Deciphering the Intricacies of Deposit Business under CRR and capital requirements for Credit Institutions under CRD IV

Josef Bergt
2023

Introduction

The landscape of banking law, particularly within the context of Regulation EU) No 575/2013 on prudential requirements for credit institutions and investment firms or the Capital Requirements Regulation (CRR) has witnessed significant evolution over the years, shaping the way deposit transactions are viewed and regulated. This article aims to dissect the intricate details of deposit business pursuant to the CRR.

The Essence of Deposit Business

The deposit business, encompasses two primary activities:

• The acceptance of funds as deposits from the public;
• The acceptance of other unconditionally repayable funds from the public, provided these are not documented in bearer or order debt securities. Notably, the interest aspect of these funds is irrelevant in this context.

While the second variation serves as a catch-all provision, since its introduction, the first variation has largely lost its independent significance. Both alternatives share the common feature of “acceptance of funds”. Both also only include funds categorized as “unconditionally repayable funds of the public.” 

Definition of Funds

Funds, in the context of this provision, refer to any legal tender. This includes sight deposits at licensed credit institutions, both domestic and foreign, equivalent to cash. Privately created payment instruments are not considered funds unless exchangeable for legal tender or equivalent book money.

Acceptance of Funds

Acceptance involves the physical receipt of cash and, in the case of book money, crediting to an account as part of cashless transactions. According to the provision's spirit, funds created through credit creation or transfer are also considered accepted funds. This includes conversion of a trade claim into a loan or allowing funds to remain deposited. Bank-technically, these processes are equivalent; such funds are subject to the same rules as other funds and are considered part of deposit business regardless of interest payment.

The Public

The term “public” defines the source of funds relevant to the deposit business. For effective investor protection, all third-party funds are intended to be covered. This includes funds from a clearly defined subset of the public. The term encompasses both natural and legal persons, including employees, friends, association members, and non-personally liable partners. However, personally liable partners actively involved in company management are excluded under certain conditions.

Exclusions and Special Cases

Funds from connected companies, personal partners not involved in management, or funds under the jurisdiction of recognized corporate investment companies are not considered public funds. Also, funds from licensed credit institutions, including those operating under the European Passport do not constitute deposit business.

Repayable Funds

Accepted funds have to be unconditionally repayable. Capital contributed by a shareholder to a corporation against the issuance of shares or for a business share is not considered "repayablefrom the company's perspective and does not fall under the deposit business. This also applies to most contracts dealing on an exchange of services or goods on a quid pro quo basis.

The classification of funds as unconditionally repayable takes into account the banking industry norms, the conditions offered to the customer, the actual nature of the fund transfer, and the financial institution's promotional activities. An unconditional repayment claim exists without any conditions that could suspend the claim and should be independent of the financial institution’s business success.

Specific case scenarios, such as mezzanine financing (hybrid forms of corporate financing that display characteristics of both equity and debt capital), including convertible loans, subordinated loans and profit-participating loans, may in individual cases be regarded as unconditionally repayable funds within the meaning of the deposit business.

• For subordinated loans, simple subordination clauses that only prioritize repayment claims in case of insolvency or liquidation are insufficient to consider the fund transfer as conditional.
• A qualified subordination agreement is required, stipulating repayment only after satisfying all other creditors in insolvency or liquidation and limiting claims to the company's freely available assets.
• The legal validity of any clause excluding the unconditional nature of the repayment claim must be scrutinized.
• Generally, profit-participating loans are considered unconditionally repayable and thus meet the deposit business criteria.
• In silent partnerships, the capital contributor's investment is typically subject to loss participation, making it conditionally repayable. The same applies to profit participation rights that involve loss participation in the company.

Exception for Bearer and Order Debt Securities

The deposit business definition does not apply when the repayment claim is documented in bearer or order debt securities. This exception was created to facilitate direct financing to  industrial companies in the capital market without needing intermediation by licensed banks.

Only instruments that are equivalent to bearer or order debt securities, regardless of the issuer's location, qualify for this exemption. Individually issued securities that are not interchangeable with others of the same kind do not fall under this exception.

The requirement is that the rights from the securities must follow the principles of general securities law, meaning the right from or contained and represented in the paper must follow the right to the paper, transferable according to property law principles or endorsement.

Security Provision Excluding the Deposit Business

Certain securities or collateral can exclude the operation from being classified as a deposit business, provided they allow direct satisfaction of the investor's claim without third-party legal transactions. Funds that are transferred as security respectively collateral are not considered deposits.

Licensing Requirement for Operating a Deposit Business

Licensing as a credit institution is required for anyone who wants to conduct banking transactions or financial services, including deposit business, on a commercial basis or to an extent requiring a commercially organized business operation.

The operation is considered commercial if it is intended to last for a certain duration and is aimed at making a profit, regardless of whether the business's scope objectively requires a commercially organized operation.

