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Europe Goes ‘Countercyclical’: A Legal Assessment of the New Countercyclical Dimension of the CRR/CRD IV Package

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Abstract

One of the most innovative features of Basel III was the introduction of a new ‘countercyclical’ regulatory dimension for banks. In 2013, this dimension was operationalised in the European prudential framework included in the CRR/CRD IV package. Although the uniform implementation of these rules has been welcomed by the European legislator as creating a level playing field for banks and investment firms, this legal analysis reveals the existence of serious competitive disadvantages for small local and regional banks. While the largest entities are incentivised to exploit the arbitrage opportunities hidden in the CRR/CRD IV countercyclical provisions, such opportunities are not available to smaller entities. Thus, the unintended result of the new prudential framework seems to be not only a re-sizing of the banking balance sheets, but also a re-composition of the banking structures. In this paper, one of the building blocks of the Legal Theory of Finance, i.e., the construction of finance as a legal by-product is taken as a point of departure to show how the adoption of the new countercyclical rules paves the way for a new consolidation wave in the banking industry.

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Notes

  1. See for the still ongoing debate on the causes of the 2007–2008 financial crisis, inter alia, Friedman (2010), Blanchard (2009), Blundell-Wignall et al. (2008), Claessens et al. (2013), Lin and Treichel (2012).

  2. See, for example, Cornelis (2015), Heremans and Bosquet (2011), Driesen (2014), Crawford (2011), Posner (2009).

  3. See Minsky (1986a, b, 1992a, b). For an overview of the theory, see also King (2013).

  4. See Pistor (2013).

  5. The IKE is a financial market theory developed in Frydman and Goldberg (2007). The contribution of the authors to the economic debate lies in the idea that markets do not achieve equilibrium outcomes, as asserted by the ECMH. Instead, the existence of imperfect knowledge as an inherent feature of financial markets leads to extreme asset price swings that eventually generate instability.

  6. The MVF may be considered as an extension of Minsky’s Financial Instability Hypothesis to contemporary financial markets and has been developed in Mehrling (2011). More importantly, according to the MVF, liquidity is strongly intertwined with imperfect knowledge and a critical determinant of asset price swings. For a discussion of the MVF and its regulatory suggestions, see Pistor (2012), at pp. 28–36.

  7. Pistor (2012), at p. 3.

  8. Pistor (2013), at pp. 317, 318; Sinapi (2011), at pp. 10, 11.

  9. Pistor (2013), at p. 318.

  10. Claessens and Kodres (2014), at p. 15.

  11. Pistor (2013), at p. 321.

  12. Pistor (2012), at p. 4.

  13. Pistor (2013), at p. 317.

  14. Pistor (2012), at p. 53.

  15. See McDonnell (2014), at p. 124.

  16. Idem.

  17. Idem.

  18. Borio et al. (2001), at p. 1.

  19. This feature of the financial cycle is usually referred as ‘financial accelerator’. For a better insight, see Bernanke et al. (1996, 1999).

  20. Borio et al. (2001), para. 2.3. See also Dierick (2004), at p. 51.

  21. A deeper perspective on the risk pricing issues arising from Basel II is given in Kashyap and Stein (2004).

  22. See infra, para. 2.3.

  23. Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, OJ L 176, 27.6.2013, pp. 338–436.

  24. Regulation (EU) No. 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms, OJ L 176, 27 June 2013, pp. 1–337.

  25. For example, in Germany, the CRD IV has been transposed into the national framework by way of the CRD IV Implementation Act (CRD-IV-Umsetzungsgesetz): see Bundesgesetzblatt Teil I Nr. 53 of 03 September 2013. In Italy, the EU package has been implemented through the Circular of Bank of Italy No. 285 of 17 December 2013.

  26. See BCBS (2011). For further insights on the Basel III framework, see Chorafas (2011). For a historical perspective on the Basel III implementation process, see Lyngen (2012).

  27. On the effects of the global financial crisis, see Ötker-Robe and Podpiera (2013), Ollivaud and Turner (2014), Gros and Alcidi (2010). For an interesting survey on how the financial crisis affected the fiscal positions of countries, see Tagkalakis (2013).

