Why Europe should comply with new banking rules

On Friday, December 5, the Basel Committee on Banking Supervision published its reports on the compliance of rules adopted last year in the European Union and in the United States with its global accord on banking regulation, adopted in 2010 and known as Basel III. As was to be expected, the Basel Committee found the EU “materially non-compliant” with Basel III, while the US was found “largely compliant” and all other jurisdictions reviewed so far were found “compliant.” The EU, which often claims leadership on championing global financial standards, thus finds itself the global laggard on this key plank of the financial regulatory agenda. But moving towards better compliance with the Basel framework remains in the EU long-term interest. This can be achieved both in the short term through appropriate action by the European Central Bank (ECB), and in the longer term through changes in the applicable EU legislation.

The two Basel Committee reports, published simultaneously on the EU and the US, are part of a multi-year initiative which the Basel Committee calls its Regulatory Consistency Assessment Programme (RCAP). The corresponding publications started in October 2012 with preliminary assessments of theEU and US, on the basis of draft rules at the time in both jurisdictions, as well as an assessment ofJapan which was found compliant. Since then, the Committee has published successive RCAP reports on Singapore (March 2013), Switzerland (June 2013), China (September 2013), Brazil(December 2013), Australia (March 2014), and Canada (June 2014), all of which were also found compliant with Basel III. Under the Committee’s current work schedule, this will be followed by assessments of Hong Kong, Mexico, India, South Africa, Saudi Arabia and Russia in 2015, and of Argentina, Turkey, Korea and Indonesia in 2016. It should be noted that the jurisdictions already assessed under the RCAP cover a dominant share of the global banking system, including all of thethirty groups currently classified by the Financial Stability Board as Global Systemically Important Banks (of which 14 are headquartered in the EU, 8 in the US, 3 in China, 3 in Japan, and 2 in Switzerland). Thus, even if some of the reports still to come find other jurisdictions to be materially non-compliant or even “non-compliant” (the worst grade), it won’t change the EU’s status as global laggard, followed by the “largely compliant” US, among the world’s most important banking jurisdictions.

Cynics will note, rightly, that having rules that comply with Basel III does not imply that all corresponding banks are safe and sound. The RCAP process does not look at how rigorously and reliably the rules are implemented and enforced, but only at their content in comparison with the global accord. For example, in some emerging markets and also in developed economies, gaps in capacity and governance may prevent proper implementation practices. The Basel Committee acknowledges this, and has initiated separate processes to assess corresponding outcomes, starting with risk-weighting calculations which are the target of many of the Basel framework’s most biting critiques. (The Basel Committee also monitors whether jurisdictions have adopted rules to adopt Basel III at all, irrespective of their compliance status.) It should be noted, however, that relying on compliant rules greatly facilitates a process of implementation and enforcement that itself conforms to the global accord.

The RCAP process appears rigorous, balanced, and thorough. An ad hoc assessment team is formed for each report, composed of delegates from the supervisory authorities of jurisdictions other than the one being assessed, supported by members of the Basel Committee’s permanent secretariat staff. The work is submitted to a separate Review Team and also to a RCAP Peer Review Board. The identities of the Assessment Team leader and members, supporting members, and Review Team members are disclosed in each report. For example, Mark Zelmer, Canada’s Deputy Superintendent of Financial Institutions, led the team that delivered the assessment for the EU, and Mark Branson, chief executive of the Swiss Financial Market Supervisory Authority (FINMA), did so for the US. Of seven other team members for the US report, five were from the European Commission or from individual authorities of EU member states, and the two other from China and Japan respectively. Additional checks and balances have been introduced over time: for example, the first reports in October 2012 did not include a separate Review Team. The assessment itself is very comprehensive, putting the rules in their local context, analysing their actual impact on a sample of selected banks (whose names are also disclosed in the report), mentioning any ongoing processes to amend them, and enclosing responses from the assessed jurisdictions’ public authorities in a transparent way. Specifically, the EU report includes a joint response from the European Commission, the European Banking Authority (EBA) and the ECB; and the US report includes a joint response from “the US agencies” which, based on the report’s preface, include the Federal Reserve Board, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency. In both cases, the responses commend the work of the RCAP assessment team, while contesting some of their conclusions, as is habitual in contradictory procedures. To be sure, financial policy is not an exact science, and it is inevitable that RCAP reports include elements of individual judgment on the part of the assessment team members. Nevertheless, these features ensure that the outcome of the assessment can be considered authoritative.

