Regulatory Initiatives
in the Financial Sector

Borka Babic and Anne-Sofie Reng Rasmussen, Financial Markets

Introduction

Credit institutions play a special role in the economy and are therefore subject to extensive regulation. The financial crisis has highlighted a number of weaknesses in the current financial regulation. Insufficient requirements in relation to financial institutions contributed to the build-up of large imbalances in the banking sector, thus exacerbating the crisis.

Against that background, authorities and international cooperation organisations have launched proposals and initiatives to address the regulation issues in the financial sector and seek to prevent a repetition of the crisis, cf. Box 1. Focus areas are liquidity, capital adequacy and financial reporting, including whether rules in the latter two areas amplify cyclical fluctuations.

Overview of initiatives in the financial area	Box 1
Note: The blue colour indicates that the topic is discussed in this article. The overview covers selected initiatives. Source: Ecofin roadmap, October 2009; G-20 statements, April and September 2009.

Capital requirements will be enhanced in a number of areas. Tighter requirements have already been adopted in relation to securitisation. The European Commission has tabled proposals for amendment of directives regarding the trading activities of credit institutions that will also raise the capital requirements. Furthermore, countercyclical capital buffers are on the drawing board as well as proposals to improve the quality of the credit institutions' capital, limit their leverage and introduce quantitative liquidity requirements. In all these areas more or less specific proposals have been put forward by the Basel Committee on Banking Supervision, BCBS, and by the Commission. Statutory amendments are expected to be proposed before the end of the year. Additional requirements for systemically important credit institutions are also being discussed. Both the BCBS and the EU are assessing the quantitative impact of the proposed amendments to the rules.

As regards financial reporting, a number of international initiatives have been launched, including amendment of the rules on the impairment of financial assets in order to ensure that larger reserves are built up during economic booms.

Capital requirements
Revisions of the capital adequacy rules are in progress under the auspices of the Basel Committee and the EU.¹Several changes have already been introduced since the onset of the crisis or are being introduced, cf. Table 1. In December 2009, the BCBS published a consultative document²outlining possible amendments to the rules in a number of areas. In February 2010, the Commission published a consultative document that broadly matches the BCBS proposals.³

Securitisation⁴
The risks in relation to securitisation were one of the issues highlighted by the subprime crisis (the "originate and distribute" model). The crisis has revealed a risk that credit policies may become too lenient where the credit risk is not retained by the original lender, but transferred to a third party via more or less transparent transactions.

To address the weaknesses of the model, the Commission in October 2008 tabled a proposal to amend the Capital Requirements Directive, including by tightening the requirements for institutions investing in securitised products. For example, investment in structured products will only be permitted if the lender, originator or sponsor retains at least 5 per cent of the nominal value of the securitised product. That will give the lender an incentive to ensure proper credit assessment of the underlying loans.

Subsequently, it has turned out that there is also a need to tighten the requirements for complex securitised products (re-securitisation). These are investment products for which the underlying portfolio of assets used as collateral contains other securitised products. The complexity of these products and their exposure to correlated losses make them more risky than ordinary securitised products. In July 2009, the Commission therefore tabled a new proposal for amendment of the Capital Requirements Directive that will increase the capital requirements for re-securitised products compared with ordinary securitised products with the same ratings.

Strengthening the capital requirements for the trading book
Many of the losses incurred by the global financial sector since the onset of the crisis in mid-2007 have been related to credit institutions' trading books. The capital reserved by credit institutions to cover such losses proved to be insufficient. The crisis has thus disclosed that the credit institutions' internal models for calculating capital requirements for their trading activities systematically underestimate potential losses in the event of volatile markets and markets on a downward trend. Moreover, the models generate pronounced increases in capital requirements if market conditions deteriorate. Consequently, the credit institutions' capital is subject to considerable procyclical volatility.

