As part of its ongoing efforts to tackle the remaining vulnerabilities of the EU banking sector that were unveiled by the financial crisis, the European Commission put forward a legislative package at the end of November. Part of this package, which is designed to make the banking sector more resilient and competitive and enhance financial stability, is a proposed review of the capital requirements regulation (CRR) and directive (CRD). Once adopted, the regulation will apply directly to all banks in all Member States, both Banking Union and non-Banking Union.

TLAC and "bail-in"

The commitment to review capital requirements rules came at the end of 2015 as part of negotiations on the introduction of a European deposit insurance scheme (EDIS), under which risk diversification and risk mitigation should go hand in hand. One key risk mitigation measure that forms part of this latest legislative package is the implementation of the G20's agreement on the Total Loss Absorption Capacity (TLAC), which global systemically important banks should hold. The basic idea is that very large banks cannot be allowed to fail, since they could drag down the entire financial system with them. In order to avoid having to use taxpayers' money to bail them out, everybody holding a stake in the bank should bear the loss, or be 'bailed-in'. Under the rules, shareholders would be the first to lose their investment, followed by investors who had invested in capital instruments similar to equity.

But while these measures should absorb the incurred loss, they will not be enough to recapitalise and 'restart' the bank, which is vital in the case of large organisations that cannot be allowed to simply go bankrupt. Therefore, these groups have to raise additional debt that can easily absorb losses. This excludes small depositors, whose bail-in would be politically unacceptable. It also excludes complex derivatives, where the valuation of those claims would take too long – and time is of the essence, since a bank usually needs to be resolved over a weekend to ensure customers can access their accounts on Monday morning. The internationally agreed TLAC standard defines how much and which kinds of debt instruments banks have to issue to make them easily resolvable without having to resort to using taxpayers' money. The transposition of TLAC into European law will require some changes to the EU's bank recovery and resolution directive (BRRD), which already contains a similar requirement ("MREL") - that will need to be integrated with the new international standard.

The leverage ratio

Another measure that will also be introduced as part of the upcoming legislative package, and which is based on work by the Basel Committee on banking supervision, is the so-called leverage ratio. The main proposal the Commission is making here is for a leverage ratio of 3% Tier 1 capital which complements the existing obligations for banks and investment firms to calculate and disclose their leverage ratio. The leverage ratio is essentially the amount of regulatory capital of an organisation divided by its (gross) total assets.

Leverage is an inherent part of banking activity; as soon as an organisation's assets exceed its capital base it is levered. The Commission is not proposing to eliminate leverage, but rather to reduce excessive leverage. The financial crisis highlighted the fact that credit institutions and investment firms were highly levered, i.e. they took on more and more loans and other financial assets with relatively limited additional capital based on risk weights applied to those assets. The leverage ratio is an additional 'prudential' measure to enhance financial stability by determining capital requirements on the basis of non-risk weighted assets. It should prevent the buildup of excessive leverage during economic upswings and act as a backstop to possibly too-low capital requirements based on banks' own internal models for credit risk.  

The Commission is proposing a 3% leverage ratio irrespective of the banks' business model, based on a detailed report from the European Banking Authority. However, some adjustments are being proposed for public development banks and officially guaranteed export credits, so as not to hamper public sector lending and export credits, which are activities conducive to jobs and growth. A 3% leverage ratio requirement reflects a suitable trade-off between being an effective backstop without undermining existing risk-sensitive capital requirements. At this point where European banks are generally very well capitalised, they would virtually all meet a 3 % leverage ratio.

Read more on CRR/CRD