  28. See Gorton and Metrick (2012), para. 1. See also Gorton (2010), Solomon (2012).

  29. See, for example, Aksoy and Basso (2015), at p. 2.

  30. Chan (2011), at p. 1. For a critical assessment, see Kalemli-Ozcan et al. (2012).

  31. Berrospide (2013), para. 3.1. For an overview of the stages of the financial crisis, see BIS (2009).

  32. For an empirical survey on the magnitude of banks’ loss-absorbing capacity and capital erosion during the financial crisis, see Strah et al. (2013). See also Rosengren (2013).

  33. BCBS (2011), para. 35. See also BCBS (2013), para. 2.

  34. Berrospide (2013), para. 1. For more details, see Gale and Yorulmazer (2011), Acharya and Merrouche (2013).

  35. Acharya and Merrouche (2013), para. 5. See also Heider et al.(2009), para. 1.

  36. On the issue, see Gorton and Metrick (2010), para. 4.

  37. For an empirical assessment, see Cornett et al. (2011). According to the authors, during the financial crisis, the poor management of liquidity risk was one of the main reasons for the decline in credit supply.

  38. BCBS (2011), paras. 8–10 and 11–15.

  39. On the issue, see BCBS (2011), para. 8. See also Musch et al. (2008), at pp. 107, 108.

  40. BCBS (2011), para. 11.

  41. See, in general, BCBS (2011), at p. 3. On the issue, see also D’Hulster (2009).

  42. BCBS (2011), paras. 40, 41. For technical insights on the LCR, see BCBS (2013).

  43. Idem, para. 42. For a technical survey on the final structure of the NSFR, see BCBS (2014b).

  44. BCBS (2011), para. 43.

  45. On the differences between microprudential and macroprudential regulatory framework, inter alia, see Schwarcz (2015). See also Kashyap et al. (2010), Borio (2003).

  46. Gordy and Howells (2006), at p. 395. See also Andersen (2011).

  47. Blundell-Wignall and Atkinson (2010), at p. 5.

  48. Idem, at pp. 5, 6.

  49. Idem, at p. 6.

  50. CGFS (2010), at p. 10.

  51. In particular, see the recommendations in FSF and BCBS (2009), at pp. 1–6.

  52. BCBS (2011), para. 18.

  53. Minsky (1986b), at p. 3. More generally, see also Delli Gatti et al. (1994), para. III, stating that to contain the eruption of a financial crisis, capitalist economies developed a set of institutions and authorities that can be considered as ‘circuit breakers’. For a deeper analysis of the role that institutions play in Minsky’s theory, see Sinapi (2011).

  54. See Caruana (2010), at pp. 3, 4.

  55. IMF (2012), at pp. 76 and 82.

  56. For the resulting aspect of risk sensitivity of Basel II, see BCBS (2011), paras. 20–22. See also FSF and BCBS (2009), at p. 2.

  57. BCBS (2011), paras. 20 and 33.

  58. See BCBS (2011), para. 97.

  59. Ibid, paras. 151–167. For a better understanding of the main features of the Basel III leverage ratio, see also BCBS (2014a).

  60. For a better understanding of how the leverage ratio behaves over the cycle, see Brei and Gambacorta (2014).

  61. BCBS (2011), para. 16.

  62. For an assessment of the impact of this forward-looking provisioning, see Cummings and Durrani (2014).

  63. See BCBS (2011), paras. 26–28 and 122–135.

  64. BCBS (2011), paras. 124–126.

  65. FSB, BIS and IMF (2011), at p. 5. See also Krishnamurti and Lee (2014), at pp. 33, 34. For a better understanding of the rationale and dynamics of macroprudential regulation, inter alia, see Hanson et al. (2011), Borio (2003, 2009), Borio and Shim (2007), Nier (2011), Gohari and Woody (2015). For a literature review, see Galati and Moessner (2011).

