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.

What next on the EU bank bonus cap?

Today has been billed as the final chance for UK Chancellor George Osborne to secure a change in the proposal to limit bank bonuses across the EU.

It is true that any change to the broad political agreement (including the level of the ratio limiting bonuses) would probably need to be secured today – a move which looks unlikely. However, as we note in today's press summary, the technical discussions over the specifics will continue for some months, presenting the opportunity to water down the proposal behind the scenes. Numerous issues remain unresolved such as: whether the cap will apply to all staff or just the highest paid, whether it will apply to all banks or only larger ones and, most importantly, whether the EU will stick with the plans to apply it to subsidiaries (both EU ones located elsewhere and foreign ones located in the EU).

So there could yet be room for some improvements to the proposal. There are also two other issues which have cropped up in this discussion: the possibility of the UK invoking the Luxembourg compromise and potential legal challenges against the proposal.

What is the Luxembourg compromise?

See below for a box from p.31 of our ‘Continental Shift’ report (really a worth a read by the way to understand the context of this and related debates) which explains the premise (click to enlarge):

It has been muted that Osborne could trigger this at today’s meeting. This is a last resort and seems unlikely – besides it is not clear how effective it would be in this case, as it is only a gentleman's agreement.

Is the proposal open to legal challenges?

According to the FT, banks have been receiving legal advice and believe they may have a case based on Article 153.5 of the Lisbon Treaty, which says:

“The provisions of this Article shall not apply to pay, the right of association, the right to strike or the right to impose lock-outs.”

Article 153 is in the social policy chapter of the treaties. Currently, the legal base for the rule is as part of CRD IV, i.e. under financial regulation and looking to address financial risk taking. 

The Commission and MEPs have also dismissed claims of illegality, on the grounds that the rules do not limit total pay, but simply set a ratio on variable pay in an attempt to reduce risk taking, and it is not therefore social policy.

It looks likely that there will be some legal challenges, although from the private sector rather than the UK Government.

EU tightens the noose on bank bonuses

As we noted in today’s press summary, a tentative EU deal was struck last night on bank bonus curbs, as part of the broader agreement on CRD IV (which implements Basel III). We’ve discussed this in detail before, so we refer you to that post for the background.

The deal looks much as expected, although a couple of changes have been added:

• Bonuses should be limited at a 1:1 ratio to salary, which can rise to 2:1 with explicit shareholder approval.
• Up to a quarter of variable pay can be discounted and issued in instruments deferred for more than five years, which could increase the ratio above 2:1.
• Bonuses in the form of long term equity or debt that can be bailed in if a bank fails will also be given more favourable treatment.

Surprisingly, the deal still includes plans to force subsidiaries of foreign banks in the EU to adhere to the bonus rules and, more importantly, forcing all subsidiaries of EU banks in the rest of the world to do so. This could hamper competitiveness and, we suspect, may still be subject to changes. This is also an area where the UK might have expected to receive a concession.

What happens now then? EU finance ministers meet next week and will discuss the proposals. Significant changes seem unlikely, which could mark a loss for the UK, which has vehemently opposed the rules from the start.

The real question for the UK is whether it should try to force a formal vote on the issue at the meeting of finance ministers. This would raise the prospect of voting down the UK on a financial services issue – that this has never happened before is often cited by the EU as a counterargument against UK concerns over EU financial regulation. If the UK is outvoted it would mark a potentially significant precedent for the UK's future relations with the EU.

It should be remembered though that this is only a small part of the large CRD IV package, which has been continuously delayed due to MEPs' demands for bank bonuses to be included. The UK has managed to secure favourable treatment on the key aspect of the legislation – the ability to adjust national capital requirements for banks.

As we have suggested before, the debate on bank bonuses seems slightly tangential in terms of the wider debate over bank capital and broader financial stability (indeed there are valid question about why it has been lumped in with CRD IV at all). For all the talk of needing bank bonuses to limit risk taking and moral hazard in banks, the EU has supported and approved €1.6 trillion in state aid to banks over the course of the financial crisis. Many countries have pushed for limits to capital requirements and supported the easing of the Basel III liquidity controls. The EU, and the eurozone in particular, has also consistently argued for and supported bank bailouts and refused to countenance imposing losses on bank creditors, instead shifting the burden to taxpayers.