Capital Requirements for Banks (Own Funds Ratios and Composition of Eligible Capital)

• Hard Core Capital (Core Equity Tier 1 (CET1); 4.5%): Capital instruments according to Art. 28 CRR and possibly Art. 29 CRR (e.g., shares),
  • + Premium on the mentioned capital instruments
  • + Retained earnings
  • + Accumulated other comprehensive income
  • + Other reserves
  • + Fund for general banking risks
  • - Deductions from hard core capital (e.g., losses of the current financial year, intangible assets, goodwill, investments in the financial sector)
  • + Minority interests according to Art. 81 ff CRR;
• Additional Core Capital (Additional Tier 1 (AT1); 1.5%): Capital instruments according to Art. 51 or Art. 61 CRR (e.g., specific subordinated bonds / Contingent Convertible Bonds – "CoCos");
  • + Premium on the mentioned capital instruments
  • - Deductions according to Art. 52 ff or Art. 79 CRR
  • + Minority interests according to Art. 82 ff CRR;
• Supplementary Capital (Tier 2 (T2); 1.5%): Capital instruments and subordinated loans according to Art. 63 ff or Art. 71 CRR (e.g., subordinated bonds / "CoCos");
  • + Premium on the mentioned capital instruments
  • + up to 1.25% of the risk-weighted position amounts calculated according to Art. 111 CRR ff
  • - Deductions according to Art. 66 ff or Art. 79 CRR
  • + Minority interests according to Art. 82 ff CRR;
• Capital Conservation Buffer according to Art. 129 CRD IV (2.5% in the form of hard core capital);
• Possible additional Pillar 2 capital requirements according to Art. 104 CRD IV (the above corresponds to Pillar 1) to cover further risks not covered by Pillar 1, e.g., due to a risky business model;
• Institution-specific countercyclical capital buffer (CCB) according to Art. 130 CRD IV (currently 0% for Liechtenstein);
• Systemic risk buffer according to Art. 133 CRD IV (2.5% of risk-weighted assets);
• Additional buffers for Global or Other Systemically Relevant Institutions are possible (G-SRI/O-SRI buffer is set by competent national supervisory authority for systemically relevant institutions; up to 2% of risk-weighted assets; G-SRI not currently relevant for Liechtenstein).

In summary, the total capital requirements of Pillar 1 amount to 8% of the capital. In addition, the capital conservation buffer and systemic risk buffer of 2.5% each must be considered. Furthermore, Pillar 2 requirements to cover additional risks must be taken into account.

Besides the capital requirements, the requirements for own funds must also be met (i.e., solvency and liquidity are equally important).

From Pillar 1, particularly the LCR (Liquidity Coverage Ratio) and the Net Stable Funding Ratio (which focuses on so-called HQLA – high-quality liquid assets) must be maintained.

From Pillar 2, in broad terms, the ILAAP (Internal Liquidity Adequacy Assessment Process), ICAAP (Internal Capital Adequacy Assessment Process), and SREP (Supervisory Review and Evaluation Process) must be complied with.

Pillar 3 also entails additional reporting obligations for compliance with key figures (ALMM; Additional Liquidity Monitoring Metrics).

The initial capital of a credit institution pursuant to CRD IV (Directive 2013/36/EU; Capital Requirements Directive) has to be at least EUR 5 million (Art 12 CRD IV) and for Liechtenstein has to be at least CHF 10 million.

Source: BaFin Factsheet on Information on the definition of deposit business pursuant to Section 1 (1) sentence 2 no. 1 KWG and CRR and CRD IV.

Executive Summary:

• Definition of Deposit Business: The deposit business is classified into two main categories: acceptance of deposits, and acceptance of other unconditionally repayable funds from the public, excluding those documented in bearer or order debt securities.
• Irrelevance of Interest: The regulation stipulates that the interest aspect of these funds is not a determining factor in classifying a transaction as a deposit business.
• Common Feature of Both Alternatives: The shared attribute in both alternatives is the “acceptance of funds,” with an unconditional obligation for repayment.
• Funds Definition: Legally, funds are defined as any legal tender, including sight deposits at licensed credit institutions. Privately created payment instruments qualify only if exchangeable for legal tender.
• Acceptance Process: The acceptance of funds involves the physical receipt of cash or the crediting of book money in an account as part of cashless transactions. Credit creation or transfer also constitutes acceptance.
• Public Funds: The term “public” is used to define the source of funds, aiming to cover all third-party funds for effective investor protection. This includes funds from any natural or legal person, with specific exclusions.
• Unconditional Repayment Claims: Assessment of funds as unconditionally repayable based on the banking industry's view and the conditions offered to the customer, focusing on the actual nature of the fund transfer and the financial institution's promotional activities.
• Bearer and Order Debt Securities Exception: The deposit business does not apply when repayment claims are documented in bearer or order debt securities, a measure to facilitate direct financing of industries.
• Security/Collateral Provision Excluding Deposit Business: Funds that are transferred as security respectively collateral are not considered deposits.