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CEBS Consultation Paper (CP14) Summary

Core Content

This Consultation Paper (CP14) by CEBS outlines its initial views on the regulation of large exposures, forming the basis for stakeholder engagement in response to the European Commission's Call for Technical Advice (No. 7) on the review of Large Exposures (LE) rules. The paper is part of a two-part process, with Part 1 focusing on objectives and purposes, and Part 2 addressing other regulatory aspects such as credit risk mitigation and intragroup exposures.

Main Views and Key Information

Purpose of Large Exposures Regulation

CEBS identifies three main types of concentration risk:

• Undiversified idiosyncratic risk: Risk arising from lack of diversification in single-name exposures.
• Sectoral and geographic concentration risk: Risk from correlations within and between sectors and geographies.
• Unforeseen event risk: Risk from events outside the scope of portfolio capital allocation that can cause significant losses.

CEBS emphasizes that the central purpose of the LE regime is to limit the risk of traumatic losses that could threaten an institution's solvency due to unforeseen events, such as the failure of a highly rated counterparty.

Market Failure / Regulatory Failure Analysis

CEBS conducts a market failure analysis (MFA) and regulatory failure analysis (RFA) to identify the extent of market inefficiencies and regulatory shortcomings.

• Relevant Markets: The LE regime primarily regulates the credit market, limiting exposures to single counterparties or groups of connected entities.
• Potential Market Failures:
  • Negative externalities: Institutions may not consider the social costs of their risk-taking on third parties.
  • Information asymmetries: There may be a lack of transparency regarding large exposures and risk management practices.
• Regulatory Failures: CEBS suggests that the LE regime may be a regulatory response to perceived market failures, or it may itself represent a regulatory failure if it is not proportionate or effective.

CEBS acknowledges that the MFA is partial and requests further input from stakeholders on the extent of market failure and whether other mechanisms can mitigate it.

Evidence of Past Failures

CEBS notes that there have been only a limited number of actual failures or difficulties due to single name concentration risk. However, it provides two examples of challenges related to exposures to groups of connected counterparties.

Cost Benefit Analysis

CEBS is in the process of conducting a cost benefit analysis (CBA) to evaluate the impact of the current LE regime on institutions. A questionnaire has been distributed to a sample of institutions in 15 EEA Member States, and the results are expected in the summer of 2007. The current orientations in the CP are considered provisional and will be reviewed in light of this data and stakeholder feedback.

Large Exposures Limits

• Credit Quality Recognition: CEBS is not persuaded that counterparty credit quality should be reflected in large exposures limits, due to the low but material default rates of highly rated entities and the nature of unforeseen event risk.
• 800% Aggregate Limit: CEBS seeks stakeholder views on the purposes, benefits, and risks addressed by the 800% limit, as well as the appropriate way forward.

Calculation of Exposure Values

CEBS explores the possibility of converging internal exposure calculation methods with regulatory requirements. It proposes principles that may allow more sophisticated institutions to use their own internal models. For less complex institutions, it considers the use of national discretions for off-balance sheet items and requests feedback on how these items are treated internally.

Treatment of Specific Exposure Types

CEBS aims to develop principles for the treatment of exposures to:

• Collective investment schemes
• Structured finance transactions
• Other arrangements involving underlying assets

CEBS has not yet addressed the treatment of liquidity facilities for structured finance or nth-to-default products, and invites stakeholders to provide their views on these matters.

Stakeholder Engagement

CEBS is seeking feedback on several key issues:

1. Agreement with the analysis of prudential objectives.
2. Views on the presence of market failure related to unforeseen event risk.
3. Additional evidence to support the market failure analysis.
4. Whether the EU LE regime is consistent with regimes in other jurisdictions and whether it causes competitive disadvantage.
5. Views on the recognition of credit quality in large exposure limits.
6. Perceived risks and benefits of the 800% aggregate limit.
7. Principles for risk measurement and management.
8. Suitability of proposed principles for institutions using advanced approaches.
9. Support for harmonisation of conversion factors for off-balance sheet items.
10. Importance of national discretions.
11. How these facilities and transactions are treated internally.
12. Views on the proposed principles for collective investment schemes and structured finance.

Timeline and Next Steps

• Consultation Period: Ends on 15 August 2007.
• Public Hearing: Organised on 11 July at CEBS premises.
• Deadline for Final Report: End of September 2007.
• Part 2 of the Call for Advice: Will address other issues such as credit risk mitigation, intragroup exposures, reporting, and definitions.

Conclusion

CEBS aims to develop a coherent and proportionate large exposures framework that aligns with the objectives of the CRD and the better regulation agenda. The current CP represents an initial orientation and will be refined based on stakeholder input and further analysis, particularly in relation to cost data and the broader regulatory implications.