The following article will take a close look at the Liquidity and Leverage requirements of the Capital Requirements Directive (CRD) IV and the Capital Requirements Regulation (CRR). Other issues such as counterparty risk and the adoption of the single Europe
wide rule will also be discussed.

Liquidity

Due to Basel III and CRD IV, close monitoring and control have increased over credit and financial institutions’ liquidity and the role of senior management in setting risk boundaries has become more essential. Several new liquidity metrics are now available, the most prominent being the liquidity coverage ratio (LCR) and the Net Stable Funding Ratio (NSFR). The rules on the calculation of the LCR and NSFR have not been finalised as yet but regulators are gathering the necessary information in order to adjust the metrics adequately.

Liquidity Coverage Ratio (LCR)

This is designed to ensure that financial and credit institutions have the assets to handle short-term liquidity disruptions and that companies are able to improve their short-term resilience. The ratio also ensures that in a 30 day period of stress with an
LCR maintained at 100%, the company would be capable to withstand the pressure by having sufficient unencumbered high quality liquidity assets. If the percentage is lower than 100%, the institution would be subject to regulatory scrutiny and a plan would have to be drafted indicating how the institution plans to raise its liquidity buffer to reach the necessary limit.

Net Stable Funding Ratio (NSFR)

This deals with ratios of both long term assets and long term funding. The NSFR supports them and will come into practice as of January 2018. Until then, there will be other general rules regarding long term funding for financial institutions from January 2016. The main objective behind these rules is for institutions to actively deliberate on their funding profile for the next 2 years.

The remaining issues concerning liquidity, the LCR and NSFR will be resolved in the following months because the EU is currently completing them to be in line with the international Basel III agreement and is currently on track with their 2015 and 2018 implementations.

Leverage

A new leverage ratio will be introduced by the CRD IV to protect against the risks often attributed to risk models. The new ratio is calculated by dividing the Tier 1 capital by a measure of the institution’s non-risk weighted assets, including the institution’s on and off balance sheet amounts. The new leverage ratio has not yet been finalised. Nonetheless, during the calibration period a 3% ratio is being considered, meaning that Tier 1 capital wouldn’t be allowed to be lower than 3% of non-RWAs. Furthermore, institutions will have to adhere to a third prudential metric because unlike with Basel II calculations, on-balance sheet loans and deposits will not be allowed to be netted.

Initially being a Pillar 2 measure, the national regulator may alter the leverage ratio. In order to set the final ratio, the data gathered from January 2014 will be used. Leverage ratios will be disclosed publically in January 2015 within the European Union and according to Basel III from 2018 onwards in all EU countries, leverage ratios will be a pillar 1 measure. The amount of capital will no longer be the sole determinant of whether certain banking business can be done. Capital, liquidity and leverage would all have to be taken into serious consideration and decisions could involve sacrificing one in order to strengthen the other.

Finance and credit institutions will have to take into consideration other aspects apart from capital, liquidity and leverage. These include the following:

1. Single Europe-wide rule book

The rule book governs all of the EU’s financial institutions and it consists of the CRR together with the EBA’s Binding Technical Standards (BTS). By compiling a single rule book, the EBA’s objective is to reduce the amount of available national discretions which would in turn reduce the number of national divergences.

2. Counterparty Risk

CRD IV includes new regulatory exposure to central counterparties (CCPs) treatments, adjustments in credit values, increased capital charges for OTS derivatives for transactions which are not centrally cleared and wrong-way risk charges.

3. Reduction on the reliance on credit rating agencies

Credit and financial institutions should no longer rely on credit rating agencies to be given an overview of their credit exposure. In order to do this, institutions need to develop their own criteria on which they can rate their own credit exposure.

4. Single Supervisory Mechanism

The aim of the mechanism is to harmonise and strengthen sanctions across the EU resulting in the increase of fines in some EU jurisdictions.

5. Remuneration

The variable bonus payment is now limited to the 100% of the fixed salary amount for risk control, risk-takers and senior management. On the other hand, it may go up to 200% pending shareholders’ consent. 50% of the variable remuneration should be
paid in equity-linked products with at least 40% of the variable payment deferred to a maximum of 5 years.

CRD IV will undoubtedly pose challenges in the manner which financial and credit institutions are regulated but it concurrently helps institutions in the EU to comply with Basel III. A change in the way institutions behave and in the economic realities of banking are
inevitable. The new economic landscape will be shaped by the new regulations, information, disclosures and internal and external infrastructures.