The reports support each jurisdiction’s overall grade with a more detailed examination of 14 specific “components.” In the EU’s case, two points are particularly weak. First, the Capital Requirements Regulation (CRR) of 2013 allows more leeway than the Basel framework to apply a zero risk-weight to banks’ claims on sovereign and other public-sector debtors, as well as reduced risk-weights to claims on small- and medium-sized enterprises. As a result, the report grades the “Credit risk: Internal Ratings-Based Approach” component as materially non-compliant. Second, the CRR exempts certain derivatives transactions of banks with public-sector entities and non-financial corporate entities from a capital charge for counterparty risks known as Credit Value Adjustment (CVA), with material impact on actual capital ratio calculations. As a result, the report grades the “Counterparty credit risk framework” component as non-compliant. In both cases, the rules have been tweaked during the EU legislative process to favor the financing of governments, other public entities, and companies by banks, which may be seen as a form of mild financial repression with European characteristics. As for the US, the two components “Credit risk: securitisation framework” and “Market risk: Standardised Measurement Method” are graded materially non-compliant, both because of a section of the Dodd-Frank Act of 2010 that prevents banking regulations from making explicit reference to the ratings produced by credit ratings agencies. For both the EU and the US, four additional components are graded largely compliant. All remaining component are deemed compliant, except one that has not been implemented in the US and is thus assessed as not applicable.

The Basel Committee’s assessment is actually milder on the EU than could have been expected on an important component, titled “Definition of capital and calculation of minimum capital requirements,” which is graded largely compliant (as it is also for the US). The report notes a number of departures from Basel III under this chapter, including most notably the treatment of insurance subsidiaries (important for large French banking groups, in particular) as well as the capital of cooperative banks (important in several member states, including Germany) and temporary accounting quirks on the booking of losses on sovereign debt portfolios. These departures from Basel III were included early in the elaboration of the CRR as a package known in specialized circles as the “Danish compromise,” since it was negotiated during the Danish Presidency of the Council of the EU, which covered the first half of 2012. This had led the first RCAP report of October 2012 to grade the draft CRR as materially non-compliant on the definition of capital criterion. It appears that, in the meantime, EU negotiators have been successful at convincing the assessment team that the corresponding impact is less significant that was initially reckoned.

The EU has decided to depart from the Basel standard more than any other advanced economy for a number of reasons. The general policy stance in most of the EU, until at least the inception of banking union in mid-2012 and partly continued beyond that date, was to hide the banks’ problems from public view as long as the banks could still satisfy their short-term obligations, an approach politely referred to as supervisory forbearance. This preference has affected both the position of several EU member states in the Basel Committee during the negotiation of Basel III in 2008-2010, and the legislative process that led to the CRR and its complement the fourth Capital Requirements Directive (CRD4) being finally adopted in June 2013. The absence of a sustainable fiscal framework at the euro area level largely explains (and arguably justifies) the risk-weighting of euro-area sovereign exposures at zero. Political impulses to favor the direction of credit to struggling member states and companies led to the amendments on SME risk-weighting and CVA risk exemption in the later phases of the CRR/CRD4 legislative process. Furthermore, the EU could have reserved the contentious provisions to small- and mid-sized banks, in which case there would have been no problem of Basel III compliance since the Basel accords are only intended at large internationally active banks. But the EU is keen to apply the same prudential rules to all banks irrespective of size, a longstanding choice which may in turn be viewed as the result of the influence of the larger banks on EU policy.

Even so, the EU choices to depart from Basel III also have downsides:

