The European Union Lags on Basel III Banking Reforms

December 10, 2014 12:15 PM

The European Union, which often claims leadership on championing global financial standards, has been found to be the global laggard on a key aspect of banking regulation, as documented by the latest report (December 5) of the Basel Committee on Banking Supervision. As was to be expected, the Basel Committee—in examining adherence to its international banking regulatory framework, known as the Basel III accord—found the European Union "materially noncompliant," and the United States "largely compliant." Other jurisdictions reviewed earlier had all been found "compliant."

Complying with the Basel framework remains in the EU long-term interest. The European Union can get closer to this goal through short-term by actions of the European Central Bank (ECB) and longer term through new legislation.

The two Basel Committee reports on the European Union and the United States are part of the Basel Committee's multiyear Regulatory Consistency Assessment Program (RCAP). In October 2012, preliminary assessments of the European Union and the United States were based on draft rules at the time. A separate assessment found Japan compliant. The Committee has also published 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 , assessments of Hong Kong, Mexico, India, South Africa, Saudi Arabia, and Russia will follow in 2015, and Argentina, Turkey, Korea, and Indonesia in 2016.

The jurisdictions already assessed cover a dominant share of the global banking system, including all 30 groups (14 in the European Union, 8 in the United States, 3 in China, 3 in Japan, and 2 in Switzerland) classified as global systemically important banks by the Financial Stability Board. Thus, even if future reports find other jurisdictions materially noncompliant or even "non-compliant" (the worst grade), the European Union and the United States will remain the laggards among the most important banking jurisdictions.

As cynics may note, compliance status for a country or region 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, only at whether the rules conform to the global accord. Gaps in governance and implementation may exist in some emerging markets and developed economies. Acknowledging these gaps, the Basel Committee has initiated separate assessments of 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 Basel III rules at all, irrespective of their compliance status.)

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. A review team and a RCAP peer review board examine its work. Relevant identities are disclosed in each report. For example, Mark Zelmer, Canada's deputy superintendent of financial institutions, led the team assessing the European Union. Mark Branson, chief executive of the Swiss Financial Market Supervisory Authority (FINMA), did so for the United States. 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 other two from China and Japan. Additional checks and balances have been introduced since the first reports in 2012.

The assessment itself is comprehensive and authoritative, citing local context, impact on selected banks (which are identified), amendment processes under way, and responses from public authorities. The EU report thus includes a joint response from the European Commission, the European Banking Authority (EBA) and the ECB. The US report includes a joint response from "the US agencies," including the Federal Reserve Board, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency. The EU and US responses commend the work of the RCAP assessment team, even while contesting some conclusions. To be sure, financial policy is not an exact science, and individual judgment by the assessment team members still plays a role.

The reports examine 14 specific "components" in each jurisdiction. For the European Union, two weaknesses are highlighted. The EU 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 noncompliant. Another weakness is that the CRR exempts certain derivatives transactions of banks with public-sector entities and nonfinancial 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 on the European Union grades the "counterparty credit risk framework" component as noncompliant.

In both these cases, the rules have been adjusted during the EU legislative process to favor the bank financing of governments, other public entities, and companies—steps that may be described as mild financial repression with European characteristics. As for the United States, the two components "credit risk: securitization framework" and "market risk: standardized measurement method" are graded materially noncompliant, in both cases because the Dodd-Frank Act of 2010 prevents banking regulations from making explicit reference to the ratings produced by credit ratings agencies. For both the European Union and the United States, four additional components are graded largely compliant. All remaining components are deemed compliant, except one that has not been implemented in the United States and is thus assessed as not applicable.

The Basel Committee's assessment is actually milder on one component regarding the European Union than could have been expected. That component, "Definition of capital and calculation of minimum capital requirements," is graded largely compliant (as it is also for the United States). The report notes a number of departures from Basel III under this chapter. Among them is the treatment of insurance subsidiaries (which are important for large French banking groups), the capital of cooperative banks (important in Germany and other member states) 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 capital requirements regulation under what has been labelled the "Danish compromise" because it was negotiated during the Danish Presidency of the Council of the European Union in 2012. The compromise led the first RCAP report of October that year to grade the draft CRR as materially noncompliant on the definition of capital criterion. Since then, EU negotiators have apparently convinced the assessment team that its impact is less significant than initially feared.

