CEBS today publishes the first part of its technical advice on the review of the large exposures regime

The Committee of European Banking Supervisors (CEBS) today publishes the first part of its response to the European Commission's Call for Advice on the review of the large exposures regime.

The first part of the advice sets out CEBS' views on a number of key concepts regarding the large exposures regime. When elaborating its views, CEBS has benefited from the input already gathered in the context of its survey of industry practices published here LE_industryreport.pdf and from the feedback received on its consultation paper CP 14. In addition, a public hearing was held on 11 July at CEBS' premises.

The advice sets out CEBS' understanding of the objectives and purposes of a large exposures regime. CEBS believes that ensuring that risks arising from individual exposures to individual counterparties or groups of connected counterparties are kept to an acceptable level follows from the overarching principles of prudential supervision. CEBS believes that a market failure arises as a result of large single name exposures that give rise to the risk of traumatic losses due to "unforeseen events" and that this market failure is not fully addressed by any of Basel II's three pillars. CEBS' view is that there is therefore a remaining risk related to large exposures that justifies some regulatory intervention.

After discussing the set of different policy options available, CEBS has concluded that a limits-based "back-stop" regime is the most appropriate regulatory tool. As the current regime has some shortcomings that need to be addressed, an amended limits-based "back-stop" regime is proposed.

CEBS' analysis of third countries' approaches to large exposures concludes that the EU regime is not generally more strict than any other individual regime, although it is possible to find some particular transactions that are treated more strictly in the EU than elsewhere.

The advice discusses the adequacy of the current large exposures limits. On the basis of the analysis carried out, and given the nature of unforeseen event risk arising from defaults on large exposures and the low but material default rates of highly rated entities, CEBS has formed the opinion that the introduction of counterparty credit quality so as to relax or remove the regulatory large exposures limits for highly rated counterparties does not fully address the identified market failures.

CEBS believes that, on balance, the 800% aggregate limit can be maintained given its merits in providing a harmonised minimum standard for ensuring granularity of the credit portfolio. It is also perceived as a mechanism for limiting the extent to which losses not covered under the Pillar 1 capital requirements are inherent in the portfolio. CEBS also believes that compliance with this limit should not replace in any way the requirement to manage concentration risk under Pillar 2.

The advice also sets out CEBS' current thinking on the calculation of exposure values. For off -balance sheet items CEBS proposes a set of principles on the basis of which advanced IRB institutions are permitted to use their own exposure calculations as used for regulatory capital requirements purposes. For institutions that have not been authorized to use their own estimates of conversion factors, CEBS recommends the assignment of a 100% conversion factor except for low risk items (as defined in the Annex II of the CRD) to which 0% will generally be applied. However, while the 100% conversion factor might prove to be too conservative for certain transactions, the 0 % conversion factor might prove to be too lenient for others. Therefore CEBS will analyse - within the context and objectives of the LE regime - which transactions can/must be exempted from these flat conversion factors.

For Collective Investment Undertakings, structured transactions and other arrangements where there is exposure to underlying assets, CEBS considers that a principles-based approach is appropriate. A set of principles is thus proposed bearing in mind that further work on to how to implement them will still be necessary.

CEBS also puts forward its initial thinking on the main issues to be considered in part 2 of its advice to the European Commission. These views are subject to the outcome of the work currently being carried out by CEBS.