Consultations on new capital adequacy framework

Consultations on a new capital adequacy framework for banks and investment firms have been launched on 22 November 1999 by the European Commission's services. Financial services practitioners, market analysts, consumer groups, Member States and other interested parties have been asked to comment by the end of March 2000 on a consultative paper prepared by the Commission's services. The paper identifies a number of areas where the most significant issues have been identified, notably credit risk (including credit risk mitigation techniques), so-called "other risks", supervisory review and market discipline. The results of this consultation will be taken into account by the Commission's services in its review of current EU legislation on capital adequacy for credit institutions and investment firms in accordance with the May 1999 Financial Services Action Plan.

Full text for downloading 

The highest standards of prudential regulation of capital adequacy are essential for both financial stability and the smooth functioning of the Single Market for financial services. The European Union has to make sure that these standards are kept up to date with market developments and ensure that capital requirements accurately reflect the risks run by banks and investment firms operating within the EU, while at the same time ensuring no deterioration in the overall levels of capital. The EU's existing capital rules have been in place since 1988. There have been substantial developments in the financial services sector in the intervening period, not only in Europe but globally, which has prompted a re-examination of the whole capital adequacy framework. It is important to ensure that the capital which supervisors require institutions to hold is appropriate to the risks to which institutions are exposed while at the same time recognising new developments in the financial sector for risk mitigation and control.

The consultations will be undertaken principally at the national level via the appropriate competent authorities. However, the Commission's services are willing to receive comments directly from European level federations and associations of industry and consumer groups. The consultation exercise complements the consultation undertaken by the Basel Committee on Banking Supervision which was launched on June 3rd 1999. Both projects are based on the concept of minimum capital requirements, supervisory review, and the potential of market discipline as an aid in strengthening and encouraging safe and sound banking practices.

The review of minimum capital requirements deals with a number of issues including risk weighting, as it relates to credit risk. Issues identified by market participants and supervisors include:

• need to strengthen the relationship between credit risk weights and economic risk
• need to improve differentiation of degrees of credit risk and
• need to align strategies for credit allocation and pricing more closely.

The consultation paper outlines two possible strategies to ensure that the economic risk of financial transactions is better captured by capital charges. These are an approach based on institutions' internal credit assessment systems and a revision of the standardised credit risk weighting scheme.

The paper also outlines a new approach to risk mitigation. There is general agreement that there is at present an insufficient recognition of sound risk management practices in the area of credit risk mitigation. The paper seeks to identify the issues which are common to mitigation techniques and design an approach that would treat common underlying risks or economic effects in a consistent manner. While individual products or techniques might require some specific tailoring, an advantage of this strategy is its perceived ability to adapt to continued innovation in this field.

On "Other Risks", the consultation paper recognises that the current framework is based largely on credit risks and market risks. However, there is a range of other risks, including for example operational, legal and reputational risk, that currently are not subject to any specific capital charge. The paper suggests that such a charge could be introduced, together with a specific charge for interest rate risk, in certain circumstances.

On supervisory review, the objective is to ensure not only that institutions have adequate capital to support their risks, but also to encourage institutions to develop and use better risk management techniques in monitoring and managing those risks. This recognises that different institutions may have very different risk profiles and it is therefore fitting that supervisors to be able to apply differentiated capital requirements relative to those risk profiles.

In relation to market discipline, the Commission's services are seeking the views of industry and all information users as to how disclosure of information by financial institutions can be best utilised to contribute to greater financial soundness and stability while at the same time maintaining a level competitive playing field and recognising the sensitivity of certain information.

The consultative paper sets out various options and approaches for all of these topics. In some instances there are firm suggestions for change whilst in others decisions for change will be taken in light of responses to the consultative process. All interested parties are invited to submit their comments no later than 31 March 2000, in the first instance to the competent national authorities in the Member States and otherwise directly to the Commission's services at:[closed]