Shadow banking exposures

Regulation (EU) 575/2013 of 26 June 2013 on prudential requirements for credit institutions and investment firms (“CRR”) establishes a regime with more stringent provisions as regards large exposures.

Large exposures are defined under Article 392 CRR as an institution’s exposure to a client or group of connected clients where its value is equal to or exceeds 10% of its eligible capital (i.e. Tier 1 capital plus Tier 2 capital). Large exposures are subject to reporting requirements and quantitative limits.

Under Article 395(2) CRR, the European Banking Authority (“EBA”) was mandated to issue guidelines setting appropriate limits to exposures to shadow banking entities.

The CSSF Circular 16/647 ("Circular") implements the EBA guidelines EBA/GL/2015/20 (Limits on exposures to shadow banking entities which carry out banking activities outside a regulated framework) (“Guidelines”) into Luxembourg law. Such implementation is done by updating Circular 12/552 on the central administration, internal governance and risk management.

The scope of the Guidelines and the new section of the Circular CSSF 12/552 implementing the Guidelines apply to credit institutions and investment firms (to the extent they are submitted to Part IV on Large Exposures of the CRR).

In the absence of a definition under the CRR, the Guidelines define “shadow banking entity” as an undertaking that carries out one or more credit intermediation activities (i.e. maturity transformation, liquidity transformation, leverage, credit risk transfer, etc.) and that is not an excluded undertaking (i.e. credit institutions, investment firms, central counterparties, payment institutions, entities which carry out intermediation activities on an intra-group basis only, etc.).

For the purposes of the Guidelines and the Circular, exposures to individual shadow banking entities are to be taken into consideration when they are equal to or in excess of 0.25% of the institution’s eligible own funds (after taking into account credit risk mitigation and possible exemptions).

Where such threshold is exceeded, institutions shall, inter alia, identify their exposures to shadow banking entities; set out an internal framework to identify, manage, control and mitigate related risks; set its risk tolerance for exposures to shadow banking entities; and determine interconnectedness between the shadow banking entities and the institution.

The Guidelines and the Circular determine two approaches in order for the institution to limit their exposure to shadow banking entities: the principal approach and the fallback approach.

• The principal approach: institutions should set an aggregate limit to their exposures to shadow banking entities (considering, inter alia, their business model, risk appetite and size). Also, they should set tighter limits on their individual exposures to shadow baking entities based on a set of criteria predefined in the Guidelines.
• The fallback approach: if institutions are not able to apply the principal approach, their aggregate exposures to shadow banking entities should be subject to the general limits on large exposures in accordance with Article 395 CRR (i.e. 25% of this eligible capital).

If institutions cannot meet the requirements regarding effective processes and control mechanisms or oversight by their management board as set out in section 4 of the Guidelines, they should apply the fallback approach to all their exposures to shadow banking entities (i.e. the sum of all their exposures to shadow banking entities).

If they can meet said requirements, but cannot gather sufficient information to enable them to apply the principal approach, institutions should only apply the fallback approach to the exposures to shadow banking entities for which the institutions are not able to gather sufficient information. The principal approach should be applied to the remaining exposures to shadow banking entities.