The present credit crisis has revealed the failure of the EU’s Capital Requirements Directives based on the so-called Basel accord. The European Commission has recently adopted a proposal for a Directive (amending Directives 2006/48/EC and 2006/49/EC) establishing an amended supervisory legal framework for credit institutions and investment firms in the EU. It attempts to amend old failing EU regulations and set up new stricter rules for banks with regards to lending and risk engagement.

Given the financial crisis and the role of failed European regulation within that crisis, the European Commission has spelt out its new changes. The Commission believes that its amending proposal will reinforce the stability of the financial system, reduce risk exposure and improve supervision of banks that operate in more than one EU country. Internal Market Commissioner Charlie McCreevy has said that the proposals on the Capital Requirements Directive (CRD) “will improve the management of large exposures and improve quality of capital through harmonising treatment of hybrid capital.” This is the first proposal of a regulatory package which will also include proposals on the regulation of ratings agencies.

John Purvis, the UK Conservative vice-chair of the European Parliament’s Economic and Monetary Affairs committee has said “The EU should be taking action to ensure [the] systemic failures are never allowed to happen again, but excessive and intrusive regulation will only damage the smooth working of the financial system.”

The Capital Requirements Directive laid down rules on how much capital a bank must hold in order to ensure it can meet customer deposits at any given time. Capital is split, in the Capital Requirements Directive, into two important types: ‘tier one’ and ‘tier two’. Whereas T2 capital is considered less secure, T1 is secure and can be counted on to fully absorb losses of a going concern. A bank can have both types, but in order to satisfy the adequacy rules, it must have a certain amount of T1 capital. However, the Capital Requirements Directive does not rule on the hybrid capital instrument (HCI) – therefore, those instruments are not presently within the EU harmonized rules on how supervisors should deal with them. (Hybrid capital instruments are securities that contain features of both equity and debt).

Older legislation is being amended to assess whether hybrid capital is eligible to be counted as part of the overall capital of a bank. In 1998, the Basel Committee on Banking Supervision adopted an agreement on the eligibility criteria and limits to inclusion of certain types of hybrid capital instruments into original own funds of credit institutions. These criteria have not yet been transposed into EU legislation. The Commission’s new proposal looks to set up EU-wide criteria for assessing whether hybrid capital is eligible to be counted as part of the overall capital of a bank, meaning the amount of capital determines how much the bank can lend and to align the old provisions in Directive 2006/48/EC to this agreement.

The existing regulatory system has created problems over exposure. The EU regime on large exposure dates back to 1992 so the Commission has decided to review the current requirements on large exposure, set out in Directive 2006/48/EC and Directive 2006/49/EC, on the capital adequacy of investment firms and credit institutions. The Commission has pointed out that the present regime “does not effectively address market failure pertaining to certain exposure types (e.g. exposures to institutions), implying a higher burden for taxpayers and capital inefficiencies.” The Commission wants to further harmonize the essential rules for monitoring and control of large exposures of credit institutions. The Commission has proposed to reduce the number of options for Members States on large exposures in order to reduce administrative burden for credit institutions.

The present CRD’s “large exposures” regime confines the size of these exposures to a percentage of the banks’ own funds. According to the Commission the existing regime which is “based on a complex mix of risk weights and differentiation on maturity, is not sufficiently prudent.” The Commission has proposed to limit all inter-bank exposures to 25% of own funds or an alternative threshold of EUR 150 million, whichever is higher. Under the Commission’s proposal, banks would be required to hold at least 25% of their own funds in order to ensure their lending operations to other banks.

A new College of Supervisors is to be set up. The Commission has stressed that in order to strengthen the crisis management framework of the Community, it is important that competent authorities coordinate their actions with other competent authorities and, where suitable, with central banks in an efficient way. The Commission has proposed the establishment of College of Supervisors with the aim of strengthening the supervision of parent credit institutions, to allow competent authorities to better carry out, on a consolidated basis, the supervision of a banking group and to better coordinated supervisory activities. The overall aim is to reinforce the supervision of ‘cross-border’ banking groups. According to the Commission the establishment of a college of supervisors would be an instrument for stronger cooperation through which competent authorities reach agreement on important supervisory tasks. The Commission believes that such college would improve co-operation and transparency in the EU cross border banking sector. The college would also be given a role in crisis management situation. The liquidity risk management of banking groups that operate in multiple EU countries will also be discussed and coordinated within colleges of supervisors. According to the Commission’s proposal, national supervisors may have to take into account in their mandates a Community dimension. Hence, financial regulators are required to take into account “the effect of their decisions on the stability of the financial system in all other Member States.”

The Commission’s new proposals look to lower the capital requirements for less risky assets. With regards to the Treatment of Collective Investment Undertakings (CIUs) under the Internal Ratings Based (IRB) Approach, the Commission pointed out that a sound and risk sensitive alternative treatment of exposures in CIUs would be provided by applying more targeted increases to the standardized risk-weights, through which the percentage increase in risk weights would be lower for well-rated exposures and higher for lower-rated and unrated exposures. The Commission pointed out that the capital requirements for investments in CIU “were too strict under the IRB approach in those cases where banks cannot or do not want to provide internal rating for the exposure held by the CIU.” The Commission has proposed to lower the capital requirements for less risky assets held by the CIU – however it retains high capital charges where the assets are either high risk or the actual risk is not known.

The Commission now also wants to tighten rules on securitised debt. The Commission wants to address potential conflict of interests in the ‘originate to distribute’ model. Under the Commission proposal, firms known as “originators” that re-package’ loans into tradable securities and other financial instruments would be required to retain a proportion of the risk that is being transfer to investors. Under the Commission’s proposal, investors are required to ensure that originators effectively retain a material share, not less than 5 per cent of the risks. The Commission has therefore proposed a 5 per cent securitisation charge that issuers of securitised loans must make on their own balance sheets.

On the other hand, firms that invest in the securities, particularly where credit risk is transferred by securitisation, would be allowed to make their decisions only after conducting comprehensive due diligence. According to the Commission “A stronger and more rigorous securitization framework including more rigorous due diligence should contribute towards more responsible underwriting and avoidance of a repeat of the enormous costs that have been borne by investors and financial institutions over the past 18 months.”

According to John Purvis “Five percent retention is being billed as a panacea, but it could also make securities less attractive, potentially pushing up the cost of credit further still.”

In order to legislate for these amended regulations during the turbulent crisis, the Commission would be empowered to adopt the so called technical amendments of Directive 2006/48/EC on the taking up and pursuit of the business of credit institutions under the legislative ‘comitology’ procedure.

The Commission’s proposals will have to be approved by the EU Member States and the European Parliament under the co-decision procedure. The Council on Economic and Financial affairs welcomed on 7 October the Commission proposals for amendments to the Capital Requirement Directive (CRD). The Commission’s proposal is not expected to enter into effect before 2010 – therefore as the Commission itself as recognized they will not solve the present financial crises. The Commission has said that “the legislative process is such that it is not possible for the Commission’s proposals to solve the current meltdown” but they are planning to “strengthen the framework for moving forward.”