Interaction between the regulations on capital adequacy and crisis management

41 Pages·2017·1.07 MB·English

JOINT REPORT FOR THE GOVERNMENT
Interaction between the regulations
on capital adequacy and crisis
management

28 APRIL 2017

FI Ref. 17-6857

Swedish National Debt Office RGR 2017/210
Foreword
The purpose of the requirements set by Finansinspektionen and the Debt Office
for firms in the financial sector is to maintain financial stability in Sweden. The
regulations of the authorities are interconnected in how they are devised.
In the Letters of Appropriation for 2017, the Government commissioned the
authorities to report, no later than 30 April, how the rules regarding capital
adequacy and crisis management function and interact. The report was to focus on
how the overall requirements affect firms’ capital structure and conduct, financial
stability and the effects on lending rates that could arise. Additionally, the report
had to take into account current negotiations in the EU regarding amending the
regulations on capital adequacy and recovery and resolution, and the
consequences thereof (such as in terms of national flexibility).
Finansinspektionen and the Debt Office hereby present their results to the
Swedish Government Offices (Ministry of Finance) in this joint report.

Erik Thedéen Hans Lindblad
Director General of Finansinspektionen Director General of the Debt Office

1
1. Summary
Finansinspektionen (FI) and the Swedish National Debt Office (the Debt
Office) were commissioned by the Government to write a report presenting
the authorities’ view on the requirements for capital adequacy and crisis
management. The assessment of the authorities is that the design of the
Swedish regulations and associated requirements is appropriate for reducing
the risk of financial crises and ensuring effective management if a crisis
were still to occur.
The report includes an analysis of the proposals from the European
Commission that could significantly alter the conditions for the national
implementation of the regulations. The report shows that, from a Swedish
perspective, the overall economic effect of the EU Commission’s proposed
amendments would primarily be negative.
FI and the Debt Office play important roles in maintaining financial stability
in Sweden. FI is primarily tasked with ensuring that firms1 are sufficiently
resilient, thus preventing financial crises from occurring. The capital
requirements that FI sets on firms are a central component in establishing
this resilience. The Debt Office is primarily tasked with managing the
financial crises that may still occur. This assignment includes ensuring that
firms can be managed through a resolution procedure. This is achieved, for
example, by the Debt Office requiring firms to hold a certain amount of
capital and bail-inable debt, i.e. the minimum requirement for own funds
and eligible liabilities (the MREL requirement).

1 The term “firms” in this report refers to banks, other credit institutions, investment firms and
certain other financial institutions subject to the regulations on capital adequacy and resolution.
2
Even if capital requirements and MREL requirements fulfil different
purposes, these two regulatory frameworks are still closely interconnected.
In order to achieve the goals of the overall regulation, it is necessary for the
requirements to not only be appropriately designed and applied but also to
complement one another.2 FI and the Debt Office consider there to be
certain fundamental principles that should guide the work in applying these
frameworks:
• Capital requirements and MREL requirements should be designed to
promote sound risk-taking by firms.
• The authorities should be transparent in how the requirements and any
related regulations are applied.
• The design of the regulation and the requirements should provide the firms
and their stakeholders with the opportunity to resolve problems on their
own, provided that an effective outcome can be achieved.
• The requirements should be designed so the authorities have sufficient
flexibility to take situation-specific measures.
• The requirements should take into account the financial system’s features
and functions.
• The requirements should be designed in such a way as to clearly
distinguish between resources that are used to ensure resilience and those
that are used to ensure resolvability.
FI and the Debt Office consider the existing capital requirements and MREL
requirements to fulfil these principles and that the requirements interconnect
in a way that contributes to the overall goal of financial stability. However,
the analysis in the report shows that the proposed amendments to the current
EU regulations overall would be negative for Sweden compared to the
current framework.

2 The two regulatory frameworks in this report refer primarily to the legislation that regulates the
design and application of the capital requirements and the MREL requirements.

