Anne Cools
Review of Capital Requirements
DG Internal Market
Unit F2 Banking and Financial Conglomerates
European Commission
B-1049 Brussels
Belgium
Date: 10.10.2003
Our ref.: 2003/00327
FJA/TH
Your ref.:
Comments on the Commission Services Third Consultation Paper on the review of capital requirements for banks and investment firms
Dear Ms Cools,
1. Introduction
The Norwegian Financial Services Association appreciates the Commission’s willingness to maintain an open dialogue with the industry on this very important set of rules.
We are aware that there will probably be a delay in the completion of the new Basle Capital Accord. We regret this situation. It is important that any delay is as short as possible. Given the importance of a level playing field, we ask that the Commission still hold on to the strategic objective that the new Capital Adequacy Directive should be based on the new Basel Capital Accord and implemented in parallel with the new Accord.
The Norwegian Financial Services Association supports the general view that the EU framework only should only deviate from the new Basel Accord where it is necessary in order to take account of important specificities of the European context. Furthermore, we fully support the principle that capital requirements should be proportionate to the risks of activities carried on regardless of the legal nature and level of complexity of the institution in question.
2. Implementation issues
Level playing field
The Norwegian Financial Services Association has been, and continues to be, concerned about the potential for divergence in implementation and interpretation of the new capital framework. There is also a great scope for different supervisory practices both with respect to the approval process for use of internal rating for credit risk and with respect to the Supervisory Review Process. Such differences can have serious effects on the competitive position of national banking systems and individual credit institutions.
Preparatory work on adjustment to the new capital framework in institutions reveals a considerable need for supervisory guidance on the interpretation of the future capital adequacy rules and on the exercise of national options contained in the new rules, in order for institutions to make informed commercial decisions. The tight time schedule that institutions need to comply with in order to make use of the IRB Approach to credit risk from day one, puts pressure on competent authorities to give such guidance before the work on coordination of such measures between competent authorities in the EEA-area has gained momentum. The task of seeking harmonisation through supervisory cooperation at a later stage will thus be a very difficult task. Even though we respect that a balance must be found between regulatory constraint and supervisory discretion, we believe the right balance incorporates more constraint than what is the case in the current consultative paper. If the balance is not changed towards more regulatory constraint we fear that harmonisation essential for a level playing field in the EEA-area will take a long time to achieve.
We welcome the proposal from the Commission to exchange some of the national options in the latest Baselconsultative paper with decisions at the EU-level, but ask that the Commission go further on this route. In particular we ask that the Commission do not allow national discretion on the maturity factor under the IRB Approach, se our comments below in Section 6. We also ask that the alternative approach for recognising eligible residential and commercial real estate collateral under the IRB Foundation is deleted, se comments below in Section 8. Removing national options from the capital adequacy framework will also contribute to reducing the complexity of the framework. Our principle view is that over time all remaining national options in the new capital framework should be removed from the framework.
Supervisory disclosure
In light of our concerns above we very much support the thinking of the Commission on the creation of effective structures for the promotion of supervisory convergence in the EEA-area. As the Commission indicate in the Explanatory Note (paragraph 65), an appropriate way to help this process and secure transparency is to include requirements concerning supervisory disclosure in the directive proposal. We agree that all the aspects mentioned in paragraph 65 of the Explanatory Document are relevant in such a context. In our view it is furthermore important that the information is presented in a standardised format, in common language (English), in common location on the Internet, and that the information is updated regularly (at least annually).
