European Politics and the Regulation of Bank/Insurance Firms

On prior occasions, European implementation of the Basel bank regulatory system had proceeded rather mechanically. The Europeans actively participated in the Basel II process, reached agreement with the world's other major banking powers, and then faithfully enacted Basel norms into EU law. This has not been the case with the latest product of Basel: Basel III. While Europe once again exerted its influence during the negotiation, it has been decidedly less determined to give full effect to its Basel III undertakings in EU legislation. And the reason -- it should be no surprise -- is politics.

The linkage between Basel III and the European implementation (known as CRD IV) involves three levels of politics: global, European and national. The uncharacteristic European reluctance to carry out the Basel III mandates to the letter results from the varying distributions of influence at each level of the lawmaking game. A case in point: so-called 'bancassurance' -- financial conglomerates that are part bank, part insurance company. France's Societe Generale and Credit Agricole are two large examples of 'bancassurance'.

The treatment of bancassurance was a sticking point in the Basel III negotiations. The United States and others (including the United Kingdom, an EU member state) identified the problem of 'double counting' equity capital in bancassurance. Basel III requires banks to maintain adequate amounts of high-quality (Tier 1) equity capital. This capital acts as a loss-absorbing buffer, protecting depositors and other bank creditors. In a similar spirit, insurance regulators demand that insurers maintain adequate equity to protect policyholders in the event insurers experience losses.

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.