European Commission’s Proposed Capital Requirements Directive – Overview and Summary of Requirements

• By: Staff Editor
• Date: October 28, 2011

The financial crisis of 2007/08 made it clear that a lack of capital among the European banks left them in an unstable, precarious position, worsening the economic conditions in various EU member states.

• They held too little capital and the capital they held was of poor quality and in effect not able to cover the losses banks were facing. As a result, when banks faced losses they had to be bailed out by tax payers.
• Banks were not holding enough liquid funds and so faced a shortage of cash when they needed it most.

• Banks took on too many assets compared to their capital. When the crisis hit, many of these assets fell in value. When banks tried to sell these assets at the same time, prices fell further and this contributed to making the crisis worse.

• Capital
  • Increases the amount of own funds banks need to hold as well as the quality of those funds.
  • Harmonizes the deductions from own funds in order to determine the amount of regulatory capital that is prudent to recognize for regulatory purposes.
• Liquidity: Introduces a Liquidity Coverage Ratio (LCR) to improve short-term resilience of the liquidity risk profile of financial institutions.
• Leverage ratio: In order to limit an excessive build-up of leverage on credit institutions' and investment firms' balance sheets, the proposed regulations requires that a leverage ratio be subject to supervisory review.
• Counter party credit risk: Encourages banks to clear Over the Counter (OTC) derivatives on CCPs (central counterparties).
• Single rule book: The regulation is directly applicable without the need for national transposition and accordingly eliminates one source of such divergence. The Regulation also sets a single set of capital rules.

• Enhanced governance: Strengthens the requirements with regard to corporate governance arrangements and processes and introduces new rules aimed at:
  • Increasing the effectiveness of risk oversight by boards,
  • Improving the status of the risk management function and
  • Ensuring effective monitoring by supervisors of risk governance.
• Sanctions: If institutions breach EU requirements, the proposed directive will ensure that all supervisors can apply sanctions that are truly dissuasive, but also effective and proportionate. These can include administrative fines of up to 10% of an institution's annual turnover, or temporary bans on members of the institution's management body.
• Capital buffers: Introduces two capital buffers on top of the minimum capital requirements:
  • A capital conservation buffer identical for all banks in the EU and
  • A countercyclical capital buffer to be determined at national level.
• Enhanced supervision: Proposes reinforcements to the supervisory regime to require the annual preparation of a supervisory program for each supervised institution on the basis of:
  • A risk assessment,
  • Greater and more systematic use of on-site supervisory examinations,
  • More robust standards and
  • More intrusive and forward-looking supervisory assessments

1. All banks' investment decisions should be based not only on ratings but also on their own internal credit opinion, and
2. Banks with a material number of exposures in a given portfolio should develop internal ratings for that portfolio instead of relying on external ratings for the calculation of their capital requirements.