As a result of the Risk Reduction Act, large parts of the European banking package have been transposed into German law. The focus is on own funds, liabilities and individuals acting on behalf of credit institutions.
The German Risk Reduction Act (Risikoreduzierungsgesetz) is undeniably complex. This comes as no surprise as it is one of the laws in Germany with which important lessons from the 2007/2008 financial crisis have been incorporated into national law. It is common knowledge that the crisis raised many difficult regulatory questions.
On 28 December, the Risk Reduction Act introduced new rules in several areas of banking supervision law. The Act primarily transposes two European Directives into German law that were adopted in the summer of 2019 as part of the EU banking package: the CRD V and BRRD II (see info box “The German Risk Reduction Act and the European banking package”). These Directives bring about changes, via the Risk Reduction Act, which primarily have an impact on the German Banking Act (Kreditwesengesetz) and the German Recovery and Resolution Act (Sanierungs- und Abwicklungsgesetz). The provisions governing deposit guarantee schemes have undergone changes, too. An overview of the new key changes can be found below.
At a glance:The German Risk Reduction Act and the European banking package
The Risk Reduction Act transposes two European Directives into German law that are part of the 2019 EU banking package. The EU banking package completes a large number of the regulatory reforms that were initiated as lessons learnt from the 2007/2008 financial crisis.
In particular, European legislators incorporated various aspects of the regulatory framework agreed by the Basel Committee on Banking Supervision (BCBS) and the Financial Stability Board (FSB) following the outbreak of the financial crisis. The reforms are designed to strengthen the resilience of European institutions and improve the supervision of cross-border banking groups.
The Risk Reduction Act implements the following Directives in particular:
CRD V: Directive (EU) 2019/878, also known as the Capital Requirements Directive V or CRD V.
The provisions of the CRD are usually incorporated into the German Banking Act. The German Banking Act has also been amended as a result of the Risk Reduction Act implementing the CRD V.
- BRRD II: Directive (EU) 2019/879 amending Directive 2014/59/EU as regards the loss-absorbing and recapitalisation capacity of credit institutions and investment firms and Directive 98/26/EC. It is commonly known as the Bank Recovery and Resolution Directive II (BRRD II).
The rules set out in the BRRD are implemented in German law via the Recovery and Resolution Act. As a result of the transposition of the BRRD II, the Risk Reduction Act has led to significant amendments to the Recovery and Resolution Act, too.
The Capital Requirements Regulation (CRR II) and the Single Resolution Mechanism Regulation (SRMR II) also form part of the European banking package. As EU Regulations, they are both directly applicable at national level.
Impact on the German Banking Act
The Risk Reduction Act expands the provisions on the identification of risk takers in the Banking Act. It also implements new rules regarding the leverage ratio buffer and introduces an authorisation procedure for parent financial holding companies. In addition, the Risk Reduction Act specifies the provisions for setting additional own funds requirements within the Supervisory Review and Evaluation Process (SREP), incorporates guidance on additional own funds in the law and obliges large third-country groups operating in Europe to establish intermediate EU parent undertakings.
Identifying risk takers
The Risk Reduction Act expands the rules on the system for identifying risk takers in section 25a (5b) of the Banking Act. Regardless of their size, all institutions are now required to identify certain groups of persons as risk takers, including not only members of the management board and supervisory board, who are explicitly listed in the new section 1 (21) of the Banking Act, but also other individuals, such as employees with managerial responsibility for the institution’s key business areas. Significant institutions must also identify risk takers outside these groups of persons based on the broader criteria in Delegated Regulation (EU) 604/2014.
The criteria as to what constitutes a significant institution within this context are now centrally defined in section 1 (3c) of the Banking Act. Section 25n of the Banking Act is no longer applicable. As a result of the new definition in section 1 (3c), institutions may no longer prove, based on a risk analysis, that they are not a significant institution.
