Capital adequacy

Author: | Published: 8 Apr 2002
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With the adoption of the second Basle Capital Accord in the near future and the its parallel implementation in EU Directives, it may be expected that the regulatory environment for prudential supervision on banks will change fundamentally in forthcoming years. Similar developments are foreseeable for insurance companies as well. In line with the regulatory framework resulting from implementation of EU Directive 93/6 on capital adequacy, investment institutions (securities brokers and asset managers) are very likely to be brought under the new regulations too.

The new Basle Capital Accord (expected to be implemented in 2006) will introduce a more risk-sensitive framework for prudential supervision on banks. The first Capital Accord of 1988 was based on broader criteria for supervision on risks taken by banks. Owing to developments in the financial markets such as the increasing importance of securitization, some elements of the internationally adopted regulatory framework on solvency requirements have been altered since 1988. It required adjustments to the existing Dutch regulations too. In this article we will discuss the current applicable regulatory framework and a number of recent changes in the Dutch solvency directives.

General outline of existing regulations in The Netherlands

The statutory basis for the prudential supervision of credit institutions in The Netherlands, can be found in Chapter 3 of the Act on the Supervision of the Credit System 1992 (ASCS 1992). In Chapter 3 the general framework has been laid down for the solvency supervision, liquidity supervision, supervision on the administrative organisation of banks and the so-called structural supervision, which is the supervision on, inter alia, participations in or by credit institutions. In this article we will only discuss the provisions on solvency supervision.

Article 20 ASCS 1992 on solvency supervision provides for a statutory basis which grants authority to the Dutch Central Bank (DCB) to issue from time to time further "directives for the conduct of the business by credit institutions in the interests of their solvency". Article 20 also provides for a consultation procedure with representative organisations that must be followed before the amendment of the directives.

Article 20 also limits the authority of the DCB to a certain number of items which may be covered in the solvency directives. In view of the broad description of these items, the authority of the DCB to formulate detailed directives on the items listed in article 20 ASCS 1992 is comprehensive. Article 20 also provides for a specific relief procedure in case a credit institution wishes to be relieved from certain parts of the solvency directives.

Character of the Dutch solvency and capital adequacy guidelines

The general provisions of statutory law in the ASCS 1992 only provide for a brief framework of rules and regulations. As regards solvency supervision, the material contents of the directives of the DCB may be found in the extensive directives published, inter alia, in the Credit System Supervision Manual that is regularly updated by the DCB. This manual must be seen as the most important document in which a detailed description may be found on various topics concerning solvency supervision on Dutch banks.

Given the need for often extensive changes in the directives in the last few years, the choice for a brief provision of statutory law and the delegation of the authority granted to the DCB to issue directives, has proved its value to the banking sector. It allowed the DCB to issue changes rapidly, upon consultation with the Dutch Bankers' Association and other representative organisations, and publish the same to the parties concerned in the Dutch banking market.

The DCB has worked hard to publish changes on the directives efficiently and the market has benefited from its service-oriented approach. For instance, for a number of years the guidelines have been published on a well-organised website ( which allows users to download the relevant documents free of charge. Documents are rapidly translated into the English language by the DCB which serves the interests of the internationally orientated Dutch banking sector.

We will discuss a number of changes in the solvency and capital adequacy directives which may be considered good examples of the way the DCB has adapted to the changing international environment of banks and the need to change certain concepts of supervision on solvency and capital adequacy requirements.

Some recent changes in the solvency directives

The concept of guarantee

In October 2001 the DCB issued a new part of the solvency directives addressing a more precise definition of guarantee as it has been used in several parts of the solvency directives. More particularly, the concept of a guarantee is relevant for all those cases where a bank seeks to substitute the risk incurred on a client by the lower risk profile of the guarantor. For instance, a non-trading book receivable on a corporate client must be accounted for as a full 100% risk-weighted asset in the denominator of the solvency ratio. In case a central government of a G-10 country gives a guarantee that may be called upon by the bank as a security for the repayment of a corporate client's debt, the relevant credit risk of the receivable may be accounted for at a 0% factor for the determination of the credit risk.

