21 June 2007
The Committee of European Banking Supervisors (CEBS) has been invited by the European Commission to check whether further convergence can be achieved on the prudential treatment of hybrids and to report back by the end of 2007.
CEBS is keen to balance out the views of investors, issuers, rating agencies and supervisors in order to find convergence in the prudential treatment of hybrid capital.
In that context, CEBS organised a hearing open to all interested parties on 'towards further convergence on own funds in Europe' on 11 June 2007 in London.
The objective of the event was to hear about the range of concerns the current definition of own funds in the EU, and especially Tier 1 hybrid capital instruments, causes for market participants and their views on what a more consistent definition would look like.
The discussion was based on the four fact-finding exercises CEBS has carried out so far, which provide a full picture of the similarities and differences between eligible capital elements across the EU and their quantitative relevance. A special focus centred on instruments which combine features of both debt and equity, and that can be eligible in some countries as original own funds. These reports are available here.
A wide range of market participants including investment banks, commercial banks, trade associations and rating agencies contributed to the discussion. CEBS Experts and representatives from the Basel Group on Definition of Capital also participated in the hearing.
The main focus of the discussion was on how to achieve convergence in the treatment of Tier 1 hybrids in Europe. Comments were also made on the other main differences highlighted in CEBS's reports of June 2006 (e.g. amortization of Tier 2 instruments and deductions) and on the application of the prudential filters.
Principles versus detailed rules
Participants in the hearing were very supportive of CEBS's emphasis on finding common high level principles but some flagged that the higher the level, the more difficult convergence is likely to be. Others commented that the principles should not be too prescriptive.
The Chair emphasized that the convergence work was intended to achieve a common interpretation of the 1998 Sydney Press Release. CEBS would work in parallel with Basel on any new framework for own funds.
Industry warmly encouraged CEBS to define clearly the economic characteristics of Tier 1 eligible hybrid instruments to ensure convergence on the application of commonly agreed principles and a level playing-field across countries.
Some market participants questioned how realistic CEBS's convergence proposals can be in practice, referring to the overall discussion on Level 3 tools which are not legally binding. They acknowledged that legal framework and tax systems are of importance when creating a level-playing field across Europe, Moreover, they indicated that what matters most was the legal clarity and certainty of the forthcoming CEBS proposals.
Disclosure and transparency were identified as important drivers of convergence. Participants were also reassured that regulators talked to each other when a new issue is in the market.
The eligibility criteria for Hybrid Capital
Overall the industry was supportive of the approach of basing convergence on the three eligibility criteria that the CEBS surveys had identified (permanence, loss absorption and flexibility of payments)
They stressed that these criteria should not be taken in isolation from each other as they are closely inter-related; indeed the criteria of 'permanence' and 'flexibility in the amount and timing of distributions/payments' can be seen as ways to ensure that the third criteria of 'loss absorption' actually works on a going concern basis and when needed in a stress situation. Defining this last criterion was unanimously seen as the most important as supervisors do not currently have the same understanding of what it means. Some market participants questioned whether permanence was not becoming less important in face of increasing need for flexibility in the capital management.
Market participants agreed that the principle of 'substance over form' should be emphasized as what matters most is to check how hybrid instruments perform under stress situations. Likewise, there was a supportive consent from attendees of not strictly following the accounting definition of 'equity' as it is still a moving target.
Some attendees suggested taking real cases, while recognizing that there have not been many cases, at least in the EU. Another suggestion was to use stress scenarios and see how a given hybrid might behave.
The limits to inclusion of Hybrid Capital in Tier 1
Market participants acknowledged that convergence was already achieved in the limits for innovative instruments (hybrids with incentives to redeem). Further work needed to be done for the other categories of hybrids.
Market participants proposed that CEBS consider making some sort of trade off between the eligibility criteria and the limits to the inclusion of hybrids as eligible Tier 1 capital.
If CEBS offers a clear understanding of sufficiently robust criteria, and is sure that the hybrids can meet them, then there is room for having limits which are less stringent.
If however CEBS cannot reach a clear understanding of these criteria, or if there is uncertainty whether hybrids are really loss-absorbent, the need to impose a stringent limit would be greater.
Some invitees argued that Basel 2 is changing the way institutions are managing their capital - bringing more volatility on the asset side. They therefore expect the capital base to adapt to that new environment and to be 'flexible' with, for instance, shorter call periods.
Others proposed a two-tiered approach: stringent limits for small and less sophisticated institutions and reliance on internal economic capital models and capital allocation for large, more complex banks to be dealt with under Pillar 2.
The use of prudential filters: Some market participants expressed concerns over the divergence of the share of unrealized gains included in additional own funds-especially for equities classified as "available for sale", which have the largest impact. Another concern related to the divergence of national filters applied to pension schemes. They welcomed CEBS's efforts to achieve more convergence in the application of the prudential filters.
Subordinated debt instruments: No concrete proposals were put forward by market participants on how to converge on the amortization of Tier 2 capital. They agreed that there should be a scaling of criteria between Tier 1 and Tier 2 instruments and that the eligibility criteria for Tier 2 instruments should be less stringent than those for Tier 1 instruments.
Deductible elements and ways of deducting from own funds: The industry invited CEBS to find greater convergence on the way participations in insurance undertakings are treated by national supervisors, with particular reference to the notion of "participation". Market participants also asked for clarification of how the other methods for the prudential treatment of participations in insurance undertakings (provided in the Financial Conglomerate Directive) work. In response, it was pointed that this was indeed currently being discussed jointly with CEIOPS.