  66. More specifically, Basel III has designed the countercyclical capital buffer as an extension of the capital conservation buffer. Banks thus have to set up this integrated buffer above the regulatory minimum Tier 1 capital requirement, enlarging the size of its range. For the technical details, see BCBS (2011), Annex I.

  67. See, for example, the Recommendation of the ESRB of 18 June 2014 on guidance for setting countercyclical buffer rates (ESRB/2014/1), Recital (1). For a literature review on the mechanisms of shock transmission, see De Bandt and Hartmann (2000), at pp. 18–36.

  68. This opinion is shared by Repullo and Saurina (2011), at p. 4. Following the Basel III Accord, specific rules on the countercyclical capital buffers have been operationalised in the US and EU. In the US, the discipline is laid down in 12 CFR § 324.11—Capital conservation buffer and countercyclical capital buffer amount. In the EU, Art. 130 of Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2012 (Capital Requirement Directive IV, or CRD IV) establishes the European framework for the countercyclical capital buffer.

  69. This flexibility has been recognised in the European framework (CRR/CRD IV), where national authorities have great discretion in the calibration and application of the buffers. On the issue, see Deutsche Bundesbank (2013), at p. 63.

  70. For a definition of time-varying instruments, see Lim et al. (2011), at p. 5. For a survey on the efficiency of time-varying policy, see Sharma (2013).

  71. Repullo and Saurina (2011), at p. 3.

  72. Caruana and Cohen (2014), at p. 18. See also Jiménez et al. (2012), showing that countercyclical capital buffers have positive effects in terms of credit availability in bad times; for the optimality of having time-varying capital requirements to tolerate a greater probability of default when economy-wide bank capital is scarce relative to lending opportunities, cf. Kashyap and Stein (2004).

  73. BCBS (2011), paras. 146, 147.

  74. Idem, paras. 139–145.

  75. For further technical details of the operationalisation of the countercyclical capital buffers, see also Detken et al. (2014).

  76. Repullo and Saurina (2011), at p. 8.

  77. See BCBS (2010a), Annex 2. For a critical assessment of the credit-to-GDP gap in calibrating this buffer, see Repullo and Saurina (2011). See also Drehmann and Tsatsaronis (2014).

  78. Inter alia, see CRD IV, Recital (79), and CRR, Recital (90).

  79. See Recitals (9) and (10) CRR.

  80. Elizalde (2007), at p. 1.

  81. See Deutsche Bundesbank (2013), at pp. 56, 57. See also Recital (11) CRR.

  82. According to Recital (12) CRR, ‘shaping prudential requirements in the form of a regulation would ensure that those requirements will be directly applicable. This would ensure uniform conditions by preventing diverging national requirements as a result of the transposition of a directive. This Regulation would entail that all institutions follow the same rules in all the Union, which would also boost confidence in the stability of institutions, especially in times of stress. A regulation would also reduce regulatory complexity and firms’ compliance costs, especially for institutions operating on a cross-border basis, and contribute to eliminating competitive distortions’.

  83. For an overview of the characteristics of contingent convertible bonds, see Avdjiev et al. (2013). For a legal analysis of CoCos, see Biljanovska (2016).

  84. See, in particular, Art. 63 CRR.

  85. For an empirical assessment of the procyclical behaviour of credit institutions arising from the approaches for the calculation of risk weights as established in Basel II and III (i.e., Standardised Approach and IRB Approach), see Heid (2007).

  86. Art. 166(8) and (9) CRR.

  87. For a brief comparison of the CRR and the CRD III framework regarding the Standardised Approach, see Allen & Overy (2014a).

  88. Idem, at p. 3.

  89. For further details on the standards for the competent authorities’ assessment of an application to use the IRB Approach, cf. Art. 144 CRR.

  90. EBA (2015), at p. 32.

  91. Behn et al. (2014), at p. 2.

  92. For details, see BCBS (2001).

  93. For an interesting empirical study on the procyclicality underlying the IRB Approach, see Goodhart and Segoviano (2004).

