, each in their own remit12. For the consumer protection directives mentioned in chapter 16.6, neither EBA nor ESMA is responsible or involved, nor is the Market directorate of the Commission itself. Instead, they belong to the remit on the consumer directorate of the Commission. These consumer specific rules fall outside the scope of the Lamfalussy/Larosière supplementary legislative framework of which EBA and ESMA are part; see chapter 23.3. However, the three level 3 authorities (EBA, ESMA and EIOPA) have all been given a mandate in the area of con-

12 See Omnibus I Directive 2010/78/EU, and the proposals for Omnibus II as discussed in chapter 19.4 and 23.3. Also see chapter 21.3 and 21.4 on EBA.

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sumer protection. The intent is ambiguous, as the directives given to e.g. EBA do not focus on the narrower consumer protection, but on depositor protection (which includes nonconsumers) as balanced with other goals such as financial stability. A very active role may not be anticipated (e.g. not in the actual execution or drafting of consumer protection directives that are not in its remit). EBA has instituted a subgroup to deal with both financial innovation and consumer protection. Its first plans on consumer protection focus on analysis of concerns in areas such as mortgages and financial education. The work plan does not explicitly limit itself to the prudential concerns that arise when banks violate their consumer protection and/or wider conduct of business obligations13. This work may overlap or lead to overlap with other initiatives described in this chapter 16. Implementation of especially more transformative EU rules can take longer than expected. For instance the 2004 Mifid introduced new rules on trading venues, and increased good conduct burdens on banks/investment firms. After inserting an original implementation deadline of 30 April 2006, the Commission proposed to extend this transposition deadline. The technical, contractual and IT facilities both for the market parties and the supervisors had been underestimated. The required supplementing level 2 directives and regulations were only established after a long and wide discussion. The changes were sweeping both for market structures and investment firm practices, each of which necessitated investment in new contracts, new systems and new legislation. As a result of the extension for detailed legislation and investment by firms and trading venues, the member states only had to implement the new provisions as per 31 January 2007 in their legislation, and apply them to the markets from 1 November 2007. Similar delays have been applied to Solvency II in the insurance sector; see chapter 19.4. Literature Several books on conduct of business supervision can be recommended. These include: – Empel, Martijn van (ed), Financial Services in Europe: An Introductory Overview, Kluwer Law International, Alphen aan den Rijn, 2008 – Moloney, Niamh, EC Securities Regulation, 2nd edition, Oxford University Press, Oxford, 2008 – Ferran, Eilís, Building an EU Securities Market, Cambridge University Press, Cambridge, 2005 – Ferran, Eilís; Moloney, Niamh; Hill, Jennifer G.; Coffee, John C. Jr, The Regulatory Aftermath of the Global Financial Crisis, Cambridge University Press, Cambridge, 2012; particularly the contribution of Niamh Moloney

13 EBA, Financial Innovation and Consumer Protection, an Overview of the Objectives and Work of the EBA’s Standing Committee on Financial Innovation (SCFI) in 2011-2012, 1 February 2012.

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– Edwards, Lilian (ed.), The New Legal Framework for E-Commerce in Europe, Hart Publishing, Portland Oregon, 2005 – Ferrarini, Guido; Hopt, Klaus J.; Wymeersch, Eddy (editors), Capital Markets in the Age of the Euro, The Hague, 2002 (though it should be noted that most directives discussed have been significantly amended since its publication in 2002) – Black, Julia, Rules and Regulators, Clarendon Press, Oxford, 1997, chapter 2-5

16.2 Restrictions on Behaviour in Investment Markets Introduction Banks are key players in investment services. They advise, manage and sell on a wide range of investments, and provide services to clients and to investment vehicles. When performing such roles, banks will be subject to the conduct of business rules set out in specialised sets of EU legislation for providers of those services. Mifid contains rules on investment work performed by investment firms (banks and non-banks; see below), while UCITS and the AIFM directive contains rules on investment work performed by investment funds, their managers and depositories (which terms include both banks and non-banks)14. The host supervisor of a branch of an investment firm or management company is responsible for supervision on the major client-facing aspects of the conduct of business rules15. Unlike the prudential regimes of the CRD (as applicable to investment firms, UCITS and AIFM, the conduct of business rules of the Mifid, AIFM and UCITS directives endows significant responsibilities on the host supervisor. This supervision is supported by local reporting requirements. Prudential supervision is allocated to the home supervisor (for banks this mainly consists of some supplementary specific requirements on e.g. governance as set-out in chapter 13.4. For non-banks it includes standalone rules such as initial and own fund requirements for management companies and investment firms; see chapter 19. This chapter is structured as follows. It sets out: – the persons who get protected when they enter the financial markets; – the protection offered to persons who enter the markets in financial instruments via investment firms (that can be banks or non-banks; Mifid);

14 Markets in Financial Instruments Directive 2004/39/EC. Undertakings for collective investment in Transferable Securities Directive 2009/65/EC. Alternative Investment Fund Managers Directive 2011/61/EU. 15 Art. 32.7 and 61-62 Mifid. Art. 14 and 16.4-16.5 UCITS Directive 2009/65/EC. Art. 31-43 (e.g. 32.5), 45.245.3 and Annex IV sub h AIFM Directive 2011/61/EU. These articles additionally contain a convoluted set of competency and content rules for marketing of funds with links to third countries.

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– the protection offered to persons who enter the markets in financial instruments via investment funds (that can be operated by or serviced by banks; UCITS and AIFM). Who Gets Protected? Retail Clients, Professionals and Eligible Counterparties Mifid is based on the assumption that an investment firm is the expert in its area of work, and that its clients deserve some protection. On top of criminal law protection (thou shalt not steal from, rip off, defraud, or lie to your clients), any licensed investment firm will also need to treat its clients somewhat fairly, with protection even overruling the own interests of the bank for the most protected categories of clients. The additional protection offered is heavily gradated, depending on the financial sophistication of the counterparty of the bank. Some clients are deemed equally sophisticated to the investment firm, and are given no protection, some are sophisticated clients that need only basic constraints on the behaviour of the investment firm (being treated fairly by the investment firm when it deals with you/or on your behalf), some are deemed non-sophisticated, at least when compared to their bank. In this context, retail clients get most protection, professionals get less protection, and so-called ‘eligible counterparties’ (a subset of professionals) are mostly expected to take care of their own protection. Mifid is not a consumer protection directive. It provides the highest level of protection to all retail clients, regardless whether the retail client is a consumer or not. This is good news for small- and medium sized companies, and not for banks. Consumer protection is limited to ‘consumers’ only: i.e. natural persons who do not act in the context of their trade. Mifid protects these consumers, but in addition it also protects countless small enterprises, such as a local bakery store when it is dealing with its bank. These are all retail clients16. Part of their protection lies in added information provision, part in safeguards that certain products are only bought if they are right for the client, part in safeguards that certain products will never be sold to less sophisticated clients. The service-provider sometimes has been made to take responsibility for its client’s actions, to the extent that it cannot sell products that the client cannot handle (financially or in respect of financial understanding). When it concerns relatively simple products and/or if sufficient information has been made available, clients can make their own decisions, and the service provider can sell without further protection. A difficulty with the choice for information provision as a safeguard is that many clients often do not have the financial education or experience to (want to) assess the products realistically. Even deposits and loans – much less complicated than most financial instruments – are poorly understood by retail clients. Many make decisions

16 Art. 4.11, 4.12 and Annex II Mifid 2004/39/EC.

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without understanding the product, the provider and the type of and restrictions on the protection offered by the vendor and the group it belongs to, or by the supervisor17. Retail clients can opt out of the detailed and relatively rule based protection given to them in Mifid if – and only if – they fulfil expertise and trading experience criteria. In that case they become a ‘professional client’. They are then allowed to enter into more risky/profitable transactions as their investment firm becomes allowed to sell such risky products to them (see below). They can be recognised, however, only as professionals for the specific type of market on which they have professional-like experience and/or expertise. Both the client and the firm are obliged to take action if the client no longer fulfils such criteria18. The prospectus directive allows an assumption that investors are professional if they invest in a financial instrument worth more than 100.000 euro per item or as a minimum investment in such instruments, leading to an exemption of the obligation to set up a prospectus. This exemption is not copied in the definitions used in other conduct of business rules such as Mifid. Likely this is because the client in a Mifid-transaction is known to the service provider, while in a prospectus the client may not be known to the issue19. Professional clients are somewhere in the middle between retail clients and so-called ‘eligible counterparties’ as to the protection level20. Eligible counterparties are a subcategory of professional clients, who are denied and/or have waived key aspects of conduct of business protection under Mifid; see below. Professional clients are either financial undertakings that are enumerated in the directive, such as banks, institutional investors such as pension funds, collective investment funds (including UCITS and alternative investment funds) and their managing companies, national and regional governments and e.g. central banks and organisations such as the world bank and the IMF, as well as large (commercial) undertakings that fulfil certain size criteria. Like retail clients, professional clients benefit from protection against the investment firms they deal with, but to a lesser extent. They are protected against unfair and dishonest treatment, and the firm needs to put their interests before its own interests (unless the professional client belongs to the subcategory of eligible counterparties; see below). The general level of protection offered

17 C. Van der Cruijsen, J. de Haan, D. Jansen & R. Mosch, Household Savings Behaviour in Crisis Times, DNB WP 315, August 2011. 18 Art. 4.1 sub 10-12 and Annex II Mifid. 19 Art. 3.2 Prospectus Directive 2003/71/EC, as amended by Directive 2010/73/EU. The 100.000 limit replaced the previous 50.000 euro threshold as per the start of 2012. Also see chapter 4.4 and 16.5. 20 The Prospectus Directive 2003/71 uses the concept of qualified investors. Directive 2010/73 (amending the prospectus and the transparency directives) changed the definition to align it to the Mifid-definitions of professional and of eligible counterparty in a rare example of terminology alignment. Also see Commission, Cross-sectoral Study on Terminology as Defined in the EU Financial Services Legislation, 27 November 2009, page 9.

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is the same as for retail clients, but instead formulated in a more principle based manner, allowing more leeway for flexible arrangements between firm and client based on the specific circumstances of the client. This means that products that cannot be right for a retail client under the detailed and rule based requirements there, may be right for a professional client under the principle based assessment by the service provider. A client that is classified as a professional clients by a firm can opt out of the protection given, and ‘upgrade’ to the eligible counterparty status to broaden their investment opportunities (with the attached downgrade in protection offered) if the member state where they are based allows this. Contrariwise, if they want to obtain more protection they can request – but not demand – the investment firm to treat it as if it were a retail client. If the firm agrees, it subsequently becomes obliged to offer more protection21. On the extreme of the no-protection spectrum in Mifid are the so-called ‘eligible counterparties’22. These are considered equal to the bank in power, money, knowledge and market savvy. As a result, the Mifid does not need to rebalance any distortion in the balance of power when dealing with a bank, neither to the benefit of the client nor – as banks are eligible counterparties too – to the benefit of the bank. The eligible counterparty has to be informed that he is categorised as such and has to confirm that it agrees to be treated as such (see below). The eligible counterparty category includes member states and banks, as well as insurers, investment firms, funds and fund management companies and regulated pension funds. Each member state has to allow its banks to deal with eligible counterparties without giving them the benefit of protection. Eligible counterparties lack protection against the investment firm (bank or non-bank) treating it unfairly, they lack best execution protection and they lack order execution protection. These eligible counterparties are assumed to be as wily and grown-up as the firm, so that they are able to check and enforce their own good treatment, without a role for the state/supervisor. Each member state can expand the category of eligible counterparties – and thus allow such clients to trade in a wider category of sophisticated financial instruments/transactions while at the same time making clear that they need no protection against the firm from the state, and that the firm can take its own interests into account first and foremost. This expansion can include e.g. municipalities and other entities, up to the outer limits of the professional client category. Once a member state has expanded the eligible counterparty category to other professional clients, both its own banks and foreign banks can treat those clients as ‘eligible’. However, these national discretion based clients need to consent in writing to the firm that they agree to being classified as an eligible counterparty, either in

21 Art. 19 Mifid and art. 28 Mifid level 2 Commission Directive 2006/73/EC. 22 Art. 24 Mifid and art. 28 and 50 Mifid level 2 Commission Directive 2006/73/EC.

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general or for a specific transaction. As a national discretion, member states can also allow its investment firms to treat foreign eligible counterparties as such (both the standard ones and – if the member state has expanded it for its own citizens – the other professional clients that it has ‘promoted’ to the eligible counterparty status). An eligible counterparty that has qualms as to whether – in relation to a specific bank, a specific type of transaction or in relation to any bank – it is indeed on an equal footing of knowledge or market savvy, can of course choose to refrain from entering into the transaction. It can also request the bank to re-classify it, so that it will receive conduct of business protection as a retail of professional client for this (or for any) transaction. The bank has to agree to this request before such protection starts to apply (and unless the client specifies it wants to be treated as a retail client it will treat it as a professional client). If the bank is for instance not set up to provide the requested level of protection, or if the transaction is not suitable in any case, the bank may decline a request to reclassify the client. In that case the eligible counterparty will need to draw its own conclusions as to whether to enter into a transaction with that bank. Other conduct of business rules offer protection along these lines or variations on them. For instance, the prospectus directive only protects if the offering is also made to retail clients (with some exceptions even there). If the offering is made solely to so-called qualified investors (the professional clients and eligible counterparties of Mifid taken together), plus to retail clients up to certain exempted limits; no prospectus is required23. Any investment fund that qualifies as a UCITS (see below) can be marketed to anyone, without distinction as to the level of sophistication. The conditions for approval of the fund, their manager and the depository are geared to offering a conservatively managed investment opportunity to retail clients. If retail clients are allowed to buy it, professional and eligible counterparties automatically also need no further protection. This is not the case for the alternative investment funds covered by the AIFM directive. The AIFM harmonises the regime for funds marketed to professional clients24. Retail clients are a different story. The AIFM directive offers member states a national discretion to allow the marketing of some or all such alternative investment funds to retail clients in their jurisdiction, and the possibility to institute additional requirements for funds that target such clients in their country25. The dividing line between retail and professional is made by reference to

23 Art. 2 sub e and 3 Prospectus Directive 2003/71/EC, as amended by Directive 2010/73/EU. 24 Member states have to accept such funds being marketed to professionals in their country once the appropriate approval and notification procedures have been followed. 25 Recital 70-71, art. 43 AIFM Directive 2011/61/EU.

703

EU Banking Supervision the Mifid directive26. Unlike in Mifid, professionals are accorded extensive and detailed protection under conduct of business rules (which can be expanded upon for retail clients by member states). There is no separate regime for eligible counterparties in either the AIFM or UCITS, so they benefit from the same protection as professionals. The UCITS directive offers no protection whatsoever if the undertaking makes use of an exemption to only offer its investments to third country ‘public’. It does protect third country investors if that exemption is not used, e.g. because the fund also targets EU public. The AIFM directive does not have such an exemption. It protects anyone anywhere as long as the directive applies to the fund manager (though some specific provisions do not apply)27. On the other hand, the AIFM does not apply any protection in any way if the fund is relatively small (even though that may be difficult to establish for less sophisticated clients)28. Some more professional persons can trade in financial instruments directly on trading platforms; without an investment firm acting as an intermediary as regulated in Mifid. If they nonetheless elect to trade via an investment firm or investment fund, they fall within the scope of protection offered to their clients as covered in this chapter. However, if they trade directly (e.g. because they are a clearing member themselves), they are not offered the benefit of protection via their intermediary. They will still/only be protected by the general rules on markets/system integrity, on market organisation and on disclosure to the markets as described in chapters 16.3-16.5. Investment Firm Rules (applicable to banks and non-banks) The markets in financial instruments directive (Mifid) became applicable to such markets in the EU in 2007, replacing the investment services directive (or ISD)29. Though the name implies a complete set of rules for markets in financial instruments, it deals only with certain elements of supervision of markets in financial instruments. A core part of Mifid deals with the arrangements for investment firms. This includes authorisation requirements for non-bank investment firms, with an exemption for licensed banks. For non-banks, it provides the licensing process, passporting for cross-border services and branches for investment firms (similar to the passporting rules for banks as set out in chapter 5.3). For both banks and non-banks that qualify as investment firms it contains internal governance rules and conduct of business rules. In addition, it contains the rights and obligations of 26 Art. 4 sub ag and sub aj AIFM Directive 2011/61/EU. 27 Art. 3 UCITS Directive 2009/65/EC, art. 2 and 34-42 AIFM Directive 2011/61/EU. 28 Art. 3 AIFM Directive 2011/61/EU. Small fund managers can opt into the regime if they want to benefit from the European passport. 29 The Investment Services Directive 1993/22/EEC was replaced by Mifid 2004/39/EC.

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conduct of business supervisors for investment services. Apart from rules on the conduct of business vis-à-vis all clients of investment firms Mifid also contains rules on trading platforms. Managing a trading platform can be a service provided by banks, and banks provide back-office services to trading platforms. These rules are discussed separately in chapter 16.4 and 22.4. The CRD and Mifid use the term ‘investment firm’ in a fundamentally different way. In Mifid the term investment firms includes banks, in the CRD the term excludes banks. When Mifid puts an obligation on an investment firm, it always applies in exactly the same manner on any bank that provides investment services or performs investment activities. The sole exception is a limited set of rules on market access (authorisation/passport requirement). Their banking authorisation under the CRD already automatically gives them the right to operate under Mifid (both domestically and under the European passport)30. Apart from these market access provisions, banks fall fully under all conduct of business requirements and all business opportunities allowed by Mifid to all bank and non-bank investment firms31. The CRD uses the term investment firm only to establish a prudential regime for non-bank investment firms32 in RCAD by making itself and large segments of the RBD applicable to them (with some specific arrangements; see chapter 19.2). Please note that in addition RCAD uses the term ‘institution’ when a rule applies to both banks and non-bank investment firms; mainly on market risk calculations; see chapter 9. This leads to a fundamental incompatibility when experts conversant in one or the other directive talk to each other Mifid includes the following types of conduct of business supervision on investment firms: – obtaining information from the client to determine what type of protection should be offered; – information provision to clients; – checking whether the transaction is suitable and appropriate for the client; – general and specific obligations on the execution of work for the client and the way they are treated; – how the investment firm (bank and non-bank) should be structured in order to ensure it treats its clients fairly and acts fairly on financial markets; see chapter 13.4 and 19.2.

30 See chapter 5.3. The Mifid services can be excluded from the licence of the bank by the licensing supervisor. 31 Unless specific limitations attached to its authorisation by the banking supervisor limit the type of activities it can engage in. 32 Art. 1.2 and 4.1 Mifid and art. 1 sub b RCAD. See chapter 13.4.

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The protection offered in Mifid under most conduct of business provisions differentiates between the type of counterparty and the type of product or activity33. To determine whether the investment firm should protect its client or not, it first is obliged to determine whether it is a retail client, a professional client or even an eligible counterparty (see above for the gradated approach to the protection offered). The first conduct of business obligation for each investment firm is thus to gather information that will allow it to allocate each client to one of these categories. Each client has to be informed about the category they belong to. The categorisation is done on the basis of relatively clear criteria. However, as some high profit/high risk instruments can only be sold to clients with less protection, sometimes both the firm and its client want to opt for a lower protection level. The Mifid accommodates this too, as well as the reverse of a low protection client wanting to be treated by the firm with the same conduct of business treatment as given to retail clients, see above under ‘who gets protected’. One the client is allocated to retail, professional or eligible counterparty status, the firm can subsequently start taking business from that client. If the firm allocates someone to the eligible counterparty category, the client has to explicitly agree to being treated in that manner. If confirmed – depending on the manner of implementation possibly per transaction or in a general agreement – the client basically is treated as an equal, without any protection with a few exceptions34. Eligible counterparties are excluded from ‘fair treatment’ and its subparts including suitability/appropriateness testing, from best execution protection and from the main client order handling protection. For the few other conduct of business provisions that relate to internal governance or derive from non-Mifid directives, they are treated as professional clients. Fair treatment, in line with the interest of the client is a general protection given to retail and professional clients, with added protection contained in the Mifid level 2 Commission directive for retail clients only. Fair treatment includes35: – the client has to be treated ‘honestly, fairly and professionally’, in line with the clients interests even if this goes against the interest of the firm (to close a deal, to gain a commission, to make a profit; also see conflict of interest and the arrangement on ‘inducements as discussed in chapter 13.4); – all information given to the client must be fair, clear, not misleading (also see disclosure below). All marketing information has to be marked as an advertisement. If investment

33 An exception is e.g. the organisational obligation to segregate client financial instruments (and client funds for non-bank investment firms) from the own assets of the firm. This is to protect each client, as well as financial stability. See chapter 13.4. 34 Art. 1.2, 4, 19, 24 Mifid and art. 28 Mifid level 2 Commission Directive 2006/73/EC. 35 Art. 1.2, 19, 20, 24, 25 Mifid, art. 24-43 (of which art. 27-33 and 39-43 are mostly concerned with disclosure; see below) Mifid level 2 Commission Directive 2006/73/EC.

706

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–

–

– – –

Conduct of Business Supervision

research could potentially be available to clients, it has to be labelled as such (and additional conflict of interest provisions apply); any service given in the context of investment advice or portfolio management has to be suitable for the client, ascertained on the basis of information on e.g. income/assets/commitments/experience of the client that the firm actively has to obtain from the client. This is the most far reaching duty of care provision, reflecting the relative dependence/powerlessness of the client on the best behaviour of the firm. It can rely on the information obtained, unless it is aware (or should be) that it is out of date, inaccurate or incomplete. There are no other exemptions. Suitability is based on the investment objectives of the individual client, whether he can bear the risks in view of his objectives, and whether he can understand the risks on the basis of his experience and knowledge36; for other investment services (i.e. all except investment advice and portfolio management), the firm has to ascertain whether the service is appropriate for the client and warn the client if it is not appropriate before it provides the service. The information has to be asked, but if the client refuses to provide complete information, a part of the risk shifts to him. The firm can rely on it, unless it is aware (or should be) that it is out of date, inaccurate or incomplete. Mifid provides a general exemption on the information gathering and appropriateness testing if the service is so-called ‘execution only’, which includes some low risk transactions that are initiated by the client, where there are no conflicts of interests and the client is clearly warned that he is thus not protected by the firm for such services (in a standardised or individual format). The Mifid level 2 Commission directive contains an assumption that a professional client knows enough on any terrain in which it is a professional, but this subsequently turned out not to be the case in the 2007-2013 subprime crisis; see chapter 2 and below under AIFM; if another firm has already fulfilled the information gathering and recommendations obligations, the firm can rely on such work already done if it acts in line with such; a document (contract) with all the rights and obligations of client and firm has to be drawn up, and full records have to be kept for at least five years; if there is overlap with client assessment between Mifid and other EU rules (see chapter 16.5), the other rules take precedence.

As stated above, the firm has to gather information on retail and professional client to be able to assess whether investment advice/portfolio management are ‘suitable’ to that client, or whether other services are ‘appropriate’ to the specific client. This goes beyond the 36 The advice needs to be personal before the suitability test becomes applicable. General communications or offers via public channels are unlikely to constitute investment advice in the sense of article 19 Mifid 2004/39/EC. Genil and CHGV versus Banco Bilbao and Bnkinter, Court of Justice 30 May 2013, Case C604/11.

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EU Banking Supervision

information needed for the more objective assessment for allocation to client categories (retail, professional, eligible counterparties), as suitability and appropriateness are linked to concrete and changeable circumstances in the life of the client, such as pension expectations, whether the funds invested are the full sum of the wealth of the client, what purpose the funds have, whether he has other sources of income, etcetera. The information that the bank needs to gather on its client to check for anti-money laundering and anti-terrorist financing is again different, as that looks at sources of funding and connections to illegal activities or illegal use of the funds; see chapter 16.3. The total amount of information to be gathered on and from the client is thus substantial, and it has to be tailored to the purpose. Please also note that the information collected has to be stored – so that the bank can show that it performed its tasks – in line with data protection rules; see chapter 20.2 for references to such EU rules. Some internal governance issues are closely linked to such fair treatment/duty of care: – conflict of interest, including the treatment of ‘inducements’; – asset segregation – the bank has to keep its records of the financial instrument entrusted to it by its clients are segregated from the financial instruments it owns itself, so that there can be no confusion as to who owns what. This requirement primarily intends to ensure that the financial instruments of the client are not captured in a bankruptcy of the bank, and as a secondary purpose helps makes clear what the client owns. Clients only give such financial instruments for safekeeping (unless permission has been given for the bank to use it for its own accounts, e.g. for securities lending). If the client loses such instruments it may also go bankrupt and/or renege on commitments to settle on agreements to sell such instruments, which would lead to chaos in the financial markets, and would negate the safekeeping role of the bank/investment firm37. The best execution rule from Mifid38 obligates the bank/investment firm to execute an order received from the client in line with the best interests of the client. There is a potential conflict of interest here, especially if – as allowed under Mifid39 – the firm can be the counterparty of its own client (for instance as a ‘systematic internaliser’; see chapter 16.4) or is a service provider in the trading, clearing and settlement context. The best out-

37 See chapter 13.4. Art. 18, 19 Mifid level 2 Commission Directive 2006/73/EC. If the assets are held elsewhere, there is an obligation to inform retail clients on the dangers of that under art. 32 of that directive. 38 Art. 1.2, 21 Mifid. 39 The predecessor directive to Mifid, the Investment Services Directive, contained a concentration rule. All transactions had to be brought onto one trading platform for a particular financial instrument. This rule prevented differentiation between (and competition) on fees and prices between trading platforms, but enabled price finding and a liquid market in each financial instrument. The best execution rule, together with transparency rules, is intended to negate the negative consequences of liberalisation of trading platform competition. See chapter 16.4.

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Conduct of Business Supervision

come for the client is to pay low fees and prices, and the best outcome for the firm is to receive the highest possible fees and prices while maintaining customer satisfaction. Such satisfaction for the bank is more likely when higher fees/prices are paid, and the customer is not aware of this40. Mifid tries to ensure that the customer is informed, and that there is downward pressure on the fees, making participation in financial markets more attractive to more investors. Best execution41 rules determine how an order or service is performed, after it has been ascertained that the bank can accept the order or provide the service under the above-mentioned fair treatment provisions (e.g. the check on appropriateness or suitability). Best execution protection is given to both retail and professional clients; but not to eligible counterparties. The obligation includes: – the firm has to take all reasonable steps to obtain the best possible result for their client when executing orders of the client and – as expanded via ‘fair treatment’ reasoning in the Mifid level 2 Commission directive – in the context of portfolio management or when transmitting/receiving orders42; – for retail clients, this requires the determination of the execution via the method under which the client achieves the best total price for his order (e.g. the lowest when buying or the highest when buying), taking into account the price of the financial instrument plus all costs/expenses incurred by the client directly related to the execution of the order (e.g. costs of the trading platform or clearing and settlement fees); – for professional clients, this requires deliberation – in line with pre-established procedures – on issues such as price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order; – if the firm is also a so-called ‘systematic internaliser’ (a trading venue; see chapter 16.4), it has to execute orders of retail clients at the prices it had published at the time of the order prices, with some room for manoeuvre if it concerns an order of a professional client; – an explicit order of the client overrules the protection provided under ‘best execution’, but the client has to be warned about this reduced protection (and thus possible higher prices) prior to the firm starting providing this service of executing orders; – the fee structure of the firm shall not unfairly discriminate between execution venues (e.g. low cost for trading/clearing/settlement via group or domestic entities, very high intermediation fees when executing elsewhere);

40 See e.g. FSA Discussion Paper 06/3, Implementing Mifid’s Best Execution Requirements, May 2006, www.fsa.gov.uk, page 8. 41 Art. 19.1, 21, 24 and 27.3 Mifid, art. 44-46 Mifid level 2 Commission Directive. 42 Art. 45.1 and 45.7 Mifid level 2 Commission Directive provide a questionable interpretation/expansion of the direct application of art. 22 Mifid to portfolio management and intermediating firms. Regardless, the fall back of fair treatment of art. 19 Mifid applies to doing your best for clients, including when trading on behalf of the client in the context of these services.

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EU Banking Supervision

– the procedures on its execution policy have to be worked out, regularly (at least annually) checked whether they are correct and complete (e.g. include the best venues) to achieve the best result for the client, and the client needs give its consent to the policy before the firm can start executing its orders. If the policy includes over the counter trading or systematic internalising of orders, the client needs to agree to this also, either in general or for a specific transaction; – the firm has to be able to show that the execution policy has been actually applied in practice on each order. A specific subset of execution of orders relates to the handling of all orders. Order handling requires43: – when executing orders, the procedures of the firm have to provide for fair and quick execution, both in relation to the interests of other clients and to the own interests of the firm, which includes an obligation that the firm has to handle comparable orders in the sequence they come in, as well as not misusing information about client orders (so-called frontrunning when a firm or preferred clients execute orders before e.g. a large order of another clients affects market prices); – order aggregation is only permissible under certain circumstances (including disclosure with a warning) and if it is unlikely that for any client involved it would be disadvantageous and the advantages are distributed fairly; – client limit orders of retail clients, professional clients and eligible counterparties have to be treated in a manner – if not immediately executed – that allows the earliest possible execution by making it public in a manner accessible to other market participants (with some exceptions). In addition to these direct conduct of business obligations, member states are obliged to ‘encourage’ the institution of an extra-judicial complaints resolution mechanism. In addition to any civil law conflict resolution, Mifid thus indirectly pushes institutions to set up an efficient and effective procedure for out-of-court settlement complaints. The focus here is on consumer complaints, even though the Mifid otherwise protects the wider category of retail clients and even of professional market parties. If such a procedure is instituted, member states are bound to prevent any legal/regulatory obligations to impact negatively on cross-border conflict resolution for such consumer complaints44. For integrity and disclosure related Mifid rules reference is made to chapter 16.3 respectively 16.5.

43 Art. 22, 24 Mifid, art. 47-49 Mifid level 2 Commission Directive 2006/73/EC. 44 Art. 53 Mifid.

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Conduct of Business Supervision

UCITS and AIFM Undertakings for collective investment in transferable securities and alternative investment fund (managers) are dealt with in two supplementary directives. The current recast and revised version of the UCITS directive entered into force in 2011, and the AIFM directive became applicable on 22 July 2013. They are thus both relatively new, thought there were previous version of the UCITS directive (the current version is sometimes referred to as UCITS IV). There is a range of temporary transitional provisions for pre-existing funds45. Prior to the July 2013 implementation date, the AIFM funds were not subject to EU level legislation, though they may have been regulated at the domestic level in member states. Both directives distinguish between requirements for the fund itself, the manager of the fund (that can be the same legal entity as the fund itself), and a depository that has to be a separate entity from the manager. The depository keeps the investments and money of the fund safe on behalf of the clients, and is charged with monitoring the manager and the way it implements the agreed investment strategy. The manager of a UCITS fund cannot be a bank, it has to be a specialised body. A UCITS itself cannot be a bank, as it is forbidden to borrow (only to attract capital, which by definition is not a ‘deposit or other repayable fund’). Both the manager and the fund can, however, be a subsidiary of a bank and/or of an investment firm, and thus captured in consolidated supervision as set out in chapter 17 and 19.2. The depository can be a bank, and for money of the fund has to be a bank. The text of the AIFM directive is less clear, the manager also has to be a specialised body, but it simultaneously indicates that banks and non-bank investment firms do not need separate authorisation to provide investment services (which can include management according to the Mifid) to alternative investment funds. The fund can fall within the definition of a bank if it uses leverage and has a specialised investment strategy. If it borrows from professionals it is fine, but if it borrows from the public (e.g. by issuing bonds) in addition to the capital raised to make loans (e.g. by buying sovereign bonds or making loans to car buyers or to ‘green’ projects or farms; see chapter 4.4) it could be a bank under the CRD definition. In that case both sets of rules could apply simultaneously, thus with added protection for shareholders. Banks are not exempted from the AIF definition itself (nor vice versa). This may not have been the intention, but neither the definitions nor the exemptions provide a clear way out from double application of the two regimes, unless it allows for restrictive interpretation of its definition elements (e.g. by excluding bonds and loans from ‘investment strategy’), which also does not appear to be the intention. The main 45 Art. 43, 61 and 66 AIFM Directive 2011/61/EU. Art. 116-118 UCITS Directive 2009/65/EC.

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EU Banking Supervision

problem would be with the obligation to have a separate depository for all assets. Under this rule the depository can be a bank, but it cannot be the same entity as the fund, see below. Unlike banks, all holding companies – including bank holding companies – are exempted, as are e.g. central banks, occupational pension funds that are covered by the relevant directive, UCITS, and securitisation special purpose vehicles (for unclear reasons, as investors in securitisations were shown to could have done with some added protection in the 2007-2013 subprime crisis, and are equally likely/unlikely to fall within the definition of an AIFM as banks; see below)46. Please note that UCITS are only required to be authorised if they attract funds from the ‘public’. This is an undefined term in the directive, but likely of a similar scope as ‘public’ in the CRD definition of a bank; not meaning ‘everyone’ or ‘anyone’ but – in short – a substantial number of people that are not professionals; see chapter 4.4. Once a UCITS is authorised, the conduct of business provisions – as noted above – apply to their relationships with all their investors equally, regardless of their status as retail, professional or eligible investor under Mifid. The protection offered is relatively high when compared to the various regimes under Mifid as it is geared towards protection of retail investors. The AIFM offers a similar level of protection, even though it is primarily geared towards professional investors. Learning from the 2007-2013 subprime crisis when many professionals such as consumer oriented banks and municipalities lost their shirt when pretending to understand risks embodied in securitisations or derivatives better than they actually did, the protection level is set high, with additional national rules possible for even higher protection of retail investors if they are allowed to invest. The management company of a UCITS or AIFM fund has to abide by general conduct of business principles47 on e.g. acting fairly and skilfully, compliance with all relevant rules and the avoidance of conflicts of interests in relation to the investors of the fund. Under AIFM, the depository has the similar obligations48. Most management companies will not have clients that are not UCITS or AIFM funds, but if the member state allows it, a UCITS management company can additionally provide some limited services to e.g. pension funds, or safekeeping of UCITS units for investors. The management company is subject to similar provisions on e.g. treating clients fairly vis-à-vis those outside clients as an investment firm would be49.

46 47 48 49

Recital 6-10, art. 2.3, and 4.1 sub a AIFM directive. Also see chapter 4.4. Art. 14 and 30 UCITS Directive 2009/65/EC. Art. 12, 14, 22.10 AIFM Directive 2011/61/E. Art. 22.10 AIFM Directive 2011/61/EU. Art. 6.3 and 6.4 UCITS Directive 2009/65/EC. The reference also includes references to Mifid internal governance, and to initial capital as applicable to non-bank investment firms; see chapter 13 and 19.2.

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Part of the protection offered is via segregation of tasks and assets. The assets of the fund have to be entrusted to a depository for safekeeping, and the manager cannot be the same entity (and thus the owner for legal purposes) as the fund. This prevents the use of assets by the manager (or by its creditors in its bankruptcy) for other purposes than agreed in the conditions under which the investment fund was marketed. This applies even if the fund is a separate legal entity – an investment company – that is limited to being a UCITS. However, if it is a separate legal entity, it need not appoint an external manager if it is willing to comply itself to similar requirements, and being limited to manage its own assets only. No legal entity can be simultaneously a fund and a depository50. An equally important safeguard to the segregation is liability. The likelihood of professional liability of the management company is a direct result of his relation (on behalf of the fund) with investors51. For depositories this direct interface is absent, and its liability has been established in the UCITS and AIFM directives. This has been detailed to a larger extent in the more recent AIFM directive than in the UCITS directive (learning from recent scandals on Ponzi schemes)52. Under the UCITS directive there is a liability of the depository towards the manager and towards the investors (possibly via the manager) for ‘unjustifiable failure to perform its obligations or its improper performance of them’. Under the AIFM directive the depositary is liable towards the fund or towards its investors, while the liability of the investors may need to be invoked via the management company, depending on the legal relationships. In addition, the depositary is liable if any financial instrument is lost by either itself or another party to which custody has been delegated, with some very limited methods to get rid of that liability. Both the management company and the depository of a UCITS common fund (i.e. a fund that is not a separate legal entity) when fulfilling those roles have to act solely in the interest of the investors. They are also bound to act independently, and thus provide checks and balances for each other53. The depository of an investment company is also bound to act solely in the interest of the investors, and to check on the investment companies’ execution of its tasks. There is no such explicit obligation to act in the interests of investors put on the fund/investment company itself under UCITS (or its potential external manager) to do so, and it can thus pursue its ‘own’ interests as a legal entity. Vis-à-vis the company, the general conduct of business rules (and the verification role of the depository) have to

50 Art. 22 and 27.3 UCITS Directive 2009/65/EC. Art. 21 AIFM Directive 2011/61/EU. 51 Art. 9.7 and 19.10, 20.3 AIFM Directive 2011/61/EC. Recital 16, art. 13.2, 79.2 UCITS Directive 2009/65/EC. 52 Art. 13.2, 22, 24, 32.2 UCITS Directive 2009/65/EC. Recital 32, 44-46, art. 21 and AIFM Directive 2011/61/EU. The Ponzi scheme most published about just prior to the AIFM negotiations was run by Bernie Madoff (arrested in 2008, pleading guilty and convicted in 2009). 53 Art. 25, 32, 34 UCITS Directive 2009/65/EC.

713

EU Banking Supervision suffice for its investors54. Under AIFM, the obligation to act in the best interest of the investors and the alternative investment fund applies to all managing companies and depositories. The management companies also have been given a duty to act in the best interest of the integrity of the market55. There is no good reason for the discrepancies between the AIFM and UCITS directives in the various areas of conduct of business rules; it appears to be a function of learning by doing, and failing to upgrade similar rules simultaneously. A key difference between the UCITS funds with alternative investment funds is the obligation that a UCITS fund has to be ‘open-ended’. This means that investors have to be able to sell their units on a stock exchange, request repurchase or redemption of their investment units, all against approximately the liquid value of the fund’s shares (the value of its assets divided by the number of shares)56. Alternative investment funds can be open-ended, but are more likely to be closed-end, which means that investors may be stuck in the investment until the fund is wrapped up if they cannot find a buyer for the share in the AIFM fund. Related to this open-ended character is an additional protection offered to UCITS investors. UCITS are only allowed to invest in certain assets, and prohibited to borrow money (which prevents leverage being used that could expand both profits and – importantly – losses)57. The limitation on allowable investments has, however, been relaxed over the years. The current version allows also investments in fairly high risk financial instruments such as e.g. financial derivatives that are traded off regulated markets. Leverage is allowed into AIFM funds, but has to be disclosed; see chapter 16.5. The depository of both types of funds can be banks, or other types of prudentially supervised entities58. If the depository is subject to conduct of business supervision as a result of being a bank and/or investment firm, those provisions apply where the services rendered to the fund are investment services as defined in the Mifid. This in addition the conduct of business provisions of either UCITS or AIFM directives that apply if the fund is regulated under those directives. Under both directives the depository and the management company can be group companies. They have to act independently of each other, however, which can lead to severe conflicts of interest between the related legal entities (e.g. will the man-

54 Art. 32, 34 UCITS Directive 2009/65/EC. 55 Art. 12 and 22.10 AIFM Directive 2011/61/EU. Strangely, the first article specifies that the management company needs to take account of the best interests of the investors ‘or’ the fund, while the second article gives a duty to that same management company (and the depository) to take account of the best interests of the investors ‘and’ the fund. As the second provision is more far reaching in this protection regard, I assume that it overrules the possibility of a choice for the management company. 56 Art. 1.2 sub b and 43-45 UCITS Directive 2009/65/EC. 57 Art. 50 and 83-89 UCITS Directive 2009/65/EC. 58 Art. 4 sub a, b, g, 6 (especially 6.8), 20.2 and 21.4 AIFM Directive 2011/61/EU. Art. 2 sub a, b, 6.

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aging company sue the depository for failing in its duties, will the depository sue the managing company for failing to follow the right investment course, each of which they are obligated to do and are liable for vis-à-vis the investors), and for the group in which the two are consolidated (will the parent of the two or the ultimate parent compensate losses just to avoid reputational damage for either the managing company or the depository, and if so, should that likely pay-out due to reputational risk not be allocated capital for at the level of the parent bank both on a solo-basis and on a consolidated basis). Such conflicts are the subject of rules under the UCITS and AIFM directives for the individual legal entities that provide the services, and under the CRD for the parent and the group; chapter 13, 14 and 17. Future Developments The Mifid is in the process of being reviewed. After a consultation on the way forward on several aspects of Mifid, the Commission has published its so-called Mifid II proposals59 in October 2011. On conduct of business, these propose a tightening of the duty of care of the banks and non-bank investment firms that offer services such as investment advice and wealth management, or sell complex financial instruments. The UCITS directive is being reviewed in a two stage process under so-called UCITS V proposals published on 3 July 2012 (containing mostly rules on depositories, remuneration and sanctions to align with the AIFM directive), and a longer term consultative process started on 26 July 2012 to review in depth UCITS funds and their role in financial markets60. Literature – Athanassiou, Phoebus, Hedge Fund Regulation in the European Union: Current Trends and Future Prospects, Kluwer Law International, Alphen aan den Rijn, 2009

16.3 Market/System Integrity (Market Abuse, AML/CFT) Introduction Market integrity is key to the trust of the public in the financial markets, and their willingness to invest via such markets. In addition to ensuring that key market players have board members that are trustworthy, that they have organisational safeguards to ensure proper 59 Commission proposals COM(2011) 656 final and COM(2011) 652 final, dated 20 October 2011 for a directive and a regulation replacing the current Mifid. The regulation deals primarily with trading and trading platforms, the directive contains the conduct of business rules in relation to clients. 60 See chapter 19.5. UCITS V, Commission, Proposal for a Directive Amending UCITS COM(2012 350 final, 3 July 2012; and see the website of the Commission under internal market, investment funds; www.ec.europa.eu.

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EU Banking Supervision conduct, and disclose all relevant information61, the need has been felt to target specific processes and abuses with specific prohibitions. These prohibitions are sanctioned under criminal law, or are subject to similar or more stringent types of supervision and sanction. It concerns: – insider dealing prohibition; – market manipulation prohibition; – money laundering prohibition; – terrorist financing prohibition; – a requirement to promote honest, fair and professional behaviour, as well as the integrity of the market. These subjects are dealt with in three directives and a regulation. The market abuse directive (MAD), the anti-money laundering directive (AML) and Mifid contain prohibitions of criminal activities and orders to act in an integer manner. Mifid and the payer information regulation contain provisions that ensure records are kept that will enable supervisors to investigate potential integrity transgressions62. General Requirement A general requirement to act in an honest, fair and professional manner is contained in Mifid for banks and for non-bank investment firms; see chapter 16.2. They are also required to act in a manner that promotes the integrity of the market. Key players in the markets are thus legally bound to make the market place a fair place for themselves, other banks and investment firms, and for non-financial firms and clients. It should be noted, however, that other key investors are not subject to this requirement (e.g. institutions that are exempted from the investment firm definition; see chapter 16.2 and 19.2. The market abuse directive deals with abuse by all market participants, including banks and investment firms. The anti-money laundering directive and the payer information regulation deal with abuse by anyone who is either a ‘regular’ criminal or an ideological criminal. This includes trying to make it appear that money earned from a criminal activity instead had a legitimate origin, or to channel money via the financial system towards potential use for criminal activities.

61 See for banks chapter 5 and 13. For other key players see this chapter 16 and chapter 19. 62 Anti-Money Laundering Directive (Directive on the Prevention of the Use of the Financial System for the Purpose of Money Laundering and Terrorist Financing) 2005/60/EC, which replaced Council Directive 91/308/EEC that prohibited intentional money laundering, but not yet terrorist financing. Regulation on Information on the Payer Accompanying Transfers of Funds, 1781/2006. Market Abuse Directive 2003/6/EC, which replaced Insider Dealing Directive 1989/592/EEC. Art. 25 Mifid.

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The division with other conduct of business rules is not clear cut. Conflict of interest rules, fair dealing with clients and not harassing consumers as described elsewhere in chapter 16 have a clear integrity component too. Whether assets that secure clients’ claims can be used for securities lending, whether a bank when advising/selling complex products such as synthetic ETF (exchange traded funds that do not hold the underlying assets but use derivatives to mirror the value development of such assets) can be both the seller of the product, its composer, its derivatives counterparty and the manager of the portfolio, and not benefit unfairly are also moral issues. They are, however, less clear cut abuse as the issues identified in this chapter, or are expected to be ‘managed’ to prevent such double roles becoming abuse. For the banks and other financial or advisory undertakings that fall within the scope of these rules, compliance with integrity rules is primarily a compliance/organisational issue. There are few incentives for them to invest in anti-money laundering investigation, except avoidance of regulatory risk and avoidance of fines. It can have large financial sanctions consequences if they do not invest in such compliance and are called out in public on it63, but on the other hand they do not get paid to take on board this public service and are usually not the primary victim, while the effectiveness of the rules is less than clear; for instance of the reporting to public authorities of suspicious transactions under money laundering rules64. The relation with a client can be lost if public authorities are called in and trouble the client at the instigation of the bank (which is of course only an issue if the client subsequently turns out not to have broken any rules). For insider dealing, market manipulation or such issues as fraud prevention, any action a bank takes to involve public authorities directly impacts on the reputation of the bank vis-à-vis all their clients and counterparties, as it is their own transgressions that fall under the prohibition. Anti-Money Laundering and Terrorist Financing The financial system including its bank-components allows anyone with money to use it for safekeeping purposes, payments, transfers and cash-management; a key public service delivered to individual clients and the economy. This use is often be desirable, but it can also be undesirable. Two aspects of undesirable use are money laundering where ill-gotten gains get a nice new clean aura because the link with the original ill-gotten funds has been cut, or where money is given by a financial backer to a person who needs it to commit 63 Within the EU, such publication is heavily circumscribed under administrative law and human rights protection. This is not the case in all third countries, including e.g. the USA, where the perp walk or similar early disclosure of not yet proven allegations is an effective way to persuade banks and others to invest in keeping the financial sector clean. 64 R.K. Gordon, ‘Losing the War Against Dirty Money: Rethinking Global Standards on Preventing Money Laundering and Terrorism Financing’, Duke Journal of Comparative & International Law, vol 21, 2011, page 503-565.

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such economic or terrorist crimes. Money laundering or terrorist financing is a necessary supporting crime for real life crime (rob, steal, bomb, hijack). If banks or other financial services providers allow themselves to be used for this purpose, they enable criminals to commit their primary crimes. If money is stolen in one country, deposited it in a bank account and wired it to another will make it appear ‘legitimise’ it in the other country if measures are not taken to show the link to criminal origins. Money in bank accounts can also be used to buy weapons in a country where persons want to commit a crime. How to prevent this undesirable use of the financial system is the goal of the anti-money laundering and counter terrorism-financing laws. These apply to all services providers that can be used to transfer value or legitimise illegitimately obtained or intended funds, including – in addition to banks – art dealers (when receiving large cash payments), independent legal professionals, and others who participate in financial transactions. Anti-oney laundering laws at first were focused only on catching certain types of identified criminals (with initial attention mainly being paid to drugs offenders). However, the 2005 version of the directive expanded the coverage from drugs offenders to look at all criminals, and further expanded the reach of such laws to people who are so well connected that they are not (yet) identified as criminal, and to terrorist financing. The 2005 directive acknowledges that ill-gotten gains are often held by persons in power who have used that power in a corrupt way (more often in less regulated countries, but also in well regulated countries). As long as they remain in power – and behave well enough to stay off sanctions lists and such – they could transfer all the money they like. The directive introduced – alongside the pre-existing identification obligation – a regime to perform a risk-sensitive customer due diligence closely on so-called politically exposed persons65. This includes e.g. heads of state or members of government, central bank board members and members of parliament, high courts, and ambassadors, their immediate family members and close associates. The terrorism financing rules were sharpened as terrorist attacks started to rise in western countries (for instance. Spain, the UK and the USA have suffered from both home-grown and foreign terrorist attacks). These expansions of the scope of EU money laundering laws were in line with the development of money laundering recommendations by the (worldwide operating) so-called financial action task force (‘FATF’). Both the EU member states and the Commission are members of this task force66. The new FATF recommendations also provided some of the further detail and scope to the fight against

65 The due diligence focuses on being politically connected, or to prove the legitimate source or intent of the money entrusted or transferred, and thus entails different questions and needs than for the purposes of client classification and the testing of suitability/appropriateness under Mifid described in chapter 16.2. 66 The FATF was established in 1989 by the G7.

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processing the proceeds of crime67. The FATF recommendations were expanded into the area of terrorist financing as a result of the 11 September 2001 (9/11) terrorist attacks on the world trade centre in New York. The perpetrators had used the financial system to pay for key aspects of the assault (for instance for pilot training and buying plane tickets). The directive requires banks and other service providers to verify the identity of the client, including any beneficial owners, under the risk-based customer due diligence procedure. Some clients, such as politically exposed persons, need to be screened carefully especially if they are from countries where corruption is rife. Other clients can be screened via a simplified due diligence process if risk of money laundering or terrorist financing is deemed low and/or where screening has already been performed elsewhere, e.g. by another bank68. Any suspicious activity has to be reported to the national financial intelligence unit (‘FIU’). Banks have to have systems in place to be able to provide such financial intelligence units quickly with all relevant information on request. Going against the grain of private client/service provider relations, the report has to be made, and the existence of such suspicions/report has to be kept secret from the client69. To some extent this may mitigate the human rights of the screened persons, especially if the report is followed by a mandatory freeze or seizure. However, such mitigations are only allowed to the extent allowed under fundamental rights, which in this case means that – at a minimum after the fact – the persons whose funds are frozen or seized need to be given a right to be heard to defend themselves, and they need to be given adequate access to legally challenge the decision to intervene70 The anti-money laundering directive is wide in scope. Banks and other financial institutions are required to operate anti-money laundering standards on a worldwide basis under the standards set in the directive (regardless of whether they operate elsewhere via branches or subsidiaries)71. It sets most of the key definitions, but has to be transposed by member states (who are allowed to goldplate its provisions as it is a minimum harmonisation

67 See www.fatf-gafi.org. R.K. Gordon, ‘Losing the War Against Dirty Money: Rethinking Global Standards on Preventing Money Laundering and Terrorism Financing’, Duke Journal of Comparative & International Law, vol 21, 2011, page 503-565. 68 Recital 5-17, 22-28, 37, art. 1-4, 6-19, 30, 34-35 Anti-Money Laundering Directive 2005/60/EC. 69 Recital 29-34, art. 20-29 and 32 Anti-Money Laundering Directive 2005/60/EC. 70 Kadi and Al Barakaat International Foundation/Council and Commission, Court of Justice 3 September 2008, Joined Cases C-402/05 P and C-415/05 P. Also see chapter 20.4. In this case the human rights mentioned were not protected, which could have lead to annulment. The Court considered this response disproportional too, and allowed the public authorities three months to legally introduce effective human right protection. 71 Banks have to report to their supervisor if they cannot comply with the standards set in the directive for their branch or subsidiary activities in a third country. Recital 35-36 and art. 31 Anti-Money Laundering Directive 2005/60/EC.

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EU Banking Supervision directive)72. The payer information regulation and Mifid contain rules to subsequently support investigation into anti-money laundering crimes; see below under record keeping. The anti-money laundering directive is supported by level 2 directives issued by the Commission. These were drafted with support from the level 2 committee on the prevention of money laundering and terrorist financing; also see chapter 23.3 on the role of level 2 committees73. The level 2 directive74 contains more specific rules on definition issues (what is a ‘politically exposed person’, who should be treated with enhanced customer due diligence), as well as the criteria for exemptions on simplified due diligence procedures regarding certain counterparties or full exemptions for low frequency/low impact incidental financial services. The European supervisory authorities (EBA/ESMA/EIOPA) jointly perform the level 3 role; including the development of regulatory and implementing standards75. Terrorism prevention is one of the few areas where data protection considerations (see chapter 20.2) are set aside also in the cooperation with a third country, most notably the USA. In an agreement of 2010 the exchange of information by Swift, the central payment information system, with USA authorities can take place after approval by Europol on the legitimacy of the request76. Market Abuse Market abuse offences – insider dealing and market manipulation – have been regulated only relatively recently. Insider dealing such as tipping and trading on that tip was perfectly normal in any financial market until late in the twentieth century. Whether the prohibition on insider dealing is necessary has been furiously debated on the academic side. Counterarguments range from it being a crime without an identifiable victim, that insider dealing makes the markets more liquid as persons with inside information will trade, and is an incentive – additional bonus – for the persons in the know. Some opponents pose that the information is ‘owned’ by the company it concerns so that it can also decide to give it to certain persons instead of to all (and limit it to those persons it actually gave it to)77. 72 73 74 75

Art. 5 and 45 Anti-Money Laundering Directive 2005/60/EC. Art. 40-41 Anti-Money Laundering Directive 2005/60/EC. Level 2 Anti-Money Laundering Commission Directive 2006/70/EC. Art. 11.4, 31.4, 34.3, 37a Anti-Money Laundering Directive 2005/60/EC, as amended by art. 8 Omnibus I Directive 2010/78/EU. See chapter 21.4 and 23.3. 76 Agreement between the EU and the USA on the processing and transfer of financial messaging data from the EU to the US for the purposes of the terrorist finance tracking program (EU/USA TFTP Agreement); art. 4. 77 See e.g. H.G. Manne, Insider Trading and the Stock Market, New York, 1966; and the discussion in R.C.H. Alexander, Insider Dealing and Money Laundering in The EU: Law and Regulation, Aldershot, 2007, chapter 1.

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Regardless of the value of these argument, the EU has firmly landed on the side of a prohibition of insider trading, and in favour of transparency of hidden defects or assets. If people who are not in the know are to trust the markets and invest their money there, they have to be able to trust that they at least have the same information as anyone else. These argument has been reinforced by the growth of the financial markets, which shows that the introduction of the prohibition definitely did not hurt the market, and may have been one of the roots for its success. The market abuse directive (MAD) is applicable for the goal of protecting the integrity of the financial markets and to enhance investor confidence. Only if these goals are impaired, the prohibitions contained in the directive lead to prosecution78. Unfair advantages that are prohibited79: – trading in instruments admitted to a regulated market while having insider information (except if no unfair advantage is made of that inside information); – unfairly manipulating markets to achieve an advantage regarding an instrument admitted to a regulated market80. Insider information is information of a precise nature – i.e. not mere opinions or rumours – that has not been made public, relating to one or more issuers or instruments, and that is likely to have a significant effect on the prices of the instruments or of related derivatives. The prohibition to deal while having such insider information is formulated so that it can be proven on the basis of verifiable facts. Problems could otherwise arise from having to prove that the transgressor had intent, or that in his mind the information and the transaction were linked. The subjective state of mind of the transgressor is difficult to prove, which becomes even more difficult if it is a legal entity. To avoid insider dealing, it is now prohibited to trade if someone has insider information, regardless whether that information was the cause for the trade. If someone has inside information, it is assumed that he based his decision to subsequently trade amongst others on that information, and thus unfairly takes advantage. The recitals to the directive and the Court of Justice establish some cases where this assumption is not applicable: – information available in a bank, market maker or similar service provider does not prevent it from normal trades in the markets;

78 Spector/CBFA, Court of Justice 23 December 2009, Case C-45/08, §61-62. 79 These are limited to certain types of instruments that are traded on a specific type of market (the ‘regulated market’) but on the other hand apply also if such instruments are traded elsewhere. Rasdaq Market, Court of Justice 22 March 2012, Case C-248/11. 80 This prohibition was added in 2003, the predecessor directive did not regulate market manipulation. Ipourgos Ikonomikon/Georgakis, Court of Justice 10 May 2007 C-391/04.

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– a person has the right to prove that he did not unfairly take advantage of the inside information in his possession when he did the trade (a protection that results from the European convention of human rights; see below), but this puts the burden of proving his subjective state of mind squarely upon him. Even with the more objective criteria, the market manipulation prohibition is a difficult one to prove for supervisors. The market abuse directive gives some examples, but it also provides examples on the type of accepted market practices (stabilising the price after an issuance, market making, short selling, share buyback programmes) that do not constitute insider dealing even though the distinction is difficult to make. The distinction often seems to be whether it helps the market instead of hinders it, with limitations on the potential negative consequences. This includes exemptions for ‘accepted market practices’, except when the market practice is used for outright deception81. To support the prohibition on insider dealing, it is also prohibited to share insider information with others as long as the information is not available to the general public82. It applies to those with special access to that information, due to e.g. being an executive or non-executive board member, a shareholder, or those who have access to the information through criminal means (e.g. hacking), or because they obtained the information due to their job (such as the accountants or lawyers of the company, or its conduct of business or prudential supervisor; also see chapter 20.2). This prohibition has several exceptions. The main exception allows insider information to become public information; by (obligatory) disclosure to the general public, see below. Another exception is that people who have inside information may share it in the context of their normal tasks. This allows managers to consult e.g. lawyers, public relations-consultants, valuation experts, banks who might underwrite a public emission etcetera. The Court has ruled that – as this is an exception on the obligation that insider information is either disclosed fully or otherwise really kept secret – the exception has to be interpreted strictly83. The person who has the insider information and discloses it to another has to consider whether (i) there is a close link between the disclosure and the exercise of the employment, profession or duties, and (ii) is the disclosure strictly necessary to exercise those tasks. He has to do this while taking into account that (i) the exception to the secrecy obligation has to interpreted strictly, (ii) that each additional disclosure may well increase the risk that the information is

81 For examples see art. 1.1, 1.2, 1.5, 5 MAD 2003/6/EC and e.g. art. 2 Commission Directive 2004/72/EC. Also see CESR 04-505b and other Commission and ESMA/CESR documents listed on www.esma.europa.eu under ‘accepted market practices’. M.M. Siems, ‘The EU Market Abuse Directive: a Case-Based Analysis’, Law and Financial Markets Review, No. 2, 2008, page 39-49. 82 Art. 2 MAD 2003/6/EC. 83 Grøngaard and Bang, Court of Justice 22 November 2005, C-384/02.

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exploited for insider trading or other market abuse, and (iii) that the obligation is proportional to the degree of sensitivity of the inside information. The Court also observed that the merger between two listed companies is in general particularly sensitive (and should thus be particularly reluctantly shared). In addition to the international organisation requirements geared towards prevention (supervised normally by the banking supervisor where it concerns banks), each actual transgression should not only have been prevented, but it should also be punished. It is not a technical rule (like some of the provisions on e.g. calculating financial buffers), but a transgression of an intrinsic obligation. Member states are obliged to ensure that he prohibition itself can be enforced and prosecuted, instead of ‘only’ giving rise to supervisory sanctions geared towards prevention. In order for white-collar criminal provisions to be credible, and thus have an effective impact on behaviour in the markets, enforcement is key. The number of aspects that need to be proven in order for a conviction to take place, the resources and expertise needed at both supervisors, police, public prosecutors and judges can impede such enforcement. Combined with the reputational risk if a case does not lead to a conviction, this is likely to be limited, especially as this area (criminalisation of financial market behaviour) is relatively young in the EU when compared to the USA84. Prosecution is nonetheless one of the main instruments to achieve the goals of this type of directive. Only if there are effective sanctions on market abuse, the prohibition becomes relevant to the business of market participants, making it more likely to be adhered to. On the other hand, prosecution raises administrative law and human rights issues (see chapter 20.4 and 20.5). The Court has indicated that the sanctions under the prohibition of insider dealing on the one hand need to be effectively sanctioned and prosecuted, and are at the same time in effect criminal sanctions in the sense of the European convention of human rights, a binding treaty that all EU members have ratified85. The prohibition for someone who has inside information to trade subsequently as formulated in the directive, according to the Court needs to be interpreted in such a way that it would not infringe human rights. This includes the presumption of innocence. Even though the directive did not contain such a limitation, the Court indicated that – though a presumption of abuse is possible in the circumstances that lead to the prosecutable offence – the defendant has to be able to claim that he had not unfairly used the inside information. If such an interpretation had not been possible, the market abuse directive prohibition would not have

84 See E. Ferran, Building an EU Securities Market, Cambridge, 2004, page 33, for the impact the limited number of enforcement cases in the EU already appears to have had on compliance and on markets. 85 Spector/CBFA, Court of Justice 23 December 2009, Case C-45/08.

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EU Banking Supervision been an acceptable mitigation of human rights86. Respect for human rights is a condition for the validity of all EU acts, including legislation87. The market abuse directive also contains obligations on disclosure. These are geared towards the prevention of insider dealing and market manipulation, by ensuring full disclosure of all relevant information. See chapter 16.5. The market abuse directive is supplemented extensively by level 2 legislation and level 3 guidance88. It focuses solely on insider dealing and market manipulation in respect of instruments that are or want to be admitted to trading on regulated markets, or to instruments the value of which is dependent on such financial instruments89. For instruments that are not admitted to such trading on regulated markets, and outside these two specific activities, member states are not obliged to introduce similar rules, though they are allowed to. In principle, there is therefore no EU rule prohibiting insider dealing or market manipulation for financial instruments that are solely traded on multilateral trading facilities, systemic internalisers or via over the counter (i.e. bilateral) deals, nor are other unfair market practices captured by the directive90. Unlike most of the financial services directives, the market abuse directive is not based on the freedoms of establishment and of services. It is fully based on the internal market provision of the treaty91. As a result, this is an area where regulations (immediately and directly applicable in the member states) can be used instead of directives (that have to be implemented by the member states, with freedom as to the methodology chosen); see chapter 3.4-3.5. Both for the internal market and for consumer protection the treaty allows such a choice to legislators and delegated legislators. For the market abuse directive itself, the regulation format was not chosen, but the Commission opted to use this for one of its 86 The Court referred here to its reasoning in Kadi and Al Barakaat International Foundation/Council and Commission, Court of Justice 3 September 2008, Joined Cases C-402/05 P and C-415/05 P. Also see chapter 20.4. 87 See chapter 18, 20.4 and 23 on the impact of human rights principles. E.g. Schräder/Hauptzollamt Gronau, Court of Justice 11 July 1989, Case 265/87. 88 Market Abuse Directive 2003/6/EC, level 2 Commission Directives 2003/124 (definitions and disclosure) and 2004/72 (accepted market practices), and level 2 Commission regulation 2273/2003 (buy backs and stabilisation safe harbour). CESR guidance adopted e.g. in May 2005, CESR/04-505b, and July 2007, CESR/06562b. 89 Art. 9 and 10 Market Abuse Directive 2003/6/EC. Rasdaq Market, Court of Justice 22 March 2012, Case C248/11. 90 Also see Ipourgos Ikonomikon/Georgakis, Court of Justice 10 May 2007, Case C-391/04, where the Court refused to apply the Insider Dealing Directive, the predecessor to MAD, to a clear market manipulation case. As market manipulation was not covered in the predecessor directive that was focused solely on insider dealing, that would have broadened the scope of the directive too much. 91 Art. 114 TFEU.

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level 2 measures (in areas where regulations can be used under the treaties, the level 1 choice of a directive does not pre-empt the choice at level 2). Record Keeping The payer information regulation supports the potential to investigate of the crime of money laundering and terrorist financing92. Unlike the anti-money laundering directive, the regulation applies directly to all banks in each member state. It does not so much deal with the content of the crime, but with the actions that needs to be taken by banks and other payment institutions to enable law enforcement to find perpetrators. It is the result of recommendations of the financial action task force (see above). The regulation forces anyone (with some exemptions that are deemed low risk) that provides payment services to make sure that complete information on the payer accompanies the transfer of the paid funds, to ensure full traceability of all transfers of funds. This includes payments from and to third countries. Records have to be kept for five years by both the payment service provider of the payer and of the recipient (the payee), to enable checks on the past financial transfers of previously unknown suspects. Mifid also contains provisions that force investment firms (bank and non-bank) to act in a integrity based manner. This is accompanied by a record keeping obligation for five years on all transactions in financial instruments – either for own account or for the account of clients – to enable compliance with integrity based rules. Such integrity based rules include (but are not limited to) market abuse and anti-money laundering requirements. Each investment firm or specialised a trading venue also has an obligation to have internal governance arrangements to supervise breaches of market integrity rules (and of its own rules).93 Future Developments The market abuse directive is being reviewed. The Commission has published proposals to replace the current directive by a new regulation94, later amended to include prohibitions on benchmark manipulation95. The Commission proposes to expand the scope of the provisions to other trading venues and to over the counter (OTC, off exchange) trading. It also introduces attempted market abuse as a separate offence, and regulates benchmark indices manipulation. Political agreement was reached in June 2013. The Commission

92 Regulation on Information on the Payer Accompanying Transfers of Funds, 1781/2006. 93 Art. 25, 26 and 43 Mifid. 94 Commission Proposal for a Regulation on Insider Dealing and Market Manipulation (Market Abuse), COM(2011) 651 final, 20 October 2011, and Commission Proposal for a Directive on Criminal Sanctions for Insider Dealing and Market Manipulation, COM(2011) 654 final, 20 October 2011. 95 Amended proposals were published on 25 July 2013: COM(2012) 421 final and COM(2012) 420 final.

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EU Banking Supervision intends to align some aspects on scope and instruments with its proposals for Mifid 296. Benchmark indices will likely be regulated separately on issues relating to their governance and the integrity of the manner in which they are composed97. New proposals to replace and update the anti-money laundering/terrorist financing directive and for a regulation on the type of information that accompanies payments have been issued by the Commission in 2013, amongst others to deal with 2012 (worldwide) work of the Financial Action Task Force (FATF)98. Literature – Moloney, Niamh, EC Securities Regulation, 2nd ed., Oxford University Press, Oxford, 2008, chapter XII on market abuse – Alexander, R.C.H., Insider Dealing and Money Laundering in the EU: Law and Regulation, Ashgate Publishing Limited, Aldershot, 2007 – Gordon, Richard K., Losing the War Against Dirty Money: Rethinking Global Standards on Preventing Money Laundering and Terrorism Financing, Duke Journal of Comparative & International Law, vol. 21, 2011, page 503-565 – Reynolds, Carmen; Rutter, Mathew, Market abuse – a pan-European approach, Journal of Financial Regulation and Compliance, vol. 12 no 4, 2004, page 306-314 – CEBS-EBA, Mapping of supervisory objectives, including early intervention measures and sanctioning powers, 2009/47, March 2009, page 46-49

16.4 Trading Venue Safeguards Introduction Stock exchanges have gone through a tumultuous few decades. Even apart from the trading booms and busts, their status and organisation have changed. Instead of being semi-public authorities, providing services for the common good of their member organisations and society at large and with substantial supervisory tasks, they have been turned into share based, profit driven and competitive companies without public authority but instead subject 96 Commission, Statement by Commissioner Michel Barnier following today’s agreement on European rules on market abuse, memo/13/595, 26 June 2013. The initial proposals and the amendments on benchmark indices were published in October 2011 and July 2012; www.ec.europa.eu. 97 The Commission launched a consultation on 5 September 2012; www.ec.europa.eu. See e.g. ESRB, Macroprudential Aspects of the Reform of Benchmark Indices, 14 November 2012, on the systemic relevance of benchmarks such as Libor and Euribor. 98 Commission, Proposal for a Regulation on Information Accompanying Transfers of Funds, COM(2013) 44 final, 5 February 2013; and Commission, Proposal for a Directive on the Prevention of the Use of the Financial System for the Purpose of Money Laundering and Terrorist Financing, COM(2013) 45 final, 5 February 2013.

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to governmental supervision and oversight99. These markets have lost their traditional selfregulatory tasks – often enshrined in local laws – vis-à-vis their member organisations (bank and non-bank investment firms), issuing companies and investors. The EU has played a significant role in this shift, responding to minor and major trading and issuer scandals causing ruptures in the financial markets, and driven to some degree by a basic mistrust at the EU level of the extent to which self-interest in keeping markets trustworthy would drive stock exchanges and their members to or keep them from strict supervisory standards and enforcement thereof100. Trading platforms have been the subject of the investment services directive, since replaced by the markets in financial instruments directive101. Follow-up services (to finalise and execute trades) have been largely left unregulated until recently. The financial crisis provided a reason to lift the regulation thereof also to the European level. Banks (and non-bank investment firms) play a wide range of roles in the financial markets. The regulation of their role as an investment firm (and lender) has been described in chapter 16.2. These roles include market making, underwriting, and securities lending. In addition, they: – issue financial instruments (e.g. bonds or shares) either directly or via specialised groupentities, either for their own funding (e.g. securitisations, covered bonds or minority interests in subsidiaries) and/or for the management fees involved (e.g. UCITS); see chapter 16.5, – provide key services in the ‘back office’ of the financial markets, e.g. by providing management of trading venues, providing clearing and settlement services, and providing associated services that are covered by the investment firm description, such as market making). Markets in Financial Instruments Along with the supervision for investment firms, the initial 1993 investment services directive also contained rules for certain traditional and likely monopolist types of stock exchanges. These were named ‘regulated markets’, and were given a monopoly on information in any financial instrument listed on them. When the directive was evaluated and recast into Mifid in 2004, a key innovation was the introduction of measures to open up such markets to competition. Mifid continued to regulate investment firms and regulated 99 Also see E. Ferran, Building an EU Securities Market, Cambridge, 2004, chapter 7. 100 In the context of the Prospectus Directive 2003/71/EC, until 2011 the exchanges can be delegated scrutiny obligations of prospectuses, with end-responsibility retained by the supervisor. 101 The Investment Services Directive 1993/6/EEC was replaced by a regime for the three types of trading platforms in article 13, 14, 26, 27, 29, 30 and 36-47 Mifid. Also see ESMA Guidelines, Systems and controls in an automated trading environment for trading platforms, investment firms and competent authorities. Also see chapter 22.4 on the supporting systems on clearing and settlement.

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markets (see chapter 16.2), but allowed investment firms and market operators to compete for market share in the trading of financial instruments. Mifid modernised the regime for regulated markets, and introduced harmonised rules for two additional types of trading venues for financial instruments: so-called multilateral trading facilities and so-called systematic internalisers. These provide trading platforms in an organised manner. Only trading venues that offer trading services on a systematic basis are captured by Mifid. Any financial instrument can also be traded off-exchange; the so-called ‘over the counter’ or ‘OTC’ trades, and are out-of-scope of Mifid. However, regarding shares that are admitted to a regulated market, all transactions have to be reported (see below) under Mifid tradetransparency rules. Under a new regulation, some OTC trades will be forcibly moved onto trading platforms; see below. Please note that the term over the counter used in the counterparty credit risk rules for derivatives is a wider concept, also covering some exchangetraded derivatives; see chapter 8.4. Both regulated markets and multilateral trading facilities are defined as bringing together multiple buyers and sellers of financial instruments. Mifid subjects them to similar internal organisation requirements and supervision. A multilateral trading facility can offer trading in any financial instrument that is admitted to a regulated market as well as in instruments that are solely listed on the trading facility itself. The regime is roughly based on the organisations for small-caps or starter issuers that were present in some member states alongside (or by) the official stock market before Mifid. The requirements for regulated markets and multilateral trading facilities on internal structure rules are similar as both need to provide buyers and sellers with the same certainty that the prices and instruments offered are correct, up to date and that a trade is actually made when the venue says it is. The main difference between the two types of multilateral facilities relates to the issuers that are listed on them. For instance the transparency and prospectus directive place additional duties on issuers of financial instruments that trade on regulated markets102. Those rules on disclosure by the listed company to potential buyers and sellers are not mandatory when issuing financial instruments that are solely traded at multilateral trading facilities. The regulated markets concept embraces the former stock exchanges and those other markets that opt to only allow trading in financial instruments on which investors in their markets benefit from the highest level of transparency and protection. Issuers traded on regulated markets need to invest more in the initial and ongoing disclosure requirements as set out in chapter 16.5, and are confronted by supervision of both supervisory authorities under the EU rules described there and by supervision of the regulated

102 Also compare Rasdaq Market, Court of Justice 22 March 2012, Case C-248/11.

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market on such disclosure, as well as continued compliance with admission rules103. Issuers of financial instruments that are only traded on multilateral trading facilities generally opt to do so to avoid costs, to avoid having to provide so much information, and/or because their structure does not comply with the listing requirements (e.g. as to ownership structures) of regulated markets. Systematic internalisers are a separate category of venues, that were made subject to equivalent, but not proportionate, sets of rules (see for a similar set of too heavy rules for innovative ventures the initial e-money directive as mentioned in chapter 19.3). When negotiations started on Mifid, two interest groups lobbied regulators (domestic and European) heavily. The incumbent stock exchanges wanted to prevent new competitors, unless there was a level playing field in respect of regulatory demands. Banks and nonbank investment firms did not want to lead every client to the stock exchange (and to its trading, clearing and settlement fees), if the bank had and was willing to buy or sell the financial instruments the client desired to sell or buy. The stock exchanges won this particular battle. Though banks/investment firms nominally gained the right to trade internally, if it wants to do so regularly in an internal trading facility it becomes subject to heavy handed requirements. It has to set up a complicated structure and make and publish offers to buy or sell the financial instruments in which it wants to (going beyond its own clients). Pure incidental selling or buying directly from clients is still allowed, but as soon as it starts to occur systematically, both organisational requirements and trading obligations (to buy or sell) become mandatory. Some exceptions were negotiated, such as the buy and sell prices not being mandatory for orders of unusual size, but the intention of the banks to easily buy and sell directly from their own clients did not materialise. Though much was expected of these venues during the initial negotiations on Mifid, they never took off because of the relatively heavy regulatory burden put on them in the final version of Mifid. These burdens were never likely to be compensated by the expected benefits. The intended increased competition between trading venues could only be introduced if three conditions were fulfilled in addition to rules on how any trading platform should behave internally to create orderly, liquid and accessible trading possibilities. These relate to price finding, ensuring that competition is based on objective criteria and known prices, and access for clients to domestic and foreign trading venues and related services. Under the 1993 investment services directive the regulated markets could be given a monopoly per financial instrument under a national discretion known as the concentration rule. This had the benefit that most price relevant information on each financial instrument was

103 Art. 40.3-40.4 Mifid, of which there is no equivalent in the rules for multilateral trading facilities or systematic internalisers.

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available at a central location, and that local markets retained the liquidity to optimize price finding (supplemented by trade reporting). Regulated markets benefited commercially from this regulatory requirements to concentrate all trades in certain financial instruments on the stock exchange that had listed it. The concentration rule enabled price finding and allowed buyers and sellers to find each other more easily, but also handicapped any potential competition to bring down fees for trading related services104. This kept prices high, and participation of investors low. Abolishing the concentration rule and introducing competition between trading platforms to service trades in the same financial instrument, required increased transparency for prices on the one hand, and on the other hand an obligation for intermediaries in such trades (investment firms, regardless of whether they also own the/a trading venue) to obtain the best possible result for their clients. Mifid set out some aspects of these preconditions, in the form of an obligation on pre trade and post trade transparency, and in the form of a ‘best execution’ obligation put on intermediaries in executing orders in financial instruments: the investment firms. To enable price finding by investment firms (initially limited to shares admitted to trading on regulated markets), regulated markets and multilateral trading venues have to publish all orders they receive. Systematic internalisers have to publish firm quotes on such shares in which they offer this internal systematic trading (which adds a trading obligation to the disclosure obligation they have jointly with regulated markets and multilateral trading venues). Every transaction in shares that eventually takes place has to be published too, regardless whether it was executed on one of the three types of trading venues or off exchange (OTC). This post-trade transparency publication is in addition to being reported to competent authorities if it regards a financial instrument admitted to trading on a regulated market, as such information may be relevant for market integrity investigations; see chapter 16. 3. The post-trade transparency is an obligation of the firms either in the context of involvement in off exchange trades, as a systematic internaliser, as operator of a multilateral trading facility or as an intermediary in trades on regulated markets or multilateral trading facilities), but in practice the trading venues do this for trades on their venues (in which case the obligation of the firm is fulfilled too). This transparency obligation is riddled with exemptions, and is e.g. not applicable to the bond and derivatives-markets. Its exemptions on large trades of shares lead to the establishment of trading facilities that offer so-called ‘dark pool’ trading, where no transparency on new orders (size and price) need be provided, though the trades still need to be reported after they have been concluded (with some possible delays)105. 104 Art. 14.3 and 14.4 Investment Services Directive 93/22/EEC. 105 Art. 27-30, 44-45 Mifid. So-called ‘dark pool’ trading facilities make use of exemptions as contained in art. 27.1 4th sentence, 28.2, 29.2, 30.2, 44.2 and 45.2 Mifid. See e.g. Commission, Emerging Trends in the European Equity Market, D(2008), 4 November 2008.

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The best execution rule is described in chapter 16.2, and is applicable to all types of financial instruments. In addition to a client protection goal to establish fair dealing by the firm with its clients, it also forces investment firms that act on behalf of clients to go to the most efficient, competitive markets based on the criteria that are most important to the client. To be able to offer access to competitive markets to their clients, investment firms (bank and non-bank) in turn have to be allowed access to markets and clearing and settlement structures on the basis of objective criteria, and either within the context of their passport if they offer a wider set of services, or separately if the only service offered is executing a trade on the trading platform. These conditions intend to allow competition between trading venues on the basis of objective criteria instead of on relationship criteria, initially at least on shares (to which the transparency obligations are limited for the time being. If these elements are not taken care off, markets would fragment and lead to arbitrage opportunities for the firms, leading to worse results for the end-users instead of the intended better service and prices. The Commission intended to break the monopolies of traditional regulated markets, and drive down prices of trading and clearing and settlement services by introducing Mifid. Once a financial instrument has been admitted to trading by any regulated market, any other regulated market or trading venue can offer trading facilities for it, even if the issuer disagrees106. In the area of post trade services (clearing and settlement; also see chapter 22.4) this was followed by a code of conduct by central market infrastructures (lobbied for by the Commission). Based on these two documents, the old fashioned national stock exchanges are no more. They have merged across borders, and have been exposed to competition from multilateral trading facilities and from foreign and new domestic stock exchanges. Systematic internalisers have not taken off in the same manner, likely due to the controversial and costly obligation to publish binding prices in the context of pre-trade transparency107. The multilateral trading facilities and the related trading freedoms did have a positive effect for investors. Prices for trading (especially in shares) and for clearing have gone down (though not so much for settlement services)108. The Commission is, however, eager to further improve, as well as to fill in and expand the regime to other areas of the financial markets109. See below under future developments, and chapter 22.4.

106 Art. 40.5 Mifid. 107 For a description of the lobbying that resulted in this obligation see e.g. L. Frach, Evaluating the Efficiency of the Lamfalussy Process: the Prospectuses Directive, Takeover Directive and MIFID as Case Studies, Research Group on Equity Market Regulation REGEM Analysis 16, Trier University, February 2008; and N. Moloney, EC Securities Regulation, 2nd edition, Oxford, 2008, chapter 10 on order execution. 108 Oxera, Monitoring Prices, Costs and Volumes of Trading and Post-Trading Services (markt/2007/02/g), Report Prepared for European Commission DG Internal Market and Services, July 2009. 109 Commission, The Code of Conduct on Clearing and Settlement: Three Years of Experience, 6 November 2009.

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The multilateral trading facilities and the systematic internalisers are part of the chapter in Mifid on investment firms; they are basically services that can be offered by investment firms (including banks)110. The regulated markets have their own chapter (in continuation of the structure of the 1993 investment services directive)111. Where a regulated market cannot be a bank, the two new formats can be operated by banks, or indeed by any investment firm. Multilateral trading facilities can be operated by banks, and a bank can be a systematic internaliser. Admission to Trading or Listing Admission to trading at a regulated market under Mifid112 is used as a trigger for the prospectus directive (in addition to offers to the public) and for the transparency directive113. In addition a separate directive114 contains rules for the subset of the regulated markets that have retained official listings. It provides a form of protection against the regulated market for issuers that want to be listed. Admission to a list can provide additional liquidity for the financial instruments that are part of it, while the list is maintained as a monopoly by the regulated market, which creates inequality in the positions (especially in the preMifid period, when the stock exchanges and their lists were even more relevant). The prospectus directive and the transparency directive replaced part of the directive, but it still contains some of the requirements the regulated market can impose on admission specifically to official listing. These are geared to allow only higher quality and higher volume issuers to an official list (if offered) with its increased likelihood of investor interest. Regulated markets have to allow any issuer that fulfils those conditions to apply. Clearing and Settlement The above-mentioned Mifid-trading platforms are obliged to set up or make use of clearing and settlement systems. In follow up to the trades done on their markets, the clearing and settlement phase ensure a proper and quick payment versus delivery process. For this purpose a range of contractual and financial arrangements have been set up to reduce the size of the risks of non-delivery or non-payment of outstanding contractual commitments as agreed to when buying or selling an instrument on a trading platform; as well as to reduce the time period such risks are allowed to exist (i.e. shorten the time period between the trade and the delivery/payment). For most trading venues it involves a separate entity, 110 111 112 113

Art. 1.2, 4, 6, 14, 26-30, 33-35 and Annex I Mifid. Title III (art. 36-47) Mifid. Art. 40-41 Mifid. See e.g. art. 1.1 and 2 Prospectus Directive 2003/71/EC, art. 1.1 Transparency Directive 2004/109/EC, and art. 9 Market Abuse Directive 2003/6/EC. This is not always the sole trigger, the other trigger for the Prospectus Directive being offers to the public. 114 Admission of securities to official stock exchange listing requirements directive 2001/34/EC, and N. Moloney, EC Securities Regulation, 2nd ed, Oxford, 2008, chapter II.

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the so-called central counterparty to verify, take over and actively manage the risk (using amongst others collateral known as margin), via ultra-safe payment channels and delivery channels. Clearing and settlement systems reduce both credit risk and market risk for any trader. Banks benefit from reduced capital requirements for these risks if their exposures (open trading positions) are managed via a central counterparty. EMIR, the European market infrastructure regulation, contains requirements (a) for all central counterparties in clearing and settlement situations on exchange or off exchange, and (b) for OTC (over the counter or off exchange) derivatives trading. The process is key to financial stability, and further described in chapter 22.4. Clearing and settlement procedures are also used for other purposes. Dividends and interest are paid via its payment channels by the issuer to the current holder of the debt or share, and to ‘settle’ periodic payments due under long running financial instruments such as derivatives (e.g. credit default swaps). New Developments The Mifid is being reviewed, and some largely blank areas will likely be filled in by EU legislation in the near future. The Commission has issued proposals for Mifid II/Mifir, consisting of a new directive and a new regulation and replacing the current Mifid. This will expand the reach of market structure rules to all trading venues and over the counter trading; and expand transparency rules on e.g. post-trading transparency to other types of financial instruments115. Literature – Moloney, Niamh, EC Securities Regulation, 2nd ed., Oxford University Press, Oxford, 2008, chapter 10 on order execution – Ferran, Eilís, Building an EU Securities Market, Cambridge University Press, Cambridge 2004

16.5 Disclosure Obligations to Clients and Markets Introduction Several EU laws contain disclosure obligations for banks. Some information has to be given to specific clients, other types of information has to be made available to everyone in the

115 Commission Proposals for Mifid II and Mifir, COM(2011) 656 final respectively COM(2011) 652 final, 20 October 2011. CESR/ESMA, Transparency of Corporate Bond, Structured Finance Product and Credit Derivatives Markets, CESR/09-348, 10 July 2009. E. Ferran, N. Moloney, J.G. Hill & J.C. jr. Coffee, The Regulatory Aftermath of the Global Financial Crisis, Cambridge, 2012, page 154-182.

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market. Information provision can have the goal to protect or help the recipient of the information, or to introduce an element of market discipline as a restraining or healthy influence on the bank. In this chapter all disclosures that are non-prudential in nature are discussed. For disclosure to specific clients it focuses on those obligations that are (also) applicable to banks when they provide those services. Examples include the information provision on investment services (for the content of such services see chapter 16.2) and the role of the bank when it operates as an insurance intermediary (for the content of such services see chapter 16.6. The regime for disclosures to the wider market informs counterparties, clients, investors and anyone else who is interested in the company. Market disclosure regimes include disclosures made by any company under company law/accountancy/corporate governance rules (see chapter 6.4 and 13). The financial markets disclosure regimes expand on the basic disclosures that apply to any company under its national regime, by e.g. requiring a prospectus. Banks will need to fulfil such obligations when they perform the activity that has been made conditional on disclosure (e.g. managing or providing safekeeping services to investment funds), but they will likely also need to check disclosures made by their clients when the bank for example advises or underwrites an issuance of financial instruments by such clients. The market disclosure regimes are different in the context of individual investments (shares or bonds issued by an industrial group), and for collective investments (by UCITS, AIFM or other collective investment institutions); see chapter 16.2. In two prudential laws disclosure requirements have been introduced to support the prudential goals. The deposit guarantee and investor compensation directives oblige banks to publish information on the scheme(s) they are a member of116. The directives prescribe that such publication cannot be used as a marketing tool, though especially for smaller or foreign banks such membership and the knowledge that the bank is a member possibly is mandatory to gain the trust of sufficient numbers of depositors (reducing such a provision to an example of either an empty-headed EU requirement or as a limit on too blatant advertising with the slogan ‘if we do not pay you back, the other banks will’). The nonadvertisement provision was especially important for the deposit guarantee directive when the protection levels across the EU were widely divergent (ranging from 20.000 euro to over 100.000 euro). As the level of the deposit guarantee has been harmonised it has become

116 See chapter 18.5. Under the ESMA Regulation the investor compensation directive has been formally allocated to ESMA, but the directive is essentially prudential in nature as it ‘guarantees’ a full payment of the financial assets that have been entrusted to the bank.

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less relevant, but this rationale still applies to the investor compensation directive, that has not yet been harmonised. The CRD introduced a disclosure in the form of pillar 3 as part of the Basel II amendment; see chapter 15. The CRD does not contain an obligation to inform the client if certain types of accounts or bonds are not covered by the depositor protection scheme (e.g. some types of subordinated accounts or membership certificates) or are not suitable for the client, though this might be useful for clients when making investment/savings account choices117. Market disclosure rules overlap with similar issues as the misleading and comparative advertising directive, and the Mifid marketing rules (see respectively chapter 16.6 and 16.2). Originally, the advertising directive was a consumer and traders protection directive, but the consumer protection aspects have been transferred to the unfair business-to-consumer commercial practices directive (see chapter 16.6). It now protects traders and competitors against misleading advertisement campaigns, and lays down the conditions under which comparative advertising is permitted. An advertisement is misleading if: – it deceives or is likely to deceive the persons (consumers, traders or others) receiving it or to whom it is addressed, and which deception is likely to affect their economic behaviour; or – is likely to injure a competitor. Member states are required to ensure that adequate and effective means exist to combat such misleading advertising, and to ensure compliance with the provisions on comparative advertising. The prospectus directive requires issuers who want to attract (additional) capital (bonds, shares, or other financial instruments) either from the public or which financial instruments will be traded on a regulated market as defined in Mifid to publish a prospectus. In addition, any issuer traded on a regulated market falls under an ongoing disclosure obligation, in order to keep the information granted in the prospectus up to date. These obligations provide opportunities to use a prospectus as a marketing tool, or to present information in a misleading manner, to entice customers who would not otherwise be interested. The sometimes rather extensive lists of information to be provided and the generic obligation to not be misleading help dampen potential abuse. They also help in making prospectuses and other disclosure documents less than interesting to read for the average investor. Nonetheless, public market disclosure helps to level the playing field as to available information, and thus in principle allows prices to reflect complete and updated information when processed by/via those few analysts and advisors who do read 117 Miss-selling issues arose in the DSB case in the Netherlands where ‘subordinated account’ holders had not understood the meaning of the word ‘subordinated’, and in the Bankia case in Spain, where investments in bonds issued by the new Bankia were riskier than anticipated by the retail clients to whom they had been marketed.

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them. They also protect buyers of shares or bonds against (unknown) conflicts of interest and controlling interests in the issuer (and other ‘agency’ problems)118. Banks are subject to disclosure requirements in various roles: – they issue financial instruments themselves (to finance their operations with new capital and/or new bonds); – they advise issuers of financial instruments on such issues and the ongoing obligations after an issue; – they underwrite initial public offerings of financial instruments, with or without a guarantee that the full offering will be taken up by the markets; – they provide services to or own management companies and depositories of investment funds; – they invest in financial instruments and are thus the beneficiaries of the information to be provided. Client Focused Information Provision on Investment Services/Activities Mifid sets out obligations for investment firms (bank and non-bank) when providing investment services to clients and performing investment activities. Obligatory disclosure to the (potential) client includes119: – information in a durable medium on the status of the client (retail, professional or eligible counterparty), though other disclosure protection is given only to retail clients and professional clients; – all information given has to be fair, clear and not misleading, also see ‘fair treatment’, with specific details provided for retail client protection in the Mifid level 2 Commission directive on issues such as obscuring important items/warnings, comparative advertisements, statements about past or future performance; – marketing information has to be clearly identified, and consistent with information given to clients on the actual provision of services; – comprehensible information on the firm and the services and financial instruments it wants to provide the client with, including about costs and associated charges (with added detailed requirements for retail clients); – clear information on segregation of assets, especially if third party safeguarders are involved; – clear warnings if the ‘appropriate’ test is not or cannot be made in full; see chapter 16.2;

118 E. Ferran, Building an EU Securities Market, Cambridge, 2004, chapter 4. 119 Art. 1.2, 19, 22, 24 Mifid, art. 3, 26-33, 39-43, 45-48 Mifid level 2 Commission Directive 2006/73/EC. For the trade-transparency rules, see chapter 16.4.

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– complete information in a durable medium on the execution policy that will be applied on orders of or on behalf of the clients (to which the client has to consent; see chapter 16.2) and updates if changes are made, including e.g. information on the trading platforms used, whether that includes off exchange trading or systematic internalising, and a warning that a specific instruction of the client will exonerate the firm from claims of less than good execution; – a document containing the rights and obligations of the client has to exist, specifically a basic written contract if it concerns a retail client. The firm is required to provide the document – with some variations on the content – to retail and professional clients ‘in good time’ before services are rendered. The client has to receive a report on the services provided, including information on the costs for the client, and has to be informed in good time of any changes in the contract; – if there are (acceptable) third party inducements (fees or benefits given or received), they have to be disclosed completely and clearly to the client prior to the service being provided; – transactions have to be reported in a durable form to the client, promptly unless it concerns portfolio management, in which case it has to be reported periodically (in combination with prompt warnings on any losses over agreed thresholds); – if there are relevant problems in order executions, the client has to be informed promptly, as well as when order aggregation may affect him (with a warning on potential negative consequences); – if a firm holds money or assets of the client, a statement on his property has to be sent at least once a year in a durable form; – in the context of trade-transparency to enable price-finding for financial instruments, firms and/or market operators also have to publish pre-trade information and posttrade information on shares offered or sold to clients (see chapter 16.4); – if there is overlap with obligations to provide information to the client between Mifid and other EU rules, the other rules take precedence. In addition, Mifid requires regulated markets to check that disclosure requirements are complied with (on top of the supervision that applies directly under the prospectus directive and transparency directive)120. Client Focused Information Provision on Payment Services The payment services directive sets out obligations for payment services providers (when providing payment services to clients). The directive applies to for instance current accounts and all associated cash and transfer activities, or similar actions relating to spending money 120 Art. 40.3-40.4 Mifid.

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under credit lines, issuing/acquiring payment instruments, money remittance and some mobile banking services, but for the conduct of business rules only if both sides of the transaction are based in the EU, and the transmission is made in a currency of a EU member state121. Banks that performs such services (e.g. by managing a current account, or making a transfer from a savings account are subject to the conduct of business obligations. They benefit from an exemption for the licensing and prudential requirements of that directive, which only apply to payment institutions that are not banks, post offices, or public authorities122 Obligatory disclosure to the (potential) client is different if it pertains to a single transaction (for instance when a tourist walks into a money transfer office), or if there is a framework agreement between the service provider and the client (e.g. when a client has a bank account at a bank). For single transactions, it includes123: – prior to the agreement information in an easily accessible manner on amongst others (i) a unique identifier or other specific information that is needed for the transaction to be executed (ii) the maximum execution time, (iii) all charges payable by the user to the service provider, and (iv) information on the actual exchange rate; – after the agreement, information has to be given both to the payer and to the recipient of the payment on the amount of the payment, a reference that allows the payment to be claimed, the exchange rate when applicable and the relevant dates for interest calculation. If the service provider and the client agree on a framework agreement on payment services a wider set of information is to be provided, amongst others on the service provider, on the services provided, on the interest rates applied, on the methods of communication, and on safeguards and corrective measures. The latter set out what happens if something goes wrong (for instance as a result of fraud, or data-theft), on redress, and on changing and terminating the framework agreement. Limits on the type of arrangements apply, such as on termination possibilities for both the service provider (possible, but with a minimum of two months’ notice) and the client (always possible with a maximum of one month notice), and the maximum amounts of own risk for the client; see chapter 19.3. Ex ante information on a specific transaction can still be requested but is otherwise not obligatory, but the information that has to be provided after each transaction is similar to the information on single transactions. At the request of the client, the information has to be given in a durable medium124.

121 Art. 1-4 and the Annex of the Payment Services Directive 2007/64/EC. 122 Art. 1 and 10 Payment Services Directive 2007/64/EC. See chapter 19.3 on the licensing/prudential regime for the payment institutions. 123 Art. 30-50 Payment Services Directive 2007/64/EC. 124 Art. 36 and 43 Payment Services Directive 2007/64/EC.

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The contractual parties can deviate from these protections if the client is not a consumer (nor a micro enterprise if the member state implements this national discretion). Partial exemptions apply to low-value payments, but what low-value means is subject to a national discretion and depends on the exact service provided. This varies between zero up to 300 euro (for prepaid instruments up to 500 euro)125. Client Focused Information Provision on Insurance Products (Insurance Mediation) For insurance mediation, banks will need to comply with the insurance mediation directive as implemented in their member state; see chapter 16.6. This includes an obligation to provide information to the customer on how free and fair he is to advise the customer. Specifically this includes information on any contractual ties or substantial investment ties to the insurer, and whether the intermediating bank will include a sufficiently large number of insurance contracts on the market to be able to give a ‘fair analysis’ of the options of the client. In addition information has to be given on name, registration as an insurance mediator, and on the complaints procedures and out-of-court redress systems available. Exceptions apply to reinsurance mediation and insurance of large risks. All information given has to be on a durable medium (paper, e-mail, disc) so that it continuous to be available to the customer, and has to be clear, accurate, as well as comprehensible to the customer126. If the contract is sold via telephone, the protection given normally only to consumers under the distance selling of financial services directive is extended to cover all such costumers of insurance mediators127. General Disclosure to the Market: Attracting Repayable or Investment Money (Not As a Fund for Collective Investments) Any company has several options to attract funds. The incorporator or other closely related persons can give it money in exchange for shares, bonds or as a normal loan/deposit. Third parties can also choose to invest in it either by giving a loan, by buying its bonds or its shares when issued128. Banks can give loans, buy bonds or shares. They are in the business of doing so, and assessing the likelihood of a return of the sum invested and any extra compensation. But companies can also opt to attract investments from other third parties. If they do so in the form of a loan, the prohibition (and exceptions) described in chapter 4 and 5 applies. Middle to large companies (both commercial, industrial or financial companies), have the option to attract funds from financial markets (for most small firms

125 Art. 30 and 34 Payment Services Directive 2007/64/EC. 126 Art. 12 and 13 Insurance Mediation Directive 2002/92/EC. 127 Art. 13.3 Insurance Mediation Directive 2002/92. See chapter 16.6 on the distance selling of Financial Services Directive 2002/65/EC. 128 Or buy such loans, bonds or shares from the original investors, and thus take over their claim on the primary issuer.

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this will be too costly). Companies will choose their preferred source of funding or mix of such sources depending on the costs of the funding, the type of funding needed (e.g. capital or loans), the amount of funding needed, the size of the company, and benefits from diversifying the sources of funding, and cultural preferences129. Companies that want to attract investors (shares/bonds/loans) have gradually been subjected to either requirements to disclose or to prudential supervision (see chapter 5.6 and 19). Along with regulation of the content of the contract with investors/clients, disclosure obligations have been selected both as an alternative to prudential rules (e.g. for companies that want to issue shares, but otherwise do not have a financial business), and to complement prudential rules (e.g. the pillar 3 rules or when investment firms advice clients). If the company fulfils the most far reaching disclosure conditions in the form of a prospectus, they may even be allowed to attract repayable funds in the form of bonds or shares from non-professional investors that they otherwise do not have a relationship with (see the definition of ‘public’; chapter 4.4 and 5.6), in direct competition with deposit taking activities of banks. Issuers can also choose to not fall under the disclosure requirements of the prospectus directive, the transparency directive and the market abuse directive by opting to be traded only on multilateral trading facilities or at systematic internalisers130, or by structuring the deal in such a way to benefit from one of the exemptions available in these directives. Issued bonds of a higher denomination than 100.000 euro are for instance exempted from the prospectus directive and some periodic reporting131. However, in practice, the disclosure made by companies (voluntarily, but sometimes necessary in order to solicit interest in the market) that do not fall within the binding prospectus obligation sometimes go as far or further than the requirements of the directives132.

129 Also see E. Ferran, Building an EU Securities Market, Cambridge, 2004, chapter 2. 130 These directives predate the Mifid. As they were focused on the type of Investment Services Directive securities markets replaced by the ‘regulated market’ concept (though the Prospectus Directive also focuses on any type of security issued to the public). See E. Ferran, Building an EU Securities Market, Cambridge, 2004, page 185-188 and 198, and N. Moloney, EC Securities Regulation, 2nd ed, Oxford, 2008, page 135. Art. 1.1 and 2 Prospectus Directive 2003/71/EC, art. 1.1 Transparency Directive 2004/109/EC, and art. 9 Market Abuse Directive 2003/6/EC. 131 Until recently this exemption applied to bonds issued in denominations of 50.000 euro and higher. Relatively unsophisticated investors bought such bonds – and lost substantial amounts of money during the crisis or in less than savory investments – and the protection was upped to 100.000 euro during the 2007-2013 subprime crisis. Art. 2, 3 and 8 Prospectus Directive 2003/71/EC and art. 8 Transparency Directive 2004/109/EC as amended by Directive 2010/73/EU. 132 Also see E. Ferran, Building an EU Securities Market, Cambridge, 2004, page 36.

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The relevant directives are the prospectus and transparency directives133. These require institutions that want to attract funds from third parties as investments or loans via the issuance of financial instruments to publish information. That information is intended to be available for the perusal and evaluation by all current and potential buyers of such financial instruments. The market abuse directive discussed in chapter 16.3 intends to establish fair conditions for competition on the financial markets, amongst others by preventing banks and other players on the financial market to take advantage of unfair trading practices including of information that is not available to all potential investors. It contains an additional transparency obligation. All relevant inside information has to be disclosed as soon as possible, unless there is a specific and legitimate reason not to publish; see below. As noted above, a separate set of directives for disclosure by financial institutions if they want to use the funds attracted to invest them in other assets as a collective investment fund, see below on the UCITS and AIFM directives. The market abuse directive, the prospectus directive and the transparency directive (as well as the UCITS, AIFM and Mifid) have been issued when the Lamfalussy structure had already been introduced in the securities sector; see chapter 2, 3 and 23.3. They are designed to benefit from a split in framework principles (level 1, in the Council and Parliament directives) and technical requirements that can easily be amended (level 2, in Commission directives and regulations or standards that are based on ESMA proposals), combined with level 3 non-binding guidance and convergence work (from ESMA/CESR). The prospectus directive (and the level 2 Commission regulation) set out the following134: – an obligation for issuing institutions to publish a prospectus for any initial public offering and for all subsequent additional offerings of transferable securities (unless the last prospectus is less than one year old), if (i) the transferable securities will be admitted to trading on a regulated market, (ii) they are offered to the public; which at the option of the market parties involved is often allowed in a language that is generally used in financial markets (i.e. currently in the EU English); – apart from containing all information that an investor needs to make an informed assessment of the issuer and the transferable securities offered, the prospectus has to contain a summary that explains succinctly and in non-technical language the key information on the issuer, any guarantor and the transferable securities offered135;

133 Prospectus Directive 2003/71/EC; Transparency Directive 2004/109/EC. 134 Prospectus Directive 2003/71/EC, and level 2 Commission Regulation 809/2004 (as amended). Banks benefit from exemptions if they issue certain types of senior ranking bonds; see art. 1.2 sub f and j Prospectus Directive 2003/71/EC and chapter 5.6. 135 This obligation was amended by Directive 2010/73/EU, to make the key information more useful for investors, and reduce the use of this part of the prospectus as a liability limitation exercise.

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– the approval is subject to the supervisor being of the opinion that the prospectus is complete, including consistency and comprehensibility under harmonised criteria (and thus does not include a quality assessment as to the accuracy of the information); – the approval has to be given in ten working days, but lack of decision does not constitute an approval; – after the approval, the prospectus functions as a passport to the other member states, which have the obligation to accept the issued instruments being traded in their local markets. They cannot require translation of the prospectus, except for the summary thereof, unless the original language is not a language generally used in financial markets; – the prospectus needs to be updated after approval; – there are substantive exemptions available for e.g. (i) off-regulated market debt issuance to the large and sophisticated ‘qualified investor’ sector, which apart from vetted investors also is assumed136 to be the case if a debt instrument can only be bought with a minimum investment of 100.000 euro137 (wholesale bond market) (ii) offerings of participations in UCITS and other open-ended collective investment undertakings (for the UCITS as there is a separate regime, for non-UCITS because these are unregulated at the EU level), (iii) debt offerings by public authorities, (iv) small offerings, up to a value of 2.500.000 euro per year, and (v) certain continuous debt offerings by banks, that are not subordinated, convertible or exchangeable, and are not linked to derivatives, if either they are covered by the deposit guarantee directive, or are of a limited total issue value per year; – in addition to the ongoing requirements of the transparency directive (see below), for transferable securities admitted to trading on a regulated market an annual overview of disclosures has to be published; – civil liability of the person responsible for the prospectus and/or its summary is both harmonised and limited in the directive. The civil liability of the supervisor, if any, is left to national law138;

136 If a non-qualified investor buys such an instrument, it may trigger a prospectus obligation, unless the offer is made to less than 150 natural or legal persons per member state, other than qualified investors, and unless the offer cannot be bought in smaller than 100.000 euro stakes. Article 13 Prospectus Directive 2003/71/EC. See N. Moloney, EC Securities Regulation, 2nd ed, Oxford, 2008, page 141-143. These rules apply to the issuer. If advisors or intermediaries are involved, they will be subject to the conduct of business rules set out elsewhere in this chapter 16 (e.g. whether they should advice positively or execute the order of the nonqualified investor). 137 Article 13.2 Prospectus Directive 2003/71/EC, as amended by Directive 2010/73/EU. The prospectus obligation thus does not apply to large denomination equity offerings, though the issuers of those do benefit from a further relaxation in the language regime, where it becomes easier to opt for a language generally used in the financial markets, and a summary is only required if locally ‘goldplated’. 138 A review of liability regimes is expected by 2016; art. 4 Directive 2010/73/EU.

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– proportionality rules for instance small- and medium sized enterprises have been made more explicit in 2012139. The Transparency directive (filled in by the related level 2 Commission laws set out the following: – an obligation to ensure a regular flow of information to ensure transparent and efficient financial markets (limited to regulated markets), as well as the protection of investors; – an issuer is required to periodically publish information, including: (i) within 4 months after the end of the financial year to publish annual accounts, and keep them publicly available for five years, (ii) within two months after the first six months of a financial year to publish half yearly financial reports, and keep them publicly available for five years, (iii) interim management statements to fill in the periods in between these publications, with information on material events and transactions, as well as a general description of the financial position and performance (also see chapter 16.3 on the market abuse directive); – notification obligation for major holdings in a listed issuer; – an issuer is required to publish specific corporate information when it comes up, including for example rights to shares, rights to dividends, or the location, time and agenda of the general meeting; – of all information that is published, a copy needs to be sent to the supervisor at the same time. Unlike the full minimum and maximum harmonisation at Mifid and the prospectus directive, the transparency directive contains minimum harmonisation only. Member states can thus ask for more or more frequent publication of information. General Market Disclosure: Collective Investments Undertakings (UCITS and AIFM) The Undertakings for Collective Investment in Transferable Securities directive is a specific form, mixing disclosure requirements with investor-focused conduct of business requirements and a limited form of prudential supervision; see chapter 16.2 and 19.5. The UCITS IV directive has replaced the previous regime as per 1 July 2011. Apart from housecleaning (deleting obsolete provisions, modernising the language and references, introducing the Lamfalussy style split between level 1 and 2 legislation), it replaced the simplified prospectus by a key investor information document in a format that can be easily adapted at level 2. Marketing rules (and translation rules) have been brought more in line with Mifid respectively the prospectus directive.

139 Introduced by Directive 2010/73/EU.

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Like Mifid and the market abuse directive, the UCITS and AIFM directives are not pure disclosure laws, but combine organisational requirements (and conduct standards; see chapter 13.4 and 16.2) with transparency. The UCITS directive requires the following:140 – a prospectus has to be provided for each fund and published as well as provided to investors on request and for free. The prospectus has to include all information needed for an investor to make an informed judgement on the investment and its risks, and a clear and easily understandable explanation of the risk profile. The prospectus amongst others has to include information on links to a master UCITS funds, the type of investments and whether that includes derivatives, valuation, units and rights, and price determination. The prospectus has to be kept up to date on its essential elements; – a key investor information document has to be made and clearly identified as such. It has to be concise and non-technical, but still include the essential characteristics of the UCITS, and should allow investors to reasonably understand the nature and the risks of the UCITS, without reference to any other document. It should thus – like the summary of the prospectus directive – enable investors to make investment decisions on an informed basis. It has to be provided to potential investors for free and in good time before that purchase. After the investment, it has to be provided for free on request (and made available on the website). The key investor information document has to be kept up to date on its essential elements; – annual and half-yearly reports for each fund have to be published within four months and 2 months respectively, and the latest version has to be provided to investors on request and for free; – each time the fund trades in units, the price has to be published (but at least twice per month, unless it has supervisory permission to only publish it once per month); – marketing information has to be clearly identified, and still be fair, clear and not misleading, and in line with the prospectus or the key investor information document; – if the fund mergers with another, the investors have to be provided with sufficient information to either agree or exchange their units for cash. The AIFM directive contains few information rights of the general public. It basically refers to the obligation to provide information if it is already applicable. Most information provision is obligatory only to current and prospective investors. Such (minor) additional obligations include an obligation to have e.g. an annual report for each managed fund separately. The obligations include141:

140 Art. 43, 63, 68-82 and Annex I UCITS Directive 2009/65/EC and the level 2 rules based on this directive. 141 Recital 60, art. 12.1, 14.2, 19.2, 19.3, 21.10, 22, 23, 28, 29, 43 AIFM Directive 2011/61/EU.

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– an obligation to provide a prospectus under the prospectus directive if that applies, or at least provide investors with information on amongst others the investment strategy and objectives, its procedures, the identities of various service providers and the rights of investors, any leverage, prior to any investment by the investor; – update the above information on liability, organisational issues and risk profile, as well as leverage regularly; – the manager has to make an annual report for each AIF it manages or markets in the EU an annual report, within six months, that has to be provided to investors if they ask for it, even if there is no applicable company law obligation to draft an annual report. It has to contain amongst others additional information on remuneration paid; – to provide current valuations to investors (if the applicable alternative investment fund rules similar documents so provide); – not to give an unfair advantage to one investor to another, unless pre-announced and disclosed; – to disclose to investors conflicts of interests; – disclosure on and to controlled companies; and – additional disclosure that may be mandated by national legislators if and when the fund can be marketed to a retail clients in a member state. Market Abuse Prevention by Additional Disclosure/Transparency Demands Apart from prohibiting insider dealing and market manipulation, see chapter 16.3, the market abuse directive142 also contains market disclosure provisions. The idea is that full disclosure of trade sensitive information and of transactions that skirt close to being market manipulation (e.g. price stabilisation) helps to prevent insider dealing and market manipulation to take place at all. The market abuse directive requires that all inside information is published promptly unless an exemption applies; see chapter 16.3). A key exemption for publication of inside information is available for information that fulfils each of the following conditions (i) the publication would damage the legitimate interests of the owner of the information, (ii) it can be kept confidential, (iii) the public is not mislead by its not being published, (iv) the information has not been given (intentionally or unintentionally) to someone who does not owe a duty of confidentiality. Is Ex Ante Disclosure Effective? While ongoing disclosure is relatively uncontroversial (information on the positions of insiders in the company, current financial information and publication of inside information

142 Art. 6 and 9 Market Abuse Directive 2003/6/EC and associated level 2 legislation; see chapter 16.3 on the market integrity aspects of this directive.

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serve price finding movements in the secondary markets), the usefulness of ex ante information in the form of the major prospectus or similar information provision mandated in the UCITS directive, the AIFM directive and the Prospectus directive is less clear. The major effort put into such prospectus/information provision prior to financial instruments being issued appears to be targeted more at liability reduction for the issuer as well as the banks, lawyers and accountants involved in the issue143. If the prospectus or key information is correct and the client belongs to a category that can be targeted (for the UCITS and prospectus directives this is the wider public), there is no obligation of the issuer to assess whether the investment is appropriate and suitable for the specific investor. This transfers the risk of unsuitability to the client. If the client is assisted by an investment firm (bank or non-bank) the test for appropriateness and suitability is made by the investment firm, if and in as far as the client is part of one of the protected categories of client; see chapter 16.2. It is accepted/standard market practice that the publication of the final prospectus is almost simultaneous with the issue itself. Few professional buyers and even fewer retail clients read the legalese and technical language contained in the final approved prospectus or its previous drafts, except ex post if the company or the issue fails and litigation ensues. This is true also of the flood of detailed annual accounts and other information updates that the companies, investment funds and banks unleash upon the world. The information often serves as a tool in litigation when the issuer fails or has lied in a manner that impacts on the value of the issued financial instruments, and probably as a tool for self-discipline. This is not, however, the conduct of business goal it purports to have. This goal is that (retail and other) clients will make better informed decisions, or fully aware that they are taking a risk. With the short time period between publication and buying execution, let alone decision, and the lack of interest in the prospectus at such times, this goal does not appear realistic. This on top of concerns that the increasing flood of regulation-mandated information – under the axiom of more is better and based on rather unrealistic assumptions on the efficiency of markets – actually results in information overload, instead of in better decisions144. Whether self-discipline and liability protection is sufficient value to compensate for imposing such a threshold to market entry is up to legislators. More value is likely contained in the key investor information (a short prospectus) that is mandated in e.g. UCITS and the value of which was increased in the prospectus directive amendment of 2010, but its usefulness will in due course have to be proven by actually being used by the targeted groups, i.e. primarily by retail investors.

143 See e.g. E. Wymeersch, The Institutional Reforms of the European Financial Supervisory System, an Interim Report, Universiteit Gent Financial Law Institute WP 2010-01. 144 T.A. Paredes, ‘Blinded by the Light: Information Overload and its Consequences For Securities Regulation’, Washington University Law Quarterly, Vol. 81, 2003, page 417.

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New Developments The transparency directive will be amended. The Commission has issued proposals to e.g. limit the quarterly publication of financial information for small- and medium sized issuers, simplify the narrative parts for such issuers, and harmonise the reporting of direct or potential stakes in listed companies, and provide minimum and maximum harmonisation for several other elements of the transparency regime145. Political agreement was reached in May 2013, making it likely to be implemented by member states and become effective in 2014/2015146. UCITS is simultaneously under two reviews, one relatively short term, one relatively long term. Both will likely impact on the information provided to (potential) clients; also see chapter 16.2. Simultaneously, in the context of the packaged retail investment products initiative, the Commission has proposed to expand an obligation to have key investor documents (as known from the current UCITS directive) to other complex investment products regardless of their legal form147. Literature – Ferran, Eilis, Building an EU Securities Market, Cambridge University Press, Cambridge 2004 – Moloney, Niamh, EC Securities Regulation, 2nd ed., Oxford University Press, Oxford, 2008, chapter II and III

16.6 Customer Protection on Financial Products Introduction Supplementary to the MIFID rules on protection of the customers that make use of investment services (see chapter 16.2; e.g. fair dealing and the duty of care on such investment services), there are several directives that protect customers of financial services in specific circumstances; related either to buying a financial product, or against a financial trader. The consumer credit directive contains rules on the core business of banks (attracting repayable funds from the public and lending it to others, including to consumers). Other consumer directives may also be relevant to the wider set of activities 145 Proposal for a Directive to amend the Transparency Directive 2004/109/EC, COM(2011) 683 final, 25 October 2011. 146 Commission, Statement by Commissioner Michel Barnier welcoming the agreement reached on the revision of the Transparency Directive, 30 May 2013. 147 Commission, Proposal for a Regulation on Key Information Documents for Investment Products, COM(2012) 352 final, 3 July 2012. Any product related to investments is covered, except for a limited list of exceptions, such as simple deposits or plain shares and bonds; see art. 2 and 4 of the proposal.

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allowed to banks under their license; see chapter 5.2. Most of these directives only protect consumers; instead of the wider category of retail clients such as small- and medium sized enterprises that enjoy the same level of protection under e.g. Mifid. Any directive giving rights to consumers is interpreted strictly by the Court of Justice (i.e. giving a wide interpretation to the protection given, and a limited interpretation to any restrictions to the protection)148. To benefit from it, a person first has to be a consumer nonetheless, meaning that – even if he has a business – for the contract to be deemed a consumer contract it needs to be related almost exclusively to issues outside of his trade or profession. If a contract e.g. has a mixed business and private purpose, the business purpose has to be truly negligible for the private person to benefit from consumer protection149. Neither consumer protection nor – by extension – client protection provide protection against not paying attention, or being gullible. The Court of Justice has indicated that the rules that protect consumers assume a consumer that is reasonably circumspect in his buying behaviour150. Protection that goes further can limit the single market too much. The problem – similar to problems with public disclosure legislation discussed in chapter 16.5 – is that many consumers do not show such circumspect behaviour and trust in the fairness of the markets and their counterparts151. It presumes an investment of time, an ability to understand, a willingness to combat service providers, and the availability of funding to follow-up. Such assets may not be available to a wide range of consumers and clients. The consumer protection legal basis used for the targeted consumer rules was only introduced in 1993 into the TFEU at the time of the Maastricht treaty amendment, in addition to the single market freedoms on which prudential and client protection rules have been based152. Previous efforts at securing protection for either clients or consumers thus had to be based on different legal basis in the treaty, leading to a varied approach and range of protection, ranging from trade distortions to conduct of business protection under (the predecessor to) Mifid. Granting credits across borders falls both within the scope of the free movement of capital and the freedom to provide services153. 148 See e.g. Heininger/Bayerische Hypo- und Vereinsbank, Court of Justice 13 December 2001, Case C-481/99. 149 Johann Gruber/Bay Wa AG, Court of Justice 20 January 2005, Case C-464/01. 150 Verein gegen Unwesen in Handel und Gewerbe Köln Ev/Mars GmbH, Court of Justice 6 July 1995, Case C470/93. As a result, possibly misleading packaging advertising that is legal in a member state has to be accepted by the host member state as otherwise it would hinder intra-EU trade. 151 S. Weatherill, ‘Consumer Policy’, in P. Craig & G. De Búrca (Eds.), The Evolution of EU Law, 2nd Edition, Oxford, 2011, chapter 27. 152 The current art. 169 TFEU that explicitly covers consumer protection entered into force in 1993 as a result of the 1992 Maastricht Treaty, supplementing general protections focusing e.g. on the cross border freedoms. 153 Fidium Finanz, Court of Justice 3 October 2006, Case C-452/04. It depends on the concrete provision contested which of the freedoms is dominant; see chapter 5.3.

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The consumer credit and mortgage credit areas cover both financial services and consumer interests. After a lengthy ‘debate’ it was decided that on these areas the protection of specifically consumer interests were dominant instead of the financial services and markets component. As a result, these are being handled not by the Markets directorate of the Commission but by the DG Health and Consumers, Consumer Affairs. The distance marketing of financial services directive was also allocated to this part of the Commission subsequent to its initial negotiation in the markets DG. Apart from the implementation of targeted directives in national rules, the protection of customers of banks can also be derived from direct effect provisions in the treaties and in regulations and directives, see chapter 3.5. Such protection is general, and can protects consumers, other retail clients and professional clients of banks, as well as banks themselves, depending on whom the provision that has direct effect is intended to protect. Other examples of protection of clients of banks are: – the right to the minimum amount guaranteed in the deposit guarantee directive given to all retail clients (consumers and small- and medium sized enterprises; see chapter 18.5); – limitations on discriminating tax treatment in e.g. dividend pay-outs by or via banks. Member states have substantial freedom in tax matters, but clients can invoke the treaty freedom on e.g. capital. Different treatment of nationals and non-nationals from other member states is possible if the situations are objectively comparable, or where necessary for overriding public interest. Both these grounds are narrowly interpreted154; – both larger clients and the banks profit from the freedom of establishment and services, that allow them to offer or to seek services in other member states, even if the bank has not sent a notification under the European passport to the member state where the client is based. A EU company can have a bank account in any member state to deal with its own or foreign governments, banks can offer the service for government dealings, with any bank you desire for all non-consumers, and banks are guarded from limitations in unfair competition when providing such services155; – the protections offered to clients as described in chapter 16.2-16.5. Consumer Credit The consumer credit directive156 contains provisions on the organisation of the service provider, and on the content of the consumer loan agreement. The consumer is protected 154 See chapter 3.4-3.5, and e.g. Finanzamt Köln-Altstadt/Schumacker, Court of Justice 14 February 1995, Case C-279/93.Fokus Bank/Norwegian state, EFTA Court 23 November 2004, Case E-1/04. 155 Commission/Austria, Court of Justice 25 June 2009, Case C-356/08, §40-50. 156 Consumer Credit Directive 2008/48/EC.

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during the negotiation phase, while the contract is applicable and from some of the negative effects of consumer loans. It provides a window of opportunity to re-assess the need for credit and the impact of such a loan and its repayment on the financial situation of the consumer. In addition, the directive protects against unscrupulous lenders and against any inclination the consumer may itself have towards over-indebtedness or irresponsible lending. The directive obliges the service providers to extend credit only if and in as far as such a loan is (also) in the best interest of the client/consumer. This is the equivalent of the Mifid-obligation to treat all clients fairly. In Mifid different levels of protection are offered, ranging from high protection for small investors to less protection for professionals; see chapter 16.2. Under the consumer credit directive the protection focuses only on consumers, leaving aside other retail clients and professionals. Even for consumers, the protection offered is limited in scope157. It excludes amongst others all kinds of credit agreements: – related to mortgage credit; – for an amount below 200 euro and over 75.000 euro; – for credit linked to an investment order given via a bank or non-bank investment firm; – short term credit free of interest; – hiring or leasing agreements without an obligation to buy the object of the agreement; and – pawnshop-credit. For all other types of consumer credit agreements, the directive protects clients both before and during the contract. During the negotiation or pre-contractual158 phase the directive protects the potential credit-taking consumer via disclosure requirements (both to the specific consumer and in advertisements) and by a requirement on the aspiring lender to assess the creditworthiness of the consumer and his ability to repay. A cooling down period so that the consumer can pull out of a (potential) credit agreement he entered into on the spur of the moment. The directive requires the creditor to provide all relevant information in a standard format, including (i) the total sum of all payments under the proposed contract, including insurance premiums, interest, and other costs (excluding notary costs), (ii) specific information on the interest rates and charges applicable (e.g. on normal payments, when in default, upon changes in reference rates, and upon early repayment), and (iii) key aspects of the agreement, such as a right of withdrawal, the duration of the agreement, mandatory other services that need to be bought from the creditor, and possible notary-costs. Some of these aspects also have to be disclosed in general in any advertisement. 157 Art. 2 Consumer Credit Directive 2008/48/EC. 158 The negotiation phase is prior to an agreement having been reached. A renewal on existing terms and conditions would not necessitate these obligations to be fulfilled again, as they had already been fulfilled when first concluded. Cofinoga/Sachithanathan, Court of Justice 4 March 2004, Case C-264/02.

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This includes information on the total sum of all payments and obligations under the possible credit agreement in a representative example for the advertised type of consumer credit. The consumer has to be allowed a period to study the received information on the specific agreement he applied for, before signing the agreement. An exemption for this cooling down period is applicable when the agreement is made over some distance communication channel, such as the internet or telephone; see below on the distance selling rules. The directive also requires the creditor to assess the credit worthiness of the credit taker before concluding the agreement or changing the total amount of the credit under the agreement (both in the own interest of the creditor and in the interest of the credit taker). The contract is subject to a range of requirements that severely restrict lending and selling practices that might be detrimental to the consumer. Like the pre-contractual information, the contract itself also has to contain all relevant information, including (i) type and amount of the credit, (ii) specific information on the interest rates and charges applicable, (iii) names and geographical addresses of the contracting parties (and, if any, of the credit intermediary, and (iv) key aspects of the agreement, such as the right of withdrawal, the duration of the agreement, required sureties and insurances. A paper copy is to be given to each party (or another permanent record that can be personally stored by the credit taker). The contract generally allows the consumer a right to withdraw within 14 calendar days from the date of the agreement or from the date that the credit taker has received the contractual terms and conditions and information, if later than the date of the agreement (the right of withdrawal also covers ancillary services and charges, but the credit taker has to repay the amount lent and the interest over the period that amount was available to him). While the loan is in place: – changes in the borrowing rate have to be communicated to the credit taker; – ongoing information needs to be provided on overdraft facilities; – open end credit agreements can be terminated at any time free of charge by the credit taker (possible with a notice period of one month) and by the creditor – if agreed – for any reason with two months’ notice or if there are objectively justified reasons; – the directive generally allows the consumer to repay the credit early, with a reduction of all interest and costs arising after the early repayment (some costs can be calculated by the creditor if there was a fixed borrowing rate, but they cannot exceed 0.5% for credit agreements that would end in any case within one year, or 1% for credit agreements that still had longer durations, unless he can prove higher actual losses due to the early termination); – if the credit is assigned to another creditor, the consumer retains any defences he may have had against the creditor, including any right of set-off.

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If any credit intermediary is involved in the negotiations between the consumer and the creditor, the obligations during the pre-contractual phase apply to both him and to the creditor (with certain exceptions for non-professional intermediaries). In addition, the intermediary needs to inform the consumer about e.g. his dependency/independency from creditors and about any fees the consumer should pay him for his services. Such fees, if any, also need to be communicated to the creditor, for incorporation into the calculation of the total annual percentage rate of charge about which the client needs to be informed. Though the consumer that actually applies for and receives the loan is protected by the directive, such protection is not extended to other consumers who have an interest in the credit agreement. For instance a consumer who guarantees the repayment of the consumer credit is not protected under the terms of the directive159, though he may be covered by the protection of other directives, such as the distance-selling directive (see below). The consumer credit directive was recast in 2008160. This version provides for minimum and maximum harmonisation in the regulation of consumer credit agreements. The stated purpose is to (a) ensure that all EU consumers enjoy a high and equivalent level of protection, and (b) to create a genuine internal market for the clients and the providers of consumer credit. The directive aims for full harmonisation, clarifying in which areas member states are still free to add national goldplating. National rules that offer a higher level of protection to clients or to providers in areas covered by the directive are no longer permitted, unless the directive explicitly allows it161. Even such exemptions are interpreted restrictively if they restrict the rights of consumers. An explicit possible widening of the scope of the directive allows member states to expand the same level of protection offered to consumers also to other borrowers such as small- and medium sized enterprises, or to agreements to lend consumers an amount of funds that is outside the target of 200 euro to 75.000 euro, while the Court of Justice162 has allowed widening of the scope to mortgage backed contracts and to contracts existing before the directive was issued. Other directives in the area of consumer protection also affect contract terms or specific types of contractual

159 Berliner Kindl Brauerei/Siepert, Court of Justice 23 March 2000, Case C-208/98. 160 Consumer Credit Directive 2008/48/EC, replacing directive 87/102/EEC, entered into force on 11 June 2010. 161 Art. 22 and 26, as well as e.g. recitals 9-11 and 22 Consumer Credit Directive 2008/48/EC. In a case based on the previous version of the Consumer Credit Directive (a minimum harmonisation directive), the Court of Justice already limited the scope of any such exemption by favouring a restrictive interpretation of discretions that limit the rights of consumers. See chapter 3.5 and Rampion/Franfinance, Court of Justice 4 October 2007, Case C-429/05. The minimum harmonisation character of the previous directive meant that national provisions that offered more protection (or less conditional protection) were allowed in all areas, Scarpelli/NEOS Banca, Court of Justice 23 April 2009, Case C-509/07. The targeted restriction to consumer rights was deleted in the 2008 recast version of the directive. 162 Volksbank/CJPC, Court of Justice 12 July 2012, Case C-602/10.

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terms or negotiation processes, e.g. on the type of general conditions that are acceptable in certain type of consumer agreements163. In the core harmonised areas the directive is clear and unconditional. Many provisions will thus have direct effect; see chapter 3.5. In addition, the Court of Justice has ruled that domestic courts are free to raise consumer protection issues covered by the consumer credit directive (as transposed in the domestic law), even if the consumer did not raise the issue in court in a procedure against the creditor (thus requiring domestic courts to go beyond the scope of the disagreement as presented by the parties in the dispute, in order to provide the protection needed)164. Self-Regulation on the Basis of Agreed Standards on Mortgage Credit The EU relied until recently solely on self-regulation for mortgage providers and intermediaries. Mortgage credit is provided by banks, but also by insurers and by non-regulated companies. It is not in and of itself an activity that leads to a mandatory license under EU rules. For mortgage providers the Commission did foster a code of conduct on pre-contractual information for residential mortgages between associations of consumers and associations of mortgage loan providers165. Part of this code may have been copied into voluntarily into domestic legislation, and many mortgage providers have signed up to compliance with the code. This does not equal a binding EU set of standards for residential mortgages. Mortgage contracts have even been specifically excluded from the scope of the consumer credit directive166. Mortgage credit received additional attention when bad risk management practices for so-called subprime mortgages in the USA – and similar lending standards slippage e.g. for buy-to-let in the UK – lead to risks for both borrowers and lenders. The risks for the lenders had been distributed to a large extent to other investors worldwide, either by selling or reinsuring the mortgage to government agencies such as Fannie Mae and Freddie Mac, and 163 See below on the Directive 85/577 on contracts negotiated away from business premises, Directive 93/13/EEC on unfair terms in consumer contracts, Directive 97/7/EC on distance contracts and Directive 1999/44/EC on consumer sales and guarantees. Also see the other directives mentioned in this chapter, and the unfair business-to-consumer commercial practices directive 2005/29/EC and related directives. 164 Rampion/Franfinance, Court of Justice 4 October 2007, Case C-429/05, §57-65. 165 European Agreement on a Voluntary Code of Conduct on Pre-Contractual Information For Home Loans, March 2001. The Commission publishes both the code of conduct and lists of all mortgage loan providers that signed up to the code on the internal market, retail financial services part of website www.ec.europa.eu. 166 See art. 2 Consumer Credit Directive 2008/48/EC, and above. The Court of Justice has allowed member states, however, to expand the provisions of that directive to mortgage backed credit agreements; see Volksbank/CJPC, Court of Justice 12 July 2012, Case C-602/10.

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the securitisation of mortgages either by the original lenders or by such government agencies, transforming the mortgages into easily transferable bonds; see chapter 8.6. The securitisation of USA and EU mortgages became the starting gun of the 2007-2013 subprime crisis. Following an study on cost of benefits, the Commission has sent a proposal for a directive on residential mortgages to the Council and Parliament167. The proposed directive introduces an authorisation and supervision requirement for all non-banks. The main focus is, however, on new conduct of business rules requiring fair treatment of the residential mortgage client, advertising and marketing, on early repayment, and codifies the information that has to be provided to the client before closing an agreement and e.g. on interest rate changes during the duration of the loan. Mortgage providers will also have to perform a creditworthiness assessments, to prevent over-indebtedness of the borrower. The borrower in turn will be obliged to fully disclose its financial situation and personal circumstances to allow the mortgage loan provider to credibly assess his creditworthiness. All creditors should also have access to databases that monitor borrowers’ existing exposures and their compliance with existing credit contracts. The proposal boils down to an obligation to behave in a responsible manner. It is designed both to protect clients and to foster the long term viability of the providers, in turn fostering financial stability. Commercial mortgages are not covered by the proposed directive, even though commercial real estate has led to equally major problems for banks and borrowers across the EU. Member states may choose to goldplate the directive by expanding all or some of its provisions to some or all commercial borrowers, e.g. to small- and medium sized enterprises. Bank Accounts and Payment Services Self-regulatory common principles for bank account switching of the European banking industry. In its report on retail financial services, the Commission has indicated it will closely monitor and evaluate the implementation of this initiative. Such self-regulatory issues may still be affected by harmonised rules on e.g. selling methods and on contractual terms; see below. There are no rules on the right of access to a bank account for EU citizens. A wider set of rules is applicable on the payment services that make use of a bank account or where clients make incidental use of payment services. The payment services directive sets out obligations for all payment services providers such as banks (when providing

167 Commission, Proposal for a Directive on Credit Agreements Relating To Residential Property, COM(2011) 142, 31 March 2011.

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payment services to clients). As noted in chapter 16.5, the directive applies to for instance payment accounts and all associated cash and transfer activities, or such actions relating to credit lines, issuing/acquiring payment instruments, money remittance and some mobile banking services. The conduct of business rules only if both sides of the transaction are based in the EU, and the transmission is made in a currency of a EU member state168. For the regime on non-bank payment service providers, see chapter 19.3, and for the disclosure rules see chapter 16.5. The key aspect of the non-disclosure conduct of business rules relates to the liability of either the user or of the service provider (the bank) if something goes wrong. The directive sets out the care the user has to apply to trying to prevent abuse, for instance by keeping secret personalised identifier information safe (for instance pin codes or log-in information), as well as a duty to inform the service provider without undue delay on becoming aware that payment instruments are lost or anything else goes wrong169. The duties of the payment services provider are more substantial170: – the client is protected against an abrupt cancellation or change of an existing framework agreement (the minimum period of notice given is two months) while he can always exit a payment services agreement with a maximum of one month notice; – except in cases of fraud, intent or gross negligence the maximum amount that a client can lose as a result of mishaps such as stolen cards or identifying details is capped at 150 euro, with any additional losses borne by the service provider (though a national discretion to deviate from this protection exists, which can change the liability of the service provider and of the client depending on the circumstances of the case); – once the provider receives a notification of lost instruments or details, any further payments made using such are for its account in full. Such a notification can be made at any time, and if the service provider does not provide continuous access for the client to make such notifications, the client is no longer liable for any of the damages, except if he acted fraudulently; – the provider is obliged to notice and act on unexpected payment orders if they do not fit the profile of the client, and has the burden of proof to show that a payment was authorised if that is contested by the client (while the use of the payment instrument is not sufficient to prove either authentication or fraud, intent or gross negligence of the client);

168 Art. 1-4 and the Annex of the Payment Services Directive 2007/64/EC. 169 Art. 51-83 Payment Services Directive 2007/64/EC, specifically art. 56, 58 and 60-63. 170 Art. 44-45 and 51-83 Payment Services Directive 2007/64/EC.

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– a payment made on behalf of the customer can only be held against him by the service provider if the customer consents in the form agreed between them either before or after the payment has been made (for instance when accessing an ATM by a bankcard protected by a code, or entering an identification code to authorise an electronic payment, or signing a check). This consent can at all times be withdrawn (though not with effect on payments already made). Limits on the maximum amount authorised via a payment instrument (such as a check or bankcard) can be agreed, and the service provider can ‘block’ the use of payment instruments to verify that the consent is indeed given by the customer himself, instead of a fraudster or other unauthorised person (in light of the above-mentioned liability); – there are rules on the possibility to ask for refunds of payments made through direct debit, on when a payment order becomes irrevocable, and on the correct administration of execution timing and value dates, and who will bear which liability if the information identifying the recipient of a payment is incorrect, or something else goes wrong with the payment. The member state has to ensure the existence of competent authorities to act on noncompliance with the directive, which need to have instruments (penalties) that are effective, proportionate and dissuasive. The authorities need to act on complaints received about infringements, amongst others by referring the clients to an out of court redress procedure (that the member state should provide for also). The contractual parties can deviate from these protections if the client is not a consumer (nor a micro enterprise if the member state implements this national discretion). Partial exemptions apply to low-value payments, but what low-value means is subject to a national discretion and depends on the exact service provided. This varies between zero up to 300 euro (for prepaid instruments up to 500 euro)171. Some of the liability rules also apply to e-money, but not all, especially if the provider cannot freeze the payment172. Insurance Mediation The insurance mediation directive provides an example of conduct of business rules that apply amongst other to banks that provide this service173. Banks can use their branch network to sell insurance in the same manner they can use it to sell units in collective invest-

171 Art. 51 and 53 Payment Services Directive 2007/64/EC. 172 Art. 53.3 Payment Services Directive 2007/64/EC. 173 Insurance Mediation Directive 2002/92/EC.

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ment funds or to provide investment and loan services. Any insurance mediator – also if he is a bank – will need to be registered as an insurance mediator, and provide a notification if he wants to perform mediation services in other member states. The management and the personnel involved in the insurance mediation services need to be of ‘good repute’; where for other financial services provided by banks such good repute is only required from management; see chapter 5. Such personnel and relevant members of the management will need to possess appropriate knowledge and ability (and provide information to customers; see chapter 16.5). Member states can opt between several measures to protect clients against bankruptcy, e.g. segregation of funds, a guarantee fund or that money paid by the customer to the intermediary is final, but payments on claims by the insurer is only final when actually received by the customer. Member states are required to set up effective supervision on these requirement, and to establish a complaints forum (and they are requested to set up an out-of-court redress forum)174. If the bank as an insurance mediator holds himself out to give advice on the basis of a ‘fair analysis’, it will need to analyse a large number of insurance offers that are available in the markets, so that he is able to advice under professional standards on the insurance contracts that would be adequate to meet the needs of the customer. Selling Methods Several directives deal with selling methods that are undertaken outside of business premises and on unfair terms used by service providers in their contracts. The latter belong to the category of private/commercial law arrangements instead of conduct of business laws, but they contain restraints on the behaviour of banks and other financial services providers too. The regulation of selling practices focuses on preventing customers becoming a victim of pressed selling or of ill-considered buying. If the consumer voluntarily enters the business premises of a service provider, he generally is aware what he is doing (and further protection is offered via directives on unfair terms and on the prudential regulation of some providers such as banks, investment firms or insurers). If, however, the consumer is approached and perhaps pushed into an agreement, he needs additional protection on top of the protection he needs when he willingly enters the premises of e.g. a bank. Laws on doorstep sellers, distance sellers (e.g. over the phone or internet) and e-commerce directives are based on the premise that in the absence of face-to-face contact or when customers are approached in a non-standard way, they need additional protection. Such protection is granted in the form of additional information rights, and often a right of cancellation/withdrawal175. The legislators balanced the need

174 Art. 4, 7, 10 and 11 Insurance Mediation Directive 2002/92/EC. 175 Heininger/Bayerische Hypo- und Vereinsbank AG, Court of Justice 13 December 2001, Case C-481/99.

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for introduction of additional protection against the fact that doing business outside of business premises is a primary channel for the creation of the single market for both service providers and service buyers176. Alternative selling methods allow service providers from EU member states to target the markets in all other member states. The choices made by national legislators as to the content of such protection were diverse prior to harmonisation. These laws reduced the level playing field, and thus in and of itself providing a barrier to the single market for all member states and proper protection in some. Introducing harmonised EU laws focuses both on the protection of the consumer and on the establishment of a single market – under common and understandable business practices rules – for service providers. The following consumer protection directives are relevant to financial services and the business of banks: – Distance marketing of consumer financial services177. The distance marketing rules protect consumers if they buy financial services over the telephone or internet, or in similar situations where the parties to the contract do not meet face-to-face. The core of the directive is information provision by each financial services provider that tries to close agreements in an organised manner without face-to-face contact to provide extensive information to the client, including on the supplier, on the financial service offered, on the distance contract itself, and on the possibilities for redress, and the provision of all contractual terms and conditions. These have to be provided in a durable medium; i.e. on paper or another format that the consumer can store long term, before the contract is closed. In addition to these information rights, the client is granted a right to withdraw from the agreement within 14 days after the start of the agreement, or if later, after he received the terms and conditions. In that case he only has to pay a reasonable price for the services already rendered. The right to withdraw unilaterally does not apply amongst others when the service relates to already bought financial instruments at the request of the client, of which the value fluctuates outside of the control of the supplier. If a range of agreements is linked or is based on an initial framework agreement, the protection offered only relates to the first agreement entered into. Unsolicited individual approaches to customers are forbidden, unless the customer has either consented or at least not objected to such approaches, depending on the national implementation of this protection against cold calling.178

176 See e.g. recital 2-5 Distance Marketing of Consumer Financial Services Directive 2002/65/EC. 177 Distance Marketing of Consumer Financial Services Directive 2002/65/EC. 178 See e.g. art. 1.2, 2 sub a, 3-5, 6, 7 and 10 Distance Marketing of Consumer Financial Services Directive 2002/65/EC. See art. 4.5 on the overlap of information obligations with the Payment Services Directive 2007/64.

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– Doorstep selling directive. The doorstep selling rules cover all agreements closed away from the business premises of the trader, unless the consumer explicitly invited the trader and the consumer reasonably could know that this type of service formed part of the traders’ activities. The directive excludes contracts for securities, insurance contracts and agreements with as its primary subject immovable property. Credit agreements and contracts secured on immovable property (ancillary to the main agreement) are covered. The directive gives the consumer a right to cancel (renounce) any agreement covered within seven days after receiving a notification from the trader that he has that right179. If the trader fails to provide that notification, the right to cancel remains active indefinitely. The consequences of the cancellation are determined by national law, including the effect the cancellation has on ancillary agreements and money already paid or lent. If the trader failed to give notice of the right to cancel, and this lead to money already being lent or paid, the consumer, however, needs to be protected180. The scope of this directive regarding financial services will change from 2014; see below under future developments. – E-commerce. The e-commerce directive contains provisions on amongst others econtracts and placing e-orders. It covers issues on how to approach consumers, and what kind of information is to be provided, as well as liability for the information provided. It covers anyone who provides information or services online, either paid by the recipient or not, e.g. ranging from search engines to radio broadcasts. The directive also applies to financial services on which information is provided or which are sold online. Member states have to allow these services to be provided in the interest of the single market, but financial services can be covered by additional restrictions due to ‘general interest’ exemptions to protect consumers, including investors181. – Unfair terms in consumer contracts. The directive182 protects consumers against the use of unfair terms by a seller or provider of amongst others financial services. The service provider cannot include in the contract any standardised terms or conditions that cause a significant imbalance to the detriment of the consumer in the parties’ rights and obligations. If the service provider nevertheless includes unbalanced standardised conditions, they will not be binding on the consumer. The annex contains examples of imbalanced conditions, some of which are particularly relevant in the area of 179 Art. 4 and 5 Doorstep Selling Directive 1985/577/EEC, Heininger/Bayerische Hypo- und Vereinsbank, Court of Justice 13 December 2001, Case C-481/99. 180 Art. 7 Doorstep Selling Directive, Cailsheimer Volksbank/Conrads and others, Court of Justice 25 October 2005, C-229/04. 181 E-commerce Directive 2000/31/EC and the (non-binding) Commission Communication COM(2003) 259 on the application of the specific provisions on financial services. See e.g. recital 11 and 27 and art. 3.4 and 8.4 E-commerce Directive 2000/31/EC. 182 Unfair Terms in Consumer Contracts Directive 1993/13/EEC.

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financial services. A condition to unilaterally change the interest rate without notice can still be deemed valid if the bank has valid reasons, and if the consumer is informed of this change and is free to dissolve the contract immediately. If those conditions are not fulfilled, a provision that allows the bank to unilaterally change the interest rate is not valid, and the consumer is only contractually bound to pay the old interest rate. The directive does not protect against imbalances in the main subject of the agreement (the subject matter and the price/remuneration), as these are the subject of individual negotiations (which is not the case for standardised terms and conditions). In one regard the directive covers the whole contract, including the price/remuneration. If the contract is in writing, it has to be drafted in plain, intelligible language. If a condition is not intelligible or plain, it will be interpreted in the way that is most favourable to the consumer. As the directive is minimum harmonisation, more protection can be offered by member states to consumers e.g. against unfair general conditions on the calculation of interest charged by a bank183. – Unfair business-to consumer commercial practices directive. The directive184 prohibits unfair business practices, and covers the whole financial services area. Unfair business practices include any practice that is contrary to the requirements of professional diligence and materially distorts the behaviour of the average consumer or is likely to do so. Particularly vulnerable groups enjoy added protection. The directive contains specific examples regarding two subcategories of unfair practices (misleading or aggressive practices). By way of example, a practice can be misleading if the service provider omits to provide material information. The directive specifies that amongst others information disclosure requirements established under Mifid, UCITS and the prospectus directives are deemed ‘material’ in this context; see chapter 16.5. If those disclosure obligations are not fulfilled, the bank is by definition engaged in an unfair commercial practice in relation to a consumer. It is a supplementary directive in the sense that it explicitly states that if more specific EU legislation already regulates specific aspects of unfair commercial practices, the other legislation takes precedence (on those specific aspects). The directive provides for full harmonisation, but some aspects (where divergent member states legislation was previously allowed under other directives) have only entered into force on 12 June 2013.

183 Caja de ahorros y monte de piedad de Madrid/Ausbanc (Caja de Madrid/Bank Users Association), Court of Justice 3 June 2010, C-484/08. 184 Unfair Business-to-Consumer Commercial Practices Directive 2005/29/EC. See especially art. 2, 3, 5, 7.5 and 13 of the Directive. The Misleading Advertisement Directive 1984/450/EEC covers some of the same aspects as this directive, with the purpose to protect traders and competitors (i.e. non-consumers).

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– The distance contracts directive and the sale of consumer goods and associated guarantees directive. These directives do not relate to financial services per se185. The distance contracts directive excludes financial services (which area was separately dealt with in the distance marketing of financial services directive; see above). The sale of consumer goods and associated guarantees directive deals with goods (tangible movable items) and the sellers’ guarantees on them. However, both directives contain provisions that cover some ancillary financial services. The Court of Justice has granted further reaching protection in a case related to the distance contracts directive. The Court ruled that ancillary financial undertakings by the consumer, including credit or guarantees, that are dependent or related to the primary (non-financial) subject of the agreement are covered by the protection offered186. The directive itself provided a narrower protection. It solely indicated that the exercise of the right of withdrawal by the consumer also cancels any related credit given to the consumer on the basis of an agreement between the seller and the credit provider. It is likely that the sale of consumer goods and associated guarantees directive would also be expansively interpreted by the Court to provide protection to the consumer also for any ancillary financial agreements, as the two directives are quite similar. This has, however, not yet been determined in case law. Each of these consumer protection directives gives specific rights in specific situations. It can thus occur that the same agreement can be annulled under several directives, or can be annulled under one directive but was excluded from the scope of another. Regarding a secured credit agreement (e.g. a credit for which the borrower has provided a security in the form of a pledge, mortgage or third party guarantee), the Court ruled that the national discretion to exclude those from the scope under the consumer credit directive did not limit the right of the consumer to cancel the agreement if that agreement also happened to fall within the scope of the doorstep selling directive. The directives are thus not specialised versions of each other, where the more detailed (extending or limiting) applicable provision replaces the more general provision (the so-called principle of ‘lex specialis derogat legi generali’), but provide separate and simultaneously applicable rights. Unless one of the directives clearly intends (via their preambles or provisions) to limit other rights given to consumers, they both provide rights to the consumer equally187.

185 Art. 3.1 Distance Contracts Directive 1997/7/EC excludes any financial service to which the Distance Marketing of Financial Services Directive 2002/65/EC applies. Art. 1 Sale of Consumer Goods and Associated Guarantees Directive 1999/44/EC limits the scope of the directive to tangible movable items. 186 Art. 6.4 Distance Contracts Directive 1997/7/EC. Berliner Kindl Brauerei/Siepert, Court of Justice 23 March 2000, Case C-208/98, §24. 187 Heininger/Bayerische Hypo- und Vereinsbank, Court of Justice 13 December 2001, Case C-481/99, §36-40.

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The legislation on distance selling and marketing overlaps to some extent with the European passport of banks. The European passport allows banks to perform cross-border services in the markets of other member states. As described in chapter 5.3, this does not apply to conduct of business regulation, where the host member state can require banks to follow local requirements. This division of responsibilities between the host and the home state has caused relatively few difficulties where banks operate in the physical area, through e.g. domestic offices or agents. However, when the service is provided fully from the home state to clients in the host state without face-to-face interaction, it is difficult and costly to ascertain that all the – not harmonised – rules have been taken into account if banks have to comply with local rules in several member states when performing essentially the same service. This applies to both traditional banking services (deposits, loans) and to investment services, as well as to selling financial services by other providers, such as insurance policies or collective investment units. The harmonisation brought by distance marketing on consumer financial services directive thus helped ease the usage of the cross-border services European passport. Consumer Protection Directives and Practical Supervision The consumer credit directive requires member states to introduce either supervision or regulation of consumer credit services. This aspect was not harmonised, as the member states could not agree on whether supervision was necessary on top of rules for the allowed content of consumer credit agreement and for instance the screening of potential borrowers. Regardless the choice, the directive already specified that the object of supervision or regulation must be market transparency and stability, in line with the requirements of the directive. If the member state chooses supervision, this additional task can be, but does not need to be, allocated to the same authority responsible for banking supervision, conduct of business supervision under Mifid, or consumer affairs in general; also see chapter 21.2. Regardless of to whom it is allocated, the job of the supervisor under this directive is different from banking supervision under the CRD, and needs to be allocated attention regardless of whether such resources would have been allocated to achieve the goals of prudential banking supervision188. Regardless whether supervision or regulation is chosen for this directive189: – penalties need to be applicable to any infringements of the obligations under the directive. Those penalties need to be effective, proportionate and dissuasive (in line with EU case law; see chapter 20.1;

188 Recital 44 and art. 20 Consumer Credit Directive 2008/48/EC. 189 Art. 23 and 24 Consumer Credit Directive 2008/48/EC, and regulation 2006/2004 on cooperation between national consumer protection enforcement authorities. Member states have flexibility on the way the out of court redress is set up; see Volksbank/CJPC, Court of Justice 12 July 2012, Case C-602/10.

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– the national authorities responsible for the enforcement of consumer protection laws need to cooperate across borders; – an alternative dispute resolution procedure needs to be available, in addition to normal redress through the courts. The accompanying EU regulation190 stipulating cross-border cooperation between consumer protection enforcement authorities helped blur the line between the mandatory supervision or regulation choice. It specifies that – if regulation is chosen – it should include enforcement, combined with ongoing coordinated market surveillance. The enforcement powers necessary to such an authority are further specified, and have a large overlap with standard supervisory powers (such as investigation on-site and through requests for information, information exchange, powers to restrict the service provider, publication of actions taken; see chapter 20). It also clarifies the harmonisation efforts that have to be undertaken to allow competent authorities to learn from each other and develop a common culture and standards, similar to the efforts undertaken in the financial services supervision area through EBA, ESMA and EIOPA. For other consumer protection directives no reference is made to specific supervision by a public authority on the compliance by the service providers with the content of those directives. However, the distance selling directives are subject to the mandatory cooperation and set-up of consumer protection enforcement authorities. The unfair business-to-consumer commercial practices directive requires that member states introduce effective, proportionate and dissuasive penalties and enforces them. Even if the local consumer protection agency and/or the conduct of business supervisor do not actively supervise, additional protection is derived from other aspect of consumer protection, such as the power of the courts to invoke consumer rights even if the consumer did not invoke such rights. Future Developments Several directives concerning consumer protection in the financial services area and/or regarding other goods and services have been integrated into a new directive on consumer rights. The Commission published a proposal for such a directive in 2008, and the directive has been published end 2011191. The original directive proposal wanted to integrate the 190 See art. 1, 4, 9, 16 and 17 Regulation 2006/2004 on Cooperation Between National Consumer Protection Enforcement Authorities. 191 After three years of negotiations on a more ambitious Commission Proposal (2008/0196 (COD)), for a new Directive on Consumer Rights 2011/83/EU has been agreed. The Directive will replace the Doorstep Selling Directive 1985/577/EEC and the Distance Contracts Directive 1997/7EC. However, the Consumer Sales and Guarantees Directive 1999/44/EC and the Unfair Terms in Consumer Contracts Directive 1993/13/EEC will not be integrated into the new directive.

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above-mentioned doorstep selling directive, the unfair terms in consumer contracts directive, the distance contracts directive and the consumer sales and guarantees directive, but the final directive only integrated and repealed the doorstep selling and distance contracts directive. The doorstep selling protection will no longer be applicable to the financial services to which it is now applicable. The doorstep selling directive has been harmonised with the (non-financial services) distance contracts regime, and now excludes financial services. This is no problem for distance selling as a specialised regime applies under the distance selling for financial services directive. For doorstep selling, there is sadly no such parallel directive for financial services directive (see above). However, the regime for ancillary credit agreements now applies both to doorstep selling and distance contracts that the consumer wants to withdraw from. If the consumer exercises his right of withdrawal within the time period set, he is also released from all obligations under a related credit agreement192. As intended the directive contains minimum and maximum harmonisation, but the member states have negotiated a substantial number of national options into the directive. The new directive has to be implemented by member states by 13 December 2013, and will apply to contracts concluded after 13 June 2014. The Consumer DG of the Commission has published its report on the fees for retail financial services, including specifically bank fees and interest rates. To put it lightly, the expenses and the transparency on those expenses did not favourably impress the Commission. It is likely that this will require follow-up legislation193. The Commission has published proposals for new EU rules on mortgage credit in March 2011, see above. It also published in July 2012 two proposals that are relevant to consumers194: – a new proposal on packaged retail investment products, instituting a so-called ‘key information document’ in which consumers who are interested in investment products can find a short, plainly worded standard form containing the relevant information on the investment products. This would cover the main features of the instrument and the main risks in a comparable manner; see chapter 16.5; – a revision of the insurance mediation directive to introduce common standards on insurance sales and ensuring that consumers receive relevant advice, regardless of whether they buy insurance directly or via intermediaries;

192 Art. 2(12), 3(d), 9 and 15 Consumer Rights Directive 2011/83/EU. 193 Commission Staff Working Document on the follow up in retail financial services to the consumer markets scoreboard SEC(2009)1251 of 22 September 2009. 194 Commission, Commission Proposes Legislation to Improve Consumer Protection In Financial Services, IP/12/736, 3 July 2012.

