April 19, 2013
By Thomas Schuster
Basically, the European Union intends to adopt the Basel III accord. For that reason the European Commission drafted a capital requirements directive CRD IV (European Commission 2011a) and a capital requirements regulation CRR (European Commission 2011b) in 2011.
Both the directive and the regulation were negotiated under the co-decision rule. Parliament and Council negotiated the two bills in the trilogue framework, i.e. representatives of the Parliament, the Council and the Commission discussed the bills and finally agreed on a compromise in March 2013 (Council of the European Union 2013a and 2013b). The trilogue framework provides that both the European Parliament and the European Council have to formally accept the final compromise. The Parliament approved the compromise on 16 April 2013. We expect that the Council will vote on the rules in May 2013.
EU proposals in line with Basel III rules
The compromise fully adopts the new capital requirements: CET 1 capital must be 4.5% of RWA, additional tier 1 capital amounts to 1.5% of RWA, and tier 2 capital shall be equal to 2%.
The three capital buffers are also adopted: The capital conservation buffer consists of 2.5% of CET 1 capital with respect to RWA. The responsible financial authorities of the member states can establish a countercyclical buffer ranging between 0 and 2.5% of RWA, and the capital buffer of between 1.0 to 3.5% for global systemically important financial institutions is also implemented into EU law.
EU proposals which deviate from Basel III rules
Basel III defines the leverage ratio as tier 1 capital divided by total exposure (without risk weighting). This includes total assets plus off-balance sheet items (Basel III, paragraphs 153-164). The CRR determines the leverage ratio in the same way but states no quantitative minimum level which must be met (CRR Art. 416). It is planned that the European Commission shall – if appropriate – submit a legislative proposal to make a minimum leverage ratio of 3% a binding element as of 2018. Moreover, the European Commission considers setting up several different levels of leverage ratios based on the business model, risk profile, and size of the banks (European Commission, 2013, 22).
The EU defines the liquidity coverage ratio (LCR) in the same way as the Basel Committee: The stock of high-quality liquid assets must be at least as large as the total net cash outflow over the next 30 calendar days under a significantly severe stress scenario (BCBS, 2010, Para. 15, CRR Art. 401). However, the list of assets that are considered as high-quality liquid assets is far more restricted than the list of the Basel rules. Thus, government bonds of the member states play a relatively more prominent role. In contrast, assets from investment firms or insurance undertakings are banned (CRR Art. 404, Points 1 and 2). Moreover, the new EU regulation does not set a limit for the exposure of banks to single debtors if the debtor is a sovereign. For other debtors a large exposure limit of 25% applies.
The CRR only loosely describes the net stable funding ratio. The clear definition of the Basel III accord is not adopted. It is only stated that the “institutions shall ensure that long term obligations are adequately met with a diversity of stable funding instruments under both normal and stressed conditions” (CRR Art. 401 a). It is planned that the European Commission shall – if appropriate – submit a legislative proposal to set up details of the net stable funding ratio by 31 December 2016 (CRR Art. 481 a).
New EU proposals compared to Basel III
The European Union also plans to establish two new measures not mentioned by Basel III. First, an overall macroprudential systemic risk buffer shall be introduced. It is defined as CET 1 capital in relation to RWA. It can be binding for the whole financial sector or for one or more subsets of the sector. It shall be established to prevent systemic or macroprudential risks in a specific member state. The systemic risk buffer for global systemically important institutions G-SIIs will be generally a subset of this overall systemic risk buffer. The national financial authority can set up the overall macroprudential systemic risk buffer in the range between 0 and 3% until the end of 2014. Afterwards, the systemic risk buffer can range between 0 and 5% (CRD Art. 124 d).
Ratios of the macroprudential risk buffer greater than 5% need the authorization of the EU Commission (CRR Recital 10b). Moreover, the national financial authority has to inform the Commission, the European Banking Authority (EBA), and the European Systemic Risk Board (ESRB) about the measure and give detailed reasons why it wants to set a buffer rate above 5% (CRD Art. 124 d, Points 9 and 10).
Second, a risk buffer for other (than globally) systemically important institutions
(O-SII) is planned. It consists of CET 1 capital, can vary between 0 and 2%, and will generally also be a subset of the overall macroprudential systemic risk buffer. National financial authorities can determine systemically important banks within their jurisdiction and can impose this additional buffer if they consider it necessary. The buffer will be introduced from January 2016 onwards (CRD Art. 124).
Evaluation of the suggested measures
The proposals of the European Union to implement the Basel III accord into European law lead in the right direction. This relates to the reform items where the EU follows the Basel III rules and particularly to the optional capital requirements going beyond the international ones. However, there is still much room for improvement. In fact, some of the planned rules should be urgently revised.
- The risk weight of EU member states’ government bonds denominated in the domestic currency is 0%, independent of their rating (CRR Art. 109 Point 4). In contrast, already the Basel II rules (which remain unaltered by Basel III) postulate risk weights of up to 150%. To deviate from this prescription is clearly not acceptable. As the current sovereign debt crisis has shown, also government bonds bear the risk of default. Moreover, banks and their national sovereigns are connected in a potentially vicious circle where bank crises can lead to sovereign debt crises and vice versa. Thus, there should be no discrimination between government bonds (risk weight of 0%) and bonds issued by financial institutions (risk weights ranging from 20 to 150% (CRD Art. 115)). Hence, risk weights based on their rating should be introduced on government bonds as prescribed in Basel III. The phasing in until 2019 can ensure that the current euro debt crisis will not be aggravated by the new rules.
