European Parliament Approves Implementation of Basel III

On April 16, the European Parliament approved the packet of legislation known as CRD IV, which largely implements the Basel III banking reforms. This completes the political phase of the European legislative process -- formal adoption of CRD IV by the Council of Ministers is expected to occur in June. Assuming the schedule is met, CRD IV will become law effective January 1, 2014. Consultations on the form of detailed regulations ('technical standards') have now been launched.

CRD IV implements Basel III -- and does more. The term 'CRD IV' signals that this is the fourth generation of the EU's Capital Requirements Directive. The name is no longer precise: CRD IV is comprised of a Regulation (law that is uniformly applied throughout Europe) and a Directive (which requires national implementation and admits a certain degree of variation).

CRD IV increases the quantity and quality of regulatory capital a financial institution must hold. In most cases, transitioning to CRD IV requirements will place pressure on European banks to retain earnings, raise additional equity capital, dispose of assets or change their respective asset mixes. Under the existing version of the Capital Requirements Directive (which were adopted immediately prior to the onset of the 2007/2008 financial crisis), many European banks reduced their capital to extremely low levels. Reportedly some European banks had leverage ratios of over 40 to 1 -- that is, maintaining less than 2 percent of effective capital. Many of these same banks remain in crisis now -- a problem that in turn has infected the balance sheets of several EU Member States. CRD IV acknowledges the insufficiency of bank capital during the financial crisis. The new requirements are complex -- and involve a stack of charges and buffers. A minimum of 8 percent capital will now be mandated, computed with regard to a bank's risk-adjusted assets. Left undetermined for the time being is the overall leverage cap -- it is this simple metric that may prove to be the most meaningful limit on a bank's level of debt.

The core content of CRD IV -- the Basel III minimum capital requirements -- is for the first time expressed in a regulation. As an EU regulation, these norms are automatically and directly binding to all 8,000 plus banks operating within the EU; the regulation component of CRD IV will not require any implementing legislation by the various EU Member States.

CRD IV -- or at least those parts of it dealing with capital requirements -- reflect a re-orientation of EU banking law. As a regulation, the reformed EU capital requirements will be uniform. This shift is described as the creating of a 'single rule book' throughout Europe -- eliminating the differences and gaps that plague the current Capital Requirements Directive. In an important deviation from uniformity, the CRD IV permits Member States (such as the United Kingdom and Sweden) to impose optional additional capital requirements (known as 'systemic risk buffers') beyond the levels set by the 'single rule book'. Other provisions of CRD IV, such as the controversial new limits on bankers compensation, are contained in the directive component; these will be implemented by Member State rule-making.

The application of the CRD IV 'single rule-book' is broad: it includes those Member States that have not adopted the Euro and is applied to all EU banks (not only large internationally active banks) and to securities firms as well. This extended coverage has in turn introduced some inconsistencies between CRD IV and the Basel III rules.

CRD IV also reflects the influence of the European Parliament. For example, CRD IV's capital adequacy rules include a reduction in the risk weights of loans of small and medium size enterprises (SMEs). The SMEs possess a mystique in European political culture not unlike that exercised by the 'family farm' in the United States. Loans to SMEs are discounted by a factor (0.7619 to be precise) for purposes of setting the CRD IV minimum capital. Effectively, a bank may hold a greater quantity of qualified SME loans given a particular quantity of capital. This should have the effect of encouraging lending to SMEs -- both in terms of total funds advanced and in lowering the interest rate charged. This rather transparent instance of credit allocation reflects on-going political concerns about the health of the European economy. Left unstated, however, is the implicit greater toleration for bank failure -- which is how the Europeans got into the current Eurozone mess in the first place.