I thank the joint committee for the invitation to appear before it to brief it on the proposed amendments to the capital requirements directive. Before setting out the main elements of the proposal before the committee, it might be useful if I provided some context on the legislative framework, of which the proposal is a part.
The legislative regime for financial regulation in Ireland is largely based on a comprehensive EU framework of directives which apply across the European Union, of which the capital requirements directive is an integral part. The directive has played a central role in supporting the development of the EU Single Market in financial services. It highlights the extent to which financial regulation in Ireland is part of a detailed and comprehensive regulatory regime in place across the Union.
In Ireland responsibility for participating in negotiations at EU level on the capital requirements directive and, in due course, transposing it into domestic legislation falls on the Department of Finance. The Financial Regulator obviously plays a very important role in providing expert advice and guidance for the Department in the negotiations, as well as on transposition issues, and will be responsible for implementing the directive when it is eventually transposed into national law.
The capital requirements directive implements the Basel II framework in the European Union. The Basel II framework is built on three pillars. Pillar 1 concerns minimum capital requirements and covers the capital required to meet credit risk, operational risk and market risk. It sets out the methodologies banks may use for the calculation of risk in each of these risk categories and the amount of capital banks must retain as a result. Therefore, a bank's total pillar 1 capital adequacy requirement is a combination of the capital components it must hold to reflect its credit risk, operational risk and market risk.
Pillar 2 concerns the supervisory review process. It covers a bank’s own internal assessment of its risk profile and resulting capital adequacy requirements. It enables regulators to review a bank’s capital assessment policy and may also require additional capital to be retained by a bank in addition to the capital requirement created under pillar 1.
The third pillar relates to market discipline and deals with disclosure by institutions of the amounts, components and features of capital, information on capital adequacy and general disclosures of credit risk exposure. There are additional requirements for banks adopting the more advanced approaches for their internal capital assessment, disclosures of equity exposure, credit risk mitigation techniques, asset securitisation, market risk, operational risk and interest rate risk.
The capital requirements directive comprises two directives — Directive No. 48 of 2006 relating to the taking up and pursuit of the business of credit institutions and Directive No. 49 of 2006 on the capital adequacy of investment firms and credit institutions. While I refer in this presentation to rules applying to banks, the directive applies also to investment firms.
The main aims of the capital requirements directive are: to enhance financial stability; safeguard the interests of creditors, including depositors; promote a stronger culture of risk management by industry; and ensure the international competitiveness of the EU banking sector. The legal framework of the directive replaces the previous directives in this field. In this regard, the directive not only implements the Basel II framework within the European Union, it also incorporates the earlier framework of rules under which institutions may become authorised to carry on banking business within the Union.
The proposal to amend the capital requirements directive reflects the fact that the directive is very much considered to be an evolving legislative framework and that it foresaw that further co-decision amendments such as this would be adopted. The directive also allows implementing provisions to be adopted by way of Commission directives in line with the Commission's comitology powers, subject to appropriate scrutiny by both the Council and the Parliament. This flexibility applies to technical adjustments to the directive annexes which will be necessary on an ongoing basis, reflecting the dynamic nature of the financial services industry. In this respect, the committee may be aware that proposals for two such Commission directives are being scrutinised by the Council and the Parliament.
The proposal before the committee arises from three principal sources. The first part of the proposal concerns elements of the capital requirements directive left open at the time it was adopted in 2006 on the basis that further analytical work was required. These include revisions to rules of the regime for large exposures included in the directive but left unchanged from previous directives, derogations from certain prudential requirements in the directive for so-called bank networks — credit institutions which are affiliated to a central body, mostly co-operative banks and not present in the Irish market — and the establishment of common EU rules for the treatment of hybrid capital instruments.
The second part of the proposal concerns largely technical adjustments found to be necessary arising from the transposition of the capital requirements directive. These technical amendments relate to inconsistent or unworkable parts of the directive text identified during the transposition phase. They do not have any particular implications for Ireland.
The final group of amendments have been prompted by the financial market disturbance that began in 2007 and concern rules related to capital requirements and risk management for securitisation positions, supervision arrangements for cross-border banking groups and the management of liquidity risk. I will deal with each of these in turn, reflecting the current position in Council where it has changed from the original Commission proposal.