The European Union has departed from the Basel standard more than other advanced economies because, in part, of its preference—at least until the inception of banking union in mid-2012—for hiding banks' problems as long as they could still satisfy their short-term obligations. This lenient approach, politely referred to as supervisory forbearance, has affected the position of several EU member states in the Basel Committee during the negotiation of Basel III in 2008–10. It has also shaped the legislative process that led to the CRR and its complement, the fourth EU 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. The aim to favor the direction of credit to struggling member states and companies led to the amendments on small and medium enterprises (SME) risk-weighting and CVA risk exemption in the later phases of the CRR/CRD4 legislative process. The European Union could have restricted the contentious provisions to small- and mid-sized banks, avoiding any problem of Basel III compliance because the Basel accords are only intended for large internationally active banks. But the European Union, perhaps influenced by larger banks, has long favored applying the same prudential rules to all banks irrespective of size.

Even so, the EU departure from Basel III has downsides:

  • It results in more lax supervisory standards. Banks' regulatory capital ratios are higher than they would be if Basel III were consistently applied. (The size of the difference depends on each bank's specific risk profile.) The looser standards undermine 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 widely referred to by the media and analysts as "fully-loaded Basel III." But that assessment was actually (as the EBA correctly described it) a CRR/CRD4 ratio based on the rules to become applicable in 2016 after the expiration of transitional provisions. Though progress from previous practice on supervisory transparency was achieved, the new standard falls short of informing investors about each bank's capital strength according to Basel III.
  • The departure from the global framework undermines the European Union'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, "compliance is influence." All things equal, 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 European Union had such moral authority following its swift adoption of the previous Basel II accord of 2004, and has not refrained from blaming the United States 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 European Union lags in adopting the more rigorous Basel III.
  • The European Union 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. But by not complying with Basel III, the European Union weakens the global authority of the Basel Committee itself. Other jurisdictions may now introduce their own deviations from the global standards, under debatable assertions of local or regional specificities, and invoke the EU precedent.

For these reasons, the European Union should readjust its supervisory practice and prudential legislation to comply with Basel III as it had with Basel I and Basel II. Annex 16 of the RCAP report helpfully lists 11 "issues that the European Union 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 being heavy-handed in seeking removal of the "materially noncompliant" mark.

Prospects for such convergence are mildly encouraging. The European Commissions' statement in response to the RCAP report's publication is more open and constructive than in October 2012, when the Basel Committee's first assessment was denounced by Michel Barnier, then European commissioner. This time, the shrill response has come from the European Parliament's main political groups via a scathing joint statement assailing the Basel Committee as "a body that is working without legitimacy and without any transparency." The lawmakers' assertion that the Basel Committee "cannot modify the decisions taken democratically by the European institutions" is beyond dispute. But the irony, not missed by some observers, is that their arguments mirror those used by Eurosceptics who paint the European Union as unaccountable, opaque, and illegitimate and reserve the democratic label for national institutions. In fact, the Basel III accord received ringing endorsements from political principals of the world's main economies, including the European Union and its largest member states, in successive summits of the G-20 since 2010. In spite of the posturing, however, future revisions of the EU CRR/CRD4 legislation, and of the Basel III accord itself, could eliminate at least some of the most egregious noncompliance provisions.

On a shorter time horizon, the ECB has an important role to play (since November 4) as the supervisor of all euro area banks—directly for the 120 largest ones and indirectly, through a common policy framework, for the others. It can use its supervisory discretion (what the Basel jargon calls Pillar II measures) to impose stricter capital requirements than the minimum ones set by the CRR and may align these with a more consistent application of the Basel III accord. It may also disclose how much a "fully-loaded" application of Basel III would reduce each bank's capital ratio, something that it has the authority to enforce under the European Union'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 had only observer status before. 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 over banks to impose practices that better comply with Basel III than the imperfect minimum set in the EU CRR/CRD4 legislation.