3. General provisions of the new framework
The Norwegian Financial Services Association supports the view reflected in the Explanatory Document that Article 5 on Prescribed methodologies should be deleted or changed. The institution’s own assessment process as described in Article 116 should be allowed to focus on the concept of ‘internal’ or ‘economic capital’ that management of the individual institution decide is the most relevant. Article 5 introduces a floor for management’s assessment of credit, position, settlement and counter-party, foreign exchange, and operational risk equal to the minimum regulatory capital requirements for such risk. In some instances managements’ judgement based on the concept of economic capital required for example for credit risk, will be lower than what is reflected in the regulatory capital requirements and in other cases higher. This outcome will inter alia depend on portfolio composition and management’s sensitivity to risk. For the more advanced institutions economic capital assessments will take into account the effect of diversification in and between different portfolios, which is not reflected in the regulatory capital requirements. In our view it should be the role of supervisors in the supervisory review process to challenge the overall outcome of the institutions own methods relating to internal or economic capital for those risks covered by the Minimum Capital Requirements in Title II of the Working Document and compare the results of these methods with those of the regulatory capital requirements and take appropriate measures if necessary. What has been proposed in Article 5 will be contrary to the principle that it is management’s responsibility in the first instance to make sure that their institution has sufficient funds in relation to its overall risk exposure.
4. Scope of consolidation
Financial groups
The Norwegian Financial Services Association finds it appropriate that the Commission seeks to prevent “double-gearing” in groups of institutions. We also support that the new capital adequacy framework take a group-wide consolidated capital view of financial services groups and of their entities. We are, however, concerned about the practical effects of full application of Title III on Supervisory Review Process on an individual basis and on a consolidated and sub-consolidated basis in large financial groups.
According to Article 16 of the Working Document the capital requirements prescribed in the document shall apply to all credit institutions and investment firms on an individual basis. Article 17 states that capital requirements also shall apply on a consolidated basis in groups, which include credit institutions or investment firms. Furthermore, the capital requirement may be applied on consolidated basis in sub-groups of institutions according to the provisions in Article 18. We assume that the reference to “the capital requirements” in the mentioned articles refers the general provisions on capital adequacy in Title I of the Working Document, which again refers to the requirements in Title II on Minimum Capital Requirements, Title III on Supervisory Review Process and Title IV on Market Discipline. Thus, according to Articles 16,17 and 18 all three Pillars of the new capital adequacy framework will be applied to institutions on an individual basis, on a consolidated basis in groups, which include credit institutions or investment firms, and on a consolidated basis in certain sub-groups of institutions. There seems, however, to be a discrepancy with regard to the requirements in Title IV on Market Discipline, which includes separate provisions on the entities that are subject to the disclosure requirements. These do not seem to correspond fully with the mentioned articles above.
Our main concern, however, is the application of Title III on Supervisory Review Process in regard to groups of institutions. The focus of this application should be on the parent undertaking institution with respect to the consolidated group and on the main sub-groups of institutions. It is not feasible, nor appropriate in our view, that competent authorities at least once a year should apply an evaluation process to all subsidiary institutions of different sizes, in a large financial group. This would not be proportionate to the risk of activities in a financial group and it would be extremely resource intensive for supervisors. Thus, there should be some flexibility for competent authorities to decide on which levels in financial groups the Title III requirement should be applied, based on their overall risk assessment of the individual financial group.
Alternative approach on sub-consolidation
The Norwegian Financial Services Association is of the opinion that the third paragraph of Article 18 regarding the alternative approach to application of capital requirements on a sub-consolidated basis (deduction method) should be removed. This method does not give as adequate measure of the capital adequacy of the sub-group as the application of the capital requirements on a sub-consolidated basis.
5. Standardised Approach
Claims on banks
In regard to claims on banks Annex C-1, paragraph 6.1 states that competent authorities shall exercise discretion regarding the treatment of all claims on institutions. They shall choose between two methodologies: The central government risk weight based methodology or the credit assessment based methodology. This choice will be of great importance for smaller credit institutions without rating, which lend from other credit institutions that make use of the standardised approach. The choice of method will not only impact on the risk weighted assets of inter-bank lenders, but also even more importantly directly on the funding cost of smaller credit institutions and thereby their competitive position. The credit assessment based methodology is based on the premises that credit institutions are rated by external credit assessment institutions. This is not the case for a large number of smaller credit institutions in Norwayand elsewhere in Europe. The credit assessment based methodology will for such Norwegian banks lead to an unwarranted hike in the risk weight from current 20 % to 50 %. The new capital charge for operational risk will come on top of the sharp increase in risk weight for credit risk. We are aware that there is pressure on the Commission to include only one methodology in the proposal for a new capital adequacy directive. Due to the serious negative effect the credit assessment based methodology will have on smaller Norwegian credit institutions, we can only support inclusion of one methodology if the central government risk weight based methodology is chosen.
