On October 10, the European Commission (Commission) adopted two delegated acts (Delegated Acts) under the Capital Requirements Regulation ((EU) 575/2013) (CRR):the Liquidity Coverage Requirement Regulation (LCR Regulation), applicable to EU credit institutions (banks) setting out detailed quantitative liquidity rules; and the Leverage Ratio Regulation (Leverage Regulation), setting out details for banks across the European Union on how to apply the existing rules on the leverage ratio in a uniform manner.
The CRR was adopted in June 2013 as the single rulebook for prudential requirements for all financial institutions in the European Union and included general rules on liquidity and leverage in addition to powers of the Commission to adopt delegated acts containing specific detailed rules in each of these areas. Each of these Delegated Acts attempts to deal with structural weaknesses that became apparent during or subsequent to the recent financial crisis in the operations of EU banks. Highlights of both the LCR Regulation and the Leverage Regulation are set out below together with links to the relevant legislation.
The financial crisis illustrated that a number of EU banks had been overly reliant on short-term financing and liquidity from central banks and did not hold sufficient liquid means (e.g., cash or other assets that can be quickly converted into cash with no or little loss of value) to meet net cash outflows in times of crisis. Consequently, when the crisis hit many EU banks suffered from a lack of liquidity and were forced to sell assets significantly below value—which contributed to the downfall of several financial institutions.
To avoid a similar situation in the future, the Commission has adopted the LCR Regulation which sets out detailed quantitative rules for the calculation of the general liquidity coverage requirement already established in the CRR, intended to improve the resilience of banks to liquidity risks over a 30-day period in stressful conditions and to ensure that banks have enough high-quality assets in their liquidity buffers to cover the difference between cash outflows and inflows during such a period (LCR Ratio). In doing so, the LCR Regulation set outs what assets are considered high-quality liquid assets (together with any percentage limits/haircuts which might apply to particular groups of assets for calculating purposes) and how cash outflows/inflows are to be calculated during such periods of stress. The LCR Regulation takes into account comprehensive reports from the European Banking Authority (EBA) and the Basel Standards (Basel III) previously introduced by the Basel Committee at the request of G20 leaders (and already generally implemented into EU law) while also applying relevant specificities of the EU banking and financial landscape.
The level of LCR Ratio required to be satisfied will be progressively implemented over the course of the next four years (with the first milestone for compliance being October 1, 2015) to allow banks the opportunity to build up liquidity buffers over time so as to avoid any adverse impact on the flow of credit.
Leverage is recognized by the Commission as an inherent part of banking activity. Similarly to those issues related to liquidity, however, the recent financial crisis highlighted the high use of leverage by financial institutions across the European Union. In an attempt to control its use, the CRR sets out a leverage ratio to which EU banks are obliged to comply (Leverage Ratio). The aims of the Leverage Ratio are: (1) to limit the risk of excessive leverage and (2) to provide a safeguard against risks associated with risk models underpinning risk-weighted assets. To the extent considered necessary, the Commission was also given the power in the CRR to amend how the Leverage Ratio was calculated if the reporting to competent authorities uncovered shortcomings (this analysis was obliged to be completed before banks must commence disclosing the Leverage Ratio on January 1, 2015).
A consistent approach regarding what is meant by the Leverage Ratio was considered necessary by the Commission after a report by the EBA indicated significant variation in interpretation and understanding by EU financial institutions across the EU Member States as to the existing rules concerning its calculation—something the Commission considers would result in significant differences in the way the leverage ratio is calculated. This would, in turn, lead to a situation where the numbers disclosed by different institutions would not be comparable throughout the European Union.
The Leverage Regulation now provides a definition of Leverage Ratio for EU banks that is aligned with the internationally agreed standard as set out under Basel III (BCBS270), making the Leverage Ratio disclosed by any EU financial institution comparable globally.
In terms of specific requirements, the Leverage Regulation introduces a number of clarifications associated with the Leverage Ratio relating to, among other things, what constitutes the calculation and reporting period, which should reduce the operational burden and align the Leverage Ratio with the solvency reporting data. The Leverage Regulation also clarifies that collateral received in securities financing transactions (SFTs) cannot generally be used to reduce exposure to the SFTs. The Leverage Regulation also introduces certain technical changes including:using the credit risk conversion factors of the standardized approach for credit risks subject to a floor of 10 percent; allowing the cash variation margin received for derivatives to be deducted from the exposure value; and providing that written credit derivatives are measured at their gross notional amounts instead of their fair values; offsetting of the fair value of protection sold with the fair value of protection bought will be allowed under certain specific conditions.
Given the relative lack of information concerning the Leverage Ratio and its calculation, the Commission has determined to gather more information before making it a binding (Pillar 1) measure. The Leverage Regulation will therefore be implemented as follows:an initial implementation as a Pillar 2 measure; data gathering on the basis of clearly defined criteria as of January 1, 2014; public disclosure from January 1, 2015, onwards; a report from the Commission by the end of 2016 including, where appropriate, a legislative proposal to introduce the leverage ratio as a binding measure as of 2018.
The EBA is expected to submit an amendment to the Implementing Technical Standard on supervisory reporting to align the supervisory reporting with the amended Leverage Ratio definition.
The Leverage Regulation can be found here.