The CRD4 package (a draft Regulation and Directive to replace the existing Capital Requirements Directives) is a series of measures to make banks etc. in the EU more resilient in crisis situations.
The draft Regulation proposes four main areas for improvement. The two most important cover the quality and quantity of reserves and liquidity measures. These aim to ensure that banks will have surer access to funds if needed. The other two are to control excessive leverage (i.e. borrowing) and protect against problems with counterparties.
The EU has already amended the Capital Requirements Directive (CRD) since the financial crisis, to avoid a repeat.
This package, which is an important part of a wider improvement plan, would implement into EU law “Basel III”, an international regulatory framework for banks agreed in late 2010.
The draft Regulation relates to financial firms: banks and investment firms.
1. Improved capital
Some banks had to be rescued during the 2008 crisis because their capital (reserves of funds) was of poor quality and lost value.
The proposal keeps the existing 8% of core reserves but requires a greater proportion of higher quality assets in this 8%.
It also adds potential additional reserves:
- A capital conservation buffer, which restricts an institution’s payments (such as dividends) if its capital ratios fall.
- A counter-cyclical reserve to build up an extra cushion in times of growth.
Further surcharges will be added for global systemically important financial institutions (SIFIs) with the option to add a similar buffer for national SIFIs. And regulatory reviews may identify other risks that will require additional capital.
2. Liquidity risk management practices
Liquidity means adequate cash resources to meet demand. This was often shown to be lacking in the crisis, because of inadequate practices such as using short-term funding for long-term needs.
CRD4 would address this weakness through a Liquidity Coverage Ratio (LCR). The proposed LCR would require a firm to match its reserve of high quality liquid assets such as cash with its representative net outflows over 30 days.
3. Counterparty credit risk occurs whenever a financial transaction occurs with a third-party organisation. Proposals include:
- An additional capital charge where there is a deterioration in the creditworthiness of a counterparty
- Incentives to conduct financial transactions through standard (“regulated”) financial exchanges
4. The proposals also include a leverage ratio to measure and restrict its build-up.
The Regulation aims for an EU-wide “Single rule book” (i.e. harmonisation) except in specific, well-defined exceptions.
The European Parliamentary Financial Services Forum notes general support for CRD4. It says that the reserve asset requirements will impact on banks’ lending activities, with implications for the real economy.
CEPS, a policy think-tank, is concerned about regulators relying on banks’ own risk management models for capital-requirement calculations, and also about supervisors’ lack of accountability.