The Commission has proposed that credit institutions should adjust their models – and thus their capital planning – so as to be better prepared for periods of market turmoil.⁵Credit institutions should perform stress tests based on a historical period of one year with considerable turmoil in the financial markets. More specifically, the institutions should calculate their stress Value-at-Risk, VaR⁶, and on this basis include an extra buffer capital requirement relative to the VaR calculations on which capital requirements have been based so far. Until now, data for the past 12 months has typically been used in the calculations, which means that a low-risk picture will emerge if the previous period was characterised by market stability. In the assessment of the Commission, this part of the proposal would more or less double the capital requirement for the trading book for credit institutions applying VaR models. Credit institutions that do not use internal models for assessment of market risk will not be affected by the amendments.

In addition, credit institutions must set aside capital to cover credit losses on their trading book that are not attributable to the default of an issuer, but to deterioration of the credit rating of the issuer and thus the price of the securities.

Raising the quality, consistency and transparency of the capital base
The crisis has demonstrated that the capital structure of credit institutions is significant when the sector comes under pressure. The crisis has revealed a shortage of high-quality capital, such as common equity, in parts of the financial system. This is the type of capital that market participants have attached importance to during the crisis – unlike other types of capital that can also be included in the calculation of the credit institutions' capital requirement. The latter includes e.g. various types of hybrid capital.⁷

There is international agreement that it is necessary to strengthen the capital base of credit institutions. The BCBS (in December 2009) and the Commission (in February 2010) have presented a number of proposals to strengthen the quality of credit institutions' capital, improve the comparability of the capital base across countries and promote transparency by increasing the disclosure requirements for credit institutions.

Both documents emphasise the need to strengthen the share of the credit institutions' Tier 1 capital, which comprises common equity and retained earnings.⁸Various criteria for classification as common shares for regulatory capital purposes have been defined. The proposals are aimed at joint stock companies, but in principle the requirements should also be met by non-joint stock companies such as cooperative societies and savings banks. It will, however, be possible for supervisory authorities to take into account the specific constitution and legal structure of the enterprise when applying the Basel criteria. Depending on how strictly the criteria are to be interpreted, this may affect Danish savings banks in particular due to the special characteristics of their guarantee capital.

Criteria have also been defined for the other two types of capital included in the credit institutions' capital base: other Tier 1 capital (hybrid capital) and Tier 2 capital. Under these proposals, hybrid capital with agreed interest-rate step-ups, which give the issuer an incentive to redeem the capital, will neither be eligible as Tier 1 nor Tier 2 capital.

The capital instruments included in Tier 2 capital must – as is already the case in Denmark – be issued with a maturity of at least five years. In the last five years before these instruments mature, their inclusion in the capital base will be reduced on a linear basis, i.e. earlier than under the current Danish rules.

In the 1st half of 2010, both the BCBS and the EU will perform quantitative assessments of the proposal and then determine minimum requirements for common equity, Tier 1 capital and total capital as percentages of risk-weighted items. The current rules stipulating that hybrid capital may constitute up to 50 per cent of the total Tier 1 capital and that Tier 2 capital cannot be included at more than 100 per cent of the Tier 1 capital after deductions will be abolished. As previously announced by the BCBS⁹, common equity and retained earnings must be the predominant form of the credit institutions' Tier 1 capital.

Countercyclical capital buffers
Financial activities are inherently procyclical. In good times, when unemployment is low and corporate earnings high, credit institutions are very willing to lend. Conversely, in recessions, when the value of the collateral declines, the risk associated with lending to households and the corporate sector is greater. The credit institutions' scope for assuming further risk also declines as write-downs are expected to increase¹⁰Hence, credit institutions become less willing to lend.

The capital adequacy rules potentially amplify this procyclicality. The risk-based approach means that the minimum capital requirement tends to fall during upswings, when risk is perceived to be limited. This leaves scope for credit institutions to expand their lending activities. Conversely, the capital requirement increases, and lending is reduced, in downturns, when risk is perceived to be high. Within the framework of the rules, credit institutions may, however, reserve more capital for unforeseeable events, etc.