  94. The CRR/CRD IV package does not directly introduce any accounting provisioning, as rules on accounting standards fall outside of the scope of the prudential package. However, the IRB Approach, albeit not dynamic, is certainly forward-looking as it is a model based on expected losses. On the role of dynamic provisioning in the CRR, see Burroni et al. (2009), at pp. 7–10. As stated in Recital (13) CRR, ‘in areas not covered by this Regulation, such as dynamic provisioning…, competent authorities or Member States should be able to impose national rules, provided that they are not inconsistent with this Regulation’.

  95. See Allen & Overy (2014b), at p. 4.

  96. The CRR defines the PD as the probability of default of a counterparty over a one-year period.

  97. The LGD is the ratio of the loss on an exposure due to the default of a counterparty to the amount outstanding at default.

  98. Using the words of the CRR, we refer to the amount outstanding at default.

  99. See Art. 162 CRR.

  100. See, in particular, Recitals (90) and (91) CRR.

  101. Art. 429(2) and (3) CRR.

  102. Art. 429(5) CRR.

  103. Art. 429(6) CRR.

  104. Art. 429(9) and (10) CRR.

  105. Recital (80) CRD IV.

  106. Art. 129(2) CRD IV.

  107. Art. 136 CRD IV.

  108. Art. 135 CRD IV.

  109. Art. 130(2) CRD IV.

  110. Art. 141 CRD IV.

  111. For a deeper understanding of the SREP, see Guidelines for common procedures and methodologies for the supervisory review and evaluation process (SREP). EBA/GL/2014/13, 19 December 2014.

  112. About the possibility to use the Pillar 2 instruments to counter procyclicality, see, in particular ESRB (2014), at pp. 133–140.

  113. Minsky (1986a, b, 1992a, b), at p. 219.

  114. Ibid; see also Palley (2013), at pp. 135, 136.

  115. See, in particular, Cerutti et al. (2015).

  116. Gerding (2013), at p. 261.

  117. Idem.

  118. Pistor (2013), at p. 327.

  119. Kaplan (2013).

  120. For incentive effects of capital requirements on off-balance sheet regulatory arbitrage in the case of securitisation contributing to the subprime crisis, cf. Calomiris (2009), at pp. 65, 66.

  121. European Commission (2013), at p. 4.

  122. See Recitals (9) and (10) CRR.

  123. Masera (2014), at pp. 394, 395.

  124. See Behn et al. (2014), at p. 2.

  125. See BCBS (2010b).

  126. Previously, other empirical studies acknowledged the same results. See, for example, Repullo and Suarez (2004), Rime (2003), Hakenes and Schnabel (2006).

  127. See, again, European Commission (2013), at p. 4.

  128. For this broad scope of application, cf. BCBS (2014c) at p. 10.

  129. On the issue, see Berger and Udell (2002). See also Berger et al. (2005).

  130. See Angelkort and Stuwe (2011), at pp. 6, 7. On the relationship between small local banks and SMEs financing, see also European Association of Cooperative Banks, ‘SMEs and co-operative banks are an essential part of the “real economy” of the EU’, Annex to EACB-UEAPME open letter, 21 November 2014. Similarly, on the fundamental role of SMEs, see Recital (44) CRR.

  131. Art. 501(2) CRR.

  132. For the definition of SMEs, see Commission Recommendation 2003/361/EC concerning the definition of micro, small and medium-sized enterprises, OJ 2003 L 124/36, Art. 2, stating that the category of SMEs is made up of enterprises which employ fewer than 250 persons and which have an annual turnover not exceeding EUR 50 million, and/or an annual balance sheet total not exceeding EUR 43 million.

  133. See Art. 123 CRR.

  134. See Art. 122 CRR.

  135. Angelkort and Stuwe (2011), at pp. 12, 13.

  136. See, for example, Eurochambres, Basel III-CRR/CRD IV, Position, Brussels, January 2012.

  137. On the channels of adjustment of banks’ capital following a regulatory increase of capital requirements, see Cohen (2013), at pp. 26, 27. See also Cohen and Scatigna (2014).