Leverage ratio buffer from early 2023 onwards
The CRR II, which is also part of the European banking package, introduces a leverage ratio that will be a binding Pillar I requirement from 28 June 2021. The leverage ratio (LR) amounts to 3% of the total exposure measure (approximately corresponding to total assets, which are adjusted for the calculation of the LR) and must be held in the form of Tier 1 capital. The CRR does not need to be transposed into national law in order to become effective as it is directly applicable as an EU Regulation.
In line with the CRD V, the Risk Reduction Act sets out the requirements for an additional leverage ratio buffer that only global systemically important institutions (G-SIIs) will be required to build up from 1 January 2023 onwards. The requirements for this buffer are now set out in section 10j of the Banking Act. Section 10j also sets out the consequences if an institution does not meet the LR buffer requirement. In such cases, the institution must draw up a capital conservation plan and have it approved by the competent authority.
Originally, the LR buffer was to become effective on 1 January 2022. However, European legislators joined the Basel Committee on Banking Supervision in postponing the effective date by a year due to the coronavirus pandemic.
Authorisation of parent financial holding companies
As set out in Article 21a of the CRD, the Risk Reduction Act introduces an authorisation procedure for mixed financial holding companies that are at the head of a regulated group; this is set out in the new section 2f of the Banking Act. As a result, the supervision of financial holding companies in the banking sector is intensified significantly.
Following an application by a company, the competent authority for group supervision decides whether the authorisation requirement applies; if the financial holding company has its registered office in another EEA country, the competent authority for group supervision takes this decision together with the competent authority in this country. BaFin is the competent authority for less significant institutions (LSIs) to the extent that supervision is carried out on a consolidated basis in Germany. The ECB is the competent authority for significant institutions (SIs).
Depending on the structure of the group and the level of involvement of the parent company, there may be cases where no authorisation is required. But once the competent authority has granted a financial holding company authorisation in accordance with section 2f of the Banking Act, the entity at the head of the group is responsible for ensuring that supervisory requirements are complied with at group level. At the same time, the supervisory authority has increased powers vis-à-vis these authorised financial holding companies.
As for financial holding companies that are subject to the provisions in section 2f of the Banking Act and that had already been established by 29 June 2019, the transitional provisions of section 64a (1) of the Banking Act stipulate that these companies can submit an application for authorisation by 28 June 2021.
Transitional provision for investment firms
Although it is not part of the CRD V implementation package, section 64a (3) of the Risk Reduction Act is still worth mentioning, as it introduces a transitional provision in the Banking Act for investment firms that fall under the scope of Regulation (EU) 2019/2033. Since these firms will have their own supervisory regime from 26 June 2021 with the German Act on the Supervision of Investment Firms (Gesetz zur Beaufsichtigung von Wertpapierinstituten), the Banking Act – in the version in force until 28 December 2020 – will remain largely applicable during the transitional period between 29 December 2020 and 26 June 2021. As a result, the firms concerned will not have to spend a significant amount of time and effort implementing requirements that will no longer be applicable six months later.
Changes to the Recovery and Resolution Act
The Risk Reduction Act changes one key aspect of the Recovery and Resolution Act: the MREL (see info box “Minimum Requirement for Own Funds and Eligible Liabilities”). Some of the requirements associated with the MREL have been amended, too.
Definition:Minimum Requirement for Own Funds and Eligible Liabilities (MREL)
In order to improve the resolvability of institutions and other entities, institutions for which resolution is in the public interest in the event of a crisis are required to have sufficient funds available. This is to ensure that the bail-in tool can be used. The MREL serves the purpose of loss absorption and recapitalisation.
In addition to the MREL, there are further subordination requirements that apply to large banks with total assets exceeding EUR 100 billion (top-tier banks). These banks are required to fulfil part of their MREL obligations (8% of total assets) with own funds and subordinated eligible liabilities. The MREL is no longer expressed as a single ratio relating to total liabilities and own funds but instead as two ratios. The MREL is expressed as a percentage of the total risk exposure amount and of the total exposure measure. As a result, the MREL relates to the same benchmarks as the supervisory own funds requirements.