- The liquidity coverage ratio also prefers government debt compared to the Basel rules. Basel III sets up a list of high-quality liquid assets containing government bonds, corporate bonds, common shares, and residential mortgage backed securities (BCBS, 2013, 12-16). The EU list mainly contains government bonds. Under certain restrictions, assets from financial institutions also count as liquid assets. Assets from investment firms, insurance undertakings and financial holding companies are, however, excluded (CRR, Art. 404). There is no point in being that restrictive and in mainly concentrating on government securities. Hence, the list on what counts as high-quality liquid assets should be more in line with the list set up in the Basel III accord. However, only assets of very high quality should be eligible.
- Moreover, also concerning the new liquidity provisions, there should be a large exposure limit also to government bonds of individual countries if these bonds serve as liquid assets.
- The EU should also principally introduce a minimum leverage ratio of 3%, as put forward by the Basel Committee. The big advantage of this leverage ratio is that it can be computed easily since the assets are not risk-weighted and can hence be compared easily to detect banks with excessive leverages. The plans of the European Commission to set different minimum leverage ratios for different business models and risk profiles should make sure that the leverage ratio deviates from 3% only in exceptional circumstances.
- The EU proposal’s definition on what counts as CET 1 capital is wider than the Basel definition. Consequently, the BCBS judged that the EU definition of capital is materially non-compliant with the Basel III accord (BCBS, 2012, 12). For two reasons the definition of capital should be in line with Basel III. First, financial institutions should only use equity capital which can really buffer losses. So the definition of capital should be very restrictive to meet this criterion. Second, the fact that the capital of European banks does not meet the Basel III criteria sends out a problematic signal to the worldwide financial community: European banks tend to bear a higher risk of bankruptcy than their counterparts in the other G20 countries. Consequently, the financial markets could charge a higher risk premium to European banks, which would increase their capital costs and weaken their ability to compete internationally. Thus, market pressure might eventually enforce a stricter definition of CET 1 capital.
- In the same document as mentioned in the previous paragraph, the Basel Committee criticizes the EU’s internal ratings-based (IRB) approach to measure credit risk as materially non-compliant with Basel III (BCBS, 2012, 12). For example, the BCBS criticizes that the EU allows a bank using the IRB approach to permanently apply the standardized approach even if the use of the standardized approach leads to lower risk weights. Under Basel III this is not possible. The standardized approach can particularly lead to lower risk weights if applied to exposures of central governments, regional governments, and local authorities. As a consequence, the amount of risk-weighted assets can be smaller, so that the banks would have to hold less capital to meet the minimum capital requirements. Again, this non-compliance sends out the signal that European banks are more exposed to financial distress and consequently the capital costs are higher. Taking into account these arguments the EU rules concerning the IRB approach should meet the blueprint of Basel III.
- If all capital requirements and the various capital buffers are added, the maximum amount of equity capital is 18%. The European legislator wants the member states not to go further (BCBS, 2013, 11). So if member states want to exceed this threshold (e.g. setting up a systemic risk buffer of more than 5%), they need the authorization of the European Commission (CRR Recital 10b). Furthermore, they have to provide detailed reasons why their banks need more capital. Some member states – e.g. Spain and Great Britain – already announced to set up stricter capital requirements for their banks (European Commission, 2013, 11). It is not sensible to restrict them. If a banking sector of a member state is far more risky and volatile, a national authority should be able to easily increase the capital requirements of domestic banks. Consequently, the rules of exceeding the systemic risk buffer beyond 5% should be modified. It should be sufficient to inform the European Commission about this step and to provide reasons.
- The net stable funding ratio is not clearly defined in the EU proposal. The regulation should come up with a clear definition, as given in the Basel III framework. Moreover, so far the rules about stable funding are only provisional. The EU should make a clear commitment to introduce the net stable funding ratio in line with Basel III and implement it in the revised regulation.
- Basel III applies the capital conservation buffer to all financial institutions, irrespective of their size. The EU directive plans that member states may exempt small and medium-sized investment firms to maintain the capital conservation buffer (CRD Art. 123 Point 1a). There is no reason to make an exception concerning smaller firms. Therefore, the EU should stick to the same rule and impose the capital conservation buffer to all financial institutions.
10. Finally, it is stated that gender balance in management boards of banks and investment companies (board of directors and supervisory boards) is important. The directive calls for a threshold for the representation of the underrepresented gender (CRD Recital 45a). However, a specific threshold is not specified. The demand for this threshold should be dropped. The management board members of financial institutions should be chosen only based on their knowledge and competence, irrespective of age, gender, cultural, geographic, educational, and professional background.
Thomas Schuster is Professor of Quantitative Methods at the University of Applied Sciences Bad Honnef ? Bonn and Visiting Research Fellow at the Cologne Institute of Economic Research.
 Basel III paragraphs refer to BCBS, 2011a.
 CRR articles can be found in Council of the European Union (2013b).
 The EU term G-SII is the same as the Basel expression G-SIFI.
 CRD articles are laid down in Council of the European Union (2013a).