Monday, July 16, 2012

Bank Capital Reform in the Shadow of the Euro Crisis

European banking reform continues to develop alongside of - and perhaps in spite of - the ongoing Euro crisis. A significant EU reform package - involving a new directive (Capital Requirements Directive IV, or CRD IV) and a new regulation (Capital Requirements Regulation, or CRR) - is making its way through the EU legislative institutions. These reforms are driven in large part by Europe's undertakings within the global Basel system: Europe has committed to implement much of the most recent Basel package of reforms (known as Basel III) by January 2013.

One of the chief requirements of the Basel III reforms is to increase both the quantity and quality of the 'regulatory capital' banks must hold. This capital is intended to operate as a financial shock absorber in the event of large losses - assuring a bank's continued solvency and sparing shareholders (and - in a worse case - taxpayers) pain. Basel III is a system of minimum standards - countries are expected to comply with Basel III's requirements but are free to impose higher standards. And several countries (Switzerland, for example) have determined to require their banks to maintain even more regulatory capital than what Basel III demands.

The combination of common minimum standards and regulatory flexibility is familiar to the EU Member States: it is a feature of most EU-level regulation, known as "harmonization". But in its most recent drafts of CRD IV and CRR, the EU proposals called for "maximum harmonization," a design where the Basel III minimum standards serve to fix mandatory standards for the implementing EU Member States. Basel III requires that national regulators impose a minimum capital requirement for so-called Tier 1 capital ratio of 6 percent. By its terms, the Basel III framework permits countries to impose higher Tier 1 capital ratio requirements. But to permit each EU Member State to impose its own Tier 1 capital ratio requirement (so long as it exceeds the Basel III minimum) would introduce competitive and operational stresses within the somewhat unified European banking market. These concerns in turn have motivated EU officials to prefer "maximum harmonization" whereby all EU Member States would enact identical Tier 1 capital ratio obligations.

Within Europe, there has been considerable push-back from certain Member States. The United Kingdom and Sweden, for example, have pressed their desires to impose higher capital ratios than what a common European standard would provide. Requiring banks to have more capital reduces the likelihood of bank bailouts - and thus would improve the creditworthiness of the home state. Note the United Kingdom and Sweden are EU Member States which maintain national currencies. Germany and France reportedly support a mandatory single common standard.

On May 15, EU finance ministers reached a tentative compromise on capital ratios, somewhat relaxing the demands of maximum harmonization. EU Member States may, according to the May 15 understanding, impose capital ratios that exceed the Basel III minima by up to 300 basis points (that is, 3%). Beyond this, a Member State would need EU approval.

The current Euro crisis has had an effect on this legislative controversy. Indeed, various outcomes of the Euro crisis promise to leave the European banking field as a substantially different state. A collapse of the Euro would greatly reduce the pressure for harmonization; a return to national currencies would require placing most flexible monetary tools (such as capital requirements) in the hands of national regulators. Greater European integration - say, in the form of a common bank regulator ("EuroFed"), a common deposit insurance regime, or common windup authority - would demand a unified approach to capital requirements. At this point, one simply does not know how the Euro crisis will end - although one suspects the resulting landscape will differ substantially from its current aspect.

Indeed, Europe's enthusiasm for Basel III (in its current form) may depend on the resolution of the Euro crisis. The EU may wish to rethink Basel III. This might take the form of implementation selectivity - picking and choosing from Basel III's various mandates those which make sense for a post-Euro crisis banking environment. Or it might induce the Europeans to re-open Basel III. Anything is possible in the event of a Euro meltdown.

A resolution of the Euro crisis - one way or the other - may sweep away much of the current reform proposals. And the United States has been taking its time in implementing Basel III reforms for a set of different considerations. January 2013 may simply be an inconvenient time to resolve the form of European banking regulation, even if EU compliance with Basel III is assumed.

Thanks to Jack Cooper for research assistance.

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