In December 2009 it was announced that the BCBS will perform a quantitative assessment of several proposals for reducing the procyclicality of the minimum capital requirement. Among other things, this requirement is based on probabilities of default, PDs. Naturally, these are low in good times and may therefore contribute to low capital requirements. The BCBS will therefore perform a quantitative assessment of the effect of to specific proposals. The first is based on the use of the highest average PD estimate applied by a bank historically to each of its exposure classes as a proxy for a downturn PD. The second is based on the use of an average of historic PD estimates for each exposure class.

The BCBS has also presented a proposal for building up countercyclical capital buffers during upswings, and so has the Commission in its consultative document. The proposal is based on simple capital conservation rules. Restrictions on dividend payments, buy-backs of shares or bonus payments are to ensure that buffers are built up. Such buffers must be in excess of the minimum capital requirement, and the lower the degree of compliance with the buffer requirement is, the greater the restrictions on profit distribution will be, cf. the example in Table 2. The proposals will be detailed during 2010.

Internationally it is also being assessed whether it would be appropriate to require extra buffers when there are indications that lending has reached a high level. Historically, high lending growth has been followed by substantial losses.

Leverage ratio
High and increasing leverage – expansion of credit institutions' balance sheets relative to their capital – characterised parts of both the global and the Danish financial sector during the period leading up to the crisis. High leverage has made the banking sector more vulnerable to losses and difficult financing conditions, thereby contributing to procyclicality.

Internationally, there is broad agreement on the need to limit increases in the credit institutions' balance sheets in upswings by supplementing the capital adequacy rules with a "simple leverage ratio". In this respect, both the BCBS and the Commission have tabled proposals for implementing a leverage ratio to supplement the Basel II risk-based requirements. The ratio will be calculated as exposures relative to capital. Exposures will include all assets, including a number of off-balance-sheet items such as derivatives, repos and liquidity facilities. Basically, the capital should be of a high quality, i.e. the total Tier 1 capital or the common equity component of Tier 1 capital, but the final decision awaits the results of the quantitative analysis.

The proposals do not distinguish between different loan types and do not provide for reduction of exposures by means of physical or financial collateral. Therefore a simple leverage ratio does not necessarily give a true and fair view of risk for all types of credit institutions. For example, Danish mortgage-credit institutes typically have high leverage ratios, but at the same time their lending is well-collateralised.

In the 1st half of 2010 calibration of the leverage ratio will be considered as part of impact assessment, including interaction with the risk-based measure. BCBS will present its final proposal by the end of the year.

Systemically important financial institutions
Internationally there is agreement on the need to reduce risks related to systemically important financial institutions. Expectations of government bail-outs may give credit institutions an incentive to assume disproportionately large risks. At the same time, these institutions may benefit from lower financing costs due to implicit government guarantees.

A basic precondition for more restrictive regulation of systemic institutions is the ability to identify these institutions and quantify their contributions to systemic risk. A number of parameters may be applied when assessing the systemic importance of such institutions. Size is an obvious indicator of systemic risk. The degree to which an institution is connected with other institutions is another important indicator of its systemic importance – the more it is connected, the higher the risk that problems will spread to the entire system. Interconnection could mean that smaller institutions are also systemically important. Lack of substitutes for the services offered is also a key indicator of systemic importance. The institution may thus be difficult to replace because of its importance to central infrastructure such as payment and settlement systems. These criteria are to be supplemented with a number of vulnerability variables such as leverage, liquidity risk and complexity.¹¹

There are various ways of limiting the systemic risk of financial institutions. G-20 has requested the Financial Stability Board, FSB, to submit proposals for measures in relation to systemically important institutions, including more intensive supervision and further capital and liquidity requirements, by end-October 2010. The BCBS, the IMF and the Commission are also looking into various issues related to systemically important institutions. The G-20 emphasises that such institutions should develop internationally consistent firm-specific contingency and resolution plans ("living wills").

In connection with an amendment of the Danish Financial Business Act that is currently underway it has been proposed that the Danish Financial Supervisory Authority should take systemic risk into account to a greater extent than is currently the case.

Single rule book in banking
In July 2009 the Commission published its deliberations on increased harmonisation of the EU rules on capital requirements.¹²The Commission wishes to limit the opportunity for "gold plating", whereby a member state introduces requirements exceeding those contained in the Directive. The Commission's proposal targets minimum capital requirements, large exposures and disclosure rules.