  138. Cohen and Scatigna (2014), at p. 1.

  139. See on the issue, Fitch Ratings. Basel III: return and deleveraging pressures. Macro Credit Research, 17 May 2012, available at www.fitchratings.com.

  140. Idem.

  141. See Timmermans (2012), at pp. 24–29.

  142. For these costs arising in different exemplary scenarios, see Baker and Wurgler (2015), Härle et al. (2010), at p. 2.

  143. For issues of new shares by large banks as examples, see Shotter J, ‘Commerzbank to raise €1.4bn to boost capital’, Financial Times, 27 April 2015, available at http://www.ft.com/intl/cms/s/0/aa01ae20-ecf8-11e4-a81a-00144feab7de.html#axzz3eMln6NxH; Aloisi S, Sassard S, ‘Monte Paschi approves capital increase for up to 2.5 billion euros’, Reuters, 5 November 2014, available at http://reut.rs/1shgwXX.

  144. See Conference of State Bank Supervisors (2011), at p. 4.

  145. Idem.

  146. Angelkort and Stuwe (2011), at pp. 11, 12.

  147. Cohen and Scatigna (2014), at p. 26.

  148. Idem.

  149. Timmermans (2012), at p. 14.

  150. Laeven et al. (2014), at p. 10. See also Masera (2013), at p. 395.

  151. Idem.

  152. See BCBS (2011), para. 152.

  153. Inter alia, Schäfer D, ‘Deutsche Bank to cut balance sheet to comply with leverage rules’, Financial Times, 30 July 2013, available at http://on.ft.com/12AHgvk. See also Stevens L, ‘Deutsche Speeds Up Plan to Shrink Size’, Wall Street Journal, 22 July 2013, available at http://on.wsj.com/1zFA6BZ.

  154. See Shotter J, ‘Commerzbank warns of future challenges’, Financial Times, 12 February 2015, available at http://on.ft.com/1MhJDqB.

  155. For better insights into the deleveraging process after the implementation of Basel III, see O’Sullivan and Kinsella (2011).

  156. See Commission Delegated Regulation (EU) 2015/62 of 10 October 2014 amending Regulation (EU) No. 575/2013 of the European Parliament and of the Council with regard to the leverage ratio, OJ L 11, 17 January 2015, pp. 37–43.

  157. According to Art. 429(8), institutions may determine the exposure value of cash receivables and cash payables of repurchase transactions, securities or commodities lending or borrowing transactions, long settlement transactions and margin lending transactions with the same counterparty on a net basis only if: (a) the transactions have the same explicit final settlement date; (b) the right to set off the amount owed to the counterparty with the amount owed by the counterparty is legally enforceable in the normal course of business or in the event of default, insolvency and bankruptcy; (c) the counterparties intend to settle net, settle simultaneously, or the transactions are subject to a settlement mechanism that results in the functional equivalent of net settlement.

  158. Art. 429(10) CRR.

  159. Art. 429(11) CRR.

  160. Art. 429(14) CRR.

  161. According to Sabine Lautenschläger, Deputy President of the Deutsche Bundesbank and President’s Alternate in the Governing Council of the ECB, this setting of the leverage ratio rules ‘punishes low-risk business models, and it favours high-risk businesses, encouraging banks to engage in more risk-taking’. See Sabine Lautenschläger, The leverage ratio: a simple and comparable measure? Speech held at the evening reception of the Deutsche Bundesbank/SAFE Conference ‘Supervising Banks in Complex Financial Systems’, Frankfurt, 21 October 2013. See also German Banking Industry Committee, Comments on the leverage ratio in follow-up to the lcr-lr-hearing of the EU Commission on 10 March 2014. In the words of this report (p. 5): ‘[B]anks which have specialised in less risky business areas such as construction finance, commercial real estate or housing loans or mortgage bond business will be significantly disadvantaged’.

  162. Inter alia, Bershidsky L, ‘The incredible shrinking EU bank’, Bloomberg View, 2 April 2015, available at http://bv.ms/1anZTIp; Moshinsky B, ‘EU banks shrink assets by $1.1 trillion as capital ratios rise’, Bloomberg Business, 17 December 2013, available at http://www.bloomberg.com/news/articles/2013-12-16/eu-banks-shrink-assets-by-1-1-trillion-as-capital-ratios-rise.

