The EU’s Capital Requirements Directive V (CRD V) introduces new rules for prudential consolidation that did not feature in previous versions of the regulation. As a result, affected firms will need to reassess the way they construct the financial figures their supervisors use to ensure financial stability.
CRD V aims to introduce greater transparency by getting a more granular, consolidated view of diversified financial institutions. The term ‘prudential’ refers to the more conservative stance CRD V requires from banks as they construct financial statements for supervisors, from which the figures used also form the inputs for calculation of their Basel and CRD V capital requirements.
At its core, prudential consolidation follows very similar principles to the financial consolidation provisions contained in IFRS 3, 10 and 11. In CRD V, the EU makes specific references to IFRS but applies so-called ‘prudential adjustments’ to ensure a more cautious approach.
As a result of this approach regulated entities may find themselves required to provide a different kind of account than under IFRS of the assets and liabilities of the firms within their purview. This would grow the level of complexity as more consolidation circles and methods need to be managed and processed under both IFRS and CRR. In addition the entity scope for IFRS and CRR might distinctly differ. Furthermore, financial institutions may face a higher number of sub-consolidations that they need to take into consideration when meeting their CRD V obligations.
Local authorities will have a say in the matter, particularly when it comes to deciding on which consolidation method to apply. In this case, additional reporting and disclosures might also be required on a sub-consolidation level.
In sum, prudential consolidation might multiply the number of disclosures and reporting requirements that institutions need to comply with. This is without taking into account the national variations.
Implications of CRD V for affected firms
With CRD V implementation under way, the implications for your finance, risk, data and regulatory activities are wideranging. CRD V adds various levels of consolidation, with sub-consolidations by country, region and other dimensions. The greater number of sub-consolidation levels that apply to your organization, the more important it is to address consolidation appropriately. Since there is a multiplication factor that can add to complexity substantially, it is essential that banks identify how many ‘CRD V units’ they have and calculate the amount of prudential consolidations they need to perform.
To begin with, CRD V (and coming CRR3 and CRD VI) will have a significant effect on your liquidity, solvency, credit and market risk calculations. This will also extend to the capital your firm needs to put aside to meet the more stringent requirements.
Outlined below are essential changes that are taking place:
b) Proportionality has been introduced, providing different methods for various levels of complexity. This applies to market risk, CVA, CCR, reporting, liquidity and NSFR.
c) The output floor has established a ‘backstop’ to minimal capital requirements when using internal models.
d) The FRTB has led to a redefinition of the boundary between the trading and non-trading books affecting both sides’ sizes.
e) Pillar 3 disclosures are now more standardized and aligned with regulatory reporting requirements.
CRD V’s consolidated prudential provisions require that financial institutions build on a consolidated view of their financial situation to create a consistent picture of:
- Consolidated liquidity (e.g. NSFR)
- Consolidated capital.
In addition, auditors and regulators will closely monitor how you organize yourself, your data and the processes to deliver these figures, not to mention your data reconciliations with other regulatory reports, such as FINREP. This indeed has all the signs of a perfect storm.
So, what steps should firms be taking not only to weather the coming storm, but to emerge on the other side stronger than before?
Finance and risk reconciliation
Although financial statements and regulatory reports serve different functions and differ in audiences, there is a need to reconcile them in order to minimize unintended effects on risk and risk management (See Basel Committee on Bank Supervision, WP 28, The interplay of accounting and regulation and its impact on bank behavior: Literature review, January 2015).
CRD V’s prudential adjustments for regulatory capital aim to build a bridge between the two. An example of this can be seen in the diagram below.