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Simultaneously plans relating to the UCITS directive were published as applicable both to consumers and to other retail clients; see chapter 16.2 and 19.5. Literature – Weatherill, Stephen; Craig, Paul; De Búrca, Gráinne (ed), The Evolution of EU Law, 2nd edition, Oxford University Press, Oxford, 2011, chapter 27

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Consolidated and Solo Requirements

17.1 Introduction Banking groups can choose to be subdivided into legal entities1. One of the many drivers for banks to prefer to have separate legal entities for different activities and regions used to be that banking supervision regulation and supervisors favoured licensing banks that had a separate legal entity for business in their country. This helped clarify the available capital and liquidity that would help repay citizens of that country, while capital movement restrictions ensured that those funds would remain in the country when the banking group was in trouble and the local subsidiary was not (yet). Within the EU there is no longer a prudential banking supervision reason to do so (see chapter 4 and 5). Banking groups have nevertheless retained and expanded their legal corporate structures with multiple legal entities in the EU (and in third countries). Licenses are given to each (regulated) legal entity, not to the group. Subsequently, however, these licensed entities act and present themselves jointly with all other regulated and unregulated entities in the group to society and to their clients and counterparts. Various reasons drive banking groups to choose multiple legal entities instead of one single legal entity for its activities. Some of the more important are2: – tax, tax, tax, tax, government subsidies and tax; – limitation of liability; – isolation of potential loss-making operations, being able to legally abandon unsustainable losses in the subsidiary without endangering the main group; – retaining the flexibility to sell country or niche operations when such are no longer core business; – regulatory requirements to put some other financial services (most prominently insurance) into a separate legal entity; – third country requirements to incorporate a locally supervised entity for all services provided in that country, and vice versa; – inherited legal structures from past mergers and acquisitions.

1 2

At least within the EU there is no longer a possibility for a government authority to force a bank from another member state to enter its financial markets via a separate legal entity; see chapter 5. BCBS, Report and Recommendations of the Cross-Border Bank Resolution Group, March 2010, page 29. H. Mehran & M. Suher, The Impact of Tax Law Changes on Bank Dividend Policy, Sell-Offs, Organizational Form, and Industry Structure, FedNY Staff Report 369, April 2009.

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These factors and the subsequent number of separately licensed subsidiaries within a banking group lead to a difference between the market and public perception of the banking group as one economic unit in going concern, and the legal (under supervisory, corporate, contract and bankruptcy laws) and factual perception of the banking group as a composite of legal entities in going concern and which falls apart especially in a bankruptcy. If a banking group would perform all its activities in one legal entity, these activities would by definition live and die together. The separation in legal entities does mitigate some of the cross-dependency, but does not end it. Group entities often transact with each other as if they were one legal entity in the internal perception too. Being part of a group exposes each entity to group risks, and the group to risks arising in each legal entity. These include risks of contagion (from a failing entity to other previously healthy entities, if assets entrusted to that failing entity are not returned), risk concentration that is not recognised because it is booked in different entities, added complexity, especially if different types of regulated and unregulated entities are part of the same group, conflicts of interest, and difficulties in determining how to allocate funds and capital to each individual entity, both for internal and supervisory reasons (and avoiding double counting)3. For prudential supervision, some of the benefits of segmentation in legal entities are similar as for the bank itself. It becomes easier to sell parts of a bank if it fails, and supervision can be focused on the activities that are closely related to its goals as determined by the scope of license requirements. However, these benefits can become pitfalls if the legal entity structure is used to put activities on which the regulated entities are dependent outside of the scope of supervision, or if they are used to inflate buffers or hide risk. Banks are like people: they are born alone and die alone, but live together. Consolidated supervision is not part of the licensing process, nor of the winding down or failing of a bank; see chapter 5 and 18. These phases of its life are supervised and executed on a solo basis, though legal commitments (and actual help once given if not on the basis of a legal commitment) and legal links can play a role in assessing whether the bank should obtain a license or should be wound down. In a bankruptcy, the liquidators of individual group entities will fight each other strenuously if that is in the best interest of the creditors of that specific entity. During the lifetime of a bank, this solo supervision remains an important aspect for some prudential demands and for the allocation of supervisory duties, but it is complemented or even superseded by consolidated supervision. This premise of consolidated supervision, which is to treat the banking group as one legal entity, with the goal to look at all activities of the group of which the licensed entities are part. This should 3

See e.g. recital 1 FCD II Directive 2011/89/EU.

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bring the cross-dependency risks within the group to light, so that the supervisor has a complete picture of the group, plus of the individual entities. The intention is that in this way no risks should be able to remain hidden by allocating them to a specific part of the corporate structure4. Prudential Supervision and Groups While a going concern – disposals of subsidiaries aside – the group functions as one entity. To a large extent, it manages its risks as if it were one, it manages its liquidity as if it were one, and in the perception of the public, there is no real difference between doing business with one or another of its subsidiaries (not even if one of them is a bank and the other is not). Apart from the legal departments, probably even most bankers and supervisors do not think of the group as a composite of legal entities but as a collection of business lines and activities (an economic and organisational approach). There are several reasons for authorities that are responsible for supervising the bank it licensed to look beyond the legal entity also at the group, and vice versa to look beyond the group also at the legal entity. The possible contagion between group entities and the need to get a true picture of the health and management of the bank are part of crisis prevention and of crisis preparation: – group entities are linked by reputation, management and loans/investments to each other, but can be saved or sold separately; – solo supervision without taking into account the health of the group can expose the bank to unexpected losses that are hidden in related entities; while looking at a bank solely on a consolidated basis creates the possibility that one of its component-banks is severely undercapitalised at the moment of bankruptcy to the detriment of its creditors, while other entities – possibly abroad – are overcapitalised; – since the 2007-2013 subprime crisis, the complexity that can follow from group structures and their influence on the potential for the bank to be resolved without harm for the wider financial markets has also drawn attention to the suitability of the legal structure in good times (see chapter 18.3, but this aspect has not yet been fully implemented in EU prudential rules pending the implementation of living wills. The extent that group supervision and colleges were not compatible with company law and bankruptcy law. From a prudential point of view the risks of a specific legal entity that is part of the group cannot be separated from the risks that materialise elsewhere in the group. Because the legal entity is part of the group, it is linked to its group entities by reputation, by dependence 4

T. Padoa-Schioppa, Regulating Finance, Oxford, 2004, page 6.

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or reliance on investments in or by group entities and by intra-group lending and other dealings. Such investments, transactions and exposures create contagion channels within groups. The discussion in the follow-up of the 2007-2013 subprime crisis on the importance of macroprudential supervision (see chapter 22.5) is an extension of this type of supervision5. Since the ever increasing liberalisation of capital markets and financial markets, contagion channels not only exist within banking groups, but also across all banking and financial groups. The various banking group legal structures means that choices have to be made on how to apply the different areas of banking requirements to either the legal entity, the group, or to combinations of the two. The BCBS capital accord works primarily on the basis of the economic and organisational concept of a group, like most bankers do. BCBS banking supervisors have fully embraced the concept of consolidated supervision; possibly to the extent that solo supervision is neglected6. For financial stability reasons, many banking supervisors emphasise that the supervision of the group as a whole is more important than the supervision of the individual legal entities in that group. This point of view is not shared in other sectors Insurance supervisors emphasise solo supervision on the entities especially for policyholder protection reasons, and use consolidated supervision as a support tool for such policyholder protection. Conduct of business supervisors tend to neglect consolidated supervision, due to the focus on the dealings between the client and the service provider (i.e. most likely the legal entity)7. The BCBS approach constitutes a basic difference with the CRD approach. The CRD starts from a legal approach to the banking group as a composite of licensed banks/legal entities, with group wide supervision added to it where useful and replacing solo basis supervision by group wide supervision only if there is no basis at all for the assumption that supervising the legal entity on a certain item would add benefit. Prime examples of this are the pillar 3 requirements on transparency, and the more advanced models that need large and diverse data pools to be able to predict the amount of needed financial buffers8.

5

6 7 8

However, please note that such contagion channels are only regulated between financial and non-financial enterprises within the group, the exemption for intra-group transactions between financial institutions if they are both captured within consolidated supervision will continue in the CRD IV project. For instance see art. 80 RBD and recital 60 and art. 113 CRR. Discussions in the BCBS started in 1977 on this topic. C.A.E. Goodhart, The Basel Committee on Banking Supervision, A History of the Early Years 1974-1977, Cambridge, 2011, chapter 4. Joint Forum, Review of the Differentiated Nature and Scope of Financial Regulation, January 2010, page 6. See art. 84.2, 84.6, and 72 RBD. Pillar 3 disclosures are only required of consolidated data of the group, except for significant subsidiaries (for which individual or sub-consolidated information has to be disclosed).

770

17

Consolidated and Solo Requirements

The CRD requires a minimum level of requirements and supervision, on some subjects focused on the legal entity, on others on subgroups (a subsidiary bank with its own subsidiaries), and on some on the whole of the group (consolidating the information of a parent bank with its subsidiaries), or sometimes even a consolidated banking group with its parent when that parent is itself not a bank. The four levels are: – solo-supervision; – sub-consolidated supervision; – consolidated supervision; – upward consolidation. On the content, the CRD follows the BCBS lead where it indicates that consolidated supervision is needed. Most of the quantitative requirements apply (also) on a consolidated level, calibrated to an assumption of a well-diversified banking group. The starting point, however, remains solo supervision for all non-quantitative issues, with quantitative issues allocated to both consolidated and – where useful – solo levels on a proportional basis. The way this is allocated is set out in chapter 17.2. Upward consolidation and other provisions on the treatment of non-bank parents and siblings are described in chapter 17.3. Subsequently, the special regime for financial conglomerates (mixed banking/insurance groups) is described in chapter 17.4, the treatment of third country parents and subsidiaries in chapter 17.5. The range of deviations from prudential requirements allowed to parts of mutual groups is described in chapter 17.6. Future Developments The solo and consolidation structure has been copied largely unchanged in the CRD IV project, with some add-ons for the new liquidity and leverage ratio requirements; see chapter 17.29.

17.2 Level of Application – Solo/Consolidated Introduction Solo supervision, i.e. looking only at the legal entity with the license, and consolidated supervision, i.e. looking at the top legal entity but including all assets and debts of the subsidiaries as if their activities were part of the top legal entity, both have advantages and disadvantages.

9

Art. 108-110 CRD IV Directive, and art. 6-23 CRR.

771

EU Banking Supervision

Solo supervision can ensure that the individual legal entity is well capitalised and equipped, and if stringent enough that it can survive even if parents or subsidiaries fail (important especially if those other entities are based in another country). The downside of solo supervision is that the risks and the benefits of being part of a larger group are not taken into account. This for instance increases costs per legal entity if functions cannot be centralised, and stimulates ‘gaming’ supervision by putting high risk activities in other legal entities (outside of the scope of solo supervisors), and by double ‘gearing’ capital. Double gearing occurs when a financial buffer is used simultaneously by a regulated subsidiary and a regulated parent both for risks of the subsidiary bank and for the risks of the parent bank10. The subsidiary uses its own capital to buffer for its own risks and the same capital (as the value of the shares in the subsidiary) increase the financial buffers of the parent and as such are available to use again for the risks of the parent; leading to double gearing or use of the same amount of financial buffer for twice the risk. Consolidated supervision avoids double gearing as it adds up all the risks faced by the group as a whole, and crosses away the interests in each other. It also takes into account risks flowing from other entities within the group (regardless of whether they are supervised on an individual basis). However, if only consolidated supervision is exercised, it could lead to a very uneven distribution of the capital, leaving some of the entities hanging without any financial buffer when the group fails, leading to high damages for the creditors of that entity, while some other entities have a surfeit of capital and its creditors benefit disproportionally in case of a liquidation. For rescue operations of multinational banking groups, the whereabouts of the capital and the cash is an important driver in determining whether a state is happy to let a group fail (e.g. if its taxpayers benefit from a surplus of capital in local group entities). If banks were supervised only on a solo basis, it would be easy to circumvent capital requirements by for instance allocating high risk activities to separate unsupervised entities (subsidiaries or parents companies), or to supervised entities in jurisdictions with lower requirements11. Putting it in a separate entity or in another country does not, however, mean that the risk no longer can impact the bank. It may be called on to help its group entity out. If the group entity fails, the reputation of the bank is sullied too, and there may be standing facilities between group entities or services from the group entities it relies upon in turn. Solo supervision helps it limits the danger an individual bank poses to its

10 The BCBS indicates the prevention of double gearing as the single reason for introducing consolidated supervision, BCBS, International Convergence of Capital Measurement and Capital Standards: A Revised Framework, June 2006 §20, page 7. 11 T. Padoa-Schioppa, Regulating Finance, Oxford, 2004, page 12.

772

17

Consolidated and Solo Requirements

group-entities and to other, unrelated, banks and counterparties, and protects its creditors and other counterparties. Level of Application The design of banking supervision takes account of both: solo supervision where needed, and consolidated supervision where needed. It is not required that each individual bank fulfils all of the obligations set out in the CRD – and in chapter 6-18 of this book – with regard to its own structures, rights and obligations on an individual basis. Neither is it required that each group fulfils each set of demands on a consolidated basis. Some requirements have been identified as being important on an individual basis, some on a consolidated basis, and some on both an individual and a consolidated basis. When a subject has been identified as important on a consolidated basis for the group, it has also been deemed helpful to gain insight to sometimes prescribe that the requirements are also fulfilled by sub-holdings. In that case, a bank in the group that is itself a subsidiary, but also has subsidiaries, may need to comply with such prudential requirements as if it were a standalone group (a subgroup, subject to sub-consolidated supervision). The CRD has made the following choices: Important on an individual basis for any bank – Solvency ratio (own funds and quantitative risk that is part of a group12 categories); ‘pillar 1’ – Large exposures – Organisational requirements set out in the licensing process And if it concerns a significant subsidiary: – Partial pillar 3 disclosure on a solo or sub-consolidated basis De facto for pillar 2 assessments13 Important on a consolidated basis (including – Solvency ratio (own funds and quantitative risk a bank operating on a standalone basis)14 categories); ‘pillar 1’ – Large exposures – Qualified holdings outside the financial sector – Pillar 2 (ICAAP) – Organisational requirements set out in the licensing process – Pillar 3

12 Art. 68.1 and 72.2 RBD. 13 Art. 68-73 RBD do not demand this for each bank (except as set out below). However, the since adapted or introduced art. 129.3 and 136 RBD assume that individual and sub-consolidated supervisors will want to be involved in the decision making on demands and the distribution thereof over the legal entities involved, or will make additional demands on a solo or sub-consolidated level. Member states are free to introduce such additional demands. 14 Art. 68.2, 68.3, 71, 72, 73.3 RBD.

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EU Banking Supervision

Important on a sub-consolidated basis if its – Organisational requirements set out in the direct parent is not a bank or financial holdlicensing process ing company based in the same member And if it concerns a significant subsidiary: 15 state – Partial pillar 3 disclosure on a solo or sub-consolidated basis And if there is also a third country bank, financial institution as meant in the RBD or an asset management company in the subgroup (or the member state makes use of goldplating): – Solvency ratio, – Qualified holdings outside the financial sector – Pillar 2 (ICAAP) plus de facto also SREP16 – Large exposures

The main rule of the CRD is thus that each individual licensed bank is subject to key aspects of supervision on an individual (solo) basis. It has to comply with organisational, large exposures, and solvency ratio (minimum capital requirements)17 requirements on an individual basis (solo supervision). The other components of prudential supervision such as pillar 3 are only applicable to it on a consolidated basis (assuming that the bank is part of a group). Determining which requirement applies to which legal entity requires an addiction to mind games and reading endless cross-references to sections or articles of the RBD as well as very strictly defined concepts used to designate different types of parent undertakings. This results from having to take into account all the various banking group structures that exist in the EU, and their links with third country entities and non-regulated holdings or holdings regulated in a different sector. For upward consolidation of non-regulated entities, reference is made to chapter 17.3, for supplementary supervision on financial conglomerates reference is made to chapter 17.4, and for groups with links to parents or subsidiaries outside the EU, to chapter 17.5. Importantly, each bank with a bank or financial institution as a subsidiary anywhere (and no parent bank or parent financial holding company based in the same member state) has to comply with all components of prudential supervision: – if it is the ultimate parent (i.e. no parent elsewhere either) on a consolidated basis; – if it is a subsidiary bank of a bank based elsewhere in the EU itself, on a sub-consolidated basis, without the pillar 3 requirement; – if it is a subsidiary bank of a parent financial holding company based elsewhere in the EU both (a) on a sub-consolidated basis, without the pillar 3 requirement, and (b) on

15 Art. 72.2, 73.2, 73.3 RBD. 16 See the footnote above on ‘de facto for pillar 2 assessment’ on the impact of art. 129.3 and 136 RBD. 17 Art. 68 RBD. Also see art. 1.2 RBD, and chapter 18.3 for the parent undertakings.

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Consolidated and Solo Requirements

a consolidated basis, including the information of the parent financial holding company and its subsidiaries (also see chapter 17.3), and including the pillar 3 requirement. A parent financial holding company is strictly defined. Other rules apply if the bank is the subsidiary of other types of holdings; see chapter 17.3 and 17.4. Each bank with a parent bank or a specific type of financially oriented parent company in the EU18: – if the parent is a bank, the subsidiary is exempted from consolidated or sub-consolidated obligations (but still has to comply with the individual obligations); – if the parent is a financial holding company, the subsidiary has to comply with the individual obligations and with the obligations on a consolidated basis, including the information of the parent financial holding company and its subsidiaries (also see chapter 17.3 and 17.4 for this and other types of holdings), and including the pillar 3 requirement. Each bank with neither a subsidiary nor a parent undertaking that includes it in its consolidation19 has to fulfil those additional obligations itself, but of course on the basis of its individual information, as there is neither a subsidiary nor a parent to consolidate. Reference is also made to the regime on qualifying holdings outside the financial sector (chapter 11.3) and on pillar 2 and 3 (chapters 14 and 15). Consolidation – Which Group Entities Are Captured? Consolidated supervision is based on the consolidation concept in the accounting area; see chapter 6.4. Whether a bank is a parent or subsidiary (and thus should be captured in some form of consolidation) is defined in the CRD by reference to the 7th Council directive on consolidated accounts; regardless of whether the bank drafts its public accounts under the ABD or under the IFRS regulation. Which undertakings are captured by a requirement to present consolidated or sub-consolidated figures is thus determined in principle by these accounting requirements, as adapted under the range of national discretions provided20. The subsidiaries or other undertakings with which there is another sufficiently clear link captured in the consolidation include:

18 Article 71 and 72 RBD. 19 This means any entity which has neither a parent nor a subsidiary, or has been excluded from consolidated supervision on the banking group by the consolidated supervisor (also see chapter 5, 6.4, and 19). 20 Art. 4.12 and 4.13, 68, 133 RBD and art. 1, 2 and 12 of the 7th Consolidated Accounts Directive 1983/349/EEC. Many of the categories mentioned can be extended or limited under national discretions, reducing the comparability across groups from different member states. For consolidation purposes, the dominant influence criterion cannot be deviated from as a result of art. 4.13b RBD.

775

EU Banking Supervision

– subsidiaries, which are for example undertakings in which the parent undertaking has the right to exercise a dominant influence, or has a majority of voting rights, or has the right to appoint or remove a majority of the members of the administrative, management or supervisory body, and is a shareholder or members, or – solely as a result of its past use of its votes as a shareholder or member – it had determined the composition of the majority of the administrative, management or supervisory body, or controls under a shareholders agreement or members agreement a majority of shareholders or members voting rights while it itself is a shareholder or member; – undertakings with which it is not connected, but which are managed with it on a unified basis on the basis of a contract or the articles of association; and – undertakings that are not a subsidiary, but either the administrative, management or supervisory bodies of those undertakings consist for the major part of the same persons in office at the bank during the financial year and until the consolidated accounts are drawn up. The choice for a reference to the ABD consolidation concept instead of to the IFRS consolidation concept is likely a conscious one. Under IFRS, every entity that is ‘controlled’ by another is a subsidiary of that other entity (the parent)21. Its data have to be included in the consolidated financial statements of the parent. Control is a wider concept than the definition set out above. For instance special purpose vehicles that are officially set up ‘at arm’s length’, but fully along the conditions and for the use by the bank, would have to be consolidated under IFRS (and not necessarily under ABD as applied under the CRD). The main rule is that all subsidiaries are captured, but there are exemptions both in the accounting rules and in the CRD. Supervisors are urged to ensure (but perhaps not obliged to ensure) that all subsidiaries that are banks or investment firms themselves are included in the consolidation. Partial consolidation is possible if it is not a fully owned subsidiary. Some other exceptions are available to the scope of solo or consolidated regime if a bank is captured both in solo and in consolidated or sub-consolidated supervision, either as a parent and/or as a subsidiary. Those are laid down either in national discretions or in enumerated supervisory decisions available on a case-by-case basis. Some are possible regardless of the location of the bank and its parent or subsidiary, others can only be applied if both are located in the same member state; see below. Especially for undertakings that are subsidiaries but in which the bank holds no shares or membership, due to e.g. significant influence, the supervisor will set rules on how the consolidation is carried out (this is not harmonised).

21 International Accounting Standard 27, Commission Regulation 2008/1126. Also see SIC-12 consolidationspecial purpose entities.

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Consolidated and Solo Requirements

Under accountancy rules, several entities can be excluded partly or fully22: – from consolidation (immaterial subsidiaries can be left out of scope, joint venture subsidiaries need only be proportionally consolidated, and pure parent holdings without industrial or commercial activity need not be consolidated if it is part of a joint venture); – from the obligation to publish (sub) consolidated accounts (if the parent is based in any EU member state). The exemptions valid in the accounting directives or regulations are generally also valid when looking at consolidated public accounts of banks for prudential purposes (see, however, the deviations for prudential purposes on e.g. upward consolidation; see chapter 17.3). The CRD adds and deletes some of these possibilities to exclude entities. A subsidiary bank is for instance only exempted from reporting to the supervisor on a sub-consolidated basis if its parent is based in the same member state (and thus has to report if its parent is based in another member state) to enable the local supervisor to fulfil its responsibilities for banks licensed in its country. The exemption on immaterial subsidiaries is doubly available, both via the applicable accounting legislation and via a later addition to the CRD. It concerns23: – exemptions allowing a bank to exclude small or immaterial subsidiaries from the consolidation; – exemptions allowing a bank to exclude third country subsidiaries on which it has difficulties obtaining information from the consolidation; – exemptions allowing a bank proportional instead of full consolidation of a subsidiary bank or financial institution. This is an exemption to the main rule of full consolidation, specifically for subsidiaries that are banks or financial institutions (as defined in the European passport context; see chapter 5) themselves, and are not fully owned by the bank. If the bank has no ownership at all, but does exert dominant influence as a result of which the other entity a subsidiary, the supervisor can set specific rules for similar ‘proportional’ consolidation. The exemption is available only if other shareholders or members are liable for the subsidiary too, and those have satisfactory solvency, or where the liability of each shareholder is limited to the share in capital they hold;

22 Art. 4.2-15, 32 7th Consolidated Accounts Directive. 23 These exemptions are based on respectively art. 69 and 70, 73.1, 133 and 134 RBD. Art. 133 and 134 overlap to some extent, to emphasise the necessity of dominant influence establishing the character of a subsidiary, and the power of the supervisor to establish how to consolidate these. This allows for deviations from public accounts consolidation criteria for e.g. special purpose vehicles used in securitisations; see chapter 8.6.

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EU Banking Supervision

– exemption allowing – if the supervisor agrees – some participations or capital ties to other banks or financial institutions (not covered by the previous exception), to be treated instead of via consolidation but as an ‘equity’ holding (similar to the solo treatment of subsidiaries). In addition to the sector specific exemptions, a similar exemption is possible to allow the coordinating supervisor of a financial conglomerate to exclude third country and/or nonmaterial entities from the consolidation; see chapter 17.424. The supervisor of a bank with subsidiaries (regardless of whether it is responsible for subconsolidated or consolidated supervision) has the final responsibility to determine which subsidiaries are captured in the consolidation25. This role of the supervisor is less important for fully owned subsidiaries, but can be quite important for subsidiaries which are not owned but where the parent has control through other means. In that case, the consolidating supervisor can also determine whether and how consolidation is to be carried out. If the consolidating supervisor excludes some participations or capital ties from consolidation, it can require (or permit) use of the equity method. In that case the information on the business of the subsidiary is excluded from the consolidated information, and the parent only puts on its balance sheet the value of the equity interest, which becomes an exposure under the credit risk calculations; see chapter 8. The bank has to supply the consolidated information, and cooperation and information obligations are applicable between the supervisors on the various supervised entities; also see chapter 17.4 and 21. For capital definition purposes, the investment sector and the banking sector have been treated as identical. Groups with banks and investment firms are thus ‘easily’ consolidated, as the same thinking is the basis for both capital and its use as the numerator in the calculation of solvency ratios. Some subsidiaries should be deducted under the Basel capital accord, but the supervisor has significant leniency here under the RBD; see chapter 7. In the Basel II version of the capital accord, the following group entities are not consolidated26: – the parent of a bank holding company if it is not predominately ‘financial’; – insurance subsidiaries;

24 Art. 6.5 Financial Conglomerates Directive. 25 Art. 133-134 RBD. 26 See §24-39 BCBS, International Convergence of Capital Measurement and Capital Standards: A Revised Framework, June 2006. Part 1 of the framework is misnamed ‘scope of application’, but instead largely deals with deductions from (consolidated) capital.

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Consolidated and Solo Requirements

– commercial subsidiaries and significant minority investments in other commercial entities above materiality levels (of at least 15% of the banks’ capital per investment and 60% of the banks’ capital for all such investments combines); – significant minority investments in banking/securities entities (and implicitly also such significant minority investments in insurance entities27); – special purpose vehicles that are ‘controlled’ under accountancy rules, but excluded under the prudential filter approach (to allow securitised assets to be taken off the balance sheet and replaced by the securitisation regime; see chapter 6.4, 8.1 and 8.6. The value of insurance subsidiaries is fully deducted from capital on a solo basis in the CRD. This may also apply on a consolidated basis if a member state wants to; but the obligation at the consolidated level is limited to some large participations in unconsolidated insurers that have to be fully deducted from the consolidated numbers28. If subsidiaries are deducted, the positions of such related entities are not consolidated in the data of the group. This allows for possibilities of arbitrage (shovelling risky assets towards the regime most amenable to it by selling them between subsidiaries). Some mitigating measures apply under the group provisions of the CRD and of the financial conglomerates directive. Instead of being consolidated (and thus truly playing a part in the risk perception and capital adequacy), the value of any stakes held by the bank in entities excluded from consolidation is deducted in full. This prevents that capital (which serves to cover risks within the subsidiary) to be double geared for additional risks in the parent or in other subsidiaries. For investments that are below e.g. the materiality threshold, risk weighting of the shares is obligatory like for any asset, but with a minimum for credit risk of at least 100% for stakes in commercial entities. In Basel, the deduction is for 50% from tier 1 and 50% from tier 2 capital29. However, though double gearing is avoided, having a full overview of the risks that are present in the group is sadly also avoided. For some other minority interests by others in entities controlled by the bank, the treatment depends on whether it is a positive item (debit) in which case it is deducted, or a negative item (credit) in which case it can be added to reserves30. Many unregulated entities will on the other hand be captured in the consolidation, such as real estate subsidiaries, concern-finance subsidiaries or even controlling interests in industrial or trading entities; unless they profit from one of the exemptions to consolidation.

27 See the last sentence of §33 BCBS, International Convergence of Capital Measurement and Capital Standards: A Revised Framework, June 2006, page 9. 28 Art. 57, 60, 66 and art. 124 and further RBD; see chapter 2 and 7. 29 §37 BCBS, International Convergence of Capital Measurement and Capital Standards: A Revised Framework, June 2006, page 10. 30 Art. 57 and 65 RBD.

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EU Banking Supervision

The primary example of unregulated entities that are captured in consolidation, are the upward consolidated parent companies that are made subject to supervision because they own a bank31. The treatment of the unregulated entities is legislated on in a complex and inaccessible manner. The treatment of groups consists amongst others of: – consolidation of the financial information of the group on external assets and total available capital (see this chapter 17 and chapter 7), sometimes including non-licensed parents and siblings, sometimes not; – heightened supervision of intra-group transactions to non-consolidated parents and siblings32; – risk weighting of intra-group exposures in the solo treatment33; – large exposures to group entities (see chapter 11); – the approval of shareholders at the time of licensing and during the lifetime of a bank, as well as attention paid to closely linked entities in third countries (see chapter 5); – the access to information in the hands of group entities (see chapter 20.2); – outsourcing of key functions to group entities (see chapter 13); – bankruptcy regimes and financial stability (see chapter 18 and 22). From a conceptual point of view the happenstance treatment (and especially the lack of solo supervision of consolidated unregulated entities within the group) is rather odd. This is a cause of unnecessary legal complexity in the CRD and in the financial conglomerates directive (see chapter 17.4). It is perhaps an overemphasis on the personification of legal entities, where it would indeed be presumptuous to keep family members under direct supervision just because a relative dabbles in banking. A banking group is, however, not a family of individuals. It is an economic unity consisting of legal entities, in which a parent or grandparent entity by definition is actively involved in the banking activities of a subsidiary Grandson Bank Inc, and may sacrifice the interests of the bank to save itself or another subsidiary. Being part of the same ‘family’ is not an accident of birth, but part of the strategy and acquisitions of the group. It is difficult to understand why the legal entities which are deemed to be of high importance to banking supervision because they are part of the consolidated group, are only accessible via the ‘kin’ that by design or coincidence is the one entity with a license. The type of group structure chosen by the banking group has a disproportional effect on the amount of access the supervisors have (e.g. if the ultimate 31 Art. 1.2 RBD. See chapter 17.3. 32 Also see recital 60 CRR. 33 Though with important carve outs, where intra-group exposures are risk weighted at 0% for intra-group transactions where both are part of a consolidated supervisory set of requirements and under an assumption of capital transferability. Art. 80 RBD and art. 113 CRR.

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Consolidated and Solo Requirements

parent is a licensed entity, the supervisors have much more access than if the ultimate parent – by design or historic accident – is an entity without a license)34. Solo Supervision Where the establishment of the activities that have to be consolidated can be complicated, the scope of solo supervision is easy, at least from a theoretical point of view. The scope is the business of the legal entity, established under the accountancy standards mentioned in chapter 6.4. This can nonetheless be difficult to determine if the legal entity is used by different business lines within the group, or has activities in multiple jurisdictions or joint enterprises with multiple other legal entities. This is a problem allocated squarely onto managers of the legal entity and their internal and external accountants. What they report (unless there are clear reasons to doubt the accuracy or veracity of the report; in which case such managers and accountants will be in trouble under licensing and organisational requirements) will determine the scope of the quantitative supervision of the licensing supervisor of the legal entity. Under the solo requirements, shares and loans to subsidiaries are treated as equity interests and as loans under credit risk, market risk and operational risk; as if the subsidiaries are third parties. Several exceptions are available in e.g. the standardised approach to credit risk and in the large exposures regime to allow trading and investments to flow more easily between group-entities; see chapter 11. If such exposures are seen only on a consolidated or sub-consolidated basis, the exposures (shares or loans) between undertakings captured in the consolidation net out against each other, and thus no capital requirements would have been necessary for those. The benefit of using both methods is that not only the health of the whole group is known, but also of each individual institution and the distribution of capital and cash across undertakings and jurisdictions (which is essential information in case of extreme risks materialising or in case of a general crisis). However, the capital requirements calculations allow important carve outs of e.g. the credit risk calculation if the supervisor agrees, negating the benefit of solo supervision if certain conditions are met such as being captured in the same consolidation requirements, and on asset transferability (see below)35. Full solo supervision would allow member states to assess their maximum exposure in a crisis; see chapter 18. In addition to the partial carve outs, several banks are fully exempted from solo supervision.

34 Joint Forum, Review of the Differentiated Nature and Scope of Financial Regulation, January 2010, www.bis.org page 7-8, 34-43. 35 Art. 80 RBD, and recital 60 and art. 113 CRR.

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EU Banking Supervision

These exemptions of solo supervision are also based on – highly debatable – assumptions of capital transferability between a parent and a subsidiary bank36. Whether these exemptions (described below) can be used is up to the licensing supervisor in a supervisory discretion, even if the CRD-criteria are fulfilled. If the criteria are fulfilled and the supervisor chooses to grant the exemption, the subsidiary no longer has to comply with internal governance, solvency ratio and large exposures requirements on a solo basis37. Similar as for the consolidated pillar 2 assessment (see chapter 14), subsequently measures must be taken to allocate risks that have been noted at the consolidated level between the parent and the exempted subsidiary (with supporting allocation of financial buffers). If the exemption is granted, it only applies to quantitative supervision. The licensing requirements (including e.g. the ongoing requirement on two executives and on initial capital) and conduct of business requirements (e.g. following from Mifid internal governance and fair treatment rules) continue to apply both to the parent and the subsidiary on a solo basis, regardless of the granted exemption38. The assumption that capital/assets can be transferred easily is quite heroic. If either of the two entities is encountering stress, this assumption will likely not translate into fact. Capital/assets usually can be transferred formally (through a dividend or an emission of shares) or informally (a transfer of cash, increasing the funds on hand in exchange for a paper commitment) quite easily when both entities and the markets are healthy. Bankruptcy laws, company laws, and prudential requirements, however, provide increasing barriers to such transfer when one or both are in worsening financial health. These compound practical issues on timeliness of the transfer, currency exchange etcetera. Bankruptcy laws impact on the validity of and liability for transactions made to the detriment of the general creditors in the approach to and during a bankruptcy; domestic company laws can put responsibilities/liabilities on the board members of each subsidiary for making loans or paying dividends when there is no certainty that the subsidiary will survive, or if the parent will be able to return the favour when needed. Banking prudential regulatory requirements (e.g. liquidity requirements and large exposures, as well as required approval for changes 36 The Commission has published reports on asset transferability. Asset transferability is hoped to improve the resilience and resolvability of banking groups, though once assets have left a legal entity to help out the wider group or specific troubled legal entities, those assets no longer are available to legal entity and any minority shareholders, nor importantly to its depositors and other creditors when it in turn becomes troubled (or the troubles of group entities overwhelm it). See chapter 18. Commission, Commission Services’ Report on ‘Asset Transferability’, 14 November 2008, DBB Law, Study on the Feasibility of Reducing Obstacles to the Transfer of Assets Within a Cross Border Banking Group During a Financial Crisis, Final Report, contract ETD/2008IM/H1/53, 20 April 2010. 37 Art. 68.1 only refers to three specific issues on solo supervision. Also see art. 118 RBD. See art. 7 and 9 CRR, and a similar possibility for the new liquidity requirements in art. 8 CRR. 38 See chapter 5 and 16. Such regimes are not referenced in art. 68.1 RBD, and apply on a solo basis to each bank.

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Consolidated and Solo Requirements

in the structure of the group), can delay or prohibit transfers of assets if value is not returned in equal measure to secure the safety of the locally licensed entity. During the 2007-2013 subprime crisis several instances of problems occurred. These lead the BCBS to limit e.g. the calculation of consolidated short term liquidity ratios in its new Basel III package to be covered only by assets that are actually likely to be available at the parent entity, unless and to the extent the assets that are imprisoned in a subsidiary actually cover funding needs at that subsidiary39. If that line of thinking is applied to the exemptions discussed here, they should no longer be available. The three full capital transferability exemptions are40: – a national discretion to allow a subsidiary bank based in the same member state as its parent bank an exemption from the obligations on solvency ratio, large exposures and organisational requirements on the basis of its own information (on an individual basis); – a national discretion to allow a parent bank in a member state (i.e. a bank with a subsidiary bank or financial institution anywhere which is not the subsidiary of a bank or financial holding company in that same member state) not to be supervised for the obligations on solvency ratio, large exposures and organisational requirements on the basis of its own information (on an individual basis). In this case, only the supervision on the basis of sub-consolidated or consolidated information remains; – a supervisory discretion on a case-by-case basis to allow the parent bank, when supervised on an individual basis (i.e. not on a sub-consolidated or consolidated basis) to include information of certain subsidiaries (based anywhere) in its individual data as if the subsidiary was not a separate legal entity but a part of the legal entity of the parent. Two of these capital transferability-exemptions were so contentious that they were only allowed if both the parent and the subsidiary are based and supervised in the same member state, thus limiting the impact on banks outside the member state (and making it a fiscal problem of the member state concerned only, if the assumption proves to be untrue). Consolidated Model, and Capital Allocation for Solo Supervision A specific issue is model approval. For instance for the AMA approach in operational risk, the model can be approved by all relevant supervisors jointly, if it is intended to apply to the full group (or by the consolidating supervisor and the supervisors involved if only to certain subsidiaries and the parent). However, the operational risk capital requirement 39 BCBS, Basel III: International Framework for Liquidity Risk Measurement, Standards and Monitoring, 16 December 2010, page 7 and 40; also see chapter 12.2. 40 See art. 69.1 and 69.2, 69.3 and 69.4, and 70 RBD respectively. See art. 7-9 CRR. Also see the partial exemption (0% risk weighting in the standardised approach) in art. 80 RBD and art. 113 CRR.

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also applies at the solo level (and sometimes the sub-consolidated level). A choice could have been made to require a solo model, or to require the subsidiary to calculate capital requirements under e.g. the standardised approaches. Instead, the RBD allows the bank to propose a capital allocation mechanism as part of the model (that has to be approved separately by the relevant supervisors)41. It ‘allocates’ the total amount of capital for the group as calculated under the model to the parent and to the subsidiaries. The available allocation mechanism is not (yet) very risk sensitive, and host supervisors may be concerned that the consolidated capital requirement, including efficiencies that apply at the group level such as diversification and risk mitigation techniques, but not at the solo level, may result in too little capital allocated to ‘their’ subsidiary bank if either they or the particular subsidiary has too little influence in the internal capital market within the group42. Similar arrangements apply to other internal models the banks may use; see chapter 6.3, 8.3, 8.4, 9.4, 10.4 and 21.7. EBA/CEBS has issued guidance on this issue43. It points out the need for separate approval of the model, of the allocation mechanism. The bank will need to demonstrate the feasibility of the allocation mechanism, taking into account size and complexity of the subsidiaries, and how much each entity should get under different alternative methodologies. CEBS/EBA stimulates/requests the development of more risk sensitive and more equitable allocation mechanisms over time, as the allocation is sometimes now simply volume-based instead of risk-based. It also requires the actual roll-out of the framework to the subsidiary, and that its risks and controls are actually included in the group-wide calculations. Return to Full Independence The executive directors of a subsidiary in troubled times are in a difficult position personally. In the jurisdictions following the Rheinland model, they have a certain autonomous obligation to act in the best interest of the legal entity of which they are the executive director, even where this might not be in the best interest of the group as a whole. This is less clear in the Anglo-Saxon countries, but even here they will need to be prepared for the situation that a group may be split up in a bailout or during liquidation. At the same time, the executives can be employees of the parent, and under company law and liability law obliged to take into account the interests of the group. The CRD provides an additional component in this mix if the subsidiary is a bank. The continuity of the subsidiary that has a separate 41 Annex X part 3 §30-31 RBD. Also see chapter 6.3, 10.4 and 21.7. 42 See for a study of the capital allocation practice in a domestic mutual bank consisting of a headquarter and 181 less and more influential member banks (i.e. without supervisory influence on the allocation): K.J.M. Cremers, R. Huang & Z. Sautner, ‘Internal Capital Markets and Corporate Politics in a Banking Group’, The Review of Financial Studies, Vol. 24, No. 2, 2011. 43 CEBS, Compendium of Supplementary Guidelines on Implementation Issues of Operational Risk, September 2009/July 2010.

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license is the prime concern of the local board (and of the local supervisor). This is also acknowledged now by the FSB in its recommendations on the resolution of systemically important financial institutions44. Apart from allowing host supervisors at the global level – treating the EU as one jurisdiction – to demand that systemic branches are being transformed into subsidiaries so that their potential resolution can be better handled at the national level, it indicates that supervisors should be able to make changes to the legal and operational structure of the bank, and asks for judicious use and limits on intra-group guarantees and lending. Such guarantees and links can make handling a failing crossborder bank extremely difficult. The Commission, on the other hand, is proposing to clarify group support arrangements and group resolution plans. In its January 2011 consultation paper45, it favoured making clear that subsidiaries and parents should enter into binding (transparent) group support agreements that clarify which legal entities in the group support which other legal entities in the group. It does not, however, link the scope of the group support agreements to the scope of consolidated supervision46, nor does it take into account whether such agreements are legal and enforceable under domestic company law of the legal entity concerned. Reference is made to chapter 18 for the recovery and resolution proposals and the potential impact of ‘resolution plans’ on the bank being forced to align its business lines to specific legal entities. Currently, it is not always clear which business belongs to which legal entity, and whether it can continue to operate such activities it if the other legal entities in the group would no longer be there (leading to additional risk of intra-group contagion that threatens to draw all legal entities into bankruptcy, and thus threatens functions provided by the group that are not the cause of the failure of the group). Imperfect Solution – Tension Between Economic Reality and Legal Reality Neither solo- nor consolidated supervision are perfect measures of the safety of the bank. Each alone would allow gaming to occur. The license to be a bank is given to an entity (most often a legal entity; see chapter 4.4 and 5.2), the powers and instruments of supervisors are fixed to that entity, the bankruptcy regime is fixed to the entity and the corporate governance obligations of board members are fixed to an entity. The regulatory treatment is sometimes confusing, and the scope and exemptions of consolidation is not aligned to 44 FSB, Reducing the Moral Hazard posed by Systemically Important Financial Institutions, FSB Recommendations and Time Lines, 20 October 2010, page 5. www.financialstabilityboard.org. 45 Commission Working Document (for consultation and discussion), Technical Details of a Possible EU Framework for Bank Recovery and Resolution, 6 January 2011. 46 R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 4.4. Also compare Commission, Commission services’ report on ‘asset transferability’, 14 November 2008, DBB Law for the Commission, Study on the Feasibility of Reducing Obstacles to the Transfer of Assets Within a Cross Border Banking Group During a Financial Crisis, Final Report, contract ETD/2008IM/H1/53, 20 April 2010.

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market perceptions of what the group is, nor with how the groups are managed. The treatment of groups and especially mixed conglomerates are rightly criticised for a lack of structure and theoretical backing47. Risky subsidiaries are left out, impairing the benefit of having a consolidated view of the group. Several risk enhancers in a group (where is the money, where is the expertise, where are decisions made) are not completely covered yet, and the treatment of diversification benefits and downsides is inconsistent. However, some of the problems consolidated supervision addresses are clear (double gearing, the relation to legal entity financial buffers as supervised by the licensing country, and the rapid flow of liquidity across borders within the group when the group is assumed to be in good health by the supervisors. The pillar 2 risk assessment at a consolidated level (and at a solo level) helps address the hidden risks in the group that are not captured in the purely quantitative solvency ratio calculations of pillar 1. Quantitative supervisors (and banks) appear sometimes confused as to the benefit of posing requirements on individual entities as well as on the group to which they belong. This has leads to imprecise wording, and ambiguous obligations, especially if the supervisors try to deal with overarching concepts that apply in all parts of pillar 1 and 2. The BCBS does not even make an attempt, but the EU policy frameworks try to differentiate. By way of example: – the CEBS-EBA stress testing guidelines introduce the concept of a ‘firm-wide’ stress test to deliver a picture of the risk of the ‘institution’48. Neither concept is clearly defined, and there is a mix-up on whether ‘firm’ means the group, the parent entity, or a concept of ‘enterprise’, that includes all consolidated entities or at least those with integrated activities. It might even refer to a different economic gestalt, such as an organisation set up in business lines (see below). The guidelines refer to group risks that arise at a firm-wide level (!), and application to e.g. consolidated level and at material entities, which might be at the ‘solo and/or sub-consolidated level if appropriate’. In this respect the befuddled guideline cannot overrule the CRD. If the entity is licensed, it needs to stress test those segments of the CRD that apply to it on a solo entity basis, such as liquidity risk management and credit risk. If consolidated supervision is applied, it needs to stress test those requirements that apply (also) at the consolidated level, if stress testing is part of those requirements (e.g. on pillar 2). See chapter 13.6. The way banking groups are managed in practice is often not linked to legal entities, but also not to the scope of consolidation with its statutory exceptions. Nonetheless, supervisors 47 H.E. Jackson, ‘Consolidated Capital Regulation for Financial Conglomerates’, in H. Scott (Ed.), Capital Adequacy Beyond Basel, New York, 2005, chapter 3. 48 CEBS-EBA, Guidelines on Stress Testing (GL32), 26 August 2010, page 22. For stress testing see chapter 13.6.

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appear blithely happy to accept that banking groups manage along business lines or business units that are not linked to the legal entity structure, nor to the licensed banks among those legal entities49. A licensed bank that is part of a group can belong to several ‘lines’, and income and assets are allocated to it from several of those lines. A line or unit of the group can consist of multiple legal entities. How the managers at the solo-level should be deemed to be effectively in control of the banks’ activities is doubtful. It is nonetheless required in the licensing requirements; on a solo basis. How to determine which assets/liabilities belong where may be largely irrelevant for financial stability and counterparty protection purposes during the lifetime except for local reporting and annual accounts, but becomes key in bankruptcy procedures. This discrepancy can result in a legal wrangle between bankrupt or still alive entities that used to be part of the same banking group. It is unclear why supervisors do not force alignment between the legal structure of a bank and the way it is governed in business lines/units, except if one presumes that banking groups will not and cannot go bankrupt (which may have been the presumption even among banking supervisors in the boom economy prior to the 2007-2013 subprime crisis in many western economies). Future resolution plans/living wills (see chapter 18.3) may result in a better alignment between legal and practical structures. At the moment the supervisors appear to accept the prerogative under EU law of the bank to determine its own business model. There is a range of – barely used – instruments to demand a type of organisation that does not hamper the goals of supervision under respectively the licensing requirements of each individual bank, the requirement to have a clear organisation within the group, and the pillar 2 assessment of the risks within the group50. These instruments are currently mainly used to limit the most excessive badly organised banks/banking groups. Future Developments The CRD IV project does not change the outline of consolidated and solo application51. For the newly added subjects it had to be determined whether they apply at either solo, or consolidated, or both levels. Unlike in previous versions of the Basel capital accord, the Basel III amendment spells out more clearly what it finds desirable. The liquidity ratios have to be applied both at the solo and the consolidated levels (an expansion from the 49 CEBS-EBA, Position Paper on the Recognition of Diversification Benefits Under Pillar 2, 2 September 2010, page 13. 50 Art. 12.2, 12.3 first sentence, 22, 71, 73.3 and 124 RBD. On the secondary role supervisors see for themselves in this regard, see e.g. CEBS/EBA, Guidelines for the Joint Assessment of the Elements Covered by the Supervisory Review and Evaluation Process (SREP) and the Joint Decision Regarding the Capital Adequacy of Cross-Border Groups (GL39), 22 December 2010, page 16. 51 Art. 108-110 CRD IV Directive, and art. 6-23 CRR. Also see for instance the lack of attention to intra-group transactions within the scope of consolidation in art. 80 RBD and recital 60 and art. 113 CRR.

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EU Banking Supervision

current EU regime of leaving this to the local/host supervisor), though the EBA guidelines on liquidity risk management already anticipated on this change52. According to the BCBS, the assets used to cover the ratio can only be used for consolidated calculations if these assets would be freely available to the parent entity in times of stress, or otherwise only to the extent they cover the liquidity needs at the legal entity where the assets are booked53. The countercyclical and capital conservation buffers will apply (from 2016) both on a solo and a consolidated basis. The mandatory individual systemic risk buffers as determined at the worldwide level apply only at the consolidated level, but such systemic risk buffers can also be set for banks – even banks that are part of such a globally systemic group – on a solo or sub-consolidated basis, and for systemic groups that are not globally systemic also at the consolidated level54. In a deviation from the Basel III and the previous versions of the capital accord, the insurance subsidiaries explicitly need no longer be deducted; see chapter 2 and 7. The leverage ratio is calculated both on a solo and a consolidated basis, except if the supervisor waives this requirement for solo calculation55. For the new corporate governance requirements, including e.g. the bonus-cap, the decision has been made to apply these both on a solo and consolidated level. The text for both internal and corporate governance has been made more strict, requiring full compliance unless it can be shown that a third country actually forbids what the EU has prescribed56. The Commission remains a valiant defender of capital transferability. In its proposals for a directive on resolution and recovery, it is proposing making commitments to come to each other’s aid explicit (and public) for so-called ‘intra-group financial support’57. Supervisors could still veto it at the moment of signing if one of the banks involved is noncompliant with the CRD, and at the moment of the actual loan if e.g. it would threaten liquidity or solvency at one of the participating banks, or it might threaten financial stability. The usefulness of such intra-group support will thus work well as long as the group as a whole is solvent and liquid, but in other circumstances (when such a commitment is most needed) it will likely not be available, unless and in as far as the proposals for a banking union come to full fruition (including joint supervision, joint deposit insurance and joint resolution cost sharing). 52 Art. 6.4, 11.3, 20, 21 and 412-413 (part six) CRR. 53 BCBS, Basel III: International Framework for Liquidity Risk Measurement, Standards and Monitoring, 16 December 2010, page 7 and 40. Also see chapter 12. 54 Art. 129-131 CRD IV Directive. 55 Art. 6.5, 7, 11 and 429 (part seven) CRR. 56 Art. 109 CRD IV Directive. 57 See proposed art. 16-22 of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012.

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17.3 Parents of EU Banking Groups Introduction Banking groups are organised in very different ways, which may make the application of consolidation requirement less than straightforward. This is especially the case for groups that have a varied set of activities, of which banking is only one. The ultimate parent of a banking group is not always a bank, it is not always regulated or supervised in the EU, and sometimes a subsidiary behaves as if it is the parent (e.g. in mutual banking groups). Depending on the organisation of the banking group, different factors influence its viability and/or the viability of licensed banks that form part of it. For EU banking supervision purposes, the clearest situation is if the ultimate parent is an EU bank and the banking group is focused solely on banking and investment services. In that case, consolidated supervision is allocated to one of the EU banking supervisors, and the licensing process and the sub-consolidation rules are straightforward on the allocation of solo supervision and sub-consolidated supervision obligations; see chapter 17.2. Each supervisor and member state then has clear rights and responsibilities towards the banks under its jurisdiction, which the banking group can take into account. These are based on relatively harmonised legislation and increasingly harmonised supervision practices. This situation is not standard for the banking groups operating in the EU. The parent of an banking group operating in the EU can appear in several different guises: – EU bank/parent of a banking group; – third country parent of a banking group composed of amongst others licensed EU banks (see chapter 17.5); – financial conglomerate/parent of a conglomerate that contains a significant number of banks, and is itself either: (i) an EU bank, (ii) an EU insurer or investment firm, (iii) an EU mixed financial holding company, or (iv) a third country entity58; – financial holding company: a company that holds shares in at least one bank but is not a bank itself, and whose shareholdings are focused in the financial sector. If it is the parent of a financial conglomerate, it is treated under those rules instead (as a mixed financial holding company or as an insurer, if it is licensed as an insurer); – mixed activity holding company: a company that holds shares in at least one bank but is not a bank itself, but whose shareholders are not focused in the financial sector alone. If it is the parent of a financial conglomerate, it is treated under those rules instead (as a mixed financial holding company or as an insurer, if it is licensed as an insurer). Examples are industrial groups with bank subsidiaries, either as an independent business line or to finance purchasers of their main product lines, such as cars; 58 For option i to iii see chapter 17.4, for option iv also see chapter 17.5.

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EU Banking Supervision

– a central cooperative bank/mutual bank of which the members are local cooperative banks, where the ‘subsidiary’ central cooperative in practice performs the function of the parent of the local cooperatives (also see chapter 17.6); – a single or controlling shareholder who is a natural person, and does not qualify as one of the above (this person is not consolidated, but ‘only’ assessed as the holder of a qualifying holding in the bank; see chapter 5). All these parents are holders of qualifying holdings as they are in control of banks, so will be assessed as to whether they are suitable for that role in light of the interests of the subsidiary bank; see chapter 5.2. The rules for banking groups, financial conglomerates, financial holding companies and mixed activity holdings are instituted in order to capture group wide events and group wide financing that potentially impact on the health (support or endanger) of the banks in the group. As a result, they are mutually exclusive if the parent is not a bank itself. The parent can be the parent of a financial conglomerate. If it is not the parent of a financial conglomerate it can be either a financial holding company if its group is mostly active in the financial sector, or a mixed activity holding if it is mostly active outside the financial sector. The scope of requirements on the parent reduces gradually depending on its categorisation. The other designations (bank, financial conglomerate and cooperative) are not mutually exclusive. A parent can be the parent of a banking group (resulting in consolidated supervision under CRD rules) and at the same time the parent of a financial conglomerate (resulting in supplementary supervision under the financial conglomerates directive on the banking group and the insurance group that is not necessarily captured under the scope of consolidation described in chapter 17.2) and at the same time a central cooperative bank if it has other cooperative banks as its members (resulting in some additional rules being applicable and dispensations of some rules apply to the local cooperative banks, but not to normal subsidiary-banks; see chapter 17.6). Financial Groups The rules for banking groups and for financial conglomerates apply at each level in a group, unless dispensations apply59. If a bank is the ultimate parent, the consolidation at the highest level is fully done under banking supervision rules; with some supplementary requirements following from the financial conglomerates directive. If a financial holding company is the ultimate parent, those same rules apply with two exceptions:

59 See chapter 17.2 for the level of application for the banking group requirements, and chapter 17.4 for the level of application for financial conglomerates supplementary supervision.

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Consolidated and Solo Requirements

– the highest bank in the group is the addressee of the obligation to provide consolidated information at the level of the holding, and to ensure the institution of organisational requirements in the group; – the financial holding company is not subject to solo-supervision, only to consolidated supervision60, with the exception that it is required to have executive managers that are of sufficiently good repute and have sufficient experience to perform their duties (also see chapter 5.2). If the parent is the head of a financial conglomerate (either a licensed bank, insurer, or investment firm, or a mixed financial holding company), those rules as set out in chapter 17.4 apply, in addition to (sub-)consolidated supervision under CRD requirements at the level of the banks that are head of the group or of subgroups of the financial conglomerate; see chapter 17.2. If the parent is a mixed-activity holding company, consolidated requirements apply at the level of the subsidiary bank; also see chapter 17.2. The remaining requirements on the holding are described below. To support consolidated supervision, the CRD stipulates that there should be no obstacles to information exchange between group entities that are relevant to supervision61. Together with access rights and cooperation right between supervisors, and the availability of corrective instruments on parent undertakings and other relevant group entities (even when situated in another member state) helps make consolidated supervision effective, where such related entities are relevant to the health of the bank62. The rules to determine which supervisor will be responsible for the consolidated supervision of the full group or of the conglomerate are quite similar (see chapter 17.4), as are the rules setting out that if the parent is not a bank (or insurer in a financial conglomerate), the consolidation will include the information at the group level, with responsibility for compliance being allocated to the highest bank in the group. The financial conglomerates rules are laid down in a separate directive and are more substantial, as the risks of an insurance/banking conglomerate not only impact on banks but also on insurers, and there are additional risks of circumvention of sectoral safeguards by exploiting the differences between the sectoral legislations; see chapter 17.4 and 19.4. As a result of the review of the financial conglomerates directive that lead to the 2011 FCD II directive, the relevant CRD provisions have also been reviewed. Further coordination

60 Art. 1.2 RBD. 61 Art. 139 RBD. 62 Art. 1.2, 139-142 RBD. Art. 2 RCAD. See chapter 20.2, 20.3 and 21.7.

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EU Banking Supervision

with the supervisors of other sectors has become mandatory. In addition, the treatment of mixed financial holding companies as defined in the financial conglomerates directive will change as of the implementation from 10 June 201363. If these unregulated entities control a regulated entity in the EU, as well as regulated entities of another sector outside of the EU that all taken together form a financial conglomerate, such entities will now become the subject of overlapping supervision. It will be captured in the supervision of the bank-subgroup, as well as in the supplementary supervision of the financial conglomerate, as well as in the group-supervision of the insurance sector. To reduce unnecessary overlap some rather complicated measures have been instituted; see chapter 17.4). Consolidated supervisors gain an additional task, in that they have to provide all supervisors concerned and EBA all information regarding the legal structure, governance and organisational structure of the group64. The FCD II directive has also lead to some streamlining of the supervision of financial conglomerates, especially on clarifying how the colleges should be set up; see chapter 21.7. Mixed Activity Holding Company and Consolidation? The mixed activity holding company need not be consolidated under the CRD ‘pending further coordination’65. The practices of member states differed too much when this regime was introduced. As a result, member states may or may not choose to require upward consolidation, and choose to which level they consolidate upwardly (with other member states forced to recognise such domestic goldplating). No subsequent work was done on upward consolidation requirements for mixed activity holdings. They were specifically left out of scope of the financial conglomerates work. However, some additional solo-requirements that were designed for use within financial conglomerates, were also deemed useful for banks at the sub-consolidated level of a mixedactivity group. When the financial conglomerates directive was introduced in 2002, it amended the banking directives.

63 Art. 3 FCD II Directive 2011/89/EU. 64 Art. 14 RBD, as amended by FCD II Directive 2011/89/EU, and the simultaneous related introduction of references to mixed financial holding companies into various articles of the RBD such as art. 135 and 140143. 65 Art. 137 RBD. This article allows access to banking supervisors from member states where additional requirements have been put on a parent mixed-activity holding, can require that holding (regardless of where in the EU it is based) to provide such information if it would be relevant for the purpose of supervising the bank, and to verify such information, regardless of whether it is e.g. an insurer and/or based in another member state. See chapter 17.3.

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Consolidated and Solo Requirements

The rules intra-group transactions as applicable in the context of financial conglomerates supplementary supervision were copied and since apply to mixed activity groups66. The supplement refers only to the banks that are directly owned by the mixed-activity holding (i.e. at the sub-consolidated level, to be supervised by the supervisor responsible at that level). However, if several banks are directly owned by the holding (without any sub-consolidation being applicable on them all), the requirement is applicable to each bank separately. The supervisor on the bank is required to exercise ‘general supervision’ on all transactions between the bank on the one hand and either the mixed-activity holding (including their parent undertakings) or its subsidiaries on the other hand. To support such general supervision, additional rules apply in the areas of: – internal governance: in addition to the internal governance requirements common to all banks (see chapter 13.3), banks that are owned by a parent mixed-activity holding need to set up internal governance processes in order to identify, measure, monitor and control intra-group transactions; – reporting: the bank is obliged, if the transactions are not already reported under the large exposures regime, to make supplementary reports to the supervisor on each and every significant intra-group transaction. The goal appears to be not to overwhelm the bank and supervisor with irrelevant information (e.g. the purchase of pencils) but to include any transaction that materially impacts or may cause future material impact on the banks’ accounts. The financial conglomerates directive includes a definition of ‘significant’, that was introduced in the identical requirement on financial conglomerates67; – measures to be taken by the supervisor: the supervisor of the bank is obliged (and should thus be authorised under domestic legislation) to take measures if the intragroup transactions are a threat to the financial position of the bank. If the holding is located in another member state, the local supervisor is obliged to assist in making the measures taken effective, and the local laws should allow their enforcement68. Reference is made to chapter 17.4 on the content of these provisions. Future Developments The treatment of parent entities was not the focus of thethe CRD IV project; see chapter 17.1 and 17.2. The proposals for a recovery and resolution directive will extend also to

66 Art. 138 RBD. 67 Art. 5-9 and 13 Financial Conglomerates Directive 2002/87/EC. Article 8.2 indicates that an intra-group transaction is presumed to be significant if its amount exceeds 5% of the capital adequacy requirements at the level of the financial conglomerate. 68 See chapter 21 on cooperation, chapter 20 on instruments of the supervisor, and art. 142 RBD.

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EU Banking Supervision

parent entities and group financial entities, and will widen the winding up directive to such entities too69. The longer term work of the FSB and the Commission on shadow banking may have its most direct impact on the scope of consolidation70. Which entities can be excluded, what the consequences of such exclusion are, and how shadow banking entities related to banks can negatively impact on financial stability directly or via the normal banking sector are the subject of a review. Though the reports are carefully circumspect on altering the treatment of securitisation special purpose vehicles (leaving the option open to regulate securitisation separately instead of also bringing such vehicles within the scope of consolidation for prudential purposes similar as for accountancy purposes) they are clear that the scope of regulatory consolidation should be expanded if they open too wide roads for regulatory arbitrage and for infection that may threaten financial stability.

17.4 Financial Conglomerates – Additional Consolidation and Additional Solo Requirements Introduction The financial conglomerates directive provides for supplementary supervision for financial groups that have significant business in both the insurance and the banking sector (counting investment services as banking services). The potentially negative effects of such cross sector business had previously been prevented in many member states by prohibiting cross-shareholdings from the insurance sector in the banking sector and vice versa. Those restrictions had gradually been lifted in some member states as part of a liberalisation of financial markets. This particular relaxation allows groups to enjoy the benefits of diversified businesses (bundled services, better use of capital, better use of liquidity). The original reasons for the prohibition (cross-sector contagion and the potential disadvantages for clients/buyers of cross-sector products) were still relevant. However, instead of an outright prohibition such negative side-effects were mitigated through improved conduct of business requirements on the sale of financial products (see chapter 16), and through additional supervision on the ties between insurers and banks in one group. As the combined insurance/banking groups gradually expanded their businesses across borders, both in insurance and banking sectors in other member states, the financial conglomerate directive was

69 See proposed art. 1 and 106 of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. See chapter 18.3. 70 FSB, Report on Shadow Banking: Strengthening Oversight and Regulation, 27 October 2011; and the related progress report FSB, Strengthening the Oversight and Regulation of Shadow Banking, 16 April 2012. Commission, Green Paper, Shadow Banking, COM(2012) 102 final, 19 March 2012.

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introduced to provide minimum requirements to ensure prudential supervision on the additional possibilities for cross-sector contagion. The work on the financial conglomerates directive and the subsequent implementation thereof lead to a clash of cultures between countries in favour of financial conglomerates and against, but above all in the realisation of the differences in the supervisory cultures and the content of supervisory requirements on banks and on insurers. In banking, consolidated supervision is a core and perhaps even dominant part of supervision. In insurance, it had only recently been introduced in a purely supplementary role in the insurance groups directive. Banking supervision focused on risk weighted assets versus capital, with short term obligations on both sides of the balance sheet. Insurance supervision focused on the liabilities, with steady and predictable (non-repayable) premium income streams, and either long term liabilities for life insurers and relatively small pay-outs for most non-life insurers that can often be delayed via expert-assessment or legal procedures. The treatment of risks by insurance supervision and by banking supervision is quite different, as are some of the instruments, goals and expectations of supervisors; see chapter 3.4 and 19.4. For insurance supervisors the goal of policyholder protection is paramount, while for banking supervisors depositor protection is at best equal to financial stability and single market goals under the CRD. In banking supervision consolidated supervision is as important or more important than solo supervision during the life of a bank, while in insurance supervision solo supervision on the legal entity with the license is paramount. The group to which that entity belongs is more of a risk factor (with insurance supervisors not expecting it to chip in with liquidity support if the licensed subsidiary insurer has financial problems) while for banking supervisors the group is a source of diversity, expertise and financial buffers (with expectations as a matter of course that the group will ride to the rescue of a troubled banking subsidiary that is short on cash)71. What is a Financial Conglomerate? The financial conglomerates directive applies to ‘financial conglomerates’. Not every conglomerate with amongst others insurance, banking and investment business qualifies72. A financial conglomerate is a group or subgroup that is identified as a financial conglom71 See chapter 4, 17.2 and 18. Also see Joint Forum, The Management of Liquidity Risk in Financial Groups, May 2006; See chapter 22.5 and e.g. IAIS, Principles on Group-wide Supervision, October 2008, page 3; IAIS, Insurance Concordat, December 1999, page 5-6. 72 Art. 2.14, 2.15, 3 and 4 Financial Conglomerates Directive 2002/87/EC as amended by the FCD II Directive 2011/89/EU. If it does not qualify as a financial conglomerate and contains a bank, it can either be a banking group owned by a bank, a bank or banking group owned by a financial holding company (consolidated with the bank) or a bank or banks owned by a mixed-activity holding company (consolidated at the level of the bank, with some intra-group provisions).

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EU Banking Supervision erate by the supervisors involved73. The European supervisory authorities via their joint committee are to issue joint guidelines on the assessment process74. When making this assessment, supervisors have to apply criteria set out in the financial conglomerates directive (which provide some leeway if all supervisors agree that the straightforward application of the criteria the result would inappropriately include or exclude some groups, for instance because the financial business in a particular sector is mainly done via offbalance-sheet activities or via services for fees). Once a group or subgroup has been identified as a financial conglomerate, the rules on supplementary supervision become applicable. It will remain a financial conglomerate for three years after it last was assessed to fulfil the criteria, unless it no longer fulfils the criteria by a fair margin (to avoid regime shifts due to even small shifts in the size of the business, as well as to avoid all too obvious calculating behaviour by the groups). The criteria to be applied by supervisors are: – the group or subgroup is either (i) headed by a bank, insurer or investment firm or (ii) contains such supervised firms and the group’s activities mainly occur in the financial sector (i.e. the ratio of the balance sheet total of the regulated and non-regulated financial sector entities in the group to the balance sheet total of the group as a whole exceeds 40%); – at least one firm in the group or subgroup is a bank or investment firm, and at least one firm in the group is an insurer; – the activities in on the one hand the banking/investment services sector taken together and in the insurance sector on the other hand are significant. Significance can be determined for both sectors either: – in the relationship between the numbers of the financial sector as compared to the numbers for all regulated and non-regulated financial sector entities in the group (i.e. not to the group as a whole if it is also active outside of the financial sector), both the balance sheet total of that financial sector and the solvency requirements of that financial sector exceeds 10% of the numbers of the financial sector entities taken together; – if the balance sheet total of the smallest financial sector in the group exceeds 6 billion (i.e. 6000 million or in continental languages 6 milliard) euro, with exceptions if the

73 Unlike in the CRD, the term ‘group’ is defined in art. 2.12 of the Financial Conglomerates Directive. It can be both a group of undertakings headed by a parent, or undertakings linked to each other through common management or management agreements as meant in (art. 12 of) the 7th Consolidated Accounts Directive. As these are part of the consolidation under the CRD, the term can be assumed to mean the same, regardless of the lack of an official definition there. ‘Cooperative’ groups are subject to supplementary supervision if the supervisors agree on this by common agreement, see art. 5.4 Financial Conglomerates Directive. 74 Art. 3.8 Financial Conglomerates Directive 2002/87/EC; an obligation introduced mid 2013 as a result of the FCD II Directive 2011/89/EU.

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Consolidated and Solo Requirements

particular financial sector is small in terms of the size of the combined financial activities of the group, or in terms of the size of the market share in any member state. If a subgroup of a financial conglomerate, of a banking group, an insurance group or an industrial/commercial group is a financial conglomerate, it will need to adhere to financial conglomerates supplementary supervision in its own right, unless it is already captured in the financial conglomerate supervision exercised on the wider group it belongs to75. If headed by a bank, insurer or investment firm, the financial conglomerate supplementary supervision focuses on this regulated parent of the group or subgroup. If not headed by a supervised entity, the parent is referred to as a mixed financial holding company. Though similar types of companies can be part of the group headed by a mixed financial holding company or a mixed activity holding company (the latter a banking sector phenomenon as applicable if a group or sub-group is not a financial conglomerate; see chapter 17.3), the difference in burdens on the group is substantial. A mixed activity holding and its subsidiaries are not captured in consolidation, and the only downside is that intra-group transactions between the unsupervised group-segments with the banking sub-group are monitored by the banks’ supervisor. For financial conglomerates additional requirements apply which bring large parts of the group under a form of supervision, and require a substantial investment by the conglomerate. This provides any group that might (or does barely) qualify as a financial conglomerates with a strong incentive to dis-invest in at least one sector and make sure they do not fulfil the criteria any more. Financial conglomerates are subject to the following additional requirements76: – own funds have to be available at the level of the financial conglomerate77, in a total amount at least equal to the sector-capital requirements of (a) banks, financial institutions or ancillary banking services undertakings, (b) insurers, reinsurers and insurance holding companies, (c) investment firms and financial institutions, and (d) a ‘notional’ capital requirement for unregulated entities in the group, including the mixed financial holding companies; 75 Art. 2.14 and 5 Financial Conglomerates Directive 2002/87/EC, as amended by FCD II Directive 2011/89/EU. 76 Art. 5-9 and 13 Financial Conglomerates Directive 2002/87/EC. 77 This requirement prevents own funds being distributed across the group in such a way that the overall own funds requirement is lower than the own funds requirement for each regulated entity in the group, and against risks aggregating in the unregulated entities in the group. There are three methods to calculate whether the own funds of the conglomerate as a whole are equal to or larger than the own funds requirements of the individual entities in the group. These are described in Annex I to the Financial Conglomerates Directive, and are the accounting consolidation method, the deduction and aggregation method, and the book value/requirements method. They can be applied in combination. The coordinating supervisor can determine which to use, within the boundaries set in its domestic implementation laws, after consulting the other supervisors and the conglomerate.

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EU Banking Supervision

– additional internal governance requirements apply, specifically that capital adequacy, risk management and internal control policies and procedures should be in place at the level of the financial conglomerate; – living wills (recovery and resolution plans) need to be drafted at the group level and kept up to date. Nominally part of ‘risk management’, this obligation is part of crisis management (crisis preparation), though lessons from living wills should filter through into the bank-subgroup and its structures. This obligation was inserted without rather unnoticed via the Omnibus I directive, and has been applicable to financial conglomerates since end 2011. However, it is only obligatory ‘when necessary’, offering an escape for groups or supervisors that do not deem it necessary. For sifi’s (see chapter 18.2) and for conglomerates that run into trouble, however, the ‘when necessary’ criterion appears to be fulfilled by definition. More detail on what is meant by such plans and the criteria (and consequences) of such plans is contained in the new (group-wide applicable) proposals for a recovery and resolution directive78; – supplementary supervision on each bank, insurer and investment firm in the group and on the conglomerate as a whole on intra-group transactions. ‘Pending further’ harmonisation, each member state can set quantitative limits Regardless of whether quantitative limits have been set, the intra-group transactions have to be supervised by the individual supervisors, and are subject to supervisory overview by the coordinator. Significant intra-group transactions need to be reported to the individual supervisors, with an intra-group transaction presumed to be significant if its amount exceeds at least 5% of the total amount of the capital adequacy requirements at the level of the financial conglomerate. The internal governance requirements need to support the supervision and internal monitoring of all intra-group transactions (significant or not). Under the FCD II directive, additional internal governance and obligatory alignment with pillar 2 requirements for banking groups will enter into force from mid-2013 (see below); – supplementary supervision on each bank, insurer and investment firm in the group and on the conglomerate as a whole on risk concentration. ‘Pending further’ harmonisation, each member state can set quantitative limits to apply at the level of the financial conglomerate. Regardless of whether quantitative limits have been set, the intra-group transactions have to supervised by the individual supervisors, and are subject to supervisory overview by the coordinator; – significant risk concentrations need to be reported to the individual supervisors. The internal governance requirements need to support the supervision and internal moni78 See art. 9.2 Financial Conglomerates Directive 2002/87/EC, as introduced by art. 2 Omnibus I Directive 2010/78/EU. On living wills, see chapter 18.3 and Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. Also see R.M. Lastra (Ed.), Cross-border Bank Insolvency, Oxford University Press, Oxford, 2011, chapter 12, as written by R. Leckow, T. Laryea & S. Kerr.

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Consolidated and Solo Requirements

toring of all risk concentrations (significant or not). This is in line with the priority identified by the joint forum at the worldwide level, though its report also highlights the problems encountered by conglomerates to adequately measure and manage it79; – the people who effectively direct the business of a mixed financial holding company (i.e. depending on their actual tasks most likely the executive board members) have to be of sufficiently good repute and sufficient experience to perform those duties (similar to the requirement for similar executives at a bank and a financial holding company; see chapter 5.2). If the highest entity is a bank, insurer or investment firm, only this entity is subject to supplementary consolidated supervision at the level of the conglomerate. If the parent of a financial conglomerate is not a regulated entity, but a mixed financial holding company or if there is no clear parent, the regulated entities directly owned by the holding are responsible, even if they are not themselves the parent of the conglomerate. They can be fined or be the subject of supervisory measures if their parent or another legal entity in the group hampers the fulfilment of these obligations. Though the above implies that for instance the unregulated entities at the top in the group are subject to consolidated supervision including all its consolidated subsidiaries, similar to the arrangements in the banking sector, the financial conglomerates directive explicitly states that those, including a mixed financial holding, are not in any way the responsibility of supervisors on a solo basis80. Whether financial conglomerates will continue to be around is doubtful. The possibilities of cross-selling to clients are limited due to more recent and expected data protection and consumer/client protection rules. Benefits from selling risks to the branch of the group that is less regulated have declined since upgrades in banking and insurance prudential requirements, and the addition of the supplementary financial conglomerates supervision. The diversification benefits of being active in multiple sectors do not appear to provide enough upside to counter the downside of the added supplementary rules and supervision. The number of EU headed financial conglomerates has been slowly but steadily declining81.

79 Joint Forum, Cross-Sectoral Review of Group-Wide Identification and Management of Risk Concentrations, April 2008, www.bis.org. 80 Art. 5.5 Financial Conglomerates Directive. Whether this is practical in a crisis situation is less than clear; see chapter 18. 81 Art. 4.3 Financial Conglomerates Directive 2002/87/EC. For instance 61 financial conglomerates as per end 2007, 59 as per end 2008, and 57 as per end 2009. See the lists published by the Joint Committee on Financial Conglomerates (JCFC, previously the Interim Working Group on Financial Conglomerates) on www.eba.eu and www.iopa.eu.

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EU Banking Supervision

Nevertheless, until insurance supervision and banking supervision are truly harmonised, the risk of the existing discrepancies being gamed by the conglomerate is simply too big. This varies from ‘risk transfers’ on first loss or other junior positions in securitisation transactions to insurance entities in the same group, to insurance-like derivatives such as credit default swaps being booked in banks to avoid insurance legislation being applicable, and the transfer of cash (liquidity) between the two sectors within a conglomerate, or ‘double gearing’ of the same capital to provide a buffer for risk in multiple entities. Aside from these avoidance and contamination risks, other drivers to harmonise prudential supervision include common problems such as the capital impact of unhappy clients and the capital treatment and internal governance surrounding alternative risk transfer instruments (derivatives, securitisations, insurance and re-insurance)82. The joint committee of EBA and its sister-authorities (previously the 3L3 Chairs) and its conglomerates working group will continue to work in this area of cross-sector risks. Minor Amendments from 10 June 2013 A relatively low key review of the financial conglomerates directive has led to the FCD II amending directive that will become applicable from 10 June 201383. This follows the changes under the Omnibus I directive, which included references to the ESA’s joint committee to the FCD, added some evident detail on cooperation between sectors, and introduced the recovery and resolution planning obligation ‘when necessary’ for all financial conglomerates and their supervisors. The FCD II directive follows up on this by providing specific rules on some lessons learned from the crisis, and add obligations to improve e.g. risk management, stress testing and the monitoring of intra-group transactions, and the disclosure of the legal structure, governance and organisational structure. It amongst others clarified that a subgroup can also in its own right be a financial conglomerate and that stress tests of both individual financial conglomerates and on a sector wide basis (integrated with the stress tests of the European supervisory authorities) should be undertaken84.

82 EIOPA/CEIOPS, Lessons Learned From the Crisis (Solvency II and beyond), CEIOPS-SEC-107/08, 19 March 2009. 83 See FCD II Directive 2011/89/EU. The directive also amends insurance and banking directives. Some provisions will only apply to alternative investment fund managers from the date of application of that directive on 22 July 2013; see chapter 19. 84 Art. 2.14 Financial Conglomerates Directive 2002/87/EC before and after the amendment by FCD II Directive 2011/89/EU, and recital 11 and art. 9b of the Financial Conglomerates Directive on stress testing. Except for EU-wide stress tests, the member states have the option to require the coordinating supervisor to perform a stress test or not. However, once the coordinating supervisor chooses to do so (or is obliged to do so) other supervisors have to cooperate.

800

17

Consolidated and Solo Requirements

For mixed financial holding companies, some effort is made to align the regime, and to reduce the burden on the holding of similar rules being applied on them by sectoral supervisors under insurance, banking and financial conglomerates directives. In that case, it is up to supervisors to ensure that the same subject matter is only checked once (but sufficiently in depth to cover all relevant provisions). This increased burden to check and cooperate is put on supervisors in the college, to avoid a higher supervisory burden on the holding85. Future Developments A more fundamental review was planned for 2012, also taking into account similar work at the worldwide level by the joint forum86. The report was issued end 2012, but the 10page report, though noting some issues that could be improved, mainly indicated that the sectoral legislation and supervisory structures were developing fast, and that a legislative proposal on financial conglomerates should not be expected in 2013, and may be further postponed depending on sectoral developments87. Supplementary supervision for financial conglomerates of which the parent is a bank will perhaps lose some of its relevance when the CRD IV directive/CRR will enter into force. In a deviation from Basel III, the Commission proposes to consolidate insurance subsidiaries into the accounts of the banking parent. This would boost the capital level that banking parents can take into account, and will at the consolidated level allow surplus capital at the insurance subgroup/subsidiaries to provide buffers for risks on the banking side (and vice versa). These are now hidden in supervisory information as insurance subsidiaries assets and capital are deducted in full from financial information on the parent bank. Another consequence will be that requirements on risk management and risk concentration (see chapters 11 and 13) will then apply, certainly on the consolidated level, also to exposures held by the insurance side. This easing some of the concerns formulated by the joint forum on risk concentrations and risk transfers88. The joint committee of EBA/EIOPA/ESMA can issue regulatory and implementing standards and guidelines on a range of financial conglomerates related issues. It has to

85 Also see chapter 17.3 for the parallel changes to the RBD. Recital 13-14 FCD II Directive 2011/89/EU. 86 Art. 5 FCD II Directive 2011/89/EU. 87 Commission, The Review of the Directive 2002/87/EC of the European Parliament and the Council on the Supplementary Supervision of Credit Institutions, Insurance Undertakings and Investment Firms in a Financial Conglomerate, COM(2012) 785 final, 20 December 2012. 88 Joint Forum, Credit Risk Transfer, Developments from 2005 to 2007, July 2008, and Joint Forum, CrossSectoral Review of Group-Wide Identification and Management of Risk Concentrations, April 2008, www.bis.org.

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EU Banking Supervision

issue regulatory standards on definitions, risk concentrations and intra-group transactions by 1 January 201589. Literature – Lelyveld, Iman van (ed.), Economic Capital Modelling, London, 2006

17.5 Third Country Parents or Subsidiaries Many banking groups have legal entities based both in the EU and outside of the EU, in third countries90. Each legal entities based in and licensed by member states in the EU falls fully under solo supervision; see chapter 17.2. However, for consolidated and sub-consolidated supervision some additional obligations have been put on the EU parent bank(s) of third country entities or on the EU subsidiaries or branches of a third country bank. These obligations aim to ensure the practical exercise of consolidated supervision over the largest possible geographical area91. In this manner the risks following from being linked together in a group are captured to the maximum extent, not limited to the EU area). To ensure that the parent supervisor (at the consolidated or sub-consolidated level) can adequately supervise all consolidated activities, the CRD also provides for a framework for cross-border cooperation with third country supervisory authorities where possible. Though non-binding, the BCBS has given guidance on how to handle some of the aspects of consolidated/solo supervision across borders. For instance, where within the EU the allocation of capital to subsidiaries is part of the model approval for operational risk (see chapter 6.3, 10.4 and 17.2), the BCBS recommends cross-border groups that are active for example in a EU member state and in a third country to have a differentiated approach. Depending on joint home and host assessments, the supervisors should attempt to agree on which subsidiaries are so significant in a host country that for instance a stand alone calculation is needed, or where joint calculations followed by a capital allocation mechanism for the parent and (relatively) non-significant subsidiaries would suffice. Each supervisor can, however, not be forced to accept the opinion of other supervisors or of the banking entities involved, but the supervisors should try to work this out92.

89 See art. 21a and 21b FCD as added and amended by the Omnibus I Directive 2010/78/EU and FCD II Directive 2011/89/EU, and chapter 23.3. 90 See chapter 5.5 on cross-border market access to and from third countries. 91 Recital 20 and art. 39, 69.4, 70.4, 73, 107, 113.2 and 143 RBD, and art. 26.3 RCAD. 92 BCBS, Principles for home host supervisory cooperation and allocation in the context of advanced measurement approaches (AMA), November 2007. Also see A.A. Jobst, ‘The Treatment of Operational Risk under the New Basel Framework: Critical Issues’, Journal of Banking Regulation, Vol. 8, No. 4, 2007, page 316-352.

802

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Consolidated and Solo Requirements

EU groups with third country subsidiaries or branches; if the parent is based and licensed in the EU, it has to: – include all its third country subsidiaries in the consolidation, though it can apply for an exemption if information flows from the third country are not sufficiently reliable and complete; – if a group with a third country bank subsidiaries or participations and it manages those via subsidiary banks (e.g. sub-holdings), those subsidiary banks are subject to the additional obligation to sub-consolidate; also see chapter 17.293. Third country groups with EU subsidiaries or branches; if the parent is based and licensed outside of the EU94: – consolidation of EU subsidiaries of third country banking groups at the level of the most important sub-holding that is licensed in the EU (and if applicable of third country financial conglomerates95), including in this sub-consolidation all other entities based in the EU, regardless of whether these are legally subsidiaries of the most important entity; – if the highest parent within the EU is included in comparable pillar 3 disclosures by its parent that is based in a third country, its supervisor may exempt it from publishing (sub-consolidated) pillar 3 disclosures on the basis of its own consolidated financial situation96. Also see chapter 5.5 and 21.8 on cross-border market access of and supervisory cooperation on third country groups. Cooperation with third country authorities is facilitated by the various ‘equivalence’ assessments. If an aspect of the regulatory regime of the third country is deemed equivalent, the EU has introduced several areas where the member states can no longer make supplementary demands on third country banking groups; in line with the market access provisions for third country-banks under the binding WTO-rules; see chapter 5.5. If the regime of the third country is not deemed equivalent, the CRD often provides clarity on the fall back regime. The two most relevant equivalence assessments for banking supervision are: – the equivalence testing of the accountancy standards of certain third countries. Upon the advice of ESMA, the Commission decides which third country accounting standards are deemed equivalent and can be used by issuers of securities that are admitted to a 93 Art. 73.2 RBD. The same applies if the third country entity is a financial institutions or an asset management company. 94 Article 73 and 143 RBD. 95 Art. 5.3 and 18 Financial Conglomerates Directive. 96 Art. 72.3 RBD.

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EU Banking Supervision

regulated market in the EU (see chapter 22). Many such issuers are banks, but the implication of the Commission decision is wider. If accounting standards are equivalent, the information contained therein is not only suitable for investors to base their decisions on, but also for supervisors to accept as the basis for the information they require from banks on their EU and consolidated worldwide activities, subject to similar prudential filters as for the accounting data of EU banking groups (see chapter 6.4). With the increase in the uptake of IFRS, this equivalence assessment has become less important. As the EU has adopted IFRS, other countries that adopt IFRS are automatically equivalent97. This, however, still excludes the USA, where many banks are based with activities in the EU; – the equivalence testing (i) of supplementary conglomerates supervision and (ii) of consolidated banking group supervision of certain third countries. Equivalence reduces the obligation to perform supplementary supervision at the sub-consolidated level on all entities based in the EU. Such equivalence has been found in a joint procedure for the USA and Switzerland of the European financial conglomerates committee and the European banking committee (based on an advice of EBA/CEBS), with some remarks that can lead to some variations depending on how exactly the group in question is supervised, which is in the USA dependent on the federal or state supervisory authority involved98. For other countries, the lead supervisor in the EU can make an independent assessment, without taking into account joint advice, but they do have to consult the joint committee or EBA respectively99. The Commission is stimulating third country participation in the colleges, as well as in the future ‘resolution’ colleges or financial stability colleges. It proposes third country membership of colleges – providing confidentiality issues are dealt with in a similar way as in the EU – in its proposed directive on bank and investment firm recovery and resolution planning, and full cooperation on resolutions in the EU and for third country groups with

97 Art. 1 Commission Decision on the Equivalence of Certain National Accounting Standards and of IFRS, 12 December 2008, 2008/961/EC. In it, the national accounting standards of the USA, Japan, China, Canada, South Korea and India are deemed equivalent, but of the latter 4 only until end 2011, when they are expected to have transferred to IFRS. 98 Art. 18 FCD and art. 143 RBD as amended by art. 2.11 and 9.38 Omnibus I Directive 2010/78/EU to make the role of EBA and the Joint Committee explicit. General Guidance from the European Financial Conglomerates Committee and the European Banking Committee to EU Supervisors on Switzerland respectively the USA, EFCC/006/08 Annex III (rev) and EFCC/006/08 Annex IV, published on the financial conglomerates subsection of the Commission website, www.ec.europa.eu on 24 April 2008. 99 Art. 18 and 21.4 FCD and art. 143 RBD. Art. 18.1a FCD allows for appeal to the dispute settlement functions of the European supervisory authorities; but such a right is lacking in the RBD.

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Consolidated and Solo Requirements

activities in the EU, provided the interests of European creditors are treated at par by third country authorities100. Future Developments The USA is reviewing its market access and ongoing supervision regime for non-USA banks and banking groups. This would apply also to EU banks with activities in the USA. Though still trusting heavily on consolidated supervision and home state supervision, larger foreign banks would need to comply with similar rules as USA banks on e.g. liquidity. The Commission is protesting this increase in local supervision costs for EU groups, and would like the USA to implement a similar ‘equivalence’ style partial exemption for some of the consolidated supervision requirements proposed for USA-subgroups of foreign banks as the EU currently has101.

17.6 Groups of Cooperative/Mutual Banks Introduction Cooperative banks go back to the roots of traditional enterprise and consumer oriented banking. They have retained this patina of solidity consumer-focus, even where they have grown as large and complex as other banks. An individual mutually organised entity can obtain a banking license if it wants to and its member state allows it to. Some of the conditions for obtaining a banking license and of ongoing supervision are not easy to fulfil in a mutual context, however, especially if the cooperative is small. There is a special regime of exemption applicable to groups of such banks, allowing them to fulfil such obligations collectively instead of on an individual entity basis. The individual banks that are part of groups can be exempted from requirements on two fit and proper directors, having a business plan, on the availability of original own funds and regarding ongoing supervision, if certain conditions are fulfilled that are geared towards joint operation and control of the group of cooperative banks. Note that where licensing requirements have to be fulfilled on a solo basis in full by ‘normal’ banks, even if they benefit from an exemption of quantitative supervision, mutual banks can thus be exempted from demands in almost every area of supervisory requirements.

100 See chapter 18.3. Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012, art. 80-89. See the proposed art. 86 for the limited number of cases where cooperation with third country authorities can be refused by EBA (also on behalf of national authorities, see the proposed art. 85.3). 101 M. Barnier, Letter to Bernanke, 18 April 2013, see www.federalreserve.gov.

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EU Banking Supervision

It is not always clear why many of these benefits are given, or given exclusively to mutuals. It is true that many of the affiliate banks are tiny, covering service provision to e.g. a village. Such a small local office might normally be a branch of a larger legal entity in other banks. But other banking groups could equally well have set it up as a separate legal entity (a subsidiary), if they were offered the score of exemptions on solo-requirements that are offered to mutuals. The larger cooperatives cannot be clearly distinguished from other large banks. Replace the largely silent shareholders meeting of a listed bank with the largely silent members’ meeting of a mutual, and that is about it. The types of business, organisation, growth oriented management are quite similar. Two big differences remain: – they cannot issue shares to beef up their financial buffers to non-members; – they frequently retain profits instead of distributing them to members which enhances their financial buffers in good economic times (though profit distribution is possible, as is distribution of services to member below cost); – for consolidated supervision purposes, a mutual of mutuals is a different animal than a parent company with subsidiaries. The predecessors of the CRD and the original CRD assumed and stimulated cooperative/mutual banks slowly becoming extinct. Existing central bodies of affiliates, often mutuals of mutuals (a so-called secondary cooperative society is a cooperative of which the members are cooperatives themselves102) would be allowed to continue operating, but new ones would not obtain the benefit of the exemptions, as they did not fit regular organisational requirements (such as a clear management structure) nor did they fit well into the CRD requirements on share-based financial buffers. The EU members of 1977 had allowed existing mutuals of mutuals to continue operating with the benefit of the series of exemptions on supervision described in more detail below if they were set up prior to 15 December 1977. Regardless of the expectation of their demise, the existing licensed mutuals have continued to grow their business, and have merged into some large behemoths. For new member countries of the EU, their access treaties usually contained grandfathering clauses for existing mutuals that already existed at the date of entry into the EU. When the existing organisations showed no sign of going away quietly, nor of supervisors pressuring them to abolish the mutual structure in favour of a share-based structure, there did not appear to be a reason not to allow new entrants to this category of banks. Why should other banks not benefit from the wide range of exemptions available to these organisations? An additional reason for allowing them was that new entrants to the EU saw benefit in allowing such mutuals in their still developing economies, similar to the 102 Recital 9 SCE Regulation 1435/2003 on the statute for a European cooperative society.

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Consolidated and Solo Requirements

benefit of mutuals that the original members enjoyed e.g. after the second world war. Pooling risk over a collective of entrepreneurs was shown to work in such settings. As new cooperatives could not be grandfathered in the treaties under which new member states became members of the EU, the decision was made to allow new cooperatives of cooperatives to start operating across the EU. The CRD II amending directive accordingly abolished the time-limit for the introduction of mutuals103. In addition to the solo supervision exceptions, the existing CRD allowed member states to accept non-equity as equity for mutuals. The focus in Basel III/CRD IV on equity as the core financial buffer (common equity tier 1; see chapter 6.2 and 7), however, necessitated the creation of additional loophole for such cooperative structures. This loophole was needed for the individual member-banks that benefited from the existing exemptions, but importantly also for the organisation as a whole. New members are unlikely for cooperatives in developed markets, as new members in the growing cooperatives have little or no influence, and little or no clear economic benefits from being a member (unlike in developing economies where credit and trust is scarce). Affiliated banks and the ‘Central Body’ Where most banks are operating in a top down organisational structure, affiliated banks and their central body are operating in a bottom up structure. A more standard groupstructure would be for a parent holding to have a controlling number of shares in (other) banks. It can vote on those shares to influence the management body of those subsidiaries, and in some cases it will employ those managers and second them to the subsidiary. In a mutual of mutual banks, the affiliate banks are the members of the central body/bank. They can vote in its member meetings, and influence the central body/bank. The central body is where all the core banking functions are gathered, from which the affiliates can be exempted. Where the affiliates are not required to be professional (because the central body is professional on their behalf), they still have the final say within the mutual structure. Their own members, however, will generally be local entrepreneurs with little or no influence at the group level. In a manner of speaking, the ‘subsidiary’ here control the ‘parents’. The above description simplifies the situation, and the company law structures of each country on cooperative ventures will be very different. The central body can offer centralised services to all affiliates, for instance by centralising the funding, and use if for expansion into investment banking or expansion abroad.

103 Art. 3 RBD was amended accordingly by recital 2 and art. 1 CRD II Directive 2009/111/EC. The recital invites CEBS-EBA to set up guidelines on the supervision of such affiliates.

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The treatment is offered as a conditional national discretion. Member states are allowed but not obliged to exempt affiliate-banks from core elements of solo-supervision (both on an ongoing basis and in the licensing process) if both the affiliate and the central/body are located in their member state. If the member state uses the discretion, the national laws have to provide that: – either the central body guarantees the commitments of affiliated banks, or central body and the affiliates are jointly and severally liable for all commitments. The term commitments is undefined and may differ per member state under its civil laws, but will at least include all contractual obligations, such as for deposits104; – the central body and affiliates are monitored on a consolidated basis for solvency and liquidity purposes (though it is not clear whether any ‘normal’ subsidiaries can be included in this consolidation, or whether this is an additional consolidation requirement); – the management of the central body can give instructions to the management of the affiliates, creating a similarity with the more standard arrangement as ‘parent’ and ‘subsidiaries’. The scope and depth of such instructions is not defined in the CRD. The official terminology relates to ‘affiliates’ and ‘central body’. Neither term is defined in the RBD. Even though mostly used for mutuals of mutuals, the member states can opt to expand the national discretion also to ‘normal’ group structures where a bank has a number of bank subsidiaries in the same member state. Prior to the CRD II this was not possible as it only allowed such groups existing in 1977 to benefit from this regime, but this limitation has been abandoned without tightening the conditions for granting the range of exemptions. The affiliates can be exempted in whole or in part from105: – the requirement to have two fit and proper executives; – the requirement to have initial capital of 5 million euro; – having a business plan, including the requirement for a proposed structural organisation; – solo supervision for the solvency ratio and its components106; – solo supervision for the own assessment part of pillar 2. In return the aspects of solvency (and liquidity, if there are such requirements at the domestic level for banks) are supervised on a consolidated basis. The affiliates and central 104 Commitments may on the other hand exclude liability for miss-selling, or other liabilities due to tort. 105 Art. 3 RBD. 106 Though the market risk calculation of the RCAD is not explicitly mentioned – unlike e.g. credit risk, operational risk and large exposures – it can be assumed that the affiliate can be exempted from market risk too. Its calculation is only relevant as part of the solvency ratio.

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Consolidated and Solo Requirements

body benefit from the European passport jointly, though the host supervisor can set liquidity requirements at the solo level (it is not bound by the exemption granted by the home supervisor). The exemptions do not apply to the central body. As the substitute ‘parent’, it will need to fulfil all normal licensing requirements (see chapter 5.2) and all normal ongoing supervision requirements. The ongoing supervision of the central body should be done on a solo basis (though the text is less than clear, it does not contain a specific exemption from solo supervision if the central body has a banking license itself) as well as on a consolidated basis under the above-mentioned conditions with the affiliates. Remaining solo-obligations and public supervision on the affiliates include107: – having a license; – assessment of qualifying holdings in and close links with the affiliates; – internal governance ‘in a proportional manner’; – host supervision for liquidity and monetary purposes; – determination of financial buffers, though without the solvency ratio this requirement has no independent meaning except as a distribution of capital over the legal entities; – the supervisory review part of pillar 2, including the allocation of any additional capital required on a solo basis to the different entities, though without solvency ratio solo supervision this has limited effect. In addition, any cooperative society (affiliate or central body) can be allowed to deviate from the standard (equity based) own funds definition. Own Funds Treatment of Cooperative Societies That Are Banks Unlike the above-mentioned exemptions for ‘affiliates’, the special regime for own funds calculation is explicitly limited to banks that are cooperative societies108. As this is not a defined concept, member states have some leeway, but less than with the ‘affiliates’ and ‘central body’ concepts. It is likely that the term is used in the same manner as the (much more recent) regulation for a European cooperative society SCE109. This does not help much, as that regulation also does not contain a definition; allowing member states to retain their local company law definitions. The recitals of the SCE regulation refer to issues such as operating to directly satisfy the needs of the members and/or the organisation of economic activities for the benefit of members.

107 Art. 6, 12, 22, 41, 56-67 RBD. 108 Art. 57 sub g and 64 RBD. 109 Recital 10 SCE Regulation 1435/2003.

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EU Banking Supervision

The share capital provided by members of mutuals can be counted as ‘own funds’ even when it does not fulfil the definition of fully paid up equity, either under the explicit provision, or under the range of national discretions that allow member states to expand or deviate from the outline of the financial buffer definitions; see chapter 7. This follows in part from the EBA guidelines on the accountancy concept of capital, and in part from some specific RBD provisions that also accept unpaid commitments for mutuals as (low quality) financial buffers. The EBA guidelines provide clarification on what constitutes the highest category of financial buffers110. These guidelines are very strict for joint stock companies, but provide exemptions on several accounts for mutuals. The guidelines state that mutual and cooperative shares issues by non-joint stock companies are deemed by definition equal to ordinary shares, if they fulfil the other criteria. Where mutuals in some member states apparently do not meet such criteria (on put options, on caps on payments or on the access to reserves), for joint stock options this would have resulted in an allocation to the lower quality hybrid category. Not for mutuals, however, if the local mutual laws do not know equity instruments that can meet such criteria. If paid up, and loss absorbent under the adapted criteria, any instrument is tier 1 capital of the highest quality, together with retained profits in the form of public reserves. In addition, many cooperative banks operate with commitments of their members that are not fully paid up (as even paid up capital often does not lead to dividends in any case). As a special arrangement, such unpaid commitments can still be counted as financial buffers, but as tier 2 capital111. They have to be immediately payable if there are losses, and cannot be repaid to the member once invested. They also have to count as own funds under local laws. The tier 2 stamp of such claims on members leaves many cooperative societies well capitalised as long as tier 2 can count for half of the minimum capital requirements (up to 100% of tier 1). This became an even more unrestricting restriction with the above-mentioned allocation of large parts of hybrid capital to tier 1 capital. However, the stricter requirements on hybrids, the added emphasis on core tier 1 capital in the form of equity and the reduced role of tier 2 capital of the thinking behind Basel III/CRD IV could have left cooperatives out in the cold. For existing cooperatives it is difficult to attract new member-fully paid up capital in significant amounts, without giving them additional say in operations or (start) paying dividends. Organising this in secondary cooperative societies (the above-mentioned central bodies with a wide range of relatively small member-affiliates), makes this even more unlikely, especially if the additional capital 110 CEBS-EBA Implementation Guidelines Regarding Instruments Referred to in art. 57(a) of Directive 2006/48/EC recast, 14 June 2010; www.eba.europa.eu. Also see CEBS-EBA Guidelines on Prudential Filters For Regulatory Capital, CEBS/04/91, December 2004; see chapter 6.2 and 7. 111 Art. 57 sub a and sub g, 61 third sentence, 64.1 and 66 RBD.

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Consolidated and Solo Requirements

is needed for subsidiaries of the central body that do not directly benefit the members of the affiliate-banks. Future Developments Unpaid capital will no longer be acceptable. For the commitments of members to be counted as capital, it will need to become fully paid under both the Basel III requirements and the CRD IV project. It is unlikely that cooperatives fully paid up member-shares are ‘equity’ under the beefed up list of conditions equity capital will need to fulfil under the Basel III version of the capital accord. Basel III requires common equity tier 1 capital to consist of common shares in joint stock companies, and for this requirement to kick in from 2013. However, it gives leeway to national legislators for both the treatment of non-joint stock companies and for the transitional regime for such non-joint stock companies for any instruments issued up to 2013112. The EU has been generous. The CRD IV project does not refer at all to common shares in order to allow mutual ‘shares’ or memberships to count as financial buffers. It also states that ‘any capital instrument’ issued by a mutual/cooperative society shall be included into common equity tier 1; the type required for the majority of solvency ratio and additional capital requirements. Paid up contributions can be counted as common equity tier 1 capital. In principle these should comply with the full range of requirements. At first sight these are only moderately adapted for mutuals in the prime article containing the requirements for normal equity stock companies, but an additional article provides a range of additional exceptions, that benefit cooperatives, mutual and saving institutions. They can issue a wider range of instruments, including such instruments that in principle have to be redeemed in a major deviation from normal equity, and get it accepted as common equity tier 1 capital113. Unlike for joint stock companies, it thus allows instruments that are basically a form of bonds. That redemption ‘just’ has to be able to be refused (likely leading to a panic in the markets) which refusal should officially not be an event of default under the contractual provisions governing the instrument. Some additional leniency applies that confirm that the mutual instruments need not be truly similar to common shares, for instance exceptions on caps on distribution, and rights of the owner/members on reserves. The other requirements to count as common equity tier 1 are otherwise fully applicable (to the extent there are no general exceptions or loopholes available for any

112 See §53, 58, 94d, 94 g, 95, and especially the footnotes on page 13, 14 and 29 of BCBS, Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems of December 2010. 113 Art. 27 and the range of reduced quality demands in favour of mutual banks in art. 28.1 sub g, h and k specifically for mutuals, the general exceptions of 28.2 and 28.3, and the specific exemptions in art. 29 CRR. For additional tier 1 and tier 2 capital, no such leniency is necessary as mutuals can issue lower quality hybrids and gone concern instruments that comply with art. 52 and 63 CRR.

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bank, such as on deferred tax assets and on insurance subsidiaries). Some of such conditions may still be difficult to fulfil. EBA has been handed the impossible task to elucidate these contradictory drivers, by drafting regulatory standards on some aspects of the three main articles involved before 1 February 2015; a month after these CRR provisions enter into force, even though the Commission may not immediately copy the new provisions114. These permanent deviations come on top of the generous transitional arrangement for the new definitions on financial buffers; see chapter 7. Any capital issued before 1 January 2014 for state aid instruments and end 2011 for non-state aid instruments (in the Commission proposals 20 July 2011), including old paid up capital with the easy conditions, and the old unpaid commitments, will continue to count as common equity tier 1 and tier 2 until end 2017 if they were granted in the form of state aid to banks, and until 2021 if they were non-state aid instruments115. Apart from the quality requirements on capital, the treatment of affiliate banks in the licensing process and in ongoing supervision has been copied materially unchanged in the CRD IV project116. Apart from the mutuals, savings banks have now been given similar deviations on quality demands on common equity tier 1, while the treatment of banks belonging to an institutional protection scheme – that were previously only referenced in passing in the CRD and otherwise benefited per member state from the application of proportionality and/or of national discretions – have been given extensive harmonised facilities to allow them to function under a lighter regime117.

114 Art. 521.2 sub c CRR. 115 Art. 483 CRR for such instruments if they were part of a state aid package; art. 484 CRR for non-state aid instruments. See chapter 2 and 7. 116 Art. 21 CRD IV Directive and art. 10 and 11.4 CRR. 117 Such schemes operate in Germany, and the participating banks benefit from art. 80.8 and 89.1e RBD, effectively making such exposures, including the guarantee itself, carry zero capital requirements, with the exception of own funds positions in each other; see chapter 8. The new completer treatment is contained in art. 4.127, 8.4, 49.3, 84 and 113.7, 422.3, 423.8, and 425 CRR. For saving banks, the same treatment on capital exceptions is contained in art. 27, 28 and 29 CRR.

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Terminating a Bank – Crisis Management

18.1 Introduction Prudential banking requirements and supervision do not promise nor do they prevent banks from being non-profitable or even from going bankrupt1. Banks are primarily businesses. Any badly run business, speculative business, or businesses that make reasonable but in hindsight bad choices go bankrupt with a predictable frequency. That frequency is reduced for banks, as prudential requirements, supervisory actions and fiscal interventions provide additional governance and additional resources to banks. Supervisory actions requiring better governance, new directors and state aid prevent many banks from going bankrupt, though usually by losing their independence or by replacing the majority of their management and/or shareholders. Those banks that still go bankrupt, despite the added governance and resources, will need to be wound down carefully and at a moment in time when the damages can best be limited. As long as the bank is still solvent and liquid, it can decide voluntarily to end its own existence (e.g. when its core activities become prohibited, are no longer competitive, or require investments that it cannot make), or be taken over by or merge with another company/bank. It is rare that a single event leads to the involuntary termination of a bank. Even then, it is usually the result of gaps in or risk management, lack in preparation of funding sources, the lapsing of the viability of the business model for the bank, increased competition or other gradual factors. The involuntary termination of the bank generally follows a period of stress. Supervisors need to be especially active during such stress, and if needed solicit support from the appropriate other public authorities, such as the monetary authorities or foreign supervisors of a parent bank. If the bank operates on a cross-border basis they will need to actively cooperate with foreign supervisors. CEBS-EBA has tried to define such stress situations for a bank to clarify when a supervisor should become (even more) active. A period of stress is when an internal or external event, activity or risk has or could have a material effect on the financial position of the bank2. The CRD is not very clear on exactly what the supervisor should do in that case. It does not contain a guide to the supervisor to prevent or deal with acute stress, nor a framework for the resolution of a bank or banking group. The CRD also is not very clear on the role of the supervisor after a bank has been declared bankrupt or is voluntarily being liquidated. It is still a bank under 1 2

See chapter 4.3. CEBS-EBA Principles for Disclosures in Times Of Stress (lessons learnt from the financial crisis), 2010, www.c-ebs.org, page 1.

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EU Banking Supervision

the definition, so the CRD applies; but it may no longer be an active bank (though liquidators can choose to continue some banking activities such as mortgage servicing for many years during a bankruptcy, if the associated assets cannot be sold at a good price). The main focus of supervision on a bank that is being liquidated will be is on orderly winding down. There are several options for such winding down: – transfer of the business (subsidiary or assets/liabilities transfer) to another bank or a new entity; – sale of assets; – a run-off of the assets, in which the liquid assets of the bank that have little upside potential are sold, while the stressed liquid assets and the illiquid assets are held to maturity. A special EU directive is applicable to the mutual recognition of banks’ insolvency procedures in the EU. There also exists an insolvency regulation that is applicable to all commercial enterprises, but the financial sector was excluded from the scope of that regulation3. The expectation was that a different regime would need to be developed to take into account the specificities of financial sector enterprises. In the end, directives were issued for banking and for insurance that bear a remarkable similarity to the general regulation. The directives do not harmonise bankruptcy proceedings, they focus on avoiding having multiple bankruptcy proceedings per legal entity with a banking license. If the bank is part of a group, each failing legal entity will nonetheless be subject to its own bankruptcy procedure. In the follow-up to the 2007-2013 subprime crisis, several reports have been issued on how to deal with banks, banking groups and financial systems that run into problems (see below for a list of some of these reports). Lacking a resolution framework for larger banks is already a problem if only one systemic bank is in trouble, let alone if several start to implode simultaneously. For smaller banks or for a single large bank, ad hoc measures may suffice. The troubles encountered when Herstatt or BCCI failed (see chapter 2) led to the introduction of some cooperation mechanisms, to clearly allocate responsibilities and strengthen aspects of ongoing prudential supervision. This did not suffice for the multitude of big locally important or multi-jurisdictional groups that became troubled in the 2007-2013 subprime crisis. The EU, the G20 and their standing or ad hoc committees and advisors have been looking for a way to show the general public (and banks) that the way this crisis was handled by large state intervention (loans, guarantees, capital injections, or the saving of large debtors such as AIG or Greece so that they can fulfil their obligations to interna-

3

Insolvency Proceedings Regulation 1346/2000. Also see the similar directive in the insurance area 2001/17/EC. Please note that there is no regime for reinsurers nor for non-bank investment firms, as they have been excluded from the regulation but lack a directive.

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tional banks) will no longer happen with taxpayers’ money. I hope I will be forgiven for thinking that many people can easily hold their breath until that promise is broken. Similar reports were written after earlier crises, and non-binding recommendations on how to deal with failing banks were issued before4. Those recommendations and new rules are fine theoretically. They are normally reasonably adequate to deal with the type of issue that has caused problems before, if they would be in fact fully applied, but crises occur so frequently that it is likely that this will continue. Previous advice has never been fully implemented, or at least not implemented in a binding format, while banks and banking groups have grown ever larger and grown ever more international. The problem proposals for resolution tools and cooperation face is that the numbers and opposed interests are so big, and the downside for the economy, jobs, savings and governments so big, that in the end nobody wants to be bound by pre-existing binding criteria and specific instructions, that may not be politically or economically opportune at that future point in time. This problem is compounded in any international situation, where each country is bound to fight for the interests of its citizens/taxpayers/voters harder than for those of other countries, and has the national legal instruments to do this. Even in Europe bankruptcy laws are not harmonised, let alone on a worldwide basis. Every legal entity with a banking license remains subject to its local supervisor, and to its local bankruptcy laws. An added problem is that those reports and recommendations are generally written after the crisis has been resolved, and there is no gain in rocking the boat and a lot of (political and economic) gain in believing in fairy tales (e.g. that countries will act for the common good instead of their own good, even if that may cost them or their citizens/voters/taxpayers billions of euros). In this chapter 18 the following issues are discussed: – the reasons for distinguishing between small and systemic banks in the termination process, which has repercussions for the way they are supervised in normal times (see chapter 18.2); – the limited current regime for dealing with banks that are in crisis (chapter 18.3) and the expected changes in this regime; – the role of central banks (liquidity support) and governments (state aid) to try to prevent a bank from being wound down (see chapter 18.4); – the deposit guarantee and investor compensation schemes that are applicable to banks in liquidation (see chapter 18.5); – the role of the supervisor after a bank has succumbed to a crisis by going into liquidation (see chapter 18.6). 4

BCBS, Supervisory Guidance on Dealing with Weak Banks, March 2002.

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EU Banking Supervision

The thinking about preventing a crisis at a bank is coalescing also around the idea to introduce a banking union and around macroprudential supervision. Two components covered in this chapter are deemed to be key components of a possible banking union: – the introduction of an effective resolution framework and possibly the establishment of a resolution authority for the EU or at least for the Eurozone including its funding (see chapter 18.3); – the introduction of a joint or at least highly cooperative deposit insurance scheme including its funding (see chapter 18.5). The single supervisory mechanism (see chapter 21.3) and the single rulebook (see chapter 2 and 5-18), are the other components of a banking union for the EU or the Eurozone. For funding-issues also see chapter 21.9. Of a more philosophical nature – but with practical consequences for supervisory decision making in a crisis – is the question whether banking supervisors responsible for the individual institutions and for preventing such an individual institution to become a source of instability (sometimes referred to as microprudential), should also be responsible for the banking sector as a whole and/or financial stability as a whole (sometimes referred to as macroprudential) supervision. The focus on ‘compliance-supervision’ in the RBD and the CRD IV project implies that only those rules that can be complied with are intended to be the remit of supervisors, though that may be a too narrow reading; see chapter 4.35. Macroprudential issues have risen to prominence in the discussions after the 2007-2013 subprime crisis. This general responsibility for sector wide or even system wide supervision had not been clearly allocated so far. Components of this general responsibility rested with the monetary authority, the supervisor, the fiscal authorities and the legislature. Definitely nobody had obtained the type of instruments needed to address it. Macroprudential issues could be considered to be the remit of central banks and central governments, using their own instruments (state aid, liquidity support, pulling monetary and tax levers) and assisted by any instruments that supervisors have been endowed with. It could also be defended that supervisors on individual banks also have to watch wider trends as these may impact on the viability of banks, or should watch those jointly with e.g. central banks. With the introduction of the ESRB (see chapter 22.5) the joint approach appears to have taken a back seat. Though the ESRB has no powers other than to issue warnings and nonbinding recommendations (and to gather input for its analysis) the membership reflects

5

Art. 4 CRD IV Directive wants supervisors to monitor banks so as to assess compliance with the CRD IV Directive and the CRR. See also implicitly for instance art. 12.3, 74.2 and 124 RBD for the current regime; but note the discussion on the scope of pillar 2 in chapter 14.

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that central banks take first seat, with supervisors delegated to the role of information providers and recipients of the warnings. Though there is no clear allocation of tasks, banking supervisors should also actively take into account the risks coming from the market, or from the total sector, to individual banks and vice versa. Their observations are input into the ESRB, and into their own supervisory planning. There are as yet no clear criteria for amongst others resolution planning, for decision making on failing a bank, or for exercising regulatory forbearance. Macroprudential considerations are not (yet) fully part of the CRD or other EU legislation, and are only partially relevant in the CRD IV project for the new recasting of prudential regulation. Those mainly relate to the introduction of additional financial buffers to reduce cyclicality or to have extra room to deal with more systemic banks; see chapter 6.2, 6.5 and 7. Banking supervisors are still only required to assume responsibility for individual licensed banking entities, and only equipped with instruments for that specific responsibility. However, an emergency procedure has been introduced to allow a member state to apply deviations that result from systemic problems; though with safeguards against abuse6. Literature – Hüpkes, Eva H.G., The Legal Aspects of Bank Insolvency: A Comparative Analysis of Western Europe, the United States and Canada, Kluwer Law International, Alphen aan den Rijn, 2000 – Lastra, Rosa M. (ed), Cross-border Bank Insolvency, Oxford University Press, Oxford, 2011 Interesting reports and recommendations on avenues to alleviate the risks of dealing with failing banks include: – BCBS, Supervisory guidance on dealing with weak banks, March 2002 – BCBS, Report and recommendations of the cross-border bank resolution group, March 2010 – FSB reports ‘key attributes of effective resolution regimes’, ‘Reducing the moral hazard posed by systemically important financial institutions’, and the joint report with the IMF and BIS ‘Guidance to assess the systemic importance of financial institutions, markets and instruments: initial considerations’7

6 7

Art. 458 CRR. FSB, Key Attributes of Effective Resolution Regimes for Financial Institutions, October 2011; FSB, Reducing the Moral Hazard posed by Systemically Important Financial Institutions, FSB Recommendations and Time Lines, 20 October 2010; IMF, BIS, FSB, Report to G20 Finance Minister and Governors, Guidance to Assess the Systemic Importance of Financial Institutions, Markets and Instruments: Initial Considerations, October 2009.

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EU Banking Supervision – Joint Forum review8 – UK FSA, The Turner review, March 2009 – Liikanen report9.

18.2 Systemically Important Financial Institutions (‘Too Big To Fail’) Introduction The failure of a bank is always devastating to its employees, its trading counterparties, and its retail and wholesale creditors, including its depositing clients. Even if they do not lose money, funding or jobs, such a failure will slash trust and cause immense anxiety in those dependent on the failing bank. News about a failing bank and the short term negative effects thereof are likely to affect trust in other banks. Both for handling the interests of those dependent on the bank and for financial stability purposes, it is easier to deal with its problems the smaller, less interconnected and more local a bank is. The reverse is also true. In general terms, the failure of a single bank-license holder with a limited market share that does not operate across borders is not a problem. Other banks will step in, the government may donate some money by increasing deposit insurance or paying some damages for presumed or actual liability to safeguard the interests of the accountholders/voters, and the overall cost will be limited. The same is true for a small non-systemic group of banks, though if they are based in more member states, problems in coordination can ensue. By definition there will be organisational and funding issues when dealing with problems if the banks involved are large, if they have multiple financial links between the banks in the group across borders, and operate in different legal systems as to bankruptcy and liability. In the bankruptcy of a smaller bank, depositors will benefit from the existence of mandatory guarantee funds, including a pay-out of up to 100.000 euro to be paid out after an assessment process (see chapter 18.5). In practice, a ‘too big to fail’ bank offers full deposit insurance – provided as a free implicit subsidy by its government – to all its counterparties. Such systemic banks will almost always be bailed-out to avoid financial stability problems. Its depositors that would also have been insured via a deposit guarantee fund do not need to go through the claims-process and benefit from continuous service, as well as coverage of their deposits that are larger than 100.000 euro. Other creditors that formally would not benefit from deposit insurance likely will not suffer a cut, unless national bankruptcy

8 9

Joint Forum, Review of the Differentiated Nature and Scope of Financial Regulation, January 2010, www.bis.org. High-level Expert Group on Reforming the Structure of the EU Banking Sector, Final Report, 2 October 2012 (Liikanen Report).

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regimes or bailout regimes allow this to happen (and the government thinks the financial stability consequences will be negligible of such a cut). The implicit state guarantee – if the state can bear it – thus de facto provides deposit guarantee to e.g. the interbank market10. This benefits systemic banks, and disadvantages small banks. They will suffer competitively both in the retail and wholesale markets from a differentiated risk profile due to the larger banks being perceived as ‘too big to fail’. This distinction and the lower funding costs for systemic banks that are the result, provides an incentive for relatively small banks to become either too big or too interconnected to fail (or at least to be perceived as such), and for systemic banks to remain too big and/or too interconnected to fail11. Systemic Relevance The size and complexity of the bank/banking group is relevant to determine the size and complexity of the allocated resources of the supervisors in the application of ongoing banking supervision in normal times and in crisis times. This has also been reflected in the applicable rules that are supervised. Basel I was written with larger international banks in mind12, but was implemented in the EU with only minor differentiation between large and small banks; see chapter 2. The market risk amendment and Basel II started to differentiate between simple and complex models to be used by standard and more complex banks. The size and complexity of banking groups has meanwhile increased exponentially since Basel I was drafted. The deregulation of capital markets and of banking services across the western markets and to some extent elsewhere lead to enormous economic growth in all western markets13. It also led to the rise of the interconnectedness, convergence and increased size of the banking giants on which all these economies are dependent as service providers/debtors/creditors. Each of these factors will automatically lead to problems everywhere if one or more of such banks stutter. With the advent of Basel III, to be implemented in the EU via CRD IV, and the planned additions for systemically important financial institution that are being developed under the umbrella of the FSB, size and complexity will now gain an explicit impact on the way a bank fulfils its prudential requirements and how it is supervised in normal times. This in the hope to prevent such banks from becoming troubled, or at least to gain additional time and financial latitude to be able to deal with troubles at such large and complex banks. These differences in

10 Also see M. Dewatripont & J. Tirole, The Prudential Regulation of Banks, Cambridge, 1994, chapter 2 and 3. 11 M. O’Hara & W. Shaw, ‘Deposit Insurance and Wealth Effects: the Value of Being “Too Big To Fail”’, The Journal of Finance, Vol. 45, No. 5, 1990, page 1587-1600. 12 At least for those banks that were considered large and international prior to the consolidation/mergers and acquisitions that took place in the banking sector from 1988 when the Basel Capital Accord was first issued until 2007 at the start of the 2007-2013 subprime crisis. 13 E.L. Rubin, ‘Deregulation, Reregulation, and the Myth of the Market’, Washington and Lee Law Review, Vol 45, 1988, page 1249.

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requirements are sometimes advantageous to the big/complex banks (e.g. diversification benefits, benefits of being able to calculate their own capital requirements because they are able to invest in internal models), but sometimes disadvantages (e.g. higher contribution to deposit insurance, more attention from and information provision to supervisors/central banks). The advantages have so far outweighed the disadvantages. Especially large banks were thinly capitalised before the crisis when looking at core tier 1 capital. They made a disproportionate use of the less risk absorbent (innovative and tier 2 and 3) financial buffer components, and were likely able to adjust the risk on their assets to a larger extent due to their investment in their own models14. The FSB is developing a long term framework on how to deal with systemically important financial institutions (sifi's)15. The planned surcharge on capital requirements for global systemically important financial institutions is part of its work; see the additional buffers discussed in chapter 6.2 and 7. This surcharge could be deemed a disadvantage of being big. On the other hand it can be seen as a measure that will help level the playing field, by balancing the implicit state aid guarantee that such banks enjoy by a requirement to be safe(r) to avoid having to use that implicit guarantee. Big banks have had a commercial advantage of the ‘too big to fail’ presumption that allowed them to attract funds from the market even though they operate at much lower capital ratios than their smaller peers16. The EU in addition tries to capture systemic banks and investment firms (and related entities) in its recovery and resolution proposals (see chapter 18.3), and is consulting on whether to capture other systemic institutions in the financial sector by a complementary regime17. The FSB has delegated some of its work to the BCBS. It published a first list in July 2011, and reached agreement on the assessment methodology and the additional buffer in November 201118. Though the FSB invites supervisors to have resolution schemes in place

14 See chapter 6.2, 6.3 and 7, and A. Demirguc-Kunt, E. Detragiache & O. Merrouche, Bank Capital, Lessons From the Financial Crisis, World Bank Policy Research Working Paper 5473, 2010. Also see C.M. Buch, S. Eickmeier & E. Prieto, In Search of Yield? Survey-based Evidence on Bank Risk Taking, Deutsche Bundesbank Economic Studies no 10/2011, page 17. 15 FSB, Reducing the Moral Hazard posed by Systemically Important Financial Institutions, FSB Recommendations and Time Lines, 20 October 2010, based on its interim report of 18 June 2010. www.financialstabilityboard.org. Also see FSB, Key Attributes of Effective Resolution Regimes for Financial Institutions, October 2011. 16 S.G. Hanson, A.K. Kashyap & J.C. Stein, A Macroprudential Approach to Financial Regulation, Chicago Booth WP 10-29 (Initiative on Global Markets Working Paper 58), November 2010. 17 Commission, Consultation on a Possible Recovery and Resolution Framework for Financial Institutions other than Banks, 5 October 2012. 18 BCBS, Globally systemically important banks: assessment methodology and the additional loss absorbency requirement, November 2011. FSB Press Release, 4 November 2011, 57/2011.

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by 2012 (see chapter 18.3 on those developments), the surcharge will not be applicable to the institutions identified in 2011. The list will be annually updated, and only institutions that make the list in November 2014 should be subjected by their supervisors/countries to the surcharge from January 2016. Approximately half the list concerns EU banks; see chapter 2 and 6.2. Whether the publication of this list with the future surcharge will have the desired effect is debatable. For the money markets, the new sifi-surcharge will likely act as a ‘too big to fail’ safety endorsement by public authorities, easing any funding restrictions these banks may face (and making it easier to fulfil the higher capital ratio required). The surcharge only adds an additional layer to the solvency ratio, and does not impact on the required amount of liquidity nor on the leverage ratio. The disadvantages are thus strictly limited, while the advantages will be legion. Depositors, investors and other lenders are likely to move their business to banks that are perceived to benefit from an implicit government guarantee in crisis times19. This is likely to make their high grade debt part of the reserve currencies of the world. If there are credible limits to the bailout certainty of such institutions, this may decline, but whether that will result even from the recovery and resolution proposals as debated in the EU remains to be seen; especially when the effectuation of such limits might cause turmoil in financial markets. The FSB/BCBS have also produced principles for the assessment and additional loss absorbency for domestically important systemic banks20. Where the global sifi’s are allocated to specific buckets and increasing capital surcharges up to 3.5%, the work on domestic systemically important banks is even more tenuous as a level playing field. The FSB and BCBS have advised to introduce the surcharge for global sifi’s and the additional loss absorbency that national authorities deem appropriate for domestic systemically important banks from 2016; see chapter 6.2. Determining which institution is systemic, and which not, is thus important. It is difficult too if it is to have impact on ongoing supervision, instead of only on emergency measures taken in a crisis. Assessment criteria need to be developed with subsets of criteria for ‘systemic’ and for ‘global’, that are helpful over time and to help differentiate between banking groups. A number of variables could be taken into account. The debate focuses mostly on qualitative indicators; though initial research into quantitative indicators is being performed 19 M. O’Hara & W. Shaw, ‘Deposit Insurance and Wealth Effects: the Value of Being “Too Big To Fail”’, The Journal of Finance, Vol. 45, No. 5, 1990, page 1587-1600; R. de F. Oliveira, R.F. Schiozer, F. Rafael & A.B. de C. Barros Lcas, Too Big To Fail Perception by Depositors: An Empirical Investigation, Banco central do Brasil WP 233, January 2011. 20 BCBS, A Framework for Dealing With Domestic Systemically Important Banks, October 2012.

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EU Banking Supervision simultaneously21. The FSB, IMF, BIS, ESM and EU Commission have come up with some input into a more generic assessment22. The approaches to the assessment are developing continuously. In many of the papers the advice is basically ‘it depends’, though efforts are made to provide quantitative basic indicators, that are subsequently negotiated between the supervisors and other authorities involved, likely with input from the banks involved (who are depended on also for the input into the newly developed indicators used)23. A consensus appears to be that relevant factors include: – size; – interconnectedness with others (especially with voters or with other big financial institutions); – whether the services provided can be substituted by other providers, e.g. think of a highly concentrated markets, niche banks, or financial infrastructure services; – complexity. The BCBS and FSB also focus on how internationally active a bank is. This reflects both their mandate (international banking), and the fact that the resolution is more difficult – and the potential spill-over is greater – for internationally operating banks24. By necessity, the evaluation must be very pragmatic, and many variables interact. It is not relevant whether a bank is a core player in interbank money markets because it is big and systemic, or whether it has become big and systemic because it is a core player in the interbank money markets. A clear cut definition – such as the damage that the failure of

21 See e.g. the discussion in M.R.C. van Oordt & C. Zhou, The Simple Econometrics of Tail Dependence, DNB WP 296, May 2011; Xin Huang, Hao Zhou & Haibin Zhu, Systemic Risk Contributions, Fed Board Staff WP 2011-08, January, 2011. The BCBS has gone furthest to develop quantitative indicators, though the strength and comparability of the data is questionable; BCBS, Globally systemically important banks: assessment methodology and the additional loss absorbency requirement, November 2011. The BCBS quantitative indicators are the starting point for an otherwise qualitative decision making process. 22 The most ‘quantified’ process is described in BCBS, Globally systemically important banks: assessment methodology and the additional loss absorbency requirement, November 2011. Also see e.g. BCBS, A Framework for Dealing With Domestic Systemically Important Banks, October 2012, and IMF, BIS, FSB, Report to G20 Finance Minister and Governors, Guidance to Assess the Systemic Importance of Financial Institutions, Markets and Instruments: Initial Considerations, October 2009. The accompanying background paper presents the results of a survey of (mainly) central banks on their assessment of systemic relevance. Also see Commission, Consultation on a Possible Recovery and Resolution Framework for Financial Institutions other than Banks, 5 October 2012, page 7 and 8; and art. 3 of ESM, Guideline on Financial Assistance for the Recapitalisation of Financial Institutions, www.esm.europa.eu. The undated guidelines were retrieved on 27 June 2013. 23 BCBS, Globally systemically important banks: assessment methodology and the additional loss absorbency requirement, November 2011; see for instance page 6 on information collection for the indicator of international liabilities. The negotiation procedure is set out on page 13. 24 BCBS, Globally systemically important banks: assessment methodology and the additional loss absorbency requirement, November 2011, page 18.

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a bank inflicts on the rest of the system as used in some economic research25 – is relevant to it, but not determinative. Neither is the distinction between ‘too big to fail’ and ‘too interconnected to fail’, both are relevant. In practice, except for the most dreary of unimportant banks, after the Lehman collapse in 2008 in the EU almost all banks were deemed too relevant to fail, while in the USA many small banks continued to fail26. This may be a result both of the availability in the USA of a standing resolution regime via the FDIC, different state supervision standards and a cultural lesser acceptance of state bailouts to benefit individual depositors beyond the deposit guarantee limit. Any definition is also prone to manipulation. For instance if balance sheet total would be the sole relevant criterion, any additional rules for systemic institutions would stimulate securitisations of assets off the balance sheet, and a focus on low-capital (but possibly not low-risk) banking activities. Other measures such as total income, services, share of the deposit market, will also need to be taken on board, as well as the mood of the market (a midsized bank failing in boom times is not a problem, but it may set off a crisis if it fails when markets are uncertain). According to the survey that is the basis of the above-mentioned IMF/FSB/BIS work, most systemic assessments are made by central banks, with input from supervisors and likely from ministries of finance. This is in line with the lack of clear allocation of end-responsibility for financial stability as a whole; see chapter 22. The EBA regulation requires EBA to identify systemic banks. It can use stress tests to identify them, and in a turnaround has to subject them to stress tests and ensure they are subject to stronger supervision. EBA has meanwhile identified 30 banks on which it will undertake a bi-annual risk assessment because they are IRB banks that have a large asset size and are important on a cross-border context. These were automatically enrolled as part of the 90 banks that participated in its 2011 EU-wide stress test27. Though the link to the status as ‘systemic’ in the list of 30 is not explicitly made, it is likely that it considers at least these individual banking groups as the systemically relevant banks at the EU level, though a case could also be made for the wider sample of 90 banks (though those include some relatively small banks that are more likely only important domestically, not at the EU level).

25 Amongst others the damage a bank inflicts on others when it fails and its size are shown to predict which banks are core players in the German interbank money markets in: B. Craig & P. von Goetz, Interbank Tiering and Money Center Banks, Deutsche Bundesbank Discussion Paper No. 12/2010. 26 High-level Expert Group on Reforming the Structure of the EU Banking Sector, Final Report, 2 October 2012 (Liikanen Report), page 25. 27 Art. 21-23 EBA Regulation 1093/2010. EBA, 2011 EU-Wide Stress Test, Aggregate Report, 15 July 2011, page 31 and Annex 2 contains the names of the 30 banks, while the names of the 90 are included in EBA, Supporting Document 1: banks participating in the 2011 EU-wide stress test, 21 April 2011.

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Existing References to Systemic/Significance in the CRD Apart from the EBA stress test and monitoring work, there is no explicit link under the CRD between systemic relevance and heavier supervision/enforcement. Differentiation of the application of CRD instruments and requirements can, however, be based on proportionality principles embedded in all EU legislation under the treaty (see chapter 3.4). Since the start of 2011 the CRD does contain references to ‘significant’ banks and ‘significant’ branches of banks, though it is not clear whether significant means systemic28. Significant banks are required to have a remuneration committee, that must be composed completely of non-executives (implying that significant banks must have non-executives, a requirement that cannot be found explicitly in the CRD; see chapter 5.2 and 13). There is no clarity as to what is a significant bank, leaving this to a national assessment of the bank entities they licensed. This applies also when they are subsidiaries of banking groups based elsewhere in the EU as the remuneration requirements are supervised both on a solo and a consolidated basis29. The supervisor/member state does have to base its decision on the size, internal organisation and the nature, the scope and the complexity of the activities of the bank, but there is no explanation of which size etcetera leads to the conclusion of significance for the bank. Such criteria do exist for the assessment of significant branches in a home/host cooperation context. Once a branch is deemed significant, host supervisors gain additional instruments to intervene in emergency times, plus additional information rights. This limits the freedom of establishment in concrete circumstances, but allows it to continue to work in normal times, and prevents local initiatives that would limit the freedom further in the ‘interest of the general good’; see chapter 3.4, 5.3 and 21.6). The RBD contains three (non-limitative) indicators of significance of the branch in the host market. When claiming that a branch is significant, the host supervisor has to provide reasons that pay specific attention to: – whether the branch has more than 2% of deposits in the host market; – the potential impact of the liquidation of the branch on market liquidity and payment/clearing/settlement systems in the host market; – the number of clients the bank has in the host market. These indicators are very fluid, and likely to be applied very differently in member states. The 2% indicator is set very low. This reflects the anxiety of host supervisors that got burned by the Icesave branch of the failed Icelandic Landsbanki bank to quickly gain 28 Annex V §24 RBD for significant banks, art. 42a RBD for significant branches. 29 See art. 129.3 RBD. Art. 123/124 (pillar 2) are decided upon in a joint manner, restraining the supervisors of subgroups and banking entities in the group. Not even this restraint applies to art. 22 and Annex V RBD that contain the remuneration provisions. See chapter 13, 14.1, 17, 21.6.

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additional rights to information and intervention powers instead of having to rely on the home supervisor (see chapter 21.6). Whether such a 2% market share of deposits is also an indicator that a bank is ‘significant’ under the above-mentioned remuneration committee obligation, or will be ‘systemic’ in a crisis or in future systemic international financial institutions supplementary capital requirements is yet to be determined. The Commission intended to implement any agreement reached at the worldwide level into EU law30. Systemic banks are not the only entities that can infect the banking system. Too big to fail worries can also lead to more indirect bailouts of the banking system. Key debtors or service providers can also be bailed out, to indirectly keep the banks involved healthy. The help given by the USA to Mexico in 1982 helped avoid uncontrollable losses at large US banks31. The same applies to the bailout by the USA of the insurance group AIG, as the collapse of its holding and financial products unit would have resulted in large losses of (investment) banks. Crisis help to Greece during the 2007-2013 subprime crisis helped to avoid large losses by banks that were key investors in Greek government bonds (and even larger losses suffered at banks if a Greek collapse would have led to other sovereigns being excluded from financial markets and defaulting). If and when the systemic definition is expanded to non-banks, many may need to be deemed systemic. Under the criteria set, any central counterparty of any relevant financial market (stock exchange or of ‘over the counter’ traded instruments, all rating agencies, and any other service provider of a monopoly/oligopoly service could be systemically relevant32. A new development is the call for extra regulation (or extra taxes) for those banks that benefit in the market from an assumption of state aid. Systemically important banks benefit from higher credit ratings (as rating agencies take the implied government backing into account when rating the bonds issued by the bank) and lower interest rates. Some member states agreed in October 2012 to introduce a financial transaction tax as a source of funding, though negotiations are still ongoing and the measure is controversial; see chapter 22.4. Systemic risk is defined as risk of disruption in the financial system with the potential to have serious negative consequences for the financial system and the real economy33. The criteria for significant branches and significant banks are not amended in the CRD IV

30 Commission, CRD IV – frequently asked questions, 20 July 2011, memo/11/527. Any G20 decisions are non-binding, but authoritative; see chapter 3.3. 31 M. Dewatripont & J. Tirole, The Prudential Regulation of Banks, Cambridge, 1994, chapter 4. 32 See e.g. page 9 of Commission, Consultation on a Possible Recovery and Resolution Framework for Financial Institutions other than Banks, 5 October 2012. 33 Art. 3.10 CRD IV Directive.

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EU Banking Supervision project34. These continue to be different, and again are different from two new sets of criteria that – if fulfilled – lead to higher financial buffer requirements. In the context of setting higher solvency ratio demands (additional buffers; see chapter 6.2 and 7 two sets of criteria are introduced to determine which groups should fall under the global identification of systemically relevant, and which could domestically be relevant35. One new set of criteria is introduced to determine which banks should be subjected to the international part of the additional systemic buffer36. The ‘global systemic important institution’ designation leads to demands set at the level of the group only. The CRD IV directive refers to the following: – size and complexity of the group; – interconnectedness with the financial system; – substitutability of its activities; – cross-border nature of its activities, both in the EU and with third countries. These non-quantified criteria allow the EU to comply with the worldwide framework as developed under the auspices of the FSB, and allocate EU groups to the same five bandwidths. EBA is to develop regulatory standards and send drafts to the Commission by 30 June 2014, taking into account such international work37. A separate, shorter and different set of criteria is developed for local use if a bank is an ‘other systemically important institutions’. The supervisors should assess systemic importance of a group, subgroup or bank on the basis of size, importance in the economy of the EU or the relevant member state, the significance of cross-border activities and the interconnectedness with the financial system. EBA is to issue guidelines (after a discussion with the ESRB) on these criteria38. If designated as systemically important under these criteria, the CRD IV project allows, but not obliges, the supervisor to require additional buffers at the consolidated, sub-consolidated or solo-level. The additional buffers for systemic risk in a member state, for being a globally important group or being important under the ‘other’ category can overlap. This applies at the group level for a globally important group, and at any level of the additional systemic risk buffer

34 Art. 51 95 CRD IV Directive. 35 Global respectively other systemically important institutions. The acronyms of G-SIIs and O-SIIs are used in the relevant art. 131 CRD IV Directive. 36 Art. 131 CRD IV Directive. 37 Art. 131.18 CRD IV Directive. 38 Art. 131.3 CRD IV Directive.

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and of the national buffer for ‘other’ important groups or banks. If a bank or (sub)group is subjected to these at the same time, only the highest applies39. This means that if a country applies a systemic risk buffer to all or some of its banks, a bank that operates there that should also have a global or other systemic risk buffer will only need to maintain the highest of these buffers, reducing the disadvantage of being too big. These additional buffers for individual groups or individual banks will gradually be introduced over the period of 2016-201940. The new requirements do not make explicit that supervisors will allocate more attention to such systemic banks or banking groups, but they do buy some additional breathing space if a systemic bank is in crisis, before the actual solvency ratio minimum requirement is breached and there is no time left to look for other alternatives than a bailout or a liquidation.

18.3 Supervision When a Bank Is in Crisis Introduction The 2007-2013 subprime crisis brought the fault lines in banking supervision to the forefront. It has led to high level as well as detailed plans to strengthen crisis prevention and crisis management. Similar discussions were held during and after previous crises. These lead to some basic assumptions and rules on the instruments central banks, ministries of finance and competition authorities should have both to prevent crises and to handle crises in the banking sector and/or the rest of the economy. Some of those lessons have led to changes in banking regulation and in public authorities’ instruments, so far especially at the national level. Some of the lessons apparently have to be relearned every business cycle. When reading a report on lessons learned from previous crises, sometimes only the date is truly different from reports on the 2007-2013 subprime crisis. Issues such as incentives, gaming existing regulation, the need to commit to international action in international crises, the danger in stimulating leverage and in bubbles in the economy were well-known, albeit arising in different areas and using different terminology. Changes in banking rules have been the result in every crisis, including e.g. the allocation of responsibilities between home and host supervisors after the BCCI failure or recently the way significant branches are treated; see chapter 2 and 5. Such changes reduce the chance that the specific causes of the one crisis will be the cause of a future crisis. Though this will not prevent crises, each of the changes over time have helped in preparing for handling a crisis, or helped reinforce the lessons of the current crisis that appear to lead to clearer resolution planning and crisis management; see below. 39 Art. 131.14-131.17 CRD IV Directive. 40 Art. 162.5 CRD IV Directive.

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Both the BCBS and the CRD make clear that failures of banks can happen. References to deposit insurance or to bankruptcy or crisis instruments would not be necessary if no bankruptcy could occur. There are several options. If a bank no longer fulfils prudential requirements, it could be forced through liquidation like any company. It can also be attempted to save it, either forcing it to take actions, or even by inserting liquidity or financial buffers by private parties or by public authorities. If a bank is systemically important, the latter option is uncontroversial from a prudential point of view, but painful for taxpayers. If a bank is not systemic, and no rescue can be arranged, failing it is theoretically uncontroversial, but the cost for depositors and counterparties that are not covered by deposit guarantee can make it unpalatable in practice. A failure and liquidation of a bank that would not disrupt systems (or cause too much grieve for depositors/voters) from a theoretical point of view can even be welcomed as a positive. The discipline an occasional bank-failure fosters at professional lenders to banks, and the acceptance of such events as a side-effect of healthy competition are indeed welcome41. The same could be said if a liquidation would serve as a welcome reminder that prudential supervision is not calibrated to a no-failure regime. It is instead drafted to balance (a) the benefits that commercial banks provide to the economy against (b) the level of acceptable risks of failure of banks for that same economy. This balance has always been deemed valuable. Crisis management at an individual firm is not necessarily a financial stability threat. If it is not, the role of the supervisor should be limited to stimulating the bank to resolve its own problems, or to stimulate other private parties to help the failing bank out. If the bank is systemic, or if there are problems at multiple banks, the bank can benefit from the so-called ‘lender of last resort’ function of the central banks, which provides short term liquidity support to banks that are otherwise solvent, and if it is systemic it can benefit from solvency support by the government. See chapter 18.2, 18.4 and 22 on the wider financial stability and macroprudential issues. The boundaries within which banks can be allowed to fail have, however, shifted since the market crash following the Lehman Brothers bankruptcy in September 2008. When Is a Bank a Failed Bank: Action or Forbearance? The state rushing to the rescue of a failing bank is a welcome sight for the creditors of that bank, but less so for the taxpayers of that country, as the cost that would otherwise be borne by some of the banks’ unsecured creditors are instead borne by the taxpayers. However, the cost for depositors and the potential for financial instability are much less welcome results if the taxpayer chooses not to step in. The state would often prefer not to

41 BCBS, Core Principles for Effective Banking Supervision, September 2012. T. Padoa-Schioppa, Regulating Finance, Oxford, 2004, chapter 8.3.

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rush in, and force the bank and its shareholders/creditors to actively monitor/manage problems and take responsibility to avoid a bankruptcy, and where needed to organise its own rescue. It the bank does not manage its own affairs diligently because it expects that the state will rush in, it has succumbed to so-called moral hazard; see chapter 4.3. To avoid stimulating such reliance, the concept of ‘constructive ambiguity’ is applied42. The reasoning is that – as long as the state publicly states that it will not rescue a bank, the bank will ensure that it will not go bankrupt under its own sails, by reducing its risky business or by ensuring it has enough capital/liquidity to survive any reasonable eventualities. Nonetheless, it is established in practice since the 2008 Lehman collapse that central banks and countries will step in for any systemic bank and for most non-systemic banks, when needed to avoid high costs to society, by instead bearing the lower cost of saving the bank. A failing bank will now need to be truly insignificant and the financial markets incredibly stable and optimistic, for the bank to avoid being bailed out43. The timing and whether the bank qualifies as being important enough and healthy enough to survive with help are the issues under debate44. The concept of constructive ambiguity on the type of action that public authorities will take is only one of the reasons that the CRD is light on guidance on what banks, supervisors and other public authorities should do when a bank is in trouble. Another is that there is no harmonisation at all of bankruptcy regimes, the moment when they are triggered, how a bankruptcy is managed nor of the order of pay-out of creditors, (see below) and a third is that supervisors are often not the authorities in charge if a banks is actually troubled, but this power shifts to the central bank and/or the ministry of finance (see below). Timing the failing of a bank or other intervention Apart from obligations to inform other supervisors and authorities involved, the supervisor is given some instruments to intervene, and an obligation to let the bank fail and start the deposit insurance pay-out once it fulfils criterions set in the deposit guarantee directive. The supervisor has to activate it at the latest five days after the supervisor becomes aware that the bank has failed to repay a deposit; see chapter 18.5. What the supervisor should do to prevent the collapse of a bank, or at least to stop depositors and/or the financial system from suffering negative consequences from such failure is not clear. Neither is it 42 R.M. Pecchioli, Prudential Supervision in Banking, OECD, 1987, page 133. 43 High-level Expert Group on Reforming the Structure of the EU Banking Sector, Final Report, 2 October 2012 (Liikanen Report), page 25 and 51. This does not mean that supervisors and legislators do not long for a return to constructive ambiguity; see e.g. the preamble of FSB, Key Attributes of Effective Resolution Regimes for Financial Institutions, October 2011. 44 See chapter 4. R.M. Lastra (Ed.), Cross-border Bank Insolvency, Oxford University Press, Oxford, 2011, chapter 13, as written by M. Waibel; C.P. Kindleberger, A Financial History of Western Europe, 2nd ed, New York Oxford, 1993, chapter 15.

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clear at exactly what time a bank should be failed, especially if the outer limits of the deposit insurance criterions are not yet – or not clearly – fulfilled. Many supervisors run into problems in the debate about the best timing of when to let a bank fail. Should they let it run by employing forbearance to transgressions of prudential requirements until the last possible moment allowed under the deposit guarantee directive in the hope that rescue will materialise, or should they take action already when they themselves see no likely path to viability, even when the bank and its shareholders (and possibly judges in bankruptcy and in liability cases) still have hope? Unless a bank is felled by a single catastrophic event (e.g. the Barings implosion due to insurmountable losses caused by a single trader), there is generally a time slot over several weeks, months or even years when a bank is not healthy but not mortally ill, but when it is not clear whether mortality can be avoided. The consequence of not acting is maintaining the unhealthy status quo, but the alternative is letting the bank fail immediately with all its bad consequences for depositors, other counterparties, for shareholders45, for falling trust in banks in general, for the economy or for other macroprudential concerns46, as well as miserable public relations for the supervisor if any bank fails. The EU legislation does not provide a clear guideline. Though the CRD solvency ratio, organisational requirements and (ongoing) licensing requirements are phrased as obligations, the associated instruments carefully refrain from obliging the supervisor to act47. Many of the underlying transgressions in which cases an intervention ‘may’ or can ‘only’ take place are in turn based on vaguely worded obligations (be fit and proper, avoid close links that hamper supervision, have sufficient financial buffers, each of which requires subjective assessments, e.g. on influence, value or risk; see chapter 5.2, 6.2 and 20.3. Relatively the most clearly worded obligation is contained in the deposit guarantee directive: to issue a declaration that deposits are ‘unavailable’ (that a depositor is unlikely to see a demand for repayment honoured)48. Following such a declaration a bank will in effect be dead in the water, unless a huge capital injection restores confidence (which in turn would be more likely prior to such a declaration). The true backstop is that a court may declare the bank to be in a moratorium or bankrupt, in which case automatically the deposit

45 Especially important if many private persons are shareholders or otherwise provided capital in the form of subordinated deposits, as was the case with Fortis in 2008 in Belgium and DSB Bank in 2009 in the Netherlands, respectively. Such persons were protected if they provided funds in the legal form of deposits, but not when providing it in the form of capital, a distinction poorly understood by many voters. 46 D. Elliot, G. Feldberg & A. Lehnert, The History of Cyclical Macroprudential Policy in the United States, WP 2013-29, 15 May 2013. 47 See art. 17, 124, 136 and Annex XI RBD. 48 Art. 1 and 10 Deposit Guarantee Directive 1994/19/EC.

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guarantee is triggered as an alternative to the supervisory declaration on unavailable deposits. The underlying thinking appears to be that the bank should be kept alive if it fulfils CRD and deposit guarantee minimum requirements and is not on a downward irreversible path. It should be closed if it no longer fulfils CRD minimum requirements (and is unlikely to do so again within a reasonable timeframe, e.g. by raising new capital) or if there is a downward irreversible path. The decision of a supervisor to fail a bank (or arrange a rescue) should thus be made at the latest when there is still sufficient capital to bear the likely losses, and there will thus be enough cash after a liquidation (or run-off) to ensure that all creditors including depositors will get their nominal credits repaid to them in full49. Unlike ‘normal’ commercial companies, banks are not allowed to eat up their capital in a last effort to reinvent themselves and become solvent again, as that would – if things go bad – reduce the final amount available for such a pay-out to depositors by the estate of a failed bank50. Still, that leaves quite a bit of ambiguity for supervisors (and central banks and ministries of finance) to determine the perfect moment in time when the bank has had enough time to pull itself together, or to accept a private sector rescue attempt, but not yet enough time to eat up its financial reserves; the solvency ratio and company law financial buffers that will allow it to absorb unexpected losses; see chapter 6.2 and 7. This makes it difficult to decide exactly when to pull the plug on a bank (or to force it into a public assistance programme if the bank is systemic). Should the public authorities take into account predictions of future turnarounds, reversals in the market, expansion in the economy, when those kind of predictions are the only thing standing between the bank and its failure? The CRD does not specify that such can or cannot be taken into account, leaving any optimistic gamble or pessimistic expectation up to national authorities. There are several things supervisors can do to delay their decision. All of these can be interpreted to be aligned with the CRD framework, and the requirement to have supervision that is ‘effective and efficient’ (see chapter 20). Such actions include51: 49 As was e.g. the case when the Icelandic banks failed, of which the bankruptcy estates to which most of the foreign activities were allocated is on course to pay out senior unsecured creditors, including depositors and foreign deposit guarantee systems, in full. T. Thorgeirsson & P. Van den Noord, The Icelandic Banking Collapse: Was the Optimal Policy Path Chosen?, Central Bank of Iceland WP 62, March 2013, page 6 and 10. 50 E.H.G. Hüpkes, The Legal Aspects of Bank Insolvency: A Comparative Analysis of Western Europe, the United States and Canada, The Hague, 2000, chapter I and II. 51 See BCBS, Supervisory Guidance on dealing with weak banks, March 2002. Also see e.g. principle 9 and 11 BCBS, Core Principles for Effective Banking Supervision, September 2012; BCBS, Report and Recommen-

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– request a turn-around plan from the bank, indicating how they will raise cash to be able to fulfil liquidity or solvency requirements (again) within a reasonable period, resulting in an approved programme in a form of formal temporary forbearance; – request the bank to draft a recovery plan and request its aid and information to allow the authorities to draft a resolution plan, to prepare it for an easy resolution in case future problems arise (the so-called living wills; see below); – demand specific actions over time by the bank that is not yet in transgression of quantitative requirements to resolve organisational issues or future funding issues; – push shareholders to ‘save’ the bank by inserting additional capital and/or liquidity; – push the central bank or the member state to provide liquidity or solvency support (lender of last resort respectively state aid; see chapter 18.4); – practice informal forbearance, by not acting on or even analysing the data it receives (in the trust/hope, often based on conversations with the banks’ board, that the bank is taking emergency measures to resolve the situation; – practice informal forbearance, by allowing the bank – implicitly or explicitly – to doctor the financial reporting (underestimating losses, overestimating values, delaying reporting, underestimating liabilities, pre-booking future income streams, etcetera)52; – if there is a general market liquidity stress, retention requirements (and the prohibition for other banks to invest in securitisations where the securitising bank holds a retained interest) can be suspended53; – in a systemic crisis, amending reporting, collateral or accountancy standards in the law, to adjust the ‘normal’ thresholds in such a manner that the banks involved no longer are non-compliant54. A prime example of such behaviour vis-à-vis relatively simple banks was the USA savings and loans crisis, where prudential requirements on banks were reduced (and not enforced) dations of the Cross-Border Bank Resolution Group, March 2010. Since 2010 the Commission has been working on legislative initiatives on proposals that would help prevent or deal with a failing bank. EU Commission Communication, An EU Framework for Crisis Management in the Financial Sector, COM(2010) 579 final, 20 October 2010; and Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. See below. 52 This would normally be a sign to replace management immediately if done to hide the financial situation from supervisors, but in an acknowledged emergency can create a breathing space for the bank to get its act together, and may thus be condoned by a supervisor in specific situation. See chapter 20.3. It may, however, also lead to supervisory liability if the gamble fails, as the EU laws in that case are not applied correctly. See chapter 21.10 and L. Dragomir, European Prudential Banking Regulation and Supervision, the Legal Dimension, 2010, chapter 11. 53 Art. 122a.8 RBD. This would free up collateral for the securitizing bank, and allow other banks to invest in (and thus underpin market prices of) securitization positions. 54 This has been done in the 2007-2013 subprime crisis, see below. Fair value accounting standards were adapted, collateral requirements of the ECB were loosened as to the quality of accepted collateral for liquidity loans (and as per 2011 slightly tightened again); see chapter 6.4, 18.4, and 22.3.

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in order to allow them to recuperate. Though some did recuperate, others did not, while the period of relaxed requirements incentivised gambling to become healthy again, and sometimes even outright fraud55. Regulatory forbearance (see chapter 20.3) has many benefits for the economy in good times to make the local banks more competitive and profitable, and stimulates them to lend more to riskier ventures that employ people and innovate56. In bad times forbearance is a strong option if the failure of the bank would elicit political or systemic consequences in the member state concerned or abroad, the right legal instruments are not in place or the financial institutions are too big to bail out relative to local GDP57. Hidden forbearance may also help temporarily safeguard the reputation of the supervisor as infallible and up to the job, providing an institutional incentive for established supervisors to not close or (publicly) intervene in a bank if they missed or underestimated early warnings, or if the bank is systemic58. If such forbearance is practiced knowingly, it is also logical to not share this information with other supervisors (in spite of undertakings to do so) as sharing the information would likely trigger supervisory actions elsewhere, undermining the hoped for effects of the forbearance59. If it works, nobody is the wiser, if it does not work, however, it opens up the supervisor to even larger accountability and liability issues, and more importantly has likely increased the impact of the liquidation of the bank on the economy and on the banks’ creditors. Different countries and the EU (see above) have reacted in different ways to this debate, ranging from the supervisory (and central bank/ministry of finance) leeway to practice forbearance for a range of public policy goals to the introduction of prompt corrective action type of response practiced by the USA Federal deposit insurance corporation. The USA prompt corrective action mechanism automatically triggers liquidation processes if certain thresholds are met (see chapter 6.2)60. Another avenue are ambiguous legal texts that use undefined concepts and/or qualifiers such as an obligation

55 M. Dewatripont & J. Tirole, The Prudential Regulation of Banks, Cambridge, 1994, chapter 4 and 12. See chapter 20 and 21.10. 56 V.V. Acharya, Is the International Convergence of Capital Adequacy Regulation Desirable?, CEPR Discussion Paper 3253, March 2002. Also see chapter 20.3. 57 BCBS, Report and Recommendations of the Cross-Border Bank Resolution Group, March 2010. 58 A.W.A. Boot & A.V. Thakor, ‘Self-interested Bank Regulation’, The American Economic Review, Vol. 83, No. 2, May 1993, page 206-212; M. O’Hara & W. Shaw, ‘Deposit Insurance and Wealth Effects: the Value of Being “Too Big To Fail”’, The Journal of Finance, Vol. 45, No. 5, 1990, page 1587-1600. 59 T.M.C. Asser, Legal Aspects of Regulatory Treatment of Banks in Distress, IMF, Washington, 2001, chapter III.4. 60 J.J. Sijben, ‘Regulation Versus Market Discipline in Banking Supervision: An Overview – Part 2’, Journal of International Banking Regulation, Vol. 4, No. 1, 2002, page 55-71 notes correctly that this reduces moral hazard. Other public policy goals might nonetheless suffer.