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2. Introduction
The services provided by financial firms serve an important purpose in the
modern economy. At the same time, both individual firms and the broader
financial system have been subject to financial crises of varying severity at
times. In turn, these have often had major adverse implications for the rest
of the economy.3 For this reason, financial firms have been subject to more
extensive requirements than most other industries. In the past, it has mainly
been done by setting the amount of equity that firms must hold. In the past
few years, new regulations have emerged. These include the Bank Recovery
and Resolution Directive (BRRD)4 adopted by the EU in the spring of 2014.
This directive established a new framework for planning for and managing
financial crises. For instance, a specific resolution authority shall be
appointed, and also a number of new duties and powers have been bestowed
on the supervisory authority, i.e. FI.
In Sweden, the National Debt Office has been the resolution authority since
February 2016. The resolution authority is responsible for managing failing
firms through a specific wind-up and reorganisation procedure, known as
resolution. Part of the responsibility of the resolution authority is to place
demands on financial firms so that they can be put into resolution in the
event they fail or, in the case of comparatively small and less complex
firms, dealt with through an ordinary insolvency procedure. An important
element is setting MREL requirements for each individual firm that is
subject to the resolution regulations. The purpose of the requirement is to
enable efficient bail-in, thus ensuring that it will be the firm’s shareholders
and creditors – not taxpayers – that bear the cost of the resolution process.
According to the rules, the requirement shall be set based on the capital
requirements which, in Sweden, are set by FI according to the capital
adequacy regulations.
In view of the links between the capital requirements and MREL, for
instance in that MREL shall be set based on the capital requirements, the
government commissioned FI and the Debt Office, no later than 30 April
2017, to jointly describe the following in a report:
 how various designs of the overall requirements in the regulations
regarding capital adequacy and crisis management affect the capital
structure of financial entities,

3 Adamczyk, G. and Windisc, B. (2015) “State Aid to European Banks: Returning to
Viability”, Occasional papers by the Competition Directorate–General of the European
Commission.
4 Directive 2014/59/EC of the European Parliament and of the Council of 15 May 2014.
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 the changes in behaviour to which different designs of the requirements
could lead,
 how different designs affect financial stability, and
 the effects on lending to corporations and households that could be
prompted by the requirements.

Both the capital adequacy and crisis management regulations are under
renegotiation regarding certain parts, and the European Commission
presented a proposal for revisions in November 2016.5 Therefore, in the
report the authorities shall consider current EU negotiations and their
expected consequences, such as in terms of financial stability and national
flexibility.
Limitations and structure
The supervisory and crisis management regulations are extensive and
address many different types of powers and requirements. This report is
primarily limited to capital adequacy rules and requirements for bail-inable
debt. For this reason, the report only addresses to a limited extent matters
pertaining to liquidity risks, and how the authorities will work together
before and during a crisis. Broader resolution planning work and the actions
and requirements of other authorities are not addressed either. However, a
general description of the broader implications and interaction of the
regulations is provided in the box below.
The report is structured as follows. Sections 3 and 4 describe the emergence,
functioning and design of the capital and MREL requirements. Section 5
presents the principles which FI and the Debt Office consider serve as a
guide for the design of the overall regulations. Section 6 presents the
implications that different designs of the requirements would have for the
firms concerned, their customers and financial stability at large.

5 See the Commission’s proposals from 23 November 2016 (COM(2016) 854 final,
COM(2016) 850 final, COM(2016) 852 final and COM(2016) 853 final).
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The roles of FI and the Debt Office during and outside of
times of crisis
Figure 1. The authorities’ roles during and outside of times of crisis

FI’s primary task is to contribute to a stable financial system that is defined by a high
level of confidence and well-functioning markets that meet the needs of households
and corporations for financial services, while at the same time providing
comprehensive protection for consumers. The task of contributing to a stable
financial system is executed by ensuring as part of its regulation issuance and
supervision that appropriate requirements (for example capital and liquidity
requirements) are imposed on financial firms, and that the firms comply therewith.6
Although FI has important duties in the event of a crisis, the primary task of the
authority is to prevent crises from occurring, for instance by ensuring that the
resilience of financial firms is good. Part of this involves FI reviewing and assessing
the recovery plans which the firms are obliged to prepare. Recovery plans will need
to be activated when the firm comes under severe stress. The plans shall describe the
measures the firms can take themselves in such a situation to preserve or restore their
financial position. With a view to preventing a crisis, FI can, at an early stage of
financial stress, also take measures in relation to firms to avoid further deterioration
that would necessitate resolution measures (known as early intervention). Recovery
and early intervention will be needed in the yellow area of the illustration.