The aim of the large exposures regime in the capital requirements directive is to prevent an institution from incurring disproportionately large losses as a result of the failure of an individual client, or a group of connected clients, due to the occurrence of unforeseen events. The proposal seeks to both harmonise and simplify the current rules relating to these exposures.
Hybrid capital instruments are securities that contain features of both equity and debt. The purpose in issuing such instruments is to cover the capital needs of banks, while appealing to an investor class which is willing to take more risk than in fixed income products and which, therefore, also expects higher returns. From the banks' perspective, hybrid capital instruments offer an additional source of funds. They are normally designed in a way that, for regulatory purposes, they qualify as original own funds and thus may be counted as a tier 1 element of a bank's capital.
While the Basel committee on banking supervision had issued guidelines in 1998 on the criteria for inclusion of hybrid capital in banks' own funds, these guidelines had not been implemented in EU directives due to the need for significant preparatory work. Rules existed only in certain member states whose national legislation enabled the recognition of hybrid capital.
The second element relates to derogation from certain prudential requirements in the CRD for so-called bank networks. These can be understood as credit institutions which are affiliated to a central body and are mostly co-operative banks. Since such entities do not operate in Ireland, I will not dwell on them.
Another change introduced by this proposal concerns capital requirements for collective investment undertakings, CIU. This is essentially a technical adjustment and arises from concern that the capital requirements for investments in collective investment undertakings, such as mutual funds, were too strict under the internal ratings based — or IRB — approach in those cases where banks could not or did not want to provide internal rating for the exposure held by the CIU.
Turning to the group of amendments that have been prompted by the financial market disturbance, the first of these concerns liquidity, or cash flow, which is a key determinant of the soundness of the banking sector. The proposed changes implement the work conducted by the committee of European banking supervisors and the Basel committee on banking supervision to develop sound principles for liquidity risk management. The proposed changes require credit institutions to put in place robust strategies, policies, processes and systems to identify, measure and manage liquidity risk. Here again, Ireland already had in place clear qualitative and quantitative requirements relating to liquidity dating from 2006 and the proposals in this text mirror the Irish requirements in most respects.
The proposal relating to management of risk in securitisation products draws upon conclusions arising from the recent financial crisis. The concern that originators of secturitisation products do not have sufficient incentives to take proper steps to both understand and quantify the risk of these products has led to the proposed requirement that originators or sponsors retain not less than a 5% material share of the risks in a securitisation product to better align the interests of the originator or sponsor, on the one hand, and the investor on the other.
This quantitative requirement will be complemented by a qualitative requirement which ensures investors have a thorough understanding of the underlying risks and the complex structural features of what they are buying through appropriate due diligence. Originators will, as a result, be required to make appropriate information available to enable investors make informed decisions.
The final set of changes relates to the way national supervisors co-ordinate their activities and provides a legal basis for the establishment of colleges of supervisors for strengthened co-ordination of supervisory activities for cross-border banking groups. The intention is that supervisors involved in the supervision of a cross-border banking group would consistently apply, within that banking group, the prudential requirements under the directive. Colleges will also be required for supervisors overseeing cross-border entities that do not have subsidiaries in other member states but that have systemically important branches. To promote a more consistent application of the directive's rules both within and between colleges, the committee of European banking supervisors is empowered to provide non-binding guidelines and recommendations.
That concludes my summary of the main elements of the proposal. As recent developments have demonstrated, capital requirements are at the heart of the soundness and stability of individual institutions and the financial system overall. The issues addressed in these CRD revisions, while technical, will play an important role in addressing weaknesses in the current Basel framework.
Further work is under way on other aspects of the capital adequacy framework for banks and other reforms of regulatory and supervisory arrangements in the context of a number of road maps adopted by EU finance Ministers. The committee will be aware that the proposal is still under consideration by the Council and the European Parliament. Whereas the Council agreed a common position at the ECOFIN meeting on 2 December last, a vote in the Parliament's ECON committee on the proposal has not yet taken place but is expected in early March with a view to a plenary vote in early April and its adoption in advance of the end of the parliamentary term. We are now available to take questions from the committee.
