RiskTech Forum

Wolters Kluwer: Are you ready for the Liquidity and Leverage requirements of CRD IV & CRR?

Posted: 11 February 2014  |  Author: Selwyn Blair-Ford  |  Source: Wolters Kluwer Financial Services


In this article I will be focusing on the Liquidity and Leverage requirements of the Capital Requirements Directive (CRD) IV and the Capital Requirements Regulation (CRR). I will also look at some of the other issues such as counterparty risk and the adaption of the single Europe wide rule book, amongst others, which firms in Europe will have to address.

Liquidity

Both Basel III and CRD IV increase the amount of oversight and control firms need to have over their liquidity. The governing body and senior management have particular roles with regards to setting firms’ liquidity risk appetite, and management of firms within select risk boundaries. There are new liquidity metrics the most important of which are the liquidity coverage ratio (LCR) and the Net Stable Funding Ratio (NSFR).

The LCR compares a stressed cash outflow over a 30 day period with the amount of liquid assets available. The purpose is to encourage firms to improve their short-term resilience. It measures whether the institution is holding enough unencumbered high quality liquid assets to withstand a 30 day stress. Ultimately the LCR is expected to be maintained at 100%.

The LCR liquidity buffer can be used and can be lower than 100%, but then firms will be subject to extra regulatory scrutiny and will need to present a plan to raise their liquidity buffer above the 100% threshold.
The NSFR looks at the ratio of longer term assets against the longer term funding used to support these assets. The NSFR is due to come into force from January 2018. However there will be general rules in place regarding long term funding for financial firms from 1 January 2016, meaning firms will have to consider their funding profile for this this year and next when calculating this ratio.

The final rules regarding the calculation of the LCR and the NSFR have not been finalized. At present, regulators - as part of the observation period - are collecting information on the behavior of these ratios as so to be able to calibrate these metrics correctly.

It is clear that of the remaining issues to be decided items concerning liquidity, the LCR and NSFR will be resolved over the coming months. This is because Europe is completing these items in line with the international Basel III agreement, and is on track for the 2015 and the 2018 implementation of the LCR and NSFR. As a result nancial firms will be even more focused on liquidity. We should all expect a firm’s liquidity profile to play an increasing role in their decision making processes.

Leverage

The CRD IV introduces a leverage ratio which is the tier 1 capital divided by a measure of the firms non-risk weighted assets. The assets will include both on and off balance sheet amounts. The aim of the leverage ratio is to have a simple limiting risk measure that safeguards against the risks associated with risk models.

At present the required leverage ratio has not been finalized, although a ratio of 3% is being considered during the calibration period, which will mean that tier 1 capital will not be allowed to be less than 3% of non-RWAs. Unlike Basel II calculations, on-balance sheet loans and deposits will not be allowed to be netted. This will introduce a third prudential metric that firms will have to adhere to.

Initially the leverage ratio will be a pillar 2 measure, and so may be altered by the national regulator. Data gathered from 1 January 2014 will be used to set the final ratio.

In the EU, leverage ratios will be publically disclosed from 1 January 2015. Basel III requires that jurisdictions implement binding leverage ratios by 2018 and from that point the leverage ratio will be a pillar 1 measure. Once the leverage limit seems to be near agreement, firms will have moved into a new regulatory space. No longer will consideration of the amount of capital be the only determinant of whether certain banking business can be done from a regulatory perspective. In this new space, capital, liquidity and leverage will all have to be considered and decisions may involve sacrificing one aspect to preserve or strengthen another.

Other key items to consider

Aside from capital, liquidity and leverage requirements, there are of course many other facets, which firms need to be aware of and start addressing, including:

Counterparty Risk
New regulatory treatments for exposures to central counterparties (CCPs) and higher capital charges for OTC derivatives for transactions that are not centrally cleared are included in CRD IV, as well as credit valuation adjustments and wrong-way risk charges.

Single Europe-wide rule book

The CRR combined with the EBAs Binding Technical Standards (BTS) make up a single rule book that governs all of Europe’s financial institutions. In creating a single rulebook the EBA has attempted to reduce the amount of national discretions that are available and so reduce the number of national divergences.

Remuneration

New policies include rules limiting variable bonus payments to the 100% of the fixed salary amount for risk-takers, risk control staff and senior management or 200% if explicitly agreed by shareholders. Any variable remuneration amount should be paid at least 50% in equity-linked products, with at least 40% of the variable payment deferred for 3 to 5 years.

Single Supervisory Mechanism

The rules facilitate the Single Supervisory Mechanism (SSM), aiming to harmonize and strengthen sanctions across the Union. The result being that in some European jurisdictions the ability to impose fines and other sanctions will be dramatically increased
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Reduced reliance on credit rating agencies

Firms must have the ability to form their own opinions on the ratings of their credit exposures. This includes firms having their own sound credit granting criteria. Where a firm has a material amount of exposures in a given portfolio it must have its own internal rating for that portfolio.

The end of the beginning

The CRD IV represents a major change in the way the European financial sector will be regulated, and allows Europe to fulfill its obligations in complying with Basel III. This however, is the end of the beginning for many. The new rules, new information and disclosures, new internal and external infrastructures will result in changes in behavior, and the economic realities of banking.

Dealing with these changes will be the next major challenge.