  163. For the decrease of lending volume following from an increase of CET 1, see the Macroeconomic Assessment Group (MAG) established by the BIS in 2010, which reported that an increase of 1 % in CET 1 in 4 years leads to a 1.4–1.5 % decrease of lending volume, with a following drop in the global real GDP of around 2 %. For details, see MAG (2010), at p. 5. See also Gavalas and Syriopoulos (2014).

  164. See Kalemli-Ozcan et al. (2012), at p. 292. The authors found that before the crisis smaller European banks displayed a surprisingly stable level of asset growth and no hint of procyclical leverage.

  165. Borgioli et al. (2013), at pp. 17, 18.

  166. Idem.

  167. See KPMG (2013), at p. 2.

  168. See for examples in Germany and Italy, where a large fraction of the banking market consists of savings and cooperative banks: Henning H, ‘Consolidation wave likely for German banks’, Wall Street Journal, 4 April 2014, available at http://on.wsj.com/1safCT4; Sanderson R, ‘Merger season looms for Italy’s popolari’, Financial Times, 30 March 2015, available at http://on.ft.com/1FaYDT.

  169. On the issue, see Berger and Humphrey (1993).

  170. Bini Smaghi (2007). For a comparative evaluation of how small banks are currently reacting to the new provision of the Dodd-Frank Act in the US largely confirming these results, see Peirce et al. (2014).

  171. Idem.

  172. See Association of Sparda Banks e.V. (2013), at p. 5.

  173. See Bini Smaghi (2007).

  174. See Mersch (2015), according to whom ‘there are too many banks in Europe relative to the size of the market. This implies that there is significant scope to benefit from rationalisation, and without exacerbating the problem of “too big to fail”’.

  175. See Peirce et al. (2014), at pp. 49–52.

  176. As seen above (see supra nn. 167 and 168 and corresponding text), Germany and Italy can be taken as proxies of such a consolidation wave in Europe.

  177. For a critical evaluation of costs and benefits of banking mergers in the EU, see Hagendorff and Nieto (2015).

  178. Inter alia, European Association of Cooperative Banks, supra n. 130; Eurochambres, supra n. 136.

  179. Deutsche Bundesbank (2013), at p. 63.

  180. Masera (2013), at p. 396.

  181. Art. 501(2) CRR.

  182. See German Banking Industry Committee, Indicators for risk development of loans to small and medium-sized enterprises (SME), 2 March 2012, at p. 6. See also Deutsche Bundesbank (2013), at p. 63.

  183. Deutsche Bundesbank (2013), at p. 63.

  184. A further buffer with countercyclical effects is the systemic risk buffer laid down in Art. 137. However, since its rationale lies in preventing and mitigating long-term non-cyclical systemic or macroprudential risks not covered by the CRR, we do not consider it as a proper countercyclical tool. For this reason, this buffer is not treated in this paper.

  185. Art. 131(5) CRD IV.

  186. Art. 131(6) CRD IV.

  187. Art. 131(14) CRD IV.

  188. Indeed, this one-size approach has been contested by the Financial Policy Committee (FPC) established by the Financial Services Act 2012 as UK macroprudential authority. For details, cf. Tucker et al. (2013).

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Acknowledgments

I gratefully acknowledge research support from the Center of Excellence SAFE, funded by the State of Hessen initiative for research LOEWE.

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  1. Doctorate/PhD Program in Law and Economics of Money and Finance, Goethe University Frankfurt, Frankfurt/M., Germany

    Luca Amorello

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Luca Amorello: Doctoral Candidate.

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Amorello, L. Europe Goes ‘Countercyclical’: A Legal Assessment of the New Countercyclical Dimension of the CRR/CRD IV Package. Eur Bus Org Law Rev 17, 137–171 (2016). https://doi.org/10.1007/s40804-016-0032-4

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