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to have ‘adequate’ internal control systems, that give supervisors a lot of leeway to either help the bank or to hang themselves61. If a supervisor chooses to act against a minor or major transgression that might lead to a failure, it does not necessarily mean that the business of the bank will close. If this is foreseen in their domestic laws, they can also ‘just’ stimulate the replacement of shareholders by more affluent private parties or by the state, replace management, sell the assets and liabilities to another bank or to a new legal entity, or to close the bank for new business but allowing it to run-off its existing activities either inside or outside a formal bankruptcy or moratorium process. For systemic banks (see chapter 18.2), the choice is often towards a scenario that excludes bankruptcy. A full liquidation would or could have a disruptive effect on clients of banks (especially depositors and other regulated entities, that in turn could fail). The fear of negative publicity and ripple effects can lead to the above-mentioned regulatory forbearance, liquidity support or outright state aid if a private sector solution cannot be found62. For banks that are not considered systemic, this could still include any of the above options, but – if all else fails – it includes the activation of the deposit guarantee scheme and of a liquidation, possibly combined with the sale of still viable business through e.g. asset/liability sales, or the sale of subsidiaries, and the gradual liquidation of the remainder within a bankruptcy estate by a liquidator. With the developments during the 2007-2013 subprime crisis, states have become hesitant to put any but the smallest, domestic and least complex banks through a formal liquidation scenario. Also see chapter 18.4-18.6. Supervisory Action and a Shift in Responsibility Some of the infrequent references to crisis prevention and management in the CRD are that: – banks need to stress test their assumptions (this requirement was beefed up in Basel II, but still proved to be inadequate)63; – the consolidating supervisor (home supervisor of the holding) has (i) to ensure information exchange, (ii) to plan and coordinate supervisory activities in going concern as well as in emergency situations, and (iii) to execute these in cooperation with the 61 Also see M. Andrews & M. Josefsson, What Happens After Supervisory Intervention? Considering Bank Closure Options, IMF WP/03/17, 2003, www.imf.org. For the specific example on the use of the word adequate see art. 22 RBD, though adequate, sufficient and such terms are widely used in the CRD. 62 R.M. Lastra (Ed.), Cross-Border Bank Insolvency, Oxford University Press, Oxford, 2011, chapter 10 by T.F. Huertas & R.M. Lastra; also see R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 3. 63 Examples are the requirements to stress test in pillar 2, large exposures as well as on credit risk and market risk in e.g. the models used on credit mitigation techniques and in the IRB approach. See chapter 13.6, and e.g. art. 114 and 124.5 RBD, Annex III part 6 §32 RBD, Annex VII part 4 §40 RBD and Annex VI §2 RCAD.

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competent authorities involved. The CRD, however, does not endows that supervisor with corresponding instruments, and deals only with the institution at hand (going concern versus emergency situation) without looking at the wider impact outside of the specific bank. Each supervisor subsequently needs to look at the potential effect on the bank it supervises if other banks default; information sharing with other interested parties has to increase exponentially in a crisis64. The consolidating supervisor and some other supervisors with a form of group responsibility have the obligation to inform amongst others the central bank in its capacity as the monetary authority and the ministry of finance if subsidiaries or significant branches within the group it supervises are in danger. Since the CRD II directive they are obliged to communicate all information that is essential to the task of the recipients, which since the Omnibus I directive include also the ESRB and EBA. There are three thresholds on this: the information needs to be shared ‘as soon as practicable’ (which is not the same as immediately), professional secrecy is explicitly applicable, and the existing channels need to be used, i.e. channelling the information to the own central bank and ministry, which are then supposed to contact their counterparts65; the intensity of supervision should be based on amongst others the systemic importance of the bank66; in an exception to home host rules, the recitals of the original version of the RBD67 appeared to allow host authorities to look at branches in their territory ‘in an emergency’ in order to verify that the activities comply with the relevant laws and with the principles of sound administrative and accounting procedures and adequate internal control, though this exception was not laid down in the directive itself (except when asked to by the home supervisor of the entity). The ‘significant’ branches regime introduced by the CRD II directive made the actions a host supervisor could take more explicit, and reinforced information rights in the run up to a crisis for host public authorities, if and when the home and host authorities have agreed that a branch is significant; see chapter 5, 18.2 and 20.6. the EBA has in 2011 gained some crisis prevention and intervention tools under the EBA regulation, as long as they do not impinge on the fiscal responsibilities of the member states; see chapter 13.6 and 21.4.

64 See e.g. BCBS, Principles for Sound Liquidity Risk Management and Supervision, September 2008, page 3436. 65 Art. 130.1 RBD as amended by art. 1:32 CRD II Directive 2009/111/EC and art. 9.33 Omnibus I Directive 2010/78/EU, and the Crisis MoU 2008. 66 Art. 124.4 RBD; also see chapter 18.2. 67 Recital 22 RBD.

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None of these focus on what the supervisor should do vis-à-vis the bank. A crucial component to understand this relative lack of detail is the obligation of the supervisors of a failing bank to inform the central banks and ministries of finance of the member states where the bank is located. National fiscal responsibilities for liquidity (the central bank) and stateaid (the treasury) come into play. These start to overrule the preventive character of the work of the prudential supervisor. Once a crisis occurs at a bank, the supervisor needs to inform them, and as of that moment the lead in handling the crisis in the economies touched starts shifting to them68. Unlike for preventive supervision, central banks and treasuries have generally not engaged in setting out how and what type of rescue they would undertake in (inter)national situations, and have not allowed their (national) supervisors to work in this area69. Part of this can be explained by the above-mentioned concept of ‘constructive ambiguity’ that central banks use to try to prevent moral hazard to build up. Another part can be explained by a reluctance for fiscal transfers to crossborder business of a bank by unilateral state aid for an international bank or by requests for burden sharing for such a bank70. These have sometimes masked a reluctance to face hard questions of who will pay what when a bank fails and which banks are too big to save banks in advance, and a too large self-confidence that public authorities will be able to wing it if and when the situation would occur. .

Until the start of the 2007-2013 subprime crisis this has effectively limited supervisory groupings such as the BCBS and its EU equivalents to work on resolution planning. As a positive side-effect, it has also reinforced the impetus towards their preventative work, even though prudential supervision cannot and does not exclude the possibility of a bank going bankrupt. Even when central banks and treasury departments gradually take over in concrete individual bank failures and in crisis circumstances, the supervisors still have all their (extensive) obligations and instruments set out in the CRD that can be used to force the bank to cooperate, and a significant amount of information that is useful for the bank and the public authorities involved. If the bank is systemic in some economies in which it functions, the public authorities with the instruments and funds to intervene are central banks and ministries of finance. If the bank is systemic also in its home state and/or

68 W.E. Alexander, et al. (Ed.), Systemic Bank Restructuring and Macroeconomic Policy, Washington, 1997, chapter 1 (incl. appendix II) and 2. On the internal or external cooperation necessary also see D.T. Llewellyn, Institutional Structure of Financial Regulation and Supervision: The Basic Issues, paper presented at World Bank Seminar ‘Aligning Supervisory Structures With Country Needs’, Washington 6/7 June 2006. 69 C. Goodhart, The Basel Committee on Banking Supervision, a History of the Early Years 1974-1997, Cambridge, 2011, chapter 11C, 11G, and 14B. 70 Speech by Paul Tucker, Bank of England, Resolution of Large and Complex Financial Institutions, 19 March 2010. For instance the FSB, Key Attributes of Effective Resolution Regimes for Financial Institutions, October 2011 do not contain clear rules on burden sharing in a bailout of an international bank using either general taxpayer funds or by using resolution funds filled by special taxes on the banking/financial sector.

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in a substantial number of states and the potential danger to the bank materialises, the shift in responsibility for the whole group becomes complete, with the banking supervisor starting to play a more subordinated role. The supervisory responsibilities are largely subsumed by the overall responsibility to protect the financial system, by saving the bank or its relevant components and will need to be coordinated with the actions of the public authorities that have the funds that are required to effectively intervene. For relatively unimportant banks the supervisor remains the key public authority involved, to herd it towards a private sector solution or to a – equally private sector – liquidation. The process in which this transfer of primary responsibility happens is amongst others described in the 2008 Crisis Memorandum of Understanding (‘2008 Crisis MoU’)71. ‘Memorandum of Understanding’ are contracts that are not legally binding. Pending new binding arrangements in future legislation, such memorandums made a cross over into crisis management. Here, to reflect the progress slowly made on cooperation in ongoing supervision on groups and other cross-border activities multilateral arrangements became convenient, as more and more authorities became involved in any systemic crisis. In earlier versions, only banking supervisors and central banks were involved, with central banks traditionally being dominant in systemic crisis resolution. Of the 2005 and 2008 version, ministries of finance are co-signatories, when they wrote an active role into the CRD when they realised that in the end any intervention may impact public finances (either in the form of central bank funds or directly from the states accounts; see chapter 18.4). The 2008 Crisis MoU contains a slightly expanded and updated version of earlier Crisis MoU’s. Controversially, this version was published as a whole, where the earlier 2003 and 2005 versions were only summarized in a press release72. On earlier MoU’s the concept of constructive ambiguity was deemed so important that it was deemed unwise to let the markets and the institutions know too much about when and how the public authorities would step in to fail or bail an institution. It also allowed public authorities more leeway if the document was not published, as there was no benchmark against which their actual actions could be measured. In the midst of an actual crisis, the 2008 version was published in the hope that it would establish some trust in the level of preparedness and the actions public authorities might take.

71 Memorandum of Understanding on Cooperation between the Financial Supervisory Authorities, Central Banks and Finance Ministries of the European Union On Cross-Border Financial Stability, 1 June 2008. Also see the division of instruments identified in CEBS-EBA, Mapping of Supervisory Objectives, including Early Intervention Measures and Sanctioning Powers, 2009/47, March 2009. 72 The press release on the 2005 version indicated that the 2003 MoU would continue to function, and deal with those early stages of a crisis in which the ministries of finance are not yet involved. Press release of 10 March 2003 and of 18 May 2005; www.ecb.europa.eu. The 2008 MoU replaces the 2005 version (but does not clarify whether supplementary arrangements of the 2003 version continue to be relevant).

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The Crisis MoU 2008 sets some clear parameters for crisis management: – the central banks, prudential supervisors and ministries of finance commit to open, full, constructive and timely cooperation; – they commit to information exchange on the preparation for, the approach of, the management of and the resolution of a crisis; – it strengthens the level of preparedness and codifies the use of the general networks of central banks, of prudential supervisors and of ministries of finance, as well as encourages setting up specific networks for specific banking groups; – it commits to consultation on external communication; – it sets the basic stream of information within each country between the three types of signatories, and any cross-border information sharing between the same types of public authorities. Again, there is no clear guidance on what should be done vis-à-vis the failing bank(s). It focuses on the interaction between public authorities, but alas contains not a word on funding of crisis management. Most importantly, from a legal point of view, it explicitly states that it is not legally binding on the signatories, cannot give rise to any legal claim, and does not prejudge or assume any particular decisions or remedies to be taken in crisis situations. Regardless of these defects, the commitments laid down in it and its publication are crucial, both from a political and a practical point of view. A benchmark has been set, vague as it is, which is more concrete and specific and practical than any previous documents. Since it was signed, several amendments to the CRD have introduced upgraded binding cooperation and information sharing obligations between supervisors; see chapter 21. Part of the non-binding crisis memorandum of understanding has as a result been codified and made binding on central banks and supervisors73. They are obliged to warn each other and the ministries of finance involved (and are likely liable if they do not provide such warning) if there is either an emergency situation as defined in the EBA regulation or any situation where the financial stability and market liquidity in any member state is potentially threatened. All central banks that are part of the European system of central banks have this duty, as well as at least74 each consolidating supervisor of the banking group; see chapter 17 and 21.7. The warnings have to be sent to:

73 Art. 130 RBD as amended by the CRD II 2009/111/EC as per end 2010 and by the Omnibus I Directive 2010/78/EU as per end 2011. 74 The provision clearly puts the obligation on the consolidating supervisor, but is ambiguous on whether other supervisors also have that duty. It refers to all supervisors under art. 125-126 RBD, which articles deal with establishing the consolidated supervisor, sometimes by negotiations between various likely candidates for that role if the parent entity of the banking group is not a bank itself, and a few words further it gives the right to warnings to all supervisors mentioned in these articles. Clumsily worded, due to the potential liability it would be wise for all key supervisors to ensure that a warning is sent out as soon as possible, by any of them.

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– supervisors that are or might have been consolidated supervisors of any banking group; – central banks that are members of the European system of central banks (ESCB); but there is no obligation to issue such a warning to central banks that are not members of this system; – EBA; – ESRB; – Ministries of finance (the department responsible for legislation on prudential supervision on banks, insurers, or similar entities. The text of the RBD is not clear as to whether all these have to be sent a warning, accompanied by additional information if it is relevant for their tasks, or whether only the relevant authorities have to be sent a warning plus information. The main obligation implies that all have to be sent a warning, but the exceptions to the secrecy provisions imply that any information (and a warning is information in and of itself) can only be sent it is relevant to the tasks of the recipient. In any case EBA and the ESRB have to be sent the warning and information in full, and their members will thus be informed automatically (and can request further information if they need it). Additional harmonised instruments are still lacking. The financial incentives to exercise forbearance, to not cooperate or share information will remain large as long as state aid (and lender of last resort) functions are based on national responsibilities. The licensing supervisor of the top holding of a group is generally allocated sole financial responsibility, with licensing supervisors of subsidiaries intervening perhaps, but only if the subsidiaries are systemic for their local economy (and perhaps not at an opportune moment for the home country). The so-called BCBS weak banks report of 200275 deals with concrete ideas on what a supervisor can do to try to prevent a bank from becoming so weak that it will be potentially faced with the withdrawal of its license and/or going into a full bankruptcy, and the type of solutions that can be envisaged if they are weakened nonetheless (chapter 5 and 18). This is all conditional on having the right intervention instruments to force this under national legislation; see the minimum demands of the CRD on instruments set out in chapter 20.3. During the 2007-2013 subprime crisis, it turned out that many supervisors, central banks, deposit guarantee schemes and governments did not have the right set of legal instruments to intervene convincingly and quickly in an ‘emergency situation’, especially on larger and more complex banking groups. The instruments that were given supervisors often focused purely on compliance, not on what measures could be taken 75 BCBS, Supervisory guidance on dealing with weak banks, March 2002.

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when a bank was no longer compliant, or when its own actions could no longer save itself. Suggestions from the 2002 report to be able to use for instance bridge banks were not backed up by legislation in most member states; keeping most solutions available only if everyone cooperates, or if another instrument could be used to convince hold-outs (e.g. depending on contract law and company law arrangements to overrule objections, or depending on the threat of replacing management, the threat of license withdrawal or the threat of withdrawing emergency liquidity support). If crisis-time measures are lacking, it becomes difficult to intervene unilaterally for public authorities. Administrative and even some human rights protection (such as the protection of privacy or property) can be limited in emergency situations, but such would require a basis in the law and a proper procedure and compensation for (additional) losses), and often such safeguards were lacking; see chapter 20.4 and 20.5. Many member states have since drawn up or are now drawing up intervention schemes along the lines of their own or others best practices. The Commission has published a wish-list of instruments, and has since taken legislative action (see below). However, this Commission work did not hint that these are part of the existing CRD requirement to make sure that supervisors or other public authorities have those instruments that ensure that the CRD is effective and efficient. This could easily have been defended, but it would have equally hinted that the Commission had been lax in its key tasks by not investigated nor prosecuted member states that had failed to ensure the existence of such effective and efficient intervention measures. The Commission instead intimated that such crisis management powers would be required under new legislation. Such powers include76: – powers to transfer shares in, or assets rights or liabilities of a failing bank to another bank or a bridge bank; – powers to write off or cancel shares; – powers to write down or convert debt of a failing bank (a so-called ‘bail-in’); – powers to replace senior management; – power to impose a temporary moratorium, and possibly; – power to require continuity of services to surviving parts of the group to which the failed bank belonged; – power to temporarily stay rights to netting.

76 EU Commission Communication, An EU Framework for Crisis Management in the Financial Sector, COM(2010) 579 final, 20 October 2010. Also see BCBS, Supervisory Guidance on Dealing with Weak Banks, March 2002.

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Whether these will be sufficient will also depend on the willingness of the supervisor to apply them; also see the remarks above and in chapter 20.3 on ‘regulatory forbearance’77. Living Wills/Recovery and Resolution Plans – Future Developments Some of the initiatives described elsewhere in this book have been introduced or are being discussed to ease the resolution of banks. These include the identification of systemically relevant financial institutions described in chapter 18.2, and the introduction of additional capital requirements on such institutions while they are a going concern as introduced in chapter 6.2, stricter ongoing prudential requirements and supervision to prevent banks failing, attempts to identify and handle potential risks to financial stability at an early stage via the ESRB78 and the introduction of new European supervisory authorities such as EBA and the likely to be introduced Eurozone single supervisory mechanism described in chapter 21. Following global work by the BCBS and the FSB, the EU Commission also published work in 2010 on crisis management, on handling specific banks that are likely to fail or are failing; eight years (and a crisis) after the BCBS report was published. The goal is to institute a common framework how supervisors and other public authorities should resolve bank failures, including how they should actually act vis-à-vis the bank in question79. The intent is that those measures would allow supervisors to let banks fail without causing systemic concerns, nor the disruption of essential services. If that goal would indeed be achieved, the Commission believes that state aid would no longer be expected by banks and their creditors, and market discipline could again play its role in curbing excessively risky banks. Regardless whether that is a realistic expectation (as it sounds quite close to the ineffective constructive ambiguity discussion mentioned above), having a common set of instruments and actions ready for use in crisis-times would be a huge improvement, likely reducing the frequency of catastrophic events, reducing some of the costs and possibly even reducing the amount of state aid necessary in a crisis. Better preparation for the event of a failure by the bank itself and by its supervisors is key, regardless whether such a failure is expected or not. A learning point of every crises is that

77 Also see A.W.A. Boot & A.V. Thakor, ‘Self-interested Bank Regulation’, The American Economic Review, Vol. 83, No. 2, May 1993, page 206-212; J. Viñals & J. Fiechter, The Making of Good Supervision: Learning to Say ‘No’, 2010, IMF SPN/10/08. 78 See chapter 2 and 22. 79 BCBS, Report and Recommendations of the Cross-Border Bank Resolution Group, March 2010; FSB, Reducing the Moral Hazard posed by Systemically Important Financial Institutions, FSB Recommendations and Time Lines, October 2010. FSB, Key Attributes of Effective Resolution Regimes for Financial Institutions, October 2011. EU Commission Communication, An EU Framework for crisis Management in the Financial Sector, COM(2010) 579 final, 20 October 2010, www.ec.europa.eu.

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many failures, especially the first ones in a crisis, are not expected. In relatively good times, any bank that looks and feels sound can thus nevertheless be the first to fail, and could trigger a wider set of problems. Thinking on a potential failure at any bank and at its supervisor could thus be beneficial to be able to deal with the unexpected. The major component of future legislation would be detailed requirements on so-called recovery and resolution plans; popularly referred to as living wills. Banking groups and the individual banks that are part of such groups (or are standalone entities) would be required to submit a reasonably detailed and realistic scenario under which the bank – if it runs into trouble – could be resolved without access to public support. A plan would include detailed proposals on how to deal with intra-group exposures, guarantees, and other facilities that could potentially prevent a group from cutting away a sick part of the group. The effectiveness of living wills as a tool for effective intervention – especially if they are introduced in different countries at consolidated, solo and sub-consolidated levels of the same banking group – is less than clear. They are untested, probably non-binding and thus ineffective in a crisis, and will necessitate a willingness to restructure banking groups not along profit lines/national interests or local bankruptcy traditions and laws, but along lines of ease of liquidation and preservation of (systemic) functions80. They can, however, help awareness at the group and at the supervisor for potential problems, and help simplify corporate structures. The harmonisation of the options of supervisors, alongside the harmonisation efforts that are implied by the work of the ESCB/ECB and especially the adoption by the ESCB/ECB of a role as lender of last resort is having a positive effect on aligning thinking on the closure/bailout of banks, and the introduction of the necessary tools in prudential and bankruptcy laws. While funding of such closures remains national, however, it is unlikely that negative effects on the single market due to for instance forbearance exercised silently by one of the supervisors or uncoordinated actions in the application of supervision and the application of resolution or recovery options are truly eliminated81. The BCBS has been promoting a need for knowing – and reducing – the complexity many larger groups have introduced via their legal structures82. An experiment is currently ongoing. The Commission slipped an obligation for recovery and resolution plans into

80 Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. FSB, Key Attributes of Effective Resolution Regimes for Financial Institutions, October 2011. Also see e.g. Avgoleas, Emilios, Goodhart, Charles, Schoenmaker, Dirk, Living wills as a catalyst for action, May 2010, DSF policy paper 4. 81 Also see V.V. Acharya, Is the International Convergence of Capital Adequacy Regulation Desirable?, CEPR Discussion Paper 3253, March 2002. 82 Principles for Enhancing Corporate Governance, October 2010, §114-119.

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the financial conglomerates directive via the Omnibus I directive83, added a obligation to stimulate plans to the EBA regulation, and added an equally unspecified obligation to have a plan as part of the CRD IV project. The financial conglomerates (see chapter 17.4) are since end 2011 subject to a requirement to have a living will This will also affect their banking subsidiaries and potential banking sub-group, but other banks are not yet required to draft them. Some of the plans will be gradually introduced for banks and banking groups alongside the implementation of Basel III. The CRD IV project of contain references to the living wills, and introduce an internal governance high level obligation to have such a plan except for those banks not deemed systemic by their local supervisor84. The more recent Commission proposals for a recovery and resolution directive provide detail, but those have not yet been agreed and issued. EBA is to stimulate the development and coordination of recovery and resolution plans, but – in the absence of a legal obligation on banks or supervisors to set such up – this is a fostering exercise, which it cannot force onto unwilling participants85. To fulfil this mandate, it published a recommendation in 2013 to national supervisors to stimulate drafting of group recovery plans by 39 specified groups, using a template provided in the non-binding recommendation The template specifies that the plans should cover the governance and process underpinning the plan, as well as early warning indicators, recovery options, and communication. The plans of the 39 groups should be submitted to the national supervisors by end 201386. From the start of 2014, the general obligation to have a plan will become binding on all banks and supervisors under the CRD IV project, though they can evade this obligation if the supervisor concludes that the institution is not systemic in any way. If the bank has a recovery plan and the supervisor a resolution plan, they have to allow access to all relevant meetings and information, which will allow EBA to play its role more clearly, and to help fine-tune more detailed demands on the content of such plans87. The Commission published its legislative proposals for such detail in June 2012, building on a 2010 Commission communication on how to deal with banks and banking groups88. The proposals include:

83 Via art. 2 Omnibus I Directive 2010/78/EU an obligation for such a plan at a groupwide level as part of supplementary risk management obligations was already inserted into the Financial Conglomerates Directive 2002/87/EC. At this stage, no such obligation exists at the EU level for banks or banking groups as such, though this is expected in the near future (see below). 84 Art. 74.4 CRD IV Directive; as applicable from the start of 2014. 85 Art. 25-27 EBA Regulation 1093/2010; and art. 74.4 CRD IV Directive as applicable from the start of 2014. 86 EBA, Recommendation on the Development of Recovery Plans, EBA/REC/2013/02, 23 January 2013. 87 Recital 34 and art. 50.3 and 74.4 CRD IV Directive. 88 Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. EU Commission Communication, An EU Framework for Crisis Management in the Financial Sector, COM(2010) 579 final, 20 October 2010.

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– planning for its own demise by each bank(ing group), in which it cannot rely on presumed government support (‘recovery plan’)89; – planning for the demise of each bank(ing group) by the authorities (‘resolution plan’)90; – the power to force the bank(ing group) to restructure itself if that would ease potential resolvability91; – the possibility to appoint an administrator to turn the bank around, or force the institution to take preventative actions itself92; – the establishment of legal ex ante arrangements for capital transfer between groupentities (but still with a veto at the ‘moment supreme’ for the authorities involved in solo-supervision)93; – the introduction of legislative tools that will help the supervisor and other public authorities to force private parties to take action or to take losses, while preserving the activities of the bank that are relevant for the general public (‘resolution tools’), including mandatory sale of business to another private entity, mandatory transfer to a government set-up bridge banks, asset separation, and bail-in of debt, with associated safeguards and valuation methodologies94, including mandatory capital write-downs, before and accompanying the use of any other resolution tools95, and by allocating the resolution authority the power to exercise control to operate the bank (taking upon itself all powers of shareholders, directors and officers of the bank) or take resolution action by executive order, at the discretion of the resolution authority96; – the contract law, company law, bankruptcy law changes needed to enforce the above new plans, early intervention mechanisms and resolution tools in the most beneficial manner for the goals safeguarded by the public authorities involved, and adaptation of contractual terms and liability rights to ensure their effectiveness97; 89 Proposed art. 4-8 of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. 90 Proposed art. 4, 9-12 of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. 91 Proposed art. 13-15 of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. 92 Proposed art. 23-25 and 100-102 of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. 93 Proposed art. 16-22 of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. 94 Proposed art. 26-89 of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. 95 Proposed art. 51-55 of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. 96 Proposed art. 64 of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. Such unilateral acts, even if subject to administrative law procedures, are far reaching, especially in light of the limitations on liability to pecuniary damages; see chapter 21.10. 97 See e.g. the proposed art. 18.2, 24, 30, 31.6, 32.10-32-11, 34.8-34.9, 48-50, 52, 56-63, 65-73, Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012.

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– using funding pre-paid by banks (and investment firms) but controlled by public authorities (and thus subject to state aid limitations; see chapter 18.4 and 18.5) to deposit guarantee funds and to new resolution funds to bailout banks, to avoid (other) public funds being used for that purpose98; – to be applied from the start of 2015, except for debt-bail-ins, which would apply from 2018 to ease the bond markets during the 2007-2013 subprime crisis99. In the context of bank termination the proposals harmonise key issues that would currently have to be dealt with under the disparate bank bankruptcy regimes across the EU. Recovery and resolution plans would become obligatory, as would a set of four resolution tools, all accompanied by a regime to write down existing financial buffers to zero, and a new set of ‘resolution authorities’ (who can be the normal supervisors, but can also be separate, or a function of e.g. central banks or ministries) and ‘financial arrangements’ i.e. ex ante collection of money from the banks that can be subsequently used for bank resolution funding, and mandatory agreements on who pays during crisis cooperation100. Having a resolution function has since been copied in the CRD IV project, and becomes mandatory in 2014101. In the preparatory phase, some instruments are added to the existing supervisory/resolution toolkit, including appointing administrators, arranging the civil consequences of administrative law interventions, and requiring banks to maintain – on top of minimum amount of financial buffers that qualify as capital/own funds, an additional minimum amount of bail in-able senior unsecured or subordinated debt as a new variety of the – initially to be abolished – requirement of tier 3 subordinated loans under a new name of mandatory levels of eligible liabilities for a bail-in (see chapter 7.3)102. The new directive would be separate from the CRD (and from the CRD IV project). This is awkward as they overlap on supervisory tasks, focus and instruments, allocated both to CRD supervisors and to new ‘resolution authorities’, who will likely be – under a national discretion – either the same CRD supervisors or other existing financial stability authorities

98 See proposed recitals 1, 27 and 44, and art. 26, 90-99 of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. 99 See page 18, proposed recital 52, and art. 115 of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. 100 Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. These proposals built on the communication from the Commission on bank resolution funds, COM(2010) 254 final of 26 May 2010, and the consultation on technical details of a possible crisis management framework for financial institutions: Commission Working Document (for consultation and discussion), Technical Details of a Possible EU Framework for Bank Recovery and Resolution, 6 January 2011. 101 Its tasks are not yet defined, nor what resolution is, but it appears to be charged with drafting resolution plans. See art. 4.7-4.8 and 74 CRD IV Directive. 102 Also compare art. 10, 15, 18 and 24 of the Commission Proposal for a Regulation on a Single Resolution Mechanism, COM(2013) 520 final, 10 July 2013.

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EU Banking Supervision such as central banks; see chapter 21.2, 21.3 and 22103. Except for some of the new resolution tools detail – and especially the new arrangements on civil law consequences – the instruments prescribe in some further detail what type of instruments should basically now already be in place under the CRD. This development can only be applauded as it allows member states to deal in a more coherent and predictable manner with banks that are failing, regardless of where they operate in the EU. Particularly badly worded and/or ill-considered is, however, the proposed article that would delay the activation of the trigger for the activation of resolution tools104. Where the current regime is difficult to read on the timing of failing a bank, but at least tries to place it at the moment in time when the bank is still able to absorb all likely losses by available capital, the proposal appears to want to allow supervisors to choose a moment between the current moment and a much later moment, when capital buffers are completely gone. This would put it at the moment of ‘normal’ insolvencies of non-banks, i.e. when no money is left to reimburse creditors, including in the deposit guarantee fund. The references include a reluctance to impede on the rights of the bank, which is strange considering the systemic consequences of a too late started resolution. The far-reaching civil law arrangements accompanying resolution tools (including nationalisation and capital and debt write downs/bail-ins) may have caused putting the moment further back, but this means that there is much less to save, and much less capital to work with at the moment of intervention. If the mandatory write downs of capital (and the use of debt bail ins) were made conditional on even the minimum levels of capital having disappeared (e.g. when asset prices fell sharply instead of gradually, or exceptional operational losses occurring) the public authorities involved would be much more clearly mandated to make the intervention in a more timely manner, when there is still a chance that unexpected losses will be absorbed by the financial buffers and creditors would not suffer losses105. The impact of the crisis on the economies of several EU members and the feedback loop between deteriorating bank balance sheets and the stretch of the member state balance sheet has since even lead to credible discussions of a political union and a banking union, as well as to discussions on direct bailouts of banks at the EU level, to avoid imperilling

103 See for the instruments art. 136 RBD as amended by the CRD III Directive 2010/76/EU. Also see art. 102107 CRD IV Directive as applicable from the start of 2014, and its reference to a new resolution function in art. 4, which will be important for the new instruments proposed in art. 23-25, 64, 100-102 of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. Also see chapter 20 on art. 136 RBD. 104 Recital 24 and art. 27 of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. 105 See e.g. art. 29 and 51 of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012.

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member state finances. The sovereign crisis in various member states is pushing them beyond what could normally be expected from the incremental progress normally achieved on issues that affect sovereignty. The proposals on recovery and resolution are comprehensive – barring the odd inconsistencies and mistakes – but the political support is not yet clear, especially on those issues that relate to fiscal burden sharing between national resolution funds (similar to that discussion on deposit guarantee funds); see chapter 18.5, 21.3 and 21.9. The tools developed adapt contract laws, bankruptcy laws, and funding arrangements in the member states, as well as a likely transfer of decision making on tax spending in crisis times. Though some elements of the plan, such as nationally setting up bridge bank arrangements, are very likely to be put into final legislative texts in due course, many aspects of the Commissions (and FSB’s) proposals are likely to be deleted or watered down in the political process, unless the crisis worsens. Some of the proposals could amount to expropriation, and limitations in the way banks and lenders to banks do business. Whether any proposals on limiting property rights and civil rights of shareholders and creditors to save a bank will survive the check of human rights protection (see chapter 20.4) can be debated. Expropriation in a clear crisis will be accepted by human rights courts106, but some of the tools on capital write downs and bail-ins may be used in cases where the crisis has not yet arrived at the bank, but is only expected to arrive. Equally, where bringing the cost to shareholders and other financial buffer providers is uncontroversial from a theoretical point of view, and expropriation and write down can be seen as the tools to enact that without negative consequences for financial stability, whether this can also be said for putting the costs of a bank failure on specific types of creditors to the benefit of others is neither theoretically sound nor as ‘equitable’ as the shareholder write down. Why would depositors be protected when the same type of persons who can qualify as depositors are not protected if they provided repayable funds to the bank in the form of buying a bond issued by the bank?107 In an acute crisis of the type and depth of the 20072013 subprime crisis, the leeway given by the courts to legislators and supervisors is wide. The above-mentioned financial arrangements that the newly established resolution authorities could use are sometimes referred to as resolution funds. For the role of deposit guarantee funds and the new resolution funds as financers, see chapter 18.5, for their designation as public sector (and thus state-aid relevant entities see chapter 18.4. If they are indeed forced to cooperate cross-border and lend to each other, or share burdens of resolution, and member states support these new roles and commitments, they would become part of plans for a banking union; see chapter 21.3.

106 See for instance the Northern Rock Case mentioned in chapter 20.4. Grainger/UK, ECHR, 10 July 2012, Case 34940/10. 107 See R.J. Theissen, Are EU Banks Safe?, The Hague, 2013.

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Unless the 2007-2013 subprime crisis perseveres, some of the more ambitious parts of the crisis management plans of the Commission are unlikely to go forward in the face of vested interests of member states, banks and banks’ shareholders/creditors and in the face of likely negative consequences for bank-financing if they are the only commercial companies that were to suffer such measures. Coordinating bankruptcy regimes in detail will for instance be very difficult, and shifting part of the burden to secured or unsecured bondholders may prove counterproductive for financial stability (and may punish retail direct and indirect investors in such products). The existing winding up directive merely focuses on accepting that the domestic bankruptcy regime governs the liquidation of a bank based in that jurisdiction (also when that legal entity has activities in other member states). Accepting that locally incorporated subsidiaries of a foreign banking group will also be governed by the bankruptcy regime of the parent is less likely, as is the drafting of a common bankruptcy law. Even if it could be managed within the Eurozone or the EU, it still leaves the third country activities of banks subject to different regimes. Some of the Commission plans also appear internally conflicted. They support asset transferability between legal entities in the group but only if the interests of the supervisors, creditors and shareholders of the transferring entity are not hurt108. The triggers for resolution should avoid delay but at the same time ensure that action is taken only after all other realistic recovery options are exhausted. In June 2012, putting the supervision (and rescue via the ESM fund; see chapter 18.4) of banks at the EU level was agreed to in principle, at least for the Eurozone. This aspect of a banking union was published simultaneously with the above-mentioned legislative proposals of the Commission on crisis management in the EU. This may help some of the burden sharing issues that are core to the Commission proposals on cross-border cooperation, and on the cross-border aspects of the use of deposit guarantee funds and resolution funds (see chapter 18.5 and 21.9), and help alleviate the fiscal problems of some overstretched member states. When publishing its thinking on recovery and resolution frameworks, the Commission indicated in an accompanying document that it is reviewing (by end 2012) whether there is a need for harmonisation of bank insolvency regimes. A European resolution authority is not ruled out, alongside or as part of EBA109. Such an authority may be a key component

108 Commission, Commission Services’ Report on ‘Asset Transferability’, 14 November 2008, DBB Law for the Commission, Study on the Feasibility of Reducing Obstacles to the Transfer of Assets Within a Cross Border Banking Group During a Financial Crisis, Final Report, contract ETD/2008IM/H1/53, 20 April 2010. 109 Commission Memo, Consultation on Technical Details of a Possible Crisis Management Framework for Financial Institutions – frequently asked questions, memo/11/6, 6 January 2011, which accompanied its document on bank recovery and resolution.

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of any future banking union in the EU or the Eurozone; see chapter 21.3. The role of bondholders will likely also be examined, likely going beyond the current proposals that would stimulate convertible obligations at the option of the supervisor (as they are part of the reduced number of instruments that are accepted as financial buffers; see chapter 7). Likely unsecured bondholders would be more clearly defined as non-protected (under the current definition of deposits, bondholders have equal rights as people with saving accounts or current accounts110. Bail-ins are controversial as they may exacerbate the tendency of lenders or potential lenders to abandon a bank well before it is insolvent to avoid bail-in obligations, which defeats the purpose111. Nonetheless, there is strong political support for the idea that bondholders should suffer costs before taxpayers do, and it is e.g. part of the Council position in the recovery and resolution directive negotiations112. A part of the debate is focused on systemically important financial institutions, but it may have consequences for all banks113. As part of the negotiations on the recovery and resolution directive, and following the uncertainty created by the Cyprus bailout in which senior bondholders and depositors were ‘bailed-in’, a common ranking of creditors may be agreed in a huge step forward for the harmonisations of bankruptcy laws, or at least if the bank is subjected to a bail-in in the context of state aid requirements; as reflected in the Council position. From a financial stability and client protection point of view, however, the proposals are likely to have unintended and unwelcome results on the financial system and on the functions that banks provide114. Literature – Llewellyn, David T., Institutional Structure of Financial Regulation and Supervision: The Basic Issues, paper presented at World Bank seminar ‘aligning supervisory structures with country needs, Washington 6/7 June 2006 – Llewellyn, David T., The Global Banking Crisis and the Post-crisis Banking and Regulatory Scenario, University of Amsterdam research papers in corporate finance, June 2010 – Nier, Erlend Walter, Financial Stability Frameworks and the Role of Central Banks: Lessons from the Crisis, IMF WP/09/70, 2009

110 See chapter 5, and R.J. Theissen, Are EU Banks Safe?, The Hague, 2013. 111 See the extensive discussion of pros and cons of going concern bail-in financial buffers on page 17-20 of BCBS, Globally systemically important banks: assessment methodology and the additional loss absorbency requirement, November 2011. 112 Council, Council agrees position on bank resolution, 27 June 2013, 11228/13, presse 270. Also see chapter 18.4. 113 FSB, Progress in the Implementation of the G20 Recommendations for Strengthening Financial Stability, 10 April 2011. BCBS, Globally systemically important banks: assessment methodology and the additional loss absorbency requirement, November 2011. Also see chapter 18.2. 114 See chapter R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 3.

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– Lastra, Rosa M. (ed), Cross-border Bank Insolvency, Oxford University Press, Oxford, 2011 – Hüpkes, Eva, special bank resolution and shareholders’ rights: balancing competing interests, Journal of financial regulation and compliance, vol 17 no 3, 2009, page 277301 – Avgoleas, Emilios, Goodhart, Charles, Schoenmaker, Dirk, Living wills as a catalyst for action, May 2010, DSF policy paper 4 – Tucker, Paul, Resolution and future of finance, The Hague, 20 May 2013 (speech) – BCBS, Supervisory guidance on dealing with weak banks, March 2002. – BCBS, Report and Recommendations of the Cross-border Bank Resolution Group, March 2010 – FSB, high-level principles for cross-border cooperation on crisis management, 2 April 2009 – IMF (Alexander, William E. et al (ed)), Systemic bank restructuring and macroeconomic policy, Washington, 1997 – Memorandum of understanding on cooperation between the financial supervisory authorities, central banks and finance ministries of the European Union on crossborder financial stability, 1 June 2008 – CEBS-EBA, Mapping of supervisory objectives, including early intervention measures and sanctioning powers, 2009/47, March 2009 – Commission, Commission services’ report on ‘asset transferability’, 14 November 2008, – DBB Law for the Commission, Study on the feasibility of reducing obstacles to the transfer of assets within a cross border banking group during a financial crisis, final report, contract ETD/2008IM/H1/53, 20 April 2010 – FSB, Key attributes of effective resolution regimes for financial institutions, October 2011 – BCBS, Globally systemically important banks: assessment methodology and the additional loss absorbency requirement, November 2011

18.4 Lender of Last Resort and State-Aid (The Role of Central Banks and Governments) Introduction To prevent a bankruptcy, especially when such a bankruptcy could trigger or aggravate a systemic crisis, it may be necessary to inject liquidity or solvency into one or more banks. If at all possible, this will be done through private sector investments. These may be the result of a private sector entity seeing a good business opportunity, or of supervisory prodding of the shareholders, of the bank or of potential investors; see chapter 20.3.

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However, if the general economic situation is uncertain, or the scope of the losses is uncertain, such private sector support sometimes is dependent on liquidity or solvency support by public authorities. Other times it is not available, not even when intense pressure or support is exercised as the risks are too big for a private enterprise to contemplate at certain stages in the economic cycle. In such cases, the baton is informally handed to public authorities. If it concerns liquidity support to an otherwise solvent bank, the central bank is invited to play its lender of last resort role. If it is (also) necessary to provide solvency support, the government is invited to consider providing state aid if this is legally possible under EU competition rules. The state can intervene via various bodies, but most likely the ministry of finance will provide the needed capital, or state sponsored entities such as the deposit guarantee fund. Lender of Last Resort Domestic central banks have traditionally provided a so-called ‘lender of last resort’ function for the domestic banking system115. If a bank is solvent, but not liquid, the central bank is in a position to provide emergency liquidity assistance. In that case normal short term lending channels for the bank will have been exhausted, are insufficient to cover the need for cash of the bank, or could not be arranged at short notice116. Central banks in that case can open their ‘emergency facilities’ and provide loans at higher interest rates, if the bank can provide sufficient collateral. This is a discretionary service of the central bank; most countries have not obliged the central bank to provide it. In its decision making process the central bank will likely take into account the potential damage to the financial system, the likelihood of survival of the bank and the quality of the remaining collateral. Some central bank have formalised part of this function in the form of standing (emergency) high interest facilities, in addition to ‘normal’ lending and depositing between banks and central banks (see chapter 22.3). From a purely theoretical point of view it is not clear whether the ESCB (the ECB and/or its component Eurozone central banks) provides or even can provide the ‘lender of last resort’ function117. At best, such a function is implicit in its monetary tasks and in its composition of national central banks. The EU treaties require full collateralisation for any loans given. This explicit obligation could have been a barrier to such a role for the

115 The function is not limited to banks. Central counterparties and other core market participants have benefited from this lender of last resort function of central banks too. J.C. Kress, ‘Credit Default Swap Clearinghouses and Systemic Risk: Why Centralised Counterparties Must Have Access to Central Bank Liquidity’, Harvard Journal on Legislation, Vol. 48, No. 1, 2011. See chapter 21. 116 Examples of short term lending channels that became stressed for many banks in the 2007-2013 subprime crisis include interbank lending, money markets, deposits, and bond markets. 117 L.E. Panourgias, Banking Regulation and World Trade Law, Oxford, 2006, page 199-207.

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EU Banking Supervision ECB/ESCB118. During the 2007-2013 subprime crisis, the ECB/ESCB rose gallantly to the challenge119, and established itself as the lender of last resort for the Eurozone (with stabilising consequences for the wider EU and world economy when trust in the individual sovereigns melted away in 2009-2012). The ESCB did have to widen its collateral requirements (i.e. accept collateral that previously was deemed insufficiently robust or liquid) in order to be able to become the lender of last resort, as prime collateral was not always available120. With higher haircuts and continuous revaluations, for instance covered bonds issued by the bank themselves became potentially eligible collateral. The ESCB/ECB does prohibit its member-banks from providing liquidity support to banks that are insolvent. The ESCB/ECB deems such aid to insolvent banks contrary to the prohibition on monetary financing, while support of illiquid but solvent banks is still compatible with those treaty provisions121. State aid to insolvent banks is deemed to be the sole territory of the government, and not part of the remit of ESCB-central banks (unless there is a full guarantee by the member state for that aid). See, however, also below under ‘aid to states’ in case the member state is incapable of providing support to banks or indeed loses credibility in the financial markets. The EU state aid rules (see below) can be applicable to liquidity support by central banks, as was e.g. the case in the loans made by the Bank of England to Northern Rock, under the responsibility of the chancellor122. The lender of last resort function as exercised by the ESCB/ECB in the Eurozone appears to be in line with Commission requirements (and ECB demands) if the bank is solvent, provides high quality collateral with a daily haircut, pays additional interest and the central bank provides assistance without an incentive or instruction of the government; see below. State Aid to Insolvent Banks If the member state is willing and able to do so, it can provide aid to a bank, or to those parts of a bank it deems of systemic importance in its member state. There is no obligation to provide such state aid, nor to make sure that all counterparties of a bank benefit in the

118 See e.g. C. Hadjiemmanuil, ‘Democracy, Supranationality and Central Bank Independence’, in J. Kleineman (Ed.), Central Bank Independence, 2001, page 131-170. 119 To its own pleasure, as pointed out in the opinion of 8 January 2010 on the establishment of the European Supervisory Authorities, CON/2010/5. T. Padoa-Schioppa, Regulating Finance, Oxford, 2004, chapter 7.5, indicates the preparation by the eurosystem for a potential crisis. 120 ECB, guideline on temporary changes to the rules relating to eligibility of collateral, 21 November 2008. 121 Art. 123-125 TFEU. ECB, Letter to Belgium, 2008/46, 8 October 2008, page 4. 122 See on the interaction with the Commission in the context of Northern Rock Grainger/UK, ECHR, 10 July 2012, Case 34940/10.

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same manner from state aid provided123. However, if a bank is systemic the member state is extremely likely to do so if it can afford to; see chapter 18.2 and 18.3. State aid can come in several forms. State aid can be found in tax benefits to certain companies, taking a capital interest in a company on non-commercial terms, loans, subsidies, guarantees and in other favourable treatment. It can also come in the form of an expropriation of all or parts of the bank, with considerable leeway for the member states involved124. State aid to a bank may be combined by the expropriation of existing shareholders, or a bail-in of the claims of subordinated or senior creditors. In that case the protections of property and proper proceedings offered by administrative laws and the human rights apply; see chapter 20.4 and 20.5. The TFEU frowns on state aid as it negatively impacts on free and fair competition with non-recipients of state-aid, and as such is deemed incompatible with the common market. Non-distortionary aid is allowed, but this is subject to a test whether a normal market investor would invest on the same terms in the company; or otherwise measures have to be taken to compensate for the undue advantage obtained125. Outside of a wide financial crisis such as the 2007-2013 subprime crisis, uncontroversial support could be given – under strict conditions – to the full banking sector (e.g. pre-financing of the deposit guarantee fund) or even – under even stricter conditionality – aid to a single bank in trouble. Sector support for instance in the form of tax breaks is scrutinised carefully, but especially support to a single bank in problems has traditionally been investigated vigilantly by the Commission, and approved only in some limited circumstances and with strict conditions attached126. Aid to banks is checked against the treaty provisions, under a policy set out by the Commission in a set of guidelines on rescue and restructuring aid. In a full crisis – which is not readily assumed by the Commission – the treaty allows the Commission to give additional leeway for state aid that is needed for systemic reasons. There is no obligation for the Commission to do so and a very local disturbance or a problem in a single bank,

123 EFTA Surveillance Authority/Iceland, EFTA Court, 28 January 2013, Case E-16/11, §218-227. 124 E.g. the UK, the Netherlands and Belgium bailed out the domestic and foreign activities of e.g. RBS, ING, Fortis, Dexia, SNS, Lloyds, while Iceland only bailed out the nationally systemic domestic banking operations while allowing the foreign branches and subsidiaries to become part of the bankruptcy estates of its three main banks. T. Thorgeirsson & P. Van den Noord, The Icelandic Banking Collapse: Was the Optimal Policy Path Chosen?, Central Bank of Iceland WP 62, March 2013. Also see EFTA Surveillance Authority/Iceland, EFTA Court, 28 January 2013, Case E-16/11, especially §227; and Netherlands & ING/Commission, Court of Justice 2 March 2012, Cases T-29/10 and T-33/10. 125 See e.g. Netherlands & ING/Commission, Court of Justice 2 March 2012, Cases T-29/10 and T-33/10, §95106. 126 Art. 107 TFEU. See e.g. Italy/Commission, Court of Justice 15 December 2005, Case C-66/02, where the Italian government provided a special tax regime to help public banks that turned into companies limited by shares. See T. Trimidas, ‘EU Financial Regulation: Federalization, Crisis Management, and Law Reform’, in P. Craig & G. De Búrca (Eds.), The Evolution of EU law, 2nd edition, Oxford, 2011, chapter 25.

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albeit big, is not likely to trigger an exception except in the context of a wider financial crisis127. During the 2007-2013 subprime crisis, the Commission competition authorities substantially relaxed the conditions applied to state aid in line with the crisis-exceptions (often temporarily, but with extensions when the crisis did not subside). The Commission published four communication in 2008 and 2009 on financial sector aid and its conditions for approving such aid as an exception to the treaty and its normal policy128: – the banking communication; replaced as per 1 August 2013; – the recapitalisation communication; – the impaired assets communication; – the restructuring communication. Under these communications, the Commission allows generic temporary aid to all banks operating in a member state if it is amongst others proportional, based on objective criteria, non-discriminatory on grounds of nationality, not given to firms that were already in decline before 1 July 2008, limited in time and regularly reviewed. The recipients have to pay for the aid obtained, and they have to start a structural readjustment. Reasons for the relaxation of state aid rules during the extreme economic circumstances in several stages of the 2007-2013 subprime crisis were the danger of contagion, the lack of trust, and the avoidance of a credit crunch129. The member states need to submit aid schemes that are available to the entire sector. Individual aid given can be subjected to additional conditions, including divestments or behavioural rules to prevent abuse of the subsidy to gain market share from unsubsidised competitors. Whether these ‘temporary’ rules can be permanently retired even if another large bank runs into trouble in due course is difficult to assess, but they are likely to remain in force as long as the financial market remains wobbly after the 2007-2013 subprime crisis. The normal rules and guidelines are relaxed on several issues. These include130: – the duration of the aid (instead of a maximum 2 years the bank can be granted 5 years to wind down the aid); 127 See H. Gilliams, Steun aan financiële instellingen na Lehman: een ‘stresstest’ voor de regels inzake staatssteun, SEW, No. 7/8, 2010 (Dutch). 128 Art. 107.3 sub b TFEU Commission, Banking Communication, [2008] C270/8, 13 October 2008, Commission Recapitalisation Communication, [2009] C10/2, 5 December 2008, Commission Communication on Impaired Assets, [2009] C72/1, 25 February 2009; Commission Communication on Bank Restructuring [2009] C195/9, prolonged in 2010 and 2011. The Banking Communication was replaced by – and the other communications last amended – by a Recast Banking Communication 2013/C 216/01, 30 July 2013, as per 1 August 2013. 129 B. Lyons, Competition Policy, Bailouts and the Economic Crisis, University of East Anglia, CCP WP 09-4, 2009. 130 See the above-mentioned communications and H. Gilliams, Steun aan financiële instellingen na Lehman: een ‘stresstest’ voor de regels inzake staatssteun, SEW, No. 7/8, 2010 (Dutch).

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– granting aid to illiquid banks is allowed, though for ‘normal’ commercial companies the requirement is that the institution has to be insolvent; – non-reversible aid (e.g. in the form of permanent share-emissions) is sometimes allowed, but this may impact on the required restructuring conditions; – multiple aid or very large aid (more than 2% of the risk weighted assets) is permitted if the financial stability concerns justify this, but this may impact on the required restructuring conditions. The ‘normal’ demands/conditions of a restructuring, an own contribution of the bank, fair payment of fees for the aid received, that the aid actually must ensure that the institution will survive, and maintaining a level playing field with other competitors (not giving unfair benefit due to the aid) are still applicable, but can be adapted if needed due to the financial crisis. A particularly double-edged condition has been the avoidance of undue market competition. Banks that have benefited from state aid should not use that aid to improve their competitive position vis-à-vis other banks that have not needed or obtained state aid. This, however, when imposed on multiple competitors in EU and domestic financial services markets has dampened competition benefits for customers, and has made mandatory disposals more difficult as likely buyers were not allowed to expand market share. Competition goals and the goal of financial stability – especially in the short term – conflict in this case. State aid thus has to come with strings attached. Often, such include commitments to limit activities, or to expand activities, or to pay a higher price for the aid. Those conditions can impact on the single market if negotiated between a member state and a cross-border operating banking group or bank that is headquartered in it, where other member states do not chip in equally into the rescue131. For example, a commitment to sell or wind down a subsidiary or cross-border branch/services in another member state has an impact on the single market. Equally demands or even ‘unsolicited’ commitments to lend more domestically impact on the single market, as it means that credit given in the market of the state aid provider (normally the member state where the license of the parent entity is given, or where a nationalised subsidiary is based) can no longer be extended in other member states, or may even need to be compensated by making credit less available elsewhere. There does not appear to be case law on such conditions, though it could be argued by state aid providers that if taxpayers fund the bill, they should also enjoy the benefits. This dilemma will not be solved until funding issues and burden sharing issues are solved;

131 See the UK, Dutch and French examples in R. de Haas & N. Van Horen, Running for the Exit: International Banks and Crisis Transmission, DNB WP 279, February 2011, page 12 and 16.

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see chapter 21.9. A positive side-effect of the ongoing 2007-2013 subprime crisis is that this might be resolved in the context of a future full banking union132. Individual state aid could until end July 2013 be quickly approved on a temporary basis if at first sight the conditions are fulfilled, or if the conditions can be fulfilled if at a future date concessions are agreed. Without such temporary approval an announced rescue of an individual bank/banking group normally cannot be executed133. However, the subsequent negotiations on such issues as an own contribution, private sector involvement (for example of shareholders or subordinated bondholders), repayment, restructuring conditions, and a fair price to be paid for the aid are all subject of a final approval process. If it instead is determined immediately or in due course that state aid has been granted that is incompatible with the TFEU, the member state that gave the state aid becomes obliged to recover the amount given, plus interest from the time it became available to the institution. This can lead to the uncomfortable situation that the government that wanted to give funds away, now has to reclaim them from someone he actually does not want to reclaim them from134. If the state aid is not voluntarily returned, the member state is under an obligation (under the TFEU obligation to loyally cooperate135) to reclaim it via the normal procedural provisions applicable in its territory. The only defence possible is if it is absolutely impossible to implement the Commission decision. It can reclaim it in cash, or in alternative ways. If so, such alternative measures must have the same effect as that of repayment by way of a transfer of funds, and thus effectively re-establish the conditions of competition prior to the transfer of the illegal aid. A statement of indebtedness or shares issued that will not be sold will thus not be acceptable136. A company that is the subject of a Commission ruling that it has received state aid (and either has to pay it back or is the subject of measures to repair the competitive advantage it has been given) can challenge the Commissions’ decision in proceedings before the Court of Justice. A successful challenge was mounted in a case where the Commission decided that the French state had overpaid a credit mutual for certain services, which decision was annulled by the Court137. Equally successful on the basis of faulty administrative

132 See 21.3 for the progress on certain aspects of a banking union for the Eurozone, and the lack of progress on a banking union for the EU. 133 Art. 108 TFEU. Exceptions are contained in regulations; such as the ‘De Minimis’ Regulation 1998/2006. 134 Commission/France, 18 October 2007, Case C-441/06. 135 Art. 4.3 TEU. 136 Commission/Germany, 12 December 2002, Case C-209/00. 137 Credit mutual/Commission, Court of Justice 18 January 2005, Case T-93/0.

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procedures and faulty reasoning was the protest against too harsh corrective conditions in the case of state aid given to ING138. Any government assistance will need to be disclosed under international accounting standards once it is given139. As the ‘guarantee’ to bail out banks is implicit, the value of that guarantee is, however, not covered on the balance sheets of either banks or of governments. Estimates of the amount covered even if only the most systemic banks are guaranteed run into billions and billions per member state140. The new banking communication of July 2013 aims to streamline the state aid procedure (reducing the use of the temporary approval and subsequent final approval process that caused delays in finalizing state aid conditionality and approval), and to increase burden sharing by shareholders and subordinated bondholders in line with discussions on bailin type proposals for recovery and resolutions141. It also intends to cap remuneration paid while the bank is under restructuring; incentivising a quick restructuring or repayment of state aid. The future regulatory developments on recovery and resolution described in chapter 18.3 are in part driven by a desire to limit state aid to banks and to limit the implicit guarantee enjoyed by systemically relevant banks. Drawing on the public purse has caused negative voter reactions across the EU and the USA. The measures to be taken are unlikely to achieve this goal, however. If a systemic bank is failing, governments are likely to rescue it. What the measures may achieve is that there is more preparation, less leverage, and thus a higher likelihood of lower amounts needed from the public purse. There is no certainty that it will achieve such effects. They might equally likely achieve an even higher faith in regulation/supervision, making preparation token and unequal to the task when a crisis will again occur, and a false sense of faith that large banks will not fail if they will just keep to the new and improved quantitative ratios. Notable in this respect is that rating agencies increased their assumptions on state aid during the crisis. In 2011 their estimates of the 138 Netherlands & ING/Commission, Court of Justice 2 March 2012, Cases T-29/10 and T-33/10. After negotiations and amendments, the Commission approved an amendment to the restructuring plan in November 2012; Commission Press Release, State aid: Commission approves amendments to the restructuring plan of ING, IP/12/1226, 19 November 2012. 139 International Accounting Standard 20, Commission Regulation 2008/1126. 140 See R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 3; A. Haldane, ‘The Doom Loop’, London Review of Books, Vol. 34, No 4, 23 February 2012, page 21-22; CPB Communication, CPB Financial Stability Report 2013, Risk Report for the Dutch House of Representatives, 30 May 2013, page 6, 18-20. 141 The Banking Communication was replaced – and the other communications last amended – by a Recast Banking Communication 2013/C 216/01, 30 July 2013, applied by the Commission as per 1 August 2013. See also Commission Press Release, State aid: Commission adapts crisis rules for banks, IP/13/672, 10 July 2013.

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likelihood of available state aid to banks was higher than in 2007 (with a three instead of two rating notches difference between the intrinsic credit rating of a bank and the credit rating including the estimate of public support)142. Aid to States Aid to states enables subsequent state aid to banks, and/or allows a government to honour its commitments to its own or foreign banks under government bonds or other credit facilities. If there are direct economic benefits for another state, it may agree a bilateral loan. However, joint action is more likely if there required amounts are large or the pain of a government default is spread over a wider group of states. In addition to some purely European rescue funds that were established during the 2007-2013 subprime crisis, several international organisations are able to provide loans or prop up the value of the sovereign bonds issued by a member state. For the EU, this would normally be lending or lending facilities by the IMF (e.g. Greece, Iceland, and Ireland) as well as lending by the EU as a whole. The lending to e.g. Iceland and Ireland had become necessary due to the collapse of their banking systems. These were disproportionally large when compared to their GDP. A key systemic risk, yet to be resolved in a final manner, is thus when a banking collapse takes its sovereign down with it, either through an ill-considered state guarantee (Ireland) or the collapse of the coin and the lack of burden sharing arrangements combined with the lack of timely intervention to stop uncontrolled growth in the banks (Iceland). The same applies if the public finances are not sound, or not sound enough to act as a credible backup guarantor of its banks (which as a result face losses on their holdings of domestic sovereign bonds, as a result of which the need for state aid increases, further depressing the credibility of the member state and so on). The EFSF and ESM are hoped to be part of the solution to cut the link between an individual member state and the banks it licensed, as is the future introduction of a banking union for the Eurozone. More importantly, in 2012 the ECB announced its intent to do whatever it takes to save the euro143. It did so by intervening not only as a lender of last resort to the banks, but as a de facto lender of last resort to the member states as a permanent backup buyer of sovereign bonds issued by troubled Eurozone member states (which helped banks and other financial institutions avoiding taking losses on the market value of such government bonds). The treaty specifies that the ECB and ESCB are prohibited to buy sovereign bonds directly, or to provide any other loan

142 F. Packer & N. Tarashev, ‘Rating Methodologies for Banks’, BIS Quarterly Review, June 2011, page 39-52. 143 Mario Draghi, Speech at the Global Investment Conference in London, 26 July 2012 (in his capacity as president of the ECB; see www.ecb.int for the verbatim of the remarks).

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facility to public authorities144. The ECB interprets this as pertaining only to the primary market of buying bonds directly from a member state, but excluding the secondary market in sovereign bonds. To accept such bonds as collateral is uncontroversial in this light, as is the incidental purchase of sovereign bonds in the secondary markets. The pre-announced large scale purchase of sovereign bonds of member states that enabled the ECB to stabilise the Eurozone crisis in 2012 could be deemed contrary to the spirit of the EU treaties, and possibly against the letter of the treaty provisions if the bonds are issued with the de facto intent to be subsequently bought by the ECB. Channelling this via a private sector middle man who buys these bonds in the primary market and immediately sells it on to the ECB who de facto is the only provider of cash was not the intent of this provision, and the middle man can even be considered an intermediary only, making the cash provision ‘directly’, and thus prohibited even under the letter of the prohibition. From a pragmatic point of view, however, the intervention can only be applauded as it ended a catastrophic risk to financial stability. The EFSF and the EFSM rescue funds were established in 2010, later added to by the ESM. The EFSM is a state aid mechanism, under which bonds can be issued to finance a state bailout, guaranteed by the EU budget145. The Council decides on providing the loan, aided by the ECB and the Commission. The EFSF has a rather diffuse legal standing from the EU legal point of view. The EFSF is not as such an EU organisation, it is a private company with the Eurozone-member states as shareholders, incorporated after a decision of the Ecofin. It is temporary in nature, but continues to service loans and supplements the ESM until it runs down. Where the EFSF is more or less informal from a treaty point of view, the ESM is its permanent successor for the Eurozone146. It has a separate intergovernmental treaty as a basis for its public sector status due to difficulties in the negotiations with the wider EU membership outside the Eurozone, but it interacts with the EU treaties by calling upon the services of the Commission and the Court of Justice. As it stands, it can only be used to help the member state via open market operations or loans. The decision on giving aid is allocated to a board of governors representing the member states. The board relies on the Commission (with the IMF and the ECB) to support it in implementing its decision in an agreement with the member state concerned on the conditionalities attached, while

144 Art. 123 TFEU. See, however, the possibility to provide definitions of the different terms given to the Council, art. 125.2 TFEU. 145 Council Regulation Establishing a European Financial Stabilization Mechanism 207/2010. 146 Treaty Establishing the European Stability Mechanism of 2 February 2012 (ESM Treaty), effective from 27 September 2012, and the Amendment Treaty to art. 136 TFEU, 25 March 2011, effective from 1 May 2013. The ESM publishes guidelines, but does not date them. On 27 June 2013 its website www.esm.europa.eu in the context of stability support instruments contained guidelines on loans, support facilities in the primary and secondary markets, on precautionary financial assistance and on the recapitalization of financial institutions (via the balance sheet of the member state as set out below).

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the ESM managing director sets out and arranges the financial aspects of the facility; but all aspects require approval by the board of governors147. The role of the European rescue funds in relation to bank bailouts is not yet clear. As the funding of banking supervision and crisis resolution remains key for the institutional arrangements underpinning banking supervision, the pressure of financial markets is leading to a demand for clarification; also see chapter 21.3 and 21.9.The credibility of the back-stop of state aid for systemically important institutions has decreased for countries where the banking system balance sheet exceeds the GDP of the country involved by too much, and there is no credible cross-border aid system. This may lead to either a financial system crash (e.g. Iceland) or to huge burdens for the sovereign, in turn leading to the chance of state insolvency if their debt to GDP ratio becomes overstretched (e.g. Ireland and Spain). The temporary European financial stability facility (EFSF) and by the European financial stabilisation mechanism (EFSM) funded the state bailouts of e.g. Ireland, Portugal and Greece. This type of role has since autumn 2012 been supplemented by the European stability mechanism (ESM), which can in due course also be used for direct bank recapitalisations148. The rescue funds were designed to assist sovereign member states when they could no longer viably fund themselves on the financial markets for instance after refinancing their financial system; see below. Any assistance given to the sovereign would take into account – and even earmark – funds that the member state in question could use to invest in its national banking systems if local banks need a bailout. The funds have so far not provided direct support to banks, but required it to be funnelled via the member state. This results in higher amounts of assistance from the rescue funds and higher debt to GDP ratios. These in turn limit the member states borrowing capacity and its credibility as a backup to its banking system, and thus the trust in its banks. To cut the reciprocal link between higher sovereign debt and the weakness of banks to fund themselves, several scenarios have been tried, including EU-wide EBA stress tests, higher capital requirements and stricter supervision on banks and on the budgets of member states. According to the ESM treaty, the route via the budget of the state towards the banks could change if a credible banking union is in place149. Negotiations are being finalised to introduce such a banking union in a segment of the EU, including the Eurozone. The initial proposals for the Eurozone banking union published in 2012, however only include a single supervisory mechanism, allocated to the ESCB/ECB, see below. This would be one aspect of such a banking union. There was debate on the whether a single supervisory 147 Art. 13 ESM Treaty. 148 Treaty Establishing the European Stability Mechanism, 2 February 2012, effective from 27 September 2012, and the Amendment Treaty to art. 136 TFEU, 25 March 2011, effective from 1 May 2013. 149 Also see chapter 21.3 and R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 4.6.

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mechanism would allow direct investment into failing banks, or even taking over some legacy loans that were used to bail out banks for instance in Ireland and Spain, as part of discussion on burden sharing of failing banks; also see chapter 21.9. The president of the Council suggested that the ESM could play a role as a backstop for EU-wide deposit guarantee and resolution funds150. A direct recapitalisation of the banking system is thus debated, but it requires a unanimous decision of the board of governors (composed of one representative per member state) to add this instrument to the possible operations of the ESM151. Whether this will happen after the establishment of single supervisory mechanism at the ESCB/ECB, or after the other components of a Eurozone banking union are in place – or ever – will be apparent in due course as will the detail on the exact conditionality. The finance ministers of the Eurozone who in effect are the ESM board of governors reached a political agreement for eventual direct recapitalisation in June 2013 envisaged for after an effective single supervisory mechanism is in place in the Eurozone152. Some financial buffers would need to be available or replenished by the member state itself, but if the bank has a solvency ratio of above 4.5% in common equity tier 1 capital, the ESM would be able to provide some of the financial buffers alongside the member state directly to the bank (with deviations of this policy possible if unanimously agreed), if there is still some of the capital reserved for this purpose available within the ESM. Until implemented, both the treaty and its guidelines assume recapitalisation via the balance sheet of the Eurozone member state, as in the Spanish recapitalisation exercise in 2012153. For legacy assets, the same pecking order applies, and a limited amount of it could thus be taken over after all supervisory structures and legislation are in place and the formal amendments are legislated on and/or agreed. When in place, the amount of money available for such purposes will need to be credible to deal with 1 or more systemic banks in individual problems, or multiple systemic banks in a banking crisis up to the risk appetite for instability of the legislators.

150 See the report prepared by the President of the Council in cooperation with the Presidents of the Commission, the Eurogroup and the ECB. H. van Rompuy, Towards a Genuine Economic and Monetary Union, EUCO 120/12, 26 June 2012. 151 Art. 5.6 and 19 ESM Treaty. 152 On the overlap with the finance ministers see ESM, ESM Board of Governors elects Jeroen Dijsselbloem as its chairman, 11 February 2013. On the political agreement, see Eurogroup, ESM Direct Bank Recapitalisation Instrument, Luxembourg, 20 June 2013, published on 21 June 2013 on www.consilium.europa.eu. On the single supervisory mechanism, see chapter 21.3 and R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 4. 153 ESM, Guideline on Financial Assistance for the Recapitalisation of Financial Institutions, www.esm.europa.eu. The undated guidelines were retrieved on 27 June 2013. On the Spanish recapitalisation – initially agreed by the EFSF but Transferred To The ESM In November 2012 – See ESM, Press Release ESM issues bonds for the Recap of the Spanish Banking Sector, 5 December 2012.

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To prevent states needing aid as a result of problems in their banking sector (and vice versa) a range of instruments are being considered. These include efforts to limit the implicit or explicit state guarantees for systemic banks, a focus on resolution plans, deposit guarantee revisions and the way the European stability mechanism (ESM) and the proposed single supervisory mechanism would operate to develop a banking union in the Eurozone. Some of these efforts may actually have a positive effect in limiting the chance of state aid being necessary, or limiting the amount concerned if state aid does become necessary. If a state can afford it, it continues to be likely, however, that is will continue to provide aid to its systemic banks if that would help avoid or delay havoc for its economy and its voters. Deposit guarantee funds, proposed new tools for bankruptcy resolution and the proposed introduction of so-called resolution funds are unlikely to keep the wallet of the state out of harms’ way154. Lacking a full agreement on sharing the funding of state aid, it is also less than clear how the allocation of prudential supervision to the ECB/ESCB would impact on the willingness of domestic governments to fund state bailouts of banks supervised by the ECB. While the ECB is likely to provide liquidity support if needed, it is less likely to provide solvency support, even when it becomes responsible for prudential supervision. The EU balance sheet itself does not appear to have the kind of stretch needed to bail out multiple crossborder banks. If member states formally have no say in how the banks operating in their country are licensed, supervised and liquidated, they may be less than enthusiastic to stump up the money. This may increase if more of the formal responsibility is allocated to the national authorities that operate under the ECB/ESCB umbrella. In the absence of preexisting credible funding available in deposit funds, resolution funds and direct lines to rescue funds such as the ESM, it is not clear whether the type of state-aid needed to quell the 2007-2013 subprime crisis could again be mustered. Of course, the official line is that this would not be needed due to the measures taken, but those measures have actually not yet been implemented or bedded down. That a crisis will not re-occur in some form at some point in time is highly unlikely based on past experience. The full implementation of the political agreements on the ESM, and the proposed burden sharing arrangements in the proposals on deposit guarantee funds and resolution funds – or a credible alternative – will need to be in place to avoid new need for ad hoc and unpredictable measures. Future Developments The CRD currently does not specify a treatment of state aid instruments, but the national discretions on the definition of financial buffers allow member states to shape the allocation

154 See chapter 18.3, and e.g. Commission Working Document (for consultation and discussion), Technical Details of a Possible EU Framework for Bank Recovery and Resolution, 6 January 2011.

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of state aid instruments into supposedly high quality categories as they see fit. This is grandfathered into the CRD IV project, where the transitional arrangements allow state aid that is issued prior to 2014 to continue to count as common equity tier 1 for several years regardless of who actually provided it, with only token requirements on quality. New instruments issued after the start of 2014 will need to fulfil some quality demands on loss absorption and they will have to (continue to) be held by public authorities. Even such new state aid instruments will not need to fulfil the full set of equity-style capital components that are applied to non-state aid instruments such as shares155. The proposals of the Commission on recovery and resolution (crisis management) as published in June 2012 seek to reduce the call on public funds to bail out banks in order to avoid a disorderly bank failure or systemic crises. For this purpose it not only sets out a wide range of resolution tools, but also ambitious arrangements on how to fund those. As burden sharing is a key-hesitancy of EU member states, especially as long as supervision and political consequences of crises remain national, important aspects of the proposals focus on using ‘privately’ funded reserves at the banking group or at bank-funded deposit guarantee and resolution funds156. Any intra-group support would be a welcome reduction of risk to avoid a crisis at the banks that are part of the group. This has no direct consequences for state-aid, except by reducing the frequency and possibly the extent of aid provided. Any resolution tool will, however likely include restructuring, possibly with the involvement of state aid e.g. by capitalising a bridge bank or allowing a write down in loans made to the bank by public authorities. In addition, the use of resolution funding obtained from the new resolution funds and the existing deposit guarantee funds – whose general functioning are the subject of the next chapter, however, are state aid relevant. If a deposit guarantee fund or any future resolution fund as proposed by the Commission would use the levies paid in by banks or other financial institutions to lend to a failing bank or to the legal entity taking over its functions, this can be considered state aid. A payout to depositors upon insolvency is likely not state aid. It either constitutes an early repayment given to the individual depositors or at worst a general form of state aid available to all clients (including smaller companies) of banks, as mandated by EU law. A loan or investment into an individual bank would not be considered private sector even though the original levies are paid by private sector entities. The funds are controlled and set up to serve a public interest, the levies are in essence specialised taxes on financial institutions, and the investment of such taxes would be subject to analysis from a state aid point of

155 Art. 31 and 483 CRR; see chapter 2 and 7. 156 See the proposed capital transfer agreements of art. 16-22 of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012, and e.g. recital 44. Also see chapter 18.3.

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view, as referred to in the Commission proposals both in respect to this form of funding and with regard to other public authorities involvement in resolutions157. The judgement and consequences of such aid are not dealt with in the Commission proposals (stemming from its financial markets directorate) except by stating that such aid would need to be state-aid-rules compliant. As a result of a desire to spare public funds, the bail-in of private sector creditors has increased in importance as a preferred option in the view of legislators. For instance in the Cyprus bailout senior creditors of two major Cyprus banks were bailed in as a condition for the member state receiving aid, and subordinate bondholders were bailed-in (expropriated) in the SNS bailout in the Netherlands; both in 2013. In the mid 2013 Ecofin position on the recovery and resolution directive negotiations, the member states representatives accordingly included a requirement that banks can only be bailed out using (semi-)public funds after 8% of liabilities – based on a ‘fair and realistic valuation’ at the time of the bailout – have been bailed-in (including equity). This would – if agreed if Parliament – amount to a minimum level of a division of risk between investors in and lenders to the bank and the state158. This may improve the negotiating position of member states vis-àvis creditors so that they become more willing to accept a loss to secure a bailout and save the 92% of their claims (even though that part may largely belong to separately guaranteed depositors). In my opinion more likely it may also increase the chances of a wholesale market ‘run’ on the bank at the first sign of minor troubles, by withdrawing funds or dumping bonds and equity to any willing buyer159. The Council position also agreed on an EU wide general ranking of claims in the context of such a bail-in, with equity at the lowest rank, then ordinary unsecured non-preferred creditors and depositors from large corporations, then eligible deposits of natural persons and small- and medium sized enterprises and e.g. the European investment bank, then the deposit guarantee scheme. Secured liabilities and guaranteed deposits would be excluded from a bail-in, leaving the burden of the 8% bail-in of all liabilities largely at the door of the wholesale markets. Unsecured, unguaranteed bonds of banks that would now rank equally with depositors, would thus de facto become the new tier 3 capital of banks (though of lower quality than even the current tier 3 short term subordinated loans, as the loans would not formally be

157 See page 5, 12, 13, 16, recital 24, 29, 35, 46, and art. 2.26, 2.46, 29.3, 32.2, 33.2, 35.4, 36.4, 47.1 and 56.2 Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. 158 The Council position on the recovery and resolution directive proposals of the Commission as indicated in Council, Council Agrees Position on Bank Resolution, 27 June 2013, 11228/13, presse 270, and in recital 48a and 48b, art. 30 and 38.3cab of the accompanying text of their amended draft for the directive (11148/1/13 rev). 159 See e.g. the reasoning on the stickiness of certain creditors in the liquidity rules; chapter 12. Also see E.J. Kane, Regulation and Supervision: an Ethical Perspective, NBER WP 13895, March 2008.

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known as subordinated, and would only partly (and then only for the few that failed to unload them at the first sign of trouble) be bailed-in. The July 2013 proposals for a Eurozone resolution fund – in the context of a banking union – would from the start of 2015 introduce the so-called single resolution board as a new agency managing a joint resolution fund covering both large and small banks; see chapter 21.3. Unlike the ESM, this fund would always directly support the bank that needs a bailout. Unlike the ESM fund, the decision making on the use of the fund, any preceding write down of capital instruments, and the investments made by the fund would not be given to the member states (or more correctly their representatives appointed in the board of governors) but the Commission proposes to allocate those powers to itself. Further checks and balances are not in place, as the board containing the representatives of the member states – the formal owner of the fund – is only empowered to act within the framework set by the Commission, instead of the other way around160. The Commission would in that case be de facto in charge (with delegated day-to-day activities) of a 55 billion euro fund and its investment strategy, as well as in charge of decisions to use the fund to bail out a bank (or force the member states to liquidate it as the only alternative). In a complicated dance, even though the decision is given to the Commission, subsequently the member state would be required to obtain state aid approval to the Commission in its other role of competition authority161. It is unlikely that this will go through in this manner, but as this division of roles will likely take the majority of negotiation time, the Commission is equally likely to get approval on other aspects of its proposals. Literature – Mishkin, Frederic S., The Economics of Money, Banking, and Financial Markets, 8th ed., Pearson Adisson Wesley, Boston, 2006, chapter 11 – Padoa-Schioppa, Tommaso, Regulating Finance: Balancing Freedom and Risk, Oxford University Press, Oxford, 2004, chapter 8 – Kindleberger, Charles P., A Financial History of Western Europe, 2nd ed., Oxford University Press, New York, 1993, chapter 15 – Trimidas, Takis, EU financial regulation: federalization, crisis management, and law reform, in Craig, Paul; and De Búrca, Gráinne (ed), The evolution of EU law, 2nd edition, Oxford, 2011, chapter 25 – Alexander, William E. et al (ed.), Systemic Bank Restructuring and Macroeconomic Policy, IMF, Washington, 1997, chapter 3 160 Page 9-10, 15 and art. 6.6, 6.7, 18, 20, 38, 64 of the Commission Proposal for a Regulation on a Single Resolution Mechanism, COM(2013) 520 final, 10 July 2013; as compared to art. 13 ESM Treaty. 161 Art. 6.9 and 6.10 of the Commission Proposal for a Regulation on a Single Resolution Mechanism, COM(2013) 520 final, 10 July 2013.

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– Gilliams, H., Steun aan financiële instellingen na Lehman: een ‘stresstest’ voor de regels inzake staatssteun, SEW 7/8, August 2010 (Dutch)

18.5 Guarantee funds Introduction The protection of the clients of banks (savers/depositors, clients with investment accounts, borrowers) is not the primary or only goal of prudential banking supervision162. Clients of banks do benefit from the decreased likelihood of a bank failure, and the increased likelihood that the liquidator of a bank will find sufficient ‘solvency’ to absorb any losses on the assets of the bank, to still be able to repay all or a large proportion of those the bank owes money to after the liquidation of the bank has been completed. That depends on how solid the prudential requirements were drafted and subsequently supervised, and upon the liquidation skills of the liquidator involved. At the least this liquidation will take time. If the clients have doubts about their bank and/or about the credibility of the prudential laws, their supervision or the possibilities for liquidators to obtain the full value of assets, they may cause problems at the bank. If clients choose not to trust the bank anymore and withdraw the money or financial instruments they entrusted to the bank, the bank will run out of liquidity fast. Clients can do this often quickly, as many loans made to the bank are immediately repayable (current accounts) or repayable soon (savings accounts, wholesale funding) unless long term lock-up provisions have been included (some types of savings accounts, some types of secured bonds, and some subordinated loans and shareholders). To limit some incentives to withdraw funds from banks, to level the playing field between established (systemic) incumbent banks that benefit from implicit government support and new deposit-taking competitors, and to protect those who cannot fend for themselves two guarantee systems under two separate directives were introduced for retail clients, such as small- and medium sized enterprises and consumers. The two guarantee systems offer: – a deposit guarantee for funds held at banks (the only institutions allowed to hold repayable funds of the public, except for issuers of bonds with a prospectus or e-money issuers that provide equal forms of protection; see chapter 5.6); – investor compensation for financial instruments entrusted to a bank or to a non-bank investment firm (the two types of institutions allowed to take custody of the financial instruments of non-professional clients under Mifid; see chapter 16.2).

162 Chapter 4.3. Also see R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 2 and 3.

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The deposit guarantee systems were introduced first. The small depositors who cannot reasonably be expected to understand when a bank is safe or not gained protection for their small scale savings, while the banks gained protection against their customers staging a ‘run’ on the bank when they lose their trust in the solidity of the bank, which is essential for microprudential and financial stability reasons. Since its introduction, the protection goal of deposit guarantees has slowly increased in importance, especially since the start of the 2007-2013 subprime crisis. This is in part due to the outrage of the electorate as to the low levels of protection given to them when their bank failed as opposed to the bailouts of the bankers employed at larger banks – but also to ameliorate the risk of a bank run even with the existence of partial cover under the existing deposit guarantee directive. This has resulted in quick political support for upgrades in the level of claims guaranteed, the abandonment of potential own risks of the client and in the speed of pay-outs necessary. This political necessity has, however, not reduced theoretical criticism on the existence of this type of protection to the clients of banks due to moral hazard; see chapter 4.3. If a bank has government protection, clients will not check whether the bank is safe. On the contrary, even if the client knows the bank may not be the safest, calculating clients – which would include the writer of this book – may still entrust funds to the bank if it pays a higher interest rate or provides better service in the secure knowledge that the bank is supervised and that the deposits are state guaranteed. Under the moral hazard reasoning, it can be argued that the issue that the existence of deposit insurance and the accompanying lack of interest of prospective clients in the banks’ soundness has led to an incentive for banks to take high risks. If the high risks pay off, bankers will take the benefits, while the losses – if they are too large to be compensated by profits – will be borne by the state, i.e. the taxpayer. Allocating such well-thought-out casino thinking to banking managers in general seems far-fetched, especially if they would lose their jobs if they gambled wrong. But it is definitely likely that the lack of client’ interest in the banks’ soundness has removed a brake on the banks’ risk taking behaviour. This has only partly been replaced by the scrutiny by unprotected depositors of the larger amounts that would exceed deposit insurance limits, unprotected professional lenders to banks, rating agencies and internal and external supervisors. Investor compensation has gathered less opponents, possibly because it deals with the return of financial instruments that are ‘owned’ by the retail client, and segregated under Mifid-rules from the own assets of the bank; see chapter 13.4. Money in a bank account is also ‘owned’ by the retail client, but in effect is treated as a loan (for free use) by the client to the bank, and is freely mixed with bank assets and used by the bank for its transformation function (making loans e.g. to companies).

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Though the primary purpose of deposit guarantees and investor compensation provided by the EU is the protection of those who cannot assess the risk of their bank failing and could not bear such risks when they materialise, an equally important goal is the opening up of a more competitive single market. For the protected depositor/investor it does not matter if a bank is large or small, benefits from an explicit or implicit state guarantee or other guarantee scheme or not, is a member of an historical oligopoly/monopoly or not, whether it is domestic or from another member state or from a third country. For protected clients under the directives such as consumers and small- and medium sized enterprises their deposits and financial instruments are protected up to the agreed amount regardless of such status-aspects. This gives small banks and foreign banks a chance to compete in a local market, and in that manner helps create a single market with the benefits of competition to the end-users in terms of interest rates, contractual arrangements and service, instead of inevitably losing out to large domestic systemic banks that would otherwise be able to set terms unilaterally as they are the only ones benefiting from an (implicit) state guarantee in a crisis. The availability of deposit guarantee and investor compensation schemes regardless of the knowledge or other activities of the protected party indicates that any saver that stays below the agreed amounts can stop with his assessment of his bank as soon as it knows that the bank is supervised in the EU and covered by a protection scheme. Larger savers should spread their funds, or do their own assessment of the risk of failure of any bank they entrust higher amounts to; investors with large financial instruments portfolios could entrust that portfolio to multiple banks/investment firms too, but are also and mainly protected by the segregation demands under Mifid; see chapter 13.4 and 16.2. Deposit insurance is not part of the CRD, but a separate directive. Still, it is a crucial component of prudential supervision, providing a back-stop for depositors that lose money when the banks and banking supervisors cannot stop a bank from failing. This protection helps reduce the chance of a bank-run when a bank is still solvent163. The directive has at the start of 2011 been clearly allocated to banking supervisors. EBA has the directive as part of its policy scope, and it has been given some practical instruments vis-à-vis (operators of) deposit guarantee schemes164. Such operators (or the public authority supervising the operator) are ‘competent authorities’. They have a role on the decision making process of EBA alongside the national member, but can be the recipient of instructions of EBA in

163 D.W. Diamond & P.H. Dybvig, ‘Bank Runs, Deposit Insurance, and Liquidity’, Journal of political Economy, Vol. 91, No. 3, June 1983, page 401-419, reprinted (edited) in Federal Reserve Bank of Minneapolis Quarterly Review, Vol. 24, No. 1, 2000, page 14-23. Also see, however, E.J. Green & Ping Lin, Ping, ‘Diamond and Dybvig’s Classic Theory of Financial Intermediation: What’s Missing?’, Federal Reserve Bank of Minneapolis Quarterly Review, Vol. 24, No. 1, 2000, page 3-13. 164 Recital 20 and art. 4 §2, 18, 19, 20, 26 and 40.6 EBA Regulation 1093/2010.

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emergency circumstances, and be the subject of binding mediation. Due to the link with Mifid-services, the investor compensation directive has been allocated to ESMA, even though it also provides back-stop protection to clients of a bank that is being liquidated. A new development is the potential use of deposit guarantee funds – and the proposed new resolution funds – in the context of bankruptcy prevention, by forcing such funds to part-finance a resolution of a failing bank. The bank would in that case not go bankrupt (or at least not the part of the bank with the guaranteed deposits) but would continue to operate under new ownership, and with part-funding done by the funds, possibly reinforced by international cooperation between such funds; see below under ‘future developments’. Deposit Guarantee Legislative Background Deposit guarantees are both the ultimate protection for small depositors in case of a failed bank, and an instrument to help prevent a bank from failing. If customers are afraid a bank might fail, a queue forms to take out their money. Nowadays that may more often be an electronic queue on the internet banking site of the bank instead of one around the corner, but both types still occur165. If depositors start clamouring for their money back, a so-called ‘run’ on the bank, this can lead to the failure of troubled banks and healthy banks alike. There is only so much liquidity a bank has available to pay out its immediately withdrawable deposits, and once a run occurs it is less likely to be able to attract additional financing in the professional markets (and more likely that professional counterparts demand their money back too). After an initial 1987 ‘Commission communication’ on the desirability and format of deposit guarantees failed to achieve EU-wide guarantee schemes, the Commission proposed a directive. In 1994 a deposit guarantee system became obligatory166, in spite of vocal German opposition. Germany went so far as to – unsuccessfully – challenge the obligation to implement the directive. It argued that the majority of its banks already were part of a different type of mutual deposit insurance system. As those in effect precluded participation by banks from other member states wanting to compete in the German savings market, they lost the case due to single market arguments. The deposit guarantee directive was strengthened in 2009, in response to the 2007-2013 subprime crisis. Improvements in the procedure of pay-out, were introduced, and due to experience gained some national discretions (e.g. on giving depositors an amount of own risk) and the different maximum levels of the guarantee (with the associated problems in the Icesave pay-out) were har-

165 E.g. the Northern Rock run in 2007 in the United Kingdom, and the (unsuccessful) efforts to withdraw funds from the Landsbanki/Icesave websites in the United Kingdom and The Netherlands in 2008 after its failure. 166 Commission Recommendation 1987/63/EEC, replaced by Directive 1994/19/EC.

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EU Banking Supervision monised at 100.000 euro. These changes fully entered into force on 31 December 2010167. The level of 100.000 euro was retroactively impact assessed by the Commission in the review of the directive168. It proposed to stay at this level mainly due to predictability arguments (changing the level every few years is bad for trust), and due to the fact that as a result of this protection amount, 72% of eligible deposits are covered in practice, and the number of fully covered deposits is 95% of eligible deposits. This would reduce the negative effects of the bankruptcy of a bank to deposits to a very limited number of wealthier depositors. The deposit guarantee directive is built around the following assumptions: – prudential supervision and market discipline do not guarantee that a bank will not fail; – non-professional depositors that entrust a limited amount of funds to a bank cannot be expected to assess the chances of repayment by a bank, and nowadays need access to those deposits on a continuous basis as a primary need of living in order to pay rent, food and other necessities; – the knowledge of availability of a deposit guarantee will reduce the chance of a run on a bank; – if a bank is not covered by a deposit guarantee, it should not be allowed to attract deposits; – professional and/or large depositors can afford to and are expected to risk manage their allocation of funds to various banks; – deposit guarantees should not lead to competitive distortion between banks from different member states. How Does A Deposit Guarantee Scheme Work? Member states are required to ensure that there is a deposit guarantee scheme for each bank that has been licensed in its state169. The deposit guarantee scheme has to cover all deposits (including saving accounts, current accounts, bonds and other credit balances following from normal banking transactions, see chapter 4.3 and 4.4) for the first 100.000 euro of the aggregate claim per depositor per bank170. This is calculated by 167 The changes are the result of Directive 2009/14/EC, amending the Deposit Guarantee Directive 1994/19/EC. 168 Commission Report, Review of Directive 94/19/EC on Deposit Guarantee Schemes, COM(2010)369 final, 12 July 2010. 169 Pre-existing protection schemes that offer protection at least equivalent to a deposit guarantee scheme can also be maintained, in which case the bank can be given an exemption from the obligation to belong to a deposit guarantee scheme. Art. 3.1 Deposit Guarantee Directive 1994/19/EC. 170 Art. 1.1, 1.2 and 7 Deposit Guarantee Directive 1994/19/EC. Joint accounts are allocated to each accountholder in line with his share (in equal measures unless there are specific provisions on a different division). That share is aggregated with other accounts of that depositor at the licensed bank. The nominal value of bonds that qualify as deposits is added; see chapter 4.4, 5.6, and compare for instance art. 1.2 sub f.iv Prospectus Directive 2003/71/EC.

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– adding up the amount of each personal account or held as another qualifying claim by a depositor (including interest already earned, even when not yet formally written onto the account); – adding the share of the individual depositor in funds held in joint accounts (e.g. with a spouse); – deducting any set-off and counterclaims under the regal and contractual conditions applicable to a deposit; – and paying out the total resulting number up to the harmonised minimum and maximum amount of 100.000 euro. The scheme has to pay out if a guaranteed bank fails to repay the funds of depositors on demand and the scheme has been activated. Each national deposit guarantee scheme covers171: – deposits held at the establishments of banks licensed in the same member state, including equal ranking bonds issued by such a bank; – deposits held at branches in other member states of banks licensed in the member state of the scheme (it includes all branches that are part of the same legal entity that has the banking license in all member states, but does not cover deposits at branches in third countries); – deposits held at branches of third country banks in the member state of the scheme; – deposits that were already held at a bank that has since lost its license. Not covered are172: – deposits held at subsidiaries, parent banks and other related entities, including e.g. bonds issued by special purpose vehicles; – deposits held at banks that benefit from an exemption because they have arranged for a different but equivalent form of deposit insurance for depositors in the member state, e.g. as the third country scheme of a third country bank covers depositors at the branch in the member state concerned (unlikely as this is); – deposits held by other banks on their own behalf and for their own account; – deposits that fall within the CRD-definition of ‘own funds’, such as shares or some types of subordinated loans; see chapter 7.2; – deposits arising from transactions in regard of which there has been a criminal conviction for money laundering; – deposits excluded by the member state scheme in as far as allowed under the national discretion in the member state, which potentially includes deposits of large companies

171 Art. 3-6 Deposit Guarantee Directive 1994/19/EC. 172 Art. 2, 7.2 and Annex I Deposit Guarantee Directive 1994/19/EC.

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(i.e. those not allowed to draw up abridged balance sheets under accounting regulations), deposits by financial institutions, insurers, collective investment undertakings, pension and retirement funds, deposits by group companies of the bank, and by the banks directors and some other directly or indirectly related persons, deposits of governments and some other public authorities, non-nominative deposits (i.e. numbered accounts and/or bonds to bearer), or deposits in currencies other than euros or of non-euro member states. This means that at a minimum consumers and small- and medium sized enterprises in EU currencies need to covered, even if the exclusions have been used to the widest extent. The term deposit is very wide, and includes all repayable claims upon the bank. ‘New’ claims that are not the result of an obligation to repay (but e.g. originating from liability or a derivative contract) may be excluded173, but any money entrusted to it (savings account, current account, in exchange for electronic or paper bonds or other debt paper, privileged or subordinated) is protected unless the entrusted funds are covered by one of the exemptions (e.g. subordinated funds that fulfil each and every one of the conditions to fall under the own funds definition). Each bank has the obligation to inform174 its customers on the deposit guarantee scheme that covers their deposits, unless the client is excluded, in line with the directive, from coverage. This includes mentioning where depositors can submit claims if necessary. This obligation treads a fine line with a simultaneously applicable rule that such references should not be used as an advertisement. This rule is ambiguous, however, giving scope for national deviations as to the force of such rules on advertisements, from quite lenient to a restriction of advertisements including at a maximum a factual reference to the scheme to which they belong. It turns out that – though many people know next to nothing about financial issues – those that have knowledge or have had a recent bad experience split up savings over more banks175, and may indirectly even opt to spread it over more deposit insurance schemes by choosing foreign banks for some of their savings. The pay-out of the deposit guarantee can be triggered independent of a bankruptcy judgement, even well in advance of a formal bankruptcy judgement. The trigger for the process – unlike bank license withdrawal – remains firmly linked to a traditional insolvency measure of liquidity in the sense that there are deposits that are not available to the 173 Depending on the interpretation of the definition of ‘deposit’ up to the moment such funds have e.g. been booked onto the payment account of the client. 174 Art. 6.2-6.3, 9 Deposit Guarantee Directive 1994/19/EC. 175 C. Van der Cruijsen, J. de Haan, D. Jansen & R. Mosch, Household Savings Behaviour in Crisis Times, DNB WP 315, August 2011.

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depositor even though they should be. The supervisor is obliged to activate the deposit guarantee scheme within five days of a depositor claiming payment and not receiving it (e.g. through a delay in paying it onward, in cash to the depositor or by transfer to an account of the client at another bank), even if the bank is not already bankrupt. The supervisor and the bank have those five days to find another solution than full liquidation, unless a court meanwhile finds the bank insolvent, and institutes a moratorium/bankruptcy process. Where the task of the supervisor to close the bank under the CRD remains firmly linked to solvency requirements (and organisational requirements) and not to the nonharmonised liquidity requirements, its role in the deposit guarantee system is to intervene at a point of time when the bank effectively does not have cash (and apparently cannot obtain credit any more) regardless of whether it is still solvent. Even if the bank is still solvent, if it is unable to access sufficient liquidity from private investors or under lender of last resort or state aid rules within the five days set, it will doubtless become insolvent when the scheme is activated. Such activation of a pay-out to depositors destroys the banks’ reputation irreparably, and precludes any possibilities to raise capital or liquidity from current investors and may even damage the power to sell the client base or the bank as a whole in going concern. As a result, resolution efforts have been shifting (further) forward in time, when there are serious concerns about a bank’s health, but deposits have not yet become ‘unavailable’; also see chapter 18.3. The process to come to a pay-out is highly structured176. It starts if a bank is observed to have ‘unavailable deposits’, meaning (i) it has deposits that are due and payable by the bank to its client, and (ii) it has not paid such a deposit to its client, and either – the supervisor has made a formal determination that the bank is unable, due to financial circumstances, to repay the deposit at the moment and has no prospect of being able to do so (which it is obliged to make within 5 days (used to be 21 days before 2010) from noticing that deposits have not been repaid, unless the situation of the bank has improved); or – a judicial authority has ruled that, due to financial situation of the bank, it has suspended the ability of depositors to make claims against the bank (e.g. by declaring it bankrupt or in a moratorium of payments), if this comes sooner than the above-mentioned supervisory determination.

176 See art. 1.3, 8, 10 and 11 Deposit Guarantee Directive 1994/19/EC. The time limits have been decreased, and the minimum cover provided increased (and maximized) since 31 December 2010. This will end the ‘topping up’ of foreign branches in host schemes, intended to level the playing field, which played a role in the Icesave default. Such topping up arrangements turned out to have a larger impact in 2008 than envisaged by the EU legislators and the Court of Justice in 1994 and 1997; Germany/Parliament and Council, Court of Justice 13 May 1997, Case C-233/94, §72.

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Within 20 days (used to be 3 months until 2010) of the determination that a bank has unavailable deposits, the scheme needs to: – collect all claims from depositors to the guarantee (for which it can set a time limit; however depositors who have been unable to submit their claim in time can submit it even after the term has expired); – verify these claims with proof provided by the depositor and against the books of the (usually bankrupt) bank; – check that the claim does not fall in one of the excluded categories in the applicable deposit guarantee scheme; – pay out the claims that are rightly made, up to the maximum of 100.000 euro177. The scheme can extend the term for its work onetime by ten working days (if the supervisor agrees). After the pay-out the scheme shall be subrogated to the rights of the depositor in any liquidation proceedings of the bank for the amount of the payment it has made to the depositor. It will thus most likely recoup much of the pay-out in due course if the bank was mainly in liquidity problems, but has substantial (illiquid) assets nonetheless. For example, long term mortgage loans or personal loans will be slowly paid back to the bankrupt estate over time, but can often not be easily transformed into cash that could have been used to prevent the bankruptcy in the first place. The 2009 amendment improved the protection offered prior to the crisis in several manners: – the supervisor has to make the formal determination that a bank appears unable to repay deposits instead of within 21 days within 5 working days from becoming aware that a bank has failed to repay a due and payable deposit; – the scheme no longer has 3 months to make the pay-out but only 20 working days, and the two previously possible extensions by 3 months have been replaced by a maximum extension of one time 10 working days. The increasing possibilities to interact with the IT facilities and bookkeeping of failing banks means that deposit guarantee schemes need less time to verify claims, and making a claim has become easier with internetbased tools; – the abolishment of ‘own risk’ for the depositor (where member states had the national option to cover not 100% but 90% of the deposit), as it had been shown in the 20072013 subprime crisis that depositors would still run to try to avoid the loss of 10% of their insured deposits when a bank was generally considered weak, without increasing

177 Initially a minimum amount of 20.000, this was subsequently increased to a minimum amount of 50.000 euro in the early stages of the crisis, and has as per end 2010 been harmonised at a (minimum and maximum) number of 100.000 euro.

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the scrutiny paid to the actual creditworthiness of a bank when it was generally considered to be healthy; – the coverage system has been further harmonised by an increase in coverage first from a minimum of 20.000 euro first to 50.000 euro and as per end 2010 a new fully harmonised amount of 100.000 euro. As a result of this and of the deletion of the own risk discretion, the need for the so-called ‘topping-up’ scheme is reduced. Under that scheme a bank that was established in a low deposit guarantee scheme country could ‘top up’ the insurance offered to depositors in branches in other member states, by demanding to become a member too of the local member state. This was a measure to promote the single market and competition, but lead to complicated schemes, and contributed to cross-border coordination and funding problems in the event of a bank failure. After the harmonisation of coverage levels, now it is only relevant to depositors excluded in one state from coverage, but included in the protection in the host member state. Member-banks of a deposit guarantee scheme can be expulsed if they fail to fulfil their obligations vis-à-vis the scheme, but only if the licensing supervisor agrees178. Such obligations include information provision obligation and the payment of fees (the most likely source of funding of the fund; see below). If the scheme finds a member non-compliant, it has to inform the authorising supervisor within the EU. The supervisor is obliged to take all appropriate measures to ensure that the bank complies with its obligations to the scheme (using its regular instruments, see chapter 20.3). If those measures fail, the scheme can give notice that it intends to exclude the bank or the branch, provided it has explicit consent of the licensing supervisor. The notice period has to be at least 12 months, after which the scheme can exclude the member, again after approval from the licensing supervisor. As such an exclusion would generate significant publicity following the (obligatory) announcement to depositors, the supervisor will find itself with conflicting interests in this matter, with on the one hand the interests of the bank and on the other hand of the scheme and its financiers (normally all other banks that are a member of the scheme). The interests of depositors are not at stake, as their deposits are covered and remain covered in as far as they were made at the time of the exclusion. If a local bank or third country branch is excluded, it will normally no longer be covered by a deposit guarantee scheme even though that is obligatory. If the supervisor agrees, it can make alternative guarantee arrangements that ensure that depositors will enjoy a level and scope of protection at least equivalent to the local scheme (so not equivalent to the directive minimum, but to the scheme as implemented, with add-ons under local legislation). An insurance policy or state guarantee might help, but the premiums or fees are likely prohibitively expensive, and would also need to fulfil the obligations on a quick pay-out. If no such alternative 178 Art. 3.2-3.5 and 4.2-4.6 Deposit Guarantee Directive 1994/19/EC.

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arrangements are possible or acceptable, the supervisor is obliged to revoke the license of the bank. The directive does not regulate the institutional set-up nor the funding of the deposit guarantee protection mechanisms. In any given member state, there can even be several deposit guarantee schemes. A scheme can be a contractual arrangements, it can be established and regulated in domestic law, and the scheme can be a legal entity or not. Often, either the central bank and/or the banking supervisor have a role in the scheme, or in a way even be the scheme, but it can be fully set up in the private sector, as long as all conditions set in the directive (as implemented in the local law) are met. EBA has been given the task to ‘contribute’ to adequate funding by contributions by participants, but this task is not supported by legal obligations to have such funding in place at this moment (see below under ‘future developments’), though it can issue non-binding guidelines and recommendations179. The non-binding recitals to the directive state that in principle the cost of financing a scheme must be borne by the banks themselves. The obligation to be able to pay within a set time period also indicates that the scheme needs to have funding in place in line with their liabilities, though it was noted that such ability should not endanger the stability of the banking system of the member state as a whole. Both this consideration and an explicit recital on the lack of liability of the member state towards depositors whose claim on a – properly set up – scheme cannot be paid out, have been eviscerated as a result of the Icesave/Landsbanki collapse180. The Icelandic scheme did not have sufficient funds to pay out the depositors of its three major banks that collapsed at the same time. In a power struggle between on the one hand the UK and Dutch authorities and the Icelandic authorities on the other hand, the Icelandic scheme and government had to accept liability incompatible with the financial stability of the member state and the liability-recital of the directive, in order to survive the broader financial crisis the collapse of its banking system had caused. As Icelandic authorities were blamed for the collapse of the three big Icelandic banks, there was little or no sympathy for their dilemma181. Their argument that the deposit guarantee directive did not oblige the authorities to chip in, and did not constitute a guarantee that a scheme, once properly set up, would be able to do pay-out even if the majority of the banking system collapsed at once, were valid in the face of the directive

179 Art. 26 EBA Regulation 1093/2010. 180 See the last recitals of Deposit Guarantee Directive 1994/19/EC. 181 See, for example, the report on the demise of Icesave and the instruments of the Dutch supervisor in relation to that branch of the Icelandic bank Landsbanki: A.J.C. De Moor-van Vlugt & C.E. Du Perron, De bevoegdheden van de Nederlandsche Bank inzake Icesave, 11 June 2009 (Dutch).

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recitals, and even based in part by the case law of the Court of Justice182. The EFTA Court since vindicated their defence on the basis of the old directive text valid at the time; while acknowledging that under the 2009 version of the directive the member state would have been liable183. This argument under the old directive did not protect them from pressure from other member states. Under the amended directive, the member state is under a obligation to implement the directive in a manner that brings the scheme in a position to pay verified claims of depositor within 20 days184. If this is a ‘direct effect’ obligation, which is likely, it effectively creates a sovereign guarantee for the funding of the scheme. The recitals to the deposit guarantee directive indicate a preference that the costs should be borne by the banking sector. Even though such a recital is not binding, it has been taken on board by all member states. However, at the time of the directive the funding mechanisms were diverse and they continued to be so until well into the 2007-2013 subprime crisis. Main differences relate(d) to: – pre-funding or post-funding (i.e. having a standing fund or only sending an invoice after a bank had failed and the fund had compensated its depositors); – whether the funding was risk-based and, if so, which factors were taken into account to determine the relative risk of the institution; – if the fund is pre-funded, how much should be in the fund, and where should the fund’s assets be kept and/or in which types of assets the fund could invest; – if the fund was insufficiently funded, or post-funded, or the banks would collectively fail if the fund was empty and a sizable member failed, who should pick up the bill. The Commission and representatives of deposit insurers have worked on this issue. After the Icelandic fund turned out to be empty when its three main banks failed simultaneously, this discussion was intensified; see chapter 18.4. Based on stocktakes of funding mechanisms and experience with risk based calculations, proposals and some consensus appears to have arrived on the need for a pre-funded, risk based funding mechanism, with a backup

182 Peter Paul/Bundesrepublik Deutschland, Court of Justice 12 October 2004, Case C-222/02 indicated that the obligations of the state were limited to setting up the scheme and providing it with information as set out in the directive, and did not provide depositors with claims to supervisors on defective supervision as long as the directive provisions is ensured. The problem for the Icelandic government was twofold: the minimum pay-out was not ensured in the face of the collapse of their financial system, and the responsible authorities had failed to limit the losses of depositors in general, and were aiming to treat local depositors better than depositors elsewhere in the EU, which was in violation of its obligations under the EU/EEA treaties. 183 EFTA Surveillance Authority/Iceland, EFTA Court, 28 January 2013, Case E-16/11 (conclusion in §178 on the Directive as in force in 2008 when the relevant banks failed, and in §138-139 on the 2009 version of the Directive, when art. 7 was replaced as a result of directive 2009/14/EC). 184 Art. 10.1 Deposit Guarantee Directive 1994/19/EC, as amended by Directive 2009/14/EC.

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EU Banking Supervision guarantee of the member state in case of insufficient funding185. This is not yet mandatory, but will be if and when the proposals of the Commission a new deposit guarantee directive are agreed, see below. Investor Compensation Scheme The investor compensation directive was introduced to safeguard similar interests as the deposit guarantee directive186. It does not provide protection to investors in banks (e.g. those who hold shares or bonds issued or guaranteed by the bank), but to investors that entrust financial instruments to banks for safekeeping. This is similar to entrusting money to banks for safekeeping. Where banks are allowed to use such entrusted money in their transformation business, they are in principle not allowed to use financial instruments entrusted to them, unless they agree this specifically with the client (and with limitations on the use of financial instruments belonging to retail clients). Under the Mifid directive they are bound to segregate financial instruments belonging to clients form their own assets. With the increase in non-professional investors in shares and other transferable securities, the investment protection directive introduced additional deposit-like protection (mainly) to non-professional investors that entrust a limited amount of financial instruments to a bank (or to an investment firm; see chapter 13.4 and 16.2). Like with deposit insurance, membership of investor compensation scheme is obligatory to be allowed to provide safekeeping services187. This scheme covers financial instruments routinely entrusted to banks by consumers and other small, non-professional investors. These are, either in a paper but nowadays almost always electronically, kept by the bank on their behalf. Unlike for deposits, the safe-keeping of financial instruments has not been limited to banks. All investment firms, including non-banks, are allowed to keep financial instruments for their clients. If the institution keeps its administration in order to comply with the segregation requirement, the risk for the client is small. They are the ‘owner’ of any paper shares kept for them (which thus do not fall in the bankruptcy of the bank or non-bank investment firm), and the same applies to electronically kept shares, where the books of the bank (bankrupt or not) establish the ‘ownership’ of the client directly on the dematerialised shares as held ultimately by a central custodian. The investor compensation scheme provides for protection in those cases where there might be discrepancies in the bank administration, e.g.:

185 Commission, Joint Research Centre, Risk-based Contributions in EU Deposit Guarantee Schemes: Current Practices, June 2008. Art. 12 Deposit Guarantee Directive 1994/19/EC as amended by Directive 2009/14/EC. 186 Directive 97/9/EC on Investor-Compensation Schemes. 187 Banks (and non-bank investment firms) that provide investment services are obliged to be a member. Art. 1.2 and 11 Mifid. Also see chapter 19.2.

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– where recent trades were not yet reflected in the administration of the investment firm/bank, or the ownership had not yet been transferred by the seller via the clearing and settlement process; – where the administration of the investment firm/bank was incorrect, due to lax procedures or due to fraud; – where the shares, though registered to the owner, were ‘lent’ to another institution and are not available to the owner. In these cases, the scheme ensures a pay-out of the value of the missing financial instruments up to an amount of – at a minimum – 20.000 euro. This amount was not raised with the amount covered by the deposit guarantee directive in the wake of the financial crisis. The structure of the pay-out and the provisions on funding are similar to those of the deposit guarantee directive as applicable before the 2009 amendments (so with longer pay-out timelines than currently allowed for the deposit guarantee). Future Developments The Commission published a more fundamental proposal to change deposit insurance in 2010, alongside a proposal to review and update the investor compensation directive188. It also published proposals on recovery and resolution that would create another type of fund that protects against negative effects of a bank failure. These would introduce socalled resolution funds (that could be the same entity as the deposit guarantee funds), and expand the use of deposit guarantee funds. Resolution funds would make loans or fund a bank resolution outside of bankruptcy, and deposit guarantee funds would become obliged to make similar investments (e.g. by making loans to failing banks in the context of a wider resolution scenario, to avoid the bankruptcy under which they would have had to compensate depositors). The Commission proposal on deposit guarantee funds would introduce a harmonised funding mechanism for guarantee funds. It also aims to shorten the delay depositors face in the pay-out of their guaranteed funds. Even the reduction of the pay-out timeline introduced in the 2009 version of the deposit guarantee directive is not instantaneous, leading to problems for depositors who need to pay the rent. Guarantee funds will need to introduce mechanisms that enable them to anticipate a failure, and are forced to build upon the IT systems and administration of the failing bank to pay out any guaranteed deposits on the basis of the information already available at the bank or the fund within 188 Commission Proposal, Directive on Deposit Guarantee Schemes (recast), COM(2010)368 final, 12 July 2010; Commission Proposal, Directive amending Directive 97/9/EC on Investor-Compensation Schemes, COM(2010)371 final, 12 July 2010. Also see the separate review report; Commission Report, Review of Directive 94/19/EC on Deposit Guarantee Schemes, COM(2010)369 final, 12 July 2010.

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seven days. The pay-out would be done directly by the fund to local savers, or by the deposit guarantee fund of the country where the depositor lives (under a set of cooperation agreements between funds), all on behalf of the fund where the legal entity with the banking license was established/licensed. The directive proposal also includes some laudable clarifications and harmonisations, such as that pay-outs will happen in the currency in which the account was held, and that interest accrued as per the date of the bankruptcy is also covered. The type of persons covered will be harmonised, and most of the national discretions eliminated. The type of accounts and claims covered will also be ‘clarified’, which is code for severely limited; see chapter 4.3. The deposits definition will no longer cover repayable funds such as bonds, but will be limited to more traditional deposits in current accounts and savings accounts. This will help clarify the intent of the legislature that anyone providing an unsecured loan over the guaranteed amount or via an unprotected depositor, or in the form of a financial instrument – even if that is a loan similar to a term-deposit – will not be protected by the guarantee fund nor likely by the CRD, and expand the number of persons at risk in a bankruptcy beyond shareholders, subordinated bondholders, and taxpayers to all bondholders and most trade-counterparties189. The level of 100.000 euro is simultaneously expanded by the prohibition of set-off190. If the depositor, in addition to its claims on the bank, also has debts to the bank, those debts cannot be set-off against the claims to reduce the pay-out by the fund. This applies both to immediately payable debts, and to long term debt such as home mortgages. This will allow the client to remain in the same payment and liquidity position as if the bank had not failed (he will still need to repay its debt under the contractual provisions in due course to the estate of the bankrupt bank). The proposals for a new deposit guarantee fund would introduce a risk based funding mechanism. This will also make binding the current recital that the costs of the fund should be borne by the banking sector, and that is should be pre-funded. This does not appear controversial. The Commission, however, also proposes mandatory lending from one EU member state deposit guarantee fund to the fund of another EU member state. The mandatory aspect of this does not appear likely to survive negotiations191, unless the 20072013 subprime crisis perseveres, and a banking union is simultaneously introduced. The proposals for a recovery and resolution directive go even further. Deposit guarantee funds could be obliged to fund resolution efforts. The proposed resolution funds would 189 See, however, R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 3. 190 See the proposed amendments to art. 6 of the Directive. 191 High-level Expert Group on Reforming the Structure of the EU Banking Sector, Final Report, 2 October 2012 (Liikanen Report), page 83.

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equally be pre-funded and subject to mandatory cross-border borrowing. In addition, the directive would make mandatory that supervisors/resolution authorities enter into financially binding agreements when starting a resolution process on who should pay what. Though this refers primarily to the use of the financing available in deposit guarantee funds and resolution funds, it still would entail a cross-border division of the burdens to save a banking group. Whether that is possible in the abstract at the start of a resolution is unlikely, whether the member states want to sign up to such a commitment in advance is even unlikelier, again unless the crisis perseveres192. EBA obtains a mediating/deciding role here. This will likely bounce against the prohibition for EBA to decide anything if there are fiscal consequences; see chapter 21.4 and 21.9. As the pre-financing by banks into public authority controlled funds transforms them the money used into state funds used for state aid, their depletion – and any backup funding directly from the general state coffers if the funds are insufficient and the remaining banking system is fragile – would no doubt be considered ‘fiscal’193. The proposals on recovery and resolution of the Commission indicate that all costs, losses or expenses in relation to the use of resolution tools should first be borne by the ‘shareholders and creditors’ of the bank (likely it is meant that the estate should pay this, perhaps funded by a further write down of capital or eligible debt). Any further costs related to a resolution should be borne by the resolution fund194. It is left to member states, otherwise, to ensure that the resolution authority has the needed expertise, resources and operational capacity to exercise the powers given with the necessary speed and flexibility to achieve the directives. The current practice of ex post financing now used in several member states will be abandoned for a mixed ex ante ex post system. The EU has had an ongoing debate between proponents of pre-paid fees, risk sensitive or not, and post-paid fees195. This debate is being settled in favour of pre-paid, risk sensitive fees if the Commission proposals are agreed by Parliament and Council. The idea is that a defaulting bank will have the ‘opportunity’ to pay part of the insurance premium on its own demise, and that the fund will have some financial leeway to deal with potential bank failures. Banks will be required to pay in advance (ex ante) contributions to the fund up to a target level of 1.5% of eligible deposits. The fund will invest this in a manner that is considered relatively safe, borrowed from the

192 See proposed art. 80.1, 83.4 and especially 83.5 sub c of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. 193 See proposed art. 11, 83 and 98 of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012; and recitals 5 and 50, and art. 19 and 38.1 EBA Regulation 1093/2010. 194 See proposed art. 92.2 of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. 195 Commission Joint Research Centre, Risk-Based Contributions in EU Deposit Guarantee Schemes: Current Practices, June 2008. Also see e.g. various essays in E.G. Furubotn & R. Richter R. (Eds.), The Economics and Law of Banking Regulation, 1989/90.

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EU Banking Supervision e-money and UCITS directives196. The investment of the collected funds can prove to be problematic. It should be invested in safe investments, but also be available within the above-mentioned seven days. In a larger economy, it can be relevant amounts of money even for a medium sized bank. If the potential investments are indeed limited, (e.g. in government bonds (and possible trigger a reduction in prices) or in triple A rated financial instruments, it could further artificially inflate the prices of such instruments, and the scarcity of such instruments for collateral purposes in e.g. clearing and settlement systems or secured lending facilities at the central bank. The banks may also be requested to pay additional money if this turns out to be necessary when the fund has to do a pay-out (ex post) with limits to ensure that other banks would not go bankrupt due to their contributions to the fund. The contribution will be ‘riskbased’ though it is controversial what constitutes a good division of risk and what should be the differentiation between the safest institutions and the least safe (e.g. should the implicit state guarantee for systemic banks reduce their payment obligation, or increase it?). The targeted level of the funds by 2020 should be such the fund has enough money to deal with the failure of a medium sized bank. Though probably unintended, this hints that if any larger bank fails, or if more medium sized banks fail, this is a systemic issue that will be dealt with via state aid; see chapter 18.2 and 18.4). The ‘safest’ institutions will of course be the ‘too big to fail’ banks, that are likely to be bailed out by the sovereign. Their contributions to the fund (and any eventual resolution fund) can be seen as part of a premium for the implicit insurance by the sovereign under this ‘too big to fail’ assumption. An additional protection of the state (tax-payer) is that guarantee funds will have an obligation to extend loans to each other, if one of them faces a pay-out obligation and lacks sufficient funds, and that any fund has to have additional borrowing facilities to cover potential pay-outs. These would come into play if the fund is not yet filled by ex ante payments, or empty again after a pay-out. This does carry the risk of contagion to the state or other funds, or the lack of money to pay out in case of additional failures within the member state or the EU. For this reason some limits as to the maximum amount that can be lent to other funds are included. The proposed cross-border solidarity between funds is controversial due to the implication of potential costs for other states (or the lack of sufficient funds in the lending fund if a local bank subsequently defaults). It may well be contrary to TFEU provisions that prohibit the EU and the member states taking over any commitments from other member states public authorities and undertakings. At first sight, at least, the resolution and deposit

196 Commission Proposal, Directive on Deposit Guarantee Schemes (recast), COM(2010)368 final, 12 July 2010, page 7. See chapter 19.5.

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guarantee funds appear to be such authorities and undertakings, as do banks after a bailout, though the prohibition only covers the EU and member states themselves, which may or may not be interpreted to extend to such prohibitions for funds controlled by the member state. The Council is, however, empowered to provide definitions for these terms, which definitions may not necessarily reflect or even approximate normal usage197. This part of the new proposals is linked to the banking union discussion; see chapter 18.4 and 21.3198. The borrowing facility between national funds is either too bold or too limited. Too bold in the absence of a joint supervisor and state aid provider, too limited as it envisages a repayment of the loan. This repayment would be funded by contributions of local banks (and thus funded by their clients and shareholders), under a solidarity concept that is limited by national borders. It is unclear why banks from one national jurisdiction should be so committed, if other banks operating in the same single market under similar rules and supervision are not expected to be so committed. This is compounded if the failing bank-entity is a cross-border operating entity, operating alongside foreign banks in foreign markets. The ‘alternative funding arrangements’ are likely to be in the form of loans from the state, possibly – if the state guarantees such lending – pre-funded by local central banks199. In the longer term, the types of use that can be made of the money collected in deposit guarantee funds may be further widened, and separate or integrated resolution funds could be introduced if the draft recovery and resolution directive is agreed as proposed200. These (also partly ex ante financed) funds would be used to co-finance any emergency funding of a bank, refinancing its new life with new shareholders and management. This is intended to (at least partially) replace state funding from the general accounts funded by taxpayers, by payments from this government controlled fund into which banks pay premiums; see chapter 18.3 on the general resolution framework, and chapter 18.4 on the state aid character of such contributions by deposit guarantee/resolution funds to a resolution of a bank. According to the Commission, such resolution funds and the existing deposit guarantee funds could be one and the same, provided there are sufficient safeguards for the protected deposits. The deposit guarantee proposals, however, prohibit depositor guarantee funds to contribute to a bank rescue beyond the amount of insured deposits held by the bank (mainly to avoid contributing to the rescue of non-guaranteed depositors and investors,

197 Art. 125 TFEU. 198 Also see R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 4. 199 Monetary financing by central banks is prohibited in the treaty, see art. 123 TFEU. ECB, Opinion on the Proposals for a Directive on Deposit Guarantee Schemes (recast) and a Directive amending the InvestorCompensation Schemes Directive, CON/2011/12, 16 February 2011. 200 See proposed art. 90-99 of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012.

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EU Banking Supervision who in the opinion of the Commission should in part be bailed in)201. Strikingly unfair is that the contributing banks will be left with a double pay-out if the public authorities decide to rescue a ban using resolution/deposit guarantee funds, and the rescue fails to keep that bank alive202. The Commission proposals in that case indicate that the deposit guarantee fund in that case would need to make a second pay-out, after the first pay-out to the extent of the covered deposits is swept down the drain of a badly executed or unlucky public rescue attempt. In this case, use of general taxpayer money of the state instead of the targeted taxes on banks alone would be a fairer backup payment facility. Like the proposals for future deposit guarantee funding, resolution funds contributions are proposed to be based on the definition of eligible deposits. The target level is set at 1% (on top of the 1.5% for the deposit guarantee fund target level). This is particularly strange for resolution funds, as they try to safeguard not (just) protected depositors, but also other functions of the bank that are important to society, and will likely be used at larger banks that have systemic consequences, instead of at the current use of deposit guarantee payouts mainly at the smaller banks. The Commission envisages similar types of cross-border mandatory borrowing facilities between resolution funds as for deposit guarantee funds. Should a banking union indeed be agreed and implemented as discussed in June 2012 for the participating country (Eurozone plus voluntary members of the banking union) and proposed in September 2012203, a key aspect will be the institution of a merged deposit guarantee fund, alongside the use of resolution planning and the potential use of the European stability mechanism for direct banking bailouts; see chapter 18.4 and 21.3. The deposit insurance fund would need to be able to pay out any guaranteed deposits of any EU (or Eurozone) licensed bank. For the fee structure this would not matter much, though member states would need to agree they will have less grip on the fees paid by banks licensed in their jurisdiction. Such fees would then become the insurance premium in an EU-wide insurance fund, instead of the current domestic insurance funds. At the same time, the tendency towards alternative resolution methodologies than liquidation (e.g. bridge banks, bail-ins, etcetera), is likely to make deposit insurance less important. Depositors will be paid out by the entity taking over the deposit taking part of the business of a failing bank. It may be that the deposit guarantee fund will get a role alongside the proposed resolution funds in funding such transfer of deposits (ensuring that there are enough assets in the 201 Commission proposal, Directive on Deposit Guarantee Schemes (recast), COM(2010)368 final, 12 July 2010, page 8, and proposed art. 99.1 of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. 202 Proposed art. 99.6 of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. 203 Euro Area Summit Statement, 29 June 2012. Commission, Proposed Single Supervisory Mechanism ECB Regulation, COM(2012 511 final, 12 September 2012.

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new entity or the newly recapitalised bank) by inserting cash/capital to cover any deficit on the asset side of the entity that will have the obligation to pay the deposits. Whether a full banking union in this co-funded respect will be introduced remains highly doubtful, even in the Eurozone. For instance in the mid 2013 Council position for the negotiations with Parliament on recovery and resolution, the cross-border lending facilities between national resolution funds become voluntary rather than obligatory, while at the same time it allows member states to raise taxes or levies from the banking sector and put it into general income instead of into a specialised fund204. The Commission has also announced a revision of the investor compensation directive. Some of the adjustments made in 2009 in the depositor guarantee directive will be copied (e.g. the elimination of the co-insurance system under which the investor could be forced to bear 10% of the risk), and some proposals are identical or similar to the ones made for the deposit guarantee review (who pays, fund solidarity across borders, an ex ante funding up to a target level of 0.5% of the covered monies and financial instruments205). In addition: – the protected amount will be adjusted from a minimum level of 20.000 euro to a fully harmonised fixed level of 50.000 euro; – the directive will also cover financial instruments held on behalf of the client at a third party custodian; – the directive will now explicitly cover Mifid services (the current version still referred to its predecessor directive), and will be expanded to losses suffered if the custodian of financial instruments used by a UCITS fails, and causes damages to the UCITS-investors. Clients of retail-AIFM (a national discretion) and pension funds are not yet similarly covered for the collapse of a third party custodians under their prudential rules. See chapter 19; – the concept of protected persons under the directive will be widened to and aligned with the concept of retail clients in Mifid (professional clients are not protected, other clients are). It is not clear why this was not copied in the depositor protection directive proposals; see above and chapter 4.3 and 16.2. Literature – Moloney, Niamh, EC Securities Regulation, 2nd ed., Oxford University Press, Oxford, 2008, chapter IX

204 Council, Council agrees position on bank resolution, 27 June 2013, 11228/13, presse 270. 205 See the proposed art. 4a and 4b of Commission Proposal, Directive amending directive 97/9/EC on InvestorCompensation Schemes, COM(2010)371 final, 12 July 2010.

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EU Banking Supervision – Cecchetti, Stephen G., Money, Banking, and Financial Markets, 2nd ed., McGraw-Hill, New York, 2008, chapter 14 – Commission Joint Research Centre, Investigating the Efficiency of EU Deposit Guarantee Schemes, May 2008

18.6 Prudential Banking Supervision in the Liquidation Process Introduction A bank is still a bank, even if it is in a moratorium of debts due to e.g. a bankruptcy judgement, or after it voluntarily decides to liquidate its business. Until its loan portfolio and debts owed to the public are repaid, it still fulfils the definition of a bank. Once it loses its license – which is likely if the courts or the court-appointed managers decide to liquidate all assets – it is closed for new business but the interests of the depositors and of financial stability still require supervision on the estate. If parts of the business in the bank itself or in subsidiaries are kept going to the benefit of the estate or to ready them for a sale, those may require an active license and ongoing supervision. Optimising the value of the assets of the bank may well require a lengthy liquidation process, in which ‘the public’ is repaid in full once illiquid assets (such as 30-year long mortgages) are fully repaid by the borrower. At the EU level the role of the supervisor is not differentiated for a going concern bank or for a bank in liquidation, or both; thought a separate resolution authority will be referred to in the CRD IV project and especially in the Commission proposals on recovery and resolution. There is no EU-wide bankruptcy regime for banks. Whether a bank can become bankrupt, and how the liquidation process is handled is largely subject to national law. At the EU level, demands are made: – on mutual recognition of bankruptcy regimes under the winding down directive for banks; – on the protection of the bank, its shareholders, creditors and other connected persons under administrative and human rights (such as the protection of property, and the access to courts206); – on the obligatory pay-out of depositors and investors under the compensation schemes (chapter 18.5); – on the intervention of public authorities to ‘save’ the bank.

206 The latter deviates from some aspects of US bank bankruptcy procedures according to R.R. Bliss & G.G. Kaufman, U.S. Corporate and Bank Insolvency Regimes: an Economic Comparison and Evaluation, Federal Reserve Bank of Chicago WP 2006-01, 10 January 2006, page 14. See chapter 20.4 and 20.5.

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Supervising a Bank in a Liquidation Process If the bank is involuntarily wound down, it likely no longer fulfils solvency and liquidity requirements, and the liquidator may have fired several key functionaries for internal control functions to save costs. A bankrupt bank that still has its license can, however, continue to operate for new business, unless restricted in that respect by either the court, the liquidator, or the supervisor. Existing business will, however, need to be maintained even after the license has been withdrawn, which may include servicing existing loans (collecting interest and repayments), and transferring segregated client assets to accounts elsewhere. While the bank is operational (regardless of whether or not it still has a license) in the sense that it continues to collect payments on its assets, continues to manage its existing assets and the repayments are re-invested pending payment to creditors, and perhaps even attracts new business while it is being restructured as a going concern, the bank continues to be subject to prudential and conduct of business rules. There is no exemption available in EU legislation to avoid the agreed minimum level of supervision in a going concern or gone concern situation. For a bank that is in a pure liquidation scenario, the goals of supervision change, as it will no longer need to be able to deal with new business, and its systemic or other relevance will slowly decrease. The few references to a situation after a withdrawal of the license focus on the best protection possible for the interests of depositors207. The lack of an explicit arrangement on how to apply various requirements on a reorganising bank (or one heading for an exit from the market) leads to substantial deviations in national practice208. Supervisors retain their powers to investigate and take measures if the management of bank that is being wound down and/or the liquidators of the bank that is in a moratorium or in a bankruptcy situation meet the prudential and conduct of business requirements. In a wind down or reorganisation situation the prudential supervisor will need to assess when to trigger the withdrawal of the license, and how to ensure that the assets are properly disbursed, or whether to license a new entity that will take over parts of the business of the failed bank. If there is a separate resolution authority or e.g. a judicial body supervising a liquidator or reorganisation official, part of these prudential tasks may have been allocated to it under domestic laws (in which case it is one of the ‘competent authorities’ in that member state under the CRD). Almost automatically some rules will be transgressed in a winding down scenario (staff at risk control functions are likely to leave, there may be only one liquidator instead of two,

207 Art. 35 RBD. 208 CEBS-EBA, Mapping of Supervisory Objectives, including Early Intervention Measures and Sanctioning Powers, 2009/47, March 2009.

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if surplus is paid out, the capital requirements may not be met). It will be up to the supervisor to assess whether such transgressions are proportional/appropriate to the bank under its current business plan: i.e. a wind down, or a restructuring, or a sale. They can and should use their instruments (which is more likely when there is a voluntary wind down than when there is a court supervised wind down under new management by court appointed liquidators). Conduct of business supervision continues unabated as long as supervised activities occur, such as investment in financial instruments or execution of orders on behalf of clients. Some conduct of business requirements will also continue to be effective even after the license has been withdrawn (e.g. an obligation to maintain its records for five years209), but most will lapse once the bank is no longer be allowed to conduct new business (e.g. investment advice) after its license has been suspended. Winding up Directive The EU legislation leaves the arrangements on terminating a bank largely to the domestic legislators. Unlike in the USA or Japan, there is no common EU bank resolution authority that deals with the assets of a failed institution210. Nor is there a single bankruptcy regime for cross-border operating groups. Bankruptcy proceedings and the subsequent liquidation process are emphatically still non-harmonised. The so-called winding down directive211 for banks only contains some procedural issues. It does not introduce a harmonised bankruptcy regime. Its main success is the introduction of mutual recognition in all member states of bankruptcy proceeding on a legal entity that has a banking license in one of them. This avoids the existence of multiple liquidators for the assets held in multiple member states by the same legal entity that has a banking license in one of them. However, this does not solve different creditor ranking regimes available in different member states that may confuse creditors as to their rights, nor – more importantly – does it deal with the multiple banks that are often part of the same banking group. See chapter 17 for the ongoing supervision on groups and the component entities of that group. This is especially disruptive as banks (and ongoing supervision) are often not organised across legal entities, 209 Art. 51 Mifid level 2 Commission Directive 2006/73/EC. See chapter 13.4. 210 Bank resolution is one of the tasks of the Federal Deposit Insurance Corporation, FDIC. In Japan, such an authority was set up in 1998 following the Japanese crisis. See M.J.B. Hall, ‘Banking Regulation and Supervision in Japan: Some Issues and Concerns’, Journal of Financial Regulation and Compliance, Vol. 11, 2003, page 45-59. 211 Banks are one of the categories exempted from the Winding up or Insolvency Regulation 1346/2000 that deals with most commercial companies, along with – roughly said – insurers, securities firms and collective investment undertakings. The subsequently negotiated Winding up Directive for banks (in full the Reorganisation and Winding up of Credit Institutions Directive 2001/24/EC) in essence provides similar arrangements as the regulation, though they do work immediately in every member state, but had to transposed into domestic law.

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but across business lines and units, each consisting of multiple legal entities within a group, and each legal entity part of various of such businesses212. How, where and when assets are booked is often more or less coincidental, depending on accountancy, tax, liquidity/debt management and company law requirements. Once several or all of these entities in a group have been declared bankrupt, suddenly where activities are booked starts to determine whether the creditors of a specific licensed or unlicensed entity within the group will get more or less of their money back than creditors of other entities within the group. If a banking group fails, the holding and each of the subsidiaries with a separate bank may well be subject to an equal number of bankruptcy proceedings (unless some subsidiaries are still solvent and/or unless subgroups, subsidiaries or some of the assets and liabilities are sold off as a going concern to e.g. other banking groups or public sector entities). The winding up directive will apply per failing entity that is a bank. Non-banks that are part of the group will fall under e.g. the winding up directive for insurers as implemented in member states, or under the insolvency regulation for non-financial companies and other debtors. Each of these mutual recognition regimes apply on a legal entity basis, not on a group-wide basis. If legal entities that are part of the same banking group are based in different member states, each will be resolved under local rules. The shares in a subsidiary will fall in the estate of the bank, not the underlying assets and debts. Bankruptcy proceedings thus follow the solo legal entity approach, not the consolidated approach favoured in banking supervision; see chapter 17. A bank branch of an entity licensed in France with a branch in e.g. London will be resolved under French law, while the subsidiary with a UK license that resides on the same premises will be resolved under UK law. However, many of the contracts entered into by a bank and some of the collateral/pledges that they provided will continue to be governed by the chosen law and/or the law applicable to that security right213. Whether non-lawyers will have a good grasp of the comparative different treatments they will encounter if they enter into a contract with the branch or the subsidiary is highly unlikely. This unlikeliness increases if the counterparty is a retail client. The different legal entities may well have claims on each other, making it important for the creditors of each to determine which entities have failed, which have received state aid,

212 R.M. Lastra (Ed.), Cross-border Bank Insolvency, Oxford University Press, Oxford, 2011, chapter 12 by R. Leckow, T. Laryea & S. Kerr. 213 Art. 3, 10, 20-27 and 31-32 Winding up Directive 2001/24/EC. Similar problems are encountered in the Winding up Regulation 1346/2000/EC that applies to non-banks. See N.W.A. Tollenaar, ‘Dealing with the Insolvency of Multinational Groups under the European Insolvency Regulation’, Tijdschrift voor insolventierecht, 2010, page 14.

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which were sold, or which are now subsidiaries of a bankrupt holding. Liquidators of individual countries will need to determine the strength of the claims (and collateral given) to each other within the group, which impacts on the pay-out upon liquidation to other creditors (including retail depositors that have larger accounts than covered under the deposit guarantee schemes). An agreement between various (liquidators of) group entities of the former Lehman Brothers group was reached fairly quickly – given the lack of any treaty or tool within the EU or across the globe – end 2011214. This after core legal entities in the USA, the UK and around the globe had been declared bankrupt/chapter 11 status in 2008. Issues such as what type of expertise is needed to be a liquidator of a bank (a supervisor, a lawyer, an accountant, or a banker), who can pronounce bankruptcy or a moratorium (a court, the supervisor) and who can make a claim for bankruptcy (creditors, supervisor, the bank, the deposit protection scheme) are all left to national law for the legal entities that are based in its territory. This also applies to the determination of who has priority/privilege against the general or specific assets of the bankruptcy, the order of pay out and whether netting is allowed (with the exception of some specific rules on financial instruments and collateral, see below), and whether liabilities can be sold with the accompanying assets to another bank or bridge bank, and against what price and with whose approval. The winding up directive does nothing to ease the complication when trying to save a bank that is part of a wider group if it is liable under intra-group financial support, and indeed leaves the voiding of such intra-group financial support e.g. if it is not done at arm’s length, without sufficient compensation, or in a ‘suspect period’ for bankruptcy-fraud up to the myriad national systems. This makes intervention and cross-border support a dangerous exercise to engage in for any commercial group, let alone with such large national interests at stake and monitored by supervisors, central banks and ministries of finance. The winding up directive did achieve a prohibition on ringfencing assets by member states for the narrow protection of their own citizens/voters. A bankruptcy of a bank (the legal entity) will have to treat all EU citizens/voters equally in the division of the spoils of any liquidation of assets. It does not guarantee the same for creditors of third country branches, and is unlikely to be able to guarantee it for third country assets. Many third countries will

214 Cross-border Insolvency Protocol for the Lehman Brothers group of companies, 12 May 2009, and Settlement Agreement Lehman Brothers Investment Management Company Ltd, Lehman US, and Lehman Brothers Securities NV, 19 October 2011, as agreed by the various liquidators subject to judicial and creditors agreements. Both found on www.ekvandoorne.com in 2013.

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seize assets of a bankrupt foreign entity, and pay out the own citizens first before transmitting the surplus to the liquidator of the main estate215. Clearing and Settlement and (Segregated) Client Assets While the non-procedural side of bankruptcy regimes has been left largely untouched, the EU did issue two directives to increase the safety of payment, clearing and settlement systems. The settlement finality directive and the collateral directive ensure that all payments, deliveries and collateral provided in the context of such systems are inviolate and final, regardless of the general bankruptcy regime in the member state where the participants are located. This to prevent clawbacks by liquidators that challenge disposals that took place earlier in the day of the liquidation decision by the appropriate public authorities (e.g. a bankruptcy court) that in some member states worked back to midnight preceding that decision. The havoc that the unweaving of all transactions of a bank prior to the moment of its bankruptcy would cause in delivery systems (where such funds and instruments would often have been onward delivered already again by the recipient) was reason to intervene here. Counterparty banks and other financial institutions including central banks have benefited from this change in legal certainty of financial transactions216. In addition, Mifid meanwhile mandates that client assets have to be segregated from the assets of each investment firm. For non-bank investment firms that includes both money and financial instruments, for banks (that are allowed to attract deposits and use that cash as if it is its own) the obligation focuses on the financial instruments; see chapter 13.4 and 16.2. Financial instruments that are registered properly in the books of the banks remain the property of their clients, and fall outside the bankrupt estate of the bank. They can be transferred by a bankrupt bank to an account of the client at another bank, without hurting the rights of creditors (as these instruments never belonged to the bank). Though there is no specific obligation to do this quickly, liquidators will generally be obliged to return the property of third parties under local bankruptcy regimes. As the retail or professional owners of the instruments may be obliged to deliver them onward to buyers, it should nonetheless be done as fast as possible to avoid delays in trading, clearing and settlement by such clients in the financial markets217. If the bank failed to segregate financial instruments properly, retail-clients can claim a (small) reimbursement under the investor compensation directive; see chapter 18.5.

215 E.g. the USA. See for a description of the various systems that protect own citizens first in cross-border bankruptcies of legal entities (and groups): BCBS, Report and Recommendations of the Cross-Border Bank Resolution Group, March 2010. 216 See chapter 22.4. 217 R.M. Lastra (Ed.), Cross-border Bank Insolvency, Oxford University Press, Oxford, 2011, chapter 12 by R. Leckow, T. Laryea & S. Kerr.

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Future Developments The FSB has put its force behind clarifying the role of the various parties involved in bank supervision. It has endorsed the BCBS cross-border bank resolution group recommendations and the FSB note on key attributes of effective resolution regimes218 and urged their implementation. Some individual member states are taking such recommendations forward until a common resolution regime can be agreed; see chapter 18.3. In the insurance sector, the sectoral winding up directive has been integrated into the Solvency II directive; along with multiple other insurance supervision directives. The full recasting of prudential banking rules into the CRD IV project was not used to integrate the winding up directive into the CRD. No reason for this discrepancy between the recasting efforts in the insurance and banking sectors has been given. The integration of the banking winding up directive into the CRD IV project would have been useful, if only to expand its application to investment firms, which is the only financial sector currently lacking a regime that forces member states to respect each other’s bankruptcy proceedings for entities that they licensed. See chapter 19.2 and 19.4. Under the Commission’s proposals for recovery and resolution, the powers and tools of supervisors and/or resolution authorities would more clearly be delineated in normal times and in the run-up and early stages of a resolution219. Also, they would expand the winding up directive to all investment firms, and to the key institutions that – though not licensed as a bank on a solo basis – are key to the functioning and resolution of the banking group220. Nonetheless, once a bank – or the remnant of the bank after a resolution has split off its systemic or otherwise important functions and activities – has entered into liquidation there is still no clear regime on the tasks of supervisors and/or resolution authorities visà-vis the liquidator and vis-à-vis the remaining creditors of the bank (such as non-insured depositors). Literature – Hüpkes, Eva H.G., The Legal Aspects of Bank Insolvency: A Comparative Analysis of Western Europe, the United States and Canada, Kluwer Law International, Alphen aan den Rijn, 2000

218 BCBS, Report of the Basel Committee Cross-Border Resolution Group, March 2010., IMF, Resolution of Cross-Border Banks – a proposed framework for enhanced coordination, June 2010, FSB, Key Attributes of Effective Resolution Regimes for Financial Institutions, October 2011. 219 Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. See chapter 18.3. 220 Proposed art. 106 of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012; amending Winding up Directive 2001/24/EC.

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– Asser, Tobias M.C., Legal Aspects of Regulatory Treatment of Banks in Distress, IMF, Washington, 2001 – Lastra, Rosa M. (ed), Cross-border Bank Insolvency, Oxford University Press, Oxford, 2011 – Basel Committee on Banking Supervision, Report and Recommendations of the Crossborder Bank Resolution Group, March 2010

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Non-Bank Prudential Regimes – A Comparison

19.1 Introduction Banks are not the only financial institutions subject to prudential supervision. They are, however, subject to the heaviest and most detailed form of such prudential supervision, even though insurance supervision comes a close second. Other institutions that suffer/benefit from EU-imposed prudential supervision are issuers of e-money, investment firms, various forms of funds for collective investment (e.g. hedge funds, UCITS and occupational pension funds), financial conglomerates, holdings, stock exchanges and in the future central counterparties and likely also central custodians1. The choices made on prudential requirements for such other financial institutions are sometimes different from the banking choices, though there are also significant similarities. Most of the EU directives contain European passport regimes for the supervised entities that work along similar lines as for banks. The prudential licensing and ongoing requirements can vary from rough and ready to reasonably sophisticated and flexible. In this chapter a brief overview is given of the EU-imposed prudential regime of key financial institutions, in as far as not already covered elsewhere in this book (see for holdings and conglomerates chapter 17, and for market structures chapter 22.4). The joint forum found many similarities between the (worldwide) standards for banking, insurance and securities sectors. But it also found key differences that cannot be explained by differences in the sectors2. As these sectors are increasingly blurred as to the services they provide to customers and are increasingly part of the same financial groups, such unexplained differences can lead to problems for customers, financial institutions and supervisors. For these other prudentially supervised institutions, the proposed single supervisory mechanism will not apply. This is part of the anticipated banking union, and will not

1

2

In addition, many member states already have regimes for the above-mentioned clearing and market institutions at the domestic level, or for other financial type organisations that are not (fully) the subject of EU laws. Joint Forum, Review of the Differentiated Nature and Scope of Financial Regulation, January 2010, www.bis.org page 28.

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expand to other types of financial institutions, except indirectly if they are captured in the consolidated supervision (or other group-wide supervisory mechanisms) on a bank. In other aspects, such as the role of the European supervisory authorities competent for a specific subject and the associated directives, the institutional setting of the competent authorities and supervisors is quite similar to the setting described for the banking sector in chapter 21. The regulations and the Omnibus I directive were issued simultaneously, and along largely similar lines; also see chapter 19.4, 21.3 and 23.3. This also means that on the issues described in this chapter, a range of delegated acts and regulatory and implementing standards can or have to be issued by the competent authority (either EIOPA or ESMA for the institutions mentioned in this chapter; though the relevant aspects of EBA’s standards will also be applicable to the prudential supervision of non-bank investment firms under the CRD). The Commission proposals on recovery and resolution will apply to both banks and investment firms, as well as related companies; see chapter 18.3. Similar plans are made for other relevant institutions. The Commission is consulting on which types of firms should be captured by this effort, and is likely to include at least insurers and it is looking at e.g. payment institutions, and the market infrastructure organisations described in chapter 22.43. The developments on shadow banks and on non-bank systemically relevant institutions will likely impact on (some of) the companies that already fall under the prudential regimes briefly described in this chapter; see chapter 4.4, 5 and 18.2.

19.2 Non-Bank Investment Firms Introduction Any person who is professionally active in the investment markets for his own account or by providing services to others is likely to be a so-called investment firm. The Mifid casts its net widely when determining who should be subject to its rules on the professional behaviour in the financial markets, and subsequently exempts those specific types of firms that are already regulated elsewhere (e.g. insurers) or not of interest for its goals (e.g. firms that only provide services within the group to which they belong)4. Exempted institutions do not need a license and are not subjected to prudential or conduct of business supervision (but also do not obtain a European passport) under Mifid.

3 4

Commission, Consultation on a Possible Recovery and Resolution Framework for Financial Institutions other than Banks, 5 October 2012. Art. 2, 3, 4.1 and Annex I Mifid.

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Non-Bank Prudential Regimes – A Comparison

As already indicated in chapter 16.2, almost every bank qualifies as an investment firm in the context of Mifid (even if they do not provide investment services for others, they generally invest for their own account on financial markets). However, not each investment firm under the Mifid definition is a bank as many do not attract repayable funds from the public; see chapter 4.4 and 5.6. Investment firms are defined as legal persons who have as a regular occupation the provision of one or more investment services to third parties (e.g. clients/counterparties) or professionally perform investment activities. These services/activities include financial instruments portfolio management, trading on financial markets for the own account or by receiving/transmitting/executing orders of others, investment advice, underwriting and placing financial instruments. For banks the CRD (RBD and RCAD) contains the licensing and the prudential regime and Mifid a relevant part of the conduct of business regime for their business; while their CRD-license also allow them to operate under Mifid; see chapter 5.2, 13.4, and 16.2. For non-bank investment firms the Mifid contains the licensing and conduct of business regime, and RCAD contains the prudential regime in the form of an adaptation of the prudential requirements for banks. The main legislative difference between bank-investment firms and non-bank investment firms is the intention to attract repayable funds from the public as part of the activities of the firm. If a firm wants to hang on to the money of its clients and use it in its own business, it needs a banking license to be allowed to do so. If it does not want or does not obtain a banking license, it cannot hold on to client money and has to make arrangements to segregate it from its own assets, so that the money of the clients will not fall into its estate in case of a bankruptcy5. If an investment firm obtains a banking license at a later date, it will then become subject to the partially similar but much stricter prudential requirements from the CRD in full. The investment firm definition focuses on financial markets activities. The market risk regime is thus equally important for both banks and non-banks. These requirements are harmonised in the RCAD for both types of institutions. For other areas of prudential requirements only light touch regimes are applicable (as they do not have deposits on their books, and are thus less risky for depositors and presumably for financial stability). For clients that buy investment services, the way they are treated by banks and non-bank investment firms is also neutral as to the type of license they have. They are thus subject to identical requirements for conduct of business with regard to clients (as regulated in Mifid) and for their own behaviour in the financial markets (as regulated in e.g. the market 5

See art. 13 Mifid, art. 18 and 19 Mifid level 2 Directive 2006/73/EC. See chapter 13.4 and 16.2.

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EU Banking Supervision

abuse directive), as described in chapter 13.4 and 16.2. With regard to financial stability it is assumed that the health of non-bank investment firms is less important, which helps explain lower initial capital and less strict solvency ratio requirements. Nonetheless, nonbank investment firms can hold financial instruments for clients (and briefly hold their money for trading purposes), and can be key players in the financial markets. In the same way as banks, non-bank investment firms perform roles in the market that are central to financial stability. These include the making of loans, providing investment services, operating trading platforms and providing services in post trade clearing and settlement, as well as substantial trading for the account of their clients and themselves and thus providing liquidity to markets, and market prices for fair value accounting. In theory, investment firms can also be as large, as complex, and as systemically relevant as banks. This was the case for so-called investment ‘banks6’ or broker/dealers in the USA in the run-up to the 2007-2013 subprime crisis, and for the unregulated UK derivatives business of AIG. However, in the EU at least, large investment firms had already chosen to transform themselves into banks or are part of banking groups. For them the expenditure on the upgrade in systems and controls are useful already from their own business point of view (as they are both large and likely involved in complex investment strategies), and the costs are thus almost automatically incurred. Key components of these systems and control are similar or identical including issues such as market risk and consolidated supervision, likely leading them to the conclusion that the (reduced) additional costs are far outweighed by the benefit of being able to handle to and even actively attract clients’ funds also for longer terms and for their own business. In this sense the EU market was already different from the US regime, where the requirements for investment firms and banks were very different prior to the 2007-2013 subprime crisis (e.g. consolidated supervision was only introduced late and with little priority by the SEC). The main reason for the change in 2007 of the large investment firms to a bank charter in the US was not due to the possibility of holding deposits for their clients, but in the access to central bank facilities and support in the wake of the Lehman collapse during the 2007-2013 subprime crisis; see chapter 18.4 for the equivalent EU lender of last resort regime. Member states are forced to designate supervisors, and to ensure that such supervisors actively monitor compliance with Mifid7.

6 7

These legal entities did not fulfill the EU definition of a bank, as they did not engage in deposit taking business from the public; see chapter 4.4 and 5. Art. 17 and 48 Mifid. This applies also to banks.

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Non-Bank Prudential Regimes – A Comparison

Definition and Licensing An investment firm is a firm that either regularly (i.e. as a regular occupation) or as a business provides investment services to others, or who professionally performs investment activities. The list of investment services and investment activities captured is long8, and includes the execution of orders, transmission of orders, dealing on own account, providing investment advice, the operation of a multilateral trading facility, all if related to financial instruments. Financial instruments are a wide range of products, such as transferable securities (e.g. shares and bonds), units in collective investment undertakings as well as options, futures and other derivatives. Several types of undertakings are exempted from the Mifid. Some of these are very active in investment activities, such as insurers. Insurers are nonetheless exempted from the whole of Mifid (unlike banks, which are only exempted from the licensing requirements). Insurers have their own prudential supervision rules, and the insurance directives limit insurance entities to activities in the context of (or directly supportive of) their insurance activities9. Similarly, traders who only trade for their own account and do not provide key services to others are not of interest from a prudential point of view nor from a investment services conduct of business point of view. They are thus put outside of the scope of Mifid. Please note, however, that other conduct of business directives may be applicable to firms exempted from Mifid, such as the market abuse directive. If an investment firm is not exempted, it will need to obtain a license. Licenses in principle can only be given to legal entities. An investment firm is required to be a legal entity (as part of the definition of investment firm). Natural persons and non-legal entity structures can obtain a license nonetheless if the member state allows it (subject to some harmonised conditions)10. The procedure and conditions for licensing are similar as for banks under the RBD, but geared more to the conduct of business goal of Mifid (and compared to the licensing process for banks relatively less to the prudential requirements). To obtain a license, the non-bank investment firm11: – must have its head office and its registered office in the same member state; – actually has to be an investment firm (a provision absent from the RBD; see however chapter 5 on the limitations of cross-border recognition of entities with a bank license

8 9

Art. 4.1.1-4.1.2, and Annex I Mifid. For the institutions exempted from the directive see art. 2 and 3 Mifid. An insurer has to be set up in a specific legal form in order to be able to be granted a license, and each licensed entity is in turn limited to specific subsets of insurance activities; see art. 15-17 and Annex I-III Solvency II Directive 2009/138/EC. See chapter 19.4. Insurers are subject to e.g. the Market Abuse Directive 2003/6/EC and some other general conduct of business directives discussed in chapter 16, but not to Mifid conduct of business or prudential requirements. 10 Art. 4.1 sub 1 Mifid. 11 Art. 5-14 Mifid.

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–

– – – – –

– – – –

under the European passport if they do not qualify as a credit institution under the EU definition); must have at least two persons who will effectively direct its business, and all such persons are of ‘sufficiently’ good repute and experience to ensure the sound and prudent management of the investment firm; the applicant complies (likely: will be able to comply if it is a new start-up) with all provisions of Mifid, and already complies with the licensing conditions; it has a business plan showing such compliance; the holders of a qualifying holding are known, and suitable to have such power over the investment firm; there are no close links with other persons that may prevent effective supervision; has initial capital as set in RCAD (differentiated for different types of investment firms; depending on the scope of the services it provides and the impact on potential clients, see below); must fulfils the organisational requirements set out in chapter 13.4; will be a fully compliant member of an investor compensation scheme; see chapter 18.5; additional requirements apply if it wants to operate a trading platform; must provide all necessary information to assess the application.