To ensure the effective resolution of a group, the competent authority will – when determining the MREL – distinguish between the entities within a group for which resolution measures are to be taken and those that are not to be resolved. As a national resolution authority in the Single Resolution Mechanism (SRM), BaFin is responsible for the less significant institutions in Germany. The Single Resolution Board (SRB) is responsible for significant institutions and for less significant groups of institutions operating on a cross-border basis.
Resolution entities must fulfil consolidated MREL requirements for the resolution group as a whole with own funds and liabilities towards external creditors. For non-resolution entities, in turn, an internal MREL requirement can be determined on a case-by-case basis. The institutions must fulfil extensive reporting and disclosure requirements if resolution planning does not provide for liquidation in normal insolvency proceedings.
In addition, the resolution authority is granted extensive powers so that it can respond to infringements of the MREL requirements. For instance, the resolution authority has the power to prohibit certain distributions and to take early intervention measures such as the replacement of members of management.
Further changes to the Recovery and Resolution Act
In future, the resolution authority will not have to wait until the resolution of an institution has been initiated in order to suspend payment or delivery obligations (section 82 of the Recovery and Resolution Act), but will be able to impose a moratorium as soon as it has found that the institution is failing or likely to fail. This is to give the resolution authority up to two extra working days to assess whether resolution is in the public interest. It may also use the time it has gained to decide which resolution measures it will take or to ensure that resolution tools are being used effectively.
Under section 55 of the Recovery and Resolution Act, institutions and group entities are obliged to stipulate in the contractual provisions for eligible liabilities governed by the law of a third country that the parties to the agreement recognise that the bail-in tool may be applied. This section also stipulates that the institution may notify the resolution authority if the required bail-in recognition clause cannot be included for legal or other reasons. As a general rule, a liability cannot be considered an MREL-eligible liability without such a bail-in recognition clause.
Minimum denomination per unit
The Risk Reduction Act has also resulted in some amendments to the German Securities Trading Act (Wertpapierhandelsgesetz). For instance, the newly introduced section 65b of the Securities Trading Act stipulates that a minimum denomination per unit of EUR 50,000 generally applies for subordinated eligible liabilities under section 2 (3) no. 40a of the Recovery and Resolution Act and relevant capital instruments under section 2 (2) of the Recovery and Resolution Act if banks are selling them to retail clients. This provision implements Article 44a(5) of the BRRD and is aimed at ensuring, for the purpose of investor protection, that retail clients do not excessively invest in these instruments. For proportionality reasons, the minimum denomination per unit for the relevant capital instruments – within the meaning of section 2 (2) of the Recovery and Resolution Act – of small and non-complex institutions has been set at EUR 25,000.
Changes to deposit guarantee schemes
The Risk Reduction Act has also led to changes to the statutory compensation schemes set out in the German Deposit Guarantee Act (Einlagensicherungsgesetz). There are currently two statutory compensation schemes: the Compensation Scheme of German Banks (Entschädigungseinrichtung deutscher Banken GmbH), for private banks, and the Compensation Scheme of the Association of German Public Sector Banks (Entschädigungseinrichtung Öffentlicher Banken Deutschlands GmbH), for public sector banks. Once the Risk Reduction Act has entered into force, the Federal Ministry of Finance (Bundesfinanzministerium) intends to terminate the rights and obligations granted to the Compensation Scheme of the Association of German Public Sector Banks (see info box “Compensation schemes: transfer and revocation of sovereign rights and obligations”), which means that there will be only one statutory compensation scheme in future.
At a glance:Compensation schemes: transfer and revocation of sovereign rights and obligations
In 1998, the Federal Ministry of Finance transferred sovereign rights and obligations to the Compensation Scheme of German Banks and to the Compensation Scheme of the Association of German Public Sector Banks by way of a statutory instrument (Rechtsverordnung) in each case. The new section 25a of the Deposit Guarantee Act specifies that such rights and obligations are to be revoked by way of a statutory instrument. These rights and obligations must be revoked if the conditions for granting these rights and obligations are no longer fulfilled, e.g. if there is a change to the number or risk profile of the member banks of a compensation scheme.
