Cutting out the capital rule risks

Rules on capital to make sure that banks were protected against risk failed miserably, which means reform of the system is high on the EU’s agenda.

The failure during the crisis of major European banks such as Royal Bank of Scotland, Fortis and Commerzbank laid bare the inadequacy of the rules on available capital that Europe had placed on its financial institutions. These rules were supposed to ensure that banks had sufficient protection against risk, but the provisions proved to be too low and too easy for banks to circumvent.

It was obvious, therefore, that reform of the minimum capital requirements placed on banks would be a core part of the EU’s financial reform agenda. It has also been a core element of the G20’s work. The rules that failed in Europe were based on an international framework drawn up by the Basel committee of banking supervisors, and there was firm agreement among the G20 countries, at a summit in April 2009, that this framework had to be improved.

The EU has made some quick progress in its reform efforts, but there is now a danger that the work could become bogged down, largely because of faltering enthusiasm on the other side of the Atlantic.

Revisions

The European Commission presented a first batch of revisions to the EU’s capital requirements in October 2008, only two weeks after the investment bank Lehman Brothers filed for bankruptcy.

The urgency of the moment prompted (relatively) rapid action on the part of the European Parliament and the Council of Ministers. The reforms, which obliged banks to retain the equivalent of 5% of the risk they sold on to investors in securitised debt, and which prevented them from investing more than 25% of their funds in a single counterparty, were agreed in May 2009.

A second package of reforms, presented by the Commission in June 2009, is expected to be agreed by MEPs and governments in the coming weeks. These reforms would prevent banks from getting round the rules by placing assets on their trading book rather than their banking book, where they are subject to far higher capital requirements. They would also place higher capital requirements on banks engaged in complex re-securitisation of debt.

Extra reserves

Both these sets of reforms, however, pale in ambition compared to draft proposals put forward by the Basel committee in December. These reforms, which follow guidelines agreed by the G20, would push banks to build up extra reserves of capital during good economic times that they could draw on during downturns. They would also require banks to meet a minimum liquidity standard.

The proposals have provoked a backlash from the banking industry, which has warned that meeting the liquidity standard would reduce its ability to lend to businesses and households, hampering economic recovery.

“We truly believe that over-burdening the banks with stringent financial measures would prevent them from fully playing their part as providers of credit to the economy at large,” Guido Ravoet, secretary-general of the European Banking Federation, said.

Concerns about the proposals have already been raised by the Danish government, which fears they could harm the country’s mortgage banks.

The Basel committee and its supporters argue that the reforms are essential to prevent a repeat of the crisis. They give the example of the bank Bear Stearns, which had to be rescued by the US government in March 2008. Bear Stearns had a strong capital base, but failed because of a short-term drop in market confidence, which rendered the assets it held illiquid.

The Basel committee has said that it will finalise its proposals by the end of 2010 so that they can be implemented by the end of 2012.

Draft legislation

Michel Barnier, the European commissioner for the internal market, has said that he is ready to incorporate the Basel proposals into EU law. He launched a consultation on them in February, and plans to present draft legislation in December.

The US, however, has been receptive to the banks’ concerns and has shown little appetite for implementing the Basel package, leading to concerns that finalisation work at Basel could be delayed. Alistair Darling, the UK chancellor, said in February that he feared the Basel timetable could slip and that this would be “very, very bad”. A major financial reform bill currently under discussion in the US Senate mentions the need to reform bank capital requirements but gives no details, instead leaving it to the country’s regulatory bodies to work out what should be done.

Should the US decide not to implement the reforms, Barnier would have to decide whether to press on regardless, leaving EU banks with a potential competitive disadvantage.