The primary task of the Debt Office in financial stability is to manage failing
financial firms. To fulfil this task, the authority has several tools and powers that can
be applied in the event of a crisis, either as part of a resolution procedure or the
government deposit guarantee. To enable effective recovery and resolution, the Debt
Office also has important duties and powers outside of times of crisis. As the
resolution authority, the Debt Office shall conduct planning work aimed at ensuring
that the firms are resolvable, i.e. that dealing with them using the resolution
framework is possible. For each individual firm, the Debt Office shall therefore
prepare individual plans for how to manage a crisis at the firm, known as resolution
plans. A number of powers are linked to this planning work, including the obligation
to decide on the MREL requirement and, if needed, direct measures applied to
individual firms in order to remove substantial obstacles to resolution. Such
measures could, for instance, consist of a requirement for firms to change their
business in some respect.

6 This report primarily focuses on the stability aspect.
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3. Capital requirements
The function of capital requirements in society
The economy relies on the ability of the financial system to grant credit and
mediate payments. If the system cannot continue to provide these services,
major socioeconomic costs would be incurred.7 At the same time, financial
firms (primarily banks) have relatively high indebtedness compared with
non-financial firms, i.e. equity is low in relation to other funding.
For the financial system to be stable, it is important that these firms hold
sufficient capital for absorbing losses, irrespective of the cause of the losses.
At the same time, resilience of the firms reduces the risks of problems
spreading to other parts of the financial system. This applies in particular to
problems at systemically important firms. In the past, financial firms, both
due to the expectation of government support measures in the event of
default (“the implicit government guarantee”), and also due to explicit
guarantees such as the deposit guarantee, have tended to have lower
solvency and higher risk-taking than is desirable from a socioeconomic
point of view. It is in light of this that that capital adequacy rules have
emerged. The rules require the firms to have a certain level of capital, and
for this capital to be of good quality to cover unexpected losses.
The emergence of the capital adequacy rules
The Basel Committee on Banking Supervision (the Basel Committee) issues
recommendations for globally harmonised minimum standards for banks. In
1988 the first global agreement was published regarding capital
requirements, also known as Basel I. In subsequent years, the regulations
were updated several times so that they also covered, for instance, capital
requirements for market risk and operational risk.
With the growing complexity of credit markets, the framework had to be
developed to further strengthen the banking system and promote
harmonisation. This resulted in the Basel II Accord8, published in 2005 and
implemented in Swedish law in 2007. Basel II introduced a higher risk
sensitivity and a possibility for firms, following authorisation from the
supervisory authority, to use internal models in which the capital
requirement depends on the risk in the underlying exposures.

