The new CRD offers different methods to ensure capital adequacy. Broader risk management, flexibility and greater risk sensitivity are key concepts of the CRD, which was implemented in January 2007. There will be a transition period until 2010.
With the introduction of CRD, regulators have taken an important step in bridging the gap between the internal models of the financial institutions and the regulators' models and requirements for capital adequacy. The use of internal models will be incorporated in order to ensure more agile and responsive regulation and capital adequacy. Standard models provided by a regulator are often "post-event models" and are usually under construction for several years.
Going forward, highly creditworthy customers will require less capital than customers with a lower credit rating. The new rules will therefore create a closer correlation between the actual risk and the capital tied up. Regulatory capital will be better aligned with economic capital, which is used for internal performance and risk management.
The three pillars of CRD
The CRD uses a three-pillar structure which is illustrated in the figure below:
- Pillar I: Calculation of minimum capital requirement Pillar I contains the generic rules for calculating credit, market and operational risk. Pillar I also sets the minimum requirement for regulatory capital.
- Pillar II: Supervisory review process Pillar II specifies the framework for the supervisory review process, and sets a framework for further capital requirements based on the situation and characteristics of the individual institution. Pillar II also comprises risk not defined under Pillar I (i.e. concentration, correlation and migration risk) as well as stress testing.
- Pillar III: Market discipline / disclosure Pillar III contains requirements to the information to be published. In the future, institutions must give external interested parties better insight into risk management as well as the quality and composition of portfolios.
Capital floorsThe regulators have ensured a gradual capital release by introducing capital floors for those banks choosing advanced methods for
credit risk estimation. The capital floors, which depend on the method chosen, are presented in the table below.
| 2007 |
- |
5 |
- |
| 2008 |
- |
10 |
10 |
| 2009 |
- |
20 |
20 |
| 2010 |
- |
100 |
100 |
The capital floors are based on a bank's capital requirement under Basel I. A bank choosing the IRB Foundation approach can therefore release 5% of its capital requirement under Basel I in 2007, a further 5% in 2008 and a further 10% in 2009. The full benefits from the CRD therefore cannot be enjoyed until in 2010.