Trying to limit moral hazard by tackling excessive bank bonuses is all well and good, but it is a drop in the ocean when it remains clear that states and central banks will continue to bailout banks at any cost.

EU caps on bankers' bonuses: the perfect regulatory storm?

The discussion over bank bonuses has been heating up inrecent days. Discussions between EU ministers, the European Parliament and the Commission (so-called trialogues) are restarting today as the three try to reach an agreement on the rules for bank bonuses to be included in CRD IV (the EU’s legislation implementing the Basel III rules and more).

The parliament is pushing for a stringent cap on bank bonuses of 1:1 ratio with fixed salaries, which could be increased to 2:1 with approval from a majority of shareholders.

There is a lot going on here, beyond the actual proposal, including:

• The UK is in a clear minority in categorically rejecting a cap, but unable to block a rule with disproportionate impact on the UK - courtesy of QMV and co-decision.
• Germany being the swing state - no surprises there - having first supported the UK's position, it has shifted as part of a wider political push to get tough on bankers, which strikes a chord with German voters. The revelation in December that Deutsche Bank hid $12bn worth of losses during the crisis and the growing Libor and Euribor rates scandals, haven't exactly helped...
• The European Parliament flexing its muscles, successfully managing to tap into the public mood, breaking the Council common position, which is unusual. (Don't worry, any favour EP thinks it wins with the electorate, would be ruined if it voted down Ministers' proposal for a reduced long-term EU budget).
• "Anglo-Saxon capitalism" in the docks - perception is one of a continental attack on British bankers (ironic since a large part of the talks have focused on making CRD4 more flexible to allow the UK and others pursuing tougher capital rules for banks). This will not make the City any more EU-enthusiastic.
• No one wants to be publicly seen to back bankers - even the UK government itself is keeping a low profile.
• Changing incentives as part of the eurozone banking union, with the club within a club dynamic again coming to the fore (see our December 2011 report to see what we mean). Looking forward, the question is, if a country decides to remain outside the banking union - therefore signalling that it will stand behind its own banks, come what may - should it not also have more discretion in getting the incentive structure in the banking sector right?

So what does the UK want?

On Friday the UK submitted a paper to its EU partners to put forward it’s case. We've seen the paper, and here are some thoughts / points - which also have been largely reported in the media:

• The UK argues against a firm cap. Any extended remuneration should be determined by shareholders (although the UK proposal does water down the size of the majority needed to approve remuneration slightly).
• The UK is pushing for a focus on non-cash deferred bonuses. This is included in the current proposal to some extent but the UK fears (with some grounding) that the current proposal will encourage an increase in fixed salaries and a focus on upfront cash bonuses - and reduce firms' ability to cut costs during a downturn, potentially leading to more lay-offs and less lending (on a bit less solid ground here, we think).
• It also argues that deferred non-cash bonuses (over three years) should not fall under any cap, while also rejecting the proposal that all employee benefits, above those mandated by law, should be categorised as a ‘bonus’.
• The government is also keen to see that subsidiaries of EU banks located in the rest of the world should not have to adhere to the rules. Furthermore, EU subsidiaries of banks headquartered outside the EU should not have to implement the rules (although their bonus plans will still need to be judged ‘prudential’ by the relevant financial supervisor).

So is this special pleading? Well, to some people in the City, the world will end if this comes into force - which is not quite the case. In fact, there's no surprise that politicians seize the opportunity to strike down on bankers' pay, given that many banks have been forced to seek taxpayer-backed bailouts and the rest of it. So the first message to the financial sector is: if you don't want to be subject to tougher regulations, stop screwing up.

But it could still be damaging and there are questions over how much difference a cap would really make on incentives and the distorting effects this could have across the board. Ultimately, the risk taken on and the decisions made by banks are dictated by much more than just bonuses - it is just a small part of a wider culture which needs to be reassessed. Targeting and correcting perverse behaviour still seems to be better done through more effective supervision and tighter regulation - the irony should not be lost that many of those pushing for a cap are also the ones advocating a maximum limit to capital levels and supporting watering down the Basel III liquidity requirements (see here for details). And there should be no doubt that this could make talent less likely to choose the EU over other part of the world, which clearly isn't in anyone's interest.

In the end, bank bonuses are also only a small part of the much larger CRD IV legislation. There is unlikely to be a formal vote on bank bonuses itself - and Ministers rarely vote in the Council - but the UK seems to be heading for a defeat on a pretty symbolic issue at a sensitive time.