7 Credits are mainly mediated by credit institutions, i.e. banks and credit market companies.
8 Basel II: International Convergence of Capital Measurement and Capital Standards: A
Revised Framework, updated November 2005.
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One reason for why the financial crisis that broke out in 2007 turned out to
be so severe was that the banking sectors had grown in many countries
while, at the same time, risk-taking and complexity on the financial market
were high. The capital adequacy of banks was insufficient, both in terms of
the size and quality of the capital, making it difficult for them to absorb
losses and restore their financial position. In the wake of the crisis, several
initiatives were taken to strengthen financial stability. One of the results was
that, in 2010, the Basel Committee agreed on the Basel III Accord.9
According to this standard, the banks needed to hold more capital, the
capital had to be of better quality10, the capital requirements had to take
account of systemic risk, and new liquidity requirements were introduced.
In the EU, the Basel III Accord was implemented through binding rules in
2014. Parts have been introduced in a directly applicable regulation11, while
other parts have been implemented through a directive.12 The directive has
then been implemented in Swedish law. Compared with the Basel Accord,
which is a minimum standard, the EU regulations mean more far-reaching
harmonisation. Nonetheless, there are specific provisions which, in some
cases, provide possibilities and also obligations for the national authorities
to apply stricter rules.
Some parts of the Basel III Accord are not complete at the time of writing.
The remaining discussion pertains to limitations on the internal models,
such as the introduction of less risk-based capital requirements, such as an
output floor for the risk-weighted assets. Internal models may be used
subject to assessment by the supervisory authority, which also supervises
the model. The models have the advantage of making the risk weights (and
thus the capital requirement) more risk-based. Hence, the firms improve
their risk management and capital is better allocated to viable investments.
At the same time, there is a risk that models are used to minimise risk
weights, since it is in the banks’ interest for the capital requirements to be
low. Also, to a great extent, internal models are based on the assumption
that historical data reflects the future, with is not always the case. By
ensuring through supervision that the models produce appropriate outcomes
regarding the probability of default and determining the classes of exposures

9 Basel III: A global regulatory framework for more resilient banks and banking systems,
December 2010, and the update in June 2011.
10 That is, a higher share of common equity, which is the capital that decreases first in the
event of losses. Losses affect earnings, and hence equity. It is normally simpler for banks to
suspend profit distribution than it is to suspend coupon payments on other own funds
instruments.
11 Regulation (EC) No. 575/2013 of the European Parliament and of the Council of 26 June
2013
12 Directive 2013/36/EC of the European Parliament and of the Council of 26 June 2013.
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that may be modelled, the benefit of internal models in terms of the risk
reflection is retained, while at the same time the incentive-related problems
are minimised.13
Design of the requirements
The Basel regulations are based on the banks having to hold a certain share
of capital in relation to the risk-weighted exposures in the form of a
minimum requirement. In addition, the Basel Committee has also introduced
a number of “macroprudential tools” to enable countries to manage systemic
risks arising as a result of procyclicality and through the interconnection in
the banking system. This was introduced in the form of buffers14 which can
be used in stressed conditions, i.e. capital requirements which the banks are
permitted to breach, but with certain restrictions emerging. A buffer creates
headroom to the minimum requirements, so that a “cushion” emerges that
can absorb losses. The buffers included in the EU regulations can, in
somewhat simplified terms, be divided into a systemic risk buffer, a buffer
for systemically important institutions, a countercyclical buffer and a capital
conservation buffer. Together, the buffers imposed on a firm are called “the
combined buffer requirement”.15
The supervisory authority shall also perform an individual supervisory
review and evaluation for each firm. Unlike minimum requirements and
buffer requirements, which are often called “Pillar 1 capital requirements”,
the capital surcharge that emerges through the individual supervisory review
and evaluation is called “Pillar 2 capital requirements”. The Pillar 2
requirement includes risks of losses that are not included in or fully captured
by Pillar 1, and the risks to which the firm exposes the financial system, i.e.
systemic risks.
Table 1 describes the capital requirements schematically. The description
does not take account of the floor to the capital level (the “Basel I floor”)16
or of the capital planning buffer which, in some cases, can have a bearing on
the total capital requirement.17

13 See FI’s new methods for banks’ risk weights and capital requirements, May 2016. 
14 Some macroprudential tools can be introduced as minimum requirements, such as
through changes in assumptions regarding the probability of default and loss given default.
15 The buffer for systemically important institutions and the systemic risk buffer overlap
only in the case where the systemic risk buffer is applied solely on exposures in Sweden.
16 The purpose of the Basel I floor is to ensure that own funds do not fall below 80% of the
capital requirement according to the Basel I regulations.
17 For more information, see Capital requirements for Swedish banks, September 2014.
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