These conditions apply on an ongoing basis, and the firm is expected to inform the supervisor on changes to its top management and to its holders of qualifying shareholders12. Assessments will take place of prospective managers and holders of qualifying holdings. Prudential Regime for Non-Bank Investment Firms Both the investor protection goal, their mandate to handle (but not hold) client money and to keep financial instruments of clients safe, as well as the core role they play in financial markets provide arguments for prudential requirements. The RCAD sets out which requirements of the CRD are applicable to non-bank investment firms, and in which areas a light touch regime applies13. Within the RCAD, for the purpose of differentiating between rules applicable to banks, to non-bank investment firms and to both these categories, the term investment firm is limited to non-bank investment firms. See chapter 16.2 for the regular usage of this term in both Mifid and RBD, where ‘investment firm’ includes the banks. 12 Art. 8, 9.2, 10.3 and 10.5, 16 Mifid. 13 Art. 12 and 67 Mifid 2004/39/EC. Art. 1, 2 and 3 sub b RCAD. The RBD adds that in some of its sections, the term institution includes non-bank investment firms; see art. 4.6 RBD as amended by the CRD II Directive 2009/11/EC. It refers to the use of that specific term in the large exposures regime, the solo/consolidated article and the credit risk.

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Non-Bank Prudential Regimes – A Comparison

The prudential regime is identical to all intents and purposes for those subjects where the business of investment firms is identical (or even more single-minded) to the business of banks: – provisions to various types of market risks along the same requirements as set out for banks in chapter 9; – the same definitions of financial buffers14 (but indemnity insurance can sometimes be accepted as an alternative to the ongoing initial capital requirement for banks; see below); – the distinction between trading book assets and non-trading book assets is identical15; – large exposures regime16 identical as for banks; – pillar 2 and pillar 3 regime identical as for banks17; – the same internal organisation requirements as for banks18; – for information provision to the prudential supervisor, the uniform formats, frequencies and dates from the RBD apply19. The regimes are similar, but with adaptations for the following subjects: – investment firms that offer the full range of services as set out in Mifid have to calculate credit risk and operational risk in the same manner as banks do. Investment firms that fall in a series of defined limited service-business, can abstain from credit risk and operational risk calculation. Instead, they have to calculate market risk requirements and add to the capital requirement for market risk a quarter of the previous years’ fixed overhead of the firm. This simplified adapted solvency ratio20 reflects the higher component of trading book assets on the balance sheet of most limited-service investment firms, while ensuring there are some additional financial buffers to cover credit risks in non-trading book assets and for operational risk. The supervisor can adjust the amount required if the business of the firm changes; – consolidation along the lines of the banking-regime, but with an extended range of discretions for the supervisor to exempt all or some of the investment firms from consolidation if it concerns limited-service non-bank investment firms in the group21 (if there is a bank that is part of the group to which the investment firm belongs, consolidation is performed under banking rules by the licensing supervisor of that bank);

14 15 16 17 18 19

Art. 12-17 (and 4-10) RCAD. Art. 11 and Annex VII RCAD. Art. 28-32 RCAD and art. 4.6 RBD as amended by the CRD II Directive 2009/111/EC. Art. 34, 37 and 39 RCAD. Art. 34 and 35.1 RCAD, art. 22 and 123 RBD and art. 13 Mifid. See chapter 13. Art. 35.6 RCAD introduces the art. 74.2 RBD arrangement that already applies to banks also for non-bank investment firms. 20 Art. 2 and 18 RCAD. 21 Art. 2 and 22-27 RCAD.

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EU Banking Supervision

– investment firms that are part of the same group as banks are covered by any joint approval of models. Prudential supervisors on non-bank investment firms have to cooperate with EBA amongst others for this purpose22; – a similar definition of initial capital as for banks (that for some of the smallest can also be covered by an indemnity insurance), but with different levels and exemptions23. Initial capital can be as low as 25.000 euro for some purely advisory firms or firms that only transmit orders (without having any debt to clients), 50.000 or 125.000 euro for firms that e.g. do not trade for their own account or offer some specific limited services, and 730.000 euro for all other firms. This is substantially less than the 5 million euro demanded as initial capital for banks; with the main distinction being that investment firms cannot have clients’ money in their accounts except during the execution of an order for the client; see chapter 4.4, 5.2 and 5.6. The amount of financial buffers can never be less than one quarter of the fixed overheads of the company of the preceding year (or – lacking such a preceding year – as budgeted in the business plan)24; – non-bank investment firms will be covered by the same harmonisation of reporting forms and dates that are being developed by EBA for banks. The frequency of their reporting is, however, already largely harmonised. Solo based information has to be sent at least monthly for full service investment firms that have to hold 730.000 euro in initial capital, the firms subject to the 125.000 euro floor quarterly. For some firms that have an exemption for the 125.000 floor, it is every half year, for other (small) firms, reporting is not obligatory under EU rules. The 125.000 and 730.000 euro firms have to send in (sub-)consolidated reports only every six months25; – the Mifid secrecy obligations apply to non-bank investment firms, instead of the CRD secrecy obligations26. The supervisory regimes are similar to the regime for banks, including on international cooperation and significant branches27. As the RCAD is explicitly a minimum harmonisation directive, member states can impose more stringent prudential requirements28. For the conduct of business regime and the organisational requirements that follow from Mifid, reference is made to chapter 13.4 and 16.2. The minimum and maximum harmonisation requirements of Mifid – as applicable 22 23 24 25 26

Art. 37-38 RCAD. Art. 4-10 RCAD. Art. 21 RCAD, also applicable to UCITS; see chapter 19.5. See chapter 20.2. Art. 35 RCAD and art. 74 RBD. Art. 38.2 RCAD. See chapter 20.2 on the banking secrecy regime, and chapter 21.7 on the difficulties the discrepancies can cause in colleges. 27 Art. 36-38 RCAD, as amended by CRD II Directive 2009/111/EC. 28 Art. 1.2 RCAD. See chapter 3.5.

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Non-Bank Prudential Regimes – A Comparison

to banks that are investment firms – also apply in the same manner to non-bank investment firms. For investment firms there is currently no regulation or directive that regulates the recognition of a single insolvency regime across borders in the EU, such as e.g. currently applicable to banks and to insurers via the sectoral winding up directives; see chapter 18.6 and 19.4. The investor compensation directive provides some protection to clients of investment firms (bank and non-bank) if the firm fails and financial instruments have been lost in spite of the segregation requirement; see chapter 18.5. However, the deposit guarantee directive does not apply to non-bank investment firms, even if they failed to segregate money of the client or used it for other purposes than envisaged under the investment firm license. Future Developments The trading book regime was revised substantially via Basel II ½, as implemented in the EU via CRD III; see chapter 9.2. Further future revisions of the Basel accord in the area of market risk are likely. The RCAD was not changed in any other material aspect when CRD III amended the CRD directives. Via the provisions that make most banking rules applicable to investment firms, they were also impacted by the new role of EBA, as well as by banking regime changes such as the new hybrid capital instruments and large exposures regime of CRD II and the new securitisation regime of CRD II and CRD III. The CRD IV project of will integrate the requirements for non-bank investment firms more closely into the banking requirements, but without material changes to the investment firm prudential regime. The division between the proposed minimum-harmonisation directive and minimum/maximum harmonisation regulation is identical as for banks, with the quantitative requirements being fully harmonised under the directive. Due to proportionality concerns, exemptions and lower requirements are available for some investment firms29. The Commission proposals for a recovery and resolution directive would apply both to banks and to investment firms30. Though the reasoning for this is tenuous (it refers to the USA firm of Lehman Brothers as an example, though such large investment firms do not appear to exist in the EU without having a banking license or falling under expanded 29 For instance on lower initial capital requirements that are copied from RCAD, and small- and medium sized investment firms can be given exemptions from the countercyclical and capital conservation buffers. See art. 28-32 and 129.2 and 130.2 CRD IV Directive. 30 See page 8 and 9, recital 8, and proposed art. 1 and 2.23 of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. See chapter 18.

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EU Banking Supervision

consolidated supervision because their subsidiaries have banking licenses), the result would be welcome. This especially as many investment firms are part of broader banking groups, or directly compete with them. As an afterthought the proposals also expand the winding up directive to investment firms, closing a gap between the existing winding up directives and regulations31. Under the ‘banking union’ proposals of the Commission, the often identical provisions for banks will no longer be allocated to a national prudential supervisor, but to the ECB. It may be that in the beginning the ECB will draw heavily on the help of the remaining parts of the current prudential banking supervisors in the participating member states, but this is not mandatory. The relevant expertise for e.g. model assessments may therefore not necessarily be available locally anymore to the prudential supervisor of non-bank investment firms.

19.3 Electronic Money Institutions and Payment Institutions Introduction Electronic money institutions and payment institutions offer specialised financial services. The services they offer are also on offer by banks, and are closely related or identical to handling (and keeping safe) client funds. The client funds are repayable funds, in the sense that they have to be repaid to the client when he wants this or paid forward to another party designated by the client, in the same manner as for e.g. current accounts. In principle, this is an activity that is only allowed to banks, unless there is another regime that provides protection; see chapter 5.6. Like the issuance of bonds with a prospectus, the handling of client funds in exchange for electronic money or in the context of onward payment is deemed desirable and low-risk enough to allow such activities to be performed by nonbanks. A specialised prudential regime contributes to the low risk nature of the business of providers of such services. The electronic money directive (or e-money directive) and the payment institution directive set out such a prudential regime for non-bank service providers. Electronic money can be issued by a bank, or by a specialised institution referred to as an electronic money institution. The original e-money directive brought even non-bank service

31 See above on investment firms not being covered by any of these existing mutual recognition regimes; and proposed art. 106 of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012; amending Winding up Directive 2001/24/EC.

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Non-Bank Prudential Regimes – A Comparison

providers within the definition of credit institutions in the CRD32. This at the behest of the ECB. Under the Treaty, the ECB only is competent where ‘credit institutions’ were concerned. It was interested in being able to set rules for any type of institution that could potentially ‘create’ money or hold money of customers, or was relevant in any payment system in its sights. A treaty-change for this purpose was not likely, so it was instead decided to expand the definition of ‘credit institution’ in the banking directives. As a result, large parts of the regulations for banks in the CRD became applicable to the many small specialised electronic money institutions. The e-money directive exempted electronic money institutions from some large and some small parts of banking regulation (e.g. quantitative requirements on the solvency ratio and its components), and partially replaced it with its own set of requirements on e.g. limitations on types of investments33. The e-money directive was not amended when the RBD replaced the consolidated banking directive. Normally, this is not a problem as references to articles are deemed to refer to the similar articles in the new directive. In this case, the reference was, however, to a whole chapter. This made the references to the much expanded pillar 1, and especially pillar 2 and 3 rather muddled, and re-emphasised the inappropriate level of requirements when compared to the (non-existent) size and complexity of non-bank electronic money issuers. To nobody’s great surprise, the very strict investment limitations and high level of requirements lead to the directive hardly being used, except by exempted institutions (e.g. banks and governments) and by institutions that benefited from the individual waiver regime. With the increase of electronic money in local public transport systems and on banking cards, it became even more noticeable that there was no progress on electronic money on mobile phones or in other commercial areas. In the meantime the Commission had gone a different route for specialised non-bank payment institutions with the issuance of the payment institutions directive in 200734. They had a separate prudential regime too, but had been left outside of the scope of the ‘credit-institution’ definition. This appeared to work better, even though it made the ECB unhappy that it did not have a direct link to monitor such institutions. The more flexible regime envisaged for payment institutions and under SEPA initiatives influenced the plans of the Commission to recast the e-money regime35. Under a new e-money directive as 32 On the definition of electronic money institution and credit institution, see chapter 4.4. 33 Electronic money institutions were already not deemed to be ‘credit institutions’ in the whole (R)CAD and in the title V, chapter 2 of the predecessor to the RBD, the consolidated banking directive 2000/12/EC. See art. 2 and recital 11 of the original E-Money Directive 2000/46/EC. 34 Payment Services Directive 2007/64/EC. 35 See the recitals to the E-money Directive 2009/110/EC, as well as e.g. art. 3 where the banking prudential regime is now replaced by a reference to the payment institutions directive. See chapter 4.4. The ECB, wary

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EU Banking Supervision

applicable since 30 April 2011, e-money institutions are no longer considered to be banks. Their prudential regime is no longer modelled on the ever expanding banking prudential regime, but on the lighter touch payment institutions regime. If either of those categories of non-bank financial services providers becomes more important in the future, the weight of the prudential regime may of course be revisited, but at the moment the light regime appears to be more balanced to the risk they form for financial stability and client protection purposes. Payment Services and Payment Institutions In the context of the plans to create SEPA (Single Euro Payments Area; see chapter 22.4), a single area for payments in the EU, amongst others the payment services directive has been proposed and completed. Directive 2007/64/EC required member states to adapt their laws by 1 November 2009. Payment services have traditionally been performed both by governments and central banks, by banks and by specialised providers such as money transfer agencies. The payment services directive has accepted this situation and has tried to fully harmonise especially the conduct of business regimes for such EU based service providers to the payment system; see chapter 16.5 and 16.6. A few clearly enumerated existing payment institutions that are deemed to be solid under their own rules can operate without a separate license or European passport for payment services (the banking license and the European passport for banks cover payment services in the EU). All other payment services providers need a license to be allowed to operate such services, and are subsequently allowed to operate across borders within the EU. Most of the conduct of business requirements are applicable to all payment service providers. But these conduct of business rules only apply if both sides of a payment are based in the EU and the currency of the payment is a currency of a member state of the EU36. The directive regulates payment services provided by banks, e-money institutions, post offices and public authorities, as well as by specialised payment institutions. The latter are subjected to a licensing regime if they want to provide services in the EU, the former de facto have permission to continue to provide payment services37. These specialised payment institutions have to38:

of its prerogatives, published a negative opinion on the direction of the initial Commission proposals; CON/2008/84, 2009/C 30/01. 36 Art. 2, 3, 4.3 and 86 and the annex of Payment Services Directive 2007/64/EC. However, note art. 73 of the directive on dating the payment for interest calculation purposes applies to a service provider regardless whether both sides of the payment are located in the EU. 37 Art. 1, 10 and 25 Payment Services Directive 2007/64/EC. Payment systems have to accept service providers in a non-discriminatory basis; see art. 28 of the Directive. 38 Art. 5-19 Payment Services Directive 2007/64/EC, but see the waivers and exclusions of art. 3 and 26. The concepts of initial capital and own funds are defined by reference to the RBD; see chapter 7.2.

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Non-Bank Prudential Regimes – A Comparison

– have initial capital of between 20.000 and 125.000 euro, depending on the types of services it provides; – have own funds of at least the initial capital required, as well as at least an amount of own funds that is calculated in one of three methods (a national discretion) that relate it to the size of the business of the payment institution in a simple calculation. The methods relate to percentages and calculations in relation either to fixed overheads, to payment volume or to a relevant indicator (specifically of interest income, interest expenses, commissions and fees received, and other operating income, each with a positive or negative sign); – safeguard the money of their clients by for instance asset segregation rules, if they also engage in other business activities than payment services, with a national discretion to waive such protection if the amounts involved per client are less than 600 euro; – have internal governance arrangements; – keep records for five year; – only use well set up agents that the supervisor is willing to register as such, and if the service provider uses other legal entities to manage parts or the whole payment service for it under an outsourcing construction, it has to remain in control of any outsourced activities, and it retains liability for employees, agents, branches or outsourced activities; – comply with money laundering rules; – any holders of qualifying holdings have to be suitable; – the directors and managers need to have good repute and have appropriate knowledge and experience. E-money Institutions Several kind of institutions are accepted as e-money issuers, including banks and specialised electronic money institutions. Some provisions apply to all issuers, including banks. To support the declaration that electronic money is identical to cash and not a ‘deposit or other repayable funds’ when an electronic money institution does it, the directive contains a set of obligations for the wider set of electronic money issuers, regardless of whether they are a specialised electronic money institution or not. These amount to an alternative system that provides protection, as meant in the prohibition to attract repayable funds that applies to non-banks; see chapter 5.6. The alternative regime includes39: – an obligation on all issuers to issue electronic money at par value for the ‘normal’ money received; – an obligation that they will repay it at par value too (see chapter 4.4 for the exception for deeming such redeemable funds to be ‘deposits’);

39 See chapter 4.4. Art. 6 and 11 Electronic Money Directive 2009/110/EC.

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EU Banking Supervision

– a prohibition to pay interest on any electronic money issued (which does not appear to protect anyone, except perhaps the issuer of electronic money); – that specialised e-money institutions can grant credit, but if they do so the funds they lend out cannot be based on or taken from the funds that are received in exchange for electronic money (those have to be safeguarded so that the electronic money commitments can be honoured; see below). These provisions, together with the applicable out-of-court complaint and redress procedures copied from the payment services directive40 can also be deemed ‘conduct of business’ provisions, though they may be too low-key for that. For the category of specialised electronic money institutions alone, the directive contains a licensing and prudential regime. The general regime for authorisation has since 2009 been based on the arrangements for payment institutions in the payment services directive. In essence the electronic money institutions has now become a special form (with some limited added protection) of payment institution. By comparison to the banking regime, the prudential regime for electronic money institutions is relatively simple41: – the licensing requirements of payment institutions apply, on a continuous basis42; – initial capital requirement of no less than 350.000 euro (until 2009 no less than 1 million euro), with own funds never to fall below initial capital; – own funds to be equal to or above 2% of the current amount of their financial liabilities related to outstanding electronic money (or the estimated amount thereof) plus the own funds requirement as calculated for payment institutions for all their non-electronic money activities. Based on a pillar 2-like assessment, the own funds requirement can be adjusted by the supervisor by 20% (up or down); – risk management process, risk loss databases and internal control mechanisms (that are the basis of the pillar 2-like assessment); – the entire outstanding float that is related to electronic money has to be invested in secure, low-risk assets; – a prohibition on the provision of services not related to payment services and electronic money (with the payment institutions directive applicable to the payment services); – sound and prudent management administrative and accounting procedures and adequate internal control mechanisms; 40 Art. 13 Electronic Money Directive 2009/110/EC. 41 Art. 3, 4, 5, 6.1, 6.4, 7 and 9 Electronic Money Directive 2009/110/EC. The definitions of initial capital and own funds are based on the RBD definitions, see chapter 7.2. 42 Art 3 Electric Money Directive 2009/110/EC.

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– a variant of the qualifying holding regime of the RBD applies; see chapter 5.2; – if the electronic money institution is part of the group of another regulated entity, double counting of own fund elements has to be prevented; – with the possibility for member states to deviate in full or in parts of this regime by granting broad exemptions, limited waivers and using national discretions43. Anti-Money Laundering Payment service providers and e-money issuers are subject to the anti-money laundering directive and the payer information regulation; see chapter 16.3. In addition, the antimoney laundering directive introduces a limited form of supervision on currency exchange offices, trust and company services providers, casinos, money transmission and remittance offices to be either licensed or registered. At a minimum (the anti-money laundering directive is a minimum harmonisation directive), the persons who effectively direct the business and the beneficial owners of the business should be assessed as to being fit and proper. If they are not, the license or registration has to be refused44. An exemption is available for small scale e-money45 Literature – Usher, J.A. The Law of Money and Financial Services in the European Community, 2nd ed., Oxford University Press, Oxford, 2000 – Penn, Bob, Commission consults on revision of the European electronic money regime, Journal of Financial Regulation and Compliance, vol. 13, no 4, 2005, page 347-355

19.4 Insurers Introduction There are separate directives applicable to prudential supervision on respectively direct non-life insurance, life assurance and reinsurance. Unlike in the banking area, the directives mix provisions on conduct of business/consumer and prudential requirements. The Solvency II directive46 will replace all existing insurance supervision directives in due course (the likely implementation time has continuously shifted backward, see below), and will apply to all types of insurers; containing both the conduct of business and prudential regimes.

43 44 45 46

See e.g. art. 1.3, 3.3, 5.7, 6.1 sub e, and 9 Electronic Money Directive 2009/110/EC. Recital 39 and art. 36 Anti-Money Laundering Directive 2005/60/EC. Art. 11.5 Anti-Money Laundering Directive 2005/60/EC. See art. 9.8 and 19 e-money directive 2009/110/EC. Solvency II Directive 2009/138/EC.

909

EU Banking Supervision The most relevant currently applicable insurance directives47 are: – the consolidated life directive (consolidating four previous directives and the solvency margin directive for life insurers); – the four direct non-life directives, as well as the solvency margin directive of 2002 for non-life insurers; – the re-insurance directive; – the insurance insolvency directive (not applicable to re-insurers). In addition, there are several insurance related directives on specific phenomena and subsectors of insurance, such as credit-insurance, export credit insurance, legal aid insurance, vehicular civil liability insurance, insurance mediation and co-insurance48. Both the licensing process and the instruments of supervisors are similar to those in the banking area. Insurers also benefit from a European passport, but with more limitations for conduct of business or consumer protection reasons. For instance, in the vehicular civil liability branch, the insurer has to nominate a representative in each other member state, in order to help potential injured party living in that member state (in an exception to the cross-border services freedom). Goals Insurance supervision focuses first and foremost on policyholder protection. All other goals are inferior to this. In the Solvency II directive (but applicable also under the current range of directives) financial stability and the single market can be taken into account, but not where this undermines the main objective of policyholder protection49. Financial stability is thus substantially less important than in the banking supervision area. In the banking area it is a dominant goal of supervision, at least at par with the single market and depositor protection, while here it takes the second seat to policyholder protection. This does not mean that financial stability is not relevant for individual insurers or insurance groups. The non-traditional activities of AIG in one of its non-insurance activities, however, caused it to be a risk to financial stability for all its counterparties (many of them banks), and thus of systemic importance; see chapter 18.2. In that case, the protection of individual policyholders may have been safeguarded sufficiently by the focus on solo supervision per 47 Solvency Margin Directives 2002/12/EC and 2002/13/EC, 2005/68/EC on re-insurance, 2001/17/EC on insurance insolvency. 48 Respectively 87/343/EEC on credit-insurance, 84/568/EEC on export credit insurance, 87/344/EEC on legal aid insurance, the Directives 90/618/EEC and 2000/26 on vehicular civil liability insurance, 2002/92/EC on insurance mediation and 78/473/EEC on co-insurance. 49 Recital 16 and art. 27-28 Solvency II Directive 2009/138/EC. Only in 2009 was the mandate of EIOPA/CEIOPS changed to include financial stability. EIOPA/CEIOPS, Lessons Learned From the Crisis (Solvency II and beyond), CEIOPS-SEC-107/08, 19 March 2009, page 6.

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legal entity with an insurance license in the group, but the financial stability goal drove the USA to go beyond that and save the group as a whole instead of only the regulated entities. For licensed individual entities, financial stability is less likely a concern. Failing insurers that focused on traditional insurance tend to have a smaller and thus more manageable impact on the financial system, and a ‘run’ on an insurer can less easily take place under more traditional insurance policies (some innovative insurance products, however, can come close to short term liabilities). Due to the often long term obligations of insurers vis-à-vis their insurance clients, the protection of their policyholders has a larger impact. In the insurance sector there is no equivalent to depositor or investor compensation schemes. No guaranteed minimum pay-out is available such as in the banking sector when the bank fails, see chapter 18.5. This may be because prudential supervision in the banking sector is fixed to a wide range of sometimes contradictory goals. As the interests of savers and those for whom the bank acts as a custodian are covered also by the compensation schemes, it becomes less controversial if their interests suffer in ongoing supervision to the benefit of financial stability considerations. In the insurance sector the requirements under prudential insurance supervision and related bankruptcy laws provide the only tool available those who count on payments under policies by the insurer and assume it to be solid no matter what. This difference in goals leads to differences in the requirements on insurers and the tools available to supervisors, though there are also many similarities. Solo+ Prudential supervision on insurers is based on a solo+ model. Primary supervision is focused on the legal entity, as this is the entity that has to fulfil the obligations under the insurance contract to the policyholder. Unlike in banking, there is no expectation in the insurance sector that group entities will run to the rescue50. The solo supervisor takes into account group wide relevant information if it so desires, but can also leave this to a lead supervisor. The lead supervisor has a coordinating role, but lacks decision making powers in a cross-border context. In addition, the financial conglomerates directive adds supplementary supervision (and a coordinating supervisor) if the group also contains a significant number of banks; see chapter 17.4. A key component of insurance supervision is using the legal firewalls allowed by legal entities to separate liabilities from risk51. This is built into the licensing process, with con50 See e.g. IAIS, Principles on Group-wide Supervision, October 2008, page 3; IAIS, Insurance Concordat, December 1999, page 5-6. 51 Unlike in banking, an insurer has to be set up in a specific legal form in order to be able to be granted a license; see art. 17 and Annex III Solvency II Directive 2009/138/EC. Also see chapter 4.4 and 5.2. The annex contains a list of legal forms, including the European company, that specifies formats per country that mostly

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tinuing obligations to engage only in specific types of (insurance) business only per holder of an individual license. Though the group to which license holders belong can as a whole be involved in all types of life, non-life and re-insurance, per legal entity it can only engage in a subset of direct insurance writing activities, combined only with certain ancillary insurance activities that are closely linked to their main line of insurance business. The various insurance directives force groups to have separate legal entities for life and nonlife business. Both main areas of direct insurance are subsequently subdivided into branches, such as fire, cars, or liability. Some of these branches can be combined within one legal entity, some cannot. Insurers are thus expected to focus per legal entity or per mutual association on their specific area of insurance, and to have a very limited set of other activities only within each licensed legal entity52. The main differences of the current insurance directives with the banking rules lie in the requirements on financial buffers. In addition to requirements that are similar to the solvency requirements for banks, they are required to maintain assets that are set aside for honouring the insurance liabilities of the legal entity. Each insurer has to have: – a minimum guarantee fund (that have to be maintained throughout the life of the insurer). These initial own funds has to be at least 2 or 3 million euro (depending on the type of insurance business), and – if that results in a higher requirement – 1/3rd of the solvency margin; – a solvency margin on the relation between liabilities and own funds. This financial buffer requirement is ‘risk’-based only to the extremely limited extent that the size of the requirement is related to the volume of liabilities. Similar to the solvency ratio for banks it is geared towards the solidity of the institution. It has to be covered by assets minus foreseeable liabilities. This comprises equity, reserves and profit/loss, as well as preferential shares and some types of subordinated loans; – an obligation to maintain technical provisions for its liabilities, covered by matching assets. The likely liabilities to policyholders are calculated, a risk margin is added to cover underestimations of potential claims, and then the insurer has to hold certain types of allowed assets to cover the total of these ‘technical provisions’ (i.e. estimated foreseeable liabilities including risk buffer) that during the life of the insurer serve to ensure that the insurer is able to honour its liabilities under the insurance policies. For risks situated within the EU the assets have to be maintained within the EU.

focus on mutual associations or public limited companies. This approach is in line with work by the international association of insurance supervisors (IAIS, the sister committee to the BCBS) that advises to define the permitted types of legal form, requiring them to provide stability to the company and the creation of own funds. IAIS Supervisory Standard on Licensing, 1998/2007, www.iaisweb.org. 52 Art. 15-17 and Annex I-III Solvency II Directive 2009/138/EC.

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The technical provisions are arguably the main differences between insurance regulation on the one hand and banking and securities regulation on the other53. There is no equivalent to the estimation of future liabilities (nor to covering them by actual assets, instead of capital). In and of itself that calculation adds value. However, the actual protection they offer when the insurer should nevertheless fail is different depending on a national option in the insurers winding up directive54. The regime providing most protection to policyholders is where the member state opts to give insurance claims absolute precedence over all other claims on all assets that belong to the technical provisions (and equal claim over other assets). If technical provisions have been calculated correctly and conservatively, as required, the policyholders should be protected against most causes of failure at banks (except if the cause is an unpredictable large amount of claims). This gives supervisors/liquidators manoeuvring room to for instance, sell the insurance portfolio indeed with all the associated technical provision-assets, even if other financial buffers have been largely run down, or could be run down when e.g. wages, taxes, suppliers or dividends would be paid. The second option is to give insurance claims a high ranking claim on all assets instead of ‘only’ on technical provision assets, but in that case allow four notoriously large other claimants to be given preference to even that high ranking claim. It concerns tax, social security, employees and security rights on assets (e.g. pledges or mortgages). These can quite easily empty the coffers of any failing company. To ameliorate this discrepancy (slightly), insurance companies also have to cover any claims that may have precedence also by assets that can cover technical provisions. A reduction in the technical provision requirements can be achieved by re-insuring part of the insurance policies the insurer has written. The re-insurance55directive was introduced only in 2005. Re-insurers can re-insure both life and non-life business. Re-insurance had long been ignored (except if it was one of the activities of a direct non-life insurer and in the context of group supervision, see below) as it is a pure professional to professional business. As a failure of a re-insurer can, however, have direct consequences for the viability of direct insurers that make use of the re-insurer, a limited form of prudential supervision was introduced at the EU level. The regime for the specialised re-insurers is derived mostly from the non-life insurance requirements. Re-insurers have to maintain a solvency margin similar to such non-life insurance requirements, applied to the re-insured life and/or non-life business. In addition, if they insure both life and non-life, they have to add up those two calculations. Separately, they 53 Joint Forum, Review of the Differentiated Nature and Scope of Financial Regulation, January 2010, www.bis.org, page 5. 54 Recital 15-17, art. 10 and 12 Directive on the Reorganisation and Winding up of Insurance Undertakings, 2001/17/EC. 55 Re-insurance Directive 2005/68/EC.

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also need to maintain at least 3 million euro as a guarantee fund (with exceptions for certain types of re-insurers). Though non-discrimination for re-insurers on the basis of their nationality56 had already been introduced in 1964, the re-insurance directive introduced a European passport (without the need of a notification for this professional market) if they have a license in another member state. The insurance group supervision directive57 introduced a form of group supervision on top of the existing solo-supervision, and constitutes the + in the solo+ approach. CEIOPS/EIOPA has formulated guidance on how the coordination committees for groups with insurers in several member states could function. In addition, its members signed the revised Siena protocol on coordination of supervision. The lead supervisor has a limited role only, mainly consisting of collecting information, making assessments and coordinating actions, in all cases fully dependent on the voluntary cooperation of the other supervisors in the committee if it sees the need for corrective actions. The group wide supervision focuses on all the insurers in the group, and gathers consolidated information on the group mainly with the view of identifying risks to the individual licensed and supervised insurers. EIOPA has been active in the stimulation of colleges of supervisors, and has published action plans and stress tests that intend to force/stimulate supervisors to work together if the insurers they supervise are part of the same group58. This work of EIOPA to some extent anticipates the new regime under the Solvency II directive by recommending actions and calculation methods that will become binding when the Solvency II regime does; see below. Supervision Instruments In addition to the types of measures also seen in the CRD (see chapter 20), supervisors are allowed – and sometimes obliged – to apply a set of very specific measures. These force the insurer to make plans to shore up its financial buffers, and to execute those plans when they are agreed with the supervisor. The name of the plan indicates whether the insurer is still in line with some or all of the financial buffers requirements when the measure is

56 Directive 64/225/EEC on the abolition of restrictions on freedom of establishment and freedom to provide services in respect of reinsurance and retrocession. 57 Directive 1998/78/EC on the supplementary supervision of insurance undertakings in an insurance group. The IAIS, the worldwide association of insurance supervisors, introduced consolidated supervision in its core principles only in 2003. Before that, the only consolidation of insurance groups was either via accountancy, or via banks that were part of insurance groups. Also see IAIS work on cross-border cooperation and on group-wide cooperation: IAIS, Principles on Group-wide Supervision, October 2008; IAIS, Insurance Concordat, December 1999. 58 EIOPA, Press Release on the second European insurance stress test, 4 July 2011. EIOPA, Report on the Functioning of Colleges and the Accomplishments of the 2011 Action Plan, 2 February 2012, and EIOPA, Action plan for Colleges 2012, 1 January 2012. www.eiopa.europa.eu.

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taken59: The obligation to draft a plan can be combined with limitations on the free disposal of assets, and with authorisation to transfer all policies to another insurer (with effect on the insured). The home supervisor can of course also, if all else has failed, withdraw the license and take measures to protect policyholders (including the opening of reorganisation or winding up procedures). The supervisor can – depending on which prudential requirements are no longer complied with to which extent – require the insurer to draw up a: – restoration plan; – short term finance scheme; – financial recovery plan60. Exposures of Banks to Insurers There are specific rules on exposures of banks to insurers. Deduction of any participation61 (note: not qualified holdings only, but any shareholding) in insurers from own funds, both on a solo and a consolidated level. There are, however exemptions possible as a national discretion (which will become standard under the CRD IV project; see chapter 2, 6.2 and 7): – if the insurers can be fully consolidated, and there is integrated management and internal control, a member state can allow such holdings instead to be included in the annual accounts under the methodologies allowed in the financial conglomerates directive; and – if the insurer is consolidated or under supplementary supervision under the financial conglomerates directive, a member state can also allow their banks not to deduct the mentioned exposures insurers when supervising on a solo basis. In a related matter, both in the large exposures regime (that covers all types of exposures) and the specific regime for qualified holdings outside the financial sector, there are national discretions to allow member states to determine that insurers are deemed to be inside the financial sector62. This is not the main rule, but for member states that stimulate financial conglomerates to be formed, using this discretion is essential to allow qualified holdings in subsidiaries, and for financing purposes also to allow other types of exposures to any

59 Art. 16, 20, 20a and 22 First Non-Life Directive 1973/239/EEC, art. 37 and 38 Consolidated Life Directive 2002/83/EC and art. 42 and 43 Reinsurance Directive 2005/68/EC. Also see chapter 6 of the Sienna protocol. 60 These partially overlap with the Commission Proposals for a recovery and resolution directive for banks; see chapter 18.3. The Commission is consulting on whether to expand some aspect of that directive in turn to other financial institutions, such as insurers, in as far as those are not already part of the current insurance directives. 61 Art. 57 sub o and p, 59, and 60 RBD; Annex I to the Financial Conglomerates Directive, 2002/87/EC. On operational risk, Annex X, part 1 §8 RBD. 62 Art. 113.3 and 122 RBD.

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related insurer (parent, subsidiaries, or subsidiaries of its parent). Those rules would otherwise be transgressed by such exposures to insurers that are group-entities of the bank. The income derived from insurance is left outside of the scope of the ‘indicator’ (i.e. the average income over the last three years) used to calculate operational risk requirements in the basic indicator approach to operational risk. For the supplementary supervisory rules and additional requirements on financial conglomerates, see chapter 17.4, and for supervisory cooperation, chapter 21.2 and 21.7. In addition, there are specific arrangements for the effect of insurance on the financial buffer requirements for both operational risk and credit risk exposures of banks to ‘protect’ against some of the unexpected losses that would otherwise need to be covered by financial buffers. Insurance can be deemed to bring down the value of the exposure as a risk mitigant (and thus the amount of exposure for which capital needs to be held)63. For insured exposures or insured operational risks, the exposure can be reduced amongst others by pledged life assurances, and insurance taken out against certain operational risks (such as fire, liability or fraud) can reduce the capital requirement. It is considered a risk transfer mechanism, and can be recognised if a noticeable risk mitigating effect is achieved. The insurer that provides the protection must be authorised to provide insurance, and has to be rated itself with a high rating (when it has to pay out under a claim, it needs to be able to fulfil its obligation). For the extent and further conditions under which insurance policies are recognised as risk mitigants, also see chapter 8.5 and 10.5. Solvency II (from 1 November 2012/1 January 2013/1 January 2014?) All insurance supervision related directives have been consolidated into one new directive; the so-called Solvency II directive. Part of the existing directives will be replaced by the intended subsidiary legislation at level 2. The requirements have been modernised and further harmonised in the process of consolidating them into the Solvency II directive. The level 1 legislation was issued in 2009 during the 2007-2013 subprime crisis. The level 1 text received some nips and tucks to accommodate some of the initial lessons learned from the crisis, but the majority of the impact will be felt in the likely more strict level 2 and 3 work in areas such as the calibration of the capital requirements, (internal) governance and supervisory cooperation64. The Commission and CEIOPS are still working on the level

63 For operational risk, Annex X, part 1 §8, part 3 §25-29 and recital 45 RBD, for credit risk mitigation, Annex VIII, part 1 §24, part 2 §13, and part 3 §80 on (pledged) life assurance policies, and part 1 §29 on insurance in general. Any actual claim arising on an insurer to pay out under an insurance claim would subsequently need to be risk weighted itself under the credit risk requirements. 64 EIOPA/CEIOPS, Lessons Learned From the Crisis (Solvency II and beyond), CEIOPS-SEC-107/08, 19 March 2009.

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2 legislation and on level 3 guidelines and standards. A series of quantitative impact studies was part of the project. Overall, EIOPA appear happy with the overall level of capital, but revisions in targeted area are continuing in response to the quantitative impact studies and due to comments and lobbying by the insurers65. The focus on technical provisions will be replaced by a dual focus on solvency and technical provisions. Technical provisions are expected to cover all expected obligations (i.e. commitments towards policyholders). These remain key, but are nonetheless expected to go down as they no longer need to cover unexpected losses and uncertainty to the same extent. Instead, the old and simple solvency margin will be replaced by a two-step solvency regime, with a large focus on risk management. The new solvency regime is intended to be enough to cover with unexpected loss with a time horizon of one year (similar to banking). The general concept of solvency has been copied from the banking (as it was prior to the 20072013 subprime crisis) but with improvements, rationalisations, and some plain deviations. Instead of the layers of solvency ratios in the Basel III/CRD IV project, it has two layers: a minimum capital requirement (that is a minimum threshold) and a more flexible higher solvency capital requirement. It will have three tiers of capital to cover the solvency requirements. These tiers are not harmonised with banking rules. Technical provisions will retain their role as the calculation of the amount another insurer or reinsurer would likely require in order to take over (and honour) the insurance obligations of the supervised insurer. It will remain to be calculated as a best estimate plus a risk margin (though as stated above the amount is expected to go down in a more risk-based and principle-based regime). The new solvency requirement comes on top of that, providing additional warning signals of when an insurer enters into problems, at a time when there is still enough value in the company to cover current and future likely claims. Some of the risk categories for which capital is required are identical to those in banking (market risk and operational risk), some are less important here than in banking (counterparty default risk is related to credit risk, but in no way as relevant for insurers as in banking). A new category is underwriting risk (differently calculated for the life, health, or non-life sector). The quantitative calculations can be based on a much fuller than in the banking sector reliance on internal models. Banks are allowed to calculate only specific inputs into a prescribed model-architecture (see chapter 6.3). Solvency II envisages the gradual development of a ‘full’ internal model for the calculation of the solvency capital requirements for insurers. CEIOPS/EIOPA considers them the cornerstone of the risk oriented system. This reliance is tempered by the above-mentioned continued reliance on technical provisions, 65 See EIOPA, Report on the Fifth Quantitative Impact Study (QIS5) for Solvency II, 14 March 2011.

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but also by an envisaged strict application of the use-test, building on lessons learned in the 2007-2013 subprime crisis66. The Solvency II package is also supplemented by a pillar 2 instrument. Solvency II is more explicit than the current CRD on what to do if an insurer has dipped into its buffering capital, but has not yet gone below the minimum buffers, and different from automatic the dividend and bonus retention obligations of the CRD IV project additional buffers discussed in chapter 2, 6.2 and 7. The supervisor can give different time periods to rebuild capital. These can be targeted to also take into account the economic cycle and the availability of outside capital. Insurers are less susceptible to immediate market pressures (no possibility to withdraw funds at short notice, like deposits) and often medium to long term insurance contracts, with penalties for the insured party if they try to skip out of their commitments. In addition to conduct of business and prudential provisions, the Solvency II directive also contain the provisions of the current directive on reorganisation and winding up of insurance undertakings67. The equivalent banking winding up directive has been left outside of the current CRD and outside of the CRD IV project. Solvency II originally envisaged implementation by the member states by 1 November 2012. This date was abandoned as necessary interim steps had not yet been taken. For instance the drafts for the level 2 regulations/directives had not yet been published. Such level 2 binding rules will fill in the high level rules that have already been agreed, and will determine the exact requirements and the financial and administrative burden on the insurers and the supervisors. Negotiations and drafting is still ongoing, even though this is severely hampered by legal uncertainty. When EIOPA replaced CEIOPS, apparently especially the insurance/pensions unit within the Commission was less than pleased. The Omnibus I directive contained no provisions to install technical standards into the currently applicable insurance directives at all, and left Solvency II aside to be dealt with at a later date68. On pensions, it contained implementing technical standards (i.e. formats and procedures, not content) and no regulatory standards. The Commission proposals on Omnibus II contained its thinking on Solvency II and on the prospectus directive. Where the prospectus directive would be embellished with powers for ESMA, the Solvency II directive would contain not one example of regulatory standards allocated to EIOPA, limiting it to 66 EIOPA/CEIOPS, Lessons Learned From the Crisis (Solvency II and beyond), CEIOPS-SEC-107/08, 19 March 2009, page 16-18. 67 Winding up of Insurance Undertakings Directive 2001/17/EC, the equivalent of the Banking Winding up Directive 2001/24/EC; see chapter 18.6. 68 Omnibus I Directive 2010/78/EU; see chapter 2, 21.4 and 23.3.

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forms and formats it could propose as implementing standards69. This deviates rather dramatically from the treatment of EBA and ESMA in the Omnibus I directive, without any clear theoretical reason. On issues where regulatory standards could have been proposed, the Commission has instead proposed the traditional delegation to the Commission. This type of delegation is used also in the policy areas of EBA and ESMA, but only on – assumedly – key issues. Another controversial part of the Omnibus II proposals on Solvency II was the introduction of the results of a fifth quantitative impact study70. Both the Commission and EIOPA have publicly stated that this study reassured them that Solvency II could be implemented, but that some changes would need to be made to reduce complexity (e.g. on the calculation of the risk margin part of the technical provisions) and to introduce a transition regime. The debate on exactly which changes should be made to take on board events since the Solvency II directive was agreed in 2009 and the results of the quantitative impact study is still ongoing between the Commission, Parliament and the Council. The Omnibus II proposals indicated that a new date of application was to be 1 January 2013,71. Pending the disagreement on Omnibus II, this was overtaken by the facts. A special directive was used to delay the implementation date to 30 June 2013 for the member states and the date of application to 1 January 201472. EIOPA has indicated that the delay in the approval of the Omnibus II proposals puts in doubt its working assumptions that the regime will enter into force in 201473. Nevertheless, its members are working to prepare the colleges and insurers, amongst others by starting a pre-application process for model approvals, and published guidelines on some preparatory issues such as the necessary internal models in March 201374. Please note that the review of the financial conglomerates directive and the amendments to the financial conglomerates regime and the banking group regime for consolidated

69 See art. 1 respectively 2 of the Omnibus II Directive Proposal of the Commission of 19 January 2011, COM(2011) 8 final; where art. 1 bestows such powers upon ESMA, and art. 2 does not do so for EIOPA. Also see the text on page 4; which apparently was more heartfelt by the Insurance Unit of the Commission. 70 EIOPA, Report on the Fifth Quantitative Impact Study (QIS5) for Solvency II, 14 March 2011. 71 Art. 2.72-2.74, 3 and 4 of the Omnibus II Directive Proposal of the Commission of 19 January 2011, COM(2011) 8 final, amending art. 309-311 of Solvency II Directive 2009/138/EC. 72 Directive 2012/23/EU of 12 September 2012 amending Solvency II on the date for its transposition and its application, and the date of repeal of certain directives. 73 EIOPA Chair, Implementation of Solvency II, 31 January 2012; EIOPA, Opinion on interim measures regarding Solvency II, EIOPA-12-388, 20 December 2012. 74 EIOPA, Action Plan For Colleges 2012, 16 January 2012, EIOPA, Opinion on interim measures regarding Solvency II, EIOPA-12-388, 20 December 2012; and guidelines on governance, information provision, preapplication for internal models and the assessment of the own risk of insurers as published in March 2013 on www.eiopa.europa.eu.

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supervision similarly impact the insurance group supervision directive and the Solvency II directive75. Future Developments Apart from the work on Solvency II, the Commission has announced its intention to introduce an insurance compensation system along the lines of deposit guarantee and investor compensation systems76. A consultation started in 2010. Whether it will be introduced, or indeed is necessary, in light of the better position of policyholders on technical provision assets, the unlikelihood of a ‘run’ on insurers, and the lesser profile of insurers re financial stability remains to be seen. The FSB and IAIS have been working on global systemically important insurers, and on their resolvability. The latest papers were published in July 2013, after the closing of this book. In a first identification, nine groups were identified as globally systemically important insurance groups, including several European headquartered groups. Alongside systemic indicators similar to those used in banking (size, interconnectedness; see chapter 18.2), the amount of non-traditional or non-insurance activities undertaken was deemed relevant77. It is not yet clear whether and how this worldwide level work will be incorporated into or added to the Solvency II plans. The FSB proposes a timeline starting immediately on preparatory work and harmonisation of baseline or backstop requirements on insurance groups (with yet to be determined content and scope), and imposing additional loss absorbing measures on the systemic groups in 2019. The type of single supervisory mechanism that has been proposed by the Commission in the context of a future banking union cannot be easily expanded to insurers. The EU treaty provision that has been used for banking does not allow allocation to the ECB of insurance supervision. However, the Commission has tried to expand it to insurers both via financial conglomerates supervision (regardless of whether the parent of the conglomerate is a bank or an insurer) and via consolidated supervision (the CRD IV project no longer would lead to a full deduction of the insurance subsidiaries from the quantitative calculations). Such proposals do not appear to be compliant with the TFEU. Also see chapter 22.5 for similar concerns on the role of the ECB in the ESRB, with its mandate that also looks at insurers.

75 Art. 1 and 4 FCD II Directive 2011/89/EU amend the Insurance Group Supervision Directive 1998/87/EC and 2009/138/EC. See chapter 17. 76 Commission, White Paper on Insurance Guarantee Schemes, 12 July 2010, COM(2010) 370. 77 FSB, Global Systemically Important Insurers (G-SIIs) and the Policy Measures That Will Apply To Them, 18 July 2013; IAIS, Globally Systemically Important Insurers: Initial Assessment Methodology, 18 July 2013 ; IAIS, Global Systemically Important Insurers: Policy Measures, 18 July 2013.

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Literature – Empel, Martijn van (ed), Financial Services in Europe: An Introductory Overview, Kluwer Law International, Alphen aan den Rijn, 2008, page 25-62 – Das, Udaibir S.; Davies, Nigel; Podpiera, Richard, Insurance and Issues in Financial Soundness, IMF WP/03/138, 2003 – Boshuizen, G.R.; Jager, B.H., Verzekerd van toezicht, Kluwer juridisch, 2010 (Dutch) – CEIOPS-EIOPA, Lessons learned from the crisis (Solvency II and beyond), 19 March 2009

19.5 Collective Investment (UCITS/AIFM/Pension Funds) Introduction Harmonising the prudential regimes for collective investment institutions, their managers and custodians has long been a limited goal of the EU. Apart from the segment of the market that falls within the scope of the previous UCITS directive and the low key pension fund directive, until recently most collective investment institutions were covered only indirectly under EU legislation. The UCITS IV directive did manage to expand its attractiveness for not yet regulated funds, pulling in many hedge funds to start offer compliant investment opportunities. During the 2007-2013 subprime crisis the Commission managed to build a consensus, however, to regulate alternative investment collective vehicles, under the new AIFM directive that will enter into force mid 2013; see chapter 16. The AIFM covers many hedge funds and closed end investment funds that were previously left to national discretions (and may have been left unregulated). In the conduct of business area, regulated collective investment undertakings – except pension funds – are subject to market disclosure requirements under a full or simplified prospectus, or at the least publish the core relevant information if no capital is attracted from the public (see chapter 16.2 and 16.5). Prudential requirements on banks, insurers, payment institutions and investment funds focus on the entity that is the provider of the service, the counterparty of the client. In most collective investment undertakings those functions are split. The provider of the service is the manager (management company) of the undertaking that issues the financial instrument in which investors invest (the collective investment undertaking). The requirement to have financial buffers is laid on those operators of collective investment institutions in the UCITS directive and AIFM directive, not on the fund itself. The Joint Forum was clearly divided on the issue of putting capital requirements on management

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EU Banking Supervision companies78. Though the need for an internal governance requirement for prudential purposes is clear (as an operator manages large amounts of money on behalf of others) this is not the case for capital requirements on the operator (as it is not the debtor if there is a separate investment vehicle). The arguments for inviting this external manager to have financial buffers are not very strong, and the requirement has been set low. It refers to a limited amount of capital to cover legal, reputational and compliance risks, and then only for a fund operator that has ex ante been deemed systemic due to e.g. the amount of assets it controls or its interconnectedness. As the operator is normally not the fund (on which investors have a claim) most clients would probably not care about whether the operator goes bankrupt or whether he has a little money to cover – at most a small part of – any claims for mismanagement. As long as the fund has a backup system to cover an operator falling away (for example by giving the supervisor or a trustee the power to nominate a new operator), the operator’s capital position is just not relevant, except if it explicitly or implicitly guarantees the fund. Anyone believing that an implicit guarantee by an unregulated financial institution is worth something if they have not done an in-depth investigation perhaps should not be allowed in the financial markets in any case. Implicit or explicit guarantees may be provided by regulated entities that manage funds, e.g. if the operator is a bank. In the prudential area, the fund, sometimes its managers and definitely its custodians can already be directly supervised if they are also banks or investment firms or fall within the scope of consolidated supervision of banks, investment firms, insurers, or financial conglomerates79. For explicit guarantees, banks are required to hold capital, for implicit guarantees they should be (in line with the amendments to the securitisation regime; chapter 8.6) but are not. In addition, any of these (managers of) funds may be subject to conduct of business rules such as the prospectus directive or the market abuse directive, if and in as far as they operate within the scope of such legislation; see chapter 16. If a collective investment institutions for instance trades in financial instruments that are admitted to a regulated market, the insider trading rules of the market abuse directive apply. At the national level, additional (prudential) regimes may be in place for either the manager or the institution. Unlike the operators, the funds themselves (the pool of assets in which investors bought a share) are generally not subject to capital requirements. The thinking is that investors do not need capital protection, as they are properly informed about the risks or should otherwise be aware of the risks as a result of the information provided to them under 78 Joint Forum, Review of the Differentiated Nature and Scope of Financial Regulation, January 2010, www.bis.org. 79 See art. 30 and 30a of the Financial Conglomerates Directive 2002/87/EC, as amended by FCD II Directive 2011/89/EU.

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conduct of business requirements; see chapter 16.5. If they lose all their money (if they invested for instance in shares of a failed bank or commercial company) as a result of bad but disclosed risks materialising is part of the possibilities in investing and the directive legislators accepts this risk both for them personally and for society. For retail funds, the types of risks they are allowed to take have nonetheless been limited for UCITS and for pension funds (but even a small risk can materialise and wipe out all or part of the assets of such collective investment undertakings). Collective investment undertakings can be differentiated into several categories: – pension funds of multiple persons (e.g. occupational pensions); – regulated collective investment vehicles such as UCITS that are regulated to be ‘safe’ investments for retail clients (see below); – collective investment vehicles that fall within the definition of a ‘bank’ or an investment firm, and do not (choose to) make use of available exemptions/definition limitations such as not attracting funds from the public; – collective investment vehicles that make use of exemptions (or fall outside the scope of definitions) of the CRD, Mifid, and UCITS directives80. Such exempted vehicles at the EU level, may potentially be prudentially regulated in some member states (as goldplating or as filling in an – until the AIFM enters into force – unregulated area at the EU level). Such funds include most private equity funds and hedge funds. – If private equity funds and hedge funds are complex or exceed a certain size, their managers will likely fall within the scope of the so-called alternative investments funds managers directive (AIFMD) from 22 July 2013. Smaller funds can opt into the regime to gain a European passport, or may gain such a passport under the regimes proposed for venture capital funds and for social entrepreneurship funds by the Commission in December 2011 (see below). UCITS Undertakings for collective investment in transferable securities can opt to become the subject of the UCITS directive81 and its supporting level 2 Commission directives and regulations82. To do so, they have to fulfil the various components of the definition,

80 P. Athanassiou, Hedge Fund Regulation in the European Union, Current Trends and Future Prospects, Alphen aan den Rijn, 2009, chapter 1 and 3. 81 Undertakings for Collective Investment in Transferable Securities 2009/65/EC, as applicable since 1 July 2011. This directive is sometimes referred to as UCITS IV, as it is the fourth major revision of the EU legislation in this area (and replaced the revised directive 85/611/EEC). It is a minimum harmonisation directive (see its art. 1.7). 82 Commission Regulation 583/2010 on key investor information, Commission Regulation 584/2010 on supervisory communication, Commission Directive 2010/42/EU on fund merges and master-feeder structures, Commission Directive 2010/43 on internal governance.

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including wanting to attract funds from the public. In return for being allowed to attract such funds, they have to fulfil a wide range of conduct of business requirements, mostly dealing with disclosure, liability of the management company and depositary (the holder of the assets), and being open-ended so that investors can reasonably easily exchange the investment unit into cash, against the current liquid value of that investment; see chapter 16.2. Apart from the limitations to their riskiness that follow from their basic business model and such conduct of business rules, there are also some prudential requirements on the management company. These aim to ensure its continued ability to perform this service in a trustworthy and stable manner (and help it bear its liability vis-à-vis the investors), and to strengthen the structuring of the fund. The depository, who like the manager needs to be stable and able to safeguard the assets of the fund – and is equally liable to investors if it fails to keep the assets safe or to check up on the management company – is also subject to some prudential requirements. The depository has a duty to safeguard all the assets in which the fund invests on behalf of the investors. It has to be a separate entity to segregate ownership on behalf of the investors. The depository83: – has to be an entity that is prudentially supervised already, such as a bank or an investment firm; – to which all assets are entrusted for safe-keeping; – has to have directors that are of sufficiently good repute and have sufficient experience in relation to the type of UCITS; – is able to ensure a range of services as well as compliance with the fund rules and laws. A UCITS management company has to be a specialised entity (i.e. it cannot be combined with a bank or investment firm or other activities in the same legal entity). The management company has to fulfil the following prudential requirements84: – it should be solvent in the sense of having both (continued) initial capital and additional own funds (possibly in part fulfilled by guarantees or liability insurance). The initial capital has to be at least 125.000 euro, plus additional own funds if the assets it manages exceed 250 million euro of 0.02% of that excess up to an additional amount of 10 million euro, of which half can be provided in the form of a guarantee of a bank or insurer. This amount can never be less than one quarter of the fixed overheads of the company of the preceding year (or – lacking such a preceding year – as budgeted in the business plan);

83 Art. 5.4 and 22-23, 32-33 UCITS Directive 2009/65/EC. 84 Recital 8-10, 25, art. 6-8, 10-13 UCITS Directive 2009/65/EC and art. 21 RCAD.

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– it has to have two managers who are of sufficiently good repute and have sufficient experience in relation to the type of UCITS, so as to guarantee internal overview; – it has to have internal control mechanisms; – it has to have suitable shareholders or members (direct or indirect), and the Mifidqualifying holding regime applies; – it has sound internal governance; – if it delegates investment management, the delegate has to be licensed for asset management and be subject to prudential supervision (e.g. a bank). An authorised management company is allowed to perform this service for multiple UCITS, as well as for other collective investment undertakings. If the fund is a legal entity, and does not have an external management company, it will need to fulfil similar requirements itself (the fund is also the management company in this case). In that case, it is only allowed to manage itself, not also other funds85. The fund (either a non-legal entity; a so-called common fund) or a legal entity (a so-called investment company), has to fulfil the following prudential requirements86: – it has to avoid excessive concentration to a specific counterparty or to a group of counterparties (with a similar rationale as the large exposures regime for banks); – if it wants to merge with another UCITS, it has to follow a merger and acquisition procedure that protects the financial interests of its investors; – it is limited in the types of assets it can invest in, and has to engage in spreading risks; – the rules for the valuation of assets (and for calculating the price of investment units) have to be laid down in the law, fund rules or in the instruments of incorporation. Non-UCITS – Alternative Investment Funds Until 2011, there was no regulation at the EU level for investment funds that were not UCITS (or banks or investment firms or occupational pension funds). After the LTCM near-default in September 1998, the BCBS had looked at the need to regulate (leveraged) hedge funds87. The BCBS gave guidance on how banks should risk manage such exposures in such funds they had on their balance sheet. Leveraged funds not only attract capital from investors, but also leverage that capital via an ability to attract loans, which increases the amount they can invest on behalf of the capital investors. This increases the risk and the potential reward for the investors (as the lenders get a fixed interest, while any larger 85 Art. 28-31 UCITS Directive 2009/65/EC. 86 Recital 25, 42, 27-33, 35-49, art. 1.2, 37-48, 49-57 and 85 UCITS Directive 2009/65/EC. Art. 58-67 contain specific rules on master-feeder structures, where some of the investment rules are relaxed but other conditions apply. 87 BCBS, Banks’ interactions with highly leveraged institutions, January 1999.

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upside in the value of the assets of the fund is for the equity investors), but also the potential losses (as lenders will be repaid in full before any equity distribution is made, which is relevant if there are losses in the investments of the fund). Such leveraged funds are deemed a risk to individual banks and possibly to the financial system. The BCBS report carefully skirted clear of a recommendation on regulating hedge funds. That was deemed out of scope for the BCBS, and in need of both more data and a political initiative. In the 2007-2013 subprime crisis the behaviour of unregulated investment funds was generally not considered to be propagated through this part of the shadow banking sector. However, it did lead to the political initiative requested by the BCBS. The regulation of especially hedge funds was suddenly identified as one of the priorities to prevent a future crisis from starting in this area. In the EU this lead to the development of the alternative investment fund managers directive or ‘AIFM’ directive, as well as the ongoing work on the shadow banking sector by the FSB and the Commission88. It contains a regime for all managers and depositories of all relevant non-UCITS funds, including their conduct of business requirements, liability and prudential requirements. It also includes added – financial stability based – rules for leveraged funds. Such funds borrow money – or employ trading techniques – in addition to raising capital so as to multiply the potential profit for investors, with the unavoidable equal multiplication of potential losses for investors (and lenders)89. In line with its financial stability goal, it applies to any fund that attracts investment capital from anyone, regardless of their wholesale or retail status. For retail funds, additional rules are a national discretion. The depository90: – has to be an entity that is prudentially supervised already, such as a bank or an investment firm, unless the fund is closed (no redemption rights) for at least five years, in which case the depository can also be someone who is subject to mandatory professional registration or to legal/regulatory/ professional conduct standards, with sufficient financial and professional guarantees to do its depository job; – to which all assets are entrusted for safe-keeping; – it has to be based in the same country as the fund, and cannot be its prime broker; – unlike in UCITS, there is no requirement to have directors that are of sufficiently good repute and have sufficient experience in relation to the type of AIFM;

88 Alternative Investment Fund Managers Directive 2011/61/EU. For the shadow banking work, see chapter 2 and 4.4; and R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 4.4. 89 See, for instance, recital 49-51 and art. 23-25 AIFM Directive 2011/61/EU. P. Athanassiou, Hedge Fund Regulation in the European Union, Current Trends and Future Prospects, Alphen aan den Rijn, 2009, chapter 2. 90 Recital 34-36, 39-43, art. 4 sub g, 21AIFM Directive 2011/61/EU.

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– it has to be able to ensure a range of services as well as compliance with the fund rules and laws. An AIFM management company has to be a specialised entity (i.e. it cannot be combined with a bank or investment firm or other activities in the same legal entity). The management company has to fulfil the following prudential requirements91: – it should be solvent in the sense of having both (continued) initial capital and additional own funds (and e.g. guarantees or liability insurance). The initial capital has to be at least 125.000 euro, plus additional own funds if the assets it manages exceed 250 million euro of 0.02% of that excess up to an additional amount of 10 million euro, of which half can be provided in the form of a guarantee of a bank or insurer. This amount can never be less than one quarter of the fixed overheads of the company of the preceding year (or – lacking such a preceding year – as budgeted in the business plan); – in addition, the management company has to have liability insurance or additional own funds to cover for liability risks arising from negligence (a provision absent in the UCITS directive); – the own funds have to be invested in liquid non-speculative assets (a provision absent in the UCITS directive); – it has to have managers who are of sufficiently good repute and have sufficient experience in relation to the type of alternative investment funds it manages (the UCITS directive requires at least two managers); – it has to have suitable shareholders or members (direct or indirect). Unlike for UCITS managers, the Mifid-qualifying holding regime does not apply; – it has sound internal governance, including procedures, and regimes on remuneration and conflicts of interests, risk management, and liquidity management; – if it delegates investment management, the delegate has to be licensed for asset management and subject to prudential supervision (e.g. a bank); – if the fund manager employs leverage at the level of the fund, the manager has to disclose information, as well as provide it to supervisors. It has to show that the leverage limits are reasonable, and may be subject to restraints on the level of leverage on an individual basis. An authorised management company is allowed to perform this service for multiple alternative investment funds, as well as for other collective investment undertakings. If the fund is a legal entity, and does not have an external management company, it will need

91 Recital 49-51, art. 4 sub s, v and ad, 4.3, 6-20 AIFM Directive 2011/61/EU and art. 21 RCAD.

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to fulfil similar requirements itself. In that case, it is only allowed to manage itself, not also other funds92. The fund (either a non-legal entity; a so-called common fund) or a legal entity (a so-called investment company), is not subject to prudential requirements, except that the rules for the valuation of assets (and for calculating the price of investment units) have to be laid down in the law, fund rules or in the instruments of incorporation93. Small alternative investment fund managers are exempted from the rules contained in the directive (as are the funds and potential depositories used by them for their funds). They are, however, required to be registered in their home country. They do not benefit from a European passport. The member state can institute a similar regime for them, and the manager has the option to apply the directive in spite of the exemption, if it wants to gain the European passport94. Two regulations were rushed through that cover some of the smaller alternative investment fund types that are excluded from the AIFM directive. The venture capital fund regulation and the social investment fund regulation provide a light touch regime for these specialised fund that should dominantly aim respectively at providing start-up capital for undertakings and funding to socially relevant projects95. Both apply from 22 July 2013, similar to the AIFM directive. If a fund does not want to restrict itself to the requirements of these regulations, it can opt into the regime of the AIFM directive. Pension Funds Pensions can be arranged in several ways. Examples are: – individual pension fund arrangements (usually in a trust or special purpose vehicle); – individual savings and investments, possibly segregated in a separate legal entity, possibly in house, possibly entrusted to a bank; – life insurance policies; – funded pension funds in a collective occupational pension fund, sometimes with a guarantee of the company which set it up; – governmental unfunded pension funds (where the premiums that come in as paid by future pensioners each year have to be sufficient to pay out the pensions in that same year for existing pensioners).

92 Recital 20, art. 5-6 AIFM Directive 2011/61/EU. 93 Art. 19 AIFM Directive 2011/61/EU. The regime on master-feeder structures is also less extensive than in the UCITS Directive 2009/65/EC, but it contains disclosure requirements as well as notifications in the context of the use of the EU passport. 94 Art. 3 AIFM Directive 2011/61/EU. 95 Venture capital fund regulation 345/2013, regulating the atrocious ‘EuVECA’ label funds; and the social entrepeneurship fund regulation 346/2013, regulating the equally atrocious ‘EuSEF’ label funds.

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Of these, only the life insurance policies and occupational pension funds have been regulated explicitly as a pension at the European level. Life insurance policies are regulated as one of the services provided by insurers, see chapter 19.4. An individual who provides for his pension by putting aside savings and investing those (either directly in his own name or via a specialised entity) is protected in part by the arrangements in banking and investment firm (prudential and conduct of business) regulation and supervision. Collective occupational pension funds are the subject of a specific EU directive dating from 2003, which had to be implemented by 23 September 200596. The formal title of the directive is ‘institutions for occupational retirement provision directive’. The title serves to clarify what it does not do. It does not cover insurers, it does not cover pension provisions that are not part of a labour-agreement (occupational) and thus excludes individual pension pots set up and funded by the beneficiary. It does not cover defined contribution schemes, and it does not cover pensions that are provided outside of a legally separated entity (institution). As a result the enormous state run unfunded minimum retirement income provisions (‘social security’) are also not covered97. These unfunded social security schemes are likely to be hammered in many mature economies where the ratio of workers to retirees is rapidly declining. The general movement of occupational pension schemes from the transfer of defined benefit schemes to defined contribution funds may (also) have been stimulated by the exclusion of (less secure) defined contributions from the scope of the directive. Pension funds occupy a niche halfway between an insurer and a collective investment institution, in the sense that they provide an insurance to their clients, that is limited to the maximum of the available assets (and possible guarantees) available in the fund as a result of the investments made with the premiums collected in the past. The pension fund directive is only applicable to pensions that result from agreements between employees and employers, or of self-employed persons and a fund. The premiums and the pension rights thus have to have a relation to the occupation of the future pensioner. It also is limited to funded pensions, where premiums paid by the employer and/or the employee are gathered in order to be invested and in due course paid out to the pensioners. If there is only a commitment by an employer to continue paying salary after retirement if and when the employer is still solvent, this does not fall within the scope of the directive.

96 Pension Fund Directive 2003/41. 97 See the key exceptions of art. 2-5 and contained in its definition of art. 6 sub a Pension Fund Directive 2003/41, as well as its recitals 5-17.

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The directive provides for registration, limited cross-border ‘business’ to enable one sponsoring company that has employees in several member states to set up a single pension fund for all these employees, and for minimum harmonisation requirements on own funds, technical provisions of a similar character to those known from the insurance sector, and for limitations in the investments pension funds can make98. The pension funds directive contains some basic provisions on solvency rules, but the regimes on the calculation of the liabilities and how to ensure their coverage can still be very varied. Technical provisions (calculating the liabilities and having sufficient assets to cover them, with member states ability to give a dispensation for underfunded schemes if they are not cross-border) are key, with own funds only necessary if the fund itself covers biometric risk (e.g. the risk that pensioners live longer than taken into account in the liability calculation) or gives a guarantee on performance99. A funded pension fund has to be legally separated from the sponsoring employer or the sponsoring employers. This with the goal that the fund will remain in a position to pay if the sponsoring employer goes bankrupt. The provision includes separating the assets of the fund and the employer, ensuring that the fund is not liable for the obligations of the employer (except for the pension obligations) and does not invest too much in the employer100. Exposures by Banks to Collective Investment Institutions All exposures to collective investment institutions (UCITS or other) are treated in the same way as any exposure to a corporate (if a loan) or equity holding (if an investment), unless specific rules apply. Such rules are available in the treatment of credit risk and market risk101, where a specific treatment is available for exposures to (regulated and supervised) collective investment institutions. The specific treatment is contained102 in the treatment of collective investment undertakings in: – the standardised approach to credit risk; – the internal ratings based approach; – credit risk mitigation; – position risk (and foreign exchange risk). 98 Art. 15-20 Pension Fund Directive 2003/41, and Commission, Call for Advice from the European Insurance and Occupational Pensions Authority (EIOPA) for the review of Directive 2003/41/EC (IORP II), 30 March 2011. 99 Art. 16 and 17 Pension Fund Directive 2003/41/EC. 100 Art. 8 and 18 Pension Fund Directive 2003/41/EC. 101 Also see chapter 8 and 9. 102 See art. 79 and Annex VI, part 1 §79 to 81 for the standardised approach, art. 87 sub 11 and 12 RBD for the internal ratings based approach, (which cross-refer to the above-mentioned standardised approach articles as to the requirements on supervision and disclosure), and Annex VIII, part 1 §9 and 11, and part 3, §40 and 58 for credit risk mitigation rules on collective investment undertakings. For the trading book, see Annex I §47-56 RCAD, as well as chapter 9.2.

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In the standardised approach, claims in the form of collective investment undertakings are in a separate exposure class. In principle, they are risk weighted in accordance with external ratings, with six categories ranging from 20% for the highest rated exposures to 150% for the lowest rated. If there is no external rating available, they are risk weighted 100%, unless the supervisor deems the exposure to be associated with ‘particularly’ high risk, and requires a 150% weighting. A look through approach is available at the option of the bank if the underlying assets contained in the collective investment undertaking are known. The manager of the fund also needs to be well supervised and the fund has to disclose relevant information on the categories of assets in which it is authorised to invest, with details on its investment policy, limits and methodologies, as well as to fulfil obligations on annual reporting. The look through approach means that the undertaking itself becomes transparent for credit risk purposes, and the bank can instead calculate the risk weight of the underlying exposures (which is favourable to the bank if those are lower risk weighted items, such as mortgages or government bonds). If the underlying exposures are not known, it can still ‘look through’ but in that case assuming that the fund has chosen the riskiest investments (and thus with the highest risk weighted exposures) available within the boundaries of its investment policy. The treatment of collective investment undertakings under position risk is identical, though the conditions are phrased differently (the conditions are basically the same, but in the market risk treatment they have not been modernised). In the internal ratings based approach, collective investment undertakings which are well supervised and discloses the relevant information, and on which the bank is aware of each of the underlying exposures of the undertaking become transparent for credit risk calculation103. Several provisions were made stricter as per end 2010104. In the credit risk mitigation techniques, investments in collective investment undertakings can be deemed eligible collateral if there is a daily public price quote and its investments are limited to instruments that are themselves eligible collateral (with conditions on their market-liquidity). There is a volatility adjustment, however, based on the assets the fund has invested in, of which the highest has to be chosen if there is insufficient information on those assets105.

103 Art. 87.11, 87.12 and Annex VI part 1, §77-78 RBD, as amended by CRD II Directive 2009/111/EC. 104 Art. 87.11 RBD refers in that case to the ‘simple risk weight approach’ of Annex VII, part 1 §19 to 21 RBD, as opposed to the more sophisticated approaches set out subsequently in the annex of the PD/LGD approach to equity or the internal models approach to equity. 105 Annex VIII, part 1 §9 and 11 and part 3 §40 and §57 RBD.

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The trading book approach is described in chapter 9.2. The BCBS in 1999 issued a paper on risk management of exposures to leveraged investment funds (since made the subjects of the AIFM directive), both for risks to the individual banks and to the financial system at large106. In addition, it recommended some of the above-mentioned tweaks to the capital requirements that were part of the Basel II amendment to the capital accord. All exposures to pension funds, regardless whether they fall within the occupational pension funds scope, are treated in the same way as any exposure to a corporate (if a loan) or equity holding (if an investment, e.g. shares in a special purpose pension legal entity). Pension funds are not mentioned specifically in the banking directives, except as a counterparty in repurchase transactions, where there is the same volatility adjustment as for collective investment institutions107. As the collective investment undertaking is not defined in the CRD, it could be defended that (collective) pension funds should be treated in the same manner. From a prudential perspective, a non-equity exposures to collective investment undertakings and to pension funds is not so different, and a pension fund might be defined as being a vehicle for the collective investment of pension premiums. For equity ‘investments’ it works quite different, however, as there are usually no shareholders for collective pension funds, and the rights of pensioners are usually reduced to zero upon their death, instead of being a proportional part of the value of the assets of the fund (at collective investment undertakings). For this reason, pension funds can at best be deemed financial undertakings (with the only consequence being that information can be exchanged between supervisors, e.g. when a bank is the manager of a pension fund). It could also be defended that pension funds are insurers, and thus should be treated in the same way, unless specific references are made to insurance directives. Future Developments For pension funds, a debate is ongoing on how to improve the occupational pension fund directive in the context of a full review. EIOPA – firmly pushed by a detailed Commission desire to copy (aspects of) Solvency II to the collective pension fund sector of the Commission – has consulted on how this may be done108. It is facing severe push-back from the sector. As changes in the calculation of liabilities, and the potential duty of employees or 106 BCBS, Banks’ interactions with highly leveraged institutions, January 1999. 107 See the remarks on collective investment undertakings in chapter 19.5, and Annex VIII, part 3 §58 RBD referring to a ‘regulated pension fund’. 108 Commission, Call for Advice from the European Insurance and Occupational Pensions Authority (EIOPA) for the review of Directive 2003/41/EC (IORP II), 30 March 2011. EIOPA, Draft Response to call for advice on the review of directive 2003/41/EC, EIOPA-CP-11/001, 8 July 2011, as well as, EIOPA, Response to call for advice on the review of Directive 2003/41/EC: second consultation’, EIOPA-CP-11/006, 25 October 2011.

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companies to chip in to their actual coverage, may have substantial implications on the political voting behaviour of current workers and on the money available in the economy for growth investment at the companies involved. As a result it is unlikely that any rules that make the pension fund more sustainable in the long term to the detriment of short term growth or by increasing premiums will be more than incrementally harmonised at best. The UCITS directive was revised in 2009 and applicable since 1 July 2011; and the current version is sometimes referred to as the UCITS IV directive. As a result of the financial crisis, however, there has been a debate on whether some of the UCITS have grown so complex that they should no longer benefit from the ‘safe’ label for retail investors. The directive is formally scheduled for a review at the latest by 1 July 2013109. The UCITS directive is being reviewed in a two stage process under so-called UCITS V proposals published on 3 July 2012 (containing mostly rules on depositories, remuneration and sanctions to align with the AIFM), and a longer term consultative process started on 26 July 2012 to review in depth UCITS funds and their role in financial markets110. For the depositaries, the regime will likely be strengthened by similar liabilities as for AIFM directive depositaries, including strict rules on delegation of custody. This is in line with the draft Mifid/Mifir proposals, which will upgrade depositary work to an activity for which a license is always required as an investment firm111. After full implementation and application from 22 July 2013, the AIFM directive is scheduled to be reviewed by 22 July 2017. Literature – Empel, Martijn van (ed), Financial Services in Europe: An Introductory Overview, Kluwer Law International, Alphen aan den Rijn, 2008, page 25-62 – Athanassiou, Phoebus, Hedge Fund Regulation in the European Union: Current Trends and Future Prospects, Kluwer Law International, Alphen aan den Rijn, 2009 – Wymeersch, Eddy, The Regulation of Private Equity, Hedge Funds and State Funds, Universiteit Gent, Financial law institute WP 2010-06, April 2010

109 Art. 115-117 UCITS Directive 2009/65/EC. 110 See the website of the Commission under internal market, investment funds; www.ec.europa.eu. 111 See the amendments to art. 22-26b UCITS as proposed in UCITS V, Commission, Proposal for a Directive amending UCITS COM(2012 350 final, 3 July 2012, and Annex I to the Mifid II Proposals, of October 2011. Also see C.M. Grundmann-van de Krol, ‘Voorstel UCITS V’, Ondernemingsrecht, 2012, page 105 (Dutch).

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Part D Prudential Supervisors Competent Authority The CRD does not refer to supervisors or supervisory authorities. EU prudential legislation instead uses the terminology of ‘competent authorities’. This refers to the public authority or authorities endowed by the member state with the supervisory instruments in the area covered by the directive. Per directive and even per area of each directive a separate public authority can be chosen by the member state. It will need to be given the tools to perform the duties assigned to it in the legislation. Member states can give them more tasks and tools, but member states have to give them at least the power to effectively perform the minimum-level of tasks allocated to them. In chapter 20 the subject is the set of instruments that CRD competent authorities need to have. Even though the EU does not set out preferences for the institutional set-up in each country, it does demand that each chosen authority has to cooperate with the other public authorities that are selected by the member state, with the public authorities that are selected as competent authority for other related directives such as insurance supervision or collective fund supervision, and with competent authorities of other member states. This cooperation is the subject of chapter 21. As elsewhere in this book, the term ‘supervisor’ refers to the public authority in charge of supervising CRD issues, unless the text clearly indicates that e.g. an employee working at the public authority is meant. Similar remarks as in this part D could be made about the various directives discussed in chapter 16 and 19 on conduct of business requirements or alternative frameworks for prudential supervision of other types of financial institutions. The provisions on the allocation of tasks on a national basis and the cooperation obligations with other competent authorities are largely identical in financial supervision directives. These issues are only discussed in this part of the book to the extent it impacts on the supervisor for CRD tasks. The major example of interaction with non-prudential supervisors relates to the core goal of financial stability. This task has been allocated to multiple authorities (none of which has been explicitly allocated final responsibility and associated powers). Financial stability driven authorities and the place of prudential banking supervisors among them are the subject of chapter 22.

20

Rights and Obligations of the Prudential Supervisor

20.1 Introduction This chapter sets out the rights and instruments that enable the prudential supervisor to do its work. They differ according to the type of work allocated to the supervisor. Three main stages in the work of prudential supervision can be identified. These determine the type of instruments used by prudential supervisors: – investigation of the soundness of the bank and its compliance with prudential requirements; – reparation/restoration/preparation; – retribution/punishment. The investigative and reparative sets of instruments can be used in a consensual manner, but the supervisor also must be able to enforce them upon the bank, its employees, owners or clients if prudential norms are transgressed, or may be transgressed if no action is taken. The ‘punishment’ set of instruments is in essence adversarial. These can only be used if norms are transgressed. Their force may be mitigated if the bank is cooperative in terms of notifying the supervisor and/or in terms of preventing recurrence, while there is less scope for softening the blow of supervisory orders of reparative and investigative instruments. Instruments are the fourth layer of regulation in the relation between lawmakers and subjects. These are: – goals (see chapter 4); – tasks and responsibilities of the subjects (see chapter 5 to 18); – tasks and responsibilities of public authorities (see chapter 4, 5, 21 and 22); – powers of public authorities vis-à-vis subjects of regulation, and limitations placed on such powers (this chapter 20). Only if his powers (and resources) match the tasks and responsibilities, the supervisors can deliver on promises made and expectations raised. On the other hand, supervisors can and should only use instruments to the extent necessary to achieve the goals set, in line with their tasks and responsibilities, and only to enforce the specific tasks and responsibilities of the banks themselves. To safeguard this, member states are obliged to give supervi-

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sors instruments that should be able to effectively and efficiently supervise compliance by the banks, while simultaneously limiting the use the supervisors make of the instruments they have to what is needed while respecting administrative procedures and human rights protection of banks and associated persons. Member states traditionally had substantial leeway to determine which instruments national supervisors need. The Court of Justice set outer limits, by pointing out that the implementation obligation of financial directives includes effective supervision and enforcement. The lack of harmonisation on instruments (and the application of those instruments) was first raised at the EU level by CESR/ESMA in its Himalaya paper1. CESR followed up by taking stock of the different instruments in domestic legislation2. The instruments issue has been brought on the agenda, and investigations on the types of instruments supervisors have, how often they use them and how ‘heavy’ they are have been carried out across the financial sector, and the Commission has indicated in a 2010 communication that it wants to take action3. The instruments of supervisors turned out to be dissimilar in different member states, making effective supervision impossible in some, and causing misunderstandings and problems in cooperating across borders. CESR/ESMA has been a vocal proponent of more harmonisation of instruments to a level that can ensure the goals set for supervisors to be reached. The CEBS/EBA review panel took stock in 2009 of available instruments and objectives, including resolution powers, and the actual use of such powers4. The Commission announced action on sanctions in financial services5, followed up by a communication and e.g. legislative proposals on a more harmonised sanctions-regimes in the CRD IV project. Supervisory tasks allocated to the new European supervisory authorities (e.g. the allocation of supervisory tasks and accompanying instruments on credit rating agencies to ESMA; see chapter 8.1) may help in this harmonisation drive.

1

2 3 4

5

CESR Consultation Paper, Which Supervisory Tools for the EU Securities Markets? An Analytical Paper by CESR, October 2004, 04-333f. CESR/ESMA noted a wide range of differences in instruments and the force with which they can be or are applied. E.g. CESR/ESMA, Report on Administrative Measures and Sanctions as well as Criminal Sanctions Available In Member States Under the Market Abuse Directive, CESR//07-693, November 2007. Commission Communication ‘Reinforcing Sanctioning Regimes in the Financial Services Sector’ COM(2010) 716 final, 8 December 2010. CEBS-EBA, Mapping of Supervisory Objectives, including Early Intervention Measures and Sanctioning Powers, 2009/47, March 2009. See J. Black, Restructuring Global and EU Financial Regulation: Capacities, Coordination and Learning, LSE Law Society and Economy WP 18/2010, page 31. Commission Communication of 2 June 2010 on regulating financial services for sustainable growth, COM(2010) 301 final.

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Effective, Proportionate, and Dissuasive Under the EU treaties, the member states have to take any appropriate measure, general or particular, to ensure fulfilment of the obligations arising out of the treaties or resulting from e.g. directives or regulations. The Court of Justice6 has held that under this obligation, the member states have leeway to choose for instance the correct penalty for an infringement of a directive rule, but they must ensure in particular that infringements of directives and other EU laws are penalised in both procedural and substantive requirements that are similar to the treatment of equally important national provisions. The penalty has to be made effective, proportionate and dissuasive. The determination of how to achieve this is left to national legislators, but it can amongst others take into account the gains made by somebody by infringing a directive provision. The proportionality requirement brings with it that a penalty can also be too heavy for the transgression, especially if it is more burdensome for nationals from other member states than for its own nationals. Whether the national legislators chooses criminal, civil or administrative instruments to achieve this proportional response is at their discretion (if not harmonised)7. If one or all of these categories is not harmonised, it is up to national legislators to determine e.g. the civil contractual consequences of non-compliance with an administrative law obligation, such as Mifid transgressions8. The TEU and the CRD both indicate that their implementation is subject to the principle of proportionality; also see chapter 3.4. In the area of instruments, this means: – small/non-complex institutions can and must be treated different than large/complex institutions, both to their benefit (lesser accent on the supervision of costly requirements, lower fines) and their downside (less likely to be bailed out, and getting less attention from supervisors, resulting in a more rough and ready treatment of their problems once discovered); – proportionality goes in two directions, with e.g. less risky institutions gaining flexibility, and more risky institutions being subject to harsher supervision than the median laid out in the law (but also more ‘entitled’ to government support)9. However, while it is relatively easy to give dispensations of harsh rules, it can be difficult to demand compliance with a higher standard in a court of law, except after risks have materialised in a bank failure or financial crises10; 6

Art. 4 TEU and art. 54 RBD as amended by CRD III Directive 2010/76/EU. Inspire Art, Court of Justice 30 September 2003, Case C-167/01. Spector/CBFA, Court of Justice 23 December 2009, Case C-45/08, §7074. 7 Ntionik and Pikoulas/Epitropi Kefalaiagoras, Court of Justice 5 July 2007, Case C-430/05, § 52-55. 8 Genil and CHGV versus Banco Bilbao and Bnkinter, Court of Justice 30 May 2013, Case C-604/11. 9 T. Poole, Proportionality in Perspective, LSE Law, Society and Economy WP 16/2010. 10 Examples are pillar 2 supervisory instruments to demand more capital or e.g. organisational safeguards, and the developments on systematically important financial institutions; see chapter 14 and 18.2.

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– instruments have to be designed by the EU legislators and by the implementing member states – and applied by the supervisor – in a way that is proportional to the purpose to be achieved. The treaties, the CRD and other directives often do not explicitly set the penalty for an infringement, nor do they refer to national laws, regulations and administrative provisions. However, there are some minimum requirements, with the dual purpose to ensure the effectiveness of EU legislation, and to ensure that procedural safeguards offered to locals are also offered to nationals of other member states. Though the content of being ‘dissuasive’ is not given, for some infringements the penalty is automatic and mandatory (i.e. the supervisor cannot decide not to apply it). These mandatory penalties are often harsh. In the securitisation regime11: – non-compliance with the retention requirement means that other banks cannot invest in the securitisation; – non-compliance with good lending standards means that the assets cannot be securitised (or at least cannot be taken from the balance sheet); – non-compliance with internal organisation standards for investors in securitisation position means that the investor-bank has to apply a risk weight of between 250% to 1250% (i.e. up to full deduction from own funds) depending on the frequency of infringement of due diligence positions. It is likely that other instruments, that are not pre-defined, need not be applied in the same stringent fashion in order to still be considered dissuasive. Escalating punishments and an upper range of full prohibitions/full deductions are, however, likely to be needed in more serious or repeated infringements. Instruments vs. Trust To some extent the goals of the prudential supervisor and of the bank run in parallel. Both are eager to get depositors to deposit their money at the bank, and eager for the bank to perform its funding role to the commercial sector and to the state, as well as other services they perform to the economy12. Banks are expected (and forced) to police themselves, and to have effective and efficient reporting in place on financial information and risk factors so that they can manage themselves. The internal part of it is (enforced) self-regulation on which the prudential supervisor trusts13. The internal reporting and back office checks

11 Art. 122a.5-122a-6 RBD. See chapter 8.6. 12 Chapter 4. Also see R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 2. 13 M. Power, Organized Uncertainty, Designing a World of Risk Management, Oxford, 2007, chapter 2.

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serve to make the bank in all its components, including its board, aware of the risks and rewards of each activity, and whether they match. Banks are also mandated – and trusted – to send accurate information on an ongoing basis to the supervisor, and contact the supervisor if incidents occur. The trust the supervisor places in the bank is often well deserved, and supported by the knowledge that the supervisor does sometimes verify information, and has reparative and corrective instruments at its disposal to evict anyone caught deliberately or incompetently providing false information. Without trusting on the procedures in the bank, the prudential supervisor would need the type of humongous resources that are not available on the public purse, not even if the banks would pay for it. Supervisors basically supervise the internal supervisors (risk officers and the executive and non-executive board members) who in turn supervise and/or manage the business risks. Part of the investigative instruments focuses on checking whether the trust placed in these internal officers is well deserved. This means that supervisors need to question directly, but also verify independently in a risk aware manner (e.g. by blind testing and validation). If transgressions occur, the response should be commensurate both with the transgression itself, and with the response of the internal supervisory regime. The latter can be either a mitigating, neutral or extenuating factor or even an independent transgression. A gradated response is necessary both to foster a mutual trust-environment (this will make reporting of incidents more speedy) but also make clear that transgressions are in and of itself a violation of trust14. Though it can be argued that in prudential supervision the final outcome is most important, if trust is not expected and demanded, and violations punished, that final outcome is certain to be ruinous. The investigative instruments detailed in chapter 20.2 are built on trust, and how to verify whether such trust was correctly given. The corrective instruments detailed in chapter 20.3 set out the palette that is available to gradate responses to violations in trust, and in primary transgressions. These range from a (formal) disciplinary talk or written warning if the transgression is both small and not repeated within the banks’ organisation to – as ultimate sanctions – a withdrawal of the license of the bank or a withdrawal of the supervisory approval of a board member as a fit and proper person. It should be noted that the above is not true for conduct of business supervision. There, the final outcome (general safety and stability) is not the primary goal. Instead, the continuous fair treatment of every client or the actual fair disclosure is the subject of supervisory interventions. A firm talk, without corresponding action to compensate the clients involved and proof that transgressions are very unlikely to occur again, is much less likely to suffice for achieving that result. Conduct of business rules are not the focus of this part of the

14 See chapter 20.3 and J. Viñals & J. Fiechter, The Making of Good Supervision: Learning to Say ‘No’, 2010, IMF SPN/10/08.

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book, but the applicable directives contain similar rules on cooperation, instruments and institutional set-up, with variations on the level of detail and/or the division of tasks. Please note that for example for the key conduct of business rules and internal organisation rules of Mifid that most banks are subject to, Mifid contains specific instruments that allow the Mifid-supervisor to check, verify and correct deviations from its rules. These powers are directly applicable to banks that have any investment activities or provide investment services15. If checking the internal governance rules of Mifid at banks is allocated to the prudential banking supervisor, he is for that purpose a Mifid-competent authority, and bound to implement it in the manner demanded by the treaties: effective, proportionate and dissuasive; see above. Balancing Domestic and European Interests There is no explicit obligation in the CRD to take the interests of foreign EU clients of supervised banks as serious as the interests of local clients when using the investigative, reparative or corrective instruments. Nor is there an explicit obligation to take the financial stability concerns of other EU member states as serious as domestic financial stability, though the CRD II directive of 2009 introduced an obligation to ‘duly consider’ the potential impact of supervisory decisions on the financial stability in other member states, and to actively participate in and ‘comply or explain’ with CEBS/EBA work16. The CRD II provisions limit this duty again by allowing supervisors to only consider available information on financial stability consequences, instead of having to actively investigate such consequences. For EBA delegates in 2010 the EBA regulation introduced a clearer obligation to take the European interest into consideration, instead of (only) the national interest; see chapter 21. The interests of foreign depositors and of financial stability in other member states do trigger e.g. deposit insurance responsibilities, potential liability for bad supervision and information exchange obligations. Within these boundaries, the domestic interests are implicitly predominant. This is reinforced by the choice by legislators until the 2007-2013 subprime crisis to rely primarily on directives for harmonisation. The national translation in the field of financial supervision allows adaptation to national interests. The allocation of cross – border responsibilities for supervision, does not necessarily imply an obligation to let the interests of other member states weigh equally heavy as the interests of the member state itself and of its taxpayers/voters/depositors. This national versus European outlook was an issue raised

15 Art. 1.2, 50-53 Mifid. See chapter 13.4 and 16.2. 16 Art. 40.3 and 42b RBD, introduced by art. 1 CRD II Directive 2009/111/EC, and since slightly rephrased by the Omnibus I Directive 2010/78/EU.

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in the 2006 report on the evaluation of the Lamfalussy system17. Introducing an obligation in national laws to act in the interests of the broader EU interest was intended to ensure that domestic authorities, operating under domestic laws geared towards local protection, would (be allowed and obliged) to treat the interests of EU clients of the institutions they supervised as equally important to local clients. As an aspirational goal (i.e. strived for, but not guaranteed), this was fully embraced. The standing practices of information exchange and cooperation are, however, less easy to change than the words on paper, due to political and financial considerations. Who is going to pay for saving non-residents and why should any countries public authorities put the interest of non-residents over residents that have a direct publicity and political influence over such domestic public authorities? A similar obligation was introduced in the regulation on cooperation between consumer protection enforcement authorities mentioned in chapter 16.6. The enforcement authorities are obliged to fulfil their obligations to cooperate as though acting on behalf of consumers in their own country, and instigate action either at their own account or at the request of other enforcement authorities even if only non-residents are concerned18. Some of the hindrances to making this effective in prudential supervision (the funding of deposit schemes or of liquidity support/state aid) of course do not apply in the consumer protection arena, leaving only the more limited concern of funding the investigative and litigation actions of the authority. See chapter 20.9. As per 1 January 2011, several provisions have been introduced that softly push towards greater cooperation/harmonisation and information sharing19. Member states should stimulate local supervisors to apply CEBS/EBA work, and any national mandate should not inhibit their EU duties under the CRD and within CEBS/EBA. Also, the possibility to share information for financial stability purposes with central banks of other member states and with lawmakers or investigators from other member states have been improved. Member states have to allow their domestic supervisors to share information with these authorities (which was previously not possible as there was not always an appropriate exemption of the secrecy obligation). Though not accompanied by an obligation to share information, it will definitely help the flow of information across the EU.

17 Inter-Institutional Monitoring Committee, First Interim Report Monitoring the Lamfalussy Process, 22 March 2006, page 14; Inter-Institutional Monitoring Committee, Final Report Monitoring the Lamfalussy Process, 15 October 2007, page 18. 18 Art. 11 Regulation 2006/2004 on cooperation between national consumer protection enforcement authorities. 19 The CRD II Directive, 2009/111/EC, introduced art. 42b RBD as well as new paragraphs in art. 49 and 50 RBD.

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CRD IV and Supervisory Tools The area of the instruments a supervisor has to have is a clear example of the failure of the political process and the failure of the Commission in its obligation20 so far to uphold EU legislation by suing member states. Implementation is much harder than writing rules, and with the lack of harmonised instrumentation, powers and credible funding and independence, banking supervisors in many countries have been kept on a too short leash to be able to uphold EU requirements21. The type of preventive instruments and the majority of the resolution powers proposed by the Commission in its consultation22 and subsequent proposals23 on crisis recovery and resolution are instruments any supervisory authority should have already had in order to be ‘effective, proportionate and dissuasive’, and above all ‘credible’. The CRD IV directive/CRR copy the existing provision, and add a ‘sanctions’ regime that focuses on e.g. harmonising fines24. This does not address the issue that the existing provision was applied very differently, and the subject of very different provisions in national law. The focus on sanctions in CRD IV is likely to miss the point. It emphasises the knee-jerk punishment response (understandable after the 2007-2013 subprime crisis), over the wider corrective instruments and their application in view of the goals of prudential supervision. Nonetheless, the fact that the EU has finally started to take an issue of application of the rules seriously – even if the CRD IV directive/CRR arrived late at the party – can only be applauded. CEBS/EBA published its inventory in 2009. The overview was a response to the various supervisory failures in both large financial centres such as Germany, the Netherlands and the United Kingdom, and in smaller financial centres that were caught up in asset bubbles or over-focus on the financial sector such as Iceland and Ireland. Huge differences occur with regard to the availability and/or the application of formal instruments. Punitive or corrective penalties are close to negligible in many member states when compared to the balance sheet size of the culpable bank25. Though this may reflect disparate implementation,

20 The so-called level 4 of the Lamfalussy/Larosière Framework, see chapter 3 and 23.3. 21 In the interest of fairness: this does reflect frustration built up over 11 years working on the supervisory side of negotiations on tools and instruments. Also see BCBS, Core Principles for Effective Banking Supervision, September 2012. J. Dickson, ‘Supervision: Looking Ahead to the Next Decade’, in A.J. Kellermann, J. de Haan, F. de Vries, (Eds.), Financial Supervision in the 21st century, Amsterdam, 2013, chapter 14. 22 Commission Working Document (for consultation and discussion), Technical Details of a Possible EU Framework for Bank Recovery and Resolution, 6 January 2011, page 39-40 and 56. 23 Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. See chapter 18.3 and 20.3. 24 Art. 136 RBD. See art. 64-72, 102-107 and 126 CRD IV Directive. Also see part I of the accompanying document: Commission, Impact Assessment Accompanying the Proposal for a Directive as part of CRD IV, COM(2011) 952 final, 20 July 2011. 25 CEBS-EBA, Mapping of Supervisory Objectives, including Early Intervention Measures and Sanctioning Powers, 2009/47, March 2009.

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it may also reflect differences of opinion on whether such sanctions are the best way forward vis-à-vis economically and politically important banks. In the atmosphere after the 20072013 crisis this is, however, not likely to remain a winning argument. If it persists, more forceful intervention will likely be introduced in many member states, and across the EU financial sector. Though the Commission communication appears to point the finger at national legislators and supervisors, the author of the communication is not a disinterested party. Even though some of the instruments given to supervisors by their national legislators appear to be lacking in achieving the required level of being effective, the Commission has for over 20 years failed to take the relevant member states to court for non-implementation of the directives. Even now the Commission appears hesitant to promote harmonisation, as a full harmonisation would impact on the laws of the member states in areas such as civil law and penal law, where it can expect severe push-back from many member states. The CRD IV directive introduces measures to legislate on and harmonise administrative sanctions. On the convergence of practical application decisions the progress remains underwhelming. On the level of interventions within the wide boundaries set, the Commission dumps the burden on EBA26. This even though the type of penalties possible in practice remains a highly politically charged issue. On the application issue, staff working at the IMF has taken a more interesting take to define what effective supervision is. They stress that not only should there be a good regulatory framework, but also a wide set of instruments, independence and funding in order to be able to speak about the ability to act, as well as the willingness to act27. In this chapter the instruments part of this equation is covered. Investigative instruments are needed to be able to be intrusive, corrective instruments to be able to be conclusive. Without those elements, there would be little use to have a formal supervisor, as it could neither discover problems, nor act to solve them. Literature – CEBS-EBA, Mapping of supervisory objectives, including early intervention measures and sanctioning powers, 2009/47, March 2009 – BCBS, Supervisory guidance on dealing with weak banks, March 2002

26 Commission, CRD IV – frequently asked questions, 20 July 2011, memo/11/527. 27 J. Viñals & J. Fiechter, The Making of Good Supervision: Learning to Say ‘No’, 2010, IMF SPN/10/08; M. Quintyn, S. Ramirez & M.W. Taylor, The Fear of Freedom: Politicians and the Independence and Accountability of Financial Sector Supervisors, IMF WP/07/25. Also see BCBS, Core Principles for Effective Banking Supervision, September 2012. J. Dickson, ‘Supervision: Looking Ahead to the Next Decade’, in A.J. Kellermann, J. de Haan, F. de Vries, (Eds.), Financial Supervision in the 21st century, Amsterdam, 2013, chapter 14. Also see chapter 21.1, 21.9 and 21.10.

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20.2 Investigative Instruments – Information, Secrecy and Data Protection Introduction There is a natural tension between public authorities obtaining and using information to assess compliance by the bank with supervisory goals, and the right of privacy and the right to keep business information confidential. Banking supervision laws require banks to share information with their supervisor, who may use that information to perform its duties. These duties range from licensing, ongoing supervision, to liquidation, and include cooperation with domestic and foreign public authorities. This raises several questions. What rights do supervisors have to obtain information, are banks obliged to give compromising information to these public authorities, and what (public or private) use can be made of this information? The CRD provides contradictory obligations in response. An almost limitless obligation to provide numerical information and to inform the supervisor of negative developments and upon request of any information the supervisor wants, is balanced by a strongly worded secrecy obligation28. Within this type of regime, the exceptions to the obligation to give information, and the exceptions to the obligation to keep such information secret are key. The hotchpotch of exceptions to secrecy obligations as scattered over the CRD (and the EBA regulation) has been made more complicated by the growth in the number and size of cross-border operating banks and banking groups, as well as by a changing palate of tasks of the supervisor, where issues such as pillar 2, collegiate supervision and the approval of internal models has on the one hand made supervision and the sharing of information more intrusive, while at the same time cost/benefit argumentation has pushed back against far reaching standardised information provision. The secrecy regime complements the data protection directive as applicable to public authorities, and the TFEU obligation on current and former members of the EU-institutions and their employees are bound by professional secrecy if they obtain information on undertakings29. These rules are discussed here in the context of information gathering and information exchange for prudential purposes. This is not the only area in which banks have to provide information to public authorities. Banks for instance also provide information for conduct of business purposes described in chapter 16, in which similar secrecy and other considerations are relevant as described here. A larger burden is put on banks for tax purposes. Banks will generally be required to give information to domestic tax

28 Art. 44 RBD and art. 70 EBA Regulation 1093/2010. Also see art. 53 CRD IV Directive. 29 Art. 16 and 339 TFEU, the Data Protection Directive 1995/46/EC, as well as Regulation 45/2001. Also see art. 71 EBA Regulation 1093/2010.

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authorities, and member states have agreed far reaching obligations for themselves (and their banks) on the exchange of information and other forms of tax cooperation in the savings tax directive and the tax cooperation directive30. Banks are obliged to cooperate in such information exchange, and bank secrecy rules are not a valid reason to limit the obligation to provide the information. Such obligations of banks to non-prudential public authorities are, however, not further discussed in this book. A basic distinction within the practice of prudential supervision is made between off-site and on-site supervision. This is not based on the CRD, but is a pre-existing distinction. The investigative phase is traditionally split into an off-site and an on-site component. On-site supervision involves supervisors visiting the premises of the bank, regardless of whether the bank welcomes this or not, and conducting research and interviews with employees and in the books and archives of the bank. On-site supervision is the more invasive part of supervision as it basically involves a search of the premises and interrogations by a public authority. Off-site supervision involves the bank sending information to the supervisor at their request or at its own initiative. The supervisor analyses and researches the information it receives at their own premises. It is a less invasive part of supervision as the supervisor ‘just’ requires cooperation and information provision to its own desks instead of searching the premises for what it requires itself. The traditions of the national supervisors and the protection against (unannounced) government actions are different in each member state, and the CRD allows – a gradually reduced amount of – leeway to focus more on off-site or on on-site supervision. It gives member states the possibility to determine the scope of reporting obligations, and the scope of verifying or discovering relevant information, with some minimum powers the supervisor should be given (and determining some minimum safeguards that banks should enjoy, especially the abovementioned secrecy obligations on supervisors). Trust but Verify The directives do not make an explicit statement on the degree supervisors should rely on the information given by the bank, and the extent to which such information should be verified, or whether additional relevant information should be actively sought; see chapter 20.1. To a large extent this will depend on national rules, and the available resources for the supervisor (number of people, expertise, experience, external assistance; see chapter

30 For instance see art. 4 and 8 Savings Tax Directive 2003/89/EC and art. 5, 6 and 18.2 Tax Cooperation Directive 2011/16/EU (which abolished the earlier bank secrecy exemptions). Similar obligations may also apply to individual member states under tax treaties with other member states and third countries sponsored by OESO; see e.g. art. 10.2 Savings Tax Directive 2003/89/EC. On savings tax, please note the transitional withholding tax for Belgium, Austria and Luxembourg dependent on the gradual abolishment of banking secrecy. The Savings Tax Directive is being reviewed and will likely be replaced in 2013/2014.

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21.9). The combination of different tools suggests that the underlying premise is that the supervisor should trust, but verify. This is deduced from e.g.: – the screening on trustworthiness and expertise of executives (chapter 5.2); – the fact that raw data on individual transactions/clients are not part of the obligatory reporting to the supervisor, but instead the processed data required in standard reporting formats; – the requirement that internal, external and management checking takes place on such processed data, making the supervisory check just another in several layers of data control; – the fact that for minimum capital levels, the supervisor is under an explicit obligation to verify compliance at least twice per year (though it does not specify how far such verification should delve, e.g. whether a bland look at a reporting form should would be considered ‘verification’)31; – that pillar 2 checking is only required once a year instead of on a continuous basis (chapter 14); – the proportionality requirement; – the fact that the number of persons in supervisory teams allocated to a bank is usually dwarfed by the number of persons working at the bank who generate information for use either within the bank or by the external supervisor. Nonetheless, the requirement to verify is important, and the required degree of verification will need to take into account past experience and the current circumstances. How trustworthy has the bank and this individual person who gives the information proven himself to be in the past, which incentives are there currently to massage the information, is the bank in problems, does the information agree with (is it in line with) similar information obtained from other banks and is it internally consistent? Even with the most trustworthy bank, the supervisor will need to make occasional unexpected testing to check whether his assumptions on trustworthiness are still correct, in order to fulfil the CRD-obligation to assess the risks to which the bank is subject at least once a year, and for the member state to correctly implement the CRD by ensuring an effective and efficient maintenance of CRD requirements32.

31 Art. 74.2 RBD. 32 Art. 124 RBD, and art. 35.1 and 36.3 RCAD, and chapter 3.5. The accessibility for verification by the supervisor at the bank is not explicitly stated in the RBD, but it is implied by the need for access for on the spot verification for e.g. internal models and at e.g. mixed activity parents. Also see chapter 2 on the issues resulting from the two directive structure of the CRD, that would be at least partially solved by the CRD IV project of the Commission (even though those are still split up between a regulation and directive).

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Verification of the provided information can be necessary both at the bank and at related institutions.33 Such verification provides the core of ongoing supervision. The supervisor can e.g. verify at the bank, and verify information both in in any member state (after involving the local supervisor34 as described in chapter 20.2), information at any other bank, an electronic money institution, a financial holding company, a financial institution, an ancillary services undertaking, a mixed-activity holding company and its subsidiaries, or a subsidiary excluded from consolidation. The supervisor has access to information for consolidated (including financial conglomerates) supervision, and to any information necessary for the supplementary supervision on financial conglomerates (entities), regardless of whether the group entity is a regulated entity or not. A similar secrecy obligation and information sharing possibility is part of the financial conglomerates directive35. There is a supporting arrangement, which is that member states have to allow entities in a banking group or financial conglomerate that are captured in consolidated supervision, to exchange information between each other that would be relevant for the purposes of supplementary financial conglomerates or consolidated banking supervision36. Within the EU, this could be sufficient if this exchange was standardised, but at the worldwide level there is a lack of protocols on obtaining information on foreign unregulated entities that are higher in the hierarchy of the group to which a bank belongs37. Both licensed banks and any entity that is part of the same group as a licensed bank are obliged to give the supervisor of that bank any information it needs to be able to perform its supervisory function (with some limitations as discussed below)38. If the other undertaking is situated in the same country, the supervisory laws can provide for direct access. This becomes more difficult for entities located in other member states or in third countries. The CRD (nor its domestic implementation laws) do not give rights of access nor instruments for third country operations. Within the EU, there is a cooperative arrangement

33 Art. 43 and 137-142 RBD, art. 36.3 RCAD and art. 15 Financial Conglomerates Directive. 34 If a supervisor wishes to verify information and one of the types of entities mentioned that has the information is based in another member state, the supervisor has to contact the supervisor of the other member state. That supervisor can choose to carry out the verification themselves, by allowing the requesting supervisor to do it or by allowing an auditor or expert to carry it out. If the requesting supervisor is not allowed to carry out the verification itself, it does have the right to participate in the verification. This process applies both to entities in the same group and to entities not in the same group, and to regulated and unregulated entities. See art. 137-142 RBD. 35 Art. 4, 10, 12, 12a, 14 and 15 FCD, as amended by the Omnibus I Directive 2010/78/EU. 36 Art. 14 Financial Conglomerates Directive and art. 139 RBD. 37 Joint Forum, Review of the Differentiated Nature and Scope of Financial Regulation, January 2010, www.bis.org page 8, 39-41. 38 Recital 58, 59 RBD. The limitations discussed relate to e.g. the reduction of administrative burdens, and the protection offered by e.g. human rights conventions and data protection laws.

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between supervisors on obtaining and sharing information and on the right to verification; see above and chapter 2139. In the absence of negotiated agreements/treaties; for third country entities the supervisors often does not have a legal right to information or assistance from the third country supervisor40. It will then depend on the (continued) willingness of third country entities and/or the relation with third country public authorities to obtain or access the information directly, or whether the local bank can provide the supervisor with information of the related entities, as well as on compatible secrecy regimes41. As indicated in chapter 5, this is an example where ‘close links’ can make adequate supervision of the licensed bank difficult, for which reason the license of the bank can be denied, made conditional, or – in extreme circumstances – be withdrawn42. Investigative Instruments Banks are required to report to the supervisor in three different ways: – periodic reporting on the main financial information; – own initiative reporting (a ‘push’ obligation that it should fulfil without additional prodding) if certain risks or events occur; – provide information on the (ad hoc) request of its own supervisor, at the request of the consolidating supervisor, or at the request of supervisors of other banks. Periodic Reporting The periodic reporting requirement has never been well harmonised, and the current CRD provision on it is dated. Banks have to calculate whether they fulfil minimum capital requirements under pillar 1 at least twice each year. They subsequently have to report the result of the calculation and the component data required to the supervisor43. In practice, especially for the larger and more important banks, these obligations have been ‘goldplated’ – if this term can be used when such an outdated provision is expanded upon – to include often monthly, but definitely quarterly information provision on key components of the minimum capital requirements under pillar 1. This is also in line with the (less dated though hardly consistent with modern IT standards and possibilities) frequency of reporting on market risk.

39 Art. 15, 42, 43, 47, 128, 129, 130, 131, 131a, 132, 137, 139, 140, 141 RBD. 40 Art. 39 and 46 RBD. Also see chapter 21.8. 41 See chapter 21.8. Also see CEBS/EBA, Methodology for the Assessment of the Equivalence of Third Country Professional Secrecy Standards with the Capital Requirements Directive for the Purposes of EEA Colleges, 15 June 2010. 42 Art. 12.3 and 17.1 sub c RBD. 43 Art. 74.2 and 110 RBD, and art. 35.4 RCAD. For non-bank investment firms art. 35 RCAD provides for monthly reporting for the largest institutions, with lower frequency investment firms that do not trade for their own account (and even lower if it also does not hold clients’ money or securities, nor underwrites issues on a firm commitment basis).

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After insistent lobbying of banking groups operating in several member states, efforts have been made to harmonise reporting templates. CEBS/EBA was ordered to provide reporting templates common to all supervisory reporting requirements across the EU, to be made available from the start of 2012 and to be applied from 31 December 201244. Those should be uniform as to formats, frequencies and dates of reporting, and proportional for different types of banks depending on their nature, scale and complexity. CEBS/EBA developed two separate but related reporting frameworks, the common reporting framework (or ‘Corep’), an interim reporting framework for large exposures that in due course should be integrated into Corep, and the financial reporting framework (or ‘Finrep’). Corep contains information that is tailored to the quantitative requirements and the calculation of the solvency ratio, Finrep provides information consistent with international accounting standards. The idea is to promote consistency and standardisation, while still allowing the member states to pick and choose which information they actually want to obtain, as allowed under the dated CRD provisions. Theoretically a bank can have the frameworks in place, and just send the parts of it that a specific supervisor wants to that specific supervisor. If none of its supervisors want to have a specific template, the bank can choose not to collect the type of information needed to fill that template. However, due to differences in definitions and different goldplating/implementation problems, the harmonisation is only available at the level of the formats, not the data that go into them. This has not appeased the banks that still have to fill in information based on different national implementation of the CRD, and at different frequencies. Also, some supervisors require all the templates to be submitted, while others require only a limited number of the templates to be used, leading to a continuing unlevel playing field between banks, and for cross-border operating groups to the necessity to prepare templates bearing in mind that they need to collect and prepare the information that the most demanding supervisor of any group-entity requires. The Omnibus I directive introduced an obligation for EBA to develop (and supervisors to apply) reporting formats, including instructions on the content, and IT systems for reporting45. EBA has consulted on some of these end 2011 and early 2012, but the required draft technical standards have not yet been published by EBA, let alone issued by the Commission; also see ‘future developments’ below.

44 Art. 74.2 RBD, as introduced by art. 1.14 CRD II Directive 2009/111/EC (since amended, see below). 45 Art. 74.2 and 110.2 RBD as amended by art. 9.21 and 9.27 Omnibus I Directive 2010/78/EU. Also see art. 29.1 sub c, which explicitly mentions reporting standards as part of the common supervisory culture EBA is supposed to foster.

951

EU Banking Supervision Corep contains separate templates (reporting forms) for46: – general information; – capital adequacy; – group solvency; – credit risk (seven templates for different components of credit risk); – market risk (eight templates for different components of market risk); – operational risk (three templates for different components of market risk). The reporting framework for large exposures has been applicable since end 2010, and functions as an addendum to Corep47. The two templates (on counterparties and on groups of connected clients) were meant as an interim regime until it can be integrated with Corep, though the RBD now contains a separate but identical instruction to develop Corep and large exposures formats48. The Finrep framework contains information that has to be submitted to supervisors, but is not specific to supervisory purposes. Where Corep is pushed quite hard by EBA, on Finrep the terminology is more relaxed as it is not information primarily necessary for quantitative supervision purposes. The templates are is set up to reflect IAS/IFRS, so that banks can use the systems for gathering information for external financial reporting also for prudential purposes. Like (the more recent revision of) Corep, the current version of Finrep has also been effective from the start of 201249. The frameworks are regularly updated to reflect legislative amendments to the quantitative requirements. The intention is that the guidelines containing the common reporting framework and the large exposures addendum (that depend on the willingness of national legislators and supervisors to apply them) will as soon as possible be replaced by uniform and binding templates, including the instructions to fill them in, as part of the abovementioned technical standards. The host member state of a branch can also impose reporting requirements, in addition to the obligation of the bank to include the branch in its reporting to its home supervisor50. The potential reporting requirements can entail: 46 EBA, Revision of the Framework on Common Reporting (Corep rev 3), 28 April 2011, consisting of excel sheets and (brief) explanatory notes to the templates. 47 CEBS/EBA, Guidelines on Common Reporting for the Revised Large Exposures Regime, 11 December 2009. See art. 110 RBD, as amended by the CRD II Directive 2009/111/EC. 48 Art. 74.2 and 110.2 RBD, both as introduced in Omnibus I Directive 2010/78/EU. 49 CEBS/EBA, Guidelines for Implementation of the Framework for Consolidated Financial Reporting (Finrep), 15 December 2009. 50 Art. 29 RBD, and chapter 5.3.

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– periodic reporting for statistical purposes on the activities in the host member state; – periodic reporting and ad hoc information provision for the purpose of either monetary policy or liquidity supervision as instituted in the host member state on incoming branches, if and in as far as similar information is requested from domestic banks. Apart from banks several other entities are bound to deliver information upon request to a bank supervisor (see below). They are subject to the right to verify information of a banking supervisor, to check e.g. upward consolidation information. A specific ‘push’ obligation is put upon any person authorised as an accountant/auditor and either (i) responsible for carrying out statutory audits of accounting documents of a bank, or (ii) performing any other statutory task (i.e. not when he is performing advice work)51. The accountant/auditor has to report promptly and on his own initiative to the supervisor of the bank any fact or decision concerning the bank – of which he has become aware while carrying out his statutory tasks – that is liable to constitute a breach of laws applicable to the bank, affect the continuous functioning of the bank, or lead to a refusal to certify the accounts or to the expression of reservations to such certification52. This obligation extends to his knowledge on all entities for which he also works that have ‘close links’ to the bank for which he performs such auditing tasks. The accountant is also obliged annually to report on the adequacy of the arrangements to segregate financial instruments belonging to clients from the assets of the bank53. Providing Non-Reporting Information to the Supervisor In addition to information the bank has to publish under pillar 3 and company law and provide under the above-mentioned reporting forms, the licensed bank itself has to give the supervisor54: – relevant information for the licensing process (strangely without an EU-level general obligation to update that information – e.g. on new executives – even though noncompliance with licensing requirements at any time can lead to withdrawals of approvals and even the license. The CRD does imply a continuous assessment of these criteria, e.g. on executives55); 51 Art. 53 RBD. 52 This obligation was introduced in the BCCI Directive 1995/26/EC. The general tasks and requirements on the auditor – with some increased burdens when auditing public-interest entities such as banks – are part of the Auditing Directive 2006/43/EC that replaced or amended the directives mentioned in art. 53 RBD; also see chapter 6.4. The accountant is protected from prosecution or liability claims for any disclosure he makes ‘in good faith’ to the supervisor; see chapter 21.10. 53 Art. 13.7-13.8 Mifid and art. 20 Mifid level 2 Commission Directive 2006/73/EC. For non-bank investment firms, the report also relates to money belonging to clients. See chapter 13.4 and 19.2. 54 Art. 6, 7, 12, 21, 25, 28, 29, 74, 84, 87, 105, 124, 129, 141 and Annex III part 6 RBD, and art. 35 (for ad hoc obligations 35.5) and 36 RCAD. 55 Art. 11.1 and 17 RBD.

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– continuous information on close links with other persons/entities, and any applicable third country laws; – continuous information on any acquisitions or disposals of qualifying holdings in the bank, and an annual overview of such qualifying holdings; – notification with relevant information for cross-border branches in the context of the European passport; – statistical information on cross-border branches to host supervisors (plus any reporting needed for monetary and liquidity supervision up to the amount obtained from local banks; see above); – the notification with relevant information for cross-border services in the context of the European passport; – access for ‘on-the-spot’ verification at other entities or in other member states, or at the request of foreign supervisors (implying that it also is available at the bank itself if the domestic supervisor wants to verify something itself; as explicitly stated only for market risk purposes in RCAD); – solo and consolidated reporting – at least twice per year – of the solvency ratio and its credit risk, operational risk, market risk, large exposures and own funds components, with harmonisation on content and frequency via EBA standards in 2012; – reporting and verification (and all other powers to obtain information supervisors need) of market risk requirements; – an ad hoc obligation to inform the supervisor if there is a default by the counterparty under (reverse) repurchase agreements or agreements to borrow or lend securities or commodities; – (implicitly) information for the supervisory review under pillar 2 on a consolidated basis (unless there is no consolidated supervision, in which case it applies on an individual basis56), at least once a year; – information for model approval for credit risk, counterparty credit risk, market risk and operational risk, on a solo or consolidated level; – information for recovery and resolution plans if the bank is the head of a financial conglomerate57. In addition, the following information provision obligations apply to other persons than the bank58: – an obligation to come forward with information on who – and how suitable – holders of qualifying holdings are (an unattributed obligation of – most likely – the bank or 56 Art. 68.2, 123, 124 and 129 RBD; see chapter 14 and 17.2. 57 See art. 9.2 sub d FCD 2002/87/EC. Banks that are part of a financial conglomerate but not its head will also be captured by the conglomerate-wide plan. See chapter 18.3. 58 Art. 12, 19, 20, 43, 127, 137 RBD.

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the holder during the licensing process, and an explicit obligation of the prospective holder and of the bank after the licensing process; see chapter 5.2 and 5.4); information from existing holders that want to dispose of or reduce that qualifying holding; anyone who performs a ‘statutory task’ such as auditing in a bank (and some closely linked entities) has to inform the supervisor any fact or decision that is liable to be a material breach of rules governing the business of the bank; subsidiaries who are not included in the consolidation shall provide information whenever asked; if the parent is a mixed-activity holding company, the supervisor can require information (directly or via the bank-subsidiary) from the holding or from its subsidiaries, including ‘on-the-spot’ verification if they are situated in the same member state, or via cross-border cooperation if situated elsewhere in the EU.

The amount of information to be given is limited by59: – the cost/benefit analysis for ‘new’ legislation introducing information obligations; – the obligation for the consolidating supervisor to not ask for information directly from the bank if another supervisor has already obtained such information; – the obligation for the supervisor of subsidiary to obtain information on models that may already available to the consolidating supervisor not from the bank but from the consolidating supervisor; – the obligation for EBA to harmonised reporting formats, frequencies and reporting dates on the solvency ratio and its components; see above and under future developments; – human rights and administrative law/penal law protections; see chapter 20.4 and 20.5, which is especially relevant where the information might be categorised as illegal under e.g. data protection laws, or results in self-incrimination when it concerns involvement by the bank as a whole or by some employees in money laundering, sanction evasion, or market or interest rate manipulation, or transgressions of prudential requirements that are punishable by fines or other public sector intervention. The right to information and documents can be self-defeating. For example, in the Libor manipulation, one of the reasons that the manipulation could be proven was that the participants were remarkably stupid in putting both the requests and reasons for them in writing in mails and other materials. Such idiocy need not be endemic. Does for example a regular request by the banking supervisor for copies of the minutes of board and senior management deliberations mean that the supervisor will have all the relevant information, 59 Art. 74.2, 130.2, 132.2 RBD.

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or does it mean that such information will be kept from the board and senior management, will not be discussed at formal board meetings, or kept out of the minutes even if discussed, if the submission of that information would lead to reputation/financial damage? If so, such request by the supervisor may well mitigate the self-cleansing capability of the executives and non-executives with regard to the organisation of the bank, without any benefits in preventing non-compliant behaviour with prudential or penal laws. If withholding the information from the supervisor is ‘legal’ under any of the human rights or administrative law protection exceptions, it should not impact on the suitability and trustworthiness of the board members or other employees involved (see chapter 5.2, unless they failed to address and stop any illegal or non-compliant activity involved. Secrecy Obligation Background The extensive obligations of banks and related parties to give information to the supervisor and for supervisors to share information are balanced by data protection obligations (see below), rules on protecting not yet public inside information of listed companies including banks60, and a secrecy obligation contained in the CRD and similar supervision laws. The initial secrecy obligations were strong, in order to prevent confidential information becoming ‘public’. The main obligation is officially phrased to protect the bank (and others such as board members that are being tested for fit and proper) and at first sight appears to focus on ‘secrets’ the bank has towards the markets and/or competitors. A key consideration for introducing it was, however, the impact of bank secrecy regimes in key jurisdictions such as Luxembourg and Switzerland on supervisory cooperation regimes. It was feared that without a strongly worded secrecy provision, no information would be forthcoming from banking supervisors in such countries, and bank branches and subsidiaries that are licensed there would be prevented from providing information to ‘foreign’ supervisors in amongst others EU member states61. This to protect business models that relied on protecting the identity of clients. This latter reason has retained some of its powers, even though the advent of anti-money laundering rules has reduced the usefulness of such secrecy provisions for criminal clients, and tax sharing deals (see above) have reduced the usefulness for tax evaders or avoiders (which is not or not necessarily criminal in tax haven countries). Data protection was more recently introduced, not specifically for

60 See chapter 16.3. Apart from managers and shareholders, it also covers those – such as supervisory authorities and individual supervisors – that have access to such information by virtue of the exercise of his employment, profession or duties. See Grøngaard and Bang, Court of Justice 22 November 2005, C-384/02, on the strict exceptions to this obligation. 61 See BCBS, Banking Secrecy and International Co-Operation in Banking Supervision, December 1981, www.bis.org. Also see C. Goodhart, The Basel Committee on Banking Supervision, a History of the Early Years 1974-1997, Cambridge, 2011, chapter 11.

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banking, but also applicable to banks (on their clients) and to banking supervisors (on the banks and any associated persons on whom they store data). The secrecy obligations are likely to qualify for direct effect, meaning that the supervisor is liable towards the protected party (definitely the foreign supervisor, and in light of the phrasing of the obligation for example also a bank or its customer) if it makes protected information public. This applies even if domestic liability laws do not provide for such liability; see chapter 3.5 and 21.10. The secrecy obligation is, however, increasingly limited. Though individual business secrets are likely still protected from being shared with competitors, the supervisor can make information public or share it with specific other parties in order to perform their tasks, and to allow other domestic and foreign public authorities to perform their tasks. It is further limited by the ever increasing burden on banks to publish prudential information under transparency obligations, including pillar 3; see chapter 15 and 16.5. Any information that is already officially public and confirmed by the institution is no longer confidential (see below). The sharing of information with other public authorities or even with the public flows from the fact that the provision of information is only useful if that information can actually be used. It will depend on a range of factors whether information can be shared with others. For ongoing supervision on a relatively healthy bank this will normally be limited to sharing information between employees of the supervisor and with other involved supervisors, e.g. within a college, as well as the limited number of cases where information can for example be shared with the minister of finance to show that supervision is effective, or that additional instruments are necessary. In emergency situations, however, when the need for secrecy will be highest to avoid a run on the bank by professional lenders and retail depositors, the need for sharing information with e.g. other public authorities or potential investors in the bank will also be at its highest. The central bank and ministry of finance (lender of last resort and potential state aid provider, as well as politically responsible party) will need to be informed, as well as all relevant personnel and key external persons of the bank (e.g. accountant, non-executives, lawyers), and other banks that might act as a white knight should be consulted on potential bids. Under the CRD II rules that became applicable in 2010 the central banks and ministries of finance of subsidiaries and significant branches gained similar information rights, which were further expanded in the Omnibus I directive to clarify that the secrecy obligation does not prevent sharing such information with central banks for any of the tasks usually attributed to them, and vice versa. Nor does the secrecy provision prevent sharing information within a college of supervisors, with EBA, nor prevent supervisors sharing with the ESRB ‘where relevant for its statutory task’; see chapter 21.6-21.7 and 22.5. The same applies vice versa on information

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EU Banking Supervision provision from central banks and ESRB to supervisors62. Equally the CRD II directive expanded the possibility for supervisors to choose to share information with finance ministries in all member states involved in an emergency situation (including some active rights to such information for the member state where a ‘significant’ branch is located, i.e. an obligation to provide that information of the supervisor)63. This makes the number of people aware of highly sensitive information potentially large. How to ensure that information given to other interested parties to serve the goals of banking supervision is used only for the purpose given is key. Otherwise the other authorities involved may use the information to grab assets to ensure payment for their individual licensed entity, their claimants, and banks that should be white knights can use the information to make a pre-emptive strike on any debts owed by the failing bank to them. If the deposit guarantee scheme is informed and starts to hire the personnel needed to execute a quick pay-out to depositors, this may tip-off all people with claims on the bank. If rumours start to circulate, e.g. by such consultations and heightened activity and speculation in the media, it may result in the messy run that all involved would like to avoid64. Practical Aspects of the Secrecy Obligation The secrecy obligation covers more than the information provided by the bank or from a foreign supervisor. Information is a catch all phrase. It can include: – information obtained from the bank (e.g. a change of the organisational structure of the branch, or a drop in available own funds in a subsidiary), or from related entities or persons such as employees, auditors or board members; – information on actions of the supervisor itself (e.g. the withdrawal of the license of the bank with a branch); or even – information on (local) market developments (e.g. a rise in delinquencies in mortgages). Professional secrecy obligations serve a dual interest. Initially introduced to protect the confidentiality of information gained in cross-border cooperation65, they also they protect 62 Art. 44-50 and 131a RBD, as introduced/amended by art. 1.5 and 1.33 CRD II Directive 2009/111/EC, expanded and rephrased by art. 9.17-9.19 and 9.35 Omnibus I Directive 2010/78/EU. For the disclaimer on the task of the ESRB that has to be verified before information can be given, see chapter 22.5. See art. 51, 5362 and 116 CRD IV Directive. 63 Art. 42a.2 and 50 RBD, as amended by art. 1.4 and 1.6 CRD II Directive 2009/111/EC. 64 Such rumours may have been caused by the increased traffic, consultations, negotiations and hiring related to attempts to try to save (or quickly resolve) DSB Bank NV in the Netherlands in 2009, which in turn may have speeded up its demise. See e.g. Minister of Finance, Measures to Limit the Risk of Leaking Information When Applying a Moratorium to a Bank, Letter to Parliament, 7 October 2010, www.minfin.nl (Dutch). 65 Gemeente Hillegom/Hillenius, Court of Justice 11 December 1985, Case 110/84. For cross-border information this additionally results in complex procedures to obtain permission if information is ‘used’ in any way, e.g.

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the confidentiality of information obtained from the bank itself about its undertakings, their business relations or their cost components from becoming available to the public and its competitors66. It has various exceptions67: – with the introduction of the CRD II and the Omnibus I directives it no longer applies to information exchange within the college of supervisors on a banking group (including EBA staff if it so desires, and with a formal obligation to give such information to EBA in specific circumstances), putting the secrecy obligation around the college as a whole instead of around each individual supervisor; – information that is already published or accessible to the public under e.g. access to documents rules (as such information does not qualify as ‘confidential’ information); – information that, though not published, is known to a large group of persons, e.g. collected via a trade organisation68. Information shared with too many people is no longer considered confidential, and such sharing is thus deemed a ‘publication’, though supervisors should tread carefully as any confirmation by them of unsubstantiated rumours can be deemed ‘new’ information that would be subject to the secrecy obligation; – information that is summarised or made collective in a way that the individual banks can no longer be identified; – information that has to be provided under criminal law; – general information can fall under public access laws; – in a limited exemption, information on a legal or natural person is not ‘secret’ towards that person to the extent it can apply to obtain it under data protection laws; in an equally limited exception described in further detail below, the exceptions contained in the CRD that oblige or allow the supervisor (or other party that has obtained information under the CRD) to either share it for specific purposes with others who are bound by secrecy obligations (e.g. EBA, other supervisors, the Commission or ministries of finance) or are not so bound (e.g. bankruptcy courts), or to use it in procedures to uphold the law.

by giving it to other public authorities, or using it in instruments. Such practical barriers can lead to delays or ineffective supervision. See BCBS, Report and Recommendations of the Cross-Border Bank Resolution Group, March 2010. Also see chapter 21. 66 Art. 339 TFEU. 67 Art. 44-49, 131a.1 and 131a.2 last paragraph RBD, art. 71 and 72 EBA Regulation 1093/2010 and art. 339 TFEU. Also see e.g. art. 16 and 17 of the EU Staff Regulations. Also see art. 9.17-9.19 Omnibus I Directive 2010/78/EU. 68 Meroni, Court of Justice 13 June 1958, Cases 9-56 and 10-56, where such information thus had to be used by the public authority in motivating its decision against a party not belonging to the trade organisation, as well as published under a separate publication obligation.

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The domestic implementation of these rules can make the secrecy obligation more stringent in goldplating provisions to protect their banks, its clients or its employees against the supervisor or others69. However, such goldplating cannot limit the CRD and EBA regulation obligations to share information with other supervisors. According to the Court of Justice the system of obligatory information provision, secrecy and the – at the time – limited number of exceptions with targeted information sharing possibilities was a closed system70. Apart from the specific permissions or obligations to share information with e.g. another supervisor who requested it for a specific supervisory purpose, the information could not be shared, even if the supervisor thought there was a good reason to share it. At the time there was also an exemption if local laws on professional secrecy in general limited the secrecy obligation71, but later amendments put in place a minimum level of protection for the benefit of both banks and of other supervisors that provide information to a (local) banking supervisor. In criminal law cases there is a general exemption if local professional secrecy obligations would be upheld, but in civil or commercial proceedings there are no longer exemptions to the obligation of secrecy unless the relevant bank is bankrupt. Neither employees of the supervisory authority nor the authority itself nor others who have obtained information under the secrecy obligation such as other supervisors and employees at e.g. the ministry of finance can thus testify or be forced to testify in civil or commercial proceedings unless it is in line with their supervisory CRD-duties to do so. A prohibition to share information does not prevent the supervisor from ‘using’ the information in the context of the pursuit of supervisory tasks and goals. This might even entail publication of supervisory assessments (or measures taken) if this is consistent with the goals of supervision e.g. to set an example to all banks or to make the action taken credible72. The supervisor can also use the information in court when its supervisory

69 See chapter 3.5, and recital 15 RBD. 70 Gemeente Hillegom/Hillenius, Court of Justice 11 December 1985, Case 110/84. 71 The relevant case dealt with the obligation under the First Banking Directive 1977//780. Art. 12 of that Directive allowed sharing information ‘by virtue of provisions laid down by law’; which provision was not maintained in later versions of the secrecy obligation. The Court even then paid particular attention to the fact that this was a first stage of several to start harmonising banking supervision and obligatory information sharing between supervisors; and ordered local courts to balance the interests of domestic and cross-border supervision served by secrecy and by the civil or public law disclosure requested; Gemeente Hillegom/Hillenius, Court of Justice 11 December 1985, Case 110/84, §33. A similar case has been put to the Court early 2013 involving a liquidated bank and a freedom of information law, but the Court has yet to rule on it; Altmann/Bafin, Request for Preliminary Holding, 20 March 2013, Case C-140/13. 72 Previous research appears to indicate that even formal measures taken are not in and of themselves destabilizing, not even in a crisis. See J.S. Jordan, J. Peek & E.S. Rosengren, The Impact of Greater Bank Disclosure Amidst A Banking Crisis, Federal Reserve Bank of Boston, 9 February 1999.

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enforcement and other instruments are challenged by the bank, or for example by persons who have been deemed not-suitable for an executive role. There is little case law on the secrecy obligation and its exceptions at the EU level. However, the case law on keeping insider information secret may provide a guide on how to interpret the general exception for ‘use’ of the information. Supervisory authorities can only ‘use’ information in the course of their duties, specifically only for (facilitating) monitoring of compliance with licensing and ongoing supervision conditions, to impose penalties, during administrative appeals upon decisions of the supervisor or any other decision taken by public authorities under the CRD or other directives. ‘Use’ in this context is likely to mean sharing beyond those already in the know, i.e. it would exclude discussions and the above-mentioned decisions (that can be – publicly – debated in an appeal, or – if it concerns a penalty – published). It is not really clear from the directive that information may be shared within the supervisory authority, between employees. This may be allowed, or this may be limited to those employees it needs to actually ‘monitor’ the bank in question. It is likely that the supervisor has at a minimum some leeway to share widely within its own organisation, as otherwise it would not be able to comply with the various obligations to share information (if an employee is not aware of information, he cannot assess or help assess whether it should be shared under the law or upon request with e.g. EBA, a foreign supervisor, the ministry of finance, or use it for peer reviewing other banks). In external cases, the CRD allows such ‘use’, but expands the secrecy obligation to all who work for or on behalf of the supervisory authority. In an insider information case, the Court noted that the obligation to keep legitimate insider information secret supports the prohibition of trading on the basis of such information. If for example a manager or expert working for a company has inside information, he can still share it onward if necessary for his duties; see chapter 16.3. The Court has ruled that such an exception on a secrecy obligation – in that case in the market abuse context – has to be interpreted strictly73. The person who has the insider information and discloses it to another has to consider whether (i) there is a close link between the disclosure and the exercise of the employment, profession or duties, and (ii) the disclosure is strictly necessary to exercise those tasks. He has to do this while taking into account that (i) the exception to the secrecy obligation has to interpreted strictly, (ii) that each additional disclosure may well increase the risk that the information is used in a manner that the directive tries to prevent, and (iii) the obligation is gradual, depending on the degree of sensitivity of the information. The Court also observed that the merger between two listed companies is in general particularly sensitive (and should thus be particularly reluctantly shared). As a yardstick for sharing of information at the initiative of the supervisor (e.g. outside of contexts where he is legally obliged to share), these criteria could usefully be applied by supervisors. 73 Grøngaard and Bang, Court of Justice 22 November 2005, C-384/02.

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The closed system is still hanging in there by its fingernails, although the number of exceptions has been greatly expanded. The secrecy obligation has several loopholes as set out above. The original few exceptions were expanded when the secrecy obligation turned out to prevent effective cooperation in the BCCI case, and again when colleges and EU cooperation became ever more important in the wake of the 2007-2013 subprime crisis74. If the exceptions apply, the banking supervisor is allowed – but not obliged – to share information or to publish it. In the wake of the crisis these exemptions have been modernised, e.g. to enable supervisors to share information also with any central bank and the ESRB, to enable them to fulfil the wider range of financial stability tasks many central banks have in the financial system. This in light of the experience in the crisis that supervisors stopped sharing information if this was not obligatory, especially if sharing the information was not in the domestic interest75. Such new obligations to share are automatic dispensations of the secrecy obligation when sharing with such bodies, but they depend on the fact that such other bodies are also obliged to keep the information secret. Any supervisor has the obligation76 to: – send essential information to any other supervisors to whom it is essential at its own initiative, and send relevant information on request; see chapter 21.5; – send information to EBA that is necessary for EBA to carry out its duties (e.g. mediation, college-participation, supervisory convergence; see chapter 21.4), which information EBA can subsequently share with other EU supervisors (see below); – send information to other supervisors within the context of college-cooperation including the above-mentioned essential information (and from mid-2013 the consolidated supervisor has to send relevant information within the college at his own initiative instead of only on request); see chapter 21.7; – send information to other supervisors within the context of supervision of the same legal entity (on cross-border services and branches); see chapter 21.6. Apart from these obligations, the supervisor has discretion to exchange information with other supervisors within the EU.

74 See e.g. art. 48-50, 52, 130-131a RBD, as introduced/amended via BCCI Directive 1995/26/EC, CRD II 2009/111/EC and Omnibus I Directive 2010/78/EC. Also see recital 8, 36, 42, 46 EBA Regulation 1093/2010. 75 See e.g. CEBS/EBA and CEIOPS/EIOPA, Recommendations on the Supplementary Requirements of the Financial Conglomerates Directive for Supervisory Colleges of Financial Conglomerates, 21 December 2010, page 7. 76 Recital 23-27, 54, 59, the various articles obliging information exchange including especially art. 130 and 132 RBD. See the amendments by art. 9.36 Omnibus I Directive 2010/78/EU and – as per 10 June 2013 – art. 3.20 FCD II Directive 2011/89/EU. Also see art. 21, 35 EBA Regulation.

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Any information received from other public authorities that allow the supervisor to perform tasks under the CRD automatically also falls within the secrecy obligation of the recipient authority. The number of such authorities (and employees of such authorities) with whom information can be shared under the common secrecy obligations has substantially increased. This includes the European supervisory authorities and the ESRB, but also domestic and foreign central banks, ministries of finance deposit guarantee funds and money laundering authorities77. If seen from a domestic point of view, this may be deplorable. A valid point may be made that a secret shared with many – even if bound by secrecy obligations – is no secret any more. If seen from the EU point of view, it merely follows the activities of the cross-border operating banks. The freer sharing of information enables the EU domestic supervisors and EBA to jointly act on the basis of the same facts created by a cross-border bank and cross-border financial markets. It can be seen as a compromise due to having cross-border problems without a single cross-border supervisor. EBA can also onward share information to other authorities, for example the ESRB. Where the behaviour of one single bank has only a limited impact, their collective behaviour in the same manner has a clear impact on the economy as a whole. If one bank chooses to hoard liquidity and stops distributing it via loans it is not so bad, if all banks do so simultaneously in the beginning of a recession, this may well result in a credit crunch and falling asset prices. Companies and consumers do not get the credit they need to buy assets, in a downward spiral. These so-called macroeconomic issues (or macroprudential issues when it relates to banks) are not the subject of (micro-)prudential legislation contained in the CRD, and thus not of prudential supervisors. The ESRB has been set up to deal with it and e.g. give warnings of macroprudential issues that can impact on the health of individual banks, leading to a necessity to intervene (either with new legislation or intervention in the risk management of individual banks). Part of the input the ESRB receives will be information collected during supervision of individual banks. This cooperation should benefit of all public authorities involved in financial stability safeguarding; see chapter 22.5. Though based on the CRD (and its domestic implementation), potential information exchange is often confirmed in (binding or non-binding) agreements with the recipients, and can include reciprocity clauses. The so-called memorandums of understanding on crisis cooperation (see chapter 18.3) or on bilateral cooperation in normal times are good examples of such agreements, as are domestic arrangements with e.g. tax and white collar

77 Prior to 1 January 2011, this was limited to sharing information domestically with the local central bank and ministry of finance. Since the introduction of the CRD II Directive, 2009/111/EC, a banking supervisor can also give such information to such authorities from other member states.

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crime agencies. For information exchange on criminal conviction – relevant e.g. to check the suitability of managers – two Council decisions contain relevant procedural safeguards to prevent abuse, including a requirement to use the information obtained only for the purpose for which it was obtained78. Data Protection Under the TFEU, every natural person has the right to the protection of personal data, and under the Human rights convention they have the right to privacy. The rights of individuals under these treaty provisions as regards the processing of personal data by companies and public authorities are set out in a separate directive on data protection79. Banks themselves are not protected under this directive, except where a natural person is the bank (see chapter 4.4), though the general secrecy provisions serve some of the same purposes. The data protection directive, however, does protect all the information the supervisor has on a banks’ executive and non-executive board members, employees and those clients that are not legal entities against unnecessary collection, use and distribution of their information by the bank or by the supervisor. The data protection directive provides for protection for the information held by supervisors or banks on natural persons. It protects any natural person, including a banks’ executive and non-executive board members, employees and those clients that are not legal entities against ‘processing’ of their information. Processing is a very wide term, and includes the collection of and any use made of the information, including disclosure to a supervisory authority, or onward disclosure by such an authority to another. In as far as the information rights and investigative powers or the official authority of the supervisor are laid down in legal obligations, the bank is free to process (in this case collect and give access to the supervisor) personal data of natural persons, under an exemption for compliance with a legal obligation on the bank, or the exercise of official authority in the supervisor to whom the data are disclosed80. The supervisor is, however, subject to the same obligations as the bank regarding personal data it receives from the bank (or has through other means)81. It has to:

78 Criminal Record Information Exchange Council Framework Decision 2009/315/JHA, 26 February 2009; European Criminal Records Information System Council Decision 2009/316/JHA, 6 April 2009. Also see art. 69.3 CRD IV Directive. 79 Data Protection Directive 95/46/EC, as amended by Regulation 1882/2003. See art. 16 TFEU, that obliges EU institutions and bodies to take data protection issues into account in their actions (including legislation), and Regulation 45/2001 on the processing of personal data. Art. 39 TEU and Protocol 21 to the treaties (Declaration on the Protection of Personal Data in the Fields of Judicial Cooperation In Criminal Matters and Police Cooperation) do not apply to non-crime related aspects of banking supervision. 80 Art. 7 Data Protection Directive 1995/46/EC. 81 Art. 6 Data Protection Directive 1995/46/EC.

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process it fairly and lawfully; use it only if compatible with the purposes for which it was collected; process it only in an adequate, relevant and not excessive manner; keep it accurate, and keep it only as long as needed.

The data protection directive is a single market directive. It is based on the TFEU provision that allows ‘approximation’ of domestic provisions if discrepancies in the different national regimes hamper the single market. Making such protection laws identical ensures that no country can object to the flow of personal information across borders, because in the other member states identical protection is being offered. The regime is applicable to both private companies (where personal data will need to flow in order to allow companies, such as banks, to engage in cross-border competition) and public authorities (where cross-border tasks laid down in EU legislation require such a flow of information). The directive forbids (in a likely direct effect provision) any restriction or prohibition of personal data across borders for data protection and fundamental rights reasons, building on the fact that those rights are guaranteed in each member state. The data protection system does place a heavy burden on private and public entities that collect, use, disclose, store (so-called ‘processing’) personal data. Regardless of whether they are the first and only user or one of many users of that information, each will have to determine (i.e. set up systems to ensure) that it is compliant with data protection requirements. The directive distinguishes between the controller (or joint controllers) of the information, who determine the purposes and means of the processing, and processors who work on behalf of the controllers. All processors have to apply the data protection rules, but the controller has additional obligations, primarily towards the persons whose information is ‘processed’, e.g. to make the information held on somebody accessible to him and for civil liability in case of damages due to unlawful processing82. Banking supervisors hold a variety of such data. The most visible is the gathering of information from individual persons, banks, domestic authorities and foreign authorities in order to screen future or existing executive board members of a bank under the (ongoing) requirements of a banking license that such persons have sufficiently good repute and sufficient experience, but other purposes include the large exposures regime reports, and the reports on anti-money laundering and anti-terrorism financing legislation. Such information is collected, stored, put in a database, used to come to a judgement, disclosed to the bank and court if the decision of the supervisor is contested, or disclosed to a colleague supervisor if they need to assess the person in question too for another executive function. Such actions amount to the data being ‘processed’ under the data protection 82 Art. 10-12, 23 Data Protection Directive 95/46/EC.

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directive. The bank is allowed to gather such data if it is legally required to have such information (either for its own work or to provide it to government authorities, such as the banking supervisor) and the supervisor can process such data where it is in line with its public tasks, as laid down in the laws83. Each controller of the data has to notify that it ‘processes’ such data to the domestic data protection agency, and comply with the domestic laws implementing the data protection directive. Each supervisor (and bank) is subject to requirements on data quality, requirements to maintain the security of the data and requirements not to store certain special categories of data (e.g. racial or ethnic origin, health or sex life)84. The data quality and security requirements prescribe that the data must be: – processed fairly and lawfully; – used for specified, explicit and legitimate purposes, and not used in ways incompatible with those purposes; – proportionate to the purpose85; – accurate and, where necessary, kept up to date; – stored no longer than is necessary to achieve its purposes; – kept confidential, even within the organisation of the processor (i.e. not divulged to employees who have not legitimate reason to access it); – protect it against unlawful use and against accidental or unlawful use, including unauthorised disclosure, commensurate to the technical possibilities and the nature of the data. Once requirements are fulfilled on such issues of data quality, notification and the legitimate purpose, the data can subsequently be used (processed) anywhere in the EU. One of the two primary goals of the directive is to bind the member states unconditionally to allow this flow of information, once the domestic processors and controllers have fulfilled their domestic obligations as implemented under the data protection directive86. Member states

83 Art. 7 Data Protection Directive 95/46/EC, of which at least the two relevant paragraphs have direct effect. Rechnungshof, Neukomm and Lauermann/Österreichischer Rundfunk, Court of Justice 20 May 2003, Joined Cases C-465/00, C-138/01 and C-139/01. 84 Art. 6 and 8 Data Protection Directive 95/46/EC. 85 This specific requirement was at issue in a case before the Court of Justice, and has been given direct effect status (see chapter 3.5), but each of these data quality requirements are phrased in a manner that makes it likely that they have direct effect, ensuring that the subjects of the data can claim its protection directly against government entities, even if the national laws are not compliant with the Directive. Rechnungshof, Neukomm and Lauermann/Österreichischer Rundfunk, Court of Justice 20 May 2003, Joined Cases C465/00, C-138/01 and C-139/01. 86 Art. 1 Data Protection Directive 95/46/EC, Rechnungshof, Neukomm and Lauermann/Österreichischer Rundfunk, Court of Justice 20 May 2003, Joined Cases C-465/00, C-138/01 and C-139/01, and European Commission/Germany, Court of Justice 9 March 2010, Case C-518/07.

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cannot impose further restrictions, as processors and (co-)controllers in the other member states that are part of this free flow will be bound by identical provisions in their own member state, and can only ‘process’ (e.g. use, store, disclose) the data if they fulfil the same legitimacy test, to be checked by their own domestic authorities (or in the case of a flow towards EU agencies the European equivalent thereof87). Where the CRD contains clear data gathering tasks or tasks to provide other supervisors with specific information, the directives are fully compatible with each other, as such provisions by definition make the CRD the basis for the legitimacy test of the data protection directive. In order to qualify as such provisions, the CRD provisions need to pass the legitimacy test, and the foreseeability test added by the Court of Justice in line with European Court of Human Rights (ECHR) case law where one of the aspects of the processing involves public disclosure88. The problem in the interaction between the prudential supervision rules and the data protection rules of the EU, is that provisions containing clear information demands are thin on the ground in the CRD. There is no harmonised rule yet on what constitutes prudential supervision information in relation to banks, let alone in relation to natural persons who are of interest to prudential supervisors because they are linked to the supervised banks. The only reference to data protection is contained in the recitals, referring to the duty of banks to respect the rights of their clients when assessing the credit risk of those clients89. The data protection directive would allow information exchange, and would even allow all supervisors from all member states jointly to be the ‘controller’ of information on e.g. bank executives. As long as different information is collected in each member state to assess for example the reputation or experience needed to be an executive, the ‘legitimacy’ in each member state is linked to the local test, making it more difficult to be joint controller, and practical difficulties in understanding why another supervisor would desire certain information. As long as the information provisions (clarifying the tasks and authority given to the supervisor) are not clearly harmonised, preferably in the CRD, but which could also be done by harmonising the database notifications made by the supervisors, the ‘flow’ of information will be hampered in practice. This is not due to the data protection directive, but due to the fact that its legitimacy requirement refers to non-harmonised aspects of domestic laws within the framework of the CRD. Specific Secrecy Regime for EBA Cooperation The European banking authority has a wide range of tasks, and a right to information to be able to fulfil those tasks (see chapter 2, 3 and 21.4). In addition to its enhanced legisla87 The European Data Protection Supervisor (EDPS), European Data Protection Regulation EC no 45/2001. 88 Rechnungshof, Neukomm and Lauermann/Österreichischer Rundfunk, Court of Justice 20 May 2003, Joined Cases C-465/00, C-138/01 and C-139/01, §77-92. 89 Recital 38 RBD.

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tive/policy tasks, it is also involved in information exchange between supervisors in a college. For its rights to information it is considered a supervisor in its own right, and it can gain additional information if needed to e.g. mediate or investigate transgressions by supervisors against EU rules90. For the employees of EBA (chair, executive director and the other staff of EBA) the situation is relatively clear. They are bound by secrecy obligations, but on the other hand have access to the information they need for their individual functions, and can use it confidentially and publicly to fulfil their tasks. The licensing supervisor remains the 'normal' authority to which regular reporting is to be addressed by each licensed bank. They share it with the other national authorities in any EU college that relates to that bank, and with any supervisor who has a need for that information. How this information is shared is not made explicit in the regulation or the CRD, but EBA is charged with ensuring the smooth flow of all ‘relevant’ information91. How to do so, especially in light of the procedural checks and limitations in some of the CRD provisions, may be bothersome, but not to the extent it could not be handled on e.g. an IT platform per college92, and a joint IT platform for information exchange outside of a college structure. The delegates of the national supervisors that previously jointly were the CEBS committee are now the voting members of the main decision making body of EBA93. The access of its members (the heads of supervision of the national supervisors) to information is not yet fully clear. For every case on which they need to decide (e.g. in a mediation, or on stress tests) they need to be able to obtain all detailed information they need to make a wellgrounded vote; depending on the issue under qualified or simple majority voting. The EBA regulation is not clear whether the members can share it with their staff for the purpose of preparing such a vote, nor whether they can share it with their staff for other purposes, e.g. investigations on the exposures of the local banks that specific member is responsible for to a troubled foreign institution on which it receives information due to for example a mediation request. It is implied that they cannot, as the secrecy obligations rests on the individual members of the various bodies of EBA, with a prohibition to share it ‘with any person or authority whatsoever’, unless such sharing is explicitly provided for in the regulation or other EU laws94. This on the other hand does not appear to be compliant with normal preparation procedures, where dossiers are prepared at his own organisation for 90 Recital 31, 32, 36 EBA Regulation 1093/2010. 91 Recital 42 EBA Regulation 1093/2010. 92 Art. 21.2 sub a EBA Regulation 1093/2010; and e.g. CEBS/EBA and CEIOPS/EIOPA, Recommendations on the Supplementary Requirements of the Financial Conglomerates Directive for Supervisory Colleges of Financial Conglomerates, 21 December 2010, page 5-6. 93 Art. 43 and 44 EBA Regulation 1093/2010. 94 Art. 70 EBA Regulation 1093/2010.

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meetings of amongst others such persons as the head of supervision when going to EBA. This type of ‘use’ appears necessary for the functioning of the EBA members, but perhaps other use (such as checking exposures to a weaker bank) is not. Whether the members of the board of supervisors also – on an individual basis – have access to all the information obtained by EBA is equally unclear. As a collective, such access is likely as the board is in charge. Even though the board has delegated tasks to the management board, the chair and the executive director, it is still responsible for all the ‘big’ decisions (though it will set up a subset of its members for the binding mediation panels that still have to be confirmed by a simple majority – for college-issues unless a blocking minority disagrees – of the board95). This implies that if it deems it needs information gathered during a specific college-meeting in which a EBA staff-member participated, it shall be given it. This can be needed e.g. for its decisions on intervention in a crisis, or for its work to check breaches of EU law. Though not stated clearly, it appears that a member that does not wish to be investigated or does not want to be ordered to chair further deliberations in a college, can stop this at the level of EBA decision making either at the phase when the order is to be decided upon, or at the preliminary stage when the authority – i.e. the board of supervisors of which it is a member – decides upon a request for information. This appears undesirable, but if the member state can negotiate enough support, the investigation itself may be stopped, except if there is a clear right of. another supervisor to start the investigation without the consent of the full board of supervisors for e.g. binding mediation. Likely this catch 22 situation could be avoided by delegating the investigative stage to for example the chair of EBA, or by instituting a clear conflict of interest rule at the board levels96. Though the decision to intervene might be blocked by members if they have enough support from other members – this should not apply to the request for information to investigate whether such a decision should be proposed. The individual EBA-members thus likely should not be able to obtain confidential information – without a supporting decision of the board of supervisors – in that capacity. Consistent with the provisions of the EBA regulation, the supervisor represented by the member can still get it if the supervisor can show it has a task that requires obtaining such information, e.g. because it suspects non-compliance by an entity related to one of its licensed banks in a manner relevant to its tasks, or improper supervision by one of the other supervisors in a manner relevant to its tasks.

95 Recital 53 and art. 19, 41 and 44 EBA Regulation 1093/2010. 96 As envisaged in art. 41.1 EBA Regulation 1093/2010. The only conflict of interest rule relates to the selection of members to sit on a mediation panel, but does not apply to the related board level decisions; see art. 19 and 41.2 of the Regulation.

