Fifteen months after the Basel II framework was published, the European Commission has turned it into a new law – the Capital Requirements Directive. Michael Imeson reports on the translation and adoption travails ahead.

The long-awaited Capital Requirements Directive (CRD), which transposes the Basel II capital accord into EU law for all credit institutions and investment firms, has finally been ratified. The European Parliament voted to approve it on September 28, and on October 11 it was rubber-stamped by the Council of Ministers.

The next challenge is for member states to transpose the directive into their national laws in time to meet Basel II’s global deadlines. The first deadline is January 1, 2007, or, for institutions taking the more sophisticated approaches to risk measurement and capital allocation, January 1, 2008.

The directive, which was drawn up by the Banking and Financial Conglomerates division of the European Commission’s Internal Market and Services Directorate-General, introduces a state-of-the-art supervisory framework in the EU that reflects the Basel II rules on risk measurement and capital standards for financial institutions. However, in some important respects it differs from the Basel accord. As it is transposed into national laws and supervisors’ rules, it could be interpreted differently in different countries. Over the coming year, Eurocrats and national legislators and supervisors will work closely together to ensure those differences do not contradict the single market ethos.

The issue was discussed at a conference hosted by The Banker and FT Business last month. Speaking at the event, “Credit Risk: Reality Check”, Peter Smith, national expert, Banking and Financial Conglomerates (one of those responsible for drawing up the directive), said that the CRD had to differ from Basel II in several areas to take account of “the EU context”. For example, it applies to all credit institutions and investment firms, whereas Basel II applies only to “internationally active banks”. So in the US, only a dozen or so banks will have to meet the Basel requirements, leaving the thousands of domestic banks unaffected.

Even handed

While this might appear to create an uneven playing field between the EU and US, Mr Smith said this would not be the case. The old capital accord has applied to all credit institutions and investment firms since 1993, the rationale being that “they are often competing for the same sort of business and taking the same sort of risks”, said Mr Smith.

As for the domestic US banks for whom Basel II will not apply, “if they did business in Europe they would become internationally active and therefore come under the Basel and CRD rules”, said Mr Smith.

Other differences between the accord and the CRD are that the CRD:

  • sets lower capital requirements for banks’ venture capital businesses because EU banks are more significant providers of this form of capital than in other countries;
  • says more about how national supervisors should work together to maintain consistency in the single market;
  •  is generally more complex and abstruse because it is a legislative document rather than an agreement between banking supervisors.

This complexity means that, although the Council of Ministers has approved the legislation, formal adoption is still needed to make sure it works in all 20 official languages of the EU. “That is no small task because it has been difficult enough getting it to work in English,” said Mr Smith. “Then we hand it over to the national authorities – the finance ministries and supervisors – to turn it into national laws and rules.”

Smooth application

The Committee of European Banking Supervisors (CEBS) will play an essential role in ensuring the CRD is applied as uniformly as possible across the EU. The committee, based in London, was set up last year to give technical banking advice to the European Commission and to contribute to the consistent implementation of EU directives and the convergence of member states’ supervisory practices.

Andrea Enria, the CEBS’ secretary-general, said at the conference: “Where Peter Smith and his team finished, the work of CEBS starts. In transposing the CRD into national law, there may be a lot of variety in the implementation. We have been working to reduce the number of discretions and setting up a framework for supervisory disclosure – in other words, a place where everyone can see how the directive has been transposed and how the national discretions are being activated in each member state.

“It is not an easy task. We are all moving from very different supervisory traditions, skills and legal settings but we are treating the implementation of the CRD as an opportunity to converge in some areas.”

This urge to converge is embodied in the directive, which defines the role of the “consolidating supervisor” responsible for the top-level supervision of an EU cross-border group – that is, the national supervisory authority in the member state where the group’s parent company is authorised. This role includes handling applications made by groups to use the more sophisticated risk measurement and capital allocation approaches. An application will be seen by supervisors in all the countries where a group is active but if the supervisors cannot agree after six months, the consolidating supervisor will make the decision for them. This is essential to get round the problem of dealing with multiple supervisors in the EU.

Insomnia remedy

Banks are finding it difficult to understand the text of the CRD because it is so legalistically worded. Richard Boulton, who works on Barclays’ Basel Programme, told delegates: “It is a very, very difficult read. A lot of the wording is not easy to understand, it is not ordered logically, and one of the things you quickly discover is you don’t have enough fingers and thumbs to figure out how a particular aspect is covered because there are so many cross references.

“The final text should be available in the next couple of months and I commend it as a solution for insomnia. It’s tempting to go back to the Basel document, but I wouldn’t suggest people do so.”

He drew attention to several areas where the CRD differs from the Basel accord. One is the treatment of intra-group exposures, “which is what British banks were least happy about”, said Mr Boulton. “There was a lot of lobbying which failed. We have ended up with what we see as a fundamentally wrong treatment. It will cause some odd behaviours by banks, just in order not to be affected by this charge.”

UK implementation

The UK’s Financial Services Authority (FSA) consulted extensively with the industry on the draft CRD and will publish a consultation paper early next year to consider the final text. The FSA’s rules need to be in place before the first deadline.

Besides drawing up the UK rules, and working with the CEBS on supervisory convergence with other states, the FSA has the responsibility of taking applications from banks in the UK that want to use the more advanced approaches for calculating regulatory capital requirements for credit and operational risk.

“We have been open since July for applications to use the internal ratings based (IRB) approach for credit risk and advanced measurement approach for operational risk, though we are still waiting for the first one,” FSA risk review head Rosemary Hilary said at the event. “These applications will be among the most complex that we have ever had to deal with.

“For all groups, whether the FSA is the home or the host supervisor, we are expecting in excess of 20 applications for the foundation IRB approach for credit risk and the advanced measurement approach for operational risk; and about 30 for the advanced IRB approach for credit risk.”

Mr Hilary’s team has been visiting banks to monitor their preparations and giving them feedback. Taking the IRB approaches as an example, the FSA has looked at large corporate rating models of probability of default; mortgages, credit cards and unsecured loans; mortgage data pools; retail small and medium-size enterprise portfolios; and banks and sovereigns portfolios (which is ongoing)

“Overall, we have been encouraged to see the amount of effort firms are putting into their IRB projects,” said Ms Hilary. “But, and there is always a ‘but’, there is much work still to do.”

Areas on which more work is necessary are validation (testing that the models work), data quality and accuracy, documentation (providing proof that the structures put in place achieve their objectives), meeting the requirements of the ‘use test’ and ensuring that senior management have the required levels of understanding of their rating systems.

Senior managers lie awake at night worrying about the mounting regulatory burden. The CRD will undoubtedly add to that worry but there is a solution. If the directive is as somniferous as Barclays’ Mr Boulton suggests, executives should absorb its contents by reading it in bed and letting it send them to sleep.

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