In the Commission's consultative document from February 2010 it is emphasised that the aim of harmonisation is not to implement uniform rules irrespective of national conditions, but to ensure that a financial product is treated in the same way, irrespective of in which member state the bank that offers the product is authorised. In addition, the Commission, on the basis of the consultation responses received in connection with the July 2009 document, states that its harmonisation proposal enjoys considerable support.

In its February 2010 document, the Commission presents its deliberations on harmonisation of rules on lending against real property as collateral. For mortgage loans, the Commission is thus contemplating introducing limits to the size of the loan relative to income and relative to the value of the property. These limits must be observed if the institution is to apply lower risk weights when calculating its capital requirement.

In addition, the Commission is considering methods to limit inappropriate increases in lending during upswings, e.g. by linking the loan-to-value threshold to the cyclical position and the development in the housing market.

Liquidity regulation

Liquidity risk for credit institutions can be defined as the risk that a credit institution is unable to meet it obligations as they fall due without assuming unacceptable costs. Liquidity risk is a natural element of a credit institution's activities due to differences in the maturities and liquidity of deposits and loans.

The financial crisis in recent years has clearly illustrated the volume of liquidity risk in the financial system and the consequences to credit institutions, the financial system and society as a whole. Against this background, the financial crisis has triggered a wish for intensified and improved liquidity regulation.

Liquidity regulation and supervision have previously been predominantly national concerns. Some countries have based their national liquidity regulation regimes on a number of general principles for liquidity management published by the BCBS, but implementation has varied from country to country. The financial crisis has highlighted the need to review liquidity regulation and ensure a higher degree of coordination and alignment. Globalisation of the financial markets means that the liquidity risks faced by individual banking groups cannot be confined within national borders. This should be taken into account in liquidity regulation.

The BCBS principles for good liquidity management were revised in 2008, and the Committee of European Banking Supervisors, CEBS, has made a number of recommendations on good practice. The principles published by the BCBS and the CEBS are similar in many respects. Overall, both are aimed at ensuring focus on internal liquidity risk and management in financial enterprises and at strengthening the role of the supervisory authorities.¹³

These qualitative principles and recommendations have been incorporated into the Capital Requirements Directive. Previously there were only a few phrases about taking liquidity risk into consideration.

It appears from the revised Capital Requirements Directive that credit institutions must prepare solid strategies, policies, processes and systems to identify, measure and manage liquidity risks. Credit institutions must take various precautions to reduce and mitigate liquidity risks, including building up liquidity buffers, ensuring a sufficiently diversified funding structure and securing access to sources of funding. When determining the scope and composition of these instruments to mitigate risk, alternative stress scenarios must be considered. These should include both institution-specific and market-wide stress, as well as scenarios combining the two. Various time horizons and stress levels should also be taken into account.

Supervisory authorities must assess the exposure of the credit institutions to liquidity risk, measurement and management of liquidity risk, including analyses of alternative scenarios, management of instruments to mitigate risk (especially the size, composition and quality of liquidity buffers) and contingency plans.

Initially, these are qualitative standards for liquidity management and supervision. The amendments to the Capital Requirements Directive are expected to be implemented in Danish law by October 2010 and to come into force on 31 December 2010.

In addition to these qualitative standards for liquidity management, the BCBS and the CEBS are still preparing more quantitative measures and requirements.

In December 2009, the CEBS published a set of guidelines on liquidity buffers which credit institutions should observe in order to be able to resist liquidity stress for at least one month without having to adapt their business models. The guidelines specify the scope and composition of the assets to be included in a liquidity buffer.

