The European Commission has launched a public consultation into possible changes to the European Capital Requirements Directive.

On 26 February 2010, as a response to the financial crisis, the European Commission launched a public consultation suggesting changes to Directives 2006/48/EC and 2006/49/EC, together, the Capital Requirements Directive (CRD). The potential measures outlined in the Consultation are set to be the third set of changes to the CRD, including those still in the pipeline. The Consultation states that the proposed measures are closely aligned with expected amendments to the Basel II Framework, and also reflect the outcome of the G-20 Pittsburgh Summit. The Commission has invited responses to the Consultation and the questions raised in it, which are to be submitted by 16 April 2010. The Consultation explores changes to the following:

  • Liquidity Standards
  • Definition of Capital
  • Leverage Ratio
  • Counterparty Credit Risk
  • Countercyclical Measures
  • Systematically Important Financial Institutions
  • Implementing a Single Banking Rulebook

and follows a range of announcements on possible over-the-counter (OTC) derivative reforms (see the following links for earlier analysis: http://www.mwe.com/info/news/ots0210n.htm and http://www.mwe.com/info/news/ots1009m.htm).

With regard to OTC derivatives, the Consultation raises a number of proposals and questions that should be considered by commodity firms in greater detail, including the following:

  • Counterparties and margin period of risk
  • Central counterparties
  • Enhanced counterparty credit risk management requirements
  • Collateralised Counterparties and Margin Period of Risk
  • The Commission feels that both collateral management and initial margining need to be strengthened. As such, the Commission is seeking to increase the margin period of risk to 20 days for netting sets which exceed 5,000 trades, are illiquid or contain bespoke or exotic derivatives. Additionally, the Commission is looking to a create a separate supervisory “haircut” category for repo transactions which use securitisation collateral, prohibit re-securitisations from falling under the eligible financial collateral category with regard to regulatory capital, and amend the “shortcut method” when calculating future exposure so that it takes into account margin call disputes. Lastly, the Commission seeks to amend the way in which exposure at default is calculated in order to reinforce collateral management practice and processes.

Central Counterparties

The Commission is seeking to use central counterparties (CCPs) to combat counterparty credit risk. In the Consultation, however, the Commission comments that “a CCP also concentrates risk, which means that a CCP with insufficiently robust risk management processes can actually increase the systemic risk.” Therefore, the Commission proposes stronger risk management procedures and, along with the Basel Committee on Banking Supervision, considers a number of measures that should be taken, including:

  • Establishing a high level of initial margin and on-going collateral positing requirements
  • Introducing more rigorous schedules for calculating margin requirements and monitoring exposures
  • Implementing risk procedures identifying and limiting specific risks
  • Requiring CCPs to have the finances necessary to withstand defaults of its largest participants
  • Requiring stress testing to assess potential losses, default fund size and how the default fund will be accessed under circumstances of exceptional risk
  • Making it clear who is responsible for the supervision of CCPs

The Commission is also seeking to amend who would qualify for zero-risk weight exposure when using CCPs.

Enhanced Counterparty Credit Risk Management Requirements

In the Consultation, the Commission makes a number of proposals to enhance counterparty credit risk management, including making the qualitative requirements for stress testing in the CRD more explicit, revising model validation requirements contained in the CRD, and adding a new operational requirement for effective expected positive exposure models, whereby entities will be obliged to have an independent risk control unit responsible for their counterparty credit risk management systems.

Conclusion

The Consultation, generally, is in line with the greater international regulatory push we have seen since the financial crisis. It remains to be seen whether or not the Commission proceeds with all of its proposals following the result of the Consultation, but they need to be considered carefully by market participants looking to operate in this ever-evolving regulatory landscape