Amending the prudential regulatory framework for credit institutions and investment firms in response to the COVID-19 pandemic

June 26, 2020 Hristescu & Partners

Regulation (EU) No 575/2013 of the European Parliament and of the Council establishes, together with Directive 2013/36/EU of the European Parliament and of the Council, the prudential regulatory framework for credit institutions and investment firms (hereafter called “institutions”) operating in the European Union. Adopted in the aftermath of the financial crisis that unfolded in 2007-2008, and largely based on international standards agreed in 2010 by the Basel Committee on Banking Supervision (BCBS), known as the Basel III framework, the prudential regulatory framework has contributed to enhancing the resilience of institutions operating in the European Union and to making them better prepared to deal with potential difficulties, including difficulties stemming from possible future crises.

In order for the measures adopted to alleviate the impact of the COVID-19 pandemic to be fully effective with regard to keeping the banking sector more resilient and providing an incentive to the institutions to continue lending, it was considered necessary for the prudential regulatory framework to be updated for the following period of time. We have hence analysed below some of these safeguarding measures.

 

We will start with the modification which states that prior to permission from the competent authorities, institutions permitted to use the IRB Approach in the calculation of risk-weighted exposure amounts may apply the Standardised Approach for exposures to central governments and central banks of the Member States and their regional governments, local authorities, administrative bodies and public sector entities. In order to do this, 

  • there must be no difference in risk between the exposures to that central government and central bank and those other exposures because of specific public arrangements; and
  • exposures to the central government and central bank must be assigned a 0 % risk weight under Article 114(2) or (4), namely exposures to central governments and central banks for which a credit assessment by a nominated ECAI is available and exposures to Member States’ central governments, and central banks denominated and funded in the domestic currency of that central government and central bank.


As a rule, an institution may exclude the following exposures to the institution’s central bank:

  • coins and banknotes constituting legal currency in the jurisdiction of the central bank;
  • assets representing claims on the central bank, including reserves held at the central bank;

However, there are some conditions that are deemed to be followed in order for the exclusion to take place. The new Regulation is rather adding one more condition to the previous two ones. Hence, pursuant to paragraph 5 of Article 429a, as amended by Regulation (EU) 2019/876, institutions may exclude the upper listed exposures if ALL of the following conditions are met:

  • the institution’s competent authority has determined, after consultation with the relevant central bank, and publicly declared that exceptional circumstances exist that warrant the exclusion in order to facilitate the implementation of monetary policies; 
  • the exemption is granted for a limited period of time not exceeding one year; AND 
  • the institution’s competent authority has determined, after consultation with the relevant central bank, the date when the exceptional circumstances are deemed to have started and publicly announced that date, which must be set at the end of a quarter.


Temporary treatment shall apply to unrealised gains and losses measured at fair value through other comprehensive income in view of the COVID-19 pandemic.

During the period from 1 January 2020 to 31 December 2022, which is considered to be the ‘period of temporary treatment’, institutions may remove from the calculation of their Common Equity Tier 1 items, an amount that is calculated based on the formula set out in the Regulation (EU) 2020/873.

If an institution decides to apply the temporary treatment set above, it must inform the competent authority of its decision at least 45 days before the date when it needs to report the information based on that treatment. Prior to the permission given by the competent authority, the institution may reverse its initial decision once during the period of temporary treatment. It is mandatory for the institutions to publicly disclose if they apply to that treatment.

If an institution removes the unrealised losses from its Common Equity Tier 1 items in accordance with the above rules, it shall recalculate all requirements that are calculated using any of the following items: 

  • the deferred tax assets that are deducted from Common Equity Tier 1 items; 
  • the amount of specific credit risk adjustments.

When recalculating these relevant requirements, the institution shall not take into account the effects that the expected credit loss provisions relating to exposures to central governments, to regional governments or to local authorities and to public sector entities, excluding those financial assets that are credit-impaired, have on those items.

During the periods of temporary treatment, institutions that have decided to apply the temporary treatment must also disclose the amounts of own funds, Common Equity Tier 1 capital and Tier 1 capital, the total capital ratio, the Common Equity Tier 1 capital ratio, the Tier 1 capital ratio, and the leverage ratio they would have in case they were not to apply that treatment.

 

Temporary treatment of public debt issued in the currency of another Member State.

Until 31 December 2024, for exposures to the central governments and central banks of Member States, if those exposures are denominated and funded in the domestic currency of another Member State, the following rules shall apply:

  • until 31 December 2022, the risk weight applied to the exposure values shall be 0 % of the risk weight assigned to exposures for which a credit assessment by a nominated ECAI is available; 
  • in 2023, the risk weight applied to the exposure values shall be 20 % of the risk weight assigned to exposures for which a credit assessment by a nominated ECAI is available; 
  • in 2024, the risk weight applied to the exposure values shall be 50 % of the risk weight assigned to exposures for which a credit assessment by a nominated ECAI is available.

It is provided that institutions may be allowed by the competent authorities to sustain the upper exposures only up to some certain limits; respectively, until 31 December 2023, 100 % of the institution’s Tier 1 capital; between 1 January and 31 December 2024, 75% of the institution’s Tier 1 capital; and between 1 January and 31 December 2025, only 50% of the institution’s Tier 1 capital. These limits shall apply to exposure values after taking into account the effect of credit risk mitigation.

 

Temporary exclusion of certain exposures to central banks from the total exposure measure in view of the COVID-19 pandemic.

Until 27 June 2021, an institution may exclude from its total exposure measure the following exposures to the institution’s central bank:

  • coins and banknotes constituting legal currency in the jurisdiction of the central bank;
  • assets representing claims on the central bank, including reserves held at the central bank.

These exposures may be excluded by an institution if the institution’s competent authority has determined, after consultation with the relevant central bank, and publicly declared that exceptional circumstances exist that warrant the exclusion in order to facilitate the implementation of monetary policies. 

In order for the upper exposures to be excluded, they must be denominated in the same currency as the deposits taken by the institution and their average maturity must not significantly exceed the average maturity of the deposits taken by the institution. An institution that excludes exposures to its central bank from its total exposure measure must also disclose the leverage ratio it would have if it did not exclude those exposures.

 

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