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Aggregate information can be sent to the ESRB (see above). The ESRB can ask the national supervisors to deliver aggregate information if the EBA does not deliver the information itself (regardless of the reason). It cannot address the individual banks directly (at least not for microprudential information; but perhaps its members have other channels domestically). The regulation guaranteeing public access to documents of EU bodies applies also to EBA; with the exception of the information protected by the secrecy obligation (for instance the information on institutions shared by national supervisors with EBA). This covers amongst others policy documents discussed or drafted within EBA97. The data protection directive is equally applicable. EBA can address the financial institutions directly if the national supervisor fails to deliver the requested information to it. Banks have also been given a reporting obligation directly to EBA as per the start of 2011. If EBA publishes a guideline or recommendation that stipulates that all banks need to report on whether they comply with such a non-binding rule, the EBA regulation makes this obligation to report binding. They will have to set out clearly whether they comply or not, in light of the obligation to make ‘every effort’ to comply98. The banks will likely send the reports to EBA via their own supervisor, but EBA may set up a different mechanism. Under the new EBA-based information sharing system for colleges each supervisor will have access to (at least the numeric) information, as the information is directly funnelled to the joint college-wide system; see chapter 21.7. If a supervisor withholds it, it can become liable towards the others (see chapter 21.10). This is a good thing, as it will force supervisors to cooperate, and force central banks to cooperate in a timely manner. Another benefit is that a common IT based platform per college will automatically lead to further harmonisation of reporting formats and of definitions used, and a reduction of double reporting. A risk of counterproductive unilateral action by a sub-consolidated/solo supervisor of subsidiaries increases somewhat due to the increased access to common information. It reduces, however, fear-driven unilateral action based on assumptions about being kept out of the loop of relevant information. It distinctly decreases the chance of unilateral action not based on facts, and decreases the chance of unilateral action by the consolidated supervisor (e.g. on Lehman, and Kaupthing/Landsbanki). The EU wide stress testing exercises (and the quantitative impact studies) also involved reporting to CEBS and later EBA, but this was not on the basis of a direct obligation to

97 Recital 62-64 and art. 70-72 EBA Regulation 1093/2010. 98 Art. 16 EBA Regulation 1093/2010.

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report to this European body. Instead, the information was gathered by the domestic supervisors, using their domestic tools, and compared and collated at the EU level. Future Developments The currently applicable non-binding Corep and Finrep guidelines will be replaced by binding templates in the form of technical standards. The Omnibus I directive orders those to be applied by year end 2012, but in light of the progress made this was not likely. The current versions of Corep and Finrep already are more standardised and contain better defined information items to prepare for this. The future version of Corep should also include the large exposures templates, which are at the moment part of a separate reporting addendum to Corep99. The anticipated timelines set have always been ambitious, in light of the lack of harmonisation on definitions and concepts until the entry into effect of the CRD IV project100. The uniform reporting appears uncontroversial for legislators, though agreeing it and implementing it in practice on banks operating in different accounting and legal frameworks with different understandings on key concepts has caused difficulties for supervisors and banks. EBA has now been ordered to develop common reporting formats for the solvency ratio, some associated information and for additional financial information at the latest on 1 February 2015, which will subsequently need to adopted by the Commission101. The extension of the legal texts to Finrep had been proposed by the ECB. It requested a clarification that the legislative basis would apply to both Corep and Finrep, as the previous texts appeared mainly to target Corep102. EBA is simultaneously working with the ECB to minimise unnecessary differences between the information gathered by the ECB for statistical purposes (in the context of its monetary work; see chapter 22.2 and 22.3) and by banking supervisors in Corep and Finrep. They have jointly published a classification system on the information gathered, including some reconciliation proposals that should be reflected in future versions of the EBA and ECB reporting templates103.

99 Art. 74.2 RBD and recital 46 and art. 29.1 sub c EBA Regulation. Also see EBA, Guidelines on Common Reporting for the Revised Large Exposures Regime, 11 December 2009. 100 See art. 99-101 CRR. Also see art. 74.2 RBD as amended by the CRD II Directive 2009/111/EC and subsequently made stricter by art. 9.21 Omnibus I Directive 2010/78/EU, which orders EBA to institute a uniform Corep by year end 2012 in the form of a technical standard. 101 Article 92, 99 and 101 CRR. See chapter 23.3. Article 394 CRR delays the drafting deadline for common reporting standards for large exposures only until 1 January 2014. See article 415 and 430 CRR for similar standards for large exposures and liquidity. 102 ECB, Opinion on CRD IV, 25 January 2012, page 11. 103 ECB/EBA, MFI Balance Sheet and Interest Rate Statistics and EBA Guidelines on Finrep and Corep/large exposures, bridging the reporting requirements – Methodological Manual, second edition, March 2012.

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To ease information exchange for the ‘good repute’ check under licensing (and ongoing) requirements, EBA is required to set up a database of administrative penalties as of the start of 2014104. The information gathering and the secrecy regime continue in outline unchanged, though the exceptions to secrecy continue to mount. In addition to the information to be published under supervisory disclosure and pillar 3 disclosure, the CRD IV adds for instance new possibilities to publish breaches of supervisory requirements, and obligations to publish penalties given. These have relatively few exceptions, though information on natural persons can be published on an anonymous basis, and the supervisor is given some leeway to assess whether information should be published in light of for instance the damage inflicted on the person and on financial stability105. The proposals for a recovery and resolution directive would provide greater detail and body to the investigative (and corrective) instruments. See chapter 18.3 for an overview of the proposals. This includes information rights to e.g. be able to obtain all relevant information to draw up a resolution plan, and a right to obtain a fully-fledged recovery plan from the bank. Oddly, a separate and awkwardly worded secrecy obligations is incorporated in the proposals106. It commits everyone to confidentiality, but also provides for a waiver by the resolution authority (which is not available in the CRD). The provision makes it unclear which (CRD or new directive) secrecy regime is applicable, and whether it only protects the goals of the resolution authority, or also general goals of confidentiality. This could have been avoided if the CRD regime was referred to, or – even better – the recovery and resolution regime would have been integrated into the CRD so that consistency (and a lack of overlap) could be ensured. A general secrecy obligation is indeed correct for the new resolution authority (with whom the CRD-supervisor will share many of the same rights and functions, if they are not the same entity in some member states). However, for the new ‘instrument’ of appointing an special manager at the bank, this leads to an awkward twist. The special manager is appointed by the CRD-supervisor, and will likely obtain background information and instructions from the supervisor and the resolution authority. But binding him to secrecy means that he is not allowed to share his insights with the bank or others, unless he obtains explicit (and general) consent from the resolution authority, or it is clearly necessary for his tasks. There should be a clearer exemption to use the information, and share it, if public tasks given under the CRD or this new directive require this.

104 Art. 69 CRD IV Directive. 105 See art. 53-63, 65, 67.2, 68, 71, 99, 116, 124 and 152 CRD IV Directive. 106 See proposed art. 76 of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012.

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20.3 Corrective Instruments – Prevention, Intervention or Punishment Introduction In ‘normal’ times, supervisors are focused on the adherence by the individual bank or banking group to supervisory requirements. In the decision making process and application of supervisory instruments (either to assess the bank or to address non-adherence to requirements) supervisors can take a stance that is more or less independent from repercussions on other banks and the financial system, unless the bank is non-compliant in a way that is itself a possible cause for a crisis107. Supervisors should have the instruments to ensure that the tasks that have been given to them can be performed in an effective proportionate and dissuasive form; see chapter 20.1. The current CRD provides some minimum standards regarding the instruments that supervisors should be given by their member state. The CEBS-EBA review panel notes that such tools are generally available in some form for ensuring compliance in normal times, but that the type of tools needed in crisis times are much less common or even lacking108. The latter part lead amongst others to the proposals on recovery and resolution discussed in chapter 18, and a new administrative sanctions regime as part of the CRD IV directive that will enter into force in 2014. Intervention tools are useful, but often not as useful as when the bank and its employees actually consider either an obligation under the CRD or a ‘suggestion’ from the supervisor to be in their own best interest. If they agree or can be persuaded to agree that a specific action is necessary, this is likely to be most effective and efficient, and quick109. However, if the bank does not agree or does not agree in light of other considerations (costs, lost business, legal obligations under other laws or foreign laws), but cannot convince the supervisor, the supervisor needs the power to ensure that the prudential rules are applied nonetheless. Those instruments need to be actually applied, for the CRD to be effective and efficient110.

107 In a (potential) crisis situation different aspects have to be taken into consideration by the supervisor in the assessment and treatment of compliance with supervisory requirements, and other authorities (e.g. central banks and ministries of finance) may have the lead in setting the strategy for supervisory actions. See chapter 18.4. 108 CEBS-EBA, Mapping of Supervisory Objectives, including Early Intervention Measures and Sanctioning Powers, 2009/47, March 2009. 109 See for instance H. Richards, ‘Influence and Incentive in Financial Institution Supervision’, in A.J. Kellermann, J. de Haan, F. de Vries, (Eds.), Financial Supervision in the 21st century, Amsterdam, 2013, chapter 5. 110 Issues of liability, resources and independence may have an effect, as well as other public policy considerations; see chapter 4.3, 20.4-20.5 and 21.9-21.10.

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The tasks and the instruments of the supervisor cannot be easily distinguished in the CRD. Is the right to assess compliance with a specific requirement a task or an instrument, or is it just the basis on which a supervisor can take corrective actions? This question can be answered in different ways in different member states, depending on their local administrative laws. A distinction could be made between: – supervisory instruments that support the exercise of supervisory tasks, e.g. regular reporting, standing information requirement if certain events occur, ad hoc information gathering by request, or verification of information or tips received; see chapter 20.2; – supervisory instruments that imply that the supervisor is allowed to come to a supervisory judgement without necessarily having an enforcement component (powers to approve, or not to approve), including the assessment of capital adequacy under pillar 2 and the assessment of models or of takeover/mergers; – supervisory instruments that intend to enforce the law or the above-mentioned supervisory judgement, e.g. individual requirements to for example hold more capital or to change the organisational structure or business plan, penalties, granting or revoking the banking license, start bankruptcy proceedings, or start criminal proceedings. The instruments of a supervisor can also be differentiated in different manners, for example. by splitting them up along the lines of the area of law they impact on111: – purely public law (information rights, power to grant or revoke a banking license); – public law instruments that impact on civil law (e.g. powers to adapt contractual obligations of a financial institution, or limiting the amount due under an insurance policy), or – public law instruments that enforce administrative law provisions that benefit third parties (such as obligations to treat counterparties fairly or giving them information)112; – public law instruments that impact on company law (e.g. powers to instruct the board to act in a certain manner, or to instruct the shareholders to sell their shares, to apply for bankruptcy, or to assess and approve potential board members); – public law instruments that have penal law elements (e.g. penalties, or instructions that – if not followed – result in monetary obligations towards the supervisor, or to apply for public prosecution).

111 See e.g. C.M. Grundmann-Van de Krol, ‘Vennootschapsrechtelijke aspecten toezicht effecteninstellingen’ (Dutch), in Aspecten van toezicht, Deventer, 1999, page 37-38. 112 Genil and CHGV versus Banco Bilbao and Bnkinter, Court of Justice 30 May 2013, Case C-604/11 indicates that such obligations – unless the relevant directive harmonises the civil consequences thereof – may or may not be given relevance in the civil laws of the member state in the relationship between the bank and the client.

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Supervision involves continuously making judgements. The clearest example of such an assessment is the obligation of the supervisor to assess whether the bank has sufficient capital for the risks it has under pillar 2 (see chapter 14). However, each of the obligations set upon a bank by the CRD needs to be monitored by the supervisor, and he has to assess whether the bank is in breach of its obligations under the CRD. Under EU rules – once the supervisor knows or should have known that the bank does not comply with prudential requirements – he is obligated to use corrective instruments early to address this situation by either making sure that the bank lives up to the specific requirement or by taking compensating measures (such as requiring excess financial buffers on top of the minimum amount required under the solvency ratio, or forcing the bank to change its remuneration payments or retain profits)113. Some of the ad-hoc instruments inserted in the CRD are quite specific114, but most also allow scope to see what kind of intervention is best suited. The standards set by the CRD are, however, often ambiguous. This makes the question whether an instrument can or should be used dependent on whether the supervisor or the bank comes to a judgement on whether a rule with vague words or terms is breached or not. The CRD rules also do not clearly focus l how and how far reaching the assessment by the supervisor needs to be to be able to decide whether an instrument needs to be used, or what is the exact minimum. Orders to assess compliance or preparedness for risk are contained in several parts of the RBD115. CEBS-EBA works on converging the content of such assessment: – market access restrictions and permissions such as licensing and European passport; see chapter 5; – model approval; see chapter 6.3; – pillar 2 supervisory measures; see chapter 14. Use of Instruments and Goals/Contradictory Other Public Policy Goals The CRD and the EU treaties requires that domestic laws give such instruments to the supervisor that ensure the correct implementation of the CRD requirements; see chapter 20.1. The supervisor can and should use them to uphold the goals of financial stability, depositor protection and the single market (and where applicable such other public policy

113 See chapter 20.1 on the treaties obligations to uphold directive-rules. Some rules on instruments are contained in art. 136 RBD as amended by art. 1.10 CRD III Directive 2010/76/EU. 114 E.g. Banks that invest in securitizations need to perform certain checks, and the banks that set up securitizations have to publish information that allows such checks. If they do not, credit risks weighting should be mandatorily increased by the supervisors involved to between 250% and 1250%; see art. 122a.5 RBD. Also see paragraph 6 of that article on the punishment that the assets will not leave the balance sheet if the lending standards have been lowered on assets that are destined to be securitised. CEBS/EBA, Guidelines to art. 122a of the Capital Requirements Directive, 31 December 2010; and also see chapter 8.6. 115 See e.g. 124, 136 and Annex XI RBD; and chapter 5.2, 6.2 and 13.5.

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goals as ensuring funding of green energy and of small- and medium sized enterprises; see chapter 4.3). The plethora of goals and the possibility of unintended consequences for one goal when acting in the interest of another goal make it sometimes difficult to use the instruments effectively116. For instance the instruments on withdrawing the authorisation or taking measures to address transgressions against CRD requirements are worded to limit the supervisor to be able to act in certain situations only, and in such cases only if they so desire (supervisors are allowed but not obliged to intervene under these instruments even if there is an important transgression)117. Is the known effect on liquidity creation and risk taking (also on the sectors mentioned in the other public policy goals mentioned in the recitals of the CRD) a factor that should limit the power of the supervisors to demand a timely recapitalisation or restructuring, or to demand a more conservative board? As the financial stability, depositor/investor protection and single market goals are more dominantly projected in the RBD and RCAD than some other policy goals, this should not be the case. Though the deliberations on lender of last resort or state aid can take into consideration any goal they want, this is not the case in the decision making process at the supervisor as to whether an intervention should take place at all. However, if an intervention could lead to a wider credit crunch, this could feedback into financial stability considerations. An even more difficult consideration is whether long term risks (for instance a potential full collapse of the bank in a few months) should or should not trump short term risks (such as an almost certain reduction in funding if the bank is forced to rebalance its lending portfolio now)118. As indicated by the Court of Justice, within the current set of goals the most appropriate goal-based decision cannot be predicted without a full knowledge of all circumstances at the time119. In the wake of the 2007-2013 subprime crisis, during the decision making process of home and host supervisors on a single bank operating in various countries, they have to at least consider the potential impact on financial stability also in all other member states involved, in particular if there is an emergency situation, even if there is no explicit obligation to weigh foreign interests as heavy as domestic interests120. This to ensure that not only local (supervisory, political or economic) consequences are taken into account in taking measures, 116 D. Nouy, ‘Unintended Consequences of Supervision’, in A.J. Kellermann, J. de Haan, F. de Vries, (Eds.), Financial Supervision in the 21st century, Amsterdam, 2013, chapter 4, as well as other writers in the same book. Also see R.J. Theissen, Are EU Banks Safe?, The Hague, 2013. 117 See art. 17, 124, 136 and Annex XI RBD. Many of the underlying transgressions in which cases an intervention ‘may’ or can ‘only’ take place are in turn based on vaguely worded obligations (be fit and proper, avoid close links that hamper supervision, have sufficient financial buffers, each of which requires subjective assessments, e.g. on influence, value or risk; see chapter 5.2 and 6.2. 118 See e.g. A.N. Berger, C.H.S. Bouwman, T. Kick & K. Schaeck, Bank Liquidity Creation and Risk Taking During Distress, Deutsche Bundesbank Discussion Paper Series 2, 05/2010. 119 Peter Paul/Bundesrepublik Deutschland, Court of Justice 12 October 2004, Case C-222/02. 120 Recital 7 and art. 1.3 CRD II 2009/111/EC, introducing art. 40.3 RBD. See chapter 20.1.

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but also the potential havoc created across borders by e.g. closing a branch of a foreign bank, or the home office of a bank operating elsewhere. The requirement is awkwardly inserted into a provision that deals only with home host cooperation on a single entity with a banking license. It is not clear whether this commitment also applies to solo or consolidated supervision on a bank that is part of a banking group, which the non-binding recital of CRD II seems to imply, but the binding article does not touch. The financial stability considerations are equal or larger there, so it is likely that this was intended. Indirectly, a consideration of each other’s interests can perhaps on the basis of the recital also be read into the (different, but broadly worded) obligation to cooperate in colleges. See chapter 21. The recital also clarifies that though it is obligatory to consider the financial stability in other member states, this in no way binds supervisors to act or refrain to act if the financial stability elsewhere is indeed threatened by their actions, as long as they stay within their competences. Please also note that the power to act under the CRD or related crisis management rules does not give the right to evade other obligations, such as data protection rules or the protection of property. An obligation or right given in one directive does not prevent the application of another directive. For instance in the TKE Bank case the Court ruled that the specific rights given in the company directives overruled banking supervision crisis management considerations in the absence of specific provisions stating that the rights of shareholders could be overruled (even outside of a liquidation procedure)121. For actions that overlap with human rights protection, see the next chapter. Intervention Instruments The CRD refers in general to intervention powers and sanctions, and gives specific minimum goals those powers and sanctions must be able to achieve. In addition for certain situations it mentions some specific instruments that should enable the supervisor to have an impact on the bank, sometimes to the benefit of its shareholders, sometimes to the benefit of its creditors. The main obligation put on supervisors is to require any bank that does not meet the CRD requirements to take the necessary actions or steps at an early stage to address the situation. Linked to this obligation, the CRD obliges member states to give their supervisor a minimum set of supervisory enforcement instruments. The supervisor has to be able to ensure

121 TKE Bank, Panagis Pafitis and others/TKE Bank and others, Court of Justice 12 March 1996, Case C-441/93, see chapter 20.2.

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compliance with the law, sometimes to oblige the bank to be stricter than the law, or to apply the law in a specific manner. This includes powers to oblige a bank to122: – pay or comply with financial and non-financial penalties or measures aimed specifically at ending the breach or the cause of the breach of banking supervision laws, regulations or administrative provisions; – hold own funds in excess of the minimum requirement calculated under quantitative supervision; – limit bonuses as a percentage of total net revenues in order to maintain a sound capital base; also compare chapter 6.2; – retain net profits to strengthen the capital base; also compare chapter 6.2; – reinforce the general organisational requirements; – apply for a specific provisioning policy in terms of own funds requirements; – apply for a different treatment of assets in terms of own funds requirements; also compare chapter 7-11; – restrict or limit the business, operations, or network; also compare chapter 5; – grant or withdraw a license; see chapter 5; – reduce the risk inherent in the activities products and systems; – make more frequent, timelier or better quality pillar 3 disclosures; also see chapter 15; – apply for criminal law prosecution. Several of these intervention instruments have already been described in other chapters: – licensing and market access, including mergers and acquisitions is described in chapter 5; – intervention instruments in crisis situations are described in chapter 18. Even though these specific powers have to be given by each member state to each supervisor, this has not lead to substantial harmonisation of intervention mechanisms; see chapter 18.3 and 20.1. The CRD IV project intends to change this for normal, ongoing, supervision. The Commission has also announced plans to further harmonise (and strengthen) the instruments supervisors must be able to use in order to prevent a crisis123. It is not yet clear how this will relate to optional instruments. These include for example intervention

122 Art. 54 and 136 RBD as amended by art. 1.4 and 1.10 CRD III Directive 2010/76/EU, for licensing/withdrawal of the licence art. 9 and 17 RBD and for pillar 3 art. 149 RBD. The penalties and measures aimed at stopping a breach of supervisory requirements (art. 54 RBD) have to be able to be addressed either to the bank or to those who effectively control the business of the bank (which can be boardmembers, shareholders, or other parties who exercise effective control e.g. through contractual or practical arrangements. Also see chapter 6.2 on the restrictions on dividends and profit distributions that will become automatically applicable if a bank breaches additional buffers requirements from 2016. 123 EU Commission Communication, An EU Framework for Crisis Management in the Financial Sector, COM(2010) 579 final, 20 October 2010, www.ec.europa.eu; see chapter 18 and 20.1.

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instruments that host member states can but are not obliged to give to their supervisors to intervene in incoming branches in emergency situations, or that are used to ensure compliance with ‘general good’ goldplating rules, or if the home supervisor refuses to ensure compliance with the CRD124. Some of the instruments contained in the current version of the CRD are wholly or partly ‘bound’ instruments, in the sense that the CRD indicates when they have to be exercised, or when they may be exercised. This includes the withdrawal of the license (a power that a supervisor is only allowed to use in the more extreme cases125). Most controversial was the obligation on the supervisor to impose a specific own funds requirement in excess of the minimum level laid down in the quantitative requirements at least on banks which do not meet the requirements to have sufficient capital under the pillar 2 supervisory assessment. Several member states were disinclined (as were their supervisors) to impose additional capital requirements, let alone to be obliged to do so. They generally trust more on other corrective measures, such as replacing board members, instructing organisational changes or requiring provisioning, or their general administrative laws prohibit putting harsher requirements on one bank if that rule does not apply to the whole banking sector. Under the compromise text such supervisors can still do so, unless the application of those alternative measures is unlikely to improve the non-compliance sufficiently within an appropriate timeframe; see chapter 14. Though there is an incentive here to oblige a bank to hold additional capital, it will most likely be a hindsight assessment only after the annual assessment process. While supervision is ongoing, the obligation on the supervisor is dependent on its own assessment of both compliance and of the possibility to address the issue via other measures. Only if their own assessment proves faulty in hindsight, the lack of obligatory additional own funds put on the bank could make the supervisor liable for the losses of third parties; see chapter 21.10. The instruments that the supervisor needs to have under the CRD focus on the intervention at the bank. The primary responsibility to comply with prudential requirements nonetheless rests at the bank. It needs to fulfil its obligations as set out in the CRD in line with the instructions of the supervisor, who can try to enforce it via the instruments if the bank does not do so itself (with administrative law and human rights safeguards for the bank). The supervisor has not been awarded tools to address issues to the individual organs of

124 See for instance art. 30-34 RBD, and chapter 3.5, 5.3 and 21.6. 125 See art. 9 and 17 RBD. In König/Germany, ECHR 28 June 1978, Case 6232/73, the Court found it relevant that an already licensed practitioner has a right to continue in his profession once licensed, though some of the judges had dissenting opinions on this aspect. It is likely, at the least, that the rights of a licensed bank to continue his business and to benefit from its investments does weigh heavily against a withdrawal of the licence, which aspects are not relevant when judging a new applicant for a banking licence.

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the bank in the CRD, but a national legislator can opt to give more targeted instruction tools at the domestic level. However, if a tool given to the supervisor would impinge on laws implementing company law requirements, such as the protection of shareholder rights, a conflict between two equal value directives ensues. In the rescue of TKE Bank in Greece, the government appointed administrator had not taken into account the exclusive rights of the shareholders meeting to decide on enlargement of capital. Even though domestic supervisory laws gave him this tool, and the enlargement was necessary to save the bank, the company law directive applied, as there was no specific provision providing an exemption from its provision, neither in that directive nor in the banking directives. The general good exemption did not apply, as there were alternative measures that could have been put in the legislation, but for which the local legislator had not prepared126. The usefulness of supervisory instruments in crisis situations will thus heavily depend on good national legislation, pending harmonisation at the EU level on the basis of the CRD IV project instruments that will apply from the start of 2014, and under the recovery and resolution proposals; see chapter 18.3. Intervention Pyramid? The CRD does not contain a clear intervention pyramid. Supervisors are exhorted to make sure that the CRD provisions are effectively and efficiently guarded, to act in a proportional manner, while taking into account the administrative and human rights protection granted to any citizen, including a bank and its connected persons (see chapter 20.1, 20.4 and 20.5). Some instruments have to be applied if a certain trigger is breached (the activation of the deposit guarantee scheme; see chapter 18.5), but even here the trigger allows for some discretionary interpretation by the supervisor. Most other instruments have triggers, but allow significant leeway for the supervisor at two moments in the decision making process, (i) to come to the conclusion that the trigger is activated plus (ii) whether or not they will subsequently intervene (e.g. the withdrawal of the license and the application of pillar 2; see chapter 5 and 14). For other measures the leeway granted is even wider, though the bottom line remains that the CRD provisions need to be effectively and efficiently guarded (effective, proportionate and dissuasive; see chapter 20.1). Regulatory theory takes into account issues such as deterrence, punishment (an eye for an eye, tit for tat), motivational, restorative, risk-based and compliance driven tools. For prudential issues this would indicate that an escalation of instruments is proportional and most effective. Depending on the type of transgression (e.g. criminal, intentional, accident) and the type of firm (cooperative, virtuous, gaming, incompetent, irrational) different instruments should be applied, escalating from an informal ‘chat’, to a formal letter, to 126 TKE Bank, Panagis Pafitis and others/TKE Bank and others, Court of Justice 12 March 1996, Case C-441/93.

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orders to correct transgressions, to withdrawal of the license, to liquidation127. The CRD does not set out how to do this. The intervention pyramid chosen – if any – is thus a national discretion and/or a supervisory discretion. The escalating intervention pyramid assumes a supervisor that has the skills and manpower to timely know that something is wrong even if the bank is uncooperative or provides faulty information (see chapter 20.2), and a supervisor that is subsequently willing, eager and politically and judicially allowed to intervene (see below, as well as chapter 18.3 and 20.9). When all forbearance (see below) and intervention fails, one of the final instruments is the withdrawal of a license to be a bank. Withdrawal of licence is an ultimum remedium, which can only be used if a bank cannot be corrected by gentler instruments. It is given as an option to the supervisor only in a limited set of circumstances, including when it has not used the license, has obtained it through fraud, or no longer fulfils the conditions to be allowed a license or no longer has own funds (or in other cases specified in national law128. However, the license has to be withdrawn by the supervisor if a bank is excluded from the deposit guarantee scheme, and is unable to make alternative arrangements (see chapter 18.5)129. Banks that consistently fail to live up to the prudential standards will likely be forbidden by their supervisors/deposit guarantee schemes to attract new deposits (even though existing deposits will remain covered). The conditions set for a withdrawal are so strict, that often the withdrawal of a license (except when it is voluntarily handed back) is simultaneous or after a bank going bankrupt; see chapter 5 and 18. If the bank has branches, the home supervisor has the obligation to inform the host supervisors as soon as possible of the withdrawal of the license. This will allow them to supervise that no new transactions are entered into in their territory, and to protect the interests of the depositors of the branch130. Regulatory Forbearance (Official, Unofficial and ‘Delay’) Generally, the supervisor has the leeway to take measures or to grant the bank some leeway to become compliant again within the context of the effective, proportionate and dissuasive enforcement of CRD obligations. Such leeway is available for instance in the vague wording of the CRD organisational requirements or in the allocation of risk weights and valuation necessary to calculate solvency ratio requirements – allowing a delay in coming to the 127 See e.g. R. Baldwin & J. Black, Really Responsive Regulation, LSE Law, Society And Economy Working Papers 15/2007; and BCBS, Supervisory Guidance on Dealing with Weak Banks, March 2002. 128 Art. 17 RBD. See chapter 5. 129 Art. 3.5 Deposit Guarantee Directive 1994/19/EC. 130 Art. 35 RBD.

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conclusion that there is a transgression, or interpreting a requirement in the most lenient manner possible – but less in trustworthiness issues and where the survival of the institution is dependent on immediate action. An intentional failure to take notice of a transgression may be illegal, but even where such intent is absent, the CRD obligations contain such vague references to ‘appropriate’ and ‘adequate’ that provide ample leeway for a supervisor to come to the conclusion that for this specific bank this specific level of organisation or calculation is ‘appropriate’, even if (too) low. Forbearance options can also be formal/legal, allowing temporary or permanent waivers of stricter requirements, and supervisory judgement as to whether or not the use of an enforcement tool is necessary131. It can also be built into the rules in order to favour certain groups of politically important voters, companies or practices (e.g. lending to house owners or to governments by reducing risk weighting)132. Regulatory forbearance is common in emergency situations, when limits have been breached but the supervisor has a reason or even just a hope that the situation can be turned around133. Official references to tempering the need for immediate action is for example available: – in emergency situations, banks can temporarily be allowed to cover capital requirements by lower quality items than are accepted in normal times under the tiering requirements134; – if an IRB approach bank no longer fulfils the conditions to be able to use the IRB approach, it shall either present to the supervisor a plan for a timely return to compliance or demonstrate that the effect of non-compliance is immaterial135; – If a bank does not fulfil organisational requirements as set in the licensing requirements, large exposures requirements or in the pillar 2 requirements, it can allow the bank an ‘appropriate timeframe’ to improve ‘sufficiently’, and if it is not expected that the bank can improve so, it can still allow it to continue operating subject to ‘a’ specific additional own funds requirement136.

131 This type of legal forbearance can be part of national laws on top of the cases where the CRD explicitly references it, for instance due to the principle of proportionality. National legal forbearance clauses in some member states were identified in CEBS-EBA, Mapping of Supervisory Objectives, including Early Intervention Measures and Sanctioning Powers, 2009/47, March 2009. 132 See chapter 4.3 and 6.2; E.J. Kane, Regulation and Supervision: an Ethical Perspective, NBER WP 13895, March 2008. Also see R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 2 and 3. 133 D. Elliot, G. Feldberg & A. Lehnert, The History of Cyclical Macroprudential Policy in the United States, WP 2013-29, 15 May 2013 mentions the example of the Savings & Loans crisis where forbearance went wrong, and some examples when the gamble paid off. Also see chapter 18.3. 134 Art. 66.4 RBD. See chapter 7 and 18.3. 135 Art. 84.5 RBD. See chapter 6.3 and 8.3. 136 Art. 136.2 RBD.

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Forbearance is also common when banks that are well behaved and well managed by accident transgress rules, and take measures to make amends unilaterally (and for example inform the supervisor immediately at their own initiative). This can be the result of unexpected situations, e.g. due to illness there is only one fit and proper executive available, or key control positions in the internal organisation are not fulfilled because the relevant officer left at short notice, or a huge loss occurs unexpectedly due to marking to market of financial instruments. In these cases forbearance can be a useful and proper (proportionate) response. However, forbearance can also be used beyond any reasonable hope or trust in the integrity or health of the institution, and in denial of obligations to other supervisors/member states that have an interest in the compliance of the bank too (e.g. via consolidation or via crossborder branches)137. If not accompanied by a strong action plan to alleviate the original reasons that led to forbearance being needed138, it can be the reason that the ultimate bankruptcy is even more destructive. Though this is a transgression of the obligation to implement and enforce the CRD, the drivers for such lack of implementation may be too strong to resist (especially in situations where the funding is lacking to increase the financial buffers at a bank, due to lack of private sector interest and lack of public authority funds or lack of willingness to act by the central bank and the government). The CRD sometimes explicitly forbids such leeway (including looking in the other direction): – a supervisor is required to explicitly look at back-testing of the market risk internal models it approved, to require at least back-testing on hypothetical outcomes, and to take measures if it deems the banks capabilities in this area insufficient139; – all provisions that are formulated along the lines of ‘shall require’, e.g. on fit and proper criteria do not leave any leeway for legal forbearance, once they have decided that the provision is transgressed140. This does not mean that the authorisation needs to be withdrawn, but the bank has to be forced to fulfil the requirement as soon as possible, taking emergency measures if necessary (e.g. hiring interim management). Regulatory forbearance in the use of instruments is the counterpart to forbearance as a result of choices made by legislators in the design of prudential requirements, e.g. when the goal of additional competition or favoured sectors of society means that risk is under137 See chapters 5.3, 17, 18.3 and 21, and the proposals contained in R.J. Theissen, Are EU Banks Safe?, The Hague, 2013. 138 BCBS, Supervisory Guidance on Dealing with Weak Banks, March 2002. 139 Annex V §4 RCAD. 140 Art. 9 and 135 RBD.

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priced and undercapitalised to begin with. Forbearance may result from entirely legitimate and objective considerations of legislators and supervisors, it can also be the result of lobbying/capture, a lack of resources, or a lack of knowledge or know-how141. Important and Unenforceable, Unimportant and Enforceable Banking rules are manifold and detailed. Enforcing them should thus also presumably be manifold and detailed. However, it appears that enforcement actions are either unpublished/informal or largely absent. The rare published enforcement actions on prudential transgressions mostly relate to unimportant details of the ‘speeding ticket’ type such as a late submission of a reporting form (except for when the bank is closed), or relate to conduct of business transgressions. If the published enforcement actions are representative, this can be a problem of the lack of instruments, a fault in the rules, excessively compliant subjects of the rules (possibly after an informal warning), a failure to act by supervisors, or a lack of publication of enforcement actions142. Likely the answer is a combination of all of these. In its CRD IV project on new sanctions in ongoing supervision, the Commission indicates that a substantial part of the CRD is not to be enforced via punitive sanctions but by administrative measures (that are equally ‘sanctions’ in the CRD IV terminology). As a result, all the detailed rules on the quantitative calculation of capital requirements (the vast majority of CRD rules) are out of scope of punishment style instruments if the institution is acting in good faith. The larger transgressions relating to capital adequacy (e.g. breaching minimum capital requirements, miscalculations, faulty models) are not expected to be fought primarily by punitive sanctions but by ameliorating initiatives143. The punitive side of the sanctions instead focus on the organisation of the bank and its relation to the supervisor, and seem indeed most likely to focus on discipline issues, such as late delivery of reporting forms. Misreporting in bad faith is not prosecuted by enforcing the quantitative rules, but by e.g. having the responsible manager sacked for incompetence or untrustworthiness, or by fining the bank on transgressing internal control requirements if and in as far as those are sufficiently detailed and the transgression is clear. Also see the discussion in chapter 13.3 on the imprecise obligations on internal governance as phrased in the CRD, that further suffer as a basis for litigation by having to be applied in a proportional manner.

141 M. Bijlsma, W. Elsenburg & M. van Leuvensteijn, Four Futures For Finance, CPB Document 211, September 2010 mention supervisory capture, lack of commitment and lack of coordination. 142 Also see P.A. Wellons, ‘Enforcement of Risk-Based Capital Rules’, in H. Scott (Ed.), Capital Adequacy Beyond Basel, New York, 2005, chapter 8. 143 Art. 64-72 and 126 CRD IV Directive. Commission, CRD IV – frequently asked questions, 20 July 2011, memo/11/527.

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The CRD does not specify whether the corrective instruments used should be subject to either an administrative law framework or to a penal law framework. In this respect it deviates from provisions in conduct of business directives144. There is no common definition of administrative measures or sanctions, let alone of penal measures or sanctions, so they can be subject to different national regimes145. Most supervisory measures are aimed at ending or preventing a breach of supervisory requirements in order to prevent the bank taking too large risks or failing, not punishing a transgression. However, some measures, especially penalties, serve the dual purpose of ending the transgression and adding a punitive element, in order to ensure that the bank or the other addressee of an obligation will not transgress that particular obligation again146. If a measure has a punitive element, it overlaps with criminal law provisions. The Court of Justice has accepted that criminal sanctions may be a necessary component of directives that have as their primary objective one of the goals of the EU for which there is a legal basis (even though criminal matters in general are not part of the competence of the EU)147. Some of the easily enforceable transgressions could easier be maintained by automatic fines or automatic prohibitions to pay out dividends or certain salaries (too late, or the lack of e.g. key internal governance personnel e.g. a credit risk officer at an IRB bank less than two executives) instead of via an internal procedure at the supervisor. However, if there is a punitive element in the fine, additional human rights safeguards apply; see chapter 20.4. Special Investigative and Enforcement Measures Related to Enabling Consolidated Supervision If the head of a banking group or a financial conglomerate is an unregulated entity in the form of a financial holding company, mixed-activity holding or a mixed financial holding, the supervisors need to be able to gather information at and take measures vis-à-vis the holding and its managers, in order to enforce the application of CRD consolidated supervision and financial conglomerates directive. Member states need to make sure that their supervisors have this possibility, and that they will cooperate if a unregulated holding is not based in the member state where the coordinator or other relevant supervisors of group entities are based. The consolidating or coordinating supervisor has to have the right148 to request information and to verify it on-site, and to take enforcement measures. Such measures need to include the possibility to give penalties or to take other measures that

144 Iris H.-Y. Chiu, Regulatory Convergence in EU Securities Regulation, Alphen aan den Rijn, 2008, page 150158. Art. 50.2 and 51 MIFID, art. 14 Market Abuse Directive 2003/6/EC, art. 25 Prospectus Directive 2003/71/EC and art. 28 Transparency Directive 2004/109/EC. 145 CEBS-EBA, Mapping of Supervisory Objectives, including Early Intervention Measures and Sanctioning Powers, 2009/47, March 2009, page 50. 146 See e.g. the penalties mentioned in art. 136 RBD and in art. 17 Financial Conglomerates Directive. 147 Commission v. Council, C-176//03, 13 September 2005, §47-49. Also see chapter 3.4 and 23 on the boundaries set by the treaty on legislating on banking supervision. 148 Art. 127, 137, 138, 141 and 142 RBD and art. 14-16 and 17.2 Financial Conglomerates Directive.

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aim at ending observed breaches (in addition to any criminal law provisions that may or may not be available). The right to request information can be used on an ad hoc basis, but the bank has to report – either at its own initiative or in the context of periodic obligatory reporting – to the supervisor in the context of the supervision of intra-group transactions if the parent is a mixed-activity holding (any such transactions need to be reported by the bank at its own initiative or in the form or periodic reporting). With regard to other unregulated entities in a banking group or financial conglomerate, the supervisors have the right to access information and verify it149. However, the supervisor does not have the power to take corrective measures against a subsidiary that is not regulated itself. Any such measures necessary are addressed instead to the parent. If in the supervision of a financial conglomerate it appears that the regulated entities have used the structures of a financial conglomerate to circumvent sectoral rules, the supervisors have to be able to take any supervisory measure deemed necessary to avoid or to deal with any such circumvention150. Special Instruments of Host Supervisors On Branches151 On subsidiaries, local supervisors have the same rights they have vis-à-vis any supervised bank in their territory, with some additional role of the consolidating supervisor. On a branch, this is not automatically the case, as the host supervisor is not the licensing authority. The RBD provides a set of instruments that can be employed by host member state authorities. Some apply to any branch that operates in its territory under the European passport, some only to those branches for which an agreement has been reached that it is a ‘significant’ branch (i.e. systemic). These give the host member state supervisors the potential to have the same type of intervention tools a home supervisor has on the monetary and liquidity tasks it has for all branches, as well as some additional rights in emergencies, with an additional layer of rights for significant branches.

149 Art. 127 and 141 RBD, and art. 14 and 15 Financial Conglomerates Directive. 150 Art. 17.1 Financial Conglomerates Directive. 151 Art. 30 RBD actually mentions both branches and cross-border provision of services. The instruments are, however, linked to the compliance with obligations to the host member state under the RBD. As the host supervisor and host member state since the coming into effect of the CRD no longer have any rights on cross-border provision of services except for the bare obligation to receive a notification of such activities, the instruments described here do not play a relevant role except for branches.

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As these rights impinge on the home country control principles laid down in the CRD, except in emergencies it requires some coordination with the home supervisor regarding enforcement; also see chapter 21.6: 1. If a bank with a branch in the host member state does not comply with the legal provisions in one of the retained areas of responsibility (monetary policy and liquidity supervision), it will require the bank to put an end to that situation. This will be in a letter or other communication, without the use of any accompanying enforcement measures unless there is an emergency situation. 2. If the bank does not amend the situation accordingly, the host supervisor shall inform the home supervisor. 3. At the earliest opportunity, the home supervisor has to take all enforcement measures needed to ensure that the bank complies, and will inform the host supervisor of the measures taken. 4. The host supervisor can take enforcement measures on the bank itself if (i) the enforcement measures taken by the home supervisor prove inadequate, (ii) enforcement measures are not available in the home member state, or (iii) the bank persists in the violating the host member states legal provisions regardless. 5. The enforcement measures of the host supervisor can152 include, (i) preventing further irregularities, (ii) punishing (further) irregularities and (iii) preventing the bank from initiating further transactions in its member state. 6. The substantiating argumentation for the measures by either the home supervisor under step 3 or the host supervisor under step 4/5 has to be communicated to the bank, and is subject to appeal (see chapter 20.4 and 20.5). In emergencies, the host supervisor can take any precautionary measures under step 1, even before starting the process with the home supervisor153. This does not appear to be limited to ‘own’ competences of the host supervisor – though the opposite could also be defended on the basis of a cross reference to ‘the procedure’ set out above – but can be taken to protect the interests of depositors, investors and others to whom services are provided. As such measures would impact immediately and unilaterally on the single market, the freedoms of establishment and to provide services, and the reputation and viability of the bank, they have to be communicated to the Commission, EBA and to the home member state immediately. The Commission has been granted the power to decide, 152 Art. 30.3 and 34 RBD contain identical powers, except that under art. 34 the punishment can also relate to the first irregularity. Except for this difference, art. 34 does not appear to serve any purpose, and may be a left over from a hasty legislative process (though one that took place in 1989). A host supervisor could, however, try to defend that it is art. 30 that is superfluous, which would give it the powers to interfere without the coordination process. As this would hamper the single market, and take away protection of legal entities of another member state, it is unlikely that such a theory would be upheld in court. 153 Art. 33 RBD.

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after consulting the host and home supervisors (but not necessarily the bank itself), whether such emergency precautionary measures shall be amended or abolished. Also this power appears to be applicable directly in any member state, regardless of implementation. Any ‘general good’ requirements on a branch set at the time of the establishment of the branch fall under a different regime. As set out in chapter 3.5 and 5, these rules are mostly linked to conduct of business and consumer protection areas, such as advertising content. They could also refer to – thus far unharmonised – emergency measures. For these (nonharmonised) general good areas, the host member state can take the types of measures mentioned under step 5 as it sees fit without consulting the home supervisor, though the right of subsequent information in emergency situations would apply. Vis-à-vis the bank it will of course need to apply domestic, non-discriminatory laws and fulfil the minimum requirements under the TFEU regarding the core freedoms. As indicated above, if a bank loses its license in its home state, the host supervisors of any branches have to take measures – for which they will need to have obtained the necessary legal instruments under local laws – to prevent further transactions in its territory and to safeguard the interests of depositors. If the branch is deemed ‘significant’ under the CRD II amending directive, the host state authorities gain additional information rights and involvement rights for itself, its central bank and ministry of finance; see chapter 5.3 and 21.6. Future Developments The CRD IV project adds detail on sanctions. Sanctions (in the sense of administrative law punitive instruments) are useful for relatively unimportant transgressions. A late delivery of information, such as notifications of qualifying holdings, or reporting requirements, can easily be punished. This increases discipline and the possibility of supervisors to monitor, but the transgressions in question can hardly be deemed important in and of itself. The larger transgressions (e.g. breaching minimum capital requirements, miscalculations, faulty models) are not expected to be fought primarily by punitive sanctions but by ameliorating initiatives154. Such include re-capitalisation plans, and other measures intending to save the bank (instead of punish it). This said, if there is culpability (e.g. fraudulent miscalculations, knowingly using bad models) or the transgression is too big, there may be ‘punishment’ that is a side effect from a withdrawal of approval as an executive, or from a withdrawal of the banking license. Sanctioning powers (sometimes overlapping with criminal law prosecution) will be applied to unauthorised banking services, late

154 Commission, CRD IV – frequently asked questions, 20 July 2011, memo/11/527. Art. 64-72 and 126 CRD IV Directive.

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reporting and other information provision, public disclosure requirements, retention obligations on securitisations and similar transgressions that can easily be proven. The more important intrinsic obligation of the bank to be safe is not likely to be captured so easily. The sanctions – including some possibilities to publish warnings and information on breaches and an obligation to publish penalties with relatively few exceptions – will need to be available to the supervisor from the start of 2014, though most could have already been assumed to be required under the obligation to implement the previous directives ‘dissuasively’155. The Commission has also proposed a range of additional tools for the supervisors and other public authorities that are involved in dealing with a bank in crisis156. Such new tools would be far-reaching, and may include mandatory asset transfers, debt bail-ins and capital write-downs. They would establish overlapping sets of information and intervention tools in the CRD and the new directive, though the majority of new recovery tools that are proposed to be used vis-à-vis a bank that is not yet in resolution could already be required under the obligation to effectively implement and enforce the CRD (though not necessarily in as much detail). It would add detail on such additional intervention rights as to appoint a special manager to the bank with the full range of statutory rights as an executive director would have, and the power to require the bank to restructure itself to allow for a potential future resolution. The proposals also include a range of resolution tools that go beyond the scope of the current CRD, with associated changes in company law, contract law and bankruptcy law rights. The resolution tools mentioned include the sale of a business to another bank in a commercial transaction, transfer of the business in full or in part to a bridge bank, separation of assets to safeguard key public interests, and debt conversion (‘bail-in’) tools. To be effective, these would indeed need to be put in law, and the balance between property rights and crisis management has to be executed in line with human rights treaties; see chapter 20.4). The single supervisory mechanism proposals of the Commission would endow the ECB with any national instruments the local prudential supervisor now has (possibly to be used via the remaining stubs of the prudential banking supervisor in that Eurozone country, if the local laws endows it with such instruments). When directly applicable union law would become available (such as CRR part of the CRD IV project, but not its rules on sanctions contained in the CRD IV directive), the Commission endows the ECB with additional instruments over and above what it already has under the TFEU. It can be assumed that 155 Art. 162 CRD IV Directive. See art. 67.2 and 68 CRD IV Directive on the publication possibilities and obligations. 156 Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. See chapter 18.3 for a description of the proposal.

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this regulation would be supposed to ‘implement’ the CRD IV directive of CRD IV for the ECB instruments. The focus here would also be on sanctions157. As indicated above, a pure sanctions based approach may not be opportune for many of the more important transgressions. The joint committee can (but is not obliged) to issue guidelines for enforcement measures to be taken in relation to mixed financial holding companies, to guide member states in the introduction of such measures158.

20.4 Human Rights Limitations Introduction The powers of banking supervisors, like of any governmental agency, are subject to checks and balances. First the conditions need to be fulfilled that are stated in law that gives a supervisor a specific power, and if those conditions are verifiably fulfilled in its opinion without being sufficiently disproven by the subject of the rule, the supervisor can act in the manner prescribed. Often, such conditions set out in the law are a direct translation of fundamental rights, such as the right to protection by a court, or of property. However, even if a power is given without conditions, or if the conditions under which an instrument has been given to a supervisor do not refer at all or correctly to fundamental rights, they are still applicable. The Court of Justice has upheld such rights, to ensure that any EU legislation ‘cannot be interpreted in such a way as to give rise to results which are incompatible with the general principles of Community law and in particular with fundamental rights’159. Fundamental rights are directly applicable, and thus limit the powers of banking supervisors and other public authorities. The fundamental rights are derived from: – general principles of law, in accordance with constitutional traditions common to the member states; – the international treaties on which the member states have collaborated or of which they are signatories (e.g. the European Convention of Human Rights, and the similar UN convention); – the charter of fundamental rights of the European union160. 157 Page 5, recital 27 and 30, art. 8 and 15 of Commission, Proposed Single Supervisory Mechanism ECB Regulation, COM(2012) 511 final, 12 September 2012. 158 Art. 16 FCD, as amended by the Omnibus I Directive 2010/78/EU. 159 Hoechst AG v Commission, Joined Cases 46/87 and 227/88, Judgment of the Court of 21 September 1989, §12 and 13; and Orkem S.A. v Commission, Case 374/87, Judgment of the Court of 18 October 1989, §2833. Also see D. Chalmers, C. Hadjiemmanuil, G. Monti & A. Tomkins, European Union Law, Cambridge, 2006, chapter 6. 160 Since the entry into force of the Lisbon Treaty, the ‘Charter of Fundamental Rights of the European Union’ is part of the treaties. It replaces the previously applicable, inter institutional and non binding charter, 2000/C

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Effect of Human Rights, and Limits to Their Power Fundamental rights limit the way legislation is applied by supervisors and other public authorities. This limit can go so far as to mean that legislation is not applicable. EU legislation can impinge on fundamental rights, but only if specific criteria are met. According to the Court of Justice, the restrictions have to be in line with objectives of general interest pursued by the EU, and cannot constitute a disproportionate and intolerable interference which infringes upon the very substance of the rights guaranteed161. If a supervisor intervenes, his actions can be challenged both by challenging the rule he wants to apply, and the way he applied it. Both have to be in line with basic human rights such as the right to property and the right to privacy, unless legitimate limits are set for such fundamental rights. The fundamental rights relevant to the instruments available to banking supervisors are: – presumption of innocence where it criminal sanctions can be imposed, or administrative sanctions that have a similar effect as criminal sanctions162; – right of privacy in the home (only for natural persons, including bank employees and board members, not for undertakings, including banks163); – right of defence and a fair trial on ‘criminal charges’, including the right to remain silent when to do otherwise would incriminate oneself (both for natural persons and undertakings)164; – right of a fair trial on civilian cases, including e.g. the withdrawal of a license and winding up orders165, in which the bank itself can be represented by the sitting board instead of by the supervisor appointed administrator166;

161 162 163 164 165

166

364/01. That was a document signed by Council, Parliament and Commission, setting out (the same or similar) fundamental rights contained also often in such documents as national constitutions and in the European Convention for the Protection of Human Rights and Fundamental Freedoms. It re-affirms rights of citizens vis-à-vis the Community or that are taken into account by the signatory institutions when drafting legislation. Three member states have taken exception to the Charter in full or in part (United Kingdom, Poland and the Czech Republic). It is as yet unclear how such exceptions will be treated by the Court, especially where such exceptions have not been granted to those member states in the aforementioned European Convention. Schräder/Hauptzollamt Gronau, Court of Justice 11 July 1989, Case 265/87. Spector/CBFA, Court of Justice 23 December 2009, Case C-45/08. E.g. Hoechst AG v Commission, Joined Cases 46/87 and 227/88, Judgment of the Court of 21 September 1989, §17-38. E.g. Orkem S.A. v Commission, Case 374/87, Judgment of the Court of 18 October 1989, §28-41. Art. 6 European Convention for the Protection of Human Rights and Fundamental Freedoms. König/Germany, ECHR 28 June 1978, Case 6232/73; Capital Bank AD v. Bulgaria, ECHR 24 November 2005, Case 49429/99. R.C.A. White & C. Ovey, The European Convention on Human Rights, 4th edition, Oxford, 2006, chapter 8. Art. 6 and 34 European Convention for the Protection of Human Rights and Fundamental Freedoms. Credit and industrial bank/Czech Republic, ECHR 21 October 2003, Case 29010/95.

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– right to the peaceful enjoyment of possessions (including e.g. the continued existence of the license as this is the condition to be allowed to carrying on the business of the bank or protection against expropriation of shareholders), unless a procedure is followed to determine that there is a public interest and subject to lawful procedures (rule of law) and general principles of international laws. This includes procedural guarantees for the individuals or entities involved to have a reasonable opportunity to present their case and effectively challenge the measures taken167. The charter goes furthest, by also acknowledging e.g. the freedom to conduct a business, right to property, consumer protection and data protection, access to services, and the right to an effective remedy and to a fair trial when rights and freedoms guaranteed by the law of the Union are violated. These rights are not absolute. They allow member states to make exemptions for specific purposes, such as the necessity to fight crime, to take emergency measures in crisis circumstances, to safeguard the economic well-being or to protect the rights and freedoms of others. Member states have a wide margin of appreciation in sensitive economic areas such as financial stability, and the views of the supervisor can be given significant weight168. However, the exemptions can only be used for the stated purpose and in the stated circumstances (for instance a search of the home of a bank executive can only take place if actually needed and intended for one of the exempted reasons, and emergency measures can only be taken if there is a clear urgency and no alternatives are available) and have to be based on a law. Within these boundaries, the Court of Justice has ruled in 2012 that nationalisations of a bank can be a reasonable action of a member state, if there is a crisis such as the 2007-2013 subprime crisis, and in the circumstances faced by the bank in question, especially if other commercial options are no longer available (with a wide margin of appreciation for the national public authorities)169. Though compensation for expropriation can be required to maintain a fair balance between the right to property and the general interest, that compensation does not need to reflect for example value created by the type of emergency loans under lender of last resort or state aid provided to the bank as mentioned in chapter 18.4, especially if it is the policy of the authorities to avoid moral hazard at other banks. If the bank is already totally dependent on state help, and no commercial alternative is available, that may mean that the market value is nil even if the price at which shares are traded is higher (reflecting the value created by the state). Preventative actions will likely sooner create a need for compensation of expropriated banks or shareholders 167 Art. 1 of Protocol 1, Capital Bank AD v. Bulgaria, ECHR 24 November 2005, Case 49429/99. 168 Capital Bank AD v. Bulgaria, ECHR 24 November 2005, Case 49429/99, paragraph 113 and 136-139; and in the Case of Northern Rock: Grainger/UK, ECHR, 10 July 2012, Case 34940/10. 169 Northern Rock; Grainger/UK, ECHR, 10 July 2012, Case 34940/10.

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than situations where key rules – such as the solvency ratio or the bank being in control of the situation – have already been breached. A lower than market value compensation for expropriated property (to be paid to shareholders if the shares are expropriated or to the bank if its assets are expropriated) is thus possible. However, this has to be motivated in the public interest, for instance to reflect undeserved or illegally obtained benefits170. An example of the latter category in the financial sector could be if a bank has long been profitable as a result of institutionalised miss-selling of financial products, and fails once that market closes and claims for damages arrive. The instruments given to supervisors – sometimes – thus allow supervisors to go against one of the fundamental rights, both in crisis and in normal times, in as far as they are be compliant with the standing legislation and case law on when such exemptions can be used. The actions of supervisors can have an effect on the ability of an institution to be or remain a bank (breaching its right to have a business, and to property), and on bank’s officers to remain in their position and/or profession. This applies both to transgressions with a criminal character (for example fraud or money laundering) and to cases where the actions of the government affect civil rights only171 (protection of others against incompetence of a bank or of an officer of a bank, or protection against the bank having insufficient capital). The possible exemptions can be based on the goals of banking supervision. The economic well-being of society, the rights of others and the fights against fraud and other crimes are legitimate reasons to impinge on human rights. Especially when supervisory work might result in a criminal or administrative sanction against the bank, against persons working at the bank or against clients, the powers of supervisors have to be more clearly restricted as the right of defence and the right to a fair trial become increasingly important. These are not only applicable when a supervisor or public prosecutor is explicitly looking at a suspected violation of banking legislation, but can also have an effect in general investigative work (without such a pre-determined crime-finding purpose). General investigative work describes most of the work of prudential banking supervisors; see chapter 20.2. There is no clear case law regarding prudential banking supervision, but there are some cases on

170 Similar protections apply outside the financial sector, with equally similar margins of appreciation to determine the public interest and the appropriate compensation, though both will be subject to judicial overview. See Pešková v. the Czech Republic, ECHR 26 November 2009, 22186/03. In that case public interest reasons to reduce the compensation below the market value were not available. 171 König/Germany, ECHR 28 June 1978, Case 6232/73 and Capital Bank AD v. Bulgaria, ECHR 24 November 2005, Case 49429/99.

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transgressions of competition law and company law, that affect general fact-finding powers to check compliance with applicable laws172. In general: – even where presumptions as to facts or misdeeds are incorporated into the law (such as for market abuse, or money laundering), these presumptions can only be compatible with the presumption of innocence if the stakes are sufficiently high to justify it, and the rights of defence is maintained, so that the defendant is allowed to prove that he did not intend to transgress173; – any intervention by the public authorities in the sphere of private activities of any natural or legal person, must have a legal basis, be justified and provide protection against arbitrary or disproportionate intervention; – investigative tasks do not infringe the fundamental rights, and can be exercised also at the premises of an undertaking. This includes asking the undertaking to deliver any relevant existing documentation and any factual information, as well as the discretion of the investigator to determine how much information it needs for its tasks (though abuse of power limitations set an outer boundary for this). The liability of the investigators for negative side-effects of the investigation can even be limited, to ensure a frank description of the facts and findings. In general, providing for an opportunity for the undertaking to comment on draft findings increases the value of a report in any follow-up; – any investigation when a violation of the law is explicitly expected cannot compel someone to incriminate himself. Supervisors can thus not prosecute for failure of a bank or its officers to deliver insight in motivations etcetera that would make a fact – instead of being just stupid – into an action with criminal intent. Though this protects the will of an accused person to remain silent, it does not extend to obtaining documents through e.g. a warrant, that exist independent of the will of the suspect; – any preparatory investigation has to explicitly recognise the right of a potentially accused person to remain silent if his answer might incriminate himself and if the preparatory investigation results may be used in the process of putting sanctions on that person; – where house searches and seizures in order to obtain physical evidence of offences and, where appropriate, to prosecute those responsible are allowed under the exemptions to the fundamental rights, the legislation and practice must afford adequate and effective safeguards against abuse; 172 The Orkem and Hoechst case law of the Court of Justice are relevant here, as is the case law of the European Court of Human Rights, that sets out the application of the European Convention of Human Rights as referred to by the Court of Justice. Relevant are Fayed v United Kingdom, application 17101/90, judgment ECHR of 25 August 1994, Funke v France, application 10828/84, judgment ECHR of 27 January 1993, and Saunders v United Kingdom, 43/1994/490/672, judgement ECHR of 17 December 1996. 173 Spector/CBFA, Court of Justice 23 December 2009, Case C-45/08. Kadi and Al Barakaat International Foundation/Council and Commission, Court of Justice 3 September 2008, Joined Cases C-402/05 P and C415/05 P.

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– the rights of the institution can remain with the (former) board members and shareholders, if liquidators or supervisory-appointed caretakers that formally are the new representatives of the bank have e.g. a conflict of interest (i.e. replacing the board members cannot make the human rights protection in case of a withdrawal of a license or a replacement of shareholders of the bank an illusory right)174. The fundamental rights can also clash with the treaties, e.g. with competition provisions or with the treaty freedoms. In a case where the fundamental right to strike and the fundamental freedom of establishment clashed, the Court determined that neither of the two is absolute, and both have to be respected. As both allow exceptions, the treaty freedom can be limited in order to respect fundamental rights, but at the same time the fundamental right can be limited in order to respect the treaty freedom. In the case at hand, the right to strike could not lead to a result that impacted beyond what is necessary on the freedom of establishment175. Provisions in a collective agreement can thus not have extraterritorial effect beyond the member state, forcing the employer to apply home member state standards also in lower standard host member states (taking away his possibility to compete locally and his incentives to use the single market). Future Developments Building upon the possibility to infringe human rights, including the right to property and to have the right to set the course for your own business, the Commission has proposed a directive on recovery and resolution. These infringe such rights, as allowed on the basis of the disculpation ground of trying to prevent or to ameliorate a crisis, and to protect amongst others depositors. The various proposed instruments for supervisors/resolution authorities (see chapter 18.3) will force capital write downs, expropriations, debt bail-ins, mandatory restructurings of a legal entity or a group of legal entities, and so on. The proposed legislation appears to meet the minimum levels of protection and safeguards, and to limit their use to legitimate circumstances. In the execution, however, the public authorities involved will still need to be able to justify that the way they used such instruments best respected the human rights that were infringed by them. Literature – Jacobs, White and Ovey, The European Convention on Human Rights, 4th ed., Clare Ovey & Robin C.A. White (ed.), Oxford University Press, Oxford, 2006

174 Capital Bank AD v. Bulgaria, ECHR 24 November 2005, Case 49429/99. 175 International Transport Workers’ Federation and Finnish Seamen’s Union/Viking Line, Court of Justice 11 December 2007, Case C-438/05, §69-75.

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– Hüpkes, Eva, special bank resolution and shareholders’ rights: balancing competing interests, Journal of financial regulation and compliance, vol 17 no 3, 2009, page 277301

20.5 Administrative Limitations on Supervisory Powers Introduction The choice in the treaties to harmonise cross-border services and establishments via directives has repercussions on the (lack of) provisions on the administrative requirements on the supervisors. Directives leave the member states free to choose the methods and form in which they implement the material content of the EU legislation, and this generally has included the procedural protections given against public authorities in each member state (see chapter 3). In each member state the ‘normal’ administrative laws on appeals and decision timelines apply, as they apply to all public authorities in that member state. The procedural requirements (e.g. time limits set to make decisions on market access) that have been included are those that were deemed necessary to protect fundamental rights (such as a fair trial), provide a common market, or where consumer protection played a role. They are found in provisions in EU prudential laws on: – appeal to the courts on penalties or measures taken against a bank; – market access; – supervisory cooperation, including in colleges and in EBA; – depositor and investor compensation (see chapter 18.5). In other areas, such as any decision of EBA or the Commission vis-à-vis banks or others, additional detail is provided on the procedural safeguards against abuse of power. Some general protections are applicable to EU and national actions due to human rights safeguards, though the status of the charter and the work of the EU ombudsman vis-à-vis national supervisors are not clear. The CRD and other banking directives are a patchwork of old and new provisions, that shows no structured approach to the inclusion of procedural requirements. There are a few general provisions on appeal processes on decisions by supervisors (see below), and the odd insertion of obligations to decide within certain timelines or to consult certain institutions (either other supervisors, the bank, or the holding of the bank). The lack of explicit references to timelines or consultation just means that during the negotiations on those subjects those issues were not put on the table, or there was no expectation of conflicts of interests. The lack of an explicit obligation in the EU directives does not mean that such timelines or consultation should not be respected.

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General Administrative Protection The outer boundaries of the timelines are set in part by the European Court of Human Rights. This Court (separate from the Court of Justice set up within the EU context) upholds amongst others the right to a fair trial (see chapter 20.4). This right includes an injunction on the state to prosecute in a timely manner, and not allow long delays (and thus prolonged insecurity for anyone accused of criminal misconduct). Such safeguards can be applicable regardless of an explicit reference either on the basis of human rights protection, or on the basis of the administrative laws of the EU and of the member states. The CRD refers explicitly to the charter of fundamental rights. The charter includes an article granting a ‘right to good administration’ of EU citizens vis-à-vis the EU institutions. Though not directly applicable in the relation of EU citizens vis-à-vis member states and national supervisory authorities, it can be assumed that such fundamental rights contain minimum standards that are of a level that need to be upheld too as common principles by national authorities when applying EU legislation176. The charter-rights will definitely apply if domestic law provides for them, or when a bank, an officer of a bank, a client of a bank or another is affected by a decision of for instance the Commission, EBA or a future Eurozone single supervisor. The specific administrative rights referred to in the fundamental rights charter include: – the right of a person whose interests are adversely affected to be heard prior to any individual measure on him is taken; – the right of access of a person to the file on him (barring reasons of secrecy obligations); – the obligation of the administration to give reasons for its decision177. The European Ombudsman has expanded on these rules between citizens and EU institutions, by publishing a code of good administrative behaviour178. The code reiterates the mentioned rights, and adds issues such as an obligation to be fair, to point out whether there is a right of appeal on a decision taken, to forward petitions to the right authority if they did not arrive at the right institution, not to abuse powers, to answer questions raised, and to address persons in a polite manner. The rights under the charter of fundamental rights appear consistent with the (haphazard) allocation of such rights to banks and others in the CRD. Examples are the requirement to substantiate a negative decision when it is communicated to the bank, and similar requirements on host supervisors regarding branches (see below). Any procedural safeguards offered to persons who are resident or 176 An item not applicable to each member state is the right of persons to address the EU bodies such as the Commission or EBA in any of the EU official languages, and get a reply in that language. 177 This obligation codifies Court of Justice case law. See e.g. Meroni, Court of Justice 13 June 1958, Cases 9-56 and 10-56, where the statement of some general facts as the basis of the decision, without references to evidence and without reasoning as to the law lead to an annulment by the Court of the decision taken by the EU institution. 178 The code is published on the ombudsman website http://www.ombudsman.europa.eu/resources/code.faces.

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nationals of the member states, also need to be offered to non-residents (from other member states), if the procedural rights are prerequisite to the protection of for instance the treaty freedoms179. EBA Procedural Safeguards Since its introduction in 2011, EBA has been empowered to take decisions that are binding upon its addressees (unlike its predecessor CEBS). The administrative safeguards that protect such addressees and others directly affected by the decisions of EBA have been reiterated in the EBA regulation180. They include a right vis-à-vis EBA: – for the addressee to be informed of a proposed decision; – for the addressee to have a time limit before adoption of that decision to express its views (the time limit can be short if there is urgency, or longer if the matter is complex or important); – the decision must be reasoned; – the addressee must be informed of the remedies available (see below and chapter 21.4); – EBA has to keep decisions taken in ‘special circumstances’ (emergency decisions overruling domestic supervisors) under review; – the main content of decisions on infringements of EU law, of decisions taken in special circumstances, or decisions in dispute settlement between supervisors are to be published, including the name of the supervisors and bank involved. There are two exceptions, when it concerns legitimate business secrets of a bank, or when publication could cause serious problems in the financial markets or to EU financial stability (also see chapter 21.4); – there is a right of appeal, and subsequent redress before the Court of Justice (see below). As financial services increasingly move towards a single market, the provisions on procedures increase in importance in the areas where full harmonisation on the content is being achieved or where regulations can be used instead of directives (see chapter 2, 3.4 and 23 on amongst others the EBA regulation and the CRD IV project). CRD-obligation on Appeal to the Courts Supervisors can take invasive actions against banks and against those who effectively control the business of banks. These can include penalties, orders to cease activities or orders to undertake certain activities. Any decision that can be taken under the domestic legislation implementing CRD obligations (e.g. by a supervisor, ministries of finance, liq-

179 Fokus Bank/Norwegian state, EFTA Court 23 November 2004, Case E-1/04 and Finanzamt Köln-Altstadt/Schumacker, Court of Justice 14 February 1995, Case C-279/93. 180 Art. 39 and 60 EBA Regulation. See for the possibility of appeal below.

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uidator, or anyone empowered to make decisions that uphold the CRD in that member state) is potentially disruptive. The CRD provides that any such decision has to be able to be appealed against in a court of law. This applies to any positive decision (a decision taken), and in specific cases also for decisions that the public authorities fail to take when requested. An example is the failure of the supervisor to grant a banking license within six months after receipt of the complete application and the failure of the home supervisor to reply within three months to a notification request to establish a new branch elsewhere by one of its banks (deemed to be an implicit rejection of the request181), both of which can be appealed. The right of appeal to the Court also applies to decisions taken by EU bodies, including EBA or the future single supervisory mechanism. The supervisors and/or the banks that are the addressees of a decision (and those directly affected by such a decision) can thus go to court. For EBA, the appeal to the Court of Justice on decisions taken has to be preceded by an appeal to the internal (joint with the other European supervisory authorities) board of appeal182. The Court gives leeway to EU bodies that have instruments on the content of both the assessment and the subsequent decision taken, but it is strict in the enforcement of administrative safeguards such as the right to be heard, and for decisions to be based on all available information. These can lead to a potential annulment of all or part of a decision183. Market Access and Joint Approval Processes The procedural requirements for market access are described in chapter 5, both for the licensing process, the mergers and acquisitions process, and the European passport for services and branches184. Market access has long been the only area where the procedural protection for the applicant is reasonably worked out, relating both to the licensing and mergers and acquisition approvals. The same applies since the implementation of Basel II in the CRD to joint approval processes. The reasons for including the administrative rights of the applicant more explicitly focus on protecting or creating a competitive single market, and the negotiating member states wanted to clarify what types of banks entered their market, and how their banks would be protected abroad or in situations where there are joint processes. For the granting of licenses (including to subsidiaries of existing banks from another member state under the freedom of establishment) a maximum term of six

181 Art. 25.4 and 55 (with 13) RBD. 182 Recital 58, art. 39, 58-61 EBA Regulation 1093/2010, and art. 263 (especially the first and fifth paragraph) TFEU. See chapter 20.3. 183 See e.g. Netherlands & ING/Commission, Court of Justice 2 March 2012, Cases T-29/10 and T-33/10, §107109, 124, 138, 142-145, 153, 157-160. 184 Art. 13, 19, 25, 26, 28, 30.3, 32 and 55 RBD.

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months has been set for deliberation after the full application has been made, and 12 months after an incomplete application has been made. At the latest when this time limit has been exceeded, the supervisor should decide positively or negatively on the application, or the member states will have to allow banks to appeal against the implied refusal of a license. Once given, the RBD limits the reasons for a withdrawal of the license to a few (though with a national discretion to expand on this number), and orders the supervisor to provide a reasoned decision to the bank185. For cross-border activities under the European passport for branches in another member state the CRD includes: – a right of the bank to receive the reasons for any refusal by the home authorities to forward the notification of a branch to the host appeal within three months after the home supervisor received the notification with all necessary information from the bank; – the right to appeal against that reasoned refusal of the home supervisor or – if the three months have passed – against the failure to reply to the bank (see above); – a right of the bank to start its activities as soon as the host has indicated that it can, or at the latest two months after the host has received the notification from the home supervisor; – a window of opportunity of those two months for the host supervisor to indicate whether there are local additional conditions in the interest of the general good the bank has to comply with (see chapter 3.5); – if the host supervisor finds that either its general good or liquidity/monetary requirements are violated by the branch, and the home supervisor does not take ensure this violation is stopped when asked to do so by the host supervisor, it can take unilateral action against the legal entity making use of the European passport. The home member state has to ensure that its laws allow the serving of legal documents by the host supervisor on the legal entity in its home member state; – any measure taken by the host member state that involves penalties or restrictions on the exercise of the freedom to provide services has to be substantiated by reasons. It also has to be communicated to the bank, and the member states have to allow the bank the possibility to appeal against such a decision. For cross-border activities under the European passport for services in another member state the CRD includes the obligation on the home supervisor (without a right of refusal) to send the notification to the host supervisor within one month of receipt.

185 Art. 17 RBD, as amended by art. 9.4 Omnibus I Directive 2010/78/EU. Copies of the withdrawal decision have to be sent to the Commission and EBA.

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For cross-border mergers and acquisitions, strict timelines are instituted in the CRD in the follow-up to the Antonveneta takeover to: – acknowledge receipt of notifications within two working days; – carryout its assessment within 60 working days from the date of the acknowledgement, and request additional information only until the fiftieth of those working days, with an interruption of a maximum of 20 working days or shorter if the additional information is received sooner. If a decision is not taken, it is deemed to be an approval (contrary to e.g. the stance taken on licensing and cross-border notifications for branches, see above). Similarly, a right of appeal is given to a bank that is denied the possibility to establish a branch in another member state by its home supervisor186. The local administrative laws can give a speedier right of appeal, but the RBD is clear that at least after the maximum time set for supervisory decisions (i.e. either three months for the first establishment of a branch or 1 month if it concerns a change of the activities of the branch) the bank will have access to the courts. It is likely that these procedural provisions in the RBD have direct effect (see chapter 3.5). The procedural requirements fall in two categories: those instituted to protect the interests of the supervisory authorities towards each other, and those instituted to protect institutions against supervisory authorities from another member state (or even against its own supervisor should it choose to restrict its bank from profiting from the single market provisions)187. In principle, the model approval for the banking entities that are part of a banking group presupposes a consensus decision of the supervisors concerned. If it purely concerns one entity, the supervisor of that entity is solely responsible. If a concerted application is made – taking into account the solo, sub-consolidated and consolidated supervision on the models in an integrated manner – this requires strong cooperation between the supervisors on the group. If consensus cannot be found, this lack of a decision would work to the detriment of the supervised group of banks. For this situation, the consolidating supervisor gains the right (not the obligation, however) to take the decision unilaterally and bindingly on the other supervisors involved. See chapter 6.3, 17 and 21.7. An additional procedural provisions that protect other supervisors, the provision of information to each other and to consult each other can be included. The CRD contains a wide range of such provisions, as further described in chapter 21. In general, there is no clear time limit for such provision of information or consultation. For certain issues refer-

186 Art. 25.4 RBD. 187 Art. 129 RBD; see chapter 6.3, 8.3, 9.4, 10.4 and 21.7.

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ences to ‘prompt’ or ‘immediately’ are included, that would need to be interpreted by the supervisor involved – and by any board of appeal or court – on the basis of the circumstances of the case. Generally, an obligation to provide information will include an obligation to do so in a timely fashion (which presupposes that the supervisor has or should have realised it has information that is of interest to the other supervisor, and has to take into account known deadlines for the other supervisor). These various – if haphazard – provisions in the CRD, and the requirements on public authorities subject to the treaties, provide a background of good administrative good practice, including such general provisions as that a decision has to contain sufficient substantiating facts as well as the reasoning of the authority as to the applicable law. The national laws and practices may, however, differ still, as identified in the mapping exercise performed by the CEBS-EBA review panel188.

20.6 Delegation of Supervisory Tasks and/or of Supervisory Responsibilities The competent authorities can employ individual experts as supervisors, or hire external individuals or firms (such as accountancy firms, valuation experts or lawyers) to perform tasks on their behalf within the context of CRD tasks. Even the instructions to the external accountant to report incidents to the supervisor, or for the bank to institute internal auditing and control departments can in a way be seen as a delegation or outsourcing of tasks on which the supervisor subsequently relies. EU legislators have also tried to stimulate cross-border delegation of supervisory tasks and/or supervisory responsibilities in the context of group supervision; though this focus on delegation between national supervisors will likely be subsumed by the discussion on a single supervisory mechanism; see chapter 21.3. The politically correct way to delegate between supervisors under the CRD provisions assumes delegation towards the more central supervisor. Apart from situations where certain tasks have been centralised in a format specifically prescribed by the CRD itself – such as in the model approval area or in the distribution of information area – this has been a dead letter. The RBD specifically allows two types of voluntary delegation, recently expanded by a delegation under the auspices of the EBA regulation189:

188 CEBS-EBA, Mapping of Supervisory Objectives, including Early Intervention Measures and Sanctioning Powers, 2009/47, March 2009. 189 Art. 131 RBD. The provision was amended by the EBA Regulation 1093/2010 to put the central role on collecting information on delegation practices at EBA instead of the Commission.

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– delegation of tasks by supervisors of subsidiaries to the consolidating supervisor as part of the written arrangements on coordination and cooperation (upwards); – delegation in a bilateral arrangement of the responsibility to supervise a subsidiary bank by its licensing supervisor to the supervisor of the parent bank (upwards); – a new delegation possibility was introduced in 2010 in the EBA regulation, between any two willing supervisors. The difference between the two RBD delegations is that by delegating tasks, the supervisor that delegates the task does not delegate the end-responsibility for (solo and sub-consolidating) supervision of the subsidiary. By delegating responsibility, the licensing supervisor theoretically no longer would have any involvement in (nor liability for) ongoing supervision. The RBD possibilities were not used, if only because the lack of clarity on responsibilities, procedures, applicable laws, allocation of costs, and the differences in importance of foreign and domestic activities. On top of this legal delegation of responsibility does not appear to have any impact at all on the political and economic fact that the local supervisor will be held accountable for a failure of local banking activities. This applies even where the delegation is set in the law, such as of branch supervision (see the Icesave discussions in the UK and the Netherlands). Add to this the lack of harmonisation on prudential requirements due to both minimum harmonisation and national discretions, which would increase or decrease the level of protection of clients of the entity involved under a full delegation. The CRD possibility that national supervisors delegate responsibility within a college has recently been expanded in the CRD and especially in the EBA regulation190. Under the version of the CRD applicable until end 2010, delegation of responsibility did not imply a distancing from the applicable legal regime. The ‘new’ supervisor was likely bound to exercise its delegated tasks in line with the legislative regime of the delegating authority (causing a supervisor of one member state to obtain powers as set out in the legislation of another member state). CEBS-EBA has been working in this area for several years under pressure from the EU institutions, but this has not lead to a significant increase of the likelihood to delegate the full responsibility for a bank or branch, or for e.g. model validation. Instead, practical advantages were discovered if certain tasks were performed jointly, or certain tasks were delegated, without delegating the responsibility (and the power to act).

190 Art. 131 RBD.

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The EBA regulation reflects the EU-level political will behind delegation of tasks and responsibilities, but at the same time allows national legislators to block or circumscribe it191. Strangely the delegation of responsibilities described in the CRD remains of a very limited – upward delegation of responsibilities within the college of supervisors – nature, while the EBA regulation allows any type of delegation (of CRD responsibilities) that two or more supervisors agree on. The prima facie reason to put it in the regulation is to allow EBA to monitor (and vet) such delegation, and to allow it to accept any delegated responsibilities as the delegated supervisor. The regulation is directly applicable in the member states but the member states have obtained extensive powers to regulate/restrict any delegation its supervisors are involved in. According to the recitals of the EBA regulation, delegation is one of the tools envisaged by EU legislators to strengthen international effective and efficient cooperation192. Legislators indicate that delegations should take place if another supervisor is better placed to take action on an issue. Legislators indicate that delegation of responsibilities was appropriate e.g.: – for reason of economies of scale or scope (e.g. having a small team execute a quantitative analysis of a new financial instrument); – coherence in group supervision (see chapter 21.6 and 21.7); and – of optimal use of technical expertise among national supervisors (e.g. allowing one national supervisor to specialise in e.g. model approvals for operational risk, and another in e.g. clearing activities, across banks based in multiple jurisdictions). The promotion of delegation of responsibilities is an example where EBA has gotten a task without instruments to enable it to achieve this task. Without a domestic level political will to align practices and instruments, this will come either to trouble or to naught. Apart from giving EBA a role in commenting on draft delegation arrangements and publishing final agreements, the EBA regulation193 does solve one of the legal tangles inhibiting its use. For the delegation of responsibilities (full transfer, instead of a delegation of tasks to be executed on behalf of the delegating supervisor), it clarifies that those responsibilities that are transferred to the delegate, are subsequently covered by the procedure, enforcement and review laws of the delegate authority. This appears to cover both administrative law and civil liability, and is likely to include funding arrangements.

191 Art. 28 EBA Regulation 1093/2010. 192 Recital 39 and art. 28 EBA Regulation 1093/2010. 193 Recital 39 and art. 28 EBA Regulation 1093/2010.

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The EU laws do not limit the scope of responsibility delegation. It can include delegation for all aspects of supervision, including licensing banks, ongoing supervision or more limited issues such as model validation. Theoretically, it allows several countries to set up a joint supervisor that will look at all banks in the various territories, or for one or more member states to delegate responsibility for one or all of its banks to EBA or to the ECB194. Both for the bank, the deposit guarantee fund, and for depositors the situation can mean either an improvement or deterioration of their position, depending on issues such as administrative law protection and the possibility to sue the supervisor under domestic laws. Any future success of delegation practices will also depend on whether the ‘new’ supervisor will treat the activities in the other member state in exactly the same manner (importance, resources, state aid) as if those activities were taking place in its own territory, with its own citizens/voters and with repercussions for its own domestic financial stability.

20.7 Supervisory Disclosure Introduction To achieve the single market, the EU has mandated disclosure by supervisors/regulators to the public. The majority of this type of supervisory disclosure is of interest mainly to the primary targets of supervisors: the banks. The obligation relates for instance to market research, economic data on the banking system, and whether and how the EU legislation is implemented. There are three main categories: – information on the banks that the supervisors or EBA are allowed to or must publish; – information on the banks or general developments that supervisors must disclose to the Commission or other authorities; – information on the implementation of the CRD that supervisors/EBA must publish (as CEBS/EBA does in its so-called supervisory disclosure framework). At the same time as introducing Basel II, an attempt was also made to increase transparency and promote harmonisation by obliging supervisors to disclose information to the public on how the CRD was implemented in their member state. This supervisory disclosure is intended to make member states less likely to deviate from the harmonised consensus,

194 Art. 28.1 EBA Regulation 1093/2010. Delegation to EBA would mean that EBA becomes a supervisor in fact. Such pooling of responsibilities could lead to significant cost savings, even though funding/liquidity support/deposit guarantee/state aid issues would deserve attention. As it is part of an EU regulation it is part of ‘agreed’ EU-wide harmonisation even if only some member states make full use of this possibility, it would not be ‘enhanced cooperation’ in the sense of art. 326-334 TFEU, even though in all practical aspects it would be similar to such enhanced cooperation. The single supervisory mechanism proposed by the Commission instead goes for direct allocation to the ECB, instead of via delegation by the member states/supervisors; see chapter 21.3.

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and to increase the mutual understanding (and thus automatic reduction) of the background for such deviations. The perhaps slightly boring material (this member state chose that option, has implemented this, etcetera) is of key interest to banks and to legislators. For banks it helps limit research costs in a cross-border business that is susceptible to multiple sets of domestic laws implementing the CRD and increases chances of successful lobbying of deviating supervisors. It can also drive future legislators (‘the majority chose this option, maybe this should be the only option in the next rewrite of the CRD’). Another aspect of disclosure is based on a main exemption to secrecy obligations. Supervisors have to publish information on policy development, and on relatively neutral data on the banks and the banking system (e.g. which banks have a license, how many assets are there in the banking system in aggregate numbers, what type of generic problems do they encounter)195. This can be described as accountability information and useful information – for the banks, their general clients and other public authorities – that can be published or has to be published in the context of the exemptions to the secrecy obligation. It includes consultation documents, meetings, seminars etcetera), and concrete information on banks, if and when allowed under secrecy obligations and in line with the goals of financial stability and depositor protection. For the general public this type of information is still not always relevant. A more relevant public warning that a specific bank is in trouble – even though many depositors would like and even expect such a warning196 – would be incompatible with the human rights and administrative rights of the bank, the secrecy obligation of the bank, and it would cause a panic and a run that would damage the financial system and those depositors that were unlucky to be last in line, so that on each of those grounds public warnings on failing banks would be illegal under the CRD. The obligation for supervisors (and EBA) to publish a the names of all licensed banks is more relevant to individual clients, as that links to the applicability of the depositor and investor compensation funds; see chapter 18.5. For the general description of what can be published under such exemptions reference is made to chapter 20.2). A new obligation to publish penalties – with few possibilities to delay or keep the information anonymous – was added in the CRD IV project197.

195 Such obligations are spread over the RBD, including for instance art. 69, 70 and 122a.9 and Annex VIII § 16 RBD in addition to the art. 144 RBD pillar 3 article. See art. 143-144 CRD IV Directive. 196 C. van der Cruijsen, J. de Haan, D. Jansen & R. Mosch, Knowledge and Opinions about Banking Supervision: Evidence from a Survey of Dutch Households, DNB WP 275, December 2010. 197 See art. 67.2 and 68 CRD IV Directive on publication possibilities and obligations.

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EBA (joint supervisory) Publications EBA has been given the remit to publish several documents and types of supervisory information, including198: – list of all banks and financial conglomerates – plus the single coordinator per conglomerate – in the EU, plus relevant information on the sector; – the advice given to EU bodies on legislation, its non-binding guidelines and recommendations, as well as its proposals for binding standards to be endorsed by the Commission, the consultation versions for the proposals for binding texts and ‘where appropriate’ of draft non-binding texts, and any deviations from non-binding texts by national supervisors under a ‘comply or explain’ approach; – the full text of any delegation of tasks or delegation of responsibilities agreements between national supervisors; – the conclusions drawn from peer reviews, as well as – if the relevant supervisors do not object – the peer review reports themselves; – opinions on mergers and acquisitions, if such publication is requested – decisions addressed to specific addressees; – the opinions and advice of its banking stakeholder group (with representatives from e.g. banks and bank employees’ unions, academics and customer groups); – the individual declarations on independence by the members of the board of appeal; – written statements of the chair to the European Parliament, including information on disagreements between supervisors in cross-border situations; – information on its procedures and plans. For remuneration, a special disclosure is made on high earners at the banks, as already mentioned in chapter 13.3. Supervisors have to collect information from the banks on persons earning over 1 million euro, and forward this to CEBS/EBA199. EBA is to disclose per member state on an aggregate basis the number of people working in its banks earning over 1 million euro (and the components of the remuneration divided over salary, bonus, long term awards and pension contributions); complementing pillar 3 disclosures by the banks; see chapter 15. These disclosures are made possible by the range of information obligations that have been put on supervisors to EBA (and by the banks to the supervisors); see chapter 20.2 and 21.4.

198 Art. 8 sub k and j, 10, 15, 16, 19.6, 20.4, 28.4, 34, 37.7, 39, 43, 44.3, 45.2, 47.7, 50, 55.4, 59.6, 60, 64.6 EBA Regulation 1093/2010, art. 6 and 14 RBD, and art. 4 and 10 Financial Conglomerates Directive 2002/87/EC, as amended by the Omnibus I Directive 2010/78/EU. If the EBA proposals for binding standards are indeed endorsed by the Commission, they are published in the Official Journal of the European Union. 199 Art. 22.5 RBD, as added by the CRD III Directive 2010/76/EU.

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Supervisory Disclosure to the Commission and other Authorities A special form of supervisory disclosure is the obligation to inform other public authorities on certain events. The predominant form set out in the CRD is disclosure of information by supervisors to the Commission; now often with the same information being sent to EBA. Supervisors are obliged to send information on for instance: – all withdrawals of authorisations for banks200; – all refusals of the European passport for branches within the EU by the home or host supervisor, and all emergency and non-emergency interventions by host supervisors on incoming EU branches201; – all authorisations for third country branches202; – all categories of credit institutions which are domestically granted a lower initial capital than 5 million euro (hall of shame), with the reasons therefore; – domestic (additional) requirements for authorisation203; – off balance sheet items204. The TFEU gives the Commission the right to collect any information and carry out any checks required for its tasks. The CRD provisions are in effect part of this information gathering effort, e.g. on more controversial types of waivers or options used by supervisors205. The main purpose of the information gathered is to allow the Commission to make well founded new proposals for amendments to banking regulation. Most of the existing information provision obligations were introduced prior to the establishment of the Lamfalussy process. Some of the information given to the Commission in the past has been transferred to EBA (see above). Information by EBA on emergency situations has to be given to the Council (which will transmit it to the European Parliament and Commission if it agrees with the EBA assessment) but this particular type of information is not to be published206.

200 Art. 14 and 17 RBD. Until end 2010 it was the job of the Commission to publish the list of all banks in the EU, but this Commission obligation was fulfilled only haphazardly. The related list of EEA banks was published more regularly. As of 2011, this obligation has been given to EBA; see art. 8 sub k and j EBA Regulation 1093/2010 and art. 14 and 17.2 RBD as amended by the Omnibus I Directive 2010/78/EU. 201 Art. 25, 26, 30, 33 and 36 RBD. 202 Art. 38.1 RBD. 203 Art. 6 RBD. 204 Annex II RBD. 205 Art. 284 TFEU, and e.g. art. 126 RBD. 206 Art. 18.2 EBA Regulation 1093/2010.

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Supervisory Disclosure on the Implementation of the CRD The CRD sets out in detail what type of information has to be disclosed by supervisors on the implementation of the CRD in its member state. The information has to be published in a common format across member states, and should allow a meaningful comparison of the approaches adopted by the supervisors of different member states. The obligation was introduced in 2006, with the securitisation disclosure added in 2009 (in the RBD and CRD II directive, respectively). The required disclosure includes207: – texts of laws and guidance of all levels208 adopted in each member state in the prudential regulation area; – the manner of exercise of the options and discretions available in EU directives; – the criteria and methodology supervisors use for the review and evaluation part of pillar 2; – the criteria and methodology supervisors use to review compliance with the retention requirement and associated obligations to improve securitisation assets quality (plus annual summary descriptions of transgressions seen and measures imposed); – aggregate statistical data on key aspects of the implementation of the prudential regulations (taking into account the conditions on publishing aggregate data under the secrecy provisions); – specific information on the use of the national discretions regarding the exemption of solo supervision of subsidiaries and the inclusion of some subsidiaries in the solo supervision of its parent as if they are one entity (see chapter 17.2). Though the obligation has been laid on the individual supervisors, in practice CEBS-EBA (of which they are all members) has been given this task. This is in line with its task to contribute to the consistent application of the CRD and to the convergence of supervisory practices. CEBS has developed a format and provided the ‘single electronic location’ the directive requires; continued by EBA. The content is subsequently provided by the individ-

207 Art. 144 and recital 61 RBD, with additional obligations in art. 69, 70 and 122a.9 RBD. The recital indicates that the goal is (a) to allow the internal banking market to operate with increasing effectiveness and (b) for EU-citizens to be afforded adequate levels of transparency. 208 This includes parliamentary laws, ministerial edicts, supervisory rules, supervisory guidance, all in the widest possible sense giving rules or guidance on issues related to prudential banking supervision. In a sense, this obligation overlaps with the obligation to send the Commission the text of all laws, regulations and administrative provisions’ to comply with specific provisions of the directive and the obligation to communicate the text of the ‘main provisions of national law which they adopt in the field covered’. These obligations are more limited, and do not include e.g. guidance, nor do the require an regular update (except for the ‘main provisions’ obligation, which does not extend as far). See art. 157 RBD and 49 RCAD.

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ual supervisors, both at the central, overarching, website as well as at the national extensions of the website with supporting information. The disclosure on national options and discretions initially focused on the ‘new’ options and discretions in the texts newly inserted in 2006, with the Basel II package. These newer texts contained over a hundred of such provisions, and those were given priority. The older texts are literally covered in national options and discretions, which were retained. Some of these texts (e.g. large exposures) have since been revised, in which context the number of options and discretions have been reduced to more manageable numbers. CEBS-EBA has also used the information contained in the supervisory disclosure framework on the ‘newer’ options and discretions in its advice to reduce their number; see chapter 3.5. The obligation to disclose nonetheless covers all national discretions; which will become a more manageable exercise after full implementation of the CRD IV project (after the transitional period has ended). EBA has to develop implementing standards by the start of 2014 on the format structure, content lists and annual publication date of supervisory disclosures209. The CRD IV project brought together the separate obligations on pillar 3 and several disclosure obligations spread over the RBD in 2 articles210.

209 Art. 144 RBD, as amended by art. 9.39 Omnibus I Directive 2010/78/EU. See art. 143 CRD IV Directive. 210 Article 143-144 CRD IV Directive.

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21.1 Introduction Neither the EU treaties nor the CRD nor other financial legislation contain direct requirements on the institutional or organisational set-up of domestic supervisors in the EU. Until 2010/2011, even for the cross-border cooperation of such national supervisors the CRD contained few clear obligations. The development of clearer demands on crossborder cooperation was different for the policy/legislative side and for the actual supervision side. On the policy side gradually an ever more powerful EU organisation had been established. The informal groupe de contact of EU supervisors, and mixed supervisory/ministerial structures in Brussels were first replaced by the CEBS and the other committees at level (2 and) 3 of the Lamfalussy structure. Set up under a Commission decision1, these were bolstered by a de facto agreement by national authorities to commit to standardising operational supervision through policy coordination. This was voluntary as to the amount of harmonisation, though expectations were set very high and have been raised each time such expectations were either met or not met; see chapter 2. In the follow-up to the 2007-2013 subprime crisis, the tasks and basic structures of CEBS have been assumed by the new ‘European banking authority’ (EBA) at the start of 2011. The EU legislators decided that CEBS and its sister committees had reached their limits, especially on the promotion of fully cooperative, harmonised and effective line side supervision. The tasks of CEBS in line side (actual) banking supervision were close to nil. It had gotten some tasks to promote better line side supervision by national supervisors, but no instruments to make this effective and efficient. It had stimulated the introduction of so-called colleges of supervisors, under which all supervisors that licensed entities in a banking group would work together, and worked on the content of joint internal model assessments. With operational supervisory work largely excluded from its mandate, this network – not unexpectedly – under crisis-circumstances was not strong enough to force a coherent, EU wide response to problems at banks and banking groups with cross-border activities. In particular deficiencies were noted in the various sectors on decision making

1

See chapters 2, 3.2 and 23.3.

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processes where more supervisors were involved, on cooperation and information exchange, on interpreting the EU and national applicable laws and requirements, and especially on a lack of EU wide solutions to EU wide problems. An expansion of EU mechanisms on both the policy side and the actual supervisory side were deemed needed2. The aim of the EBA regulation is to deepen the cooperative but loose arrangements into a European system of financial supervision that links national financial supervisors within a strong EU network (see below). In addition to the EBA innovation, which also impact on the way domestic supervisors interact and should apply their resources, the requirements on consolidation, on the single market and on instruments had and continue to have repercussions for the institutional organisation of national and regional supervision, and their cooperation in supervising banking groups; see e.g. chapters 5, 17 and 20. The domestic and EU organisations involved will need to be able to deliver upon the CRD requirements. After giving EBA and the colleges of supervisors a full year to be set up and function, the lack of trust of the financial markets in several member states and their banks, and in the viability of the euro and the single market, EBA and the national supervisors are likely to be supplanted or supplemented by additional EU level structures that are planned to result in a ‘banking union’ in the Eurozone and/or the EU; see chapter 21.3. Does the Institutional Set-Up of Supervisors Matter? Two answers are equally correct: yes, it is extremely important, and no, it is irrelevant. The answer depends on the point of view taken. If you are a politician, or somebody responsible for the continued existence and relevance of a public body, then definitely it is very important. For the division of power in a country, the discussion on allocation of more tasks and power to a central bank (or not), one supervisory authority (or not), two or more authorities with sectoral tasks or goal-related tasks, or tasks shared over several authorities is very relevant. However, for the content of supervision and its effectiveness, this type of discussion generally is not very important (though time- and resources intensive, for the previously mentioned reasons). The content of banking supervision can function in any type of institutional set-up, and equally it can fail to function in any type of institutional set-up3. 2 3

Consideration 8 EBA Regulation 1093/2010. H. Davies & D. Green, Banking on the Future, The Fall and Rise of Central Banking, Princeton, 2010, chapter 3. T. Padoa-Schioppa, Regulating Finance, Oxford, 2004, page 70, notes that the problems of a single agency are not necessarily less complex than the coordination and interaction between agencies. The same applies to the reverse. Various goals and departments will need to interact, either within or across institutions. UK FSA, The Turner Review, March 2009, page 86-93, notes that both intensive and more light touch, as well as integrated and non-integrated supervisors have failed during the 2007-2013 subprime crisis.

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Regardless of the domestic and EU institutional set-up, there are, however, minimum requirements that have to be put on any institution with an involvement in banking supervision. These do not relate to it having to be part of a central bank, or whether it is a single supervisor, or a twin peaks prudential versus a conduct of business supervisor, or any of the other types of discussion formats usually seen. The demands on the organisations involved in banking supervision from a content point of view relate to: – the quality of supervision performed; – the quantity of supervision performed; – the power and resources that allow them to act decisively; – the ease of information flow between various interested authorities; – the ease of cooperation between various interested authorities when performing tasks; – who will pay the bill if the goals of banking supervision are not achieved. These in turn depend on the funding of the authorities, their legal instruments and the clarity (and relative importance) of the goals given to various authorities, whether the rules they have to supervise fit those goals, as well as their liability if their stated goals turn out not to be achieved. The goals mentioned include goals related to prudential banking, deposit/investor compensation, conduct of business, data protection, money laundering, monetary, competition, insurance, pension fund, asset management, consumer protection, prosecution, ministry of finance, or any other type of regulatory or supervisory task that has to be fulfilled within one country, which all impact on banks. Even within one country, this variety of tasks will never be in the hands of one authority, let alone if the cross-border aspects within the EU and the involvement of important third country legislators and authorities are considered too. The institutional set up should balance clear powers of the supervisor and some form of operational independence from costumers, the banking community and the political community with a strong sense of accountability for actions undertaken4. That accountability comes in the form of disclosure on past actions, a clear audit trail on what decision was taken for which actions, and backed-up by a form of liability for transgressions.

4

BCBS, Core Principles for Effective Banking Supervision, September 2012. J. Dickson, ‘Supervision: Looking Ahead to the Next Decade’, in A.J. Kellermann, J. de Haan, F. de Vries, (Eds.), Financial Supervision in the 21st century, Amsterdam, 2013, chapter 14; D.Q. Rendón, ‘The Formal Regulatory Approach to Banking Regulation, Journal of International Banking Regulation, Vol. 2, 2001, page 27-49; M. Quintyn, S. Ramirez & M.W. Taylor, The Fear of Freedom: Politicians and the Independence and Accountability of Financial Sector Supervisors, IMF WP/07/25.

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Basel Core Principles and the IMF Financial Sector Assessment Program (‘Will To Act’) The Basel core principles contain a consensus on what is needed to have a good supervisory system, ranging from. The principles were revised in 2012, and integrated with the previously separate accompanying assessment methodology used by the IMF to see whether the principles were implemented5. In addition to the preconditions for banking, the content of supervision and the organisation of supervision, the principles now cover supervisory attention to issues such as corporate governance and crises, with added detail and focus on supervisory action, macroprudential assessments and to systemic institutions. The core principles can be applied to both Basel members and non-Basel members; but they were initially drafted mainly as an outreach to emerging financial markets6. Nonetheless, they also show what supervisors in more financially advanced economies think they (and their national legal system on supervision) should live up to. The core principles have been reasonably well implemented. This is shown from the regular financial sector assessments executed by the IMF and published (with the consent of the country assessed) on its website7. As shown by the assessments carried out across the world, the least effective core principles, however, are those relating to the types of instruments and legal/institutional set-up that supervisors need, as well as laws guarding against undue delay in undertaking corrective actions, which de facto leads to forbearance8. Within the EU, the way the domestic supervisor is set up and financed has been left almost wholly to local legislators. The core principles are not binding, and have not been copied into binding EU legislation. The IMF assessment process has nonetheless supported their implementation by the EU member states9.

5 6

7

8

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BCBS, Core Principles for Effective Banking Supervision, September 2012, based upon a consultative document published in December 2011. See e.g. the previous versions of the core principles, such as BCBS, Core Principles for Effective Banking Supervision, October 2006; and C. Goodhart, The Basel Committee on Banking Supervision, a History of the Early Years 1974-1997, Cambridge, 2011, chapter 8. For countries with systemically important financial systems the IMF FSAP’s have become mandatory. This includes the EU as a whole as well as several member states. IMF, Integrating stability assessments under the financial sector assessment program into art. IV surveillance, 27 August 2010, as approved in 2011, www.imf.org. J. Black, ‘Restructuring Global and EU Financial Regulation’, in E. Wymeersch, K.J. Hopt, & G.Ferrarini (Eds.), Financial Regulation and Supervision, Oxford, 2012, chapter 1. Art. 1 and 23 BCBS, Core Principles for Effective Banking Supervision, October 2006; BCBS, Core Principles Methodology, October 2006, page 6-10 and 38; both documents as since replaced by BCBS, Core Principles for Effective Banking Supervision, September 2012. J. Viñals & J. Fiechter, The Making of Good Supervision: Learning to Say ‘No’, 2010, IMF SPN/10/08. Also see the toolkit for self-assessments and IMF assessments developed by the BCBS. The most recent version is contained in BCBS, Core Principles for Effective Banking Supervision, September 2012.

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According to IMF staff10, good supervision has to be intrusive, sceptical, proactive, comprehensive, adaptive and conclusive. In the crisis, many supervisors turned out to fail on one or more of these elements, due to lack of staff, knowledge, conflicting implicit or explicit goals (e.g. competitiveness and/or open financial systems versus safety), supervisory capture11 and going with the flow of optimism. To achieve these elements supervisors need both the ability to act (good laws, resources, instruments and cooperation) and the will to actually act. Lacking such characteristics of individual supervisors and supervisory authorities and the associated instruments and rules, there is a failure (capture, lack of commitment or lack of coordination) that de facto leads to regulatory forbearance12. On the written regulation issues, the EU has done well. As shown in the crisis, however, written law does not mean execution. The execution is in the hands of the supervisors. The core principles have suffered here from being drafted by supervisors themselves instead of by legislators. Legislators have sort of ignored these particular principles as and deemed them little more than self-interested presents supervisors wanted for themselves, such as independence, funding, instruments to act. Implementation has been very uneven especially on the issues of operational independence, funding (translating into skills and numbers) and personal liability of supervisors13. Prudential supervision is expensive if you want to do it well, and in good times the appearance of supervision (cheap) is as effective as actual supervision (expensive). And an independent supervisor with a large staff translates in a brake on banks and in irritating warnings that spoil any nice economic party and/or may diminish the stature and growth potential of the local banks in the EU/global arena. Unsurprisingly, slightly more support has come forward during the crisis in the form of assessments and papers to advice political leaders to reinforce the implementation of the Basel core principles at the EU level. Equally unsurprisingly, this has been less welcomed than the expansion of the rulebook, as making local or EU supervisors more powerful impinges directly on the political domestic sovereignty. Within the EU, with the establishment of EBA, some line side power has been transferred to a new EU institution. This power transfer has been mostly from member states to EBA, though it is strongly conditional

10 J. Viñals & J. Fiechter, The Making of Good Supervision: Learning to Say ‘No’, 2010, IMF SPN/10/08. Also see chapter 20.1. 11 Identification of the supervisory employees or even supervisory authorities with the interests of the bank they have licensed and (long) supervised due to intensive contacts and cooperation. 12 M. Bijlsma, W. Elsenburg & M. van Leuvensteijn, Four Futures For Finance, CPB Document 211, September 2010. 13 M. Quintyn, S. Ramirez & M.W. Taylor, The Fear of Freedom: Politicians and the Independence and Accountability of Financial Sector Supervisors, IMF WP/07/25. BCBS, Core Principles for Effective Banking Supervision, September 2012.

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on the voting behaviour of national supervisor in the board of EBA, and cannot force emergency funding in a bank crisis. Neither the Commission nor Parliament and the Council transferred rulemaking power to EBA. In return for a partial delegation of its right to draft some potentially binding rules, the Commission claiming a seat at the table of both the final decision making committee of EBA and of its de facto ruling committee; see chapter 21.3. That some of the drafting of delegated law-making would be done at EBA (a partial transfer of the right of initiative of the Commission) was vigorously opposed by the Commission in spite of the checks it can perform before issuing – amended – proposals of EBA under its name. Parliament and Council can rescind their delegated drafting and rulemaking powers any time they see fit. The veto and intermittent political influence leaves EBA far from politically independent on the policy side too. European System of Financial Supervisors For the banking area the establishment of a European system of financial supervision14 means the institution of EBA as the link between its member-national supervisors. EBA is linked to the sister authorities ESMA (for the securities and markets sector) and EIOPA (for the insurance and occupational pensions sector) via its ‘joint committee’. This joint committee basically is the three chairs of the three authorities. EBA and its sister authorities also send members/observers at various forums and committees. The link to the central banking/macroprudential side received most attention at the time of creation of the new system; see chapter 22). For cross-sector work, the ESRB will be the forum for macro issues, but for all normal supervisory issues the new joint committee and its sub-committee on financial conglomerates will be the forum to achieve consistency across the sectors15. All participants in the authorities are obliged to cooperate with trust and full mutual respect, though it is noteworthy that this apparently needed to be stated explicitly. The member state governments and legislature is not mentioned here, but their cooperation will be essential, especially in the implementation process of EU rules and in emergency situations. On the policy side, EBA is CEBS under a new name, with a slightly16 expanded role on rulemaking and tightened governance procedures. On rulemaking, the role of CEBS was 14 Art. 2 EBA Regulation 1093/2010, as well as the equivalent articles in ESMA Regulation 1095/2010, EIOPA Regulation 1094/2010 and ESRB Regulation 1092/2010. 15 Art. 2.3 and 54-57 EBA Regulation 1093/2010. The Joint Committee is identical to the 3L3 (three level 3 committees) meetings, though the Commission and the ESRB will now be invited to send representatives as observers. See chapter 2 and 3. 16 Slight on the substance, where CEBS already was influential as an advisory body. From a constitutional point of view, the change is more fundamental as the powers of the Commission to deviate from advice on delegated rules is more circumscribed; see chapter 23, especially 23.3.

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previously limited to advice on binding rules, in some prudential areas it can now propose the text of future binding ‘technical’ and ‘implementing’ rules if the Commission agrees to use its delegated power of rulemaking to endorse such proposals; though it can deviate from the advice in a reasoned manner if it does not think the drafts EBA sent in is right. On the line side, limited role of CEBS has been expanded. It will be deemed a supervisor in its own right, and will be able to send observers from its own employees to the meetings of the colleges of its members (national supervisors) focusing on specific banking groups. In addition, the board of EBA, consisting of all the domestic banking supervisors, will be able to take some limited decisions on the course to be taken by the authorities of one of the member states, but will not be able to force anything that may cost money to the taxpayers of that country. Basically, this means that the power of EBA, will remain the (soft but valuable) power to provide a forum for deliberation, provide peer pressure and advice on the best course possible, but now also on the line side. The centre of power remains at the domestic level. EU wide legislation that would embrace supervision in normal times and in crisis – and especially its funding – has so far not been agreed on. Such consensus to delegate responsibility for the financial system or parts of it to the EU is absent in spite of the 2007-2013 subprime crisis showing that no government or banking supervisor or market supervisor can deal with these issues on a standalone basis. If – in an attempt to end the crisis for the EU – a ‘banking union’ will indeed be proclaimed, this may result in a shift to the EU or to the Eurozone; see chapter 21.3. Most likely this will be a partial shift only, with such a ‘union’ only covering line side supervision, perhaps only of banks operating in or headquartered in the Eurozone, perhaps only of larger banking groups. Without joint deposit insurance, a joint fully harmonised supervisory law and bankruptcy regime, and a joint state aid regime based on burden sharing, key components of a successful banking system or ‘union’ would remain to be dealt with at the national level17. Home Host Line Side Cooperation With the increase of cross-border services, cross-border banking groups, and the size and frequency of cross-border financial transactions, the cross-border interdependency of supervisors increased automatically. So did the request of such banks for consistent treatment across the group in different countries18. A free flow of information and full cooperation on banks and banking groups with activities in various countries would be automatic, if there was full harmonisation, full mutual trust, full alignment of interests and full reci-

17 Also see R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 4.6. 18 See e.g. M. Wolgast, ‘M&As in the Financial Industry: a Matter of Concern for Bank Supervisors?’, Journal of Financial Regulation and Compliance, Vol. 9, No. 3, 2001, page 233-234.

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procity. In the past, prior to the binding rules now contained in the CRD, this was often left to non-binding agreements between two or more supervisors. Such an agreement, often referred to as a ‘memorandum of understanding’ is a contract that is not legally binding on the two supervisors that sign it. Before the introduction of cross-border cooperation arrangements in the CRD, they were the sole tool, in which on a bilateral nonbinding basis some working processes were laid down, enabling two supervisors which had common interests (such as entities of one group in both countries) to talk to each other, exchange some information, and inspect holdings of a bank in the country of another supervisor. As there was a limited amount of articles on cooperation initially, this habit persisted when predecessors of the CRD were introduced in the EU. Though not a legal necessity between member states now, such memorandums of understanding may still be maintained to establish good practical contacts. For relations with third country supervisors, they are still regularly used in the absence of clear cross-border treaties or binding agreements with third countries. Under the new home host provisions, memorandums of understanding have been replaced by RBD provisions on general cooperation, on cooperation on a legal entity, and on banking group specific arrangements; see chapter 21.5-21.7. The terminology made a cross over into crisis management; see chapter 18.3. Instead of bilateral arrangements, here multilateral arrangements became convenient, as more and more authorities became involved in any systemic crisis. In earlier versions, only banking supervisors and central banks were involved, with central banks traditionally being dominant in systemic crisis resolution. Ministries of finance are co-signatories, when they wrote an active role into the CRD when they realised that in the end public finances will foot the bill (either in the form of central bank funds or directly from the states accounts; see chapter 18.4). The 2008 Crisis MoU is in as far as known still in force, and brings together practical arrangements, that are non-binding (to the extent they have not since been legislated upon for instance in the EBA regulation or in the CRD amendments). Obligatory information sharing and obligatory cooperation have been instituted to try to bridge some of the gaps in normal times and in crisis times. These divide the work under the political compromise as laid down in the CRD, and improve working relationships on a bilateral and increasingly multilateral practical level; though they may be replaced in full or in part by a banking union (or elements thereof). Some other elements impacting on the discussion whether cooperation is opportune or even feasible are: – domestic priorities for banks, as laid down in domestic supervisory laws; – balance of power between the member states and domestic pride; – balance of power between the member states and the EU institutions;

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– misalignment of costs and benefits of supervision, and more importantly of crisis resolution, when a banking group has activities in several member states19; – differences in resources (number of people working at supervisors, their expertise and payment) both in absolute and relative numbers; – lack of harmonisation in several key areas of the CRD (e.g. licensing requirements, definitions, reporting requirements, goldplating and national discretions); – institutional and political inertia; – lack of a common supervisory culture, both institutional and in the approach to supervised entities; and – differences in political interference in line side supervision (both on state owned banks and on systemic banks or the domestic banking sector as a whole). In light of these factors, it is remarkable that there is actually a relatively high amount of cooperation in normal times, and even in crisis times. This is due both to imperatives following from the single market thinking, and the lobbying of cross-border operating banking groups on harmonising supervision, and limiting the supervisory burden on them. The progress has been easier in the areas where the above-mentioned counter-incentives are less dominant, or can be controlled by direct influence of the member states on the result. It has been more difficult to institute binding, enforceable and practical line side cross-border supervision, the focus of this chapter, and the target of e.g. EBA and the increasingly ‘binding’ nature of its guidelines and of the regulatory standards it drafts. To ease the burden on banks, the legislation promotes a departure of the ‘trust but verify” attitude that many supervisors will have to information sharing and cooperation (as they are obliged to have vis-à-vis banks; see chapter 20.2). Certain tasks are clearly divided, and the other supervisor in that case – even if he has a direct interest in the subject matter – will have to rely on the information provided by the supervisor with exclusive competence (without being allowed to verify such information. The same applies to reporting information obtained from the bank, which has to be received at one supervisor and shared with others (instead of the bank having to send it multiple times). Most often, however, there remains an option to join investigations and to verify information at the bank, if there is a direct competence that overlaps (e.g. on consolidated and solo supervision). In cases where there is a clear obligation to rely on information that has to be given by another supervisor or is obtained from another supervisor, this will increase the liability of the supervisor that is obliged to give that information towards the supervisor that has to rely on it; see chapter 21.10.

19 CEBS/EBA and CEIOPS/EIOPA, Recommendations on the Supplementary Requirements of the Financial Conglomerates Directive for Supervisory Colleges of Financial Conglomerates, 21 December 2010, page 7.

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Cooperation Domestically, and with Third Counties Apart from the cooperation on supervising a single bank or a banking group within the EU, there are also regulations and practices on cooperation with third country supervisors on subsidiaries or subgroups within the EU of third country banking groups, as well as the reciprocal cooperation on subsidiaries or subgroups of EU banking groups in third countries. On a related, but not cross-border, subject, the RBD requires supervisors within a member state to cooperate. If a member state has split the responsibility for prudential supervision of banks over two or more supervisors (such as in France, where licensing and ongoing supervision is divided over two supervisory authorities), the member state must take the requisite measures to organise coordination between the domestic supervisors20. Future Developments The CRD IV project does not result in material changes in the institutional structure of supervisors, though some of the requirements are made more explicit (such as on the skillset and resources needed at domestic supervisors; see chapter 21.2 and 21.9), and additional procedures have been added for group wide assessment of new subjects such as liquidity (see chapter 21.7). The Commission is proposing the establishment of new resolution authorities and of new resolution funds, who will all be required to create additional cross-border networks; see chapter 18.321. Though these may well be the supervisory authority, deposit insurer or another existing national player in the field of banking supervision or banking liquidation, the addition of another layer of bureaucracy and an additional set of rules is likely not helpful. Negotiations on a banking union may result in a partial shift of tasks to the EU level. The Commission has proposed to limit it to the Eurozone, allocate this task to a new committee that should operate under the umbrella of the ECB, and which should cooperate with the EBA for policy side discussions and for the links with non-Eurozone member states. Due to the sovereignty and fiscal consequences of such a shift, the exact form of such a ‘union’ remains to be seen. Literature – European financial supervision – delegating power to community agencies and legal bases for doing so, Document considered by the European Scrutiny committee of the

20 Art. 128 RBD. 21 Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012.

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UK parliament on 4 November 2009, available on www.parliament.the-stationeryoffice.co.uk CEPS, Concrete Steps Towards More Integrated Financial Oversight, The EU’s Policy Response to the Crisis, 2008 Moloney, Niamh, EC Securities Regulation, 2nd ed., Oxford University Press, Oxford, 2008, chapter XIV Kellermann, A. Joanne; Haan, Jakob de; Vries, Femke de (ed.), Financial Supervision in the 21st Century, Springer, Berlin, 2013 Padoa-Schioppa, Tommaso, Regulating Finance: Balancing Freedom and Risk, Oxford University Press, Oxford, 2004, chapter 6 Wymeersch, Eddy; Hopt, Klaus J.; Ferrarini, Guido (ed), Financial Regulation and Supervision, Oxford University Press, Oxford, 2012 UK Financial Services Authority, The Turner review, March 2009

21.2 Domestic Organisation and Cooperation Introduction Both the treaties and the CRD are neutral as to the organisational set-up of domestic supervision. Different set-ups of supervision are allowed, as long as each member state identifies a supervisor (competent authority) and ensures that tasks are clearly allocated22. Several institutional settings occur in the member states (and in third countries): – separated per subject (insurance, banking, pensions, monetary, retail and consumer conduct of business, market conduct of business); – separated, but with some combinations (e.g. banking and monetary authority combined); – twin peaks, with prudential/monetary on one side and conduct of business supervision on the other; – largely or fully integrated, though with exceptions, such as a separate monetary authority or pension supervisor. The CRD carefully skirts the issue on how a member state (or third country) chooses to allocate powers to a range of public or public/private authorities. It leaves this to local political tastes and the fashion of the day, as long as the various domestic authorities

22 Art. 4.4 RBD and 36.1 RCAD. Unlike in e.g. the investment firm sector, there is no register of all competent authorities, nor an obligation to have a single supervisor as the contact point for that member state; see art. 48.3 and 56.Mifid.

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EU Banking Supervision cooperate together23. The EU cares, however, a great deal that those authorities share information, cooperate with each other and with EBA and supervisors of other member states, and that the various public authorities involved deliver on the tasks allocated to them under the CRD. As a result of the lessons learned from the 2007-2013 subprime crisis, the EU now also explicitly invites member states to make certain that supervisory authorities have sufficient personnel – with ‘appropriate’ knowledge and experience – and other resources to comply with all supervisory tasks24. As this invitation is not part of the binding articles of the CRD but only a recital, the member states can ignore it to some extent. The recitals help interpret the binding tasks of a member state and its supervisor, though, so having an inadequately resourced or experienced (and thus costly) supervisor may lead to liability if a bank fails without the supervisor noticing or if he fails to act on early warning signals; see chapter 21.9-21.10. The obligation to cooperate domestically applies both to public authorities who share or have different tasks within the scope of the CRD, but also across sectors with e.g. supervisors competent for insurance, or investment services directives25. There is no clear rule that extends this to consumer-based conduct of business rules (see chapter 16.6), nor to cooperation with EU or national data protection or competition authorities and vice versa. This makes it more likely that their investigations and the measures taken are at odds with each other. For domestic cooperation, the member state is free to expand the number of cooperative arrangements, though it will need to take secrecy rules into consideration; see chapter 20.2. The CRD lacks an explicit rule that different units within a domestic public authority have to cooperate with each other if they have tasks under different directives, but such an obligation to cooperation would be in line with the charge to cooperate if they were part of separate public authorities. There do not appear to be clear economic or governance factors in governing the domestic choices made, leaving the optimal political choice at any given moment to local authorities. This said, many authors and public bodies have strong opinions on what the best institutional l set-up is26. Factors such as resource allocation, costs and benefits, internal and 23 Art. 128 RBD. Also see for instance the Memorandum of Understanding on cooperation between the financial supervisory authorities, central banks and finance ministries of the European Union on crossborder financial stability, 1 June 2008. 24 Recital 28 CRD II 2009/111/EC; also see chapter 21.9. 25 Art. 128 RBD and e.g. art. 1.2 and 49 Mifid. Mifid restricts the delegation of supervision on issues within its scope – also when it applies to banks – to private sector entities; art. 1.2 and 48 Mifid. 26 See e.g. the overview as per 2004 given by D. Masciandaro, ‘Unification in Financial Sector Supervision: The Trade-Off Between Central Bank and Single Authority’, Journal of Financial Regulation and Compliance, Vol. 12, No. 2, 2004, page 151-169; D. Masciandaro, M. Nieto & M. Quintyn, ‘Financial Supervision in the EU: Is There Convergence in the National Architectures?’, Journal of Financial Regulation and Compliance, Vol. 17, No. 2, 2009. P.C. Boyer & J. Ponce, Central Banks, Regulatory Capture and Banking Supervision

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external cooperation, proper attention paid to core goals, prioritisation and expertise are brought to the fore. These are all important, and – like the CRD – the author of this book is totally neutral (as in ‘does not care’) which institutional set up is chosen as long as such issues are well taken care off; see chapter 21.1. Apart from issues of proper cooperation – which is as difficult within a single public authority as it is across public authorities – and a clear allocation of goals and responsibilities, it is mainly a factor of needing to shake things up regularly (always a good idea to cut away the obsolete parts of organisations and re-think priorities and working methods) and otherwise it remains the remit of institutional/political power-play. Neither obligations to perform risk analysis and prioritisation by supervisors, nor the amount of resources needed are dealt with in the CRD. Every modern supervisor nowadays has a risk analysis tool to help focus on the important issues, and to allow for comparison across the banks27. The level of sophistication varies, depending on ICT and staff investment in such functions. It can vary from heavily automated systems that highlight where the input suggests weak spots in the bank(s), to a set of paper fact sheets from several banks with a staple through it. The input is gathered from the firms (e.g. management information), from supervisory visits, from analysis of quantitative information, or focused factgathering on specific risks. Such risk analysis tools incorporate both objective and subjective information to allow supervisors to come to a risk assessment for the future. The quality and comparability of the input will to a large extent determine the outcome, as will the quality of the methodology for analysing it and the time invested by staff on the analysis per bank and benchmarking across banks. In this regard, it is similar to the models and processes used for risk analysis by the banks themselves; see chapter 6.3. The same applies to expertise and experience requirements, working methods, information storage, front office/back office requirements, rotation of supervisors to avoid capture, the amount of resources to be spent on banks with non-systemic or systemic impact, the amount of Reforms, ‘Paolo Baffi’ Centre Research Paper Series 2010-83; USA Treasury, Blueprint for a Modernised Financial Regulatory Structure, March 2008; M. Van Hengel, P. Hilbers & D. Schoenmaker, ‘Experiences with the Dutch Twin Peaks Model: Lessons for Europe’, in A.J. Kellermann, J. de Haan, F. de Vries, (Eds.), Financial Supervision in the 21st century, Amsterdam, 2013, chapter 12; K.K. Mwenda, Legal Aspects of Financial Services Regulation and the Concept of a Unified Regulator, World Bank, Washington, 2006; E.W. Nier, Financial Stability Frameworks and the Role of Central Banks: Lessons from the Crisis, IMF WP/09/70. As described in H. Davies & D. Green, Banking on the Future, The Fall and Rise of Central Banking, Princeton, 2010, the issue has been shifting again since the start of the 2007-2013 subprime crisis. 27 See F.S. Mishkin, The Economics of Money, Banking, and Financial Markets, 8th ed., Pearson Adisson Wesley, Boston, 2006, chapter 11, for a description of the CAMELS system used in the USA. In the Netherlands, it is the Financial Institutions Risk-analysis Method (‘FIRM’), at the UK FSA it was the advanced, risk-responsive operating framework (‘ARROW’); Financial Services Authority, The FSA’s Risk Assessment Framework, August 2006. See e.g. DNB, External Evaluation of Insurance Supervision, Summary, Amsterdam, July 2009, www.dnb.nl, or T. Kick & A. Pfingsten, The Importance of Qualitative Risk Assessment in Banking Supervision Before and During the Crisis, Deutsche Bundesbank Discussion Paper Series 2, 09/2011.

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resources to be spent on consolidated supervision abroad for which the domestic supervisor has the responsibility that will be needed to correctly assess the relative risk in parts of banks and of the banking sector, and allocate additional supervisory resources to their solution. The EU rules set no qualitative requirement on the supervisors nor their organisation, apart from the above-mentioned recent requirement that it should be ‘appropriate’. Member states have to ensure that they can fulfil the tasks given to them in the directives. If they cannot, their implementation of the directive is not efficient, proportionate and dissuasive; see chapter 20.1. What that implies for the amount of resources needed, is not very clear. There are also no explicit demands on the quality of the internal governance at the supervisor. It leaves a wide range of possible requirements and thus a wide range on the requisite funding and available resources in the labour markets. Some insight on the needed numbers and expertise might be derived: – as to the quality of the individual supervisors employed by supervisory authorities from the Commission recommendation on statutory audit quality assurance28; – as to the quality of the internal governance/corporate governance of supervisory authorities from the requirements applicable to banks (see chapter 13) and from the Commission recommendation on statutory auditors’ independence, as well as from the independence/conflict of interest requirements as set out in the market disclosure directives29. This leaves a wide range of issues that are not regulated at the EU level but have a direct impact on the quality of supervision. Some of these are: on supervisory staff: – requirements on job rotation to avoid regulatory capture; – requirements on language skills and international experience or attitude when supervising international banks; – requirements to be able to be cranky and to discuss the difficult issues rather than the easy low-key issues both with the bank and internally30.

28 Statutory Audit Quality Assurance Commission Recommendation 2001/25/E. 29 Statutory Auditors’ Independence Commission Recommendation 2002/590/EC, and the market disclosure directives articles referenced in chapter 16.5. 30 FSB, Intensity and effectiveness of SIFI supervision, recommendations for enhanced supervision, 2 November 2010, page 15, mentions staff at banks and supervisors focusing on immaterial issues, or following the approach ‘don’t escalate bad news’.

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on the supervisory organisation: – front office/back office arrangements; – risk functions; – legal functions; – responsibilities of senior management and board members and necessary skills to be available within senior management and within the board; – quality of ICT support. on the supervisory working methods: – define the member state risk appetite, in consultation with the lender of last resort (central bank monetary function) and the responsible authorities for state aid (ministries of finance) and for deposit guarantees; – how contacts with non-executives/supervisory board members at banks should be maintained, and at what level of the supervisor; – how contacts with risk functions at banks should be maintained. Many of these could be easily incorporated into the CRD by indicating that the demands on banks’ organisations apply also to their supervisor in as far as possible. Some of these are covered by the (non-binding) Basel core principles; see chapter 21.1, including on independence and prioritisation. Independence and Accountability A difficult balancing act is the necessary political and operational independence needed to actually being able to act against transgressing politically powerful actors, and the accountability needed in a democratic society31. Once rules have been set, any short term intervention from lobbyists or politicians in the execution of individual decisions at the supervisor is unhelpful in creating a strong supervisor and a culture in which adherence to the content of the prudential requirements is important. On the contrary, political interference may lead to ever changing prioritisation of different public policy goals or favouritism to powerful sectors of society that are linked to currently powerful politicians pressuring a non-independent supervisor to practice regulatory forbearance32. The BCBS and the IMF indicate that operational policy on the execution of those requirements (licensing, exit decisions, liability, funding) should be set without fear of future budgets or political intervention. Legislators should set the framework, based on a public debate 31 J. Viñals & J. Fiechter, The Making of Good Supervision: Learning to Say ‘No’, 2010, IMF SPN/10/08; M. Quintyn, S. Ramirez & M.W. Taylor, The Fear of Freedom: Politicians and the Independence and Accountability of Financial Sector Supervisors, IMF WP/07/25. 32 E. Hüpkes, M. Quintyn & M.W. Taylor, The Accountability of Financial Sector Supervisors: Principles and Practice, WP/05/51. Also see chapter 20.3.

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on the balance between costs and benefits, and based on strong accountability. Like at banks, the risk appetite should fit within the boundaries set by legislators and public debate. How much is the state willing to spend from its own money or of the money of the banks in the short term, and what costs/risks of short and/or long term disaster is it willing to accept? The same applies to de facto independence from the financial sector. In some ways it is the subject of supervision, in others it is the client, it can be a future or former employer, and it definitely is a key political and technical influence when drafting rules and policies. These factors necessitate a deliberation on what type of accountability is necessary to counterbalance independence. See the similar debate on central bank independence, which has been won by the proponents of a conservative monetary policy authority in the setting up of the ECB; chapter 22). The CRD does not yet require supervisory independence, leaving it to national discretion to fulfil the guidance contained in the Basel core principles (see chapter 21.1)33. A lack of independence is highlighted by the FSB as a reason why many supervisors did not even question lending practices if those were in line with national financial prosperity. How can supervisors be reasonably requested to act for instance act in a countercyclical manner if the bank in question is powerful, or the unsafe practice stimulates local growth, if he is not truly independent34? However, a small step forward is that the heads of national authorities that are members of EBA have to be able to vote independently at EBA (see chapter 21.3-21.4), without taking or seeking instructions from amongst others their member state. Similar independence requirements apply to other functionaries within EBA, such as members of the management board, the chairperson and the executive director. The independence meant is wide-ranging, including from EU institutions and bodies, governments or any other public or private bodies35. By way of example, if the career path at a national supervisor is solely through the ranks of the supervisory authority itself (making employees very dependent on the goodwill of their internal bosses; who may or may not wish to hear bad news), the interaction with the market is different than if the supervisor authority has many positions occupied by persons who used to work and may again work in the private financial sector (making employees very dependent on the goodwill of their external counterparts, as well as their 33 Independence will become mandated for national supervisors in 2014 as a result of art. 4 CRD IV Directive; see under future developments. 34 FSB, Intensity and effectiveness of SIFI supervision, recommendations for enhanced supervision, 2 November 2010. 35 Art. 42, 46, 49, 52, 59 EBA Regulation 1093/2010.

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internal bosses who may have been or will start to be their counterpart at a commercial bank they supervise). Such traditions some supervisory authorities a more ‘papa knows best’ or top down feeling and other authorities a self-regulatory feeling. In the case of the UK FSA this was in line with the light touch regime inherited from predecessor self-regulatory bodies (though this is changing to some extent as a result of the 2007-2013 subprime crisis)36. The EU does not prescribe a certain set-up or mind-set. Nevertheless, the debate is often heated on the advantages and disadvantages of twin peaks, sectoral, unified or altogether different types of division of labour. None of these institutional formats have gained particular acclaim, all of them have been locally decried for allowing the 2007-2013 subprime crisis to happen. Defenders and detractors are often vehement, depending on whether they work in the context of a particular set-up, or whether strong action is needed in response to past troubles37. The requirements on accountability are slowly increasing. The main channel for political accountability of the national supervisors at the EU level is via EBA, at which they vote on the annual reports and other reports to e.g. Parliament or Commission/Council groupings. Other EU requirements on accountability relate to: – legal challenges on decisions taken in the context of cross-border supervision, where the host supervisor or college supervisors may challenge acts or negligence of a national supervisor at EBA and via the board of appeal and Court of Justice; – accountability to the addressees of decisions via mandatory legal challenges possibilities in local courts; see chapter 20.4 and 20.5, as a basic human rights/administrative rights issue; – accountability on compliance with the CRD via the supervisory disclosure framework; see chapter 15 and 20.7; – accountability on compliance with EBA guidelines via the ‘comply or explain’ route mandated in the EBA regulation; see chapter 23.3. Other issues on, accountability to Parliament and courts are left to national rules. The Central Bank As Monetary Authority and Prudential Supervisor for Banks The literature on whether it is either an excellent idea or the worst idea ever to combine the central bank as a monetary authority with the prudential supervisor of banks is diverse.

36 UK FSA, The Turner Review, March 2009. 37 For a description of the similar USA discussion during the 2007-2013 subprime crisis prior to the adoption of the USA 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, see L.A. Cunningham & D. Zaring, ‘The Three or Four Approaches to Financial Regulation: a Cautionary Analysis Against Exuberance in Crisis Response’, The George Washington Law Review, Vol. 78, 2009, p. 39.

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EU Banking Supervision

Generally, it appears as if central banks that are politically allowed to say so favour also having supervision over the banks as the banks are38: – the main channel for their interest rate instruments in the economy; – the main participants in the payments systems the central banks supervise; – the main recipients of liquidity support from the central bank as lender of last resort; – it would bring the information into one ‘hand’, though this would necessitate good internal cooperation, which – like good external cooperation – is not a given. On the other hand banking supervisors that are independently organised from the central bank generally do not appear to favour a merger. There is almost a pendulum, however, between merging and demerging banking supervision from central banks, depending on whether there has recently been a crisis and whether that has been handled well. The main arguments in favour of separating them are39: – banking supervision does not require political independence as to policy (as has been introduced for the ESCB/ECB in order allow it to focus on long term inflation)40, though it does require operational autonomy as to execution; – accountability can be introduced to a higher degree (unless some of the main banks in the economy are state owned); – introducing multiple goals for one supervisory authority makes it likely that none of those goals are achieved in their optimal form, or even that conflicts of interest occur in a non-transparent manner. By way of example, it may well be that interest rates are being kept lower for a longer time than necessary for monetary purposes after a banking crisis, to allow banks a longer time to make profits on interest margins in order to recapitalise. Though from a stability point of view this is understandable, without any doubt this transferral of profits from net lenders (depositors or more prudent banks) to net borrowers through the reduction of interest rates is a weird incentive to give, especially if given in a non-transparent and democratically accountable manner; – Banking supervision carries substantial downward reputational risk (if banks fail supervisors are blamed by definition) and no upward reputational profits (if banks survive due to supervisory action this remains largely secret or becomes part of ‘normal’ commercial restructuring). Damage to the central banks reputation as a supervisor will taint also its reputation as a monetary authority.

38 See chapters 18, 21.3 and 22. 39 See the literature at the end of this paragraph and S.C.W. Eijffinger & J. De Haan, The Political Economy of Central-Bank Independence, Princeton, New Jersey, 1996. Also compare Final Report of the High-Level Group on Financial Supervision in the EU, chaired by Jacques de Larosière, 25 February 2009 (De Larosière Report), page 43-44. 40 See, however, R.M. Lastra, Central Banking and Banking Regulation, LSE, London, 1996, chapter 1.5 and 2.3.

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Regardless of the institutional set-up, good cooperation between the monetary authority and the prudential authority, as well as with the macroprudential authority and the conduct of business authority and the markets authority will be necessary, whether they are part of the same legal entity (e.g. the central bank) or not41. Even if they are part of the same legal entity, good cooperation is not automatic. Future Developments The impact on domestic institutional set up, especially on the resources required, of new legislative developments is high. Some additional obligations may need to be supervised, while some tasks in some member states may be allocated instead to a central EU or Eurozone supervisor. The new clearer descriptions of instruments and sanctions in the CRD IV directive and the CRR, the demands made in resources and expertise in colleges and EBA, and ever increasing transparency and harmonisation in other aspects of day to day licensing, ongoing supervision and crisis management. In order to be able to execute these tasks, the CRD IV directive requires member states to ensure that the supervisor will have a range of characteristics, which have previously not been harmonised. The supervisor will need to be constituted in a manner that ensures it has the powers and the resources it needs (see chapter 20 and 21.9), as well as the independence it needs to be able to execute its tasks under the CRR and the CRD IV directive42. The directive does not specify what independence means; but perhaps the same type of (seek nor accept instructions) is meant as in the EBA regulation for amongst others members of its board. The European dimension will remain a factor that the national supervisors will need to take into consideration when taking action, but they are not bound to consider effects elsewhere as more or equally important as effects of their action or non-action domestically43. If the single supervisory mechanism is introduced, the ECB either by EU law be deemed a competent authority, or the member state can designate it to be a supervisory authority and allocate it directly powers under its national laws (and help delineate the role of the ECB and the (remaining tasks of the national supervisor)44. Also, new authorities, or at least new functions of already existing supervisory or monetary authorities will be added to the spectrum that needs to be covered in each member state:

41 Also see ESRB, Recommendation on the Macroprudential Mandate of National Authorities, 22 December 2011, ESRB/2011/3. 42 Art. 4 CRD IV Directive, effective from the start of 2014. 43 Art. 7 CRD IV Directive. 44 Art. 4.1 CRD IV Directive; though the allocation of tasks and instruments, will need to be along the lines of the yet to be published regulation (with direct effect) on the tasks of the single supervisory mechanism.

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– There should be a national authority that obtains certain macroprudential tasks and instruments, as referred to in the recommendations for national macroprudential authorities and their instruments as issued by the ESRB, which should be implemented in 2013 and 2014, and in the CRD IV directive certain specific macroprudential tasks need to allocated to such an authority; see chapter 22.5; – The harmonisation of a reference to a resolution function (and the authority that has this function deemed the resolution authority) adds some institutional thinking on crisis management. Such a function can now be a supervisory authority or other body, but it can also be a court. Though the tasks of the function are not yet defined (see chapter 18.3), it appears to include drafting resolution plans. The CRD IV directive mandates that it can be any type of authority, but if it is the same authority as the supervisor, these functions need to be separate and independent. This obligation becomes mandatory in 201445. Literature – Hadjiemmanuil, Christos, Democracy, supranationality and central bank independence in Kleineman, Jan (ed.) Central bank independence, 2001, page 131-170 – Davies, Howard; Green, David, Banking on the Future: The Fall and Rise of Central Banking, Princeton University Press, Princeton USA, 2010 – Llewellyn, David T., Institutional Structure of Financial Regulation and Supervision: The Basic Issues, paper presented at World Bank seminar ‘aligning supervisory structures with country needs, Washington 6/7 June 2006 – Lastra, Rosa María, Central Banking and Banking Regulation, London School of Economics and Political Science, London, 1996

21.3 Constitutional Issues for EBA and for a Eurozone Supervisor Introduction EBA and its sister authorities ESMA and EIOPA are hybrid organisations of national supervisors with some centralised EU functions. They have a role in legislation, guidance and practice. For such key players, it is strange that their role is not laid down in the EU treaties. The politically agreed single banking supervisor or supervisory system for the Eurozone at the ESCB/ECB at least has such a hook in the EU treaties, but it may not be solid enough to hang all aspects of a credible banking union on it46. An open question is whether – by setting up institutional arrangements at the EU level in the form of commit45 Its tasks are not yet defined, nor what resolution is, but it appears to be charged with drafting resolution plans. See art. 4.7-4.8 and 74 CRD IV Directive. 46 W. Schäuble, Banking Union Must Be Built On Firm Foundations, Financial Times 13 May 2013, page 9.

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tees, boards or authorities – the EU legislators have gone beyond the boundaries set in the EU treaties for creating new bodies and allocating legislative and practical powers to them. The EU treaties do not foresee common supervisory authorities such as EBA or the ESRB. They do refer to the possibility that the Council can unanimously allocate ‘specific tasks upon the European Central Bank concerning policies relating to the prudential supervision of credit institutions and other financial institutions with the exception of insurance undertakings’. Outside of this restricted possibility the EU treaties instead often limit harmonisation to the substance of supervision, often via the flexible format of directives (see chapter 3.4). The existing legal basis for unitary banking supervision in the EU treaties has so far not been used except for some support functions of the ECB that is has to provide to the ESRB. Both the ESRB and EBA have been established by a regulation that is based on the EU treaty provision to harmonise in order the to achieve the internal market47. For unclear reasons the logistical and secretariat support the ECB provides to the ESRB is set out in a separate document based on the placeholder provision related to banking supervision, even though the tasks of the ECB are secretarial support that also deals with macro issues and insurance supervision. The EU treaty placeholder provision was included in addition to the right of the ECB to give its opinions on any financial supervision issues48. It was not expected that the placeholder would ever be used, with the development of aspects of a banking union being an unexpected development that can only be explained in the context of the 2007-2013 subprime crisis49. Using the banking supervision placeholder for secretariat-support to the ESRB is legally controversial, as its role is both smaller and outside the scope of the provision. It perhaps was politically useful for the ECB, to clear a stumbling block for its usage in a future banking union. Like the ESRB itself, the supporting role of the ECB should have been based on the legal basis to harmonise in order to achieve the internal market. The support given by the ECB also concerns the insurance market (which the EU treaty placeholder explicitly prohibits by excluding insurers from the ambit of the ECB). The support given is also not actual banking supervision, but administrative support to a body of predominantly central bankers without any powers except publishing nonbinding recommendations and warnings.

47 Art. 114 TFEU; see chapter 2 and 3. 48 Art. 127.6 TFEU. See the proposals of the Commission on the single supervisory mechanism described below, as well as the ECB/ESRB regulation on supporting tasks of the ECB towards the ESRB. 49 Also see H. Davies & D. Green, Banking on the Future, The Fall and Rise of Central Banking, Princeton, 2010, chapter 7.

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EBA, however, has been set up with binding powers. According to its constituting regulation EBA – like ESMA and EIOPA – has been set up with ambitious goals. EBA should50: – contribute to short, medium and long term financial stability and an effective financial system; – ensure a high, effective and consistent level of regulation and supervision (counterbalanced by the injunction to take account of the varying interests of member states and the different types of financial institutions); – protect transparency of markets and products; – protect depositors and investors; – prevent regulatory arbitrage; – guarantee a level playing field and promoting equal conditions of competition; – strengthen international coordination; – promote supervisory convergence; – provide advice to EU institutions. Setting up EBA with such goals and the powers to enforce their achievement may have skirted over the border of the leeway the Court of Justice has given to EU institutions to set up agencies that have no specific placeholder provision in the treaties. For the planned use of the existing placeholder for the allocation of ‘specific tasks’ to the ECB/ESCB in the context of a single supervisory mechanism a similar expansive use of the treaty provision is envisaged. The tasks and organisation of EBA are further described in chapter 2, 3.3, 21.4 and 23.3; this chapter 21.3 focuses on the role and status EU agencies such as the single supervisory mechanism and EBA can have and still stay within the boundaries of the EU treaties. Legal Basis for EU Wide Institutional Arrangements In the absence of a TFEU basis, the member states and EU institutions have only limited possibilities to institutionalise EU level banking supervision outside of the ECB. Even for the ECB – where a TFEU basis exists – it has to concern ‘specific tasks’ on ‘prudential supervision’ and excludes anything to do with insurance supervision (making an awkward match for allocating any consolidated supervision tasks)51. However, this does not mean that no institutional arrangements are possible at the EU level, even without a change of the treaties. These, as interpreted by Court of Justice case law, allow five distinct possibilities to set up cross-border institutions with their own role in EU legislative or executive processes. One of these possibilities concerns delegation of existing powers, three possibilities

50 Consideration 11 and art. 1.5 EBA Regulation 1093/2010. 51 Art. 127.6 TFEU.

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regard the creation of an entity with new powers, one the allocation of specific tasks to the ECB: 1. Creation of an agency with new (possibly only non-binding) powers via new EU legislation – under the normal legislative procedure with majority voting – on the basis of existing treaty provisions52. Such advisory or facilitating bodies can be set up at the discretion of the EU legislators within the boundaries of a treaty-legal basis such as the internal market or freedom of establishment provisions used for the CRD. This does technically not impact on the authority of EU legislators nor on the authority of the member state institutions. Such new agencies can be given powers to take decisions, gather and disseminate information and/or an explicit role in rule-making however. Through its role and activities, effectively they can have strong moral authority to further the single market. The stance of the Commission is sometimes ambivalent; especially if the agencies are very independent in their relation to the Commission53. The same ambiguity is present in the stances of member states for a variety of reasons. These include democratic legitimacy, possible impingements on national prerogatives, the potential for capture of the agency by active industry groups or by member states bureaucracies, and the added complexity of the beehive of European/worldwide/national rules and guidance in their area. On the other hand such agencies are deemed useful due to considerations of effectiveness, know-how and consensus building for which they provide a format. The advisory agencies can also provide a more prominent role of member state delegates, enabling centralisation of tasks when the member states do not want to entrust such tasks to the Commission. Examples of these advisory agencies are the ESRB (with low level powers) and for their practical and advisory tasks EBA, ESMA and EIOPA (with very broad powers); also see chapter 3 and 21.454. 2. Delegation of existing powers of EU institutions on the basis of existing treaty provisions to either other EU bodies or committees, or to a separate legal body, under the so-called Meroni doctrine55. An example is the (level 2 Lamfalussy) delegation of legislation to the Commission by Council and Parliament; see chapter 3.3, 3.4 and 23. A conditional delegation to the Commission has been used to give EBA, ESMA and EBA the additional power to prepare and draft binding legislation (the so-called standards that are subsequently issued and thus made binding by the Commission with limited deviation

52 United Kingdom/European Parliament and Council, Court of Justice 2 May 2006, Case C-217/04, on the legal basis for the European network and information security agency. The contested regulation did not provide the agency with binding powers, as a result of which the Court did not rule on whether such powers could be introduced in this way. 53 Commission, European Agencies – the Way Forward, Commission Communication COM(2008) 135 final. 54 C. Harlow, ‘Three Phases in the Evolution of EU Administrative Law’, in P. Craig & G. De Búrca (Eds.), The Evolution of EU law, 2nd edition, Oxford, 2011, page 455-463. 55 Meroni, Court of Justice 13 June 1958, Cases 10-56 and 9-56, and Tralli/ECB, Court of Justice 26 May 2006, Case C-301/02 P, §41-43.

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options). This option is mainly relevant for the legislative side of banking supervision as the legislators do not have line side supervision tasks to delegate. Whether the delegation of specific legislative tasks to EBA, ESMA and EBA, and thus limiting the freedom to initiate legislation of the Commission, has not yet been confirmed in case law. The Commission is of the opinion that it goes too far56, but some units appear more amenable to using the procedure than others. 3. The member states can in the context of the Council unanimously decide to allocate specific tasks on prudential supervision to the ECB. This placeholder is restricted to specified and enumerated tasks. Allocation of responsibilities for unspecific areas such as ‘banking supervision in general’ is not possible. The treaty also restricts it to prudential supervision, and excludes insurance supervision, making it a matter of interpretation whether e.g. crisis management is part of prudential supervision or not, and whether consolidated supervision on banking groups with insurance subsidiaries or on financial conglomerates can be part of the tasks allocated to the ECB. Under the decision making procedures as specified in the treaties, any delegation to the ECB automatically includes an allocation to the decision making body for the ESCB, the governing Council57. 4. The member states can in the context of the Council unanimously decide to issue legislation creating amongst others an agency with new powers via new EU legislation to go beyond the EU treaties (effectively creating an expansion of the subjects covered by the treaties)58. This treaty provision allows the member states to ‘expand’ the treaty to new areas, without going through a renegotiation of the formal treaty, if all governments agree. 5. Some member states can unanimously decide that they will act as an advance party to create an institution that covers their territories only under the so-called ‘enhanced cooperation’ process, to which other member states can accede when and if they want to59. An example is the treaty backing up the stability and growth pact60. The provision is also used – without setting up a new body – for the controversial financial transaction tax61.

56 See the proposals on Omnibus II, and on any legislative proposals containing the related conditional delegation of tasks to the Commission, conditional on drafts submitted by the European Supervisory Authorities. See below, chapter 19.4 and 22.3. 57 Art. 127.6 TFEU. For the functioning of the ECB/ESCB, see chapter 3 and 22.2. 58 Art. 352 TFEU, on which basis several agencies were set up, such as the European Agency for Fundamental Rights (Regulation 168/2007) and the European Agency for Safety and Health at Work (Regulation 2062/94). 59 Art. 20 TEU and art. 326-334 TFEU. This can only be used if unanimous action cannot be achieved within a reasonable period, and if at least nine member states want to go ahead. 60 Treaty on Stability, Coordination and Governance in the Economic and Monetary Union, 2 March 2012. See chapter 22.3. 61 See chapter 22.4.

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In the context of banking supervision, the first two options are already being used, the third option is likely to be used – in a process similar to enhanced cooperation – to allow the Eurozone to have a single supervisory mechanism under the longer term banking union project. Delegation to Other Bodies of Existing Powers – Option 1 The delegation of (conditional) legislative powers to the Commission was provided for in the treaties. Though not provided for in the treaties, it has been accepted by the Court of Justice that any EU institution can delegate some types of executive powers. Powers given in the treaty to the Commission (or to other bodies given specific powers in the treaty) can be delegated under the so-called Meroni doctrine. A power to act includes the power to delegate it if the following conditions are fulfilled: – a delegating authority can only delegate powers that it actually has; – the exercise of the delegated powers is subject to the same conditions as would have been applicable if the delegating authority had exercised them directly (such as on motivation, publication and judicial review, type of measure to be taken, right of appeal); – even if entitled to delegate, the delegating authority must take an express decision transferring them; and – the delegation can relate only to clearly defined executive powers that have to be reviewed on the basis of objective criteria; it cannot relate to discretionary powers that would make possible the execution of actual policy (even when any such discretionary decisions are subject to veto or approval). If these conditions are not fulfilled, the Court judged the delegation to infringe the treaty. The Meroni doctrine distinguishes between ‘true delegation’, where the full power is given to another without interference in the decision-making process (except a possible approval or veto procedure), and non-‘true delegation’, where only the power to draw up decisions is given, without transferring full responsibility and taking over any preparatory deliberations as its own (with the freedom to deviate). Such limited preparatory authority – as well as internal delegation62 within a collegiate responsibility to e.g. one of the Commissioners in the Commission – does not infringe the treaties, because the responsibility and powers of the full college as given under the treaties are not changed. The Meroni doctrine thus only applies to ‘true’ delegation.

62 Internal delegation within an EU collective decision making body such as the Commission has been accepted on the basis Tralli/ECB, Court of Justice 26 May 2006, Case C-301/02 P, §58-59 and the case law mentioned there.

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Such a power to delegate belonging to one EU institution cannot be abdicated. It can also not be limited by the other EU institutions except where this is provided in the treaties. However, the Commission did of its own accord propose a Council regulation that sets out boundaries to the creation of separate agencies to which the Commission intends to delegate decision making powers. If the Commission complies with this regulation, the agency that is set up unilaterally by the Commission benefits from EU funding and facilities. See the next paragraph on the so-called regulatory agencies and ‘executive agencies’. The Commission, Council and Parliament do not have powers given to them in the treaties that relate to line side banking supervision, and thus cannot delegate such. If a new authority is deemed necessary, it needs to be created in another manner, which allows new powers to be created. The Delegation to Other Bodies of New Powers – Option 1 (Continued) Various agencies have been set up via EU legislation that do not use powers bestowed upon e.g. the Commission in the treaty, and thus could not have been set up under the Meroni doctrine via a delegation. Instead, such executive agencies have tasks and powers that are allocated to them in EU legislation itself. They deal with specific technical, scientific or managerial issues, where specialist skills are required in areas where the Council, Parliament and Commission could not take individual decisions, but where they do have the power to legislate. In this legislation the specialist expertise of a new or existing body is used to issue for instance decisions that are binding upon member states or their residents, or non-binding advice, preparations or forums. The new powers to for instance review legislation or send in reports, or take actions can be given to the Commission, but it can also be delegated to newly set up agencies. The more technical and low key such an agency is, executing large swathes of work under clearly set criteria, the more such a set-up is acceptable to member states. That acceptance in the negotiations on a new directive or regulation can then be obtained in spite of not agreeing to such an arrangement in the treaties. After an initial ad hoc approach to agencies, the Commission requested an academic report into the role of agencies in EU governance in 199963. This resulted in two strands of legislative approaches to agencies, separating them into ‘executive’ and ‘regulatory’ agencies. For ‘executive agencies’, the Council unanimously agreed to a regulation, establishing the stringent conditions under which the Commission is free to set up agencies to perform any tasks required to implement an EU programme, with the exception of tasks requiring

63 G. Majone, M. Everson, L. Metcalfe & A. Schout, The Role of Specialised Agencies in Decentralising EU Governance, Florence and Maastricht, September 1999.

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discretionary powers in translating political choices into action64. The limitation of the potential subject matter and the restrictions on location, independence and intense scrutiny are quite similar to those developed by the Court for delegation of existing powers in the Meroni doctrine. The executive agency can thus – aside from its tasks under the legislation that created it – also be delegated tasks by the Commission. The Council regulation explicitly mentions as one of the potential tasks of executive agencies that they take decisions under such delegated authority. In addition, non-executive tasks can also be given to an executive agency such as preparation of draft legislation, information gathering and analysis, all necessary to allow for harmonised implementation or execution of short term or long term EU programmes. Executive bodies set up under the regulation by Commission decision benefit from EU funding and support. They are legal entities with the same or similar status as EU institutions. They have to be established where the Commission is established, in line with the assumption that they are extensions of the executive power of the Commission. The Commission separately published a (non-binding) communication on the approach it would take when proposing (legislation on) regulatory agencies, as a starting point for an inter-institutional discussion with the Council and Parliament. The Council was been divided on this issue, as the regulatory agencies can basically be bestowed any function (within the boundaries of the treaties on that function as set out above) and thus potentially limit the sovereignty of the member states governments as represented in the Council. After a break-down of the discussions on the basis of a 2005 draft for an inter-institutional agreement, the Commission published a new approach in 2008, on which basis the Council, Parliament and Commission have started deliberations in 2010. The negotiations resulted in 2012 in a legally non-binding joint statement and a new common approach65. Pending the implementation of this discussions and until the outcome thereof is enshrined in legislation or firm commitments, the creation and functioning of regulatory agencies remains an ad hoc event with heavy opposition by those member states that oppose new agencies (or new tasks in general) in the EU context. Regulatory agencies so far tend to be relatively powerless; unless there is a strong political need for more convincing powers 64 Council Regulation 58/2003 on executive agencies, with the delegated Commission Regulation 1635/2004 on their budgets. By way of an example, see the Commission Decision 2009/336/EC setting up the education, audiovisual and culture executive agency. 65 Commission Communication COM(2002) 718 on the operating framework for the European regulatory agencies, Commission draft COM(2005)59 for an inter-institutional agreement on the operating framework for the European regulatory agencies, Commission Communication COM(2008)135, on the way forward on European agencies (with the accompanying staff working document SEC/2008/323), and press release IP/09/413 announcing the start of the inter-institutional working group. Joint statement of the Parliament, Council and Commission of 19 July 2012, with annexed a ‘common approach’, and published accompanied by a ‘roadmap on the follow-up to the common approach on decentralised agencies’, all published on www.europa.eu, verified on 22 July 2013.

