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Ninth Report of Session 2019-21 Contents

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6COVID-19: Relaxation of EU capital requirements for banks47

These EU documents are legally and politically important because: they contain a series of amendments to EU rules on capital requirements to “maximise the ability of banks to lend during the coronavirus pandemic, while also ensuring their continued resilience”. The UK is expected to apply these legal changes when they become EU law for the duration of the post-Brexit transition period, but has no formal say in their making and the Government has not yet set out its views on the proposals. Action Write to the Economic Secretary to the Treasury (John Glen MP) to clarify the Government’s position on these changes to EU banking rules, and their implications for the British financial services industry and lending to businesses. Draw these developments to the attention of the Treasury Committee and the Committee on the Future Relationship with the EU.

Overview

6.1Actions taken by governments across the world to contain the coronavirus pandemic, including restrictions on people and businesses, have had severe economic consequences. Many companies have seen business dry up, and both workers and the self-employed have experienced sharp reductions in their income. Although this impact has been to some extent cushioned by government-funded interventions, such as the Coronavirus Job Retention Scheme in the UK, it has still led to a severe economic contraction globally.

6.2The Committee has focussed its work in recent weeks on the European Union’s policy and legislative responses to the coronavirus crisis and their implications for the UK during the post-Brexit transition period (during which the Withdrawal Agreement says at Article 127 that the UK should continue to apply EU law).48 This includes scrutiny of EU measures to help ensure that businesses hit by the crisis have sufficient funds to remain going concerns, and prevent workers and the self-employed from loss of income.49 The European Commission has, for example, significantly relaxed the rules around taxpayer-funded guarantees for bank loans, which we addressed in our recent Report on EU State aid rules and the coronavirus crisis.50

6.3The EU has also been mindful of the specific implications of the current situation for the banking sector, given its key role in facilitating business and access to funds in the wider economy. Due to the pandemic, lenders are simultaneously facing an increased risk of defaults on their existing loans, and more demand for funding from struggling businesses.

6.4Under banking laws, a substantial deterioration in the credit risk associated with its loan book has an impact on banks’ regulatory capital (shareholders’ equity) and other prudential requirements, which they need to maintain their solvency and preserve overall financial stability. For EU Member States and the UK, the current rules determining how banks must assess the risks associated with their loans — and how to adjust their capital in response those exposures — are set out in EU legislation:

• first, and most importantly, the EU has put in place a Capital Requirements Regulation (CRR) and Directive (CRD).51 They determine, among other things, the level of capital banks must have relative to their debt. The Regulation and Directive were originally agreed in 2013 in the aftermath of the financial crisis, but substantially amended only a year ago, in May 2019, to bring EU law further in line with international financial regulatory standards52 (with the bulk of the changes due to take effect in stages from the end of 2020 onwards);53 and
• separately, the EU has also passed legislation — based on the new international “IFRS9” accounting standard — setting stricter rules from January 2018 on how companies, including listed banks,54 should treat expected credit risk related to their commercial activities (i.e. likely losses on loans) on their balance sheet.55 In 2017, banks were given a special transition period to mitigate the impact of this change on their accounts and therefore on their prudential capital.56

6.5Since the coronavirus crisis increases the need for banks to lend to businesses, the potentially adverse effects of the EU’s prudential legislation under the current circumstances have therefore been the subject of numerous pieces of guidance from regulators in recent months.57 For example, the EU has been working for a number of years to address the financial stability risks arising from the large stock of bank loans unlikely ever to be repaid — called “non-performing loans” — in many of its Member States.58 However, despite these efforts, the widespread economic impact of COVID-19 is now causing banks’ “Expected Credit Losses” (ECLs), as calculated under the new IFRS9 standard, to increase again. This in turn would require them to provision more significantly for the expected losses on the loans, and “result in an erosion of [...] their ability to continue lending”.59 Other elements of the CRR and CRD could also inhibit the provision of bank credit to businesses during the current unprecedented economic circumstances.

6.6To address these concerns, the European Commission published an “interpretative communication“ on 28 April 2020, which emphasised the options already available under the EU’s capital and accounting legislation to both banks and their national regulators to limit — insofar as permitted by those laws — the impact of worsening credit risks of lenders’ loans on their ability to continue lending.60 It covers, for example, how the granting of payment holidays or other forbearance measures to borrowers should be taken into account when calculating banks’ assets, and therefore their capital requirements.

The proposal to amend the EU’s Capital Requirements Regulation

6.7In addition to the European Commission encouraging banks and regulators to make use of the existing flexibilities available under EU rules, it has also proposed a number of amendments to the Capital Requirements Regulation to “maximise the ability of EU banks to lend during the coronavirus pandemic, while also ensuring their continued resilience”.

