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Firms should be well prepared for CRD Back  
The Capital Requirements Directive (CRD), which will introduce a new supervisory framework for capital requirements in Europe, will take effect on January 1st, 2007. The Directive enables firms to take one of three approaches in implementing the Directive. Kevin Allen assesses the Irish implementation progress, and says that firms should be well advanced in their decision making process with respect to how the new requirements will impact on their operations going forward.
Implementation
The Capital Requirements Directive (CRD) will take effect on 1 January 2007. The Financial Regulator has engaged with the industry regarding the implementation process for Ireland and has set out in detail the approach it proposes to take in areas where national discretion (of which there are in the region of 120) exist.

Application
It was originally intended that the implementation date for CRD would dovetail with that of the Markets in Financial Instruments Directive (MiFID). However the MiFID implementation date has been pushed out to November 2007 whilst the CRD will become applicable in January, ahead of MiFID.

The CRD replaces the existing capital framework set out in the Capital Adequacy Directive (for firms currently authorised under the Investment Intermediaries Act, 1995 or the Stock Exchange Act, 1995) and under the Banking Consolidation Directive (for Credit Institutions). Accordingly , subject to some transition arrangements, on 1 January 2007 all investment firms and credit institutions authorised by the Financial Regulator will be required to comply with the CRD.

Funds industry issues
Fund promoters are currently required to hold minimum capital of ?635,000. The Financial Regulator has stated that the requirement to hold this level of capital will be unaffected by the CRD but has clarified that in cases where a promoter is authorised under the Investment Intermediaries Act, 1995 as well as acting as a UCITS promoter it will be required to satisfy the higher CRD capital requirements.

Initial capital requirement
Under the CRD, as is currently the position, the initial level of capital to be maintained will continue to depend on:
• The range of investment business services for which the firm is authorised
• Whether the firm is to hold client money/assets
• Whether the firm deals on own account

By way of example, a firm which holds client money and receives/transmits or executes orders must have initial capital of €125,000 provided the firm does not deal in any financial instruments for its own account or underwrite issues of financial instruments:
If the firm also deals on own account its initial capital requirement increases to €730,000.

Ongoing capital requirement
As is the case at present, under the CRD a firm must maintain capital equivalent to or more than the amount of either (a) or (b) below. What is new under the CRD is the requirement to maintain additional capital for operational and credit risk.

Accordingly, from January 2007 a firm must ensure the capital it maintains is equal to or in excess of either:

a) One quarter of its preceding year’s fixed overheads
b) The sum of:
• the capital requirements calculated in respect of position risk, settlement and counterparty risk for trading book business
• the capital requirements calculated in respect of foreign exchange and commodities risk
• the capital requirement in respect of credit risk
• the capital requirement in respect of operational risk

Importantly, in recognising that a one size fits all model is not appropriate, credit institutions and investment firms are being given the choice of adopting different models in respect of their calculation of credit risk and operational risk.

Credit risk
Two methods for calculating the capital required for risk weighted exposure amounts are provided for in the CRD.
First, is the Standardised Approach. This approach requires firms to maintain capital at an eight per cent of risk weighted exposure level. (An exposure is ‘an asset or off-balance sheet item’).
The alternative is the Internal Ratings Based Approach. This approach allows firms to provide their own estimate of credit risk.

The Financial Regulator must approve all proposals to adopt an Internal Ratings Based Approach. It will only approve this approach if the firm has sophisticated systems in place to manage credit risk. In many cases the cost of instituting new structures within an organisation could far outweigh any benefits that might arise over and above conforming to the Standardised Approach.

Operational risk
Four methods of calculation are provided for in the CRD. The adoption of one of these options - the Alternative Standardised Approach - is left to the discretion of each Member State. The Financial Regulator has stated that they do not intend implementing this approach in Ireland. Accordingly only three calculation methods are available for operational risk in Ireland. They are:

• The Basic Indicator Approach - under this approach the capital requirement will be based on a percentage of the average over 3 years of net interest income and net non-interest income. (The CRD sets down detailed rules on how to calculate this amount.)
• The Standardised Approach - In order to use this approach firms must be able to comply with the following qualifying criteria:
a) The firm’s board must have appropriate involvement in the oversight of operational risk
b) The firm must have a sound operational risk system
c) It must have sufficient resources in each line of business
• The Advanced Measurement Approach – more stringent qualifying criteria are set for firms wishing to use this approach. This approach will allow firms to calculate the capital requirement based on the firms own internal risk management measurement system. It appears that very few firms, if any, have indicated they will adopt this approach.
It is the case that only larger firms will be in a position to satisfy either the Advanced Measurement Approach or the Standardised Approach. The difficulty with the Basic Indicator Approach is that the capital charge on net income is likely to be quite significant. (The Financial Services Authority in the UK is looking at a 15 per cent capital charge in this regard). Accordingly, the availability of potential waivers from these requirements are an important consideration.
Firms which fall within either Article 20 (2) of the CRD (limited licence firms) or Article 20 (3) of the CRD (certain firms that maintain the €730,000 level of minimum capital) will not have to calculate an operational risk charge if the Financial Regulator grants a waiver.

If firms have not already done so they need to consider whether they fall within either of these two waivers. This should be done as soon as possible as there is likely to be a considerable capital requirement saving if an exemption is available from the Operation Risk requirements.

Conclusion
The CRD consists of what are known as three Pillars. In addition to the new minimum capital requirements (known as Pillar 1), firms will also be required to monitor on an ongoing basis whether, irrespective of the minimum requirements, they should hold additional capital against risks particular to their operations (Pillar 2). Going forward firms will also be required to publish details of their risks, capital and risk management procedures (Pillar 3).
Each of these Pillars contributes to the CRD being more comprehensive and risk sensitive than the existing capital adequacy regime.

As part of Pillar 2 all Credit Institutions are required to submit their completed Internal Capital Adequacy Assessment Process (ICAAP) to the Financial Regulator. At this stage all Credit Institutions adopting CRD between 1st January 2007 and 1st April 2007 should have already submitted their ICAAP. Credit Institutions adopting CRD on or after 1 April 2007 are required to submit theirs six months prior to changeover.

Firms should be well advanced in their decision making process with respect to how the new requirements will impact on their operations going forward. In particular, they should have assessed what options are available to them in relation to the methods for calculating the capital required.

In addition, they should have given consideration to when the new regime will become applicable to them. An option is given to firms to continue under the existing capital regime until 31 December 2007. If a firm avails of this option it cannot do so on a piecemeal basis. On 1 January 2007 it must either comply entirely with the new rules or continue to operate under the current regime. Importantly, if a firm intends taking this approach it must notify the Financial Regulator without delay, or in any event before 31 December 2006.

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