The BCBS' consultative document from December 2009 includes proposals for two new quantitative liquidity ratios. In addition, it suggests various monitoring tools that supervisory authorities should use. The Commission's consultative document from February 2010 includes more or less the same proposals. The two quantitative liquidity ratios proposed are:

• "Liquidity Coverage Ratio" – This ratio relates to the credit institutions' liquidity buffers. It indicates the volume of unencumbered¹⁴high-quality assets that an institution must hold as a buffer against the net payments to be made by the institution in the event of intensive short-term liquidity stress, based on a stress scenario determined by the supervisory authority. The volume of liquid assets to be held by each institution will thus depend on the liquidity risks faced by the institution.
• "Net Stable Funding Ratio" – The second quantitative ratio concerns the funding structure of financial institutions. This ratio indicates the volume of stable sources of long-term funding used by an institution relative to the liquidity profile of the assets financed by the institution, as well as the potential liquidity withdrawals arising out of off-balance-sheet commitments and obligations. A minimum level of stable funding is laid down, which must be observed by the institution. Stable funding is defined as funding that can be expected to be stable over a 1-year horizon.

The proposed Liquidity Coverage Ratio could have consequences for the Danish market for mortgage bonds if implemented in its current form. It envisages a very stringent definition of the assets eligible for inclusion in the liquidity buffer. This narrow definition does not include covered bonds, which constitute a substantial part of the Danish bond market. A large proportion of the Danish credit institutions' liquidity is currently invested in covered bonds. If covered bonds can no longer be included in the definition of "highly liquid high-quality assets", demand for these bonds will presumably fall. The proposed Net Stable Funding Ratio could also pose a challenge for the Danish mortgage-credit system. The definition applied means that Danish mortgage bonds with a term to maturity of less than one year cannot be recognised as stable funding. At the same time, it is a requirement that loans with a maturity of more than one year are fully financed by stable funding. This will affect Danish adjustable-rate loans as they are financed via short-term bonds.

Financial reporting

Since the onset of the crisis, several aspects of financial reporting have been in focus, including:

• rules for measurement and classification of assets, and
• rules on impairment/provisions for loans.

Valuation and classification of financial assets
The International Financial Reporting Standards, IFRS, are laid down by the International Accounting Standards Board, IASB, which is an independent organisation. The IFRS prescribe the use of various measurement methods, including fair value. Since the onset of the crisis, fair value has been criticised for being procyclical and for not functioning when the markets are under stress or when assets are illiquid. In response to the criticism, the IASB is reviewing the guidelines for the use of fair value, including when the instruments are illiquid.¹⁵

Moreover, in November 2009, the IASB adopted an amendment to the financial reporting standards concerning classification of assets.¹⁶The number of measurement methods has been reduced, and in future classification will depend on the business model applied. Against this background, it will be possible to classify assets as assets measured at amortised cost¹⁷or as assets measured at fair value with value adjustment over the income statement.

With the new standards, the "available for sale" category will be abolished. Financial assets in this category are measured at fair value and value adjustments are carried directly to equity. The same applies to the "held to maturity" category, which currently gives credit institutions the option to value listed bonds at amortised cost if they are to be held until maturity.

In principle, these amendments apply to financial statements from 2013 onwards, but the IASB permits application of the rules from 2009. The Commission has, however, chosen not to approve the amendments until the other two phases of the IASB project on replacement of IAS standards have been completed.

Consequently, Danish credit institutions were not able to apply the amended standards in 2009. The IASB is expected to complete its project in 2010.

The amendments entail a much-needed simplification of the rules. How these amendments will affect the credit institutions' financial statements depends on the business models applied. In this context it should be noted that a bank may operate with several business models.

From a Danish point of view, it is important that mortgage-credit institutes can still apply fair value on both sides of the balance sheet, i.e. for lending as well as bonds issued. This will also be possible under the new rules.

Impairment of financial assets
Under the IFRS, impairment of financial assets measured at amortised cost should take place on the basis of objective indications of impairment (the "incurred loss model"). In Denmark this principle was introduced in 2005 in connection with the transition to the IFRS and replaced the prudential principle. Combined with cyclical developments, the new rules contributed to reducing provisions in the period leading up to the financial crisis.¹⁸ This made the credit institutions vulnerable to the cyclical downturn.