This ensures that deposits remain fully protected. Section 25a of the Deposit Guarantee Act stipulates that the remaining compensation scheme, as the legal successor to the scheme whose rights and obligations have been revoked, will assume all of the rights and obligations of the revoked scheme. The member institutions concerned will then switch to the compensation scheme that remains or they can alternatively join an institutional protection scheme, provided that they meet the applicable legal requirements. In this case, the assets saved in the revoked deposit guarantee scheme are to be split up in a risk-based manner. These options give the institutions affected by the revocation of rights and obligations as much room for manoeuvre as possible.
This change takes into account that promotional banks no longer fall under the scope of the CRD IV and CRR and thus no longer fall under the scope of the Deposit Guarantee Act. As a result, the Compensation Scheme of the Association of German Public Sector Banks comprises only five members instead of a previous 17 member institutions. Out of these five institutions, only one of them holds the majority of the deposits to be protected. To ensure that deposits continue to be adequately protected in the long term, German legislators had to reorganise the protection of deposits. The reasons for this are obvious: a deposit guarantee scheme is more stable the more member institutions it has and the more homogeneous their risk profiles are.
BaFin Division for the Development of National Law
Dr Andreas Möller
BaFin Division for the Development of National and EU Law (Resolution)
Dr Nathalie Schreyer
BaFin Division for Deposit Guarantee and Investor Compensation Schemes
BaFin’s Chief Executive Director of Banking Supervision, Raimund Röseler, gives his thoughts on the Risk Reduction Act (Risikoreduzierungsgesetz)
© Bernd Roselieb
Mr Röseler, how significant is the Risk Reduction Act?
The German Risk Reduction Act transposes the 2019 European banking package – and thus a significant part of the Basel III package of reforms – into national law. It therefore constitutes another key element in addressing the 2007/2008 financial crisis, and we are coming much closer to our objective of learning all the lessons to be learnt from the crisis. This Act has resulted in numerous measures to strengthen the stability of the banking sector and to ensure that losses in banking crises are borne by the banks’ investors and not taxpayers. For this reason, we are strengthening the loss-absorbing buffers that banks are required to build up. This marks the end of lengthy discussions and negotiations held at global and European level in recent years.
The current coronavirus pandemic clearly shows that the road to reform we embarked on after the collapse of Lehman Brothers was the right way forward. Our banking system is now far more resilient than it was before Lehman’s collapse. The Risk Reduction Act takes us one step further in this direction and ensures even more resilience.
Is an end to reform in sight?
Of course, there will be reforms in the future, too. We still need to implement other parts of the Basel III reform package – both at European level and national level. The output floor, for example, comes to mind here. But even after we have completed the main parts of the post-Lehman reform process, it would simply be wrong to say that this would mean the end of reforms. Regulation needs to keep up with the times, which means that we must review this time and again. We will also need to take further steps to reduce risks in the EU: for instance, we need to address non-performing loans and build up loss-absorbing buffers.
As regards the issue of proportionality, we could make even more improvements in Brussels in the future. The European banking package and the German Risk Reduction Act set out key initial steps in the right direction that we have been striving for: the term “small and non-complex institutions” has now been defined for the first time, and these institutions can now use a simplified method to calculate their liquidity ratio, for instance.
On the other side of the spectrum, we will need to get used to the term “PSI”, which stands for “potentially systemically important institution”. PSIs are subject to stricter regulatory requirements. This differentiation between the categories of supervisory requirements reflects the risks associated with each supervised institution and is the main idea behind the principle of proportionality, which we have called for.
In your view, what are the most significant changes that the Risk Reduction Act has brought about?
Overall, the Risk Reduction Act has resulted in many changes – which are highly complex in some cases. One example I could certainly mention is the fact that an authorisation procedure has been introduced for financial holding companies at the head of a supervised group. This will strengthen the supervision of financial holding companies in the banking sector to a noticeable degree.
Dr Thorsten Pötzsch, Chief Executive Director of BaFin’s Resolution Sector, gives his thoughts on the Risk Reduction Act (Risikoreduzierungsgesetz).