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allocated to them. Even the new tasks and powers are often compliant with many of the Meroni doctrine criteria for delegation of existing (treaty based) powers. Creating new powers can be impossible under treaty provisions requiring unanimity if even one member state does not agree that the route chosen is the right one, leading to the application, if possible, of the other two methods to create a regulatory agency. Those do not require unanimity, but are subject to restrictions (e.g. to the scope of an existing legislative power, or to the territory of participating member states in the ‘enhanced cooperation’ process). Are EBA and the ESRB Agencies? – Option 1 (Continued) To determine which type of agency an EU body is, it first needs to be determined whether they have binding powers, and if so whether they are delegated by an existing body, or newly created (in the treaties) or in directives or regulations. The level 2 European banking committee and its sister level 2 committees would sooner be agencies, as they have been established by legislative instruments, and have tasks that have a direct influence on (level 2) legislation. They do not have their own organisation, however, and – unlike the level 3 bodies of first CEBS and now EBA – is supported by secretariat and chairmanship provided by the Commission. CEBS was not set up by a legislative instrument, but by a Commission decision. Such a decision is binding upon those to whom it is addressed, provided that it is within the remit of the Commissions. Strangely, the Commission decisions establishing the EBC and CEBS did not quite manage to refer to the treaty, directive or regulation provision that bestows this particular competence on the Commission. Their establishment as an advisory body or a body to which certain tasks were allocated was thus doubtful. Nonetheless, its existence was a fact accompli, referenced in the initial version of the CRD. Even if not an agency, it was definitely a cooperation of national supervisors, which each had the possibility to advice on legislation and to work with other supervisors. EBA was established in formal EU legislation based on the EU treaties, and is referenced frequently in the version of the CRD as applicable from 1 January 201166. The Commission decision to set up CEBS partly consisted of advisory or facilitating tasks, that do not limit the powers of the Commission nor of the member states, and partly of a delegation of a strictly limited set of preparatory tasks for new legislative proposals and investigative tasks on the correct implementation of EU legislation. All of its work were non-binding, in a similar way as e.g. the work of the European network and information

66 Directive 2009/111 introduces several changes into legislation, codifying several obligations of national supervisors towards CEBS-EBA non-binding work and of the Joint Supervisors embodied in CEBS-EBA into the CRD.

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security agency. In that case, the UK disagreed that such an agency could be set up, even with only non-binding powers, without full unanimity67. The basis chosen for that agency was the harmonisation of laws to achieve the internal market. The Court found that such harmonisation approximation could consist of amongst others setting up an agency with non-binding powers. For CEBS this means the Court would have likely ruled that it stayed within the boundaries set by it. For CEBS, the effect of the institutional development went beyond what could be expected of its limited powers. Its members developed joint standards, but the member states were free to ignore it (though requested to explain this when they did deviate from CEBS work). The reason why the existence of CEBS (and CESR and CEIOPS) was not challenged at the Court is probably its low key adoption in the form of a decision, and the fact that CEBS was in practice not separate from the domestic institutions. It was not a legal entity with a separate persona, and the domestic supervisors jointly determined its output and its impact. Apart from the limited central secretariat with preparatory and supportive tasks, the development and decision making powers rested jointly with the domestic authorities represented in its top layer committee and its supporting working groups. EBA – to which CEBS tasks have been transferred68 – has been created by a regulation. If there would have been unanimity, it could have been granted far reaching powers without any doubt69. As there is no unanimity on granting such an autonomous status at this stage, but sufficient support in the Council and Parliament to attract a majority vote, it can be indeed created on the basis of the intention to further the introduction of the single market as long as it stays within the (wide but not unlimited) boundaries of this legal basis. The EBA regulation, however, skirts much closer to the boundaries of the case law of the Court with regard to both its role in establishing (potentially binding) technical and implementation standards, and with regard to its decision making powers in conflicts and in emergency circumstances. In the above-mentioned judgement the Court has ruled that EU legislation may establish a Union body with responsibilities (and powers) to implement a process of harmonisation with (non-binding) supporting and framework measures. Such measures can include services to national authorities and/or operators that affect the homogenous implementation of harmonisation legislation. The Court in that case insisted that the tasks of such a body should be closely linked to the subject-matter of any acts 67 UK/Parliament and Council, Court of Justice 2 May 2006, Case C-217/04. The UK contested that the predecessor to art. 352 TFEU, requiring unanimity in the Council, should have been used, instead of the predecessor of art. 114 TFEU, that ‘only’ requires a majority in the Council. Also see UK/Parliament and Council, Court of Justice 6 December 2005, Case C-66/04. 68 EBA Regulation 1093/2010. Consideration 18 and 19, as well as art. 1 EBA Regulation 1093/2010. See art. 1.1 and 54.1 for its establishment, and consideration 10 and 67 as well as art. 76 and 80 for the transfer of all tasks, powers, assets and liabilities of CEBS to EBA. 69 Art. 352 TFEU, or even art. 115 TFEU.

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approximating the content of domestic laws (i.e. linked to directives and regulations addressed to the member states). This link has been improved in the EBA regulation, which explicitly refers to the directives EBA is competent on (the CRD and the deposit guarantee directive), and the directives in which it has a joint responsibility with other European supervisory authorities. The latter include legislation in areas such as group supervision (financial conglomerates directive, insurance group supervision), abuse of the financial system (anti-money laundering directive and the payer information directive), money services (e-money directive and payment services directive, and consumer protection in cross-border circumstances (the distance marketing directive, but strangely not Mifid and the investor compensation directive)70. The ambiguous phrasing in the EBA regulation allows for various legal theories as to the binding work of EBA and its sister-authorities. In effect, instead of the provision of advice on potential legislation by the Commission, Council and Parliament and of domestic public authorities, the authorities become drafters of legislation and takers of decisions. This may lead to the official EU institutions and domestic public authorities taking a backseat in practice, overruled by coalitions of domestic supervisors within EBA. Some are concerned that this will limit the scrutiny exercised, and overemphasise the opinion of at least some supervisory authorities71. The consultation practices and the checks and balances built into the process will need to alleviate such concerns. The combination of tasks allocated to EBA (and ESMA and EIOPA) qualify them as both executive and regulatory agencies. The institutional arrangements of EBA do not fully comply with the outline of the EU institutions 2012 common approach for regulatory agencies, amongst others on naming of the authority and on the voting arrangements (absolute majority and 2/3 majority for sensitive issues). Such issues may be adapted in due course, even though the non-binding statement excludes executive agencies and issues such as changing existing names can be avoided if that would entail too high costs72. On issues such as location, the authorities also do not comply with the rules on executive agencies (see above). The status as any type of agency, however, does not fit well with one part of its tasks, however, which is the almost mandatory nature of its drafting work in the legislative process for binding rules (standards).The legislative drafting powers of EBA can be designated as 70 See chapters 16, 17, 18 and 19. 71 See e.g. E. Ferran, Building an EU Securities Market, Cambridge, 2004, page 91. 72 Joint statement of the Parliament, Council and Commission of 19 July 2012, with annexed a ‘common approach’, and published accompanied by a ‘roadmap on the follow-up to the common approach on decentralised agencies’, all published on www.europa.eu, verified on 22 July 2013.

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a newly created task of the agency and are classified as such in EU texts73. This, though defensible, does not fit well with the theories on clearly circumscribing the task of such agencies, as the new binding regulations have application to all banks in all future circumstances on almost all aspects of supervision; see chapter 21.4 and 23.3. It can better be designated as a condition to the delegation to the Commission under the second option mentioned above; though as the phrasing of the condition here in practice eviscerates the tasks of the Commission as envisaged in the EU treaties for such legislative delegation. Though advice of the level 2 committees has in the financial sector been accepted practice, the draft standards of EBA and its sister-authorities have a protected status that goes beyond normal advice. Delegation of Legislative Powers to the Commission – Option 2 The treaties provide for the possibility that the Council and Parliament delegate in a directive or regulation the power to amend or supplement non-essential elements of the legislative act to the Commission74. The comitology and Lamfalussy/Larosière process for level 2 legislation has been built on this basis, see chapter 23.3. The delegation to the Commission can be quite broad, excepting only essential elements of EU policy. As established by the Court of Justice, only those provisions that are intended to give concrete shape to the fundamental guidelines of EU policy are essential and have to be included at level 1 in legislation agreed by Council and Parliament. Everything else can be delegated in a generic manner to the Commission, if the Council and Parliament choose to do so75. In the delegation conditions can be included. This refers both to a call-back option if the Council and/or Parliament do not agree with the manner in which the Commission uses its new legislative powers. A condition can also be for instance that an existing or new body will need to be consulted by the Commission prior to issuing delegated legislation. The level 2 European banking committee is an example of a body created by a combination of a Commission decision and a CRD provision76. Its main role is advisory, but the Commission has to allow it to ‘assist’ the Commission in all its legislative work. As a result the EBC has a restricting role on the power delegated by Parliament and Council to the Commission to issue level 2 legislation (or to be more precise in the context of the CRD: its equivalent of amending the technical components of the CRD).

73 See www.europa.eu; verified on 22 July 2013. 74 Art. 290 TFEU. 75 Afrikanische Frucht-companie/Council and Commission, Court of Justice 10 February 2004, Joint Cases T-64/1 and T-65/1, § 116-121. Also see D. Chalmers, C. Hadjiemmanuil, G. Monti & A. Tomkins, European Union Law, Cambridge, 2006, chapter 3. 76 The EBC is the level 2 Committee under the Lamfalussy/Larosière procedure; see chapter 3 and 23.3. See art. 151 RBD and Commission Decision 2004/10/EC.

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The role of EBA for the binding standards, can also be designated as a condition to the ‘normal’ delegation to the Commission. Such delegation has always been conditional. The Council and Parliament can rescind it, they can say no to specific proposals, etcetera. The role of EBA – and its sister-authorities – is in this case the fulfilment of just another condition. The Commission can use its level 2 delegated authority to issue technical rules if they are identical to technical advice drafted by the national authorities and the Commission in the context of EBA. If the Commission cannot agree with the proposals, it can either follow the deviation procedure set in the regulation, or alternatively it is free to propose level 1 amendments that would negate that advice, but in that case it needs to convince the Council and Parliament. All this would be in line with the treaty, though this particular condition takes away the slowness of the previous level 2 process and the deviations between supervisors and Commission. In the power struggle between the EU institutions, the new arrangement means a loss of the previous autonomy for the Commission, to propose delegated acts more or less as it deems fit. That loss may not have been unwelcome to the Parliament and the Council. One of the functions is fulfilling one of the conditions in the context of a conditional delegation of legislative powers to the Commission. This new set-up amounted to a full redrafting of delegated rulemaking powers in the area of banking (and other financial services). In essence the Council and Parliament specify areas where they do delegate rulemaking power to the Commission, but simultaneously limit its power severely on the content of a number of banking rules by stating that the Commission on those specific issues can only issue rules if they have been drafted by EBA. Only in very limited circumstances can the Commission deviate from the drafting of EBA; see chapter 21.4 and 23.3. The Commission is protesting that such limitations are not in line with the treaty77. This particular position is not very strong as it concerns legislative areas allocated to the Council and Parliament. The Council and Parliament have a discretion to delegate these own powers to the Commission (or not), and it is also at their discretion to make such delegation conditional. A better argument would be that the essence of the delegation is that EBA gains rulemaking power. The treaty only mentions delegation to the Commission, not to any other body. The Commission could argue that the formal delegation is so bound by restrictions that it is not a delegation as meant in the TFEU to the Commission, but has to be declared an outright delegation to EBA (or its sister-authorities). In that case, the delegating acts would not be assessed as a delegation to the Commission under the treaty, but a delegation to an agency not mentioned in the treaty (EBA), which for binding rules is less likely to be allowed by the Court of Justice.

77 See e.g. page 10 of Commission, Proposal for a Directive as part of CRD IV, COM(2011) 453 final, 20 July 2011.

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Banking Union Developments – Option 3 Even with the enhanced powers, EBA cannot be equated to a national supervisor, nor compared to the federal supervisors in the USA78. The ECB is similar to the FED in powers as to monetary policy role, but unlike the FED the ECB does not have a role in line side banking supervision. The current EU supervisory cooperation is more similar to the cooperation between insurance supervisors in the USA. It combines state based authority and legislation with some joint functions (in the USA via the national association of insurance commissioners), and without an alternative federal supervisor. The changes as a result of the establishment of EBA add some elements already available to USA state commissioners, such as a common IT platform for all ‘colleges’ of commissioners containing the financial reporting done by insurers under the jointly developed formats79. Regardless of whether EBA performs the tasks allocated to it, and manages to stimulate or force national supervisors to cooperate seamlessly within the range of boundaries set, the line side tasks EBA may soon be de facto replaced or its working mandate and methods may change due to the institution of joint supervision in a partial banking union; also see chapter 21.1. Member states balance sheets have been unable to sustain the banking groups that have their headquarters in their jurisdiction. Fear for the solidity of the banks leads to fear for the solidity of the sovereign and vice versa, especially if the sovereign is as leveraged as its banks and thus mainly depends on its local banks and other institutional investors to find buyers for its sovereign bonds. In the context of the 2007-2013 subprime crisis, this has pushed up funding costs for both banks and sovereigns in a fear driven downward cycle in financial markets, and has in some cases frozen member states and their banks out of funding markets. Necessary bailouts by other EU member states and the IMF followed, but continued uncertainty may lead member states to take a leap forward in the thinking about the role of the EU or of the Eurozone in bank bailouts in addition or in place of the role of domestic governments; see chapter 18.4. The plans for a mutualisation of line side supervision may include a mutualisation of the funding of that supervision and of crisis management. A problem with the mutualisation of such funding is that it may well be contrary to TFEU provisions that prohibit the EU and the member states taking over any commitments from other member states, public authorities and undertakings. At first sight, such mutualisation in a Eurozone resolution authority (and in any deposit guarantee mutualisation), are likely to be covered, as are debts issued by bailed-out banks. The

78 For a comparison, see R. Petschnigg, The Institutional Framework for Financial Market Policy in the USA Seen From an EU Perspective, ECB Occasional Paper 35, September 2005. 79 See chapter 20.2.

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Council is, however, empowered to provide definitions for these terms, which definitions may not necessarily reflect or even approximate normal usage80. This is part of a wider and longer term vision to create a wider range of union building on the monetary union, expanding it to a banking union, fiscal union, and economic policy union81. The first step endorsed by Eurozone governments would be to reduce the link between the health of banks and the health of the local government, and increase the link with each Eurozone member state (for a proportional part). A second step would be to agree a common resolution mechanism and burden sharing to fund it, a third would be a joint deposit guarantee fund to be used for banks that are not resolved as a going concern but liquidated. For the single supervisory mechanism and the single resolution mechanism proposals have been published, and negotiations are ongoing, with expectations for introduction in the second half of 2014 for the single supervisory mechanism, and as per the beginning of 2015 for the resolution fund; see below. A full banking union would have a wider impact, both territorially (it would include the full EU) and on content, including on deposit guarantee funds, lender of last resort roles and whether solvent member states would be required to continue individually funding for bailouts of failing banks, or whether they could also mutualise such debt to the wider set of governments or to the ESM rescue fund82. In order to accept a banking union, the relatively healthy member states will want to be sure that all banks in member states that could draw directly on EU aid, would be supervised on the basis of a common – harshly executed – set of rules and supervisory standards. The condition requires a centralisation of supervision of at least the larger banks that might draw on such funding. This would require banking supervision to be upgraded on content and organisation. Legislative Developments on Banking Union The Commission drafted proposals for a so-called single supervisory mechanism for the Eurozone and on how it would relate to the EU-wide EBA83. Though initially proposals for integrated crisis management and deposit guarantee authority were expected too, the focus in the published proposals is on the single supervisory mechanism. The Eurozone statement called for the proposals to be considered by the Council by end 2012, the Com-

80 Art. 125 TFEU. 81 See the report prepared by the President of the Council in cooperation with the Presidents of the Commission, the Eurogroup and the ECB. H. van Rompuy, Towards a Genuine Economic and Monetary Union, EUCO 120/12, 26 June 2012. 82 See chapter 18.4 on the ESM Treaty. 83 Commission, Proposed Single Supervisory Mechanism ECB Regulation and Proposed Single Supervisory Mechanism Amendment to the EBA Regulation, COM(2012) 511 final and COM(2012) 512 final, 12 September 2012. Also see Commission Communication, A Roadmap Towards a Banking Union, COM(2012) 510 final.

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mission put additional pressure on its proposals by calling for an implementation by 1 January 2013. The proposals were politically agreed on the main outlines in a relatively speedy process in 2013, with an expected entry into force in 201484. The idea to move to a single supervisor for the Eurozone does not appear controversial at this stage of the 20072013 subprime crisis, but the devil is as always in the detail. Though the intent appears to be the creation of a single supervisor, in a EU compromise the national prudential supervisors remain too. The ECB would be allocated responsibility for all prudential subjects that have been regulated at the EU level, but national supervisors would retain a responsibility for day to day supervision of smaller banks, and the ECB is expected to in part delegate work on larger banking groups to national supervisors. National banking/financial supervisors would also remain responsible for all goldplating adopted under national laws, and for non-prudential subjects such as money laundering and investor protection. In addition, the national supervisors would have two roles: – deliver a member for EBA, for all EU wide policy and operational tasks of EBA that would not apply solely to the Eurozone; – deliver a member for a new supervisory Council at the ECB, that would operate on delegated authority from the ECB/ESCB governing Council (in which the national central bank presidents sit). Whether a full banking union will materialise or not in the EU, nor whether its first step of a truly single supervisory mechanism will materialise or not either in the EU or in the Eurozone remains open to question. The Commission proposals were a rush-job to satisfy market demands for heavier integration in the Eurozone, and to make creditor states more at ease with providing aid to debtor states that have been locked out of the financial markets, and whose banking systems may need successive rounds of state-aid if the feedback-loop between sovereign and its banks is not broken85. Final texts are not yet available. As to good intentions, establishing a banking union or even ‘only’ a single supervisor cannot be faulted, as it addresses both single markets and financial stability concerns. Allocating it to the ECB, within a separately organised part of its structure can be defended. Giving a successful institution too much to chew in an ultra-short timeline may challenge it to grow, or it may make it fail86. However, end 2012 the ESCB/ECB has the trust of financial markets 84 The EU laws setting up the supervisory tasks of the ECB/ESCB were not yet published when this book closed. See e.g. Commission, European Financial Stability and Integration Report 2012, April 2013, and Council, Bank Supervision: Council Confirms Agreement with EP, 8001/13 presse 136, 18 April 2013. 85 Also see chapter 8.1 on the 0% risk weighting of member state sovereign bonds that stimulates this feedback loop by making local bonds ‘cheap’ in capital requirements for local banks. 86 Final Report of the High-Level Group on Financial Supervision in the EU, chaired by Jacques de Larosière, 25 February 2009 (De Larosière Report), page 43-44; R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 4.

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and the power to bully the Commission and the member states into giving it what it needs to credibly fulfil the huge responsibility it would gain. The ECB has indicated that it would need at least a year after its tasks and responsibilities would become clear to build the organisation needed to fulfil those. Pending publication of the detail and the final texts of the legislation at the time of closing of this book, the Commission is now counting on activation in late 201487. A year for implementation of a fully new and large organisation would be ambitious, but building upon the existing supporting staff and wallet of the ECB, this might be achievable. The Commission proposals lacked details, and some provisions were contradictory. Hopefully this will be addressed in the final texts later in 2013. The working relationship between the responsible governing Council and a newly proposed supervisory Council within the ECB/ESCB was not clear, making it undesirable for non-Eurozone countries to accede to this arrangement (as the governing Council with a strictly circumscribed membership of Eurozone central banks will have all power). The national prudential authorities are to be built on by the ECB, but their budget should be reduced. The budget of the ECB supervisory task should be largely built on bank fees, but it is unclear what this means and how the pain should be distributed. Double costs and administrative mishaps are likely in the first period if these proposals were to be agreed unchanged. The political agreement press release indicated88: – the system will not be a single entity but a joint effort of the ECB and the national supervisors, with responsibility for the good functioning allocated to the ECB; – The ECB has direct oversight of the banks, but in a ‘differentiated manner’ likely meaning that large banks will be allocated to the ECB, and smaller primarily to the national supervisors, all in close cooperation within the system of ECB and national supervisors (the Commission indicated that the ECB will directly supervise banks with assets over 30 billion euro or constituting at least 20% of their home country GDP, and those in an EFSF/ESM programme); – accountability and transparency are improved, with additional rights allocated to Parliament; – a strict separation between monetary and supervisory tasks at the ECB; – non-Eurozone countries joining the single supervisory mechanism would obtain full and equal voting rights on the supervisory board; 87 Commission Proposal for a regulation on a single resolution mechanism, COM(2013) 520 final, 10 July 2013. 88 Council, Bank Supervision: Council Confirms Agreement with EP, 8001/13 presse 136, 18 April 2013, and the preceding Commission memo, an important step towards a real banking union in Europe, Memo/13/251, 19 March 2013.

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– the draft decisions of the supervisory board are deemed adopted unless rejected by the ECB governing Council (though the exact phrasing of this will determine its legality under the EU treaties arrangements on decision making at the governing Council; see chapter 22.2; – the ECB will start its work twelve months after entry into force of the required legislation, subject to operational arrangements. The monetary tasks and the supervisory tasks should be fully separate, leaving only the governing Council (and possibly the ECB board) as the overlapping feature between the two tasks. This makes the vaunted benefit of allocating the task to the central banks due to ‘synergies’89 less than clear. The governing Council composed of central bank presidents would gain additional tasks to have specific knowledge on each individual bank in its purview that has the slightest chance of failing, and will need to make decisions on monetary policy and on crisis-hit banks often at the same time. So far, it did not appear that they had too little to do even when ‘only’ focusing on monetary policy and liquidity support. Though many practical aspects of their power will be assumed either by the supervisory Council or by individual ECB employees/departments, the final responsibility if everything fails has been allocated to the governing Council and its voting procedures. The treaty-conditions for giving the ECB prudential supervision tasks lead to additional complexities and thus to possibilities for delay. As described in chapter 23.2, this treaty provision requires a positive vote not only of Eurozone countries, but of each single EU member. The allocation legal basis in the treaty can as a result only be used if there is unanimous support of all EU member states. For non-Eurozone countries a form of banking union may reduce turbulence on their borders and in their main trading partners, which gives an incentive to vote for any proposal. However, the countries that are obliged by treaty to in due course adopt the Euro, or any country that is not under such legal obligation but may need to if an economic crisis hits their country at a future point in time (e.g. if financial markets would no longer believe an ‘out’-country to be helped by the financial firepower of a much more integrated and ever larger Eurozone), are rightly concerned with the lack of clarity as to what they would automatically be subject to once they adopt the Euro. National parliaments will lose power as the ECB will not be accountable to them but only to the European Parliament. The European Parliament in its turn appeared to have strong reservations on the need for additional accountability instruments for it, and on the dangers to a split in the EU single market, and the less than clear division of labour between the 89 Commission Communication, A Roadmap Towards a Banking Union, COM(2012) 510 final, page 8.

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EU Banking Supervision national and international supervisory level90. Until a wide range of supporting measures is implemented (including the CRR that will gradually become applicable to banks in the period of 2014 until 2021) the ECB will need to use the national requirements, national legal systems and national prudential supervisors to execute its decisions. The vice-president of the ECB has indicated that the larger banks would be supervised centrally, but that it would delegate supervision – under its guidance and instruction – of small banks to the former national supervisor91. This division of labour is in line with the political agreement on the proposals, but the detail and conditions under which such a shift can take place will need to be clarified. For the governments and for national central banks that are also the national prudential supervisor the benefits of increased trust will compensate for the reduced stature and headcount of their national organisations, especially as they will continue to be involved in the decision making process at the governing Council and the supervisory Council, in a process that looks similar to the ESCB process on monetary policy; see chapter 3 and 22. For the fiscal side, member states will be stuck with the bill as long as the single supervisory mechanism would remain the sole aspect of a banking union that would be in force. The Commission proposals did not account how member states will be made comfortable with that division of labour, especially with the reduced influence of national ministries of finance on prudential supervision. EBA will officially not lose powers. In practice, its influence will deteriorate due to the reduced number of colleges (no colleges are envisaged by the Commission on intraEurozone banking groups), and especially the fact that the Commission proposes that the ECB will orchestrate and voice the opinion of all participating national members in EBA (how that common opinion will be arrived at is less than clear, the regulation does not specify whether such common opinions have to be pre-approved at the supervisory Council or not, and whether dissenters within the Eurozone are truly forbidden to talk or to vote in line with national policy as implied in the proposals)92. This is particularly bad plan. EBA is an EU body that for its policy development and regulatory tasks should follow EU voting procedures. Forcing members that are sent to EBA on behalf of member states to follow ECB coordinated positions, will reduce the quality of discussions at EBA, put ‘out’-countries at an unacceptable disadvantage and may reduce the willingness even of Eurozone member states to delegate such rulemaking tasks to EBA (when they would in 90 European Parliament, press release ‘Banking Union: Economic Affairs Committee Starts Work on Supervision Proposals, 24 September 2012. 91 V. Constâncio, Towards a European Banking Union (lecture at Duisenberg School of Finance), 7 September 2012. This is in line with differentiated approach referred to in Council, Bank Supervision: Council Confirms Agreement with EP, 8001/13 presse 136, 18 April 2013. 92 Page 4, recital 25, and art. 5 of Commission, Proposed Single Supervisory Mechanism ECB Regulation, COM(2012) 511 final, 12 September 2012.

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effect be giving them to the biggest bully in the EBA-playground). For the operational tasks of EBA, a coordination could be useful, but it is less than clear what would be gained by that coordination that could not also openly be discussed with the other members of the college in which national members, EBA, and the ECB as the future supervisor will participate. The ECB will also gain legislative power if the EBA does not act or its legislation is not specific enough, and the colleges that EBA now is a member of would be abolished if they only cover Eurozone activities. A wide range of consequences have not been worked out or thought out in the hastily published Commission proposals, including e.g. the additional information rights that national central banks and ministries of finance now enjoy if a branch in their country is ‘significant’, the relation to the ESRB, and whether the stubs of national banking supervisors will continue to participate in colleges that the ECB organisation also attends. If the home host procedures no longer apply, what consequences does this have for the European passport for Mifid-activities? Should Eurozone banks no longer be exempted from the Mifid licensing and notification procedures? An impact assessment of the proposals appears not to have been made, but hopefully the details and a cost/benefit analysis will be part of the final legal texts and the proposals for the follow-up on other aspects of the banking union. The Commission proposals indicated that this single supervisory mechanism aspect of the banking union should be in place by 1 January 2013, and current planning and political agreement is for mid or late 2014. This timing also depends on negotiations for other aspects of the banking union. Whether these can be based on the treaty-placeholder for the ECB is doubtful as that is limited to ‘prudential supervision’, which at the time of drafting definitely did not envisage resolution powers. The Commission has – after the progress was made on the single supervisory mechanism – also published proposals on a EU level resolution mechanism, that instead establish a separate single resolution board as an agency, which will own a 50 billion euro resolution fund to be built up over ten years from 1 January 2015. The July 2013 proposals for a Eurozone resolution fund – in the context of a banking union – would from the start of 2015 introduce the so-called single resolution board as a new agency managing a joint resolution fund covering both large and small banks. See chapter 18.4 on the unbalanced allocation of all key decision powers to the Commission instead of – such as in the ESM treaty – to the board of governors appointed by the member states and a separate fund manager. The regulation would be based on the same EU-treaty article as the EBA regulation. The decision making on the framework for the use of the fund in an individual case and the instructions to liquidate any bank that is not bailed out by the fund (both primarily

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allocated to the Commission in its proposals) would impinge on the fiscal responsibilities of the member states in either allocating funds from taxes/levies raised from their banks, or ordering member states if the fund has not yet reached the level necessary93. Whether the Commission can be deemed an independent arbiter and whether it will have the capacity to do such work at short notice is not clear. Casting a resolution authority and/or a deposit guarantee authority as an agency without an explicit treaty basis is a possibility within the boundaries accepted by EU legislators and the Court of Justice, as set out above. The haste with which the drafting and the negotiations take place is driven by political necessities. These include the need to avoid bailing out member states that cannot afford to bail out their banks, and the elections in 2014 for the European Parliament. Such haste may result in a lack of credible implementation. A better alternative for the single mechanisms with their complicated array of central and decentralised tasks may have been to use the delegation tool that is already available in EU legislation. While fiscal responsibilities are domestic, member states might have been more comfortable with delegating power and the use of national resolution funds for all line side supervision to a central authority. It would remain accountable to member states in that case, and member states could have retained policy-voting powers at EBA, in coordination with a central supervisor and a central executive resolution board, but not bound by it. See chapter 20.6 on delegation. Literature – Chiu, Iris H.-Y., Regulatory Convergence in EU Securities Regulation, Kluwer Law International, Alphen aan den Rijn, 2008, chapter 7 – Dragomir, Larisa, European Prudential Banking Regulation and Supervision: The Legal Dimension, Routledge, 2010, chapter 7-10 – Meerten, H. van; Ottow, A.T., The proposals for the European Supervisory Authorities (ESAs): the right (legal) way forward?, Tijdschrift voor financieel recht, February 2010 – Wymeersch, Eddy; Hopt, Klaus J.; Ferrarini, Guido (ed), Financial Regulation and Supervision, Oxford University Press, Oxford, 2012 – Final report of the high-level group on financial supervision in the EU, chaired by Jacques de Larosière, 25 February 2009 (De Larosière report)

93 Page 9-10, 15 and art. 6.6, 6.7, 18, 20, 38, 64 of the Commission Proposal for a Regulation on a Single Resolution Mechanism, COM(2013) 520 final, 10 July 2013; as compared to art. 13 ESM Treaty.

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21.4 Cross-Border Cooperation in the European Banking Authority (EBA) by National and Future Cross-Border Supervisors Introduction The European system of supervision remains at the time of writing a predominantly national system, in which some centralisation and rationalisation is, however, gradually being introduced. As set out in chapter 2 and 21.1, first CEBS and since January 2011 (the re-constituted CEBS in the guise of) EBA have gained informal and even some formal powers in the policy area. The role of CEBS in the line side supervision on individual banks has always been limited. When it succeeded CEBS, EBA has been given some operational tasks as an EU agency; see chapter 21.3. It has been granted a seat at the table of the supervisors involved in supervising specific banks in colleges (see chapter 21.7), as well as a limited role in supporting those supervisory colleges on a day to day basis. It can also intervene directly in the supervision of individual banks in a limited number of circumstances. The applicable treaties and directives envisage a collaborative effort by the domestic supervisors in the EU (and the central banks and ministries of finance), assisted and supplemented by EBA. As on domestic structures, there does not appear to be a ‘perfect’ solution on how to structure supervision; though many have specific thoughts on such perfection, or at least on the next incremental step towards perfection94. The intention is and should be that this cooperation should be so good that it in practice is as if a single supervisor is responsible, seamless and without obstacles95. However, both practical considerations (funding, liability, language, power) and formal considerations (assessment processes on when information can/should be shared, delay if consensus is not reached, the absence of quick resolution processes) impede such a utopia from existing. The rules continue to stimulate the development of trust and cooperation, especially in normal times and sometimes even in crisis times. Supervisors have to provide EBA with all information necessary to carry out its duties either upon request or in a standardised format. This is part of enabling EBA to perform all its various tasks. In this context EBA is given access to e.g. colleges and a wide range of information rights, intervention rights and rights to be warned or invoked96. A supporting 94 See the literature mentioned in chapter 21.2 on structuring the institutional set-up in national and international circumstances; and e.g. I. Begg, ‘Regulation and Supervision of Financial Intermediaries in the EU: The Aftermath of the Financial Crisis’, Journal of Common Market Studies, Vol. 47, No. 5, 2009, page 11071128. 95 T. Padoa-Schioppa, Regulating Finance, Oxford, 2004, page 92. 96 See e.g. art. 6.1, 9.2, 14, 33, 36, 38.2, 39.2, 44, 46, 49, 111, 126.4, 132 and 140.3 RBD and art. 22.1 and 32.1, 36.1 and 38.1 RCAD, as amended by the Omnibus I Directive 2010/78/EU, and art. 17-21, 30-31, and 35

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task of EBA in this context is the duty to publish different sets of information, such as the register of all licensed banks in the EU, and the publication of policy information and supervisory disclosure information; see chapter 20. Role of EBA in Drafting Proposed Binding Rules, as well as Non-Binding Guidelines EBA, and its predecessor CEBS, has the power to issue guidelines on any subject relevant to the supervision of banks. EBA has also gained status by being allowed to draft binding rules in specific areas; so called (technical) standards. Those binding rules only become binding when endorsed by the Commission under the process set out in chapter 23.3, but the influence of the Commission, Parliament and Council is relatively limited if EBA remains within the boundaries set. Both for binding rules and non-binding guidance the intention is to harmonise the prudential requirements and the way they are supervised. In some areas the EU mandated EBA/CEBS to draft such rules (‘shall’ draw up, sometimes even setting deadlines), in other areas it just allowed EBA/CEBS to issue such rules or guidance if it desires to do so (‘may’ draw up). The regulatory standards concern actual rules, the implementing standards concern forms, templates and procedures to standardise the application of the rules. The guidelines are non-binding, but a comply-or-explain regime applies97, supported by work by the review panel; see chapter 23.3. The timelines for the standards are very ambitious. In addition to work on crisis management, organisational changes for setting EBA up, and negotiating on and adapting to a possible new banking union, the EBA work programme for 2012 identified around 200 deliverables in relation to the CRD IV project98. When political agreement on CRD IV was achieved in April 2013, the EBA published a series of consultative papers on possible technical standards in May 201399. The Commission will on 1 January 2014 send a report to the Council and Parliament on the drafts received by that date100. The number of mandates for level 2 legislation (by the Commission and EBA) is expansive. An overview of the mandates allocated in the Omnibus I directive is provided in chapter 23.3. These have since been added to by the CRD IV project.

97 98 99 100

EBA Regulation 1093/2010. The Joint Committee, of which EBA is part, is given similar rights in the Financial Conglomerates Directive 2002/87/EC, as amended by the Omnibus I Directive 2010/78/EU. Also see chapter 20.2. Art. 42b.1 sub b RBD. EBA, Work Programme 2012, EBA BS 2011 137 final, 15 December 2011. See the EBA website www.eba.europa.eu for these consultation papers published after the closing of this book. Art. 12 Omnibus I Directive 2010/78/EU.

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Role of EBA in Colleges The consolidating supervisor is dominant in a college of supervisors on a banking group, but cannot force the hand of the individual supervisors that are members of the college. Except for model approval and pillar 2 and 3, the consolidating supervisor has no tools to force supervisors of subsidiaries to act in a certain manner if they do not agree voluntarily on the best approach to supervising the banks that are part of the group. As set out in chapter 21.7 the role of the consolidating supervisor has been gradually strengthened in the years prior to and in the early stages of the crisis; principally by the allocation of some explicit responsibilities in the initial RBD, and further allocation of instruments and tasks in the CRD II directive101 by 2010. Within a year, however, the dominance of the consolidating supervisor had been balanced by some new tasks and powers of EBA. EBA has been made responsible for oversight of the tasks of the supervisors that are part of the colleges, and can set best practices both in the form of binding standards and non-binding guidelines102. EBA is in effect a member of all banking group colleges, and can send a member of its staff to meetings and all activities of the colleges, including joint on-site examinations103. It has access to all information shared, as if it is a supervisor in its own right. If it chooses not to participate in activities of the college, the consolidating supervisor is still obliged to inform EBA of all activities, including in emergency circumstances104. It is charged to set and promote the above-mentioned best practices, provide a central system for information sharing and coordinate stress testing and effective and efficient activities across colleges. Specifically, it can call meetings of a specific college and add items to the agenda. In addition, if there are conflicts, the work of EBA in dispute settlement and mediation – and its instruments in emergency situations – can be applied also in between supervisors that are part of the college105. Role of EBA in Dispute Settlement and Mediation CEBS – the EBA predecessor – had a mediation process. It introduced a copy of the CESR mediation procedures after a pointed request of the Commission (as did CEIOPS). The lengthy and rather bureaucratic conflict resolution procedure could be set in motion if one supervisor disagrees with another supervisor on e.g. potential conflicts between supervisors in the context of colleges. From the annual accounts of the three level 3 committees, it appears that the process had never been used. Despite the attractiveness of 101 Art. 129 RBD, as amended by art. 1.31 CRD II Directive 2009/111/EC. 102 Art. 21.1, 21.2 sub d, and art. 21.3 EBA Regulation 1093/2010, and art. 129 RBD, as amended by art. 9.32 Omnibus I Directive 2010/78/EU. 103 Recital 36 and art. 21 EBA Regulation 1093/2010, and art. 131a.1 RBD (as introduced by the CRD II Directive 2009/111/EC, and amended by the Omnibus I Directive 2010/78/EU). 104 Art. 131a.2 last paragraph RBD. 105 Art. 18, 19, 21.4, 41 and 44 EBA Regulation 1093/2010, and art. 129.1 RBD (as amended by the Omnibus I Directive 2010/78/EU).

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having a process able to resolve conflicts of interest in a relatively benign atmosphere and involving the expertise of qualified peers, there were several factors making the process into an empty letter: – its use would need to be disclosed; – it would involve two supervisors publicly stating that they do not agree with each other’s judgement or working methods; – it would involve a lengthy process, in a sector where few issues can await a long delay; – its results were non-binding; – it would involve asking for the supervisory judgement of other supervisors on which of the two supervisors is correct, which could be impacted by past relationships and impact on future relationships; – it would involve disclosing information protected by secrecy obligations to supervisors without a primary (CRD-based) interest in the bank; – the ambiguous wording and long list of national discretion of the CRD was likely to make both supervisors ‘right’ in the light of their domestic implementation of the CRD); – banks were prohibited from starting such a mediation process, though they would be the main beneficiaries if more technical differences could be mediated, e.g. on the definition of technical terms. There are extreme cases where even then mediation could be useful (e.g. where a consolidating supervisor finds the banking group completely unimportant, and neglects its consolidating duties to the detriment of other supervisors on subsidiary-banks or branches). Under the old regime, conflict resolution continued to be a bilateral negotiating process, which only becomes public if a bank fails106. The EBA regulation and the Omnibus I directive introduce a binding dispute settlement system between supervisors as per 31 December 2011 in addition to the non-binding mediation possibility107. The new regime tries to deal with the weak points of the CEBS mediation procedure. The EBA regulation contains the procedure, the decision making body, and the appeal process; see below. Both the EBA regulation and the CRD contain

106 E.g. in the Icesave Case in 2007/2008 the different perceptions on the viability of the bank (going concern accounting or realistically assessing future funding problems) lead to an impasse between the Icelandic versus the Dutch and UK supervisors. Combined with the fact that it was not in the Icelandic interest to keep in contact and be transparent, the flow of information towards the branch supervisors stopped. This concerned branches instead of subsidiaries, but the issue of different national interests remains the same. A.J.C. De Moor-van Vlugt & C.E. Du Perron, De bevoegdheden van de Nederlandsche Bank inzake Icesave, 11 June 2009 (Dutch). 107 Art. 19 and 31 (introduction and sub c) EBA Regulation 1093/2010 identify the procedure, while the Omnibus I Directive 2010/78/EU inserted some specific types of issues that can be settled by EBA into the CRD.

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provisions that set out the issues on which disputes could be referred at the initiative of one of the supervisors involved to EBA, with both supervisors being bound by the outcome. Without such a provision, the issue at hand cannot be submitted to the dispute settlement process. The CRD IV project will expand the number of cases that can be referred to dispute settlement by EBA, with tight timelines. The main feature of the role of EBA in conflict resolution is that one of the supervisors involved will need to invoke it, but – though the text is ambiguous – if two belligerent supervisors refuse to settle an argument and refuse to invoke the dispute settlement procedure – EBA can also on its own initiative start a dispute settlement procedure108. EBA has been allocated the goal to stimulate good cooperation between all supervisors in the EU, and conflict resolution can help. Especially if the two (or more) supervisors involved are influential, however, it is unlikely that the board of supervisors will start such a proceeding without the (silent) permission at least of the supervisors involved. Since 31 December 2011, supervisors can refer to EBA for a binding settlement: – all disputes between supervisors in a college of supervisors109; – if the consolidating supervisor does not do its work or the other supervisors do not cooperate with the consolidating supervisor110; – disputes on (a lack of) collaboration and information exchange on a cross-border operating single entity bank (e.g. via a branch or cross-border services)111; – the determination whether a branch is ‘significant’ (and thus whether the host supervisor will gain additional rights and instruments)112, for which EBA gets one month after the two months ‘conciliation phase’ after the host makes it request to get the branch recognised as significant; – if a supervisor has not communicated essential information (which it should have provided at its own initiative) or where a request for cooperation, including information exchange has been rejected or not acted upon within a reasonable time113; – decisions on pillar 2 and on any additional capital required114.

108 Art. 19.1 EBA Regulation 1093/2010. The supervisors can in all these cases start procedures, but the text on EBA is ambiguous as to whether it has to be given this opportunity explicitly in the CRD. One could argue that the provision should be interpreted widely to enable EBA to solve disputes between supervisors in the interests of the single market, even if none of the supervisors involved has indicated it wants to resolve the dispute. 109 Art. 21.4 EBA Regulation 1093/2010. 110 Art. 129.1 RBD. 111 Art. 42 RBD. 112 Art. 42a.1 RBD. 113 Art. 132.1 RBD, and see chapter 20. 114 Art. 129.3, with art. 123, 124 and 136.2 RBD, the latter as added to by art. 1.10 CRD III Directive 2010/76/EU.

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As per 1 January 2011, supervisors can also refer to the Joint Committee (the chairs of EBA, ESMA and EIOPA; see chapter 3, 16 and 17.4) any dispute between supervisors competent in different sectors115. For cross-sector disputes there is no requirement that there should be a basis in the CRD or its equivalents in the other sectors. These types of disputes will between prudential supervisors, however, likely focus on the same issues mentioned above on conflicts between banking supervisors, such as group supervision of banks with insurance subsidiaries or vice versa, or lack of information exchange. However, this is less obvious for issues such as actions of market supervisors that impact on the business of individual banks or rescue actions that may impede the functioning of trading services providers. The exact nature of potential conflicts is difficult to predict, so the wide autonomy granted to the joint committee (to coordinate the parallel decisions needed) is welcome, though strange in light of restrictions placed on intra-sector conflict resolution. The joint committee will be in a particularly difficult position if not only e.g. the market supervisor of a member state disagrees with the banking supervisor of another member state on excluding a bank from dealing on a regulated market or fining it to a crippling extent, but also if ESMA votes to back the market supervisor and EBA to back the prudential supervisor. In such cases, it is likely that no decision will be taken on the dispute in question, at least not in time. Such a situation is in effect a decision not to decide, and can be appealed against (see below). If a dispute is referred to EBA, the decision on the case will be made by the board of supervisors, who will delegate the preparation of the decision to a panel consisting of the chair plus two neutral board of supervisors members. They will try to facilitate an impartial settlement, or failing such settlement will propose a decision for the board116. The board of supervisors includes the voting members (the prudential supervisors) from all the member states. Most of the disputes will relate to supervision of individual institutions. If so, all observers and non-voting members will be excluded from the room if such disputes are being discussed (except the chair, the executive director, as well as the EEA-prudential supervisors if they have a direct interest in the case at hand). The ECB, ESRB, Commission, and central banks are thus normally not involved in dispute resolution by the board of supervisors unless the conflict relates to e.g. crisis management117. The board decides by a simple majority except when the contested decision (or lack of decision) should be normally be taken by the consolidated supervisor. This is the case for centralised procedures within the college of supervisors; such as on model approval. In that case the simple majority can be blocked if rejected by a blocking minority, in order to support the power

115 Art. 20, 55.1 and 56 (second paragraph) EBA Regulation 1093/2010. 116 Recital 53 and art. 41 EBA Regulation 1093/2010. 117 Art. 40, 44.4 and 75.3 EBA Regulation 1093/2010.

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of the consolidated supervisor118. For cross-sector disputes, the chairs are the members of the joint committee, so they can decide on the mediation in line with their own rules of procedure. However, this does not limit the decision to the three chairs (instead of the 30odd members of the board of supervisors), but expands it to the 90-odd members of all three authorities (EBA, ESMA and EIOPA). Any decisions (e.g. on the length of the period for conciliation), and the decision on the dispute (and potentially subsequently addressed to the institution) have to be taken by the authorities involved in parallel. This is a cumbersome procedure, especially in cases of urgency. The EBA sets a period for conciliation, during which period it acts as a mediator. The period sometimes is already specified in the CRD (e.g. two months for the determination of the significance of a branch), but the board can otherwise set any period it deems proper in view of the complexity and urgency of the case. If no consensus is achieved between the parties, EBA is allowed to (but not bound to) decide the matter and ensure compliance with EU law. The supervisors involved are bound by any decision taken. If the supervisor who ‘lost’ the dispute refuses to implement the decision, EBA can adopt an individual decision that is binding upon the institution involved (overruling any other decision from the actual supervisor). If EBA chooses to not take a decision, the time period for its decision set in the CRD has passed (e.g. 1 month for the determination of the significance of a branch), or a reasonable period has passed and it still has not taken a decision, this lack of a positive decision to settle the dispute can be deemed to be decisions not to decide; and thus subject to the right of appeal. Appeal Procedures for Decisions by EBA There are two separate types of appeal, which can apply simultaneously: 1. the appeal by a member state to the Council on the grounds that the decision of EBA impinges on its fiscal responsibilities (a process balanced in favour of the member state and likely to result in the irrelevance of the decision of EBA and thus of the disapplication of EU law; see below under ‘fiscal responsibilities’). EBA can overrule local supervisors in emergency circumstances, but its powers are severely circumscribed if fiscal responsibilities would be touched upon. If so, the member state can achieve a suspension by choosing this appeal procedure; 2. the appeal to the board of appeal by one of the supervisors involved in the dispute, or by any other natural or legal person to which the decision is addressed, or to whom it is of direct and individual concern (this includes most often the bank in question, or e.g. a manager or shareholder of the bank that is or will get disapproved under a decision taken, or will be forced to allow new capital raising). 118 Art. 44.1 (third and fourth paragraph) EBA Regulation 1093/2010.

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Both the decision of the Council and the decision of the board of appeal are subsequently subject to appeal at the Court of Justice. There are some quaint aspects in the process, where the public authorities involved in the dispute are allowed to participate in the decision making process (in EBA via the supervisor and in the Council via the ministry of finance). The EBA regulation has, however, made a valid attempt to come to a more balanced process than the previous CEBS mediation process, with clearer mandates and binding results. Some criticisms remain, that make it doubtful that the process will be useful: – the fiscal exception of the member states applies, making the ‘binding’ nature of EBA decisions into an empty word in any resolution situation; – EBA is not a true independent authority, but a network in which decisions have to be taken by the voting members, who are the 30-odd independent national supervisors with different goals, traditions and interests119; – the voting members will likely simultaneously be involved in multiple negotiations on new legislation and concrete banking groups, which may be weighed against being strict against powerful members and the general need for good relations (i.e. not rapping each other on the fingers). In addition to the normal rights to contest decisions taken to the Court of Justice as set out in the EU treaties (see chapter 3), the EBA regulation contains an internal appeal procedure. The board of appeal is a joint body of the three European supervisory authorities. The types of challenges and expertise needed are similar, and this is a cost effective solution120. The decisions of the board of appeal can be challenged before the Court of Justice121. When setting up EBA the UK was adamant in defending its right on taking its own decisions on any expenditure of public funds. Especially in view of the amount of state aid already given to banks by the UK and member states, and the disagreements on burden sharing if a bank is important or present in many member states, there was a fear that EBA would ‘decide’ that the state should spend money on the bank. More indirectly, EBA can and may decide that a bank is undercapitalised, and that the home supervisor has to ensure that additional capital is raised. If the bank fails to do so in the private market, it may come knocking on the door of the state if the supervisor is forced by EBA, at the request of host supervisors, to take preventative measures at a time it either truly disagrees with the assessment that capital is lacking or will become lacking, or just would like to bet along with the bank that all will be fine if there is just a little more time for e.g. the market to 119 J. Black, Restructuring Global and EU Financial Regulation: Capacities, Coordination and Learning, LSE Law Society and Economy WP 18/2010, page 32-46. 120 Recital 58 EBA Regulation 1093/2010. 121 Recital 58 EBA Regulation 1093/2010.

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turn (turning a semi-blind eye in a process known as regulatory forbearance; see chapter 18.3 and 20.3). For any decision taken in the context of dispute resolution or directing supervisors to act in a certain manner in emergency situations, EBA is obliged to take into consideration that its decisions should not impinge on the fiscal responsibilities of member states. This is indeed an issue as such decisions overrule the ‘normal’ autonomy of the national supervisor to exercise its own responsibilities under the CRD. If a member state thinks the decision overruling its national supervisor nevertheless ‘impinges’ on its fiscal responsibilities, it can start a process that lifts the decision away from the supervisors involved122, and gives the final decision to a less technical and more political body, the Council. The decision tree is heavily skewed in favour of the complaining member state, but in return it has to ‘clearly and specifically’ explain why and how its fiscal responsibilities are touched to the Council, with a copy to EBA and the Commission. The timing, the routing and the voting process at the Council of this appeal differ depending on whether it concerns conflict resolution or so-called exceptional circumstances (crisis management). Within two weeks if the decision was taken in the context of conflict resolution after its supervisor being notified of the EBA decision, the member state can send a reasoned notification to EBA and the Commission of such an impingement (and the fact that its supervisor will not implement it). This notification suspends the decision of EBA. EBA has a month to respond. EBA can revoke the decision, maintain the decision or amend it, but if it maintains it (unchanged or amended) it has to state that it does not impinge on the fiscal responsibilities of the member state. If maintained, it automatically is put on the agenda of the Council. The Council has to decide at a meeting by a majority of the votes cast (so abstentions and absentees are not taken into account) whether the decision is maintained. The member state concerned is not excluded from the discussions nor from the voting. If no decision is taken within two months after EBA informed the member state that it maintains its decision, the decision of EBA is automatically terminated. If the EBA decision is confirmed by the Council, however, it enters into force vis-à-vis the supervisors. If they refuse to execute, EBA can take a decision that is directly binding on the institution involved (regarding which the member state does not have the ‘fiscal responsibilities’ appeal any more. The appeal period is shortened to three working days if it concerns an exceptional circumstances decision. The EBA is not given a period to reconsider, but the matter is directly referred to the Council. The Council has ten working days to decide the matter. The 122 Recital 50 and art. 38 EBA Regulation 1093/2010.

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Council has ten working days to have a meeting at which a simple majority of the members agrees with EBA. If there is no meeting, or if a simple majority of members, absentees and abstentions disagrees with EBA, the member state will be deemed in the right. If the Council decides in favour of EBA, the member state can request the Council to re-examine the matter (with a copy to EBA and Commission); an additional step that does not exist for the dispute resolution decisions of EBA. The Council has four weeks (possibly extended by four weeks) to re-confirm or to take a new decision. The EBA regulation is not clear as to whether the EBA decision is still suspended during this additional re-appeal to the same body. It is defensible that – as the exceptions to the regulation limit the single market – that the Court of Justice will interpret it as limited as possible, and will deem the suspension only applicable during the first phase of the Council-process. The member state concerned is explicitly forbidden to abuse its right to delay the decision of EBA being implemented under the guise of a fiscal responsibility claim. If the EBA decision does not have a significant or material fiscal impact, the appeal will be deemed incompatible with the internal market. This strong language is a recipe for the creation of liability vis-à-vis those who have suffered damages during the delay (e.g. if the bank and its activities in another member state have failed during the delay, leading to a pay-out of deposit guarantee or local state aid, or the estate of the bank suffering additional negative effects). The Court of Justice has the final authority on acts, including decisions, of the Council. The decision of the Council on the fiscal responsibilities appeal (which includes a lack of action to call a meeting and/or a lack of a decision at the meeting) can be challenged before the Court even though this is not explicitly stated in the EBA regulation123. The member states, the Parliament, the Council or the Commission, as well as by any natural or legal person to which it is addressed or for whom it is of direct and individual concern can bring the challenge. The latter will likely include EBA, the supervisors involved in the case, and the institution involved. The possibility to challenge the decision conflicts with the duty to publish all EBA decisions. In the recitals, the EBA regulation indicates that strict confidentiality for the ‘fiscal responsibilities’ appeal is necessary124, but fails to make such an appeal (or the possibility of such an appeal) a situation in which EBA should delay or suspend the publication of its original decision. Confidentiality on the existence of the appeal, indeed covered by the general confidentiality provisions, does not overrule the duty of EBA to publish the decision.

123 See chapter 23.2, and art. 263 and 265 TFEU. 124 Recital 50 and art. 39.5 EBA Regulation 1093/2010.

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The publication can only be avoided in two limited circumstances: if it conflicts with the legitimate interests of the bank to guard its business secrets, or if the publication could seriously jeopardise the financial markets or financial stability. The EBA decision could actually be meant to stabilise the markets or economy by taking away an existing concern. The regulation does not state, however, when the publication must be done. Unless there is a pressing need for immediate publication, it is likely that EBA will delay the publication until the appeal period for fiscal responsibilities has passed. Unless the member state makes a convincing case that one of the two reasons not to publish apply (when EBA has not yet stated that in its original decision) waiting longer would not be compliant with the regulation. Future Developments A single supervisor in the Eurozone and perhaps a banking union may be created; see chapter 2 and 21.3125. Such developments are expected to only cover the Eurozone. EBA’s role on policy development would remain, and it would retain its role as a bridge between the Eurozone structure and the non-Eurozone supervisors. The intervention tools of EBA will likely be applicable both in the Eurozone and outside it, though the ECB may be a too powerful player for it to be credibly subject to EBA procedures. EBA will set up a database on administrative penalties, that has to be consulted by the supervisors when assessing the good repute of e.g. the managers of a new bank, or those other parties whose good repute is required under the CRD IV project126. This supplements the existing information exchange structures between member states on criminal convictions. The proposals of the Commission for a recovery and resolution directive envisage a wide range of tasks for EBA127. Though the Commission is reserving many of the delegated legislative issues for itself, it still proposes already that EBA will draft technical standards, be part of the resolution colleges, mediate and help, and provide assistance in relation to the cooperation with third countries in this area.

125 Commission, Proposed Single Supervisory Mechanism ECB Regulation and Proposed Single Supervisory Mechanism Amendment to the EBA Regulation, COM(2012) 511 final and COM(2012) 512 final, 12 September 2012. 126 Art. 69 CRD IV Directive. 127 Page 18 and e.g. proposed art. 5, 12, 17, 80 and 83 of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012.

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21.5 General Cross-Border Practical Cooperation Introduction Cross-border cooperation is traditionally focused on policy development and regulation, and on cooperation on branches (and increasingly on subsidiaries within a group)128. For other issues, the cooperation is more tenuous and on a case-by-case basis, but no less important. It involves ad hoc cooperation, if one supervisor either has facts of interest to another supervisors’ tasks, or needs facts or assessments from another supervisor. The cooperation entails information provision, help in gathering/verifying information, as well as assistance on enforcement on banks or entities, regardless of whether they are part of the same group or not. On three issues the RBD requires prudential supervisors to assist other competent authorities under the RBD in various manners, even if there is no joint interest in a bank that operates in both countries129: Firstly, a supervisor has a binding duty to provide information if a banking supervisor has information essential or relevant to the tasks of another supervision. Some of this binding information provision obligation is also copied in the non-binding crisis MoU and in bilateral or group-wide non-binding MoUs for normal times. The underlying obligation remains, regardless of whether it is copied in a non-binding document. Essential information has to be provided at the own initiative of the supervisor that has it (a ‘push’ obligation if the information potentially could materially influence the assessment of the financial soundness of a bank in another member state). Relevant information has to be provided at the request of the supervisor of another bank. This deviates since mid-2013 from the situation in colleges of supervisors. There the consolidated supervisor has a push obligation both for essential and for relevant information130. Apparently, his tasks as head of the college include a reasonable expectation of each college member that it will receive all relevant information, without having to trigger the obligation by e.g. sending an e-mail with a request every week. To determine what is essential or relevant for the tasks of the receiving supervisor, the sending supervisor can take into account the importance of the other bank in the financial system of the member state where it is based131. The CRD does provide some indication 128 129 130 131

See respectively chapter 2, 3, 5 and 17. Art. 132, 19b RBD. Art. 132 RBD – applicable from mid 2013 – as amended by FCD II Directive 2011/89/EU. If the supervisor with the information supervises the parent of the bank, it has to send more information if the subsidiary is systemically important in the financial system where it is based.

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on the concept of essential information. It contains a definition and some examples132. Information is deemed essential if it (potentially) could materially influence the assessment of the financial soundness of a bank in another member state. Essential information shall include e.g.: – identification of the entities in a group containing a bank, and of the supervisor of the banks and other regulated entities in the group; – adverse developments in banks or other entities in a group, that could seriously affect any of the banks in the same group; – major sanctions and exceptional measures taken by supervisors; supervisory procedures for the collection of information from the banks in the group as well as the verification of and response to that information (see chapter 20.2-20.3). This obligation is most obviously important when both supervisors supervise banks that are part of the same group, but supervisors can also discover essential information for other supervisors when supervising e.g. a counterparty of a bank supervised in another member state. The obligation directs the supervisor to send the information to other supervisors that also would have been sent internally if both banks were supervised by the same supervisor133. Secondly, a supervisor has a binding duty to request information or verification if a banking supervisor is involved in assessing a bank or parent from another country (and similar obligations on other types of regulated and unregulated entities). If a supervisor wishes to verify information134 available at a bank based in another member state, the supervisor has to contact the supervisor of the other member state. That supervisor can choose (i) to carry out the verification itself, (ii) to allow the requesting supervisor to do it, or (iii) to allow an auditor or expert to carry it out. If the requesting supervisor is not allowed to carry out the verification itself, it does have the right to participate in the verification. This process applies both to entities in the same group and to entities not in the same group, and to a list of regulated and unregulated entities that may hold information relevant to banking supervision; see chapter 20.2. Thirdly, a supervisor has a binding duty to consult135 each other supervisor to whose task the following decisions are of importance: (a) changes in the shareholder (including but 132 Art. 132.1 RBD, as amended by FCD II Directive 2011/89/EU. 133 It differs here from the Financial Conglomerates Directive, which puts this obligation solely on supervisors that supervise entities of the same group, not on supervisors that have information relevant or essential for supervisors of other groups. Art. 12 Financial Conglomerates Directive. 134 Art. 137.2, 140 and 141 RBD. There are also some specific cross-sector group specific obligations, see e.g. art. 139.2 and 140 RBD, and chapter 17 and 19. 135 Art. 19b and 132.3 RBD, which partly overlap.

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not limited to mergers and acquisitions), organisational or management structure of banks in a group, that require the approval or authorisation of supervisors (b) major sanctions or exceptional measures (this will be most relevant in a group, but can be important too on major participations, or where the bank is a major counterparty to other banks). This duty to consult each other on major sanctions and exceptional measures is the more far reaching obligation. However, there are exceptions that make the consultation obligation less useful for the other supervisor. A supervisor may decide not to consult when: – the measure is urgent. With the improved modern communication mechanisms, this exception will need to be interpreted in the most limited manner. The time needed to consult within the organisation of a supervisor will provide ample time to inform and request input from another involved supervisor. Even if not done simultaneously, it requires little time to call a colleague-supervisor, and ask for their speedy response if there is indeed an objective reason for urgency. Objective reasons for urgency can exist in e.g. a crisis, though even their response-packages are generally put together over a few days (e.g. a weekend); – consultation may jeopardise the effectiveness of the decision. This can almost always be defended for major sanctions directly impacting on the banks’ trading in financial markets or the value of a banks’ shares. The existence is a prime example of a (very understandable) lack of trust. If a large bank will suffer a truly major sanction or will be required to accept government aid or a takeover bid in order to resolve solvency issues, this will impact on its standing in the market. If other supervisors start taking measures in their own market to limit the damage to their banks and/or their financial system, this will impact on the effectiveness of the decision, which will generally be geared towards (sometimes punishment but always the prime purpose of) survival of the bank under its own supervision. No public material indicates whether supervisors actively and timely supply this information or consult each other, and some of the research on cooperation on failed banks, indicates that the information flows haltingly, if at all, when national interests start to conflict136. The information sharing and consultation obligations help fill in the exceptions to the secrecy provision; see chapter 20.2.

136 See e.g. A.J.C. De Moor-van Vlugt & C.E. Du Perron, De bevoegdheden van de Nederlandsche Bank inzake Icesave, 11 June 2009 (Dutch). BCBS, Report and Recommendations of the Cross-Border Bank Resolution Group, March 2010, amongst others page 16 and 34-35 and the case-studies contained therein.

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21.6 Home Host Cooperation Regarding the Same Legal Entity Introduction A licensed bank can have branches in other member states, and/or provide cross-border services to customers in other member states (see chapter 5.3). The licensing supervisor of the legal entity (the home supervisor) has a valid interest in supervising the full entity, the supervisor of the member state where services are rendered (the host supervisor) has a valid interest to protect its local financial markets, and the bank involved has a valid right under the freedom of establishment and freedom of services to operate in both member states with the minimum hassle possible. The distribution of labour between supervisors is set up under the concept of so-called ‘home country control’. This allocates primary responsibility to the licensing supervisor, but with exceptions. If a directive allocates a responsibility to the home supervisor, it is the sole competent authority. Examples include compliance with the licensing conditions, or ongoing solvency supervision. Doubts whether the home supervisor did his work correctly in no way allow the host supervisor to put additional barriers in place that would block or hamper the market access or ease of functioning of the bank. In effect there is an obligation to trust the other supervisor to handle those issues that are exclusively allocated to him under EU law137. For issues on the bank that impinge on the legitimate interests of the host supervisor, there is cooperation in the form of information sharing or joint work, e.g. the new rules on significant branches (see below). If there is a true concern between two supervisors whether one of them is holding up its part of the bargain, the other can call upon mediation by EBA, or invoke the treaty to claim that the other member state is not in compliance with the treaty (and either start a procedure before the Court or ask the Commission to start an investigation for non-compliance with an obligation to correctly implement and apply a CRD provision)138. Apart from the cases where the CRD or the EU treaties specify that a member state may take action, a member state supervisor is not allowed to unilaterally take corrective or protective measures vis-à-vis the bank with the intention to buffer for a (suspected) breach of duty of the other member state or its supervisor139.

137 Commission/Belgium, Court of Justice 10 September 1996, Case C-11/95, §34 and 88; Commission Interpretative Communication, Freedom to Provide Services and the Interest of the General Good in the Second Banking Directive, SEC(97) 1193 final, 20 June 1997. 138 Art. 258 and 259 TFEU. See chapter 20.3 and 21.10. 139 See §37 and 89 of Commission/Belgium, Court of Justice 10 September 1996, Case C-11/95.

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Home Country Control The division of labour between the home and the host supervisor on a licensed legal entity with activities in other member states is relatively simple140: – The home supervisor is solely responsible for the supervision of the entity, including the branch, on the solvency ratio and all its components, on its organisational structure and on its licensing and all related aspects. On these issues there is a harmonised minimum level of supervision the home supervisor has to meet under the CRD and the EU treaties, in return for which the host supervisor allows access to these banks into its financial markets (with reciprocity for its own banks; see chapter 5). – The home supervisor is responsible for liquidity supervision of the entity, including branches, but shares the responsibility for the liquidity of the branches in the other member state with the host supervisor. There is no harmonisation on the content, so neither the home nor the host supervisor is bound to supervise this issue until the relevant provisions of the CRD IV project enter into force; see chapter 12. – Both have instruments vis-à-vis the bank on prudential issues, though the host supervisor cannot use the corrective instruments without involving the home supervisor first, except in emergencies (see chapter 17 and 20). – The host member state and the home member state both are responsible for their own monetary policy (with this responsibility, if they are both part of the Eurozone, being united at the ESCB/ECB level; see chapter 3 and 22). General prudential concerns can establish a power to intervene by the host supervisor in the branch if either the home supervisor or the bank itself is in breach of its obligations vis-à-vis the host member state. If the bank is in breach with its obligations to the host member state, an additional condition is that the home supervisor has to have had the opportunity to set it aright first, but if it does not, the host can intervene and take measures ranging up to limitations on the business of the branch in its country141. In an emergency, the host supervisor can even take any measure it deems necessary to protect the interests of depositors, investors and others who use the services of the branch; though the Commission has the power to require an amendment or abolishment of such measures142. The Landsbanki (Icesave) failure led to a clarification and expansion of the intervention possibilities. The RBD has been amended via the CRD II directive since end 2010 to strengthen the rights of host supervisors in this respect; see below, and also chapter 2 and 5.

140 Art. 40 and 41 RBD. 141 Art. 30-34 RBD. Also see chapter 5.3 and 20.3. C. Hadjiemmanuil, Banking Regulation and the Bank of England, London, 1996, page 95-102. L. Dragomir, European Prudential Banking Regulation and Supervision, The Legal Dimension, Oxon, 2010, chapter 6. 142 Art. 33 RBD, both before and after the amendment by the Omnibus I Directive 2010/78/EU.

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The accent on home country control is aligned with the fiscal responsibility for the legal entity of the licensing supervisor, with its responsibilities to supervise at least to the minimum level agreed in the CRD vis-à-vis host supervisors, and with the responsibility of the home country deposit guarantee fund for all deposits made at the legal entity anywhere in the EU up to the now harmonised level of 100.000 euro; see chapter 18. If the home country lets the bank fail, the host authorities can still intervene (on top of the deposit guarantee provided by the home deposit guarantee fund) if they think this will limit damages to the local financial system. See chapter 20.6 on the possibility to delegate either tasks of responsibilities between supervisors. Close Collaboration of the Home and Host Supervisor on the Legal Entity The supervisors of the head office and of the branches are obligated to collaborate closely, including by obligatory exchanging information. These include information on143: – (both for branches and cross-border services) concerning the management and ownership of banks that is likely to facilitate the supervision by the home or by the host and the examination of the conditions for authorisation, and likely to facilitate the monitoring of banks, in particular with regard to liquidity, solvency, deposit guarantees, limiting large exposures administrative and accounting procedures and internal control mechanisms; – the start of new activities being planned by the bank in the other member state, which were not yet part of the original notification; – changes in the organisational structure of the branch, of its corresponding address in the host member state, or of its management; – non-compliance by the branch with a request to apply relevant host-rules; – measures taken by the host supervisor, for instance in emergencies; – withdrawal of the authorisation of the bank. Apart from these obligatory items, any other information can be exchanged within the limits of the secrecy, procedural and data protection provisions (see chapter 20.2). These combine to throw up a significant threshold to formal information exchange, if only because of the resources which need to be spent by the supervisors involved to decide on the provision of information and subsequently on the monitoring of the source and use of information received through such channels.

143 Art. 42 RBD provides the basic obligation to collaborate. It includes both cross-border services provision, but is geared more towards branches. Most of the specific obligations, except those contained in art. 42 itself, are only applicable to branches. See art. 25, 26.3 30.2, 33, 35 and 151 sub g RBD.

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The home supervisor is allowed to visit both the head office and the branches to verify the information it needs. When it visits branches in another member state, it only has to inform the host supervisor before the visit. If the home supervisor so desires, it can also follow the more formal process established for subsidiaries supervision (see chapter 21.7). The host supervisor retains several powers, especially in emergency situations regarding locally relevant branches (see chapter 20.3 and below). For liquidity and monetary policies, it has its full intervention instruments at its disposal (if those are part of its domestic legislation). For ‘general good’ provisions, if any, it can uphold them within the limitations on such provisions144. It can require local reporting for the issues on which it is competent, and the branch has to publish local accounts within the boundaries of the bank branch directive; see chapter 6.4. The host supervisor has the power to verify the information it needs for its limited responsibilities by visiting the branch (but not the head office). The relation between the RBD provisions that specify the role and limits of the host supervisor and the TFEU and case law based ‘general good’ concept is murky145. Under the TFEU, the freedoms of establishment and cross-border services – as harmonised by the RBD that is based on those freedoms – can be limited by the member states if they fulfil a set of conditions that constitute the ‘general good’ of that country. The RBD does not provide for full harmonisation, and can in any case not overrule the TFEU except for those areas where the TFEU allows it. The RBD does harmonise some key elements of the power of host supervisors and the areas of (remaining) competence146. Additional ongoing requirements are likely to be increasingly restricted as the conditions to be allowed such ongoing requirements are ever further harmonised; including monetary policy within the euro-zone and liquidity when Basel III/CRD IV are fully implemented. In this system for branches, prudential rules were largely the remit of the home supervisor, and liquidity rules for branches are very limited in scope, except if the host supervisor could justify an intervention on the general good basis. If the bank did not adhere to the prudential rules and the home supervisor had not adequately prevented it, the host was largely limited to asking for clarification and warning the home supervisor. Only if that supervisor did not (effectively) do its job to ensure that the bank (and its branch) adhered to the minimum agreed level, did the host supervisor gain the power to intervene. As branch supervisors often only obtained very limited information, such transgressions were difficult to spot. An added difficulty was that not all member states had implemented the 144 See art. 31 RBD and chapter 3.5. 145 Art. 25-37 RBD. See chapter 3.4 and 3.5. 146 See chapter 3.5 and the discussion described in L. Dragomir, European Prudential Banking Regulation and Supervision, The Legal Dimension, Oxon, 2010, chapter 6.

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(optional) powers to intervene even within the narrow confines set147. This caused problems in emergency situations, especially where it concerned incoming services/establishments of a reasonable size such as the Icesave branches of the Icelandic bank Landsbanki. This led to some further harmonisation, with the above-mentioned intervention rights, and additional rights to information for significant branches. Significant Branches A complicating factor in the home host cooperative setting and the relatively easy crossborder market access under the European passport, is the establishment or potential establishment of systemic branches. From a business point of view, the choice for either a branch or subsidiary in another member state is often not so relevant, and both are protected by the freedom of establishment. From a consolidated point of view, the choice for a branch or a subsidiary in another member state is equally unimportant, and even on a solo basis regarding the legal entity it is more happenstance whether it is beneficial to have the shares in a subsidiary in the books, or the activities in a branch. For the host supervisor, it is nonetheless easier to supervise a subsidiary than a branch, as it will have licensed a subsidiary and has the normal rights of access and intervention towards it (with only the above-mentioned limited set of instruments mentioned above for a branch). This is reasonably acceptable if a branch is small, but not if the branch has a larger market share in the host country. The existence of ever larger branches in host countries, sometimes after a subsidiary was merged into the parent, has frustrated host member states. Prior to the 2007-2013 subprime crisis host branch supervisors increasingly had little or nothing to say on significant parts of their banking sector. They were dependent on the prioritisation by the home supervisor and the banking group on whether its banking sector will be fully funded and well supervised. A balance was struck in the wake of the crisis by keeping the involvement of host supervisors limited if the bank is not systemic in its country, while on the other hand granting increased rights and obligations to host branch supervisors if the branch is systemic in its country, including participation in a college (see below). For these so-called significant branches, the home supervisor has been placed under an obligation to send this information also to ministries of finance and central banks of the member states where the significant branch of its bank is located148. A complicating factor in this debate is the enormous differences in the size of the economies involved as home and host markets, and of the banking groups involved vis-à-vis the host member states. In one of the smaller member states, a branch or subsidiary may well be

147 Art. 31, 33, 34 and 35 RBD, as since amended by CRD II 2009/111/EC. Also see art. 62 Mifid for emergency powers of the host supervisor if the bank is not compliant, and the home supervisor is not effective. 148 Art. 42a.2 RBD, as introduced via recital 10 and art. 1.4 CRD II Directive 2009/111/EC. See chapter 5.3.

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systemic, while if those activities had been located in the home member state and when compared to the whole banking group, it would fall within the margin of error of relevancy. To ask the home supervisor and the banking group to spend resources on keeping the host supervisor of a – for them – irrelevant activity well informed may be much to ask. It nonetheless is price to be paid for more centralised supervision, and less direct supervision of the host supervisor vis-à-vis the bank. The CRD II directive introduced the procedure where the host supervisor can request the designation of the branch in its country as ‘significant’149. If the branch is significant, on top of the rights each host supervisor has for e.g. liquidity supervision and in emergency situations150, additional rights are bestowed upon the host supervisor. This includes participation in the college on the bank or banking group, as well as rights to information for itself (similar to the rights of supervisors of subsidiaries) and for its central bank and ministry of finance when there is an emergency situation151. If one or more of the branches of a bank has been deemed significant, a college of supervisors becomes obligatory, even if the bank is not part of a banking group. In addition to normal information exchange and cooperation as set out above, the existence of a college for a single entity mainly impacts on joint planning and coordination of supervisory activities – where necessary also with the central bank – in preparation for or during crises, and added information on adverse developments in other parts of the group. It does not impact on the allocation of responsibilities, but on the non-binding coordination of the execution of those responsibilities152. If the bank is part of a banking group, a college for the whole group is already obligatory; see chapter 21.7. No separate college is necessary in that case. If the bank is a standalone entity, not part of a banking group, the home supervisor of the bank and the host supervisors of the significant branches have to set up a college for the legal entity. The home supervisor determines the written college-arrangements, who attends the meetings and who participates in college-activities. These powers (especially on which supervisors of significant branches will attend meetings or activities) go beyond the powers of the home/consolidating supervisor in a group with multiple licensed banks. Until there are binding standards for the operations of these single entity colleges of supervisors, this gives the home supervisor the power, even though he has to ‘hear’ the host supervisors153. Consensus on such issues remains preferred, as bad relations with a host supervisor may impact on the use it makes

149 150 151 152

The procedure of art. 42a is described in chapter 5.3. See chapter 20.3. Art. 42a.2 RBD. Recital 6 and 10 CRD II Directive 2009/111/EC. Art. 42a.2, 42a.3, 129.1 sub c and 132.1 sub c RBD. For a full college – of multiple banks – these aspects are part of a wider set of cooperative arrangements that equally do not impact on responsibilities; see chapter 21.7. 153 Art. 42a.3 RBD.

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of its instruments on the operations of the bank. The decisions of the home supervisor can be appealed at EBA. Role of EBA EBA has is required to issue drafts for binding (regulatory and implementing) standards by 1 January 2014 on collaboration and information sharing in single entity cooperation, and is allowed to issue drafts for such binding standards on the operation of single entity colleges of supervisors. Binding mediation can be requested from EBA if they disagree on the assessment of significance of a branch, or if one of the supervisors in the member states where the legal entity has activities feels it is being asked for too much collaboration or information, or provided with too little collaboration or information154. Guidelines – CEBS/EBA, Guidelines for cooperation between consolidating supervisors and host supervisors (GL09), 25 January 2006 (Home host guidelines) – CEBS/EBA, Guidelines for the operational functioning of colleges (GL 34), 15 June 2010

21.7 Colleges (Home Host) Cooperation on Entities in the Same Group Introduction Chapter 21.6 dealt with the cooperation on supervision across borders per legal entity; on a solo basis. As set out in chapter 17, a key aspect of prudential supervision is the attention paid to consolidated supervision. Some subjects are even only subject to consolidated supervision, e.g. pillar 3. When banks are part of the same group, the supervisors involved in supervision on the operations of each entity at home and abroad need to cooperate to ensure that155: – there are no gaps or overlaps in consolidated supervision; – each has the information it needs for the solo supervision it exercises on one or more of the legal entities in the group, including – if applicable – as host supervisor of crossborder services or cross-border branches of individual banks; – supervision is effective and efficient amongst others by coordinating activities;

154 Art. 42 and 42a RBD; see chapter 21.4. Also see art. 50 CRD IV Directive. The powers of the host supervisor and the principles on cooperation are contained in art. 40-46 and 49-52 CRD IV Directive. 155 Recital 21-23 CRD 2006/48/EC, recital 6-16 CRD II 2009/111/EC, recital 36 EBA Regulation.

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– that measures taken take into account financial stability and other goals of banking supervision in all countries involved and in the EU as a whole (if and in so far as this fits with national interests156); – the supervisors involved will also be able to cooperate – including with the central banks in the countries involved – in crisis times. Until quite recently157, this cooperation was part of voluntary bilateral arrangements where they were deemed necessary by each and every supervisor involved. Supervisors who found a common important issue on a banking group made written or unwritten arrangements to share information, allowing each other access to bank establishments in their country and sometimes to consult each other on measures taken. The groupe de contact and the BCBS were established in 1972 and 1974 respectively in part to deal with problems in cooperation/coordination of internationally operating banks158. The BCBS issued (and continuously updated) the so-called Basel concordat on cross-border cooperation between supervisors on cross-border operating banks and banking groups159. For the EU, these non-binding but authoritative standards are applied in the context of cross-border cooperation with third countries, and helped inspire the recent binding rules on EU supervisory cooperation; see chapter 21.8. Many banks, and especially almost all systemically relevant banks, have a large presence also outside of the EU. This presence can be locally systemic, and can be systemic for the bank. In such cases, home host cooperation solely within the EU would not capture all the risks. For this purpose, colleges can be expanded to include third country bank supervisors. The current CRD provisions on this cooperation are few and far between, but in future provisions more possibilities will be included. Some references will be made in this chapter, but in general cooperation with third countries will be described in chapter 21.8.

156 Recital 7 CRD II 2009/111/EC, and art. 40.3 RBD as introduced by CRD II. On national interest as a driver for non-cooperation, also see chapter 18 and e.g. BCBS, Report and Recommendations of the Cross-Border Bank Resolution Group, March 2010, 16 and 34-35. 157 See below for the timeline. The first hint of an obligatory college was the obligation to have ‘written arrangements’ on cooperation, introduced in 2006 in the RBD. In various steps, guidance and laws have been upgraded to the current CRD provisions that bindingly prescribe a college of supervisors for each banking group. 158 C.A.E. Goodhart, The Basel Committee on Banking Supervision, A History of the Early Years 1974-1977, Cambridge, 2011, chapter 2 and 4. 159 Basel Concordat BS/75/44e of 26 September 1975, www.bis.org. The Concordat was replaced in 1983, and since upgraded and added to continuously, e.g. importantly by the July 1992 Standards for the supervision of international banking groups and their cross-border establishment. It has also been added to by a range of papers on the recommended division of labour in home host situations for Basel II implementation and on the working of colleges. A.F. Lowenfeld, International Economic Law, Second Edition, New York, 2008, chapter 23.2. BCBS, Good practice principles on supervisory colleges, October 2010.

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Gradual Increase in Coordination and Centralisation in the EU Where the Basel concordat sets out its non-binding principles the EU has taken such principles and made them binding. The CRD now includes mandatory cooperation obligations and a mandatory division of labour/responsibilities between EU supervisors. Within the EU, some aspects of cooperation and access across borders were stimulated already in the predecessors of the CRD160: – cooperation on branches of the same legal entity; – access to branches for on the spot verification; – a possibility to delegate supervision on a subsidiary to the supervisor of the parent; – an obligation to exchange ‘all relevant information which may allow or aid the exercise of supervision on a consolidated basis’ and to cooperate closely to ensure that penalties or measures on financial holding companies or mixed-activity holding companies are effective; – the (sub-)consolidating supervisor being solely responsible for determining which subsidiaries are captured in the (sub-)consolidation. Though this does not directly impact on solo- and sub-consolidated supervision on the subsidiaries, it does create some of the mentioned information and cooperation rights. This is applicable even if the supervisor of the subsidiary would not agree with the decision to have the bank it licensed captured in the consolidation; – a possibility to approach subsidiaries for information, with procedural safeguards on the transmission path and verification, including (a) professional secrecy, and (b) verification requests go to the supervisor of the subsidiary, which either carries out the verification itself or allows access to the supervisor of the parent. Though these provisions were high in ambition, they did not carry equally high impact powers and instruments. The rather toothless and ambiguous set of obligations and possibilities of consolidating supervisor of a bank made his tasks regarding the foreign subsidiaries more of a formality, and based mostly on the information provided by the bank and – hopefully – good relationships between certain supervisors. The introduction in 2002 of the financial conglomerates directive equally gave the supervisor of the highest entity in the financial conglomerate (named the ‘coordinating’ supervisor to distinguish it from the consolidating supervisor of the banking group) some additional tasks, without additional instruments. The enforcement of consolidation requirements was dependent on the supervisors of the individual banks (and investment

160 See e.g. art. 28-30, 52.9-52.10, 53-56 of the Consolidated Banking Directive 2000/12/EC, the predecessor of the RBD.

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firms and insurers) in the conglomerate, with direct additional powers only vis-à-vis the highest entity in the group and coordinating tasks towards the supervisors161. In line with the Basel revised framework and accompanying cooperation guidance, the 2006 version of the CRD improved the powers needed to effectively coordinate supervision on banking groups in several ways162: – the soft touch coordinating tasks of the consolidating supervisor were enhanced by codifying their content; – written arrangements were made obligatory between all supervisors involved in supervising a banking group; – introducing an obligation (on all supervisors, but particularly on supervisors supervising banks of the same banking group) to share information at on the own initiative of the supervisor all information essential to the exercise of the other supervisors’ tasks under the CRD, and on request all information necessary for the exercise of the other supervisors’ tasks; see chapter 17.2 and 21.5; – the consolidating supervisor gained the possibility to take the first decision with repercussions for all supervised banks within the banking group. In the model approval process for the internal ratings based approach for credit risk, the advanced measurement approach for operational risk and the internal model for market risk, the consolidating supervisor can decide on the approval of a group wide model if the supervisors involved cannot reach a joint decision within six months of the model and the supporting documentation being submitted for approval163; – an obligation to consult each other was introduced on decisions that – apart from impacting on the ‘own’ supervised bank also impact on other banks in the group; – for banks, costs and efforts to comply with supervisory information requests were reduced by obligating supervisors to request information from each other on certain issues, instead of each supervisor approaching (its ‘own’ supervised entity in) the banking group directly164, including an obligation on the consolidating (or sub-consolidating) supervisor to request information from the supervisors of the individual banks

161 Art. 16 and 17 Financial Conglomerates Directive. 162 Art. 129, 131 132 RBD, art. 37, last sentence and 37.2 RCAD, and BCBS, International Convergence of Capital Measurement and Capital Standards: A Revised Framework, June 2006 page 3. The new provisions supplemented the existing provisions of 2000/12/EC, which were copied into the RBD with some renumbering and added detail (art. 42-44, 125-132 and 137-143 RBD). 163 For the model approval process for the ‘new’ models for credit risk and operational risk introduced in the CRD in 2006, CEBS-EBA developed an extensive set of cooperative arrangements described in the EBACEBS Guidelines on Model Validation, currently page 110-274 of the EBA Electronic Handbook. 164 Art. 130.2 RBD puts this obligation on the consolidating supervisor, art. 132.2 on the supervisor of a subsidiary of a EU based parent bank. Art. 139.2 RBD provides the obligation to provide each other all relevant information for consolidated supervision purposes.

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in the group if the banking group has already given that supervisor the information necessary. Whether the beefed up cooperation obligations of supervisors on banks in the same group meant that there was going to be a true collaborative effort was the subject of hearty discussions during the implementation of the CRD in 2006. In and of itself, the introduction of a written arrangements or even a college of supervisors does not change the responsibilities of any of the supervisors involved at a solo, consolidated or sub-consolidated level. Opponents (both supervisors and banks who preferred the status quo and the clarity and good relations already available to new additional work and unknown quantities in the decision making process) stepped on the brakes, while supporters (both supervisors and banks who preferred the potential benefits over the existing independent but inefficient processes) advocated the widest possible interpretation of the CRD obligations. The fights focused both on semantics and content. Though this term at the time was not part of any binding text, the word ‘college of supervisors’ became the word du jour when referring to the low key obligation in the 2006 version of the CRD for supporters, while the opponents focused on non-binding agreements (the so-called memorandums of understanding) and mostly bilateral contacts with some minor group wide dissemination of information. Both were possibilities within the text of the CRD on written arrangements. Due to the financial crisis, and the criticism on the functioning of supervisory (and ministerial and central bank) cooperation under stress, the majority opinion as laid down in the CRD and the new EBA regulation has shifted decisively towards the colleges approach after the publication of the De Larosière report (see chapter 2). The CRD II directive, the Omnibus I directive and the EBA regulation all changed the role of the colleges and of EU bodies in them; further centralising the supervision of cross-border operating banking groups165. From the earliest stages in the crisis (and likely before) it was clear that national supervisors, however, were under strong pressure to stop fully cooperating when a crisis hits a crossborder operating banking group166. The public authorities a national supervisor is accountable to, and the public authorities that will have to pick up the bill in any liquidity support, state aid or deposit guarantee scenario will be inclined to limit the bill they will have to pay. At least they will want to pay in the manner that is most favourable not to worldwide creditors, not to EU or Eurozone creditors, but to national creditors/voters/taxpayers. The public authorities in other member states where the group has subsidiaries or activities will have similar incentives for their local public purse and their local creditors/vot165 Art. 131a.1 RBD as introduced by CRD II 2009/111/EC (also see recital 6 and 9 CRD II), and re-affirmed by art. 9.35 sub a Omnibus I Directive 2010/78/EU. 166 BCBS, Report and Recommendations of the Cross-Border Bank Resolution Group, March 2010, page 3435.

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ers/taxpayers. These incentives can easily clash when large amounts are being transferred within the group, or large debts owned, or where for one legal entity in the group it would be favourable to wait a day or days with an intervention and for another legal entity it might not be. If state aid is being considered, the local banking supervisor is likely to be pushed into a conflicting role of supervisor (high price or capital injection so that a healthy new bank results) and part of the member states public authorities (advice on keeping the cost of the member state down). If information is not shared with other supervisors, this may improve the cash-position of the local entities and thus of their local creditors in a liquidation-scenario, and the negotiation position of the member state authorities. As long as the costs of intervention are not shared equitably across the group and all member states involved in the group, this will not be resolved167. Some efforts were made to improve information sharing, based on the (lofty but in most cases faulty) assumption of a common purpose. Indeed the total costs will likely go down if information is shared, but the costs for an individual member state may go up. Legal obligations to share information were added subsequently in the CRD. Even these are, however, in a crisis unlikely to make information sharing and cooperation go beyond lip-service in light of the enormous amounts of taxpayer cash that are at stake. Only if one member state that dragged its feet would have to pay compensation to another member state that suffered a larger bankruptcy locally as a result of bad information provision – or if full and equitable burden sharing would be agreed in the context of any future banking union – would the cash incentives be aligned with minimising overall costs; see chapter 21.9 and 21.10. To bring down the bill of failures and of financial stability in general, there are initial references to college-type cooperative schemes in the 2008 Crisis MoU (set out in more detail in chapter 18). CEBS-EBA had already been working along the lines of setting up ‘college’ type arrangements and content. A ‘written arrangements’ requirement in the RBD was code for a formalised coordination mechanism between all supervisors involved, for which CEBS developed home host guidelines, see below168. Though this already appeared to be a victory of the proponents of active colleges and centralisation, it was in fact another holding pattern. Whether the practice would follow these non-binding rules was not clear, and many of the principles set out appeared to be direct translations of the obligations already in the CRD, or advice to implement those obligations not only in writing but also in practice. Regardless, the move towards greater formal cooperation, with meetings and 167 See chapter 18 and 21.9; and R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 4.4. 168 Art. 131 RBD (before the introduction of art. 131a RBD by CRD II 2009/111/EC as per end 2010), and CEBS/EBA, Guidelines for cooperation between consolidating supervisors and host supervisors (GL09), 25 January 2006 (Home Host Guidelines).

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formal structures, no doubt lead to greater contacts in practice, with greater trust and consultation following if minds meet (and as long as supervisory and national interests are aligned). Since end 2010, the CRD II directive reinforced the rights and duties of the consolidating supervisor, under the explicit obligation to institute a college for all licensing supervisors of banks in the group, and to grant rights on college-participation and information for supervisors of significant branches169. The Omnibus I directive subsequently gave some of the powers of the consolidating supervisor to EBA, and gave EBA additional powers to mediate between supervisors in a college if they disagree on priorities or on the content of decisions, e.g. if there is a stalemate on model approval or pillar 2. More importantly, EBA has now been given a formal role to oversee the colleges, and to promote their effective, efficient and consistent working. Surprisingly, it actually gained some powers to achieve that goal, including rights to information, participation, and to call meetings, settle disputes and issue both non-binding and binding rules for the operation of colleges170. Its powers on colleges have also been used to force the union-wide stress tests171. In the spirit of a compromise, the introduction of a explicit reference to colleges in the CRD and some limited instruments of the consolidating supervisor (and later EBA), was balanced by making it explicit that a college of supervisors is not a supervisor. The rights and instruments of each supervisor remain their own, and they remain responsible on a solo basis for the entity they licensed. The increase in powers of the collective (the joint supervisors in the form of a college and EBA) are as a result laid softly on top of individual prerogatives, and only where explicit power is granted to the college, the consolidating supervisor or EBA to direct the action of the national supervisor, it is bound to obey172. In the majority of cases, consensus will thus be needed, especially of the supervisors in the college that licensed the larger or more systemic banks within the banking group. The FCD II directive expands the task of banking group colleges for those groups with activities in other financial sectors, and clarifies some of the interactions between the different supervisors from mid-2013173.

169 Recital 6-16 and 1.31-34 CRD II 2009/111/EC, introducing amendments to art. 129-132 RBD and introducing the college-obligation in art. 131a RBD. On significant branches see art. 42a.2 RBD, and chapter 21.6. 170 Art. 129-131a RBD as amended by the Omnibus I Directive 2010/78/EU, and art. 16-25 EBA Regulation 1093/2010. 171 Art. 21.2 sub b and c, and 23, 32 EBA Regulation 2010/1093, and art. 131a RBD. Also see chapter 13.6, 14.3, 20 and 21.4. 172 Art. 131a.1 last paragraph RBD as introduced by art. 1.33 CRD II Directive 2009/111/EC, and repeated unchanged in art. 9.35 Omnibus I Directive 2010/78/EU. 173 FCD II Directive 2011/89/EU.

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The consolidating supervisor has also gained both the duty and the right to send and to receive warnings on threats to the financial stability in any of the key jurisdictions where the group is active174. If threats are noted through the activities of the college or e.g. through an own investigation as consolidating supervisor, it has to send warnings to e.g. central banks, the ESRB and EBA. In return, central banks that are aware of emergency situations as defined in the EBA regulation or similar threats to financial stability or market liquidity in any member state have to send a warning to the consolidating supervisor. This adds to the key role of the consolidating supervisor as collector and disseminator of key information for the group. Though the development of colleges is recent (gradual between 2006 and 2013), it was evaluated in 2010 by CEBS/EBA. This was before colleges were explicitly obligatory, but when written arrangements had already been bindingly prescribed and there was a range of guidance papers available on group-wide supervisory cooperation. The report was cautiously optimistic on the evolution, and discussed and compared the colleges on 17 named groups. Only in two cases (RBS and National Bank of Greece) there was no real college active at the time, in some groups there were mixed or bad results in some areas, but in the majority of cases a good effort was being made, with best practices evolving175. Establishing who is the Consolidating and Coordinating Supervisor, and Who Participates If the consolidated supervisor has ever increasing tasks and instruments to achieve them, it is important to have clear criteria on who bears this responsibility. The CRD contains criteria to determine this both at the consolidated and sub-consolidated level176. The financial conglomerates directive sets out effectively similar criteria at the level of the full financial conglomerate, and at a sub-conglomerate level if part of a larger group fulfils the financial conglomerate definition (even if the larger group is itself not a financial conglomerate but e.g. an industrial group); see chapter 17.4. All banks that are caught within the scope of consolidated or sub-consolidated supervision have a consolidating supervisor in addition to their licensing supervisor. The only banks that are not captured in a consolidation are banks that have neither subsidiaries nor parents legal entities; see chapter 17. The role of the consolidating supervisor is allocated to the supervisor that gave a license to the most important or dominant EU bank in the group. The process to decide this is multi-layered, and set out below. The complexity of the process 174 Art. 130 RBD as amended by both CRD II 2009/111/EC and the Omnibus I Directive 2010/78/EU. Also see art. 18 EBA Regulation 1093/2010; and chapter 18.2. 175 CEBS/EBA Review Panel, Report of the Peer Review on the Functioning of Supervisory Colleges, 18 October 2010. 176 Art. 4.48, 125-126 RBD; see chapter 17.

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reflects the complex and different group structures chosen by banks. The consolidating supervisor is responsible for the consolidated supervision of a bank and its subsidiaries, in addition to its solo-supervision responsibilities for the individual banks it gave a license to. If the bank is the ultimate parent worldwide its licensing supervisor is also the consolidated supervisor at the highest level of the group (provided that the group is not a financial conglomerate)177. However, if it is not the worldwide parent (either because there is a third country parent holding, or the EU based holding company does not itself have a banking license) this cannot apply. If the bank has as its parent only financial holding companies, and the other banks owned by those companies are either subsidiaries of the bank or less important than the bank determined according to the following criteria: – the bank set up in the same member state as the holding company is most important (but if there are more holding companies and in each of those member states there is also a bank, then the supervisor that authorised the bank with the largest balanced sheet total is the consolidating supervisor); – if no bank has been set up in the same member state as the holding company, then the supervisor that authorised the bank with the largest balance sheet total is the consolidating supervisor; – if these criteria are ‘inappropriate’ according to all supervisors involved, taking into account the banks and the relative importance of their activities in different countries, the supervisors can agree on a different supervisor being the consolidated supervisor, after having consulted the banking group. If the bank has as its parent a mixed-activity holding company, then the licensing supervisor of the bank is the consolidating supervisor. Similarly, the licensing supervisor of the bank is also the coordinating and consolidating supervisor of a financial conglomerate at the level of the group178: – if the bank is the ultimate parent worldwide; – if the bank has as its parent only mixed financial holding companies (i.e. not another bank, an insurer or an investment firm), and the other banks, insurers or investment firms are either subsidiaries of the bank or less important than the bank determined according to the same criteria set out above, though with the addendum that the coordinating supervisor comes from the most important financial sector within the

177 Art. 3.12-3.20, 73, 125-126 and 137 RBD. 178 Art. 125-126 RBD and art. 10 FCD 2002/87/EC as amended by Omnibus I Directive 2010/78/EU. Also see chapter 20.7 on supervisory disclosures.

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financial conglomerate. The identity of the coordinator per identified conglomerate is published. If a financial conglomerate is headed by an insurer or by an investment firm, the licensing supervisor of that regulated entity is the coordinating supervisor. Consolidation at the full group level will in that case be supervised by the coordinating supervisor. However, this increases the importance of sub-consolidated supervision in the banking sector (and likewise in the insurance sector if the situation is reversed). The sub-consolidated banking supervisor of the highest bank has similar tasks as the consolidating banking supervisor of the group, but in this case without a ‘higher’ supervisor from its sector taking care of the sector-specific tasks. The highest sub-consolidating banking supervisor (of the banking subgroup within a financial conglomerate) takes on many of the responsibilities of the subgroup normally associated with the group wide consolidating supervisor. It looks at all the banking issues, in close cooperation with the coordinating supervisor. If both roles are in the same hands (e.g. when the member state of an insurance controlled financial conglomerate also is the member state where the highest bank of the banking subgroup is situated, and the insurance and banking sectors are supervised for prudential purposes by the same authority) there is no external problem. If there are two different authorities, or the highest bank and the highest insurer/conglomerate parent are based in different member states, these will need to coordinate very closely. At the sub-consolidated level, the same criteria determine the responsibility that also determine it at the full consolidation level. By way of example, if the ultimate parent owns a financial holding company in another member state that in turn owns a bank in that member state, the supervisor of that member state is responsible for sub-consolidated supervision at the level of the financial holding company. If the ultimate parent of the group is based in a third country, the consolidating supervisor as determined under these EU rules will either have a heavy burden or not. The emphasis to determine whether he has to take on responsibility as a consolidated supervisor for the activities within the EU is on whether the parent is a supervised entity, and on the quality of such supervision both on a solo level and on a consolidated level. If the third country has similar rules as the EU, the EU consolidated supervisor may have a relatively light supplementary role. If, however, there is little or no supervision (that also takes into account e.g. financial stability concerns in the EU) the EU consolidating supervisor will need to ensure that there are no risks left uncaptured within the EU, or caused by third country entities within the group. In extreme cases, this might lead to a license being revoked under

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the ‘close links’ rules, or permission to be a shareholder being revoked. See chapter 5 and 17. The consolidating supervisor has the responsibility to set out the arrangements and most of the practical work of the college. The consolidating supervisor has no say, however, in the determination of which EU authorities are the members of the college. The following entities may choose to participate in the college of any banking group179: – the consolidating supervisor; – the supervisors of all subsidiaries in the group (see below); – the host supervisor of a significant branch; – EBA (for this purpose considered to be a supervisor); – central banks ‘as appropriate’; – third country supervisors where the consolidating supervisor set this up as part of appropriate coordination and cooperation, and secrecy of information is safeguarded. Being a member of the college guarantees access to information, but not necessarily access to meetings or activities180. The consolidating supervisor has the obligation to give advance information on the planning and agenda of each meeting, and the decision taken. Participation in the meetings is not guaranteed, but can be determined by the consolidating supervisor on the basis of the written arrangements that support the college. The decision of the consolidating supervisor on who is invited has to take account of the potential relevance of the agenda and actions for each particular member of the college, and especially the impact on financial stability in their member state. EBA is the only member that can at its own discretion decide to participate as it deems appropriate181. It is not entirely clear which supervisors of subsidiaries can opt into the college. The RBD uses the term competent authorities, which is defined in that directive to be a supervisor of a bank. Such a restrictive interpretation would be consistent with more loosely worded obligations to cooperate with for instance insurance supervisors182. On the other hand, the term subsidiaries in the next article of the RBD (on the information exchange) refers to amongst others any regulated entity183. In order to exercise cross-sectoral tasks bestowed under the amended FCD from mid-2013, a clearer reference could have been useful. All bank-supervisors can definitely opt to be a full member, for others it could be useful, 179 Art. 131a.1 and 131a.2 RBD (as amended by FCD II Directive 2011/89/EU) and art. 21 EBA Regulation 1093/2010. Also see chapter 21.4, 21.6 and 21.8 on EBA, significant branches respectively on third country cooperation. 180 Art. 131a.2 RBD. 181 Art. 131a.1 RBD and art. 21.1 EBA Regulation 1093/2010. 182 Art. 1.4 and 140 RBD. 183 Art. 132 RBD.

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especially if the banking college is given tasks under the financial conglomerates directive to coordinate the supplementary supervision under that directive184. However, as that directive refers to separate colleges for the insurance sector and the banking sector, with the chair of one of the two being the coordinating supervisor for the full conglomerate, it may be that no cross-membership is intended for supervisors of subsidiaries in a financial conglomerate. The two directives structure of the CRD causes problems when looking at the membership of investment firm (prudential) supervisors. The RBD is not very clear on the membership of non-bank investment firm prudential supervisors in the college, as such are defined and given tasks in RCAD. As the tasks of the college include such issues as model approval – that includes application of the model on a solo-basis and a consolidated basis to nonbank investment firms in the group – it is likely that they have to be included in a banking college185. College-arrangements Since 2011, the consolidating supervisor is obliged to set up a college, and establish written arrangements. Arrangements on information exchange and cooperation were already obligatory since the 2006 version of the CRD was implemented (see above), but it was a joint responsibility to institute them, without any supervisor being responsible (and thus liable) if they did not exist or did not meet the intended purpose186. Especially when the banking group was not important in the home country of the consolidating supervisor, or the cross-border subsidiaries were not deemed important by the consolidating supervisor, this could mean that neither written arrangements nor the actual cooperation and coordination took place. This now cannot be the case any more if any of the supervisors involved has a concern about this. If the consolidating supervisor fails to take up its – now explicit – task host supervisors can request it, under the monitoring of EBA. EBA has not (yet) been given binding mediation tasks here, but it is likely that those will be allocated if consolidated supervisors fail to live up the responsibility allocated.

184 Recital 4 and art. 2.11 FCD II Directive 2011/89/EU. 185 Art. 131a RBD refers to art. 129 RBD. This article is applicable in part to non-bank investment firms that are part of a banking group; art. 41.2 RCAD. Also see chapter 2. 186 Art. 131 RBD as part of the original RBD of 2006, given a detailed content by art. 131a RBD as introduced by CRD II 2009/111/EC, and with a monitoring role and potential regulatory standards of EBA as a result of the Omnibus I Directive 2010/78/EU.

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The consolidating supervisor for example has to187: – establish the college and its written arrangements; – plan and coordinate supervisory activities in cooperation with the other supervisors, including exceptional measures, joint assessments, permissions sought and the implementation of contingency plans and public communications; – keep all members of the college informed of meetings and the substance of planned meetings and decisions taken; – circulate all essential or relevant information at its own initiative to the supervisors it concerns within the college, and receive essential information from other supervisors inside and outside of the college; – keep EBA informed of all activities, including in emergency situations; – inform the relevant central banks that may be affected by emergency situations as soon as possible, and if necessary involve them in the above-mentioned planning and coordination of supervisory activities to prepare for emergency situations; – if the banking group is part of a financial conglomerate, from mid-2013 the bankingcollege written arrangements will also need to include a separate reflection of the supplementary arrangements for the conglomerate. In addition to these obligations on cooperation and information exchange contained in the RBD itself, the written arrangements have to enable the supervisors to achieve the purpose of the college. They will thus have to include detail on188: – how to exchange information between the supervisors involved and with EBA (which has been facilitated by a suspension of secrecy obligations between the members of the college; see chapter 20.2); – possibly entrustment of tasks or responsibilities voluntarily to other supervisors (however, see chapter 20.6 on delegation); – how to agree on supervision activities based on group-wide risk assessments under pillar 2; – how to increase efficiency of supervision; – how to come to a consistent application of the CRD across the group, with full respect to the large number of options and discretions available to either the individual banks in the banking group, the individual supervisors and the individual member states, and without changing the responsibilities of the supervisors;

187 Art. 129-132 RBD and art. 11 FCD 2002/87/EC, as amended by CRD II Directive 2009/111/EC, Omnibus I Directive 2010/78/EU and FCD II Directive 2011/89/EU. For consolidating supervisors, the duty to send ‘relevant’ information does not need to be triggered by a request of another supervisor; art. 132.1 RBD, as amended – as per mid 2013 – by the FCD II Directive 2011/89/EU. This increases their liability significantly. 188 Art. 131a.1 RBD, and art. 9 FCD 2002/87/EC, as amended by the FCD II Directive 2011/89/EU as applicable from mid 2013.

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– how to coordinate group wide pillar 2 and model validation work, including the internal governance requirements following from financial conglomerates supplementary supervision. This does not yet address the reporting complaint by cross-border operating banks189 that, due to the different implementation, interpretation and interaction with domestic company and contract laws, the reporting to be done under the same CRD still needs to be built up separately in each member states. Until a full harmonisation is achieved of the formats and the underlying definitions of what should be entered into the formats, consolidating those into consolidated information requires a significant conciliation effort; see chapter 20.2. The written college arrangements remain the backbone of cooperation, now supported by minimum-conditions such as the obligatory meeting and/or network of supervisors involved in the supervision of a specific banking group. Even though now obliged to have a college, including a wider dissemination of information and cooperative obligations than some consolidating supervisors may have deemed useful for their own purposes, consolidated supervisors did gain authority in being allowed to set out such arrangements, after consultation with other licensing supervisors of banks in the group (and the host supervisors of significant branches; see chapter 21.6). The written arrangements on colleges are most useful if they provide specifics on the various obligatory forms of integrated group-wide supervision, and provide voluntary additions where most useful for the specific group under supervision. CEBS/EBA developed a template for such written arrangements, and in 2010 became obliged to develop college guidelines, issued that same year190. The obligation to issue guidelines was replaced as per end 2011 by the possibility, but not obligation, for EBA to propose regulatory standards; since again upgraded to an obligation to draft such standards by the end of 2014191. The written arrangements can be in addition to or instead of any existing bilateral memorandum of understanding, in which arrangements between two or more supervisors set out arrangements on cross-border on-site supervision, and information exchange on branches and in more recent years on cross-border subsidiaries.

189 See e.g. M. Wolgast, ‘M&As in the Financial Industry: a Matter of Concern for Bank Supervisors?’, Journal of Financial Regulation and Compliance, Vol. 9, No. 3, 2001, page 233-234. 190 CEBS/EBA, Template for the Multilateral Cooperation and Coordination Agreement for the Supervision of the XY group, 27 January 2009. 191 Art. 42a.3 and 131a.2 RBD. Compare art. 51 and 116 CRD IV Directive; requiring both regulatory and implementing standards by 31 December 2014.

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The increased importance of cooperation on subsidiaries has had two contradictory effects: – subsidiaries have increasingly been treated (definitely by the consolidating supervisor, and even – where relatively small – by local supervisors) as branches; – very large branches are now being treated almost as if they are a form of subsidiaries if they become systemically important to the market in the member state in which it is situated under the ‘significant branches’ status (see chapter 21.6); meaning that the local supervisor has more involvement than was the case for the relatively small branches that were standard practice in the seventies and eighties of the last century. The over-emphasis on the legal form chosen for the cross-border establishment under the EU-passport for branches is thus declining. If the activities are significant the host supervisor has to be involved, if they are not, the solo supervisor may limit its own involvement, e.g. by taking a less active role or even delegating the responsibility for supervision to the consolidating supervisor. However, even with these shifts in power the supervisor of a significant branch has less tasks in day-to-day supervision than the supervisor of a significant subsidiary, and has likely even less instruments or practical possibilities to intervene if the bank fails; see chapter 5, 18, 19 and 21.6. Specific contact-obligations in the RBD relate to issues such as obtaining information from each other instead of via the bank, and consulting each other when taking measures with repercussions for other entities in the group192. The proof of the pudding is in the eating, and difficult as it is, the cooperation in normal times is good natured and well intentioned (in absence of additional bureaucratic duties on individual supervisors) compared to the cooperation in times of stress. Stress can result from any public intervention into the bank, impacting on the remit of other supervisors, and especially from emergency measures on either bank specific problems or general financial system problems. In those cases, the incentives for the supervisors and other public authorities to put the local interests first are proportional to the amount of funding or damages inflicted on their local society if the bank should fail. Tasks of the Consolidating Supervisor as Regards Model Approval and Pillar 2/3 The RBD contains specific powers – built into college arrangements and with checks and balances allocated to EBA – for the consolidating supervisor on model approval for pillar 1, and on the follow-up for pillar 2 and 3. The model approval tasks impact on the banking group and its supervisors at the consolidated, sub-consolidated and solo level. For pillar 2 the consolidating supervisor can only overrule other supervisors at the consolidated level 192 Art. 129.1, 131, 132 RBD.

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(not at the sub-consolidated and solo levels). Pillar 3 only applies at the consolidated level, leading automatically to a large role for the consolidating supervisor (and a lesser role for supervisors who did not license the entity responsible for the publication). When the CRD was introduced, the consolidated supervisor only gained an explicit power to overrule objections by other supervisors on the issue of model approval. A special process was set up, that has since only been amended to reflect a role for EBA193. All advanced models mentioned in chapter 6.3 can be approved (‘recognised’) on a cross-border and cross-entity basis if this is requested by the bank. If the supervisors involved cannot reach an agreement, the role of the consolidating supervisor has been strengthened to the point that he can make the decision if six months have passed since the complete application was made. A large component of the initial work of CEBS-EBA after its establishment in 2004 was focused on this area. The model validation guidelines not only focused on the content of the models and the supporting internal governance rules, but also on the ‘home host’ cooperation on the research and the formal approvals process, as well as on how such an overruling decision would work in day-to-day practice194. Ideally, if supervisors applied the guidelines, such a decision would not need to be taken. The guidelines emphasised the full involvement of all relevant supervisors, and a compromise-driven process in order to be able to work country specific demands into the approval (and where relevant into the model described in the application). The application for the models to be applied on a consolidated basis has to be submitted to the consolidated supervisor. This authority shares the complete application with the other supervisors of banks captured in the consolidation. In order to be complete, the application has to contain all the relevant information in order to be able to decide on the application. The supervisors are obliged to work together, in full consultation, to decide on the application. They are urged to decide jointly on whether or not to grant the permission, and whether or not to include terms and conditions on any such permission. For this joint, consensus-driven, process, they have six months from the receipt of the complete application195 by the consolidating supervisor. If no consensus is achieved within the six months, in principle the consolidating supervisor can overrule the objections of the other supervisors. The other supervisors subsequently are obliged to fall in line, and apply the decision taken faithfully, also at the solo and sub-consolidated level. However, with the replacement of CEBS by EBA an even more central power was created. If one of the 193 Art. 129.2 RBD and art. 37.2 RCAD, as amended by art. 9.32 Omnibus I Directive 2010/78/EU; see below and chapter 21.4. 194 CEBS-EBA, Model Validation Guidelines (CP03), April 2006. 195 The CRD does not set out what information should be contained in a ‘complete’ application. CEBS-EBA has worked on this issue, and provided guidelines; see chapter 14.

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supervisors chooses to refer the disagreement to EBA, the consolidated supervisor loses its power to take a decision until the dispute has been resolved under the process described in chapter 21.4. Only when EBA has given its ruling on the dispute, the consolidated supervisor can make the final decision, but it has to be in line with the EBA ruling even if that does not reflect the original position of the consolidating supervisor196. If the six months have passed without the issue having been referred to EBA by one of the supervisors of the subsidiaries, the consolidating supervisor, however, still has the power to take a decision. This decision cannot be referred to EBA. The CRD refers to a joint decision, set out in a document (containing also the motivation) to be sent by the consolidating supervisor to the applicant. Though this is sufficient for CRD consolidated supervision purposes and for the parent of the group, the supervisors of the subsidiaries in the group that want to apply the model also on a solo basis will need to ensure that the entity they supervise receives permission in line with local administrative law requirements197 to set up its organisation and its reporting framework in line with the approved model (with the terms and conditions attached to it). On a conceptual level the coordination of the pillar 2 measures introduced in the CRD II directive may be even more important. The consolidating supervisor has gained the instrument to decide on pillar 2 applications for the whole group if there is a stalemate in the college (though unlike for model approval this has no impact on pillar 2 decisions at solo or sub-consolidated level). This is the first time that a consolidating supervisor would directly enforce a measure on a group where it bites directly in the required level of capital and the risk profile of the group. Model approval and reporting are also important, but both are more ‘back-office’ subjects and only indirectly impact the required capital and expenditure. The process on the annual consolidated pillar 2 assessments and the application of measures if the ICAAP or SREP show insufficiencies is similar but not the same as the process for model approval. Instead of six months, the consensus decision has to be taken within four months, reflecting the annual nature of this process. During those four months any of the supervisors can refer the decision to EBA. CRD II only applies to pillar 2 on the consolidated level, without changing the responsibilities on a sub-consolidated or individual basis198. All supervisors involved do have to take the consolidated decision into account, however, and disagreements on the measures taken by the sub-consolidated and solo level 196 This power is effective since the start of 2012. See art. 129.2 RBD as amended by Omnibus I Directive 2010/78/EU, and art. 19 EBA Regulation 1093/2010. 197 Art. 129.2 CRD provides that the joint decision, or the backup unilateral decision by the consolidating supervisor, are ‘determinative’ and shall be ‘applied’ by the supervisors in the various member states where subsidiaries are licensed. 198 Art. 129.3 RBD (as introduced by recital 9 and art. 1.31 CRD II Directive 2009/111/EC, and amended in the Omnibus I Directive 2010/78/EU and the FCD II Directive 2011/89/EU).

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can also be contested by other supervisors at EBA to obtain a ruling, or EBA can be asked for its advice. A ruling would be binding on all supervisors. Any advice of EBA is nonbinding but a ‘comply or explain’ provision applies199. The joint decision also has to be given to the parent institution of the banking group, and lacking such a joint decision, all individual decisions of all competent authorities have to be accumulated into one document (including their reasoning on the divergence) and this document has to be provided to the parent institution of the banking group. EBA is allowed – but not required – to develop implementing standards on model validation decisions and pillar 2 decisions200. Pillar 3 is in principle applicable only on the consolidated level; see chapter 15 and 17. Automatically, the consolidating supervisor has the key-role here. However, ‘significant’ subsidiaries also have to disclose a limited pillar 3 information on own funds, the solvency ratio and the ICAAP part of pillar 2, either on a solo basis or a sub-consolidated basis. This is supervised separately by its licensing supervisor, and there is no binding law to determine when a subsidiary is ‘significant’. If the two supervisors disagree on the significance of the subsidiary or demand contradictory information to be part of the disclosure, they can currently not appeal to EBA for conflict resolution201. Tasks of the Coordinating Supervisor on a Financial Conglomerate Like in banking colleges, the most important feature of the cooperation between supervisors in the context of financial conglomerates is its non-binding and consensus-based nature. The supervisors are: – obliged to cooperate closely with each other; – obliged to communicate at their own initiative all essential information to another supervisor under its sectoral or financial conglomerates supervisory tasks; – obliged to communicate on request all relevant information to another supervisor under its sectoral or financial conglomerates supervisory tasks; – obliged to consult each other on (a) changes in the shareholder, organisational or management structure of regulated entities in a financial conglomerate, which require supervisory approval or authorisation (b) major sanctions or exceptional measures

199 Art. 129.3 RBD; also see chapter 14 and 21.4. The advice route to CEBS was initially the only appeal possible, but it was maintained alongside the binding ruling route to EBA in the Omnibus I Directive 2010/78/EU. 200 Art. 129.2 and 129.3 RBD, as amended in the Omnibus I Directive 2010/78/EU and the FCD II Directive 2011/89/EU. This type of content has so far been the subject of guidelines, see chapter 6.3 and 13.5. 201 Art. 68, 72, 145-149 and Annex XII part 1 sub 5 and part 2 sub 3 and 4 RBD, and art. 19 EBA Regulation 1093/2010.

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taken by supervisors (c) with the same exceptions as in the CRD on urgency and a potential impact on the effectiveness of the decision; – unlike in the CRD, there is only a potential to request information from other supervisors if they already have it, not an obligation to alleviate the burden on the conglomerate. Most of the tasks of the coordinating supervisor are soft-touch. They include coordinating and dissemination of information, supervisory overview and assessment of the financial situation, assessment of the group as a whole on finances and internal organisation, as well as of compliance with capital adequacy, risk concentration and intra-group transactions. Vis-à-vis the group, it has a reasonable amount of power to enact those responsibilities as it is the supervisor of the parent entity (and can require the cooperation of other supervisors if the parent is an unregulated entity). However, it has limited powers vis-à-vis the other supervisors involved. A similar decision making power as known in the CRD on model approval is not available in the financial conglomerates directive, and each supervisor has powers only towards those entities it has licensed under sector specific rules, also on transgressions of the financial conglomerates directive. The sector specific tasks and responsibilities of supervisors (e.g. of the solo and sub-consolidated supervisor of a banksubsidiary in the financial conglomerate) are not affected by the presence of the financial conglomerate coordinating supervisor202. The obligations of the other supervisors are limited to cooperation, though they are obliged to provide assistance on mixed financial holding companies. An obligation to draft written arrangements was introduced in the Omnibus I directive, as applicable since end 2011. As a result of the FCD II directive, those arrangements will need to be specifically referenced in the written arrangements of the banking college if the coordinating supervisor is a banking supervisor from mid-2013. Decision making is generally a joint responsibility, based on full consensus. However, like in banking consolidated supervision, the coordinator can decide unilaterally which legal entities not to include in the consolidation (though sometimes with a consultation obligation)203. A separate college is not required, neither in the current FCD nor in the amended version of the FCD applicable from mid-2013204. The supplementary supervision tasks are bestowed upon the insurance or the banking college, depending on whether the coordinating

202 Art. 11 and 12 Financial Conglomerates Directive, as amended by art. 2.6 Omnibus I Directive 2010/78/EU and 2.11 FCD II Directive 2011/89/EU. 203 Art. 6.5 Financial Conglomerates Directive. 204 The current Financial Conglomerates Directive does not require a college, and recital 4 and art. 2.11 FCD II Directive 2011/89/EU principally confer this task in the new art. 11 Financial Conglomerates Directive to the banking or the insurance college.

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supervisor is also the chair of the banking or of the insurance college. The recitals of the FCD II directive imply that this is different if there is neither a banking nor an insurance college active within the group, but there is no legally binding provision to introduce a financial conglomerates college in that case. Mixed-Activity Groups For mixed-activity groups that have a banking subsidiary, the structure will determine whether there will be a banking college. Such groups can include: – car producing companies (such as Ford or General Motors) that have or originally set up their financing vehicles as a bank; – industrial or services conglomerates that are not primarily financial in nature, the most well-known example being General Electric of the USA, that have banking subsidiaries that may be substantial, but not in relation to the size of the group. If the parents and/or the rest of the group are not regulated entities themselves or financial holding companies, the grasp of the banking supervisors on the rest of the group is relatively tenuous. Unlike a holding companies that is financial in nature and are thus deemed to be included in the scope of the supervision of the highest bank in the group (under upward consolidation rules), a mixed-activity holding company is not included in the scope of consolidation of the supervisor of the highest bank in the group (see chapter 17). The CRD makes clear that even where information is gathered by supervisors on mixed-activity holding companies, this in no way implies either solo or consolidated supervisory responsibility for them205. If there are other regulated entities as parents or as other subsidiaries of a parent, some obligations to cooperate exist206. Member states have to ensure that there are no legal impediments to exchange information between undertakings and a mixed-activity holding, to ensure supervision of the intra-group transactions. There has to be ‘close’ cooperation between the bank-supervisors and the supervisors of any insurance companies or other licensed investment service providers, including a binding duty to provide one another with any information likely to simplify their task and to allow supervision of the activity and overall financial situation of the banks, insurers or investment service providers (subject to secrecy obligations on the information exchanged; see chapter 20.2. The supervisor is also obliged to cooperate on information gathering and verification in another 205 See the limitation in art. 139.3 RBD, where a difference is made between a lack of solo-supervision responsibility on e.g. financial holding companies, and the lack of any type of supervision responsibility on mixedactivity holding companies. 206 Art. 139 RBD (in relation to the content of supervision as set out in art. 137 and 138 RBD, including any goldplating under the first article ‘pending further coordination’) and art. 140-142 RBD.

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member state if the mixed-activity holding is based there, and has to cooperate with other supervisors to make measures taken vis-à-vis mixed-activity holdings effective. The FCD II directive – effective from mid-2013 – introduces similar provisions in the RBD, the FCD and the insurance directives on how to supervise such mixed activity groups. It contains an obligation to work towards equivalence assessments and cooperation if the obligations in the diverse directives overlap with regard to the same mixed activity holding, including an obligation to develop guidelines and subsequently regulatory standards via the joint committee of EBA, EIOPA and ESMA207. Secrecy Obligations/Pillar 2 Approval and Investment Firms That Are Part of the Group The two directives structure of the CRD causes several problems in the context of colleges; also see chapter 2. As indicated above, it is likely that prudential supervisors of non-bank investment firms that are regulated under RCAD are part of the banking college if the investment firm is part of a banking group. The amended RBD secrecy obligations – that as a result no longer apply to information exchange within a banking college – have made life considerably easier for supervisors that want to share information and cooperate within the college208. It has also made life more difficult for supervisors that do not want to share information e.g. to try to delay off the bankruptcy of one of the local banks that is part of the group, or to improve its financial position relative to other group entities, to the benefit of creditors of that specific group-entity. These amendments to the secrecy obligations have also made clarified that the college can share information with or via EBA. What it has, however, not clarified is how it interacts with the secrecy regimes of Mifid. If non-bank investment firms are part of the group, and are captured in the consolidation, this will mean that information obtained in the prudential supervision of these non-bank investment firms under RCAD is shared. RCAD makes the secrecy obligations of Mifid applicable to prudential supervisors of non-bank investment firms, regardless of whether these firms are part of a banking group or not. The RBD article that dis-applies the RBD secrecy regime for a banking college, does not refer to the Mifid secrecy regime. That Mifid regime therefore legally continues to apply (even though this is undesirable and makes the college difficult to be effective; e.g. when there is a need to gain permission for onward sharing within the college209). Though this cannot have been the intention, the text of the provisions involved leaves little leeway for a favourable interpretation. 207 See e.g. recitals 13 and 14, and art. 1.1, 1.3, 3.1, 3.2 and 3.8 FCD II Directive 2011/89/EU, introducing as per mid 2013 the overlap-arrangement of a new art. 72a RBD, and diverse other references to mixed activity holdings. 208 See the last paragraph of art. 131a.1 RBD. 209 Art. 54.4 Mifid.

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A related mix-up applies to the participation and right of information of EBA and/or ESMA. According to the RBD and the EBA regulation, EBA is a member of the college, and deemed a supervisor. According to Mifid and the ESMA regulation, ESMA is a member of the college210. This is a relatively minor issue, as the RCAD has been allocated to the remit of EBA, and the ESMA regulation acknowledges this in as far as it concerns prudential supervision211. In this case it is defensible that EBA is the only European supervisory authority that is a member of the college set up under the RBD/RCAD for banking groups that contain non-bank investment firms; even though a case could be made for dual membership too. The secrecy provisions of Mifid state that information can be shared with ESMA, a separate provision in RCAD provides the same for sharing information with EBA; implying a dual right of access to information212. A separate oddity is the disparate role of the consolidating supervisor for model validation and for pillar 2 when the banking group also contains non-bank investment firms. The college of supervisors has been competent to deal with model validation on a consolidated basis, with effect on both the banks and the non-bank investment firms that are captured in the consolidation since the directives were issued in 2006. The CRD II directive introduced a similar task for the consolidated approach to pillar 2 into the RBD. The provision in RCAD that made the model validation aspect applicable to non-bank investment firms, however, was not similarly expanded213. As a result, the role of the consolidating supervisor if no consensus is achieved and the accountability on that lack towards the group is not clear when it relates to the prudential supervisor of non-bank investment firms that are part of the banking group. Future Developments The CRD IV project does not result in material changes in the procedures within colleges. Two additional procedures have been added, however, for the joint assessment of liquidity, one very similar to the model approval procedure (with binding effect on the supervisors of subsidiaries), one more similar to the pillar 2 procedure (with freedom to deviate for the supervisors of subsidiaries)214. The cooperation in colleges was presented in 2009 as a phase in the development to further convergence of rules and integration of supervisors215. In which direction such further 210 Art. 57 Mifid and art. 21 ESMA Regulation 1095/2010. 211 Art. 1.2 EBA Regulation gives RCAD to EBA in full. Art. 1.2 ESMA Regulation gives RCAD to ESMA too, but ‘without prejudice’ to the prudential supervision competence of EBA. 212 Art. 58 Mifid and art. 38 RCAD. 213 See CRD II Directive 2009/111/EC, and art. 37.2 RCAD. 214 Art. 20 and 21 CRR. 215 Recital 12 CRD II Directive 2009/111/EC.

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development will take the EU (and the world) is unknown. The strengthening of the role of EBA, especially its binding decision making in quarrels in the college or between supervisors, has been a further step in this development; see chapter 21.3, as is the expected finalisation of the creation of a single supervisory mechanism of the Eurozone. If a single supervisory mechanism would indeed be introduced under the October 2012 proposals of the Commission216, the number of colleges would be reduced. All colleges for banks that do not have subsidiaries outside the Eurozone would be abolished. The proposals are not clear as to whether national authorities of Eurozone member states would sit in the remaining colleges alongside the ECB, or whether their seat at the table would be usurped by the ECB. It is also not clear what would happen with the role of central banks and ministries of finance in single legal entity colleges (for significant branches) nor what would happen with their role in colleges when the bank is in crisis. This will become clearer when the detailed arrangements following the political agreement are published; see chapter 21.3. The Commission has communicated that it would like to build so-called ‘resolution colleges’ around existing supervisory colleges, and has issued legislative proposals for a new resolution and recovery directive along these lines217. The public authorities responsible for resolving failed banks would come together regularly to prepare for the failure of each particular banking group. The proposals envisage that these colleges will e.g. exchange information, assess resolvability, and agree on the use of instruments and agree group resolution schemes (including burden-sharing arrangements)218. Whether it is truly different from inviting e.g. central banks, deposit guarantee schemes and ministries of finance on an as-needed basis is debatable. Such authorities sometimes are already members of a college, or can be invited at any time to meetings (with some minor constraints due to secrecy obligations), and will likely be invited or convene their own gatherings/debate in emergency situations; see chapter 18. The proposals also include a regime on cooperation – within a college or otherwise – with third country authorities219. Similar expansion on an ad-hoc basis can be done with third country authorities, under e.g. the FSB principles for cross-border cooperation on crisis management220. 216 Commission, Proposed Single Supervisory Mechanism ECB Regulation and Proposed Single Supervisory Mechanism Amendment to the EBA Regulation, COM(2012) 511 final and COM(2012) 512 final, 12 September 2012. 217 Commission Communication, An EU framework for Crisis Management in the Financial Sector, COM(2010) 579 final, 20 October 2010; Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. 218 See proposed art. 80-83 of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. 219 See proposed art. 84- 89 of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. 220 See chapter 18, and FSB/FSF, Principles for cross-border cooperation on crisis management, 2009.

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Relevant Guidelines – CEBS/EBA, Guidelines for cooperation between consolidating supervisors and host supervisors (GL09), 25 January 2006 (Home host guidelines) – CEBS/EBA and CEIOPS/EIOPA, 10 Common principles for colleges of supervisors, 27 January 2009 – CEBS/EBA, Template for the multilateral cooperation and coordination agreement for the supervision of the XY group’, 27 January 2009 – CEBS/EBA and CEIOPS/EIOPA, Recommendations on the supplementary requirements of the financial conglomerates directive for supervisory colleges of financial conglomerates, 21 December 2010 – CEBS/EBA, Guidelines for the operational functioning of colleges (GL 34), 15 June 2010 – CEBS/EBA, Guidelines for the joint assessment of the elements covered by the supervisory review and evaluation process (SREP) and the joint decision regarding the capital adequacy of cross-border groups (GL39), 22 December 2010. – CEBS/EBA, CESR/ESMA, CEIOPS/EIOPA, Guidelines for the prudential assessment of acquisitions and increase of holdings in the financial sector required by directive 2007/44/EC, 11 July 2008

21.8 Cooperation with Third Countries Introduction The binding provisions in the CRD on cross-border cooperation in general or between supervisors of banks belonging to the same banking group only ‘bind’ the supervisors of member states. Such binding commitments equally only apply vis-à-vis supervisors from other member states. However, such cooperation, including some binding arrangements on such cooperation, can also be opportune for the activities of EU banking groups in third countries and the activities of third country banking groups in the EU, as well as for dealings between EU banks and third country banks in general. This is true for consolidated supervision, but also for the open markets for mutual bank funding and securities trading, with potential avenues of one banks problems affecting other banks, regardless of their location. The general outline and – absent a binding agreement or treaty – governing principles of such cooperation with third country authorities are the subject of work of the BCBS and supplementary work of the FSB. Some binding agreements exist between the EU and third countries that do affect banking supervision. The most important one of those is the agreement under which the EEA states become EU member states for all intents and purposes of the CRD, and the WTO work.

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Basel Concordat The BCBS was established in 1974 as a direct result of problems in cooperation/coordination of internationally operating banks221. The BCBS issued (and continuously updated) the so-called Basel concordat on cross-border cooperation between supervisors on crossborder operating banks and banking groups. Within the boundaries of the EU, such have been replaced by the binding set of rules of the CRD, which go beyond Basel especially on the obligatory trust in each other222 (which is not presumed on each supervisor of each third country in the Basel context); see chapter 21.7. The Basel concordat advised cooperation between supervisors on different entities within a group, with a focus on the cooperation between the supervisor of a bank and the supervisor of its branches or subsidiaries (or joint ventures). The concordat proposed a division of labour, and advised countries to supervise specific aspects of the local/global presence of the banks that were present in their banking system223. In addition to the concordat, the BCBS also gives specific guidance. In the context of the Basel II accord, the BCBS favoured ‘enhanced cooperation’ between supervisors for three reasons224: – to ensure effective implementation of the Basel capital accord on large cross-border operating banks; – to reduce implementation burdens on banks; – to conserve supervisory resources. These BCBS work are the standard for cooperation with third country supervisors, if and in as far as they are willing to commit to them and are allowed to under their local laws (e.g. on sharing supervisory information abroad, and on allowing local establishments to share information with their parents or subsidiaries). They are maintained by peer pressure and by the fact that key supervisors signed up to these standards (see chapter 3.3 and 21.7).

221 C.A.E. Goodhart, The Basel Committee on Banking Supervision, A History of the Early Years 1974-1977, Cambridge, 2011, chapter 2 and 4. 222 See e.g. Commission/Belgium, Court of Justice 10 September 1996, Case C-11/95. 223 Basel Concordat BS/75/44e of 26 September 1975, www.bis.org. The original Concordat has since been replaced in 1983 (BCBS Principles for the supervision of banks’ foreign establishments, May 1983), and since been added to continuously, e.g. importantly by the July 1992 Standards for the Supervision of International Banking Groups and their Cross-Border Establishment. It has also been added to by a range of papers on the recommended division of labour in home host situations for Basel II implementation and on the working of colleges; see for instance BCBS, Good practice principles on supervisory colleges, October 2010, which includes an annex on EU/non-EU cooperation A.F. Lowenfeld, International Economic Law, Second Edition, New York, 2008, chapter 23.2. 224 BCBS, International Convergence of Capital Measurement and Capital Standards: A Revised Framework, June 2006 page 3, the 2003 paper ‘High-level principles for the cross-border implementation of the new accord’, the 2006 paper ‘Home-host information sharing for effective Basel II implementation’, and e.g. BCBS, Principles for home host supervisory cooperation and allocation in the context of advanced measurement approaches (AMA), November 2007. Also see CEBS/EBA, Guidelines for cooperation between consolidating supervisors and host supervisors (GL09), 25 January 2006 (Home Host Guidelines).

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The BCBS focuses on home host cooperation within banking groups, on which it issued principles on supervisory colleges in 2010225. The exact format chosen by two or more countries for such cooperation can be laid down in written arrangements between supervisors, normally non-binding memorandums of understanding. Such MoU’s are, however, not necessary for cooperation and information exchange between supervisors, as long as the demands of for instance the secrecy obligation are fulfilled226. The cooperative arrangements can also be laid down in an agreement between a member state and a third country, or between the EU as a whole and one or more third countries. The EU has indicated that it wants its supervisors to be able to participate in colleges on banks with third country parents227. Equally important is the work of the FSB of cooperation with other authorities in times of stress228. The FSB has – in its non-binding reports and recommendations – stimulated further cooperation at the worldwide level on global systemically important financial institutions, of a similar type as mandatory within the EU; also see chapter 18.2. It recommends entering into arrangements that set out clearly the roles of the various public authorities in good and in bad times. It also favours making such arrangements gradually more binding, though it no doubt realises that that will be difficult in light of the sums of money involved and the continuing disparity between resolution regimes. For that purpose it also favours the development of similar resolution regimes, and continuous cooperation on peer reviewing those229. There may be factors that restrict full harmonisation and crossborder cooperation between the jurisdictions, as may competitive pressures in making certain financial systems more attractive and profitable230, at least in the short term. Agreements, Treaties, and the Status of EEA Member States Though the Basel concordat and other non-binding worldwide work govern the thinking on supervisory cooperation, there is also an option to agree in a binding format cooperation agreements with one or more third countries. Those agreements will likely be in line with the non-binding work, but has the added advantage of being certain, instead of voluntary. 225 BCBS, Good practice principles on supervisory colleges, October 2010. 226 Art. 46 and 131a CRD and CEBS/EBA, Methodology for the Assessment of the Equivalence of Third Country Professional Secrecy Standards with the Capital Requirements Directive for the Purposes of EEA colleges, 15 June 2010. 227 Recital 8 CRD II Directive 2009/111/EC. 228 FSB/FSF, Principles for cross-border cooperation on crisis management, 2009. 229 FSB, Reducing the Moral Hazard posed by Systemically Important Financial Institutions, FSB Recommendations and Time Lines, 20 October 2010. Also see FSB/FSF, Principles for Cross-Border Cooperation on Crisis Management, 2009, www.financialstabilityboard.org. 230 See L.A. Cunningham & D. Zaring, ‘The Three or Four Approaches to Financial Regulation: a Cautionary Analysis Against Exuberance in Crisis Response’, The George Washington Law Review, Vol. 78, 2009, p. 39; and chapter 5.5.

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The TFEU provides the basis for agreements with third countries on specific issues231. This feature can be used also in the area of banking supervision. In a superfluous feature, the CRD mentions that the Commission can use its right of initiative (under the TFEU) to propose starting negotiations with one or more third countries). If the Council agrees, negotiations are led by the Commission, with subsequent approval and consultation rights for Parliament and Council. As banking supervision is a majority voting issue, for any new agreements only a majority of the member states would need to vote in favour for the agreement to become binding in the EU. Additional powers to cooperate with third countries are mentioned in the EBA regulation (though it cannot bind the EU or member states to commitments vis-à-vis such third countries), and are open to member states individually as long as for instance conditions on secrecy are fulfilled232. Currently, the relevant agreements are: – the Agreement on the European economic area (the EEA Agreement233); – the WTO agreement between the European Communities and the individual member states and third countries that are members of the WTO. The bilateral agreements with Switzerland do not cover financial services, except in the area of direct insurance234. The EEA agreement is the most far reaching. It provides with regard to financial services that the EEA member states are deemed to be ‘member states’ as referred to in the financial services directives, including the CRD. Their banks profit from the EU passport when branching into the EU, and EU banks can use their EU passport to branch into their territories. Their supervisors are treated as EU member state supervisors in the context of the cooperation and information provisions of the CRD. For the purpose of this book, EEA countries are thus effectively not third countries. However, there is one exception, which relates to the decision making process. The EEA states do not have a vote in the legislative process nor do their supervisors have a vote in the level 3 Lamfalussy process at EBA, though they are recognised as observers during the deliberations on such legislation and 231 Art. 181a, 300 and 310 TFEU. Also see art. 39 RBD that overlaps with these TFEU provisions. 232 Art. 33 EBA Regulation 1093/2010, and art. 46 and 131a RBD. Also see CEBS/EBA, Methodology for the Assessment of the Equivalence of Third Country Professional Secrecy Standards with the Capital Requirements Directive for the Purposes of EEA Colleges, 15 June 2010. 233 The Agreement on the European Economic Area of 17 March 1993, as amended, between the European Community, the individual EU member states, on the one hand and currently Iceland, the principality of Liechtenstein and the Kingdom of Norway on the other hand. The agreement was negotiated and signed by the Swiss Confederation too, but it never entered into force with Switzerland as it was voted down in a Swiss referendum held on 6 December 1992. 234 Agreement between the EEC and the Swiss Confederation on Direct Insurance other than Life Insurance dated 27 July 1991.

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related documents, and can thus help debate on the drafts that are submitted to voting. See chapter 3.3-3.4 on the way the EEA banks and authorities are integrated. Under the WTO, third countries have gained some rights of access to the EU for their banks, and vice versa. The European Union (as allowed to under the TFEU) has been a WTO member since 1995 alongside the EU member states. In the area of financial services, the EU has a common interest, and thus a common negotiating stance. The results of the Uruguay round of negotiations and subsequent amendments include the General Agreement on Trade in Services (GATS) with specific protocols on financial services. Though also there is a focus on insurance, in the area of banking amongst others measures to open the financial markets are incorporated; see chapter 5.5. Some of these are binding commitments to prevent discriminatory rules or procedures, and are accompanied by a separate document setting out good intentions to endeavour to remove non-discriminatory obstacles235. Taken together, these commit WTO members to remove both discriminatory and non-discriminatory obstacles to or to limit any significant adverse effects of financial service suppliers based in another WTO member states to operate in its territory. Such obstacles can be in the form of supervisory actions in the context of licensing or in the context of ongoing supervision, and in a lack of recognition of the supervision by or cooperation with the third country supervisor. These issues are partly addressed in the GATS and in the schedule of commitments of each WTO member. The GATS, however, does make an explicit exemption if there are real prudential concerns. Under these rules, cooperation with WTO-third country supervisors need to be favourably approached, similar to the market access by their banks in the EU (and of EU banks in the third countries. On the banking side, there are no EU wide memorandums of understanding or models for such with third countries. Such memorandums of understanding and models do exist for insurance supervision236. Similar provisions can be expected in banking memorandums, including (non-enforceable) arrangements to request or volunteer information or assistance,

235 General Agreement on Tariffs and Trade 1994 or GATT 1994, of which Annex 1B contains the General Agreement on Trade in Services or GATS, as amended by subsequent protocols, and accompanied by the ‘Understanding on Commitments in Financial Services’ that provides some background and endeavours for the individual commitments of the WTO members in individual ‘schedules’ that are part of the GATS. 236 The members of CEIOPS jointly signed an MoU on 11 April 2006 with the Swiss insurance supervisors (individually signed by each ‘as a member of CEIOPS’). The text was published on the EIOPA website and several individual member state supervisors published the version with their signatures (e.g. Belgium and Estonia). In addition EIOPA and Finma signed an MoU on their specific cooperation on 21 September 2012; also published on the EIOPA website. The USA National Association of Insurance Commissioners and CEIOPS also jointly developed a model for an MoU between a state insurance supervisor in the USA and a member state insurance supervisor in the EU (http://www.naic.org/Releases/2006_docs/european_mou.htm and the text was published e.g. on http://www.knf.gov.pl/Images/MoU_EU-US_(model)_20060322_tcm201965.pdf).

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which will in principle be granted unless they are overly burdensome or go against national interests237. Cooperation on the Same Group In the banking sector, there are thus no binding commitments to include third country supervisors into the colleges of supervisors, though there are commitments to avoid where possible regulatory or practical barriers to third country banks. There is nonetheless a clear interest to cooperate, as many EU groups have significant operations in third countries, and vice versa. Following the 2007-2013 subprime crisis, the necessity of cross-border cooperation with third country supervisors has been made even clearer, e.g. by the problems on potential rescue scenarios and bankruptcy information on Lehman Brothers between the USA and UK authorities. The EU legislation also does not prohibit the inclusion of third country supervisors in the college. One of the new tasks of a consolidating supervisor is to ensure ‘appropriate coordination and cooperation with relevant third country supervisors where appropriate’238. The appropriate/relevant/appropriate terminology shows a reluctance by the negotiators of the text to introduce an obligation to cooperate as the legal systems elsewhere may be unknown or changing, but equally allows key supervisory cooperation and information exchange239. Arrangements would need to be made to protect the secrecy of information obtained from the bank or other supervisors, and other EU laws such as data protection. The text is flexible on how to cooperate and coordinate, and opens the possibility that third country supervisors can join the college and access the information obtained240. That would increase trust. The third country link up could be clearer, however. There is no obligation – and this can be regretted – to ensure that the cooperation and coordination is fully reciprocal. If obligations to share information are undertaken between EU member states, this is in line with the obligation to take an EU point of view in all circumstances (though this is not backed up by common funding, and thus may be hampered by pragmatism; see chapter 21.7 and 21.9). Unless both the third country and the EU supervisors agree to act in the interest of all stakeholders of the bank irrespective of the nationality of such stakeholders, such cooperation and coordination has value mainly in normal times, not in crisis times (even leaving

237 BCBS, Report and Recommendations of the Cross-Border Bank Resolution Group, March 2010, page 16 and 34-35. 238 Art. 131a RBD, as introduced by the CRD II Directive 2009/111/EC. CEBS/EBA, Template for the Multilateral Cooperation and Coordination Agreement for the Supervision of the XY Group, 27 January 2009. 239 See, for instance, art. 46 and 70.3 RBD. 240 See both the first subparagraph of art. 131a.1, and the sixth subparagraph of art. 131a.2 RBD.

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aside the fiscal pressures if sharing the information might impact on who bears the burden of a bailout). This is in line with the WTO-exemption that limits access if there are real prudential concerns, but nevertheless the flow of information and cooperation may result in a better situation for both countries, avoiding ultimate crisis measures. Of the third countries, Switzerland and USA are generally deemed most important for the EU. There are substantial cross-border banking groups operating from these two countries in the EU and vice versa. They have thus e.g. been the focus of equivalence assessments by EBC and EFCC on equivalence of consolidated supervision (releasing Swiss and USA groups from some aspects of supplementary sub-consolidated supervision within the EU; see chapter 17.5. The cooperation between supervisors of various legal entities in the group gains an added dimension if the group (possibly systemic as a whole) contains systemically relevant legal entities in many jurisdictions; see chapter 18.2. The supervisors on those entities will want a role in ongoing supervision on a higher intensity than if the local entity is not (locally) systemically relevant. In good times, the host supervisor of such an entity may pressure the local entity not to enter into intra-group guarantees, and to ensure that it can continue to function in a well-financed manner even if the parent (or even all other entities in the group) are failing241. General Cross-Border Cooperation Apart from treaty based cooperation, and cooperation in the context of e.g. the BCBS and BIS, relations are generally good with a wide range of third countries. Bilateral memorandums of understandings are often in place, or specific arrangements have been made when e.g. EU banking groups expanded into the territory of third countries, by opening branches, providing cross-border services, or having joint ventures or subsidiaries. The type of information needed will include information necessary to asses cross-border links, such as those necessary for the assessment of who is systemically relevant at a regional or global scale, or for the fulfilment of licensing requirements (e.g. on close links) and for consolidated supervision or the assessment of exposures to third country entities242. Also see chapter 17, 18.2 and 18.3. 241 See e.g. FSB, Reducing the Moral Hazard posed by Systemically Important Financial Institutions, FSB Recommendations and Time Lines, 20 October 2010, page 5. 242 See for instance the assessment of third country entities that are related to a bank in chapter 5 and the assessment of systemic institutions in chapter 18.2. Banks will also have exposures to third country banks and collective investment undertakings, which will need to be correctly categorized under credit risk and market risk calculations; see for instance Annex VI part 1 §5, 11 and 17 RBD, and art. 19 RCAD and Annex 1 §52 RCAD. See chapter 18.1, and e.g. IMF, BIS, FSB, Report to G20 Finance Minister and Governors,

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Literature – Lowenfeld, Andreas F., International Economic Law, 2nd ed., Oxford University Press, New York, 2008, chapter 6 and 23.2 Guidelines – CEBS/EBA, Methodology for the assessment of the equivalence of third country professional secrecy standards with the capital requirements directive for the purposes of EEA colleges, 15 June 2010 – CEBS/EBA, Template for the multilateral cooperation and coordination agreement for the supervision of the XY group’, 27 January 2009 – BCBS, Principles for the supervision of banks’ foreign establishments, May 1983 (Basel concordat) – BCBS, Standards for the supervision of international banking groups and their crossborder establishment, July 1992 – BCBS, High-level principles for the cross-border implementation of the new accord, 2003 – BCBS, Home-host information sharing for effective Basel II implementation, 2006 – BCBS, Principles for home host supervisory cooperation and allocation in the context of advanced measurement approaches (AMA), November 2007 – BCBS, report and recommendations of the cross-border bank resolution group, March 2010 – BCBS, Good practice principles on supervisory colleges, October 2010 – FSB/FSF, Principles for cross-border cooperation on crisis management, 2009

21.9 Funding Introduction Supervision is expensive. Conservative, experienced, self-confident and knowledgeable supervision is even more expensive243. Expenses are borne both by society and by the supervised entities in direct and indirect manners. Indirect costs relate to brakes on innovation or rapid growth, opportunity costs due to safety measures, and expenses to comply with prudential requirements of banks and their clients. These costs are de facto borne by those affected, and indirectly by the government due to lower tax income in an economic

Guidance to Assess the Systemic Importance of Financial Institutions, Markets and Instruments: Initial Considerations – Background Paper, October 2009, page 28. 243 J. Viñals & J. Fiechter, The Making of Good Supervision: Learning to Say ‘No’, 2010, IMF SPN/10/08. Also see E. Ribakova, Liberalization, Prudential Supervision, and Capital Requirements: the Policy Trade-offs, IMF WP/05/136.

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boom. Direct costs include the costs of intervention via compensation funds, lender of last resort and state aid, and actual funding costs at the supervisor. These are either borne by public authorities (indirectly by general tax income) or by taxes on specific groups within society (such as levies on banks, or clients of banks or levied on financial transactions), depending on the choices made by legislators. Of these costs, the funding of the personnel, training, travel and facilities of the supervisor is likely relatively low compared to the potential (but unpredictable) costs borne by funds and public authorities in a crisis management contexts. Most of these unpredictable costs can be recuperated from the estate of a failed bank upon its liquidation (or when the shares of a bailed out bank are floated again) but this depends on whether the supervisor had the skill set and resources needed to ensure that the bank is failed when there is still enough solvency to cover unexpected losses; see chapter 18.3. The funding-issue can be distinguished into three separate categories: – funding of the functioning of the supervisor, including funding of the line side work of supervisors and funding of the policy work of the supervisors (technical advice on supervisory laws, drafting supervisory guidance, harmonisation work, and other work for the common good (e.g. sitting on a review panel or mediation panel); – funding of the deposit guarantee system; see chapter 18.5; – funding of emergency support, both liquidity support (generally a central bank task in its monetary authority capacity), and solvency support (generally a state task, subject to the rules on state aid); see chapter 18.4. A separate category is the issue of hidden costs, including the outsourcing of supervision to mandatory internal control functions. Arguably, the costs suffered by market participants in a crisis and the loss of business opportunities of banks and their clients in good times as a result of prudential or conduct of business restrictions are also hidden costs. Funding of the Supervisory Authority If the range of products offered by banks grows, if their complexity grows, if the size of banks or financial markets grows, supervisory spending has to grow too. Individual supervisors will need skills, time and an independent and authoritative mind-set that allows them to challenge and say no, to fulfil the task of not only looking at the letter of the law, but also assessing as an additional conservative non-executive civic minded board member whether the developments are good for the bank, for the banking system, and play its role in determining whether it is good for society/the economy244. This does not come cheaply, 244 Some of its intervention instruments are based on compliance of the bank with the law; see chapter 20. The triggers include, however, heading off non-compliance, the assessment of all risks the bank is facing (chapter

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and both the supervisory authority that employs and trains such individuals and the other public authorities involved in ongoing supervision and crisis management need to foster this in their own and each other’s employees and board members. Such skills have to be trained and kept up, and are popular in the private sector too (though in some undertakings probably without the conservative mind-set). The level of salaries will need to be high enough to retain them, or at least to retain the supervisors that have a public sector mindset rather than a commercial mind-set. This leads to another problem, which is that public sector deference to authority can be hard to shake when talking to the banks. This applies both to individual supervisors and to the supervisory authority. When supervisors earn a factor two to ten less than their counterparties at the bank, and the bank has a balance sheet size that dwarfs the supervisory budget and sometimes dwarfs the government budget, the relation can be giant/minion unless the supervisor has independent minded people on board that are willing and stimulated to say no to power if they have well substantiated concerns. To have that mind-set, or retain it, it is also necessary to have the knowledge and the number of people to be able to have a level playing field in any discussion with the bank. Which leads to the question how much funding this will need, and who should pay for this. The CRD does not deal with the funding of the supervision and related actions it bestows upon supervisors, and in this respect does not comply with the Basel core principles245. It instead contains an unfunded mandate to install banking supervision and finance it in the manner the member state sees fit, as long as it is ‘appropriate’; see chapter 21.2. The CRD IV project only adds that the supervisor should be given the ‘expertise, resources, operational capacity, powers and independence necessary’ to do its work under the CRD IV directive and the CRR, without specifying what the benchmark is246. This is in line with the view that the directives provides the harmonisation necessary for member states to allow each other’s banks access to their domestic market, as well as with the accent on supervisory responsibility for the bank it has licensed (with some limited add-ons bestowing responsibility for coordination and cooperation upon mostly the consolidating and sub-consolidating supervisor for the subsidiaries of the bank. However, with the increase in the tasks and responsibilities of the consolidating supervisor, the increase in the relative size and importance of both cross-border branches and cross-border subsidiaries, and additional powers allocated on a solo basis, funding deserves more attention. 14 and 20), and some of its non-intervention instruments are not strictly bound to investigating a current non-compliance, such as its investigative instruments, stress testing, and analyzing and warning on financial stability threats; see chapter 13.6, 18, 20, 21.2, 21.4 and 22. 245 According to BCBS, Core Principles for Effective Banking Supervision, September 2012, the independence and autonomy of the supervisor can only be assured if it has the type of funding that is consonant with its tasks (page 23). 246 Art. 4 CRD IV Directive.

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By introducing the EU level and domestic public authorities needed to perform supervision or crisis intervention, there is an implicit obligation to make sure they can function, e.g. at least to fund some operations, and in case of deposit guarantee funds to have arrangements in place that allow them to pay out the minimum amount guaranteed. There is little or no detail, however, on how to ensure that these have the right size, the right skill sets and the right flexibility to deal both with emergency events and the lengthy periods in between247. Equally, the current CRD does not deal with the sources of the funding at all, and the CRD IV directive does not specify how the necessary resources to pay for supervision should be gathered248. The deposit guarantee directive recitals at least contain a recommendation that ‘in principal’ the costs of the fund should be borne by the participating banks, if and in as far as that funding by the banks does not itself harm financial stability249. The proposals of the Commission on deposit compensation and on recovery and resolution do include binding cost-allocation to the banking sector, see the future developments sketched below, and EBA is funded in part by the EU and in part by national supervisors. Emergency liquidity support is conditional on collateral being available, and the name of ‘state aid’ implies the source of funding; see chapter 18. The lack of detail on funding and its sources has caused problems in various member states where supervisory authorities were – intentionally or not – underfunded or not able to attract sufficiently experienced personnel, train them, let them travel or use sophisticated resources250. Equally, a duty to assess the suitability of a new executive manager is an empty gesture if the supervisor can only – or does only – allocate two hours of a junior supervisor to such an assessment, including reading the file, perhaps phone one referee provided by the candidate and writing a report to be rubberstamped internally, instead of allowing/funding interviews similar to hiring a new employee, independent background checks, going beyond the sources/references provided by the bank or the candidate to e.g. former coworkers and employees, and perhaps setting case-study type exams to the candidates251.

247 Which is a worldwide problem. FSB, Intensity and Effectiveness of SIFI Supervision, Recommendations for Enhanced Supervision, 2 November 2010; FSB, Intensity and Effectiveness of SIFI Supervision, Recommendations for Enhanced Supervision, 2 November 2010, page 5-6. 248 Art. 4.4 CRD IV Directive. 249 Third to last recital of the Deposit Guarantee Directive 1994/19/EC. 250 BCBS, Core Principles Methodology, October 2006, page 7 and 8, as since copied into the updated BCBS, Core Principles for Effective Banking Supervision, September 2012, page 23. 251 See for the very different practices in member states page 181-182 of Commission, impact assessment accompanying the proposal for a directive as part of CRD IV, COM(2011) 952 final, 20 July 2011.