Exposures on SMEs and exposures secured on real estate
For comments on the treatment of exposures on SMEs and loans secured on real estate under the Standardised Approach, see Section 7 and 8.
6. Internal Ratings Based Approach
Roll out of IRB Approach
The Norwegian Financial Services Association believes that Article 49 on the roll out of IRB Approach should incorporate a provision on temporary partial use in case of mergers between institutions on a different level of sophistication in regard to use of the more advanced methods for credit or operational risk. The same applies to acquisitions of less sophisticated institutions. The rules in the current proposal on partial use are not sufficient to tackle the practical issues that will arise in regard to mergers and acquisitions.
National discretion on the maturity factor
Annex D-3, paragraph 9 of the consultative paper still makes it a decision for competent authorities in each jurisdiction to decide on use of the effective maturity or the standard 2,5 years in the IRB Foundation Approach for corporates, institutions and sovereigns. The same is the case for the exemption in paragraph 11 of the same Annex for exposures on corporates situated in the EU and having consolidated sales and consolidated assets of less than EUR 500 millions, under IRB Advanced Approach. National discretion on these very important policy issues is unfortunate from point of view of the objective of creating a level playing field in Europe. The risk weight functions have a high sensitivity to the maturity factor. Different national implementations of these provisions have the potential to distort competition between banks from different jurisdictions operating in the same marketplace.
Reference to the EEA-area
We ask that the Commission in regard to Annex D-3, paragraph 11, of the consultative document change the wording “… corporates situated in the EU …” to “... corporates situated in the EEA-area …” in order to reflect the fact that EFTA-countries are part of the Internal Market in Financial Services and subject to the new capital adequacy framework of the EU.
Exposures on SMEs and exposures secured on real estate
For our comments on the treatment of exposures on SMEs and loans secured on real estate under the IRB Approach, see Section 7 and 8.
7. Treatment of SMEs
Calibration
The Commission wish to ensure that the capital requirements in respect of lending to SMEs are proportionate to the risks involved and do not give rise to undue burdens for such entities. The Norwegian Financial Services Association is of the opinion that the current proposals for the treatment of SMEs should not be regarded as too conservative. We are rather more concerned with the fact that some competent authorities may regard the proposal as too lenient towards the SME-sector, particularly the possibility to include small businesses in the retail portfolio under both the Standardised Approach and the IRB Approaches.
Size of SMEs to be allowed in the retail portfolio
The proposal does not contain any quantitative limit as to the size of firms that may be regarded as “small businesses” and included in the retail portfolio, as is the case for claims on SMEs included in the corporate asset class under the IRB Approach. In order to avoid widely different implementation of the rules on the retail portfolio across Europe, we ask for further clarification of which SME exposures should be eligible for retail treatment in regard to Article 27 under the Standardised Approach and 47 under the IRB Approach.
Exposure threshold in retail portfolio
There is a EUR 1 million threshold for exposures to “small businesses” in the IRB Approach, Article 47, and for retail exposures in general under the Standardised Approach, Article 27. The size of credit exposures may vary over time according to the nature of the business relationship. We ask that the Commissions propose some flexibility as to re-classification of exposures that cross the exposure threshold. There is need for a practical approach where, for example, re-classification can be carried out on a yearly basis.
8. Real estate lending
National discretion
According to Annex C-1, paragraphs 9.1.4 and 9.2.6, and Annex E-1, paragraph 1.1.3.4 national discretion can be used to waive the following condition for recognition of real estate collateral in regard to the Standardised approach and the IRB Foundation Approach:
“The risk of the borrower does not materially depend upon the performance of the of the underlying property or project, but rather on the underlying capacity of the borrower to repay the debt from other sources. “
We fully support that the relevant competent authorities must document the exercise of this discretion. This documentation should be published in a common language (English) by the Commission. This will be necessary in order for other competent authorities to make an informed decision on whether to allow similar treatment for their institutions for such assets located in the jurisdiction of the other competent authority. It will also be necessary in order to give the market necessary information for evaluating the regulatory capital charge that individual institutions must comply with.