Given the increasing operation by Dutch banks in an international environment, the precise concept of a guarantee is not always clear. More particularly, Dutch civil law does not provide for a precise definition, nor did the solvency directives provide for specific guidance on this expression until October 2001. With a view to the various appearances of legal structures that may have a similar effectiveness as a guarantee, the DCB has provided for a set of conditions that must be fulfilled in order for a legal instrument to qualify as guarantee within the meaning of the solvency directives. By providing for these criteria the concept of guaranteed obligations is on the one hand expanded to a number of legal techniques typically not qualifying as a contractual guarantee in the strictest sense of the expression. On the other hand further conditions are imposed on the parties applying such instruments for mitigation of the credit risk.

Expansion of the concept of a guarantee follows from the condition that the guarantee must result in a direct commitment from the guarantor towards the beneficiary following an agreement or another normative position (such as a regulatory or statutory provision). Therefore, the guarantee does not follow necessarily from a contractual obligation, but may also result from other legal instruments too. The DCB explicitly states that the name of the legal instrument is irrelevant and refers to other instruments as well that may qualify as a guarantee, such as sureties and liability guarantees.

More restrictions on the application of a guarantee as a risk-mitigating instrument may, for instance, be found in the condition that the guarantee may not be restricted to the effect that the beneficiary can only benefit from recourse on the guarantor if the debtor is in default. Conditional guarantees do not qualify for lowering the risk profile from the debtor to the risk profile of the guarantor. It appears that this condition may cause some pressure on certain instruments applied in international transactions with more specific recourse provisions.

Policy rule on credit derivatives

In October 2001 the DCB issued a comprehensive policy rule on credit derivatives which must be applied by banks from January 1 2002 for the assessment of solvency weighting issues. The policy rules also contain further guidance for the impact of the use of credit derivatives for the bank's organization and internal control. The DCB clearly states that the policy rules must be seen as an interim position for the treatment of credit derivatives. The policy rules are intended to create a level-playing field internationally on the basis of a "growing international consensus on the future capital adequacy rules" (Manual 4011b1-01).

The policy rules adopt the policies developed by the major foreign banking regulators. The DCB clearly envisages adapting to international developments and anticipates the adoption of the second Basle Capital Accord. Whenever the outcome of the new Basle Capital Accord requires adjustment of the policy rules, the DCB will undertake to implement the amendments in due course.

From a legal point of view it may be noted that the DCB is conscious of the current applicable practices with regard to documentation of derivatives transactions. The policy rules contain clear references to ISDA documentation definitions and discusses the various issues arising from the application of ISDA documentation as regards to the effects for the bank's solvency requirements. It results in recognisable language and reference points to the applicable practice of credit derivatives. For parties that apply credit derivatives in their business, the policy rules provide for a pragmatic approach.

The policy rules also contain some references to the synthetic securitization practice, which is becoming more and more relevant in the Dutch market . The policy rules may be applied too, should the securitization policy guidelines issued by the DCB in 1997 fail to provide sufficient guidance as regards a synthetic securitization transaction. The most common synthetic securitization transaction structures are clearly described in the policy rules and the solvency weighting issues are clearly addressed in this document.

Final remarks

With the examples of amendments to the solvency directives of the DCB, we have shown that the Dutch banking sector profits from a well-developed regulatory environment as regards the treatment of solvency and capital adequacy issues for banks. The DCB clearly follows trends in the market and adjusts its existing solvency directives framework to keep up with the pace of the market.

We have refrained from mentioning other changes such as the adoption of the capital adequacy framework for trading and non-trading book positions following implementation of EU Directive 93/6, the approach towards internal models for calculating capital requirements for market risks, the introduction on guidelines for the look-through approach of asset-backed securities (implementing Directive 98/32/EEC on mortgage backed structures), the acceptance of the use of innovative Tier I instruments and the position of the DCB towards risk-mitigation structures by application of risk-participation structures. All these amendments confirm our view that the DCB has followed a market-orientated approach over the last decade.

With the implementation of the second Basle Capital Accord in the near future, the Dutch banking sector may be required to accept fundamental changes in the solvency directives. With the approach chosen so far by the DCB, we expect that such fundamental changes will require thorough investment by the market participants in the necessary consultation rounds as well as in the implementation of the new rules on determination of the final capital adequacy framework. Particularly for the smaller and medium-sized organizations it may be expected that this will become a heavy burden. The expected, more comprehensive framework for the approach of capital requirements in funded and synthetic securitization transactions will probably give rise to new opportunities too.

Steins Bisschop Meijburg & Co
Hullenbergweg 300
Amsterdam 1101 BV
Tel: +31 20 656 1777
Fax: +31 20 656 1700