Dr Thorsten Pötzsch
© Bernd Roselieb
Dr Pötzsch, the name speaks for itself: the Risk Reduction Act is aimed at reducing risks in the banking sector. And if this is not achieved, resolution authorities such as BaFin come into play. Correct?
That’s only half-correct. Of course, the Act is aimed at reducing the risk that banks come under pressure. But if that happens, the goal is to reduce risks for other banks and minimise threats to the stability of the financial system in the best way possible – to prevent a domino effect, so to speak.
What changes has the Risk Reduction Act brought about?
The Act has resulted in new effective tools for us as Germany’s national resolution authority. These tools have an impact on two fronts, as they strengthen the resolution framework and improve the resolvability of institutions. To give you just a few examples: we now have the power to suspend payment and delivery obligations before we determine that resolution is in the public interest, which is a condition for resolution. And we can prohibit certain distributions if institutions violate the MREL requirements. We can also take further measures – and in extreme cases, we may even require the dismissal of managing directors.
Are we getting closer to a solution to the "too-big-to-fail" problem with the Risk Reduction Act?
Yes, that is the plan. The objective of the new provisions is to reduce the risk that taxpayers’ money is used in the event of a bank resolution. With the Risk Reduction Act, we are moving one step closer in ensuring that those who control the banks, such as shareholders, are the ones who foot the bill.
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The Risk Reduction Act is a complex law in Germany that incorporates important lessons from the 2007/2008 financial crisis into national law. It transposes two European Directives, CRD V and BRRD II, into German law as part of the EU banking package. These Directives bring about changes in the German Banking Act and the German Recovery and Resolution Act. The Risk Reduction Act focuses on own funds, liabilities, and individuals acting on behalf of credit institutions. It also introduces new rules in several areas of banking supervision law, including provisions governing deposit guarantee schemes [].
The Risk Reduction Act expands the provisions on the identification of risk takers in the German Banking Act. It introduces new rules regarding the leverage ratio buffer and an authorization procedure for parent financial holding companies. It also specifies the provisions for setting additional own funds requirements within the Supervisory Review and Evaluation Process (SREP) and obliges large third-country groups operating in Europe to establish intermediate EU parent undertakings [].
The Risk Reduction Act expands the rules on the system for identifying risk takers in the Banking Act. All institutions, regardless of size, are now required to identify certain groups of persons as risk takers, including members of the management board and supervisory board, as well as employees with managerial responsibility for the institution's key business areas. Significant institutions must also identify risk takers based on broader criteria. The Risk Reduction Act also introduces an additional leverage ratio buffer for global systemically important institutions (G-SIIs) from January 1, 2023 [].
The Risk Reduction Act introduces an authorization procedure for mixed financial holding companies that are at the head of a regulated group. The supervision of financial holding companies in the banking sector is intensified significantly. The competent authority for group supervision decides whether the authorization requirement applies. BaFin is the competent authority for less significant institutions (LSIs), while the ECB is the competent authority for significant institutions (SIs) [].
The Risk Reduction Act also amends the Recovery and Resolution Act, particularly in relation to the Minimum Requirement for Own Funds and Eligible Liabilities (MREL). The MREL serves the purpose of loss absorption and recapitalization. The Act introduces changes to the MREL requirements, including the introduction of two ratios and the distinction between resolution entities and non-resolution entities. The resolution authority is granted extensive powers to ensure compliance with the MREL requirements [].
The Risk Reduction Act also brings about changes to the German Securities Trading Act, including the introduction of a minimum denomination per unit for subordinated eligible liabilities sold to retail clients. The Act also leads to changes in the statutory compensation schemes set out in the German Deposit Guarantee Act, resulting in the termination of the Compensation Scheme of the Association of German Public Sector Banks and the establishment of a single statutory compensation scheme [].
Overall, the Risk Reduction Act is a significant piece of legislation in Germany that incorporates lessons from the financial crisis and introduces various changes to strengthen the stability of the banking sector and improve the supervision of credit institutions [].