In November 2009, the IASB published a draft "expected cash flow model" for calculation of impairment of financial assets. The new model enables earlier recognition of credit losses than the current rules do.¹⁹One of the differences compared with the current incurred loss model lies in the calculation of the effective interest rate on the loan. Under the existing rules, interest income, fees and transaction costs are amortised over the expected maturity of the loan on the basis of the effective interest rate, which is calculated exclusive of expected credit losses. In the proposed expected cash flow model, the effective interest rate is to be calculated on the basis of expected cash flows. Cash flows are to be estimated on the basis of probability-weighted potential outcomes, in relation to both the size and timing of payments. Under the expected cash flow model initially expected credit losses will thus be included in the effective interest rate.

The expected cash flow model entails that the credit institution must, on every balance-sheet date, reassess its estimates of expected cash flows. Any change to the amortised cost as a result of changes in expected cash flows must be included on the income statement. Value adjustments may be negative or positive, depending on whether the credit institution expects the borrower's payment ability to deteriorate or improve.

The transition from a model only permitting impairment losses when there is objective evidence of impairment to a model which regularly takes into account expected losses can be expected to lead to larger provisions in good times. This will boost the credit institutions' resilience to cyclical reversals, while also reducing the procyclicality of impairment charges.

The IASB proposal includes extensive presentation and disclosure requirements. The credit institutions must provide information about the estimates applied and any changes to such estimates, policies for writing off loans that have been impaired, and information on any stress testing performed as part of the institution's internal risk management.

Countercyclical provisioning
Countercyclical provisioning is another topic included in the European Commission's consultative document from February 2010. According to the document, the purpose of implementing the provisions would be to ensure that credit institutions hold reserves to cover the losses expected over a business cycle. Capital buffers, on the other hand, are to be used to cover unexpected losses. For banks applying internal models for calculating credit risk (the Internal Ratings-Based – IRB – approach), provisions must be calculated on the basis of, inter alia, the average default rate expected over a business cycle, i.e. through-the-cycle probability of default. In good times, expected losses will be higher than write-downs calculated in accordance with the current method (the incurred loss model). In bad times, the opposite applies. Reserves will thus be built up in good times and reduced in bad times, thereby dampening procyclicality and making the institutions more resilient to economic fluctuations.

An advantage of this model compared with dynamic provisioning,²⁰which is the model previously considered by the Commission, is that IRB banks will be able to apply bank-specific models and data.

Hence, it will be possible to take bank-specific credit risks into account²³, and thus the non-availability of data for calculation of dynamic provisions in many countries will no longer constitute a problem.

However, many banks do not apply the IRB approach today, which limits the advantages of this model. Moreover, the model is based on the current model for impairment of financial assets and therefore does not immediately tie in with the expected cash flow model as proposed by the IASB.

In addition, capital buffers are generally preferable to countercyclical provisioning as they make the credit institutions' income statements more transparent.

Summary

It is important to address the weaknesses in financial regulation highlighted by the crisis. Consequently, new rules are underway in a number of areas.

The timing of the introduction of the new rules is crucial. On the one hand, immediate tightening of capital and liquidity requirements could lead to undesirable intensification of the balance-sheet contraction performed by many credit institutions worldwide. On the other hand, due diligence requires credit institutions to adapt to expected changes in the rule set and to adjust their balance sheets accordingly.

Like countercyclical provisioning, the IASB's proposal to switch to an expected cash flow model would increase the banks' resilience to recessions and reduce procyclicality. The proposal for countercyclical provisioning should be viewed in relation to other measures to counteract procyclicality, such as the implementation of capital buffers and leverage ratios. It is important to assess the overall impact of these and other proposed measures.

When amending financial reporting standards, it is important to keep in mind that while simplification of the rules is desirable, the information content in the credit institutions' financial statements must not deteriorate.

From a Danish point of view, the proposals submitted so far contain a number of particularly significant elements. More stringent liquidity rules are among the requirements that – if implemented as proposed by the BCBS – can be expected to have an impact on the Danish mortgage-credit system. Furthermore, the BCBS proposal to implement a leverage ratio that does not make a distinction between different loan types and does not permit reduction of exposures by way of collateralisation, will be to the disadvantage of the Danish mortgage-credit institutes.