On the other hand, if the UK government can pull this one off, it should be given a lot of credit. Ultimately, the final outcome of CRD IV as a whole will be the more important bellwether by which to judge UK success or failure.

Easing of the Basel III rules - a test case on conflicts of interest?

A lot has been written over the past few weeks regarding the easing of the Basel III banking rules, which we've been meaning to cover but didn't get round to doing.

The specifics and details have been well covered so instead we'll look at some of motivations behind the changes. In our view, the change provides an interesting insight into the potential conflicts between monetary policy and financial supervision – something we have discussed at length with regards to the ECB being turned into the single financial supervisor for the eurozone (see also Felix Salmon’s blog for a wider discussion of this issue).

The changes, which are fairly technical and complex, focus on easing the burden of banks in creating what is known as the Liquidity Coverage Ratio (LCR). This is essentially a liquidity buffer which banks will be required to hold to ensure that they have enough cash (or cash like assets) on hand in a crisis to cover themselves for 30 days. The time frame in which the banks must have this buffer in place has now been increased by 4 years as well.

Again we won’t go into the detail of whether this change undermines the attempts to make banks safer but we would highlight that many banks already meet the adjusted standards, albeit with significant support from central banks (a point we’ll expand on in second) – given the on-going banking troubles in Europe and the US this is naturally a concern.

Monetary policy vs. financial regulation

More interesting from our perspective is the motivation for this change. As Bank of England Governor Mervyn King said:

“Most banks are completely overflowing with liquid assets…[Which] reflects the way in which central banks around the world have expanded balance sheets to provide economic stimulus. That won’t always be the case in the future.”

“Since we attach great importance to try to make sure that banks can indeed finance a recovery, it does not make sense to impose a requirement on banks that might damage the recovery.”

So it seems that the ultimate motivation for the move is to make it easier for central banks to remove themselves from non-standard monetary policy measures (such as QE or the LTRO) without fearing a massive drop in lending.

Clearly, both these concerns fall into the realm of monetary policy, rather than supervision or regulation. Obviously, a collapse in bank lending would be bad for everyone, so the measures are tied to some notion of short term financial stability, but surely these comprehensive Basel III regulations – which will set the basis for financial regulation over the next decade or more – should be taking a much more long term view than this. There are very real concerns that in the long term this could hamper the safety of banks and their ability to withstand future crises without taxpayer help.

A further motivation for the changes seems to be an attempt to encourage demand for a wider variety of assets by allowing them to be held as part of the LCR. Again this is all well and good, but it is the job of monetary policy to manage such demands and should not become ingrained in long term regulation. It is hard not to see this as a sop to the current crisis and immediate economic problems. (On the other hand we would note that this does help ease concerns that the requirements for banks to hold more sovereign debt would worsen the sovereign-banking-loop, although again increasing the risk on banks’ balance sheets is not a desirable trade-off.)

As mentioned above, the easing of regulations may make it much easier for central banks to exit their non-standard monetary policy measures without causing market distortions. The lack of a clear exit strategy is something which we have continuously warned of within regards to greater ECB intervention and the problem still applies. Obviously, finding the best way out is important but not at the expense of a safer banking system. Furthermore, taking such substantial action, such as that seen during the crisis, should not be done lightly and altering regulations to ease the potential problems or side effects of such actions could lead to a situation where the final cost of such actions are not fully considered. It is not hard to imagine similar pressure being applied to the ECB’s monetary policy, particularly if the eurozone crisis escalates again, while easing supervision would provide an easy out rather than managing the imperfect one size fits all monetary policy.

We must note that these regulations are produced by the Basel Committee and the BIS, not the ECB, so it is far from certain that the ECB will act in a similar way (although many of the central bankers involved do overlap). Additionally, the ECB will not be directly responsible for regulation but supervision, although there is substantial flexibility within this bracket and the people involved will still have a large say on regulation at the European Banking Authority (EBA). 

Our main point is that there will be very similar pressures and very similar powerful lobbies, which seem to have had a substantial impact here. This of particular concern for the ECB, where the Chinese walls could well prove insufficient, with the ultimate power for both supervision and monetary policy residing with the Governing Council.

We would suggest the previously mostly theoretical conflict of interest between financial supervision/ regulation and monetary policy just got a little bit more real.