The European Commission is currently working on its biggest banking regulatory reform since the financial crash of 2008. The new reform will directly apply to all Banks and Investment Firms within the European Union. The Capital Requirements Directive (CRD V) is part of a broad package of legislative amendments which includes the Capital Requirements Regulation II (CRR II) and aims to improve the risk and compliance management of the firms. For this, the European Banking Authority (EBA) has been mandated to produce the four Regulatory Technical Standards (RTS) on the  Standardized Approach for Counterparty Credit Risk (SA-CCR) of the CRR II.

Within this article, we take the opportunity to answer the three main questions:
a) What are the expected changes?
b) When are the changes expected to take effect?
c) Who is affected by these changes?

What is changing?
– The new reforms include new methodologies for calculating the exposure value of derivatives exposures, known as the “Standardized Approach for Counterparty Credit Risk”  (SA-CCR) and ensure that parties are adequately protected in the event of a counterparty default to a derivatives transaction. Two new categories will be introduced:
1. “replacement cost” representing the loss that would occur if a counterparty defaults and the transactions are closed out immediately,
2. “potential future exposure” measuring the potential change in the transaction value over a one-year period.
– An obligatory 3% leverage ratio, to assess the ability to meet long-term financial obligations,
– A net stable funding ratio to address liquidity mismatches,
– A revised risk-weighting and large exposure standards including higher capital requirements for institutions that trade in securities and derivatives (market risk),
– A revised way to calculate the interest rate risks for the banking-book position.

When shall we expect the changes to take place?
A public hearing is expected to take place in Paris on the 17th of June 2019, while the consultation period will run until the 2nd of August 2019. The new reforms will be applicable two years after they enter into force – this means within 2021.

Who is affected by the changes?
The “STP” brokers with a minimum capital requirement of 125K are expected to be heavily impacted by the proposed changes, as their business activity is concentrated on counterparty risk.

The new changes introduce new ways to calculate the potential future exposure, which is determined by the “risk category” assigned to the particular transaction and by using a qualitative and/or quantitative approach. Smaller institutions may be allowed to use a simpler methodology for the quantitative assessment of the risk drivers. In reality though, smaller brokers might be affected more than bigger ones as the new changes might force them to increase their share capital and subsequently their tier 1 own funds. This is in order to account for a possibly higher Credit Risk Exposure and in order to maintain a Capital Adequacy Ratio well above the minimum requirements.

It is worth mentioning that the changes will heavily impact the UK’s access to the Union, as they were suggested post-Brexit. The new directive includes provisions that require the non-EU institutions to establish an EU based intermediate parent company, IF:
1. they have assets with over 30 billion euros in the EU, or
2. are considered globally systemically important.

The EBA estimates that the top 10 investment firms are concentrated in the UK and they control about 80% of the assets of all investment firms in the EEA.

To conclude, the new regulatory framework calls for consistency on the methods applied by the firms. The counterparty credit risk results must be consistent across the credit and market risk, the liquidity coverage, the net stable funding and leverage ratios, as well as the own funds. It is worth noting that the Investment Firms shall now maintain capital over and above the minimum capital requirement of 8%, plus a capital conservation buffer of common equity tier 1 capital equal to 2.5% of its total risk exposure amount.

It seems that the new calculations will increase the risk exposure amount, thus an additional capital will be needed in order to be well above the adequate ratio. All those changes allow us to raise the obvious question;

Will investment firms and banks take the necessary steps and be ready to recapitalize their balance sheet on time, if needed?  

Please feel free to contact us at info@salvusfunds.com if you have any questions.

The information provided in this article is for general information purposes only. You should always seek professional advice suitable to your needs.