6.8The need for amendments to the EU’s existing prudential framework flowed in part from a set of recommendations made in late March and early April by the Basel Committee (BCBS) — a standard-setting body for the banking industry composed of the Central Banks of 28 different jurisdictions, including the UK — on how bank regulations should be treated in the context of the coronavirus crisis. In particular, the Committee endorsed a one-year delay to the internationally-agreed deadline to implement the leverage ratio buffer, a specific capital requirement for the largest banks related to their total debt levels under the latest “Basel III“ capital requirement standards. This was due to be applied under EU law via the Capital Requirements Regulation from 2022, but the Committee agreed an extension until 2023 “in order to free up the operational capacity of banks and supervisors”. The BCBS also approved a two-year delay to the full implementation of the aforementioned IFRS9 accounting standard for banks, softening the impact of the new way of assessing expected credit losses on their capital requirements.61

6.9Following these recommendations, in late April the European Commission put forward a proposal for a Regulation amending the CRR, to “maximise the capacity of [banks] to lend and to absorb losses related to the COVID-19 pandemic”.62 Subject to the approval of the European Parliament and a qualified majority of the EU’s Council of Ministers, the draft legislation would not only implement the BCBS’ suggestions with respect to the leverage ratio buffer and the IFRS9 accounting standard for banks, but also:

• allow for more favourable prudential treatment for bank loans where the borrower is struggling to pay and the loan is covered by a taxpayer-funded guarantee scheme (like the CBILS and CLBILS guarantee schemes in the UK), given that the full credit risk to the bank of such loans is lower;63
• modify how the leverage ratio — the calculation of a bank’s capital expressed as a proportion of its debt — is affected by access to coronavirus-related emergency liquidity assistance provided by monetary institutions like the Bank of England;64 and
• make a number of changes to the favourable prudential treatment under the CRR of banks’ software assets, loans backed by pensions or salaries, and loans to small businesses and infrastructure projects.

6.10Many of the European Commission’s recent proposals to adapt existing EU legislation to the coronavirus pandemic would simply delay their date of application, given resource constraints in both the private and public sector. Examples of this include the postponement of the Medical Devices Regulation and new EU VAT rules. The Commission’s proposed amendment to the capital requirements framework is, however, substantive in nature. The Council and the European Parliament are still discussing the proposal, and it not yet clear what changes they may make to the legal text or when they will formally adopt the new Regulation. By extension, it is unknown when the new rules may take effect in the EU and, until the end of the post-Brexit transition period, the UK.

6.11Prior to the current crisis, the European Commission had already planned a substantive amendment to EU capital requirements legislation to fully implement the aforementioned Basel III standards.65 A proposal to that effect had originally been due in the second quarter of 2020, but this appears to have now been delayed. The Commission has also said that it will “take into account the impact of the Coronavirus pandemic on banks’ financial situation” in its impact assessment accompanying the forthcoming draft legislation.

The Government’s position

6.12As noted, the EU’s capital requirement rules for banks apply to the UK for the duration of the post-Brexit transition period. However, the Government no longer has formal representation in the EU institutions that formally adopt those laws. This may be considered particularly problematic for a sector, like the banking industry, where the UK has a significant economic and political interest in ensuring any legislative changes are appropriate.

6.13The European Commission published its proposal to amend the Capital Requirements Regulation on 28 April 2020. We had already asked the Government, in late March, whether it saw a need for any “legal changes to regulation or supervision of the banking sector […] at EU level” because of the coronavirus crisis.66 On 20 May, the Treasury submitted — with some delay — its customary Explanatory Memorandum setting out the UK’s position on the proposal, as it is required to do for all draft EU legislation put forward during the transition period. It does not offer any significant information about the Government’s views, noting only that “this package of immediate and longer-term measures provides some additional capital support to banks and should help support lending to the SME and infrastructure sector in the EU and in the UK”.

6.14The Committee is keen nonetheless to have the Treasury set out its views on the changes to the prudential framework for banks more expansively, in particular with respect to those elements of the Commission proposal that go beyond the recommendations made by the Basel Committee. We consider this important because the UK is represented in the BCBS — where decisions “are taken by consensus among its members”, i.e. with the Bank of England’s agreement — whereas the Government is no longer represented in the EU’s institutions, in particular the Council of Ministers.67 Where the EU goes beyond the measures announced by the Basel Committee, the UK would have to rely on the goodwill of the remaining Member States and the European Parliament to ensure the amendments to Europe’s banking rules — which it is expected to apply until the end of the transition — reflect the Government and Bank of England’s preferred approach.