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Underfunding of supervision and of crisis management funds also can lead to problems in member states where the banking system is or was relatively large compared to the domestic economy, overwhelming even relatively prudent member state finances252. The lack of funding arrangements, burden sharing and crisis management system have resulted in an antiquated bankruptcy regime and in incentives to not cooperate and share information in crisis times253. If light touch or no touch supervision due to lack of funding or stature leads to bank failures, in a single market/global market this has an impact on other jurisdictions. Any gradual harmonisation of funding issues that has taken place was not lead by the EU but by individual member states revisiting their financial laws. Even in the run-up to the 2007-2013 subprime crisis, funding of supervision and of deposit guarantees was almost universally paid by the banking sector itself, skills have been shared in the various policy cooperative efforts, and attention has been paid to the differences in the budgets of supervisory authorities at the national level (mostly in those countries where a reduction of headcount and budgets was sought). As a result of the 2007-2013 subprime crisis, light touch countries have increased their relatively small budget allocated to prudential supervision (e.g. in the UK), ex ante funding of deposit guarantee funds has gained popularity (e.g. in the Netherlands) and there are discussions about bank levies to fund future state aid. This is in tune with an increased awareness that a supervisor that does not have the resources to supervise is more of an advertising tool for safety than a deliverer of safety. This was followed by a high level but non-binding recital in the CRD II directive254. As part of the first set of quick fix rules, the EU now explicitly refers in the non-binding recitals that member states should ensure that domestic supervisors are set up in a way that they can perform all their tasks under the CRD. This includes domestic tasks on local banks, cross-border supervision tasks on cross-border banks, but also the tasks on policy preparation, information exchange and cooperation as set out in this and other chapters. Supervision has to be effective and efficient, and that includes a supervisory authority that is equipped to supervise and enforce the obligations on banks, and cooperate in the single market with others with similar or compatible tasks. The focus is both on quantity (of personnel and resources) and quality (each employee should have the knowledge and experience for the duties assigned). A supervisory authority is helpless if its directors and the employees assigned to models, fit and proper assessments and other tasks in line side 252 As was the case in Ireland and Spain. Also compare F.S. Mishkin, The Economics of Money, Banking, and Financial Markets, 8th ed., Pearson Adisson Wesley, Boston, 2006, chapter 11, on the underfunding of the relevant supervisor that was one of the causes of the savings and loan crisis in the USA. 253 See e.g. BCBS, Report and Recommendations of the Cross-Border Bank Resolution Group, March 2010. 254 Recital 28 CRD II 2009/111/EC.

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supervision do not have the time, knowledge and experience to properly assess whether the bank is in danger, or otherwise non-compliant in a manner commensurate to the complexity of the financial market, issues and the bank(s) supervised. The above-mentioned CRD IV project provision will make the necessary funding a binding obligation on the member state from the start of 2014, upgrading it from the recitals where it can be ignored, though as said without specifying a benchmark nor the source of funding. Member states as a result have and will retain high flexibility in determining the resources needed and the way such resources are allocated to the authorities involved. In part, this can be explained by the flexibility needed to set up their own supervisory bodies within their own governmental framework, and in part by the pre-existing differences in salary levels, perceptions of the safety needed, and relative importance of the financial sectors in the member states (both to provide various financial services and as employers and lobbyists). EBA is the only banking supervisory body that receives partial funding from the EU budget, in addition to obligatory contributions from national supervisory authorities255. According to the recitals of the regulation, this will guarantee its full autonomy and independence. As the board of supervisors consists of the national supervisory authorities, this is not entirely true, but as long as the national members find EBA important and the budget has to be externally defended and validated, EBA is likely to be funded. It has to budget in its revenue and its expenditures. A balance has to be struck between the subsidy from the EU budget, the contributions from national budgets, and any other fees may receive under future EU laws. The proposal is transmitted to the Commission, that pencils in its preferences into the budget of the EU. The budget and the subsidy are subsequently decided upon by Council and Parliament. There are procedures to accommodate new developments during the year, as well as the management of the budget and anti-fraud measures. For the initial period, it was foreseen that EBA would be financed for 40% from the EU budget and for sixty per cent through contributions from the members/member states; divided between them under voting weights256. This system is somewhat unfair on countries with large populations that have a limited financial system, as the voting weight does not reflect the size of the banking system but factors such as the number of citizens. If and when the tasks of EBA are expanded, that will also impact on (the EU subsidy to) its budget. E.g. for the recovery and resolution directive proposals, the Commission esti255 Recital 59 and art. 62-66 EBA Regulation 1093/2010. There is no specification as to the sources of the funding to be provided by national supervisors, so those can come from central bank funds, from levies on the banking or financial sector, or from general tax income, see below. 256 Recital 68 EBA Regulation 1093/2010.

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mates that for initial setting-up in 2014 and 2015 11 temporary employees are necessary, in addition to 5 permanent staff257. The CRD IV directive and CRR recitals invite a reassessment of the EBA budget to reflect the additional tasks given, according to the CRR recital ‘without delay’258. Sources of Income The sources of funding include, but are not limited to, the fines levied on transgressors, fees for specific licenses or approvals, profitable other activities of the legal entity of which the supervisor is part (e.g. the central bank profits on financial market interventions and from the issuance of banknotes), specific taxes on society at large, on customers of financial services or on financial institutions, or from general tax income of the state, or combinations of these. The Court of Justice has for example ruled that a member state is free to impose direct taxes on financial firms based on distributing the operating costs of a supervisor, by levying an annual duty depending on the gross profits made by the financial firm259. Such general levies are considered a tax, which designation might also apply to any contribution to e.g. deposit guarantee funds or future resolution funds if participation and payment are mandatory. Whether a member state can impose a fee or other tax on specific financial services was not ruled on by the Court in that judgement, as the funding system in that case did not qualify as an indirect tax, but it is likely that it would be permitted under the terms of the indirect taxes on capital raising directive. The qualification as a tax of the levy systems based on revenue of the financial firm gives extensive freedom to the member states to set it up in the way it deems fit, as the TEU and tax directives have a very limited impact on tax issues (e.g. the savings tax directive and the tax cooperation directives were introduced via a procedure that required unanimity in the Council260). However, the treaty freedoms do limit the scope of direct and indirect taxes to ensure non-discrimination of foreign nationals from other member states when they are in comparable circumstances as domestic competitors261. The ECB has opined that the funding by a national central bank of the national supervisor that is part of it, or of its contribution to the funding of the new European supervisory 257 Page 18-19 and 155-171 Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. 258 Recital 8 CRD IV Directive and recital 28 CRR. 259 Optiver/Stichting Autoriteit Financiële Markten, Court of Justice 10 March 2005, Case C-22/03, in which Optiver challenged the levy with a call to the Indirect Taxes On Capital Raising Directive 69/335/EEC. 260 Art. 113 and 115 TFEU. Savings Tax Directive 2003/89/EC and Tax Cooperation Directive 2011/16/EU. 261 See e.g. Fokus Bank/Norwegian State, EFTA Court 23 November 2004, Case E-1/04, and Finanzamt KölnAltstadt/Schumacker, Court of Justice 14 February 1995, Case C-279/93.

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authorities, is in line with the treaty. The TFEU contains a prohibition of monetary funding of EU or national bodies via overdrafts or credits, but that does not appear to cover such ‘internal’ financing that is not credit but payment262. Hidden Costs The more indirect costs of supervision including designing regulation, of developing crossborder policy and practical cooperation, of the deposit guarantee fund employees and deposit guarantee pay-outs, state aid and any civil liability of public authorities, of compliance by the banks and compliance by the clients (e.g. by reading laws and information sheets, collecting and providing information to their bank) are equally a factor when setting up prudential supervision as are the direct costs of the supervisory authority. The costs borne by the supervisor are part of its budget and annual accounts, but are only part of the picture. Almost none of the costs are directly and clearly allocated to the ultimate beneficiaries, the banks depositors, other counterparties and taxpayers/voters and other members of the local and foreign public. This has the unfortunate consequence that for individual depositors, counterparties and other ultimate beneficiaries, the costs of supervision on a bank they do business with seem close to zero. Ultimately, the costs are borne by the taxpayers in general, and by the depositors and shareholders of banks (via lower interest rates and lower values/dividends, and for expenditure from the public wallet). Without an overview of actual costs (instead of the often artificially low time and wage/fees allocation in cost/benefit calculations), there is, however, no true image of the costs to be weighed against the goals of supervision. This may lead both to a too large demand from voters in crisis times, and a too large supply from risk-averse regulators in all times263. An important part of the funding of supervision – in addition to any fees levied – concerns the unfunded mandate given to the bank to set itself up in a manner that it is in control of its business and that allows it to give information to the supervisor, both in a standardised format and ad hoc. The bank is itself primarily responsible for being well managed and to ensure its continued viability as a commercial company. Supervision is supplementary to this, and the reduction of the administrative costs of supervision and the costs that have to be borne by the banks or by the other taxpayers has been a key consideration in setting up supervisory procedures, cooperation and lay-out of supervisory authorities. To reduce costs, and reduce government spread, the majority of supervision is thus outsourced to the bank itself. Within the bank, primary responsibility rests with the executives, with 262 Art. 123 TFEU. See ECB Opinion of 8 January 2010 on the establishment of the European supervisory authorities, CON/2010/5. 263 See e.g. D.T. Llewellyn, Institutional Structure of Financial Regulation and Supervision: The Basic Issues, paper presented at World Bank Seminar ‘Aligning Supervisory Structures With Country Needs’, Washington 6/7 June 2006, page 5.

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secondary oversight responsibilities allocated to the non-executives and the external auditor, who all in turn rely on risk control functions and on the correct application of presumably well thought out procedures by all its middle managers and other employees, both on a consolidated and a solo basis. The role of the – often relatively small – supervisory authority is supplementary to these, and is delivered mainly in interaction with the board (executives and, when necessary, non-executives and the external auditor) and the various risk controllers within the organisation. The number of persons involved with internal and external supervising a bank is – in line with that allocation of responsibility – mostly employed directly by the bank. The public authority generally employs a small fraction of the total number compared to the number of persons working as compliance, controllers, non-executives or auditors or similar internal supervision functions for the bank. For example, for a small bank a part of the time of very few supervisory authority-employees, or up to e.g. 20 persons for the solo and consolidated supervision of a bank-holding that controls systemic services in multiple jurisdictions around the world (though depending on local importance supervisors responsible for individual entities in the group will add to the number of employees working on external supervision of a banking group). Future Developments The costs of supervisory tasks are growing, and are likely to grow in the future. In addition to the travel costs and coordination costs supervisors have for the colleges and for the ever increasing EBA and BCBS work, the work to be done by supervisors now also is being modernised to include IT systems for information transfer, for supervisory disclosure and for information reception for the banks. Light touch regimes are being abandoned and downsizing plans are being abandoned, reflecting national priorities on better and especially more supervision264. Future plans that will force member states to set up new resolution authorities and force public authorities to assess living wills, group support structures, restructurings and risks, and draft resolution plans and attend additional colleges (plus preparation, plus information exchange, plus information assessment by experts). Such obligations will increase the size of staff at supervisory authorities and their travel and support budgets265. A mooted ‘resolution fund’ – to be established in addition to deposit guarantee funds might ease some of the unfunded budgetary requirements266. None of this is funded at the EU level, except for some limited support from the EU budget to EBA; see above. At the same time, this brings with it the inflexibility of the EU bureaucracy directly into the supervisory authorities. In the CRD IV project, it is acknowledged that the tasks 264 See e.g. UK FSA, The Turner Review, March 2009. 265 Commission Working Document (for consultation and discussion), Technical Details of a Possible EU Framework for Bank Recovery and Resolution, 6 January 2011. 266 EU Commission Communication, An EU Framework for Crisis Management in the Financial Sector, COM(2010) 579 final, 20 October 2010.

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given to EBA are increasing, and Council, Parliament and Commission are invited to ensure ‘adequate’ human and financial resources to be made available267. Even more importantly, the member states are ordered to ensure that the supervisor has the resources (‘expertise, resources, operational capacity, powers and independence’) to carry out all supervisory work under the CRD IV project; filling in the member state obligation to implement directives in a ‘effective, proportionate and dissuasive’ manner268. Some member states are negotiating controversial proposals on a financial transaction tax. As this is linked to specific transactions, it is further discussed in chapter 22.4. This proposed tax does not appear well suited to taxing banks, more likely the costs will be borne by their clients, and the proceeds are not necessarily reserved explicitly for the funding of supervision or resolution. The IMF has studied some alternatives to such a tax, with the aim to recoup net or gross costs of banking bailouts, or establish forward looking tax or fee structures269. EBA has been given the task to improve recovery and resolution planning, with specific focus on fair burden sharing270. Whether true burden sharing for lender of last resort functions and state aid will surface is to be doubted, though proposals are surfacing, e.g. in BCBS work and in the proposals of the Commission on recovery and resolution271. Part of the banking union is not only a single supervisory mechanism with hopefully a single funding system (see below), but also the centralisation of crisis management functions and burden sharing on its funding. For domestic banks, the burden is undoubtedly with the national public authorities to fund any support given to the bank or its clients. For international situations, such support could be given by the national public authorities, but they may be unwilling to go beyond the levels of e.g. the deposit guarantee directive for ‘foreign’ creditors at branches or subsidiaries in other member states, let alone in third countries. If state aid is likely to be recouped, this may still be done; but if it is a true large scale rescue of an inherently sick bank, cross-border funding may be needed simultaneously. During a crisis, such cooperation is often not the best feature of states, but they are equally unlikely to bind themselves ex ante to funding such a rescue if ‘their’ local public authorities have no real say in day to day supervision and intervention. Several ideas have been floated for such burden sharing, but no consensus is evident at the EU level, though burden

267 Recital 8 CRD IV Directive and recital 28 CRR. 268 Art. 4.4 CRD IV Directive. See chapter 20.1. 269 IMF, a Fair and Substantial Contribution by the Financial Sector: Final Report for the G20, June 2010. Also see R.J. Theissen, Are EU Banks Safe?, The Hague, 2013, chapter 3.4. 270 Art. 25-27 EBA Regulation 1093/2010. Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012. 271 BCBS, Report and Recommendations of the Cross-Border Bank Resolution Group, March 2010.

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sharing is part of Commission proposals on resolution at the Eurozone level272. The EBA regulation on the contrary keeps fiscal contributions firmly nationalistic, and until recently this appeared unlikely to change in the short term; see chapter 18.4 and 21.4. The problems of several sovereign member states – whose fortunes have been interlinked with past mistakes or with a too large banking sector for them to credibly uphold – is pushing member states of the Eurozone and/or the EU into a banking union. For the funding structures proposed on future versions of the deposit guarantee funds and potential resolution funds; see chapter 18.5. The proposals of the Commission for a single supervisory mechanism would lift the funding of the prudential supervisor to the EU level, or at least to the Eurozone level273. Pending agreement on the related funding of common deposit insurance and resolution funding – including state aid – those costs would remain national for the time being. However, a role for the ESM is also being considered by the Eurozone governments; see chapter 18.4. Though the Commission proposals for the regulation presupposes that the ECB would delegate many tasks to be executed by the former prudential supervisors at the national level, it also presupposes that those will shrink, and thus require less contributions from the domestic banking system. It introduces a levy on all banks within the proposed remit of the ECB, irrespective of whether those banks would also be subject to a national levy, or whether that would shrink. The proposed regulation appears to indicate that the costs of the ECB for prudential supervision would largely, but not in full be borne by the banks. It does not distinguish between policy development costs (e.g. participating in the rulemaking process at EBA, and coordinating policy positions with the Eurozone member states representatives in EBA), application costs, IT costs etcetera. Part of the costs may be funded from pecuniary sanctions and penalties. Another part of the costs may be borne by the ECB itself, likely reducing profits the ECB would otherwise distribute to the ESCB central banks, its shareholders274.

272 C. Goodhart & D. Schoenmaker, Burden Sharing in a Banking Crisis in Europe, LSE Financial Markets Group Special Paper 164, March 2006; R.J. Theissen & A. Houmann, Funding is Key, 2009, www.thebanker.com; E. Avgoleas, C. Goodhart, & D. Schoenmaker, Living Wills as a Catalyst For Action, DSF Policy Paper 4 May 2010. 273 Commission, Proposed Single Supervisory Mechanism ECB Regulation and Proposed Single Supervisory Mechanism Amendment to the EBA Regulation, COM(2012) 511 final and COM(2012) 512 final, 12 September 2012. It is not clear yet whether the costs of the national banking supervisors in Eurozone countries will decline, potentially leading to double levies. 274 See e.g. recital 27, 28, 39, art. 22, 23 and 24 proposed ECB Regulation COM(2012) 511 final, 12 September 2012.

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21.10 Civil Liability Introduction The treaties and the case law of the Court of Justice provide protection for individuals against non-compliance with EU legislation by EU institutions, member states, and (sometimes) other citizens. The right of anyone to invoke the direct effect of many treaty, regulation and directive provisions is one part of this protection as described in chapter 3.5. A second layer is provided by civil liability of the entity responsible for losses and damages resulting from failures to fulfil EU obligations. Both are important elements of the accountability of those entrusted with specific tasks and obligations. On the other hand, the Basel core principles (see chapter 21.1) indicate that there should be legal protection for supervisors. This is one of the few aspects that have not been taken on board in the CRD, at least not in an unrestricted fashion. There are five categories of persons who might theoretically be liable for failures in relation to banking related EU legislation, specifically in the context of prudential supervision under the CRD, in in addition to civil law personal liability of the bank and/or some of its officers or agents towards creditors or shareholders for breach of civil law undertakings or for tort (which help alleviate some aspects of agent-principal problems275). These are: 1. liability of a bank, or personal liability of its officers or its accountants towards the counterparties of the bank, based not on contractual obligations (or tort), but on not fulfilling obligations under prudential legislation or under the related treaty provisions; 2. personal liability of board members of the bank and its accountants and other third parties towards the bank, if they give information to or cooperate with supervisors, leading to e.g. the bank being forced to close or to be subjected to fines or restrictions; 3. liability of the supervisory authority and/or the member state276; 4. personal liability of the individual persons who work at the supervisory authority or other public authority that are involved in or have functional responsibility; 5. liability of EBA, the Commission and other EU bodies for their role in banking supervision277.

275 Compare art. 51 Council Regulation on the Statute for a European Company (SE) 2157/2001. K. Alexander, ‘Corporate Governance and Banks: the Role of Regulation in Reducing the Principal-Agent Problem’, Journal of Banking Regulation, Vol. 7, No. 1-2, 2006, page 17-40; L. Bebchuk & J. Fried, Pay Without Performance, the Unfulfilled Promise of Executive Compensation, Cambridge, 2004. 276 D. Chalmers, C. Hadjiemmanuil, G. Monti & A. Tomkins, European Union Law, Cambridge, 2006, chapter 9; L. Dragomir, European Prudential Banking Regulation and Supervision, the Legal Dimension, 2010, chapter 12. Haim II, Court of Justice 4 July 2000, Case C-424/97 §25-34. 277 D. Chalmers, C. Hadjiemmanuil, G. Monti & A. Tomkins, European Union Law, Cambridge, 2006, chapter 10.

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The liability of public sector authorities including the supervisory authority and/or the member state, EBA or their employees can be subdivided in several subcategories: – towards the supervised bank or its officers if it prevents the bank to pursue its business in the way it deems fit, or takes decisions which damage individual interests of the bank or its officers, or does not offer the protection the treaties or other EU legislation contain for banks; – towards counterparties (including e.g. depositors or shareholders) of the bank if the bank fails in spite of being under prudential supervision, or if they did not offer the protection the treaties or other EU legislation contain for the counterparties of banks; – towards risk bearing investors (e.g. shareholders and subordinated debtors278) for a reduction in the value of their investment due to supervisory intervention (or nonintervention) towards the bank, or if they did not offer the protection the treaties or other EU legislation contain for risk bearing investors; – towards other member states and their supervisors, for failure to fulfil the duties under the CRD towards each other, by not performing a duty or not implementing the protection the treaties or other EU legislation provide to other member states or to their public institutions; – liability of the member state towards the EU for failures by it and by governmental bodies (e.g. supervisors) to implement EU legislation, though this is, however, not put in the form of a civil liability, but one of public law prosecution and subsequent fines, see chapter 3.5 and 20.1. In the relation between clients and their bank, liability may be the result of the contract or contract law (for instance many public law conduct of business duties towards customers define the minimum-level of contractual obligations under the contract between the bank and its clients, or are part of civil law requirements on any contract with the bank; depending on how the member state fulfilled its obligation to implement some direct effect provisions; see chapter 3.5). The focus of this chapter is, however, on non-contractual civil liability that impacts on issues relevant for the good implementation of the CRD. Under non-contractual liabilities a person or institution can be liable to make reparations to someone who has suffered losses or damages, in spite of there being no clear civil law contractual obligation between the two to pay such compensation. Such non-contractual liability can be introduced for various reasons, such as misconduct resulting in damages, intent to cause another entity damages, or even where a bank or authority makes legitimate choices that, however, unevenly distribute the burden thereof on specific people. A legis-

278 Or senior unsecured creditors if they do not benefit from the same protection or place in the pay-out queue in a liquidation as agreed in the Council deliberations on the recovery and resolution Commission proposals; see chapter 18.3.

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lator or court may introduce non-contractual liability e.g. where the end result is not fair, or where incentives are needed to ensure appropriate conduct. In principle, such liability is left to the member states279. However, the treaties contain a liability regime for the EU institutions, and provided minimum requirements as to the liability regime that has to be in place on various of the other categories mentioned. For the EU institutions, the EU treaties contain a regime on the liability for failures to act or for acting wrongly. The member states have no such general regime. In principle member states can have their own laws and case law on liability. Several possibilities can be chosen by the member states: – liability (or not) for abuse of its powers; – liability (or not) for the lack of action by a supervisor when it was obliged to act; – liability (or not) for a correct use of its powers which led to damages of a stakeholder that should not come for its account; – general liability (or not) if a bank fails; – non-liability or caps on liability of the supervisory authority. However, if the damages are a result of non-compliance with EU rules, it cannot evade liability if the conditions as defined by the Court of Justice are fulfilled (see below), and its courts will need to grant protection in line with the EU rule or grant damages to compensate the party that was supposed to be protected. The EBA dispute settlement regime and its powers to investigate breaches of union law can add substance to any complaints of for example the authorities of one member state regarding non-compliance by another member state or its institutions280. Both EBA and any authority that wants another authority to fulfil its obligations under college-arrangements can act. If the consolidating supervisor fails to carry out its tasks, or one of the other supervisors fails to carry out its tasks, the complaining supervisor can activate the EBA dispute settlement system. EBA can also act at its own initiative or at the request of the Parliament, any supervisor, the Council, the Commission, the banking stakeholder group, to investigate a breach of union law. Should a formal opinion be issued, anyone who has suffered damages from non-compliance (such as another member state that had to bail out a bank on more

279 See e.g. Genil and CHGV versus Banco Bilbao and Bnkinter, Court of Justice 30 May 2013, Case C-604/11. Exceptions apply if the EU law harmonises civil law liability, e.g. of the custodian in the AIFM Directive; see chapter 16. 280 See art. 129.1 RBD, and art. 17, 19-21 EBA Regulation 1093/2010.

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onerous terms than would otherwise have been necessary) could argue that compensation would need to be paid. An additional question – once liability of an EU institution, a member state or a supervisor is established – is to determine who will bear the costs. For instance a supervisor is not a commercial entity with a free cash flow, but is likely to work on a budget without necessarily being free to spend money on other issues, such as fines or damages. Depending on the funding mechanisms in place, its normal costs will either be borne by the public budgets (i.e. in the end by the taxpayer) or by the banking sector in general (i.e. in the end by their investors and customers) or by a specific bank. If liability of the supervisory authority is established, i.e. a failure of the public authority to fulfil its obligations leading to liability towards a bank, another domestic or foreign public authority or towards a civilian counterparty of a bank, it has to be established too under which option those costs will be borne. As the funding and liability issues have been left with the domestic legislators, this is true too of this interlink between the two subjects. Liability as an Incentive to (not) Implement and Apply EU Legislation Just because legislation is being issued, does not mean it will necessarily be implemented, applied and complied with. Some legal rules are of a nature generally accepted by society as an inherent right or protection (e.g. the prohibition of killing). Even such fundamental and accepted laws do not lead to everyone complying with the prohibition or protection, and certain exceptions to the law are equally accepted as the main rule (for instance killing in self-defence). Many of the bank supervision rules issued by EU legislation are not of such a self-evident nature. They are technical, inaccessible and difficult to understand out of context. Even some of the fundamental rules (secrecy, cooperation, solvency) are not always so clear that everyone would agree on the correct way to apply them. For the technical rules and where different interpretations are possible (e.g. either self-serving, practical, or holier than thou), first interpretation and then enforcement is necessary. Interpretation can flow from several sources (such as the Commission, the Lamfalussy committees, academic papers) but the final authority under the treaty is the Court of Justice. Even when the interpretation is clear, an enforcement mechanism is necessary. Part of this mechanism is the task of the Commission at level 4 (currently ‘assisted’ in some aspects by EBA; see chapter 21.3-21.4 and 23.3), to remind and enforce EU legislation if needed via the Court of Justice, and of public authorities that have the possibility to challenge unlawful lower legislation and actions of other authorities before the Court of Justice. Supervisors likely have only limited resources, limited knowledge, and sometimes no clear interest in applying the law against powerful parties, such as other public authorities who are shareholders or borrowers of weak banks, or where they deem it ‘negligible’ transgres-

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sions. To give public authorities or other parties who have rights and obligations under EU legislation a strong incentive to act in line with their obligations, individual banks, authorities and counterparties who rely on the protection offered need to be able to invoke the law. The route for individuals to challenge an incorrect application of public law instruments is, however, circumscribed in as far as it concerns access to the Court of Justice, and may equally be circumscribed in national liability and accountability laws. If the EU legislation, including prudential supervision, is not in line with higher laws, is not implemented (correctly), not applied (correctly) or leads to damages for parties that should not bear them, such transgressions may not be forcefully protected if only other public authorities could demand compliance. Apart from public opinion pressure tools, the Court of Justice has expanded upon two concepts to introduce rights of individuals: – the direct effect regime described in chapter 3.5, under which certain types of provisions are applicable and can be invoked by the people that were implicitly supposed to be protected by the provision, even to the detriment of local laws or other deviating arrangements; – liability of the parties responsible for breaches of EU legislation to certain parties who have been given explicit rights in the provision(s) breached281. For those provisions that may lead to civil liability, individuals have an incentive to ‘monitor’ the correct implementation and application of EU legislation that protects them, and public authorities (legislative or executive) have a monetary incentive for correctly implementing and applying it, increasing its effectiveness. However, the incentives are not perfectly aligned, as neither the goals of different bits of banking supervision are clear, nor do the supervisors have the (expensive in costs for banks, the state or the economy) tools to guarantee them. While the bank is alive and going concern, the majority of provisions that could cause potential liability of the banking supervisor intend to protect the bank or its key personnel. If the correct procedure is not followed, or the assessment of the situation was wrong or incomplete, or if for another reason an action of the supervisor is voided or deemed incorrect, such actions as withdrawing the license, deeming someone untrustworthy or incompetent and banning them from being an executive, closing down activities on fears of potential failure, asking them to issue capital at bad prices because there is a fear that the bank may have too little capital, breaking the secrecy obligation on purpose or by mistake) are all sources of damage to the

281 Brasserie du Pêcheur and Factortame III, Court of Justice 5 March 1996, Joined Cases C-46/93 and C-48/93 §38-39, also see chapter 3.4-3.5 and C. Hadjiemmanuil, Banking Regulation and the Bank of England, London, 1996, page 371-3745.

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bank and third parties related to the bank (shareholders, executives, employees). The conditions under which these instruments can be used, are aimed to protect the bank or bankers, and if the supervisor did not do this in every way correct, the bank or the banker may seek reimbursement of those damages. For the application of these individual instruments, the interests of depositors and financial stability may seem abstract or far removed, while at that time the bank is directly in front of you and likely unhappy with the course of action that might be taken to restrict it. Fear of liability can in that case lead the supervisor – instead of towards strict implementation in a conservative manner – towards regulatory forbearance. This is reinforced if the criteria for intervention are not clear, or not easy to prove, and can be implicit if the legislator set prudential requirements too weak, if there are no or unclear liability arrangements vis-à-vis the supervised entity or the law did not fund an effective and high quality supervisor282. The liability regimes for supervisors are different per member state, ranging from immunity for instance when acting in good faith to normal liability rules as apply to any (public authority) entity283. Forbearance – either for fear of liability or for other reasons – leads to too late intervention, to not saying ‘no’ to the bank284. When none of these actions are taken, another potential liability comes in play, namely towards those who might have expected to be protected by an active and strict supervisors, such as depositors if the bank fails. If depositors or other clients are indeed the intended protectee of a specific provision or of prudential supervision in general, they would have a case to sue the supervisor in their turn if he fails in any – hopefully clearly delineated – duty towards them. The opposing duties and interests would result in a catch 22 situation for supervisors, with a strong role for their key counterparty: the bank. General Liability Regime of the Union and of Member States for Actions of Their Institutions The liability regime for EU institutions and the minimum requirements regarding liability of member states has been harmonised by the Court of Justice. The Court builds on parallels between similar governmental liabilities for failing to fulfil EU obligations. It was assisted in this by the TFEU provision that indicated that EU institutions are liable to make good damages caused by unlawful acts or omissions. The treaty specifies that the liability is 282 C. Goodhart, Some Regulatory Concerns, LSE Special Paper 79, December 1995. E. Ribakova, Liberalization, Prudential Supervision, and Capital Requirements: the Policy Trade-offs, IMF WP/05/136. F. de Vries, ‘How Can Principles-Based Regulation Contribute to Good Supervision’, in A.J. Kellermann, J. de Haan, F. de Vries, (Eds.), Financial Supervision in the 21st century, Amsterdam, 2013, chapter 11 (mentioning fear of liability on page 180). 283 See e.g. W.H. van Boom, in W.H. van Boom, M. Lukas & C. Kissling (Eds.), Tort and Regulatory Law, Rotterdam/Linz/Vienna, 2007, page 428. The German system of immunity that is discussed in the Peter Paul Judgement mentioned above, and the partial immunity (if acting in good faith) in the UK mentioned in J. Gray, ‘Court Castigates BCCI Liquidators Claims Against Bank of England’, Journal of Financial Regulation and Compliance, Vol. 14, No. 4, 2006, page 411-417. 284 J. Viñals & J. Fiechter, The Making of Good Supervision: Learning to Say ‘No’, 2010, IMF SPN/10/08.

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judged in accordance with the general principles of domestic liability regimes. The Court has decided that this can be read in two directions, indicating that non-contractual liability for damages caused by the governmental institutions (or individual governmental ‘servants’) for issues that are their responsibility to safeguard at the EU level, is thus also a general principle in the member states laws. This principle is applicable when a member state or domestic public authority breaches EU legislation, even where the obligation is not made explicit in the treaty or in domestic law. As a result, member states have to be liable if any of their institutions (including the legislative body and/or the supervisor) fails to ensure correct implementation or application of EU legislation, though the body itself can also be liable (and may ultimately have to bear the cost associated with the liability)285. The Court, however, does require certain conditions to be fulfilled before liability for noncompliance with EU law is established, as the exercise of legislative power and executive power necessarily means that choices are made that may adversely affect individual interests. The potential for claiming compensation is reduced to allow such choices to be made, as public authorities might otherwise fail to fulfil any EU obligations for fear of the resulting damages. The conditions for liability are different for cases where public authorities have wide discretion and for cases where they have only limited discretion. Liability for damages resulting from areas where the EU or member states have wide discretion can only arise they have manifestly and gravely disregarded the limits on the exercise of their powers286. There is a right to reparation if: – the infringed provision had the intention to confer rights on individuals; – the breach is sufficiently serious, i.e. the member state or Union institution has manifestly and gravely disregarded the limits on its discretion287, which definitely is the case if it has persisted in spite of clear case law or a preliminary judgement by the Court of Justice, and which can otherwise be based on factors such as288 (a) the clarity and precision of the rule breached, (b) the measure of discretion left to the authorities, (c) whether the infringement and the damage was intentional or involuntary, (d) whether the error of law was excusable or inexcusable, (e) whether the positions of other

285 Haim II, Court of Justice 4 July 2000, Case C-424/97 §25-34. L. Dragomir, European Prudential Banking Regulation and Supervision, the Legal Dimension, 2010, chapter 12. 286 Bayerische HNL Vermehrungsbetriebe and others/Council and Commission, Court of Justice 25 May 1978, Joined Cases 83/76, 94/76, 4/77, 15/77 and 40/77. 287 The mere fact that legislation turns out not to be compatible with the treaties, and thus void, is not enough for such an assumption. See HNL and others/Council and Commission, Court of Justice 25 May 1978, Joined Cases 83 and 94/76, 4, 15 and 40/77. The additional circumstances need to be exceptional, before liability is assumed, as otherwise the legislative process could be paralysed. 288 Brasserie du Pêcheur and Factortame III, Court of Justice 5 March 1996, Joined Cases C-46/93 and C-48/93 §51-57.

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authorities have contributed to the act or omission, (f) the adoption or retention of national practices contrary to EU law; – there is a direct causal link between the breach of the obligation resting on the state and the actual damage sustained by the injured parties289. Liability for issues where there was no discretion, such as the obligation to implement directives, or to act in a certain manner, can result from the mere transgression290. For the liability of non-implementation of the content of directives, the Court291 has made liability – directly based on EU law – conditional. The Court demands that: (i) the directive should have resulted in rights of individuals, (ii) it is possible to identify the content of those rights, and (iii) there is a causal link between the breach of the obligation of the member state to implement the directive and the losses and damages suffered by the individuals with the above-mentioned rights. If this is clear, the individual has a right to damages directly based on EU law, which can be sought within the context of national liability law procedures292. Those procedures have to safeguard this EU right to damages, meaning that they should not be unduly restrictive and in addition treat it at least as favourable as similar liability claims established under domestic law. Liability of the member state may derive from direct effect provisions (in addition to the above-mentioned right to invoke the provision against the state in order to force or stop it applying non-compliant domestic legislation) where damages have occurred because the member state did not fulfil its own obligation under a direct effect provision. Sometimes, however, a direct effect provision does not put an obligation on the state but on a commercial entity (e.g. in the payment services directive), and some provisions that clearly intend to provide protection do not qualify as direct effect provisions under those criteria. In that case, liability may also derive from the (failure in) basic obligation of the member state to implement both direct effect and non-direct effect EU legislation, depending on the nature of the breach of the EU legislation that resulted in losses and damages. For member states,

289 290 291 292

Julia Abad Pérez/Council and Commission, Court of Justice 13 December 2006, Case T-304/01. Francovich and Bonifaci/Italy, Court of Justice 19 November 1991, Joined Cases C-6/90 and C-9/90. Francovich and Bonifaci/Italy, Court of Justice 19 November 1991, Joined Cases C-6/90 and C-9/90. The Court of Justice is the body where Union bodies and member states can be sued in cases specified in the treaties, but such cases, except where exclusivitiy is intended, can also be brought in national courts. Art. 274 TFEU. The EBA can also only be sued for damages at the Court of Justice; art. 67 and 69 EBA Regulation 1093/2010.

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their liability for breaches of EU legislation that are their (legislative or executive) responsibility is based on293: – the need for full effectiveness of EU rules; – the effective protection of the rights conferred to individuals; – the obligation to cooperate of the member states. State (and Supervisory Authority) Liability For the purposes of EU law, the liability of the member state and the supervisory authority executing the public tasks in practice is indistinguishable. If a direct effect provision is not correctly applied, or a directive is not properly implemented, including applied, the member state is liable under the direct effect case law for all bodies that provide a public service under the control of the state that has special powers to pursue that public service that go beyond normal inter-individual relationships. Though not each public body is liable for the member states’ failure to implement, that failure can be invoked in proceedings on issues that fall within the remit of the public body294. Civil liability of the supervisor is not specifically legislated upon in financial service legislation, and thus largely left to national law295. The CRD is no exception in this respect. The liability of supervisors (individuals and the authority as such) is an issue is not mentioned in the CRD itself, in effect failing to copy one of the Basel core principles into EU law, and leaving their application to national discretion as a non-harmonised area. The core principles require legal protection for supervisors who have discharged their duties in good faith296. The CRD thus largely ignores the liability question, leaving it to national legislation and case law to determine whether under national rules a specific failure of supervision or the non-achievement of one of the goals of supervision can lead to liability of the supervisor. The CRD does, however, contain one provision on liability, limiting the liability of the accountant if he fulfils in good faith a legal obligation to inform the supervisor about his client (the bank)297. This provision was inserted at the request of accountants/auditors 293 Brasserie du Pêcheur and Factortame III, Court of Justice 5 March 1996, Joined Cases C-46/93 and C-48/93, which builds on Francovich and Bonifaci/Italy, Court of Justice 19 November 1991, Joined Cases C-6/90 and C-9/90. 294 Foster/British Gas, Court of Justice 12 July 1990, Case C-188/89. Also see chapter 3. 295 See e.g. art. 6 and 13.6 Prospectus Directive 2003/71/EC which only indicates mandatory civil liability for the issuer in relation to the information given in a prospectus, while leaving civil liability of the competent authorities explicitly to national laws. Also see N. Moloney, EC Securities Regulation, 2nd ed, Oxford, 2008, page 156 and 163-166. 296 Principle 2 and page 24 of BCBS, Core Principles for Effective Banking Supervision, September 2012. 297 Art. 53.2 RBD. Also see chapter 6.4 on the statutory tasks of the auditor under the Auditing Directive 2006/43/EC. A similar arrangement as in art. 53 RBD is contained in art. 17 of the Commission Proposal

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when the duty to inform the supervisor of problems at the bank was introduced, as they will need to violate client confidentiality and client trust to do so. For accountants, the duty to cooperate has been compensated by a strict limitation of their liability. The ‘good faith’ clause protects them if they report something that – under subsequent investigation – turns out not to be an event triggering the duty to inform. Extrapolating from this example, the fulfilment of a specific obligation to inform the supervisor under the CRD in good faith should not lead to liability, though it is a shame that the provision does not mention it explicitly. The liability of the state under EU rules can be derived from the ‘direct effect’ that clear and unconditional EU rules can have (see chapter 3.5). If the EU legislation was intended to give clear rights to individuals, and the member state can be held responsible (as a serious breach) for failing to give those rights, it becomes liable to repair the loss and damages if those damages would not have occurred if the individual had its rights as intended. In its Peter Paul judgment298, the Court of Justice gave some indicators when a supervisory authority (or the state in general to be precise) would be liable under EU law. It indicated that the directives that were applicable at the time (the deposit guarantee directive and the predecessor directives of the CRD and Mifid) intended to achieve the essential harmonisation necessary for mutual recognition, allowing banks to operate across the EU on their European passport, with a specific addition for depositor protection in the form of the guarantee under the deposit guarantee directive (see chapter 18.5). The Court indicated that some of the obligations are express, (and implied that those could lead to liability). However, where such a specific rule of law that intends to confer rights on individuals is absent, or if such a rule is not infringed, there is no state liability under EU rules. The Court clearly stated that none of the directives mentioned ‘conferred upon depositors a right to have the supervisors take supervisory measures in their interest’. The state/supervisor was thus not the ‘agent’ for the depositors299, at least not to the point of mandatory liability under EU rules. Germany was therefore free to stipulate that banking supervision (in general) should be performed solely in the public interest, even if such a

for a Regulation on Statutory Audits of Annual Accounts and Consolidated Accounts of Public-Interests Entities COM(2011) 779 final, 30 November 2011. 298 Peter Paul/Bundesrepublik Deutschland, Court of Justice 12 October 2004, Case C-222/02. Also see Francovich and Bonifaci/Italy, Court of Justice 19 November 1991, Joined Cases C-6/90 and C-9/90, and Brasserie du Pêcheur and Factortame III, Court of Justice 5 March 1996, Joined Cases C-46/93 and C-48/93. 299 Some indicate that the supervisor or the state should be the agent to ameliorate the weak points in banking for specific groups of stakeholders (such as depositors), or for all stakeholders jointly. For the latter, see K. Alexander, ‘Corporate Governance and Banks: the Role of Regulation in Reducing the Principal-Agent Problem’, Journal of Banking Regulation, Vol. l 7, No. 1-2, 2006, page 17-40.

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determination under national law prevents individuals from claiming compensation for damage resulting from defective supervision on the part of that authority. If the specific rights and obligations of the directives are fulfilled (which Germany had not, but for which failure it had already been convicted by the domestic court, so this was not an issue on which the Court of Justice had to rule), there is thus no need for domestic legislators to make supervisors liable for faulty supervision, if any, leading to the bankruptcy of a bank. In an additional consideration, the Court considered that, as the liability issue vis-à-vis depositors was not necessary to ensure mutual recognition, the directives did not need to address the coordination of such liability. The Court based its judgment on the deposit guarantee directive and on the banking supervision directives valid at the time of the incident. The directives at that time did not contain the newer extension of home host cooperation and specifically the increased responsibilities of the consolidated supervisor, nor did they contain the Basel II, Basel II ½ and the Basel III innovations. As these changes as well as the proposed amendments to the CRD appear to indicate a ‘single market’ character more than a ‘minimum harmonisation mutual recognition’ directive, some of the Courts’ deliberation on the need for an EU stance on supervisory liability may no longer be valid300. Some of the changes on amongst others significant branches could be deemed to protect depositors, though like in the Peter Paul case they could as easily be judged to be (also) instituted in the interest of financial stability. In the insurance sector, on the other hand, it is quite certain that supervision has as its primary goal policyholder protection, not the public good in general. The Solvency II directive has served to re-emphasise that point, leading to likely civil liability of the state and/or supervisory authorities in case supervision failed to safeguard those interests (possibly with an exemption if nothing the supervisor could have done, even in theory, could have safeguarded those interests, such as in a full financial system collapse). For those instances where the supervisor has been allocated a wider discretion (where it for instance has to take into account a wider range of goals, or has been given the choice to intervene or not in a legal forbearance deliberation) that liability becomes more limited. In no case can the supervisor or its member state be liable for damages to individuals if either that particular damage or that particular individual is not the intended person that should be protected by the EU rule. Regulatory Forbearance Versus Not Doing Your Job Forbearance comes in many shapes, many of them legal under the EU rules, which as a result do not lead to liability. Legislative forbearance was abundantly applied in the 2007-

300 L. Dragomir, European Prudential Banking Regulation and Supervision, the Legal Dimension, 2010, page 309.

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2013 subprime crisis by relaxing accounting rules on the valuation of assets, relaxing the strict demands on collateral that can be given to central bank in return for liquidity facilities, relaxing quality standards on financial buffers and relaxing competition requirements301. Supervisors also apply forbearance when being strict would be counterproductive in their opinion; see chapter 18.3 and 20.3. A strict application of capital requirements or an increase in pillar 2 demands could lead to the bankruptcy proceedings if applied indiscriminately (i.e. at the moment of the crisis instead of in the run-up to the crisis, when reparative measures are still possible for the bank). Regulatory forbearance is not only used when there is a good chance that the added breathing space will help the bank address the issue at hand (instead of immediately keeling over), but also when the bank likely has no good chance to survive unless there is a dramatic change in external circumstances that are beyond the control of the bank or the supervisor. This takes it into the area of a gamble, where the bank (and regulators) may get lucky, and on the other hand may increase the losses at the bank dramatically. If unlucky, the forbearance granted actually deepens the negative consequences when the bank finally fails. Whether the bank has good chances or not so good chances is a question of assessment. In this assessment, both objective and subjective criteria play a role (how deep is the trouble, is it limited to certain areas, is it something caused by the institution or by outside factors, do you trust these people, have they shown previous abilities to pull something good out of potential disaster, what are the foreseeable consequences/losses if this bank fails now, and what if it fails in a year or two years instead?). There is no denying, however, that political considerations also play a role. These range from fear of reputational damage (of the banking sector, of the regulator, of the politicians involved), lobbying efforts at board level or political level, and an assessment of the preparedness of the taxpayers, the central bank or the deposit guarantee funds to bear the losses at this stage. An important driver can also be different (or unwelcome) opinions on the likelihood of the bank failing or the phase of the economic cycle within the regulatory and political community. In the USA, the limit to regulatory forbearance is the prompt corrective action tool/obligation of the federal deposit insurance corporation. This supervisor/deposit guarantee fund is obliged to intervene at an early stage (mandated by certain capital/leverage ratio thresholds) and in the manner that ensures that it is least costly to the fund302. Financial stability considerations are taken out of the loop here. Though leverage ratios (that set off 301 See chapters 5, 6, 7, 18.3, 20.1, 20.3. Member states can also choose to relax goldplating or other national restrictions that would otherwise have forced them to intervene (e.g. higher than normal solvency requirements, mergers and acquisitions restrictions, or liquidity or monetary requirements); see chapter 3.5. 302 Introduced in response to the savings & loans crisis by the Federal Deposit Insurance Corporation Improvement Act of 1991. See www.fdic.gov.org.

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this tool) have gained some ground in the EU in the follow-up to the 2007-2013 subprime crisis, leading to a likely introduction of a form of the leverage ratio from 2016 (see chapter 6.2), supervisors and central banks in the EU have continued to be underwhelmed by the recommendation by the FDIC to introduce prompt corrective action, as it would rob them of leeway to address problems in other manners (for example by arranging a rescue outside of bankruptcy proceedings)303. A factor speaking against the introduction of both the leverage ratio and the prompt corrective action is that they did not prevent the 2007-2013 subprime crisis from starting in the USA because the first institutions to fail were not (on a solo basis) deposit taking institutions but mortgage lenders and investment firms (in the USA referred to as investment banks). Nor did they prevent subsequent crippling losses at failing deposit taking banks nor the necessity for state aid to be provided to such banks and non-banks. On the other hand it may have limited losses in the USA, and given supervisors an objective reason to intervene, even if there were political and financial pressures not to304. The outer limit for this in the EU is the obligation contained in the deposit insurance directive to set the mechanism in action within five working days upon concluding that deposits are not being paid, see chapter 18.3 and 18.5. This leads to the possibility to exercise forbearance by changing legislation, or interpreting or applying legislation in the most lenient manner possible to a much later date. However, even in this case, there are limits. If there are transgressions, and the institution is non-compliant with prudential rules and has no reasonable expectation based circumstances within its control that it will improve its health and become compliant again, the supervisor will need to act. If it does not, and the gamble on a miracle fails, it will become liable towards those that are the intended individuals protected. Under the Peter Paul judgement, this is unlikely to be an individual depositor or counterparty, at least not for a general obligation under the applicable directives to keep the bank safe. The discretion for supervisors may be too wide for this, and the directives in general do not aim to give a right of protection to individual depositors. Several specific obligations do, however, intend to give protection to specific individuals, such as the deposit guarantee obligation especially since the funding obligation was reinforced to become a member state obligation. Importantly, the general obligations for supervision may not be written as general obligations towards depositors, but they are written as general obligations towards other member states, to fulfil their obligations under the mutual recognition framework. If another member state suffers damages from a failure of a member state to exercise supervision on for example the

303 Prompt corrective action with an automatic trigger is not available in a credible manner to national supervisors; see CEBS-EBA, Mapping of Supervisory Objectives, including Early Intervention Measures and Sanctioning Powers, 2009/47, March 2009, page 43-44. 304 R.R. Bliss & G.G. Kaufman, U.S. Corporate and Bank Insolvency Regimes: an Economic Comparison and Evaluation, Federal Reserve Bank of Chicago WP 2006-01, 10 January 2006.

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licensed bank that has a branch in the host member state, it may for that reason try to claim damages it suffers as a result. CRD Influence on Domestic Liability for Specific Obligations The CRD does indicate several issues that are important in the context of determining liability. It indicates some obligations of supervisors that are unconditional (the competent authorities shall, cannot and similar terminology). These impose strict limitations on the government (in the form of the competent authority), and if the authority transgresses it, it could be liable towards the persons that the specific norm seeks to protect if they have incurred damages as a result of the transgression. The CRD more often, however, gives the supervisor some leeway. This can entail leeway in judgement and/or leeway in taking a decision or not. Liability here should only follow if a supervisor with the appropriate expertise and dealing with facts that are known or should be known in a reasonable manner will not be deemed liable. There is a question if the supervisor might have known better, but acted in good faith. Liability could be adjudged differently here (also depending on whether it had resources and expertise, or, if available, did not allocate these. In some member states this might be the risk of the supervisory authorities, in others not, depending on their regular approach to monetary liability of public authorities. If the supervisory authorities acted in bad faith or intentional, liability can generally be assumed. Here again, they are liable only towards the persons whom the norm seeks to protect, and to the extent of damages suffered by them. The domestic rules – going beyond the minimum liability on the basis of EU law for e.g. failing to transpose EU rules correctly or failing to fulfil certain explicit duties – vary widely, in line with local thinking on government liability. The arguments pro and contra include the following: 1. Banking supervision is complex, and is mainly intended for financial stability purposes, not for individual protection. 2. Supervision does not guarantee banks not failing or not being compliant, it just intends to prevent this where possible and limit damages to the extent possible if not. Similar to e.g. police, supervisors cannot be held liable on the basis of its goals to prevent transgressions, as transgressions will happen regardless of the quality of police work or supervision. 3. Liability will limit the power to act of supervisors, as they will be liable if it acts too soon, and if it acts too late, and there is no sure way to determine what the perfect time is to intervene. 4. The amount of supervision is determined to a large extent by resources and instruments. Giving supervisors the resources and instruments to be able to guarantee no bank will

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EU Banking Supervision fail, will be incredibly expensive in terms of funds and lost opportunities305. This means priorities will need to be set, and the goal is to limit damages, not to exclude them. Supervisors get the resources (funding) and instruments that are deemed (in a political decision) to give the right balance between achieving the goals of supervision generally, without suffocating the financial services industry and its clients. 5. If a supervisor makes a faulty judgment, either by mistake, lack of interest of on purpose for e.g. political, liability or national reasons, the supervisor should pick up the tab, as the counterparts of the bank should not suffer the consequences of faulty supervision. 6. If a supervisor is liable towards the bank or to counterparties of the bank, this means the supervisory budget would need to bear these costs, meaning that – depending on the funding arrangements for that budget – either the banks in general or the state (and thus the taxpayer) would bear the costs. Alternatively, if the costs would need to be found in the budget, supervisors would need to be let go as they are the main costs of a supervisory authority, leading to less supervision in the future. Liability of the Supervisor vis-à-vis The Bank The second has received attention of the supervisors, and regards liability towards the entities under supervision if the acts of the supervisor prevent the entity from pursuing its business in the way it deems fit (for example by withdrawing authorisations in whole or in part, or by receiving an order to seek additional own funds; which is likely expensive for the institution). The third has received most public attention, and regards liability of the competent authority if a bank fails, despite being under prudential supervision the general goals of supervision have not been achieved. Such liability has been sought by both shareholders of the entities under supervision, and by creditors of entities under supervision. From a practical point of view, a nuanced approach may be best. A scared supervisor is by definition a bad supervisor; much more likely to make unbalanced or late decisions. Liability is an important consideration, especially if the financial interests involved in an institution are huge (in the sense of larger than the balance sheet of the supervisor itself, and in some cases larger than the balance of the member states involved). Explicit limitations on liability are now only available for e.g. solo supervision on financial holding companies or non-regulated entities captured in consolidation, including parents and subsidiaries in financial conglomerates306. Liability of a member state or supervisor to other member states/supervisors for failure to fulfil obligations towards each other under the CRD or the financial conglomerates directive

305 C. Goodhart, Some Regulatory Concerns, LSE Special Paper 79, December 1995. 306 Art. 127.1, RBD, art. 12.4 Financial Conglomerates Directive.

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could well be envisaged. There is no case law available, but a great deal of supervision is exercised in the understanding that one supervisor should be able to rely on other supervisors, both for the European passport and for consolidated supervision. If outright obligations vis-à-vis each other are broken, liability of one supervisor to the other, one member state to the other is appropriate, and in line with the direct effect reasoning set out above and in chapter 3.5. Liability of a bank, its officers or third parties to the banks’ counterparties for failing to fulfil CRD obligations could be a useful route to help enforce some of the clearer prudential requirements. Like with the debate on sanctions, however, the majority of prudential regulations (such as credit risk calculations) do not appear directly linked to a specific protected person, and cannot be distinguished from the wider obligation to have financial buffers. If those overall are fine, liability should be limited to e.g. outright fraudulent disclosures to the public. In the prospectus directive an obligation was inserted to force member states to make persons who make the necessary declarations on the accuracy and completeness of the prospectus liable towards the buyers307. The transparency directive imposes ‘appropriate’ liability, not necessarily civil liability. Liability of the EU Institutions EBA was not set up in the EU treaties itself, but the EBA regulation contains a separate regime for liability. It is based on the TFEU regime for Union bodies. The EBA shall pay for any damage it (or its staff) causes in the performance of its duties. The Court of Justice is competent to judge any claims for damages for failed acts or failures to act308. It is likely that its standing case law will also be applied to such claims for damages. The regulation does not contain specific provisions to ensure that EBA has funds to make good this commitment. According to the budget rules309, expenditure and revenue have to be in balance, but it is not clear how this works if normal expenditures are dwarfed by a large liability claim. It is also not clear whether damages EBA would be convicted to pay would be part of the obligatory contributions to be paid by national supervisory authorities (for instance if a member state, national supervisory authority or nationalised bank is the party suing EBA), or part of the subsidy to be paid by the EU to EBA.

307 Art. 6 Prospectus Directive 2003/71/EC (also note article 13.6 of that Directive). Recital 10 and art. 7 Transparency Directive 2004/109/EC. E. Ferran, Building an EU Securities Market, Cambridge, 2004, page 188-193. 308 Art. 61 and 69 EBA Regulation 1093/2010. 309 Art. 62 EBA Regulation 1093/2010.

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For EU institutions, their officials and servants the TEU contains a regime for contractual and non-contractual liability. The regime of the treaties has generally been copied into the protocols and regulations establishing EU organisations310. For non-contractual liability, the Union shall make good any damage caused by its institutions or by its servants in the performance of their duties ‘in accordance with the general principles common to the laws of the member states’. This regime covers the Commission, ECB/ESCB311, Council and Parliament for any non-contractual liability for damages caused by them. Most likely, CEBS-EBA and its proposed successor are also covered by this regime, though they would most likely need to bear their own costs. The EU liability is limited by the general principles of the domestic regimes, most likely the common aspects of the domestic regimes for liability of the government for bad legislation and bad execution of banking supervision. The Court of Justice has indicated when such non-contractual liability can be invoked312. The conditions are that: – the rule of law that the EU institution infringed must be one that was intended to confer rights on individuals; – the infringement must be sufficiently serious, in the sense that the institution manifestly and gravely disregarded the limits of its discretion. Factors taken into account include the clarity and precision of the rule breached, the measure of discretion left by that rule to the authority, was the infringement and the damage intentional or involuntary, was the error of law excusable or inexcusable, were the positions supported by community institutions, was a measure or practice contrary to EU law adopted or retained. An infringement is in any case serious if it continued after a judgement confirming it as an infringement; – there must be a direct causal link (established under national law) between the infringement and the damage sustained by the individual that has the right infringed. The domestic public authorities involved in supervision are not EU institutions or servants, so for them the national regimes are applicable (but the Court of Justice has emphasised the similarities between the two regimes, see above).

310 Art. 340 TFEU, art. 46 protocol 3 (Statutes of the Court of Justice), art. 35 protocol 4 (Statutes ESCB and ECB), and e.g. art. 27 Regulation on the EU Agency for Fundamental Rights 168/2007 and art. 21 Regulation on the European Agency for Safety and Health at Work 2062/94. The Union bears the costs for the main institutions, but the ECB and the agencies generally bear their own costs for damages. 311 Under art. 14.4 of the ESCB/ECB Statutes (protocol 4 to the Treaties), the liability of the domestic central banks is ruled by national laws for those tasks that fall outside of the area of monetary policy. This would mean that any banking supervision tasks of ESCB members would fall under the national liability regime. 312 Brasserie du Pêcheur and Factortame III, Court of Justice 5 March 1996, Joined Cases C-46/93 and C-48/9.

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In the stability and growth pact case, the Commission sued the Council for failing to hold Germany and France to the deficit procedure. Under the treaty313, not the Commission but the Council is the institution responsible for the decision, but it has to act in a certain manner if the circumstances demand it. The decision to instead put the deficit procedure in abeyance was deemed unlawful by the Court. The stability and growth pact was nonetheless as a result substantially weakened when France and Germany refused to abide by its rules themselves and were not forced to by the Council314. Civil liability Between the Bank and its Counterparties Non-compliance with prudential requirements by the bank and its directors and any resulting liability vis-à-vis the bank or its counterparties has been neglected in the CRD, and thus left to national legislation. For ongoing prudential supervision – in light of Peter Paul case law – it is unlikely that e.g. not applying the right risk parameters under the credit risk calculation will be deemed to result in a direct claim of a bank counterparty on the bank. It is striking that the requirements for a bank to keep itself safe by following the prudential requirements can thus theoretically be fully constructed under the CRD as an obligation of the bank towards the state only, not as an obligation towards its counterparts. This takes away a large incentive for a bank and its officers to comply with (prudential) safety requirements. In the conduct of business area, the obligations of the bank are often fairly targeted (leaving direct effect claims as a fall back), and reflected in contractual arrangements, increasing the chance that clients can make claims if the bank does not fulfil the conduct of business requirements. Member states are required to implement conduct of business protection. It has to be given, but e.g. the Mifid does not clarify whether it has to be guaranteed by the supervisor, or whether it is guaranteed via a civil claim of the client vis-à-vis its bank315. If the member state has a duty of care/fair conduct of the bank towards its clients in its liability/contract law (either as minimum contractual regime or under tort-rules), it is likely that the EU-conduct of business rules contained e.g. in Mifid will be the baseline, the minimum of the duty of care in disputes between the bank and its client on investment services. Such a regime has – in a limited but more explicit way – also been introduced in the prospectus directive, where civil liability has been introduced in a minimum harmonisation manner for the issuer and some of the main other interested parties in the disclosure, and in the AIFMD directive for liability of the

313 Commission/Council, Court of Justice 13 July 2004, Case C-27/04. 314 Also see F. Snyder, ‘EMU – Integration And Differentiation: Metaphor for European Union’, in P. Craig & G. De Búrca (Eds.) The Evolution of EU law, 2nd edition, Oxford, 2011, chapter 22. Also see chapter 22 and 23. 315 M. Tison, ‘De civielrechtelijke dimensie van Mifid in rechtsvergelijkend perspectief’, Ondernemingsrecht, 2010, page 61 (Dutch).

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EU Banking Supervision custodian316. Like in the CRD, civil consequences are often not taken into account of in the conduct of business rules (though newer rules such as in the AIFM directive make more use of the liability weapon as an incentive for compliance/vigilance; see chapter 16 and 19.5). Where not harmonised, the member state is free to include civil (or criminal or administrative) liabilities to help discourage infringements of directive rules, as long as the liabilities are not disproportionate to the gravity of the infringement317. The civil law consequences of non-compliance of the bank with market access provisions (no license, no European passport, no notification) or with ongoing requirements (not enough solvency, liquidity, internal organisation, no assessment by an external accountant, no timely disclosure of trouble) is not dealt with in the CRD. Different member states approach this in (very) different manners in respect of the interaction between regulation and liability on a contractual or non-contractual basis, including the proof, causality, damages, and disculpations318. The same applies to the liability of directors and auditors of companies (including banks) vis-à-vis the bank/company319. For market access requirements pros and cons can be debated of such non-compliance with e.g. notification, license or general good requirements resulting in automatic or – if the client desires – annulment of contracts. For harmonised general good issues such as consumer protection, the case is more likely to be made for annulment possibilities, or at least for the possibility of civil liability if the transgression actually resulted in damages for the client. Future Developments If a single supervisory mechanism is indeed introduced at the ECB along the proposals of the Commission320, the ECB will also gain liability as the competent authority under national supervisory laws, and – once the CRR is in force – under the EU treaty for the proper execution of its tasks under that regulation for Eurozone banks. For its tasks under the proposed Council regulation allocating tasks to it, it may be liable towards the member 316 Art. 6 Prospectus Directive 2003/71/EC and art. 7 Transparency Directive 2004/109/EC; N. Moloney, EC Securities Regulation, 2nd ed, Oxford, 2008, 163-166, 193-194. For the liability of the custodian also see chapter 19.5. 317 Ntionik and Pikoulas/Epitropi Kefalaiagoras, Court of Justice 5 July 2007, Case C-430/05, § 52-55. Also see chapter 20.1 and 20.3 on the obligation to ensure the implementation in practice in an effective, proportionate and dissuasive manner. 318 See for instance the contributions of A. Ogus, M. Faure and the editors in W.H. van Boom, M. Lukas & C. Kissling (Eds.), Tort and Regulatory Law, Rotterdam/Linz/Vienna, 2007. 319 C. Gerner-Beuerle, P. Paech, E.P. Schuster, Study on Directors’ Duties and Liability, April 2013, www.ec.europa.eu. Also see e.g. art. 31 Auditing Directive 2006/43/EC, and recital 40 and art. 46.4 of the Commission Proposal for a Regulation on Statutory Audits of Annual Accounts and Consolidated Accounts of Public-Interests Entities COM(2011) 779 final, 30 November 2011; see chapter 6.3. 320 Commission, Proposed Single Supervisory Mechanism ECB Regulation and Proposed Single Supervisory Mechanism Amendment to the EBA Regulation, COM(2012) 511 final and COM(2012) 512 final, 12 September 2012.

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states and/or their citizens if it does not execute correctly the responsibilities allocated to it under the regulation (e.g. by not allocating ‘the necessary resources to the exercise of the tasks’ given to it321. The proposals limit the types of remedies available to claimants who suffered from incorrect resolution decisions, or those who suffer damages as a result of (correct) resolution decisions322. The basic principle is that (except for the bank) nobody should be in a worse position as a result of the application of resolution tool. Anyone who would have obtained a better pay-out if the bank had gone into liquidation under normal insolvency proceedings, can claim the difference from the resolution authority (though it does not prescribe how that is funded, perhaps it is part of the ‘costs’ that have to be borne by the resolution funds). In case a decision assessing the need for application was mistaken, or it was applied or processed in the wrong manner, anyone who suffers damages cannot ask for a reversal of the actions taken on the basis of the earlier assessments or choices made (except in the specific case that a transfer is void because it relates to an asset in a third country that is not or may not be transferred). For example, the property or shares will not be transferred back. Any damages suffered will instead be compensated as a monetary value. For this purpose the mandatory ex ante and ex post valuations will be key. An important imperfection is, however, that those articles do not clarify what should be the valuation basis. Any assessment whether the bank is in problems will likely be on a liquidation standard, and if the wider banking system is in crisis even on a fire-sale ‘fair value’ assessment, while anyone claiming a wrongful decision will claim that the bank would have remained a going concern, and thus appraisals should be on a going concern basis, without a need to sell under pressure at potential fire-sale prices. Literature – Walker, George A., European Banking Law – Policy and Programme Construction, British Institute of International and Comparative, London, 2006, chapter 4 – Dragomir, Larisa, European Prudential Banking Regulation and Supervision: The Legal Dimension, Routledge, 2010, chapter 11-13 – Goodhart, Charles, Some Regulatory Concerns, London School of Economics special paper 79, December 1995 – Tison, Michel, Do not attack the watchdog! Banking supervisors’ liability after Peter Paul, Common Market law Review, vol. 42, issue 3, page 639-675

321 See art. 22 of the September 2012 Proposals for the Single Supervisory Mechanism ECB Regulation, COM(2012) 511 final. 322 See proposed art. 29, 30, 65, 66, 67, 73, and 78 of Commission, Proposal for a Recovery and Resolution Directive, COM(2012) 280 final, 6 June 2012.

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– Tison, Michel, De civielrechtelijke dimensie van Mifid in rechtsvergelijkend perspectief, Ondernemingsrecht 2010, 61 (Dutch)

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22

Financial stability

22.1 Introduction One of the main reasons to institute supervision on individual banks and banking groups is the important role banks play in the financial system. If a bank or banking group fails, there are risks to financial stability, as their bankruptcy could lead to the bankruptcy of their counterparts and clients, including other banks, which could in turn affect their counterparties and clients, including other banks, and so on1. This domino effect is not the only reason banks are liable to cause financial instability, if one of them is not trusted anymore, all banks and their services become suspect. Without banks the monetary authorities lose a key instrument to manage the economy, and member states, companies and consumers lose a key buyer for their bonds or a lender. The supervision of banks and banking groups is, however, only one of several instruments developed to maintain financial stability. Such instruments include monetary policy, insurance and markets supervision, and even issues such as financial education and disclosure of risks. Financial stability is not a defined concept in the CRD or in other EU legislation. Several economists have proposed definitions, but there does not appear to be any true consensus. Common elements are a safe and well-functioning financial environment and the absence of shocks and the absence of ‘negative externalities (i.e. the absence of financial instability)2. In this sense, anything that helps to make financial structures safer and less prone to shocks is geared towards financial stability. Arguably one could also reason that it works the other way around, where financial stability is not the result of banking being prudential and safe, but the cause of banking being prudential and safe. In the absence of financial stability, there is no safe bank, currency, insurer or market, and vice versa. Though there is a chicken and egg component to this, it is safe to say that public authorities in western capitalist societies have tried to promote financial stability through indirect measures such as supervising or legislating components, instead of the other way around.

1 2

See for example the recitals to the EBA Regulation and the ESRB Regulation, 1093/2010 and 1092/2010. H. Davies & D. Green, Banking on the Future, The Fall and Rise of Central Banking, Princeton, 2010, chapter 3. G.J. Schinasi, Safeguarding Financial Stability, Theory and Practice, IMF, Washington, 2006, chapter 5, who also provides an overview of other definitions, proposes the following definition: ‘the ability of the financial system to facilitate and enhance economic processes, manage risks, and absorb shocks’. L. Dragomir, European Prudential Banking Regulation and Supervision, The Legal Dimension, Oxon, 2010, chapter 2. P. De Grauwe, Economics of Monetary Union, 8th ed., Oxford, 2009, chapter 8.6.

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EU Banking Supervision The EBA regulation3 does provide a definition of systemic risk. It is seen as the risk of disruption in the financial system with the potential to have serious negative consequences for the internal market and the real economy. For the internal market (and the public finances of the EU and of member states), it defines cross-border risk as all risk caused by economic imbalances or financial failures in all or part of the EU that can have significant negative consequences for transactions between parties in two or more member states. This would serve well as a definition of risk to financial stability too. Financial Stability and Financial Crises When a shock to financial stability occurs, this is called a financial crisis. Financial crises are of all times and places and can be caused by any source of instability. Banks are inherently instable due to their short term borrowing and long term lending business alone, with additional instability and contagion sources added by procyclical valuation standards, investments, cross-border business and size, as well as the use of their business to stimulate risky lending to enterprises and governments4. The most consistent feature of financial crises is that they turn up everywhere and again and again, regardless of the best efforts of public authorities, and sometimes thanks to the best efforts of public authorities (e.g. in the absence of strict quality control the stimulation of private homeownership lead to the development of the subprime market, and the loose monetary policy introduced to help solve the dot.com or Asian crisis in the west helped set the stage for the current 2007-2013 subprime crisis). Amongst others the BIS, the IMF and the World Bank5 have published overviews of the various crises, and published a raft of policy papers drawing lessons from previous crises. For market risk stress testing purposes related to the VAR model, the BCBS specifically mentions the 1987 equity crash, the exchange rate mechanism crises of 1992 and 1993, the fall in bond markets early 1994, the 1998 Russian crisis, the IT-bubble of 20006. The phenomenon of crises is not unknown, and the existing framework is largely a result of responses to past crises; also see chapter 2. Measures taken in the wake of crises

3

4 5

6

Consideration 15 and 16 EBA Regulation 1093/2010. The CRD does not contain references to this risk, but the CRD IV project includes a definition in art. 3.1 sub 10 CRD IV Directive (to which art. 4 CRR refers when it uses the concept). See for instance chapter 4.3, 6.2, 6.4, 6.5, 8.1, 18 and 20.3. L. Laeven, & F. Valencia, Systemic Banking Crisis: a New Database, IMF WP/08/224, 2008 http://www.imf.org/external/pubs/ft/wp/2008/wp08224.pdf, which encompasses previous databases published by the World Bank. Also see www.imf.org, www.bis.org and www.worldbank.org. The BIS posted papers on e.g. ‘initial lessons of the crisis’, and similar reports and research on the Asian crisis, the 1989 (Russian currency and LTCM) events. See C. Furfine, The Interbank Market During a Crisis, BIS Working Paper 99, Basel, 2001. Also see C.M. Reinhart & K.S. Rogoff, Banking Crises, an Equal Opportunity Menace, NBER Working Paper 14587, December 2008; C.M. Reinhart & K.S. Rogoff, This Time is Different: Eight Centuries of Financial Folly, Princeton 2009. Basel II ½, Revisions to the Basel II Market Risk Framework, July 2009, page 16.

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generally prevent exactly the same crisis from developing from exactly the same roots, but not slightly different crises developing from slightly different roots. There appears to be a cycle following from business or regulatory new (or innovative) initiatives7. A new initiative (business innovations such as securitisations, derivatives, conglomerates, or regulatory innovations such as the partial transferral of responsibilities across borders, Basel I, public sector stimulus of homeownership or loans to small- and medium sized enterprises) is introduced for good reasons, increasing the safety of the sector in combination with strict internal and external scrutiny and quality controls. Then the process starts being used by other players in the market, with a lesser understanding of the risks and controls involved or a greater interest in avoiding the stricter underlying purpose. The weakest spots of regulations (where regulation can be ‘gamed’ or at least used to the most optimum profitability) are strengthened in the products, and the products start being used not for their original purpose, but to increase profitability or economic growth. Users, buyers, politicians and supervisors become more complacent, and quality controls lapse or balancing harsher requirements are relaxed or no longer reflect the size or increased risk of the business. A belief surfaces that systemic risk is fully under control by these brave new rules and market structures that have been developed, and that restrictive supervision is outdated, and should be left to the markets instead8. More conservative organisations get priced out of the market, and banks demand a level playing field with lesser regulated banks or shadow banks. If this cycle culminates at a moment of stability and trust, nothing much happens. If, however, it culminates together with other cycles, a financial crisis can develop. The 2007-2013 subprime crisis is the only the most recent example of a long series of crises9. In this case the relaxation of quality control on mortgages, the securitisation with its spread of risks, the low interest rate/high risk appetite, reliance on external ratings, and the hybrid capital/off balance sheet items cycles all culminated at around the same time, feeding off each other10. After the financial system rescue, leading to a deleveraging of the

7 8

Also see e.g. P.A. Volcker, The Rediscovery of the Business Cycle, New York, 1978. See by way of example the 2005 claim that the extent of systemic risk in the banking systems of the developed world should be seriously questioned. H. Scott (Ed.), Capital Adequacy Beyond Basel II, New York, 2005, introduction, page 4-7. 9 See the reports mentioned above, and e.g. M. Brunnermeier, A. Crockett, C. Goodhart, A.D. Persaud, H.S. Shin, The Fundamental Principles of Financial Regulation, Geneva Reports on The World Economy 11, introduction. Also see C.M. Reinhart & K.S. Rogoff, Banking Crises, an Equal Opportunity Menace, NBER Working Paper 14587, December 2008; C.M. Reinhart & K.S. Rogoff, This Time is Different: Eight Centuries of Financial Folly, Princeton 2009. 10 A. Maddaloni & J. Peydró, Bank Risk-Taking, Securitization, Supervision and Low Interest Rates, ECB WP 1248, October 2010.

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financial sector, subsequently the public sector investment in that rescue and in stimulating the economy needs to be deleveraged, extending economic woes11. Financial Stability Instruments Financial stability instruments aim to prevent or resolve financial instability. Financial instability may lead to damage to the general economy if shocks to it are not resolved quickly. As such, each of the instruments that have as one of their goals financial stability are set up to disappoint, as financial stability inherently cannot be guaranteed12. Even worse, financial stability perhaps should not be guaranteed. If it were guaranteed, the possibility of growth would be thrown away (for a chance to prevent a collapse temporarily). By way of example, if solvency requirements for banks are very high indeed, there is less return on investment in banks and less lending, which would limit growth in the economy13. Full safety in the sense that each loan made has to be 100% certain to be returned would in practice mean no lending, unless the borrower would not have needed the loan in the first place (and even then there is still a risk). None of the instruments are geared towards a guarantee, but to prevent avoidable negative shocks, to dampen the negative effects of financial instability when it occurs, while attempting not to inhibit growth too much. Some negative shocks can be prevented by for example monitoring traders to avoid fraud, ensuring liquidity, etcetera, each of which has caused crises in the past and for which we are thus forewarned. Financial stability can be strived for by a wide range of instruments, mainly geared towards not rocking the boat or shock absorbers once the boat starts rocking in any case, and allowing economic growth and wellbeing to develop (still but also only) at a measured pace. The concept of financial stability has not been allocated to be the responsibility of a single specific body. Apart from banks, many other organisations are ‘too big to fail’ or have a more limited – but still significant – potential systemic impact. This includes foreign governments (systemic if a large portion of its debt is carried by local banks/insurers/pension funds), to central counterparties and central custodians in the clearing and settlement process (which are systemic by definition14), and insurers/pension funds. Some of these

11 C. Roxburgh, Debt and Deleveraging: the Global Credit Bubble and its Economic Consequences, McKinsey Global Institute, London, January 2010. 12 As evidenced by the boom and bust cycles, and even by smaller disruptions to market trust. 13 Also see G.J. Schinasi, Safeguarding Financial Stability, Theory and Practice, IMF, Washington, 2006, page 91. 14 A.W. Glass, ‘The Regulatory Drive Towards Central Counterparty Clearing of OTC Credit Derivatives and the Necessary Limits on This’, Capital Markets Law Journal, Vol. 4, 2009, S95; J.C. Kress, ‘Credit Default Swap Clearinghouses and Systemic Risk: Why Centralised Counterparties Must Have Access to Central Bank Liquidity’, Harvard Journal on Legislation, Vol. 48, No. 1, 2011; and chapter 16.4 and 22.4.

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institutions have a limited impact only, the risk of others can be sufficiently moderated by conditional rescues or the new stability requirements in the Eurozone, or can be required to be as bankruptcy remote as possible. Banks are a relatively big player in this category, as their business is high risk by definition (leveraged lending), with little or no delay in the redeemability of their obligations vis-à-vis savers; which is a key distinction with governments, insurers and pension funds. But all these categories are relevant, so that banking supervisors and/or central banks cannot be allocated full or lead responsibility. Some informal bodies exist who have been asked to ‘supervise’ financial stability. Examples at the worldwide level are the financial stability board, and at the EU level the financial stability table of the EFC (ministries of finance and central banks; see chapter 3). Other boards or agencies have been asked to ‘contribute to’ financial stability, but have been given another primary goal. Those goals can be viewed as sub-goals of financial stability. Amongst these are the ESCB/ECB (in the context of its price stability goal), the ESRB (which was set up as a result of the lessons learned from the 2007-2013 subprime crisis to look at the ‘new’ concept of macroprudential oversight; see chapter 22.5), EBA (for prudential supervision of banks and banking groups, nowadays also referred to as microprudential supervision). The Commission is now also publishing financial stability reports15. These boards and agencies, though they have been allocated some political responsibility, do not necessarily have targeted instruments to intervene if they see signs of unwanted developments for financial stability, at least not at a moment in time when those could be helpful. The ECB and EBA can try to adjust interest rates respectively risk weightings or capital requirements, but whether this will be able to prevent instability is doubtful. They can also try to adjust or propose adjustments to the legislative framework. The ESRB can issue warnings if events might develop into future dangers for financial stability, but cannot force subsequent action (and some dangers – such as a panic in the markets – cannot always be avoided, at least not by public policy). In as far as the tasks of the various bodies imply supervision of financial stability, the term supervision is in this context used as meaning monitor and warn, and try to take or stimulate actions to prevent the dangers that they foresee. They can only legally intervene if a specific provision entrusted to them has been triggered. National (macroprudential or supervision) authorities can add some form of systemic risk buffers pending harmonisation, and some countercyclical and systemic risk buffers will be introduced from 2016; see chapter 6.2. This is, however, a relatively inflexible tool, that will be most useful if the systemic risk is acknowledged far ahead, so that the institutions in question can build up the required additional core equity tier 1 buffers.

15 Commission Staff Working Paper, European Financial Stability and Integration Report 2010, SEC(2011) 489, May 2011.

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The boards and agencies mentioned above bring together or report to all or most national and European institutions responsible for some of the identified supporting pillars for financial stability. These include for example: – ministries of finance, as the representative of government and bearer of fiscal endresponsibility (see chapter 18.4); – prudential supervisors of banks (see chapter 21.2; sometimes part of central banks); – (national and the European) central banks16, as the responsible bodies for setting monetary policy and implementing it, and for liquidity lender of last resort (see chapter 18.4); – EBA, ESMA, EIOPA as well as the ECB, the Commission, Parliament and Council; – various other types of ‘public purpose’ bodies including national conduct of business supervisors and financial markets supervisors (see chapter 16), supervisors or managers of clearing and settlement and/or payment systems (often a combination of the central bank and the financial markets supervisor; see chapter 22.4), the managers of safety nets for small depositors and investors or member states (see chapter 18.5), and national insurance supervisors (see chapter 19.4). All of the supporting pillars for financial stability are relevant for banks, as is the overall monitoring by financial stability boards and agencies. Though other types of financial institutions are subject to parts of these rules (e.g. insurers17, stock exchanges), banks are in the crosshairs of each and every one of these targeted regulations and supervisory efforts. This chapter 22 brings together the different strands of financial stability efforts as described elsewhere in this book, as well as describes those strands that have not yet been previously discussed. This includes: – the monetary policy tasks of central banks; – the clearing and settlement/payments systems tasks of central banks and market supervisors; – the new concept of macroprudential supervision, including the role of the ESRB and national macroprudential bodies. First, however, some institutional aspects of the ESCB/ECB set-up are discussed, that impact both on the role of these central banks in EBA and the new banking union proposals, as well as in each of the strands subsequently discussed in this chapter 22. Central banks 16 H. Davies & D. Green, Banking on the Future, The Fall and Rise of Central Banking, Princeton, 2010, chapter 3. 17 E.g. U.S. Das, N. Davies & R. Podpiera, Insurance and Issues in Financial Soundness, IMF WP/03/138, 2003, note that insurers have become more important to financial stability since deregulation of financial conglomerates and since the type of products insurers have been allowed to sell has been expanded to bank-like products, but even so the exposure to a run can make problems at banks more contagious and less predictable than at (most) insurers.

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will – similar to supervisors – focus most of their attention to institutions that are systemic. Which institutions might become systemic in a crisis is still an open issue; see chapter 18.2. In the EU, it is likely that the ECB and/or the ESRB assisted by the ECB will play a key role. Apart from the ECB’s documents and guidance given to others18, it also has the money and monetary channels to actively help market players it deems systemic. Future Developments – Collateral and Shadow Banking The route to systemic trouble at both the shadow banking and the ‘normal’ banking sector (mutually reinforcing) via interconnections such as lending/investing in each other, collateral management at central banks and at clearing and settlement systems is part of the FSB and Commission work on shadow banking19. This term is used to designate enterprises that perform similar functions as banks, though without falling under the definition of a bank and thus without falling under the associated level of prudential supervision; see chapter 4.4 and 5. The connections between banks are similar to those between banks and shadow banks. Part of the shadow banking sector consists of (non-supervised or nonconsolidated) group entities of banks such as securitisation special purpose vehicles) or (less supervised) funds that banks manage, others are standalone financial services entities that are not or less supervised (such as alternative investment funds or tax efficient funding centralisation vehicles of commercial groups); often managed or supported by banks or borrowing from or lending to banks. Such vehicles may engage in similar activities as banks (such as maturity transformation from wholesale depositors and lending), or engage in services provision or lending of excess cash). Shadow banking sectors can have assets up to 45% of the banking sector assets, with shadow banks more susceptible to infection from banks than vice versa if the limited data on such connections is correct20. If a shadow bank is important to the parent or to the local economy, they can cause an intervention or bailout (such as the AIG subsidiary in London). If collateral loses its value, or if entities meet conditions of default or conditions that trigger collateral requirements, any bank or shadow-bank can quickly run out of liquidity and other acceptable collateral-assets, default on its obligations and cause trouble for the entities that it owed repayment or good quality collateral. An additional cause of concern is if collateral is used repeatedly (e.g. via security lending or re-hypothecation of received col18 Such as the ECB ‘Systemic Impact Assessment Handbook’ referenced in IMF, BIS, FSB, Report to G20 Finance Minister and Governors, Guidance to Assess the Systemic Importance of Financial Institutions, Markets and Instruments: Initial Considerations, October 2009, page 20. 19 FSB, Report on Shadow Banking: Strengthening Oversight and Regulation, 27 October 2011; and the Related Progress Report FSB, Strengthening the Oversight and Regulation of Shadow Banking, 16 April 2012. Commission, Green Paper, Shadow Banking, COM(2012) 102 final, 19 March 2012. Also see for example UK FSA, The Turner Review, March 2009. 20 FSB, Global Shadow Banking Monitoring Report 2012, 18 November 2012.

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lateral to a creditor of the creditor), or otherwise can increase the leverage in the financial system. How to ensure that collateral is well managed, even in economic boom-times so that demands for additional collateral cannot act as a procyclical event, is part of an ongoing review. This may impact on collateral standards at central banks, for payment, clearing and settlement systems, and for bilateral arrangements between banks, shadow banks and other financial institutions. Literature – Goodhart, Charles, The Evolution of Central Banks, MIT Press, London, 1988 – Lastra, Rosa María, Central Banking and Banking Regulation, London School of Economics and Political Science, London, 1996 – Smit, René, The European Central Bank, Institutional Aspects, Kluwer, The Hague, 1997 – Dragomir, Larisa, European Prudential Banking Regulation and Supervision: The Legal Dimension, Routledge, 2010, chapter 2 – Padoa-Schioppa, Tommaso, Regulating Finance: Balancing Freedom and Risk, Oxford University Press, Oxford, 2004, chapter 8 – Usher, J.A., The Law of Money and Financial Services in the European Community, 2nd ed., Oxford University Press, Oxford, 2000 – Davies, Howard; Green, David, Banking on the future, The Fall and Rise of Central Banking, Princeton University Press, Princeton USA, 2010 – Kenen, Peter B., Economic and Monetary Union in Europe: Moving beyond Maastricht, Cambridge University Press, Cambridge 1995 – De Grauwe, Paul, Economics of Monetary Union, 8th ed., Oxford University Press, Oxford, 2009, chapter 8.6 and 9.3 – Cecchetti, Stephen G., Money, Banking and Financial Markets, 2nd ed., McGraw-Hill, New York, 2007 – Schinasi, Garry J., Safeguarding Financial Stability, Theory and Practice, IMF, Washington, 2006 – Mishkin, Frederic S., The Economics of Money, Banking, and Financial Markets, 8th ed., Pearson Adisson Wesley, Boston, 2006, page 322-325, 273-392, 401-406 – Volcker, Paul A., The Rediscovery of the Business Cycle, The Free Press, New York, 1978

22.2 ESCB/ECB – Institutional Aspects As part of the introduction of the euro, a monetary union was established in the EU; supported by a new central bank, the European central bank or ECB. The ECB exists in the

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context of the European system of central banks, the ESCB. The two are indistinguishable in many aspects, but it may help to think of a central pillar with employees, led by day to day managers, that supports and is supported by a committee of in which delegates (the presidents) of all member-organisations (the national central banks) take the key decisions, and can instruct both the ECB and the national central banks that are part of the same cooperative system. Within the EU, there are currently two types of national central banks: 1. Eurozone central banks, which do not have national monetary policy rights, but set monetary policy jointly in the European system of central banks, assisted by the ECB. 2. Non-Eurozone central banks, which have national monetary policy rights: – most of the non-Eurozone central banks are from more recent member states that have committed to join the Eurozone in due course, after their member state fulfils the admission conditions. Though independent, they do strive to ensure a monetary policy that aligns with Eurozone monetary policy; – some non-Eurozone central banks from member states that did not commit to join, notably the United Kingdom and Denmark, set their monetary policy independently. In these countries, there appears to be a lack of popular and political support for transferring to the euro; – the EEA countries (Iceland, Norway and Liechtenstein), though member states for the purpose of prudential supervision of banks and banking groups, are not part of the TFEU and do not have the option to join the Eurozone, unless they become full EU member states. The ECB tasks are21 to: – assist the ECSB in executing the monetary policy set by the ESCB and issue binding regulations in this area; – assist the ESRB with analytical, statistical, logistical and administrative support; – promote the sound functioning of payments systems, and issue binding regulations to ensure efficient and sound clearing and payment systems within the EU and with other countries; – contribute to the smooth conduct of policies pursued by the prudential banking supervisors and to the stability of the financial system (without the power to regulate); – issue banknotes within the EU and allow the national central banks to issue banknotes and member states to issue coins up to certain amounts; – make non-binding recommendations and issue non-binding opinions on any legislation in its areas of competence. 21 See the TFEU, as further set out below, and the ECB/ESRB Regulation 1096/2010.

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Within the boundaries set by the TFEU and its protocol on the statute of the ESCB and of the ECB, it can thus influence directly the business of banks through for example requirements to keep reserves at central banks, and on the way they effectuate transactions on financial instruments in the financial markets. De facto it has in addition obtained a role as lender of last resort to banks and to member states; see chapter 18.4. In the area of prudential supervision, its influence is at the moment more indirect, as it is competent to make recommendations, offer advice/opinions and be consulted, but not to issue binding regulations. In a way, its role is similar to the Commission, without the right of initiative, and limited by its basic goals, which are monetary policy and financial stability. Also see chapter 2 and 3. The creation of the EBA, the successor of CEBS, initially appeared to end any ambitions the ECB may have had to add (micro-)prudential supervision of banks to its range of responsibilities. As the European Banking Authority continues to be mainly a coordination forum, not a supervisory authority outside of certain very, very limited circumstances, this continued the situation that banking supervision primarily remains a national pastime even though financial markets in which the banks and their owners operate are increasingly international, while monetary policy in the Eurozone has already evolved into an international pastime22. With the increasing number of crossborder operating banks, and the loopholes available in the continuing absence of seamless supervision resulting in regulatory arbitrage by the banks, this will mean a continuing pressure to increase the Europeanisation of banking supervision. Under the continuous pressure of the 2007-2013 subprime crisis, the ECB will now indeed be allocated microprudential tasks. Similar to the ESCB, this will be in the context of a ‘single’ system of Eurozone banking supervisors. A supervisory board is expected to take day-to-day decisions; segregated from the existing tasks of the ECB/ESCB to avoid conflicts of interests. See chapter 21.3 on the (changing) detail on the diverse pillars of a banking union, and the likely implementation in 2014 and 2015 if all goes as planned. These developments do not change the institutional framework set out in the EU treaties on the functioning of the ESCB/ECB. Both the ESCB and the ECB are governed23 by the governing Council and the executive board. The executive board forms the day-to-day management, and the governing Council is empowered for the fundamental choices to be made, such as setting interest rates and long term policy. The executive board is appointed by the Eurozone governments, upon a recommendation of the Council and after consulting the European Parliament and the governing Council. The governing Council is composed of the national central bank presidents and the members of the executive board (with observers such as the EU presi22 P. De Grauwe, Economics of Monetary Union, 8th ed., Oxford, 2009, chapter 7.6. 23 Art. 129, 141, 282-284 TFEU, and protocol 4 to the treaties, containing the statute of the ESCB and the ECB.

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dency and the Commission). As long as some EU member states remain outside of the Eurozone and thus outside of the ESCB, the ECB also has the general Council as a decision making body, in which the non-Eurozone central banks are also represented to discuss EU wide central bank policy. To enable if to execute its tasks, the ECB can issue (binding) regulations that work directly in all member states, (binding) decisions that apply to e.g. specific national central banks or banks, and (non-binding) guidance and recommendations24. However, it cannot issue (binding) directives that have to be implemented by member states and national central banks. Strangely, instead of one of these TFEU based terms, it sometimes issues ‘guidelines’25 with unclear status, but which appear to have the same function as a directive. National central banks are expected to implement them in their local requirements. As the TFEU does not recognise these guidelines, they are (non-binding) recommendations in as far as their legislative force. However, in their internal relations, the guidelines have been agreed to by the members of the governing Council (the presidents of the national central banks, so it is unlikely that they would not be implemented. Under the TFEU, the primary objective of the ESCB is to maintain price stability. Unlike the term ‘financial stability’, this is a rather clear concept, which has been further elucidated by ECB publications. As long as this primary task of price stability does not suffer, the ESCB is also required to support the general economic policies in the EU in order to achieve e.g. a common market and an economic and monetary union26. To achieve price stability (and the other goals if and in as far as price stability does not suffer) the ESCB is tasked with: – defining and implementing the monetary policy of the EU; – conduct foreign-exchange operations; – to hold and manage the official foreign reserves of the member states; – to promote the smooth operation of payment systems. The ESCB currently sets monetary policy, aimed at price stability, in more than half of the EU member states The ESCB, ECB, national central banks and the members of their decision-making bodies are forbidden to seek or take instructions from Community institutions or bodies or from the government of any member state or from any other body; they are bound to have full independence in the execution of their tasks and voting behaviour. The EU institutions and the member states governments are bound by treaty

24 Art. 132 TFEU (compare to art. 288 TFEU that applies to EU institutions in general). 25 E.g. on accepted collateral for lending to banks, and on Target2 (ECB/2000/7 respectively ECB/2007/2). 26 Art. 2, 8 and 105 TFEU.

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not to seek to influence the decision-making bodies of the ECB or of the national central banks in the performance of the above-mentioned tasks. This independence is based on the partly theoretical and partly empirical economic benefits from having monetary policy set independently by people operating – within democratically set boundaries – with a longer term perspective and a more limited set of goals, instead of by shorter term politicians on the basis of the goal of the day. Such arguments include the impact of independence on inflation, on reliability of economic and inflation data and on long term economic growth. Arguments to limit independence include democratic accountability and the potential of conflicts between central bank policy and central government policy27. The choice for the ESCB and ECB has clearly fallen on the side of those in favour of independence, in line with the German experience with the benefits of an independently operating Bundesbank prior to the introduction of the euro. The lack of democratic accountability is tempered by the fact that the treaty in which the ECB/ESCB was set up and given its goals and tools was drafted by governments and ratified by Parliaments, subjected to judicial control by the European Court of Justice, and by the introduction of a range of accountability obligations in the treaty and in practice via the appearance of the ECB president before the European Parliament, and by the obligation to publish its policy and research. It should be noted, however, that the ECB has acted with some freedom of interpretation in the sometimes vague or not-fit-for-purpose aspects of the treaty provisions as discussed in chapter 18.4. The lender of last resort function of the ECB/ESCB for banks was less than clear, though clearly needed. The same applies to its role as backup for the euro, and de facto for the member states and for the banking systems they have informally guaranteed. The declaration to do ‘whatever it takes’ to save the euro is not part of the language of the EU treaties, and may well be close to or over the border of what is prohibited in such treaties28. Without the credibility and clarity of this statement, however, the continued survival of the Eurozone and the financial stability of the Eurozone and other EU member states (and possibly of third countries) would have been in doubt. For the way monetary policy has been framed in the Eurozone, see chapter 22.3, alongside some examples of other types of monetary policy goals.

27 For a discussion on the advantages and disadvantages see e.g. S.C.W. Eijffinger & J. De Haan, The Political Economy of Central-Bank Independence, Princeton, New Jersey, 1996; R.M. Lastra, Central Banking and Banking Regulation, LSE, London, 1996, chapter 1; D. Howarth & P. Loedel, The European Central Bank, the New European Leviathan?, 2nd ed. rev., Houndsmills, 2005, chapter 5. 28 Art. 123 TFEU and Mario Draghi, Speech at the Global Investment Conference in London, 26 July 2012 (in his capacity as President of the ECB; see www.ecb.int for the verbatim of the remarks). See chapter 18.4.

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22.3 Central Banks’ Monetary Policy Introduction Monetary policy can be defined by its goals and by its instruments: – The goals are different in different countries, with different levels of abstraction. They can include employment levels, price stability (normally set as an inflation target), interest rates, confidence in the national currency, a stable exchange rate of the national currency to another currency (notably of the main trading partner), or a combination of these. – The instruments given to the authority that sets and executes monetary policy can also vary. These range from setting interest rates, reserve requirements, research and being a lender of last resort. That authority given such goals and/or such instruments in advanced economies normally is a so-called central bank. These exist in various shapes, some of which only execute monetary policy set by for instance the domestic government. If given to a central bank independent from direct political influence, it is a set-up that has proven that it reduces economic instability resulting from monetary policy, and instead increases financial stability. The debate on monetary policy has been stimulated by it being a truly international playing field since the liberalisation of capital markets in western societies. Regardless of monetary policy goals often being focused on domestic end-goals, the international dimension is inescapable in any country with an open or even slightly open economy or of which the currency is being traded on international currency markets. This has led to widespread copying of instruments, and international research and exchange of ideas between central banks on the underlying theories, as well as – sometimes – coordinated actions in the financial markets. International research by the central banks of e.g. the USA and the EU is published on www.bis.org (the BIS is also the home of the committees such as the BCBS, and is the hub for central banking cooperation). There are various instruments to enable and enforce monetary policy. The main instruments available are: – statistical information gathering from all monetary financial institutions (often referred to as ‘MFI’; of which banks are the main category)29;

29 See the overview in ECB/EBA, MFI Balance Sheet and Interest Rate Statistics and EBA Guidelines on Finrep and Corep/Large Exposures, Bridging the Reporting Requirements – Methodological Manual, second edition, March 2012. Other MFI’s are e.g. central bank, electronic money institutions and money market funds.

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– information gathering via other public authorities, such as banking supervisors and EBA30; – reserve requirements for banks; – interest rate determination; – exchange rate interventions; – open market operations (buying and selling of securities, normally in the secondary market); – standing facilities to lend overnight or longer term to banks, with accompanying requirements on collateral; – incidental lending facilities, with accompanying requirements on collateral (lender of last resort loans to banks with liquidity problems or e.g. the longer term refinancing operation (‘LTRO’) of the ESCB/ECB of end 2011 and early 2012). Many of these instruments use the information available at banks and the transmission mechanism of banks. This mechanism presupposes that if banks have to hold money at the central bank, they will lend less to consumers and companies, and if they have to pay a certain interest rate to the central bank, they will charge an interest rate close to that to their private sector clients. These instruments aim to influence the amount of loans banks make available to others (and indirectly the amount of loans made to banks) and thus the amount of funds available for investment in production or consumption goods and services31. Changes in the economy (e.g. the recent increase in non-depositor funding for banks or the longer term change in opening up capital markets across borders) also affect the effectiveness of the monetary policy instruments32. If these instruments do not have the required effect, or have been used to depletion, additional mechanisms have been used by central banks, such as quantitative easing and investments in government bonds or other assets33. The use of such instruments underpins the value of such assets and frees the funds of other participants in the economy up (in the sense that they are forced to look for other investment opportunities). Their use is, however, controversial, due to the risks for the central bank balance sheet and for their neutral arbiter role, as well as due to the inflationary pressures created by the creation of money and the effect on international currency markets. If central banks manage to create upward pressure on interest rates (corrected inflation) they stimulate savings and reduce loans/investment and thus inflation and can cool an overheated economy. By way of example, if central banks manage to create 30 E.g. the information gathered via the Corep and Finrep frameworks is used primarily for prudential purposes, but also for macroprudential, monetary or crisis-management purposes. 31 L. Gambacorta & D. Marques-Ibanez, The Bank Lending Channel Lessons From The Crisis, ECB WP 1335, May 2011. 32 See e.g. P. Disyatat, The Bank Lending Channel Revisited, BIS Working Papers 297, Basel, 2010. 33 See e.g. Bank of England, Quantitative Easing Explained, London, 2009, in which the bank tried to explain the benefits of such easing.

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downward pressure on interest rates (corrected for inflation), they underpay savers for the risk they have in order to stimulate them to spend (in search for higher returns or because it does not pay to keep it in an account). This has a negative effect on savers such as pension funds, on net depositors or on banks that are more prudent than others, and on the value of e.g. bonds held by investors such as banks, but may be needed to stimulate loans and capital investments to help re-grow the economy. The EU has a process aiming towards one currency and one monetary policy at some point in the future; see chapter 22.2. As this goal has not yet been reached, the treaties set out a transition phase on the determination of monetary policy. There is already a single currency and one monetary policy for the majority of the member states, but not all member states participate yet. As long as the euro-zone does not extend to all EU member states, there will be a dual system regarding monetary policy. The ESCB and the ECB determine and execute the monetary policy for the Eurozone countries within the boundaries of the TFEU34; while the central banks of the non-Eurozone countries set their own monetary policy, and are not bound by nor can they determine the monetary policy of the EU. For the member states that intend to enter the Eurozone, it is likely that they will closely coordinate their monetary policy to the policy of the ESCB, unless crisis circumstances intervene. Adjustments will be necessary in order to allow the local economy and interest rates to adjust gradually towards the criteria set for entrance. For the member states that have no intention to enter the Eurozone, notably the UK and Denmark, they will set their own course, though closely linked to Eurozone monetary policy as a result of their economies being intertwined with euro-zone economies. Different Monetary Policy Goals The main goal of ESCB monetary policy is price stability; see chapter 22.2. This has been defined by the ESCB as aiming at an inflation rate of consumer prices below, but close to 2%. All the other functions and goals of the ESCB and ECB are subservient to this main goal. So far, this single minded purpose has given it a clear steer in the first years of the euro and in the follow-up to the 2007-2013 subprime crisis. The goal of Danish monetary policy is to retain a stable exchange rate with the euro35. UK monetary policy is linked to both price stability (also aiming at an inflation rate of 2%) and at confidence in the currency. In the US, it is aimed at three goals: maximum employment, stable prices and moderate long term interest rates36.

34 Within the boundaries set by the EU Treaties. See art. 119,123-124, 127-133, 136-144, 263, 271, 282-284 TFEU, and art. 7 ESCB/ECB Statutes; and chapter 3 and 22.3. 35 Monetary Policy in Denmark, June 2003, Danmarks Nationalbank, chapter 1. 36 The Federal Reserve System, Purposes & Functions, 2005.

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The ESCB/ECB Example The governing Council of the ESCB/ECB is responsible for monetary policy for the EU (but currently only for the Eurozone countries)37. It can formulate the guidelines and take decisions, including the goal of 2% inflation, and on related subjects including key interest rates and the supply of reserves. It has thus taken over the independent roles of the central banks on monetary policy (by forcing them to agree a policy together in the context of the ESCB institutions). Where the RBD refers to monetary policy being excluded from harmonisation under the banking directives, and being kept in national hands, for the Eurozone countries that role has now been ‘harmonised’ in the sense of centralised at the ESCB. In return for giving up this part of sovereignty, the national central bankers have gained a say in the monetary policy of a much wider geographic zone, and gained the backing for the economy of their member state and the central bank itself by the full Eurosystem. In addition, they have deleted currency risk from dealings in euro between countries in the Eurozone, providing a huge benefit to banks, companies and consumers that travel or deal across borders. The type of instruments the ESCB/ECB uses are set out in its statute, as attached to the TFEU38. They include: – set key interest rates for the various lending and borrowing facilities it offers (see below), setting reference rates for the market; – require banks to hold minimum reserves at accounts held with the ESCB or its members; – determine the issuance of banknotes (by itself) and coins (by the member states); – operate in the financial markets, amongst others in the foreign exchange markets to affect the exchange rate of the euro; – lend and borrow in the financial markets, with lending being based on adequate collateral (e.g. overnight in the marginal lending facility, providing a ceiling to interest rates in the interbank market, and in the short term main refinancing operations minimum bid rate); – open accounts for banks, public entities and other market participants, and accept deposit (e.g. overnight in the deposit facility, providing a floor in interests in the overnight interbank market); – lend to banks and accept assets as collateral; – take any other measures, if two thirds of the votes cast in its governing Council agree, as it sees fit.

37 Art. 12.1 Protocol 18 to the TFEU, on the Statutes of the ESCB and of the ECB. 38 Art. 12-23 Protocol 18 to the TFEU, on the Statutes of the ESCB and of the ECB, as well as art. 105, 106 TFEU. See e.g. S.G. Cecchetti, Money, Banking and Financial Markets, 2nd ed., New York, 2008, chapter 17.

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Due to the integration with worldwide capital markets and the activities of EU based banking groups in other large capital markets, this can include joint operations with Swiss, Japanese and USA central banks on exchange rates, or entering into swap agreements with the US Federal Reserve to ensure access to dollar funding for EU based banks (which helps the EU banks to fulfil their obligations and not go bankrupt, and the USA economy as otherwise loans to USA banks and money market funds may not have been repaid when such institutions withdrew funding from the EU money markets in the early stages of the 2007-2013 subprime crisis)39. The last instrument allows the ESCB/ECB to enter into amongst others quantitative easing (purchasing bonds of companies or sovereigns from ‘new’ money by extending its balance sheet, and thus putting downward pressure on interest rates and upward pressure on the value of the bonds it purchases). The ECB prefers not to do so, but on the other hand has vowed to do whatever it takes to keep the Eurozone safe40. Its traditional instruments have been used extensively and leniently during the follow-up to the 2007-2013 subprime crisis. Apart from extensive lending to banks to provide liquidity and purchasing member state bonds in secondary markets, it has eased substantially the quality standards on the type of collateral it accepts from banks when lending to them between 2008 and 201241. This further reduced its already rather loose standards; that were more or less an amalgamation of the collateral policies of both its strict and loose national central banks prior to their accession to the Eurozone42. As a result, banks that did no longer have the high grade collateral accepted exclusively before (e.g. government bonds) could now gain access to much needed liquidity on the basis of for instance certain secured bonds it issued itself. This helped banks that no longer had access to commercial lending from wholesale markets to gaining access to central bank lending, helping to prevent (systemically relevant waves of) bankruptcies at the expense of enlarging central bank risk. Whether its actions have been successful will need to be assessed in the long term. In the short term, the ECB has been reasonably successful, in the sense that fewer banks and fewer member states failed than otherwise would have, maintaining financial stability. The ECB has vigorously defended 39 See e.g. S.B. Kamin, Financial Globalisation and Monetary Policy, Fed Board International Finance Discussion Papers 1002, June 2010. 40 The covered bond purchase programme, formally issued under the ESCB’s licence to operate in the financial market, can also be perceived as a limited form of quantitative easing. Decision of the ECB of 2 July 2009 on the implementation of the covered bond purchase programme, ECB/2009/16. Also see chapter 18.4 on the role of the ECB during the crisis. 41 J. Capel, ‘The Post-Crisis World of Collateral and International Liquidity’, DNB Occasional Studies, Vol. 9, No. 3, 2011. 42 See the Emergency Regulation 1053/2008 of the ECB of 23 October 2008, ECB 2008/11, and the permanent and temporary relaxations of collateral standards in the ECB Guidelines ECB/2000/7 (via e.g. ECB 2008/13 (reversed on some aspects by ECB/2009/1) and ECB/2008/18. M. Lenza, H. Pill & L. Reichlin, Monetary Policy in Exceptional Times, ECB WP 1053, 2010, page 15.

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EU Banking Supervision its normal and more extreme actions during the crisis43. Monetary policy does, however, have side effects (see below). The ECB is empowered to impose sanctions on all the binding regulations and decisions it or the ESCB have issued, e.g. on minimum reserves or on any future microprudential rules it issues within the context of task allocation under the banking union44. In addition, for those activities on which it operates in the financial markets, the national central banks and the ECB can opt to not interact with certain counterparties any more if they do not fulfil the conditions in any of the legislation (binding or non-binding) on e.g. collateral or clearing and settlement. In the stability and growth pact case, the Commission sued the Council for failing to act in line with the treaty when the Commission recommended that it should hold Germany and France to the deficit procedure. The treaty45 appoints the Council as the institution responsible for the decision, but it has to act in a specific manner if the circumstances demand it. The failure to act was deemed unlawful by the Court, leading to the annulment of the Council decision to hold the deficit procedure in abeyance. As the decision process was shown to be political, especially if two member states with a large vote were simultaneously in deficit, the initial version of the pact46 has since been effectively toothless. A renegotiation allowed considerable flexibility for the member states, and longer terms to comply (and emphasised the possibility to hamper decision making by large transgressing member states acting in concert). It thus failed to prevent the sovereign confidence crisis during the 2007-2013 subprime crisis, and failed to provide a solution to it. To redeem themselves in the eye of the markets, the member states are currently further beefing up the budgetary discipline elements. The Lisbon treaty strengthened the role of the Commission in excessive deficit procedures47. The member states in the Council also agreed to a range of laws in 2011 (the so-called economic governance ‘six-pack’) that enable the Commission to monitor them and to start proceedings if boundaries are transgressed48.

43 For instance by President Trichet of the ECB on ‘impeccably’ achieving the monetary mandate at the press conference on 8 september 2011, and ECB sponsored papers such as M. Lenza, H. Pill & L. Reichlin, Monetary Policy in Exceptional Times, ECB WP 1053, 2010. 44 Art. 110 TFEU, Council Regulation EC/2532/98 and ECB Regulation ECB/1999/4. Also see chapter 21.3. 45 Commission/Council, Court of Justice 13 July 2004, Case C-27/04. 46 See J.A. Usher, The Law of Money and Financial Services in the European Community, 2nd ed, Oxford, 2000, chapter 8.5; and F. Snyder, ‘EMU – Integration and Differentiation: Metaphor For European Union’, in P. Craig & G. De Búrca (Eds.), The Evolution of EU Law, 2nd edition, Oxford, 2011, chapter 22. 47 Art. 126 and 293 TFEU indicate that the Council can still refuse to act, but now only if such a decision is unanimously reached. 48 Including a regulation amending Regulation 1466/97 on the strengthening of the surveillance of budgetary positions and the surveillance and coordination of economic policies, 1175/2011. For the stability and growth pact regulations see recital 2 of the amending regulation.

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In addition – and largely overlapping with the six-pack, a separate treaty was signed by the willing EU-members to bind themselves to such more binding rules49. All EU member states except the Czech Republic and the United Kingdom signed. It entered into force on 1 January 2013, as enough member states ratified it (but only for those member states that did ratify it). It would require a balanced budget with only minor deficits. It would bind the Eurozone countries immediately, and other ratifying member states to the extent they signed up to be bound immediately or at a later time. The Commission can otherwise intervene. Final authority on compliance by a member state is – enhancing its credibility – placed with the Court of Justice. Both the Commission and each ratifying member state can sue another ratifying member state if they are both bound by this supplementary financial stability treaty. Member states are expected to comply with Court of Justice judgements. If they do not comply, the Court can – at the request of the Commission or of contracting member state – impose a fine of up to 0.1% of its gross domestic product (payable to the ESM if it is a Eurozone member state, or to the EU general budget if it is not)50. Side Effects of Monetary Policy Monetary policy can also lead to long term destabilisation. In order to achieve the (short term) primary goal of e.g. price stability or economic growth, loans have become cheap in general, and adjustments of monetary interest rates are assumed (or even targeted) to have on the lending behaviour of banks. This lending behaviour filters into the economy. The ESRB will need to look into the cross effects of various single-goal monetary and microprudential purposes both in the short term and the long term. An acknowledged effect is that buying securities will help stabilise market prices, but it may be difficult to sell them again without triggering the same downward spiral. Cheap crisis liquidity from the central bank may aid banks, but may crowd out normal interbank lending, and force lending banks to either leave that market or to lend at rates that are not proportional to the actual risk at the time. Excess liquidity also becomes addictive, especially when it does not quite manage to jump-start economic growth in the face of continued fear of losses. Such central bank activities create a dependency, with likely difficulties to re-establish private sector markets and market prices when a central bank wants to stop performing such actions after the immediate risk of a crisis has receded51. 49 Treaty on Stability, Coordination and Governance in the Economic And Monetary Union, 2 March 2012. The treaty is an example of so-called enhanced cooperation; but does not comply with art. 20 TEU and art. 326-334 TFEU. As a result, the content could not be agreed in e.g. a regulation, but is a treaty outside of the EU, but in effect bound to the EU. 50 Art. 8 Treaty on Stability, Coordination and Governance in the Economic And Monetary Union, 2 March 2012. 51 See e.g. M. Lenza, H. Pill & L. Reichlin, Monetary Policy in Exceptional Times, ECB WP 1053, 2010, page 11 and 22.

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For short term effects following monetary shocks, research is ongoing. Links have for example been shown between reduced interest rates in a monetary shock and the increase in risk taking by small, well capitalised US banks for smaller fees in the area of on balance sheet business loans, though such an effect at large banks was not shown52. Literature – Mishkin, Frederic S., The Economics of Money, Banking, and Financial Markets, 8th ed., Pearson Adisson Wesley, Boston, 2006, chapters 12-25 – ECB, The single monetary policy in the Euro Area, Frankfurt, April 2002 – De Grauwe, Paul, Economics of Monetary Union, 8th ed., Oxford University Press, Oxford, 2009, chapter 9 – Smit, René, The European Central Bank, Institutional Aspects, Kluwer, The Hague, 1997 – Sleijpen, Olaf, Does European monetary union require a fiscal union?, Some evidence from the United States, Amsterdam, 1999 – Davies, Howard; Green, David, Banking on the Future: The Fall and Rise of Central Banking, Princeton University Press, Princeton USA, 2010

22.4 Oversight and Supervision of Payment, Trading and Delivery Systems Introduction One of the key underpinnings of trade within the EU is the speed and safety of financial cash and instruments delivery systems. This includes both payment for ‘regular’ trade on goods and services, and both sides of financial trades on stock exchanges (delivery of financial instruments versus payment of the purchase price). Cross-border trade restrictions within and outside the EU have relaxed, increasing the size and importance of cross-border payments and cross-border delivery of financial instruments. From a largely domestic issue for national central banks, with the international aspects taken care of by some private banks and in cooperative structures of central banks such as the bank of international settlements, the cross-border delivery and payment systems have become a key part of financial architecture. Such systems for the transfer of money and financial instruments have the interest of central banks for financial stability purposes, and are part of the mandate

52 C.M. Buch, S. Eickmeier & E. Prieto, In Search of Yield? Survey-based Evidence on Bank Risk Taking, Deutsche Bundesbank Economic Studies No. 10/2011.

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of for instance the ESCB/ECB; see chapter 22.2. Arguably, central banks developed from the payment, clearing and settlement process53. The bankruptcy of one institution handling such transfers, or of a large counterparty in the underlying financial transactions, could lead to financial troubles for many clients. Problems arise in recent agreements for which payment and delivery is not yet due, agreements that are due but where payment and delivery has not yet taken place, agreements where obligations are dependent on future events, and agreement that are booked as completed but where there legal uncertainties on the effectiveness of the ownership transfer. Contagion will take place if the bankruptcy of one of the parties involved will disrupt the delivery process of a specific payment or delivery, and of subsequent onward payments or deliveries, and where uncertainty about ownership or exposure to the bankruptcy of one of the parties involved cause the market to overreact on the safe side (thereby creating havoc on financial markets as they no longer trust anyone tainted by association). The associated systemic risk is reduced amongst others by requiring the main financial intermediaries involved in the payment and delivery process to be under prudential supervision on an individual basis. Rules for trading platforms as set out in the Mifid have both opened markets and introduced minimum requirements on their functioning and transparency (also see chapter 16). Legal certainty has been improved in the EU by introducing targeted rules that reduce the influence of a bankruptcy of one of the parties involved on a completed transaction in financial instruments. A substantial risk reduction can, however, also or even better be achieved by speedy documentation, clarification of who is whose counterparty in any open market trade and the provision of collateral for any open commitments. These are all part of the so-called clearing and settlement process. Despite the available legislation, this has long been a relatively underdeveloped piece of financial market legislation54. Apart from the legal certainty improvements, there was little or no EU legislation on clearing and settlement until 2013, leaving the three step process of trade, clearing and settlement process for trading platform financial instruments unbalanced, and for off-trading platform financial instruments uncharted territory. Payment systems had received more attention, but less in legislation – except for the conduct of business rules on payment services providers such as banks and prudential rules for specialised 53 For a very readable history of the development of clearing and settlement processes and the role of central banks see B. Norman, R. Shaw & G. Speight, The History of Interbank Settlement Arrangements: Exploring Central Banks’ Role In The Payment System, Bank of England WP 412, 2011. 54 See e.g. the incentives built into the market risk requirements (Annex I RCAD, and chapter 9) to deal via (safely collateralized through margin requirements) clearing houses in the treatment of position risk. Also see the Finality Directive referenced in chapter 18 and below, and the Mifid requirements on markets set out below and in chapter 16.4).

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payment services providers – than in the efforts of the ECB to actually offer a pan-EU payment system, reducing many of the uncertainties (and costs) of cross-border payments. The macro aspects of safety of payment systems and trading systems, because of its systemic consequences, have been in the remit of central banks; shared with for instance prudential banking supervisors for the key-participants and trading platform supervisors for trading system supervision). The interest of central banks in the underpinnings of financial transactions has generally not been supported by a legal right of intervention, but has been limited to so-called ‘oversight’. If they see developments that may be or may become detrimental to financial stability, they have soft tools only (similar to the ESRB; see chapter 22.5). Their role is not supervision, but oversight in the sense that they follow the market developments, stimulate improvements by studies and discussions with market participants. The right of the ECB/ESCB to provide input in reforms of bankruptcy regimes, banking supervision and market supervision requirements is one of its core soft tools. Their main contribution has, however, been in providing central payment facilities backed-up by central banks’ deep pockets. The participation of banks in clearing/settlement/payment systems has been facilitated in the CRD. The exposures can be quite large, but attract little or no risk weight if they are e.g. towards a central counterparty that fulfils certain conditions. The exposures are also exempted – if handled within the usual timeframe for the type of transaction – from the large exposures regime. EBA is to draft (binding) standards by end 2013 for some of these excepted exposures where it concerns e.g. exposures arising from client activity, and intraday exposures on money transmissions55. Payment Systems The proper functioning of EU payment systems has been allocated to the ESCB (though as a less important goal than its primary goal of price stability; see chapter 22.2). It has the task to ‘promote’ the smooth operation of payment systems. The ESCB has worked in this area extensively, though this work has not necessarily resulted in standards or guidelines56. Two projects are key to its work in this area: – developing a facility that supports payments and trading in financial instruments, known as Target2; – developing the single euro payments area (also known as SEPA).

55 Chapter 8.4, 11.2 and 16.4. 56 Art. 127 TFEU.

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SEPA is a project to allow payments to be made within the Eurozone as if they were made domestically. This includes using a bankcard with a pin code at automated teller machines (ATM’s) and in shops, paying electronically in web shops, and paying for electricity in one country automatically from a bank account in another country. The introduction of IBAN and BIC codes for bank accounts is part of this project (these codes identify the bank and the specific account of the counterparty with a unique number that is not duplicated elsewhere in the Eurozone). SEPA is being gradually introduced, with European transfer orders accepted since 2008, and other services being gradually rolled out. In part it is practical work, building IT systems and offering services from the ESCB. From a legislative point of view, it has been facilitated by e.g. the payment services directive; see chapter 19.3. The payment systems are also supported by joint work of the Eurozone central banks on collateral lists and on collateral management on each other’s behalf, in the context of either normal monetary operations or in the context of lender of last resort functions57. Trade, Clearing and Settlement Financial instruments are created (by issuance against payment of for example shares in a company or government bonds, or by entering into a derivative contract of for instance a stock option or a credit default swap). Such instruments can be traded on an exchange or off an exchange, and subsequently paid for or delivered, while during the lifetime of the instrument additional payments or deliveries need to be made (e.g. cash or stock dividends, interest, or periodic payments under some derivatives). These payments and the transfer of ownership of the financial instruments could be done bilaterally. In that case, the two parties need to risk manage their own exposures vis-à-vis each other (credit risk, change in value of the currency agreed or the market price of the instrument sold, risk of default of the other party before it has fulfilled its part of the agreement). For financial instruments that are intended to be of interest to multiple buyers and sellers, the trades and the subsequent risk management and actual payment and delivery is managed via an institutionalised trading, clearing and settlement process. Clearing and settlement systems intend to reduce and risk manage the financial risks following from trades in financial instruments that have been agreed between participants in financial markets, but where either the payment of the agreed purchase amount or the transfer of ownership of the financial instruments that were sold has not yet been finalised. The two stages follow a trade and are intended to reduce the risk that money is not received, or instruments are not obtained in legal ownership, especially if that cash or those instruments are needed to fulfil obligations under subsequent multiple transactions by traders and their banks on

57 See chapter 18.4 and 22.2. Also see J. Capel, ‘The Post-Crisis World of Collateral and International Liquidity’, DNB Occasional Studies, Vol. 9, No. 3, 2011.

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EU Banking Supervision financial markets58. In the process of clearing and settlement facts are checked, safeties created and payment/delivery executed, reducing the risks for the parties involved. An important component of this risk reduction is the centralisation of the process in the hands of specialised entities, such as the central counterparty (for the risk management tasks) and the central custodian (for the administration of the ownership), as well as by using dependable payment systems. During the clearing phase of the follow-up of a trade on a trading platform or off exchange, all transactions executed by or via a clearing member (mostly banks) are booked and accumulated in preparation for final payment and delivery (known as settlement), while risks for the open positions are limited by novation, margin (collateral) and verification. In the settlement phase, the actual payment and delivery of ownership are executed. Trading can take place on the various trading platforms possible under Mifid. These include regulated markets, multilateral trading facilities and systematic internalisers. These bring buyers and sellers together on a systematic basis, and have set up ongoing trading facilities. Trading is not limited to such trading facilities, the alternative is a buyer and a seller reaching a bilateral agreement to create a new financial instrument (such as a derivative) or to sell and buy financial instruments (both these bilaterally created financial instruments and financial instruments that are also traded on trading platforms). Such bilateral agreements on financial instruments are generally referred to as the ‘over the counter’ or OTC market, though the boundaries of that concept are not set in stone. Part of the OTC market concern fairly standardised, easily tradable products, others can be highly specific to the two parties setting up the contract. Originally, the subsequent trading of OTC products got little attention as the volumes were relatively low and the buyers and sellers knew each other. With the increase in the size of the (barely regulated) OTC markets and the number of times especially standardised OTC products were traded subsequently, this turned out to be a mistaken assumption during the 2007-2013 subprime crisis, leading to problems e.g. when Bear Stearns almost failed and when Lehman Brothers failed59. A form of the clearing and settlement process is already standard for all financial instruments that are exchange traded. The FSB, in line with developments at the EU and in the USA, has been pushing so-called ‘over the counter’ traded instruments onto exchanges, or at least into the type of clearing and settlement processes that exchanges have set up60. 58 A description of the common denominators of the process can also be found I §1-74 of Clearstream/Commission, Court of Justice 9 September 2009, Case T-301/04. The case itself concerned discriminatory pricing to keep the market in these services closed. 59 A.W. Glass, ‘The Regulatory Drive Towards Central Counterparty Clearing of OTC Credit Derivatives and the Necessary Limits on This’, Capital Markets Law Journal, Vol. 4, 2009, S79-98. 60 A.W. Glass, ‘The Regulatory Drive Towards Central Counterparty Clearing of OTC Credit Derivatives and the Necessary Limits on This’, Capital Markets Law Journal, Vol. 4, 2009, S79-98; J.C. Kress, ‘Credit Default

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Some shares and bonds have restrictions on their trading due to company law statutes and others have contractual or legal limitations, but even when such restrictions apply most can be traded. If the number of potentially interested buyers and sellers is large, this can lead to admittance on a trading platform. In a bilateral trade in a financial instrument that is not admitted to a trading platform, for example a share in a limited company, the followup is relatively simple. If the buyer and seller fulfil the statutory requirements for the sale, after the trade agreement money is handed over (or wired over) to pay for the shares, and the statutory process for the transfer of the ownership (delivery) is followed the buyer owns the share and the seller ‘owns’ the money. Though this can be an arduous and/or costly process, the risks are manageable because the seller and buyer know each other and the counterparty risk they pose, they can take measures to limit this risk, and they can control the speed and effectiveness of the post trade delivery process. Bad risk management can increase the risk, e.g. by delaying the transfer process as one of the two parties may go bankrupt, or for another reason become unable or unwilling to fulfil its obligations. The transfer of ownership process in many respects is unimportant for the people involved in the trade. The trade is done, the price is agreed, and the potential profit is locked in. It becomes an issue only in exceptional circumstances, where one of the two is unable to fulfil its obligations nor pay damages61. In that case, the legal ownership determines whether an asset falls into the bankruptcy, and it may well be that both the already received payment and the not yet delivered shares both fall in the bankrupt estate of the seller, leaving the buyer without any assets except a claim of doubtful value in the estate. Worse, if he had already sold the shares to a subsequent buyer, he is left exposed as he will have to buy the shares again, possibly at a higher price, in order to fulfil his new obligations. Without a good clearing and settlement process unfulfilled promises thus would lead to high risks for all parties involved in trading, both on and off exchanges. On exchanges the risk increases as the buyer and seller generally will not know each other, are not in a position to assess their counterparty risk and are not in a position to control the process of delivery and payment. Determining the claims and assets would require an assessment of the many parties involved in the process, including the banks/investment firms involved in trading on behalf of the buyer and seller, the central custodian of the financial instruments (who holds the instruments on behalf of the owner), the trading platform itself with its legal Swap Clearinghouses and Systemic Risk: Why Centralised Counterparties Must Have Access to Central Bank Liquidity’, Harvard Journal on Legislation, Vol. 48, No. 1, 2011. 61 For over the counter trades, bilateral clearing and settlement with delays due to its non-standardised nature and the sometimes manual steps to be taken was a common practice up to the crisis. Central banks and supervisors started to draw attention to the huge backlog of open deals, and the risk associated with that backlog. The time needed to deliver the documentation after a deal has been agreed but not yet fulfilled has since been shortened. See chapter 14 and 16.4. Also see for instance ECB, OTC derivatives and post-trading infrastructures, September 2009.

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structures, and the structures involved in the payment process. An additional complication is that many of the traders are professionals, who may sell the instruments bought onward quickly, leading to multiple transactions in the same financial instruments, involving the same traders in the role of buyer and seller. If one of them does not fulfil its obligations, all the subsequent buyers and sellers may lack the funds or instruments to fulfil their own obligations. When transacting in financial instruments without using the facilities of an exchange, the two institutions involved may not have proper procedures to ensure that the other is the owner, and that payment and delivery of ownership is properly executed, or the counterparty risk is well managed by netting and collateralisation. Especially for derivatives with a volatile management, the ‘open’ commitment of both parties against the other needs constant attention so that the unsecured part of any commitment remains within the thresholds of the (counterparty) risk appetite set. Clearing and settlement was initially instituted to manage and limit these risks by trading facilities for their membership/local traders. Following the harmonisation of trading platform requirements from 1993 in the investment services directive and subsequently Mifid (see chapter 16 and 19), the harmonisation of post trade facilities may have been expected. The relatively secluded area, with its high profitability, the potential high cost of harmonisation and the support it gives to trading on the national stock exchange, had up to the 2007-2013 subprime crisis avoided such harmonisation, except around the edges. The only binding legislation on clearing and settlement was confined to the Mifid (in the abovementioned requirements on trading platforms) and indirectly via incentives and exemptions built into prudential requirements such as the CRD (that acknowledge the risk mitigating factor of solid payment and delivery processes in its quantitative risk requirements; see chapter 8.4-8.5). In addition, there were both worldwide and European non-binding standards and recommendations on clearing and settlement, e.g. the self-regulatory 2006 code of conduct on clearing and settlement62. The ECB had expanded upon its payment systems role to include an interest in clearing and settlement in general (as they are interlinked with and essential for smoothly operating payment systems63). The ECB and CESR have worked on standards for the clearing and settlement process, though this process became limited in scope for political reasons. The EU institutions, supported by negative feedback on the draft standards from the industry, did not appreciate others working in this area without a specific mandate, even though they did not work in the area themselves. After the Commission published a communication on its strategy in the area of clearing and settlement, a more limited ambition set of standards were published by the ESCB and 62 See Commission, The Code of Conduct on Clearing and Settlement: Three Years of Experience, 6 November 2009. 63 See e.g. the ECB Opinion of 8 January 2010 on the Establishment of the European Supervisory Authorities, CON/2010/5.

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CESR, adopting a worldwide set of standards developed by CPSS and IOSCO (the global equivalents of the ESCB and CESR)64. The Commission established a working group called CESAME (clearing and settlement advisory and monitoring experts) to remove private sector barriers and advise on public sector barriers, taking into account the previous industry work to identify the so-called Giovannini barriers on post-trading within the EU65. Little or no attention had previously been paid to the clearing and settlement structures underpinning the off exchange so-called ‘over the counter’ market (where bilateral deals in e.g. derivatives take place that are not standardised or are not traded for other reasons on trading platforms). Especially this last market has led to increased demands for joined-up action at the EU and global level, following the bankruptcy and near bankruptcy of several large players in the over the counter derivatives market during the 2007-2013 subprime crisis. Two subjects are now being tackled simultaneously. The EMIR regulation66 will from 2013 regulate so-called central counterparties or CCP’s in all types of financial instruments. The new regulation serves a dual purpose: – bringing more OTC derivatives into a clearing structure, and making other open (not yet settled) OTC derivatives subject to collateralisation requirements; – regulating central counterparties that operate on exchange traded financial instruments such as shares, bonds and exchange traded derivatives, as well as on OTC traded financial instruments (such as standardised off exchange agreed derivative contracts). The details on exactly which OTC derivatives will be brought into a clearing structure are left to more flexible level 2 legislation/standards. The clearing process has a positive effect on financial stability by reducing the risk for all traders, including banks. It reduces the number and size of open transactions, and provides improved risk management via its central counterparty. As a downside of the risk reduction for individual traders, the central counterparties of any clearing system of almost any size become systemic themselves. If it loosens standards

64 Commission Communication, Clearing and Settlement in the European Union – the Way Forward, COM(2004) 312 final; CESR/ESCB, Standards for Securities Clearing and Settlement in the European Union, CESR/04-561, September 2004. The CPSS and IOSCO issued recommendations and principles for payment systems, securities settlement systems and central counterparties in 2001 and 2004, since updated and consolidated after consultation by CPSS-IOSCO, Principles for Financial Market Infrastructures, April 2012. 65 Cesame Report, The Work of the Clearing and Settlement Advisor and Monitoring Experts’ Group (‘Cesame’ Group), solving the industry Giovannini barriers to post-trading within the EU, Brussels, 28 November 2008, published on the website of the Commission. 66 EMIR Regulation 648/2012. EMIR is the result of the Commission Proposal for a regulation on OTC derivatives, central counterparties and trade repositories, COM(2010) 484/5.

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for its acceptance of its members, or reduces the required collateral explicitly or via a change in its models in order to attract more business, the central counterparty becomes vulnerable to bankruptcy67. As the spider in the web of all open transactions that it clears (e.g. derivatives, or all transactions performed on a specific regulated markets), its bankruptcy would result in havoc in the books of its members. Central counterparties are thus correctly being placed under supervision in EMIR and will attract the interest of central banks for their financial stability mandates and the payment systems they support. The CRD IV project complements the EMIR regulation, by increasing capital requirements for exposures that do not benefit from the highest level of safety measures introduced in it (e.g. OTC derivatives that are not centrally cleared because they are e.g. exempted); see chapter 8.4. Example Taking the example of all trades on a regulated market (a stock exchange), the process works approximately (with variations per market) as follows. All trades are accumulated at the level of the financial institution allowed direct access as a so-called clearing member to the financial market for its own trades and trades made on behalf of its clients. This happens in the intermediate phase between transactions and actual payment and delivery (settlement). During this clearing stage, the transactions made are verified. The data needed for this verification is sent to the central counterparty. This is especially important for trades done on trading platforms, where the buyer and seller in a given transaction generally do not know each other, and may not with to assume the counterparty risk on each other if they had known each other. Clearing members acting on behalf of their clients or for their own account are normally either banks or investment firms. The main difference between the two is that banks can also have the money of their clients on their books even outside the context of a concrete trade; see chapter 5.6. Financial institution that invest on behalf of clients either are clearing member, or have a contract with a clearing member that provides these specialised services. The contracts between the seller and the buyer of e.g. financial instruments sold on a regulated market are replaced by two new contracts between a central counterparty and respectively the (representatives of the) buyer and the seller (novation of the original agreement into two). The central counterparty becomes the buyer to the seller, and in an identical agreement the seller to the buyer. It does this with the traders it has admitted to this process (the clearing members), and leaves the risk management with their clients (and the clients of clients) to them. The central counterparty has a contractual relation with such clearing members, with standing arrangements on scrutiny and on the calculation of the open positions between the central counterparty

67 J.C. Kress, ‘Credit Default Swap Clearinghouses and Systemic Risk: Why Centralised Counterparties Must Have Access to Central Bank Liquidity’, Harvard Journal on Legislation, Vol. 48, No. 1, 2011.

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and the clearing member. Depending on the contractual arrangements, several financial buffers are available to ensure that the (systemic) central counterparty cannot fail: – collateral for any potential loss as calculated by the central counterparty and demanded to be handed over to it at the end of the day and increasingly also on an intraday68 basis (margin); – a backup fund (clearing fund) into which payments are made or into which collateral is deposited, for any shortfall in the margin to cover open positions; – potentially a right to call on other clearing members to make good any losses the central counterparty suffers; and – the own funds of the central counterparty. All trades, either buying or selling, in a specific financial instruments via a specific clearing member are thus taken together and often netted, resulting in a single, much lower, obligation to buy or deliver that financial instrument. This is done for all financial instruments traded. The same is done for all agreed purchase prices, either to be paid or received. This is also normally netted, resulting in a single, much lower obligation to pay or right to receive a payment. For banks participating as clearing members, traders or agents for clients this has an immense risk reducing effect; see chapter 8.4. The exposure can, however, still be huge to single counterparties, not all of which are sufficiently covered by collateral (margin) at the end of the day or intra-day. The central counterparty shall require the clearing members to post additional margin for these obligations (and the clearing members will likely ask for the same type of collateral from their own clients who have a mismatch between obligations and claims as a result of open trading positions). For the new large exposures regime, exemptions were introduced to cover such temporary large exposures in the context of money transmission and/or financial instruments transmission services under specific conditions69. In the settlement process, the central counterparty gives the orders to transfer the ownership of the financial instruments involved, and of the sums of money (payment) involved. This process is often done in a so-called delivery versus payment process, meaning that the transfers are done as simultaneous as possible, to limit the risk that one of the parties involved goes bankrupt while one leg of the transaction is settled and the other is not. The delivery and payment are done via separate channels (often Target 2 system in the Eurozone between banks for payment, and transfer in the books of the central custodian appointed 68 Intraday margining covers both unexpected changes in the value of the underlying financial instruments, as well as unexpected large trading by the clearing member during the day, that is not reflected in open positions at the start or end of the day. 69 Art. 106.2 sub c and d RBD, as amended by Directive 2009/111/EC. CEBS-EBA implementation guidelines on art. 106(2)(c) and (d) of Directive 2006/48/EC recast, 28 July 2010. See chapter 11.2.

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for the specific financial instrument). The settlement is – depending on local rules – performed within a set time. The code for this is either T+1 or T+3: the maximum number of days between the day of the trade (T) and the settlement. All of this is relatively unimportant as long as nobody goes bankrupt. It isn’t, as long as everything goes well. The process proves its usefulness when someone goes bankrupt who yet has to pay or to deliver. The system of clearing and settlement reduces existing debts, clarifies who has a right to what, and provides ‘buffers’ via a connected system of clearing members and contractual arrangements (collateral). Stage

Transaction

Clearing

Action

Buy or sell a financial instrument Accumulate (and possi(e.g. buy a share offered on a bly net) all trades of the regulated market) trader in the specific financial instrument, as well as all payments owed by or due to that trader

Transfer ownership of the number of financial instruments (where offered after netting) either to or from the trader and ‘transfer ownership’ (i.e. pay) the amount owed by or due to the trader (also after netting)

Participants

The traders buying and selling, their agents that are members of the stock exchange (mostly banks or investment firms) and the stock exchange.

Clearing members, central payment systems, central counterparties and the custodian of the financial instruments

The stock exchange, clearing members, the trader and its agent in the trade (mostly banks or investment firms)

Settlement

Target270 replaced the original Target system in 2007. Target stands for trans-European automated real-time gross settlement express transfer system, though it is unclear whether the name necessitated the acronym or the acronym the name. The system is open to the ECB, national central banks, banks and to clearing and settlement organisations. The clearing and settlement organisations can be based inside and outside of the EEA, acknowledging that the safety of such organisations, if they operate internationally, can be crucial for EU financial stability. Legal Certainty Outside of the scope of this supervision book, but key for reasons of financial certainty in bankruptcy situations are the legal risk that financial collateral given to the clearer does not provide the surety it promised to give, or that the delivery of financial instruments can be rescinded by the liquidator of a company. These aspects are dealt with in the settlement finality directive and the financial collateral arrangements directive. Basically, they aim to

70 Decision of the ECB of 24 July 2007 concerning the terms and conditions of Target2-ECB, ECB/2007/7.

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ensure that, even in those jurisdictions that generally allow liquidators to challenge any transactions made in the approach to bankruptcy, they cannot do so where it concerns financial collateral or the delivery of financial instruments through a clearing and settlement system71. Prudential supervision on many of the entities involved has also been introduced. Many traders are banks, and others are investment firms with its derived prudential supervision. Other large firms that have substantial investments are also regulated, as e.g. pension funds or insurers. The facilities providers are to some extent banks too72, either because they fall under the EU definition due to other activities they have, or because the EU regime has been expanded nationally to include them in the prudential supervision regime (see, however, chapter 5.3 on the limitations on the European passport in this respect). Other key players fall under specialised regimes, either at the EU level (payment institutions) or at the domestic binding or ‘self-regulatory’ level. Future Developments All three steps of the trading, clearing and settlement process are being addressed in the wake of the 2007-2013 subprime crisis and – less urgent – concerns from before the crisis. For the trading and depositories parts proposals have been published, for clearing the EMIR regulation has been agreed (see above) and different provisions of the regulation become applicable from mid-2013. The Commission has: – published proposals to deal with central depositories of financial instruments73. This includes provisions to make the depository function more remote from risks (e.g. services related to settlement such as intra-day lending) by requiring legal separation;

71 Settlement Finality Directive 1998/26/EC, financial collateral arrangements Directive 2002/47/EC. Both were amended by Directive 2009/44/EC, which had to be implemented by 30 December 2010 and applied to the markets from 30 June 2011. Apart from some technical updates, the use of credit claims (loans) as collateral was facilitated, and the interlinkages between various systems should now be better reflected in light of the further integration of previously national markets. Also see N. Moloney, EC Securities Regulation, 2nd ed, Oxford, 2008, chapter XI.4. 72 E.g. several of the parties in the Clearstream/Commission case operate their clearing or settlement activities as a bank; Court of Justice 9 September 2009, Case T-301/04. 73 Commission, Proposal for a Regulation on Improving Securities Settlement in the EU and on central securities depositories, COM(2012) 73 final, 7 March 2012.

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– published proposals to amend Mifid to force more pre- and post-trade transparency in non-equity markets and to bring more OTC derivatives onto organised trading platforms; see chapter 16.4-16.574. The Commission has not only taken the opportunity to bring more financial transactions onto trading platforms and/or their follow up clearing and settlement procedures, but also tries to open up those services further. Mifid II proposals as well as the EMIR regulation intend to force interoperability between trading venues as well as central counterparties. This would prevent monopolistic behaviour, where an entity strong in a particular field can force market players to use possibly less competitive follow-up or preceding services that are provided by related companies. Interoperability and obligatory access eases the entry into such closed sectors and reduces prices for end-users (both capital seekers and investors). However, it also leads to further potential systemic risk75. More links also form contagion channels, especially if the – not yet fully developed – safety measures do not live up to expectations in practice. Safety measures such as margin may not work as well in a cross-CCP setting as it does in a cross-trader setting. The CRD IV project will support this by requiring a large amount of capital to be held for open positions in financial instruments that are not cleared, or not cleared via a central counterparty of the highest quality. It will also take exposures to CCP’s out of the risk free category (0% risk weighted) into a new low risk category with a risk weighting of 2% or 3%. This is intended to remind banks that evens such exposures to ‘safe’ market structures may in extreme circumstances not be safe, especially if safety standards (e.g. margin calls) are loosened in response to market pressure76. Simultaneously, the EMIR regulation is amended by the CRR to ensure that qualifying central counterparties indeed offer higher safety to the banks (and others) that make use of them, and that banks apply the right risk weight. Running counter to its plans to reduce costs associated with trading financial instruments, the Commission and a group of eleven member states plan to introduce a financial transaction tax of not less than 0.1% of the consideration paid or owed on trades in non-

74 Commission Communication of 2 June 2010 on regulating financial services for sustainable growth, COM(2010) 301 final. Commission proposals for Mifid II and Mifir, COM(2011) 656 final respectively COM(2011) 652 final, 20 October 2011. 75 See e.g. J. Mägerle & T. Nellen, Interoperability Between Central Counterparties, SNB Working Papers 201112, 10 August 2011. 76 EMIR, as amended by art. 520 CRR. Also see recital 81-87 and for example art. 107, 300-312, 382.3 and 400.1 sub j, 497 CRR. Also see chapter 8.4.

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derivatives, and 0.01% of the notional amount on trades in derivatives77. The original Commission proposals failed to receive sufficient support, but the Council and Parliament agreed that the 11 member states could use the enhanced cooperation route under the EU treaties to make new proposals. The new proposals are copied from the failed initial EU proposals, with expanded anti-abuse and scope provisions78. This so-called Tobin tax or ‘robin hood’ levy will impose a stamp tax on each transaction in e.g. derivatives or shares associated with one of this group of member states, regardless where or between whom the transaction is executed. Other member states and third countries may be unhappy with this extraterritorial effect, and there is doubt about its effectiveness and unintended consequences. The UK has started proceedings at the Court of Justice to annul the Council approval for the enhanced cooperation, in light of the extraterritorial effects of the proposals79. The financial transaction tax is a response to the 2007-2013 subprime crisis, and an attempt to take the sheer volume of trades between financial parties down, and to re-coup some of the costs associated with a financial crisis. The financial transaction tax would become applicable at the earliest in 2014, though no agreement on final texts, incentives and implementation date has yet been reached. Central counterparties or trading platforms may be asked to collect the tax on behalf of their clients. The Commission proposals on recovery and resolution will apply to banks and investment firms, as well as to related companies; see chapter 18.3. Similar plans are made for other relevant institutions. The Commission is consulting on which types of firms should be captured by this effort, and is likely to include institutions that play key roles in the clearing and settlement framework, such as central counterparties and central securities depositories80. Literature – Capel, Jeannette, The post-crisis world of collateral and international liquidity, DNB Occasional Studies vol. 9(3), 2011 – Wendt, Froukelien, Intraday Margining of Central Counterparties: EU Practice and a Theoretical Evaluation of Benefits and Costs, DNB WP 107/2006, 1 July 2006 77 The failed initial proposal is contained in Commission, Proposal for a Council Directive on a Common System of Financial Transaction Tax, 28 September 2011, COM(2011) 594 final. Parliament endorsed the route to enhanced cooperation under art. 20 TEU and art. 326-334 TFEU in the area of a financial transaction tax on 12 December 2012, and the Council on 22 January 2013, 2013/52/EU. 78 Commission, Proposal for a Council Directive Implementing Enhanced Cooperation in the Area of Financial Transaction Tax, COM(2013) 71 final, 14 February 2013. 79 IMF, a Fair and Substantial Contribution by the Financial Sector: Final Report for the G20, June 2010. UK/Council, Financial Transaction Tax Enhanced Cooperation, Case C-209/13, action brought on 18 April 2013. 80 Commission, Consultation on a Possible Recovery and Resolution Framework for Financial Institutions other than Banks, 5 October 2012.

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EU Banking Supervision – Moloney, Niamh, EC Securities Regulation, 2nd ed, Oxford University Press, Oxford, 2008, chapter X and XI – Kress, J.C., Credit Default Swap Clearinghouses and Systemic Risk: Why Centralised Counterparties Must Have Access to Central Bank Liquidity, Harvard Journal on Legislation, vol. 48, no. 1, 2011 – Lastra, Rosa M. (ed), Cross-border Bank Insolvency, Oxford, 2011, chapter 12, as written by Leckow, Ross; Laryea, Thomas; and Kerr, Sean – CEBS-EBA, Report on the outcome of CEBS’s call for evidence on custodian banks’ internationalisation of settlement and CCP-like activities, 17 April 2009 – CPSS-IOSCO, principles for financial market infrastructures, April 2012

22.5 Macroprudential Supervision Introduction The 2009 De Larosière report identified as one of the causes of (the aggravation of) the 2007-2013 subprime crisis the lack of attention paid to so-called macroprudential issues, and references to such macroprudential problems started to occur in legislative texts for future attention81. Though no definition is provided, the reference is to problems that lie at the interface between macroeconomic policy and financial system regulation, including cyclicality, counter-cyclicality and leverage. Previously undefined, the long term success story on addressing such issues via banking or housing regulation such as credit controls, reserve requirements or normal prudential supervision is mixed82. The FSB refers to macroprudential policies as policies that use prudential tools to limit systemic or systemwide financial risk, complementing microprudential and macroeconomic policies in their support of financial stability83. While helpful to get an idea of what is meant, there is no agreed definition84. A tentative definition is that the focus of macroprudential supervision is the risk in the financial system as a whole instead of in its individual components. 81 See e.g. recital 33-34 CRD II Directive 2009/111/EC. Final Report of the High-Level Group on Financial Supervision in the EU, chaired by Jacques de Larosière, 25 February 2009 (De Larosière Report). 82 D. Elliot, G. Feldberg & A. Lehnert, The History of Cyclical Macroprudential Policy in the United States, WP 2013-29, 15 May 2013, describes the USA experience with countercyclical tools for the last century. 83 FSB, Macroprudential Policy Tools and Frameworks, Update to G20 Finance Ministers and Central Bank Governors, 14 February 2011. 84 For example S.G. Hanson, A.K. Kashyap & J.C. Stein, A Macroprudential Approach to Financial Regulation, Chicago Booth WP 10-29 (Initiative on Global Markets Working Paper 58), November 2010, refer primarily to the prevention of a credit crunch and fire-sales due to excessive balance sheet shrinkage when the financial sector is hit by a common shock. The IMF instead refers to indicators such as limiting and minimizing disruptions to the provision of all financial services, with a focus on the whole financial system and to target systemic risk; see e.g. C. Lim, F. Columba, A. Costa, P. Kongsamut, A. Otani, M. Saiyid, T. Wezel, X. Wu, Macroprudential Policy: What Instruments and How to Use Them? Lessons From Country Experiences, IMF WP/11/238, 2011.

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Prior to the 2007-2013 subprime crisis even the term macroprudential was not widely used85. Some had noted that a focus on individual risks meant that risks in the system could go unnoticed86. Past experience and research had focused on either the prevention of systemic risk, prudential supervision to prevent individual banks and banking groups to become a risk to the financial system, or financial stability as the overarching concept, including price stability and well-functioning financial systems. Even now the work on macroprudential issues lacks definition, research and instruments; and hints at a strong overlap with regular (micro)prudential issues and with systemic risk87. De Larosière noted that prudential supervision did not yet take account of the building up of risks in the financial system as a whole. Even with price stability, well capitalised banks and functioning financial systems, risks can build up that appear to be spread or manageable, but taken together can lead to a crisis. The incentives for herd-like behaviour in the prudential requirements of the BCBS and the EU, the pumping of unlimited liquidity into the economy by central banks to avoid or ameliorate a recession and the tax and other incentives pushed into the real economy to stimulate people to spend on debt (such as mortgage deductibility, obligations to banks to lend to private persons, tax treatment of interest between group companies as opposed to the treatment of dividend payments) can create bubbles and troughs in the value of (financial) assets and thus of financial firms. Though closely linked to procyclicality (see chapter 6.5), the term also embraces interlinkages between sectors, between financial institutions, contamination and information gathering to assess trends. These newly identified macroprudential issues were not clearly within the remit of any established authority or grouping at the EU level. Financial stability reports had been made by the ESCB/ECB, central banks and by the level 2 committees (CEBS/CESR/CEIOPS), but those had not the force to bring immediate change, and often looked piecemeal at

85 L.E. Panourgias, Banking Regulation and World Trade Law, Oxford, 2006, page 199-207, chapter 1, notes that the ECB used this term in the EU context to defend its role in prudential supervision in 2001 (referring to ECB, The role of central banks in prudential supervision, March 2001). Clement, P., The term ‘macroprudential’: origins and evolution, BIS quarterly review, Basel, March 2010. D. Elliot, G. Feldberg & A. Lehnert, The History of Cyclical Macroprudential Policy in the United States, WP 2013-29, 15 May 2013. In its guise of overall capital in the banking system, it has sometimes been referred to as systemic capital adequacy, see e.g. J.L. Simpson & J. Evans, ‘Benchmarking and Crosschecking International Banking Economic and Regulatory Capital’, Journal of Financial Regulation and Compliance, Vol. 13, No. 1, 2005, page 68. The obligation – under art. 127.5 TFEU – of the ECB to contribute to prudential supervision on banks and financial stability has been equated to macroprudential in L. Dragomir, European Prudential Banking Regulation and Supervision, the Legal Dimension, 2010, page 257. A similar statement could be made on the wide range of goals set out in the CRD (see chapter 4.3). 86 Goodhart, Charles A.E., Financial regulation, credit risk and financial stability, National institute economic review no. 192, page 118-127, April 2005. 87 Committee on the global financial system, Macroprudential instruments and frameworks: a stocktaking of issues and experiences, CGFS paper 38, May 2010, including an annexed (economic) literature review.

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EU Banking Supervision issues, and failed to correlate the various developments88. Apparently the ECB has specific expertise on macroprudential issues89, but this had previously not resulted in a (sufficiently clear) task or power to act in that area. High profile reports on macroprudential risks may also not have been welcome, or could have run counter to other goals of the institutions involved (e.g. warning against bubbles can impact negatively on price stability and against keeping banks healthy in the short term)90. The lack of a clear definition, the reputational risk of calling a potential bubble at the wrong time, and the close link with the goals of a myriad of public authorities hamper an allocation to one party. This is exacerbated by the lack of a clear dividing line between macroprudential on the one hand, and monetary policy and institution based prudential supervision on the other hand. These interact and overlap to a large extent91. Adding the undefined but popular and evocative term to the financial stability stable nonetheless will likely result in a – both amusing and exasperating – tug of war between the various candidates for institutional dominance, unless a compromise is found. The allocation to a committee consisting of the various current players in the field is the fall-back option in such cases. The ESRB was set up for this purpose, with a membership of central banks and supervisors, and support by the ECB92. The ESRB – like its lower level predecessors within the ECB and in other EU and national bodies – and its national equivalents that will look at the additional buffers for banks, and its international equivalent of the FSB and IMF, lacks instruments consonant with any perceived or true responsibility in this area93. Most of the potential ‘macroprudential’ instruments are already allocated e.g. to monetary policy or normal prudential supervision per bank94. True bargaining power is only available in negotiations on bailouts of member states or banks which is primarily left to the Commission, the ECB and the IMF (see chapter 18.4), at which time the phase of resolution has arrived instead of the phase of prevention. The interest rate instruments of central banks are mostly too blunt to serve as 88 See the websites of the institutions mentioned, and e.g. art. 156 RBD and art. 22-24 EBA Regulation 1093/2010. 89 Recital 7 ECB/ESRB regulation 1096/2010. 90 A. Houben, R. Van der Molen & P. Wierts, Making macroprudential policy operational, Banque central du Luxembourg, Revue de stabilité financière 2012, page 13-25. 91 Also see D. Elliot, G. Feldberg & A. Lehnert, The History of Cyclical Macroprudential Policy in the United States, WP 2013-29, 15 May 2013; C. Lim, F. Columba, A. Costa, P. Kongsamut, A. Otani, M. Saiyid, T. Wezel, X. Wu, Macroprudential Policy: What Instruments and How to Use Them? Lessons From Country Experiences, IMF WP/11/238, 2011. 92 ESRB regulation 1092/2010 and ECB/ESRB regulation 1096/2010. 93 High-level Expert Group on Reforming the Structure of the EU Banking Sector, Final Report, 2 October 2012 (Liikanen Report), page 81 and 105. 94 G. Galati, R. Moessner, Macroprudential policy – a literature review, BIS WP 337, February 2011. A. Houben, R. Van der Molen & P. Wierts, Making macroprudential policy operational, Banque central du Luxembourg, Revue de stabilité financière 2012, page 13-25; C. Lim, F. Columba, A. Costa, P. Kongsamut, A. Otani, M. Saiyid, T. Wezel, X. Wu, Macroprudential Policy: What Instruments and How to Use Them? Lessons From Country Experiences, IMF WP/11/238, 2011.

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preventive tools for specific risks, the instruments of prudential supervisors are geared towards the health of the specific institution under supervision, which leaves such ‘instruments’ as monitoring, debate and (perhaps public) warnings. These low key instruments have been generously allocated to the ESRB. It is empowered to monitor and collect information, to colour code risks, publish general or specific recommendations and warnings, and to monitor whether its warnings are followed-up upon by the addressees. It cannot enforce any of this, even though the addressees should ‘comply or explain’ any deviations95. Its harshest instrument is the publication of a specific warning or recommendation, but this publication is subject to a strict procedure involving the Council. Until a warning or recommendation is published, everyone involved is bound by secrecy obligations96. Until June 1, 2013 only five recommendations were published, all of a general nature. Short term benefits of loose liquidity and the practical problems and short term negatives in solving tax issues or acknowledging loan losses on corporate and sovereign debts are likely to prevent the abolishment of long term macroprudential destabilisers, or the introduction of ‘teeth’ for the ESRB. But one can hope. It is not that the issue is unknown – it has amongst others been raised during the review of the financial structures, see chapter 2, 21.3 and below – but a true prevention of macroprudential risk outside of some tinkering with e.g. microprudential regulations to enable banking supervisors to take the wider threat to the financial system into account to determine whether a bank contravenes the supervisory laws, and perhaps some possibility to adjust capital requirements for exposures to overleveraged or otherwise overvalued asset classes, is unlikely. Central banks, regulators and/or supervisors could control leverage in certain areas or stimulate funding if under-funded by adjusting for instance the credit risk weighting of lending to specific sectors, increasing financial buffer requirements or interest rates. These types of instruments are not always apparently effective when used for both monetary and macroprudential or for both solidity and macroprudential purposes, or can run counter to other policy objectives such as deregulation, the growth of the economy or access to lending for all. Most macroprudential instruments appear to be introduced after a crisis, and have an ad hoc nature to address a specific and already identified concern, such as foreign currency mortgages, and experience is short on their continued application in good times. When used in such a targeted fashion, they appear to be effective though data on the impact of other tools and economic developments is very limited97. The lack of use of the existing 95 Recital 10, 17-22 and art. 3, 15-18 ESRB Regulation 1092/2010. 96 Art. 8, 16.3 17.2, and 18.4 ESRB Regulation 1092/2010. 97 D. Elliot, G. Feldberg & A. Lehnert, The History of Cyclical Macroprudential Policy in the United States, WP 2013-29, 15 May 2013; C. Lim, F. Columba, A. Costa, P. Kongsamut, A. Otani, M. Saiyid, T. Wezel, X.