Capital Requirements under the Standardised Approach
The Norwegian Financial Services Association welcomes the lowering of the risk weight for residential real estate lending under the standardised approach to 35 %. We ask that the new capital framework include a clear provision on the treatment of residential real estate loans or part of such loans that do not fulfil the eligibility criteria for treatment as claims fully secured on residential property. Such loans and part of such loans should be included in the regulatory retail portfolio.
Transitional LGD-floor
The transitional provision in Article 146, third paragraph, introduces LGD floor of 10 % under the IRB Approaches for portfolios of retail exposures secured by residential properties for three years after introduction of the new capital framework. The Norwegian Financial Services Association cannot see that this floor is warranted from perspective of the risk associated with loans secured on high quality residential real estate (RRE) and that have low loan-to-value ratios. This provision will in effect reduce the risk sensitivity of the new capital framework for an important asset class in the Norwegian banking system. The introduction of such a floor will make RRE-lending with high quality security an unattractive asset for credit institutions to hold on their balance sheets. On this background we ask the Commission to dele this transitional provision and rather address concerns regarding the quality of own LGD-estimates through the minimum requirements that these estimates must fulfil.
Alternative IRB Foundation Approach
Annex E-3, paragraph 3.1.4.2 introduces an alternative approach under the IRB Foundation Approach for calculating the capital requirements for credit risk recognising eligible residential and commercial real estate collateral. The main approach is to reduce LGD from 45 % to 35 % for senior claims. The alternative approach is similar to the rules on
50 % risk weighting of commercial real estate (CRE) lending in the Standardised Approach. In our view this alternative approach add complexity and unwanted national discretions to the new capital adequacy framework, and should therefore be deleted.
Eligibility criteria
In the Standardised Approach claims may only be treated as fully secured on residential property if the value of the property exceeds by a substantial margin the claim. We ask that the Commission makes clear what is meant by this requirement. If the Commission does not find it appropriate to lay down a maximum LTV-ratio, there should be a requirement on individual competent authorities to state the reason for and explain their implementation of this requirement in national legislation, i.e. as part of the requirements on supervisory disclosure.
Minimum operational requirements
Annex E-3, paragraph 2.1.4 contain minimum requirements for the recognition of real estate collateral under the Standardised Approach and the IRB Foundation Approach. In regard to the requirement on monitoring of property values there are similar demands on residential real estate lending and commercial real estate lending, which reads:
The institution shall monitor the value of collateral and property on a frequent basis and at a minimum once every year. More frequent monitoring shall be required where the market is subject to significant changes in conditions. Statistical methods may be used to monitor the value of property and to identify property that needs revaluation. The property shall be evaluated by a qualified professional when information indicates that the value of the property may have declined materially relative to general market prices
These requirements are fair in regard to commercial real estate lending. In regard to residential real estate lending, however, they are unduly burdensome. Residential real estate markets are more homogeneous and exhibit less volatility than commercial real estate markets, thus the need for yearly or more frequent revaluation of all such exposures does not exist. This is particularly the case for residential mortgage loans with low to moderate loan-to-value ratios. Furthermore, institutions using the IRB Approach for retail exposures are in Annex D-5, paragraph 29 required to review a relevant sample of such exposures on a yearly basis. We assume this requirement also includes evaluation of collateral in regard to RRE-lending. This review should be seen as sufficient in regard to RRE-lending under the IRB-approach.
9. Operational risk
Incentives
The Norwegian Financial Services Association finds that there still are little economic incentives for banks to move from the Basic Indicator Approach to the Standardised Approach for operational risk. This should be rectified by lowering the betas under the Standardised Approach relative to the alpha in the Basic Indicator Approach.