Action

6.15In light of the above, the Committee asks the Economic Secretary to the Treasury (John Glen MP) to supplement his Explanatory Memorandum on the proposed amendments to the Capital Requirements Regulation, in particular by clarifying to what extent the Commission proposal goes beyond the suggested actions agreed by the Basel Committee in March and April 2020 and the Government’s position on those discretionary changes. A copy of that letter is shown below.

6.16We also draw the European Commission’s proposal to amend the EU Capital Requirements Regulation to the attention of the Treasury Committee, which may wish to assess its technical details further in the context of its inquiry into the economic impact of coronavirus, and to the Committee on the Future Relationship with the EU.

Letter from Sir William Cash MP to the Economic Secretary to the Treasury (John Glen MP)

COVID-19: Amendments to the EU’s Capital Requirements Regulation

As you are aware, the European Commission published a proposal on 28 April containing substantive changes to the EU’s Capital Requirements Regulation to soften the impact prudential rules may have on banks’ ability to lend to businesses and help them weather the economic crisis triggered by the coronavirus pandemic. It appears to go beyond the recommendations for additional flexibility in the implementation of the Basel III standards agreed by the Basel Committee on Banking Standards in March and April this year, especially with respect to the prudential treatment of certain loans and the calculation of banks’ leverage ratio.

We are disappointed that the Explanatory Memorandum you provided on the Commission proposal on 20 May was not submitted within the usual 10 working days and, moreover, contained very little information on the Government’s position, as any changes to the Capital Requirements Regulation will be of direct relevance to the UK during the post-Brexit transition period.

First, as the Government itself recognises, the UK is in a unique position, affected by EU laws and policies for as long as the transition period lasts, but with no presence or formal say when they are being discussed and agreed by the EU. This is of particular concern in a case such as this, where legislative changes are being considered that affect a key British industry, without Treasury input and UK representation and agreement.

Second, this particular EU proposal is directly linked to the COVI9–19 crisis and relates to a sector that is important economically in its own right and plays a vital role in the recovery.

In this context, noting the information provided in your Memorandum, we ask you to write to us by 10 June. We expect this letter to:

• set out the Government’s position on the proposed changes made to the EU’s prudential framework in more detail, especially with respect to the proposed amendments that do not flow from the Basel Committee’s recommendations, and the package’s expected impact on business lending by the British banking industry during this crisis; and
• clarify whether the Government has sought or is seeking any changes to the draft Capital Requirements Regulation, and whether it has been successful in securing them.

Letter from the Chair to the Chief Secretary to the Treasury (Rt Hon. Steve Barclay MP)

UK participation in EU funding programmes from 2021

You will be aware that the European Scrutiny Committee wrote to you on 26 March 2020, asking for a number of clarifications from you — in consultation with other relevant Departments — about the scope and terms of the UK’s participation in EU funding programmes from 2021 onwards.

In particular, we asked you to:

• set out the Government’s reasoning for the selection of the four EU programmes in which it wants to obtain continued UK involvement, and why pursuit of British participation in others had been dropped;
• clarify the Government’s position on the EU’s proposals for the calculation of the UK’s financial contribution to the EU programmes in which it chooses to participate, including the new “correction mechanism” that would require the UK to pay more into the EU budget if it became a net beneficiary of EU funds; and
• explain if the Government could accept the EU’s demands for a continued, if limited, jurisdiction for the Court of Justice of the EU and the European Commission’s anti-fraud body OLAF in relation to the spending and management of European funds, despite its explicit insistence that there should not be “any jurisdiction for the CJEU over the UK’s laws [and] any supranational control” under future UK-EU agreements.

Although the question of UK participation in “Union programmes” has featured in every negotiating round with the EU to date, and the latter’s Chief Negotiator Michel Barnier has noted there was “convergence” with the UK on this particular matter, you have so far failed to reply to our questions of 26 March or provide a reason why the requested information has not been provided nearly two months on. This is particularly disappointing in light of the fact that the clarifications we sought related either to the reasons underpinning a Government policy decision (the selection of EU programmes in which the UK wishes to continue participating) or to demands the Government must have known the EU would make in return for such involvement (a financial contribution and a limited role for certain EU institutions, including the CJEU).

You will appreciate that the Government’s apparent inability to facilitate parliamentary scrutiny on this matter, a relatively non-controversial element of the UK’s new relationship with the EU, is deeply worrying. We ask you to provide the information asked for in our initial letter of 26 March urgently, by [ ] May, including an update on the extent to which the UK and EU have ‘converged’ on an agreement on the conditions for UK participation. We also request that you explain why the provision of the requested clarifications has been subject to such delay. If your response is unsatisfactory, or delayed further, it is likely you will be asked to give evidence about this matter in person.

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