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instrument for that purpose in the CRD does not bode well for the willingness of political or politically dependent bodies to intervene except in times of acute crisis. New instruments that impact on macroprudential mandate are not allocated to the ESRB. Some instruments of other authorities are cast in macroprudential terms98: – national authorities (supervisors or another designated authority; see below) will gain powers to set countercyclical buffers and systemic risk buffers, and deviate in emergency circumstances; – mortgage market risk weighting can be adjusted; and – supervisors and EBA can intervene with an eye to systemic developments. All these actual intervention instruments are given to national supervisors or other authorities, likely central banks, or to EBA, with advisory or non-binding roles for the ESRB99. Composition and Functioning of the ESRB The ESRB consists predominantly of the governors of national central banks (plus a nonvoting member of the national supervisory authorities), supplemented by representatives of other EU bodies, such as the ECB and the European supervisory authorities100. It is unknown why it is more likely that such a collective body will issue unwelcome warnings than the current national institutions will (against the huge incentives not to rock the boat) nor why those warnings it does issue are more likely to be listened to than the warnings of the current national institutions (or of any other invited or uninvited doomsayers), nor even when they are able to agree on the assessment of the underlying data101. There is no proof that the macroprudential instruments will be fully developed and used, or that they will be effective if used. On the other hand, neither was there such proof when cross-border cooperation was first developed in the regular microprudential area, and these have nonetheless developed into a widely populated and researched area; see chapter 2. The proof of the pudding will be in the eating, and the ESRB committee may well exceed expectations in due course. It was established during a crisis, so while its functioning might be judged against its ability to help avoid additional systemic risks (for example on its unknown role during the year-long stress of the finances of Cyprus and its banking system

98 99 100 101

Wu, Macroprudential Policy: What Instruments and How to Use Them? Lessons From Country Experiences, IMF WP/11/238, 2011. Art. 9.5, 18, 22-25 and 32 EBA Regulation 1093/2010, art. 124, 164 and 458 CRR, art. 131 and 133 CRD IV Directive. For example in art. 36 EBA Regulation 1093/2010 and art. 458 CRR. Art. 6 ESRB Regulation 1092/2010. Recital 24 notes that the lead should be at the central banks. P. Angelini, A. Enria, S. Neri, F. Panetta, & M. Quagliariello, Pro-cyclicality of Capital Regulations: Is It a Problem? How to Fix It?, Banca d’Italia Occasional Papers 74, October 2010, page 35.

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prior to the EU bailout), it has not yet functioned in a baseline scenario other than an ongoing EU financial crisis. Value will be derived in any case if it were to provide publicly available information on leveraging in the public, private or household sectors102. The ESRB, like the ESCB, will build to a large extent on the support to be provided by the ECB. The ECB provides the secretariat, including analytical, statistical, administrative and logistical support, based on its own information and information gathered under its ESRB secretariat hat from national supervisors, central banks and EBA, ESMA and EIOPA103. The secretariat will be given both staff and resources for the fulfilment of all its tasks, fully funded by the ECB. The head of the secretariat is subject to the chair of the ESRB (which this first period is by happy coincidence also the president of the ECB), jointly with the ESRB steering committee. Simultaneously, the information gathered by the ECB employees who work at the ESRB secretariat has to be ringfenced from the rest of the ECB, making both daily working methodologies, their position as employees, and the potential failure to link relevant information from different parts of the ECB/ESCB system into prime future reputational and legal problems104. The one-way provision of information (even if some of it may filter down through the high level members of the ESRB back into the organisations they head at home) is unlikely to lead to a happy marriage, even less so if they eat in the same canteen. The slant to central bank involvement (lodged at the ECB, populated mainly by central bank governors who are allocated the voting rights) appears to indicate a bigger focus on the monetary policy side of financial stability than on (micro)prudential. Nonetheless the ESRB advice supposedly will ensure that future laws take into account both the solidity of the individual institutions and of all financial institutions jointly (plus possibly their impact on the wider economy). Hopefully this will help ensure that both the regulation and the application of prudential supervision and monetary policy will complement each other to jointly achieve financial stability105. The legal basis for the role of the ESRB is the same as the single market legal basis used for the European supervisory authorities EBA, EIOPA and ESMA106. However, the role of the

102 As proposed by C. Roxburgh, Debt and Deleveraging: the Global Credit Bubble and its Economic Consequences, McKinsey Global Institute, London, January 2010. 103 Recital 6 ESRB Regulation 1092/2010 and recital 7-11, art. 2-5 ECB/ESRB regulation 1096/2010. 104 Art. 6 ECB/ESRB Regulation 1096/2010. This sounds similar to the separation of tasks between the monetary and the supervisory tasks that is likely for the banking union single supervisory mechanism; see chapter 21.3. 105 P.R. Agénor, K. Alper & L. Pereira da Silva, Capital Regulation, Monetary Policy and Financial Stability, Banco Central Do Brasil Working Paper Series 237, April 2011. 106 Art. 114 TFEU.

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ECB at the ESRB has been awkwardly positioned on the article under which it can be given a practical supervisory role in the financial system107. That is actually not what it is supposed to do in the context of the ESRB (analysing and warning is not actual supervision). The TFEU article on which the ECB role in practical supervision is now based explicitly excludes any role of the ECB in insurance supervision, which at the same time is explicitly within the remit of the ESRB (and should thus be taken into account by the ECB when analysing relevant information). The ECB role could much better have been based also on the single market legal basis. However, politically, by using this article it was possible to posit that the ECB has been given a practical supervisory role, even though this practical role cannot be found in the actual regulation. For national macroprudential supervisors no binding rules are yet available, but one of the ESRB recommendations focuses on such national institutions and the instruments they need, while the CRD IV project allows the allocation of the instruments with a dominant macroprudential character to a specialised national authority; see below under future developments. How these will cooperate is not yet clear, but discrepancies between member states are likely. For instance the countercyclical capital buffer will not be set by the ESRB, but by an individual designated authority in each member state; see below. This is as if each central bank in the Eurozone can set its own interest rates under ‘guidance’ of the ECB, instead of jointly setting interest rates for the whole of the Eurozone. The ESRB is allocated a role to set guidance for the countercyclical buffers, that has to be taken ‘into account’ by the national authorities, but is not binding108. Compliance will be monitored, but commonly understood and applied criteria will likely be thin on the ground in the initial years; see chapter 6.2. Though this diversified – national – setting of countercyclical buffers is applauded for its flexibility109, national authorities can deviate even within the rudimentary guidance available. Other factors that may not be aligned with countercyclical considerations may play a role in setting them. Such considerations could include an overeager national view that short term economic growth by having bigger banks or enterprises or more lending to the state would be better now than constraining such lending for macroprudential long term reasons; beyond the next election cycle.

107 The ECB/ESRB Regulation refers to art. 127.6 TFEU. See chapter 3 and 23. Also see R. Smit, The European Central Bank, Institutional Aspects, The Hague, 1997, chapter 5; and H. Davies & D. Green, Banking on the Future, The Fall and Rise of Central Banking, Princeton, 2010, chapter 7. 108 Art. 135-140 CRD IV Directive. 109 M. Brunnermeier, A. Crockett, C. Goodhart, A.D. Persaud, H.S. Shin, The Fundamental Principles of Financial Regulation, Geneva Reports on The World Economy 11, 2009, chapter 4.

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Macro/Micro Solved? The reason macroprudential supervision was conceived was to take a view on issues that may be sensible on an individual or microprudential basis (invest in a booming market, try to sell as quick as possible in a market going down, before it goes down even more because others are feared to sell too), but not on a collective basis. The ESRB is however only empowered to look at broad trends. Neither supervisors, central banks, nor ministries of finance have been empowered nor can they be forced to intervene if something happens now. An example of possible intervention measures are the bans on short selling. These help, at least if you believe the allegation that speculators are the main sources of e.g. bank bonds or government bonds being sold in the 2007-2013 subprime crisis. However, such bans do not address the fact that selling e.g. Greek bonds, or USA money market funds stopping to fund EU banks with enough dollars during the summer of 2011, is a wise move on an individual basis, but exacerbates a crisis if done collectively. The herd is causing the crisis it was anticipating. How to address it without for instance stopping trading in whole categories of bonds for extended periods with all its unintended consequences for the markets and any further funding sought by the banks, governments or other entities sought is unclear. Pointing to speculators rather than traders overloaded on negative, of buoyed on overly positive, emotive analysis is an easy thing to do. Stopping the music when everyone wants to continue dancing is not, neither is keeping the party going if everyone wants to leave. Part of the problem for any macroprudential authority is that many of its current or future instruments are built into areas that are not macroprudential but microprudential, trading/payment system related, monetary or fiscal110. The BCBS has built instruments with a macroprudential slant into the microprudential capital accord. Its countercyclical buffer and even e.g. its leverage ratio, the liquidity ratios, the upgrade of equity definitions with loss absorbing features in going concern could be named ‘macroprudential’ in nature, though they also make the individual bank that is subject to them more resilient (microprudential)111. Even though both central bankers and supervisors have always been represented in the BCBS and in EBA (and its predecessors), the tasking with this new-fangled concept of the ESRB will mostly ensure that it is less likely that the overarching concept of financial stability (nor the other pillars that should support it) will not be ignored when each of the parties involved looks at its own primary mission. This could be part solved

110 A. Houben, R. Van der Molen & P. Wierts, ‘Making Macroprudential Policy Operational’, Banque central du Luxembourg, Revue de stabilité financière, 2012, page 13-25; C. Lim, F. Columba, A. Costa, P. Kongsamut, A. Otani, M. Saiyid, T. Wezel, X. Wu, Macroprudential Policy: What Instruments and How to Use Them? Lessons From Country Experiences, IMF WP/11/238, 2011. 111 P. Went, Basel III Accord: Where Do We Go From Here, 15 October 2010, www.ssrn.com/abstract=1693622.

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EU Banking Supervision by allocating all these tasks to the same entity112. Within the banking union thinking, several of these tasks will revolve around the ECB. However, the Chinese walls that are or will be built between the ESRB secretariat, the monetary tasks (of the ECB/ESCB), and the prudential tasks under the single supervisory mechanism will make effective coordination difficult even if all such tasks are worked on – with outside parties such as national central banks, the European supervisory authorities, and national supervisors – on the premises of the ECB. This area will need a lot of development to become a pillar to build financial stability on. Whether it can manage that – absent clear and binding instruments such as intervening in accountancy standards, in prudential rules and in the markets – is highly unlikely. Even if it could do those things, the effect might be mixed. By sounding the horn at an early stage on the development of e.g. securitisation from a helpful small scale funding and risk spreading tool into a main business model and a key part of ‘hide and seek’ regulatory arbitrage, this might have been useful. However, nothing stopped central bankers and supervisors from coming to such research and conclusions prior to the event. If a macroprudential supervisor – better resourced and more independently structured than the ESRB – would be allocated such hard core instruments, it might well lead to abuse (e.g. setting too low countercyclical buffers as a measure of macroprudential forbearance), or finger-pointing at entities who are not key-players or influencers on its decision making committee for failing to live up to voiced but unrealistic expectations. The first decisions published of the ESRB might already point in this direction113. The first two recommendations are expansive on what supervisors should do, short on what national legislators should do, and very short on what EU legislators should do. There is barely any indication as to what the key-players on its decision making committee (i.e. the ECB/ESCB and the individual central banks) should themselves do to address the issues identified. Such could include warnings to take prudential issues (on banks, but also on insurers, pension funds or other core financial institutions) and procyclical effects of capital regulation into account in the determination of monetary policy, as well as obligations to work well and constructively domestically with other authorities in the financial

112 L.E. Panourgias, Banking Regulation and World Trade Law, Oxford, 2006, page 199-207, chapter IV notes the interdependencies of these aspects and proposed that the ECB should play an active role. 113 ESRB, Recommendation on Lending in Foreign Currencies, 21 September 2011, ESRB/2011/1; ESRB, Recommendation on US dollar Denominated Funding of Credit Institutions, 22 December 2011, ESRB/2011/2; ESRB, Recommendation on the Macroprudential Mandate of National Authorities, 22 December 2011, ESRB/2011/3.

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stability area114. In an ideal world the ESRB could assume that its own members would always behave in the best way and with the best intentions for the Eurozone and the EU as a whole, and with domestic and institutional humility (i.e. lacking a lust for power and avoiding extra-territorial effects). Sadly this is not an ideal world. The lack of homework for the organisations controlled by the ESRB decision makers themselves does not lead to optimism, and shows a distinct difference from work of EBA (where e.g. work on pillar 2, model validation, supervisory disclosure and supervisory colleges spells out the tasks of both banks and of the supervisors controlled by the members of EBA). Whether the ESRB will work is yet to be determined. The early stages of the crisis can of course not be ‘blamed’ on it – though its component authorities were of course already involved in financial stability – but it appeared to have been silent on issues that may have benefited from a private or public macroprudential warning, such as the approaching crisis in Cyprus in 2013. Time will tell, however, but if the ESRB is waiting to become contrarian and wildly unpopular115 and warn on impending mini-booms and busts until after a full cycle has turned and the 2007-2013 subprime crisis is finally ended, it may be too late for its continued existence in the present format. On the other hand, that may lead to a more independent institution with more instruments to achieve the goals of macroprudential policy; and possibly a clearer final responsibility allocated to some authority for financial stability in all its facets. Future Developments The CRD IV project will impact on the ESRB remit. Though the current legislation allows member states to do both less and more than possibly desirable for long term financial stability/macroprudential issues as a result of the large number of national discretions and minimum-harmonisation norms, this will be reduced by the CRD IV project. It will eliminate some national discretions, amongst others by its largest part being issued as a regulation instead of a directive, and the limits on the number of issues where member states and their supervisors can ‘goldplate’. This harmonisation is desirable, but it could lead to difficulties if ESRB advice could no longer be legally followed up upon as it would be deemed goldplating. The CRD IV project addresses this only implicitly by keeping the pillar 2 instrument and other core macroprudential instruments in the directive with its implied implementation flexibility. The ECB correctly proposes that national supervisors in some clearly identified cases should be allowed to go beyond the agreed level of super114 S.G. Cecchetti & L. Li, Do Capital Adequacy Requirements Matter For Monetary Policy?, NBER Working Paper Series WP 11830, December 2005. 115 See e.g. C.A.E. Goodhart, The Macroprudential Authority: Powers, Scope and Accountability, LSE FMGPS Special Paper 203, October 2011; and chapter 6.5 on the countercyclical buffer and efforts to end procyclicality.

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visory requirements at least in those cases where there is a consensus in the ESRB that there are macroprudential risks116. The ESRB has only a (limited) guidance and monitoring role in setting countercyclical buffer requirements. The procedures on assessing macroprudential risks in the context of the additional buffers appear to be burdensome, and may need to be streamlined. The CRD IV project requires that a designated national authority sets the countercyclical buffer. The member state also has three other macroprudential type instruments that have to be allocated to a national authority: – setting a individual systemically relevant risk buffer for a group or individual bank (see chapter 6.2); – setting a general systemic risk buffer for the financial sector if needed for systemic/macroprudential reasons (see chapter 6.2); and – instituting the emergency procedure to deviate from the CRD IV project binding requirements for systemic/macroprudential reasons (see below). The member state is allowed to choose between the designated authority that sets the countercyclical buffer, or the supervisor. De facto a member state can thus create a single macroprudential authority with some actual own instruments vis-à-vis banks117. The supervisor will also be able to set a higher risk weight for mortgage lending, depending on financial stability considerations118. The CRR introduces an emergency procedure to allow a member state to apply deviations that result from systemic/macroprudential problems119. A situation where this might occur is for instance when the member state anticipates that it will suffer a full-blown crisis, that it is likely to apply for a state bailout or if another catastrophe happens that also makes the prudential demands on banks not strict enough. The proposed stricter rules would apply for up to two year (or until the problems disappear), but can be extended if needed120. The procedure is thought to be exceptional, and the member state will have to show that the existing flexibility contained in the CRR and CRD IV directive are not sufficient. These safeguards against abuse are only effective if both the Commission and (a qualified majority of) the Council are opposed to the proposed actions by the member state. However, 116 See the opinion of the ECB on the CRD IV Proposed Regulation and Directive, 25 January 2012, CON/2012/5, page 5-6, 46-49. 117 Art. 131.1, 133.2 and 136.1 CRD IV Directive, and art. 458.1 CRR. 118 Art. 124 CRR, with EBA required to develop regulatory standards by end 2014 on how to assess the value and the circumstances where higher risk weights are appropriate. 119 Recital 20 and art. 458 CRR. If the anticipated problems touch multiple member states, they can make a joint submission according to the recital. 120 Art. 458.4 and 458.9 CRR.

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the procedure may result in a delay for the applicability of the measures needed by at least one month (it can introduce them if the Commission failed to appeal to the Council within a month, within which period the ESRB and EBA are also to advice the Commission, Council and the member state involved). Whether stricter requirements will be helpful in such situations, especially if the crisis situation has meanwhile materialised, remains to be seen. Banks will find it difficult to fulfil higher safety requirements if the crisis has materialised or is expected by the markets too. Other member states may decide to apply the stricter rules to branches of their banks in the affected member state. From the moment the procedure has been started (and all documents has been submitted), and regardless of its outcome, some specific measures may be taken for two years, including a 25% increase in some credit risk weightings121. In addition, the Commission can by a delegated act temporarily increase some own funds, large exposures and pillar 3 requirements, if there are EU wide market developments that necessitate it, or reduce them if there are ‘specific circumstances’122. The Commission will review the macroprudential rules in the CRD IV project already by mid-2014, well before some of them (such as the systemic risk buffer, the countercyclical buffer, and/or the individual buffers demanded from groups or banks that are systemically important) are implemented, and has to send a report plus possible changes in the rules to Parliament and Council by end of 2014123. The Commission proposals on the single supervisory mechanism124, including its allocation to the ECB in a separate supervisory department, do not clarify how the EU wide ESRB would cooperate with the Eurozone wide operating supervisory department of the ECB. It might be expected that the ECB will participate in the ESRB not only as the host organisation and secretariat provider, but also as a member in its own right. This even though currently the national supervisors are not members (they are but represented at the ESRB via EBA and via their national central bank). How this chimes with the envisaged coordination of Eurozone positions by the ECB at EBA, is not clear. As stated in chapter 21.3 this coordination of points of view of Eurozone delegates by the ECB does not seem advisable in the first place. The same applies to the overlap at board level between ESRB and ECB, and at the secretariat level between the ECB-employees that in practice provide

121 122 123 124

Art. 458.10 CRR. Recital 21, 125 and art. 459 respectively 456-457 CRR. Art. 513 CRR. Commission, Proposed Single Supervisory Mechanism ECB Regulation and Proposed Single Supervisory Mechanism Amendment to the EBA Regulation, COM(2012) 511 final and COM(2012) 512 final, 12 September 2012.

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the ESRB secretariat. Circular puppeteerism or a blank spot for any action to be taken by the ECB that it internally has not yet agreed upon could be envisaged. The Liikanen report amongst others proposes to improve the instruments that macroprudential authorities have, with EU level harmonisation. The report refers to the possibility of such authorities being able to set loan-to-value and/or loan-to-income caps to limit excessive growth, and common definitions on when such caps should be imposed125. The Liikanen recommendation is in line with ESRB recommendations for the set-up, tasks and instruments of national macroprudential authorities126. The recommended wide range of instruments – if and when introduced and if and when allocated to a sufficiently independent and contrarian authority without conflicting goals as also recommended – could help alleviate some of the cyclical or structural deficiencies in the financial economy. The ESRB plans monitoring of compliance after the recommended timeline of introduction of national authorities as per end June 2013, and of the instruments as per end 2014, but as indicated above has no teeth if its recommendations are not followed up upon by the member states127. Past experience, however, does not provide a hopeful outlook for such instruments leading to long term financial stability even if all implemented and maintained128. Several instruments were withdrawn or cancelled when thought to be ineffective, or when they ran counter to other policy objectives such as deregulation, the growth of the economy, or access to affordable lending. During the simultaneous review of the structure of the European financial supervision structures in early 2013, the former chair of the group that proposed establishing the ESRB voiced concerns on what has been achieved129. Literature – Final report of the high-level group on financial supervision in the EU, chaired by Jacques de Larosière, 25 February 2009 (De Larosière report).

125 High-level Expert Group on Reforming the Structure of the EU Banking Sector, Final Report, 2 October 2012 (Liikanen Report), page 80-81. 126 ESRB, Recommendation on the Macroprudential Mandate of National Authorities, ESRB/2011/3, 22 December 2011, and ESRB, Recommendation on Intermediate Objectives and Instruments of Macroprudential Policy, ESRB/2013/1, 4 April 2013. Also see A. Houben, R. Van der Molen & P. Wierts, ‘Making Macroprudential Policy Operational’, Banque central du Luxembourg, Revue de stabilité financière, 2012, page 13-25. 127 ESRB, Recommendation on the Macroprudential Mandate of National Authorities, ESRB/2011/3, 22 December 2011, section 2, and ESRB, Recommendation on Intermediate Objectives and Instruments of Macroprudential Policy, ESRB/2013/1, 4 April 2013, section 2. 128 D. Elliot, G. Feldberg & A. Lehnert, The History of Cyclical Macroprudential Policy in the United States, WP 2013-29, 15 May 2013. 129 J. De Larosière, Keynote Speech at the public hearing ‘Financial Supervision in the EU’, 24 May 2013.

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– Committee on the Global Financial System, Macroprudential Instruments and Frameworks: a Stocktaking of Issues and Experiences, CGFS paper 38, May 2010, www.bis.org, including an annexed (economic) literature review – BCBS, Guidance for national authorities operating the countercyclical capital buffer, December 2010 – Brunnermeier, Markus; Crockett, Andrew; Goodhart, Charles; Persaud, Avinash D.; Song Shin, Hyun, The Fundamental Principles of Financial Regulation: Geneva Reports on the World Economy, Centre for Economic Policy Research, 2009 – Roxburgh, Charles, Debt and deleveraging: the global credit bubble and its economic consequences, McKinsey Global Institute, London, January 2010 – Davies, Howard; Green, David, Banking on the Future: The Fall and Rise of Central Banking, Princeton University Press, 2010, chapter 7 – Wall, Larry D., Prudential Discipline for Financial Firms: Micro, Macro, and Market Structures, Federal Reserve Bank of Atlanta, WP 2010-9, March 2010 – Hanson, Samuel G.; Kashyap, Anil K.; Stein, Jeremy C., A Macroprudential Approach to Financial Regulation, Chicago Booth WP 10-29 (Initiative on global markets working paper 58), November 2010 – Agénor, P.R.; Alper, K.; Pereira da Silva, L., Capital Regulation, Monetary Policy and Financial Stability, Banco Central do Brasil, working paper series 237, April 2011 – Crockett, Andrew, Market Discipline and Financial Stability, speech 23 May 2001 – Panourgias, Lazaros E., Banking regulation and world trade law, Oxford, 2006, chapter IV – Goodhart, C.A.E., The macroprudential authority: powers, scope and accountability, LSE FMGPS special paper 203, October 2011 – Elliot, Douglas, Feldberg, Greg, Lehnert, Andreas, The history of cyclical macroprudential policy in the United States, WP 2013-29, 15 May 2013 – Rethel, Lena; Sinclair, Timothy J., The Problem with Banks, London/New York, 2012

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Part E Legislative Process

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The EU Legislative Process for Banking Supervision

23.1 Introduction The European Union, its institutions and powers are the result of an agreement between sovereign states. They voluntarily entered into the agreement, in order to enjoy the benefits of the common market and common policies agreed under that agreement. In return, they delegated a limited amount of their sovereign power to the commonality of their interests, personified in the European Union and its institutions. That transfer of power also relates to the possibility to set common binding rules in several areas, including the legislation in the area of financial services and its supervision. The European Union agreements are laid down in two treaties. Both have been amended frequently since their inception by amending treaties often referred to by the location they were signed, such as Maastricht or Nice. The most recent amendment was by the Lisbon treaty. One of the two treaties is focused on the areas of competence and the institutions, the other on the establishment of the Union itself, as well as dealing with sovereign issues such as limitations on the power of the EU and foreign policy: – the treaty on the functioning of the European Union (the ‘TFEU’; previously known as the treaty establishing the European Community or ‘TEC’, or as the treaty of Rome after its original place of signing); – the treaty on European Union (the ‘TEU’, previously also known as the Maastricht treaty after its original place of signing). The two treaties were fundamentally overhauled on the legislative process and their general structure by the so-called Lisbon treaty, which entered into force on 1 December 2009. Parts of the versions of the treaties in the previous (Nice) treaty version will remain valid for a transitional period1. The Lisbon treaty – drafted when the proposed constitution for the EU failed to be ratified by the member states – did not entail great changes on the various provisions on which legislation in the area of financial services can be based; see chapter 3.4. It does, however, 1

The 2001 Nice Treaty, named after the city where it was agreed, amended the TEU and TFEU as per 2003. It introduced e.g. different voting weights for the Council, some of which will remain valid until 2017 under the Lisbon Treaty Transition Rules. See art. 16 TEU and art. 238 TFEU.

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clarify the process and enlarges the role of the European Parliament and the domestic parliaments. The treaty is intended to improve the functioning of the institutions, in light of the enlargement of the EU by 12 new member states in 2004 and 2007. The decision making process was assumed not to be able to handle negotiations in the enlarged membership of the Council, Commission and Parliament, though the predicted slowdown of the EU does not appear to have materialised. More speed should not be expected from the changes in the Lisbon Treaty. On the contrary, the added step to give domestic parliaments an independent timeslot to intervene in the legislative process will further slow the process down, unless there is an outside driver (such as the 2007-2013 subprime crisis). TFEU and TEU The TFEU deals with the following issues: – the basic freedoms and policies of the single market, including free movement of persons, services and capital, common economic and monetary policy and consumer protection; – measures to enhance competition and to prevent state-aid from influencing competition; – citizenship of the Union; – the institutions of the Community, including the European Parliament, the Council, the Commission and the Court of Justice. The TEU deals with the following issues: – common foreign and security policy; – police and judicial cooperation in criminal matters (including terrorism, corruption and fraud; – enhanced cooperation by (at least) 8 member states. Enhanced cooperation has so far not been used for banking supervision, though it has been used in economic areas such as the treaty supporting the stability and growth pact, and may be used for the financial transaction tax; see chapter 22.3-22.4. These EU treaties set out both the content on which the institutions can act, as well as the limitations they have to take into consideration. Beyond the authority given to them in the treaties, they cannot take measures, except if a new treaty amends the currently applicable version2. Several protocols have been added to the two treaties (annexed to both) on issues such as the Schengen acquis, the position of the UK, Ireland and Denmark, the Court of Justice, and on the principles of subsidiarity and proportionality (see chapter 3.4 and below). However, where the EU acts on the basis of the treaty, either directly via provisions in the EU treaties or via secondary legislation such as the banking directives, these 2

Art. 13 TEU.

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acts have supremacy over national legislation, including over subsequent national legislation and over national constitutions3. The cross-border access of banks to the markets in other member states within the internal market in the EU is covered by the freedom of establishment and by the free movement of services, which have been part and parcel of the treaties since the development of the common market concept. These basic freedoms, however, do not always provide the intended open borders in the absence of detailed directives that provide a clear route for their application (see, however, the cases in which ‘direct effect’ of EU legislation provisions lead to the direct application of these freedoms; chapter 3.4). In areas that have not been fully harmonised, member states to some extent are still allowed to implement restrictions: – if the particular market has not been liberalised (i.e. if no harmonised EU rules are in place); – if necessary for public policy purposes. They cannot implement restrictions that clearly hinder the basic freedoms4, but in absence of detailed agreement on the content of public policy requirements, this still gives them substantial leeway to impose their own requirements if they can legitimately claim that this is necessary for the (domestic) so-called ‘general good’ or for public policy reasons (see chapter 3.5). A member state can impose additional requirements if needed either for true governmental national interest purposes (public policy) and where the interest of society is best served (general good) by additional requirements. But the test to pass this hurdle is strictly applied by the Court of Justice. The member state can do so if, and only if: – there is a valid interest to be protected (an overriding requirement relating to the public interest; – the measure taken is suitable to secure that specific objective; – the objective cannot be achieved in another way, which would not hinder the application of the main rule.5

3

4 5

Van Gend & Loos/ Netherlands Inland Revenue Administration, Court of Justice 5 February 1963, Case 2662; Costa/Enel, Court of Justice 15 July 1964, Case 6/64. Internationale Handelsgesellschaft/Einfuhr- und Vorratstelle für Getreide und Futtermittel, Court of Justice 17 December 1970, Case 11/70; D. Chalmers, C. Hadjiemmanuil, G. Monti & A. Tomkins, European Union Law, Cambridge, 2006, chapter 2 and 5. Such hinder nonetheless needs to be proven; see Volksbank/CJPC, Court of Justice 12 July 2012, Case C-602/10. See case law ranging from e.g. Van Binsbergen, Court of Justice 3 December 1974, Case 33/74; the coinsurance cases such as Commission/Denmark, Court of Justice 4 December 1986, Case 252/83; to Caixabank France, Court of Justice 5 October 2004, Case C-442/02.

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In the area of banking, the various financial services directives contain detailed provisions that fill in and facilitate the application of the basic freedoms of establishment and services. Where full agreement has been reached, the public policy/general good doctrine prevents member states from adding requirements on banks based in other member states, though for local banks and for non-harmonised issues they can still develop their own rules (see chapter 3.5). For issues as sensitive to the public interest as deposit taking, payment services and investment services, the harmonisation agreed under the EU treaties by the member states in Council and EU Parliament effectively prevents the use of the general good/public policy exceptions to add prudential supervision requirements6. The directives that can fill in the conditionality for the freedom of establishment and for the freedom of services are subject to the same legislative procedure (the ordinary legislative procedure as described in chapter 23.2). There were slight differences in the pre-Lisbon treaty version in the legislative procedure, but even then they both included parliamentary involvement and qualified majority voting at the Council. Understanding Court of Justice case law7, the legislative procedure chosen to approve the CRD – in the co-decision process between Council and Parliament in the ordinary legislative procedure – would appear correct. In the wake of the Lisbon treaty, there has been little appetite to revisit the EU treaties. In order to deal with the sovereign crisis during the latter phases of the 2007-2013 subprime crisis, the willing EU members signed a treaty to reinforce the stability and growth pact that entered into force on 1 January 2013; see chapter 22. This additional treaty, however, does not focus on the legislative process, but on the Eurozone and on fiscal discipline of the signatories, including monitoring by the Commission and the possibility to sue each other for non-compliance at the Court of Justice. For further reading, see e.g.: – Craig, Paul, De Búrca, Gráinne (ed), The evolution of EU law, 2nd edition, Oxford, 2011 – European Union Law, Chalmers, Damian; Hadjiemmanuil, Christos; Monti, Giorgio, Tomkins, Adam, Cambridge, 2006 – Chiu, Iris H.-Y., Regulatory convergence in EU securities regulation, Alphen aan den Rijn, 2008 6 7

The directives instead specify where member states have instruments to intervene, and where they can introduce harsher rules than the minimum level of protection agreed. See chapter 3.5. See its case law ranging from the Titanium Dioxide Case, Commission/Council, Court of Justice 11 June 1991, Case C-300/89 to Parliament/Council, Court of Justice 6 November 2008, Case C-155/07, as referenced in the latter judgment.

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– Dragomir, Larisa, European prudential banking regulation and supervision, the legal dimension, Oxon, 2010, chapter 7-10

23.2 The Formal Legislative Process For Banking Legislation: the TFEU Introduction The TFEU sets out the legislative process. It defines in which areas the EU can legislate (see above for the banking sector), under which circumstances (see above) and whether the legislation subsequently is binding as to results, form, both or neither. The institutions can issue binding so-called regulations, directives or decisions, and non-binding recommendations or opinions8: – Regulations are binding in both substance and form, as they apply directly in each member state. As this is the form most intrusive upon the sovereignty of the member states, regulations can only be issued in certain specific areas where allowed in the treaties. On banking legislation, regulations can only be used if they can be based either on the goal to approximate laws to achieve the internal market or to achieve the goal of consumer protection9. – Directives are binding as to the specific targets that are set out in them. They are addressed to the member states, and ‘bind’ them to achieve the target. It leaves member states free as to the choice of form and methods. On all the goals mentioned in chapter 3.4 and 4.3 in the area of banking legislation, the EU can issue directives. This has been the instrument of choice for prudential banking requirements. – Decisions are binding on the specific entity or entities to which they are addressed. This is not so much a legislative power (binding many to the same rule), but an implementation power of the EU institutions (directed at individuals). – Recommendations are non-binding. They are used where the EU or one of its institutions has a clear view of how it would like the member states to approach a certain area in their legislation or actions, but either has no legislative power, or (at that stage) lacks sufficient data or sufficient consensus to legislate bindingly at that time. Such recommendations may well be followed by legislative proposals in due course. If worded in an imperative manner, they may be deemed by the Court to have a binding intent. In that case, the Court is very likely to declare it void, as such a binding text cannot be issued in the form of a recommendation, and it is unlikely that the correct legal proce-

8 9

Art. 288/289 TFEU. Art. 114 and 169 TFEU both refer to ‘measures’ that can be taken to achieve these goals. The term ‘measures’ refers to all legislative instruments mentioned in art. 288 TFEU, including both regulations and directives. All other EU goals on which banking legislation can be based (see chapter 3.4) specifically limit the EU to directives.

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dure is followed that would allow the issuance of binding texts (i.e. a directive or regulation)10. – Opinions are non-binding, and are usually addressed to another law-making entity with the request to take the views expressed in the opinion into account when legislating or taking action. The treaties distribute the rights and obligations in the legislative process over the main EU institutions. The main EU institutions involved in the area of financial regulation are the Commission, the Parliament, the Council, and the European Court of Justice11. The ESCB/ECB, the Economic and Social Committee and national parliaments have specific rights to advise. The newly established president and European Council (of heads of state or government) are not expected to have a direct role in banking supervision. The Council (of ministers of finance) has been allocated the legislative role. In addition, EU legislation based on the treaties (amongst which the CRD for the banking area) establishes several bodies with supportive functions on financial regulation (such as EBA, see chapter 3 and 21). They function under the authority of the TFEU institutions (who have delegated certain tasks) in a process referred to as the Lamfalussy/Larosière process (see chapter 2, 3 and 23.3). Being set up by decisions, directives and other mandates of TFEU institutions, they are bound by the same limitations and procedures as the EU institutions themselves. The treaty differentiates between two types of legislative processes12, the ordinary (‘joint’) process by Council and Parliament, and legislation by the Council. In the ordinary (or joint) legislative process, where agreement of both the European Parliament and Council is necessary to issue new legislation. This process is applicable to the treaty freedoms, as well as to consumer protection (see chapter 3.4). If the Council has been given the power to legislate by itself, the Parliament nonetheless has been given a window of opportunity to indicate its approval or rejection. That approval or rejection impacts on the voting procedure within the Council. If the Parliament rejects the proposed legislation, the

10 See France/Commission, Court of Justice 20 March 1997, C-57/95. This applies also to guidelines and such. This would in principle also apply to other documents without binding status, such as guidelines, principles or others, which can only be binding if based on a sufficient legal basis. Whether the comply or explain language that gives any EBA guideline semi-binding status is acceptable will depend on future case law; see article 16 EBA regulation 1093/2010. It could be defended that certain acts prescribe a specific legislative procedure, which is not followed in the creation of guidelines. 11 Art. 13 TEU. It also refers to a Court of Auditors, which is not relevant for banking supervision at the moment, as it concerns the financial organisation of the EU. The Economic and Social Committee and the Committee of the Regions, Advisory Bodies, have not played a large role on banking supervision. Banking supervision is still nationally funded, though EU funds have begun to flow towards some EU cooperation projects; see chapter 21.9. For a description of the EU institutions, see D. Chalmers, C. Hadjiemmanuil, G. Monti & A. Tomkins, European Union Law, Cambridge, 2006, chapter 3. 12 Described in art. 294 and art. 115/352 TFEU respectively.

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Council can still adopt the legislation in spite of a rejection by the Parliament if the members of the Council are unanimous in that decision. This process is applicable for internal market issues not related to the cross-border freedoms, and on issues that are out of scope of the treaty, but where the Council unanimously decides to issue measures. Under the predecessor treaty, this special regime had a wider applicability. In a newly introduced provision of the Lisbon treaty, the European Council (the government leaders, if unopposed by national parliaments) can opt to allow the Council (composed of the national ministers competent on banking; generally the finance ministers) to follow the normal legislative process even when the special process is prescribed13. Under the old treaty, under which the various directives were drawn up, this would have made the resulting legislation invalid. Ordinary (Joint) Legislative Process In practice, since its introduction into the TFEU, the joint legislative process has been used for amendments to EU banking supervision legislation, with Parliament and Council sharing responsibility. This is in line with a broader shift to involvement of Parliament in legislation as evidenced in every revision of the treaties, including the recent Lisbon treaty and in line with the democratic principle on involvement of the people via their elected assembly14. The joint process brings together – in a very complicated dance – the prerogatives of the Commission, Council and Parliament. The Commission (in banking supervision represented by the directorate general Market) functions as the body that comes closest to the EU equivalent of a national political bureaucracy (ministries). It has a core role in the legislative process, as it is the only body that can initiate legislative proposals; the right of initiative. This power is balanced by the fact that the Parliament and the Council can subsequently amend the proposal and are the only ones that can actually adopt EU legislation under the TFEU (though they can delegate some legislative tasks to the Commission if they so desire; see chapter 21.3 and 23.3). The European Parliament is composed of parliamentarians chosen directly for a term of five years by the electorate of the 28 EU member states15. Before voting on new EU laws, the Parliament allocates the task of first scrutiny of Commission proposals to committees. In the area of banking supervision all the parliamentary work in the legislative process is prepared and discussed in ECON16, its specialised committee in this area. The full Parliament needs to endorse the ECON recom-

13 Art. 48.7 TEU. 14 The Court of Justice has noted several times that the protection of the rights of the Parliament is important, as it is a reflection of that democratic principle. See e.g. Parliament/Council, Court of Justice 6 November 2008, Case C-155/07, in which a legislative measure taken by the Council alone was annulled. 15 Art. 14 TEU and 223-234 TFEU. As of 1 July 2013, when Croatia joined, there are 28 member states. 16 It normally appoints one of its members as a rapporteur. He is required to study the proposal in depth, and submit a report to the ECON. With the proposals this is the basis for any deliberations, and for the subsequent draft parliament opinion, submitted for voting (normally without further discussion) in the plenary session of Parliament.

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mendations. The Council (in the area of banking supervision also referred to as Ecofin), brings together the domestic governments of the member states, to play its part in the balance of EU, public representation and member states governments interests. Also see chapter 3.3. The ordinary legislative process consists of twelve steps17: 1. The Commission has the sole right of initiative, meaning it is the only body that can initiate new legislation or amendments to existing legislation. Neither the Council nor the Parliament can independently start the legislative process, though they can request the Commission to submit a proposal. If the majority of the members of the Commission agree on a proposal, it sends the proposal to both Council and Parliament. The Commission has in recent years followed a process under which it normally arrives at the text of a proposal for new legislation as the result of an in-depth consultative process, taking into account the results of meetings with experts from member state institutions and ministries, as well as public consultations. For the financial sector, this is shaped amongst others in the so-called Lamfalussy/Larosière process (see chapter 23.3). Once sent to Council and Parliament, the proposal is also the basis for advice sought from the ECB (as required for all legislation on banking supervision, see below) and from the Economic and Social Committee, an advisory body of the EU in all areas covered by the TFEU. 2. National parliaments receive the proposals at the same time as Parliament and Council. They have some time to make clear whether they have concerns on the proposals, especially if they are of the opinion that the issue could better be dealt with at the member state level instead of at the EU level. This scrutiny procedure was newly introduced as a result of the Lisbon treaty. 3. The Parliament subsequently has to take the formal step to issue a so-called position on the proposals. Its positions, including amendments, are reached by an absolute majority of the votes that are cast (so 50% plus one of all members that actually voted). 4. The Council (ministerial level; on banking the so-called ‘Ecofin’ of finance ministers) can subsequently decide on the proposal. Its decisions are prepared in the committee of permanent representatives of the member states (‘coreper’). It has two options: (a) The Council can adopt the proposal as it stands, including all amendments the Parliament has proposed if it votes in favour by a qualified majority. The vote of each member state is weighted in line with the TFEU (large countries having more votes than smaller), and of the votes cast a reinforced majority needs to be in favour (around 70% of the

17 Art. 5, 16, 17 TEU and art. 127, 225, 231, 238, 240, 241, 250, 288-299, 304 TFEU as well as protocols 1 and 2 to the treaties.

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6.

7. 8.

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votes cast)18. If a sufficient quota of votes by member states is cast in favour, the legislative process would be concluded, and the proposal would be adopted (see step 10-12). Except for very technical and uncontroversial issues, this is not a much travelled route. (b) However, if the Council does not agree in full with the opinion of the Parliament (e.g. it wants to make some amendments itself, or a qualified majority does not agree with all amendments proposed by Parliament), it needs to adopt its own position on the proposals, also by qualified majority voting. With its reasoning, this is sent to Parliament. At this stage, the Commission is to comment on the various amendments to its original proposal. It will need to inform Parliament of its position on the common position of the Council. Parliament has three choices, to accept (or ignore, which is deemed to be an acceptance), accept with amendments, or reject. If it rejects the Council position, the proposal is off the table definitively, until the Commission restarts the legislative process with a new proposal. If it accepts (or ignores for three months, which term for its deliberation it can extend by one month) the Council position, the new legislation would be adopted (see step 10-12). If it accepts with amendments, the amended text is sent to Council and Commission. The Commission has to deliver an opinion on each of the amendments proposed by Parliament, and specify on which of the amendments it advices negatively. The Council can either approve all amendments or it can reject some or all of them. As before, it has to decide by qualified majority. However, if the Commission has given a negative opinion on one of the amendments, the Council can only overrule this veto if it votes unanimously in favour of the amendment. If the Council rejects some or all of the amendments, or cannot reach a decision within three months (possibly extended by one month), a ‘conciliation committee’ is convened. The committee is composed of equal numbers of members of the Council and of representatives of Parliament, with the Commission joining as an observer and facilitator. The conciliation committee has six weeks (that can be extended by two weeks) to try to reconcile the positions of Parliament and Council. If it approves a joint text, the full Council and Parliament have six weeks (that can also be extended by two weeks) to adopt the proposal on the basis of the joint text. If the conciliation committee or subsequently Council or Parliament19 do not approve a joint text, the proposal is off the table definitively, until the Commission restarts the legislative process with a new

18 From 2014, a different vote weighting process becomes applicable to Council qualified majority voting, as set out in art. 16 TEU. 19 With the Council again voting by qualified majority, and the Parliament by absolute majority.

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proposal. If all approve the joint text in time, the new legislation would be adopted (see step 10-12). 10. If the proposal is adopted, it has to be signed by the president of the European Parliament and by the president of the Council, and published in the Official Journal of the European Union. They are required to state the reasons for its issuance, and refer to any proposals or opinions that were obtained pursuant to the TFEU (see step 1). The new binding requirements enter into force on the day stipulated in the legislation itself. Normally, this is between one day and 20 days after the publication in the official journal of the EU. 11. After the legislation has entered into force, it is usually not yet the legislation that has to be applied. This depends in part on the type of legislation (see above) and in part on practicalities. If it concerns a so-called ‘regulation’, its contents can be immediately directly valid (without translation into domestic laws, the so-called ‘transposition’) or from a specified moment in time in each member state (see step 12). The delay-option is often driven by the need for changes in domestic laws that are necessary to be able to uphold the content of the regulation (e.g. to ensure enforceability in courts or to delete currently existing conflicting domestic legislation). If it concerns a so-called ‘directive’, the form so far most used in prudential banking legislation, it is addressed to the member states and obliges them to bring their local laws into conformity with the obligations in the directive. For this local legislative process, normally up to a year is granted to the member states. For the EU, the way in which domestic legislation is amended is not relevant. This can be by domestic legislative processes ranging from full formal parliamentary processes to changes in policies by (in banking) the banking supervisor. The more formal the process, the more difficult it becomes for domestic legislators to be able to adopt the necessary amendments within the time set, but it is its own responsibility to comply. See chapter 3.5. During the period between the entry into force and the date from which it has to be applied as a result of step 12, the old legislation will likely remain in force if this is specified in the transitional provision. 12. Apart from specifying the date by which the domestic legislation needs to be amended, the legislation also specifies from what day it will need to be applied in practice. This can be as short as the day after the amended domestic legislation needs to be in force, but can be much longer, e.g. if the changes necessitate changes in the IT systems of the subjects of the new legislation (such as banks). Apart from its right of initiative and its forceful interventions in the various steps of the legislative process mentioned above, the Commission also is charged with several other tasks in the context of preparation and implementation of EU legislation20. These vary 20 Art. 16, 17 TEU and 218, 220, 245, 290, 291, 337 TFEU.

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from research, issuing of (non-binding) opinions and recommendations on any subject, including on the interpretation of EU legislation, maintaining relations with international organisations, and ensuring that the provisions of the treaties and of EU legislation are applied in practice. It can also be delegated rule-making powers by the Council and Parliament under the conditions that they deem fit, within the boundaries set in the EU treaties. Normally, this option is used on more technical issues21. In order to protect the interests of the EU as a whole, the members of the Commission are required to be completely independent in the performance of their duties. They are forbidden to seek or take instructions from any government or from any other body, and refrain from any action incompatible with their duties under the treaties. The president of the Commission, respectively its other members as a body are, however, appointed by the Council, after a vote of approval by the European Parliament on a proposal that the Council makes upon proposals by the member states. The texts of draft Community legislation are fluid until the last moment. At every stage of the negotiation process, the whole text is under debate. There is relatively little time to consider inconsistencies, faulty cross-references and other minor discrepancies at later stages in the process, as such could impact on and confuse the negotiation process. After the political compromise has been reached, there can be no changes except in as far as they derive from the juris legis process. This process focuses, however, not so much on internal discrepancies as to the content but on the possibilities to translate the text in a consistent manner into the various languages in the EU. For the single market harmonisation of laws that impact on the internal market, but do not have the internal market as its primary target, a different and incompatible legislative process is applicable than the normal joint (or ordinary) legislative process. The Council has to act unanimously, and only has to consult Parliament instead of negotiate with it. As every member state in effect has a veto, it is not the legislative process of choice for the Commission, which – except for issues that are truly uncontroversial – prefers to choose the more flexible and inclusive joint legislative process. Court of Justice The Court of Justice22 is the final arbiter in any dispute in which the interpretation or application of EU legislation is relevant. It is the only arbiter that can determine that a

21 Art. 290, 291 TFEU. See chapter 3.4 and 23.3. 22 Art. 19 TEU, art. 251-281 TFEU and protocol 3 to the treaties, containing the statute of the Court of Justice. Also see D. Chalmers, C. Hadjiemmanuil, G. Monti & A. Tomkins, European Union Law, Cambridge, 2006, amongst others chapter 7 and 10.

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23 Foto-Frost/Hauptzollamt Lübeck-Ost, Court of Justice 22 October 1987, Case 314/85. 24 Van Gend & Loos/ Netherlands Inland Revenue Administration, Court of Justice 5 February 1963, Case 2662, D. Chalmers, C. Hadjiemmanuil, G. Monti & A. Tomkins, European Union Law, Cambridge, 2006, chapter 2. 25 Art. 260 TFEU makes explicit that member states are expected to comply with such a judgement, without further incentives. However, if they fail to do so, in a subsequent process penalties can be imposed by the Court of Justice. 26 Art. 263 and 277 TFEU indicates that the legality can be questioned on grounds of competence, infringement of an essential procedural requirement, infringement of the TFEU or of any rule of law relating to its application, or misuse of powers. If not legal, the act becomes void (in whole or in part).

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As the Court has summarised27, the EU is based on the rule of law, as a result of which neither its institutions nor its member states can avoid a review of the question whether the measures adopted by them (e.g. regulations, directives, decisions or all other actions) are in conformity with the basic constitutional charter. The TFEU (and since the reshuffle of provisions due to the implementation of the Lisbon treaty also the TEU) provide a complete system of legal remedies and procedures designed to permit the Court of Justice to review the legality of measures adopted by the institutions. For the Court to rule an act of an EU institution, including legislation, unlawful, it has to fall in one of four categories of review, which are interpreted restrictively as the EU institutions are allowed a broad discretion28: – lack of competence; – infringement of an essential procedural requirement; – infringement of the treaties of any rule of law relating to its application; – misuse of power. The use by individuals of this right to challenge has been severely restricted. Individual parties either need to be the addressee, or to have a direct and individual concern in the matter. A direct concern is only assumed if the concern affects the legal position of the applicant. This required individual interest is interpreted restrictively by the Court. The applicant must be uniquely concerned, in the sense that it is unlikely that others could be in the same position (distinguished in a similar manner as an addressee would have been)29. The Court of Justice is the final authority on disputes under the EU treaties, but the judicial route starts with proceedings at the ‘General Court’. This subsidiary Court to the Court of Justice (previously known as the Court of first instance) deals with the majority of cases. Its decisions can be appealed against at, reviewed by, or referred directly to, the Court of Justice itself on issues of law or of principle, not on the factual contested issues. In some areas, so-called Specialised Courts can be set up, that deal with all cases arising in that area instead of the General Court. The Court of Justice is a distinct entity from the European Court of Human Rights. All EU member states are, however, also a signatory to the European Convention on Human Rights, under which the European Court of Human Rights functions. Some of the provisions of the convention, and the judgements of the Court on their applicability, are also directly 27 Commission/European Investment Bank, Court of Justice 10 July 2003, Case C-15/00. 28 Art. 263 treaty. See D. Chalmers, C. Hadjiemmanuil, G. Monti & A. Tomkins, European Union Law, Cambridge, 2006, chapter 10. 29 Plaumann, Court of Justice 15 July 1963, Case 25/62. See D. Chalmers, C. Hadjiemmanuil, G. Monti & A. Tomkins, European Union Law, Cambridge, 2006, chapter 10.

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relevant to banking supervision. These include the right to privacy and the right to a fair trial (see chapter 20.4). ECB/ESCB The ECB is – with the national central banks of the Eurozone – part of the ESCB30. The ESCB is competent to set the monetary policy of the EU (at least for those member states that belong to the Eurozone), and has a primary goal to ensure price stability. The tasks of the ECB are thus also aimed at financial stability, which is also one of the goals of banking supervision. In addition, monetary policy is to a large extent effected via the interaction between the ECB and the banks. The ECB thus has a vested interest in the design and application of banking supervision legislation. For the tasks and organisational structure of the ECB, see chapter 22. The ECB is privileged and required to advice on any EU rules that affect basic tasks of the European System of Central Banks (ESCB), such as: – defining and implementing the monetary policy of the Community; – promoting the smooth operation of payment systems; – the smooth conduct of policies pursued by the competent authorities relating to the prudential supervision of banks (credit institutions) and the stability of the financial system. It is jealously guarding this right, and is claiming it also for Union laws that will be issued by other bodies than the Council and Parliament, e.g. via the adapted legislative process in the financial sector for more technical issues as described in chapter 23.331. The ECB has gained an additional channel of influence due to the establishment of the European systemic risk board (ESRB)32. The ESRB has been set up to provide warnings on developments that may threaten financial stability (also see chapter 3, 18 and 22). The ECB provides both the chair, one of the two vice chairs and the secretariat of the ESRB, and – like e.g. EBA – will provide information to the ESRB to ensure it can fulfil its role. The joint committee (consisting of the chairs of EBA, ESMA and EIOPA) will provide the second vice chair of the ESRB33.

30 Art. 13 TEU and 127-144, 282-284 TFEU, and e.g. art. 3, 19, 22 and 25 of protocol 4 to the treaties, containing the statute of the ESCB and of the ECB. For background on the development of the institutions, see e.g. J.A. Usher, The Law of Money and Financial Services in the European Community, 2nd ed., Oxford, 2000, chapter 10. See chapter 22.2. 31 See the opinion of the ECB on the CRD IV Proposed Regulation and Directive, 25 January 2012, CON/2012/5. 32 See ESRB Regulation 1092/2010 as well as ECB/ESRB Regulation 1096/2010. 33 Both the ECB and the ESRB also have a non-voting representative on the board of supervisors of EBA.

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Future Developments If and when the Commission proposals on the single supervisory mechanism would enter into force34, the ECB would gain two additional routes to influence legislation. It would gain a seat as an influential supervisor the EBA (putting pressure on the ability of EBA to get anything done, as well as likely increasing the reluctance of member states to entrust EBA with legislative tasks; see chapter 21.3 and 23.3). It would also become the primary supervisory authority for the Eurozone within the context of the single supervisory system, thus de facto having a large say on how supervision is performed (and regulation is applied). But most importantly it would gain legislative powers for the banks that are allocated to its remit. Though invited to exercise restraint in the recitals of the proposed regulation allocating prudential tasks to it, the treaty gives it unrestrained power to legislate on any subject allocated to it, where it itself feels that EU laws (including but not limited to EBA initiated standards) lack detail or are fully missing, and the proposed regulation adds a legislative basis to it in as far as such additional legislation is necessary to carry out its (very widely defined) tasks35.

23.3 Adapted Legislative Process in the Financial Sector (Lamfalussy/Larosière) Introduction The ordinary legislative process provides the member states in the Council – as well as the appointed members of the Commission and the chosen members of Parliament – with the opportunity to provide both concrete input into the drafting and the potential to stop unwanted legislation. This legitimises the process vis-à-vis the citizens of the EU, vis-à-vis the national political governments and vis-à-vis the central bureaucracy. A common complaint is, however, that it is a lengthy process, which is difficult to manage. Even small amendments to legislation can take as much time as large revisions. This makes it difficult to allow for desirable innovation and difficult to adapt to changing market circumstances or newfound insights. Especially in the financial sector innovations went quickly while effective integration of the cross-border markets was deemed to progress only slowly. Another complaint was that directives have not always been fully compatible internally or with other directives. A complaint from stakeholders was that the legislation in the past

34 Commission, Proposed Single Supervisory Mechanism ECB Regulation and Proposed Single Supervisory Mechanism Amendment to the EBA Regulation, COM(2012) 511 final and COM(2012) 512 final, 12 September 2012. 35 Recital 26, art. 4.1 and 4.3 of the Commission Proposals for the ECB Regulation COM(2012) 511 final, 12 September 2012. Art. 132 TFEU.

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has not always been based on technical expertise. Such discrepancies within EU legislation and with day-to-day practice resulted in difficult to apply and easy to evade legislation. The 2001 Lamfalussy Report and the 2009 De Larosière Report These complaints were vocal and deemed especially relevant in the securities sector. Innovations in financial products had been coming at an increasing pace, the relevant legislation was not always to the point and changes came often too late to be an important factor in the structuring and architecture of financial markets. As the problem was clear, but the solution was not (at least lacking a political consensus on the type of solution needed), a committee was established to study the issue. Under the chairmanship of the Belgian/Hungarian baron Lamfalussy, the so-called committee of wise men came up with proposals36 to make optimal use of the leeway provided in the Treaty provisions37. The treaties provide for the possibility that the Council and Parliament delegate in a legislative act certain issues to amend or supplement non-essential elements of the legislative act to the Commission38. As established by the Court of Justice, only those provisions that are intended to give concrete shape to the fundamental guidelines of EU policy are essential, everything else can be delegated in a generic manner to the Commission39. The Lamfalussy group proposed to differentiate between four distinct stages or levels in legislation. Two levels relate to binding legislation, separating: 1. highly political issues (so-called ‘framework principles’) that require the full parliamentary process; from 2. technical issues (so-called ‘implementing principles’), necessitating only checks and balances and involvement of the Parliament when and if it so desires. The other two levels relate to the implementation process, separating: 3. practical technical guidance for correct and harmonised implementation; from 4. legal enforcement possibilities under the treaty40. For each stage or level, Lamfalussy defined different roles for EU legislators and for (committees of) supervisors. The input of the financial industry and their clients would 36 Final Report of the Committee of Wise Men on the Regulation of European Securities Markets, Brussels, 15 February 2001 (the Lamfalussy Report). The Report also contained specific proposals on securities regulations, apart from the institutional arrangements discussed here. See for a critical appraisal e.g. G. Hertig & R. Lee, Four Predictions About the Future of EU Securities Regulation, January 2003. 37 Art. 290, 291 TFEU (of which art. 291 builds on art. 202 of the Nice version of the TFEU). 38 Art. 290 TFEU. 39 Afrikanische Frucht-companie/Council and Commission, Court of Justice 10 February 2004, Joint Cases T-64/1 and T-65/1, § 116-121. Also see D. Chalmers, C. Hadjiemmanuil, G. Monti & A. Tomkins, European Union Law, Cambridge, 2006, chapter 3. 40 E.g. art. 258 TFEU gives the Commission a key role in addressing non-compliance by member states. Other obligations to review and address compliance is e.g. given in the EBA Regulation 1093/2010 to EBA.

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be sought through consultation processes. The proposals for the second level of binding legislation built on the existing so-called comitology process, in which the Commission could be delegated a limited amount of law-making authority by the Council and Parliament41. Prior to the Lamfalussy advice, the possibility to delegate implementing powers via the comitology process42 was formally available but only rarely used in the financial services area. It was mostly limited to amending e.g. lists of banks exempted from the banking directives. The Lamfalussy report recommended expanding upon the existing possibility, to allow the Commission to deal with the less-political issues in a fast track process, though with scrutiny by representatives of ministries (at home accountable to their members of the Council). The process would also allow the European Parliament a window of opportunity to indicate the issues they do not want to delegate to others. Such issues are bumped up from level 2 or 3 to the full negotiation process at level 1, in a compromise on the recast role of the Parliament in this adapted comitology procedure43. Based on the compromise, the EU institutions adopted the proposals44. The Lamfalussy structures were introduced in the securities sector mid-2001. The base for such delegation under the previous version of the TFEU was (to phrase it politely) very narrow for the extended delegation envisaged by the wise men chaired by Lamfalussy. In spite of the narrow legal basis, the establishment in the securities sector was a success. The adoption in the securities sector in 2001 was well in time to allow it to be taken fully into account in several important new directives, e.g. the market abuse directive, the prospectus directive and Mifid (see chapter 16 on the applicability of these directives to banks). The benefits in added technical expertise and the potential speed of technical legislative changes were apparent, as well as the benefit of supervisors actually working intensively with each other in the level 3 committee for the securities sector (CESR, currently ESMA). The recommendation to expand the process to all financial regulation was made based upon the positive experiences in the securities sector. The CRD negotiations were reasonably advanced at the time of introduction. The choice was made not to make 41 Comitology Decision 99/468/EC, as replaced in the financial services sector by the Lamfalussy structures described in this chapter. Comitology was used only for details, and correspondingly allowed less scrutiny by the Council (at the time, the Parliament had an even more limited role). Also see E. Ferran, Building an EU Securities Market, Cambridge, 2004, page 77-82. 42 See D. Chalmers, C. Hadjiemmanuil, G. Monti & A. Tomkins, European Union Law, Cambridge, 2006, chapters 3 and 4. 43 L. Frach, Evaluating the Efficiency of the Lamfalussy Process: the Prospectuses Directive, Takeover Directive and MIFID as Case Studies, Research Group on Equity Market Regulation REGEM Analysis 16, Trier University, February 2008. 44 The final report by the Committee of Wise Men, chaired by Alexandre Lamfalussy, was published on 15 February 2001, and endorsed by the Council at the Stockholm on 22 March 2001. See www.ec.europa.eu.

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the CRD fully compatible with the Lamfalussy legislative structure. In 2004, the Lamfalussy structures were copied in the banking (and insurance/occupational pensions) sector. The restrictively narrow legal basis was addressed in the context of the Lisbon treaty amendment. Apart from delegating powers to ensure proper implementation in the member states, the treaty now allows for delegation to the Commission of powers to supplement or amend certain non-essential elements of the legislative act. When the Lamfalussy process was introduced across the sectors in 2004, it was also decided to perform an evaluation. For this purpose the so-called inter-institutional monitoring group had been set up to evaluate the effectiveness and efficiency of the Lamfalussy process. The investigation was performed in the best and worst tradition of the EU. Open, transparent, inclusive, but somewhat politically correct and bland, and delivered just at the time another event was starting to take away attention (the 2007-2013 subprime crisis). The main handicap was that nobody agreed on what the final architecture of EU financial services supervision should be. Consisting of representatives nominated by Council, Parliament and Commission, their clearest recommendations concerned the level 3 committees. Their report45 was generally positive on what had been done, but critical due to the fact that even the output delivered was not sufficient to keep up with the pace of innovation and integration in the financial markets. The results of the additional work actually showed that an open market for financial services with similar supervision in each of the member states was further away than previously admitted. The group recommended a further strengthening of the powers and role of the committees vis-à-vis (mainly) the national supervisors. A recommendation was made for some improvements, mainly on the working procedures of the level 3 committees. These were introduced by changes in the Commission decisions establishing the level 3 committees and by changes in their statutes, resulting in a broadening of qualitative majority voting (reducing the issues that required unanimity of all national supervisors), the introduction of non-binding mediation mechanisms between national supervisors and improvement of the accountability of the committees towards the Parliament and Council. The evaluation report was made less relevant by the 2007-2013 subprime crisis. The Commission set up a new group, chaired by the Frenchman Jacques De Larosière to make recommendations on strengthening European supervisory arrangements. The ‘De Larosière’ report46 recommended replacing the committees of supervisors instituted under the Lamfalussy report by the new authorities with wider legislative and operational powers. 45 Inter-Institutional Monitoring Committee, Final Report Monitoring the Lamfalussy Process, 15 October 2007. 46 Final Report of the High-Level Group on Financial Supervision in the EU, chaired by Jacques de Larosière, 25 February 2009 (De Larosière Report).

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These were to be part of a European system of financial supervisors. The EU legislators followed their advice to a large extent. The ESRB and the three new European supervisory authorities (again lead by boards composed of the national supervisors) were set up, including references to a European system of financial supervision, a term without a clear meaning or tasks except to stress that the authorities, the ESRB as well as the national supervisors that are members of the authorities should be nice to each other and do their job as stated in e.g. the CRD47. The new European supervisory authorities – like their predecessors in 2001 and 2004 – are set up aggressively seeking the outer boundaries of the (expanded but still limited) legal basis of the TFEU48. The 2007-2013 subprime crisis proved to provide the proper incentive to overhaul the ambivalent structure of level 3. The purely cooperative structure, even if backed up by a decision by the Commission was not felt to be able to deal with the cross-border problems identified in the aftermath of the crisis. The set-up of practical supervision, the Lamfalussy structures and the relation to the ECB have again surfaced in the political debate. The ECB performed very well on its targeted mandate in the crisis, and hinted it would do a similar job if allocated EU banking supervision tasks. The arguments against allocating either policy or practical supervision to the ECB remained in place (except that it no longer needs to prove its rightful place in the international arena). Perversely, its success in its targeted mandate may have prevented it in being successful in its bid for a larger role in banking supervision via the De Larosière report, as it was able to act decisively in part because it had no conflict of interest between its current goals and any responsibilities nor liabilities for individual banking supervision. The De Larosière report recommended transforming the level 3 committees into policy authorities. In line with this proposal, the Commission proposed an ambitious mandate for those authorities, with powers both in the policy area and in the ongoing supervision area. Though supported in essence by the European Parliament, several member-states opposed such a far reaching re-alignment. Especially the UK balked at the possibility that decisions of the new authorities could have national budgetary consequences (e.g. in the form of state-aid) and to a further transference of national powers to European institutions. A compromise was reached, which established the new authorities, but with severely limited powers; see chapter 21.3 and 21.4. The previously existing committees in the three sectors would be replaced by (submerged in) three new European authorities with formal standing. In the banking sector, the new European Banking Authority (EBA) will not have formal powers in ongoing supervision. It will provide supporting tasks, however, and thus become

47 Art. 2 and recitals 3-9 EBA Regulation 1093/2010. 48 See chapter 3 and 21.3.

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actively involved in ongoing supervision. In a crisis, it may gain further powers, though with the limitation that those powers should not be used in a way that will cause budgetary consequences at the national level. This in practice defangs those instruments. However in the core area of previous CEBS work, policy harmonisation, the change was more profound. EBA will be able to draft binding rules. Lamfalussy/ Larosière Legislative Process In the Lamfalussy/Larosière framework, the legislative process is divided in four levels. LEVEL 1: Basic European legislation. For these basic issues, the legislative process of the treaties is fully applicable and result in directives and regulations of the Council and Parliament. As a result, the Commission has the right of initiative and Parliament and Council have the co-decision rights. The principles underlying the legislative goals should be defined, as well as the basic outline of the division of tasks between member states and between member states and citizens of the EU. The binding results of this process are laid down in directives and regulations of the Council and Parliament, and provide the limitations and framework for the next levels. LEVEL 2: Legally important technical issues. For these technical issues, representatives of the Council (in the form of the level 2 committees, in which mid-ranking bureaucrats representatives of the competent ministries of finance of the member states have a seat under the chairmanship of a Commission representative) have the decision making power jointly with the Commission. At this level, the principles as laid out at level 1 should be buttressed by implementing measures. The Commission has the right of initiative, and the binding results of this process are named (confusingly) Commission regulations or Commission directives. As the full joint legislative process of the TFEU does not have to be followed, both their adoption and adaptation can be ensured at (relatively) short notice. The role of Parliament was initially limited, but has been expanded49. Draft level 2 regulation needs now to be submitted to Parliament (its ECON committee) and the Council. Both Parliament and the Council have a right to revoke the delegation, and a delegated act may enter into force only if neither has expressed an objection against it within the period set in the level 1 directive. As a result of the Larosière proposals, the Commission now also has a new type of legislation for which it can use its delegated authority. It can approve, or approve with amendments, the proposals developed at level 3 for (binding) regulatory technical standards and – with fewer safeguards for the Council and Parliament – for (binding) implementing technical standards50. 49 See art. 150-151c RBD and 41-41c RCAD as amended by CRD III Directive 2010/76/EU. 50 Some name these standards as level 3, but binding, instead of proper level 2. E. Wymeersch, ‘The European Financial Supervisory Authorities or ESA’s’, in E. Wymeersch, K.J. Hopt, & G.Ferrarini (Eds.), Financial Regulation and Supervision, Oxford, 2012, chapter 9.

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LEVEL 3: Practical application and harmonisation work. At this technical level, all debate takes place on how the level 1 and level 2 work can be applied in a consistent manner across the EU, and how the practical cooperation on issues which have a crossborder impact can be shaped. The original Lamfalussy level 3 committees were as per the beginning of 2011 replaced by Larosière style European supervisory authorities, including EBA51. The authorities consist of the competent authorities nominated by the member states for the directives within the sector. The national supervisors thus jointly advise the Commission on its level 2 (and in practice also level 1) work, jointly work to try to establish a common understanding of the application of such work and issue non-binding policy papers containing guidelines and recommendations in order to facilitate common supervisory approaches. Within the authorities, a chair and an executive director – confirmable by the European Parliament – now have roles to play to assist and coordinate the work of the board composed of national supervisors. The initial supervisory committees also issued non-binding standards, but this instrument has been upgraded. The authorities from 2011 can draft standards, and send them to the Commission. If endorsed by the Commission under its delegated law making powers as described at level 2, the standards drafted by the level 3 authorities become binding technical standards. LEVEL 4: Ensuring compliance with the obligations under the directives. At this practical level, the Commission has the right to remind member states to apply the binding legislation and initiate infringement proceedings if they do not (as laid out in the TFEU). The Lamfalussy report advised reinforcing this function. The policy agreed at Level 3 can play a role in interpreting the obligations of the directive that a member states has or has not complied with. The regulations setting up the level 3 authorities – building upon nonbinding work done by their predecessor committees – instituted binding arbitration, public peer review and increased supervisory disclosure, as well as giving the authorities the right to alert the Commission to start infringement proceedings and to intervene in a limited number of circumstances.

51 Omnibus I Directive 2010/78/EU and e.g. the EBA Regulation 1093/2010.

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Figure 23.1 Lamfalussy Structure 2004-2010

Level 1 Council Commission European Parliament

Level 2 European Securities Committee ESC (Brussels) Units G3 and G4 of the EC DG Markets

Level 2 European Banking Committee EBC (Brussels) Unit H1 of the EC DG Markets

Level 3 Committee of European Securities Regulators CESR (Paris)

Level 3 Committee European Banking Supervisors CEBS (London)

Level 2: European Financial Conglomerates Committee EFCC (Brussels) Unit H1 of the EC DG Markets

Joint Working Committe on Financial Conglomerates JWCFC (London/Frankfurt)

Chairs of the three level 3 committees 3L3 Level 4 European Commission

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Level 2: European Insurance and Occupational Pensions Committee EIOPC (Brussels) Unit H2 of the EC DG Markets Level 3 Committee of Insurance and Occupational Pensions Supervisors CEIOPS (Frankfurt)

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Figure 23.2 Lamfalussy Structure 2011

Level 1 Council Commission European Parliament

Level 2 European Securities Committee ESC (Brussels) Units G3 and G4 of the EC DG Markets

Level 2 European Banking Committee EBC (Brussels) Unit H1 of the EC DG Markets

Level 3 European Securities and Markets Authority ESMA (Paris)

Level 3 European Banking Authoriy EBA (London)

Level 2: European Financial Conglomerates Committee EFCC (Brussels) Unit H1 of the EC DG Markets

Level 2: European Insurance and Occupational Pensions Committee EIOPC (Brussels) Unit H2 of the EC DG Markets Level 3 European Insurance and Occupational Pensions Authority EIOPA (Frankfurt)

Joint Committee (Chairs of the three Level 3 Authorities) Sub-Committee on Financial Conglomerates (London/Frankfurt) Level 4 European Commission, with help from the Level 3 Authorities

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EU Banking Supervision The Lamfalussy directive52 introduced the initial necessary changes in EU legislation to facilitate the working of the various levels as established in 2004. After several amendments in CRD II, CRD III, the Commission is currently competent to clarify definitions, align terminology, and make adjustments needed in some articles or annexes to take accountancy standards or developments on financial markets into account. The Council and Parliament have rights to screen and object to delegated acts (level 2 legislation)53. Instead of having full level 2 legislation54, in effect the specified areas of the CRD can be adapted in a similar manner as level 2 directives and regulations. The level 2 committee in the banking sector, the European banking committee, basically consists of the ministries of finance representatives (though many bring experts from the banking supervisors with them), and has similar powers on the CRD issues identified as it would have on level 2 legislation. The Lamfalussy directive brought the number of level 2 committees up to four. Apart of the original European securities committee, it established the European banking committee, the European insurance and occupational pensions committee and the European financial conglomerates committee (respectively ESC, EBC, EIOPC, and the EFCC). The level 3 committees were only referred to in the recitals to the directives. The Commission at the time did not deem it desirable to refer in the legislation to the supervisory committees, because they did not have binding instruments and tasks. The Omnibus I directive amended the various directives to bring them in line with the Larosière proposals, including the newly established European supervisory authorities such as EBA55. The original Lamfalussy level 3 committees were established by so-called Commission decisions. A decision has no legislative status, but is binding on the addressees, as long as the issue is within the scope of the Commissions’ mandate under the TFEU (see chapter 23.2). Originally, it was therefore the intention that the level 3 committees solely worked for the Commission and for their own members (which in turn were accountable on an individual basis towards their domestic government and parliament). In practice, the Parliament and the Council wanted to have a say in the process, and accountability vis-à-vis the Parliament (through ECON, its competent subcommittee) and the Council (through the level 2 committees and through the specialised subsidiary committees of Ecofin) was established in practice. The accountability was codified for the committees in amendments to their institution Commission decisions, and copied into the upgraded

52 Directive establishing a New Organisational Structure for Financial Services Committees 2005/1/EC (Lamfalussy Directive). 53 Art. 150-151c RBD. 54 Such as the Commission regulations and directives in the securities sector under Mifid and the Prospectus Directive; see chapter 16 and 19. 55 Omnibus I Directive 2010/78/EU and e.g. the EBA Regulation 1093/2010.

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legislative instrument used to establish the European supervisory authorities in great detail56. The EBA and its sister authorities have been set up by regulation, using the legislative basis on targeting the single market57. Regulations have direct effect in each member state, and are binding on everyone involved (see chapter 3.4-3.5). The accountability vis-à-vis the EU bodies has been improved, and normal accountability in the member states remains in place. However, this is balanced by the obligation on independence for the voting members of EBA and for its chair. Each has to act independently and objectively in the sole interest of the EU, disregarding narrow national interests58. They are forbidden to ask for or accept instructions from anyone, and member states and EU institutions are obliged not to try to influence them in the performance of their tasks. This applies also to other key functionaries of EBA. The fine line between influencing and (demanding) accountability is narrow, especially as criticism on past behaviour will no doubt influence future behaviour on similar types of decisions. The independence provisions are similar to those established for the ESCB and for the other EU institutions in the EU treaties59. Technical vs. Political, Regulatory vs. Implementing The Lamfalussy group worked on the presumption that all the work done at level 2 and 3 should not be politically important, but technical. The same criterion was used in the De Larosière follow-up to see on which binding rules the preparation could be allocated to EBA in the so-called Omnibus I directive60. Determining what is political and what is technical is, however, a purely political process. There are no objective criteria available for this determination, so it has to be determined at the political level. The EBA regulation refers to aspects that require technical expertise, but do not require strategic decisions or policy choices61. Helpfully, the recitals of the Omnibus I directive add that to be technical, it should be genuinely technical (and require the expertise of supervisory experts; apparently unlike other aspects of e.g. the CRD). Apart from having the word ‘technical’ inserted in almost every reference to this process, the function of determining what is political and 56 See art. 1, 3, 8-16, 22, 32, 48-51, 63 and 64 EBA Regulation 1093/2010. 57 E.g. the EBA Regulation 1093/2010, based on art. 114 TFEU. 58 Whether they do so is moot. It is in any case not borne out by past experience; see e.g. BCBS, Report and Recommendations of the Cross-Border Bank Resolution Group, March 2010, page 16. The obligation can, however, provide an incentive to at least consider the European interest equally with the interests protected by the national legislators and politicians who appoint and set up national supervisors, and to whom such national supervisors are accountable (and dependent on for e.g. crisis-funding. 59 Art. 42, 46, 49, 52, 59 EBA Regulation 1093/2010, and art. 17 TEU, art. 7 of protocol 4 on the statute of the ESCB and of the ECB, and art. 130, 228, 245 and 282 TFEU. 60 Recital 9-12 Omnibus I Directive 2010/78/EU in which a ‘first set’ of such standards were allocated to EBA, ESMA and EIOPA. 61 Recital 22 and art. 10.1 and 15.1 EBA Regulation 1093/2010, in relation to the technical standards.

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what is not is largely performed in a very pragmatic way by the Commission when commenting on or requesting work at levels 2 and 3. As indicated before, if the European Parliament or the Council do not agree with the choices made or finds that the end-result has political implications, it can veto the work and upgrade it to level 1 work62. In practice, this is a very internally focused institutional debate. It puts either the Commission in the driving seat of all negotiations, or allocates part of the negotiations to level 3. In all cases the advice of the level 3 authorities on the content is important. For issues deemed political (or more polite: to involve policy choices though even here it should involve non-essential elements of the legislation63), the Commission has greater leeway to deviate from or ignore the advice of supervisors, but in that case it may not be able to keep the Council and Parliament out of the loop. In general, the following subjects are deemed political: – main lay-out/structure; – choice to follow worldwide standards, such as Basel; – pressure to harmonise; – pressure on timelines; – all issues which impact on the balance of power between member states and between competent authorities; – all decisions that can be taken without a long study of the context. In general, the following issues are deemed technical: – all issues that cannot be solved at the political level; – all detailed issues that do not impact on the balance of power mentioned above; – all issues that do not impact on special interests (unless these are also controversial at the political level). This may sound like a critique, but it is not. The pragmatic approach taken by the Commission works like a charm in the complicated structures of the EU. There has been support and critique on the benefits of level 2 legislation and level 3 guidance64. Disadvantages include layered legislation, with a lack of accessibility, different terminologies and multiple documents containing technical requirements and guidance/commitments with unclear legal status and reliability, in addition to similar content contained 62 Except on implementing standards; where this is not foreseen in the EBA Regulation 1093/2010. Compare art. 290 and 291 TFEU. 63 See e.g. recital 91 CRD IV Directive. 64 See e.g. N. Moloney, EC Securities Regulation, 2nd ed, Oxford, 2008, page 919-923 on the experience on the Market Abuse Directive 2003/6/EC, one of the first Lamfalussy style legislative projects.

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in worldwide and national documents (e.g. from the BCBS or national legislators or supervisors). Advantages include the responsiveness to market concerns, flexibility and sometimes detailed help. Under the Lisbon treaty, the institutions, member states and any individual can challenge the legality of any Commission directive or regulation within two months of its publication; see chapter 23.2. The legality can be questioned on grounds of competence, infringement of an essential procedural requirement, infringement of the TFEU or of any rule of law relating to its application, or misuse of powers. If not legal, the act becomes void (in whole or in part65). This instrument is an important aspect, in addition to the Parliament and Council scrutiny, to redress the lack of accountability and democracy of the delegated legislative powers of the Commission66. In addition to the more traditional level 2 legislation issued by the Commission, EBA and its sister authorities can now also propose binding technical standards. These are differentiated between regulatory standards and implementing standards67. The regulatory standards are more politically sensitive as they contain rules (albeit ‘technical’ rules). The implementing standards are less sensitive as they contain mostly forms and formats that are important for harmonisation purposes, but are not intended to set new rules on content. By way of example, EBA can develop regulatory standards on the general functioning of colleges of supervisors, and implementing standards on the operational functioning of such colleges68. Though this division is ambiguous (e.g. who gets invited for a specific investigatory meeting of experts on the banks’ operational risk model can be both a general issue or an operational issue, depending the situation at the bank and the cordiality of relations between the supervisors), the intent of the division is clear. For the implementing standards, the involvement of Parliament and Council is minimal. The power to endorse these implementing standards is delegated for an unlimited period on all issues on which the various directives, such as the CRD, indicate that implementing standards are possible or required. Parliament and Council are informed of draft implementing standards, but in the EBA regulation they have no explicit role to veto, withdraw or otherwise intervene formally in the process of endorsement (though if there are strong views presented, a wise Commission would take those into account). The process instead focuses only on the balance of power between the European supervisory authority drafting the standards and the Commission. This is different for regulatory standards. The power

65 Questions as to the unlawfulness of EU legislation can only be settled by the Court, not by national courts. If a national court thinks a EU binding rule should be voided, they thus have to refer such a decision to the Court of Justice. Foto-Frost/Hauptzollamt Lübeck-Ost, Court of Justice 22 October 1987, Case 314/85. 66 Art. 263 and 277 TFEU. See chapter 3 and 23.2. 67 Art. 10-15 and recitals 21-26 EBA Regulation 1093/2010. Compare article 290 and 291 TFEU. 68 Art. 131a.2 RBD.

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to endorse these has been delegated for a limited period only, until 16 December 2014. It is automatically extended for periods of four year, but either the Parliament or the Council can revoke it unilaterally at any time in full or in part (after allowing the other institution and the Commission a chance to be heard). Here, the procedure as laid down in the EBA regulation balances the relative powers of the authority and the Commission with a veto power for the Council and the Parliament. Table 23.1 Legislative Steps For Technical Standards Procedure step

Regulatory tech- Implementing technical standards69 nical standards70

1

Determine whether there is scope for technical standards, and – where not legally obliged to issue such – whether there is a need for technical standards.

Yes, both at the initiative of authority or of Commission.

Yes, by the authority. If the standard is obligatory and has not been issued in time, the Commission can set a new deadline.

2

Developing standards.

Yes.

Yes.

3

Public consultation and cost benefit analysis.

Yes, unless dispro- Yes, unless disproportional. portional.

Consultation of banking stakeholders group.

Yes.

Yes.

Agree the draft standards by qualified majority71.

Yes.

Yes.

Submit revised draft standards to Commission .

Yes.

Yes.

Commission to forward the draft standards to Council and Parliament.

Yes.

Yes.

4 5

6

72

Commission decides to endorse, to endorse with Yes. amendments, or not to endorse (3 months). If it intends to deviate from the proposal, it so informs the authority, with its motivation.

Yes, but the Commission can delay its decision once by 1 month.

70 Art. 15 and 44 EBA Regulation 1093/2010. Art. 15.3 contains a separate procedure if the authority refuses (see the previous footnote). 69 See recital 48, 53 and art. 10.1, 10.4, 11.2, 13, 14 and 44 EBA Regulation 1093/2010 for the main procedure. Art. 10.2 and 10.3 contain a separate procedure if the authority refuses (e.g. as it deems the issue too contentious or it turns out to be so during the development process) or does not have the resources to develop the draft regulatory standards within the time limits set, in which case the Commission can take over its role in steps 2 and 3. 71 Recital 53 and art. 44 EBA Regulation 1093/2010 stipulates simple majority voting, except for all issues with a general nature, such as standards. 72 The EBA Regulation does not refer to a waiting period for advice from amongst others the ECB, though the ECB is claiming this right. The stage at which it would need to sought is not clear; see below.

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7

If not endorsed or only with amendments, the Yes. authority has six weeks to amend the proposed draft standards and resubmit it as an ‘opinion’ with a copy to Council and Parliament.

Yes.

8

The Commission can then formally adopt the tech- Yes. nical standards, adopt with amendments after considering (but not being bound by) the new ‘opinion’ or reject them. If adopted they have to designate it either a regulation (binding on everyone in all member states) or a decision (binding on the specific parties addressed, in all member states).

Yes, and the adopted standards can be published.

9

Council and Parliament are informed if the stand- Yes. ards are adopted without any amendments. If amended or rejected, the Commission has to inform the authority, the Parliament and Council, stating the reasons for the amendment or rejection.

The Commission is under no legal obligation to do so.

10

After an adoption by the Commission, the Council and Parliament have a period to ‘object to’ the adopted technical standards. (3 months plus an identical extension possibility if they were amended, one month plus an identical extension possibility if adopted as proposed by the authority.) In the CRD IV project, an additional month delay is introduced to allow more scrutiny73. If the standards were amended, the Council and/or the Parliament can invite the Commissioner plus the chair to present and explain their differences.

After a rejection, Yes. the Council and Parliament can invite the Commissioner plus the chair of EBA to present and explain their differences. The procedure starts anew at step 1, or stops.

Not applicable.

11

If either the Council or the Parliament objects to the Yes. adopted technical standards within the time set, the technical standards are vetoed and will not enter into force. If a statement of no objection is received from both institutions or when the time set has passed, it can be published.

Not applicable.

12

Publication in the ‘Official journal of the European Yes. union’, after which it enters into force on the date set in all member states. It becomes part of the ‘single rulebook’74 from that date.

Yes.

In this procedure, the time limits for the authority, the Council and Parliament are ‘fatal’, in the sense that automatically the next step occurs75. However, if the Commission lets its time limits to endorse or to adopt the standards pass without taking any action (in steps 6 or 8) there is no immediate loss of rights for the Commission. The standards in that case 73 Recital 131 and art. 463 CRR. 74 Recital 22 EBA Regulation 1093/2010. 75 Or if the authority delays or refuses to develop the standards, the Commission can take over its role in part.

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do not enter into force, but are not rejected either. For sensitive issues that hurt the interests of an important country or market participant, this may well happen. The interested institutions, likely to be EBA, the Council and the Parliament, can however sue the Commission at the Court of Justice for failing to fulfil its legal duty to take a decision to say yes or no to the proposed standards. Like all legislation delegated to the Commission (see above), the legislation is void if it does not remain within the boundaries set for it in the EU legislative process. See chapter 23.2. For EU banking laws, the treaty refers to the right and obligation to advice of the ECB. The ECB is also claiming it for the new binding standards. As standards will be as binding as legislation issued by the Council and Parliament, and its Treaty-mandated contribution could otherwise be avoided by naming a political issue ‘technical’, this appears correct. The EBA regulation cannot go outside the confines of the EU treaties. However, the EBA regulation does not clarify when the advice of the ECB should be sought. It is unclear whether it should advice on the version EBA publishes for consultation, or on the version sent to the Commission (and forwarded by the Commission to Council and Parliament)76. As the Commission has only limited adaptation rights under the EBA regulation, it is likely that the ECB advice could already be sought on the consultation version. The ECB could subsequently use its formal advice to support its contributions as an observer at the EBA board of supervisors deliberations. However, it should at the latest be sought when the institution that gives the standards their status of binding law – the Commission – starts its formal work. The regulation does not set out a similar decision making framework for the development of guidelines. This is strange. As seen in the guidelines EBA has issued or taken over from CEBS, the language is often set in a ‘binding’ format, and sometimes range well beyond the scope of the binding rules in the CRD on which they are putatively based. See for instance the buffers that have to be held for liquidity purposes that anticipate binding rules that will only apply in due course, the stress tests and capital exercise demanded by EBA, and on the scope and definitions of internal governance in general (see chapter 6.2, 12, 13). The ‘comply or explain’ rule of the EBA regulation is used to push national supervisors, national legislators and banks to compliance; see chapter 3. The nuance between nonbinding but influential and just plain binding is often lost in practice, especially when many supervisors are either not legally minded, or in pursuit of a ‘higher goal’ of stability in a financial crisis. If this is indeed the case, the lack of controls and input of the ECB advice, of the Parliament, of the Council, and the lesser obligations on impact assessment and consultation is becoming increasingly indefensible. It may have been better to force 76 See the Opinion of the ECB on the CRD IV Proposed Regulation and Directive, 25 January 2012, CON/2012/5.

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EBA to transform the guidelines that it thinks should have been made binding long ago by the Commission into standards, and keep guidelines for the purpose they were initially meant to fulfil: to guide, not bind. Overview of MandatesSupplementedProject Mandates The Omnibus I directive, the FCD II directive and the CRD IV project put in motion a tsunami of follow-up work in the form of delegated legislation, either initiated by the Commission or by EBA (and the joint committee of EBA/ESMA/EIOPA). These cover all areas of prudential superivision. The legislative agenda consists of: – an option and in some cases an order for the Commission to issue level 2 directives and regulations (that can be independently drafted); – EBA ‘shall’ draw up binding rules in the form of regulatory or implementing standards (to be enacted by the Commission before they become binding), often with clear deadlines; – EBA ‘may’ draw up binding rules in the form of regulatory or implementing standards (to be enacted by the Commission before they become binding), though some of these have been upgraded in the CRD IV project to ‘shall’ draw up obligations; – EBA is sometimes given a direct order to draw up non-binding guidelines on specific issues (and sometimes kindly reminded on specific issues of its option to draw up nonbinding guidelines) under the EBA regulation77. If binding rules are envisaged by a date set in the CRR, this delays the applicability of the CRR under its transitional regime. For the CRD IV there is no clarity on the delaying effect of not yet published or enacted EBA standards. The following provides an indication of the legislative work: General

Commission level 2 delegated acts with further detail on definitions and mandatory information exchange (option), as well as to adapt capital requirements to new accounting standards (option).78

Market access

– Regulatory and implementing standards (drafted by 1 January 2014) on infor-

mation provided in European passport for branch and for cross-border services notifications79. – Regulatory and implementing standards (drafted by 1 January 2014) on information provision for ‘general good’ restrictions on branches, and for changes to the branch80

77 Where specifically mentioned in addition to the general power to issue guidance on anything within the scope of union law as set out in art. 16 EBA Regulation 1093/2010. 78 Art. 150 RBD. The scope of Commission delegated acts was widened in the CRD IV project. Also see art. 145 CRD IV Directive and art. 456 and 457 CRR. 79 Art. 25.5 and 28.4 RBD. 80 Art. 26.1, 26.3 and 26.5 RBD.

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– Regulatory and implementing standards on the information in an authorisation

application, regulatory standards for preventing economic need considerations, and regulatory standards for requirements on shareholders, and obstacles to effective supervision (option)81. – Regulatory and implementing standards on M&A applications (option)82 assessment of the persons who direct the business – Guidelines for the suitability of the bank (obligatory)83. Regulatory standards on a range of own funds related issues by 1 February 201584. Regulatory standards (by 1 January 2014) on hybrid instruments85. Guidelines on the definition of (going concern) capital (obligatory)86. Guidelines on the systems and controls relating to fair value and own funds adjustments (obligatory)87. on amongst others the solvency ratio compo– Commission level 2 delegated act nents and on the leverage ratio88.

Financial buffers

– – – –

Credit risk

– Regulatory standards (by 1 January 2014) on the credibility and transparency – – – –

of credit assessments of credit rating agencies, and – where relevant – a demonstrated ability in the area of securitisations89. Regulatory standards (by 1 January 2014) for convergence of supervisory practices on the treatment of exposures to transferred credit risk (securitisations)90. Implementing standards on aspects of the mapping between credit ratings assigned by approved ECAI’s to credit steps in the standardised approach (by 1 January 2014)91. Regulatory standards on the internal model (IRB approach) approval92. Commission level 2 delegated act on exposure classes, on off-balance sheet items and covered bonds (option)93.

Operational – Regulatory standards on the internal model (AMA approach) approval in 2014 risk or 201694.

81 Art. 6.2 RBD. The ‘economic needs’ standards are deleted from the CRD IV, but the remainder of the standards envisaged here are upgraded to a requirement to draw up standards by art. 9 CRD IV directive, to be delivered by end 2015. 82 Art. 19.9 RBD. This option for EBA is upgraded to a requirement to draw up standards by art. 22 CRD IV directive, to be delivered by end 2015. 83 Art. 11.1 RBD; see chapter 5.2. 84 See art. 26, 27.2, 28.5, 29.6, 36.3, 41.2, 49.6, 53.2, 73.7, 76.4, 78.5, 79.2, 83.2, 84.4 CRR. 85 Art. 63a.6 RBD. 86 Art. 63a.6 RBD, see CEBS-EBA implementation guidelines regarding instruments referred to in art. 57(a) of directive 2006/48/EC recast, 2010. 87 Art. 64.5 RBD. 88 Art 456 and 457 CRR. 89 Art. 81.2 and 97.2 RBD. 90 Art. 122a.10 RBD, as amended. The issue of the retained interest in securitisations is now covered by the aptly named guidance: CEBS/EBA, Guidelines to Art. 122a of the Capital Requirements Directive, 31 December 2010; see chapter 8.6. 91 Art. 150.3 RBD. 92 Art. 84.2 RBD. Initially an option, the IRB approach will be the subject of a range of mandatory standards; see e.g. art. 20, 143, 144, 148, 164 and 180-183 CRR. 93 Art. 150 RBD. The scope of this delegation was widened in the CRD IV project. See art. 456, 457 and 503 CRR. 94 Art. 105.1 RBD. Initially an option, the AMA approach will be the subject of a range of mandatory standards; see art. 312 and 314 CRR.

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the basic indicator approach and on the standardised – Regulatory standards on 95 approach by end 2017 .

Market risk

– Regulatory standards on the internal model approval (option)96 for requirements for calculating the incremental – Guidelines on the exemption 97 risk charge (obligation) .

– Guidelines on the large exposures avoidance assessment (obligation)98. – Commission delegated acts on counterparty credit risk Large expo- – Regulatory standards (by 1 January 2014) on certain money transmission sures exemptions, as well as on the notion of ‘connected clients’99. Liquidity

– Commission delegated100act (by 30 June 2014) on the content of the liquidity coverage requirement .

delegated act by EBA with implementing – Follow-up on the abovementioned 101 standards (option) .

delegated act on the liquidity coverage ratio implementation – Commission 102 (option) .

Internal gov- – Implementing standards on aspects of the management of funding risk of ernance and remuneration policies (by 1 January 2014)103. pillar 2 – Regulatory standards on internal governance (option)104. of supervisory practices on the pillar 2 – Regulatory standards for convergence supervisory review process (option)105. – Guidelines on remuneration (obligatory)106. – Guidelines on the disclosure of large earners at banks by supervisors (option)107. on stress test parameters for financial conglomerates – Joint committee/ESRB (option)108. Pillar 3109

– By 1 February 2015, uniform templates on own funds disclosure are to sent to

the Commission. Implementing standards (by end 2014) on countercyclical buffer calculators. Implementing standards (by July 2014) for the G-sifi’s disclosure on indicators. Implementing standards (by June 2014) on leverage disclosure. Guidelines on several issues relating to exemptions to disclosure or increased frequency of disclosures by the start of 2014. – Guidelines on unencumbered assets by end June 2014, to be followed in 2016 by implementing standards

– – – –

95 96 97 98 99 100 101 102 103 104 105 106 107 108 109

Art. 316 and 318 CRR. Art. 18.5 RCAD. Annex V §5j RCAD. Art. 32.1 RCAD. Art. 106.2 RBD. Also see art. 390.8, 394 and 395 CRR. Art. 460 CRR. Art. 436 CRR. Art. 461.2 CR. Art. 150.3 RBD. Art. 22.3 RBD. Art. 124.6 RBD. Art. 22.4 RBD. Art. 22.5 RBD. Art. 9b.2 FCD as introduced by the FCD II directive 2011/89/EU. See art. 432-433, 437, 440, 441 and 451 CRR.

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Consolidated

– Joint committee regulatory standards on the application of the banking or the – – – –

–

insurance rules to mixed financial holding companies (to be drafted within 3 years after the obligatory guidelines based on the same article are issued)110. Joint committee regulatory standards on more detailed definitions, and on intragroup transactions and risk concentrations (to be drafted by 1 January 2015)111. Joint committee regulatory and implementing standards on a range of financial conglomerates issues, including identification issues and reporting formats (option)112. Joint committee guidelines on converging practices on mixed financial holding companies (obligatory)113. Joint committee guidelines on identifying financial conglomerates, on risk concentrations, on intra-group transactions, on internal control and risk management, and on risk-based assessments and supplementary supervision on mixed financial holding companies (obligatory)114. Joint committee guidance on third country equivalence (option)115

Supervisory – Regulatory and implementing standards (to be drafted by 1 January 2014) on practices collaboration and information exchange on a single entity bank operating in a (instrucross-border context116. ments, coop- – Reporting on several issues, including the solvency ratio and large exposures eration) requirements: implementing standards on uniform formats, frequencies, dates and IT solutions for reporting by the banks to supervisors, expanded to several other subjects in the CRD IV project (initially to be drafted by 1 January 2012, which deadline is delayed to either 1 January 2014 or 1 February 2015)117. – With regard to supervisory disclosure: implementing standards on format, structure, contents list and annual publication date (to be drafted by 1 January 2014)118. requests for a joint – Implementing standards to ensure uniform conditions for119 decision process for model approvals and pillar 2 (option) . – Regulatory standards to specify how the colleges of supervisors should function and implementing standards on their operational functioning (by end 2014)120 – Joint committee guidelines on convergence of supervisory coordination arrangements between the banking and insurance sector (obligatory)121. measures to be taken on mixed – Joint committee guidelines on enforcement financial holding companies (option)122. Macroprudential

– Commission level 2 delegated act to make the financial buffer requirement, the

large exposure requirement and the pillar 3 requirement more stringent for a period of one year to address microprudential or macroprudential risks arising

110 Art. 72a RBD as introduced by the FCD II Directive 2011/89/EU. 111 Art. 21a.1a FCD, as introduced by the FCD II Directive 2011/89/EU. 112 Art. 21a.1 and 21.a.2 FCD, as introduced by the Omnibus I directive 2010/78/EU and the FCD II directive 2011/89/EU. 113 Art. 72a RBD, as introduced by the FCD II Directive 2011/89/EU. 114 Art. 3.8, 7.5, 8.5, 9.6 and 12b FCD as introduced by the FCD II directive 2011/89/EU. 115 Art. 21.4 FCD, as added by the Omnibus I directive. 116 Art. 42 RBD. 117 Art. 74.2 and 110.2 RBD, to be replaced and added to by art. 99, 101, 394, 415 and 430 CRR, which specifies Finrep, Corep and associated information, some liquidity and the leverage ratio reporting standards to be developed by 1 February 2015, and large exposures and aspects of liquidity reporting by 1 January 2014. 118 Art. 144 RBD. 119 Art. 129.2 respectively 129.3 RBD. 120 Art. 42a.3 and 131a.2 RBD; initially formulated as an option for EBA. Compare art. 51 and 116 CRD IV Directive; requiring both regulatory and implementing standards by 31 December 2014. 121 Art. 11.1 FCD, as added by the Omnibus I directive 2010/78/EU. 122 Art. 16 FCD, as added by the Omnibus I directive 2010/78/EU.

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from market developments (option)123. Almost all of the abovementioned standards and acts can also be used to respond to market developments by loosening or tightening requirements. – EBA regulatory standards (by end 2014) on how to assess the circumstances where higher risk weights for mortgages are appropriate for financial stability considerations124.

Role of the Commission A key role at all four levels has been allocated to the Commission. It has the right of initiative on legislation, it provides the chairman of the level 2 committee and has a non-voting seat at the table at the level 3 authorities (both at the board of supervisors and since 2011 in its management board125), and has the right to start proceedings against member states failing to implement EU legislation correctly. These taken together make the Commission the spider in the web of the EU legislative process126. Its central role is further strengthened by its seat at the table in international gatherings, such as the G20, the financial stability board and the Basel Committee of Banking Supervisors (BCBS). The Commission can thus influence the international agenda and/or determine the content of global standards on banking supervision. The Commission can only function well if it is well informed and takes on board views from around the EU, of the public sector, the private sector and consumers. Apart from the public consultations on draft legislation and the advice it receives from the level 3 authorities and the discussion at the level 2 committees, it used to receive a substantial amount of information directly under a diverse set of requirements contained in the CRD. These concern e.g. reports or informal input sent by lobbying organisations, as well as information the member states and supervisors are bound to deliver to the Commission e.g. on their implementation of legislation. Since the introduction of the authorities in 2011, part of the information on banks and banking has been funnelled through EBA, sometimes in addition to such information being sent to the Commission. This includes e.g. a notification of all banks that receive a license, to be put into a central (public) list. All this information serves several purposes: – establishing peer pressure and/or a hall of shame (where options were introduced into the legislation that were controversial or where it was considered impossible to fulfil the conditions set, the Commission is to be informed of any use of the option);

123 124 125 126

Art. 459 CRR. Art. 124 CRR. Art. 40 and 45 EBA Regulation 1093/2010. E. Ferran, N. Moloney, J.G. Hill & J.C. jr. Coffee, The Regulatory Aftermath of the Global Financial Crisis, Cambridge, 2012, page 54-83.

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– to centralise information for joint or public use, as the Commission at the time of introduction was the only European central body involved in banking supervision policy (at the time, the ECB and CEBS-EBA had not yet been set up); – to gather information for purposes of evaluating distinct areas of legislation that are due to be revised, or on issues where consensus is still lacking. These in principle enabled the Commission to assess how best to propose changes to the legislation. Such a decision can be based on e.g. accumulated information that highlights any national deviations that affect the establishment of the single market. The public exposure gives the member states and banks an incentive to not deviate from the main option given if – and in as far as – the public or its banks do not actively agree with such a deviation. Funnelling it through the Commission-offices, however, was an inefficient way of preparing this. Most of the information gathered quickly becomes dated unless used. It was often not available systematically for supervisors and legislators, or other interested parties. The task of the Commission to collect information and make it accessible to the public and/or to supervisors no longer fitted well with the increased transparency in the legislative process, nor with the Lamfalussy framework, where the technical advice is drawn from CEBS-EBA. The Commission does need to have a trigger to independently assess whether work is necessary. The other parts of the information gathering tasks have since 2011 been transferred to EBA. EBA, in addition to its general power to collect information on an ad hoc basis127, now also obtains a copy of the information on banks licensing, and has been given the duty to keep this information up to date and publicly available on its website, replacing the previous haphazardly fulfilled annual publication obligation of the Commission. The Commission failed to propose level 2 into the currently applicable directives, and the comitology provisions to amend the annexes to e.g. the CRD are barely used. In the banking sector, its use was limited in practice to expanding the lists of exempted banks and multilateral development banks, and copy paste work from Basel II ½ in 2009128. As a speedy process to be able to take account of innovations and developments in the financial sector, level 2 was a distinct failure in the banking side. Under the EU treaties, the Commission has the task to propose legislation and to prosecute member states for non-implementation. This monopoly is under threat as a result of the new tasks of EBA to draft standards (that the Commission is more or less bound to adopt), 127 Art. 337 TFEU gave the Commission the right to collect information and verify it if it needs it for its duties. See EBA Regulation 1093/2010 and Omnibus I Directive 2010/78/EU. See chapter 20.2 and 21.4. 128 See for instance level 2 Commission Directive 2007/18/EC, Commission Directive 2009/27/EC, and Commission Directive 2009/83/EC.

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and the new role of EBA to check compliance with EU laws at level 2 and 4 of the Lamfalussy/Larosière legislative process in the financial sector. EBA focuses on the (non-)implementation of EU laws by specific public authorities in the member states (i.e. the supervisors)129. The work in this area is supported by the supervisory disclosure work EBA coordinates, and by the work of the review panel to peer review implementation of rules and convergence of practices130. Peer reviews can be particularly powerful, but can face for instance resource and conflict of interest problems131. At CEBS, such reports were published on a named basis. This was downgraded in the EBA regulation. In principle the reports should still be published to promote lessons learned, but any named supervisor is now empowered to stop publication. Since 2010 no new reports of the review panel have been published, though one can always try to hope that has not made this work less effective132. As non-compliance by supervisors will be indistinguishable from non-compliance by member states to copy EU laws and enforce it, also at level 4 the freedom to act or not to act of the Commission has become more limited. The Commission has formally protested the fact that its prerogatives as established in the EU treaties are no longer monopolies. A case could be made for this stance, but as the Commission appears unwilling to bring this stance to the Court, it is unlikely that it will be resolved. As the Commission was not terribly effective at level 2 or 4 in the financial sector, any additional players in the field could have a stimulating effect. Also in this case, the Commission appears to be split within itself. Its securities unit is almost eager to delegate both regulatory and technical standards to ESMA in the Omnibus II directive proposal, while in the same proposal the insurance unit denies EIOPA any role at level 2133. It proposes level 2 legislation to be initiated solely by the Commission, with EIOPA relegated to a sparse set of implementing standards only. Consultation and Impact Analysis In line with the general development of good regulation principles at the EU level, the Lamfalussy/Larosière structures have specific arrangements to ensure the good quality of legislative efforts. The Commission had already included provisions on consultation in

129 Art. 1.4 and 17 EBA Regulation 1093/2010 add a task of EBA to the existing tasks of the Commission under art. 258 TFEU. 130 See chapter 20.7 and 21.4. On the review panel, see CEBS/EBA, Review Panel: Protocol, 15 October 2007, and CEBS/EBA, Peer Review: Methodology (Revised), 21 July 2009 (recasting the original version of 15 October 2007). 131 N. Moloney, ‘Supervision in the Wake of the Financial Crisis’, in E. Wymeersch, K.J. Hopt, & G.Ferrarini (Eds.), Financial Regulation and Supervision, Oxford, 2012, chapter 4. 132 Art. 11 CEBS/EBA, Review Panel: Protocol, 15 October 2007 and §38-53 of CEBS/EBA, Peer Review: Methodology (Revised), 21 July 2009. Recital 41 and art. 30 EBA Regulation 1093/2010. 133 See art. 1 respectively 2 of the Omnibus II Directive Proposal of the Commission of 19 January 2011, COM(2011) 8 final; where art. 1 bestows such powers upon ESMA, and art. 2 does not do so for EIOPA. Also see the text on page 4; which apparently was more heartfelt by the insurance unit of the Commission.

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134 See art. 5 Commission Decision 2004/5/EC that established CEBS; and art. 12 of the Recast Commission Decision of 23 January 2009, C(2009) 177 final. 135 See Inter-Institutional Monitoring Committee, First Interim Report Monitoring the Lamfalussy Process, 22 March 2006; Inter-Institutional Monitoring Committee, Final Report Monitoring the Lamfalussy Process, 15 October 2007; and E. Ferran, Building an EU Securities Market, Cambridge, 2004, page 102-107. Also see L. Frach, Evaluating the Efficiency of the Lamfalussy Process: the Prospectuses Directive, Takeover Directive and MIFID as Case Studies, Research Group on Equity Market Regulation REGEM Analysis 16, Trier University, February 2008. 136 See e.g. the recitals to the new Solvency II Directive 2009/138/EC for the insurance sector. 137 R. Lall, Why Basel II Failed and Why Any Basel III Is Doomed, University College Oxford, GEG Working Paper 2009/52, October 2009.

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into the impact assessment on the Basel III amendment138. The impact of the Basel II ½ and Basel III proposals and the November 2011 add-on on Sifi’s have since been monitored on a semi-annual basis139. The impact assessment gives an overall view of all the (quantitative) improvements to the EU rules (and the Basel accords on which these improvements are based) that are adopted or may be adopted in the wake of the 2007-2013 subprime crisis. The overall conclusions are generally positive, though it would be hard to imagine that a proposal would be made in which the drafters did not come to a positive impact assessment when proposing it140. This may lead to the age-old question of which was first: the chicken or the egg. It is safe to say that an impact assessment is likely to be a more neutral input if the issue researched is not politically sensitive, or if the drafters of the impact assessment are fully independent from political bodies and from the bodies involved in drafting or impacted by the proposals contained in the draft. It turns out that neither of these conditions is currently fulfilled. Equally it should be noted that quantitative impact assessments do not add certainty on the outcome. Quantitative impact assessments are based on modelling both the costs and the benefits. Where benefits are often abstract and thus (even) harder to grasp, the cost side also will depend on assumptions on data and restrictions in the models used, never approaching reality. Any outcome needs to be taken with caution, and accepted only with a proper understanding of its qualifications and limitations141. With the establishment of EBA the developed procedures have been codified into the EBA regulation. The EBA has a banking stakeholder group (the descendent of the CEBS consultative panel), composed of representatives of banks, their employee-unions, academics, consumers, small- and medium sized enterprises and other users of banking services. It assists in consultations, and can give (public) opinions and advice on any issue related to the tasks given to EBA142. The technical standards EBA wants to submit to the Commission for endorsement have to be the subject of both public consultation, a requested opinion of the banking stakeholder group and of an analysis of costs and benefits143. In two cases this is not necessary. For minor, low-impact, proposals, a full consultation and analysis

138 CEBS/EBA, Results of the Comprehensive Quantitative Impact Study, 16 December 2010; EBA, Results of the Basel III Monitoring Exercise as of 30 June 2011, April 2012. 139 EBA, Results of the Basel III Monitoring Exercise as of 30 June 2011, April 2012. 140 See for a critical discussion on the impact assessment arguments of both industry and regulators: B. Allen, K.K. Chan, A. Milne & S. Thomas, Basel III: is the Cure Worse Than the Disease?, Cass Business School, City University London, 30 September 2010. 141 See e.g. the qualifications noted in P. Angelini, L. Clerc, V. Cúrdia, L. Gambacrta, A. Gerali, A. Locarno, R. Moto, W. Roeger, S. Van den Heuvel & J. Viček, Basel III: Long-Term Impact on Economic Performance and Fluctuations, BIS Working Papers No. 338, February 2011. 142 Art. 37 EBA Regulation 1093/2010. 143 Art. 10.1, 10.3, 15.1, 15.3, and 16.2 EBA Regulation 1093/2010.

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would be disproportional. Also in cases of ‘particular urgency’, a full consultation and analysis may be left aside. For the non-binding guidelines and recommendations the same obligation applies with more escapes (even though the guidelines have become more influential and closer to binding with the ‘comply or explain’ rule in the EBA regulation; see above). The obligation to consult and obtain an opinion of the banking stakeholder group is conditional upon words like ‘where appropriate’, and ‘proportionate’ consultation and cost/benefit analysis. Individual decisions (e.g. in binding mediations or on breaches of EU law) are not subject to public consultations or cost/benefit analysis, except in as far as demanded by administrative and human rights protection in the form of for instance a duty to hear the parties involved (see chapter 20.4 and 20.5). Language For legislation issued at level 1 and 2, as well as for the negotiation process at the Commission, Council and Parliament, the general requirements of the EU on languages and translations apply. This highly inefficient and expensive process has the benefit of allowing all residents of the EU to gain access to EU legislation in their own language (in an authentic version), and for negotiators from member states that have a knowledge of the subject matter – but not of the common negotiating language – to be able to bring their expertise to the table. Even in the financial services sector, where English has become the dominant language for any international trading activity in the EU and even worldwide, the number of individual market participants and supervisors whose activities would otherwise be limited to their home market is still considerable. CEBS (like CESR and CEIOPS not officially an EU institution) in the past built upon the policy process already benefiting from a predilection towards the English language. They instituted a policy that all discussions and papers would be in the English language only. The supervisory authorities from different member states were free to translate documents for home-consumption, but those translations were not required for CEBS purposes and are not authentic (only the English version is valid). Cost reductions and an increase in the speed and efficiency of the process was the result. It should be noted that it is true that this has helped mono-lingual English native speakers to the detriment of e.g. Spanish, Italian or French mono-lingual speakers. However, in addition to speed and cost-efficiency, at the same time it has created a common supervisory language, incentivising supervisors to learn or improve their understanding of the common language and of common supervisory terminology. This has been one of the greatest steps forward in creating a common supervisory culture: significantly reducing language barriers to cooperation and information exchange. In the CESR area, it is likely that this development, combined with pressures

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from issuers of financial instruments, helped reduce the burden of translations on issuers under the prospectus directive144. The advantage of e.g. United Kingdom speakers should also not be overestimated. The language spoken in the committees was not the ‘Queen’s English’ with its larger vocabulary, literary references and sometimes convoluted structure, but a simpler, trade language continental version of English. EBA is likely to continue this policy for internal working procedures, but is bound by the convoluted politics of EU language regimes for its external final documents. Its final guidelines, recommendations and the standards issued along its proposals by the Commission now need to be translated into the 23 official EU languages145, and documents addressed to individual persons (including private and public legal entities) need to be set in the language of the relevant member state. Future Developments The voting procedures at EBA would change if and when the Commission proposals for a banking union single supervisory mechanism would be implemented; see chapter 21.3146. Otherwise, the single supervisory system of the ECB and the Eurozone banking supervisors would have an almost automatic majority under the current voting arrangements. A convoluted mechanism will be introduced under which the voting weights would shift. Depending on how many member states of the EU would not be members of the Eurozone, the concurring vote of one or more non-Eurozone member state representatives at EBA would be needed to adopt a rule. If EBA fails to reach a compromise under this arrangement, the ECB can still unilaterally adopt rules for the banks allocated to its remit directly under its TFEU mandate; see chapter 23.2. The non-Eurozone member states can adopt domestic rules in the absence of EBA consensus if and in as far that is allowed under the goldplating rules; see chapter 3.5. Literature – Ferran, Eilis, Building an EU securities market, Cambridge, 2004, chapter 3. Please note that at the time of publication, CESR had already been functioning, but CEBSEBA and CEIOPS were still in the process of being set up – Moloney, Niamh, EC Securities Regulation, 2nd ed., Oxford University Press, Oxford, 2008, chapter XIII

144 Recital 35 and art. 3.2 sub h.v and 19 Prospectus Directive 2003/71/EC. Also see E. Ferran, Building an EU Securities Market, Cambridge, 2004, page 164-167. 145 Art. 73 EBA Regulation 1093/2010 and Regulation 1958/1/EEC. 146 Commission, Proposed Single Supervisory Mechanism ECB Regulation and Proposed Single Supervisory Mechanism Amendment to the EBA Regulation, COM(2012) 511 final and COM(2012) 512 final, 12 September 2012.

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EU Banking Supervision

– Chiu, Iris H.-Y., Regulatory Convergence in EU Securities Regulation, Kluwer Law International, Alphen aan den Rijn, 2008 – CEBS/EBA, Review panel: protocol, 15 October 2007, and CEBS/EBA, Peer review: methodology (revised), 21 July 2009 (recasting the original version of 15 October 2007 – Inter-institutional monitoring committee, Final report monitoring the Lamfalussy process, 15 October 2007 – Final report of the high-level group on financial supervision in the EU, chaired by Jacques de Larosière, 25 February 2009 (De Larosière report) – Wymeersch, Eddy, The European financial supervisory authorities or ESA’s, in Wymeersch, Eddy, Hopt, Klaus J., Ferrarini, Guido (ed), Financial regulation and supervision, Oxford, 2012, chapter 9

1224

Acronyms and Definitions ABD

AIFM directive art. bank BCBS BCCI directive CAD CEBS CESR CEIOPS CBD Commission Council Court of Justice CRD CRD II CRD III CRD IV project

CRD IV directive

CRR

EBA ECB

Accounts of Banks Directive (Council Directive of 8 December 1986 on the annual accounts and consolidated accounts of banks and other financial institutions (86/635/EEC) Alternative Investment Fund Managers Directive 2011/61/EU article credit institution as defined in art. 4 RBD unless otherwise indicated Basel Committee on Banking Supervision Bank of Credit and Commerce International Directive (no longer valid) Capital Adequacy Directive 1993/6/EEC (no longer valid, replaced by RCAD) Committee of European Banking Supervisors (now EBA) Committee of European Securities Regulators (now ESMA) Committee of European Insurance and Occupational Pension Supervisors (now EIOPA) Consolidated Banking Directive 2000/12/EC (no longer valid, replaced by RBD) European Commission Council of the European Union Court of the European Union, unless otherwise indicated Capital Requirements Directives (RBD and RCAD taken together) Amendments to the CRD, CRD II directive 2009/111/EC Amendments to the CRD, CRD III directive 2010/76/EC Commission proposals to recast the CRD, published on 20 July 2011, which lead to the CRD IV directive and the CRR as published on 26 June 2013 Capital Requirements Directive IV 2013/36/EU, replacing the CRD (both RBD and RCAD). With the CRR, it is the result of the CRD IV project Capital Requirements Regulation 575/2013. With the CRD IV directive, it is the result of the CRD IV project to replace both the RBD and RCAD European Banking Authority European Central Bank

1225

EU Banking Supervision

ECHR EIOPA EMIR ESCB ESM ESM Treaty ESMA EU FCD FCD II directive IAS IASB IFRS IFRS regulation

Parliament RBD RCAD supervisor SME TEU TFEU OECD UCITS UK USA VAR WP or RDP

European Court of Human Rights European Insurance and Occupational Pensions Authority European Markets Infrastructure Regulation 2012/648 European System of Central Banks European Stability Mechanism Treaty Establishing the European Stability Mechanism of 2 February 2012 (ESM Treaty) European Securities and Markets Authority European Union Financial Conglomerates Directive 2002/87/EC Amendments to the FCD (and group supervision provisions in the banking and insurance sector), FCD II directive 2011/89/EU International Accounting Standard, part of IFRS International Accounting Standards Board International Financial Reporting Standards, set by the IASB Regulation (EC) No 1606/2002 of the European Parliament and of the Council of 19 July 2002 on the application of international accounting standards European Parliament, unless otherwise indicated Recast Banking Directive 2006/48/EC (replacing CBD) Recast Capital Adequacy Directive 2006/49/EC (replacing the Capital Adequacy Directive 1993/6/EEC) Competent authority under art. 4.4 RBD or art. 36.1 RCAD, unless otherwise indicated Small- and medium sized enterprises Treaty on European Union Treaty on the Functioning of the European Union Organisation for Economic Co/operation and Development Undertakings for collective investment in transferable securities, see directive 2009/65/EC United Kingdom of Great Britain and Northern Ireland United States of America Value at risk Working paper/research discussion paper

1226

Index 2007-2013 subprime crisis, 27, 60 2008 Crisis MoU, 837 3L3, 84

A ability to act, 1015 abuse, 270, 693, 994 abuse of power, 994 accountability, 1013, 1025, 1027, 1047, 1144 accountancy, 71 accountancy standards, 803 accountant, 953 accounting, 387, 621, 643 accounting standards, 340, 389, 439, 471, 550 acquirer, 264 acquisition, 198, 259 actual sale, 486 ad hoc cooperation, 1062 additional buffers, 303 additional protection, 482 additional tier 1, 400, 405 addressee, 608 administration, 621, 643 administrative law, 1004 administrative requirements, 996 administrative sanctions, 991 advanced approaches, 462 advanced IRB, 454, 460 advanced IRB approach, 482 advanced measurement approach, 546, 555, 561, 654 adversary, 695 advice, 237 affiliate, 808

agency, 198 AIFM, 523, 703, 711, 744, 921 allocation procedures, 515 alternative investment fund, 926 alternative standardised approach, 546, 551 annual accounts, 603, 679, 681 anticipated losses, 376 anti-money laundering, 643 application, 1086 appropriate, 707 appropriate measure, 939 approval assumption, 268 arbitrary, 994 assessment process, 261 asset management, 236 asset segregation, 708, 891 asset transferability, 584, 848 asset/liability take-over, 262 assets, 347 assumptions, 322, 326, 437, 537, 653 audit, 343 audit committee, 626 auditor, 649 authorisation, 204, 238, 384 authorisation obligation, 250 automatic punishment, 500

B backtesting, 335, 438, 538, 647 bail-in, 864 bail-inable claims, 306 bailout, 420 balance sheet, 387 bank, 173, 226, 641 bank account, 694, 738, 754

1227

Index

bank account switching, 754 bank insolvency, 848 bank secrecy, 956 banking book, 510, 515, 664 banking sector, 794 banking union, 65, 96, 816, 860, 920, 1030, 1044, 1076 bank-run, 868 bankrupt, 217, 813 bankruptcy, 287 bankruptcy regime, 888 Basel accord, 34 Basel concordat, 1072 Basel I floor, 292, 336 Basel III, 38, 52 basic indicator approach, 546 basic services, 694 BCBS, 87 best execution, 642, 708, 730 best practices, 600 binding, 123 binding settlement, 1055 BIS, 88 board, 612 board of appeal, 1058 board of directors, 609 board of supervisors, 81 board structures, 611 bonds, 178, 281 bonus, 363, 630, 640, 978 book value, 398 bookkeeping, 642 branch, 198, 230, 244, 274, 276, 359, 590, 986 branch reporting, 952 breach, 1118 burden sharing, 836, 861, 863, 1058, 1110 business continuity plans, 623 business cycle, 622

business disruption, 544 business lines, 550, 557, 629 business plan, 207 business to, 176 buy-back, 393

C calculation, 537, 551 calculation of probabilities, 326 calibration, 571 capital, 384, 385 capital accord, 29 capital allocation mechanism, 784 capital conservation buffer, 302, 303, 447 capital conservation plan, 303 capital measures, 370 capital requirements, 294 capital transfer, 844 capital transferability, 782 cash, 593 cash equivalents, 593 cash reserves, 581 causal link, 1119 CCR, 464 CEBS, 80 CEBS stress test, 658 central bank, 96, 582, 836, 1081, 1083 central body, 808 central counterparty, 1156, 1159 central custodian, 1156 central governments, 445 certificate of compliance, 253 checks and balances, 990 civil law, 268 clarity and precision, 1118 clean break, 486 clearing, 891, 1155 clearing and settlement, 732 clearing fund, 1161

1228

Index

client assessment, 707 client protection, 748 close link, 222, 223, 276 cold calling, 758 collateral, 347, 362, 450, 474, 574, 594, 851, 1162 collective, 218 collective investment, 711 collective investment institutions, 930 collective investment undertaking, 523, 921 college of supervisors, 959, 1053, 1055 comitology, 1041, 1199 Commission, 76, 85, 1192, 1217 commodities, 516, 521 commodities risk, 327, 527, 530, 541 common equity tier 1, 395, 400 common reporting framework, 951 common shares, 393, 394, 400, 402 communication strategy, 681 company law, 358, 375, 601 company law directives, 340 comparability, 289 compensation, 992 competent authorities competing goals, 437 competition, 163, 192, 207, 270 complaints resolution, 710 complexity, 145 compliance, 123, 612, 623, 641, 642, 647, 649, 978 comply or explain, 126, 590 comprehensive method, 477 concentration risk, 566, 623, 664 conciliation, 1057 conduct of business, 148, 183, 512, 603, 679, 691, 705, 888, 897, 941 conferral, 105 confidence level, 436, 437, 534, 536, 557 confidential information, 686

conflict of interest, 124, 637, 995 conflict rule, 545 conflicts of interests, 623, 642, 644 conglomerate, 789, 794 connected clients, 569 conservatism, 385 conservative, 438 consistent, 457 consolidated, 914 consolidated basis, 357, 393, 625, 809 consolidated supervision, 222, 408, 771, 896, 985, 1032, 1071 consolidating supervisor, 1053, 1077, 1078 consolidation, 251, 269, 409, 490, 638, 673, 683, 685, 775 constructive ambiguity, 167, 829, 836, 837 consultation, 1219, 1221 consumer, 151, 182, 693, 739, 748, 756 consumer credit, 749, 761 consumer protection, 102, 637, 691 consumption abroad, 274 contagion, 770, 794 contingent bank capital, 404 continuity, 643 control, 569 control functions, 612, 634 control unit, 647 conversion, 404 conversion factor, 459 cooperation, 1018, 1089 cooperative bank, 790 cooperative banking, 394 cooperative societies, 809 coordinating supervisor, 1089 core principles, 1014 core tier 1, 403, 419 Corep, 952, 971 corporate governance, 599, 601, 638 corporates, 449, 457

1229

Index

corrective actions, 1014 corrective instruments, 1066 correlation, 326, 363, 557, 656 correlation trading portfolio, 522, 532 costs, 1102 costs and benefits, 1221 Council, 85 counter terrorism, 718 countercyclical, 368 countercyclical buffer, 303, 369, 370, 447, 688 countercyclical capital buffer, 302 counterparty credit risk, 435, 464, 472, 480, 515, 525, 541, 654, 683, 728 counterparty protection, 151 counterparty risk, 327, 510 Court of Justice, 1060, 1193 court of law, 999 covered bonds, 457, 484, 504, 574, 593 CRD, 31, 41 CRD IV, 52 CRD IV project, 29 credit crunch, 387 credit derivatives, 472, 475, 490 credit enhancement, 484 credit institution, 173, 186 credit protection, 436 credit reference services, 237 credit risk, 327, 431, 545, 568, 646, 654, 683, 952 credit risk calculation, 294 credit risk mitigation, 450, 472, 569, 572, 623, 654 credit risk protection, 471 credit valuation adjustment, 469 creditor, 177, 287 credits, 184 criminal intent, 994 criminal law, 716

criminal sanctions, 991 crisis, 60, 593 crisis management, 65, 838 crisis management powers, 840 currencies, 629 currency, 525, 872 currency risk, 1148 customer due diligence, 718 cyclical, 636 cyclicality, 362

D damage, 1119 dark pool, 730 data, 320, 326, 365, 534, 557, 559, 599, 650, 657 data protection, 720, 964, 965, 1099 dealing on own account, 899 debt instruments, 522 decision, 1057, 1187 deducted holdings, 410 deduction, 378, 401, 408, 409, 412, 571, 579 default, 355, 381, 459 default risk, 509, 516 defence, 994 deferred tax assets, 400 definition, 139, 173 delegation, 1003, 1007, 1035 denominator, 294, 320, 431 deposit guarantee, 182, 281, 576, 679, 693, 866, 869 depositor protection, 103, 148, 151, 795 depositors, 282, 376, 1032 depository, 711, 924, 926 deposits, 142, 178, 236, 280 deregulation, 171 derivatives, 347, 435, 450, 464, 521, 654 designated authority, 305, 1172

1230

Index

direct effect, 127, 129, 206, 500, 592, 749, 1001, 1112, 1116, 1119 directive, 104, 112, 129, 1187 disclosed reserves, 419 disclosure, 625, 677, 680, 681, 722, 760, 800 disclosure obligations, 733 disclosure practices, 681 disclosure to clients, 696 discretion, 1118 discrimination, 544 discriminatory treatment, 250 disproportionate, 991 dispute, 1087 dispute resolution, 1059 dispute settlement, 1054, 1114 dissuasive, 939 distance contracts, 761, 764 distance marketing, 758, 761 distance selling, 739 diversification, 315, 326, 489, 622, 672 diversity, 544 dividends, 363, 630 domestic, 74, 96 domestic cooperation, 1020 doorstep selling, 759, 761, 764 double counting, 473, 497, 558 double gearing, 772 drugs, 718 due diligence, 492 duration based approach, 523 duty of care, 543, 696, 707 dynamic provisioning, 357

E EBA, 80, 108, 125, 1030 EBA stress test, 299, 659 EBC, 80 EBRD, 94, 191 ECAI, 435, 440, 494

ECB, 80, 1034, 1140, 1171, 1196, 1212 Ecofin, 85 e-commerce, 759 ECON, 85 economic, 71 economic capital models, 321 economic need, 207, 271 economic unit, 357 EEA, 110, 1141 EEA Agreement, 1097 effective remedy, 992 effective, proportionate and dissuasive, 939 effectively direct, 216, 608, 799 EFTA Court, 1194 EIB, 191 EIOPA, 896 electronic money, 180, 186, 625, 904 electronic money institutions, 908 eligible, 474 eligible capital, 415, 567, 575 eligible counterparty, 702 emergency, 1066 emergency circumstances, 1053 emergency measures, 988, 992 emergency procedure, 1176 emergency situation, 246, 838, 1083, 1093 e-money, 186 endowment capital, 239, 277, 385, 396, 584, 592 enforceability, 476 enforcement, 155, 977 enhanced cooperation, 1034, 1165 equal opportunity, 695 equal treatment, 232 equity, 293, 345, 376, 392, 419, 517, 523, 577, 606, 781, 807 equity claims, 457 equivalence, 803 equivalent disclosure, 686

1231

Index

ESCB, 1034, 1141 ESM, 859 ESMA, 442, 697, 896 ESRB, 87, 816, 963, 1031, 1168 essential information, 962, 1055, 1062, 1083 establishment, 198, 228, 229, 274 ethical standards, 637 ethics, 691 EU level supervision, 157 European companies, 214 European economic area, 1097 European Economic Area, 110 European passport, 199, 204, 590, 809, 895, 1000 European stability mechanism, 860 evaluation, 670 evasion, 211 ex ante, 881 exceptional circumstances, 1059 exceptional measures, 1064 exchange rate, 1145 exclusive, 281 excusable, 1118 execution, 643 executive, 616, 799 executive agencies, 1036 executive director, 219 exempted institutions, 190 exemptions, 648 expected losses, 292, 460, 496, 556 expertise, 216, 218 exposure class, 449, 456 exposure value, 450, 464, 479 exposures, 347, 433 expropriation, 992 extended maturity ladder approach, 528 external credit assessment institution, 440 external ratings, 371 extreme events, 562

F fair, 691, 716, 997 fair market, 695 fair treatment, 644, 706 fair trial, 991 fair value, 349, 439 fair value accounting, 352 fat tail, 653 favouritism, 164 fiduciary duty, 691 financial action task force, 718 financial buffers, 292, 297, 347, 375, 386 financial collateral, 474, 477 financial conglomerate, 789, 794, 795, 985, 1078 financial crime, 692 financial crisis, 1134 financial education, 698 financial holding company, 789 financial institution, 252 financial instruments, 512, 516, 899, 1155 financial intelligence unit, 719 financial leasing, 236 financial reporting framework, 951 financial stability, 103, 148, 150, 229, 695, 1032, 1072, 1081, 1133 financial transaction tax, 1034, 1164 Finrep, 952, 971 fire-sale, 517 fire-sale prices, 350, 376 first loss position, 376 first losses, 394 fiscal, 881 fiscal responsibilities, 1057, 1059 fit and proper, 217 five million euro, 291 for its own account, 176, 375

1232

Index

forbearance, 149, 312, 369, 419, 423, 665, 830, 832, 833, 842, 982, 983, 1014, 1025, 1059, 1117, 1122, 1123 foreign currency, 525 foreign exchange risk, 327, 510, 525, 530, 541 foreign-exchange, 1143 format, 687 formation expenses, 399 foundation IRB, 454, 460 four eyes, 216 fraud, 544 free banking, 165 free delivery, 524 free disposal, 915 freedom of capital, 100, 591 freedom of establishment, 100, 214, 592, 824, 987 freedom of services, 100 freedom of workers, 100 freedoms, 99 frequency, 686 FSB, 93 full repayment, 376 fully paid up, 394 fund, 711 fund manager, 711 fundamental rights, 106, 990 funded credit protection, 474 funding, 629, 879, 1013, 1102 funding risk, 327, 595, 623 funds for general banking risks, 398 future profitability, 400 future risk, 320, 331

G G20, 88, 91 gaming, 231, 255, 289, 335, 432, 514, 519, 595

GATS, 76, 94, 273, 1098 GATT 1994, 273 General Council, 1143 General Court, 1195 general good, 102, 120, 239, 584, 592, 988, 1068, 1185 general loss reserves, 354 general risk, 522 goals, 146, 1032 goals in conflict, 164 goals on the latitude given, 146 going-concern, 375 gold, 525 goldplating, 115, 187, 643 gone concern, 377 good repute, 216, 757, 799 good standing, 222 goodwill, 399 Governing Council, 1034, 1142 government banks, 190 government bonds, 598 granting credits, 184 group, 198, 1071 group of connected clients, 569 group solvency, 952 groupe de contact, 79, 1072 guarantee, 472 guarantee fund, 224, 914 guaranteed bonuses, 634 guarantees, 236 guidelines, 1052

H hard law, 77 harmonisation, 105, 160 head office, 211 hedge, 517 hedge fund, 925 hedging, 540

1233

Index

held to maturity, 348 helicopter view, 1 herding, 365 high earners, 1007 higher quality capital, 302 hold to maturity, 510 home country control, 987, 1065 home host, 1018, 1076 home supervisor, 243, 1065 honest, 716 host market, 824 host supervisor, 699, 1065 human judgement, 647 human rights, 201, 224, 723, 990, 1195 hybrid capital, 380, 393 hybrids, 376, 379, 398, 399, 401, 419

I IAASB, 95 IAS, 340 IASB, 95 ICAAP, 666 Iceland, 110 IFAC, 95 IFRS, 340, 490 illiquid, 517 illiquid assets, 350, 351, 484 IMF, 94 immovable property, 759 impact assessment, 50, 594, 1220 impaired, 356 implementation, 112, 1009 implementing standards, 1202, 1209 in control, 617 incentive, 356 incentive for compliance, 625 incompatibility, 200 incremental risk charge, 531, 535, 541, 648, 654, 658

incriminate, 994 indemnity insurance, 901 independence, 368, 612, 1013, 1025, 1143 indicator, 73 inducements, 644 inflation target, 1145 inflows, 593 influence, 222 information exchange, 791, 1055 information sharing, 1018 information to be gathered, 708 infringement, 1118 initial capital, 208, 209, 385, 395, 399 injured party, 1119 innocence, 991 innovative products, 665 insider dealing, 720 institution, 705 institutional, 1021 institutional protection scheme, 452, 463, 812 instruments, 162, 977 insurance, 121, 472, 558, 561, 563, 909, 1034, 1097 insurance mediation, 739, 756, 764 insurance sector, 794 insurance subsidiary, 409 insurer, 789, 796, 899, 909 intangible, 400 intangible assets, 398 integrity, 217, 642, 645, 715, 721 intention, 1118 intentional, 1118 interbank market, 572 interconnected, 565, 818 interest, 355 interest income, 549 interest rate risk, 623, 664, 671, 683 internal audit, 612

1234

Index

internal capital, 621, 666 internal capital adequacy assessment, 683 internal capital adequacy assessment process, 666 internal control, 558, 620, 621, 643 internal governance, 224, 476, 500, 543, 550, 555, 569, 582, 589, 599, 666, 667, 671, 798 internal hedge, 475, 541 internal model, 321, 327, 331, 434, 466, 511, 528, 541, 646, 683 internal model method, 467 internal models approach, 480, 530 internal organisation, 455, 467, 480, 517, 683 internal oversight function, 612 internal processes, 543 internal ratings based approach, 454, 654 internal review, 666 international organisation, 723 interpretation, 173 interpreting national/EU rules, 132 intervention pyramid, 980 intra-day, 629 intra-group, 576 intra-group financial support, 890 intra-group loans, 452 intra-group transactions, 358, 793, 798 investment activities, 899 investment firm, 141, 512, 641, 705, 796, 896 investment services, 699, 899 investor compensation, 866, 878, 885 investor confidence, 721 investors, 282, 1032 IRB, 454, 646 IRB approach, 434, 465, 490, 536

J jargon, 513 jump to default risk, 366 juris legis process, 1193

K key information, 741, 764 key investor information, 744

L Lamfalussy, 1198 Lamfalussy/Larosière, 1202 Landesbanken, 193 language, 359, 1222 large exposures, 296, 327, 379, 565, 572, 624, 952 Larosière, 1200 LCR, 593 legal, 71 legal basis, 103, 994 legal certainty, 481, 891 legal entity, 175, 197, 206, 358, 629, 899 legal merger, 263 legal opinions, 481 legal structure, 683 legality, 1194 legislative process, 1187 legitimate business secrets, 998 lender of last resort, 832, 851, 858, 1028 lending, 184, 236 level 2 legislation, 1041 levels in legislation, 1198 leverage, 363, 527, 925, 927 leverage ratio, 299, 311, 319, 401, 665 lex specialis, 761 LGD, 458 liability, 129, 133, 347, 354, 641, 713, 746, 755, 767, 833, 994, 1004, 1013, 1022, 1060, 1118 liberalisation, 171, 794

1235

Index

license, 142, 197, 204, 248, 384, 991 license conditions, 205 licensing process, 621 Liechtenstein, 110 life insurance, 929 lines of responsibility, 621 liquid, 517 liquid assets, 584 liquidation, 153, 377, 886 liquidity, 239, 291, 655, 872, 1066 liquidity assistance, 851 liquidity coverage ratio, 593 liquidity facilities, 492 liquidity management, 582 liquidity risk, 327, 581, 623, 684 liquidity risk management, 629 liquidity shock, 593 Lisbon treaty, 1183 list, 1007 listing rules, 603 living will, 641, 798, 832, 842 loan applicants, 684 loan loss accounting, 351, 355, 439 location of assets, 304 look through approach, 931 loss absorbency, 394, 413 loss absorbent, 381, 404, 406, 417 loss absorbing, 387, 399 loss absorption, 421 loss event, 557 loss given default, 458

M macroprudential, 366, 368, 370, 770, 816, 1166 macroprudential authority, 1030 MAD, 721 main activity, 177 main sum, 355

major need, 119 management, 544 management body, 220, 609 management company, 924 management functions, 612 managerial function, 609 mapping, 624 margin, 1161 margin of appreciation, 992 mark to market, 351, 354, 517 mark to market method, 466 mark to model, 351, 354, 517 market abuse, 643, 716, 720 market access, 197, 201, 375, 999 market data, 534 market distortions, 165 market imperfections, 147 market integrity, 715 market manipulation, 720 market participants, 684 market pressures, 677 market risk, 327, 379, 465, 509, 545, 568, 623, 625, 647, 654, 657, 667, 683, 897, 901, 952 market risk calculation, 294 market risk protection, 540 market value, 479 master netting agreements, 477 material information, 760 material losses, 398 maturity based approach, 522 maturity ladder approach, 527 maximum harmonisation, 113 maximum limits, 572 mediation, 1053, 1054 member states, 112 memorandum of understanding, 1018, 1098 merger, 198 merger and acquisition, 251, 259, 1064

1236

Index

Meroni doctrine, 1035 Mifid, 183, 236, 512, 625, 641, 700, 760, 866, 878 mild recession, 653 minimum guarantee fund, 912 minimum harmonisation, 113, 116 minimum own funds, 291, 293 ministry of finance, 96, 836 minority interests, 410 mirage, 335 mixed activity holding company, 789, 792 mixed financial holding company, 789, 792, 797, 801 model, 320, 437, 626 model approval, 334, 533, 555, 646, 783, 1074, 1085 model developers, 647 monetary authorities, 592 monetary authority, 1027 monetary financial institutions, 1145 monetary policy, 240, 1066, 1143, 1145 monetary union, 1044 money broking, 237 money laundering, 708, 716, 717, 871, 909 money transfer, 738 moral hazard, 164, 166, 170, 564, 602, 836, 867, 992 moratorium, 287, 886 mortgage, 472, 574, 698 mortgage credit, 750, 753 most favoured nation, 273 multilateral trading facility, 728 mutual bank, 790 mutual recognition, 160, 886 mutuals, 383, 394, 427

N national discretions, 117, 375, 379, 386, 1009 national level, 96 national options and discretions, 117 nationalisation, 992 natural person, 175 near banks, 143 negligence, 927 net stable funding ratio, 593, 596 netting, 450, 472, 474, 522, 540 netting agreements, 472 netting set, 467 non-bank investment firm, 512, 642, 705, 897 non-binding, 125 non-executives, 219, 610, 616, 626, 634 non-financial subsidiaries, 378 Norway, 110 notification procedure, 240 novation, 450, 1160 NSFR, 594 numerator, 294, 377, 385, 431

O objective/subjective, 330 objectivity, 289, 321, 353 occupational pension fund, 929 OECD, 94 off balance sheet, 347, 433, 451 off-site supervision, 947 one branch, 245 one year period, 458 one year time horizon, 460 ongoing supervision, 143 on-site supervision, 947 onward passporting, 257 open market operations, 1146

1237

Index

operational risk, 327, 543, 620, 624, 637, 648, 654, 683, 952 operational risk calculation, 295 operational risk protection, 561 opinion, 1187 opt out, 701 options and discretions, 1009 order execution, 236 order handling, 710 ordinary legislative process, 1188, 1190 organisational requirements, 599 organisational structure, 621 original exposure method, 466 original own funds, 385, 397, 402, 419 originator, 488 OTC, 728 OTC derivatives, 465, 515 other public policy goals, 333 outflows, 593 outsourcing, 627, 643, 907 over the counter, 728, 1156 overlapping risks, 545 overshooting, 538 oversight, 1154 own fund tiers, 301 own fund-concepts, 385 own funds, 209, 295, 341, 377, 384, 406, 565, 871 own risk, 874 own shares, 398

P packaged retail investment products, 764 paid up capital, 347 par value, 907 Parliament, 85 partial consolidation, 776 partial coverage, 482 partial use, 461, 538, 560

participations, 223 partner, 175 past due items, 449 payer information, 716, 720, 725 payment, 891 payment institution, 904, 908 payment services, 236, 737, 754 payment services providers, 1153 payment systems, 1143, 1156 payments, 625 PD, 458 peer pressure, 124 peer review, 1007, 1219 pension fund, 401, 923 per depositor per bank, 870 periodic reporting, 950 periodicity, 537 permanency, 230 perpetual, 394 personal data, 964 Peter Paul, 1121 physical assets, 544 pillar 1, 47 pillar 2, 47, 369, 497, 545, 566, 568, 583, 589, 621, 652, 654, 655, 663, 979, 1009, 1055, 1085, 1087 pillar 2 capital requirements, 302 pillar 3, 47, 625, 679, 682, 978, 1086 point of time information, 650 policyholder protection, 795, 910 political, 1208 political independence, 1028 political intervention, 1025 politically exposed persons, 719 portfolio management, 237 position risk, 327, 510, 520, 530, 540 possessions, 992 precautionary measures, 987 prevention of bankruptcy, 153

1238

Index

price finding, 729 price stability, 1143, 1147 principle-based, 548, 600 privacy, 946, 991 privileged access, 194 probability of default, 458, 551 procedural guarantees, 992 procedural protections, 996 processing data, 964 procyclicality, 164, 310, 352, 362, 363, 365, 368, 369, 370, 372, 408, 419, 1166, 1167 professional, 151 professional clients, 181, 642, 701 professional standards, 637 profits, 402 programme of operations, 207 prohibited restrictions, 199 prohibition, 281, 378 prompt corrective action, 311, 1123 proportionality, 105, 116, 146, 162, 316, 638, 668, 824, 939, 948, 1184 proportionate, 991 proprietary information, 686 prosecute member states, 123 prospectus, 679 protection, 182, 672 provisions, 354 prudential filters, 345 prudential supervision, 1034 public, 141, 181, 215, 255, 280, 712, 897 public accounts, 375 public disclosure, 696 public interest, 992 public policy, 102, 119, 1185 public policy goals, 158, 632 publication, 998, 1060 published reserves, 293

Q qualified holding, 577 qualified investors, 181 qualified majority, 1190 qualifying holding, 222, 260, 565 qualitative requirements, 287 quality, 646 quality levels, 375 quality steps, 441 quantifiable risks, 292 quantitative impact, 50 quantitative requirements, 287

R rating agency, 372, 435, 440, 449, 494, 825, 857, 1214 rating system, 684 RBD, 31 RCAD, 31 real estate, 449, 481 recalibrated, 509 receive, 178 reciprocity, 278 recommendation, 1187 record keeping, 625 records, 643, 707 recovery and resolution plan, 576, 641, 798, 842 recovery plan, 209, 844, 915 refusal, 224 registered office, 211 regulated entity, 222 regulated markets, 512, 727 regulation, 104, 112, 1187 regulatory agencies, 1036, 1037 regulatory arbitrage, 519 regulatory forbearance, 167, 419, 597, 665 regulatory risk, 717 regulatory standards, 918, 1202, 1209

1239

Index

relevant information, 962, 1062, 1083 remuneration, 621, 623, 630, 683, 1007 remuneration committee, 609, 634 remuneration limits, 623 repayable, 740 repayable claims, 872 repayable funds, 178, 280, 897, 904, 907 replacement cost, 466 reporting, 571, 572 reporting currency, 525 representative office, 237 reputation, 220, 266, 489, 543, 583, 637 reputational risk, 149, 327, 545, 623, 641, 653, 715 reregulation, 171 rescue funds, 859, 860 rescue operations, 579 reserve requirements, 1146 reserves, 347 residence, 221 residential mortgage, 754 resolution, 813, 1049 resolution authority, 844, 845, 888, 972 resolution college, 1093 resolution function, 1030 resolution funds, 879, 880 resolution plan, 844 resolution tools, 844 resources, 162 restoration plan, 915 restricted circle, 181 retail, 552, 712 retail clients, 181, 642, 700, 866, 885, 923 retain profits, 978 retained interest requirement, 492 retention obligation, 506 retention requirement, 498 reverse stress test, 656 review and evaluation, 669

right of initiative, 1189 ring fence, 591 ringfencing, 276, 890 risk, 326, 600, 617, 622 risk appetite, 326, 327, 600, 619, 631 risk assessment, 558 risk awareness, 548 risk based, 877, 880 risk committee, 626 risk concentration, 798 risk control, 476 risk investors, 376 risk management, 489, 491, 543, 559 risk mitigation, 546, 561, 563 risk profile, 625, 684 risk sensitive, 292 risk takers, 633 risk transfer, 916 risk types, 513, 533 risk weight, 441, 445, 458, 522, 551, 569, 574 risk weighted, 378, 595 risk weighted assets, 294 risk weighting, 496, 1177 risk-bearing funds, 375 risk-bearing instrument, 387 risk-investors, 630 roll-out plan, 462 rule of law, 992, 1195 run, 867, 869 run-off, 814

S safeguards against abuse, 994 safekeeping, 140, 237, 878 safety endorsement, 821 salary, 630 sale, 472, 485, 495 sanctions, 1064 savers, 151

1240

Index

saving institutions, 427 savings banks, 812 scope European passport, 238 scope of application, 408 seat, 211 secondary freedom, 231 secrecy, 658, 680, 684, 950, 1096 secrecy obligation, 946, 956, 968, 1006, 1091 securitisation, 345, 354, 356, 358, 363, 410, 432, 436, 442, 450, 472, 484, 485, 486, 495, 521, 533, 535, 623, 625, 636, 655, 667, 671, 683, 1009 see through, 594 segregate trading activities, 515 segregation, 708, 713 segregation of assets, 643 self-assessment, 668 self-employed persons, 101 self-incrimination, 994 self-regulation, 156 selling methods, 757 senior management, 219, 517, 609, 612 sensitivity tests, 656 servicer, 488 services, 198, 228, 278 settlement, 891, 1155 settlement finality, 891, 1162 settlement risk, 327, 524 shadow bank, 576, 634 shadow banking, 68, 188, 1139 shaming, 677 shareholder, 219, 222, 287, 376 sifi, 169, 820 significant, 220 significant bank, 634, 824 significant branch, 246, 278, 824, 986, 1055, 1069, 1081, 1085 significant stress, 535 significant subsidiaries, 685

significant transfer, 491, 495 significant transfer of credit risk, 496 simplified approach, 528 single market, 75, 98, 101, 148, 159, 204, 228, 855, 868, 1047 single rulebook, 58 single supervisor, 1045 single supervisory mechanism, 65, 860, 861, 895, 989, 1093 size, 145 skillsets, 219 small- and medium sized enterprises, 447 soft law, 77 solo, 202, 393, 409, 638, 673, 685, 799, 809, 889, 1009, 1071, 1077, 1086 solo basis, 357 solo supervision, 771, 781 solo+, 911, 914 Solvency II, 916 solvency margin, 912 solvency ratio, 288, 292, 294, 320, 355, 375, 385, 574, 595, 901, 1066 sophistication, 700 sovereign risk, 445, 598, 659 special purpose vehicle, 489, 490 specific risk, 521, 536, 540, 575 sponsor, 488 SREP, 670 stability and growth pact, 1150 staff, 648 standard approach, 540 standard model, 327, 331 standard treatment, 511 standardised approach, 327, 434, 448, 462, 465, 480, 490, 533, 546, 550, 568 standardised conditions, 759 standardised models, 321 standards, 1033, 1052, 1202 start up costs, 208

1241

Index

state aid, 270, 832, 845, 851, 852, 863, 881 state aid instruments, 414 state insolvency, 860 statutory audit, 343, 681, 953 statutory seat, 213 stickiness, 593 sticky deposits, 363 stochastic, 321 stock exchanges, 726 strategic risk, 327, 545 stress testing, 335, 369, 438, 532, 535, 568, 636, 647, 650, 672 stressed conditions, 532 stressed scenarios, 590 stressed VAR, 532, 535, 651, 654, 657 stupidity, 545 sub-consolidated, 1086 subordinated debt, 416 subordinated loans, 376, 377, 380 subsidiaries of EU banks, 200 subsidiarisation, 247 subsidiarity, 105, 1184 subsidiary, 198, 200, 248, 592, 776, 1081 subsidiary bank, 986 suitability, 216, 217, 616, 707, 708 supervision, 155, 762 supervisory disclosure, 125, 1005 supervisory function, 609 supervisory review, 669 supervisory review and evaluation process, 497 supervisory spending, 1102 supplementary supervision, 794 Switzerland, 111 syndicated loan, 505 syndication, 484 synthetic securitisation, 490, 496 systematic internaliser, 729 systemic, 169, 261, 589, 686, 819, 853, 1069

systemic bank buffer, 306 systemic banks, 306 systemic buffer, 826 systemic market shocks, 653 systemic relevance, 232 systemic risk, 1134 systemically important, 820

T tail risk, 562 tail-events, 322 take-over, 222, 261, 274 target bank, 264 tax, 767, 946, 1102, 1107 tax incentive, 401 tax treatment of debt, 363 technical, 1207 technical provisions, 912, 917 temporarily for rescue operations, 579 temporary activity, 241 temporary excess, 578 terrorism, 718 terrorist financing, 708 TEU, 1183 TFEU, 1183 third country, 215, 223, 232, 273, 774, 802, 950, 1020, 1080, 1081, 1093, 1094 third country banks, 275 third country branch, 397, 871 third country public, 215 third pillar, 678 three pillars, 47 three tiers, 386 thresholds, 264 through the cycle, 369, 650 tier 1, 419 tier 1 capital, 397, 400 tier 2, 411, 421 tier 3, 379, 421, 511, 514, 570

1242

Index

tiering, 386, 416 time commitment, 615, 616 time horizon, 437, 557, 629, 660 timing of failing, 846 timing the failing, 830 too big to fail, 821, 882 tradability, 517 trade finance, 454 trading, 1155 trading book, 433, 465, 480, 510, 514, 515, 520, 565, 574, 625 trading for own account, 236 trading intent, 349, 515, 516 trading platform, 705, 727, 737, 900 trading position, 535 trading venue, 645, 679 traditional securitisation, 496 tranches, 495 transfer, 814 transfer of seat, 212 transferability, 225 transferable securities, 923 transferred assets, 486 transformation function, 140 translations, 1222 transmission mechanism, 1146 transparency, 57, 341, 344, 350, 354, 358, 359, 365, 408, 601, 630, 645, 677, 679, 680, 681, 682, 684, 697, 721, 728, 730, 732, 737, 741, 742, 743, 744, 747, 957, 1005, 1032, 1153, 1164 treasury, 96 true sale, 485, 495 trust, 156, 291, 677, 818, 940 trust but verify, 948 trustworthiness, 217 trustworthy, 715

U UCITS, 523, 703, 711, 744, 760, 921, 923 unanticipated losses, 375, 376 unavailable deposits, 873 undertaking, 174 underwriting, 574 unenforceable, 639 unexpected losses, 292, 460, 556 unfair business, 760 unfair terms, 759 unfunded credit protection, 475 unidentified losses, 417 universal banking, 198 unlawful, 1195 unpaid commitments, 383 unregulated entities, 780 unsecured bondholders, 849 unsecured creditor, 376 unsecured loan, 880 unsecured wholesale funding, 593 use of information, 961 use-test, 335, 456, 559, 647

V validation, 646, 647 valuation, 346, 362, 482, 517, 623, 636 valuation techniques, 348 value, 433 value at risk, 331, 334, 436, 531 VAR, 436 variable remuneration, 634 verification, 949, 1063 viability, 207 violation of the law, 994 volatile, 354 volatility adjustment, 477

W weak banks, 839 wholesale funding, 586, 593

1243

Index

will to act, 1015 winding down, 814, 886, 888 winding up, 892, 904, 913, 918 withdrawal of a license, 981 workplace safety, 544 World Bank, 94 worldwide, 73 written arrangements, 1082 WTO, 76, 94, 273, 1097

1244