Europe’s finance ministers are currently deciding on the legislation intended to implement the Basel III international agreement on bank capital, leverage, liquidity, and risk management. This column argues that many officials, within Europe and beyond, severely underestimate the importance of this debate for reaching a global standard for financial regulation.
The EU’s finance ministers are furiously debating the piece of banking legislation known as CRD4/CRR (the abbreviations stand for the fourth Capital Requirements Directive and the Capital Requirements Regulation). The measure is intended to implement the Basel III accord on bank capital, leverage, liquidity and risk management, which was adopted at the global level by the Basel Committee on Banking Supervision in late 2010.
There are two main unresolved issues.
- First, the legislation’s departures from the Basel III Accord.
- Second, whether individual member states should be allowed to impose core prudential requirements (known in the Basel jargon as Pillar I) beyond the commonly agreed minimum, especially as regards capital ratios.
The first item matters not only for the EU but also from a global perspective. The current EU debate is mostly about the definition of bank capital. The particular points turn on two exceptions, which are commercially important for German and French banks.
- So-called “silent participations” in some German banks.
- Capital treatment of insurance subsidiaries, which affect some large French banks among others.
On both items, the CRD4/CRR draft is seen by many observers as not compliant with Basel III.
The issue is part of a broader question. The EU was a strong promoter of internationally consistent financial standards before the crisis. Its stance helped EU institutions fulfil their own agenda of single market harmonisation (Posner and Véron 2010).
The EU adoption of the original Capital Requirements Directive (implementing the previous global capital accord, known as Basel II) and its adoption in 2002-5 of International Financial Reporting Standards (IFRS) arose from an alignment of interests between EU institutions and global standard-setters.
EU institutions viewed such harmonisation as an overriding good, superseding any misgivings they may have had about a particular standard’s content. There were exceptions, of course. For example, the European Commission “carved out” some parts of an international accounting standard on financial instruments (IAS 39) when it was endorsed into EU legislation in late 2004. But the general picture was very consistent. This made the EU unique in the global context, as a consistent champion of global standards even when it did not determine their content.
A new dynamic between EU and global regulators
The crisis has changed the dynamics between the EU and global standard-setters. EU institutions now seem to care more about the content of the standards than about global harmonisation or convergence. This is not necessarily a conscious change. In both the Commission and Parliament, most people still see the EU as an internationalist player. But in practice, the EU now looks much more like the US, in favour of global standards when it “likes” them and not in favour when it “dislikes” them.
The EU’s new position is complicated by the lack of a consistent policy infrastructure to determine whether a standard is “liked” or “disliked.” As a consequence, the process is more often than not vulnerable to special-interest pleading. Meanwhile, global standard-setters have lost the EU as a consistent global champion – as it had been before the crisis.
Many EU officials underestimate the potential of the CRD4/CRR legislation to undermine the global authority of the Basel Committee. Many other jurisdictions are carefully watching the EU legislative debate. If the EU adopts final legislation that is not compliant with the definition of capital under Basel III, other countries could well introduce deviations of their own, dictated by local special interests.
The US delay has not helped
The US, in delaying its own proposals for Basel III implementation, has not helped the situation. In November 2011, Federal Reserve Board Governor Daniel Tarullo suggested that a public regulatory proposal to implement the Basel III accord in the US would be unveiled in the first quarter of 2012 (Tarullo 2011). We are in early May, and still waiting. This is a regrettable failure of US leadership.
A published American proposal compliant with Basel III would encourage the EU to comply as well. Also disappointing is the delay by the US Securities and Exchange Commission (SEC) on the adoption of international reporting standards, which has undermined the global credibility of IFRS. Almost everybody accepts that domestic political constraints are preventing the US from adopting all IFRS standards in the short term or even setting a firm date for complete adoption. But the SEC’s “condorsement” concept (SEC 2011) allows for a lot of flexibility in terms of gradual adoption. The SEC’s inability to commit itself to even a minimalist condorsement schedule undercuts the quest for global financial reform.
The second big issue in the CRD4/CRR debate is more of an internal EU matter. The European Commission favours a “maximum harmonisation” that would prevent member states from raising their Pillar I capital requirements above a commonly agreed minimum.
The argument is that harmonisation in this fashion would minimise competitive distortions inside the EU. But the main distortion by far in the EU market for banking services is the fact that most of the bank supervision/resolution policy framework remains national, pegging banks’ financial health to the situation of their home-country sovereign. This link has disastrous effects these days, particularly in the Eurozone (Merler and Pisani-Ferry 2012). The Commission’s Directorate General for the Internal Market and Services (DG MARKT) has failed to address this distortion. A legislative proposal on bank crisis management and resolution, which is not even published in draft form, should have been advanced forcefully and as far back as mid-2009. Had it been put forward, it could have pre-empted diverging legislative moves on national resolution frameworks already adopted by many member states.
Given this failure, the Commission’s assertion that higher capital requirements in Sweden or the UK would harm a single market rings hollow. The Basel Committee has explicitly stated that its standards were a mere minimum and that individual jurisdictions were encouraged to go beyond them, as Switzerland has already decided to do. In its comment letter on the CRD4/CRR proposals in March, the European Systemic Risk Board has come up with a balanced proposal that would combine freedom to decide macro-prudential measures in individual member states, including by raising Pillar I capital requirements, with the need for EU-level coordination (ESRB 2012). These proposals make sense and should be endorsed in the final legislation.
•ESRB (2012), “Principles for the development of a macro-prudential framework in the EU in the context of the capital requirements legislation”, comment letter, ESRB/2012/0050, March
•Merler, S and J Pisani-Ferry (2012), “Who’s Afraid of Sovereign Bonds?”, Bruegel Policy Contribution 2012/02, February
•Posner, E and N Véron (2010), “The EU and financial regulation: Power without purpose?”, Journal of European Public Policy, March
•SEC (2011), “Exploring a Possible Method of Incorporation”, Securities and Exchange Commission Staff Paper, May.
•Tarullo, D (2011), “The Evolution of Capital Regulation”, Speech at the Clearing House Business Meeting and Conference, New York, 9 November.