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Friday, December 05, 2014

EU falling short on implementing bank capital rules

The BIS Basel Committee has today released its assessment of the EU’s (and the USA’s) implementation of the Basel III rules on bank capital and it does not make good reading for the EU. They key findings of the report are (as detailed in the press release and the graphic below, click to enlarge):

  • “Eight of the 14 components meet all minimum provisions of the relevant Basel standards and these were therefore graded as "compliant".”
  • “Four of the components were assessed as "largely compliant", reflecting the fact that most but not all provisions of the global standard were satisfied.”
  • “One component - the Internal Ratings-based (IRB) approach for credit risk - was assessed "materially non-compliant" and pertained primarily to the treatment of exposures to SMEs, corporates and sovereigns.” In particular, the report notes that exposures to SMEs are given concessionary risk weightings, presumably to try to encourage this specific type of lending, however it is nonetheless not in line with the rules. Furthermore, it finds that banks are given a significant amount of leeway in how to value their sovereign debt holdings, with most across the EU simply applying zero-risk weighting – again this is a deliberate attempt to limit any distortions to the sensitive Eurozone government debt markets.
  • “Another component was found to be "non-compliant". This relates to the EU's counterparty credit risk framework, which provides an exemption from the Basel framework's credit valuation adjustment (CVA) capital charge for certain derivatives exposures.” Essentially the current rules allow exemptions for instruments which are not traded on exchanges or the wider market and therefore may be hard to value. Furthermore, this “materially boosts bank capital ratios,” though the report accepts that the EU is considering changes to these specific rules.
  • Overall the EU was given the second lowest rating (on a scale of four) of “materially non-compliant”, making it the first jurisdiction to be found on the whole not the be complying with the Basel rules. The assessment is also particularly poor compared to the US, which was found to be “largely compliant” with the rules, in general its failings also seem to be more minor as well as less numerous.
The European Commission’s response can be found here, while there is also a response section following the executive summary in the main report. The EC claims the EU’s approach is “particularly ambitious approach, unique in the world”, which is true to an extent given the diverse nature of national banking systems. The response notes that some changes are already in the pipeline, but largely challenges the interpretation which the Basel Committee makes of the rules. On the whole it is not entirely convincing but then, since the Committee cannot force the EU to change, it seems the Commission is largely happy to ‘agree to disagree’ on a number of areas.

While all of this may seem rather mundane and technical it does have some important implications.

First off, it raises questions about the quality and thoroughness of the recent ECB and European Banking Authority stress tests. We, along with plenty of others, have already raised concerns about this and the report adds further weight to those concerns. Furthermore, the specific problems outlined would certainly have helped present European banks as having higher capital ratios largely by reducing the perceived riskiness of certain assets they hold.

A report by Yalman Onaran for Bloomberg earlier this week highlighted the problems relating to the use of banks internal models to weight risk by contrasting this approach to that of using the pure leverage ratio. As the article notes, under the leverage ratio approach 12 large European banks would need to raise a further €66bn in capital. While neither approach is perfect, the Basel Committee’s indictment of the bank’s internal models and the way a large number of exposures in a number of sectors are valued seems to support such analysis and criticisms.

The second important implication is that is once again clearly highlights that the EU probably remains the more important level of policy making and legislation than international level or international organisations – at least when it comes to how things are structure on the ground.

Despite agreeing to follow the Basel III rules the EU is the one that designs and implements the specific legislation. In this case it has clearly altered the rules significantly to suit its own needs – the gap with the original rules as well as how they are interpreted and implemented in other jurisdictions is clear. Furthermore, while the Basel Committee can issue a damning judgement of the EU’s approach, it cannot force it to change. In this relationship all the hard (legal) power lies with the EU. This also extends beyond just implementation to interpretation. Despite writing the Basel III rules the Basel Committee is not even able to guarantee primacy on how they should be interpreted as the EU’s response to the report clearly shows.


Jesper said...

The introduction of regulation on supra-national level only adds to complexity and the added complexity leads to even more unmanageable banks.

No matter where the HQ of the bank is the cash placed in (as an example) Luxembourg should only be backed by Luxembourg government finances.
It would force the HQs to be more vigilant and also the national regulators to be more vigilant.

If it would have been like that maybe the UKs banks (mis)adventures in Ireland would have been less costly to the UK-taxpayer....

Credit-bubbles are national and should be dealt with accordingly -> subsidiarity principle. A local, regional or even national credit-bubble should not be dealt with by supra-national monetary tools - it is for the national regulator to deal with. Monetary tools is not the only tool to deal with credit-bubbles.

Valen said...

All financial systems are flawed in one way or another, the only question really is can the system provide stability and a means to transact which requires the population to have a degree of confidence in it. If the confidence is there people will use it. These people are not trust worthy. They don't care about you but they will tell people that to get extra means for short term is easy. If you think these people are going to solve this problem you are gravely mistaken.

Valen said...

More regulations are not the answer. They cause banks to either retreat from the lending market place (bad for consumers, housing and so on) or they take on more risk in other areas to compensate for losses to their revenue growth. No one is in charge in modern finance. And ordinary people have no chance to survive without all those "find online loans here" ads. The financial system is completely rigged against them.

Laura Knight said...

More regulations are not the answer. They cause banks to either retreat from the lending market place (bad for consumers, housing and GDP growth) or they take on more risk in other areas to compensate for losses to their revenue growth. No one is in charge in modern finance. And ordinary people have no chance and need to avail of this money tool. The financial system is completely rigged against them.