Charge for investment firms with a limited licence
We agree with the Commissions general approach to operational risk for investment firms and services in the EU as stated in paragraph 348 in the Explanatory document.
In Article 112 it is proposed that investment firms with a limited licence based on national discretion may be exempt from the capital requirement for operational risk. This exemption may also be applied on a consolidated level provided all the investment firms in the group have limited licence and the group does not include credit institutions. Investment firms, which only carry out the following investment services, are regarded as firms with a limited licence:
- Reception and transmission of orders in relation to one or more financial instruments
- Execution of orders on behalf of clients
- Managing portfolios in accordance with mandates given by clients a\on a
discretionary client-by-client basis where such portfolios include one or more
financial instruments
- Investment advice
- Placing without firm commitment or other activities undertaken in agreement with the
issuer of the instrument to assist the distribution of or subscription to public or
private offers of financial instruments
- Operation of Multilateral Trading Systems
This proposal is not according to the guiding principle that similar risk should be treated similarly in the capital adequacy rules. A large proportion of investment firms will be classified as investment firms with limited licence according to annex H-1. Many credit institutions own investment firms with a limited licence, particularly asset management companies. These will however, not have the potential for being exempt from the capital requirement for operational risk due to the requirement on consolidation. Thus the proposal will give independent investment firms potential competitive advantages as compared to bank owned investment firms. In order to rectify this we propose that the exemption also is given effect on a consolidated level for groups that include credit institutions. If this is not acceptable, the Commission should consider changing Annex H-1 such that limited licence investment firm are restricted to firms carrying out the two investment services, which does not involve coming into the possession of client money:
- Reception and transmission of orders in relation to one or more financial instruments,
and
- Investment advice.
10. Supervisory review process (SRP)
We support the idea of a supervisory review process that takes into account the individual circumstances relating to each institution, and which aims to capture the whole strength of the institution (organisation, internal controls, capital, etc) against its whole risk profile. We do not, however, believe that the Commission has found the right balance in the Working Document Title III, Annex I, and Annex J.
The proposal describes, on the one hand, an assessment process to be undertaken by the individual institution and, on the other hand, a supervisory evaluation process that supervisors shall apply to each institution. Accompanying the evaluation process is a set of prudential measures. The prescriptive nature of the supervisory evaluation process results in a danger that the assessments of management often will be overruled by supervisors. Management is responsible for the activities of the institution. It is important that this basic principle is respected.
The SRP should focus more on establishing incentives for a process of internal self-risk assessment that can create a common understanding between management and the supervisor regarding the whole risk profile and whole strength of the individual institution. Supervisor’s role should be to challenge management’s assessments and the adequacy of their policies to deal with the sum of risks facing the institution.
Additional capital requirements should only be applied when other prudential measures are not sufficient, and not applied as a general rule to institutions not representing an outlier in terms of risk. The wording of the second paragraph of Article 128 should be changed to reflect this more clearly by deleting the two words “at least”.
Annex I, section 2 to 9 lists the minimum risks that must be part of the management assessment process, and it also gives a description of how firms should control and measure such risks. The prescriptive wording of these requirements is unfortunate. It can result in overly focus on the risk items that are mentioned and lack of focus on other items that may be of even greater importance. Secondly, it can be regarded as intrusive in regard to the responsibility of management. We ask that the mentioned list of risk items and accompanying requirements be deleted altogether and replaced with a general requirement on institutions to take into account all relevant risks that can be considered to be material to the individual institution. We are not opposed to, however, that supervisors for their internal purposes develop a list of possible relevant risk factors and appropriate ways of dealing with such risk, that they can make use of when discussing with institutions in the Supervisory Evaluation Process. Such lists should however, not be part of the formal EU capital adequacy framework.
Confer also our comments on the application of the capital requirements on a consolidated level in Section 4 above.
Yours sincerely,
Norwegian Financial Services Association
Tor A. Hvidsten
Deputy director
Copy:
- Kredittilsynet (The Banking, Insurance and Securities Commission of Norway)