• First, they result in laxer supervisory standards, as banks’ regulatory capital ratios are higher than they would be if Basel III was consistently applied (the size of the difference depends on each bank’s specific risk profile). This in turn undermines trust in the European banking sector as a whole. Investors are left in the dark as to how much lower the ratios would be under “full” Basel III. For example, the recent Comprehensive Assessment of the euro area’s 130 largest banks resulted in the publication by the EBA of a measure of capital ratios that was widely referred to in the media and commentariat as “fully-loaded Basel III,” but was actually (as the EBA correctly described it) a CRR/CRD4 ratio based on the rules that will be applicable in 2016 after the expiration of transitional provisions. This disclosure marked significant progress from previous practice in the direction of supervisory transparency, but still fell short of informing investors about each bank’s capital strength according to the actual Basel III standards.
• Second, the departure from the global framework undermines the EU’s influence in the Basel Committee and more generally in global financial standard-setting bodies. In such bodies, as a senior policymaker once put it (and all things equal, i.e. at a given level of demographic, economic and geopolitical heft), “compliance is influence” – i.e., the more a jurisdiction can credibly claim that it applies the agreed standards faithfully, the more impact it can have on future revisions or new standards. The EU had such moral authority following its swift adoption of the previous Basel II Accord of 2004, and has not refrained from blaming the US about its own delayed process of Basel II adoption. But this advantage was eroded when the crisis revealed major flaws in the Basel II framework, and is now impaired as the EU lags behind in adopting the more rigorous Basel III.
• Third, the EU has long championed the emergence and strengthening of global financial standards as a general proposition. Its long-term interest remains aligned with successful global financial regulatory initiatives. By not complying with Basel III, it weakens not only its own authority within the Basel Committee, but also the global authority of the Basel Committee itself. Other jurisdictions may now be tempted to introduce their own deviations from the global standards, under debatable assertions of local or regional specificities, and invoke the EU precedent.

As a result of these three factors, it would be in the EU’s best interest to readjust its supervisory practice and prudential legislation, in order to become compliant with Basel III as it had been with Basel I and Basel II in the past. Annex 16 of the RCAP report helpfully lists 11 “issues that the EU should consider to evaluate progress in aligning the EU capital regulations with the Basel Framework.” The Basel Committee prefers this diplomatic phrase to simpler “recommendations,” because it does not want to be seen as setting heavy-handed conditions for the removal of the infamous “materially non-compliant” mark.

Prospects for such convergence are mildly encouraging. The European Commissions’ statement in response to the RCAP report’s publication suggests a more open and constructive stance than back in October 2012, when the previous assessment has elicited a furious reaction from then-European Commissioner Michel Barnier. This time however, the shriller response has come from the European Parliament, as parliamentary leaders from the main political groups issued a scathing joint statementthat lambasts the Basel Committee as “a body that is working without legitimacy and without any transparency” and righteously proclaims that it “cannot modify the decisions taken democratically by the European institutions” – a statement of fact that the Basel Committee presumably has no intention to contest. The irony, which was not missed by some observers, is that these arguments closely mirror those used in individual member states by Eurosceptics who paint the EU as unaccountable, opaque and illegitimate, and reserve the democratic label exclusively to national institutions. In fact, the Basel III accord received ringing endorsements from political principals of the world’s main economies, including the EU and its largest member states, in successive summits of the G20 since 2010. In spite of the posturing, however, it can be expected that future revisions of the EU CRR/CRD4 legislation, and of the Basel III accord itself, may facilitate a gradual elimination of at least some of the areas of most egregious non-compliance.

On a shorter time horizon, the ECB has an important role to play. Since November 4, 2014, it is the supervisor of all banks in the euro area, directly for the 120 largest ones and indirectly, but through a common policy framework, for all others. It can use its supervisory discretion (what the Basel jargon calls Pillar II measures) to impose stricter capital requirements than the minimum set by the CRR, and may align these with a more consistent application of the Basel III accord. Short of this, it may disclose how much a “fully-loaded” application of Basel III would reduce each bank’s capital ratio, something that it also has the authority to enforce under the EU’s Banking Union legislation. In October 2014, both the ECB and the Single Supervisory Mechanism that it hosts have become full members of the Basel Committee, in which the ECB only had observer status until then. The compliance-is-influence principle also applies to it. To maximize its impact in setting the future global standards on bank capital and prudential regulation, the ECB should use its new authority to quickly impose more practices that better comply with Basel III than the imperfect minimum set in the EU CRR/CRD4 legislation.

This article is published in collaboration with Bruegel. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Nicolas Véron is a senior fellow at Bruegel

Image: European Union flags fly outside the European Commission headquarters in Brussels June 15, 2005. The EU budget battle and salvaging the proposed constitution will top the summit agenda for the 25-nation bloc when it meets on June 16-17 at its Brussels headquarters. UNICS REUTERS/Thierry Roge.